[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2019 Edition]
[From the U.S. Government Publishing Office]
[[Page i]]
Title 26
Internal Revenue
________________________
Part 1 (Sec. Sec. 1.441 to 1.500)
Revised as of April 1, 2019
Containing a codification of documents of general
applicability and future effect
As of April 1, 2019
Published by the Office of the Federal Register
National Archives and Records Administration as a
Special Edition of the Federal Register
[[Page ii]]
U.S. GOVERNMENT OFFICIAL EDITION NOTICE
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[[Page iii]]
Table of Contents
Page
Explanation................................................. v
Title 26:
Chapter I--Internal Revenue Service, Department of
the Treasury (Continued) 3
Finding Aids:
Table of CFR Titles and Chapters........................ 829
Alphabetical List of Agencies Appearing in the CFR...... 849
Table of OMB Control Numbers............................ 859
List of CFR Sections Affected........................... 877
[[Page iv]]
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Cite this Code: CFR
To cite the regulations in
this volume use title,
part and section number.
Thus, 26 CFR 1.441-0
refers to title 26, part
1, section 441-0.
----------------------------
[[Page v]]
EXPLANATION
The Code of Federal Regulations is a codification of the general and
permanent rules published in the Federal Register by the Executive
departments and agencies of the Federal Government. The Code is divided
into 50 titles which represent broad areas subject to Federal
regulation. Each title is divided into chapters which usually bear the
name of the issuing agency. Each chapter is further subdivided into
parts covering specific regulatory areas.
Each volume of the Code is revised at least once each calendar year
and issued on a quarterly basis approximately as follows:
Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1
The appropriate revision date is printed on the cover of each
volume.
LEGAL STATUS
The contents of the Federal Register are required to be judicially
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie
evidence of the text of the original documents (44 U.S.C. 1510).
HOW TO USE THE CODE OF FEDERAL REGULATIONS
The Code of Federal Regulations is kept up to date by the individual
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together to determine the latest version of any given rule.
To determine whether a Code volume has been amended since its
revision date (in this case, April 1, 2019), consult the ``List of CFR
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative
List of Parts Affected,'' which appears in the Reader Aids section of
the daily Federal Register. These two lists will identify the Federal
Register page number of the latest amendment of any given rule.
EFFECTIVE AND EXPIRATION DATES
Each volume of the Code contains amendments published in the Federal
Register since the last revision of that volume of the Code. Source
citations for the regulations are referred to by volume number and page
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those instances where a regulation published in the Federal Register
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inserted following the text.
OMB CONTROL NUMBERS
The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires
Federal agencies to display an OMB control number with their information
collection request.
[[Page vi]]
Many agencies have begun publishing numerous OMB control numbers as
amendments to existing regulations in the CFR. These OMB numbers are
placed as close as possible to the applicable recordkeeping or reporting
requirements.
PAST PROVISIONS OF THE CODE
Provisions of the Code that are no longer in force and effect as of
the revision date stated on the cover of each volume are not carried.
Code users may find the text of provisions in effect on any given date
in the past by using the appropriate List of CFR Sections Affected
(LSA). For the convenience of the reader, a ``List of CFR Sections
Affected'' is published at the end of each CFR volume. For changes to
the Code prior to the LSA listings at the end of the volume, consult
previous annual editions of the LSA. For changes to the Code prior to
2001, consult the List of CFR Sections Affected compilations, published
for 1949-1963, 1964-1972, 1973-1985, and 1986-2000.
``[RESERVED]'' TERMINOLOGY
The term ``[Reserved]'' is used as a place holder within the Code of
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``[Reserved]'' location at any time. Occasionally ``[Reserved]'' is used
editorially to indicate that a portion of the CFR was left vacant and
not accidentally dropped due to a printing or computer error.
INCORPORATION BY REFERENCE
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This material, like any other properly issued regulation, has the force
of law.
What is a proper incorporation by reference? The Director of the
Federal Register will approve an incorporation by reference only when
the requirements of 1 CFR part 51 are met. Some of the elements on which
approval is based are:
(a) The incorporation will substantially reduce the volume of
material published in the Federal Register.
(b) The matter incorporated is in fact available to the extent
necessary to afford fairness and uniformity in the administrative
process.
(c) The incorporating document is drafted and submitted for
publication in accordance with 1 CFR part 51.
What if the material incorporated by reference cannot be found? If
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CFR INDEXES AND TABULAR GUIDES
A subject index to the Code of Federal Regulations is contained in a
separate volume, revised annually as of January 1, entitled CFR Index
and Finding Aids. This volume contains the Parallel Table of Authorities
and Rules. A list of CFR titles, chapters, subchapters, and parts and an
alphabetical list of agencies publishing in the CFR are also included in
this volume.
[[Page vii]]
An index to the text of ``Title 3--The President'' is carried within
that volume.
The Federal Register Index is issued monthly in cumulative form.
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the revision dates of the 50 CFR titles.
REPUBLICATION OF MATERIAL
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INQUIRIES
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The e-CFR is a regularly updated, unofficial editorial compilation
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of the Federal Register and the Government Publishing Office. It is
available at www.ecfr.gov.
Oliver A. Potts,
Director,
Office of the Federal Register
April 1, 2019.
[[Page ix]]
THIS TITLE
Title 26--Internal Revenue is composed of twenty-two volumes. The
contents of these volumes represent all current regulations issued by
the Internal Revenue Service, Department of the Treasury, as of April 1,
2019. The first fifteen volumes comprise part 1 (Subchapter A--Income
Tax) and are arranged by sections as follows: Sec. Sec. 1.0-1.60;
Sec. Sec. 1.61-1.139; Sec. Sec. 1.140-1.169; Sec. Sec. 1.170-1.300;
Sec. Sec. 1.301-1.400; Sec. Sec. 1.401-1.409; Sec. Sec. 1.410-1.440;
Sec. Sec. 1.441-1.500; Sec. Sec. 1.501-1.640; Sec. Sec. 1.641-1.850;
Sec. Sec. 1.851-1.907; Sec. Sec. 1.908-1.1000; Sec. Sec. 1.1001-
1.1400; Sec. Sec. 1.1401-1.1550; and Sec. 1.1551 to end of part 1. The
sixteenth volume containing parts 2-29, includes the remainder of
subchapter A and all of Subchapter B--Estate and Gift Taxes. The last
six volumes contain parts 30-39 (Subchapter C--Employment Taxes and
Collection of Income Tax at Source); parts 40-49; parts 50-299
(Subchapter D--Miscellaneous Excise Taxes); parts 300-499 (Subchapter
F--Procedure and Administration); parts 500-599 (Subchapter G--
Regulations under Tax Conventions); and part 600 to end (Subchapter H--
Internal Revenue Practice).
The OMB control numbers for title 26 appear in Sec. 602.101 of this
chapter. For the convenience of the user, Sec. 602.101 appears in the
Finding Aids section of the volumes containing parts 1 to 599.
For this volume, Michele Bugenhagen was Chief Editor. The Code of
Federal Regulations publication program is under the direction of John
Hyrum Martinez, assisted by Stephen J. Frattini.
[[Page 1]]
TITLE 26--INTERNAL REVENUE
(This book contains part 1, Sec. Sec. 1.441 to 1.500)
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Part
chapter i--Internal Revenue Service, Department of the
Treasury (Continued)...................................... 1
[[Page 3]]
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY
(CONTINUED)
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SUBCHAPTER A--INCOME TAX (CONTINUED)
Part Page
1 Income taxes (Continued).................... 5
Supplementary Publications: Internal Revenue Service Looseleaf
Regulations System.
Additional supplementary publications are issued covering Alcohol and
Tobacco Tax Regulations, and Regulations Under Tax Conventions.
[[Page 5]]
SUBCHAPTER A_INCOME TAX (CONTINUED)
PART 1_INCOME TAXES (CONTINUED)--Table of Contents
Normal Taxes and Surtaxes (Continued)
DEFERRED COMPENSATION, ETC. (CONTINUED)
ACCOUNTING PERIODS AND METHODS OF ACCOUNTING
Accounting Periods
Sec.
1.441-0 Table of contents.
1.441-1 Period for computation of taxable income.
1.441-2 Election of taxable year consisting of 52-53 weeks.
1.441-3 Taxable year of a personal service corporation.
1.441-4 Effective date.
1.442-1 Change of annual accounting period.
1.443-1 Returns for periods of less than 12 months.
1.444-0T Table of contents (temporary).
1.444-1T Election to use a taxable year other than the required taxable
year (temporary).
1.444-2T Tiered structure (temporary).
1.444-3T Manner and time of making section 444 election (temporary).
1.444-4 Tiered structure.
Methods of Accounting
Methods of Accounting in General
1.446-1 General rule for methods of accounting.
1.446-2 Method of accounting for interest.
1.446-3 Notional principal contracts.
1.446-3T Notional principal contracts (temporary).
1.446-4 Hedging transactions.
1.446-5 Debt issuance costs.
1.446-6 REMIC inducement fees.
1.446-7 Net asset value method for certain money market fund shares.
1.448-1 Limitation on the use of the cash receipts and disbursements
method of accounting.
1.448-1T Limitation on the use of the cash receipts and disbursements
method of accounting (temporary).
1.448-2 Nonaccrual of certain amounts by service providers.
Taxable Year for Which Items of Gross Income Included
1.451-1 General rule for taxable year of inclusion.
1.451-2 Constructive receipt of income.
1.451-4 Accounting for redemption of trading stamps and coupons.
1.451-5 Advance payments for goods and long-term contracts.
1.451-6 Election to include crop insurance proceeds in gross income in
the taxable year following the taxable year of destruction or
damage.
1.451-7 Election relating to livestock sold on account of drought.
1.453-1--1.453-2 [Reserved]
1.453-3 Purchaser evidences of indebtedness payable on demand or readily
tradable.
1.453-4-1.453.8 [Reserved]
1.453-9 Gain or loss on disposition of installment obligations.
1.453-10 [Reserved]
1.453-11 Installment obligations received from a liquidating
corporation.
1.453-12 Allocation of unrecaptured section 1250 gain reported on the
installment method.
1.453A-0 Table of contents.
1.453A-1 Installment method of reporting income by dealers on personal
property.
1.453A-2 [Reserved]
1.453A-3 Requirements for adoption of or change to installment method by
dealers in personal property.
1.454-1 Obligations issued at discount.
1.455-1 Treatment of prepaid subscription income.
1.455-2 Scope of election under section 455.
1.455-3 Method of allocation.
1.455-4 Cessation of taxpayer's liability.
1.455-5 Definitions and other rules.
1.455-6 Time and manner of making election.
1.456-1 Treatment of prepaid dues income.
1.456-2 Scope of election under section 456.
1.456-3 Method of allocation.
1.456-4 Cessation of liability or existence.
1.456-5 Definitions and other rules.
1.456-6 Time and manner of making election.
1.456-7 Transitional rule.
1.457-1 General overviews of section 457.
1.457-2 Definitions.
1.457-3 General introduction to eligible plans.
1.457-4 Annual deferrals, deferral limitations, and deferral agreements
under eligible plans.
1.457-5 Individual limitation for combined annual deferrals under
multiple eligible plans.
1.457-6 Timing of distributions under eligible plans.
1.457-7 Taxation of Distribution Under Eligible Plans.
1.457-8 Funding rules for eligible plans.
1.457-9 Effect on eligible plans when not administered in accordance
with eligibility requirements.
1.457-10 Miscellaneous provisions.
[[Page 6]]
1.457-11 Tax treatment of participants if plan is not an eligible plan.
1.457-12 Effective dates.
1.458-1 Exclusion for certain returned magazines, paperbacks, or
records.
1.458-2 Manner of and time for making election.
1.460-0 Outline of regulations under section 460.
1.460-1 Long-term contracts.
1.460-2 Long-term manufacturing contracts.
1.460-3 Long-term construction contracts.
1.460-4 Methods of accounting for long-term contracts.
1.460-5 Cost allocation rules.
1.460-6 Look-back method.
Taxable Year for Which Deductions Taken
1.461-0 Table of contents.
1.461-1 General rule for taxable year of deduction.
1.461-2 Contested liabilities.
1.461-3 Prepaid interest. [Reserved]
1.461-4 Economic performance.
1.461-5 Recurring item exception.
1.461-6 Economic performance when certain liabilities are assigned or
are extinguished by the establishment of a fund.
1.465-1T Aggregation of certain activities (temporary).
1.465-8 General rules; interest other than that of a creditor.
1.465-20 Treatment of amounts borrowed from certain persons and amounts
protected against loss.
1.465-27 Qualified nonrecourse financing.
1.466-1 Method of accounting for the redemption cost of qualified
discount coupons.
1.466-2 Special protective election for certain taxpayers.
1.466-3 Manner of and time for making election under section 466.
1.466-4 Manner of and time for making election under section 373(c) of
the Revenue Act of 1978.
1.467-0 Table of contents.
1.467-1 Treatment of lessors and lessees generally.
1.467-2 Rent accrual for section 467 rental agreements without adequate
interest.
1.467-3 Disqualified leasebacks and long-term agreements.
1.467-4 Section 467 loan.
1.467-5 Section 467 rental agreements with variable interest.
1.467-6 Section 467 rental agreements with contingent payments.
[Reserved]
1.467-7 Section 467 recapture and other rules relating to dispositions
and modifications.
1.467-8 Automatic consent to change to constant rental accrual for
certain rental agreements.
1.467-9 Effective/applicability dates and automatic method changes for
certain agreements.
1.468A-0 Nuclear decommissioning costs; table of contents.
1.468A-1 Nuclear decommissioning costs; general rules.
1.468A-2 Treatment of electing taxpayer.
1.468A-3 Ruling amount.
1.468A-4 Treatment of nuclear decommissioning fund.
1.468A-5 Nuclear decommissioning fund qualification requirements;
prohibitions against self-dealing; disqualification of nuclear
decommissioning fund; termination of fund upon substantial
completion of decommissioning.
1.468A-6 Disposition of an interest in a nuclear power plant.
1.468A-7 Manner of and time for making election.
1.468A-8 Special transfers to qualified funds pursuant to section
468A(f).
1.468A-9 Effective/applicability date.
1.468B Designated settlement funds.
1.468B-0 Table of contents.
1.468B-1 Qualified settlement funds.
1.468B-2 Taxation of qualified settlement funds and related
administrative requirements.
1.468B-3 Rules applicable to the transferor.
1.468B-4 Taxability of distributions to claimants.
1.468B-5 Effective dates and transition rules applicable to qualified
settlement funds.
1.468B-6 Escrow accounts, trusts, and other funds used during deferred
exchanges of like-kind property under section 1031(a)(3).
1.468B-7 Pre-closing escrows.
1.468B-8 Contingent-at-closing escrows. [Reserved]
1.468B-9 Disputed ownership funds.
1.469-0 Table of contents.
1.469-1 General rules.
1.469-1T General rules (temporary).
1.469-2 Passive activity loss.
1.469-2T Passive activity loss (temporary).
1.469-3 Passive activity credit.
1.469-3T Passive activity credit (temporary).
1.469-4 Definition of activity.
1.469-4T Definition of activity (temporary).
1.469-5 Material participation.
1.469-5T Material participation (temporary).
1.469-6 Treatment of losses upon certain dispositions. [Reserved]
1.469-7 Treatment of self-charged items of interest income and
deduction.
1.469-8 Application of section 469 to trust, estates, and their
beneficiaries. [Reserved]
1.469-9 Rules for certain rental real estate activities.
1.469-10 Application of section 469 to publicly traded partnerships.
1.469-11 Effective date and transition rules.
[[Page 7]]
Inventories
1.471-1 Need for inventories.
1.471-2 Valuation of inventories.
1.471-3 Inventories at cost.
1.471-4 Inventories at cost or market, whichever is lower.
1.471-5 Inventories by dealers in securities.
1.471-6 Inventories of livestock raisers and other farmers.
1.471-7 Inventories of miners and manufacturers.
1.471-8 Inventories of retail merchants.
1.471-9 Inventories of acquiring corporations.
1.471-10 Applicability of long-term contract methods.
1.471-11 Inventories of manufacturers.
1.472-1 Last-in, first-out inventories.
1.472-2 Requirements incident to adoption and use of LIFO inventory
method.
1.472-3 Time and manner of making election.
1.472-4 Adjustments to be made by taxpayer.
1.472-5 Revocation of election.
1.472-6 Change from LIFO inventory method.
1.472-7 Inventories of acquiring corporations.
1.472-8 Dollar-value method of pricing LIFO inventories.
1.475-0 Table of contents.
1.475(a)-1--1.475(a)-2 [Reserved]
1.475(a)-3 Acquisition by a dealer of a security with a substituted
basis.
1.475(a)-4 Valuation safe harbor.
1.475(b)-1 Scope of exemptions from mark-to-market requirement.
1.475(b)-2 Exemptions--identification requirements.
1.475(b)-3 [Reserved]
1.475(c)-1 Definitions--dealer in securities.
1.475(c)-2 Definitions--security.
1.475(d)-1 Character of gain or loss.
1.475(g)-1 Effective dates.
Adjustments
1.481-1 Adjustments in general.
1.481-2 Limitation on tax.
1.481-3 Adjustments attributable to pre-1954 years where change was not
initiated by taxpayer.
1.481-4 Adjustments taken into account with consent.
1.481-5 Effective dates.
1.482-0 Outline of regulations under section 482.
1.482-1 Allocation of income and deductions among taxpayers.
1.482-1T Allocation of income and deductions among taxpayers
(temporary).
1.482-2 Determination of taxable income in specific situations.
1.482-3 Methods to determine taxable income in connection with a
transfer of tangible property.
1.482-4 Methods to determine taxable income in connection with a
transfer of intangible property.
1.482-5 Comparable profits method.
1.482-6 Profit split method.
1.482-7 Methods to determine taxable income in connection with a cost
sharing arrangement.
1.482-8 Examples of the best method rule.
1.482-9 Methods to determine taxable income in connection with a
controlled services transaction.
1.483-1 Interest on certain deferred payments.
1.483-2 Unstated interest.
1.483-3 Test rate of interest applicable to a contract.
1.483-4 Contingent payments.
Regulations Applicable for Taxable Years Beginning on or Before April
21, 1993
1.482-1A Allocation of income and deductions among taxpayers.
1.482-2A Determination of taxable income in specific situations.
1.482-7A Methods to determine taxable income in connection with a cost
sharing arrangement.
1.484-1.500 [Reserved]
Authority: 26 U.S.C. 7805.
Section 1.441-2T also issued under 26 U.S.C. 441(f).
Section 1.441-3T also issued under 26 U.S.C. 441.
Section 1.442-2T and 1.442-3T also issued under 26 U.S.C. 422, 706,
and 1378.
Section 1.444-0T through 1.444-3T and
Section 1.444-4 is also issued under 26 U.S.C. 444(g).
Section 1.446-1 also issued under 26 U.S.C. 446 and 461(h).
Section 1.446-4 also issued under 26 U.S.C. 1502.
Section 1.446-6 also issued under 26 U.S.C. 446 and 26 U.S.C. 860G.
Section 1.446-7 also issued under 26 U.S.C. 446.
Section 1.451-5 also issued under 96 Stat. 324, 493.
Section 1.453-11 also issued under 26 U.S.C. 453(j)(1) and (k).
Section 1.453A-3 also issued under 26 U.S.C. 453A.
Section 1.458-1 also issued under 26 U.S.C. 458.
Section 1.460-1 also issued under 26 U.S.C. 460(h).
Section 1.460-2 also issued under 26 U.S.C. 460(h).
Section 1.460-3 also issued under 26 U.S.C. 460(h).
Section 1.460-4 also issued under 26 U.S.C. 460(h) and 1502.
Section 1.460-5 also issued under 26 U.S.C. 460(h).
[[Page 8]]
Section 1.460-6 also issued under 26 U.S.C. 460(h).
Section 1.461-1 also issued under 26 U.S.C. 461(h).
Section 1.461-2 also issued under 26 U.S.C. 461(h).
Section 1.461-4 also issued under 26 U.S.C. 461(h).
Section 1.461-4(d) also issued under 26 U.S.C. 460 and 26 U.S.C.
461(h).
Section 1.461-5 also issued under 26 U.S.C. 461(h).
Section 1.461-6 also issued under 26 U.S.C. 461(h).
Section 1.465-8 also issued under 26 U.S.C. 465.
Section 1.465-20 also issued under 26 U.S.C. 465.
Section 1.465-27 also issued under 26 U.S.C. 465(b)(6)(B)(iii).
Section 1.466-1 through 1.466-4 also issued under 26 U.S.C. 466.
Section 1.467-1 is also issued under 26 U.S.C. 467.
Section 1.467-2 is also issued under 26 U.S.C. 467.
Section 1.467-3 is also issued under 26 U.S.C. 467.
Section 1.467-4 is also issued under 26 U.S.C. 467.
Section 1.467-5 is also issued under 26 U.S.C. 467.
Section 1.467-6 is also issued under 26 U.S.C. 467.
Section 1.467-7 is also issued under 26 U.S.C. 467.
Section 1.467-8 is also issued under 26 U.S.C. 467.
Section 1.467-9 is also issued under 26 U.S.C. 467.
Section 1.468A-5 also issued under 26 U.S.C. 468A(e)(5).
Section 1.468A-5T also issued under 26 U.S.C. 468A(e)(5).
Section 1.468B-1 also issued under 26 U.S.C. 461(h) and 468B(g).
Section 1.468B-2 also issued under 26 U.S.C. 461(h) and 468B(g).
Section 1.468B-3 also issued under 26 U.S.C. 461(h) and 468B(g).
Section 1.468B-4 also issued under 26 U.S.C. 461(h) and 468B(g).
Section 1.468B-5 also issued under 26 U.S.C. 461(h) and 468B(g).
Section 1.468B-7 also issued under 26 U.S.C. 461(h) and 468B(g).
Section 1.468B-9 also issued under 26 U.S.C. 461(h) and 468B(g).
Section 1.469-1 also issued under 26 U.S.C. 469.
Section 1.469-1T also issued under 26 U.S.C. 469.
Section 1.469-2 also issued under 26 U.S.C. 469(l).
Section 1.469-2T also issued under 26 U.S.C. 469(l).
Section 1.469-3 also issued under 26 U.S.C. 469(l).
Section 1.469-3T also issued under 26 U.S.C. 469(l).
Section 1.469-4 also issued under 26 U.S.C. 469(l).
Section 1.469-5 also issued under 26 U.S.C. 469(l).
Section 1.469-5T also issued under 26 U.S.C. 469(l).
Section 1.469-7 also issued under 26 U.S.C. 469(l).
Section 1.469-9 also issued under 26 U.S.C. 469(c)(6), (h)(2), and
(l)(1).
Section 1.469-11 also issued under 26 U.S.C. 469(l).
Section 1.471 also issued under 26 U.S.C. 471.
Section 1.471-3 also issued under 26 U.S.C. 471(a).
Section 1.471-4 also issued under 26 U.S.C. 263A.
Section 1.471-5 also issued under 26 U.S.C. 263A.
Section 1.471-6 also issued under 26 U.S.C. 471.
Section 1.472-8 also issued under 26 U.S.C. 472.
Section 1.475(a)-3 also issued under 26 U.S.C. 475(e).
Section 1.475(a)-4 also issued under 26 U.S.C. 475(g).
Section 1.475(b)-1 also issued under 26 U.S.C. 475(b)(4) and 26
U.S.C. 475(e).
Section 1.475(b)-2 also issued under 26 U.S.C. 475(b)(2) and 26
U.S.C. 475(e).
Section 1.475(b)-4 also issued under 26 U.S.C. 475(b)(2), 26 U.S.C.
475(e), and 26 U.S.C. 6001.
Section 1.475(c)-1 also issued under 26 U.S.C. 475(e).
Section 1.475(c)-2 also issued under 26 U.S.C. 475(e) and 26 U.S.C.
860G(e).
Section 1.475(d)-1 also issued under 26 U.S.C. 475(e).
Section 1.475(e)-1 also issued under 26 U.S.C. 475(e).
Section 1.481-1 also issued under 26 U.S.C. 481.
Section 1.481-2 also issued under 26 U.S.C. 481.
Section 1.481-3 also issued under 26 U.S.C. 481.
Section 1.481-4 also issued under 26 U.S.C. 481.
Section 1.481-5 also issued under 26 U.S.C. 481.
Section 1.482-1 also issued under 26 U.S.C. 482 and 936.
Sections 1.482-1 and 1.482-1T also issued under 26 U.S.C. 482.
Section 1.482-2 also issued under 26 U.S.C. 482.
Section 1.482-3 also issued under 26 U.S.C. 482.
Section 1.482-4 also issued under 26 U.S.C. 482.
[[Page 9]]
Section 1.482-5 also issued under 26 U.S.C. 482.
Section 1.482-7 is also issued under 26 U.S.C. 482.
Section 1.482-7T also issued under 26 U.S.C. 482.
Section 1.482-9 also issued under 26 U.S.C. 482.
Section 1.482-2A also issued under 26 U.S.C. 482.
Section 1.482-7A also issued under 26 U.S.C. 482.
Section 1.482-9 also issued under 26 U.S.C. 482.
Section 1.483-1 through 1.483-3 also issued under 26 U.S.C. 483(f).
Section 1.483-4 also issued under 26 U.S.C. 483(f).
DEFERRED COMPENSATION, ETC. (CONTINUED)
ACCOUNTING PERIODS AND METHODS OF ACCOUNTING
Accounting Periods
Sec. 1.441-0 Table of contents.
This section lists the captions contained in Sec. Sec. 1.441-1
through 1.441-4 as follows:
Sec. 1.441-1 Period for computation of taxable income.
(a) Computation of taxable income.
(1) In general.
(2) Length of taxable year.
(b) General rules and definitions.
(1) Taxable year.
(1) Required taxable year.
(i) In general.
(ii) Exceptions.
(A) 52-53-week taxable years.
(B) Partnerships, S corporations, and PSCs.
(C) Specified foreign corporations.
(3) Annual accounting period.
(4) Calendar year.
(5) Fiscal year.
(i) Definition.
(ii) Recognition.
(6) Grandfathered fiscal year.
(7) Books.
(8) Taxpayer.
(c) Adoption of taxable year.
(1) In general.
(2) Approval required.
(i) Taxpayers with required taxable years.
(ii) Taxpayers without books.
(d) Retention of taxable year.
(e) Change of taxable year.
(f) Obtaining approval of the Commissioner or making a section 444
election.
Sec. 1.441-2 Election of taxable year consisting of 52-53 weeks
(a) In general.
(1) Election.
(2) Effect.
(3) Eligible taxpayer.
(4) Example.
(b) Procedures to elect a 52-53-week taxable year.
(1) Adoption of a 52-53-week taxable year.
(i) In general.
(ii) Filing requirement.
(2) Change to (or from) a 52-53-week taxable year.
(i) In general.
(ii) Special rules for short period required to effect the change.
(3) Examples.
(c) Application of effective dates.
(1) In general.
(2) Examples.
(3) Changes in tax rates.
(4) Examples.
(d) Computation of taxable income.
(e) Treatment of taxable years ending with reference to the same
calendar month.
(1) Pass-through entities.
(2) Personal service corporations and employee-owners.
(3) Definitions.
(i) Pass-through entity.
(ii) Owner of a pass-through entity.
(4) Examples.
(5) Transition rule.
Sec. 1.441-3 Taxable year of a personal service corporation
(a) Taxable year.
(1) Required taxable year.
(2) Exceptions.
(b) Adoption, change, or retention of taxable year.
(1) Adoption of taxable year.
(2) Change in taxable year.
(3) Retention of taxable year.
(4) Procedures for obtaining approval or making a section 444 election.
(5) Examples.
(c) Personal service corporation defined.
(1) In general.
(2) Testing period.
(i) In general.
(ii) New corporations.
(3) Examples.
(d) Performance of personal services.
(1) Activities described in section 448(d)(2)(A).
(2) Activities not described in section 448(d)(2)(A).
(e) Principal activity.
(1) General rule.
(2) Compensation cost.
(i) Amounts included.
(ii) Amounts excluded.
(3) Attribution of compensation cost to personal service activity.
(i) Employees involved only in the performance of personal services.
[[Page 10]]
(ii) Employees involved only in activities that are not treated as the
performance of personal services.
(iii) Other employees.
(A) Compensation cost attributable to personal service activity.
(B) Compensation cost not attributable to personal service activity.
(f) Services substantially performed by employee-owners.
(1) General rule.
(2) Compensation cost attributable to personal services.
(3) Examples.
(g) Employee-owner defined.
(1) General rule.
(2) Special rule for independent contractors who are owners.
(h) Special rules for affiliated groups filing consolidated returns.
(1) In general.
(2) Examples.
Sec. 1.441-4 Effective date
[T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.441-1 Period for computation of taxable income.
(a) Computation of taxable income--(1) In general. Taxable income
must be computed and a return must be made for a period known as the
taxable year. For rules relating to methods of accounting, the taxable
year for which items of gross income are included and deductions are
taken, inventories, and adjustments, see parts II and III (section 446
and following), subchapter E, chapter 1 of the Internal Revenue Code,
and the regulations thereunder.
(2) Length of taxable year. Except as otherwise provided in the
Internal Revenue Code and the regulations thereunder (e.g., Sec. 1.441-
2 regarding 52-53-week taxable years), a taxable year may not cover a
period of more than 12 calendar months.
(b) General rules and definitions. The general rules and definitions
in this paragraph (b) apply for purposes of sections 441 and 442 and the
regulations thereunder.
(1) Taxable year. Taxable year means--
(i) The period for which a return is made, if a return is made for a
period of less than 12 months (short period). See section 443 and the
regulations thereunder;
(ii) Except as provided in paragraph (b)(1)(i) of this section, the
taxpayer's required taxable year (as defined in paragraph (b)(2) of this
section), if applicable;
(iii) Except as provided in paragraphs (b)(1)(i) and (ii) of this
section, the taxpayer's annual accounting period (as defined in
paragraph (b)(3) of this section), if it is a calendar year or a fiscal
year; or
(iv) Except as provided in paragraphs (b)(1)(i) and (ii) of this
section, the calendar year, if the taxpayer keeps no books, does not
have an annual accounting period, or has an annual accounting period
that does not qualify as a fiscal year.
(2) Required taxable year--(i) In general. Certain taxpayers must
use the particular taxable year that is required under the Internal
Revenue Code and the regulations thereunder (the required taxable year).
For example, the required taxable year is--
(A) [Reserved]
(B) In the case of a personal service corporation (PSC), the taxable
year determined under section 441(i) and Sec. 1.441-3;
(C) In the case of a nuclear decommissioning fund, the taxable year
determined under Sec. 1.468A-4(c)(1);
(D) In the case of a designated settlement fund or a qualified
settlement fund, the taxable year determined under Sec. 1.468B-2(j);
(E) In the case of a common trust fund, the taxable year determined
under section 584(i);
(F) In the case of certain trusts, the taxable year determined under
section 644;
(G) In the case of a partnership, the taxable year determined under
section 706 and Sec. 1.706-1;
(H) In the case of an insurance company, the taxable year determined
under section 843 and Sec. 1.1502-76(a)(2);
(I) In the case of a real estate investment trust, the taxable year
determined under section 859;
(J) In the case of a real estate mortgage investment conduit, the
taxable year determined under section 860D(a)(5) and Sec. 1.860D-
1(b)(6);
(K) In the case of a specified foreign corporation, the taxable year
determined under section 898(c)(1)(A);
(L) In the case of an S corporation, the taxable year determined
under section 1378 and Sec. 1.1378-1; or
[[Page 11]]
(M) In the case of a member of an affiliated group that makes a
consolidated return, the taxable year determined under Sec. 1.1502-76.
(ii) Exceptions. Notwithstanding paragraph (b)(2)(i) of this
section, the following taxpayers may have a taxable year other than
their required taxable year:
(A) 52-53-week taxable years. Certain taxpayers may elect to use a
52-53-week taxable year that ends with reference to their required
taxable year. See, for example, Sec. Sec. 1.441-3 (PSCs), 1.706-1
(partnerships), 1.1378-1 (S corporations), and 1.1502-76(a)(1) (members
of a consolidated group).
(B) Partnerships, S corporations, and PSCs. A partnership, S
corporation, or PSC may use a taxable year other than its required
taxable year if the taxpayer elects to use a taxable year other than its
required taxable year under section 444, elects a 52-53-week taxable
year that ends with reference to its required taxable year as provided
in paragraph (b)(2)(ii)(A) of this section or to a taxable year elected
under section 444, or establishes a business purpose to the satisfaction
of the Commissioner under section 442 (such as a grandfathered fiscal
year).
(C) Specified foreign corporations. A specified foreign corporation
(as defined in section 898(b)) may use a taxable year other than its
required taxable year if it elects a 52-53-week taxable year that ends
with reference to its required taxable year as provided in paragraph
(b)(2)(ii)(A) of this section or makes a one-month deferral election
under section 898(c)(1)(B).
(3) Annual accounting period. Annual accounting period means the
annual period (calendar year or fiscal year) on the basis of which the
taxpayer regularly computes its income in keeping its books.
(4) Calendar year. Calendar year means a period of 12 consecutive
months ending on December 31. A taxpayer who has not established a
fiscal year must make its return on the basis of a calendar year.
(5) Fiscal year--(i) Definition. Fiscal year means--
(A) A period of 12 consecutive months ending on the last day of any
month other than December; or
(B) A 52-53-week taxable year, if such period has been elected by
the taxpayer. See Sec. 1.441-2.
(ii) Recognition. A fiscal year will be recognized only if the books
of the taxpayer are kept in accordance with such fiscal year.
(6) Grandfathered fiscal year. Grandfathered fiscal year means a
fiscal year (other than a year that resulted in a three month or less
deferral of income) that a partnership or an S corporation received
permission to use on or after July 1, 1974, by a letter ruling (i.e.,
not by automatic approval).
(7) Books. Books include the taxpayer's regular books of account and
such other records and data as may be necessary to support the entries
on the taxpayer's books and on the taxpayer's return, as for example, a
reconciliation of any difference between such books and the taxpayer's
return. Records that are sufficient to reflect income adequately and
clearly on the basis of an annual accounting period will be regarded as
the keeping of books. See section 6001 and the regulations thereunder
for rules relating to the keeping of books and records.
(8) Taxpayer. Taxpayer has the same meaning as the term person as
defined in section 7701(a)(1) (e.g., an individual, trust, estate,
partnership, association, or corporation) rather than the meaning of the
term taxpayer as defined in section 7701(a)(14) (any person subject to
tax).
(c) Adoption of taxable year--(1) In general. Except as provided in
paragraph (c)(2) of this section, a new taxpayer may adopt any taxable
year that satisfies the requirements of section 441 and the regulations
thereunder without the approval of the Commissioner. A taxable year of a
new taxpayer is adopted by filing its first Federal income tax return
using that taxable year. The filing of an application for automatic
extension of time to file a Federal income tax return (e.g., Form 7004,
``Application for Automatic Extension of Time to File Corporation Income
Tax Return''), the filing of an application for an employer
identification number (i.e., Form SS-4, ``Application for Employer
Identification Number''), or the payment of estimated taxes, for a
particular taxable year do
[[Page 12]]
not constitute an adoption of that taxable year.
(2) Approval required--(i) Taxpayers with required taxable years. A
newly-formed partnership, S corporation, or PSC that wants to adopt a
taxable year other than its required taxable year, a taxable year
elected under section 444, or a 52-53-week taxable year that ends with
reference to its required taxable year or a taxable year elected under
section 444 must establish a business purpose and obtain the approval of
the Commissioner under section 442.
(ii) Taxpayers without books. A taxpayer that must use a calendar
year under section 441(g) and paragraph (f) of this section may not
adopt a fiscal year without obtaining the approval of the Commissioner.
(d) Retention of taxable year. In certain cases, a partnership, S
corporation, electing S corporation, or PSC will be required to change
its taxable year unless it obtains the approval of the Commissioner
under section 442, or makes an election under section 444, to retain its
current taxable year. For example, a corporation using a June 30 fiscal
year that either becomes a PSC or elects to be an S corporation and, as
a result, is required to use the calendar year under section 441(i) or
1378, respectively, must obtain the approval of the Commissioner to
retain its current fiscal year. Similarly, a partnership using a taxable
year that corresponds to its required taxable year must obtain the
approval of the Commissioner to retain such taxable year if its required
taxable year changes as a result of a change in ownership. However, a
partnership that previously established a business purpose to the
satisfaction of the Commissioner to use a taxable year is not required
to obtain the approval of the Commissioner if its required taxable year
changes as a result of a change in ownership.
(e) Change of taxable year. Once a taxpayer has adopted a taxable
year, such taxable year must be used in computing taxable income and
making returns for all subsequent years unless the taxpayer obtains
approval from the Commissioner to make a change or the taxpayer is
otherwise authorized to change without the approval of the Commissioner
under the Internal Revenue Code (e.g., section 444 or 859) or the
regulations thereunder.
(f) Obtaining approval of the Commissioner or making a section 444
election. See Sec. 1.442-1(b) for procedures for obtaining approval of
the Commissioner (automatically or otherwise) to adopt, change, or
retain an annual accounting period. See Sec. Sec. 1.444-1T and 1.444-2T
for qualifications, and 1.444-3T for procedures, for making an election
under section 444.
[T.D. 8996, 67 FR 35012, May 17, 2002, as amended at by T.D. 9849, 84 FR
9234, Mar. 14, 2019]
Sec. 1.441-2 Election of taxable year consisting of 52-53 weeks.
(a) In general--(1) Election. An eligible taxpayer may elect to
compute its taxable income on the basis of a fiscal year that--
(i) Varies from 52 to 53 weeks;
(ii) Ends always on the same day of the week; and
(iii) Ends always on--
(A) Whatever date this same day of the week last occurs in a
calendar month; or
(B) Whatever date this same day of the week falls that is the
nearest to the last day of the calendar month.
(2) Effect. In the case of a taxable year described in paragraph
(a)(1)(iii)(A) of this section, the year will always end within the
month and may end on the last day of the month, or as many as six days
before the end of the month. In the case of a taxable year described in
paragraph (a)(1)(iii)(B) of this section, the year may end on the last
day of the month, or as many as three days before or three days after
the last day of the month.
(3) Eligible taxpayer. A taxpayer is eligible to elect a 52-53-week
taxable year if such fiscal year would otherwise satisfy the
requirements of section 441 and the regulations thereunder. For example,
a taxpayer that is required to use a calendar year under Sec. 1.441-
1(b)(2)(i)(D) is not an eligible taxpayer.
(4) Example. The provisions of this paragraph (a) are illustrated by
the following example:
Example. If the taxpayer elects a taxable year ending always on the
last Saturday in November, then for the year 2001, the taxable
[[Page 13]]
year would end on November 24, 2001. On the other hand, if the taxpayer
had elected a taxable year ending always on the Saturday nearest to the
end of November, then for the year 2001, the taxable year would end on
December 1, 2001.
(b) Procedures to elect a 52-53-week taxable year--(1) Adoption of a
52-53-week taxable year--(i) In general. A new eligible taxpayer elects
a 52-53-week taxable year by adopting such year in accordance with Sec.
1.441-1(c). A newly-formed partnership, S corporation or personal
service corporation (PSC) may adopt a 52-53-week taxable year without
the approval of the Commissioner if such year ends with reference to
either the taxpayer's required taxable year (as defined in Sec. 1.441-
1(b)(2)) or the taxable year elected under section 444. See Sec. Sec.
1.441-3, 1.706-1, and 1.1378-1. Similarly, a newly-formed specified
foreign corporation (as defined in section 898(b)) may adopt a 52-53-
week taxable year if such year ends with reference to the taxpayer's
required taxable year, or, if the one-month deferral election under
section 898(c)(1)(B) is made, with reference to the month immediately
preceding the required taxable year. See Sec. 1.1502-76(a)(1) for
special rules regarding subsidiaries adopting 52-53-week taxable years.
(ii) Filing requirement. A taxpayer adopting a 52-53-week taxable
year must file with its Federal income tax return for its first taxable
year a statement containing the following information--
(A) The calendar month with reference to which the 52-53-week
taxable year ends;
(B) The day of the week on which the 52-53-week taxable year always
will end; and
(C) Whether the 52-53-week taxable year will always end on the date
on which that day of the week last occurs in the calendar month, or on
the date on which that day of the week falls that is nearest to the last
day of that calendar month.
(2) Change to (or from) a 52-53-week taxable year--(i) In general.
An election of a 52-53-week taxable year by an existing eligible
taxpayer with an established taxable year is treated as a change in
annual accounting period that requires the approval of the Commissioner
in accordance with Sec. 1.442-1. Thus, a taxpayer must obtain approval
to change from its current taxable year to a 52-53-week taxable year,
even if such 52-53-week taxable year ends with reference to the same
calendar month. Similarly, a taxpayer must obtain approval to change
from a 52-53-week taxable year, or to change from one 52-53-week taxable
year to another 52-53-week taxable year. However, a taxpayer may obtain
approval for 52-53-week taxable year changes automatically to the extent
provided in administrative procedures published by the Commissioner. See
Sec. 1.442-1(b) for procedures for obtaining such approval.
(ii) Special rules for the short period required to effect the
change. If a change to or from a 52-53-week taxable year results in a
short period (within the meaning of Sec. 1.443-1(a)) of 359 days or
more, or six days or less, the tax computation under Sec. 1.443-1(b)
does not apply. If the short period is 359 days or more, it is treated
as a full taxable year. If the short period is six days or less, such
short period is not a separate taxable year but instead is added to and
deemed a part of the following taxable year. (In the case of a change to
or from a 52-53-week taxable year not involving a change of the month
with reference to which the taxable year ends, the tax computation under
Sec. 1.443-1(b) does not apply because the short period will always be
359 days or more, or six days or less.) In the case of a short period
which is more than six days and less than 359 days, taxable income for
the short period is placed on an annual basis for purposes of Sec.
1.443-1(b) by multiplying such income by 365 and dividing the result by
the number of days in the short period. In such case, the tax for the
short period is the same part of the tax computed on such income placed
on an annual basis as the number of days in the short period is of 365
days (unless Sec. 1.443-1(b)(2), relating to the alternative tax
computation, applies). For an adjustment in deduction for personal
exemption, see Sec. 1.443-1(b)(1)(v).
(3) Examples. The following examples illustrate paragraph (b)(2)(ii)
of this section:
[[Page 14]]
Example 1. A taxpayer having a fiscal year ending April 30, obtains
approval to change to a 52-53-week taxable year ending the last Saturday
in April for taxable years beginning after April 30, 2001. This change
involves a short period of 362 days, from May 1, 2001, to April 27,
2002, inclusive. Because the change results in a short period of 359
days or more, it is not placed on an annual basis and is treated as a
full taxable year.
Example 2. Assume the same conditions as Example 1, except that the
taxpayer changes for taxable years beginning after April 30, 2002, to a
taxable year ending on the Thursday nearest to April 30. This change
results in a short period of two days, May 1 to May 2, 2002. Because the
short period is less than seven days, tax is not separately computed.
This short period is added to and deemed part of the following 52-53-
week taxable year, which would otherwise begin on May 3, 2002, and end
on May 1, 2003.
(c) Application of effective dates--(1) In general. Except as
provided in paragraph (c)(3) of this section, for purposes of
determining the effective date (e.g., of legislative, regulatory, or
administrative changes) or the applicability of any provision of the
internal revenue laws that is expressed in terms of taxable years
beginning, including, or ending with reference to the first or last day
of a specified calendar month, a 52-53-week taxable year is deemed to
begin on the first day of the calendar month nearest to the first day of
the 52-53-week taxable year, and is deemed to end or close on the last
day of the calendar month nearest to the last day of the 52-53-week
taxable year, as the case may be. Examples of provisions of this title,
the applicability of which is expressed in terms referred to in the
preceding sentence, include the provisions relating to the time for
filing returns and other documents, paying tax, or performing other
acts, and the provisions of part II, subchapter B, chapter 6 (section
1561 and following) relating to surtax exemptions of certain controlled
corporations.
(2) Examples. The provisions of paragraph (c)(1) of this section may
be illustrated by the following examples:
Example 1. Assume that an income tax provision is applicable to
taxable years beginning on or after January 1, 2001. For that purpose, a
52-53-week taxable year beginning on any day within the period December
26, 2000, to January 4, 2001, inclusive, is treated as beginning on
January 1, 2001.
Example 2. Assume that an income tax provision requires that a
return must be filed on or before the 15th day of the third month
following the close of the taxable year. For that purpose, a 52-53-week
taxable year ending on any day during the period May 25 to June 3,
inclusive, is treated as ending on May 31, the last day of the month
ending nearest to the last day of the taxable year, and the return,
therefore, must be made on or before August 15.
Example 3. Assume that a revenue procedure requires the performance
of an act by the taxpayer within ``the first 90 days of the taxable
year,'' by ``the 75th day of the taxable year,'' or, alternately, by
``the last day of the taxable year.'' The taxpayer employs a 52-53-week
taxable year that ends always on the Saturday closest to the last day of
December. These requirements are not expressed in terms of taxable years
beginning, including, or ending with reference to the first or last day
of a specified calendar month, and are accordingly outside the scope of
the rule stated in Sec. 1.441-2(c)(1). Accordingly, the taxpayer must
perform the required act by the 90th, 75th, or last day, respectively,
of its taxable year.
Example 4. X, a corporation created on January 1, 2001, elects a 52-
53-week taxable year ending on the Friday nearest the end of December.
Thus, X's first taxable year begins on Monday, January 1, 2001, and ends
on Friday, December 28, 2001; its next taxable year begins on Saturday,
December 29, 2001, and ends on Friday, January 3, 2003; and its next
taxable year begins on Saturday, January 4, 2003, and ends on Friday,
January 2, 2004. For purposes of applying the provisions of part II,
subchapter B, chapter 6 of the Internal Revenue Code, X's first taxable
year is deemed to end on December 31, 2001; its next taxable year is
deemed to begin on January 1, 2002, and end on December 31, 2002, and
its next taxable year is deemed to begin on January 1, 2003, and end on
December 31, 2003. Accordingly, each such taxable year is treated as
including one and only one December 31st.
(3) Changes in tax rates. If a change in the rate of tax is
effective during a 52-53-week taxable year (other than on the first day
of such year as determined under paragraph (c)(1) of this section), the
tax for the 52-53-week taxable year must be computed in accordance with
section 15, relating to effect of changes, and the regulations
thereunder. For the purpose of the computation under section 15, the
determination of the number of days in the period before the change, and
in the period on and after the change, is to be
[[Page 15]]
made without regard to the provisions of paragraph (b)(1) of this
paragraph.
(4) Examples. The provisions of paragraph (c)(3) of this section may
be illustrated by the following examples:
Example 1. Assume a change in the rate of tax is effective for
taxable years beginning after June 30, 2002. For a 52-53-week taxable
year beginning on Friday, November 2, 2001, the tax must be computed on
the basis of the old rates for the actual number of days from November
2, 2001, to June 30, 2002, inclusive, and on the basis of the new rates
for the actual number of days from July 1, 2002, to Thursday, October
31, 2002, inclusive.
Example 2. Assume a change in the rate of tax is effective for
taxable years beginning after June 30, 2001. For this purpose, a 52-53-
week taxable year beginning on any of the days from June 25 to July 4,
inclusive, is treated as beginning on July 1. Therefore, no computation
under section 15 will be required for such year because of the change in
rate.
(d) Computation of taxable income. The principles of section 451,
relating to the taxable year for inclusion of items of gross income, and
section 461, relating to the taxable year for taking deductions,
generally are applicable to 52-53-week taxable years. Thus, except as
otherwise provided, all items of income and deduction must be determined
on the basis of a 52-53-week taxable year. However, a taxpayer may
determine particular items as though the 52-53-week taxable year were a
taxable year consisting of 12 calendar months, provided that practice is
consistently followed by the taxpayer and clearly reflects income. For
example, an allowance for depreciation or amortization may be determined
on the basis of a 52-53-week taxable year, or as though the 52-53-week
taxable year is a taxable year consisting of 12 calendar months,
provided the taxpayer consistently follows that practice with respect to
all depreciable or amortizable items.
(e) Treatment of taxable years ending with reference to the same
calendar month--(1) Pass-through entities. If a pass-through entity (as
defined in paragraph (e)(3)(i) of this section) or an owner of a pass-
through entity (as defined in paragraph (e)(3)(ii) of this section), or
both, use a 52-53-week taxable year and the taxable year of the pass-
through entity and the owner end with reference to the same calendar
month, then, for purposes of determining the taxable year in which items
of income, gain, loss, deductions, or credits from the pass-through
entity are taken into account by the owner of the pass-through, the
owner's taxable year will be deemed to end on the last day of the pass-
through's taxable year. Thus, if the taxable year of a partnership and a
partner end with reference to the same calendar month, then for purposes
of determining the taxable year in which that partner takes into account
items described in section 702 and items that are deductible by the
partnership (including items described in section 707(c)) and includible
in the income of that partner, that partner's taxable year will be
deemed to end on the last day of the partnership's taxable year.
Similarly, if the taxable year of an S corporation and a shareholder end
with reference to the same calendar month, then for purposes of
determining the taxable year in which that shareholder takes into
account items described in section 1366(a) and items that are deductible
by the S corporation and includible in the income of that shareholder,
that shareholder's taxable year will be deemed to end on the last day of
the S corporation's taxable year.
(2) Personal service corporations and employee-owners. If the
taxable year of a PSC (within the meaning of Sec. 1.441-3(c)) and an
employee-owner (within the meaning of Sec. 1.441-3(g)) end with
reference to the same calendar month, then for purposes of determining
the taxable year in which an employee-owner takes into account items
that are deductible by the PSC and includible in the income of the
employee-owner, the employee-owner's taxable year will be deemed to end
on the last day of the PSC's taxable year.
(3) Definitions--(i) Pass-through entity. For purposes of this
section, a pass-through entity means a partnership, S corporation,
trust, estate, closely-held real estate investment trust (within the
meaning of section 6655(e)(5)(B)), common trust fund (within the meaning
of section 584(i)), controlled foreign corporation (within the meaning
of section 957), foreign personal holding company (within the meaning of
section 552), or passive foreign investment company that is a qualified
electing
[[Page 16]]
fund (within the meaning of section 1295).
(ii) Owner of a pass-through entity. For purposes of this section,
an owner of a pass-through entity generally means a taxpayer that owns
an interest in, or stock of, a pass-through entity. For example, an
owner of a pass-through entity includes a partner in a partnership, a
shareholder of an S corporation, a beneficiary of a trust or an estate,
an owner of a closely-held real estate investment trust (within the
meaning of section 6655(e)(5)(A)), a participant in a common trust fund,
a U.S. shareholder (as defined in section 951(b)) of a controlled
foreign corporation, a U.S. shareholder (as defined in section 551(a))
of a foreign personal holding company, or a U.S. person that holds stock
in a passive foreign investment company that is a qualified electing
fund with respect to that shareholder.
(4) Examples. The provisions of paragraph (e)(2) of this section may
be illustrated by the following examples:
Example 1. ABC Partnership uses a 52-53-week taxable year that ends
on the Wednesday nearest to December 31, and its partners, A, B, and C,
are individual calendar year taxpayers. Assume that, for ABC's taxable
year ending January 3, 2001, each partner's distributive share of ABC's
taxable income is $10,000. Under section 706(a) and paragraph (e)(1) of
this section, for the taxable year ending December 31, 2000, A, B, and C
each must include $10,000 in income with respect to the ABC year ending
January 3, 2001. Similarly, if ABC makes a guaranteed payment to A on
January 2, 2001, A must include the payment in income for A's taxable
year ending December 31, 2000.
Example 2. X, a PSC, uses a 52-53-week taxable year that ends on the
Wednesday nearest to December 31, and all of the employee-owners of X
are individual calendar year taxpayers. Assume that, for its taxable
year ending January 3, 2001, X pays a bonus of $10,000 to each employee-
owner on January 2, 2001. Under paragraph (e)(2) of this section, each
employee-owner must include its bonus in income for the taxable year
ending December 31, 2000.
(5) Transition rule. In the case of an owner of a pass-through
entity (other than the owner of a partnership or S corporation) that is
required by this paragraph (e) to include in income for its first
taxable year ending on or after May 17, 2002 amounts attributable to two
taxable years of a pass-through entity, the amount that otherwise would
be required to be included in income for such first taxable year by
reason of this paragraph (e) should be included in income ratably over
the four-taxable-year period beginning with such first taxable year
under principles similar to Sec. 1.702-3T, unless the owner of the
pass-through entity elects to include all such income in its first
taxable year ending on or after May 17, 2002.
[T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.441-3 Taxable year of a personal service corporation.
(a) Taxable year--(1) Required taxable year. Except as provided in
paragraph (a)(2) of this section, the taxable year of a personal service
corporation (PSC) (as defined in paragraph (c) of this section) must be
the calendar year.
(2) Exceptions. A PSC may have a taxable year other than its
required taxable year (i.e., a fiscal year) if it makes an election
under section 444, elects to use a 52-53-week taxable year that ends
with reference to the calendar year or a taxable year elected under
section 444, or establishes a business purpose for such fiscal year and
obtains the approval of the Commissioner under section 442.
(b) Adoption, change, or retention of taxable year--(1) Adoption of
taxable year. A PSC may adopt, in accordance with Sec. 1.441-1(c), the
calendar year, a taxable year elected under section 444, or a 52-53-week
taxable year ending with reference to the calendar year or a taxable
year elected under section 444 without the approval of the Commissioner.
See Sec. 1.441-1. A PSC that wants to adopt any other taxable year must
establish a business purpose and obtain the approval of the Commissioner
under section 442.
(2) Change in taxable year. A PSC that wants to change its taxable
year must obtain the approval of the Commissioner under section 442 or
make an election under section 444. However, a PSC may obtain automatic
approval for certain changes, including a change to the calendar year or
to a 52-53-week taxable year ending with reference to the calendar year,
pursuant to administrative procedures published by the Commissioner.
[[Page 17]]
(3) Retention of taxable year. In certain cases, a PSC will be
required to change its taxable year unless it obtains the approval of
the Commissioner under section 442, or makes an election under section
444, to retain its current taxable year. For example, a corporation
using a June 30 fiscal year that becomes a PSC and, as a result, is
required to use the calendar year must obtain the approval of the
Commissioner to retain its current fiscal year.
(4) Procedures for obtaining approval or making a section 444
election. See Sec. 1.442-1(b) for procedures to obtain the approval of
the Commissioner (automatically or otherwise) to adopt, change, or
retain a taxable year. See Sec. Sec. 1.444-1T and 1.444-2T for
qualifications, and 1.444-3T for procedures, for making an election
under section 444.
(5) Examples. The provisions of paragraph (b)(4) of this section may
be illustrated by the following examples:
Example 1. X, whose taxable year ends on January 31, 2001, becomes a
PSC for its taxable year beginning February 1, 2001, and does not obtain
the approval of the Commissioner for using a fiscal year. Thus, for
taxable years ending before February 1, 2001, this section does not
apply with respect to X. For its taxable year beginning on February 1,
2001, however, X will be required to comply with paragraph (a) of this
section. Thus, unless X obtains approval of the Commissioner to use a
January 31 taxable year, or makes a section 444 election, X will be
required to change its taxable year to the calendar year under paragraph
(b) of this section by using a short taxable year that begins on
February 1, 2001, and ends on December 31, 2001. Under paragraph (b)(1)
of this section, X may obtain automatic approval to change its taxable
year to a calendar year. See Sec. 1.442-1(b).
Example 2. Assume the same facts as in Example 1, except that X
desires to change to a 52-53-week taxable year ending with reference to
the month of December. Under paragraph (b)(1) of this section X may
obtain automatic approval to make the change. See Sec. 1.442-1(b).
(c) Personal service corporation defined--(1) In general. For
purposes of this section and section 442, a taxpayer is a PSC for a
taxable year only if--
(i) The taxpayer is a C corporation (as defined in section
1361(a)(2)) for the taxable year;
(ii) The principal activity of the taxpayer during the testing
period is the performance of personal services;
(iii) During the testing period, those services are substantially
performed by employee-owners (as defined in paragraph (g) of this
section); and
(iv) Employee-owners own (as determined under the attribution rules
of section 318, except that the language ``any'' applies instead of ``50
percent'' in section 318(a)(2)(C)) more than 10 percent of the fair
market value of the outstanding stock in the taxpayer on the last day of
the testing period.
(2) Testing period--(i) In general. Except as otherwise provided in
paragraph (c)(2)(ii) of this section, the testing period for any taxable
year is the immediately preceding taxable year.
(ii) New corporations. The testing period for a taxpayer's first
taxable year is the period beginning on the first day of that taxable
year and ending on the earlier of--
(A) The last day of that taxable year; or
(B) The last day of the calendar year in which that taxable year
begins.
(3) Examples. The provisions of paragraph (c)(2)(ii) of this section
may be illustrated by the following examples:
Example 1. Corporation A's first taxable year begins on June 1,
2001, and A desires to use a September 30 taxable year. However, if A is
a personal service corporation, it must obtain the Commissioner's
approval to use a September 30 taxable year. Pursuant to paragraph
(c)(2)(ii) of this section, A's testing period for its first taxable
year beginning June 1, 2001, is the period June 1, 2001 through
September 30, 2001. Thus, if, based upon such testing period, A is a
personal service corporation, A must obtain the Commissioner's
permission to use a September 30 taxable year.
Example 2. The facts are the same as in Example 1, except that A
desires to use a March 31 taxable year. Pursuant to paragraph (c)(2)(ii)
of this section, A's testing period for its first taxable year beginning
June 1, 2001, is the period June 1, 2001, through December 31, 2001.
Thus, if, based upon such testing period, A is a personal service
corporation, A must obtain the Commissioner's permission to use a March
31 taxable year.
(d) Performance of personal services--(1) Activities described in
section 448(d)(2)(A). For purposes of this section, any activity of the
taxpayer described in section 448(d)(2)(A) or the regulations thereunder
will be treated
[[Page 18]]
as the performance of personal services. Therefore, any activity of the
taxpayer that involves the performance of services in the fields of
health, law, engineering, architecture, accounting, actuarial science,
performing arts, or consulting (as such fields are defined in Sec.
1.448-1T) will be treated as the performance of personal services for
purposes of this section.
(2) Activities not described in section 448(d)(2)(A). For purposes
of this section, any activity of the taxpayer not described in section
448(d)(2)(A) or the regulations thereunder will not be treated as the
performance of personal services.
(e) Principal activity--(1) General rule. For purposes of this
section, the principal activity of a corporation for any testing period
will be the performance of personal services if the cost of the
corporation's compensation (the compensation cost) for such testing
period that is attributable to its activities that are treated as the
performance of personal services within the meaning of paragraph (d) of
this section (i.e., the total compensation for personal service
activities) exceeds 50 percent of the corporation's total compensation
cost for such testing period.
(2) Compensation cost--(i) Amounts included. For purposes of this
section, the compensation cost of a corporation for a taxable year is
equal to the sum of the following amounts allowable as a deduction,
allocated to a long-term contract, or otherwise chargeable to a capital
account by the corporation during such taxable year--
(A) Wages and salaries; and
(B) Any other amounts, attributable to services performed for or on
behalf of the corporation by a person who is an employee of the
corporation (including an owner of the corporation who is treated as an
employee under paragraph (g)(2) of this section) during the testing
period. Such amounts include, but are not limited to, amounts
attributable to deferred compensation, commissions, bonuses,
compensation includible in income under section 83, compensation for
services based on a percentage of profits, and the cost of providing
fringe benefits that are includible in income.
(ii) Amounts excluded. Notwithstanding paragraph (e)(2)(i) of this
section, compensation cost does not include amounts attributable to a
plan qualified under section 401(a) or 403(a), or to a simplified
employee pension plan defined in section 408(k).
(3) Attribution of compensation cost to personal service activity--
(i) Employees involved only in the performance of personal services. The
compensation cost for employees involved only in the performance of
activities that are treated as personal services under paragraph (d) of
this section, or employees involved only in supporting the work of such
employees, are considered to be attributable to the corporation's
personal service activity.
(ii) Employees involved only in activities that are not treated as
the performance of personal services. The compensation cost for
employees involved only in the performance of activities that are not
treated as personal services under paragraph (d) of this section, or for
employees involved only in supporting the work of such employees, are
not considered to be attributable to the corporation's personal service
activity.
(iii) Other employees. The compensation cost for any employee who is
not described in either paragraph (e)(3)(i) or (ii) of this section (a
mixed-activity employee) is allocated as follows--
(A) Compensation cost attributable to personal service activity.
That portion of the compensation cost for a mixed activity employee that
is attributable to the corporation's personal service activity equals
the compensation cost for that employee multiplied by the percentage of
the total time worked for the corporation by that employee during the
year that is attributable to activities of the corporation that are
treated as the performance of personal services under paragraph (d) of
this section. That percentage is to be determined by the taxpayer in any
reasonable and consistent manner. Time logs are not required unless
maintained for other purposes;
(B) Compensation cost not attributable to personal service activity.
That portion of the compensation cost for a mixed
[[Page 19]]
activity employee that is not considered to be attributable to the
corporation's personal service activity is the compensation cost for
that employee less the amount determined in paragraph (e)(3)(iii)(A) of
this section.
(f) Services substantially performed by employee-owners--(1) General
rule. Personal services are substantially performed during the testing
period by employee-owners of the corporation if more than 20 percent of
the corporation's compensation cost for that period attributable to its
activities that are treated as the performance of personal services
within the meaning of paragraph (d) of this section (i.e., the total
compensation for personal service activities) is attributable to
personal services performed by employee-owners.
(2) Compensation cost attributable to personal services. For
purposes of paragraph (f)(1) of this section--
(i) The corporation's compensation cost attributable to its
activities that are treated as the performance of personal services is
determined under paragraph (e)(3) of this section; and
(ii) The portion of the amount determined under paragraph (f)(2)(i)
of this section that is attributable to personal services performed by
employee-owners is to be determined by the taxpayer in any reasonable
and consistent manner.
(3) Examples. The provisions of this paragraph (f) may be
illustrated by the following examples:
Example 1. For its taxable year beginning February 1, 2001, Corp A's
testing period is the taxable year ending January 31, 2000. During that
testing period, A's only activity was the performance of personal
services. The total compensation cost of A (including compensation cost
attributable to employee-owners) for the testing period was $1,000,000.
The total compensation cost attributable to employee-owners of A for the
testing period was $210,000. Pursuant to paragraph (f)(1) of this
section, the employee-owners of A substantially performed the personal
services of A during the testing period because the compensation cost of
A's employee-owners was more than 20 percent of the total compensation
cost for all of A's employees (including employee-owners).
Example 2. Corp B has the same facts as corporation A in Example 1,
except that during the taxable year ending January 31, 2001, B also
participated in an activity that would not be characterized as the
performance of personal services under this section. The total
compensation cost of B (including compensation cost attributable to
employee-owners) for the testing period was $1,500,000 ($1,000,000
attributable to B's personal service activity and $500,000 attributable
to B's other activity). The total compensation cost attributable to
employee-owners of B for the testing period was $250,000 ($210,000
attributable to B's personal service activity and $40,000 attributable
to B's other activity). Pursuant to paragraph (f)(1) of this section,
the employee-owners of B substantially performed the personal services
of B during the testing period because more than 20 percent of B's
compensation cost during the testing period attributable to its personal
service activities was attributable to personal services performed by
employee-owners ($210,000).
(g) Employee-owner defined--(1) General rule. For purposes of this
section, a person is an employee-owner of a corporation for a testing
period if--
(i) The person is an employee of the corporation on any day of the
testing period; and
(ii) The person owns any outstanding stock of the corporation on any
day of the testing period.
(2) Special rule for independent contractors who are owners. Any
person who is an owner of the corporation within the meaning of
paragraph (g)(1)(ii) of this section and who performs personal services
for, or on behalf of, the corporation is treated as an employee for
purposes of this section, even if the legal form of that person's
relationship to the corporation is such that the person would be
considered an independent contractor for other purposes.
(h) Special rules for affiliated groups filing consolidated
returns--(1) In general. For purposes of applying this section to the
members of an affiliated group of corporations filing a consolidated
return for the taxable year--
(i) The members of the affiliated group are treated as a single
corporation;
(ii) The employees of the members of the affiliated group are
treated as employees of such single corporation; and
(iii) All of the stock of the members of the affiliated group that
is not owned by any other member of the affiliated group is treated as
the outstanding stock of that corporation.
[[Page 20]]
(2) Examples. The provisions of this paragraph (h) may be
illustrated by the following examples:
Example 1. The affiliated group AB, consisting of corporation A and
its wholly owned subsidiary B, filed a consolidated Federal income tax
return for the taxable year ending January 31, 2001, and AB is
attempting to determine whether it is affected by this section for its
taxable year beginning February 1, 2001. During the testing period
(i.e., the taxable year ending January 31, 2001), A did not perform
personal services. However, B's only activity was the performance of
personal services. On the last day of the testing period, employees of A
did not own any stock in A. However, some of B's employees own stock in
A. In the aggregate, B's employees own 9 percent of A's stock on the
last day of the testing period. Pursuant to paragraph (h)(1) of this
section, this section is effectively applied on a consolidated basis to
members of an affiliated group filing a consolidated Federal income tax
return. Because the only employee-owners of AB are the employees of B,
and because B's employees do not own more than 10 percent of AB on the
last day of the testing period, AB is not a PSC subject to the
provisions of this section. Thus, AB is not required to determine on a
consolidated basis whether, during the testing period, its principal
activity is the providing of personal services, or the personal services
are substantially performed by employee-owners.
Example 2. The facts are the same as in Example 1, except that on
the last day of the testing period A owns only 80 percent of B. The
remaining 20 percent of B is owned by employees of B. The fair market
value of A, including its 80 percent interest in B, as of the last day
of the testing period, is $1,000,000. In addition, the fair market value
of the 20 percent interest in B owned by B's employees is $50,000 as of
the last day of the testing period. Pursuant to paragraphs (c)(1)(iv)
and (h)(1) of this section, AB must determine whether the employee-
owners of A and B (i.e., B's employees) own more than 10 percent of the
fair market value of A and B as of the last day of the testing period.
Because the $140,000 [($1,000,000 x .09) + $50,000] fair market value of
the stock held by B's employees is greater than 10 percent of the
aggregate fair market value of A and B as of the last day of the testing
period, or $105,000 [$1,000,000 + $50,000 x .10], AB may be subject to
this section if, on a consolidated basis during the testing period, the
principal activity of AB is the performance of personal services and the
personal services are substantially performed by employee-owners.
[T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.441-4 Effective date.
Sections 1.441-0 through 1.441-3 are applicable for taxable years
ending on or after May 17, 2002.
[T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.442-1 Change of annual accounting period.
(a) Approval of the Commissioner. A taxpayer that has adopted an
annual accounting period (as defined in Sec. 1.441-1(b)(3)) as its
taxable year generally must continue to use that annual accounting
period in computing its taxable income and for making its Federal income
tax returns. If the taxpayer wants to change its annual accounting
period and use a new taxable year, it must obtain the approval of the
Commissioner, unless it is otherwise authorized to change without the
approval of the Commissioner under either the Internal Revenue Code
(e.g., section 444 and section 859) or the regulations thereunder (e.g.,
paragraph (c) of this section). In addition, as described in Sec.
1.441-1(c) and (d), a partnership, S corporation, electing S
corporation, or personal service corporation (PSC) generally is required
to secure the approval of the Commissioner to adopt or retain an annual
accounting period other than its required taxable year. The manner of
obtaining approval from the Commissioner to adopt, change, or retain an
annual accounting period is provided in paragraph (b) of this section.
However, special rules for obtaining approval may be provided in other
sections.
(b) Obtaining approval--(1) Time and manner for requesting approval.
In order to secure the approval of the Commissioner to adopt, change, or
retain an annual accounting period, a taxpayer must file an application,
generally on Form 1128, ``Application To Adopt, Change, or Retain a Tax
Year,'' with the Commissioner within such time and in such manner as is
provided in administrative procedures published by the Commissioner.
(2) General requirements for approval. An adoption, change, or
retention in annual accounting period will be approved where the
taxpayer establishes a business purpose for the requested annual
accounting period and agrees to
[[Page 21]]
the Commissioner's prescribed terms, conditions, and adjustments for
effecting the adoption, change, or retention. In determining whether a
taxpayer has established a business purpose and which terms, conditions,
and adjustments will be required, consideration will be given to all the
facts and circumstances relating to the adoption, change, or retention,
including the tax consequences resulting therefrom. Generally, the
requirement of a business purpose will be satisfied, and adjustments to
neutralize any tax consequences will not be required, if the requested
annual accounting period coincides with the taxpayer's required taxable
year (as defined in Sec. 1.441-1(b)(2)), ownership taxable year, or
natural business year. In the case of a partnership, S corporation,
electing S corporation, or PSC, deferral of income to partners,
shareholders, or employee-owners will not be treated as a business
purpose.
(3) Administrative procedures. The Commissioner will prescribe
administrative procedures under which a taxpayer may be permitted to
adopt, change, or retain an annual accounting period. These
administrative procedures will describe the business purpose
requirements (including an ownership taxable year and a natural business
year) and the terms, conditions, and adjustments necessary to obtain
approval. Such terms, conditions, and adjustments may include
adjustments necessary to neutralize the tax effects of a substantial
distortion of income that would otherwise result from the requested
annual accounting period including: a deferral of a substantial portion
of the taxpayer's income, or shifting of a substantial portion of
deductions, from one taxable year to another; a similar deferral or
shifting in the case of any other person, such as a beneficiary in an
estate; the creation of a short period in which there is a substantial
net operating loss, capital loss, or credit (including a general
business credit); or the creation of a short period in which there is a
substantial amount of income to offset an expiring net operating loss,
capital loss, or credit. See, for example, Rev. Proc. 2002-39, 2002-22
I.R.B., procedures for obtaining the Commissioner's prior approval of an
adoption, change, or retention in annual accounting period through
application to the national office; Rev. Proc. 2002-37, 2002-22 I.R.B.,
automatic approval procedures for certain corporations; Rev. Proc. 2002-
38, 2002-22 I.R.B., automatic approval procedures for partnerships, S
corporations, electing S corporations, and PSCs; and Rev. Proc. 66-50,
1966-2 C.B. 1260, automatic approval procedures for individuals. For
availability of Revenue Procedures and Notices, see Sec. 601.601(d)(2)
of this chapter.
(4) Taxpayers to whom section 441(g) applies. If section 441(g) and
Sec. 1.441-1(b)(1)(iv) apply to a taxpayer, the adoption of a fiscal
year is treated as a change in the taxpayer's annual accounting period
under section 442. Therefore, that fiscal year can become the taxpayer's
taxable year only with the approval of the Commissioner. In addition to
any other terms and conditions that may apply to such a change, the
taxpayer must establish and maintain books that adequately and clearly
reflect income for the short period involved in the change and for the
fiscal year proposed.
(c) Special rule for change of annual accounting period by
subsidiary corporation. A subsidiary corporation that is required to
change its annual accounting period under Sec. 1.1502-76, relating to
the taxable year of members of an affiliated group that file a
consolidated return, does not need to obtain the approval of the
Commissioner or file an application on Form 1128 with respect to that
change.
(d) Special rule for newly married couples. (1) A newly married
husband or wife may obtain automatic approval under this paragraph (d)
to change his or her annual accounting period in order to use the annual
accounting period of the other spouse so that a joint return may be
filed for the first or second taxable year of that spouse ending after
the date of marriage. Such automatic approval will be granted only if
the newly married husband or wife adopting the annual accounting period
of the other spouse files a Federal income tax return for the short
period required by that change on or before the 15th day of the 4th
month following the close of the short period. See section
[[Page 22]]
443 and the regulations thereunder. If the due date for any such short-
period return occurs before the date of marriage, the first taxable year
of the other spouse ending after the date of marriage cannot be adopted
under this paragraph (d). The short-period return must contain a
statement at the top of page one of the return that it is filed under
the authority of this paragraph (d). The newly married husband or wife
need not file Form 1128 with respect to a change described in this
paragraph (d). For a change of annual accounting period by a husband or
wife that does not qualify under this paragraph (d), see paragraph (b)
of this section.
(2) The provisions of this paragraph (d) may be illustrated by the
following example:
Example. H & W marry on September 25, 2001. H is on a fiscal year
ending June 30, and W is on a calendar year. H wishes to change to a
calendar year in order to file joint returns with W. W's first taxable
year after marriage ends on December 31, 2001. H may not change to a
calendar year for 2001 since, under this paragraph (d), he would have
had to file a return for the short period from July 1 to December 31,
2000, by April 16, 2001. Since the date of marriage occurred subsequent
to this due date, the return could not be filed under this paragraph
(d). Therefore, H cannot change to a calendar year for 2001. However, H
may change to a calendar year for 2002 by filing a return under this
paragraph (d) by April 15, 2002, for the short period from July 1 to
December 31, 2001. If H files such a return, H and W may file a joint
return for calendar year 2002 (which is W's second taxable year ending
after the date of marriage).
(e) Effective date. The rules of this section are applicable for
taxable years ending on or after May 17, 2002.
[T.D. 8996, 67 FR 35019, May 17, 2002]
Sec. 1.443-1 Returns for periods of less than 12 months.
(a) Returns for short period. A return for a short period, that is,
for a taxable year consisting of a period of less than 12 months, shall
be made under any of the following circumstances:
(1) Change of annual accounting period. In the case of a change in
the annual accounting period of a taxpayer, a separate return must be
filed for the short period of less than 12 months beginning with the day
following the close of the old taxable year and ending with the day
preceding the first day of the new taxable year. However, such a return
is not required for a short period of six days or less, or 359 days or
more, resulting from a change from or to a 52-53-week taxable year. See
section 441(f) and Sec. 1.441-2. The computation of the tax for a short
period required to effect a change of annual accounting period is
described in paragraph (b) of this section. In general, a return for a
short period resulting from a change of annual accounting period shall
be filed and the tax paid within the time prescribed for filing a return
for a taxday of the short period. For rules applicable to a subsidiary
corporation which becomes a member of an affiliated group which files a
consolidated return, see Sec. 1.1502-76.
(2) Taxpayer not in existence for entire taxable year. If a taxpayer
is not in existence for the entire taxable year, a return is required
for the short period during which the taxpayer was in existence. For
example, a corporation organized on August 1 and adopting the calendar
year as its annual accounting period is required to file a return for
the short period from August 1 to December 31, and returns for each
calendar year thereafter. Similarly, a dissolving corporation which
files its returns for the calendar year is required to file a return for
the short period from January 1 to the date it goes out of existence.
Income for the short period is not required to be annualized if the
taxpayer is not in existence for the entire taxable year, and, in the
case of a taxpayer other than a corporation, the deduction under section
151 for personal exemptions (or deductions in lieu thereof) need not be
reduced under section 443(c). In general, the requirements with respect
to the filing of returns and the payment of tax for a short period where
the taxpayer has not been in existence for the entire taxable year are
the same as for the filing of a return and the payment of tax for a
taxable year of 12 months ending on the last day of the short period.
Although the return of a decedent is a return for the short period
beginning with the first day of his last taxable year and ending with
the date of his death, the filing of a return and the
[[Page 23]]
payment of tax for a decedent may be made as though the decedent had
lived throughout his last taxable year.
(b) Computation of tax for short period on change of annual
accounting period--(1) General rule. (i) If a return is made for a short
period resulting from a change of annual accounting period, the taxable
income for the short period shall be placed on an annual basis by
multiplying such income by 12 and dividing the result by the number of
months in the short period. Unless section 443(b)(2) and subparagraph
(2) of this paragraph apply, the tax for the short period shall be the
same part of the tax computed on the annual basis as the number of
months in the short period is of 12 months.
(ii) If a return is made for a short period of more than 6 days, but
less than 359 days, resulting from a change from or to a 52-53-week
taxable year, the taxable income for the short period shall be
annualized and the tax computed on a daily basis, as provided in section
441(f)(2)(B)(iii) and Sec. 1.441-2(b)(2)(ii).
(iii) For method of computation of income for a short period in the
case of a subsidiary corporation required to change its annual
accounting period to conform to that of its parent, see Sec. 1.1502-
76(b).
(iv) An individual taxpayer making a return for a short period
resulting from a change of annual accounting period is not allowed to
take the standard deduction provided in section 141 in computing his
taxable income for the short period. See section 142(b)(3).
(v) In computing the taxable income of a taxpayer other than a
corporation for a short period (which income is to be annualized in
order to determine the tax under section 443(b)(1)) the personal
exemptions allowed individuals under section 151 (and any deductions
allowed other taxpayers in lieu thereof, such as the deduction under
section 642(b)) shall be reduced to an amount which bears the same ratio
to the full amount of the exemptions as the number of months in the
short period bears to 12. In the case of the taxable income for a short
period resulting from a change from or to a 52-53-week taxable year to
which section 441(f)(2)(B)(iii) applies, the computation required by the
preceding sentence shall be made on a daily basis, that is, the
deduction for personal exemptions (or any deduction in lieu thereof)
shall be reduced to an amount which bears the same ratio to the full
deduction as the number of days in the short period bears to 365.
(vi) If the amount of a credit against the tax (for example, the
credits allowable under section 34 (for dividends received on or before
December 31, 1964), and 35 (for partially tax-exempt interest)) is
dependent upon the amount of any item of income or deduction, such
credit shall be computed upon the amount of the item annualized
separately in accordance with the foregoing rules. The credit so
computed shall be treated as a credit against the tax computed on the
basis of the annualized taxable income. In any case in which a
limitation on the amount of a credit is based upon taxable income,
taxable income shall mean the taxable income computed on the annualized
basis.
(vii) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. A taxpayer with one dependent who has been granted
permission under section 442 to change his annual accounting period
files a return for the short period of 10 months ending October 31,
1956. He has income and deductions as follows:
Income
Interest income........................ ........ ......... $10,000.00
Partially tax-exempt interest with ........ ......... 500.00
respect to which a credit is allowable
under section 35......................
Dividends to which sections 34 and 116 ........ ......... 750.00
are applicable........................
-----------
........ ......... 11,250.00
Deductions
Real estate taxes...................... ........ ......... 200.00
2 personal exemptions at $600 on an ........ ......... 1,200.00
annual basis..........................
The tax for the 10-month period is
computed as follows:
Total income as above.................. ........ ......... 11,250.00
Less:
Exclusion for dividends received..... ........ $50.00
2 personal exemptions ($1,200 x \10/ ........ 1,000.00
12\)................................
Real estate taxes.................... ........ 200.00
........ -------- 1,250.00
-----------
Taxable income for 10-month period ........ ......... 10,000.00
before annualizing................
[[Page 24]]
Taxable income annualized (10,000 x \12/ ........ ......... 12,000.00
10\)..................................
Tax on $12,000 before credits.......... ........ ......... 3,400.00
Deduct credits:
Dividends received for 10-month $750.00
period..............................
Less: Excluded portion............... 50.00
----------
Included in gross income............. 700.00
Dividend income annualized ($700 x 840.00
\12/10\)............................
Credit (4 percent of $840)........... ........ 33.60
Partially tax-exempt interest 500.00
included in gross income for 10-
month period........................
Partially tax-exempt interest 600.00
(annualized) ($500 x \12/10\).......
Credit (3 percent of $600)........... ........ 18.00
........ -------- 51.60
-----------
Tax on $12,000 (after credits)..... ........ ......... 3,348.40
-----------
Tax for 10-month period ($3,348.40 x ........ ......... 2,790.33
\10/12\)..............................
------------------------------------------------------------------------
Example 2. The X Corporation makes a return for the one-month period
ending September 30, 1956, because of a change in annual accounting
period permitted under section 442. Income and expenses for the short
period are as follows:
Gross operating income....................................... $126,000
Business expenses............................................ 130,000
------------
Net loss from operations..................................... (4,000)
Dividends received from taxable domestic corporations........ 30,000
------------
Gross income for short period before annualizing........... 26,000
Dividends received deduction (85 percent of $30,000, but not 22,100
in excess of 85 percent of $26,000).........................
------------
Taxable income for short period before annualizing......... 3,900
Taxable income annualized ($8,900 x 12)...................... 46,800
============
Tax on annual basis:
$46,800 at 52 percent........................... $24,336
Less surtax exemption........................... 5,500
-------- $18,836
==========
Tax for 1-month period ($18,836 x \1/12\).................... 1,570
Example 3. The Y Corporation makes a re- turn for the six-month
period ending June 30, 1957, because of a change in annual accounting
period permitted under section 442. Income for the short period is as
follows:
Taxable income exclusive of net long-term capital gain....... $40,000
Net long-term capital gain................................... 10,000
------------
Taxable income for short period before annualizing......... 50,000
Taxable income annualized ($50,000 x \12/6\)................. 100,000
============
Regular tax computation
Taxable income annualized.................................... 100,000
Tax on annual basis:
$100,000 at 52 percent.......................... $52,000
Less surtax exemption........................... 5,500
============
46,500
Tax for 6-month period ($46,500 x \6/12\).................... 23,250
============
Alternative tax computation
Taxable income annualized.................................... 100,000
Less annualized capital gain ($10,000 x \12/6\).............. 20,000
------------
Annualized taxable income subject to partial tax........... 80,000
============
Partial tax on annual basis
$60,000 at 52 percent............................. $41,600
Less surtax exemption............................. 5,500
-------- 36,100
25 percent of annualized capital gain ($20,000).............. 5,000
------------
Alternative tax on annual basis............................ 41,100
Alternative tax for 6-month period ($41,100 x \6/12\)........ 20,550
Since the alternative tax of $20,550 is less than the tax computed
in the regular manner ($23,250), the corporation's tax for the 6-month
short period is $20,550.
(2) Exception: computation based on 12-month period. (i) A taxpayer
whose tax would otherwise be computed under section 443(b)(1) (or
section 441(f)(2)(B)(iii) in the case of certain changes from or to a
52-53-week taxable year) for the short period resulting from a change of
annual accounting period may apply to the district director to have his
tax computed under the provisions of section 443(b)(2) and this
subparagraph. If such application is made, as provided in subdivision
(v) of this subparagraph, and if the taxpayer establishes the amount of
his taxable income for the 12-month period described in subdivision (ii)
of this subparagraph, then the tax for the short period shall be the
greater of the following--
(a) An amount which bears the same ratio to the tax computed on the
taxable income which the taxpayer has established for the 12-month
period as the taxable income computed on the basis of the short period
bears to the taxable income for such 12-month period; or
(b) The tax computed on the taxable income for the short period
without placing the taxable income on an annual basis.
However, if the tax computed under section 443(b)(2) and this
subparagraph
[[Page 25]]
is not less than the tax for the short period computed under section
443(b)(1) (or section 441(f)(2)(B)(iii) in the case of certain changes
from or to a 52-53-week taxable year), then section 443(b)(2) and this
subparagraph do not apply.
(ii) The term ``12-month period'' referred to in subdivision (i) of
this subparagraph means the 12-month period beginning on the first day
of the short period. However, if the taxpayer is not in existence at the
end of such 12-month period, or if the taxpayer is a corporation which
has disposed of substantially all of its assets before the end of such
12-month period, the term ``12-month period'' means the 12-month period
ending at the close of the last day of the short period. For the
purposes of the preceding sentence, a corporation which has ceased
business and distributed so much of the assets used in its business that
it cannot resume its customary operations with the remaining assets,
will be considered to have disposed of substantially all of its assets.
In the case of a change from a 52-53-week taxable year, the term ``12-
month period'' means the period of 52 or 53 weeks (depending on the
taxpayer's 52-53-week taxable year) beginning on the first day of the
short period.
(iii)(a) The taxable income for the 12-month period is computed
under the same provisions of law as are applicable to the short period
and is computed as if the 12-month period were an actual annual
accounting period of the taxpayer. All items which fall in such 12-month
period must be included even if they are extraordinary in amount or of
an unusual nature. If the taxpayer is a member of a partnership, his
taxable income for the 12-month period shall include his distributive
share of partnership income for any taxable year of the partnership
ending within or with such 12-month period, but no amount shall be
included with respect to a taxable year of the partnership ending before
or after such 12-month period. If any other item partially applicable to
such 12-month period can be determined only at the end of a taxable year
which includes only part of the 12-month period, the taxpayer, subject
to review by the Commissioner, shall apportion such item to the 12-month
period in such manner as will most clearly reflect income for the 12-
month period.
(b) In the case of a taxpayer permitted or required to use
inventories, the cost of goods sold during a part of the 12-month period
included in a taxable year shall be considered, unless a more exact
determination is available, as such part of the cost of goods sold
during the entire taxable year as the gross receipts from sales for such
part of the 12-month period is of the gross receipts from sales for the
entire taxable year. For example, the 12-month period of a corporation
engaged in the sale of merchandise, which has a short period from
January 1, 1956, to September 30, 1956, is the calendar year 1956. The
three-month period, October 1, 1956, to December 31, 1956, is part of
the taxpayer's taxable year ending September 30, 1957. The cost of goods
sold during the three-month period, October 1, 1956, to December 31,
1956, is such part of the cost of goods sold during the entire fiscal
year ending September 30, 1957, as the gross receipts from sales for
such three-month period are of the gross receipts from sales for the
entire fiscal year.
(c) The Commissioner may, in granting permission to a taxpayer to
change his annual accounting period, require, as a condition to
permitting the change, that the taxpayer must take a closing inventory
upon the last day of the 12-month period if he wishes to obtain the
benefits of section 443(b)(2). Such closing inventory will be used only
for the purposes of section 443(b)(2), and the taxpayer will not be
required to use such inventory in computing the taxable income for the
taxable year in which such inventory is taken.
(iv) The provisions of this subparagraph may be illustrated by the
following examples:
Example 1. The taxpayer in Example 1 under paragraph (b)(1)(vii) of
this section establishes his taxable income for the 12-month period from
January 1, 1956, to December 31, 1956. The taxpayer has a short period
of 10 months, from January 1, 1956, to October 31, 1956. The taxpayer
files an application in accordance with subdivision (v) of this
subparagraph to compute his tax under section 443(b)(2). The taxpayer's
income and
[[Page 26]]
deductions for the 12-month period, as so established, follow:
Income
Interest income............................................... $11,000
Partially tax-exempt interest with respect to which a credit 600
is allowable under section 35................................
Dividends to which sections 34 and 116 are applicable......... 850
---------
12,450
Deductions
Real estate taxes............................................. 200
2 personal exemptions at $600................................. 1,200
Tax computation for short period under section 443(b)(2)(A)(i)
Total income as above......................................... $12,450
Less:
Exclusion for dividends received...................... $50
Personal exemptions................................... 1,200
Deduction for taxes................................... 200
--------
...... 1,450
---------
Taxable income for 12-month period......................... 11,000
=========
Tax before credits............................................ 3,020
Credit for partially tax-exempt interest (3 percent of 18
$600)................................................
Credit for dividends received (4 percent of ($850-50)) 32
--------
...... 50
---------
Tax under section 443(b)(2)(A)(i) for 12-month period......... 2,970
Taxable income for 10-month short period from Example 1 of 10,000
paragraph (b)(1)(vii) of this section before annualizing.....
Tax for short period under section 443(b)(2)(A)(i) ($2,970 x 2,700
$10,000 (taxable income for short period)/$11,000 (taxable
income for 12-month period)).................................
Tax computation for short period under section
443(b)(2)(A)(ii)
Total income for 10-month short period........................ 11,250
Less:
Exclusion for dividends received.................... 50
2 personal exemptions............................... 1,200
Real estate taxes................................... 200
--------
...... 1,450
---------
Taxable income for short period without annualizing and 9,800
without proration of personal exemptions...................
Tax before credits............................................ 2,572
Less credits:
Partially tax-exempt interest (3 percent of $500)... 15
Dividends received (4 percent of ($750-50))......... 28
--------
...... 43
---------
Tax for short period under section 443(b)(2)(A)(ii)........ 2,529
The tax of $2,700 computed under section 443(b)(2)(A)(i) is greater than
the tax of $2,529, computed under section 443(b)(2)(A)(ii), and is,
therefore, the tax under section 443(b)(2). Since the tax of $2,700
(computed under section 443(b)(2)) is less than the tax of $2,790.33
(computed under section 443(b)(1)) on the annualized income of the short
period (see Example 1 of paragraph (b)(1)(vii) of this section), the
taxpayer's tax for the 10-month short period is $2,700.
Example 2. Assume the same facts as in Example 1 of this
subdivision, except that, during the month of November 1956, the
taxpayer suffered a casualty loss of $5,000. The tax computation for the
short period under section 443(b)(2) would be as follows:
Tax computation for short period under section 443(b)(2)(A)(i)
Taxable income for 12-month period from Example 1............. $11,000
Less: Casualty loss........................................... 5,000
-----------
Taxable income for 12-month period......................... 6,000
===========
Tax before credits.................................. $1,360
Credits from Example 1.............................. 50
==========
Tax under section 443(b)(2)(A)(i) for 12-month 1,310
period.............................................
===========
Tax for short period ($1,310 x $10,000/$6,000) under 2,183
section 443(b)(2)(A)(i)............................
Tax computation for short period under section
443(b)(2)(A)(ii)
Total income for the short period................... 11,250
Less:
Exclusion for dividends received.................. 50
2 personal exemptions............................. 1,200
Real estate taxes................................. 200
----------
........ 1,450
---------
Taxable income for short period without annualizing and 9,800
without proration of personal exemptions...................
Tax before credits............................................ 2,572
Less credits:
Partially tax-exempt interest (3 percent of $500). 15
Dividends received (4 percent of $750-50))........ 28
-----------
........ 43
---------
Tax for short period under section 443(b)(2)(A)(ii)........... 2,529
The tax of $2,529, computed under section 443(b)(2)(A)(ii) is greater
than the tax of $2,183 computed under section 443(b)(2)- (A)(i) and is,
therefore, the tax under section 443(b)(2). Since this tax is less than
the tax of $2,790.33, computed under section 443(b)(1) (see Example 1 of
paragraph (b)(1)(vii) of this section), the taxpayer's tax for the 10-
month short period is $2,529.
(v)(a) A taxpayer who wishes to compute his tax for a short period
resulting from a change of annual accounting period under section
443(b)(2) must make an application therefor. Except as provided in (b)
of this subdivision, the taxpayer shall first file his return for the
short period and compute his tax under section 443(b)(1). The
application for
[[Page 27]]
the benefits of section 443(b)(2) shall subsequently be made in the form
of a claim for credit or refund. The claim shall set forth the
computation of the taxable income and the tax thereon for the 12-month
period and must be filed not later than the time (including extensions)
prescribed for filing the return for the taxpayer's first taxable year
which ends on or after the day which is 12 months after the beginning of
the short period. For example, assume that a taxpayer changes his annual
accounting period from the calendar year to a fiscal year ending
September 30, and files a return for the short period from January 1,
1956, to September 30, 1956. His application for the benefits of section
443(b)(2) must be filed not later than the time prescribed for filing
his return for his first taxable year which ends on or after the last
day of December 1956, the twelfth month after the beginning of the short
period. Thus, the taxpayer must file his application not later than the
time prescribed for filing the return for his fiscal year ending
September 30, 1957. If he obtains an extension of time for filing the
return for such fiscal year, he may file his application during the
period of such extension. If the district director determines that the
taxpayer has established the amount of his taxable income for the 12-
month period, any excess of the tax paid for the short period over the
tax computed under section 443(b)(2) will be credited or refunded to the
taxpayer in the same manner as in the case of an overpayment.
(b) If at the time the return for the short period is filed, the
taxpayer is able to determine that the 12-month period ending with the
close of the short period (see section 443(b)(2)- (B)(ii) and
subparagraph (2)(ii) of this paragraph) will be used in the computations
under section 443(b)(2), then the tax on the return for the short period
may be determined under the provisions of section 443(b)(2). In such
case, a return covering the 12-month period shall be attached to the
return for the short period as a part thereof, and the return and
attachment will then be considered as an application for the benefits of
section 443(b)(2).
(c) Adjustment in deduction for personal exemption. For adjustment
in the deduction for personal exemptions in computing the tax for a
short period resulting from a change of annual accounting period under
section 443(b)(1) (or under section 441(f)(2)(B)(iii) in the case of
certain changes from or to a 52-53-week taxable year), see paragraph
(b)(1)(v) of this section.
(d) Adjustments in exclusion of computing minimum tax for tax
preferences. (1) If a return is made for a short period on account of
any of the reasons specified in subsection (a) of section 443, the
$30,000 amount specified in section 56 (relating to minimum tax for tax
preferences), modified as provided by section 58 and the regulations
thereunder, shall be reduced to the amount which bears the same ratio to
such specified amount as the number of days in the short period bears to
365.
(2) Example. The provisions of this paragraph may be illustrated by
the following example:
Example. A taxpayer who is an unmarried individual has been granted
permission under section 442 to change his annual accounting period
files a return for the short period of 4 months ending April 30, 1970.
The $30,000 amount specified in section 56 is reduced as follows:
(120/365) x $30,000 = $9,835.89.
(e) Cross references. For inapplicability of section 443(b) and
paragraph (b) of this section in computing--
(1) Accumulated earnings tax, see section 536 and the regulations
thereunder;
(2) Personal holding company tax, see section 546 and the
regulations thereunder;
(3) Undistributed foreign personal holding company income, see
section 557 and the regulations thereunder;
(4) The taxable income of a regulated investment company, see
section 852(b)(2)(E) and the regulations thereunder; and
(5) The taxable income of a real estate investment trust, see
section
[[Page 28]]
857(b)(2)(C) and the regulations thereunder.
[T.D. 6500, 25 FR 11705, Nov. 26, 1960, as amended by T.D. 6598, 27 FR
4093, Apr. 28, 1962; T.D. 6777, 29 FR 17808, Dec. 16, 1964; T.D. 7244,
37 FR 28897, Dec. 30, 1972, T.D. 7564, 43 FR 40494, Sept. 12, 1978; T.D.
7575, 43 FR 58816, Dec. 18, 1978; T.D. 7767, 465 FR 11265, Feb. 6, 1981;
T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.444-0T Table of contents (temporary).
This section lists the captions that appear in the temporary
regulations under section 444.
Sec. 1.444-1T Election to use a taxable year other than the required
taxable year (temporary).
(a) General rules.
(1) Year other than required year.
(2) Effect of section 444 election.
(i) In general.
(ii) Duration of section 444 election.
(3) Section 444 election not required for certain years.
(4) Required taxable year.
(5) Termination of section 444 election.
(i) In general.
(ii) Effective date of termination.
(iii) Example.
(iv) Special rule for entity that liquidates or is sold prior to
making a section 444 election, required return, or required payment.
(6) Re-activating certain S elections.
(i) Certain corporations electing S status that did not make a back-
up calendar year request.
(ii) Certain corporations that revoked their S status.
(iii) Procedures for re-activating an S election.
(iv) Examples.
(b) Limitation on taxable years that may be elected.
(1) General rule.
(2) Changes in taxable year.
(i) In general.
(ii) Special rule for certain existing corporations electing S
status.
(iii) Deferral period of the taxable year that is being changed.
(iv) Examples.
(3) Special rule for entities retaining 1986 taxable year.
(4) Deferral period.
(i) Retentions of taxable year.
(ii) Adoptions of and changes in taxable year.
(A) In general.
(B) Special rule.
(C) Examples.
(5) Miscellaneous rules.
(i) Special rule for determining the taxable year of a corporation
electing S status.
(ii) Special procedure for cases where an income tax return is
superseded.
(A) In general.
(B) Procedure for superseding return.
(iii) Anti-abuse rule.
(iv) Special rules for partial months and 52-53-week taxable years.
(c) Effective date.
(d) Examples.
(1) Changes in taxable year.
(2) Special rule for entities retaining their 1986 taxable year.
Sec. 1.444-2T Tiered structure (temporary).
(a) General rule.
(b) Definition of a member of a tiered structure.
(1) In general.
(2) Deferral entity.
(i) In general.
(ii) Grantor trusts.
(3) Anti-abuse rule.
(c) De minimis rules.
(1) In general.
(2) Downstream de minimis rule.
(i) General rule.
(ii) Definition of testing period.
(iii) Definition of adjusted taxable income.
(A) Partnership.
(B) S corporation.
(C) Personal service corporation.
(iv) Special rules.
(A) Pro-forma rule.
(B) Reasonable estimates allowed.
(C) Newly formed entities.
(1) Newly formed deferral entities.
(2) Newly formed partnership, S corporation, or personal service
corporation desiring to make a section 444 election.
(3) Upstream de minimis rule.
(d) Date for determining the existence of a tiered structure.
(1) General rule.
(2) Special rule for taxable years beginning in 1987.
(e) Same taxable year exception.
(1) In general.
(2) Definition of tiered structure.
(i) General rule.
(ii) Special flow-through rule for downstream controlled
partnerships.
(3) Determining the taxable year of a partnership or S corporation.
(4) Special rule for 52-53-week taxable years.
(5) Interaction with de minimis rules.
(i) Downstream de minimis rule.
(A) In general.
(B) Special rule for members of a tiered structure directly owned by
a downstream controlled partnership.
(ii) Upstream de minimis rule.
(f) Examples.
(g) Effective date.
[[Page 29]]
Sec. 1.444-3T Manner and time of making section 444 election
(temporary).
(a) In general.
(b) Manner and time of making election.
(1) General rule.
(2) Special extension of time for making an election.
(3) Corporation electing to be an S corporation.
(i) In general.
(ii) Examples.
(4) Back-up section 444 election.
(i) General rule.
(ii) Procedures for making a back-up section 444 election.
(iii) Procedures for activating a back-up section 444 election.
(A) Partnership and S corporations.
(1) In general.
(2) Special rule if Form 720 used to satisfy return requirement.
(B) Personal service corporations.
(iv) Examples.
(c) Administrative relief.
(1) Extension of time to file income tax returns.
(i) Automatic extension.
(ii) Additional extensions.
(iii) Examples.
(2) No penalty for certain late payments.
(i) In general.
(ii) Example.
(d) Effective date.
[T.D. 8205, 53 FR 19693, May 27, 1988]
Sec. 1.444-1T Election to use a taxable year other than the required
taxable year (temporary).
(a) General rules--(1) Year other than required year. Except as
otherwise provided in this section and Sec. 1.444-2T, a partnership, S
corporation, or personal service corporation (as defined in Sec. 1.441-
3(c)) may make or continue an election (a ``section 444 election'') to
have a taxable year other than its required taxable year. See paragraph
(b) of this section for limitations on the taxable year that may be
elected. See Sec. 1.444-2T for rules that generally prohibit a
partnership, S corporation, or personal service corporation that is a
member of a tiered structure from making or continuing a section 444
election. See Sec. 1.444-3T for rules explaining how and when to make a
section 444 election.
(2) Effect of section 444 election--(i) In general. A partnership or
S corporation that makes or continues a section 444 election shall file
returns and make payments as required by Sec. Sec. 1.7519-1T and
1.7519-2T. A personal service corporation that makes or continues a
section 444 election is subject to the deduction limitation of Sec.
1.280H-1T.
(ii) Duration of section 444 election. A section 444 election shall
remain in effect until the election is terminated pursuant to paragraph
(a)(5) of this section.
(3) Section 444 election not required for certain years. A
partnership, S corporation, or personal service corporation is not
required to make a section 444 election to use--
(i) A taxable year for which such entity establishes a business
purpose to the satisfaction of the Commissioner (i.e., approved under
section 4 or 6 of Rev. Proc. 87-32, 1987-28 I.R.B. 14, or any successor
revenue ruling or revenue procedure), or
(ii) A taxable year that is a ``grandfathered fiscal year,'' within
the meaning of section 5.01(2) of Rev. Proc. 87-32 or any successor
revenue ruling or revenue procedure.
Although a partnership, S corporation or personal service corporation
qualifies to use a taxable year described in paragraph (a)(3) (i) or
(ii) of this section, such entity may, if otherwise qualified, make a
section 444 election to use a different taxable year. Thus, for example,
assume that a personal service corporation that historically used a
January 31 taxable year established to the satisfaction of the
Commissioner, under section 6 of Rev. Proc. 87-32, a business purpose to
use a September 30 taxable year for its taxable year beginning February
1, 1987. Pursuant to this paragraph (a)(3), such personal service
corporation may use a September 30 taxable year without making a section
444 election. However, the corporation may, if otherwise qualified, make
a section 444 election to use a year ending other than September 30 for
its taxable year beginning February 1, 1987.
(4) Required taxable year. For purposes of this section, the term
``required taxable year'' means the taxable year determined under
section 706(b), 1378, or 441(i) without taking into account any taxable
year which is allowable either--
(i) By reason of business purpose (i.e., approved under section 4 or
6 of Rev.
[[Page 30]]
Proc. 87-32 or any successor revenue ruling or procedure), or
(ii) As a ``grandfathered fiscal year'' within the meaning of
section 5.01(2) of Rev. Proc. 87-32, or any successor revenue ruling or
procedure.
(5) Termination of section 444 election--(i) In general. A section
444 election is terminated when--
(A) A partnership, S corporation, or personal service corporation
changes to its required taxable year; or
(B) A partnership, S corporation, or personal service corporation
liquidates (including a deemed liquidation of a partnership under Sec.
1.708-1 (b)(1)(iv)); or
(C) A partnership, S corporation, or personal service corporation
willfully fails to comply with the requirements of section 7519 or 280H,
whichever is applicable; or
(D) A partnership, S corporation, or personal service corporation
becomes a member of a tiered structure (within the meaning of Sec.
1.444-2T), unless it is a partnership or S corporation that meets the
same taxable year exception under Sec. 1.444-2T (e); or
(E) An S corporation's S election is terminated; or
(F) A personal service corporation ceases to be a personal service
corporation.
However, if a personal service corporation, that has a section 444
election in effect, elects to be an S corporation, the S corporation may
continue the section 444 election of the personal service corporation.
Similarly, if an S corporation that has a section 444 election in effect
terminates its S election and immediately becomes a personal service
corporation, the personal service corporation may continue the section
444 election of the S corporation. If a section 444 election is
terminated under this paragraph (a)(5), the partnership, S corporation,
or personal service corporation may not make another section 444
election for any taxable year.
(ii) Effective date of termination. A termination of a section 444
election shall be effective--
(A) In the case of a change to the required year, on the first day
of the short year caused by the change;
(B) In the case of a liquidating entity, on the date the liquidation
is completed for tax purposes;
(C) In the case of willful failure to comply, on the first day of
the taxable year (determined as if a section 444 election had never been
made) determined in the discretion of the District Director;
(D) In the case of membership in a tiered structure, on the first
day of the taxable year in which the entity is considered to be a member
of a tiered structure, or such other taxable year determined in the
discretion of the District Director;
(E) In the case of termination of S status, on the first day of the
taxable year for which S status no longer exists;
(F) In the case of a personal service corporation that changes
status, on the first day of the taxable year, for which the entity is no
longer a personal service corporation.
In the case of a termination under this paragraph (a)(5) that results in
a short taxable year, an income tax return is required for the short
period. In order to allow the Service to process the affected income tax
return in an efficient manner, a partnership, S corporation, or personal
service corporation that files such a short period return should type or
legibly print at the top of the first page of the income tax return for
the short taxable year--``SECTION 444 ELECTION TERMINATED.'' In
addition, a personal service corporation that changes its taxable year
to the required taxable year is required to annualize its income for the
short period.
(iii) Example. The provisions of paragraph (a)(5)(ii) of this
section may be illustrated by the following example.
Example. Assume a partnership that is 100 percent owned, at all
times, by calendar year individuals has historically used a June 30
taxable year. Also assume the partnership makes a valid section 444
election to retain a year ending June 30 for its taxable year beginning
July 1, 1987. However, for its taxable year beginning July 1, 1988, the
partnership changes to a calendar year, its required year. Based on
these facts, the partnership's section 444 election is terminated on
July 1, 1988, and the partnership must file a short period return for
the period July 1, 1988-December 31, 1988. Furthermore, pursuant to
[[Page 31]]
Sec. 1.702-3T(a)(1), the partners in such partnership are not entitled
to a 4-year spread with respect to partnership items of income and
expense for the taxable year beginning July 1, 1988 and ending December
31, 1988.
(iv) Special rule for entity that liquidates or is sold prior to
making a section 444 election, required return, or required payment. A
partnership, S corporation, or personal service corporation that is
liquidated or sold for tax purposes before a section 444 election,
required return, or required payment is made for a particular year may,
nevertheless, make or continue a section 444 election, if otherwise
qualified. (See Sec. Sec. 1.7519-2T (a)(2) and 1.7519-1T (a)(3),
respectively, for a description of the required return and a definition
of the term ``required payment.'') However, the partnership, S
corporation, or personal service corporation (or a trustee or agent
thereof) must comply with the requirements for making or continuing a
section 444 election. Thus, if applicable, required payments must be
made and a subsequent claim for refund must be made in accordance with
Sec. 1.7519-2T(a)(6). The following examples illustrate the application
of this paragraph (a)(5)(iv).
Example 1. Assume an existing S corporation historically used a June
30 taxable year and desires to make a section 444 election for its
taxable year beginning July 1, 1987. Assume further that the S
corporation is liquidated for tax purposes on February 15, 1988. If
otherwise qualified, the S corporation (or a trustee or agent thereof)
may make a section 444 election to have a taxable year beginning July 1,
1987, and ending February 15, 1988. However, if the S corporation makes
a section 444 election, it must comply with the requirements for making
a section 444 election, including making required payments.
Example 2. The facts are the same as in Example 1, except that
instead of liquidating on February 15, 1988, the shareholders of the S
corporation sell their stock to a corporation on February 15, 1988.
Thus, the corporation's S election is terminated on February 15, 1988.
If otherwise qualified, the corporation may make a section 444 election
to have a taxable year beginning July 1, 1987, and ending February 14,
1988.
Example 3. The facts are the same as in Example 2, except that the
new shareholders are individuals. Furthermore, the corporation's S
election is not terminated. Based on these facts, the S corporation, if
otherwise qualified, may make a section 444 election to retain a year
ending June 30 for its taxable year beginning July 1, 1987. Furthermore,
the S corporation may, if otherwise qualified, continue its section 444
election for subsequent taxable years.
(6) Re-activating certain S elections--(i) Certain corporations
electing S status that did not make a back-up calendar year request. If
a corporation that timely filed Form 2553, Election by a Small Business
Corporation, effective for its first taxable year beginning in 1987--
(A) Requested a fiscal year based on business purpose,
(B) Did not agree to use a calendar year in the event its business
purpose request was denied, and
(C) Such business purpose request is denied or withdrawn,
such corporation may retroactively re-activate its S election by making
a valid section 444 election for its first taxable year beginning in
1987 and complying with the procedures in paragraph (a)(6)(iii) of this
section.
(ii) Certain corporations that revoked their S status. If a
corporation that used a fiscal year revoked its S election (pursuant to
section 1362(d)(1)) for its first taxable year beginning in 1987, such
corporation may retroactively re-activate its S election (i.e. rescind
its revocation) by making a valid section 444 election for its first
taxable year beginning in 1987 and complying with the procedures in
paragraph (a)(6)(iii) of this section.
(iii) Procedures for re-activating an S election. A corporation re-
activating its S election pursuant to paragraph (a)(6) (i) or (ii) of
this section must--
(A) Obtain the consents of all shareholders who have owned stock in
the corporation since the first day of the first taxable year of the
corporation beginning after December 31, 1986,
(B) Include the following statement at the top of the first page of
the corporation's Form 1120S for its first taxable year beginning in
1987--``SECTION 444 ELECTION--RE-ACTIVATES S STATUS,'' and
(C) Include the following statement with Form 1120S--``RE-ACTIVATION
CONSENTED TO BY ALL SHAREHOLDERS WHO HAVE OWNED STOCK AT ANY TIME SINCE
THE FIRST DAY OF THE FIRST TAXABLE YEAR OF THIS CORPORATION BEGINNING
AFTER DECEMBER 31, 1986.''
[[Page 32]]
(iv) Examples. The provisions of this paragraph (a)(6) may be
illustrated by the following examples.
Example 1. Assume a corporation historically used a June 30 taxable
year and such corporation timely filed Form 2553, Election by a Small
Business Corporation, to be effective for its taxable year beginning
July 1, 1987. On its Form 2553, the corporation requested permission to
retain its June 30 taxable year based on business purpose. However, the
corporation did not agree to use a calendar year in the event its
business purpose request was denied. On April 1, 1988, the Internal
Revenue Service notified the corporation that its business purpose
request was denied and therefore the corporation's S election was not
effective. Pursuant to paragraph (a)(6)(i) of this section, the
corporation may re-activate its S election by making a valid section 444
election and complying with the procedures in paragraph (a)(6)(iii) of
this section.
Example 2. The facts are the same as in Example 1, except that as of
July 26, 1988, the Internal Revenue Service has not yet determined
whether the corporation has a valid business purpose to retain a June 30
taxable year. Based on these facts, the corporation may, if otherwise
qualified, make a back-up section 444 election as provided in Sec.
1.444-3T(b)(4). If the corporation's business purpose request is
subsequently denied, the corporation should follow the procedures in
Sec. 1.444-3T(b)(4)(iii) for activating a back-up section 444 election
rather than the procedures provided in this paragraph (a)(6 for re-
activating an S election.
Example 3. Assume a corporation has historically been an S
corporation with a March 31 taxable year. However, for its taxable year
beginning April 1, 1987, the corporation revoked its S election pursuant
to section 1362 (d)(1). Pursuant to paragraph (a)(6)(ii) of this
section, such corporation may retroactively rescind its S election
revocation by making a valid section 444 election for its taxable year
beginning April 1, 1987, and complying with the procedures provided in
paragraph (a)(6)(iii) of this section. If the corporation retroactively
rescinds its S revocation, the corporation shall file a Form 1120S for
its taxable year beginning April 1, 1987.
(b) Limitation on taxable years that may be elected--(1) General
rule. Except as provided in paragraphs (b)(2) and (3) of this section, a
section 444 election may be made only if the deferral period (as defined
in paragraph (b)(4) of this section) of the taxable year to be elected
is not longer than three months.
(2) Changes in taxable year--(i) In general. In the case of a
partnership, S corporation, or personal service corporation changing its
taxable year, such entity may make a section 444 election only if the
deferral period of the taxable year to be elected is not longer than the
shorter of--
(A) Three months, or
(B) The deferral period of the taxable year that is being changed,
as defined in paragraph (b)(2)(iii) of this section.
(ii) Special rule for certain existing corporations electing S
status. If a corporation with a taxable year other than the calendar
year--
(A) Elected after September 18, 1986, and before January 1, 1988,
under section 1362 of the Code to be an S corporation, and
(B) Elected to have the calendar year as the taxable year of the S
corporation,
then, for taxable years beginning before 1989, paragraph (b)(2)(i) of
this section shall be applied by taking into account the deferral period
of the last taxable year of the corporation prior to electing to be an S
corporation, rather than the deferral period of the taxable year that is
being changed. Thus, the provisions of the preceding sentence do not
apply to a corporation that elected to be an S corporation for its first
taxable year.
(iii) Deferral period of the taxable year that is being changed. For
purposes of paragraph (b)(2)(i)(B) of this section, the phrase
``deferral period of the taxable year that is being changed'' means the
deferral period of the taxable year immediately preceding the taxable
year for which the taxpayer desires to make a section 444 election.
Furthermore, the deferral period of such year will be determined by
using the required taxable year of the taxable year for which the
taxpayer desires to make a section 444 election. For example, assume P,
a partnership that has historically used a March 31 taxable year,
desires to change to a September 30 taxable year by making a section 444
election for its taxable year beginning April 1, 1987. Furthermore,
assume that pursuant to paragraph (a)(4) of this section, P's required
taxable year for the taxable year beginning April 1, 1987 is a year
ending December 31. Based on these facts the deferral period of the
taxable year being changed is nine
[[Page 33]]
months (the period from March 31 to December 31).
(iv) Examples. See paragraph (d)(1) of this section for examples
that illustrate the provisions of this paragraph (b)(2).
(3) Special rule for entities retaining 1986 taxable year.
Notwithstanding paragraph (b)(2) of this section, a partnership, S
corporation, or personal service corporation may, for its first taxable
year beginning after December 31, 1986, if otherwise qualified, make a
section 444 election to have a taxable year that is the same as the
entity's last taxable year beginning in 1986. See paragraph (d)(2) of
this section for examples that illustrate the provisions of this
paragraph (b)(3).
(4) Deferral period--(i) Retentions of taxable year. For a
partnership, S corporation, or personal service corporation that desires
to retain its taxable year by making a section 444 election, the term
``deferral period'' means the months between the beginning of such year
and the close of the first required taxable year (as defined in
paragraph (a)(4) of this section). The following example illustrates the
application of this paragraph (b)(4)(i).
Example. AB partnership has historically used a taxable year ending
July 31. AB desires to retain its July 31 taxable year by making a
section 444 election for its taxable year beginning August 1, 1987.
Calendar year individuals, A and B, each own 50 percent of the profits
and capital of AB; thus, under paragraph (a)(4) of this section AB's
required taxable year is the year ending December 31. Pursuant to this
paragraph (b)(4)(i), if AB desires to retain its year ending July 31,
the deferral period is five months (the months between July 31 and
December 31).
(ii) Adoptions of and changes in taxable year--(A) In general. For a
partnership, S corporation, or personal service corporation that desires
to adopt or change its taxable year by making a section 444 election,
the term ``deferral period'' means the months that occur after the end
of the taxable year desired under section 444 and before the close of
the required taxable year.
(B) Special rule. If a partnership, S corporation or personal
service corporation is using the required taxable year as its taxable
year, the deferral period is deemed to be zero.
(C) Examples. The provisions of this paragraph (b)(4)(ii) may be
illustrated by the following examples.
Example 1. Assume that CD partnership has historically used the
calendar year and that CD's required taxable year is the calendar year.
Under the special rule provided in paragraph (b)(4)(ii)(B) of this
section, CD's deferral period is zero. See paragraph (b)(2)(i) of this
section for rules that preclude CD from making a section 444 election to
change its taxable year.
Example 2. E, a newly formed partnership, began operations on
December 1, 1987, and is owned by calendar year individuals. E desires
to make a section 444 election to adopt a September 30 taxable year. E's
required taxable year is December 31. Pursuant to paragraph
(b)(4)(ii)(A) of this section E's deferral period for the taxable year
beginning December 1, 1987, is three months (the number of months
between September 30 and December 31).
Example 3. Assume that F, a personal service corporation, has
historically used a June 30 taxable year. F desires to make a section
444 election to change to an August 31 taxable year, effective for its
taxable year beginning July 1, 1987. For purposes of determining the
availability of a section 444 election for changing to the taxable year
ending August 31, the deferral period of an August 31 taxable year is
four months (the number of months between August 31 and December 31).
The deferral period for F's existing June 30 taxable year is six months
(the number of months between June 30 and December 31). Pursuant to
Sec. 1.444-1T(b)(2)(i), F may not make a section 444 election to change
to an August 31 taxable year.
(5) Miscellaneous rules--(i) Special rule for determining the
taxable year of a corporation electing S status. For purposes of this
section, and only for purposes of this section, a corporation that
elected to be an S corporation for a taxable year beginning in 1987 or
1988 and which elected to be an S corporation prior to September 26,
1988, will not be considered to have adopted or changed its taxable year
by virtue of information included on Form 2553, Election by a Small
Business Corporation. See Example 8 in paragraph (d) of this section.
(ii) Special procedure for cases where an income tax return is
superseded--(A) In general. In the case of a partnership, S corporation,
or personal service corporation that filed an income tax return for its
first taxable year beginning
[[Page 34]]
after December 31, 1986, but subsequently makes a section 444 election
that would result in a different year end for such taxable year, the
income tax return filed pursuant to the section 444 election will
supersede the original return. However, any payments of income tax made
with respect to such superseded return will be credited to the
taxpayer's superseding return and the taxpayer may file a claim for
refund for such payments. See examples (5) and (7) in paragraph (d)(2)
of this section.
(B) Procedure for superseding return. In order to allow the Service
to process the affected income tax returns in an efficient manner, a
partnership, S corporation, or personal service corporation that desires
to supersede an income tax return in accordance with paragraph
(b)(5)(ii)(A) of this section, should type or legibly print at the top
of the first page of the income tax return for the taxable year
elected--``SECTION 444 ELECTION--SUPERSEDES PRIOR RETURN.''
(iii) Anti-abuse rule--If an existing partnership, S corporation or
personal service corporation (``predecessor entities''), or the owners
thereof, transfer assets to a related party and the principal purpose of
such transfer is to--
(A) Create a deferral period greater than the deferral period of the
predecessor entity's taxable year, or
(B) Make a section 444 election following the termination of the
predecessor entity's section 444 election,
then such transfer will be disregarded for purposes of section 444 and
this section, even if the deferral created by such change is effectively
eliminated by a required payment (within the meaning of section 7519) or
deferral of a deduction (to a personal service corporation under section
280H). The following example illustrates the application of this
paragraph (b)(5)(iii).
Example. Assume that P1 is a partnership that historically used the
calendar year and is owned by calendar year partners. Assume that P1
desires to make a section 444 election to change to a September year for
the taxable year beginning January 1, 1988. P1 may not make a section
444 election to change taxable years under section 444(b)(2) because its
current deferral period is zero. Assume further that P1 transfers a
substantial portion of its assets to a newly-formed partnership (P2),
which is owned by the partners of P1. Absent paragraph (b)(5)(iii) of
this section, P2 could, if otherwise qualified, make a section 444
election under paragraph (b)(1) of this section to use a taxable year
with a three month or less deferral period (i.e., a September 30,
October 31, or November 30 taxable year). However, if the principal
purpose of the asset transfer was to create a one-, two-, or three-month
deferral period by P2 making a section 444 election, the section 444
election shall not be given effect, even if the deferral would be
effectively eliminated by P2 making a required payment under section
7519.
(iv) Special rules for partial months and 52-53-week taxable years.
Except as otherwise provided in Sec. 1.280H-1T(c)(2)(i)(A), for
purposes of this section and Sec. Sec. 1.7519-1T, 1.7519-2T and 1.280H-
1T--
(A) A month of less than 16 days is disregarded, and a month of more
than 15 days is treated as a full month; and
(B) A 52-53-week taxable year with reference to the end of a
particular month will be considered to be the same as a taxable year
ending with reference to the last day of such month.
(c) Effective date. This section is effective for taxable years
beginning after December 31, 1986.
(d) Examples--(1) Changes in taxable year. The following examples
illustrate the provisions of paragraph (b)(2) of this section.
Example 1. A is a personal service corporation that historically
used a June 30 taxable year. A desires to make a section 444 election to
change to an August 31 taxable year, effective with its taxable year
beginning July 1, 1987. Under paragraph (b)(4)(ii) of this section, the
deferred period of the taxable year to be elected is four months (the
number of months between August 31 and December 31). Furthermore, the
deferral period of the taxable year that is being changed is six months
(the number of months between June 30 and December 31). Pursuant to
paragraph (b)(2)(i) of this section, a taxpayer may, if otherwise
qualified, make a section 444 election to change to a taxable year only
if the deferral period of the taxable year to be elected is not longer
than the shorter of three months or the deferred period of the taxable
year being changed. Since the deferral period of the taxable year to be
elected (August 31) is greater than three months, A may not make a
section 444 election to change to the taxable year ending August 31,
However, since the deferral period of the taxable year that is being
changed is three months or more, A may, if otherwise qualified, make a
section
[[Page 35]]
444 election to change to a year ending September 30, 1987 (three-month
deferral period), a year ending October 31, 1987 (two-month deferral
period), or a year ending November 30, 1987 (one-month deferral period).
In addition, instead of making a section 444 election to change its
taxable year, A could, if otherwise qualified, make a section 444
election to retain its June end, pursuant to paragraph (b)(3) of this
section.
Example 2. B, a corporation that historically used an August 31
taxable year, elected on November 1, 1986 to be an S corporation for its
taxable year beginning September 1, 1986. As a condition to having the S
election accepted, B agreed on Form 2553 to use calendar year. Pursuant
to the general effective date provided in paragraph (c) of this section,
B may not make a section 444 election for its taxable year beginning in
1986. Thus, B must file a short period income tax return for the period
September 1 to December 31, 1986.
Example 3. The facts are the same as in Example 2, except that B
desires to make a section 444 election for its taxable year beginning
January 1, 1987. Absent paragraph (b)(2)(ii) of this section, B would
not be allowed to change its taxable year because the deferral period of
the taxable year being changed (i.e., the calendar year) is zero.
However, pursuant to the special rule provided in paragraph (b)(2)(ii)
of this section, B shall apply paragraph (b)(2)(i) of this section by
taking into account the deferral period of the last taxable year of B
prior to B's election to be an S corporation (four months), rather than
the deferral period of B's taxable year that is being changed (zero
months). Thus, if otherwise qualified, B may make a section 444 election
to change to a taxable year ending September 30, October 31, or November
30, for its taxable year beginning January 1, 1987.
Example 4. The facts are the same as in Example 3, except that B
files a calendar year income tax return for 1987 rather than making a
section 444 election. However, for its taxable year beginning January 1,
1988, B desires to change its taxable year by making a section 444
election. Given that the special rule provided in paragraph (b)(2)(ii)
of this section applies to section 444 elections made in taxable years
beginning before 1989, B may, if otherwise qualified, make a section 444
election to change to a taxable year ending September 30, October 31, or
November 30 for its taxable year beginning January 1, 1988.
Example 5. C, a corporation that historically used a June 30 taxable
year, elected on December 15, 1986 to be an S corporation for its
taxable year beginning July 1, 1987. As a condition to having the S
election accepted, C agreed on Form 2553 to use a calendar year.
Although pursuant to paragraph (b)(3) of this section, C would, if
otherwise qualified, be allowed to retain its June 30 taxable year, C
desires to change to a September 30 taxable year by making a section 444
election. Pursuant to paragraph (b)(2) of this section, a taxpayer may,
if otherwise qualified, make a section 444 election to change to a
taxable year only if the deferral period of the taxable year to be
elected is not longer than the shorter of three months or the deferral
period of the taxable year being changed. Given these facts, the
deferral period of the taxable year to be elected is 3 months (September
30 to December 31) while the deferral period of the taxable year being
changed is 6 months (June 30 to December 31). Thus, C may, if otherwise
qualified, change to a September 30 taxable year for its taxable year
beginning July 1, 1987, by making a section 444 election. The fact that
C agreed on Form 2553 to use a calendar year is not relevant.
Example 6. D, a corporation that historically used a March 31
taxable year, elects on June 1, 1988 to be an S corporation for its
taxable year beginning April 1, 1988. D desires to change to a June 30
taxable year by making a section 444 election for its taxable year
beginning April 1, 1988. Pursuant to paragraph (b)(2)(i) of this
section, D may not change to a June 30 taxable year because such year
would have a deferral period greater than 3 months. However, if
otherwise qualified, D may make a section 444 election to change to a
taxable year ending September 30, October 31, or November 30 for its
taxable year beginning April 1, 1988.
Example 7. E, a corporation that began operations on November 1,
1986, elected to be an S corporation on December 15, 1986, for its
taxable year beginning November 1, 1986. E filed a short period income
tax return for the period November 1 to December 31, 1986. E desires to
change to a September 30 taxable year by making a section 444 election
for its taxable year beginning January 1, 1987. Although E elected to be
an S corporation after September 18, 1986, and before January 1, 1988,
paragraph (b)(2)(ii) of this section does not apply to E since E was not
a C corporation prior to electing S status. Thus, E may not change its
taxable year for the taxable year beginning January 1, 1987, by making a
section 444 election.
Example 8. The facts are the same as in Example 7, except that E
began operations on April 15, 1987, and elected to be an S corporation
on June 1, 1987, for its taxable year beginning April 15, 1987. As a
condition to being an S corporation, E agreed on Form 2553 to use a
calendar year. E desires to make a section 444 election to use a year
ending September 30 for its taxable year beginning April 15, 1987.
Pursuant to paragraph (b)(5)(i) of this section, E's agreement to use a
calendar year on Form 2553 does not mean that E has adopted a calendar
year. Thus, E's desire to make a section 444 election to use a
[[Page 36]]
September 30 taxable year will not be considered a change in taxable
year and thus paragraph (b)(2) of this section will not apply. Instead,
E will be subject to paragraph (b)(1) of this section. Since a September
30 taxable year would result in only a three-month deferral period
(September 30 to December 31), E may, if otherwise qualified, make a
section 444 election to use a year ending September 30 for its taxable
year beginning April 15, 1987.
(2) Special rule for entities retaining their 1986 taxable year. The
following examples illustrate the provisions of paragraph (b)(3) of this
section.
Example 1. F, an S corporation that elected to be an S corporation
several years ago, has historically used a June 30 taxable year. F
desires to retain its June 30 taxable year by making a section 444
election for its taxable year beginning July 1, 1987. Pursuant to
paragraph (b)(4)(i) of this section, the deferral period of the taxable
year being retained is 6 months (June 30 to December 31, F's required
taxable year). Absent the special rule provided in paragraph (b)(3) of
this section, F would be subject to the general rule provided in
paragraph (b)(1) of this section which limits the deferral period of the
taxable year elected to three months or less. However, pursuant to
paragraph (b)(3) of this section, F may, if otherwise qualified, make a
section 444 election to retain its year ending June 30 for its taxable
year beginning July 1, 1987.
Example 2. The facts are the same as in Example 1, except that F
received permission from the Commissioner to change its taxable year to
the calendar year, and filed a short period income tax return for the
period July 1 to December 31, 1986. F desires to make a section 444
election to use a year ending June 30 for its taxable year beginning
January 1, 1987. Given that F had a December 31 taxable year for its
last taxable year beginning in 1986, the special rule provided in
paragraph (b)(3) of this section does not allow F to use a June 30
taxable year for its taxable year beginning January 1, 1987.
Furthermore, pursuant to paragraph (b)(2)(i) of this section, F is not
allowed to change its taxable year from December 31 to June 30 because
the deferral period of the taxable year being changed is zero months.
Example 3. G, a corporation that historically used an August 31
taxable year, elected be an S corporation on November 15, 1986, for its
taxable year beginning September 1, 1986. As a condition to obtaining S
status, G agreed to use a calendar year. Thus, G filed its first S
corporation return for the period September 1 to December 31, 1986. G
desires to make a section 444 election to use a year ending August 31
for its taxable year beginning January 1, 1987. Since G's last taxable
year beginning in 1986 was a calendar year, G cannot use paragraph
(b)(3) of this section, relating to retentions of taxable years, to
elect an August 31 taxable year. Thus, G is subject to paragraph
(b)(2)(i) of this section, relating to changes in taxable year. Although
G, if otherwise qualified, may use the special rule provided in
paragraph (b)(2)(ii) of this section, G may only change from its current
taxable year (i.e., the calendar year) to a taxable year that has no
more than a three-month deferral period (i.e., September 30, October 31,
or November 30).
Example 4. The facts are the same as in Example 3, except that G
elected to be an S corporation for its taxable year beginning September
1, 1987, rather than its taxable year beginning September 1, 1986. As a
condition to making its S election, G agreed, on Form 2553, to use the
calendar year. However, G has not yet filed a short period income tax
return for the period September 1 to December 31, 1987. Given these
facts, paragraph (b)(3) of this section would allow G, if otherwise
qualified, to make a section 444 election to retain an August 31 taxable
year for its taxable year beginning September 1, 1987.
Example 5. The facts are the same as in Example 4, except that G has
already filed a short period income tax return for the period September
1 to December 31, 1987. Pursuant to paragraph (b)(5)(ii)(A) of this
section, G may supersede the return it filed for the period September 1
to December 31, 1987. Thus, pursuant to paragraph (b)(3) of this
section, G may, if otherwise qualified, make a section 444 election to
retain an August 31 taxable year for the taxable year beginning
September 1, 1987. In addition, G should follow the special procedures
set forth in paragraph (b)(5)(ii)(B) of this section.
Example 6. H, a corporation that historically used a May 31 taxable
year, elects to be an S corporation on June 15, 1988 for its taxable
year beginning June 1, 1988. H desires to make a section 444 election to
use a taxable year other than the calendar year. Since the taxable year
in issue is not H's first taxable year beginning after December 31,
1986, H may not use the special rule provided in paragraph (b)(3)(i) and
thus may not retain its May 31 year. However, H may, if otherwise
qualified, make a section 444 election under paragraph (b)(2)(i) of this
section, to change to a taxable year that has no more than a three-month
deferral period (i.e., September 30, October 31, or November 30) for its
taxable year beginning June 1, 1988.
Example 7. I is a partnership that has historically used a calendar
year. Sixty percent of the profits and capital of I are owned by Q, a
corporation (that is neither an S corporation nor a personal service
corporation) that has a June 30 taxable year, and 40 percent of the
profits and capital are owned by
[[Page 37]]
R, a calendar year individual. Since the partner that has more than a
fifty percent interest in I has a June 30 taxable year, I's required
taxable year is June 30. Accordingly, I filed an income tax return for
the period January 1 to June 30, 1987. Based on these facts, I may,
pursuant to paragraph (b)(5)(ii)(A) of this section, disregard the
income tax return filed for the period January 1 to June 30, 1987. Thus,
if otherwise qualified, I may make a section 444 election under
paragraph (b)(2)(i) of this section to use a calendar year for its
taxable year beginning January 1, 1987. If I makes such a section 444
election, I should follow the special procedures set forth in paragraph
(b)(5)(ii)(B) of this section.
[T.D. 8205, 53 FR 19694, May 27, 1988, as amended by T.D. 8996, 67 FR
35012, May 17, 2002]
Sec. 1.444-2T Tiered structure (temporary).
(a) General rule. Except as provided in paragraph (e) of this
section, no section 444 election shall be made or continued with respect
to a partnership, S corporation, or personal service corporation that is
a member of a tiered structure on the date specified in paragraph (d) of
this section. For purposes of this section, the term ``personal service
corporation'' means a personal service corporation as defined in Sec.
1.441-3(c).
(b) Definition of a member of a tiered structure--(1) In general. A
partnership, S corporation, or personal service corporation is
considered a member of a tiered structure if--
(i) The partnership, S corporation, or personal service corporation
directly owns any portion of a deferral entity, or
(ii) A deferral entity directly owns any portion of the partnership,
S corporation, or personal service corporation.
However, see paragraph (c) of this section for certain de minimis rules,
and see paragraph (b)(3) of this section for an anti-abuse rule. In
addition, for purposes of this section, a beneficiary of a trust shall
be considered to own an interest in the trust.
(2) Deferral entity--(i) In general. For purposes of this section,
the term ``deferral entity'' means an entity that is a partnership, S
corporation, personal service corporation, or trust. In the case of an
affiliated group of corporations filing a consolidated income tax return
that is treated as a personal service corporation pursuant to Sec.
1.441-4T (i), such affiliated group is considered to be a single
deferral entity.
(ii) Grantor trusts. The term ``deferral entity'' does not include a
trust (or a portion of a trust) which is treated as owned by the grantor
or beneficiary under Subpart E, part I, subchapter J, chapter 1, of the
Code (relating to grantor trusts), including a trust that is treated as
a grantor trust pursuant to section 1361(d)(1)(A) of the Code (relating
to qualified subchapter S trusts). Thus, any taxpayer treated under
subpart E as owning a portion of a trust shall be treated as owning the
assets of the trust attributable to that ownership. The following
examples illustrate the provisions of this paragraph (b)(2)(ii).
Example 1. A, an individual, is the sole beneficiary of T. T is a
trust that owns 50 percent of the profits and capital of X, a
partnership that desires to make a section 444 election. Furthermore,
pursuant to Subpart E, Part I, subchapter J, chapter 1 of the Code, A is
treated as an owner of X. Based upon these facts, T is not a deferral
entity and 50 percent of X is considered to be directly owned by A.
Example 2. The facts are the same as in Example 1, except that A is
a personal service corporation rather than an individual. Given these
facts, 50 percent of X is considered to be directly owned by A, a
deferral entity. Thus, X is considered to be a member of a tiered
structure.
(3) Anti-abuse rule. Notwithstanding paragraph (b)(1) of this
section, a partnership, S corporation, or personal service corporation
is considered a member of a tiered structure if the partnership, S
corporation, personal service corporation, or related taxpayers have
organized or reorganized their ownership structure or operations for the
principal purpose of obtaining a significant unintended tax benefit from
making or continuing a section 444 election. For purposes of the
preceding sentence, a significant unintended tax benefit results when a
partnership, S corporation, or personal service corporation makes a
section 444 election and, as a result, a taxpayer (not limited to the
entity making the election) obtains a significant deferral of income
[[Page 38]]
substantially all of which is not eliminated by a required payment under
section 7519. See examples (15) through (19) in paragraph (f) of this
section.
(c) De minimis rules--(1) In general. For rules relating to a de
minimis exception to paragraph (b)(1)(i) of this section (the
``downstream de minimis rule''), see paragraph (c)(2) of this section.
For rules relating to a de minimis exception to paragraph (b)(1)(ii) of
this section (the ``upstream de minimis rule''), see paragraph (c)(3) of
this section. For rules relating to the interaction of the de minimis
rules provided in this paragraph (c) and the ``same taxable year
exception'' provided in paragraph (e) of this section, see paragraph
(e)(5) of this section.
(2) Downstream de minimis rule--(i) General rule. If a partnership,
S corporation, or personal service corporation directly owns any portion
of one or more deferral entities as of the date specified in paragraph
(d) of this section, such ownership is disregarded for purposes of
paragraph (b)(1)(i) of this section if, in the aggregate, all such
deferral entities accounted for--
(A) Not more than 5 percent of the partnership's, S corporation's,
or personal service corporation's adjusted taxable income for the
testing period (``5 percent adjusted taxable income test''), or
(B) Not more than 2 percent of the partnership's, S corporation's,
or personal service corporation's gross income for the testing period
(``2 percent gross income test''). See section 702 (c) for rules
relating to the determination of gross income of a partner in a
partnership.
See examples (3) through (5) in paragraph (f) of this section.
(ii) Definition of testing period. For purposes of this paragraph
(c)(2), the term ``testing period'' means the taxable year that ends
immediately prior to the taxable year for which the partnership, S
corporation, or personal service corporation desires to make or continue
a section 444 election. However, see the special rules provided in
paragraph (c)(2)(iv) of this section for certain special cases (e.g.,
the partnership, S corporation, personal service corporation or deferral
entity was not in existence during the entire testing period). The
following example illustrates the application of this paragraph
(c)(2)(ii).
Example. A partnership desires to make a section 444 election for
its taxable year beginning November 1, 1987. The testing period for
purposes of determining whether deferral entities owned by such
partnership are de minimis under paragraph (c)(2) of this section is the
taxable year ending October 31, 1987. If either the partnership or the
deferral entities were not in existence for the entire taxable year
ending October 1, 1987, see the special rules provided in paragraph
(c)(2)(iv) of this section.
(iii) Definition of adjusted taxable income--(A) Partnership. In the
case of a partnership, adjusted taxable income for purposes of paragraph
(c)(2) of this section is an amount equal to the sum of the--
(1) Aggregate amount of the partnership items described in section
702(a) (other than credits and tax-exempt income),
(2) Applicable payments defined in section 7519(d)(3) that are
deducted in determining the amount described in paragraph
(c)(2)(iii)(A)(1) of this section, and
(3) Guaranteed payments defined in section 707(c) that are deducted
in determining the amount described in paragraph (c)(2)(iii)(A)(1) of
this section and are not otherwise included in paragraph
(c)(2)(iii)(A)(2) of this section. For purposes of determining the
aggregate amount of partnership items under paragraph (c)(2)(iii)(A)(1)
of this section, deductions and losses are treated as negative income.
Thus, for example, if under section 702(a) a partnership has $1,000 of
ordinary taxable income, $500 of specially allocated deductions, and
$300 of capital loss, the partnership's aggregate amount of partnership
items under paragraph (c)(2)(iii)(A)(1) of this section is $200 ($1,000-
$500-$300).
(B) S corporation. In the case of an S corporation, adjusted taxable
income for purposes of paragraph (c)(2) of this section is an amount
equal to the sum of the--
(1) Aggregate amount of the S corporation items described in section
1366(a) (other than credits and tax-exempt income), and
(2) Applicable payments defined in section 7519(d)(3) that are
deducted in
[[Page 39]]
determining the amount described in paragraph (c)(2)(iii)(B)(1) of this
section.
For purposes of determining the aggregate amount of S corporation items
under paragraph (c)(2)(iii)(B)(1) of this section, deductions and losses
are treated as negative income. Thus, for example, if under section
1366(a) an S corporation has $2,000 of ordinary taxable income, $1,000
of deductions described in section 1366(a)(1)(A) of the Code, and $500
of capital loss, the S corporation's aggregate amount of S corporation
items under paragraph (c)(2)(iii)(B)(1) of this section is $500 ($2,000-
$1,000-$500).
(C) Personal service corporation. In the case of a personal service
corporation, adjusted taxable income for purposes of paragraph (c)(2) of
this section is an amount equal to the sum of the--
(1) Taxable income of the personal service corporation, and
(2) Applicable amounts defined in section 280H(f)(1) that are
deducted in determining the amount described in paragraph
(c)(2)(iii)(C)(1) of this section.
(iv) Special rules--(A) Pro-forma rule. Except as provided in
paragraph (c)(iv)(C)(2) of this section, if a partnership, S
corporation, or personal service corporation directly owns any interest
in a deferral entity as of the date specified in paragraph (d) of this
section and such ownership interest is different in amount from the
partnership's, S corporation's, or personal service corporation's
interest on any day during the testing period, the 5 percent adjusted
taxable income test and the 2 percent gross income test must be applied
on a pro-forma basis (i.e., adjusted taxable income and gross income
must be calculated for the testing period assuming that the partnership,
S corporation, or personal service corporation owned the same interest
in the deferral entity that it owned as of the date specified in
paragraph (d) of this section). The following example illustrates the
application of this paragraph (c)(2)(iv)(A).
Example. A personal service corporation desiring to make a section
444 election for its taxable year beginning October 1, 1987, acquires a
25 percent ownership interest in a partnership on or after October 1,
1987. Furthermore, the partnership has been in existence for several
years. The personal service corporation must modify its calculations of
the 5 percent adjusted taxable income test and the 2 percent gross
income test for the testing period ended September 30, 1987, by assuming
that the personal service corporation owned 25 percent of the
partnership during such testing period and the personal service
corporation's adjusted taxable income and gross income were
correspondingly adjusted.
(B) Reasonable estimates allowed. If the information necessary to
complete the pro-forma calculation described in paragraph (c)(2)(iv)(A)
of this section is not readily available, the partnership, S
corporation, or personal service corporation may make a reasonable
estimate of such information.
(C) Newly formed entities--(1) Newly formed deferral entities. If a
partnership, S corporation, or personal service corporation owns any
portion of a deferral entity on the date specified in paragraph (d) of
this section and such deferral entity was not in existence during the
entire testing period (hereinafter referred to as a ``newly formed
deferral entity''), both the 5 percent adjusted taxable income test and
the 2 percent gross income test are modified as follows. First, the
partnership, S corporation, or personal service corporation shall
calculate the percentage of its adjusted taxable income or gross income
that is attributable to deferral entities, excluding newly formed
deferral entities. Second, the partnership, S corporation, or personal
service corporation shall calculate (on the date specified in paragraph
(d) of this section) the percentage of the tax basis of its assets that
are attributable to its tax basis with respect to its ownership
interests in all newly formed deferral entities. If the sum of the two
percentages is 5 percent or less, the deferral entities are considered
de minimis and are disregarded for purposes of paragraph (b)(1)(i) of
this section. If the sum of the two percentages is greater than 5
percent, the deferral entities do not qualify for the de minimis rule
provided in paragraph (c)(2) of this section and thus the partnership, S
corporation, or personal service corporation is considered to be a
member of a tiered structure for purposes of this section.
(2) Newly formed partnership, S corporation, or personal service
corporation
[[Page 40]]
desiring to make a section 444 election. If a partnership, S
corporation, or personal service corporation desires to make a section
444 election for the first taxable year of its existence, the 5 percent
adjusted taxable income test and the 2 percent gross income test are
replaced by a 5 percent of assets test. Thus, if on the date specified
in paragraph (d) of this section, 5 percent or less of the assets
(measured by reference to the tax basis of the assets) of the newly
formed partnership, S corporation, or personal service corporation are
attributable to the tax basis with respect to its ownership interests in
the deferral entities, the deferral entities will be considered de
minimis and will be disregarded for purposes of paragraph (b)(1)(i) of
this section.
(3) Upstream de minimis rule. If a partnership, S corporation, or
personal service corporation is directly owned by one or more deferral
entities as of the date specified in paragraph (d) of this section, such
ownership is disregarded for purposes of paragraph (b)(1)(ii) of this
section if on the date specified in paragraph (d) of this section the
deferral entities directly own, in the aggregate, 5 percent or less of--
(i) An interest in the current profits of the partnership, or
(ii) The stock (measured by value) of the S corporation or personal
service corporation.
See examples (6) and (7) in paragraph (f) of this section.
(d) Date for determining the existence of a tiered structure--(1)
General rule. For purposes of paragraph (a) of this section, a
partnership, S corporation, or personal service corporation will be
considered a member of a tiered structure for a particular taxable year
if the partnership, S corporation, or personal service corporation is a
member of a tiered structure on the last day of the required taxable
year (as defined in section 444 (e) of the Code) ending within such
year. If a particular taxable year does not include the last day of the
required taxable year for such year, the partnership, S corporation, or
personal service corporation will not be considered a member of a tiered
structure for such year. The following examples illustrate the
application of this paragraph (d)(1).
Example 1. Assume that a newly formed partnership whose first
taxable year begins November 1, 1988, desires to adopt a September 30
taxable year by making a section 444 election. Furthermore, assume that
for its taxable year beginning November 1, 1988, the partnership's
required taxable year is December 31. If the partnership is a member of
a tiered structure on December 31, 1988, it will not be eligible to make
a section 444 election for a taxable year beginning November 1, 1988,
and ending September 30, 1989.
Example 2. Assume an S corporation that historically used a June 30
taxable year desires to make a section 444 election to change to a year
ending September 30 for its taxable year beginning July 1, 1987. If the
S corporation can make the section 444 election, it will have a short
taxable year beginning July 1, 1987, and ending September 30, 1987.
Given these facts, the short taxable year beginning July 1, 1987, does
not include the last day of the S corporation's required taxable year
for such year (i.e., December 31, 1987). Thus, pursuant to paragraph
(d)(1) of this section, the S corporation will not be considered a
member of a tiered structure for its taxable year beginning July 1,
1987, and ending September 30, 1987.
(2) Special rule for taxable years beginning in 1987. For purposes
of paragraph (a) of this section, a partnership, S corporation, or
personal service corporation will not be considered a member of a tiered
structure for a taxable year beginning in 1987 if the partnership, S
corporation, or personal service corporation is not a member of a tiered
structure on the day the partnership, S corporation, or personal service
corporation timely files its section 444 election for such year. The
following examples illustrate the application of this paragraph (d)(2).
Example 1. Assume that a partnership desires to retain a June 30
taxable year by making a section 444 election for its taxable year
beginning July 1, 1987. Furthermore, assume that the partnership's
required taxable year for such year is December 31 and that the
partnership was a member of a tiered structure on such date. Also assume
that the partnership was not a member of a tiered structure as of the
date it timely filed its section 444 election for its taxable year
beginning July 1, 1987. Based upon the special rule provided in this
paragraph (d)(2), the partnership will not be considered a member of a
tiered structure for its taxable year beginning July 1, 1987.
Example 2. Assume the same facts as in Example 1, except that the
partnership was a member of a tiered structure on the date it filed its
section 444 election for its taxable
[[Page 41]]
year beginning July 1, 1987, but was not a member of a tiered structure
on December 31, 1987. Paragraph (d)(1) of this section would still apply
and thus the partnership would not be considered part of a tiered
structure for its taxable year beginning July 1, 1987. However, the
partnership would be considered a member of a tiered structure for its
taxable year beginning July 1, 1988, if the partnership was a member of
a tiered structure on December 31, 1988.
(e) Same taxable year exception--(1) In general. Although a
partnership or S corporation is a member of a tiered structure as of the
date specified in paragraph (d) of this section, the partnership, S
corporation may make or continue a section 444 election if the tiered
structure (as defined in paragraph (e)(2) of this section) consists
entirely of partnerships or S corporations (or both), all of which have
the same taxable year as determined under paragraph (e)(3) of this
section. However, see paragraph (e)(5) of this section for the
interaction of the de minimis rules provided in paragraph (c) of this
section with the same taxable year exception. For purposes of this
paragraph (e), two or more entities are considered to have the same
taxable year if their taxable years end on the same day, even though
they begin on different days. See examples (8) through (14) in paragraph
(f) of this section.
(2) Definition of tiered structure--(i) General rule. For purposes
of the same taxable year exception, the members of a tiered structure
are defined to include the following entities--
(A) The partnership or S corporation that desires to qualify for the
same taxable year exception,
(B) A deferral entity (or entities) directly owned (in whole or in
part) by the partnership or S corporation that desires to qualify for
the same taxable year exception,
(C) A deferral entity (or entities) directly owning any portion of
the partnership or S corporation that desires to qualify for the same
taxable year exception, and
(D) A deferral entity (or entities) directly owned (in whole or in
part) by a ``downstream controlled partnership,'' as defined in
paragraph (e)(2)(ii) of this section.
(ii) Special flow-through rule for downstream controlled
partnerships. If more than 50 percent of a partnership's profits and
capital are owned by a partnership or S corporation that desires to
qualify for the same taxable year exception, such owned partnership is
considered a downstream controlled partnership for purposes of paragraph
(e)(2)(i) of this section. Furthermore, if more than 50 percent of a
partnership's profits and capital are owned by a downstream controlled
partnership, such owned partnership is considered a downstream
controlled partnership for purposes of paragraph (e)(2)(i) of this
section.
(3) Determining the taxable year of a partnership or S corporation.
The taxable year of a partnership or S corporation to be taken into
account for purposes of paragraph (e)(1) of this section is the taxable
year ending with or prior to the date specified in paragraph (d) of this
section. Furthermore, the determination of such taxable year will take
into consideration any section 444 elections made by the partnership or
S corporation. See examples (10) and (11) in paragraph (f) of this
section.
(4) Special rule for 52-53-week taxable years. For purposes of this
paragraph (e), a 52-53-week taxable year with reference to the end of a
particular month will be considered to be the same as a taxable year
ending with reference to the last day of such month.
(5) Interaction with de minimis rules--(i) Downstream de minimis
rule--(A) In general. If a partnership or S corporation that desires to
make or continue a section 444 election is a member of a tiered
structure (as defined in paragraph (e)(2) of this section) and directly
owns any member (or members) of the tiered structure with a taxable year
different from the taxable year of the partnership or S corporation,
such ownership is disregarded for purposes of the same taxable year
exception of paragraph (e)(1) of this section provided that, in the
aggregate, the de minimis rule of paragraph (c)(2) of this section is
satisfied with respect to such owned member (or members). The following
example illustrates the application of this paragraph (e)(5)(i)(A).
Example. P, a partnership with a June 30 taxable year, owns 60
percent of P1, another partnership with a June 30 taxable year. P also
owns 1 percent of P2 and P3, calendar
[[Page 42]]
year partnerships. If, in the aggregate, P's ownership interests in P2
and P3 are considered de minimis under paragraph (c)(2) of this section,
P meets the same taxable year exception and may make a section 444
election to retain its June 30 taxable year.
(B) Special rule for members of a tiered structure directly owned by
a downstream controlled partnership. For purposes of paragraph
(e)(5)(i)(A) of this section, a partnership or S corporation desiring to
make or continue a section 444 election is considered to directly own
any member of the tiered structure (as defined in paragraph (e)(2) of
this section) directly owned by a downstream controlled partnership (as
defined in paragraph (e)(2)(ii) of this section). The adjusted taxable
income or gross income of the partnership or S corporation that is
attributable to a member of a tiered structure directly owned by a
downstream controlled partnership equals the adjusted taxable income or
gross income of such member multiplied by the partnership's or S
corporation's indirect ownership percentage of such member. The
following example illustrates the application of this paragraph
(e)(5)(i)(B).
Example. P, a partnership, desires to retain its June 30 taxable
year by making a section 444 election. However, as of the date specified
in paragraph (d) of this section, P owns 75 percent of P1, a June 30
partnership, and P1 owns 40 percent of P2, a calendar year partnership.
P also owns 25 percent of P3, a calendar year partnership. Pursuant to
paragraphs (e)(5)(i) (A) and (B) of this section, P may only qualify to
use the same taxable year exception if, in the aggregate, P2 and P3 are
de minimis with respect to P. Pursuant to paragraph (e)(5)(i)(B) of this
section, P's adjusted taxable income or gross income attributable to P2
equals 30 percent (75 percent times 40 percent) of P2's adjusted taxable
income or gross income.
(ii) Upstream de minimis rule. If a partnership or S corporation
that desires to make or continue a section 444 election is a member of a
tiered structure (as defined in paragraph (e)(2) of this section) and is
owned directly by a member (or members) of the tiered structure with
taxable years different from the taxable year of the partnership or S
corporation, such ownership is disregarded for purposes of the same
taxable year exception of paragraph (e)(1) of this section provided
that, in the aggregate, the de minimis rule of paragraph (c)(3) of this
section is satisfied with respect to such owning member (or members).
See Example 12 of paragraph (f) of this section.
(f) Examples. The provisions of this section may be illustrated by
the following examples.
Example 1. A, a partnership, desires to make or continue a section
444 election. However, on the date specified in paragraph (d) of this
section, A is owned by a combination of individuals and S corporations.
The S corporations are deferral entities, as defined in paragraph (b)(2)
of this section. Thus, pursuant to paragraph (b)(1)(ii) of this section,
A will be a member of a tiered structure unless under paragraph (c)(3)
of this section, the S corporations, in the aggregate, own a de minimis
portion of A. If the S corporations' ownership in A is not considered de
minimis under paragraph (c)(3) of this section, A is a member of a
tiered structure and will be allowed to make or continue a section 444
election only if it meets the same taxable year exception provided in
paragraph (e) of this section.
Example 2. B, a partnership, desires to make or continue a section
444 election. However, on the date specified in paragraph (d) of this
section, B is a partner in two partnerships, B1 and B2. B1 and B2 are
deferral entities, as defined in paragraph (b)(2) of this section. Thus,
under paragraph (b)(1)(i) of this section, B will be a member of a
tiered structure unless B's aggregate ownership interests in B1 and B2
are considered de minimis under paragraph (c)(2) of this section. If B
is a member of a tiered structure on the date specified in paragraph (d)
of this section, B will be allowed to make or continue a section 444
election only if it meets the same taxable year exception provided in
paragraph (e) of this section.
Example 3. C, a partnership with a September 30 taxable year, is 100
percent owned by calendar year individuals. C desires to make a section
444 election for its taxable year beginning October 1, 1987. However, on
the date specified in paragraph (d) of this section, C owns a 1 percent
interest in C1, a partnership. C does not own any other interest in a
deferral entity. For the taxable year ended September 30, 1987, 10
percent of C's adjusted taxable income (as defined in paragraph
(c)(2)(iii) of this section) was attributable to C's partnership
interest in C1. Furthermore, 4 percent of C's gross income for the
taxable year ended September 30, 1987, was attributable to C's
partnership interest in C1. Under paragraph (c)(2) of this section, C's
partnership interest in C1 is not de minimis because during the testing
period more than 5 percent of C's adjusted taxable income is
attributable to C1 and more than 2 percent
[[Page 43]]
of C's gross income is attributable to C1. Thus, C is a member of a
tiered structure for its taxable year beginning October 1, 1987.
Example 4. The facts are the same as Example 3, except that for the
taxable year ended September 30, 1987, only 2 percent of C's adjusted
taxable income was attributable to C1. Under paragraph (c)(2) of this
section, C's partnership interest in C1 is considered de minimis for
purposes of determining whether C is a member of a tiered structure
because not more than 5 percent of C's adjusted taxable income during
the testing period is attributable to C1. Thus, C is not a member of a
tiered structure for its taxable year beginning October 1, 1987.
Example 5. The facts are the same as Example 4, except that in
addition to owning C1, C also owns 15 percent of C2, another
partnership. For the taxable year ended September 30, 1987, 2 percent of
C's adjusted taxable income is attributable to C1 and an additional 4
percent is attributable to C2. Furthermore, for the taxable year ended
September 30, 1987, 4 percent of C's gross income is attributable to C1
while 3 percent is attributable to C2. Under paragraph (c)(2) of this
section, C1 and C2 must be aggregated for purposes of determining
whether C meets either the 5 percent adjusted taxable income test or the
2 percent gross income test. Since C's adjusted taxable income
attributable to C1 and C2 is 6 percent (2 percent + 4 percent) and C's
gross income attributable to C1 and C2 is 7 percent (4 percent + 3
percent), C does not meet the downstream de minimis rule provided in
paragraph (c)(2) of this section. Thus, C is a member of a tiered
structure for its taxable year beginning October 1, 1987.
Example 6. The facts are the same as Example 3, except that instead
of determining whether C is part of a tiered structure, the issue is
whether C1 is part of a tiered structure. In addition, assume that on
the date specified in paragraph (d) of this section, the remaining 99
percent of C1 is owned by calendar year individuals and C1 does not own
an interest in any deferral entity. Although C in Example 3 was
considered to be a part of a tiered structure by virtue of its ownership
interest in C1, C1 must be tested separately to determine whether it is
part of a tiered structure. Since C's interest in C1 is 5 percent or
less, C's interest in C1 is de minimis with respect to C1. See paragraph
(c)(3) of this section. Thus, based upon these facts, C1 is not part of
a tiered structure.
Example 7. The facts are the same as Example 6, except that the
remaining 99 percent of C1 is owned 94 percent by calendar year
individuals and 5 percent by C3, another partnership. Thus, deferral
entities own 6 percent of C1 (1 percent owned by C and 5 percent owned
by C3). Under paragraph (c)(3) of this section, deferral entities own
more than a de minimis interest (i.e., 5 percent) of C1, and thus C1 is
part of a tiered structure.
Example 8. D, a partnership with a September 30 taxable year,
desires to make a section 444 election for its taxable year beginning
October 1, 1987. On December 31, 1987, and the date D plans to file its
section 444 election, D is 10 percent owned by D1, a personal service
corporation with a September 30 taxable year, and 90 percent owned by
calendar year individuals. Furthermore, D1 will retain its September 30
taxable year because it previously established a business purpose for
such year. Since D is owned in part by D1, a personal service
corporation, and the ownership interest is not de minimis under
paragraph (c)(3) of this section, D is considered a member of a tiered
structure for its taxable year beginning October 1, 1987. Furthermore,
although D and D1 have the same taxable year, D does not qualify for the
same taxable year exception provided in paragraph (e) of this section
because D1 is a personal service corporation rather than a partnership
or S corporation. Thus, pursuant to paragraph (a) of this section, D may
not make a section 444 election for its taxable year beginning October
1, 1987.
Example 9. The facts are the same as Example 8, except that D1 is a
partnership rather than a personal service corporation. Based upon these
facts, D qualifies for the same taxable year exception provided in
paragraph (e) of this section. Thus, D may make a section 444 election
for its taxable year beginning October 1, 1987.
Example 10. The facts are the same as Example 9, except that D1 has
not established a business purpose for a September 30 taxable year. In
addition, D1 does not desire to make a section 444 election and, under
section 706(b), D1 will be required to change to a calendar year for its
taxable year beginning October 1, 1987. Pursuant to paragraph (e)(3) of
this section, D and D1 do not have the same taxable year for purposes of
the same taxable year exception provided in paragraph (e) of this
section. Thus, D may not make a section 444 election for its taxable
year beginning October 1, 1987.
Example 11. The facts are the same as Example 8, except that D1 is a
partnership with a March 31 taxable year. Furthermore, for its taxable
year beginning April 1, 1987, D1 will change to a September 30 taxable
year by making a section 444 election. Pursuant to paragraph (e)(3) of
this section, D1 is considered to have a September 30 taxable year for
purposes of determining whether D qualifies for the same taxable year
exception provided in paragraph (e) of this section. Since both D and D1
will have the same taxable year as of the date specified in paragraph
(d) of this section, D may make a section 444 election for its taxable
year beginning October 1, 1987.
Example 12. The facts are the same as Example 11, except that
instead of the remaining 90 percent of D being owned by calendar
[[Page 44]]
year individuals, it is owned 86 percent by individuals and 4 percent by
D2, a calendar year partnership. Thus, D, a September 30 partnership, is
10 percent owned by D1, a September 30 partnership, 86 percent owned by
calendar year individuals, and 4 percent owned by D2, a calendar year
partnership. Under paragraph (e)(5)(ii) of this section, D2's ownership
interest in D is considered de minimis for purposes of the same taxable
year exception. Since D2's ownership interest in D is considered de
minimis, it is disregarded for purposes of determining whether D
qualifies for the same taxable year exception provided in paragraph (e)
of this section. Thus, since both D and D1 will have the same taxable
year as of the date specified in paragraph (d) of this section, D may
make a section 444 election for its taxable year beginning October 1,
1987.
Example 13. E, a partnership with a June 30 taxable year, desires to
make a section 444 election for its taxable year beginning July 1, 1987.
On the date specified in paragraph (d) of this section, E is 100 percent
owned by calendar year individuals; E owns 99 percent of the profits and
capital of E1, a partnership with a June 30 taxable year; and E1 owns 30
percent of the profits and capital of E2, a partnership with a September
30 taxable year. E owns no other deferral entities. Pursuant to
paragraph (b)(1)(i) of this section, E is considered to be a member of a
tiered structure. Furthermore, pursuant to paragraph (e) of this
section, E does not qualify for the same taxable year exception because
E2 does not have the same taxable year as E and E1.
Example 14. The facts are the same as Example 13, except that E owns
only 49 percent (rather than 99 percent) of the profits and capital of
E1. Pursuant to paragraph (e) of this section, E qualifies for the same
taxable year exception because E and E1 have the same taxable year.
Pursuant to paragraph (e) of this section, E1's ownership interest in E2
is disregarded since E does not own more than 50 percent of E1's profits
and capital.
Example 15. Prior to consideration of the anti-abuse rule provided
in paragraph (b)(3) of this section, H, a partnership that commenced
operations on October 1, 1987, is eligible to make a section 444
election for its taxable year beginning October 1, 1987. Although H may
obtain a significant deferral of income substantially all of which is
not eliminated by a required payment under section 7519 (since there
will be no required payment for H's first taxable year), the anti-abuse
rule of paragraph (b)(3) will not apply unless the principal purpose of
organizing H was the attainment of a significant deferral of income that
would result from making a section 444 election.
Example 16. F, a partnership with a January 31 taxable year, desires
to make a section 444 election to retain its January 31 taxable year for
the taxable year beginning February 1, 1987. F is 100 percent owned by
calendar year individuals. Prior to the date specified in paragraph (d)
of this section, F contributes substantially all of its assets to F1, a
partnership, in exchange for a 51 percent interest in F1. The remaining
49 percent of F1 is owned by the calendar year individuals owning 100
percent of F. If F is allowed to make a section 444 election to retain
its January 31 taxable year, F1's required taxable year will be January
31 since a majority of F1's partners use a January 31 taxable year (see
Sec. 1.706-3T). F's principal purpose for creating F1 and contributing
its assets to F1 is to obtain an 11-month deferral on 49 percent of the
income previously earned by F and now earned by F1. Pursuant to
paragraph (b)(3) of this section, F is not allowed to make a section 444
election for its taxable year beginning February 1, 1987.
Example 17. The facts are the same as in Example 16, except that F
does not create F1 and contribute its assets to F1 until immediately
after F makes its section 444 election for the taxable year beginning
February 1, 1987. Thus, F is allowed to make a section 444 election for
its taxable year beginning February 1, 1987. However, pursuant to
paragraph (b)(3) of this section, F will have its section 444 election
terminated for subsequent years unless the tax deferral inherent in the
structure is eliminated (e.g., F1 is liquidated or the individual owners
of F contribute their interests in F1 to F) prior to the date specified
in paragraph (d) of this section for subsequent taxable years beginning
on or after February 1, 1988.
Example 18. The facts are the same as in Example 16, except that F1
is 99 percent owned by F and none of the individual owners of F own any
portion of F1. Furthermore, F obtained no tax benefit from creating and
contributing assets to F1. Given these facts paragraph (b)(3) of this
section does not apply and thus, F may make a section 444 election for
its taxable year beginning February 1, 1987.
Example 19. G, a partnership with an October 31 taxable year,
desires to retain its October 31 taxable year for its taxable year
beginning November 1, 1987. However, as of December 31, 1987, G owns a
30 percent interest in G1, a calendar year partnership. G owns no other
deferral entity, and G is 100 percent owned by calendar year
individuals. Furthermore, G's interest in G1 does not meet the de
minimis rule provided in paragraph (c)(3) of this section. Thus, in
order to avoid being a tiered structure, G sells its interest in G1 to
an unrelated third party prior to the date G timely makes it section 444
election for its taxable year beginning November 1, 1987. Although the
sale of G1 allows G to qualify to make a section 444 election, and
therefore to obtain a significant tax benefit, such benefit is not
unintended. Thus, paragraph (b)(3) of
[[Page 45]]
this section does not apply, and G may make a section 444 election for
its taxable year beginning November 1, 1987.
(g) Effective date. This section is effective for taxable years
beginning after December 31, 1986.
[T.D. 8205, 53 FR 19698, May 27, 1988, as amended by T.D. 8996, 67 FR
35012, May 17, 2002]
Sec. 1.444-3T Manner and time of making section 444 election (temporary).
(a) In general. A section 444 election shall be made in the manner
and at the time provided in this section.
(b) Manner and time of making election--(1) General rule. A section
444 election shall be made by filing a properly prepared Form 8716,
``Election to Have a Tax Year Other Than a Required Tax Year,'' with the
Service Center indicated by the instructions to Form 8716. Except as
provided in paragraphs (b) (2) and (4) of this section, Form 8716 must
be filed by the earlier of--
(i) The 15th day of the fifth month following the month that
includes the first day of the taxable year for which the election will
first be effective, or
(ii) The due date (without regard to extensions) of the income tax
return resulting from the section 444 election.
In addition, a copy of Form 8716 must be attached to Form 1065 or Form
1120 series form, whichever is applicable, for the first taxable year
for which the section 444 election is made. Form 8716 shall be signed by
any person who is authorized to sign Form 1065 or Form 1120 series form,
whichever is applicable. (See sections 6062 and 6063, relating to the
signing of returns.) The provisions of this paragraph (b)(1) may be
illustrated by the following examples.
Example 1. A, a partnership that began operations on September 10,
1988, is qualified to make a section 444 election to use a September 30
taxable year for its taxable year beginning September 10, 1988. Pursuant
to paragraph (b)(1) of this section, A must file Form 8716 by the
earlier of the 15th day of the fifth month following the month that
includes the first day of the taxable year for which the election will
first be effective (i.e., February 15, 1989) or the due date (without
regard to extensions) of the partnership's tax return for the period
September 10, 1988 to September 30, 1988 (i.e., January 15, 1989). Thus,
A must file Form 8716 by January 15, 1989.
Example 2. The facts are the same as in Example 1, except that A
began operations on October 20, 1988. Based upon these facts, A must
file Form 8716 by March 15, 1989, the 15th day of the fifth month
following the month that includes the first day of the taxable year for
which the election will first be effective.
Example 3. B is a corporation that first becomes a personal service
corporation for its taxable year beginning September 1, 1988. B
qualifies to make a section 444 election to use a September 30 taxable
year for its taxable year beginning September 1, 1988. Pursuant to this
paragraph (b)(1), B must file Form 8716 by December 15, 1988, the due
date of the income tax return for the short period September 1 to
September 30, 1988.
(2) Special extension of time for making an election. If, pursuant
to paragraph (b)(1) of this section, the due date for filing Form 8716
is prior to July 26, 1988, such date is extended to July 26, 1988. The
provisions of this paragraph (b)(2) may be illustrated by the following
examples.
Example 1. B, a partnership that historically used a June 30 taxable
year, is qualified to make a section 444 election to retain a June 30
taxable year for its taxable year beginning July 1, 1987. Absent
paragraph (b)(2) of this section, B would be required to file Form 8716
by December 15, 1987. However, pursuant to paragraph (b)(2) of this
section, B's due date for filing Form 8716 is extended to July 26, 1988.
Example 2. C, a partnership that began operations on January 20,
1988, is qualified to make a section 444 election to use a year ending
September 30 for its taxable year beginning January 20, 1988. Absent
paragraph (b)(2) of this section, C is required to file Form 8716 by
June 15, 1988 (the 15th day of the fifth month following the month that
includes the first day of the taxable year for which the election will
first be effective). However, pursuant to paragraph (b)(2) of this
section, the due date for filing Form 8716 is July 26, 1988.
(3) Corporation electing to be an S corporation--(i) In general. A
corporation electing to be an S corporation is subject to the same time
and manner rules for filing Form 8716 as any other taxpayer making a
section 444 election. Thus, a corporation electing to be an S
corporation that desires to make a section 444 election is not required
to file Form 8716 with its Form 2553, ``Election by a Small Business
Corporation.'' However, a corporation electing to be an S corporation
after September 26,
[[Page 46]]
1988, is required to state on Form 2553 its intention to--
(A) Make a section 444 election, if qualified, or
(B) Make a ``back-up section 444 election'' as described in
paragraph (b)(4) of this section.
If a corporation electing to be an S corporation fails to state either
of the above intentions, the District Director may, at his discretion,
disregard any section 444 election for such taxpayer.
(ii) Examples. The provisions of this paragraph (b)(3) may be
illustrated by the following examples.
Example 1. D is a corporation that commences operations on October
1, 1988, and elects to be an S corporation for its taxable year
beginning October 1, 1988. All of D's shareholders use the calendar year
as their taxable year. D desires to adopt a September 30 taxable year. D
does not believe it has a business purpose for a September 30 taxable
year and thus it must make a section 444 election to use such year.
Based on these facts, D must, pursuant to the instructions to Form 2553,
state on Form 2553 that, if qualified, it will make a section 444
election to adopt a year ending September 30 for its taxable year
beginning October 1, 1988. If D is qualified (i.e., D is not a member of
a tiered structure on December 31, 1988) to make a section 444 election
for its taxable year beginning October 1, 1988, D must file Form 8716 by
March 15, 1989. If D ultimately is not qualified to make a section 444
election for its taxable year beginning October 1, 1988, D's election to
be an S corporation will not be effective unless, pursuant to the
instructions to Form 2553, D made a back-up calendar year election
(i.e., an election to adopt the calendar year in the event D ultimately
is not qualified to make a section 444 election for such year).
Example 2. The facts are the same as in Example 1, except that D
believes it can establish, to the satisfaction of the Commissioner, a
business purpose for adopting a September 30 taxable year. However, D
desires to make a ``back-up section 444 election'' (see paragraph (b)(4)
of this section) in the event that the Commissioner does not grant
permission to adopt a September 30 taxable year based upon business
purpose. Based on these facts, D must, pursuant to the instructions to
Form 2553, state on Form 2553 its intention, if qualified, to make a
back-up section 444 election to adopt a September 30 taxable year. If,
by March 15, 1989, D has not received permission to adopt a September 30
taxable year and D is qualified to make a section 444 election, D must
make a back-up election in accordance with paragraph (b)(4) of this
section.
(4) Back-up section 444 election--(i) General rule. A taxpayer that
has requested (or is planning to request) permission to use a particular
taxable year based upon business purpose, may, if otherwise qualified,
file a section 444 election (referred to as a ``back-up section 444
election''). If the Commissioner subsequently denies the business
purpose request, the taxpayer will, if otherwise qualified, be required
to activate the back-up section 444 election. See examples (1) and (2)
in paragraph (b)(4)(iv) of this section.
(ii) Procedures for making a back-up section 444 election. In
addition to following the general rules provided in this section, a
taxpayer making a back-up section 444 election should, in order to allow
the Service to process the affected returns in an efficient manner, type
or legibly print the words ``BACK-UP ELECTION'' at the top of Form 8716,
``Election to Have a Tax Year Other Than a Required Tax Year.'' However,
if such Form 8716 is filed on or after the date a Form 1128, Application
for Change in Accounting Period, is filed with respect to a period that
begins on the same date, the words ``FORM 1128 BACK-UP ELECTION'' should
be typed or legibly printed at the top of Form 8716.
(iii) Procedures for activating a back-up section 444 election--(A)
Partnerships and S corporations--(1) In general. A back-up section 444
election made by a partnership or S corporation is activated by filing
the return required in Sec. 1.7519-2T (a)(2)(i) and making the payment
required in Sec. 1.7519-1T. The due date for filing such return and
payment will be the later of--
(i) The due dates provided in Sec. 1.7519-2T, or
(ii) 60 days from the date the Commissioner denies the business
purpose request.
However, interest will be assessed (at the rate provided in section 6621
(a)(2)) on any required payment made after the due date (without regard
to any extension for a back-up election) provided in Sec. 1.7519-2T
(a)(4)(i) or (a)(4)(ii), whichever is applicable, for such payment.
Interest will be calculated from such due date to the date such amount
is actually paid. Interest assessed under this paragraph will be
separate
[[Page 47]]
from any required payments. Thus, interest will not be subject to refund
under Sec. 1.7519-2T.
(2) Special rule if Form 720 used to satisfy return requirement. If,
pursuant to Sec. 1.7519-2T (a)(3), a partnership or S corporation must
use Form 720, ``Quarterly Federal Excise Tax Return,'' to satisfy the
return requirement of Sec. 1.7519-2T (a)(2), then in addition to
following the general rules provided in Sec. 1.7519-2T, the partnership
or S corporation must type or legibly print the words ``ACTIVATING BACK-
UP ELECTION'' on the top of Form 720. A partnership or S corporation
that would otherwise file a Form 720 on or before the date specified in
paragraph (b)(4)(iii)(A)(1) of this section may satisfy the return
requirement by including the necessary information on such Form 720.
Alternatively, such partnership or S corporation may file an additional
Form 720 (i.e., a Form 720 separate from the Form 720 it would otherwise
file). Thus, for example, if the due date for activating an S
corporation's back-up election is November 15, 1988, and the S
corporation must file a Form 720 by October 31, 1988, to report
manufacturers excise tax for the third quarter of 1988, the S
corporation may use that Form 720 to activate its back-up election.
Alternatively, the S corporation may file its regular Form 720 that is
due October 31, 1988, and file an additional Form 720 by November 15,
1988, activating its back-up election.
(B) Personal service corporations. A back-up section 444 election
made by a personal service corporation is activated by filing Form 8716
with the personal service corporation's original or amended income tax
return for the taxable year in which the election is first effective,
and typing or legibly printing the words--``ACTIVATING BACK-UP
ELECTION'' on the top of such income tax return.
(iv) Examples. The provisions of this paragraph (b)(4) may be
illustrated by the following examples. Also see Example 2 in paragraph
(b)(3) of this section.
Example 1. E, a partnership that historically used a June 30 taxable
year, requested (pursuant to section 6 of Rev. Proc. 87-32, 1987-28
I.R.B. 14) permission from the Commissioner to retain a June 30 taxable
year for its taxable year beginning July 1, 1987. Furthermore, E is
qualified to make a section 444 election to retain a June 30 taxable
year for its taxable year beginning July 1, 1987. However, as of the
date specified in paragraph (b)(2) of this section, the Commissioner has
not determined whether E has a valid business purpose for retaining its
June 30 taxable year. Based on these facts, E may, by the date specified
in paragraph (b)(2) of this section, make a back-up section 444 election
to retain its June 30 taxable year.
Example 2. The facts are the same as in Example 1. In addition, on
August 12, 1988, the Internal Revenue Service notifies E that its
business purpose request is denied. E asks for reconsideration of the
Service's decision, and the Service sustains the original denial on
September 30, 1988. Based on these facts, E must activate its back-up
section 444 election within 60 days after September 30, 1988.
Example 3. The facts are the same as in Example 1, except that E
desires to make a section 444 election to use a year ending September 30
for its taxable year beginning July 1, 1987. Although E qualifies to
make a section 444 election to retain its June 30 taxable year, E may
make a back-up section 444 election for a September 30 taxable year.
(c) Administrative relief--(1) Extension of time to file income tax
returns--(i) Automatic extension. If a partnership, S corporation, or
personal service corporation makes a section 444 election (or does not
make a section 444 election, either because it is ineligible or because
it decides not to make the election, and therefore changes to its
required taxable year) for its first taxable year beginning after
December 31, 1986, the due date for filing its income tax return for
such year shall be the later of--
(A) The due date established under--
(1) Section 6072, in the case of Form 1065,
(2) Sec. 1.6037-1 (b), in the case of Form 1120S,
(3) Section 6072 (b), in the case of other Form 1120 series form; or
(B) August 15, 1988.
The words ``SECTION 444 RETURN'' should, in order to allow the Service
to process the affected returns in an efficient manner, be typed or
legibly printed at the top of the Form 1065 or Form 1120 series form,
whichever is applicable, filed under this paragraph (c)(1)(i).
(ii) Additional extensions. If the due date of the income tax return
for the first taxable year beginning after December 31, 1986, extended
as provided in paragraph (c)(1)(i)(B) of this section,
[[Page 48]]
occurs before the date that is 6 months after the date specified in
paragraph (c)(1)(i)(A) of this section, the partnership, S corporation,
or personal service corporation may request an additional extension or
extensions of time (up to 6 months after the date specified in paragraph
(c)(1)(i)(A) of this section) to file its income tax return for such
first taxable year. The request must be made by the later of the date
specified in paragraph (c)(1)(i)(A) or (c)(1)(i)(B) of this section and
must be made on Form 7004, ``Application for Automatic Extension of Time
To File Corporation Income Tax Return'', or Form 2758, ``Application for
Extension of Time to File U.S. Partnership, Fiduciary, and Certain Other
Returns,'' whichever is applicable, in accordance with the form and its
instructions. In addition, the following words should be typed or
legibly printed at the top of the form--``SECTION 444 REQUEST FOR
ADDITIONAL EXTENSION.''
(iii) Examples. The provisions of paragraph (c)(1) of this section
may be illustrated by the following examples.
Example 1. G, a partnership that historically used a January 31
taxable year, makes a section 444 election to retain such year for its
taxable year beginning February 1, 1987. Absent paragraph (c)(1)(i) of
this section, G's Form 1065 for the taxable year ending January 31,
1988, is due on or before May 15, 1988. However, if G types or legibly
prints ``SECTION 444 RETURN'' at the top of Form 1065 for such year,
paragraph (c)(1)(i) of this section automatically extends the due date
of such return to August 15, 1988.
Example 2. The facts are the same as in Example 1, except that G
desires to extend the due date of its income tax return for the year
ending January 31, 1988, to a date beyond August 15, 1988. Pursuant to
paragraph (c)(1)(ii) of this section, G may extend such return to
November 15, 1988 (i.e., the date that is up to 6 months after May 15,
1988, the normal due date of the return). However, in order to obtain
this additional extension, G must file Form 2758 pursuant to paragraph
(c)(1)(i) of this section on or before August 15, 1988.
Example 3. H, a partnership that historically used a May 31 taxable
year, makes a section 444 election to use a year ending September 30 for
its taxable year beginning on June 1, 1987. Absent paragraph (c)(1)(i)
of this section, H's Form 1065 for the taxable year beginning June 1,
1987, and ending September 30, 1987, is due on or before January 15,
1988. However, if H types or legibly prints ``SECTION 444 RETURN'' at
the top of Form 1065 for such year, paragraph (c)(1)(i) of this section
automatically extends the due date of such return to August 15, 1988.
Example 4. The facts are the same as in Example 3, except H desires
to further extend (i.e., extend beyond August 15, 1988) the due date of
its income tax return for its taxable year beginning June 1, 1987, and
ending September 30, 1987. Since August 15, 1988, is 6 months or more
after the due date (without extensions) of such return, paragraph
(c)(1)(ii) of this section prevents H from further extending the time
for filing such return.
Example 5. I, a partnership that historically used a June 30 taxable
year, considered making a section 44 election to retain such taxable
year, but eventually decided to change to a December 31, taxable year
(I's required taxable year). Absent paragraph (c)(1)(i) of this section,
I's Form 1065 for the taxable year beginning July 1, 1987, and ending
December 31, 1987, is due on or before April 15, 1988. Pursuant to
paragraph (c)(1)(i) of this section, if I types or legibly prints
``SECTION 444 RETURN'' at the top of Form 1065 for such year, paragraph
(c)(1)(i) of this section automatically extends the due date of such
return to August 15, 1988. In addition, I may further extend such return
pursuant to paragraph (c)(1)(ii) of this section.
(2) No penalty for certain late payments--(i) In general. In the
case of a personal service corporation or S corporation described in
paragraph (c)(1)(i) of this section, no penalty under section 6651
(a)(2) will be imposed for failure to pay income tax (if any) for the
first taxable year beginning after December 31, 1986, but only for the
period beginning with the last date for payment and ending with the
later of the date specified in paragraph (c)(1)(i) or paragraph
(c)(1)(ii) of this section.
(ii) Example. The provisions of paragraph (c)(2)(i) of this section
may be illustrated by the following example.
Example. J, a personal service corporation that historically used a
January 31 taxable year, makes a section 444 election to retain such
year for its taxable year beginning February 1, 1987. The last date
(without extension) for payment of J's income tax (if any) for its
taxable year beginning February 1, 1987, is April 15, 1988. However,
under paragraph (c)(2)(i) of this section, no penalty under section
6651(a)(2) will be imposed on any underpayment of income tax for the
period beginning April 15, 1988 and ending August 15, 1988.
[[Page 49]]
(d) Effective date. This section is effective for taxable years
beginning after December 31, 1986.
[T.D. 8205, 53 FR 19703, May 27, 1988]
Sec. 1.444-4 Tiered structure.
(a) Electing small business trusts. For purposes of Sec. 1.444-2T,
solely with respect to an S corporation shareholder, the term deferral
entity does not include a trust that is treated as an electing small
business trust under section 1361(e). An S corporation with an electing
small business trust as a shareholder may make an election under section
444. This paragraph is applicable to taxable years beginning on and
after December 29, 2000; however, taxpayers may voluntarily apply it to
taxable years of S corporations beginning after December 31, 1996.
(b) Certain tax-exempt trusts. For purposes of Sec. 1.444-2T,
solely with respect to an S corporation shareholder, the term deferral
entity does not include a trust that is described in section 401(a) or
501(c)(3), and is exempt from taxation under section 501(a). An S
corporation with a trust as a shareholder that is described in section
401(a) or section 501(c)(3), and is exempt from taxation under section
501(a) may make an election under section 444. This paragraph is
applicable to taxable years beginning on and after December 29, 2000;
however taxpayers may voluntarily apply it to taxable years of S
corporations beginning after December 31, 1997.
(c) Certain terminations disregarded--(1) In general. An S
corporation that is described in this paragraph (c)(1) may request that
a termination of its election under section 444 be disregarded, and that
the S corporation be permitted to resume use of the year it previously
elected under section 444, by following the procedures of paragraph
(c)(2) of this section. An S corporation is described in this paragraph
if the S corporation is otherwise qualified to make a section 444
election, and its previous election was terminated under Sec. 1.444-
2T(a) solely because--
(i) In the case of a taxable year beginning after December 31, 1996,
a trust that is treated as an electing small business trust became a
shareholder of such S corporation; or
(ii) In the case of a taxable year beginning after December 31,
1997, a trust that is described in section 401(a) or 501(c)(3), and is
exempt from taxation under section 501(a) became a shareholder of such S
corporation.
(2) Procedure--(i) In general. An S corporation described in
paragraph (c)(1) of this section that wishes to make the request
described in paragraph (c)(1) of this section must do so by filing Form
8716, ``Election To Have a Tax Year Other Than a Required Tax Year,''
and typing or printing legibly at the top of such form--``CONTINUATION
OF SECTION 444 ELECTION UNDER Sec. 1.444-4.'' In order to assist the
Internal Revenue Service in updating the S corporation's account, on
Line 5 the Box ``Changing to'' should be checked. Additionally, the
election month indicated must be the last month of the S corporation's
previously elected section 444 election year, and the effective year
indicated must end in 2002.
(ii) Time and place for filing Form 8716. Such form must be filed on
or before October 15, 2002, with the service center where the S
corporation's returns of tax (Forms 1120S) are filed. In addition, a
copy of the Form 8716 should be attached to the S corporation's short
period Federal income tax return for the first election year beginning
on or after January 1, 2002.
(3) Effect of request--(i) Taxable years beginning on or after
January 1, 2002. An S corporation described in paragraph (c)(1) of this
section that requests, in accordance with this paragraph, that a
termination of its election under section 444 be disregarded will be
permitted to resume use of the year it previously elected under section
444, commencing with its first taxable year beginning on or after
January 1, 2002. Such S corporation will be required to file a return
under Sec. 1.7519-2T for each taxable year beginning on or after
January 1, 2002. No payment under section 7519 will be due with respect
to the first taxable year beginning on or after January 1, 2002.
However, a required payment will be due on or before May 15, 2003, with
respect to such S corporation's second continued section 444 election
year that begins in calendar year 2002.
[[Page 50]]
(ii) Taxable years beginning prior to January 1, 2002. An S
corporation described in paragraph (c)(1) of this section that requests,
in accordance with this paragraph, that a termination of its election
under section 444 be disregarded will not be required to amend any prior
Federal income tax returns, make any required payments under section
7519, or file any returns under Sec. 1.7519-2T, with respect to taxable
years beginning on or after the date the termination of its section 444
election was effective and prior to January 1, 2002.
(iii) Section 7519: required payments and returns. The Internal
Revenue Service waives any requirement for an S corporation described in
paragraph (c)(1) of this section to file the federal tax returns and
make any required payments under section 7519 for years prior to the
taxable year of continuation as described in paragraph (c)(3)(i) of this
section, if for such years the S corporation filed its federal income
tax returns on the basis of its required taxable year.
[T.D. 8994, 67 FR 34394, May 14, 2002]
Methods of Accounting
methods of accounting in general
Sec. 1.446-1 General rule for methods of accounting.
(a) General rule. (1) Section 446(a) provides that taxable income
shall be computed under the method of accounting on the basis of which a
taxpayer regularly computes his income in keeping his books. The term
``method of accounting'' includes not only the overall method of
accounting of the taxpayer but also the accounting treatment of any
item. Examples of such over-all methods are the cash receipts and
disbursements method, an accrual method, combinations of such methods,
and combinations of the foregoing with various methods provided for the
accounting treatment of special items. These methods of accounting for
special items include the accounting treatment prescribed for research
and experimental expenditures, soil and water conservation expenditures,
depreciation, net operating losses, etc. Except for deviations permitted
or required by such special accounting treatment, taxable income shall
be computed under the method of accounting on the basis of which the
taxpayer regularly computes his income in keeping his books. For
requirement respecting the adoption or change of accounting method, see
section 446(e) and paragraph (e) of this section.
(2) It is recognized that no uniform method of accounting can be
prescribed for all taxpayers. Each taxpayer shall adopt such forms and
systems as are, in his judgment, best suited to his needs. However, no
method of accounting is acceptable unless, in the opinion of the
Commissioner, it clearly reflects income. A method of accounting which
reflects the consistent application of generally accepted accounting
principles in a particular trade or business in accordance with accepted
conditions or practices in that trade or business will ordinarily be
regarded as clearly reflecting income, provided all items of gross
income and expense are treated consistently from year to year.
(3) Items of gross income and expenditures which are elements in the
computation of taxable income need not be in the form of cash. It is
sufficient that such items can be valued in terms of money. For general
rules relating to the taxable year for inclusion of income and for
taking deductions, see sections 451 and 461, and the regulations
thereunder.
(4) Each taxpayer is required to make a return of his taxable income
for each taxable year and must maintain such accounting records as will
enable him to file a correct return. See section 6001 and the
regulations thereunder. Accounting records include the taxpayer's
regular books of account and such other records and data as may be
necessary to support the entries on his books of account and on his
return, as for example, a reconciliation of any differences between such
books and his return. The following are among the essential features
that must be considered in maintaining such records:
(i) In all cases in which the production, purchase, or sale of
merchandise of any kind is an income-producing factor, merchandise on
hand (including finished goods, work in process, raw
[[Page 51]]
materials, and supplies) at the beginning and end of the year shall be
taken into account in computing the taxable income of the year. (For
rules relating to computation of inventories, see section 263A, 471, and
472 and the regulations thereunder.)
(ii) Expenditures made during the year shall be properly classified
as between capital and expense. For example, expenditures for such items
as plant and equipment, which have a useful life extending substantially
beyond the taxable year, shall be charged to a capital account and not
to an expense account.
(iii) In any case in which there is allowable with respect to an
asset a deduction for depreciation, amortization, or depletion, any
expenditures (other than ordinary repairs) made to restore the asset or
prolong its useful life shall be added to the asset account or charged
against the appropriate reserve.
(b) Exceptions. (1) If the taxpayer does not regularly employ a
method of accounting which clearly reflects his income, the computation
of taxable income shall be made in a manner which, in the opinion of the
Commissioner, does clearly reflect income.
(2) A taxpayer whose sole source of income is wages need not keep
formal books in order to have an accounting method. Tax returns, copies
thereof, or other records may be sufficient to establish the use of the
method of accounting used in the preparation of the taxpayer's income
tax returns.
(c) Permissible methods--(1) In general. Subject to the provisions
of paragraphs (a) and (b) of this section, a taxpayer may compute his
taxable income under any of the following methods of accounting:
(i) Cash receipts and disbursements method. Generally, under the
cash receipts and disbursements method in the computation of taxable
income, all items which constitute gross income (whether in the form of
cash, property, or services) are to be included for the taxable year in
which actually or constructively received. Expenditures are to be
deducted for the taxable year in which actually made. For rules relating
to constructive receipt, see Sec. 1.451-2. For treatment of an
expenditure attributable to more than one taxable year, see section
461(a) and paragraph (a)(1) of Sec. 1.461-1.
(ii) Accrual method. (A) Generally, under an accrual method, income
is to be included for the taxable year when all the events have occurred
that fix the right to receive the income and the amount of the income
can be determined with reasonable accuracy. Under such a method, a
liability is incurred, and generally is taken into account for Federal
income tax purposes, in the taxable year in which all the events have
occurred that establish the fact of the liability, the amount of the
liability can be determined with reasonable accuracy, and economic
performance has occurred with respect to the liability. (See paragraph
(a)(2)(iii)(A) of Sec. 1.461-1 for examples of liabilities that may not
be taken into account until after the taxable year incurred, and see
Sec. Sec. 1.461-4 through 1.461-6 for rules relating to economic
performance.) Applicable provisions of the Code, the Income Tax
Regulations, and other guidance published by the Secretary prescribe the
manner in which a liability that has been incurred is taken into
account. For example, section 162 provides that a deductible liability
generally is taken into account in the taxable year incurred through a
deduction from gross income. As a further example, under section 263 or
263A, a liability that relates to the creation of an asset having a
useful life extending substantially beyond the close of the taxable year
is taken into account in the taxable year incurred through
capitalization (within the meaning of Sec. 1.263A-1(c)(3)) and may
later affect the computation of taxable income through depreciation or
otherwise over a period including subsequent taxable years, in
accordance with applicable Internal Revenue Code sections and related
guidance.
(B) The term ``liability'' includes any item allowable as a
deduction, cost, or expense for Federal income tax purposes. In addition
to allowable deductions, the term includes any amount otherwise
allowable as a capitalized cost, as a cost taken into account in
computing cost of goods sold, as a cost allocable to a long-term
contract, or as
[[Page 52]]
any other cost or expense. Thus, for example, an amount that a taxpayer
expends or will expend for capital improvements to property must be
incurred before the taxpayer may take the amount into account in
computing its basis in the property. The term ``liability'' is not
limited to items for which a legal obligation to pay exists at the time
of payment. Thus, for example, amounts prepaid for goods or services and
amounts paid without a legal obligation to do so may not be taken into
account by an accrual basis taxpayer any earlier than the taxable year
in which those amounts are incurred.
(C) No method of accounting is acceptable unless, in the opinion of
the Commissioner, it clearly reflects income. The method used by the
taxpayer in determining when income is to be accounted for will
generally be acceptable if it accords with generally accepted accounting
principles, is consistently used by the taxpayer from year to year, and
is consistent with the Income Tax Regulations. For example, a taxpayer
engaged in a manufacturing business may account for sales of the
taxpayer's product when the goods are shipped, when the product is
delivered or accepted, or when title to the goods passes to the
customers, whether or not billed, depending on the method regularly
employed in keeping the taxpayer's books.
(iii) Other permissible methods. Special methods of accounting are
described elsewhere in chapter 1 of the Code and the regulations
thereunder. For example, see the following sections and the regulations
thereunder: Sections 61 and 162, relating to the crop method of
accounting; section 453, relating to the installment method; section
460, relating to the long-term contract methods. In addition, special
methods of accounting for particular items of income and expense are
provided under other sections of chapter 1. For example, see section
174, relating to research and experimental expenditures, and section
175, relating to soil and water conservation expenditures.
(iv) Combinations of the foregoing methods. (a) In accordance with
the following rules, any combination of the foregoing methods of
accounting will be permitted in connection with a trade or business if
such combination clearly reflects income and is consistently used. Where
a combination of methods of accounting includes any special methods,
such as those referred to in subdivision (iii) of this subparagraph, the
taxpayer must comply with the requirements relating to such special
methods. A taxpayer using an accrual method of accounting with respect
to purchases and sales may use the cash method in computing all other
items of income and expense. However, a taxpayer who uses the cash
method of accounting in computing gross income from his trade or
business shall use the cash method in computing expenses of such trade
or business. Similarly, a taxpayer who uses an accrual method of
accounting in computing business expenses shall use an accrual method in
computing items affecting gross income from his trade or business.
(b) A taxpayer using one method of accounting in computing items of
income and deductions of his trade or business may compute other items
of income and deductions not connected with his trade or business under
a different method of accounting.
(2) Special rules. (i) In any case in which it is necessary to use
an inventory the accrual method of accounting must be used with regard
to purchases and sales unless otherwise authorized under subdivision
(ii) of this subparagraph.
(ii) No method of accounting will be regarded as clearly reflecting
income unless all items of gross profit and deductions are treated with
consistency from year to year. The Commissioner may authorize a taxpayer
to adopt or change to a method of accounting permitted by this chapter
although the method is not specifically described in the regulations in
this part if, in the opinion of the Commissioner, income is clearly
reflected by the use of such method. Further, the Commissioner may
authorize a taxpayer to continue the use of a method of accounting
consistently used by the taxpayer, even though not specifically
authorized by the regulations in this part, if, in the opinion of the
Commissioner, income is clearly reflected by the use of such
[[Page 53]]
method. See section 446(a) and paragraph (a) of this section, which
require that taxable income shall be computed under the method of
accounting on the basis of which the taxpayer regularly computes his
income in keeping his books, and section 446(e) and paragraph (e) of
this section, which require the prior approval of the Commissioner in
the case of changes in accounting method.
(iii) The timing rules of Sec. 1.1502-13 are a method of accounting
for intercompany transactions (as defined in Sec. 1.1502-13(b)(1)(i)),
to be applied by each member of a consolidated group in addition to the
member's other methods of accounting. See Sec. 1.1502-13(a)(3)(i). This
paragraph (c)(2)(iii) is applicable to consolidated return years
beginning on or after November 7, 2001.
(d) Taxpayer engaged in more than one business. (1) Where a taxpayer
has two or more separate and distinct trades or businesses, a different
method of accounting may be used for each trade or business, provided
the method used for each trade or business clearly reflects the income
of that particular trade or business. For example, a taxpayer may
account for the operations of a personal service business on the cash
receipts and disbursements method and of a manufacturing business on an
accrual method, provided such businesses are separate and distinct and
the methods used for each clearly reflect income. The method first used
in accounting for business income and deductions in connection with each
trade or business, as evidenced in the taxpayer's income tax return in
which such income or deductions are first reported, must be consistently
followed thereafter.
(2) No trade or business will be considered separate and distinct
for purposes of this paragraph unless a complete and separable set of
books and records is kept for such trade or business.
(3) If, by reason of maintaining different methods of accounting,
there is a creation or shifting of profits or losses between the trades
or businesses of the taxpayer (for example, through inventory
adjustments, sales, purchases, or expenses) so that income of the
taxpayer is not clearly reflected, the trades or businesses of the
taxpayer will not be considered to be separate and distinct.
(e) Requirement respecting the adoption or change of accounting
method. (1) A taxpayer filing his first return may adopt any permissible
method of accounting in computing taxable income for the taxable year
covered by such return. See section 446(c) and paragraph (c) of this
section for permissible methods. Moreover, a taxpayer may adopt any
permissible method of accounting in connection with each separate and
distinct trade or business, the income from which is reported for the
first time. See section 446(d) and paragraph (d) of this section. See
also section 446(a) and paragraph (a) of this section.
(2)(i) Except as otherwise expressly provided in chapter 1 of the
Code and the regulations thereunder, a taxpayer who changes the method
of accounting employed in keeping his books shall, before computing his
income upon such new method for purposes of taxation, secure the consent
of the Commissioner. Consent must be secured whether or not such method
is proper or is permitted under the Internal Revenue Code or the
regulations thereunder.
(ii) (a) A change in the method of accounting includes a change in
the overall plan of accounting for gross income or deductions or a
change in the treatment of any material item used in such overall plan.
Although a method of accounting may exist under this definition without
the necessity of a pattern of consistent treatment of an item, in most
instances a method of accounting is not established for an item without
such consistent treatment. A material item is any item that involves the
proper time for the inclusion of the item in income or the taking of a
deduction. Changes in method of accounting include a change from the
cash receipts and disbursement method to an accrual method, or vice
versa, a change involving the method or basis used in the valuation of
inventories (see sections 471 and 472 and the regulations under sections
471 and 472), a change from the cash or accrual method to a long-term
contract method, or vice versa (see Sec. 1.460-4), certain changes in
computing depreciation or amortization (see paragraph (e)(2)(ii)(d) of
this
[[Page 54]]
section), a change involving the adoption, use or discontinuance of any
other specialized method of computing taxable income, such as the crop
method, and a change where the Internal Revenue Code and regulations
under the Internal Revenue Code specifically require that the consent of
the Commissioner must be obtained before adopting such a change.
(b) A change in method of accounting does not include correction of
mathematical or posting errors, or errors in the computation of tax
liability (such as errors in computation of the foreign tax credit, net
operating loss, percentage depletion, or investment credit). Also, a
change in method of accounting does not include adjustment of any item
of income or deduction that does not involve the proper time for the
inclusion of the item of income or the taking of a deduction. For
example, corrections of items that are deducted as interest or salary,
but that are in fact payments of dividends, and of items that are
deducted as business expenses, but that are in fact personal expenses,
are not changes in method of accounting. In addition, a change in the
method of accounting does not include an adjustment with respect to the
addition to a reserve for bad debts. Although such adjustment may
involve the question of the proper time for the taking of a deduction,
such items are traditionally corrected by adjustment in the current and
future years. For the treatment of the adjustment of the addition to a
bad debt reserve (for example, for banks under section 585 of the
Internal Revenue Code), see the regulations under section 166 of the
Internal Revenue Code. A change in the method of accounting also does
not include a change in treatment resulting from a change in underlying
facts. For further guidance on changes involving depreciable or
amortizable assets, see paragraph (e)(2)(ii)(d) of this section and
Sec. 1.1016-3(h).
(c) A change in an overall plan or system of identifying or valuing
items in inventory is a change in method of accounting. Also a change in
the treatment of any material item used in the overall plan for
identifying or valuing items in inventory is a change in method of
accounting.
(d) Changes involving depreciable or amortizable assets--(1) Scope.
This paragraph (e)(2)(ii)(d) applies to property subject to section 167,
168, 197, 1400I, 1400L(c), to section 168 prior to its amendment by the
Tax Reform Act of 1986 (100 Stat. 2121) (former section 168), or to an
additional first year depreciation deduction provision of the Internal
Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)).
(2) Changes in depreciation or amortization that are a change in
method of accounting. Except as provided in paragraph (e)(2)(ii)(d)(3)
of this section, a change in the treatment of an asset from
nondepreciable or nonamortizable to depreciable or amortizable, or vice
versa, is a change in method of accounting. Additionally, a correction
to require depreciation or amortization in lieu of a deduction for the
cost of depreciable or amortizable assets that had been consistently
treated as an expense in the year of purchase, or vice versa, is a
change in method of accounting. Further, except as provided in paragraph
(e)(2)(ii)(d)(3) of this section, the following changes in computing
depreciation or amortization are a change in method of accounting:
(i) A change in the depreciation or amortization method, period of
recovery, or convention of a depreciable or amortizable asset.
(ii) A change from not claiming to claiming the additional first
year depreciation deduction provided by, for example, section 168(k),
1400L(b), or 1400N(d), for, and the resulting change to the amount
otherwise allowable as a depreciation deduction for the remaining
adjusted depreciable basis (or similar basis) of, depreciable property
that qualifies for the additional first year depreciation deduction (for
example, qualified property, 50-percent bonus depreciation property,
qualified New York Liberty Zone property, or qualified Gulf Opportunity
Zone property), provided the taxpayer did not make the election out of
the additional first year depreciation deduction (or did not make a
deemed election out of the additional first year depreciation deduction;
for further guidance, for example, see Rev. Proc. 2002-33 (2002-1 C.B.
963), Rev. Proc. 2003-50 (2003-2 C.B. 119), Notice 2006-77 (2006-40
I.R.B. 590), and
[[Page 55]]
Sec. 601.601(d)(2)(ii)(b) of this chapter) for the class of property in
which the depreciable property that qualifies for the additional first
year depreciation deduction (for example, qualified property, 50-percent
bonus depreciation property, qualified New York Liberty Zone property,
or qualified Gulf Opportunity Zone property) is included.
(iii) A change from claiming the 30-percent additional first year
depreciation deduction to claiming the 50-percent additional first year
depreciation deduction for depreciable property that qualifies for the
50-percent additional first year depreciation deduction, provided the
property is not included in any class of property for which the taxpayer
elected the 30-percent, instead of the 50-percent, additional first year
depreciation deduction (for example, 50-percent bonus depreciation
property or qualified Gulf Opportunity Zone property), or a change from
claiming the 50-percent additional first year depreciation deduction to
claiming the 30-percent additional first year depreciation deduction for
depreciable property that qualifies for the 30-percent additional first
year depreciation deduction, including property that is included in a
class of property for which the taxpayer elected the 30-percent, instead
of the 50-percent, additional first year depreciation deduction (for
example, qualified property or qualified New York Liberty Zone
property), and the resulting change to the amount otherwise allowable as
a depreciation deduction for the property's remaining adjusted
depreciable basis (or similar basis). This paragraph
(e)(2)(ii)(d)(2)(iii) does not apply if a taxpayer is making a late
election or revoking a timely valid election under the applicable
additional first year depreciation deduction provision of the Internal
Revenue Code (for example, section 168(k), 1400L(b), or 1400N(d)) (see
paragraph (e)(2)(ii)(d)(3)(iii) of this section).
(iv) A change from claiming to not claiming the additional first
year depreciation deduction for an asset that does not qualify for the
additional first year depreciation deduction, including an asset that is
included in a class of property for which the taxpayer elected not to
claim any additional first year depreciation deduction (for example, an
asset that is not qualified property, 50-percent bonus depreciation
property, qualified New York Liberty Zone property, or qualified Gulf
Opportunity Zone property), and the resulting change to the amount
otherwise allowable as a depreciation deduction for the property's
depreciable basis.
(v) A change in salvage value to zero for a depreciable or
amortizable asset for which the salvage value is expressly treated as
zero by the Internal Revenue Code (for example, section 168(b)(4)), the
regulations under the Internal Revenue Code (for example, Sec. 1.197-
2(f)(1)(ii)), or other guidance published in the Internal Revenue
Bulletin.
(vi) A change in the accounting for depreciable or amortizable
assets from a single asset account to a multiple asset account
(pooling), or vice versa, or from one type of multiple asset account
(pooling) to a different type of multiple asset account (pooling).
(vii) For depreciable or amortizable assets that are mass assets
accounted for in multiple asset accounts or pools, a change in the
method of identifying which assets have been disposed. For purposes of
this paragraph (e)(2)(ii)(d)(2)(vii), the term mass assets means a mass
or group of individual items of depreciable or amortizable assets that
are not necessarily homogeneous, each of which is minor in value
relative to the total value of the mass or group, numerous in quantity,
usually accounted for only on a total dollar or quantity basis, with
respect to which separate identification is impracticable, and placed in
service in the same taxable year.
(viii) Any other change in depreciation or amortization as the
Secretary may designate by publication in the Federal Register or in the
Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
(3) Changes in depreciation or amortization that are not a change in
method of accounting. Section 1.446-1(e)(2)(ii)(b) applies to determine
whether a change in depreciation or amortization is not a change in
method of accounting. Further, the following changes in depreciation or
amortization are not a change in method of accounting:
[[Page 56]]
(i) Useful life. An adjustment in the useful life of a depreciable
or amortizable asset for which depreciation is determined under section
167 (other than under section 168, section 1400I, section 1400L(c),
former section 168, or an additional first year depreciation deduction
provision of the Internal Revenue Code (for example, section 168(k),
1400L(b), or 1400N(d))) is not a change in method of accounting. This
paragraph (e)(2)(ii)(d)(3)(i) does not apply if a taxpayer is changing
to or from a useful life (or recovery period or amortization period)
that is specifically assigned by the Internal Revenue Code (for example,
section 167(f)(1), section 168(c), section 168(g)(2) or (3), section
197), the regulations under the Internal Revenue Code, or other guidance
published in the Internal Revenue Bulletin and, therefore, such change
is a change in method of accounting (unless paragraph
(e)(2)(ii)(d)(3)(v) of this section applies). See paragraph
(e)(2)(ii)(d)(5)(iv) of this section for determining the taxable year in
which to correct an adjustment in useful life that is not a change in
method of accounting.
(ii) Change in use. A change in computing depreciation or
amortization allowances in the taxable year in which the use of an asset
changes in the hands of the same taxpayer is not a change in method of
accounting.
(iii) Elections. Generally, the making of a late depreciation or
amortization election or the revocation of a timely valid depreciation
or amortization election is not a change in method of accounting, except
as otherwise expressly provided by the Internal Revenue Code, the
regulations under the Internal Revenue Code, or other guidance published
in the Internal Revenue Bulletin. This paragraph (e)(2)(ii)(d)(3)(iii)
also applies to making a late election or revoking a timely valid
election made under section 13261(g)(2) or (3) of the Revenue
Reconciliation Act of 1993 (107 Stat. 312, 540) (relating to amortizable
section 197 intangibles). A taxpayer may request consent to make a late
election or revoke a timely valid election by submitting a request for a
private letter ruling. For making or revoking an election under section
179 of the Internal Revenue Code, see section 179(c) and Sec. 1.179-5.
(iv) Salvage value. Except as provided under paragraph
(e)(2)(ii)(d)(2)(v) of this section, a change in salvage value of a
depreciable or amortizable asset is not treated as a change in method of
accounting.
(v) Placed-in-service date. Except as otherwise expressly provided
by the Internal Revenue Code, the regulations under the Internal Revenue
Code, or other guidance published in the Internal Revenue Bulletin, any
change in the placed-in-service date of a depreciable or amortizable
asset is not treated as a change in method of accounting. For example,
if a taxpayer changes the placed-in-service date of a depreciable or
amortizable asset because the taxpayer incorrectly determined the date
on which the asset was placed in service, such a change is a change in
the placed-in-service date of the asset and, therefore, is not a change
in method of accounting. However, if a taxpayer incorrectly determines
that a depreciable or amortizable asset is nondepreciable property and
later changes the treatment of the asset to depreciable property, such a
change is not a change in the placed-in-service date of the asset and,
therefore, is a change in method of accounting under paragraph
(e)(2)(ii)(d)(2) of this section. Further, a change in the convention of
a depreciable or amortizable asset is not a change in the placed-in-
service date of the asset and, therefore, is a change in method of
accounting under paragraph (e)(2)(ii)(d)(2)(i) of this section. See
paragraph (e)(2)(ii)(d)(5)(v) of this section for determining the
taxable year in which to make a change in the placed-in-service date of
a depreciable or amortizable asset that is not a change in method of
accounting.
(vi) Any other change in depreciation or amortization as the
Secretary may designate by publication in the Federal Register or in the
Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
(4) Item being changed. For purposes of a change in depreciation or
amortization to which this paragraph (e)(2)(ii)(d) applies, the item
being changed generally is the depreciation
[[Page 57]]
treatment of each individual depreciable or amortizable asset. However,
the item is the depreciation treatment of each vintage account with
respect to a depreciable asset for which depreciation is determined
under Sec. 1.167(a)-11 (class life asset depreciation range (CLADR)
property). Similarly, the item is the depreciable treatment of each
general asset account with respect to a depreciable asset for which
general asset account treatment has been elected under section 168(i)(4)
or the item is the depreciation treatment of each mass asset account
with respect to a depreciable asset for which mass asset account
treatment has been elected under former section 168(d)(2)(A). Further, a
change in computing depreciation or amortization under section 167
(other than under section 168, section 1400I, section 1400L(c), former
section 168, or an additional first year depreciation deduction
provision of the Internal Revenue Code (for example, section 168(k),
1400L(b), or 1400N(d))) is permitted only with respect to all assets in
a particular account (as defined in Sec. 1.167(a)-7) or vintage
account.
(5) Special rules. For purposes of a change in depreciation or
amortization to which this paragraph (e)(2)(ii)(d) applies--
(i) Declining balance method to the straight line method for MACRS
property. For tangible, depreciable property subject to section 168
(MACRS property) that is depreciated using the 200-percent or 150-
percent declining balance method of depreciation under section 168(b)(1)
or (2), a taxpayer may change without the consent of the Commissioner
from the declining balance method of depreciation to the straight line
method of depreciation in the first taxable year in which the use of the
straight line method with respect to the adjusted depreciable basis of
the MACRS property as of the beginning of that year will yield a
depreciation allowance that is greater than the depreciation allowance
yielded by the use of the declining balance method. When the change is
made, the adjusted depreciable basis of the MACRS property as of the
beginning of the taxable year is recovered through annual depreciation
allowances over the remaining recovery period (for further guidance, see
section 6.06 of Rev. Proc. 87-57 (1987-2 C.B. 687) and Sec.
601.601(d)(2)(ii)(b) of this chapter).
(ii) Depreciation method changes for section 167 property. For a
depreciable or amortizable asset for which depreciation is determined
under section 167 (other than under section 168, section 1400I, section
1400L(c), former section 168, or an additional first year depreciation
deduction provision of the Internal Revenue Code (for example, section
168(k), 1400L(b), or 1400N(d))), see Sec. 1.167(e)-1(b), (c), and (d)
for the changes in depreciation method that are permitted to be made
without the consent of the Commissioner. For CLADR property, see Sec.
1.167(a)-11(c)(1)(iii) for the changes in depreciation method for CLADR
property that are permitted to be made without the consent of the
Commissioner. Further, see Sec. 1.167(a)-11(b)(4)(iii)(c) for how to
correct an incorrect classification or characterization of CLADR
property.
(iii) Section 481 adjustment. Except as otherwise expressly provided
by the Internal Revenue Code, the regulations under the Internal Revenue
Code, or other guidance published in the Internal Revenue Bulletin, no
section 481 adjustment is required or permitted for a change from one
permissible method of computing depreciation or amortization to another
permissible method of computing depreciation or amortization for an
asset because this change is implemented by either a cut-off method (for
further guidance, for example, see section 2.06 of Rev. Proc. 97-27
(1997-1 C.B. 680), section 2.06 of Rev. Proc. 2002-9 (2002-1 C.B. 327),
and Sec. 601.601(d)(2)(ii)(b) of this chapter) or a modified cut-off
method (under which the adjusted depreciable basis of the asset as of
the beginning of the year of change is recovered using the new
permissible method of accounting), as appropriate. However, a change
from an impermissible method of computing depreciation or amortization
to a permissible method of computing depreciation or amortization for an
asset results in a section 481 adjustment. Similarly, a change in the
treatment of an asset from nondepreciable or nonamortizable to
depreciable or amortizable (or vice versa) or a change in the
[[Page 58]]
treatment of an asset from expensing to depreciating (or vice versa)
results in a section 481 adjustment.
(iv) Change in useful life. This paragraph (e)(2)(ii)(d)(5)(iv)
applies to an adjustment in the useful life of a depreciable or
amortizable asset for which depreciation is determined under section 167
(other than under section 168, section 1400I, section 1400L(c), former
section 168, or an additional first year depreciation deduction
provision of the Internal Revenue Code (for example, section 168(k),
1400L(b), or 1400N(d))) and that is not a change in method of accounting
under paragraph (e)(2)(ii)(d) of this section. For this adjustment in
useful life, no section 481 adjustment is required or permitted. The
adjustment in useful life, whether initiated by the Internal Revenue
Service (IRS) or a taxpayer, is corrected by adjustments in the taxable
year in which the conditions known to exist at the end of that taxable
year changed thereby resulting in a redetermination of the useful life
under Sec. 1.167(a)-1(b) (or if the period of limitation for assessment
under section 6501(a) has expired for that taxable year, in the first
succeeding taxable year open under the period of limitation for
assessment), and in subsequent taxable years. In other situations (for
example, the useful life is incorrectly determined in the placed-in-
service year), the adjustment in the useful life, whether initiated by
the IRS or a taxpayer, may be corrected by adjustments in the earliest
taxable year open under the period of limitation for assessment under
section 6501(a) or the earliest taxable year under examination by the
IRS but in no event earlier than the placed-in-service year of the
asset, and in subsequent taxable years. However, if a taxpayer initiates
the correction in useful life, in lieu of filing amended Federal tax
returns (for example, because the conditions known to exist at the end
of a prior taxable year changed thereby resulting in a redetermination
of the useful life under Sec. 1.167(a)-1(b)), the taxpayer may correct
the adjustment in useful life by adjustments in the current and
subsequent taxable years.
(v) Change in placed-in-service date. This paragraph
(e)(2)(ii)(d)(5)(v) applies to a change in the placed-in-service date of
a depreciable or amortizable asset that is not a change in method of
accounting under paragraph (e)(2)(ii)(d) of this section. For this
change in placed-in-service date, no section 481 adjustment is required
or permitted. The change in placed-in-service date, whether initiated by
the IRS or a taxpayer, may be corrected by adjustments in the earliest
taxable year open under the period of limitation for assessment under
section 6501(a) or the earliest taxable year under examination by the
IRS but in no event earlier than the placed-in-service year of the
asset, and in subsequent taxable years. However, if a taxpayer initiates
the change in placed-in-service date, in lieu of filing amended Federal
tax returns, the taxpayer may correct the placed-in-service date by
adjustments in the current and subsequent taxable years.
(iii) Examples. The rules of this paragraph (e) are illustrated by
the following examples:
Example 1. Although the sale of merchandise is an income producing
factor, and therefore inventories are required, a taxpayer in the retail
jewelry business reports his income on the cash receipts and
disbursements method of accounting. A change from the cash receipts and
disbursements method of accounting to the accrual method of accounting
is a change in the overall plan of accounting and thus is a change in
method of accounting.
Example 2. A taxpayer in the wholesale dry goods business computes
its income and expenses on the accrual method of accounting and files
its Federal income tax returns on such basis except for real estate
taxes which have been reported on the cash receipts and disbursements
method of accounting. A change in the treatment of real estate taxes
from the cash receipts and disbursements method to the accrual method is
a change in method of accounting because such change is a change in the
treatment of a material item within his overall accounting practice.
Example 3. A taxpayer in the wholesale dry goods business computes
its income and expenses on the accrual method of accounting and files
its Federal income tax returns on such basis. Vacation pay has been
deducted in the year in which paid because the taxpayer did not have a
completely vested vacation pay plan, and, therefore, the liability for
payment did not accrue until that year. Subsequently, the taxpayer
adopts a completely vested vacation pay plan that changes its year for
accruing the deduction from the year in which payment is made to
[[Page 59]]
the year in which the liability to make the payment now arises. The
change for the year of deduction of the vacation pay plan is not a
change in method of accounting but results, instead, because the
underlying facts (that is, the type of vacation pay plan) have changed.
Example 4. From 1968 through 1970, a taxpayer has fairly allocated
indirect overhead costs to the value of inventories on a fixed
percentage of direct costs. If the ratio of indirect overhead costs to
direct costs increases in 1971, a change in the underlying facts has
occurred. Accordingly, an increase in the percentage in 1971 to fairly
reflect the increase in the relative level of indirect overhead costs is
not a change in method of accounting but is a change in treatment
resulting from a change in the underlying facts.
Example 5. A taxpayer values inventories at cost. A change in the
basis for valuation of inventories from cost to the lower of cost or
market is a change in an overall practice of valuing items in inventory.
The change, therefore, is a change in method of accounting for
inventories.
Example 6. A taxpayer in the manufacturing business has for many
taxable years valued its inventories at cost. However, cost has been
improperly computed since no overhead costs have been included in
valuing the inventories at cost. The failure to allocate an appropriate
portion of overhead to the value of inventories is contrary to the
requirement of the Internal Revenue Code and the regulations under the
Internal Revenue Code. A change requiring appropriate allocation of
overhead is a change in method of accounting because it involves a
change in the treatment of a material item used in the overall practice
of identifying or valuing items in inventory.
Example 7. A taxpayer has for many taxable years valued certain
inventories by a method which provides for deducting 20 percent of the
cost of the inventory items in determining the final inventory
valuation. The 20 percent adjustment is taken as a ``reserve for price
changes.'' Although this method is not a proper method of valuing
inventories under the Internal Revenue Code or the regulations under the
Internal Revenue Code, it involves the treatment of a material item used
in the overall practice of valuing inventory. A change in such practice
or procedure is a change of method of accounting for inventories.
Example 8. A taxpayer has always used a base stock system of
accounting for inventories. Under this system a constant price is
applied to an assumed constant normal quantity of goods in stock. The
base stock system is an overall plan of accounting for inventories which
is not recognized as a proper method of accounting for inventories under
the regulations. A change in this practice is, nevertheless, a change of
method of accounting for inventories.
Example 9. In 2003, A1, a calendar year taxpayer engaged in the
trade or business of manufacturing knitted goods, purchased and placed
in service a building and its components at a total cost of $10,000,000
for use in its manufacturing operations. A1 classified the $10,000,000
as nonresidential real property under section 168(e). A1 elected not to
deduct the additional first year depreciation provided by section 168(k)
on its 2003 Federal tax return. As a result, on its 2003, 2004, and 2005
Federal tax returns, A1 depreciated the $10,000,000 under the general
depreciation system of section 168(a), using the straight line method of
depreciation, a 39-year recovery period, and the mid-month convention.
In 2006, A1 completes a cost segregation study on the building and its
components and identifies items that cost a total of $1,500,000 as
section 1245 property. As a result, the $1,500,000 should have been
classified in 2003 as 5-year property under section 168(e) and
depreciated on A1's 2003, 2004, and 2005 Federal tax returns under the
general depreciation system, using the 200-percent declining balance
method of depreciation, a 5-year recovery period, and the half-year
convention. Pursuant to paragraph (e)(2)(ii)(d)(2)(i) of this section,
A1's change to this depreciation method, recovery period, and convention
is a change in method of accounting. This method change results in a
section 481 adjustment. The useful life exception under paragraph
(e)(2)(ii)(d)(3)(i) of this section does not apply because the assets
are depreciated under section 168.
Example 10. In 2003, B, a calendar year taxpayer, purchased and
placed in service new equipment at a total cost of $1,000,000 for use in
its plant located outside the United States. The equipment is 15-year
property under section 168(e) with a class life of 20 years. The
equipment is required to be depreciated under the alternative
depreciation system of section 168(g). However, B incorrectly
depreciated the equipment under the general depreciation system of
section 168(a), using the 150-percent declining balance method, a 15-
year recovery period, and the half-year convention. In 2010, the IRS
examines B's 2007 Federal income tax return and changes the depreciation
of the equipment to the alternative depreciation system, using the
straight line method of depreciation, a 20-year recovery period, and the
half-year convention. Pursuant to paragraph (e)(2)(ii)(d)(2)(i) of this
section, this change in depreciation method and recovery period made by
the IRS is a change in method of accounting. This method change results
in a section 481 adjustment. The useful life exception under paragraph
(e)(2)(ii)(d)(3)(i) of this section does not apply because the assets
are depreciated under section 168.
[[Page 60]]
Example 11. In May 2003, C, a calendar year taxpayer, purchased and
placed in service equipment for use in its trade or business. C never
held this equipment for sale. However, C incorrectly treated the
equipment as inventory on its 2003 and 2004 Federal tax returns. In
2005, C realizes that the equipment should have been treated as a
depreciable asset. Pursuant to paragraph (e)(2)(ii)(d)(2) of this
section, C's change in the treatment of the equipment from inventory to
a depreciable asset is a change in method of accounting. This method
change results in a section 481 adjustment.
Example 12. Since 2003, D, a calendar year taxpayer, has used the
distribution fee period method to amortize distributor commissions and,
under that method, established pools to account for the distributor
commissions (for further guidance, see Rev. Proc. 2000-38 (2000-2 C.B.
310) and Sec. 601.601(d)(2)(ii)(b) of this chapter). A change in the
accounting of distributor commissions under the distribution fee period
method from pooling to single asset accounting is a change in method of
accounting pursuant to paragraph (e)(2)(ii)(d)(2)(vi) of this section.
This method change results in no section 481 adjustment because the
change is from one permissible method to another permissible method.
Example 13. Since 2003, E, a calendar year taxpayer, has accounted
for items of MACRS property that are mass assets in pools. Each pool
includes only the mass assets that are placed in service by E in the
same taxable year. E is able to identify the cost basis of each asset in
each pool. None of the pools are general asset accounts under section
168(i)(4) and the regulations under section 168(i)(4). E identified any
dispositions of these mass assets by specific identification. Because of
changes in E's recordkeeping in 2006, it is impracticable for E to
continue to identify disposed mass assets using specific identification.
As a result, E wants to change to a first-in, first-out method under
which the mass assets disposed of in a taxable year are deemed to be
from the pool with the earliest placed-in-service year in existence as
of the beginning of the taxable year of each disposition. Pursuant to
paragraph (e)(2)(ii)(d)(2)(vii) of this section, this change is a change
in method of accounting. This method change results in no section 481
adjustment because the change is from one permissible method to another
permissible method.
Example 14. In August 2003, F, a calendar year taxpayer, purchased
and placed in service a copier for use in its trade or business. F
incorrectly classified the copier as 7-year property under section
168(e). F elected not to deduct the additional first year depreciation
provided by section 168(k) on its 2003 Federal tax return. As a result,
on its 2003 and 2004 Federal tax returns, F depreciated the copier under
the general depreciation system of section 168(a), using the 200-percent
declining balance method of depreciation, a 7-year recovery period, and
the half-year convention. In 2005, F realizes that the copier is 5-year
property and should have been depreciated on its 2003 and 2004 Federal
tax returns under the general depreciation system using a 5-year
recovery period rather than a 7-year recovery period. Pursuant to
paragraph (e)(2)(ii)(d)(2)(i) of this section, F's change in recovery
period from 7 to 5 years is a change in method of accounting. This
method change results in a section 481 adjustment. The useful life
exception under paragraph (e)(2)(ii)(d)(3)(i) of this section does not
apply because the copier is depreciated under section 168.
Example 15. In 2004, G, a calendar year taxpayer, purchased and
placed in service an intangible asset that is not an amortizable section
197 intangible and that is not described in section 167(f). G amortized
the cost of the intangible asset under section 167(a) using the straight
line method of depreciation and a determinable useful life of 13 years.
The safe harbor useful life of 15 or 25 years under Sec. 1.167(a)-3(b)
does not apply to the intangible asset. In 2008, because of changing
conditions, G changes the remaining useful life of the intangible asset
to 2 years. Pursuant to paragraph (e)(2)(ii)(d)(3)(i) of this section,
G's change in useful life is not a change in method of accounting
because the intangible asset is depreciated under section 167 and G is
not changing to or from a useful life that is specifically assigned by
the Internal Revenue Code, the regulations under the Internal Revenue
Code, or other guidance published in the Internal Revenue Bulletin.
Example 16. In July 2003, H, a calendar year taxpayer, purchased and
placed in service ``off-the-shelf'' computer software and a new
computer. The cost of the new computer and computer software are
separately stated. H incorrectly included the cost of this software as
part of the cost of the computer, which is 5-year property under section
168(e). On its 2003 Federal tax return, H elected to depreciate its 5-
year property placed in service in 2003 under the alternative
depreciation system of section 168(g) and H elected not to deduct the
additional first year depreciation provided by section 168(k). The class
life for a computer is 5 years. As a result, because H included the cost
of the computer software as part of the cost of the computer hardware, H
depreciated the cost of the software under the alternative depreciation
system, using the straight line method of depreciation, a 5-year
recovery period, and the half-year convention. In 2005, H realizes that
the cost of the software should have been amortized under section
167(f)(1), using the straight line method of depreciation, a 36-month
useful life, and a monthly convention. H's change from 5-years to 36-
months is a change in
[[Page 61]]
method of accounting because H is changing to a useful life that is
specifically assigned by section 167(f)(1). The change in convention
from the half-year to the monthly convention also is a change in method
of accounting. Both changes result in a section 481 adjustment.
Example 17. On May 1, 2003, I2, a calendar year taxpayer, purchased
and placed in service new equipment at a total cost of $500,000 for use
in its business. The equipment is 5-year property under section 168(e)
with a class life of 9 years and is qualified property under section
168(k)(2). I2 did not place in service any other depreciable property in
2003. Section 168(g)(1)(A) through (D) do not apply to the equipment. I2
intended to elect the alternative depreciation system under section
168(g) for 5-year property placed in service in 2003. However, I2 did
not make the election. Instead, I2 deducted on its 2003 Federal tax
return the 30-percent additional first year depreciation attributable to
the equipment and, on its 2003 and 2004 Federal tax returns, depreciated
the remaining adjusted depreciable basis of the equipment under the
general depreciation system under 168(a), using the 200-percent
declining balance method, a 5-year recovery period, and the half-year
convention. In 2005, I2 realizes its failure to make the alternative
depreciation system election in 2003 and files a Form 3115,
``Application for Change in Accounting Method,'' to change its method of
depreciating the remaining adjusted depreciable basis of the 2003
equipment to the alternative depreciation system. Because this equipment
is not required to be depreciated under the alternative depreciation
system, I2 is attempting to make an election under section 168(g)(7).
However, this election must be made in the taxable year in which the
equipment is placed in service (2003) and, consequently, I2 is
attempting to make a late election under section 168(g)(7). Accordingly,
I2's change to the alternative depreciation system is not a change in
accounting method pursuant to paragraph (e)(2)(ii)(d)(3)(iii) of this
section. Instead, I2 must submit a request for a private letter ruling
under Sec. 301.9100-3 of this chapter, requesting an extension of time
to make the alternative depreciation system election on its 2003 Federal
tax return.
Example 18. On December 1, 2004, J, a calendar year taxpayer,
purchased and placed in service 20 previously-owned adding machines. For
the 2004 taxable year, J incorrectly classified the adding machines as
items in its ``suspense'' account for financial and tax accounting
purposes. Assets in this suspense account are not depreciated until
reclassified to a depreciable fixed asset account. In January 2006, J
realizes that the cost of the adding machines is still in the suspense
account and reclassifies such cost to the appropriate depreciable fixed
asset account. As a result, on its 2004 and 2005 Federal tax returns, J
did not depreciate the cost of the adding machines. Pursuant to
paragraph (e)(2)(ii)(d)(2) of this section, J's change in the treatment
of the adding machines from nondepreciable assets to depreciable assets
is a change in method of accounting. The placed-in-service date
exception under paragraph (e)(2)(ii)(d)(3)(v) of this section does not
apply because the adding machines were incorrectly classified in a
nondepreciable suspense account. This method change results in a section
481 adjustment.
Example 19. In December 2003, K, a calendar year taxpayer, purchased
and placed in service equipment for use in its trade or business.
However, K did not receive the invoice for this equipment until January
2004. As a result, K classified the equipment on its fixed asset records
as being placed in service in January 2004. On its 2004 and 2005 Federal
tax returns, K depreciated the cost of the equipment. In 2006, K
realizes that the equipment was actually placed in service during the
2003 taxable year and, therefore, depreciation should have began in the
2003 taxable year instead of the 2004 taxable year. Pursuant to
paragraph (e)(2)(ii)(d)(3)(v) of this section, K's change in the placed-
in-service date of the equipment is not a change in method of
accounting.
(3)(i) Except as otherwise provided under the authority of paragraph
(e)(3)(ii) of this section, to secure the Commissioner's consent to a
taxpayer's change in method of accounting the taxpayer generally must
file an application on Form 3115, ``Application for Change in Accounting
Method,'' with the Commissioner during the taxable year in which the
taxpayer desires to make the change in method of accounting. See
Sec. Sec. 1.381(c)(4)-1(d)(2) and 1.381(c)(5)-1(d)(2) for rules
allowing additional time, in some circumstances, for the filing of an
application on Form 3115 with respect to a transaction to which section
381(a) applies. To the extent applicable, the taxpayer must furnish all
information requested on the Form 3115. This information includes all
classes of items that will be treated differently under the new method
of accounting, any amounts that will be duplicated or omitted as a
result of the proposed change, and the taxpayer's computation of any
adjustments necessary to prevent such duplications or omissions. The
Commissioner may require such other information as may be necessary to
determine whether the proposed change will be permitted.
[[Page 62]]
Permission to change a taxpayer's method of accounting will not be
granted unless the taxpayer agrees to the Commissioner's prescribed
terms and conditions for effecting the change, including the taxable
year or years in which any adjustment necessary to prevent amounts from
being duplicated or omitted is to be taken into account. See section 481
and the regulations thereunder, relating to certain adjustments
resulting from accounting method changes, and section 472 and the
regulations thereunder, relating to adjustments for changes to and from
the last-in, first-out inventory method. For any Form 3115 filed on or
after May 15, 1997, see Sec. 1.446-1T(e)(3)(i)(B).
(ii) Notwithstanding the provisions of paragraph (e)(3)(i) of this
section, the Commissioner may prescribe administrative procedures under
which taxpayers will be permitted to change their method of accounting.
The administrative procedures shall prescribe those terms and conditions
necessary to obtain the Commissioner's consent to effect the change and
to prevent amounts from being duplicated or omitted. The terms and
conditions that may be prescribed by the Commissioner may include terms
and conditions that require the change in method of accounting to be
effected on a cut-off basis or by an adjustment under section 481(a) to
be taken into account in the taxable year or years prescribed by the
Commissioner.
(iii) This paragraph (e)(3) applies to Forms 3115 filed on or after
December 31, 1997. For other Forms 3115, see Sec. 1.446-1(e)(3) in
effect prior to December 31, 1997 (Sec. 1.446-1(e)(3) as contained in
the 26 CFR part 1 edition revised as of April 1, 1997).
(4) Effective date--(i) In general. Except as provided in paragraphs
(e)(3)(iii), (e)(4)(ii), and (e)(4)(iii) of this section, paragraph (e)
of this section applies on or after December 30, 2003. For the
applicability of regulations before December 30, 2003, see Sec. 1.446-
1(e) in effect prior to December 30, 2003 (Sec. 1.446-1(e) as contained
in 26 CFR part 1 edition revised as of April 1, 2003).
(ii) Changes involving depreciable or amortizable assets. With
respect to paragraph (e)(2)(ii)(d) of this section, paragraph
(e)(2)(iii) Examples 9 through 19 of this section, and the language
``certain changes in computing depreciation or amortization (see
paragraph (e)(2)(ii)(d) of this section)'' in the last sentence of
paragraph (e)(2)(ii)(a) of this section--
(A) For any change in depreciation or amortization that is a change
in method of accounting, this section applies to such a change in method
of accounting made by a taxpayer for a depreciable or amortizable asset
placed in service by the taxpayer in a taxable year ending on or after
December 30, 2003; and
(B) For any change in depreciation or amortization that is not a
change in method of accounting, this section applies to such a change
made by a taxpayer for a depreciable or amortizable asset placed in
service by the taxpayer in a taxable year ending on or after December
30, 2003.
(iii) Effective/applicability date for paragraph (e)(3)(i). The
rules of paragraph (e)(3)(i) of this section apply to corporate
reorganizations and tax-free liquidations described in section 381(a)
that occur on or after August 31, 2011.
[T.D. 6500, 25 FR 11708, Nov. 26, 1960]
Editorial Note: For Federal Register citations affecting Sec.
1.446-1, see the List of CFR Sections Affected, which appears in the
Finding Aids section of the printed volume and at www.govinfo.gov.
Sec. 1.446-2 Method of accounting for interest.
(a) Applicability--(1) In general. This section provides rules for
determining the amount of interest that accrues during an accrual period
(other than interest described in paragraph (a)(2) of this section) and
for determining the portion of a payment that consists of accrued
interest. For purposes of this section, interest includes original issue
discount and amounts treated as interest (whether stated or unstated) in
any lending or deferred payment transaction. Accrued interest determined
under this section is taken into account by a taxpayer under the
taxpayer's regular method of accounting (e.g., an accrual method or the
cash receipts and disbursements method). Application of an exception
described in paragraph (a)(2) of this section to one party to a
transaction does not affect
[[Page 63]]
the application of this section to any other party to the transaction.
(2) Exceptions--(i) Interest included or deducted under certain
other provisions. This section does not apply to interest that is taken
into account under--
(A) Sections 1272(a), 1275, and 163(e) (income and deductions
relating to original issue discount);
(B) Section 467(a)(2) (certain payments for the use of property or
services);
(C) Sections 1276 through 1278 (market discount);
(D) Sections 1281 through 1283 (discount on certain short-term
obligations);
(E) Section 7872(a) (certain loans with below-market interest
rates); or
(F) Section 1.1272-3 (an election by a holder to treat all interest
on a debt instrument as original issue discount).
(ii) De minimis original issue discount. This section does not apply
to de minimis original issue discount (other than de minimis original
issue discount treated as qualified stated interest) as determined under
Sec. 1.1273-1(d). See Sec. 1.163-7 for the treatment of de minimis
original issue discount by the issuer and Sec. Sec. 1.1273-1(d) and
1.1272-3 for the treatment of de minimis original issue discount by the
holder.
(b) Accrual of qualified stated interest. Qualified stated interest
(as defined in Sec. 1.1273-1(c)) accrues ratably over the accrual
period (or periods) to which it is attributable and accrues at the
stated rate for the period (or periods).
(c) Accrual of interest other than qualified stated interest.
Subject to the modifications in paragraph (d) of this section, the
amount of interest (other than qualified stated interest) that accrues
for any accrual period is determined under rules similar to those in the
regulations under sections 1272 and 1275 for the accrual of original
issue discount. The preceding sentence applies regardless of any
contrary formula agreed to by the parties.
(d) Modifications--(1) Issue price. The issue price of the loan or
contract is equal to--
(i) In the case of a contract for the sale or exchange of property
to which section 483 applies, the amount described in Sec. 1.483-
2(a)(1)(i) or (ii), whichever is applicable;
(ii) In the case of a contract for the sale or exchange of property
to which section 483 does not apply, the stated principal amount; or
(iii) In any other case, the amount loaned.
(2) Principal payments that are not deferred payments. In the case
of a contract to which section 483 applies, principal payments that are
not deferred payments are ignored for purposes of determining yield and
adjusted issue price.
(e) Allocation of interest to payments--(1) In general. Except as
provided in paragraphs (e)(2), (e)(3), and (e)(4) of this section, each
payment under a loan (other than payments of additional interest or
similar charges provided with respect to amounts that are not paid when
due) is treated as a payment of interest to the extent of the accrued
and unpaid interest determined under paragraphs (b) and (c) of this
section as of the date the payment becomes due.
(2) Special rule for points deductible under section 461(g)(2). If a
payment of points is deductible by the borrower under section 461(g)(2),
the payment is treated by the borrower as a payment of interest.
(3) Allocation respected in certain small transactions. [Reserved]
(4) Pro rata prepayments. Accrued but unpaid interest is allocated
to a pro rata prepayment under rules similar to those for allocating
accrued but unpaid original issue discount to a pro rata prepayment
under Sec. 1.1275-2(f). For purposes of the preceding sentence, a pro
rata prepayment is a payment that is made prior to maturity that--
(i) Is not made pursuant to the contract's payment schedule; and
(ii) Results in a substantially pro rata reduction of each payment
remaining to be paid on the contract.
(f) Aggregation rule. For purposes of this section, all contracts
calling for deferred payments arising from the same transaction (or a
series of related transactions) are treated as a single contract. This
rule, however, generally only applies to contracts involving a single
borrower and a single lender.
(g) Debt instruments denominated in a currency other than the U.S.
dollar. This section applies to a debt instrument
[[Page 64]]
that provides for all payments denominated in, or determined by
reference to, the functional currency of the taxpayer or qualified
business unit of the taxpayer (even if that currency is other than the
U.S. dollar). See Sec. 1.988-2(b) to determine interest income or
expense for debt instruments that provide for payments denominated in,
or determined by reference to, a nonfunctional currency.
(h) Example. The following example illustrates the rules of this
section.
Example. Allocation of unstated interest to deferred payments. (i)
Facts. On July 1, 1996, A sells his personal residence to B for a stated
purchase price of $1,297,143.66. The property is not personal use
property (within the meaning of section 1275(b)(3)) in the hands of B.
Under the loan agreement, B is required to make two installment payments
of $648,571.83 each, the first due on June 30, 1998, and the second due
on June 30, 2000. Both A and B use the cash receipts and disbursements
method of accounting and use a calendar year for their taxable year.
(ii) Amount of unstated interest. Under section 483, the agreement
does not provide for adequate stated interest. Thus, the loan's yield is
the test rate of interest determined under Sec. 1.483-3. Assume that
both A and B use annual accrual periods and that the test rate of
interest is 9.2 percent, compounded annually. Under Sec. 1.483-2, the
present value of the deferred payments is $1,000,000. Thus, the
agreement has unstated interest of $297,143.66.
(iii) First two accrual periods. Under paragraph (d)(1) of this
section, the issue price at the beginning of the first accrual period is
$1,000,000 (the amount described in Sec. 1.483-2(a)(1)(i)). Under
paragraph (c) of this section, the amount of interest that accrues for
the first accrual period is $92,000 ($1,000,000 x .092) and the amount
of interest that accrues for the second accrual period is $100,464
($1,092,000 x .092). Thus, $192,464 of interest has accrued as of the
end of the second accrual period. Under paragraph (e)(1) of this
section, the $648,571.83 payment made on June 30, 1998, is treated first
as a payment of interest to the extent of $192,464. The remainder of the
payment ($456,107.83) is treated as a payment of principal. Both A and B
take the payment of interest ($192,464) into account in 1998.
(iv) Second two accrual periods. The adjusted issue price at the
beginning of the third accrual period is $543,892.17 ($1,092,000 +
$100,464-$648,571.83). The amount of interest that accrues for the third
accrual period is $50,038.08 ($543,892.17 x .092) and the amount of
interest that accrues for the final accrual period is $54,641.58, the
excess of the amount payable at maturity ($648,571.83), over the
adjusted issue price at the beginning of the accrual period
($593,930.25). As of the date the second payment becomes due,
$104,679.66 of interest has accrued. Thus, of the $648,571.83 payment
made on June 30, 2000, $104,679.66 is treated as interest and
$543,892.17 is treated as principal. Both A and B take the payment of
interest ($104,679.66) into account in 2000.
(i) [Reserved]
(j) Effective date. This section applies to debt instruments issued
on or after April 4, 1994, and to lending transactions, sales, and
exchanges that occur on or after April 4, 1994. Taxpayers, however, may
rely on this section for debt instruments issued after December 21,
1992, and before April 4, 1994, and for lending transactions, sales, and
exchanges that occur after December 21, 1992, and before April 4, 1994.
[T.D. 8517, 59 FR 4804, Feb. 2, 1994]
Sec. 1.446-3 Notional principal contracts.
(a) Table of contents. This paragraph (a) lists captioned paragraphs
contained in Sec. 1.446-3.
Sec. 1.446-3 Notional principal contracts.
(a) Table of contents.
(b) Purpose.
(c) Definitions and scope.
(1) Notional principal contract.
(i) In general.
(ii) Excluded contracts.
(iii) Transactions within section 475.
(iv) Transactions within section 988.
(2) Specified index.
(3) Notional principal amount.
(4) Special definitions.
(i) Related person and party to the contract.
(ii) Objective financial information.
(iii) Dealer in notional principal contracts.
(d) Taxable year of inclusion and deduction.
(e) Periodic payments.
(1) Definition.
(2) Recognition rules.
(i) In general.
(ii) Rate set in arrears.
(iii) Notional principal amount set in arrears.
(3) Examples.
(f) Nonperiodic payments.
(1) Definition.
(2) Recognition rules.
(i) In general.
(ii) General rule for swaps.
(iii) Alternative methods for swaps.
(A) Prepaid swaps.
(B) Other nonperiodic swap payments.
[[Page 65]]
(iv) General rule for caps and floors.
(v) Alternative methods for caps and floors that hedge debt
instruments.
(A) Prepaid caps and floors.
(B) Other caps and floors.
(C) Special method for collars.
(vi) Additional methods.
(3) Term of extendible or terminable contracts.
(4) Examples.
(g) Special rules.
(1) Disguised notional principal contracts.
(2) Hedged notional principal contracts.
(3) Options and forwards to enter into notional principal contracts.
(4) Swaps with significant nonperiodic payments.
(5) Caps and floors that are significantly in-the-money. [Reserved]
(6) Examples.
(h) Termination payments.
(1) Definition.
(2) Taxable year of inclusion and deduction by original parties.
(3) Taxable year of inclusion and deduction by assignees.
(4) Special rules.
(i) Assignment of one leg of a contract.
(ii) Substance over form.
(5) Examples.
(i) Anti-abuse rule.
(j) Effective date.
(b) Purpose. The purpose of this section is to enable the clear
reflection of the income and deductions from notional principal
contracts by prescribing accounting methods that reflect the economic
substance of such contracts.
(c) Definitions and scope--(1) Notional principal contract--(i) In
general. A notional principal contract is a financial instrument that
provides for the payment of amounts by one party to another at specified
intervals calculated by reference to a specified index upon a notional
principal amount in exchange for specified consideration or a promise to
pay similar amounts. An agreement between a taxpayer and a qualified
business unit (as defined in section 989(a)) of the taxpayer, or among
qualified business units of the same taxpayer, is not a notional
principal contract because a taxpayer cannot enter into a contract with
itself. Notional principal contracts governed by this section include
interest rate swaps, currency swaps, basis swaps, interest rate caps,
interest rate floors, commodity swaps, equity swaps, equity index swaps,
and similar agreements. A collar is not itself a notional principal
contract, but certain caps and floors that comprise a collar may be
treated as a single notional principal contract under paragraph
(f)(2)(v)(C) of this section. A contract may be a notional principal
contract governed by this section even though the term of the contract
is subject to termination or extension. Each confirmation under a master
agreement to enter into agreements governed by this section is treated
as a separate notional principal contract.
(ii) Excluded contracts. A contract described in section 1256(b), a
futures contract, a forward contract, and an option are not notional
principal contracts. An instrument or contract that constitutes
indebtedness under general principles of Federal income tax law is not a
notional principal contract. An option or forward contract that entitles
or obligates a person to enter into a notional principal contract is not
a notional principal contract, but payments made under such an option or
forward contract may be governed by paragraph (g)(3) of this section.
(iii) Transactions within section 475. To the extent that the rules
provided in paragraphs (e) and (f) of this section are inconsistent with
the rules that apply to any notional principal contract that is governed
by section 475 and regulations thereunder, the rules of section 475 and
the regulations thereunder govern.
(iv) Transactions within section 988. To the extent that the rules
provided in this section are inconsistent with the rules that apply to
any notional principal contract that is also a section 988 transaction
or that is integrated with other property or debt pursuant to section
988(d), the rules of section 988 and the regulations thereunder govern.
(2) Specified index. A specified index is--
(i) A fixed rate, price, or amount;
(ii) A fixed rate, price, or amount applicable in one or more
specified periods followed by one or more different fixed rates, prices,
or amounts applicable in other periods;
(iii) An index that is based on objective financial information (as
defined in paragraph (c)(4)(ii) of this section); and
[[Page 66]]
(iv) An interest rate index that is regularly used in normal lending
transactions between a party to the contract and unrelated persons.
(3) Notional principal amount. For purposes of this section, a
notional principal amount is any specified amount of money or property
that, when multiplied by a specified index, measures a party's rights
and obligations under the contract, but is not borrowed or loaned
between the parties as part of the contract. The notional principal
amount may vary over the term of the contract, provided that it is set
in advance or varies based on objective financial information (as
defined in paragraph (c)(4)(ii) of this section).
(4) Special definitions--(i) Related person and party to the
contract. A related person is a person related (within the meaning of
section 267(b) or 707(b)(1)) to one of the parties to the notional
principal contract or a member of the same consolidated group (as
defined in Sec. 1.1502-1(h)) as one of the parties to the contract. For
purposes of this paragraph (c), a related person is considered to be a
party to the contract.
(ii) Objective financial information. For purposes of this paragraph
(c), objective financial information is any current, objectively
determinable financial or economic information that is not within the
control of any of the parties to the contract and is not unique to one
of the parties' circumstances (such as one party's dividends, profits,
or the value of its stock). Thus, for example, a notional principal
amount may be based on a broadly-based equity index or the outstanding
balance of a pool of mortgages, but not on the value of a party's stock.
(iii) Dealer in notional principal contracts. A dealer in notional
principal contracts is a person who regularly offers to enter into,
assume, offset, assign, or otherwise terminate positions in notional
principal contracts with customers in the ordinary course of a trade or
business.
(d) Taxable year of inclusion and deduction. For all purposes of the
Code, the net income or net deduction from a notional principal contract
for a taxable year is included in or deducted from gross income for that
taxable year. The net income or net deduction from a notional principal
contract for a taxable year equals the total of all of the periodic
payments that are recognized from that contract for the taxable year
under paragraph (e) of this section and all of the nonperiodic payments
that are recognized from that contract for the taxable year under
paragraph (f) of this section.
(e) Periodic payments--(1) Definition. Periodic payments are
payments made or received pursuant to a notional principal contract that
are payable at intervals of one year or less during the entire term of
the contract (including any extension periods provided for in the
contract), that are based on a specified index described in paragraph
(c)(2)(i), (iii), or (iv) of this section (appropriately adjusted for
the length of the interval), and that are based on either a single
notional principal amount or a notional principal amount that varies
over the term of the contract in the same proportion as the notional
principal amount that measures the other party's payments. Payments to
purchase or sell a cap or a floor, however, are not periodic payments.
(2) Recognition rules--(i) In general. All taxpayers, regardless of
their method of accounting, must recognize the ratable daily portion of
a periodic payment for the taxable year to which that portion relates.
(ii) Rate set in arrears. If the amount of a periodic payment is not
determinable at the end of a taxable year because the value of the
specified index is not fixed until a date that occurs after the end of
the taxable year, the ratable daily portion of a periodic payment that
relates to that taxable year is generally based on the specified index
that would have applied if the specified index were fixed as of the last
day of the taxable year. If a taxpayer determines that the value of the
specified index as of the last day of the taxable year does not provide
a reasonable estimate of the specified index that will apply when the
payment is fixed, the taxpayer may use a reasonable estimate of the
specified index each year, provided that the taxpayer (and any related
person that is a party to the contract) uses the same method to make the
estimate consistently from year to
[[Page 67]]
year and uses the same estimate for purposes of all financial reports to
equity holders and creditors. The taxpayer's treatment of notional
principal contracts with substantially similar specified indices will be
considered in determining whether the taxpayer's estimate of the
specified index is reasonable. Any difference between the amount that is
recognized under this paragraph (e)(2)(ii) and the corresponding portion
of the actual payment that becomes fixed under the contract is taken
into account as an adjustment to the net income or net deduction from
the notional principal contract for the taxable year during which the
payment becomes fixed.
(iii) Notional principal amount set in arrears. Rules similar to the
rules of paragraph (e)(2)(ii) of this section apply if the amount of a
periodic payment is not determinable at the end of a taxable year
because the notional principal amount is not fixed until a date that
occurs after the end of the taxable year.
(3) Examples. The following examples illustrate the application of
paragraph (e) of this section.
Example 1. Accrual of periodic swap payments. (a) On April 1, 1995,
A enters into a contract with unrelated counterparty B under which, for
a term of five years, A is obligated to make a payment to B each April
1, beginning April 1, 1996, in an amount equal to the London Interbank
Offered Rate (LIBOR), as determined on the immediately preceding April
1, multiplied by a notional principal amount of $100 million. Under the
contract, B is obligated to make a payment to A each April 1, beginning
April 1, 1996, in an amount equal to 8% multiplied by the same notional
principal amount. A and B are calendar year taxpayers that use the
accrual method of accounting. On April 1, 1995, LIBOR is 7.80%.
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section, and both LIBOR and a fixed interest
rate of 8% are specified indices under paragraph (c)(2) of this section.
All of the payments to be made by A and B are periodic payments under
paragraph (e)(1) of this section because each party's payments are based
on a specified index described in paragraphs (c)(2)(iii) and (c)(2)(i)
of this section, respectively, are payable at periodic intervals of one
year or less throughout the term of the contract, and are based on a
single notional principal amount.
(c) Under the terms of the swap agreement, on April 1, 1996, B is
obligated to make a payment to A of $8,000,000 (8% x $100,000,000) and A
is obligated to make a payment to B of $7,800,000 (7.80% x
$100,000,000). Under paragraph (e)(2)(i) of this section, the ratable
daily portions for 1995 are the amounts of these periodic payments that
are attributable to A's and B's taxable year ending December 31, 1995.
The ratable daily portion of the 8% fixed leg is $6,010,929 (275 days/
366 days x $8,000,000), and the ratable daily portion of the floating
leg is $5,860,656 (275 days/366 days x $7,800,000). The net amount for
the taxable year is the difference between the ratable daily portions of
the two periodic payments, or $150,273 ($6,010,929--$5,860,656).
Accordingly, A has net income of $150,273 from this swap for 1995, and B
has a corresponding net deduction of $150,273.
(d) The $49,727 unrecognized balance of the $200,000 net periodic
payment that is made on April 1, 1996, is included in A's and B's net
income or net deduction from the contract for 1996.
(e) If the parties had entered into the contract on February 1,
1995, the result would not change because no portion of either party's
obligation to make a payment under the swap relates to the period prior
to April 1, 1995. Consequently, under paragraph (e)(2) of this section,
neither party would accrue any income or deduction from the swap for the
period from February 1, 1995, through March 31, 1995.
Example 2. Accrual of periodic swap payments by cash method
taxpayer. (a) On April 1, 1995, C enters into a contract with unrelated
counterparty D under which, for a period of five years, C is obligated
to make a fixed payment to D each April 1, beginning April 1, 1996, in
an amount equal to 8% multiplied by a notional principal amount of $100
million. D is obligated to make semi-annual payments to C each April 1
and October 1, beginning October 1, 1995, in an amount equal to one-half
of the LIBOR amount as of the first day of the preceding 6-month period
multiplied by the notional principal amount. The payments are to be
calculated using a 30/360 day convention. C is a calendar year taxpayer
that uses the accrual method of accounting. D is a calendar year
taxpayer that uses the cash receipts and disbursements method of
accounting. LIBOR is 7.80% on April 1, 1995, and 7.46% on October 1,
1995.
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section, and LIBOR and the fixed interest rate
of 8% are each specified indices under paragraph (c)(2) of this section.
All of the payments to be made by C and D are periodic payments under
paragraph (e)(1) of this section because they are each based on
appropriate specified indices, are payable at periodic intervals of one
year or less
[[Page 68]]
throughout the term of the contract, and are based on a single notional
principal amount.
(c) Under the terms of the swap agreement, D pays C $3,900,000 (0.5
x 7.8% x $100,000,000) on October 1, 1995. In addition, D is obligated
to pay C $3,730,000 (0.5 x 7.46% x $100,000,000) on April 1, 1996. C is
obligated to pay D $8,000,000 on April 1, 1996. Under paragraph
(e)(2)(i) of this section, C's and D's ratable daily portions for 1995
are the amounts of the periodic payments that are attributable to their
taxable year ending December 31, 1995. The ratable daily portion of the
8% fixed leg is $6,000,000 (270 days/360 days x $8,000,000), and the
ratable daily portion of the floating leg is $5,765,000 ($3,900,000 +
(90 days/180 days x $3,730,000)). Thus, C's net deduction from the
contract for 1995 is $235,000 ($6,000,000--$5,765,000) and D reports
$235,000 of net income from the contract for 1995.
(d) The net unrecognized balance of $135,000 ($2,000,000 balance of
the fixed leg--$1,865,000 balance of the floating leg) is included in
C's and D's net income or net deduction from the contract for 1996.
Example 3. Accrual of swap payments on index set in arrears. (a) The
facts are the same as in Example 1, except that A's obligation to make
payments based upon LIBOR is determined by reference to LIBOR on the day
each payment is due. LIBOR is 8.25% on December 31, 1995, and 8.16% on
April 1, 1996.
(b) On December 31, 1995, the amount that A is obligated to pay B is
not known because it will not become fixed until April 1, 1996. Under
paragraph (e)(2)(ii) of this section, the ratable daily portion of the
periodic payment from A to B for 1995 is based on the value of LIBOR on
December 31, 1995 (unless A or B determines that the value of LIBOR on
that day does not reasonably estimate the value of the specified index).
Thus, the ratable daily portion of the floating leg is $6,198,770 (275
days/366 days x 8.25% x $100,000,000), while the ratable daily portion
of the fixed leg is $6,010,929 (275 days/366 days x $8,000,000). The net
amount for 1995 on this swap is $187,841 ($6,198,770--$6,010,929).
Accordingly, B has $187,841 of net income from the swap in 1995, and A
has a net deduction of $187,841.
(c) On April 1, 1996, A makes a net payment to B of $160,000
($8,160,000 payment on the floating leg--$8,000,000 payment on the fixed
leg). For purposes of determining their net income or net deduction from
this contract for the year ended December 31, 1996, B and A must adjust
the net income and net deduction they recognized in 1995 by $67,623 (275
days/366 days x ($8,250,000 presumed payment on the floating leg--
$8,160,000 actual payment on the floating leg)).
(f) Nonperiodic payments--(1) Definition. A nonperiodic payment is
any payment made or received with respect to a notional principal
contract that is not a periodic payment (as defined in paragraph (e)(1)
of this section) or a termination payment (as defined in paragraph (h)
of this section). Examples of nonperiodic payments are the premium for a
cap or floor agreement (even if it is paid in installments), the payment
for an off-market swap agreement, the prepayment of part or all of one
leg of a swap, and the premium for an option to enter into a swap if and
when the option is exercised.
(2) Recognition rules--(i) In general. All taxpayers, regardless of
their method of accounting, must recognize the ratable daily portion of
a nonperiodic payment for the taxable year to which that portion
relates. Generally, a nonperiodic payment must be recognized over the
term of a notional principal contract in a manner that reflects the
economic substance of the contract.
(ii) General rule for swaps. A nonperiodic payment that relates to a
swap must be recognized over the term of the contract by allocating it
in accordance with the forward rates (or, in the case of a commodity,
the forward prices) of a series of cash-settled forward contracts that
reflect the specified index and the notional principal amount. For
purposes of this allocation, the forward rates or prices used to
determine the amount of the nonperiodic payment will be respected, if
reasonable. See paragraph (f)(4) Example 7 of this section.
(iii) Alternative methods for swaps. Solely for purposes of
determining the timing of income and deductions, a nonperiodic payment
made or received with respect to a swap may be allocated to each period
of the swap contract using one of the methods described in this
paragraph (f)(2)(iii). The alternative methods may not be used by a
dealer in notional principal contracts (as defined in paragraph
(c)(4)(iii) of this section) for swaps entered into or acquired in its
capacity as a dealer.
(A) Prepaid swaps. An upfront payment on a swap may be amortized by
assuming that the nonperiodic payment represents the present value of a
series of equal payments made throughout the term of the swap contract
(the level payment method), adjusted as appropriate to take account
[[Page 69]]
of increases or decreases in the notional principal amount. The discount
rate used in this calculation must be the rate (or rates) used by the
parties to determine the amount of the nonperiodic payment. If that rate
is not readily ascertainable, the discount rate used must be a rate that
is reasonable under the circumstances. Under this method, an upfront
payment is allocated by dividing each equal payment into its principal
recovery and time value components. The principal recovery components of
the equal payments are treated as periodic payments that are deemed to
be made on each of the dates that the swap contract provides for
periodic payments by the payor of the nonperiodic payment or, if none,
on each of the dates that the swap contract provides for periodic
payments by the recipient of the nonperiodic payment. The time value
component is needed to compute the amortization of the nonperiodic
payment, but is otherwise disregarded. See paragraph (f)(4) Example 5 of
this section.
(B) Other nonperiodic swap payments. Nonperiodic payments on a swap
other than an upfront payment may be amortized by treating the contract
as if it provided for a single upfront payment (equal to the present
value of the nonperiodic payments) and a loan between the parties. The
discount rate (or rates) used in determining the deemed upfront payment
and the time value component of the deemed loan is the same as the rate
(or rates) used in the level payment method. The single upfront payment
is then amortized under the level payment method described in paragraph
(f)(2)(iii)(A) of this section. The time value component of the loan is
not treated as interest, but, together with the amortized amount of the
deemed upfront payment, is recognized as a periodic payment. See
paragraph (f)(4) Example 6 of this section. If both parties make
nonperiodic payments, this calculation is done separately for the
nonperiodic payments made by each party.
(iv) General rule for caps and floors. A payment to purchase or sell
a cap or floor must be recognized over the term of the agreement by
allocating it in accordance with the prices of a series of cash-settled
option contracts that reflect the specified index and the notional
principal amount. For purposes of this allocation, the option pricing
used by the parties to determine the total amount paid for the cap or
floor will be respected, if reasonable. Only the portion of the purchase
price that is allocable to the option contract or contracts that expire
during a particular period is recognized for that period. Thus, under
this paragraph (f)(2)(iv), straight-line or accelerated amortization of
a cap premium is generally not permitted. See paragraph (f)(4) Examples
1 and 2 of this section.
(v) Alternative methods for caps and floors that hedge debt
instruments. Solely for purposes of determining the timing of income and
deductions, if a cap or floor is entered into primarily to reduce risk
with respect to a specific debt instrument or group of debt instruments
held or issued by the taxpayer, the taxpayer may amortize a payment to
purchase or sell the cap or floor using the methods described in this
paragraph (f)(2)(v), adjusted as appropriate to take account of
increases or decreases in the notional principal amount. The alternative
methods may not be used by a dealer in notional principal contracts (as
defined in paragraph (c)(4)(iii) of this section) for caps or floors
entered into or acquired in its capacity as a dealer.
(A) Prepaid caps and floors. A premium paid upfront for a cap or a
floor may be amortized using the ``level payment method'' described in
paragraph (f)(2)(iii)(A) of this section. See paragraph (f)(4) Example 3
of this section.
(B) Other caps and floors. Nonperiodic payments on a cap or floor
other than an upfront payment are amortized by treating the contract as
if it provided for a single upfront payment (equal to the present value
of the nonperiodic payments) and a loan between the parties as described
in paragraph (f)(2)(iii)(B) of this section. Under the level payment
method, a cap or floor premium paid in level annual installments over
the term of the contract is effectively included or deducted from income
ratably, in accordance with the level payments. See paragraph (f)(4)
Example 4 of this section.
(C) Special method for collars. A taxpayer may also treat a cap and
a floor
[[Page 70]]
that comprise a collar as a single notional principal contract and may
amortize the net nonperiodic payment to enter into the cap and floor
over the term of the collar in accordance with the methods prescribed in
this paragraph (f)(2)(v).
(vi) Additional methods. The Commissioner may, by a revenue ruling
or a revenue procedure published in the Internal Revenue Bulletin,
provide alternative methods for allocating nonperiodic payments that
relate to a notional principal contract to each year of the contract.
See Sec. 601.601(d)(2)(ii)(b) of this chapter.
(3) Term of extendible or terminable contracts. For purposes of this
paragraph (f), the term of a notional principal contract that is subject
to extension or termination is the reasonably expected term of the
contract.
(4) Examples. The following examples illustrate the application of
paragraph (f) of this section.
Example 1.Cap premium amortized using general rule. (a) On January
1, 1995, when LIBOR is 8%, F pays unrelated party E $600,000 for a
contract that obligates E to make a payment to F each quarter equal to
one-quarter of the excess, if any, of three-month LIBOR over 9% with
respect to a notional principal amount of $25 million. Both E and F are
calendar year taxpayers. E provides F with a schedule of allocable
premium amounts indicating that the cap was priced according to a
reasonable variation of the Black-Scholes option pricing formula and
that the total premium is allocable to the following periods:
------------------------------------------------------------------------
Pricing
allocation
------------------------------------------------------------------------
1995.................................................... $55,000
1996.................................................... 225,000
1997.................................................... 320,000
---------------
$600,000
------------------------------------------------------------------------
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section, and LIBOR is a specified index under
paragraph (c)(2)(iii) of this section. Any payments made by E to F are
periodic payments under paragraph (e)(1) of this section because they
are payable at periodic intervals of one year or less throughout the
term of the contract, are based on an appropriate specified index, and
are based on a single notional principal amount. The $600,000 cap
premium paid by F to E is a nonperiodic payment as defined in paragraph
(f)(1) of this section.
(c) The Black-Scholes model is recognized in the financial industry
as a standard technique for pricing interest rate cap agreements.
Therefore, because E has used a reasonable option pricing model, the
schedule generated by E is consistent with the economic substance of the
cap, and may be used by both E and F for calculating their ratable daily
portions of the cap premium. Under paragraph (f)(2)(iv) of this section,
E recognizes the ratable daily portion of the cap premium as income, and
F recognizes the ratable daily portion of the cap premium as a deduction
based on the pricing schedule. Thus, E and F account for the contract as
follows:
------------------------------------------------------------------------
Ratable daily
portion
------------------------------------------------------------------------
1995.................................................... $55,000
1996.................................................... 225,000
1997.................................................... 320,000
---------------
$600,000
------------------------------------------------------------------------
(d) Any periodic payments under the cap agreement (that is, payments
that E makes to F because LIBOR exceeds 9%) are included in the parties'
net income or net deduction from the contract in accordance with
paragraph (e)(2) of this section.
Example 2. Cap premium allocated to proper period. (a) The facts are
the same as in Example 1, except that the cap is purchased by F on
November 1, 1994. The first determination date under the cap agreement
is January 31, 1995 (the last day of the first quarter to which the
contract relates). LIBOR is 9.1% on December 31, 1994, and is 9.15% on
January 31, 1995.
(b) E and F recognize $9,192 (61 days/365 days x $55,000) as the
ratable daily portion of the nonperiodic payment for 1994, and include
that amount in their net income or net deduction from the contract for
1994. If E's pricing model allocated the cap premium to each quarter
covered by the contract, the ratable daily portion would be 61 days/92
days times the premium allocated to the first quarter.
(c) Under paragraph (e)(2)(ii) of this section, E and F calculate
the payments using LIBOR as of December 31, 1994. F recognizes as income
the ratable daily portion of the presumed payment, or $4,144 (61 days/92
days x .25 x .001 x $25,000,000). Thus, E reports $5,048 of net income
from the contract for 1994 ($9,192-$4,144), and F reports a net
deduction from the contract of $5,048.
(d) On January 31, 1995, E pays F $9,375 (.25 x .0015 x $25,000,000)
under the terms of the cap agreement. For purposes of determining their
net income or net deduction from this contract for the year ended
December 31, 1995, E and F must adjust their respective net income and
net deduction from the cap
[[Page 71]]
by $2,072 (61 days/92 days x ($9,375 actual payment under the cap on
January 31, 1995--$6,250 presumed payment under the cap on December 31,
1994)).
Example 3. Cap premium amortized using alternative method. (a) The
facts are the same as in Example 1, except that the cap provides for
annual payments by E and is entered into by F primarily to reduce risk
with respect to a debt instrument issued by F. F elects to amortize the
cap premium using the alternative level payment method provided under
paragraph (f)(2)(v)(A) of this section. Under that method, F amortizes
the cap premium by assuming that the $600,000 is repaid in 3 equal
annual payments of $241,269, assuming a discount rate of 10%. Each
payment is divided into a time value component and a principal
component, which are set out below.
----------------------------------------------------------------------------------------------------------------
Time value Principal
Level payment component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $241,269 $60,000 $181,269
1996................................................... 241,269 41,873 199,396
1997................................................... 241,269 21,934 219,335
--------------------------------------------------------
$723,807 $123,807 $600,000
----------------------------------------------------------------------------------------------------------------
(b) The net of the ratable daily portions of the principal component
and the payments, if any, received from E comprise F's annual net income
or net deduction from the cap. The time value components are needed only
to compute the ratable daily portions of the cap premium, and are
otherwise disregarded.
Example 4. Cap premium paid in level installments and amortized
using alternative method. (a) The facts are the same as in Example 3,
except that F agrees to pay for the cap in three level installments of
$241,269 (a total of $723,807) on December 31, 1995, 1996, and 1997. The
present value of three payments of $241,269, discounted at 10%, is
$600,000. For purposes of amortizing the cap premium under the
alternative method provided in paragraph (f)(2)(v)(B) of this section, F
is treated as paying $600,000 for the cap on January 1, 1995, and
borrowing $600,000 from E that will be repaid in three annual
installments of $241,269. The time value component of the loan is
computed as follows:
----------------------------------------------------------------------------------------------------------------
Time value Principal
Loan balance component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $600,000 $60,000 $181,269
1996................................................... 418,731 41,873 199,396
1997................................................... 219,335 21,934 219,335
-------------------------------------
................. $123,807 $600,000
----------------------------------------------------------------------------------------------------------------
(b) F is treated as making periodic payments equal to the amortized
principal components from a $600,000 cap paid in advance (as described
in Example 3), increased by the time value components of the $600,000
loan, which totals $241,269 each year. The time value components of the
$600,000 loan are included in the periodic payments made by F, but are
not characterized as interest income or expense. The effect of the
alternative method in this situation is to allow F to amortize the cap
premium in level installments, the same way it is paid. The net of the
ratable daily portions of F's deemed periodic payments and the payments,
if any, received from E comprise F's annual net income or net deduction
from the cap.
Example 5. Upfront interest rate swap payment amortized using
alternative method. (a) On January 1, 1995, G enters into an interest
rate swap agreement with unrelated counterparty H under which, for a
term of five years, G is obligated to make annual payments at 11% and H
is obligated to make annual payments at LIBOR on a notional principal
amount of $100 million. At the time G and H enter into this swap
agreement, the rate for similar on-market swaps is LIBOR to 10%. To
compensate for this difference, on January 1, 1995, H pays G a yield
adjustment fee of $3,790,786. G provides H with information that
indicates that the amount of the yield adjustment fee was determined as
the present value, at 10% compounded annually, of five annual payments
of $1,000,000 (1% x $100,000,000). G and H are calendar year taxpayers.
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section. The yield adjustment fee is a
nonperiodic payment as defined in paragraph (f)(1) of this section.
(c) Under the alternative method described in paragraph
(f)(2)(iii)(A) of this section, the yield adjustment fee is recognized
over the life of the agreement by assuming that the
[[Page 72]]
$3,790,786 is repaid in five level payments. Assuming a constant yield
to maturity and annual compounding at 10%, the ratable daily portions
are computed as follows:
----------------------------------------------------------------------------------------------------------------
Time value Principal
Level payment component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $1,000,000 $379,079 $620,921
1996................................................... 1,000,000 316,987 683,013
1997................................................... 1,000,000 248,685 751,315
1998................................................... 1,000,000 173,554 826,446
1999................................................... 1,000,000 90,909 909,091
--------------------------------------------------------
$5,000,000 $1,209,214 $3,790,786
----------------------------------------------------------------------------------------------------------------
(d) G also makes swap payments to H at 11%, while H makes swap
payments to G based on LIBOR. The net of the ratable daily portions of
the 11% payments by G, the LIBOR payments by H, and the principal
component of the yield adjustment fee paid by H determines the annual
net income or net deduction from the contract for both G and H. The time
value components are needed only to compute the ratable daily portions
of the yield adjustment fee paid by H, and are otherwise disregarded.
Example 6. Backloaded interest rate swap payment amortized using
alternative method. (a) The facts are the same as in Example 5, but H
agrees to pay G a yield adjustment fee of $6,105,100 on December 31,
1999. Under the alternative method in paragraph (f)(2)(iii)(B) of this
section, H is treated as paying a yield adjustment fee of $3,790,786
(the present value of $6,105,100, discounted at a 10% rate with annual
compounding) on January 1, 1995. Solely for timing purposes, H is
treated as borrowing $3,790,786 from G. Assuming annual compounding at
10%, the time value component is computed as follows:
----------------------------------------------------------------------------------------------------------------
Time value Principal
Loan balance component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $3,790,786 $379,079 0
1996................................................... 4,169,865 416,987 0
1997................................................... 4,586,852 458,685 0
1998................................................... 5,045,537 504,554 0
1999................................................... 5,550,091 555,009 6,105,100
----------------------------------------------------------------------------------------------------------------
(b) The amortization of H's yield adjustment fee is equal to the
amortization of a yield adjustment fee of $3,790,786 paid in advance (as
described in Example 5), increased by the time value component of the
$3,790,786 deemed loan from G to H. Thus, the amount of H's yield
adjustment fee that is allocated to 1995 is $1,000,000 ($620,921 +
$379,079). The time value components of the $3,790,786 loan are included
in the periodic payments paid by H, but are not characterized as
interest income or expense. The net of the ratable daily portions of the
11% swap payments by G, and the LIBOR payments by H, added to the
principal components from Example 5 and the time value components from
this Example 6, determines the annual net income or net deduction from
the contract for both G and H.
Example 7. Nonperiodic payment on a commodity swap amortized under
general rule. (a) On January 1, 1995, I enters into a commodity swap
agreement with unrelated counterparty J under which, for a term of three
years, I is obligated to make annual payments based on a fixed price of
$2.35 per bushel times a notional amount of 100,000 bushels of corn and
J is obligated to make annual payments equal to the spot price times the
same notional amount. Assume that on January 1, 1995, the price of a one
year forward for corn is $2.40 per bushel, of a two year forward $2.55
per bushel, and of a 3 year forward $2.75 per bushel. To compensate for
the below-market fixed price provided in the swap agreement, I pays J
$53,530 for entering into the swap. I and J are calendar year taxpayers.
(b) This contract is a notional principal contract as defined by
paragraph (c)(1) of this section, and $2.35 and the spot price of corn
are specified indices under paragraphs (c)(2)(i) and (iii) of this
section, respectively. The $53,530 payment is a nonperiodic payment as
defined by paragraph (f)(1) of this section.
(c) Assuming that I does not use the alternative methods provided
under paragraph (f)(2)(iii) of this section, paragraph (f)(2)(ii) of
this section requires that I recognize the nonperiodic payment over the
term of the agreement by allocating the payment to each forward contract
in accordance with the forward price of corn. Solely for timing
purposes, I treats the $53,530 nonperiodic payment as a loan that J will
repay in three
[[Page 73]]
installments of $5,000, $20,000, and $40,000, the expected payouts on
the in-the-money forward contracts. With annual compounding at 8%, the
ratable daily portions are computed as follows:
----------------------------------------------------------------------------------------------------------------
Expected forward Time value Principal
payment component component
----------------------------------------------------------------------------------------------------------------
1995................................................... $5,000 $4,282 $718
1996................................................... 20,000 4,225 15,775
1997................................................... 40,000 2,963 37,037
--------------------------------------------------------
$65,000 $11,470 $53,530
----------------------------------------------------------------------------------------------------------------
(d) The ratable daily portion of the principal component is added to
I's periodic payments in computing its net income or net deduction from
the notional principal contract for each taxable year. The time value
components are needed only to compute the principal components, and are
otherwise disregarded.
(g) Special rules--(1) Disguised notional principal contracts. The
Commissioner may recharacterize all or part of a transaction (or series
of transactions) if the effect of the transaction (or series of
transactions) is to avoid the application of this section.
(2) Hedged notional principal contracts. If a taxpayer, either
directly or through a related person (as defined in paragraph (c)(4)(i)
of this section), reduces risk with respect to a notional principal
contract by purchasing, selling, or otherwise entering into other
notional principal contracts, futures, forwards, options, or other
financial contracts (other than debt instruments), the taxpayer may not
use the alternative methods provided in paragraphs (f)(2)(iii) and (v)
of this section. Moreover, where such positions are entered into to
avoid the appropriate timing or character of income from the contracts
taken together, the Commissioner may require that amounts paid to or
received by the taxpayer under the notional principal contract be
treated in a manner that is consistent with the economic substance of
the transaction as a whole.
(3) Options and forwards to enter into notional principal contracts.
An option or forward contract that entitles or obligates a person to
enter into a notional principal contract is subject to the general rules
of taxation for options or forward contracts. Any payment with respect
to the option or forward contract is treated as a nonperiodic payment
for the underlying notional principal contract under the rules of
paragraphs (f) and (g)(4) or (g)(5) of this section if and when the
underlying notional principal contract is entered into.
(4) [Reserved]. For further guidance, see Sec. 1.446-3T(g)(4).
(5) Caps and floors that are significantly in-the-money. [Reserved]
(6) Examples. The following examples illustrate the application of
paragraph (g) of this section.
Example 1. Cap hedged with options. (a) On January 1, 1995, K sells
to unrelated counterparty L three cash settlement European-style put
options on Eurodollar time deposits with a strike rate of 9%. The
options have exercise dates of January 1, 1996, January 1, 1997, and
January 1, 1998, respectively. If LIBOR exceeds 9% on any of the
exercise dates, L will be entitled, by exercising the relevant option,
to receive from K an amount that corresponds to the excess of LIBOR over
9% times $25 million. L pays K $650,000 for the three options.
Furthermore, K is related to F, the cap purchaser in paragraph (f)(4)
Example 1 of this section.
(b) K's option agreements with L reduce risk with respect to F's cap
agreement with E. Accordingly, under paragraph (g)(2) of this section, F
cannot use the alternative methods provided in paragraph (f)(2)(v) of
this section to amortize the premium paid under the cap agreement. F
must amortize the cap premium it paid in accordance with paragraph
(f)(2)(iv) of this section.
(c) The method that E may use to account for its agreement with F is
not affected by the application of paragraph (g)(2) of this section to
F.
Example 2. [Reserved]. For further guidance, see Sec. 1.446-
3T(g)(6), Example 2.
Example 3. [Reserved]. For further guidance, see Sec. 1.446-
3T(g)(6), Example 3.
Example 4. [Reserved]. For further guidance, see Sec. 1.446-
3T(g)(6), Example 4.
(h) Termination payments--(1) Definition. A payment made or received
to extinguish or assign all or a proportionate part of the remaining
rights
[[Page 74]]
and obligations of any party under a notional principal contract is a
termination payment to the party making the termination payment and the
party receiving the payment. A termination payment includes a payment
made between the original parties to the contract (an extinguishment), a
payment made between one party to the contract and a third party (an
assignment), and any gain or loss realized on the exchange of one
notional principal contract for another. Where one party assigns its
remaining rights and obligations to a third party, the original
nonassigning counterparty realizes gain or loss if the assignment
results in a deemed exchange of contracts and a realization event under
section 1001.
(2) Taxable year of inclusion and deduction by original parties.
Except as otherwise provided (for example, in section 453, section 1092,
or Sec. 1.446-4), a party to a notional principal contract recognizes a
termination payment in the year the contract is extinguished, assigned,
or exchanged. When the termination payment is recognized, the party also
recognizes any other payments that have been made or received pursuant
to the notional principal contract, but that have not been recognized
under paragraph (d) of this section. If only a proportionate part of a
party's rights and obligations is extinguished, assigned, or exchanged,
then only that proportion of the unrecognized payments is recognized
under the previous sentence.
(3) Taxable year of inclusion and deduction by assignees. A
termination payment made or received by an assignee pursuant to an
assignment of a notional principal contract is recognized by the
assignee under the rules of paragraphs (f) and (g)(4) or (g)(5) of this
section as a nonperiodic payment for the notional principal contract
that is in effect after the assignment.
(4) Special rules--(i) Assignment of one leg of a contract. A
payment is not a termination payment if it is made or received by a
party in exchange for assigning all or a portion of one leg of a
notional principal contract at a time when a substantially proportionate
amount of the other leg remains unperformed and unassigned. The payment
is either an amount loaned, an amount borrowed, or a nonperiodic
payment, depending on the economic substance of the transaction to each
party. This paragraph (h)(4)(i) applies whether or not the original
notional principal contract is terminated as a result of the assignment.
(ii) Substance over form. Any economic benefit that is given or
received by a taxpayer in lieu of a termination payment is a termination
payment.
(5) Examples. The following examples illustrate the application of
this paragraph (h). The contracts in the examples are not hedging
transactions as defined in Sec. 1.1221-2(b), and all of the examples
assume that no loss-deferral rules apply.
Example 1. Termination by extinguishment. (a) On January 1, 1995, P
enters into an interest rate swap agreement with unrelated counterparty
Q under which, for a term of seven years, P is obligated to make annual
payments based on 10% and Q is obligated to make semi-annual payments
based on LIBOR and a notional principal amount of $100 million. P and Q
are both calendar year taxpayers. On January 1, 1997, when the fixed
rate on a comparable LIBOR swap has fallen to 9.5%, P pays Q $1,895,393
to terminate the swap.
(b) The payment from P to Q extinguishes the swap contract and is a
termination payment, as defined in paragraph (h)(1) of this section, for
both parties. Accordingly, under paragraph (h)(2) of this section, P
recognizes a loss of $1,895,393 in 1997 and Q recognizes $1,895,393 of
gain in 1997.
Example 2. Termination by assignment. (a) The facts are the same as
in Example 1, except that on January 1, 1997, P pays unrelated party R
$1,895,393 to assume all of P's rights and obligations under the swap
with Q. In return for this payment, R agrees to pay 10% of $100 million
annually to Q and to receive LIBOR payments from Q for the remaining
five years of the swap.
(b) The payment from P to R terminates P's interest in the swap
contract with Q and is a termination payment, as defined in paragraph
(h)(1) of this section, for P. Under paragraph (h)(2) of this section, P
recognizes a loss of $1,895,393 in 1997. Whether Q also has a
termination payment with respect to the payment from P to R is
determined under section 1001.
(c) Under paragraph (h)(3) of this section, the assignment payment
that R receives from P is a nonperiodic payment for an interest rate
swap. Because the assignment payment is not a significant nonperiodic
payment within the meaning of paragraph (g)(1) of this section, R
amortizes the $1,895,393 over the five year term of the swap
[[Page 75]]
agreement under paragraph (f)(2) of this section.
Example 3. Assignment of swap with yield adjustment fee. (a) The
facts are the same as in Example 2, except that on January 1, 1995, Q
paid P a yield adjustment fee to enter into the seven year interest rate
swap. In accordance with paragraph (f)(2) of this section, P and Q
included the ratable daily portions of that nonperiodic payment in their
net income or net deduction from the contract for 1995 and 1996. On
January 1, 1997, $300,000 of the nonperiodic payment has not yet been
recognized by P and Q.
(b) Under paragraph (h)(2) of this section, P recognizes a loss of
$1,595,393 ($1,895,393-$300,000) in 1997. R accounts for the termination
payment in the same way it did in Example 2; the existence of an
unamortized payment with respect to the original swap has no effect on
R.
Example 4. Assignment of one leg of a swap. (a) On January 1, 1995,
S enters into an interest rate swap agreement with unrelated
counterparty T under which, for a term of five years, S will make annual
payments at 10% and T will make annual payments at LIBOR on a notional
principal amount of $50 million. On January 1, 1996, unrelated party U
pays T $15,849,327 for the right to receive the four remaining
$5,000,000 payments from S. Under the terms of the agreement between S
and T, S is notified of this assignment, and S is contractually bound
thereafter to make its payments to U on the appropriate payment dates.
S's obligation to pay U is conditioned on T making its LIBOR payment to
S on the appropriate payment dates.
(b) Because T has assigned to U its rights to the fixed rate
payments, but not its floating rate obligations under the notional
principal contract, U's payment to T is not a termination payment as
defined in paragraph (h)(1) of this section, but is covered by paragraph
(h)(4)(i) of this section. The economic substance of the transaction
between T and U is a loan that does not affect the way that S and T
account for the notional principal contract under this section.
(i) Anti-abuse rule. If a taxpayer enters into a transaction with a
principal purpose of applying the rules of this section to produce a
material distortion of income, the Commissioner may depart from the
rules of this section as necessary to reflect the appropriate timing of
income and deductions from the transaction.
(j)(1) Effective/applicability date. These regulations are effective
for notional principal contracts entered into on or after December 13,
1993.
(2) [Reserved]. For further guidance, see Sec. 1.446-3T(j)(2).
[T.D. 8491, 58 FR 53128, Oct. 14, 1993; 59 FR 9411, Feb. 28, 1994, as
amended by T.D. 8554, 59 FR 36358, July 18, 1994; T.D. 9719, 80 FR
26440, May 8, 2015; 80 FR 34051, June 15, 2015]
Sec. 1.446-3T Notional principal contracts (temporary).
(a) through (g)(3) [Reserved]. For further guidance, see Sec.
1.446-3(a) through (g)(3).
(4) Notional principal contracts with nonperiodic payments--(i)
General rule. Except as provided in paragraph (g)(4)(ii) of this
section, a notional principal contract with one or more nonperiodic
payments is treated as two separate transactions consisting of an on-
market, level payment swap and one or more loans. The loan(s) must be
accounted for by the parties to the contract independently of the swap.
The time value component associated with the loan(s) is not included in
the net income or net deduction from the swap under Sec. 1.446-3(d),
but it is recognized as interest for all purposes of the Internal
Revenue Code. See paragraph (g)(6) Example 2 of this section.
(ii) Exceptions--(A) Notional principal contract with a term of one
year or less--(1) General rule. Except for purposes of sections 514 and
956, paragraph (g)(4)(i) of this section does not apply to a notional
principal contract if the term of the contract is one year or less. For
purposes of this paragraph (g)(4)(ii)(A), the term of a notional
principal contract is the stated term of the contract, inclusive of any
extensions (optional or otherwise) provided for in the terms of the
contract, without regard to whether any extension is unilateral, is
subject to approval by one or both parties to the contract, or is based
on the occurrence or non-occurrence of a specified event.
(2) Anti-abuse rule. For purposes of determining the term of a
contract under paragraph (g)(4)(ii)(A)(1) of this section, the
Commissioner may treat two or more contracts as a single contract if a
principal purpose of entering into separate contracts is to qualify for
the exception set forth in paragraph (g)(4)(ii)(A)(1) of this section. A
purpose may be a principal purpose even
[[Page 76]]
though it is outweighed by other purposes (taken together or
separately).
(B) Notional principal contract subject to margin or collateral
requirements. Subject to the requirements in paragraph (g)(4)(ii)(C) of
this section, paragraph (g)(4)(i) of this section does not apply to a
notional principal contract if the contract is described in paragraph
(g)(4)(ii)(B)(1) or (2) of this section. See Sec. 1.956-2T(b)(1)(xi)
for a related exception under section 956.
(1) The contract is cleared by a derivatives clearing organization
(as such term is defined in section 1a of the Commodity Exchange Act (7
U.S.C. 1a)) or by a clearing agency (as such term in defined in section
3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)) that is
registered as a derivatives clearing organization under the Commodity
Exchange Act or as a clearing agency under the Securities Exchange Act
of 1934, respectively, and the derivatives clearing organization or
clearing agency requires the parties to the contract to post and collect
margin or collateral to fully collateralize the mark-to-market exposure
on the contract (including the exposure on the nonperiodic payment) on a
daily basis for the entire term of the contract. The mark-to-market
exposure on a contract will be fully collateralized only if the contract
is subject to both initial variation margin in an amount equal to the
nonperiodic payment (except for variances permitted by intraday price
changes) and daily variation margin in an amount equal to the daily
change in the fair market value of the contract. See paragraph (g)(6)
Example 3 of this section.
(2) The parties to the contract are required, pursuant to the terms
of the contract or the requirements of a federal regulator, to post and
collect margin or collateral to fully collateralize the mark-to-market
exposure on the contract (including the exposure on the nonperiodic
payment) on a daily basis for the entire term of the contract. The mark-
to-market exposure on a contract will be fully collateralized only if
the contract is subject to both initial variation margin or collateral
in an amount equal to the nonperiodic payment (except for variances
permitted by intraday price changes) and daily variation margin or
collateral in an amount equal to the daily change in the fair market
value of the contract. For purposes of this paragraph (g)(4)(ii)(B)(2),
the term ``federal regulator'' means the Securities and Exchange
Commission (SEC), Commodity Futures Trading Commission (CFTC), or a
prudential regulator, as defined in section 1a(39) of the Commodity
Exchange Act (7 U.S.C. 1a), as amended by section 721 of the Dodd-Frank
Act. See paragraph (g)(6) Example 4 of this section.
(C) Limitations and special rules--(1) Cash requirement. A notional
principal contract is described in paragraph (g)(4)(ii)(B) of this
section only to the extent the parties post and collect margin or
collateral to fully collateralize the mark-to-market exposure on the
contract (including the exposure on the nonperiodic payment) by paying
and receiving the required margin or collateral in cash. The term
``cash'' includes U.S. dollars or cash in any currency in which payment
obligations under the notional principal contract are denominated.
(2) Excess margin or collateral. For purposes of paragraph
(g)(4)(ii)(B)(2) of this section, if the amount of cash margin or
collateral posted and collected is in excess of the amount necessary to
fully collateralize the mark-to-market exposure on the contract
(including the exposure on the nonperiodic payment) on a daily basis for
the entire term of the contract, any excess is subject to the rule in
paragraph (g)(4)(i) of this section.
(3) Margin or collateral paid and received in cash and other
property. If the parties to the contract post and collect both cash and
other property to satisfy margin or collateral requirements to
collateralize the mark-to-market exposure on the contract (including the
exposure on the nonperiodic payment), any excess of the nonperiodic
payment over the cash margin or collateral posted and collected is
subject to the rule in paragraph (g)(4)(i) of this section.
(5) [Reserved]. For further guidance, see Sec. 1.446-3(g)(5).
(6) Examples through Example 1. [Reserved]. For further guidance,
see
[[Page 77]]
Sec. 1.446-3(g)(6), Examples through Example 1.
Example 2. Nonperiodic payment. (i) On January 1, 2016, unrelated
parties M and N enter into an interest rate swap contract. Under the
terms of the contract, N agrees to make five annual payments to M equal
to LIBOR times a notional principal amount of $100 million. In return, M
agrees to pay N 6% of $100 million annually, plus an upfront payment of
$15,163,147 on January 1, 2016. At the time M and N enter into the
contract, the rate for similar on-market swaps is LIBOR to 10%, and N
provides M with information that the amount of the upfront payment was
determined as the present value, at 10% compounded annually, of five
annual payments from M to N of $4,000,000 (4% of $100,000,000). The
contract does not require the parties to post and collect margin or
collateral to collateralize the mark-to-market exposure on the contract
on a daily basis for the entire term of the contract.
(ii) The exceptions in paragraphs (g)(4)(ii)(A) and (B) of this
section do not apply. Under paragraph (g)(4)(i) of this section, the
transaction is recharacterized as consisting of both a $15,163,147 loan
from M to N that N repays in installments over the term of the contract
and an interest rate swap between M and N in which M immediately pays
the installment payments on the loan back to N as part of its fixed
payments on the swap in exchange for the LIBOR payments by N.
(iii) The upfront payment is recognized over the life of the
contract by treating the $15,163,147 as a loan that will be repaid with
level payments over five years. Assuming a constant yield to maturity
and annual compounding at 10%, M and N account for the principal and
interest on the loan as follows:
----------------------------------------------------------------------------------------------------------------
Interest Principal
Level payment component component
----------------------------------------------------------------------------------------------------------------
2016................................................... $4,000,000 $1,516,315 $2,483,685
2017................................................... 4,000,000 1,267,946 2,732,054
2018................................................... 4,000,000 994,741 3,005,259
2019................................................... 4,000,000 694,215 3,305,785
2020................................................... 4,000,000 363,636 3,636,364
--------------------------------------------------------
20,000,000 4,836,853 15,163,147
----------------------------------------------------------------------------------------------------------------
(iv) M recognizes interest income, and N claims an interest
deduction, each taxable year equal to the interest component of the
deemed installment payments on the loan. These interest amounts are not
included in the parties' net income or net deduction from the swap
contract under Sec. 1.446-3(d). The principal components are needed
only to compute the interest component of the level payment for the
following period and do not otherwise affect the parties' net income or
net deduction from this contract.
(v) N also makes swap payments to M based on LIBOR and receives swap
payments from M at a fixed rate that is equal to the sum of the stated
fixed rate and the rate calculated by dividing the deemed level annual
payments on the loan by the notional principal amount. Thus, the fixed
rate on this swap is 10%, which is the sum of the stated rate of 6% and
the rate calculated by dividing the annual loan payment of $4,000,000 by
the notional principal amount of $100,000,000, or 4%. Using the methods
provided in Sec. 1.446-3(e)(2), the fixed swap payments from M to N of
$10,000,000 (10% of $100,000,000) and the LIBOR swap payments from N to
M are included in the parties' net income or net deduction from the
contract for each taxable year.
Example 3. Full margin--cleared contract. (i) A, a domestic
corporation enters into an interest rate swap contract with unrelated
counterparty B. The contract is required to be cleared and is accepted
for clearing by a U.S.-registered derivatives clearing organization
(DCO). The standardized terms of the contract provide that A, for a term
of X years, will pay B a fixed coupon of 1% per year and receive a
floating coupon on a notional principal amount of $Y. When A and B enter
into the interest rate swap, the market coupon for similar interest rate
swaps is 2% per year. The DCO requires A to make an upfront payment to
compensate B for the below-market annual coupon payments that B will
receive, and A makes the upfront payment in cash. The DCO also requires
B to post initial variation margin in an amount equal to the upfront
payment and requires each party to post and collect daily variation
margin in an amount equal to the change in the fair market value of the
contract on a daily basis for the entire term of the contract. B posts
the initial variation margin in U.S. dollars, and the parties post and
collect daily variation margin in U.S. dollars.
(ii) Because the contract is subject to initial variation margin in
an amount equal to the upfront payment and daily variation margin in an
amount equal to the change in the fair market value of the contract on a
[[Page 78]]
daily basis for the entire term of the contract, the contract is
described in paragraph (g)(4)(ii)(B)(1) of this section and paragraph
(g)(4)(i) of this section does not apply to the contract.
Example 4. Full margin--uncleared contract. (i) On June 1, 2016, P,
a domestic corporation, enters into an interest rate swap contract with
an unrelated domestic counterparty, CP. Under the terms of the contract,
CP agrees to make five annual payments to P equal to a specified
contract rate of 3% times the notional amount of $10,000,000 plus an
upfront payment of $1,878,030. In exchange, P agrees to make five annual
payments to CP equal to the same notional amount times LIBOR. At the
time the parties enter into the contract, the fixed rate for an on-
market swap is 7.52%. The contract is not required to be cleared and is
not accepted for clearing by a U.S.-registered derivatives clearing
organization. However, pursuant to the terms of the contract, P is
obligated to post $1,878,030 as collateral with CP, and P and CP are
obligated to post and collect collateral each business day in an amount
equal to the daily change in the fair market value of the contract for
the entire term of the contract. All collateral on the contract is
required to be in U.S. dollars.
(ii) Because the contract is required to be collateralized in an
amount equal to the upfront payment and changes in the fair market value
of the contract on a daily basis for the entire term of the contract,
the contract is described in paragraph (g)(4)(ii)(B)(2) of this section
and paragraph (g)(4)(i) of this section does not apply to the contract.
(h) through (j)(1) [Reserved]. For further guidance, see Sec.
1.446-3(h) through (j)(1).
(2) Application of Sec. 1.446-3T(g)(4). Paragraph (g)(4)(i) of this
section and paragraph (g)(6) Example 2 of this section apply to notional
principal contracts entered into on or after the later of January 1,
2017, or 180 days after the date of publication of the Treasury decision
adopting these rules as final regulations in the Federal Register.
Paragraph (g)(4)(ii) of this section applies to notional principal
contracts entered into on or after May 8, 2015. However, before the
later of January 1, 2017, or 180 days after the date of publication of
the Treasury decision adopting paragraph (g)(4)(i) of this section as
final regulations in the Federal Register, taxpayers may rely on the
provision in Sec. 1.446-3(g)(4), as contained in 26 CFR part 1, revised
April 1, 2015, which (except for purposes of section 956) limits the
application of the embedded loan rule to nonperiodic payments that are
significant, even if the requirements for the exceptions in paragraph
(g)(4)(ii) of this section are not met. Taxpayers may apply paragraph
(g)(4)(i) of this section, paragraph (g)(4)(ii) of this section, or both
to notional principal contracts entered into before the dates set forth
in this paragraph (j)(2).
(k) Expiration date. The applicability of paragraph (g)(4) of this
section and paragraph (g)(6) Examples 2, 3 and 4 of this section expires
May 7, 2018.
[T.D. 9719, 80 FR 26440, May 8, 2015, as amended by 80 FR 61308, Oct.
13, 2015]
Sec. 1.446-4 Hedging transactions.
(a) In general. Except as provided in this paragraph (a), a hedging
transaction as defined in Sec. 1.1221-2(b) (whether or not the
character of gain or loss from the transaction is determined under Sec.
1.1221-2) must be accounted for under the rules of this section. To the
extent that provisions of any other regulations governing the timing of
income, deductions, gain, or loss are inconsistent with the rules of
this section, the rules of this section control.
(1) Trades or businesses excepted. A taxpayer is not required to
account for hedging transactions under the rules of this section for any
trade or business in which the cash receipts and disbursements method of
accounting is used or in which Sec. 1.471-6 is used for inventory
valuations if, for all prior taxable years ending on or after September
30, 1993, the taxpayer met the $5,000,000 gross receipts test of section
448(c) (or would have met that test if the taxpayer were a corporation
or partnership). A taxpayer not required to use the rules of this
section may nonetheless use a method of accounting that is consistent
with these rules.
(2) Coordination with other sections. This section does not apply
to--
(i) Any position to which section 475(a) applies;
(ii) An integrated transaction subject to Sec. 1.1275-6;
(iii) Any section 988 hedging transaction if the transaction is
integrated under Sec. 1.988-5 or if other regulations issued under
section 988(d) (or an advance ruling described in 1.988-5(e))
[[Page 79]]
govern when gain or loss from the transaction is taken into account; or
(iv) The determination of the issuer's yield on an issue of tax-
exempt bonds for purposes of the arbitrage restrictions to which Sec.
1.148-4(h) applies.
(b) Clear reflection of income. The method of accounting used by a
taxpayer for a hedging transaction must clearly reflect income. To
clearly reflect income, the method used must reasonably match the timing
of income, deduction, gain, or loss from the hedging transaction with
the timing of income, deduction, gain, or loss from the item or items
being hedged. Taking gains and losses into account in the period in
which they are realized may clearly reflect income in the case of
certain hedging transactions. For example, where a hedge and the item
being hedged are disposed of in the same taxable year, taking realized
gain or loss into account on both items in that taxable year may clearly
reflect income. In the case of many hedging transactions, however,
taking gains and losses into account as they are realized does not
result in the matching required by this section.
(c) Choice of method and consistency. For any given type of hedging
transaction, there may be more than one method of accounting that
satisfies the clear reflection requirement of paragraph (b) of this
section. A taxpayer is generally permitted to adopt a method of
accounting for a particular type of hedging transaction that clearly
reflects the taxpayer's income from that type of transaction. See
paragraph (e) of this section for requirements and limitations on the
taxpayer's choice of method. Different methods of accounting may be used
for different types of hedging transactions and for transactions that
hedge different types of items. Once a taxpayer adopts a method of
accounting, however, that method must be applied consistently and can
only be changed with the consent of the Commissioner, as provided by
section 446(e) and the regulations and procedures thereunder.
(d) Recordkeeping requirements--(1) In general. The books and
records maintained by a taxpayer must contain a description of the
accounting method used for each type of hedging transaction. The
description of the method or methods used must be sufficient to show how
the clear reflection requirement of paragraph (b) of this section is
satisfied.
(2) Additional identification. In addition to the identification
required by Sec. 1.1221-2(f), the books and records maintained by a
taxpayer must contain whatever more specific identification with respect
to a transaction is necessary to verify the application of the method of
accounting used by the taxpayer for the transaction. This additional
identification may relate to the hedging transaction or to the item,
items, or aggregate risk being hedged. The additional identification
must be made at the time specified in Sec. 1.1221-2(f)(2) and must be
made on, and retained as part of, the taxpayer's books and records.
(3) Transactions in which character of gain or loss is not
determined under Sec. 1.1221-2. A section 988 transaction, as defined
in section 988(c)(1), or a qualified fund, as defined in section
988(c)(1)(E)(iii), is subject to the identification and recordkeeping
requirements of Sec. 1.1221-2(f). See Sec. 1.1221-2(a)(4).
(e) Requirements and limitations with respect to hedges of certain
assets and liabilities. In the case of certain hedging transactions,
this paragraph (e) provides guidance in determining whether a taxpayer's
method of accounting satisfies the clear reflection requirement of
paragraph (b) of this section. Even if these rules are satisfied,
however, the taxpayer's method, as actually applied to the taxpayer's
hedging transactions, must clearly reflect income by meeting the
matching requirement of paragraph (b) of this section.
(1) Hedges of aggregate risk--(i) In general. The method of
accounting used for hedges of aggregate risk must comply with the
matching requirements of paragraph (b) of this section. Even though a
taxpayer may not be able to associate the hedging transaction with any
particular item being hedged, the timing of income, deduction, gain, or
loss from the hedging transaction must be matched with the timing of the
aggregate income, deduction, gain, or loss from the items being hedged.
For example, if a notional principal contract hedges a taxpayer's
aggregate
[[Page 80]]
risk, taking into account income, deduction, gain, or loss under the
provisions of Sec. 1.446-3 may clearly reflect income. See paragraph
(e)(5) of this section.
(ii) Mark-and-spread method. The following method may be appropriate
for taking into account income, deduction, gain, or loss from hedges of
aggregate risk:
(A) The hedging transactions are marked to market at regular
intervals for which the taxpayer has the necessary data, but no less
frequently than quarterly; and
(B) The income, deduction, gain, or loss attributable to the
realization or periodic marking to market of hedging transactions is
taken into account over the period for which the hedging transactions
are intended to reduce risk. Although the period over which the hedging
transactions are intended to reduce risk may change, the period must be
reasonable and consistent with the taxpayer's hedging policies and
strategies.
(2) Hedges of items marked to market. In the case of a transaction
that hedges an item that is marked to market under the taxpayer's method
of accounting, marking the hedge to market clearly reflects income.
(3) Hedges of inventory--(i) In general. If a hedging transaction
hedges purchases of inventory, gain or loss on the hedging transaction
may be taken into account in the same period that it would be taken into
account if the gain or loss were treated as an element of the cost of
inventory. Similarly, if a hedging transaction hedges sales of
inventory, gain or loss on the hedging transaction may be taken into
account in the same period that it would be taken into account if the
gain or loss were treated as an element of sales proceeds. If a hedge is
associated with a particular purchase or sales transaction, the gain or
loss on the hedge may be taken into account when it would be taken into
account if it were an element of cost incurred in, or sales proceeds
from, that transaction. As with hedges of aggregate risk, however, a
taxpayer may not be able to associate hedges of inventory purchases or
sales with particular purchase or sales transactions. In order to match
the timing of income, deduction, gain, or loss from the hedge with the
timing of aggregate income, deduction, gain, or loss from the hedged
purchases or sales, it may be appropriate for a taxpayer to account for
its hedging transactions in the manner described in paragraph (e)(1)(ii)
of this section, except that the gain or loss that is spread to each
period is taken into account when it would be if it were an element of
cost incurred (purchase hedges), or an element of proceeds from sales
made (sales hedges), during that period.
(ii) Alternative methods for certain inventory hedges. In lieu of
the method described in paragraph (e)(3)(i) of this section, other
simpler, less precise methods may be used in appropriate cases where the
clear reflection requirement of paragraph (b) of this section is
satisfied. For example:
(A) Taking into account realized gains and losses on both hedges of
inventory purchases and hedges of inventory sales when they would be
taken into account if the gains and losses were elements of inventory
cost in the period realized may clearly reflect income in some
situations, but does not clearly reflect income for a taxpayer that uses
the last-in, first-out method of accounting for the inventory; and
(B) Marking hedging transactions to market with resulting gain or
loss taken into account immediately may clearly reflect income even
though the inventory that is being hedged is not marked to market, but
only if the inventory is not accounted for under either the last-in,
first-out method or the lower-of-cost-or-market method and only if items
are held in inventory for short periods of time.
(4) Hedges of debt instruments. Gain or loss from a transaction that
hedges a debt instrument issued or to be issued by a taxpayer, or a debt
instrument held or to be held by a taxpayer, must be accounted for by
reference to the terms of the debt instrument and the period or periods
to which the hedge relates. A hedge of an instrument that provides for
interest to be paid at a fixed rate or a qualified floating rate, for
example, generally is accounted for using constant yield principles.
Thus, assuming that a fixed rate or qualified floating rate instrument
remains outstanding, hedging gain or loss is taken
[[Page 81]]
into account in the same periods in which it would be taken into account
if it adjusted the yield of the instrument over the term to which the
hedge relates. For example, gain or loss realized on a transaction that
hedged an anticipated fixed rate borrowing for its entire term is
accounted for, solely for purposes of this section, as if it decreased
or increased the issue price of the debt instrument. Similarly, gain or
loss realized on a transaction that hedges a contingent payment on a
debt instrument subject to Sec. 1.1275-4(c) (a contingent payment debt
instrument issued for nonpublicly traded property) is taken into account
when the contingent payment is taken into account under Sec. 1.1275-
4(c).
(5) Notional principal contracts. The rules of Sec. 1.446-3 govern
the timing of income and deductions with respect to a notional principal
contract unless, because the notional principal contract is part of a
hedging transaction, the application of those rules would not result in
the matching that is needed to satisfy the clear reflection requirement
of paragraph (b) and, as applicable, (e)(4) of this section. For
example, if a notional principal contract hedges a debt instrument, the
method of accounting for periodic payments described in Sec. 1.446-3(e)
and the methods of accounting for nonperiodic payments described in
Sec. 1.446-3(f)(2)(iii) and (v) generally clearly reflect the
taxpayer's income. The methods described in Sec. 1.446-3(f)(2)(ii) and
(iv), however, generally do not clearly reflect the taxpayer's income in
that situation.
(6) Disposition of hedged asset or liability. If a taxpayer hedges
an item and disposes of, or terminates its interest in, the item but
does not dispose of or terminate the hedging transaction, the taxpayer
must appropriately match the built-in gain or loss on the hedging
transaction to the gain or loss on the disposed item. To meet this
requirement, the taxpayer may mark the hedge to market on the date it
disposes of the hedged item. If the taxpayer intends to dispose of the
hedging transaction within a reasonable period, however, it may be
appropriate to match the realized gain or loss on the hedging
transaction with the gain or loss on the disposed item. If the taxpayer
intends to dispose of the hedging transaction within a reasonable period
and the hedging transaction is not actually disposed of within that
period, the taxpayer must match the gain or loss on the hedge at the end
of the reasonable period with the gain or loss on the disposed item. For
purposes of this paragraph (e)(6), a reasonable period is generally 7
days.
(7) Recycled hedges. If a taxpayer enters into a hedging transaction
by recycling a hedge of a particular hedged item to serve as a hedge of
a different item, as described in Sec. 1.1221-2(d)(4), the taxpayer
must match the built-in gain or loss at the time of the recycling to the
gain or loss on the original hedged item, items, or aggregate risk.
Income, deduction, gain, or loss attributable to the period after the
recycling must be matched to the new hedged item, items, or aggregate
risk under the principles of paragraph (b) of this section.
(8) Unfulfilled anticipatory transactions--(i) In general. If a
taxpayer enters into a hedging transaction to reduce risk with respect
to an anticipated asset acquisition, debt issuance, or obligation, and
the anticipated transaction is not consummated, any income, deduction,
gain, or loss from the hedging transaction is taken into account when
realized.
(ii) Consummation of anticipated transaction. A taxpayer consummates
a transaction for purposes of paragraph (e)(8)(i) of this section upon
the occurrence (within a reasonable interval around the expected time of
the anticipated transaction) of either the anticipated transaction or a
different but similar transaction for which the hedge serves to
reasonably reduce risk.
(9) Hedging by members of a consolidated group--(i) General rule:
single-entity approach. In general, a member of a consolidated group
must account for its hedging transactions as if all of the members were
separate divisions of a single corporation. Thus, the timing of the
income, deduction, gain, or loss on a hedging transaction must match the
timing of income, deduction, gain, or loss from the item or items being
hedged. Because all of the members are treated as if they were divisions
of a single corporation, intercompany
[[Page 82]]
transactions are neither hedging transactions nor hedged items for these
purposes.
(ii) Separate-entity election. If a consolidated group makes an
election under Sec. 1.1221-2(e)(2), then paragraph (e)(9)(i) of this
section does not apply. Thus, in that case, each member of the
consolidated group must account for its hedging transactions in a manner
that meets the requirements of paragraph (b) of this section. For
example, the income, deduction, gain, or loss from intercompany hedging
transactions (as defined in Sec. 1.1221-2(e)(2)(ii)) is taken into
account under the timing rules of Sec. 1.446-4 rather than under the
timing rules of Sec. 1.1502-13.
(iii) Definitions. For definitions of consolidated group, divisions
of a single corporation, intercompany transaction, and member, see
section 1502 and the regulations thereunder.
(iv) Effective date. This paragraph (e)(9) applies to transactions
entered into on or after March 8, 1996.
(f) Type or character of income and deduction. The rules of this
section govern the timing of income, deduction, gain, or loss on hedging
transactions but do not affect the type or character of income,
deduction, gain, or loss produced by the transaction. Thus, for example,
the rules of paragraph (e)(3) of this section do not affect the
computation of cost of goods sold or sales proceeds for a taxpayer that
hedges inventory purchases or sales. Similarly, the rules of paragraph
(e)(4) of this section do not increase or decrease the interest income
or expense of a taxpayer that hedges a debt instrument or a liability.
(g) Effective date. This section applies to hedging transactions
entered into on or after October 1, 1994.
(h) Consent to change methods of accounting. The Commissioner grants
consent for a taxpayer to change its methods of accounting for
transactions that are entered into on or after October 1, 1994, and that
are described in paragraph (a) of this section. This consent is granted
only for changes for the taxable year containing October 1, 1994. The
taxpayer must describe its new methods of accounting in a statement that
is included in its Federal income tax return for that taxable year.
[T.D. 8554, 59 FR 36358, July 18, 1994, as amended by T.D. 8653, 61 FR
519, Jan. 8, 1996; T.D. 8674, 61 FR 30138, June 14, 1996; T.D. 8985, 67
FR 12865, Mar. 20, 2002; 67 FR 31955, May 13, 2002]
Sec. 1.446-5 Debt issuance costs.
(a) In general. This section provides rules for allocating debt
issuance costs over the term of the debt. For purposes of this section,
the term debt issuance costs means those transaction costs incurred by
an issuer of debt (that is, a borrower) that are required to be
capitalized under Sec. 1.263(a)-5. If these costs are otherwise
deductible, they are deductible by the issuer over the term of the debt
as determined under paragraph (b) of this section.
(b) Method of allocating debt issuance costs--(1) In general. Solely
for purposes of determining the amount of debt issuance costs that may
be deducted in any period, these costs are treated as if they adjusted
the yield on the debt. To effect this, the issuer treats the costs as if
they decreased the issue price of the debt. See Sec. 1.1273-2 to
determine issue price. Thus, debt issuance costs increase or create
original issue discount and decrease or eliminate bond issuance premium.
(2) Original issue discount. Any resulting original issue discount
is taken into account by the issuer under the rules in Sec. 1.163-7,
which generally require the use of a constant yield method (as described
in Sec. 1.1272-1) to compute how much original issue discount is
deductible for a period. However, see Sec. 1.163-7(b) for special rules
that apply if the total original issue discount on the debt is de
minimis.
(3) Bond issuance premium. Any remaining bond issuance premium is
taken into account by the issuer under the rules of Sec. 1.163-13,
which generally require the use of a constant yield method for purposes
of allocating bond issuance premium to accrual periods.
(c) Examples. The following examples illustrate the rules of this
section:
Example 1. (i) On January 1, 2004, X borrows $10,000,000. The
principal amount of the loan ($10,000,000) is repayable on December 31,
2008, and payments of interest in the amount of $500,000 are due on
December 31 of each
[[Page 83]]
year the loan is outstanding. X incurs debt issuance costs of $130,000
to facilitate the borrowing.
(ii) Under Sec. 1.1273-2, the issue price of the loan is
$10,000,000. However, under paragraph (b) of this section, X reduces the
issue price of the loan by the debt issuance costs of $130,000,
resulting in an issue price of $9,870,000. As a result, X treats the
loan as having original issue discount in the amount of $130,000 (stated
redemption price at maturity of $10,000,000 minus the issue price of
$9,870,000). Because this amount of original issue discount is more than
the de minimis amount of original issue discount for the loan determined
under Sec. 1.1273-1(d) ($125,000 ($10,000,000 x .0025 x 5)), X must
allocate the original issue discount to each year based on the constant
yield method described in Sec. 1.1272-1(b). See Sec. 1.163-7(a). Based
on this method and a yield of 5.30%, compounded annually, the original
issue discount is allocable to each year as follows: $23,385 for 2004,
$24,625 for 2005, $25,931 for 2006, $27,306 for 2007, and $28,753 for
2008.
Example 2. (i) Assume the same facts as in Example 1, except that X
incurs debt issuance costs of $120,000 rather than $130,000.
(ii) Under Sec. 1.1273-2, the issue price of the loan is
$10,000,000. However, under paragraph (b) of this section, X reduces the
issue price of the loan by the debt issuance costs of $120,000,
resulting in an issue price of $9,880,000. As a result, X treats the
loan as having original issue discount in the amount of $120,000 (stated
redemption price at maturity of $10,000,000 minus the issue price of
$9,880,000). Because this amount of original issue discount is less than
the de minimis amount of original issue discount for the loan determined
under Sec. 1.1273-1(d) ($125,000), X does not have to use the constant
yield method described in Sec. 1.1272-1(b) to allocate the original
issue discount to each year. Instead, under Sec. 1.163-7(b)(2), X can
choose to allocate the original issue discount to each year on a
straight-line basis over the term of the loan or in proportion to the
stated interest payments ($24,000 each year). X also could choose to
deduct the original issue discount at maturity of the loan. X makes its
choice by reporting the original issue discount in a manner consistent
with the method chosen on X's timely filed federal income tax return for
2004. If X wanted to use the constant yield method, based on a yield of
5.279%, compounded annually, the original issue discount is allocable to
each year as follows: $21,596 for 2004, $22,736 for 2005, $23,937 for
2006, $25,200 for 2007, and $26,531 for 2008.
(d) Effective date. This section applies to debt issuance costs paid
or incurred for debt instruments issued on or after December 31, 2003.
(e) Accounting method changes--(1) Consent to change. An issuer
required to change its method of accounting for debt issuance costs to
comply with this section must secure the consent of the Commissioner in
accordance with the requirements of Sec. 1.446-1(e). Paragraph (e)(2)
of this section provides the Commissioner's automatic consent for
certain changes.
(2) Automatic consent. The Commissioner grants consent for an issuer
to change its method of accounting for debt issuance costs incurred for
debt instruments issued on or after December 31, 2003. Because this
change is made on a cut-off basis, no items of income or deduction are
omitted or duplicated and, therefore, no adjustment under section 481 is
allowed. The consent granted by this paragraph (e)(2) applies provided--
(i) The change is made to comply with this section;
(ii) The change is made for the first taxable year for which the
issuer must account for debt issuance costs under this section; and
(iii) The issuer attaches to its federal income tax return for the
taxable year containing the change a statement that it has changed its
method of accounting under this section.
[T.D. 9107, 69 FR 464, Jan. 5, 2004]
Sec. 1.446-6 REMIC inducement fees.
(a) Purpose. This section provides specific timing rules for the
clear reflection of income from an inducement fee received in connection
with becoming the holder of a noneconomic REMIC residual interest. An
inducement fee must be included in income over a period reasonably
related to the period during which the applicable REMIC is expected to
generate taxable income or net loss allocable to the holder of the
noneconomic residual interest.
(b) Definitions. For purposes of this section:
(1) Applicable REMIC. The applicable REMIC is the REMIC that issued
the noneconomic residual interest with respect to which the inducement
fee is paid.
(2) Inducement fee. An inducement fee is the amount paid to induce a
person to become the holder of a noneconomic
[[Page 84]]
residual interest in an applicable REMIC.
(3) Noneconomic residual interest. A REMIC residual interest is a
noneconomic residual interest if it is a noneconomic residual interest
within the meaning of Sec. 1.860E-1(c)(2).
(4) Remaining anticipated weighted average life. The remaining
anticipated weighted average life is the anticipated weighted average
life determined using the methodology set forth in Sec. 1.860E-
1(a)(3)(iv) applied as of the date of acquisition of the noneconomic
residual interest.
(5) REMIC. The term REMIC has the same meaning in this section as
given in Sec. 1.860D-1.
(c) General rule. All taxpayers, regardless of their overall method
of accounting, must recognize an inducement fee over the remaining
expected life of the applicable REMIC in a manner that reasonably
reflects, without regard to this paragraph, the after-tax costs and
benefits of holding that noneconomic residual interest.
(d) Special rule on disposition of a residual interest. If any
portion of an inducement fee received with respect to becoming the
holder of a noneconomic residual interest in an applicable REMIC has not
been recognized in full by the holder as of the time the holder
transfers, or otherwise ceases to be the holder for Federal tax purposes
of, that residual interest in the applicable REMIC, then the holder must
include the unrecognized portion of the inducement fee in income at that
time. This rule does not apply to a transaction to which section
381(c)(4) applies.
(e) Safe harbors. If inducement fees are recognized in accordance
with a method described in this paragraph (e), that method complies with
the requirements of paragraph (c) of this section.
(1) The book method. Under the book method, an inducement fee is
recognized in accordance with the method of accounting, and over the
same period, used by the taxpayer for financial reporting purposes
(including consolidated financial statements to shareholders, partners,
beneficiaries, and other proprietors and for credit purposes), provided
that the inducement fee is included in income for financial reporting
purposes over a period that is not shorter than the period during which
the applicable REMIC is expected to generate taxable income.
(2) The modified REMIC regulatory method. Under the modified REMIC
regulatory method, the inducement fee is recognized ratably over the
remaining anticipated weighted average life of the applicable REMIC as
if the inducement fee were unrecognized gain being included in gross
income under Sec. 1.860F-2(b)(4)(iii).
(3) Additional safe harbor methods. The Commissioner, by revenue
ruling or revenue procedure (see Sec. 1.601(d)(2) of this chapter), may
provide additional safe harbor methods for recognizing inducement fees
relating to noneconomic REMIC residual interests.
(f) Method of accounting. The treatment of inducement fees is a
method of accounting to which the provisions of sections 446 and 481 and
the regulations thereunder apply. A taxpayer is generally permitted to
adopt a method of accounting for inducement fees that satisfies the
requirements of paragraph (c) of this section. Once a taxpayer adopts a
method of accounting for inducement fees, that method must be applied
consistently to all inducement fees received in connection with
noneconomic REMIC residual interests and may be changed only with the
consent of the Commissioner, as provided by section 446(e) and the
regulations and procedures thereunder.
(g) Effective date. This section is applicable for taxable years
ending on or after May 11, 2004.
[T.D. 9128, 69 FR 26041, May 11, 2004]
Sec. 1.446-7 Net asset value method for certain money market fund shares.
(a) In general. This section provides a permissible method of
accounting (the net asset value method, or NAV method) for gain or loss
on shares in a money market fund (or MMF).
(b) Definitions. For purposes of this section--
(1) Computation period. Computation periods are the periods (of
either equal or varying length) that a taxpayer selects for computing
gain and loss under the NAV method for shares in an MMF. Computation
periods must possess all of the following attributes:
[[Page 85]]
(i) Every day during the taxable year falls within one, and only
one, computation period;
(ii) Each computation period contains days from only one taxable
year; and
(iii) If the taxpayer is a regulated investment company (RIC) that
is not described in section 4982(f)--
(A) The same computation periods are used for purposes of both
income tax accounting under chapter 1 and excise tax computations under
section 4982; and
(B) The requirements in paragraphs (b)(1)(i) and (ii) of this
section are also satisfied if applied by substituting the RIC's section
4982 period for the RIC's taxable year.
(2) Ending value. The ending value of a taxpayer's shares in an MMF
for a computation period is the aggregate fair market value of the
taxpayer's shares at the end of that computation period.
(3) Fair market value. The fair market value of a share in an MMF is
determined as follows:
(i) Presumption based on applicable published redemption amount. For
purposes of this section, the fair market value of a share in an MMF is
presumed to be the applicable published redemption amount for the share.
(ii) Published redemption amount. The published redemption amount
for a share in an MMF is the published amount for which the MMF would
redeem the share (usually, the net asset value per share (NAV)), taking
into account any corrections and not taking into account any liquidity
fee described in Rule 2a-7(c)(2) under the Investment Company Act of
1940 (17 CFR 270.2a-7(c)(2)).
(iii) Applicable published redemption amount. The applicable
published redemption amount is--
(A) For purposes of determining the ending value of a taxpayer's
shares in an MMF for a computation period under paragraph (b)(2) of this
section, the last published redemption amount on the last day of that
computation period;
(B) For purposes of determining the value of MMF shares received in
a redemption or exchange described in paragraph (b)(5)(ii)(A) of this
section, the published redemption amount for such MMF shares used to
determine the consideration received in the redemption or exchange, or
if the consideration received is not based on a published redemption
amount, the first published redemption amount for such MMF shares after
the redemption or exchange;
(C) For purposes of determining the amount received in a redemption
or exchange described in paragraph (b)(5)(ii)(B) of this section in
which the consideration received is based on a published redemption
amount for the redeemed shares, that published redemption amount; and
(D) For purposes of determining the amount received in an exchange
described in paragraph (b)(5)(ii)(B) of this section that is not
described in paragraph (b)(3)(iii)(C) of this section, or the amount of
any adjustment resulting from a disposition transaction described in
paragraph (b)(5)(iii) of this section, the first published redemption
amount for the exchanged or disposed of MMF shares after the exchange or
other transaction.
(iv) Facts and circumstances determination. If there is no
applicable published redemption amount or if circumstances indicate that
the amount does not represent the fair market value of a share in the
MMF, the fair market value is determined on the basis of all of the
facts and circumstances.
(4) Money market fund (or MMF). An MMF is a regulated investment
company that is permitted to hold itself out to investors as a money
market fund under Rule 2a-7 under the Investment Company Act of 1940 (17
CFR 270.2a-7). See paragraph (c)(5) of this section for the treatment of
shares in a single MMF held in more than one account.
(5) Net investment--(i) In general. The net investment in an MMF for
a computation period may be a positive amount, a negative amount, or
zero. Except as provided in paragraph (b)(5)(iii) of this section, the
net investment is equal to--
(A) The aggregate cost of shares in the MMF purchased during the
computation period (including purchases through reinvestment of
dividends); minus
[[Page 86]]
(B) The aggregate amount received during the computation period in
redemption of (or otherwise in exchange for) shares in the MMF in
transactions in which gain or loss would be recognized if the taxpayer
did not apply the NAV method to the shares.
(ii) Aggregate amount received. For purposes of paragraph
(b)(5)(i)(B) of this section, the amount received in a redemption or
exchange of an MMF share is--
(A) If no property other than cash and shares in one or more other
MMFs is received, the amount of any cash plus the fair market value of
any MMF shares received; or
(B) If any property other than cash or shares in one or more other
MMFs is received, the fair market value of the redeemed MMF share.
(iii) Adjustments--(A) Dispositions in which gain or loss is not
recognized. If, during the computation period, any shares in an MMF are
disposed of in transactions in which gain or loss would not be
recognized if the taxpayer did not apply the NAV method to the shares,
the net investment in the MMF for the computation period is decreased by
the fair market value of each such share at the time of its disposition.
(B) Acquisitions other than by purchase. If, during the computation
period, any shares in an MMF are acquired other than by purchase, the
net investment in the MMF for the computation period is increased by the
adjusted basis (for purposes of determining loss) of each such share
immediately after its acquisition. If the adjusted basis of an acquired
share would be determined by reference to the basis of a share or shares
in an MMF that are being disposed of by the taxpayer in a transaction
that is governed by paragraph (b)(5)(iii)(A) of this section, then the
adjusted basis of each such disposed share is treated for purposes of
this section as being the fair market value of that share at the time of
its disposition. If the adjusted basis of an acquired share would be
determined by reference to the basis of that share in the hands of the
person from whom the share is acquired and that person was applying the
NAV method to the share at the time of the transaction, then the
adjusted basis of the share in the hands of the person from whom the
share is acquired is treated for purposes of this section as being the
fair market value of that share at the time of the transaction.
(6) Section 4982 period. If a taxpayer using the NAV method is a RIC
to which section 4982 applies, the section 4982 period is the one-year
period with respect to which gain or loss is determined for purposes of
section 4982(e)(2) and (e)(6). The preceding sentence is applied taking
into account the application of section 4982(e)(4). See paragraph (c)(8)
of this section regarding the application of section 4982(e)(6).
(7) Starting basis. The starting basis of a taxpayer's shares in an
MMF for a computation period is--
(i) Except as provided in paragraph (b)(7)(ii) of this section, the
ending value of the taxpayer's shares in the MMF for the immediately
preceding computation period; or
(ii) For the first computation period in a taxable year, if the
taxpayer did not use the NAV method for shares in the MMF for the
immediately preceding taxable year, the aggregate adjusted basis of the
taxpayer's shares in the MMF at the end of the immediately preceding
taxable year.
(c) NAV method--(1) Scope. A taxpayer may use the NAV method
described in this section to determine the gain or loss for a taxable
year on the taxpayer's shares in an MMF. A taxpayer may have different
methods of accounting, different computation periods, and gains or
losses of differing character, for its shares in different MMFs. See
paragraph (c)(5) of this section for the treatment of shares in a single
MMF held in more than one account. See paragraph (c)(6) of this section
for rules applicable to RICs to which section 4982 applies. See
paragraph (c)(8) of this section for rules applicable to accounting
method changes.
(2) Net gain or loss for a taxable year--(i) Determination for each
computation period. Subject to any adjustment under paragraph (c)(2)(ii)
of this section, the net gain or loss for each computation period with
respect to the shares in an MMF to which the NAV method applies equals
the ending value, minus the starting basis, minus the net investment in
the MMF for the
[[Page 87]]
computation period. If the computation produces a result that is greater
than zero, the taxpayer has a gain for the computation period with
respect to the shares in the MMF; if the computation produces a result
that is less than zero, the taxpayer has a loss for the computation
period with respect to the shares in the MMF; and if the computation
produces a result that is equal to zero, the taxpayer has no gain or
loss for the computation period with respect to the shares in the MMF.
(ii) Adjustment of gain or loss to reflect any basis adjustments.
If, during a computation period, there is any downward (or upward)
adjustment to the taxpayer's basis in the shares in the MMF under any
provision of internal revenue law, then the net gain or loss for the
computation period on shares in the MMF determined under paragraph
(c)(2)(i) of this section is increased (or decreased) by the amount of
the adjustment.
(iii) Timing of gains and losses. Gain or loss determined under the
NAV method with respect to a taxpayer's shares in an MMF during a
computation period is treated as arising on the last day of the
computation period.
(iv) Determination of net gain or loss for each taxable year. The
taxpayer's net gain or loss for a taxable year on shares in an MMF is
the sum of the net gains or losses on shares in the MMF for the
computation period (or computation periods) that comprise the taxable
year.
(3) Character--(i) In the case of a taxpayer that applies the NAV
method to shares in an MMF, the gain or loss with respect to those
shares for a computation period is treated as gain or loss from a sale
or exchange of a capital asset provided the sale or exchange of one or
more of those shares during the computation period would give rise to
capital gain or loss if the taxpayer did not apply the NAV method to the
shares.
(ii) In the case of a taxpayer that applies the NAV method to shares
in an MMF, the gain or loss with respect to those shares for a
computation period is treated as ordinary gain or loss provided the sale
or exchange of every one of those shares during the computation period
would give rise to ordinary gain or loss if the taxpayer did not apply
the NAV method to the shares.
(iii) See paragraph (c)(5) of this section for the treatment of
shares in a single MMF held in more than one account.
(4) Holding period. Capital gains and losses determined under the
NAV method are treated as short-term capital gains and losses.
(5) More than one account. If a taxpayer holds shares in an MMF
through more than one account, the taxpayer must treat its holdings in
each account as a separate MMF for purposes of this section. A taxpayer
therefore may have different methods of accounting, different
computation periods, and gains or losses of differing character, for its
shares of a single MMF held in different accounts.
(6) Consistency requirement for MMF shareholders that are RICs. If
the taxpayer is a RIC that is not described in section 4982(f) (and
therefore is subject to the section 4982 excise tax), then, for each
MMF, the taxpayer must use the NAV method for both income tax and excise
tax computations or for neither computation. See paragraph (c)(5) of
this section for the treatment of shares in a single MMF held in more
than one account. See paragraph (c)(8)(ii) of this section for changes
to or from the NAV method by a RIC.
(7) Treatment of ordinary gains and losses under section 4982(e)(6).
Under section 4982(e)(6)(B), this section is a specified mark to market
provision, and therefore any ordinary gains and losses determined under
the NAV method are governed by section 4982(e)(6)(A).
(8) Accounting method changes--(i) In general. A change to or from
the NAV method is a change in method of accounting to which the
provisions of section 446 and the accompanying regulations apply. A
taxpayer seeking to change to or from the NAV method must secure the
consent of the Commissioner in accordance with Sec. 1.446-1(e) and
follow the administrative procedures issued under Sec. 1.446-
1(e)(3)(ii) for obtaining the Commissioner's consent to change the
taxpayer's accounting method. Any such change will be made on a cut-off
basis. Because there will be no duplication or omission of amounts as a
result of such a change to
[[Page 88]]
or from the NAV method, no adjustment under section 481(a) will be
required or permitted.
(ii) RICs--(A) In general. A RIC that is subject to the excise tax
under section 4982 and that changes to or from the NAV method for its
shares in an MMF for income tax purposes must apply the new method for
excise tax purposes starting with the first day of the RIC's income tax
year of change. If that first day is not the first day of the RIC's
section 4982 period that ends in or with the RIC's income tax year, then
solely for purposes of applying the NAV method to compute the RIC's
required distribution for the calendar year that ends with or within the
RIC's income tax year of change, the section 4982 period is bifurcated
into two portions, each of which is treated as a separate taxable year.
The first portion begins on the first day of the section 4982 period and
ends on the last day of the RIC's income tax year that precedes the year
of change. The second portion begins on the first day of the income tax
year of change and ends on the last day of the section 4982 period.
(B) Example. If a RIC that holds MMF shares as capital assets
changes from a realization method to the NAV method for its income tax
year ending January 31, 2019, the section 4982 period is bifurcated into
two portions that are treated as separate taxable years solely for
purposes of applying this section. For the portion starting on November
1, 2017, and ending on January 31, 2018, the RIC applies its realization
method for excise tax purposes. For the portion starting on February 1,
2018, and ending on October 31, 2018, the RIC applies the NAV method for
excise tax purposes, treating February 1, 2018, as the first day of the
RIC's tax year for purposes of paragraphs (b)(1) and (6) of this
section. The RIC's net gain or loss for this later portion is determined
under paragraph (c)(2)(iii) of this section. This net gain or loss and
any gains and losses for the earlier portion determined under the
realization method are taken into account in determining the RIC's
capital gain net income for the full one-year period described in
section 4982(b)(1)(B).
(d) Example. The provisions of this section may be illustrated by
the following example:
Example. (i) Fund is an MMF. Shareholder is a person whose taxable
year is the calendar year. On January 1 of Year 1, Shareholder owns
5,000,000 shares in Fund with an adjusted basis of $5,000,000.00. The
price of Fund shares has not varied from $1.00 from the date Shareholder
acquired the shares through January 1 of Year 1. During that period,
Shareholder has engaged in multiple purchases and redemptions of Fund
shares, but Shareholder has reported no gains or losses with respect to
the shares because Shareholder realized an amount in each redemption
equal to Shareholder's basis in the redeemed shares. During Year 1, the
price of Fund shares begins to float. During Year 1, Shareholder
receives $32,158.23 in taxable dividends from Fund and makes 120
purchases of additional shares in Fund (including purchases through the
reinvestment of those dividends) totaling $1,253,256.37 and 28
redemptions totaling $1,124,591.71. The fair market value of
Shareholder's shares in Fund at the end of Year 1 is $5,129,750.00. All
of Shareholder's shares in Fund are held in a single account and as
capital assets. There is no adjustment to the basis in Shareholder's
shares in Fund under any provision of internal revenue law during Year
1.
(ii) Prior to Year 1, Shareholder has had no gains or losses to
report with respect to the Fund shares under a realization method and no
changes in fair market value that would have been reported under the NAV
method. Therefore, Shareholder may use the NAV method for the shares in
Fund for Year 1. Shareholder uses the NAV method for the shares with its
taxable year as the computation period. Shareholder's net investment in
Fund for Year 1 equals $128,664.66 (the $1,253,256.37 in purchases,
minus the $1,124,591.71 in redemptions). Shareholder's Year 1 gain
therefore is $1,085.34, which is the ending value of Shareholder's
shares ($5,129,750.00), minus the starting basis of Shareholder's shares
($5,000,000.00), minus Shareholder's net investment in the fund for the
taxable year ($128,664.66). The gain of $1,085.34 is treated as short-
term capital gain. Shareholder's starting basis for Year 2 is
$5,129,750.00. Shareholder also must include the $32,158.23 in dividends
in its income for Year 1 in the same manner as if Shareholder did not
use the NAV method.
(iii) If Shareholder had instead adopted the calendar month as its
computation period, it would have used the NAV method for every month of
Year 1, even though prices of Fund shares may have been fixed for some
months.
(e) Effective/applicability date. Except as provided in the
following sentence, this section applies to taxable years
[[Page 89]]
ending on or after July 8, 2016. For taxable years ending on or after
July 28, 2014, and beginning before July 8, 2016, however, shareholders
of MMFs may rely either on this section or on Sec. 1.446-7 of the 2014
proposed regulations REG-107012-14 (79 FR 43694).
[T.D. 9774, 81 FR 44512, July 8, 2016]
Sec. 1.448-1 Limitation on the use of the cash receipts
and disbursements method of accounting.
(a)-(f) [Reserved]
(g) Treatment of accounting method change and timing rules for
section 481(a) adjustment--(1) Treatment of change in accounting method.
Notwithstanding any other procedure published prior to January 7, 1991,
concerning changes from the cash method, any taxpayer to whom section
448 applies must change its method of accounting in accordance with the
provisions of this paragraph (g) and paragraph (h) of this section. In
the case of any taxpayer required by this section to change its method
of accounting for any taxable year, the change shall be treated as a
change initiated by the taxpayer. The adjustments required under section
481(a) with respect to the change in method of accounting of such a
taxpayer shall not be reduced by amounts attributable to taxable years
preceding the Internal Revenue Code of 1954. Paragraph (h)(2) of this
section provides procedures under which a taxpayer may change to an
overall accrual method of accounting for the first taxable year the
taxpayer is subject to this section (``first section 448 year''). If the
taxpayer complies with the provisions of paragraph (h)(2) of this
section for its first section 448 year, the change shall be treated as
made with the consent of the Commissioner. Paragraph (h)(3) of this
section provides procedures under which a taxpayer may change to other
than an overall accrual method of accounting for its first section 448
year. Unless the taxpayer complies with the provisions of paragraph
(h)(2) or (h)(3) of this section for its first section 448 year, the
taxpayer must comply with the provisions of paragraph (h)(4) of this
section. See paragraph (h) of this section for rules to effect a change
in method of accounting.
(2) Timing rules for section 481(a) adjustment--(i) In general.
Except as otherwise provided in paragraphs (g)(2)(ii) and (g)(3) of this
section, a taxpayer required by this section to change from the cash
method must take the net section 481(a) adjustment into account over the
section 481(a) adjustment period as determined under the applicable
administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for
obtaining the Commissioner's consent to a change in accounting method
(for example, see Rev. Proc. 2002-9 (2002-1 C.B. 327) and Rev. Proc. 97-
27 (1997-1 C.B. 680) (also see Sec. 601.601(d)(2) of this chapter)),
provided the taxpayer complies with the provisions of paragraph (h)(2)
or (3) of this section for its first section 448 year.
(ii) Hospital timing rules--(A) In general. In the case of a
hospital that is required by this section to change from the cash
method, the section 481(a) adjustment shall be taken into account
ratably (beginning with the year of change) over 10 years, provided the
taxpayer complies with the provisions of paragraph (h)(2) or (h)(3) of
this section for its first section 448 year.
(B) Definition of hospital. For purposes of paragraph (g) of this
section, a hospital is an institution--
(1) Accredited by the Joint Commission on Accreditation of
Healthcare Organizations or its predecessor (the JCAHO) (or accredited
or approved by a program of the qualified governmental unit in which
such institution is located if the Secretary of Health and Human
Services has found that the accreditation or comparable approval
standards of such qualified governmental unit are essentially equivalent
to those of the JCAHO);
(2) Used primarily to provide, by or under the supervision of
physicians, to inpatients diagnostic services and therapeutic services
for medical diagnosis, treatment, and care of injured, disabled, or sick
persons;
(3) Requiring every patient to be under the care and supervision of
a physician; and
(4) Providing 24-hour nursing services rendered or supervised by a
registered professional nurse and having a licensed practical nurse or
registered nurse on duty at all times.
[[Page 90]]
For purposes of this section, an entity need not be owned by or on
behalf of a governmental unit or by a section 501(c)(3) organization, or
operated by a section 501(c)(3) organization, in order to be considered
a hospital. In addition, for purposes of this section, a hospital does
not include a rest or nursing home, continuing care facility, daycare
center, medical school facility, research laboratory, or ambulatory care
facility.
(C) Dual function facilities. With respect to any taxpayer whose
operations consist both of a hospital, and other facilities not
qualifying as a hospital, the portion of the adjustment required by
section 481(a) that is attributable to the hospital shall be taken into
account in accordance with the rules of paragraph (g)(2) of this section
relating to hospitals. The portion of the adjustment required by section
481(a) that is not attributable to the hospital shall be taken into
account in accordance with the rules of paragraph (g)(2) of this section
not relating to hospitals.
(iii) Untimely change in method of accounting to comply with this
section. Unless a taxpayer (including a hospital and a cooperative)
required by this section to change from the cash method complies with
the provisions of paragraph (h)(2) or (h)(3) of this section for its
first section 448 year within the time prescribed by those paragraphs,
the taxpayer must take the section 481 (a) adjustment into account under
the provisions of any applicable administrative procedure that is
prescribed by the Commissioner after January 7, 1991, specifically for
purposes of complying with this section. Absent such an administrative
procedure, a taxpayer must request a change under Sec. 1.446-1(e)(3)
and shall be subject to any terms and conditions (including the year of
change) as may be imposed by the Commissioner.
(3) Special timing rules for section 481(a) adjustment--(i)Cessation
of trade or business. If the taxpayer ceases to engage in the trade or
business to which the section 481(a) adjustment relates, or if the
taxpayer operating the trade or business terminates existence, and such
cessation or termination occurs prior to the expiration of the
adjustment period described in paragraph (g)(2)(i) or (ii) of this
section, the taxpayer must take into account, in the taxable year of
such cessation or termination, the balance of the adjustment not
previously taken into account in computing taxable income. For purposes
of this paragraph (g)(3)(i), the determination as to whether a taxpayer
has ceased to engage in the trade or business to which the section
481(a) adjustment relates, or has terminated its existence, is to be
made under the principles of Sec. 1.446-1(e)(3)(ii) and its underlying
administrative procedures.
(ii) De minimis rule for a taxpayer other than a cooperative.
Notwithstanding paragraph (g)(2)(i) and (ii) of this section, a taxpayer
other than a cooperative (within the meaning of section 1381(a)) that is
required to change from the cash method by this section may elect to
use, in lieu of the adjustment period described in paragraph (g)(2)(i)
and (ii) of this section, the adjustment period for de minimis section
481(a) adjustments provided in the applicable administrative procedure
issued under Sec. 1.446-1(e)(3)(ii) for obtaining the Commissioner's
consent to a change in accounting method. A taxpayer may make an
election under this paragraph (g)(3)(ii) only if--
(A) The taxpayer's entire net section 481(a) adjustment (whether
positive or negative) is a de minimis amount as determined under the
applicable administrative procedure issued under Sec. 1.446-1(e)(3)(ii)
for obtaining the Commissioner's consent to a change in accounting
method,
(B) The taxpayer complies with the provisions of paragraph (h)(2) or
(3) of this section for its first section 448 year,
(C) The return for such year is due (determined with regard to
extensions) after December 27, 1993, and
(D) The taxpayer complies with any applicable instructions to Form
3115 that specify the manner of electing the adjustment period for de
minimis section 481(a) adjustments.
(4) Additional rules relating to section 481(a) adjustment. In
addition to the rules set forth in paragraph (g) (2) and (3) of this
section, the following rules shall apply in taking the section 481(a)
adjustment into account--
[[Page 91]]
(i) Any net operating loss and tax credit carryforwards will be
allowed to offset any positive section 481(a) adjustment,
(ii) Any net operating loss arising in the year of change or in any
subsequent year that is attributable to a negative section 481(a)
adjustment may be carried back to earlier taxable years in accordance
with section 172, and
(iii) For purposes of determining estimated income tax payments
under sections 6654 and 6655, the section 481(a) adjustment will be
recognized in taxable income ratably throughout a taxable year.
(5) Outstanding section 481(a) adjustment from previous change in
method of accounting. If a taxpayer changed its method of accounting to
the cash method for a taxable year prior to the year the taxpayer was
required by this section to change from the cash method (the section 448
year), any section 481(a) adjustment from such prior change in method of
accounting that is outstanding as of the section 448 year shall be taken
into account in accordance with the provisions of this paragraph (g)(5).
A taxpayer shall account for any remaining portion of the prior section
481(a) adjustment outstanding as of the section 448 year by continuing
to take such remaining portion into account under the provisions and
conditions of the prior change in method of accounting, or, at the
taxpayer's option, combining or netting the remaining portion of the
prior section 481(a) adjustment with the section 481(a) adjustment
required under this section, and taking into account under the
provisions of this section the resulting net amount of the adjustment.
Any taxpayer choosing to combine or net the section 481(a) adjustments
as described in the preceding sentence shall indicate such choice on the
Form 3115 required to be filed by such taxpayer under the provisions of
paragraph (h) of this section.
(h) Procedures for change in method of accounting--(1)
Applicability. Paragraph (h) of this section applies to taxpayers who
change from the cash method as required by this section. Paragraph (h)
of this section does not apply to a change in accounting method required
by any Code section (or regulations thereunder) other than this section.
(2) Automatic rule for changes to an overall accrual method--(i)
Timely changes in method of accounting. Notwithstanding any other
available procedures to change to the accrual method of accounting, a
taxpayer to whom paragraph (h) of this section applies who desires to
make a change to an overall accrual method for its first section 448
year must make that change under the provisions of this paragraph
(h)(2). A taxpayer changing to an overall accrual method under this
paragraph (h)(2) must file a current Form 3115 by the time prescribed in
paragraph (h)(2)(ii). In addition, the taxpayer must set forth on a
statement accompanying the Form 3115 the period over which the section
481(a) adjustment will be taken into account and the basis for such
conclusion. Moreover, the taxpayer must type or legibly print the
following statement at the top of page 1 of the Form 3115: ``Automatic
Change to Accrual Method--Section 448.'' The consent of the Commissioner
to the change in method of accounting is granted to taxpayers who change
to an overall accrual method under this paragraph (h)(2). See paragraph
(g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is
applicable, for rules to account for the section 481(a) adjustment.
(ii) Time and manner for filing Form 3115--(A) In general. Except as
provided in paragraph (h)(2)(ii)(B) of this section, the Form 3115
required by paragraph (h)(2)(i) must be filed no later than the due date
(determined with regard to extensions) of the taxpayer's federal income
tax return for the first section 448 year and must be attached to that
return.
(B) Extension of filing deadline. Notwithstanding paragraph
(h)(2)(ii)(A) of this section, the filing of the Form 3115 required by
paragraph (h)(2)(i) shall not be considered late if such Form 3115 is
attached to a timely filed amended income tax return for the first
section 448 year, provided that--
(1) The taxpayer's first section 448 year is a taxable year that
begins (or, pursuant to Sec. 1.441-2(c), is deemed to begin) in 1987,
1988, 1989, or 1990,
[[Page 92]]
(2) The taxpayer has not been contacted for examination, is not
before appeals, and is not before a federal court with respect to an
income tax issue (each as defined in applicable administrative
pronouncements), unless the taxpayer also complies with any requirements
for approval in those applicable administrative pronouncements, and
(3) Any amended return required by this paragraph (h)(2)(ii)(B) is
filed on or before July 8, 1991.
Filing an amended return under this paragraph (h)(2)(ii)(B) does not
extend the time for making any other election. Thus, for example,
taxpayers that comply with this section by filing an amended return
pursuant to this paragraph (h)(2)(ii)(B) may not elect out of section
448 pursuant to paragraph (i)(2) of this section.
(3) Changes to a method other than overall accrual method--(i) In
general. A taxpayer to whom paragraph (h) of this section applies who
desires to change to a special method of accounting must make that
change under the provisions of this paragraph (h)(3), except to the
extent other special procedures have been promulgated regarding the
special method of accounting. Such a taxpayer includes taxpayers who
change to both an accrual method of accounting and a special method of
accounting such as a long-term contract method. In order to change an
accounting method under this paragraph (h)(3), a taxpayer must submit an
application for change in accounting method under the applicable
administrative procedures in effect at the time of change, including the
applicable procedures regarding the time and place of filing the
application for change in method. Moreover, a taxpayer who changes an
accounting method under this paragraph (h)(3) must type or legibly print
the following statement on the top of page 1 of Form 3115: ``Change to a
Special Method of Accounting--Section 448.'' The filing of a Form 3115
by any taxpayer requesting a change of method of accounting under this
paragraph (h)(3) for its taxable year beginning in 1987 will not be
considered late if the form is filed with the appropriate office of the
Internal Revenue Service on or before the later of: the date that is the
180th day of the taxable year of change; or September 14, 1987. If the
Commissioner approves the taxpayer's application for change in method of
accounting, the timing of the adjustment required under section 481 (a),
if applicable, will be determined under the provisions of paragraph
(g)(2)(i), (g)(2)(ii), or (g)(3) of this section, whichever is
applicable. If the Commissioner denies the taxpayer's application for
change in accounting method, or if the taxpayer's application is
untimely, the taxpayer must change to an overall accrual method of
accounting under the provisions of either paragraph (h)(2) or (h)(4) of
this section, whichever is applicable.
(ii) Extension of filing deadline. Notwithstanding paragraph
(h)(3)(i) of this section, if the events or circumstances which under
section 448 disqualify a taxpayer from using the cash method occur after
the time prescribed under applicable procedures for filing the Form
3115, the filing of such form shall not be considered late if such form
is filed on or before 30 days after the close of the taxable year.
(4) Untimely change in method of accounting to comply with this
section. Unless a taxpayer to whom paragraph (h) of this section applies
complies with the provisions of paragraph (h)(2) or (h)(3) of this
section for its first section 448 year, the taxpayer must comply with
the requirements of Sec. 1.446-1 (e)(3) (including any applicable
administrative procedure that is prescribed thereunder after January 7,
1991 specifically for purposes of complying with this section) in order
to secure the consent of the Commissioner to change to a method of
accounting that is in compliance with the provisions of this section.
The taxpayer shall be subject to any terms and conditions (including the
year of change) as may be imposed by the Commissioner.
(i) Effective date--(1) In general. Except as provided in paragraph
(i)(2), (3), (4), and (5) of this section, this section applies to any
taxable year beginning after December 31, 1986.
(2) Election out of section 448--(i) In general. A taxpayer may
elect not to have this section apply to any (A) transaction with a
related party (within the meaning of section 267(b) of the
[[Page 93]]
Internal Revenue Code of 1954, as in effect on October 21, 1986), (B)
loan, or (C) lease, if such transaction, loan, or lease was entered into
on or before September 25, 1985. Any such election described in the
preceding sentence may be made separately with respect to each
transaction, loan, or lease. For rules relating to the making of such
election, see Sec. 301.9100-7T (temporary regulations relating to
elections under the Tax Reform Act of 1986). Notwithstanding the
provisions of this paragraph (i)(2), the gross receipts attributable to
a transaction, loan, or lease described in this paragraph (i)(2) shall
be taken into account for purposes of the $5,000,000 gross receipts test
described in paragraph (f) of this section.
(ii) Special rules for loans. If the taxpayer makes an election
under paragraph (i)(2)(i) of this section with respect to a loan entered
into on or before September 25, 1985, the election shall apply only with
respect to amounts that are attributable to the loan balance outstanding
on September 25, 1985. The election shall not apply to any amounts
advanced or lent after September 25, 1985, regardless of whether the
loan agreement was entered into on or before such date. Moreover, any
payments made on outstanding loan balances after September 25, 1985,
shall be deemed to first extinguish loan balances outstanding on
September 25, 1985, regardless of any contrary treatment of such loan
payments by the borrower and lender.
(3) Certain contracts entered into before September 25, 1985. This
section does not apply to a contract for the acquisition or transfer of
real property or a contract for services related to the acquisition or
development of real property if--
(i) The contract was entered into before September 25, 1985; and
(ii) The sole element of the contract which was not performed as of
September 25, 1985, was payment for such property or services.
(4) Transitional rule for paragraphs (g) and (h) of this section. To
the extent the provisions of paragraphs (g) and (h) of this section were
not reflected in paragraphs (g) and (h) of Sec. 1.448-1T (as set forth
in 26 CFR part 1 as revised on April 1, 1993), paragraphs (g) and (h) of
this section will not be adversely applied to a taxpayer with respect to
transactions entered into before December 27, 1993.
(5) Effective date of paragraph (g)(2)(i). Paragraph (g)(2)(i) of
this section applies to taxable years ending on or after June 16, 2004.
[T.D. 8514, 58 FR 68299, Dec. 27, 1993, as amended by T.D. 8996, 67 FR
35012, May 17, 2002; T.D. 9131, 69 FR 33572, June 16, 2004]
Sec. 1.448-1T Limitation on the use of the cash receipts
and disbursements method of accounting (temporary).
(a) Limitation on accounting method--(1) In general. This section
prescribes regulations under section 448 relating to the limitation on
the use of the cash receipts and disbursements method of accounting (the
cash method) by certain taxpayers.
(2) Limitation rule. Except as otherwise provided in this section,
the computation of taxable income using the cash method is prohibited in
the case of a--
(i) C corporation,
(ii) Partnership with a C corporation as a partner, or
(iii) Tax shelter.
A partnership is described in paragraph (a)(2)(ii) of this section, if
the partnership has a C corporation as a partner at any time during the
partnership's taxable year beginning after December 31, 1986.
(3) Meaning of C corporation. For purposes of this section, the term
``C corporation'' includes any corporation that is not an S corporation.
For example, a regulated investment company (as defined in section 851)
or a real estate investment trust (as defined in section 856) is a C
corporation for purposes of this section. In addition, a trust subject
to tax under section 511 (b) shall be treated, for purposes of this
section, as a C corporation, but only with respect to the portion of its
activities that constitute an unrelated trade or business. Similarly,
for purposes of this section, a corporation that is exempt from federal
income taxes under section 501 (a) shall be treated as a C corporation
only with respect to the portion of its activities that constitute an
unrelated trade or
[[Page 94]]
business. Moreover, for purposes of determining whether a partnership
has a C corporation as a partner, any partnership described in paragraph
(a)(2)(ii) of this section is treated as a C corporation. Thus, if
partnership ABC has a partner that is a partnership with a C
corporation, then, for purposes of this section, partnership ABC is
treated as a partnership with a C corporation partner.
(4) Treatment of a combination of methods. For purposes of this
section, the use of a method of accounting that records some, but not
all, items on the cash method shall be considered the use of the cash
method. Thus, a C corporation that uses a combination of accounting
methods including the use of the cash method is subject to this section.
(b) Tax shelter defined--(1) In general. For purposes of this
section, the term ``tax shelter'' means any--
(i) Enterprise (other than a C corporation) if at any time
(including taxable years beginning before January 1, 1987) interests in
such enterprise have been offered for sale in any offering required to
be registered with any federal or state agency having the authority to
regulate the offering of securities for sale,
(ii) Syndicate (within the meaning of paragraph (b)(3) of this
section), or
(iii) Tax shelter within the meaning of section 6662(d)(2)(C).
(2) Requirement of registration. For purposes of paragraph (b)(1)(i)
of this section, an offering is required to be registered with a federal
or state agency if, under the applicable federal or state law, failure
to register the offering would result in a violation of the applicable
federal or state law (regardless of whether the offering is in fact
registered). In addition, an offering is required to be registered with
a federal or state agency if, under the applicable federal or state law,
failure to file a notice of exemption from registration would result in
a violation of the applicable federal or state law (regardless of
whether the notice is in fact filed).
(3) Meaning of syndicate. For purposes of paragraph (b)(1)(ii) of
this section, the term ``syndicate'' means a partnership or other entity
(other than a C corporation) if more than 35 percent of the losses of
such entity during the taxable year (for taxable years beginning after
December 31, 1986) are allocated to limited partners or limited
entrepreneurs. For purposes of this paragraph (b)(3), the term ``limited
entrepreneur'' has the same meaning given such term in section 464
(e)(2). In addition, in determining whether an interest in a partnership
is held by a limited partner, or an interest in an entity or enterprise
is held by a limited entrepreneur, section 464 (c)(2) shall apply in the
case of the trade or business of farming (as defined in paragraph (d)(2)
of this section), and section 1256 (e)(3)(C) shall apply in any other
case. Moreover, for purposes of this paragraph (b)(3), the losses of a
partnership, entity, or enterprise (the enterprise) means the excess of
the deductions allowable to the enterprise over the amount of income
recognized by such enterprise under the enterprise's method of
accounting used for federal income tax purposes (determined without
regard to this section). For this purpose, gains or losses from the sale
of capital assets or section 1221 (2) assets are not taken into account.
(4) Presumed tax avoidance. For purposes of paragraph (b)(1)(iii) of
this section, marketed arrangements in which persons carrying on farming
activities using the services of a common managerial or administrative
service will be presumed to have the principal purpose of tax avoidance
if such persons use borrowed funds to prepay a substantial portion of
their farming expenses (e.g., payment for farm supplies that will not be
used or consumed until a taxable year subsequent to the taxable year of
payment).
(5) Taxable year tax shelter must change accounting method. A
partnership, entity, or enterprise that is a tax shelter must change
from the cash method for the later of (i) the first taxable year
beginning after December 31, 1986, or (ii) the taxable year that such
partnership, entity, or enterprise becomes a tax shelter.
(c) Effect of section 448 on other provisions. Nothing in section
448 shall have any effect on the application of any other provision of
law that would otherwise limit the use of the cash method, and no
inference shall be drawn
[[Page 95]]
from section 448 with respect to the application of any such provision.
For example, nothing in section 448 affects the requirement of section
447 that certain corporations must use an accrual method of accounting
in computing taxable income from farming, or the requirement of Sec.
1.446-1(c)(2) that an accrual method be used with regard to purchases
and sales of inventory. Similarly, nothing in section 448 affects the
authority of the Commissioner under section 446(b) to require the use of
an accounting method that clearly reflects income, or the requirement
under section 446(e) that a taxpayer secure the consent of the
Commissioner before changing its method of accounting. For example, a
taxpayer using the cash method may be required to change to an accrual
method of accounting under section 446(b) because such method clearly
reflects that taxpayer's income, even though the taxpayer is not
prohibited by section 448 from using the cash method. Similarly, a
taxpayer using an accrual method of accounting that is not prohibited by
section 448 from using the cash method may not change to the cash method
unless the taxpayer secures the consent of the Commissioner under
section 446(e), and, in the opinion of the Commissioner, the use of the
cash method clearly reflects that taxpayer's income under section
446(b).
(d) Exception for farming business--(1) In general. Except in the
case of a tax shelter, this section shall not apply to any farming
business. A taxpayer engaged in a farming business and a separate
nonfarming business is not prohibited by this section from using the
cash method with respect to the farming business, even though the
taxpayer may be prohibited by this section from using the cash method
with respect to the nonfarming business.
(2) Meaning of farming business. For purposes of paragraph (d) of
this section, the term ``farming business'' means--
(i) The trade or business of farming as defined in section
263A(e)(4) (including the operation of a nursery or sod farm, or the
raising or harvesting of trees bearing fruit, nuts, or other crops, or
ornamental trees), or
(ii) The raising, harvesting , or growing of trees described in
section 263A(c)(5) (relating to trees raised, harvested, or grown by the
taxpayer other than trees described in paragraph (d)(2)(i) of this
section).
Thus, for purposes of this section, the term ``farming business''
includes the raising of timber. For purposes of this section, the term
``farming business'' does not include the processing of commodities or
products beyond those activities normally incident to the growing,
raising or harvesting of such products. For example, assume that a C
corporation taxpayer is in the business of growing and harvesting wheat
and other grains. The taxpayer processes the harvested grains to produce
breads, cereals, and similar food products which it sells to customers
in the course of its business. Although the taxpayer is in the farming
business with respect to the growing and harvesting of grain, the
taxpayer is not in the farming business with respect to the processing
of such grains to produce food products which the taxpayer sells to
customers. Similarly, assume that a taxpayer is in the business of
raising poultry or other livestock. The taxpayer uses the livestock in a
meat processing operation in which the livestock are slaughtered,
processed, and packaged or canned for sale to customers. Although the
taxpayer is in the farming business with respect to the raising of
livestock, the taxpayer is not in the farming business with respect to
the meat processing operation. However, under this section the term
``farming business'' does include processing activities which are
normally incident to the growing, raising or harvesting of agricultural
products. For example, assume a taxpayer is in the business of growing
fruits and vegetables. When the fruits and vegetables are ready to be
harvested, the taxpayer picks, washes, inspects, and packages the fruits
and vegetables for sale. Such activities are normally incident to the
raising of these crops by farmers. The taxpayer will be considered to be
in the business of farming with respect to the growing of fruits and
vegetables, and the processing activities incident to the harvest.
[[Page 96]]
(e) Exception for qualified personal service corporation--(1) In
general. Except in the case of a tax shelter, this section does not
apply to a qualified personal service corporation.
(2) Certain treatment for qualified personal service corporation.
For purposes of paragraph (a)(2)(ii) of this section (relating to
whether a partnership has a C corporation as a partner), a qualified
personal service corporation shall be treated as an individual.
(3) Meaning of qualified personal service corporation. For purposes
of this section, the term ``qualified personal service corporation''
means any corporation that meets--
(i) The function test paragraph (e)(4) of this section, and
(ii) The ownership test of paragraph (e)(5) of this section.
(4) Function test--(i) In general. A corporation meets the function
test if substantially all the corporation's activities for a taxable
year involve the performance of services in one or more of the following
fields--
(A) Health,
(B) Law,
(C) Engineering (including surveying and mapping),
(D) Architecture,
(E) Accounting,
(F) Actuarial science,
(G) Performing arts, or
(H) Consulting.
Substantially all of the activities of a corporation are involved in the
performance of services in any field described in the preceding sentence
(a qualifying field), only if 95 percent or more of the time spent by
employees of the corporation, serving in their capacity as such, is
devoted to the performance of services in a qualifying field. For
purposes of determining whether this 95 percent test is satisfied, the
performance of any activity incident to the actual performance of
services in a qualifying field is considered the performance of services
in that field. Activities incident to the performance of services in a
qualifying field include the supervision of employees engaged in
directly providing services to clients, and the performance of
administrative and support services incident to such activities.
(ii) Meaning of services performed in the field of health. For
purposes of paragraph (e)(4)(i)(A) of this section, the performance of
services in the field of health means the provision of medical services
by physicians, nurses, dentists, and other similar healthcare
professionals. The performance of services in the field of health does
not include the provision of services not directly related to a medical
field, even though the services may purportedly relate to the health of
the service recipient. For example, the performance of services in the
field of health does not include the operation of health clubs or health
spas that provide physical exercise or conditioning to their customers.
(iii) Meaning of services performed in the field of performing arts.
For purposes of paragraph (e)(4)(i)(G) of this section, the performance
of services in the field of the performing arts means the provision of
services by actors, actresses, singers, musicians, entertainers, and
similar artists in their capacity as such. The performance of services
in the field of the performing arts does not include the provision of
services by persons who themselves are not performing artists (e.g.,
persons who may manage or promote such artists, and other persons in a
trade or business that relates to the performing arts). Similarly, the
performance of services in the field of the performing arts does not
include the provision of services by persons who broadcast or otherwise
disseminate the performances of such artists to members of the public
(e.g., employees of a radio station that broadcasts the performances of
musicians and singers). Finally, the performance of services in the
field of the performing arts does not include the provision of services
by athletes.
(iv) Meaning of services performed in the field of consulting--(A)
In general. For purposes of paragraph (e)(4)(i)(H) of this section, the
performance of services in the field of consulting means the provision
of advice and counsel. The performance of services in the field of
consulting does not include the performance of services other than
advice and counsel, such as sales or brokerage services, or economically
similar services. For purposes of the preceding sentence, the
determination of whether a
[[Page 97]]
person's services are sales or brokerage services, or economically
similar services, shall be based on all the facts and circumstances of
that person's business. Such facts and circumstances include, for
example, the manner in which the taxpayer is compensated for the
services provided (e.g., whether the compensation for the services is
contingent upon the consummation of the transaction that the services
were intended to effect).
(B) Examples. The following examples illustrate the provisions of
paragraph (e)(4)(iv)(A) of this section. The examples do not address all
types of services that may or may not qualify as consulting. The
determination of whether activities not specifically addressed in the
examples qualify as consulting shall be made by comparing the service
activities in question to the types of service activities discussed in
the examples. With respect to a corporation which performs services
which qualify as consulting under this section, and other services which
do not qualify as consulting, see paragraph (e)(4)(i) of this section
which requires that substantially all of the corporation's activities
involve the performance of services in a qualifying field.
Example 1. A taxpayer is in the business of providing economic
analyses and forecasts of business prospects for its clients. Based on
these analyses and forecasts, the taxpayer advises its clients on their
business activities. For example, the taxpayer may analyze the economic
conditions and outlook for a particular industry which a client is
considering entering. The taxpayer will then make recommendations and
advise the client on the prospects of entering the industry, as well as
on other matters regarding the client's activities in such industry. The
taxpayer provides similar services to other clients, involving, for
example, economic analyses and evaluations of business prospects in
different areas of the United States or in other countries, or economic
analyses of overall economic trends and the provision of advice based on
these analyses and evaluations. The taxpayer is considered to be engaged
in the performance of services in the field of consulting.
Example 2. A taxpayer is in the business of providing services that
consist of determining a client's electronic data processing needs. The
taxpayer will study and examine the client's business, focusing on the
types of data and information relevant to the client and the needs of
the client's employees for access to this information. The taxpayer will
then make recommendations regarding the design and implementation of
data processing systems intended to meet the needs of the client. The
taxpayer does not, however, provide the client with additional computer
programming services distinct from the recommendations made by the
taxpayer with respect to the design and implementation of the client's
data processing systems. The taxpayer is considered to be engaged in the
performance of services in the field of consulting.
Example 3. A taxpayer is in the business of providing services that
consist of determining a client's management and business structure
needs. The taxpayer will study the client's organization, including, for
example, the departments assigned to perform specific functions, lines
of authority in the managerial hierarchy, personnel hiring, job
responsibility, and personnel evaluations and compensation. Based on the
study, the taxpayer will then advise the client on changes in the
client's management and business structure, including, for example, the
restructuring of the client's departmental systems or its lines of
managerial authority. The taxpayer is considered to be engaged in the
performance of services in the field of consulting.
Example 4. A taxpayer is in the business of providing financial
planning services. The taxpayer will study a particular client's
financial situation, including, for example, the client's present
income, savings and investments, and anticipated future economic and
financial needs. Based on this study, the taxpayer will then assist the
client in making decisions and plans regarding the client's financial
activities. Such financial planning includes the design of a personal
budget to assist the client in monitoring the client's financial
situation, the adoption of investment strategies tailored to the
client's needs, and other similar services. The taxpayer is considered
to be engaged in the performance of services in the field of consulting.
Example 5. A taxpayer is in the business of executing transactions
for customers involving various types of securities or commodities
generally traded through organized exchanges or other similar networks.
The taxpayer provides its clients with economic analyses and forecasts
of conditions in various industries and businesses. Based on these
analyses, the taxpayer makes recommendations regarding transactions in
securities and commodities. Clients place orders with the taxpayer to
trade securities or commodities based on the taxpayer's recommendations.
The taxpayer's compensation for its services is typically based on the
trade orders. The taxpayer is not considered to be engaged in the
performance of services in the field of consulting. The taxpayer is
engaged in brokerage services. Relevant to this
[[Page 98]]
determination is the fact that the compensation of the taxpayer for its
services is contingent upon the consummation of the transaction the
services were intended to effect (i.e., the execution of trade orders
for its clients).
Example 6. A taxpayer is in the business of studying a client's
needs regarding its data processing facilities and making
recommendations to the client regarding the design and implementation of
data processing systems. The client will then order computers and other
data processing equipment through the taxpayer based on the taxpayer's
recommendations. The taxpayer's compensation for its services is
typically based on the equipment orders made by the clients. The
taxpayer is not considered to be engaged in the performance of services
in the field of consulting. The taxpayer is engaged in the performance
of sales services. Relevant to this determination is the fact that the
compensation of the taxpayer for its services it contingent upon the
consummation of the transaction the services were intended to effect
(i.e., the execution of equipment orders for its clients).
Example 7. A taxpayer is in the business of assisting businesses in
meeting their personnel requirements by referring job applicants to
employers with hiring needs in a particular area. The taxpayer may be
informed by potential employers of their need for job applicants, or,
alternatively, the taxpayer may become aware of the client's personnel
requirements after the taxpayer studies and examines the client's
management and business structure. The taxpayer's compensation for its
services is typically based on the job applicants, referred by the
taxpayer to the clients, who accept employment positions with the
clients. The taxpayer is not considered to be engaged in the performance
of services in the field of consulting. The taxpayer is involved in the
performance of services economically similar to brokerage services.
Relevant to this determination is the fact that the compensation of the
taxpayer for its services is contingent upon the consummation of the
transaction the services were intended to effect (i.e., the hiring of a
job applicant by the client).
Example 8. The facts are the same as in Example 7, except that the
taxpayer's clients are individuals who use the services of the taxpayer
to obtain employment positions. The taxpayer is typically compensated by
its clients who obtain employment as a result of the taxpayer's
services. For the reasons set forth in Example 7, the taxpayer is not
considered to be engaged in the performance of services in the field of
consulting.
Example 9. A taxpayer is in the business of assisting clients in
placing advertisements for their goods and services. The taxpayer
analyzes the conditions and trends in the client's particular industry,
and then makes recommendations to the client regarding the types of
advertisements which should be placed by the client and the various
types of advertising media (e.g., radio, television, magazines, etc.)
which should be used by the client. The client will then purchase,
through the taxpayer, advertisements in various media based on the
taxpayer's recommendations. The taxpayer's compensation for its services
is typically based on the particular orders for advertisements which the
client makes. The taxpayer is not considered to be engaged in the
performance of services in the field of consulting. The taxpayer is
engaged in the performance of services economically similar to brokerage
services. Relevant to this determination is the fact that the
compensation of the taxpayer for its services is contingent upon the
consummation of the transaction the services were intended to effect
(i.e., the placing of advertisements by clients).
Example 10. A taxpayer is in the business of selling insurance
(including life and casualty insurance), annuities, and other similar
insurance products to various individual and business clients. The
taxpayer will study the particular client's financial situation,
including, for example, the client's present income, savings and
investments, business and personal insurance risks, and anticipated
future economic and financial needs. Based on this study, the taxpayer
will then make recommendations to the client regarding the desirability
of various insurance products. The client will then purchase these
various insurance products through the taxpayer. The taxpayer's
compensation for its services is typically based on the purchases made
by the clients. The taxpayer is not considered to be engaged in the
performance of services in the field of consulting. The taxpayer is
engaged in the performance of brokerage or sales services. Relevant to
this determination is the fact that the compensation of the taxpayer for
its services is contingent upon the consummation of the transaction the
services were intended to effect (i.e., the purchase of insurance
products by its clients).
(5) Ownership test--(i) In general. A corporation meets the
ownership test, if at all times during the taxable year, substantially
all the corporation's stock, by value, is held, directly or indirectly,
by--
(A) Employees performing services for such corporation in connection
with activities involving a field referred to in paragraph (e)(4) of
this section,
(B) Retired employees who had performed such services for such
corporation,
[[Page 99]]
(C) The estate of any individual described in paragraph (e)(5)(i)
(A) or (B) of this section, or
(D) Any other person who acquired such stock by reason of the death
of an individual described in paragraph (e)(5)(i) (A) or (B) of this
section, but only for the 2-year period beginning on the date of the
death of such individual.
For purposes of this paragraph (e)(5) of this section, the term
``substantially all'' means an amount equal to or greater than 95
percent.
(ii) Definition of employee. For purposes of the ownership test of
this paragraph (e)(5) of this section, a person shall not be considered
an employee of a corporation unless the services performed by that
person for such corporation, based on the facts and circumstances, are
more than de minimis. In addition, a person who is an employee of a
corporation shall not be treated as an employee of another corporation
merely by reason of the employer corporation and the other corporation
being members of the same affiliated group or otherwise related.
(iii) Attribution rules. For purposes of this paragraph (e)(5) of
this section, a corporation's stock is considered held indirectly by a
person if, and to the extent, such person owns a proportionate interest
in a partnership, S corporation, or qualified personal service
corporation that owns such stock. No other arrangement or type of
ownership shall constitute indirect ownership of a corporation's stock
for purposes of this paragraph (e)(5) of this section. Moreover, stock
of a corporation held by a trust is considered held by a person if, and
to the extent, such person is treated under subpart E, part I,
subchapter J, chapter 1 of the Code as the owner of the portion of the
trust that consists of such stock.
(iv) Disregard of community property laws. For purposes of this
paragraph (e)(5) of this section, community property laws shall be
disregarded. Thus, in determining the stock ownership of a corporation,
stock owned by a spouse solely by reason of community property laws
shall be treated as owned by the other spouse.
(v) Treatment of certain stock plans. For purposes of this paragraph
(e)(5) of this section, stock held by a plan described in section 401
(a) that is exempt from tax under section 501 (a) shall be treated as
held by an employee described in paragraph (e)(5)(i)(A) of this section.
(vi) Special election for certain affiliated groups. For purposes of
determining whether the stock ownership test of this paragraph (e)(5) of
this section has been met, at the election of the common parent of an
affiliated group (within the meaning of section 1504 (a)), all members
of such group shall be treated as one taxpayer if substantially all
(within the meaning of paragraph (e)(4)(i) of this section) the
activities of all such members (in the aggregate) are in the same field
described in paragraph (e)(4)(i)(A)-(H) of this section. For rules
relating to the making of the election, see 26 CFR 5h.5 (temporary
regulations relating to elections under the Tax Reform Act of 1986).
(vii) Examples. The following examples illustrate the provisions of
paragraph (e) of this section:
Example 1. (i) X, a Corporation, is engaged in the business of
providing accounting services to its clients. These services consist of
the preparation of audit and financial statements and the preparation of
tax returns. For purposes of section 448, such services consist of the
performance of services in the field of accounting. In addition, for
purposes of section 448, the supervision of employees directly preparing
the statements and returns, and the performance of all administrative
and support services incident to such activities (including secretarial,
janitorial, purchasing, personnel, security, and payroll services) are
the performance of services in the field of accounting.
(ii) In addition, X owns and leases a portion of an office building.
For purposes of this section, the following types of activities
undertaken by the employees of X shall be considered as the performance
of services in a field other than the field of accounting: (A) services
directly relating to the leasing activities, e.g., time spent in leasing
and maintaining the leased portion of the building; (B) supervision of
employees engaged in directly providing services in the leasing
activity; and (C) all administrative and support services incurred
incident to services described in (A) and (B). The leasing activities of
X are considered the performance of services in a field other than the
field of accounting, regardless of whether such leasing activities
constitute a trade or business under the Code. If the employees of X
spend 95% or
[[Page 100]]
more of their time in the performance of services in the field of
accounting, X satisfies the function test of paragraph (e)(4) of this
section.
Example 2. Assume that Y, a C corporation, meets the function test
of paragraph (e)(4) of this section. Assume further that all the
employees of Y are performing services for Y in a qualifying field as
defined in paragraph (e)(4) of this section. P, a partnership, owns 40%,
by value, of the stock of Y. The remaining 60% of the stock of Y is
owned directly by employees of Y. Employees of Y have an aggregate
interest of 90% in the capital and profits of P. This, 96% of the stock
of Y is held directly, or indirectly, by employees of Y performing
services in a qualifying field. Accordingly, Y meets the ownership test
of paragraph (e)(5) of this section and is a qualified personal service
corporation.
Example 3. The facts are the same as in Example 2, except that 40%
of the stock of Y is owned by Z, a C corporation. The remaining 60% of
the stock is owned directly by the employees of Y. Employees of Y own
90% of the stock, by value, of Z. Assume that Z independently qualifies
as a personal service corporation. The result is the same as in Example
2, i.e., 96% of the stock of Y is held, directly or indirectly, by
employees of Y performing services in a qualifying field. Thus, Y is a
qualified personal service corporation.
Example 4. The facts are the same as in Example 3, except that Z
does not independently qualify as a personal service corporation.
Because Z is not a qualified personal service corporation, the Y stock
owned by Z is not treated as being held indirectly by the Z
shareholders. Consequently, only 60% of the stock of Y is held, directly
or indirectly, by employees of Y. Thus, Y does not meet the ownership
test of paragraph (e)(5) of this section, and is not a qualified
personal service corporation.
Example 5. Assume that W, a C corporation, meets the function test
of paragraph (e)(4) of this section. In addition, assume that all the
employees of W are performing services for W in a qualifying field.
Nominal legal title to 100% of the stock of W is held by employees of W.
However, due solely to the operation of community property laws, 20% of
the stock of W is held by spouses of such employees who themselves are
not employees of W. In determining the ownership of the stock, community
property laws are disregarded. Thus, Y meets the ownership test of
paragraph (e)(5) of this section, and is a qualified personal service
corporation.
Example 6. Assume that 90% of the stock of T, a C corporation, is
directly owned by the employees of T. Spouses of T's employees directly
own 5% of the stock of T. The spouses are not employees of T, and their
ownership does not occur solely by operation of community property laws.
In addition, 5% of the stock of T is held by trusts (other than a trust
described in section 401(a) that is exempt from tax under section
501(a)), the sole beneficiaries of which are employees of T. The
employees are not treated as owners of the trusts under subpart E, part
I, subchapter J, chapter 1 of the Code. Since a person is not treated as
owning the stock of a corporation owned by that person's spouse, or by
any portion of a trust that is not treated as owned by such person under
subpart E, only 90% of the stock of T is treated as held, directly or
indirectly, by employees of T. Thus, T does not meet the ownership test
of paragraph (e)(5) of this section, and is not a qualified personal
service corporation.
Example 7. Assume that Y, a C corporation, directly owns all the
stock of three subsidiaries, F, G, and H. Y is a common parent of an
affiliated group within the meaning of section 1504(a) consisting of Y,
F, G, and H. Y is not engaged in the performance of services in a
qualifying field. Instead, Y is a holding company whose activities
consist of its ownership and investment in its operating subsidiaries.
Substantially all the activities of F involve the performance of
services in the field of engineering. In addition, a majority of (but
not substantially all) the activities of G involve the performance of
services in the field of engineering; the remainder of G's services
involve the performance of services in a nonqualifying field. Moreover,
a majority of (but not substantially all) the activities of H involve
the performance of services in the field of engineering; the remainder
of H's activities involve the performance of services in the field of
architecture. Nevertheless, substantially all the activities of the
group consisting of Y, F, G, and H, in the aggregate, involve the
performance of services in the field of engineering. Accordingly, Y
elects under paragraph (e)(5)(vi) of this section to be treated as one
taxpayer for determining the ownership test of paragraph (e)(5) of this
section. Assume that substantially all the stock of Y (by value) is held
by employees of F, G, or H who perform services in connection with a
qualifying field (engineering or architecture). Thus, for purposes of
determining whether any member corporation is a qualified personal
service corporation, the ownership test of paragraph (e)(5) of this
section has been satisfied. Since F and H satisfy the function test of
paragraph (e)(4) of this section, F and H are qualified personal service
corporations. However, since Y and G each fail the function test of
paragraph (e)(4) of this section, neither corporation is a qualified
personal service corporation.
Example 8. The facts are the same as in Example 7, except that less
than substantially all the activities of the group consisting of
[[Page 101]]
Y, F, G, and H, in the aggregate, are performed in the field of
engineering. Substantially all the activities of the group consisting of
Y, F, G, and H, are, in the aggregate, performed in two fields, the
fields of engineering and architecture. Y may not elect to have the
affiliated group treated as one taxpayer for purposes of determining
whether group members meet the ownership test of paragraph (e)(5) of
this section. The election is available only if substantially all the
activities of the group, in the aggregate, involve the performance of
services in only one qualifying field. Moreover, none of the group
members are qualified personal service corporations. Y fails the
function test of paragraph (e)(4) of this section because less than
substantially all the activities of Y are performed in a qualifying
field. In addition, F, G, and H fail the ownershp test of paragraph
(e)(5) of this section because substantially all their stock is owned by
Y and not by their employees. The owners of Y are not deemed to
indirectly own the stock owned by Y because Y is not a qualified
personal service corporation.
Example 9. (i) The facts are the same as in Example 8, except Y
itself satisfies the function tests of paragraph (e)(4) of this section
because substantially all the activities of Y involve the performance of
services in the field of engineering. In addition, assume that all
employees of Y are involved in the performance of services in the field
of engineering, and that all such employees own 100% of Y's stock.
Moreover, assume that one-third of all the employees of Y are separately
employed by F. Similarly, another one-third of the employees of Y are
separately employed by G and H, respectively. None of the employees of Y
are employed by more than one of Y's subsidiaries. Also, no other
persons except the employees of Y are employed by any of the
subsidiaries.
(ii) Y is a personal service corporation under section 448 because Y
satisfies both the function and the ownership test of paragraphs (e) (4)
and (5) of this section. As in Example 8, Y is unable to make the
election to have the affiliated group treated as one taxpayer for
purposes of determining whether group members meet the ownership test of
paragraph (e)(5) of this section because less than substantially all the
activities, in the aggregate, of the group members are performed in one
of the qualifying fields. However, because Y is a personal service
corporation, the stock owned by Y is treated as indirectly owned,
proportionately, by the owners of Y. Thus, the employees of F are
collectively treated as owning one-third of the stock of F, G, and H.
The employees of G and H are similarly treated as owning one-third of
each subsidiary's stock.
(iii) F, G, and H each fail the ownership test of paragraph (e)(5)
of this section because less than substantially all of each
corporation's stock is owned by the employees of the respective
corporation. Only one-third of each corporation's stock is owned by
employees of that corporation. Thus, F, G, and H are not qualified
personal service corporations.
Example 10. (i) Assume that Y, a C corporation, directly owns all
the stock of three subsidiaries, F, G, and Z. Y is a common parent of an
affiliated group within the meaning of section 1504(a) consisting of Y,
F, and G. Z is a foreign corporation and is excluded from the affiliated
group under section 1504. Assume that Y is a holding company whose
activities consist of its ownership and investment in its operating
subsidiaries. Substantially all the activities of F, G, and Z involve
the performance of services in the field of engineering. Assume that
employees of Z own one-third of the stock of Y and that none of these
employees are also employees of Y, F, or G. In addition, assume that Y
elects to be treated as one taxpayer for determining whether group
members meet the ownership tests of paragraph (e)(5) of this section.
Thus, Y, F, and G are treated as one taxpayer for purposes of the
ownership test.
(ii) None of the members of the group are qualified personal service
corporations. Y, F, and G fail the ownership test of paragraph (e)(5) of
this section because less than substantially all the stock of Y is owned
by employees of either Y, F, or G. Moreover, Z fails the ownership test
of paragraph (e)(5) of this section because substantially all its stock
is owned by Y and not by its employees.
(6) Application of function and ownership tests. A corporation that
fails the function test of paragraph (e)(4) of this section for any
taxable year, or that fails the ownership test of paragraph (e)(5) of
this section at any time during any taxable year, shall change from the
cash method effective for the year in which the corporation fails to
meet the function test or the ownership test. For example, if a personal
service corporation fails the function test for taxable year 1987, such
corporation must change from the cash method effective for taxable year
1987. A corporation that fails the function or ownership test for a
taxable year shall not be treated as a qualified personal service
corporation for any part of that taxable year.
(f) Exception for entities with gross receipts of not more than $5
million--(1) In general. Except in the case of a tax shelter, this
section shall not apply to any C corporation or partnership with a C
corporation as a partner for any taxable year if, for all prior taxable
[[Page 102]]
years beginning after December 31, 1985, such corporation or partnership
(or any predecessor thereof) meets the $5,000,000 gross receipts test of
paragraph (f)(2) of this section.
(2) The $5,000,000 gross receipts test--(i) In general. A
corporation meets the $5,000,000 gross receipts test of this paragraph
(f)(2) for any prior taxable year if the average annual gross receipts
of such corporation for the 3 taxable years (or, if shorter, the taxable
years during which such corporation was in existence) ending with such
prior taxable year does not exceed $5,000,000. In the case of a C
corporation exempt from federal income taxes under section 501(a), or a
trust subject to tax under section 511(b) that is treated as a C
corporation under paragraph (a)(3) of this section, only gross receipts
from the activities of such corporation or trust that constitute
unrelated trades or businesses are taken into account in determining
whether the $5,000,000 gross receipts test is satisfied. A partnership
with a C corporation as a partner meets the $5,000,000 gross receipts
test of this paragraph (f)(2) for any prior taxable year if the average
annual gross receipts of such partnership for the 3 taxable years (or,
if shorter, the taxable years during which such partnership was in
existence) ending with such prior year does not exceed $5,000,000. The
gross receipts of the corporate partner are not taken into account in
determining whether the partnership meets the $5,000,000 gross receipts
test.
(ii) Aggregation of gross receipts. For purposes of determining
whether the $5,000,000 gross receipts test has been satisfied, all
persons treated as a single employer under section 52 (a) or (b), or
section 414 (m) or (o) (or who would be treated as a single employer
under such sections if they had employees) shall be treated as one
person. Gross receipts attributable to transactions between persons who
are treated as a common employer under this paragraph shall not be taken
into account in determining whether the $5,000,000 gross receipts test
is satisified.
(iii) Treatment of short taxable year. In the case of any taxable
year of less than 12 months (a short taxable year), the gross receipts
shall be annualized by (A) multiplying the gross receipts for the short
period by 12 and (B) dividing the result by the number of months in the
short period.
(iv) Determination of gross receipts--(A) In general. The term
``gross receipts'' means gross receipts of the taxable year in which
such receipts are properly recognized under the taxpayer's accounting
method used in that taxable year (determined without regard to this
section) for federal income tax purposes. For this purpose, gross
receipts include total sales (net of returns and allowances) and all
amounts received for services. In addition, gross receipts include any
income from investments, and from incidental or outside sources. For
example, gross receipts include interest (including original issue
discount and tax-exempt interest within the meaning of section 103),
dividends, rents, royalties, and annuities, regardless of whether such
amounts are derived in the ordinary course of the taxpayer's trade of
business. Gross receipts are not reduced by cost of goods sold or by the
cost of property sold if such property is described in section 1221 (1),
(3), (4) or (5). With respect to sales of capital assets as defined in
section 1221, or sales of property described in 1221 (2) (relating to
property used in a trade or business), gross receipts shall be reduced
by the taxpayer's adjusted basis in such property. Gross receipts do not
include the repayment of a loan or similar instrument (e.g., a repayment
of the principal amount of a loan held by a commercial lender). Finally,
gross receipts do not include amounts received by the taxpayer with
respect to sales tax or other similar state and local taxes if, under
the applicable state or local law, the tax is legally imposed on the
purchaser of the good or service, and the taxpayer merely collects and
remits the tax to the taxing authority. If, in contrast, the tax is
imposed on the taxpayer under the applicable law, then gross receipts
shall include the amounts received that are allocable to the payment of
such tax.
(3) Examples. The following examples illustrate the provisions of
paragraph (f) of this section:
Example 1. X, a calendar year C corporation, was formed on January
1, 1986. Assume
[[Page 103]]
that in 1986 X has gross receipts of $15 million. For taxable year 1987,
this section applies to X because in 1986, the period during which X was
in existence, X has average annual gross receipts of more than $5
million.
Example 2. Y, a calendar year C corporation that is not a qualified
personal service corporation, has gross receipts of $10 million, $9
million, and $4 million for taxable years 1984, 1985, and 1986,
respectively. In taxable year 1986, X has average annual gross receipts
for the 3-taxable-year period ending with 1986 of $7.67 million ($10
million + 9 million + 4 million / 3). Thus, for taxable year 1987, this
section applies and Y must change from the cash method for such year.
Example 3. Z, a C corporation which is not a qualified personal
service corporation, has a 5% partnership interest in ZAB partnership, a
calendar year cash method taxpayer. All other partners of ZAB
partnership are individuals. Z corporation has average annual gross
receipts of $100,000 for the 3-taxable-year period ending with 1986
(i.e., 1984, 1985 and 1986). The ZAB partnership has average annual
gross receipts of $6 million for the same 3-taxable-year period. Since
ZAB fails to meet the $5,000,000 gross receipts test for 1986, this
section applies to ZAB for its taxable year beginning January 1, 1987.
Accordingly, ZAB must change from the cash method for its 1987 taxable
year. The gross receipts of Z corporation are not relevant in
determining whether ZAB is subject to this section.
Example 4. The facts are the same as in Example 3, except that
during the 1987 taxable year of ZAB, the Z corporation transfers its
partnership interest in ZAB to an individual. Under paragraph (a)(1) of
this section, ZAB is treated as a partnership with a C corporation as a
partner. Thus, this section requires ZAB to change from the cash method
effective for its taxable year 1987. If ZAB later desires to change its
method of accounting to the cash method for its taxable year beginning
January 1, 1988 (or later), ZAB must comply with all requirements of
law, including sections 446(b), 446(e), and 481, to effect the change.
Example 5. X, a C corporation that is not a qualified personal
service corporation, was formed on January 1, 1986, in a transaction
described in section 351. In the transaction, A, an individual,
contributed all of the assets and liabilities of B, a trade or business,
to X, in return for the receipt of all the outstanding stock of X.
Assume that in 1986 X has gross receipts of $4 million. In 1984 and
1985, the gross receipts of B, the trade or business, were $10 million
and $7 million respectively. The gross receipts test is applied for the
period during which X and its predecessor trade or business were in
existence. X has average annual gross receipts for the 3-taxable-year
period ending with 1986 of $7 million ($10 million + $7 million + $4
million / 3). Thus, for taxable year 1987, this section applies and X
must change from the cash method for such year.
[T.D. 8143, 52 FR 22766, June 16, 1987, as amended by T.D. 8329, 56 FR
485, Jan. 7, 1991; T.D. 8514, 58 FR 68299, Dec. 27, 1993; T.D. 9174, 70
FR 704, Jan. 5, 2005]
Sec. 1.448-2 Nonaccrual of certain amounts by service providers.
(a) In general. This section applies to taxpayers qualified to use a
nonaccrual-experience method of accounting provided for in section
448(d)(5) with respect to amounts to be received for the performance of
services. A taxpayer that satisfies the requirements of this section is
not required to accrue any portion of amounts to be received from the
performance of services that, on the basis of the taxpayer's experience,
and to the extent determined under the computation or formula used by
the taxpayer and allowed under this section, will not be collected.
Except as otherwise provided in this section, a taxpayer is qualified to
use a nonaccrual-experience method of accounting if the taxpayer uses an
accrual method of accounting with respect to amounts to be received for
the performance of services by the taxpayer and either--
(1) The services are in fields referred to in section 448(d)(2)(A)
and described in Sec. 1.448-1T(e)(4) (health, law, engineering,
architecture, accounting, actuarial science, performing arts, or
consulting); or
(2) The taxpayer meets the $5 million annual gross receipts test of
section 448(c) and Sec. 1.448-1T(f)(2) for all prior taxable years.
(b) Application of method and treatment as method of accounting. The
rules of section 448(d)(5) and the regulations are applied separately to
each taxpayer. For purposes of section 448(d)(5), the term taxpayer has
the same meaning as the term person defined in section 7701(a)(1)
(rather than the meaning of the term defined in section 7701(a)(14)).
The nonaccrual of amounts to be received for the performance of services
is a method of accounting (a nonaccrual-experience method). A change to
a nonaccrual-experience method, from one nonaccrual-experience method to
another nonaccrual-experience
[[Page 104]]
method, or to a periodic system (for example, see Notice 88-51 (1988-1
C.B. 535) and Sec. 601.601(d)(2)(ii)(b) of this chapter), is a change
in method of accounting to which the provisions of sections 446 and 481
and the regulations apply. See also paragraphs (c)(2)(i), (c)(5),
(d)(4), and (e)(3)(i) of this section. Except as provided in other
published guidance, a taxpayer who wishes to adopt or change to any
nonaccrual-experience method other than one of the safe harbor methods
described in paragraph (f) of this section must request and receive
advance consent from the Commissioner in accordance with the applicable
administrative procedures issued under Sec. 1.446-1(e)(3)(ii) for
obtaining the Commissioner's consent.
(c) Definitions and special rules--(1) Accounts receivable--(i) In
general. Accounts receivable include only amounts that are earned by a
taxpayer and otherwise recognized in income through the performance of
services by the taxpayer. For purposes of determining a taxpayer's
nonaccrual-experience under any method provided in this section, amounts
described in paragraph (c)(1)(ii) of this section are not taken into
account. Except as otherwise provided, for purposes of this section,
accounts receivable do not include amounts that are not billed (such as
for charitable or pro bono services) or amounts contractually not
collectible (such as amounts in excess of a fee schedule agreed to by
contract). See paragraph (g) Examples 1 and 2 of this section for
examples of this rule.
(ii) Method not available for certain receivables--(A) Amounts not
earned and recognized through the performance of services. A nonaccrual-
experience method of accounting may not be used with respect to amounts
that are not earned by a taxpayer and otherwise recognized in income
through the performance of services by the taxpayer. For example, a
nonaccrual-experience method may not be used with respect to amounts
owed to the taxpayer by reason of the taxpayer's activities with respect
to lending money, selling goods, or acquiring accounts receivable or
other rights to receive payment from other persons (including persons
related to the taxpayer) regardless of whether those persons earned the
amounts through the provision of services. However, see paragraph (d)(3)
of this section for special rules regarding acquisitions of a trade or
business or a unit of a trade or business.
(B) If interest or penalty charged on amounts due. A nonaccrual-
experience method of accounting may not be used with respect to amounts
due for which interest is required to be paid or for which there is any
penalty for failure to timely pay any amounts due. For this purpose, a
taxpayer will be treated as charging interest or penalties for late
payment if the contract or agreement expressly provides for the charging
of interest or penalties for late payment, regardless of the practice of
the parties. If the contract or agreement does not expressly provide for
the charging of interest or penalties for late payment, the
determination of whether the taxpayer charges interest or penalties for
late payment will be made based on all of the facts and circumstances of
the transaction, and not merely on the characterization by the parties
or the treatment of the transaction under state or local law. However,
the offering of a discount for early payment of an amount due will not
be regarded as the charging of interest or penalties for late payment
under this section, if--
(1) The full amount due is otherwise accrued as gross income by the
taxpayer at the time the services are provided; and
(2) The discount for early payment is treated as an adjustment to
gross income in the year of payment, if payment is received within the
time required for allowance of the discount. See paragraph (g) Example 3
of this section for an example of this rule.
(2) Applicable period--(i) In general. The applicable period is the
number of taxable years on which the taxpayer bases its nonaccrual-
experience method. A change in the number of taxable years included in
the applicable period is a change in method of accounting to which the
procedures of section 446 apply. A change in the inclusion or exclusion
of the current taxable year in the applicable period is a change in
method of accounting to which the procedures of section 446 apply. A
change
[[Page 105]]
in the number of taxable years included in the applicable period or the
inclusion or exclusion of the current taxable year in the applicable
period is made on a cut-off basis.
(ii) Applicable period for safe harbors. For purposes of the safe
harbors under paragraph (f) of this section the applicable period may
consist of at least three but not more than six of the immediately
preceding consecutive taxable years. Alternatively, the applicable
period may consist of the current taxable year and at least two but not
more than five of the immediately preceding consecutive taxable years. A
period shorter than six taxable years is permissible only if the period
contains the most recent preceding taxable years and all of the taxable
years in the applicable period are consecutive.
(3) Bad debts. Bad debts are accounts receivable determined to be
uncollectible and charged off.
(4) Charge-offs. Amounts charged off include only those amounts that
would otherwise be allowable under section 166(a).
(5) Determination date. The determination date in safe harbor 2
provided in paragraph (f)(2) of this section is used as a cut-off date
for determining all known data to be taken into account in the
computation of the taxable year's uncollectible amount. The
determination date may not be later than the earlier of the due date,
including extensions, for filing the taxpayer's Federal income tax
return for that taxable year or the date on which the taxpayer timely
files the return for that taxable year. The determination date may be
different in each taxable year. However, once a determination date is
selected and used for a particular taxable year, it may not be changed
for that taxable year. The choice of a determination date is not a
method of accounting.
(6) Recoveries. Recoveries are amounts previously excluded from
income under a nonaccrual-experience method or charged off that the
taxpayer recovers.
(7) Uncollectible amount. The uncollectible amount is the portion of
any account receivable amount due that, under the taxpayer's nonaccrual-
experience method, will be not collected.
(d) Use of experience to estimate uncollectible amounts--(1) In
general. In determining the portion of any amount due that, on the basis
of experience, will not be collected, a taxpayer may use any nonaccrual-
experience method that clearly reflects the taxpayer's nonaccrual-
experience. The determination of whether a nonaccrual-experience method
clearly reflects the taxpayer's nonaccrual-experience is made in
accordance with the rules under paragraph (e) of this section.
Alternatively, the taxpayer may use any one of the five safe harbor
nonaccrual-experience methods of accounting provided in paragraphs
(f)(1) through (f)(5) of this section, which are presumed to clearly
reflect a taxpayer's nonaccrual-experience.
(2) Application to specific accounts receivable. The nonaccrual-
experience method is applied with respect to each account receivable of
the taxpayer that is eligible for this method. With respect to a
particular account receivable, the taxpayer determines, in the manner
prescribed in paragraphs (d)(1) or (f)(1) through (f)(5) of this section
(whichever applies), the uncollectible amount. The determination is
required to be made only once with respect to each account receivable,
regardless of the term of the receivable. The uncollectible amount is
not recognized as gross income. Thus, the amount recognized as gross
income is the amount that would otherwise be recognized as gross income
with respect to the account receivable, less the uncollectible amount. A
taxpayer that excludes an amount from income during a taxable year as a
result of the taxpayer's use of a nonaccrual-experience method may not
deduct in any subsequent taxable year the amount excluded from income.
Thus, the taxpayer may not deduct the excluded amount in a subsequent
taxable year in which the taxpayer actually determines that the amount
is uncollectible and charges it off. If a taxpayer using a nonaccrual-
experience method determines that an amount that was not excluded from
income is uncollectible and should be charged off (for example, a
calendar-year taxpayer determines on November
[[Page 106]]
1st that an account receivable that was originated on May 1st of the
same taxable year is uncollectible and should be charged off), the
taxpayer may deduct the amount charged off when it is charged off, but
must include any subsequent recoveries in income. The reasonableness of
a taxpayer's determination that amounts are uncollectible and should be
charged off may be considered on examination. See paragraph (g) Example
12 of this section for an example of this rule.
(3) Acquisitions and dispositions--(i) Acquisitions. If a taxpayer
acquires the major portion of a trade or business of another person
(predecessor) or the major portion of a separate unit of a trade or
business of a predecessor, then, for purposes of applying this section
for any taxable year ending on or after the acquisition, the experience
from preceding taxable years of the predecessor attributable to the
portion of the trade or business acquired, if available, must be used in
determining the taxpayer's experience.
(ii) Dispositions. If a taxpayer disposes of a major portion of a
trade or business or the major portion of a separate unit of a trade or
business, and the taxpayer furnished the acquiring person the
information necessary for the computations required by this section,
then, for purposes of applying this section for any taxable year ending
on or after the disposition, the experience from preceding taxable years
attributable to the portion of the trade or business disposed may not be
used in determining the taxpayer's experience.
(iii) Meaning of terms. For the meaning of the terms acquisition,
separate unit, and major portion, see paragraph (b) of Sec. 1.52-2. The
term acquisition includes an incorporation or a liquidation.
(4) New taxpayers. The rules of this paragraph (d)(4) apply to any
newly formed taxpayer to which the rules of paragraph (d)(3)(i) of this
section do not apply. Any newly formed taxpayer that wants to use a safe
harbor nonaccrual-experience method of accounting described in paragraph
(f)(1), (f)(2), (f)(3), (f)(4), or (f)(5) of this section applies the
methods by using the experience of the actual number of taxable years
available in the applicable period. A newly formed taxpayer that wants
to use one of the safe harbor nonaccrual-experience methods of
accounting described in paragraph (f)(2), (f)(4), or (f)(5) of this
section in its first taxable year and does not have any accounts
receivable upon formation may not exclude any portion of its year-end
accounts receivable from income for its first taxable year. The taxpayer
must begin creating its moving average in its second taxable year by
tracking the accounts receivable as of the first day of its second
taxable year. The use of one of the safe harbor nonaccrual-experience
methods of accounting described in paragraph (f)(2), (f)(4), or (f)(5)
of this section in a taxpayer's second taxable year in this situation is
not a change in method of accounting. Although the taxpayer must
maintain the books and records necessary to perform the computations
under the adopted safe harbor nonaccrual-experience method, the taxpayer
is not required to affirmatively elect the method on its Federal income
tax return for its first taxable year.
(5) Recoveries. Regardless of the nonaccrual-experience method of
accounting used by a taxpayer under this section, the taxpayer must take
recoveries into account. If, in a subsequent taxable year, a taxpayer
recovers an amount previously excluded from income under a nonaccrual-
experience method or charged off, the taxpayer must include the
recovered amount in income in that subsequent taxable year. See
paragraph (g) Example 13 of this section for an example of this rule.
(6) Request to exclude taxable years from applicable period. A
period shorter than the applicable period generally is permissible only
if the period consists of consecutive taxable years and there is a
change in the type of a substantial portion of the outstanding accounts
receivable such that the risk of loss is substantially increased. A
decline in the general economic conditions in the area, which
substantially increases the risk of loss, is a relevant factor in
determining whether a shorter period is appropriate. However, approval
to use a shorter period will not be granted unless the taxpayer supplies
evidence that the accounts receivable outstanding at the close of the
taxable
[[Page 107]]
years for the shorter period requested are more comparable in nature and
risk to accounts receivable outstanding at the close of the current
taxable year. A substantial increase in a taxpayer's bad debt experience
is not, by itself, sufficient to justify the use of a shorter period. If
approval is granted to use a shorter period, the experience for the
excluded taxable years may not be used for any subsequent taxable year.
A request for approval to exclude the experience of a prior taxable year
must be made in accordance with the applicable procedures for requesting
a letter ruling and must include a statement of the reasons the
experience should be excluded. A request will not be considered unless
it is sent to the Commissioner at least 30 days before the close of the
first taxable year for which the approval is requested.
(7) Short taxable years. A taxpayer with a short taxable year that
uses a nonaccrual-experience method that compares accounts receivable
balance to total bad debts during the taxable year should make
appropriate adjustments.
(8) Recordkeeping requirements--(i) A taxpayer using a nonaccrual-
experience method of accounting must keep sufficient books and records
to establish the amount of any exclusion from gross income under section
448(d)(5) for the taxable year, including books and records
demonstrating--
(A) The nature of the taxpayer's nonaccrual-experience method;
(B) Whether, for any particular taxable year, the taxpayer qualifies
to use its nonaccrual-experience method (including the self-testing
requirements of paragraph (e) of this section (if applicable));
(C) The taxpayer's determination that amounts are uncollectible;
(D) The proper amount that is excludable under the taxpayer's
nonaccrual-experience method; and
(E) The taxpayer's determination date under paragraph (c)(5) of this
section (if applicable).
(ii) If a taxpayer does not maintain records of the data that are
sufficient to establish the amount of any exclusion from gross income
under section 448(d)(5) for the taxable year, the Internal Revenue
Service may change the taxpayer's method of accounting on examination.
See Sec. 1.6001-1 for rules regarding records.
(e) Requirements for nonaccrual method to clearly reflect
experience--(1) In general. A nonaccrual-experience method clearly
reflects the taxpayer's experience if the taxpayer's nonaccrual-
experience method meets the self-test requirements described in this
paragraph (e). If a taxpayer is using one of the safe harbor nonaccrual-
experience methods described in paragraphs (f)(1) through (f)(4) of this
section, its method is deemed to clearly reflect its experience and is
not subject to the self-testing requirements in paragraphs (e)(2) and
(e)(3) of this section.
(2) Requirement to self-test--(i) In general. A taxpayer using, or
desiring to use, a nonaccrual-experience method must self-test its
nonaccrual-experience method for its first taxable year for which the
taxpayer uses, or desires to use, that nonaccrual-experience method
(first-year self-test) and every three taxable years thereafter (three-
year self-test). Each self-test must be performed by comparing the
uncollectible amount (under the taxpayer's nonaccrual-experience method)
with the taxpayer's actual experience. A taxpayer using the safe harbor
under paragraph (f)(5) of this section must self-test using the safe
harbor comparison method in paragraph (e)(3) of this section.
(ii) First-year self-test. The first-year self-test must be
performed by comparing the uncollectible amount with the taxpayer's
actual experience for its first taxable year for which the taxpayer
uses, or desires to use, that nonaccrual-experience method. If the
uncollectible amount for the first-year self-test is less than or equal
to the taxpayer's actual experience for its first taxable year for which
the taxpayer uses, or desires to use, that nonaccrual-experience method,
the taxpayer's nonaccrual-experience method is treated as clearly
reflecting its experience for the first taxable year. If, as a result of
the first-year self-test, the uncollectible amount for the test period
is greater than the taxpayer's actual experience, then--
[[Page 108]]
(A) The taxpayer's nonaccrual-experience method is treated as not
clearly reflecting its experience;
(B) The taxpayer is not permitted to use that nonaccrual-experience
method in that taxable year; and
(C) The taxpayer must change to (or adopt) for that taxable year
either--
(1) Another nonaccrual-experience method that clearly reflects
experience, that is, a nonaccrual-experience method that meets the
first-year self-test requirement; or
(2) A safe harbor nonaccrual-experience method described in
paragraphs (f)(1) through (f)(5) of this section.
(iii) Three-year self-test--(A) In general. The three-year self-test
must be performed by comparing the sum of the uncollectible amounts for
the current taxable year and prior two taxable years (cumulative
uncollectible amount) with the sum of the taxpayer's actual experience
for the current taxable year and prior two taxable years (cumulative
actual experience amount).
(B) Recapture. If the cumulative uncollectible amount for the test
period is greater than the cumulative actual experience amount for the
test period, the taxpayer's uncollectible amount is limited to the
cumulative actual experience amount for the test period. Any excess of
the taxpayer's cumulative uncollectible amount over the taxpayer's
cumulative actual nonaccrual-experience amount excluded from income
during the test period must be recaptured into income in the third
taxable year of the three-year self-test period.
(C) Determination of whether method is permissible or impermissible.
If the cumulative uncollectible amount is less than 110 percent of the
cumulative actual experience amount, the taxpayer's nonaccrual-
experience method is treated as a permissible method and the taxpayer
may continue to use its alternative nonaccrual-experience method,
subject to the three-year self-test requirement of this paragraph
(e)(2)(iii). If the cumulative uncollectible amount is greater than or
equal to 110 percent of the cumulative actual experience amount, the
taxpayer's nonaccrual-experience method is treated as impermissible in
the taxable year subsequent to the three-year self-test year and does
not clearly reflect its experience. The taxpayer must change to another
nonaccrual-experience method that clearly reflects experience,
including, for example, one of the safe harbor nonaccrual-experience
methods described in paragraphs (f)(1) through (f)(5) of this section,
for the subsequent taxable year. A change in method of accounting from
an impermissible method under this paragraph (e)(2)(iii)(C) to a
permissible method in the taxable year subsequent to the three-year
self-test year is made on a cut-off basis.
(iv) Determination of taxpayer's actual experience. [Reserved]
(3) Safe harbor comparison method--(i) In general. A taxpayer using,
or desiring to use, a nonaccrual-experience method under the safe harbor
in paragraph (f)(5) of this section must self-test its nonaccrual-
experience method for its first taxable year for which the taxpayer
uses, or desires to use, that nonaccrual-experience method (first-year
self-test) and every three taxable years thereafter (three-year self-
test). A nonaccrual-experience method under the safe harbor in paragraph
(f)(5) of this section is deemed to clearly reflect experience provided
all the requirements of the safe harbor comparison method of this
paragraph (e)(3) are met. Each self-test must be performed by comparing
the uncollectible amount (under the taxpayer's nonaccrual-experience
method) with the uncollectible amount that would have resulted from use
of one of the safe harbor methods described in paragraph (f)(1), (f)(2),
(f)(3), or (f)(4) of this section. A change from a nonaccrual-experience
method that uses the safe harbor comparison method for self-testing to a
nonaccrual-experience method that does not use the safe harbor
comparison method for self-testing, and vice versa, is a change in
method of accounting to which the provisions of sections 446 and 481 and
the regulations apply. A change solely to use or discontinue use of the
safe harbor comparison method for purposes of determining whether the
nonaccrual-experience method clearly reflects experience must be made on
a cut-off basis and without audit protection.
[[Page 109]]
(ii) Requirements to use safe harbor comparison method--(A) First-
year self-test. The first-year self-test must be performed by comparing
the uncollectible amount with the uncollectible amount determined under
any of the safe harbor methods described in paragraph (f)(1), (f)(2),
(f)(3), or (f)(4) of this section (safe harbor uncollectible amount) for
its first taxable year for which the taxpayer uses, or desires to use,
that nonaccrual-experience method. If the uncollectible amount for the
first-year self-test is less than or equal to the safe harbor
uncollectible amount, then the taxpayer's nonaccrual-experience method
is treated as clearly reflecting its experience for the first taxable
year. If, as a result of the first-year self-test, the uncollectible
amount for the test period is greater than the safe harbor uncollectible
amount, then--
(1) The taxpayer's nonaccrual-experience method is treated as not
clearly reflecting its experience;
(2) The taxpayer is not permitted to use that nonaccrual-experience
method in that taxable year; and
(3) The taxpayer must change to (or adopt) for that taxable year
either--
(i) Another nonaccrual-experience method that clearly reflects
experience, that is, a nonaccrual-experience method that meets the
first-year self-test requirement; or
(ii) A safe harbor nonaccrual-experience method described in
paragraphs (f)(1) through (f)(5) of this section.
(B) Three-year self-test. The three-year self-test must be performed
by comparing the sum of the uncollectible amounts for the current
taxable year and prior two taxable years (cumulative uncollectible
amount) with the sum of the uncollectible amount determined under any of
the safe harbor methods described in paragraph (f)(1), (f)(2), (f)(3),
or (f)(4) of this section for the current taxable year and prior two
taxable years (cumulative safe harbor uncollectible amounts). If the
cumulative uncollectible amount for the three-year self-test is less
than or equal to the cumulative safe harbor uncollectible amount for the
test period, then the taxpayer's nonaccrual-experience method is treated
as clearly reflecting its experience for the test period and the
taxpayer may continue to use that nonaccrual-experience method, subject
to a requirement to self-test again after three taxable years. If the
cumulative uncollectible amount for the test period is greater than the
cumulative safe harbor uncollectible amount for the test period, the
taxpayer's uncollectible amount is limited to the cumulative safe harbor
uncollectible amount for the test period. Any excess of the taxpayer's
cumulative uncollectible amount over the taxpayer's cumulative safe
harbor uncollectible amount excluded from income during the test period
must be recaptured into income in the third taxable year of the three-
year self-test period. If the cumulative uncollectible amount is less
than 110 percent of the cumulative safe harbor uncollectible amount, the
taxpayer's nonaccrual-experience method is treated as a permissible
method and the taxpayer may continue to use its alternative nonaccrual-
experience method, subject to the three-year self-test requirement of
this paragraph (e)(3)(ii)(B). If the cumulative uncollectible amount is
greater than or equal to 110 percent of the cumulative safe harbor
uncollectible amount, the taxpayer's nonaccrual-experience method is
treated as impermissible in the taxable year subsequent to the three-
year self-test year and does not clearly reflect its experience. The
taxpayer must change to another nonaccrual-experience method that
clearly reflects experience, including, for example, one of the safe
harbor nonaccrual-experience methods described in paragraphs (f)(1)
through (f)(5) of this section, for the subsequent taxable year. A
change in method of accounting from an impermissible method under this
paragraph (e)(3)(ii)(B) to a permissible method in the taxable year
subsequent to the three-year self-test year is made on a cut-off basis.
(4) Methods that do not clearly reflect experience. [Reserved]
(5) Contemporaneous documentation. For purposes of this paragraph
(e), including the safe harbor comparison method of paragraph (e)(3) of
this section, a taxpayer must document in its books and records, in the
taxable year any first-year or three-year self-test is
[[Page 110]]
performed, the method used to conduct the self-test, including
appropriate documentation and computations that resulted in the
determination that the taxpayer's nonaccrual-experience method clearly
reflected the taxpayer's nonaccrual-experience for the applicable test
period.
(f) Safe harbors--(1) Safe harbor 1: revenue-based moving average
method. A taxpayer may use a nonaccrual-experience method under which
the taxpayer determines the uncollectible amount by multiplying its
accounts receivable balance at the end of the current taxable year by a
percentage (revenue-based moving average percentage). The revenue-based
moving average percentage is computed by dividing the total bad debts
sustained, adjusted by recoveries received, throughout the applicable
period by the total revenue resulting in accounts receivable earned
throughout the applicable period. See paragraph (g) Example 4 of this
section for an example of this method. Thus, the uncollectible amount
under the revenue-based moving average method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.003
(2) Safe harbor 2: actual experience method--(i) Option A: single
determination date. A taxpayer may use a nonaccrual-experience method
under which the taxpayer determines the uncollectible amount by
multiplying its accounts receivable balance at the end of the current
taxable year by a percentage (moving average nonaccrual-experience
percentage) and then increasing the resulting amount by 5 percent. See
paragraph (g) Example 5 of this section for an example of safe harbor 2
in general, and paragraph (g) Example 6 of this section for an example
of the single determination date option of safe harbor 2. The taxpayer's
moving average nonaccrual-experience percentage is computed by dividing
the total bad debts sustained, adjusted by recoveries that are allocable
to the bad debts, by the determination date of the current taxable year
related to the taxpayer's accounts receivable balance at the beginning
of each taxable year during the applicable period by the sum of the
accounts receivable at the beginning of each taxable year during the
applicable period. Thus, the uncollectible amount under Option A of the
actual experience method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.004
(ii) Option B: multiple determination dates. Alternatively, in
computing its bad debts related to the taxpayer's accounts receivable
balance at the beginning of each taxable year during the applicable
period, a taxpayer may use the original determination date for each
taxable year during the applicable period. That is, the taxpayer may use
bad debts sustained, adjusted by recoveries received that are allocable
to the bad debts, by the determination date of each taxable year during
the applicable period rather than the determination date of the current
taxable year. See paragraph (g) Example 7 of this section for an example
of the multiple determination date option of safe harbor 2.
[[Page 111]]
Thus, the uncollectible amount under Option B of the actual experience
method is computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.005
(iii) Tracing of recoveries--(A) In general. Bad debts related to
the taxpayer's accounts receivable balance at the beginning of each
taxable year during the applicable period must be adjusted by the
portion, if any, of recoveries received that are properly allocable to
the bad debts.
(B) Specific tracing. If a taxpayer, without undue burden, can trace
all recoveries to their corresponding charge-offs, the taxpayer must
specifically trace all recoveries.
(C) Recoveries cannot be traced without undue burden. If a taxpayer
has any recoveries that cannot, without undue burden, be traced to
corresponding charge-offs, the taxpayer may allocate those or all
recoveries between charge-offs of amounts in the relevant beginning
accounts receivable balances and other charge-offs using an allocation
method that is reasonable under all of the facts and circumstances.
(1) Reasonable allocations. An allocation method is reasonable if
there is a cause and effect relationship between the allocation base or
ratio and the recoveries. A taxpayer may elect to trace recoveries that
are traceable and allocate all untraceable recoveries to charge-offs of
amounts in the relevant beginning accounts receivable balances. Such an
allocation method will be deemed to be reasonable under all the facts
and circumstances.
(2) Allocations that are not reasonable. Allocation methods that
generally will not be considered reasonable include, for example,
methods in which there is not a cause and effect relationship between
the allocation base or ratio and methods in which receivables for which
the nonaccrual-experience method is not allowed to be used are included
in the allocation. See paragraph (c)(1)(ii) of this section for examples
of receivables for which the nonaccrual-experience method is not
allowed.
(3) Safe harbor 3: modified Black Motor method. A taxpayer may use a
nonaccrual-experience method under which the taxpayer determines the
uncollectible amount by multiplying its accounts receivable balance at
the end of the current taxable year by a percentage (modified Black
Motor moving average percentage) and then reducing the resulting amount
by the bad debts written off during the current taxable year relating to
accounts receivable generated during the current taxable year. The
modified Black Motor moving average percentage is computed by dividing
the total bad debts sustained, adjusted by recoveries received, during
the applicable period by the sum of accounts receivable at the end of
each taxable year during the applicable period. See paragraph (g)
Example 8 of this section for an example of this method. Thus, the
uncollectible amount under the modified Black Motor method is computed:
[[Page 112]]
[GRAPHIC] [TIFF OMITTED] TR06SE06.006
(4) Safe harbor 4: modified moving average method. A taxpayer may
use a nonaccrual-experience method under which the taxpayer determines
the uncollectible amount by multiplying its accounts receivable balance
at the end of the current taxable year by a percentage (modified moving
average percentage). The modified moving average percentage is computed
by dividing the total bad debts sustained, adjusted by recoveries
received, during the applicable period other than bad debts that were
written off in the same taxable year the related accounts receivable
were generated by the sum of accounts receivable at the beginning of
each taxable year during the applicable period. See paragraph (g)
Example 9 of this section for an example of this method. Thus, the
uncollectible amount under the modified moving average method is
computed:
[GRAPHIC] [TIFF OMITTED] TR06SE06.007
(5) Safe harbor 5: alternative nonaccrual-experience method. A
taxpayer may use an alternative nonaccrual-experience method that
clearly reflects the taxpayer's actual nonaccrual-experience, provided
the taxpayer's alternative nonaccrual-experience method meets the self-
test requirements described in paragraph (e)(3) of this section.
(g) Examples. The following examples illustrate the provisions of
this section. In each example, the taxpayer uses a calendar year for
Federal income tax purposes and an accrual method of accounting, does
not require the payment of interest or penalties with respect to past
due accounts receivable (except in the case of Example 3) and, in the
case of Examples 5 through 7, selects an appropriate determination date
for each taxable year. The examples are as follows:
Example 1. Contractual allowance or adjustment. B, a healthcare
provider, performs a medical procedure on individual C, who has health
insurance coverage with IC, an insurance company. B bills IC and C for
$5,000, B's standard charge for this medical procedure. However, B has a
contract with IC that obligates B to accept $3,500 as full payment for
the medical procedure if the procedure is provided to a patient insured
by IC. Under the contract, only $3,500 of the $5,000 billed by B is
legally collectible from IC and C. The remaining $1,500 represents a
contractual allowance or contractual adjustment. Under paragraph
(c)(1)(i) of this section, the remaining $1,500 is not a contractually
collectible amount for purposes of this section and B may not use a
nonaccrual-experience method with respect to this portion of the
receivable.
Example 2. Charitable or pro bono services. D, a law firm, agrees to
represent individual E in a legal matter and to provide services to E on
a pro bono basis. D normally charges $500 for these services. Because D
provides its services to E pro bono, D's services are never billed or
intended to result in revenue.
[[Page 113]]
Thus, under paragraph (c)(1)(i) of this section, the $500 is not a
collectible amount for purposes of this section and D may not use a
nonaccrual-experience method with respect to this portion of the
receivable.
Example 3. Charging interest and/or penalties. Z has two billing
methods for the amounts to be received from Z's provision of services
described in paragraph (a)(1) of this section. Under one method, for
amounts that are more than 90 days past due, Z charges interest at a
market rate until the amounts (together with interest) are paid. Under
the other billing method, Z charges no interest for amounts past due.
Under paragraph (c)(1)(ii) of this section, A may not use a nonaccrual-
experience method of accounting with respect to any of the amounts
billed under the method that charges interest on amounts that are more
than 90 days past due. Z may, however, use the nonaccrual-experience
method with respect to the amounts billed under the method that does not
charge interest for amounts past due.
Example 4. Safe harbor 1: Revenue-based moving average method. (i) F
uses the revenue-based moving average method described in paragraph
(f)(1) of this section with an applicable period of six taxable years.
F's total accounts receivable and bad debt experience for the 2006
taxable year and the five immediately preceding consecutive taxable
years are as follows:
------------------------------------------------------------------------
Total accounts
receivable Bad debts
Taxable year earned during adjusted for
the taxable recoveries
year
------------------------------------------------------------------------
2001.................................... $40,000 $5,700
2002.................................... 40,000 7,200
2003.................................... 40,000 11,000
2004.................................... 60,000 10,200
2005.................................... 70,000 14,000
2006.................................... 80,000 16,800
-------------------------------
Total................................. 330,000 64,900
------------------------------------------------------------------------
(ii) F's revenue-based moving average percentage is 19.67% ($64,900/
$330,000). If $49,300 of accounts receivable remains outstanding as of
the close of that taxable year (2006), F's uncollectible amount using
the revenue-based moving average safe harbor method is computed by
multiplying $49,300 by the revenue-based moving average percentage of
19.67%, or $9,697. Thus, F may exclude $9,697 from gross income for
2006.
Example 5. Safe harbor 2: Actual experience method . (i) G is
eligible to use a nonaccrual-experience method and wishes to adopt the
actual experience method of paragraph (f)(2) of this section. G elects
to use a three-year applicable period consisting of the current and two
immediately preceding consecutive taxable years. G determines that its
actual accounts receivable collection experience is as follows:
------------------------------------------------------------------------
Bad debts,
adjusted for
Total A/R recoveries,
Taxable year balance at related to A/R
beginning of balance at
taxable year beginning of
taxable year
------------------------------------------------------------------------
2006.................................... $1,000,000 $35,000
2007.................................... 760,000 75,000
2008.................................... 1,975,000 65,000
-------------------------------
Total................................. 3,735,000 175,000
------------------------------------------------------------------------
(ii) G's ending A/R Balance on December 31, 2008, is $880,000. In
2008, G computes its uncollectible amount by using a three-year moving
average under paragraph (f)(2) of this section. G's moving average
nonaccrual-experience percentage is 4.7%, determined by dividing the sum
of the amount of G's accounts receivable outstanding on January 1 of
2006, 2007, and 2008, that were determined to be bad debts (adjusted for
recoveries allocable to the bad debts) on or before the corresponding
determination date(s), by the sum of the amount of G's accounts
receivable outstanding on January 1 of 2006, 2007, and 2008 ($175,000/
$3,735,000 or 4.7%). G's uncollectible amount for 2008 is determined by
multiplying this percentage by the balance of G's accounts receivable on
December 31, 2008 ($880,000 x 4.7% = $41,360), and increasing this
amount by 105% ($41,360 x 105% = $43,428). G may exclude $43,428 from
gross income for 2008.
Example 6. Safe harbor 2: Single determination date (Option A). H is
eligible to use a nonaccrual-experience method and wishes to adopt the
actual experience method of paragraph (f)(2) of this section. H elects
to use a six-year applicable period consisting of the current and five
immediately preceding taxable years. H also elects to use a single
determination date in accordance with paragraph (f)(2)(i) of this
section. H selects December 31, its taxable year-end, as its
determination date. Since H is using a single determination date from
the current taxable year, its determination date for the 2001-2006
applicable period is December 31, 2006. H has a $800 charge-off in 2003
of an account receivable in the 2003 beginning accounts receivable
balance. In 2005, H has a recovery of $100 which is traceable, without
undue burden, to the $800 charge-off in 2003. Since the $100 recovery
occurred prior to H's December 31, 2006, determination date, it reduces
the amount of H's bad debts in the numerator of the formula for purposes
of determining H's moving average nonaccrual-experience percentage. In
addition, H must include the $100 recovery in income in 2005 (see
paragraph (d)(5) of this section regarding recoveries).
Example 7. Safe harbor 2: Multiple determination dates (Option B).
The facts are the same as in Example 6, except H elects to use multiple
determination dates in accordance with
[[Page 114]]
paragraph (f)(2)(ii) of this section. Consequently, H's determination
date is December 31, 2001, for its calculations of the portion of the
numerator relating to the 2001 taxable year, December 31, 2002, for its
calculations of the portion of the numerator relating to the 2002
taxable year, and so on through the final taxable year (2006), which has
a determination date of December 31, 2006. Since the $100 recovery did
not occur until after December 31, 2003 (the determination date for the
2003 taxable year), it does not reduce the amount of H's bad debts in
the numerator of the formula for purposes of determining H's moving
average nonaccrual-experience percentage. However, H still must include
the $100 recovery in income in 2005 (see paragraph (d)(5) of this
section regarding recoveries).
Example 8. Safe harbor 3: Modified Black Motor method. (i) J uses
the modified Black Motor method described in paragraph (f)(3) of this
section and a six-year applicable period. J's total accounts receivable
and bad debt experience for the 2006 taxable year and the five
immediately preceding consecutive taxable years are as follows:
------------------------------------------------------------------------
Accounts
receivable at Bad debts
Taxable year end of taxable (adjusted for
year recoveries)
------------------------------------------------------------------------
2001.................................... $130,000 $9,100
2002.................................... 140,000 7,000
2003.................................... 140,000 14,000
2004.................................... 160,000 14,400
2005.................................... 170,000 20,400
2006.................................... 180,000 10,800
-------------------------------
Total................................. 920,000 75,700
------------------------------------------------------------------------
(ii) J's modified Black Motor moving average percentage is 8.228%
($75,700/$920,000). If the accounts receivable generated and written off
during the current taxable year are $3,600, J's uncollectible amount is
$11,210, computed by multiplying J's accounts receivable on December 31,
2006 ($180,000) by the modified Black Motor moving average percentage of
8.228% and reducing the resulting amount by $3,600 (J's accounts
receivable generated and written off during the 2006 taxable year). J
may exclude $11,210 from gross income for 2006.
Example 9. Safe harbor 4: Modified moving average method. (i) The
facts are the same as in Example 8, except that the balances represent
accounts receivable at the beginning of the taxable year, and J uses the
modified moving average method described in paragraph (f)(4) of this
section and a six-year applicable period. Furthermore, the accounts
receivable that were written off in the same taxable year they were
generated, adjusted for recoveries of bad debts during the period are as
follows:
------------------------------------------------------------------------
Accounts
receivable
written off in
same taxable
Taxable year year as
generated
(adjusted for
recoveries)
------------------------------------------------------------------------
2001.................................................... $3,033
2002.................................................... 2,333
2003.................................................... 4,667
2004.................................................... 4,800
2005.................................................... 6,800
2006.................................................... 3,600
---------------
Total................................................. 25,233
------------------------------------------------------------------------
(ii) J's modified moving average percentage is 5.486% (($75,700-
$25,233)/$920,000). J's uncollectible amount is $9,875, computed by
multiplying J's accounts receivable on December 31, 2006 ($180,000) by
the modified moving average percentage of 5.486%. J may exclude $9,875
from gross income for 2006.
Example 10. First-year self-test. Beginning in 2006, K is eligible
to use a nonaccrual-experience method and wants to adopt an alternative
nonaccrual-experience method under paragraph (f)(5) of this section, and
consequently is subject to the safe harbor comparison method of self-
testing under paragraph (e)(3) of this section. K elects to self-test
against safe harbor 1 for purposes of conducting its first-year self-
test. K's uncollectible amount for 2006 is $22,000. K's safe harbor
uncollectible amount under safe harbor 1 is $21,000. Because K's
uncollectible amount for 2006 ($22,000) is greater than the safe harbor
uncollectible amount ($21,000), K's alternative nonaccrual-experience
method is treated as not clearly reflecting its nonaccrual experience
for 2006. Accordingly, K must adopt either another nonaccrual-experience
method that clearly reflects experience (subject to the self-testing
requirements of paragraph (e)(2)(ii) of this section, or a safe harbor
nonaccrual-experience method described in paragraph (f)(1) (revenue-
based moving average), (f)(2) (actual experience method), (f)(3)
(modified Black Motor method), (f)(4) (modified moving average method)
of this section, or another alternative nonaccrual-experience method
under paragraph (f)(5) of this section that meets the self-testing
requirements of paragraph (e)(3) of this section.
Example 11. Three-year self-test. The facts are the same as in
Example 10, except that K's safe harbor uncollectible amount under safe
harbor 1 for 2006 is also $22,000. Consequently, K meets the first-year
self-test requirement and may use its alternative nonaccrual-experience
method. Subsequently, K's cumulative uncollectible amount for 2007
through 2009 is $300,000. K's safe harbor uncollectible amount for 2007
through 2009 under its chosen safe harbor method for self-testing (safe
harbor 1) is $295,000. Because K's cumulative uncollectible amount for
the
[[Page 115]]
three-year test period (taxable years 2007 through 2009) is greater than
its safe harbor uncollectible amount for the three-year test period
($295,000), under paragraph (e)(3)(ii)(B) of this section, the $5,000
excess of K's cumulative uncollectible amount over K's safe harbor
uncollectible amount for the three-year test period must be recaptured
into income in 2009 in accordance with paragraph (e)(3)(ii)(B) of this
section. Since K's cumulative uncollectible amount for the three-year
test period ($300,000) is less than 110% of its safe harbor
uncollectible amount ($295,000 x 110% = $324,500), under paragraph
(e)(3)(ii)(B) of this section, K may continue to use its alternative
nonaccrual-experience method, subject to the three-year self-test
requirement.
Example 12. Subsequent worthlessness of year-end receivable. The
facts are the same as in Example 4, except that one of the accounts
receivable outstanding at the end of 2002 was for $8,000, and in 2003,
under section 166, the entire amount of this receivable becomes wholly
worthless. Because F does not accrue as income $1,573 of this account
receivable ($8,000 x .1967) under the nonaccrual-experience method in
2002, under paragraph (d)(2) of this section F may not deduct this
portion of the account receivable as a bad debt deduction under section
166 in 2003. F may deduct the remaining balance of the receivable in
2003 as a bad debt deduction under section 166 ($8,000-$1,574 = $6,426).
Example 13. Subsequent collection of year-end receivable. The facts
are the same as in Example 4. In 2007, F collects in full an account
receivable of $1,700 that was outstanding at the end of 2006. Under
paragraph (d)(5) of this section, F must recognize additional gross
income in 2007 equal to the portion of this receivable that F excluded
from gross income in the prior taxable year ($1,700 x .1967 = $334).
That amount ($334) is a recovery under paragraph (d)(5) of this section.
(h) Effective date. This section is applicable for taxable years
ending on or after August 31, 2006.
[T.D. 9285, 71 FR 52437, Sept. 6, 2006]
taxable year for which items of gross income included
Sec. 1.451-1 General rule for taxable year of inclusion.
(a) General rule. Gains, profits, and income are to be included in
gross income for the taxable year in which they are actually or
constructively received by the taxpayer unless includible for a
different year in accordance with the taxpayer's method of accounting.
Under an accrual method of accounting, income is includible in gross
income when all the events have occurred which fix the right to receive
such income and the amount thereof can be determined with reasonable
accuracy. Therefore, under such a method of accounting if, in the case
of compensation for services, no determination can be made as to the
right to such compensation or the amount thereof until the services are
completed, the amount of compensation is ordinarily income for the
taxable year in which the determination can be made. Under the cash
receipts and disbursements method of accounting, such an amount is
includible in gross income when actually or constructively received.
Where an amount of income is properly accrued on the basis of a
reasonable estimate and the exact amount is subsequently determined, the
difference, if any, shall be taken into account for the taxable year in
which such determination is made. To the extent that income is
attributable to the recovery of bad debts for accounts charged off in
prior years, it is includible in the year of recovery in accordance with
the taxpayer's method of accounting, regardless of the date when the
amounts were charged off. For treatment of bad debts and bad debt
recoveries, see sections 166 and 111 and the regulations thereunder. For
rules relating to the treatment of amounts received in crop shares, see
section 61 and the regulations thereunder. For the year in which a
partner must include his distributive share of partnership income, see
section 706(a) and paragraph (a) of Sec. 1.706-1. If a taxpayer
ascertains that an item should have been included in gross income in a
prior taxable year, he should, if within the period of limitation, file
an amended return and pay any additional tax due. Similarly, if a
taxpayer ascertains that an item was improperly included in gross income
in a prior taxable year, he should, if within the period of limitation,
file claim for credit or refund of any overpayment of tax arising
therefrom.
(b) Special rule in case of death. (1) A taxpayer's taxable year
ends on the date of his death. See section 443(a)(2) and paragraph
(a)(2) of Sec. 1.443-1. In computing taxable income for such year,
there shall be included only amounts
[[Page 116]]
properly includible under the method of accounting used by the taxpayer.
However, if the taxpayer used an accrual method of accounting, amounts
accrued only by reason of his death shall not be included in computing
taxable income for such year. If the taxpayer uses no regular accounting
method, only amounts actually or constructively received during such
year shall be included. (For rules relating to the inclusion of
partnership income in the return of a decedent partner, see subchapter
K, chapter 1 of the Code, and the regulations thereunder.)
(2) If the decedent owned an installment obligation the income from
which was taxable to him under section 453, no income is required to be
reported in the return of the decedent by reason of the transmission at
death of such obligation. See section 453(d)(3). For the treatment of
installment obligations acquired by the decedent's estate or by any
person by bequest, devise, or inheritance from the decedent, see section
691(a)(4) and the regulations thereunder.
(c) Special rule for employee tips. Tips reported by an employee to
his employer in a written statement furnished to the employer pursuant
to section 6053(a) shall be included in gross income of the employee for
the taxable year in which the written statement is furnished the
employer. For provisions relating to the reporting of tips by an
employee to his employer, see section 6053 and Sec. 31.6053-1 of this
chapter (Employment Tax Regulations).
(d) Special rule for ratable inclusion of original issue discount.
For ratable inclusion of original issue discount in respect of certain
corporate obligations issued after May 27, 1969, see section 1232(a)(3).
(e) Special rule for inclusion of qualified tax refund effected by
allocation. For rules relating to the inclusion in income of an amount
paid by a taxpayer in respect of his liability for a qualified State
individual income tax and allocated or reallocated in such a manner as
to apply it toward the taxpayer's liability for the Federal income tax,
see paragraph (f)(1) of Sec. 301.6361-1 of this chapter (Regulations on
Procedure and Administration).
(f) Timing of income from notional principal contracts. For the
timing of income with respect to notional principal contracts, see Sec.
1.446-3.
(g) Timing of income from section 467 rental agreements. For the
timing of income with respect to section 467 rental agreements, see
section 467 and the regulations thereunder.
[T.D. 6500, 25 FR 11709, Nov. 26, 1960, as amended by T.D. 7001, 34 FR
997, Jan. 23, 1969; T.D. 7154, 36 FR 24996, Dec. 28, 1971; 43 FR 59357,
Dec. 20, 1978; T.D. 8491, 58 FR 53135, Oct. 14, 1993; T.D. 8820, 64 FR
26851, May 18, 1999]
Sec. 1.451-2 Constructive receipt of income.
(a) General rule. Income although not actually reduced to a
taxpayer's possession is constructively received by him in the taxable
year during which it is credited to his account, set apart for him, or
otherwise made available so that he may draw upon it at any time, or so
that he could have drawn upon it during the taxable year if notice of
intention to withdraw had been given. However, income is not
constructively received if the taxpayer's control of its receipt is
subject to substantial limitations or restrictions. Thus, if a
corporation credits its employees with bonus stock, but the stock is not
available to such employees until some future date, the mere crediting
on the books of the corporation does not constitute receipt. In the case
of interest, dividends, or other earnings (whether or not credited)
payable in respect of any deposit or account in a bank, building and
loan association, savings and loan association, or similar institution,
the following are not substantial limitations or restrictions on the
taxpayer's control over the receipt of such earnings:
(1) A requirement that the deposit or account, and the earnings
thereon, must be withdrawn in multiples of even amounts;
(2) The fact that the taxpayer would, by withdrawing the earnings
during the taxable year, receive earnings that are not substantially
less in comparison with the earnings for the corresponding period to
which the taxpayer would be entitled had he left the account on deposit
until a later date (for example, if an amount equal to
[[Page 117]]
three months' interest must be forfeited upon withdrawal or redemption
before maturity of a one year or less certificate of deposit, time
deposit, bonus plan, or other deposit arrangement then the earnings
payable on premature withdrawal or redemption would be substantially
less when compared with the earnings available at maturity);
(3) A requirement that the earnings may be withdrawn only upon a
withdrawal of all or part of the deposit or account. However, the mere
fact that such institutions may pay earnings on withdrawals, total or
partial, made during the last three business days of any calendar month
ending a regular quarterly or semiannual earnings period at the
applicable rate calculated to the end of such calendar month shall not
constitute constructive receipt of income by any depositor or account
holder in any such institution who has not made a withdrawal during such
period;
(4) A requirement that a notice of intention to withdraw must be
given in advance of the withdrawal. In any case when the rate of
earnings payable in respect of such a deposit or account depends on the
amount of notice of intention to withdraw that is given, earnings at the
maximum rate are constructively received during the taxable year
regardless of how long the deposit or account was held during the year
or whether, in fact, any notice of intention to withdraw is given during
the year. However, if in the taxable year of withdrawal the depositor or
account holder receives a lower rate of earnings because he failed to
give the required notice of intention to withdraw, he shall be allowed
an ordinary loss in such taxable year in an amount equal to the
difference between the amount of earnings previously included in gross
income and the amount of earnings actually received. See section 165 and
the regulations thereunder.
(b) Examples of constructive receipt. Amounts payable with respect
to interest coupons which have matured and are payable but which have
not been cashed are constructively received in the taxable year during
which the coupons mature, unless it can be shown that there are no funds
available for payment of the interest during such year. Dividends on
corporate stock are constructively received when unqualifiedly made
subject to the demand of the shareholder. However, if a dividend is
declared payable on December 31 and the corporation followed its usual
practice of paying the dividends by checks mailed so that the
shareholders would not receive them until January of the following year,
such dividends are not considered to have been constructively received
in December. Generally, the amount of dividends or interest credited on
savings bank deposits or to shareholders of organizations such as
building and loan associations or cooperative banks is income to the
depositors or shareholders for the taxable year when credited. However,
if any portion of such dividends or interest is not subject to
withdrawal at the time credited, such portion is not constructively
received and does not constitute income to the depositor or shareholder
until the taxable year in which the portion first may be withdrawn.
Accordingly, if, under a bonus or forfeiture plan, a portion of the
dividends or interest is accumulated and may not be withdrawn until the
maturity of the plan, the crediting of such portion to the account of
the shareholder or depositor does not constitute constructive receipt.
In this case, such credited portion is income to the depositor or
shareholder in the year in which the plan matures. However, in the case
of certain deposits made after December 31, 1970, in banks, domestic
building and loan associations, and similar financial institutions, the
ratable inclusion rules of section 1232(a)(3) apply. See Sec. 1.1232-
3A. Accrued interest on unwithdrawn insurance policy dividends is gross
income to the taxpayer for the first taxable year during which such
interest may be withdrawn by him.
[T.D. 6723, 29 FR 5342, Apr. 21, 1964, as amended by T.D. 7154, 36 FR
24997, Dec. 28, 1971; T.D. 7663, 44 FR 76782, Dec. 28, 1979]
Sec. 1.451-4 Accounting for redemption of trading stamps and coupons.
(a) In general--(1) Subtraction from receipts. If an accrual method
taxpayer issues trading stamps or premium coupons with sales, or an
accrual method
[[Page 118]]
taxpayer is engaged in the business of selling trading stamps or premium
coupons, and such stamps or coupons are redeemable by such taxpayer in
merchandise, cash, or other property, the taxpayer should, in computing
the income from such sales, subtract from gross receipts with respect to
sales of such stamps or coupons (or from gross receipts with respect to
sales with which trading stamps or coupons are issued) an amount equal
to--
(i) The cost to the taxpayer of merchandise, cash, and other
property used for redemptions in the taxable year,
(ii) Plus the net addition to the provision for future redemptions
during the taxable year (or less the net subtraction from the provision
for future redemptions during the taxable year).
(2) Trading stamp companies. For purposes of this section, a
taxpayer will be considered as being in the business of selling trading
stamps or premium coupons if--
(i) The trading stamps or premium coupons sold by him are issued by
purchasers to promote the sale of their merchandise or services,
(ii) The principal activity of the trade or business is the sale of
such stamps or coupons,
(iii) Such stamps or coupons are redeemable by the taxpayer for a
period of at least 1 year from the date of sale, and
(iv) Based on his overall experience, it is estimated that not more
than two-thirds of the stamps or coupons sold which it is estimated,
pursuant to paragraph (c) of this section, will be ultimately redeemed,
will be redeemed within 6 months of the date of sale.
(b) Computation of the net addition to or subtraction from the
provision for future redemptions--(1) Determination of the provision for
future redemptions. (i) The provision for future redemptions as of the
end of a taxable year is computed by multiplying ``estimated future
redemptions'' (as defined in subdivision (ii) of this subparagraph) by
the estimated average cost of redeeming each trading stamp or coupon
(computed in accordance with subdivision (iii) of this subparagraph).
(ii) For purposes of this section, the term ``estimated future
redemptions'' as of the end of a taxable year means the number of
trading stamps or coupons outstanding as of the end of such year that it
is reasonably estimated will ultimately be presented for redemption.
Such estimate shall be determined in accordance with the rules contained
in paragraph (c) of this section.
(iii) For purposes of this section, the estimated average cost of
redeeming each trading stamp or coupon shall be computed by including
only the costs to the taxpayer of acquiring the merchandise, cash, or
other property needed to redeem such stamps or coupons. The term ``the
costs to the taxpayer of acquiring the merchandise, cash, or other
property needed to redeem such stamps or coupons'' includes only the
price charged by the seller (less trade or other discounts, except
strictly cash discounts approximating a fair interest rate, which may be
deducted or not at the option of the taxpayer provided a consistent
course is followed) plus transportation or other necessary charges in
acquiring possession of the goods. Items such as the costs of
advertising, catalogs, operating redemption centers, transporting
merchandise or other property from a central warehouse to a branch
warehouse (or from a warehouse to a redemption center), and storing the
merchandise or other property used to redeem stamps or coupons should
not be included in costs of redeeming stamps or premium coupons, but
rather should be accounted for in accordance with the provisions of
sections 162 and 263.
(2) Changes in provision for future redemptions. For purposes of
this section, a ``net addition to'' or ``net subtraction from'' the
provision for future redemptions for a taxable year is computed as
follows:
(i) Carry over the provision for future redemptions (if any) as of
the end of the preceding taxable year,
(ii) Compute the provision for future redemptions as of the end of
the taxable year in accordance with subparagraph (1) of this paragraph,
and
(iii) If the amount referred to in subdivision (ii) of this
subparagraph exceeds the amount referred to in subdivision (i) of this
subparagraph, such
[[Page 119]]
excess is the net addition to the provision for future redemptions for
the taxable year. On the other hand, if the amount referred to in such
subdivision (i) exceeds the amount referred to in such subdivision (ii),
such excess is the net subtraction from the provision for future
redemptions for the taxable year.
(3) Example. The provisions of this paragraph and paragraph (a)(1)
of this section may be illustrated by the following example:
Example. (a) X Company, a calendar year accrual method taxpayer, is
engaged in the business of selling trading stamps to merchants. In 1971,
its first year of operation, X sells 10 million stamps at $5 per 1,000;
it redeems 3 million stamps for merchandise and cash of an average value
of $3 per 1,000 stamps. At the end of 1971 it is estimated (pursuant to
paragraph (c) of this section) that a total of 9 million stamps of the
10 million stamps issued in 1971 will eventually be presented for
redemption. At this time it is estimated that the average cost of
redeeming stamps (as described in subparagraph (1)(iii) of this
paragraph) would continue to be $3 per 1,000 stamps. Under these
circumstances, X computes its gross income from sales of trading stamps
as follows:
Gross receipts from sales (10 million stamps at $5 ........ $50,000
per 1,000).........................................
Less:
Cost of actual redemptions (3 million stamps at $3 $9,000 ........
per 1,000).......................................
Provision for future redemptions on December 31, 18,000 ........
1971 (9 million stamps - 3 million stamps x $3
per 1,000).......................................
----------
........ 27,000
---------
1971 gross income from sales of stamps.............. ........ 23,000
(b) In 1972, X also sells 10 million stamps at $5 per 1,000 stamps.
During 1972 X redeems 7 million stamps at an average cost of $3.01 per
1,000 stamps. At the end of 1972 it is determined that the estimated
future redemptions (within the meaning of subparagraph (1)(ii) of this
paragraph) is 8 million. It is further determined that the estimated
average cost of redeeming stamps would continue to be $3.01 per 1,000
stamps. X thus computes its gross income from sales of trading stamps
for 1972 as follows:
Gross receipts from sales (10 million stamps at $5 per 1,000). $50,000
Less:
Cost of actual redemptions (7 million stamps at $21,070
$3.01 per 1,000).................................
Plus:
Provision for future redemptions on Dec. 31, 1972 24,080
(8 million stamps at $3.01 per 1,000)............
Minus provision for future redemptions on Dec. 31, 18,000
1971...............................................
----------
Addition to provision for future redemptions........ 6,080
----------
Total cost of redemptions.................................. 27,150
---------
1972 Gross income from sales of stamps.............. ........ 22,850
(c) Estimated future redemptions--(1) In general. A taxpayer may use
any method of determining the estimated future redemptions as of the end
of a year so long as--
(i) Such method results in a reasonably accurate estimate of the
stamps or coupons outstanding at the end of such year that will
ultimately be presented for redemption,
(ii) Such method is used consistently, and
(iii) Such taxpayer complies with the requirements of this paragraph
and paragraphs (d) and (e) of this section.
(2) Utilization of prior redemption experience. Normally, the
estimated future redemptions of a taxpayer shall be determined on the
basis of such taxpayer's prior redemption experience. However, if the
taxpayer does not have sufficient redemption experience to make a
reasonable determination of his ``estimated future redemptions,'' or if
because of a change in his mode of operation or other relevant factors
the determination cannot reasonably be made completely on the basis of
the taxpayer's own experience, the experiences of similarly situated
taxpayers may be used to establish an experience factor.
(3) One method of determining estimated future redemptions. One
permissible method of determining the estimated future redemptions as of
the end of the current taxable year is as follows:
(i) Estimate for each preceding taxable year and the current taxable
year the number of trading stamps or coupons issued for each such year
which will ultimately be presented for redemption.
(ii) Determine the sum of the estimates under subdivision (i) of
this subparagraph for each taxable year prior to and including the
current taxable year.
(iii) The difference between the sum determined under subdivision
(ii) of
[[Page 120]]
this subparagraph and the total number of trading stamps or coupons
which have already been presented for redemption is the estimated future
redemptions as of the end of the current taxable year.
(4) Determination of an ``estimated redemption percentage.'' For
purposes of applying subparagraph (3)(i) of this paragraph, one
permissible method of estimating the number of trading stamps or coupons
issued for a taxable year that will ultimately be presented for
redemption is to multiply such number of stamps issued for such year by
an ``estimated redemption percentage.'' For purposes of this section the
term ``estimated redemption percentage'' for a taxable year means a
fraction, the numerator of which is the number of trading stamps or
coupons issued during a taxable year that it is reasonably estimated
will ultimately be redeemed, and the denominator of which is the number
of trading stamps or coupons issued during such year. Consequently, the
product of such percentage and the number of stamps issued for such year
equals the number of trading stamps or coupons issued for such year that
it is estimated will ultimately be redeemed.
(5) Five-year rule. (i) One permissible method of determining the
``estimated redemption percentage'' for a taxable year is to--
(a) Determine the percentage which the total number of stamps or
coupons redeemed in the taxable year and the 4 preceding taxable years
is of the total number of stamps or coupons issued or sold in such 5
years; and
(b) Multiply such percentage by an appropriate growth factor as
determined pursuant to guidelines published by the Commissioner.
(ii) If a taxpayer uses the method described in subdivision (i) of
this subparagraph for a taxable year, it will normally be presumed that
such taxpayer's ``estimated redemption percentage'' is reasonably
accurate.
(6) Other methods of determining estimated future redemptions. (i)
If a taxpayer uses a method of determining his ``estimated future
redemptions'' (other than a method which applies the 5-year rule as
described in subparagraph (5)(i) of this paragraph) such as a
probability sampling technique, the appropriateness of the method
(including the appropriateness of the sampling technique, if any) and
the accuracy and reliability of the results obtained must, if requested,
be demonstrated to the satisfaction of the district director.
(ii) No inference shall be drawn from subdivision (i) of this
subparagraph that the use of any method to which such subdivision
applies is less acceptable than the method described in subparagraph
(5)(i) of this paragraph. Therefore, certain probability sampling
techniques used in determining estimated future redemptions may result
in reasonably accurate and reliable estimates. Such a sampling technique
will be considered appropriate if the sample is--
(a) Taken in accordance with sound statistical sampling principles,
(b) In accordance with such principles, sufficiently broad to
produce a reasonably accurate result, and
(c) Taken with sufficient frequency as to produce a reasonably
accurate result.
In addition, if the sampling technique is appropriate, the results
obtained therefrom in determining estimated future redemptions will be
considered accurate and reliable if the evaluation of such results is
consistent with sound statistical principles. Ordinarily, samplings and
recomputations of the estimated future redemptions will be required
annually. However, the facts and circumstances in a particular case may
justify such a recomputation being taken less frequently than annually.
In addition, the Commissioner may prescribe procedures indicating that
samples made to update the results of a sample of stamps redeemed in a
prior year need not be the same size as the sample of such prior year.
(d) Consistency with financial reporting--(1) Estimated future
redemptions. For taxable years beginning after August 22, 1972, the
estimated future redemptions must be no greater than the estimate that
the taxpayer uses for purposes of all reports (including consolidated
financial statements) to shareholders, partners, beneficiaries, other
proprietors, and for credit purposes.
[[Page 121]]
(2) Average cost of redeeming stamps. For taxable years beginning
after August 22, 1972, the estimated average cost of redeeming each
stamp or coupon must be no greater than the average cost of redeeming
each stamp or coupon (computed in accordance with paragraph (b)(1)(iii)
of this section) that the taxpayer uses for purposes of all reports
(including consolidated financial statements) to shareholders, partners,
beneficiaries, other proprietors, and for credit purposes.
(e) Information to be furnished with return--(1) In general. For
taxable years beginning after August 22, 1972, a taxpayer described in
paragraph (a) of this section who uses a method of determining the
``estimated future redemptions'' other than that described in paragraph
(c)(5)(i) of this section shall file a statement with his return showing
such information as is necessary to establish the correctness of the
amount subtracted from gross receipts in the taxable year.
(2) Taxpayers using the 5-year rule. If a taxpayer uses the method
of determining estimated future redemptions described in paragraph
(c)(5)(i) of this section, he shall file a statement with his return
showing, with respect to the taxable year and the 4 preceding taxable
years--
(i) The total number of stamps or coupons issued or sold during each
year, and
(ii) The total number of stamps or coupons redeemed in each such
year.
(3) Trading stamp companies. In addition to the information required
by subparagraph (1) or (2) of this paragraph, a taxpayer engaged in the
trade or business of selling trading stamps or premium coupons shall
include with the statement described in subparagraph (1) or (2) of this
paragraph such information as may be necessary to satisfy the
requirements of paragraph (a)(2)(iv) of this section.
[T.D. 7201, 37 FR 16911, Aug. 23, 1972, as amended by T.D. 7201, 37 FR
18617, Sept. 14, 1972]
Sec. 1.451-5 Advance payments for goods and long-term contracts.
(a) Advance payment defined. (1) For purposes of this section, the
term ``advance payment'' means any amount which is received in a taxable
year by a taxpayer using an accrual method of accounting for purchases
and sales or a long-term contract method of accounting (described in
Sec. 1.451-3), pursuant to, and to be applied against, an agreement:
(i) For the sale or other disposition in a future taxable year of
goods held by the taxpayer primarily for sale to customers in the
ordinary course of his trade or business, or
(ii) For the building, installing, constructing or manufacturing by
the taxpayer of items where the agreement is not completed within such
taxable year.
(2) For purposes of subparagraph (1) of this paragraph:
(i) The term ``agreement'' includes (a) a gift certificate that can
be redeemed for goods, and (b) an agreement which obligates a taxpayer
to perform activities described in subparagraph (1)(i) or (ii) of this
paragraph and which also contains an obligation to perform services that
are to be performed as an integral part of such activities; and
(ii) Amounts due and payable are considered ``received''.
(3) If a taypayer (described in subparagraph (1) of this paragraph)
receives an amount pursuant to, and to be applied against, an agreement
that not only obligates the taxpayer to perform the activities described
in subparagraph (1) (i) and (ii) of this paragraph, but also obligates
the taxpayer to perform services that are not to be performed as an
integral part of such activities, such amount will be treated as an
``advance payment'' (as defined in subparagraph (1) of this paragraph)
only to the extent such amount is properly allocable to the obligation
to perform the activities described in subparagraph (1) (i) and (ii) of
this paragraph. The portion of the amount not so allocable will not be
considered an ``advance payment'' to which this section applies. If,
however, the amount not so allocable is less than 5 percent of the total
contract price, such amount will be treated as so allocable except that
such treatment cannot result in delaying the time at which the taxpayer
would otherwise accrue the amounts attributable to the activities
[[Page 122]]
described in subparagraph (1) (i) and (ii) of this paragraph.
(b) Taxable year of inclusion--(1) In general. Advance payments must
be included in income either--
(i) In the taxable year of receipt; or
(ii) Except as provided in paragraph (c) of this section.
(a) In the taxable year in which properly accruable under the
taxpayer's method of accounting for tax purposes if such method results
in including advance payments in gross receipts no later than the time
such advance payments are included in gross receipts for purposes of all
of his reports (including consolidated financial statements) to
shareholders, partners, beneficiaries, other proprietors, and for credit
purposes, or
(b) If the taxpayer's method of accounting for purposes of such
reports results in advance payments (or any portion of such payments)
being included in gross receipts earlier than for tax purposes, in the
taxable year in which includible in gross receipts pursuant to his
method of accounting for purposes of such reports.
(2) Examples. This paragraph may be illustrated by the following
examples:
Example 1. S, a retailer who uses for tax purposes and for purposes
of the reports referred to in subparagraph (1)(ii)(a) of this paragraph,
an accrual method of accounting under which it accounts for its sales of
goods when the goods are shipped, receives advance payments for such
goods. Such advance payments must be included in gross receipts for tax
purposes either in the taxable year the payments are received or in the
taxable year such goods are shipped (except as provided in paragraph (c)
of this section).
Example 2. T, a manufacturer of household furniture, is a calendar
year taxpayer who uses an accrual method of accounting pursuant to which
income is accrued when furniture is shipped for purposes of its
financial reports (referred to in subparagraph (1)(ii)(a) of this
paragraph) and an accrual method of accounting pursuant to which the
income is accrued when furniture is delivered and accepted for tax
purposes. See Sec. 1.446-1(c)(1)(ii). In 1974, T receives an advance
payment of $8,000 from X with respect to an order of furniture to be
manufactured for X for a total price of $20,000. The furniture is
shipped to X in December 1974, but it is not delivered to and accepted
by X until January 1975. As a result of this contract, T must include
the entire advance payment in its gross income for tax purposes in 1974
pursuant to subparagraph (1)(ii)(b) of this paragraph. T must include
the remaining $12,000 of the gross contract price in its gross income in
1975 for tax purposes.
(3) Long-term contracts. In the case of a taxpayer accounting for
advance payments for tax purposes pursuant to a long-term contract
method of accounting under Sec. 1.460-4, or of a taxpayer accounting
for advance payments with respect to a long-term contract pursuant to an
accrual method of accounting referred to in the succeeding sentence,
advance payments shall be included in income in the taxable year in
which properly included in gross receipts pursuant to such method of
accounting (without regard to the financial reporting requirement
contained in subparagraph (1)(ii) (a) or (b) of this paragraph). An
accrual method of accounting to which the preceding sentence applies
shall consist of any method of accounting under which the income is
accrued when, and costs are accumulated until, the subject matter of the
contract (or, if the subject matter of the contract consists of more
than one item, an item) is shipped, delivered, or accepted.
(4) Installment method. The financial reporting requirement of
subparagraph (1)(ii) (a) or (b) of this paragraph shall not be construed
to prevent the use of the installment method under section 453. See
Sec. 1.446-1(c)(1)(ii).
(c) Exception for inventoriable goods. (1)(i) If a taxpayer receives
an advance payment in a taxable year with respect to an agreement for
the sale of goods properly includible in his inventory, or with respect
to an agreement (such as a gift certificate) which can be satisfied with
goods or a type of goods that cannot be identified in such taxable year,
and on the last day of such taxable year the taxpayer--
(a) Is accounting for advance payments pursuant to a method
described in paragraph (b)(1)(ii) of this section for tax purposes,
(b) Has received ``substantial advance payments'' (as defined in
subparagraph (3) of this paragraph) with respect to such agreement, and
(c) Has on hand (or available to him in such year through his normal
source
[[Page 123]]
of supply) goods of substantially similar kind and in sufficient
quantity to satisfy the agreement in such year,
then all advance payments received with respect to such agreement by the
last day of the second taxable year following the year in which such
substantial advance payments are received, and not previously included
in income in accordance with the taxpayer's accrual method of
accounting, must be included in income in such second taxable year.
(ii) If advance payments are required to be included in income in a
taxable year solely by reason of subdivision (i) of this subparagraph,
the taxpayer must take into account in such taxable year the costs and
expenditures included in inventory at the end of such year with respect
to such goods (or substantially similar goods) on hand or, if no such
goods are on hand by the last day of such second taxable year, the
estimated cost of goods necessary to satisfy the agreement.
(iii) Subdivision (ii) of this subparagraph does not apply if the
goods or type of goods with respect to which the advance payment is
received are not identifiable in the year the advance payments are
required to be included in income by reason of subdivision (i) of this
subparagraph (for example, where an amount is received for a gift
certificate).
(2) If subparagraph (1)(i) of this paragraph is applicable to
advance payments received with respect to an agreement, any advance
payments received with respect to such agreement subsequent to such
second taxable year must be included in gross income in the taxable year
of receipt. To the extent estimated costs of goods are taken into
account in a taxable year pursuant to subparagraph (1)(ii) of this
paragraph, such costs may not again be taken into account in another
year. In addition, any variances between the costs or estimated costs
taken into account pursuant to subparagraph (1)(ii) of this paragraph
and the costs actually incurred in fulfilling the taxpayer's obligations
under the agreement must be taken into account as an adjustment to the
cost of goods sold in the year the taxpayer completes his obligations
under such agreement.
(3) For purposes of subparagraph (1) of this paragraph, a taxpayer
will be considered to have received ``substantial advance payments''
with respect to an agreement by the last day of a taxable year if the
advance payments received with respect to such agreement during such
taxable year plus the advance payments received prior to such taxable
year pursuant to such agreement, equal or exceed the total costs and
expenditures reasonably estimated as includible in inventory with
respect to such agreement. Advance payments received in a taxable year
with respect to an agreement (such as a gift certificate) under which
the goods or type of goods to be sold are not identifiable in such year
shall be treated as ``substantial advance payments'' when received.
(4) The application of this paragraph is illustrated by the
following example:
Example. In 1971, X, a calendar year accrual method taxpayer, enters
into a contract for the sale of goods (properly includible in X's
inventory) with a total contract price of $100. X estimates that his
total inventoriable costs and expenditures for the goods will be $50. X
receives the following advance payments with respect to the contract:
1971......................................................... $35
1972......................................................... 20
1973......................................................... 15
1974......................................................... 10
1975......................................................... 10
1976......................................................... 10
The goods are delivered pursuant to the customer's request in 1977.
X's closing inventory for 1972 of the type of goods involved in the
contract is sufficient to satisfy the contract. Since advance payments
received by the end of 1972 exceed the inventoriable costs X estimates
that he will incur, such payments constitute ``substantial advance
payments''. Accordingly, all payments received by the end of 1974, the
end of the second taxable year following the taxable year during which
``substantial advance payments'' are received, are includible in gross
income for 1974. Therefore, for taxable year 1974 X must include $80 in
his gross income. X must include in his cost of goods sold for 1974 the
cost of such goods (or similar goods) on hand or, if no such goods are
on hand, the estimated inventoriable costs necessary to satisfy the
contract. Since no further deferral is allowable for such contract, X
must include in his gross income for the remaining years of the
contract, the advance payment received each year. Any variance between
estimated costs and the costs actually incurred in fulfilling the
contract is to be taken into
[[Page 124]]
account in 1977, when the goods are delivered. See paragraph (c)(2) of
this section.
(d) Information schedule. If a taxpayer accounts for advance
payments pursuant to paragraph (b)(1)(ii) of this section, he must
attach to his income tax return for each taxable year to which such
provision applies an annual information schedule reflecting the total
amount of advance payments received in the taxable year, the total
amount of advance payments received in prior taxable years which has not
been included in gross income before the current taxable year, and the
total amount of such payments received in prior taxable years which has
been included in gross income for the current taxable year.
(e) Adoption of method. (1) For taxable years ending on or after
December 31, 1969, and before January 1, 1971, a taxpayer (even if he
has already filed an income tax return for a taxable year ending within
such period) may secure the consent of the Commissioner to change his
method of accounting for such year to a method prescribed in paragraph
(b)(1)(ii) of this section in the manner prescribed in section 446 and
the regulations thereunder, if an application to secure such consent is
filed on Form 3115 within 180 days after March 23, 1971.
(2) A taxpayer who is already reporting his income in accordance
with a method prescribed in paragraph (b)(1)(ii)(a) of this section need
not secure the consent of the Commissioner to continue to utilize this
method. However, such a taxpayer, for all taxable years ending after
March 23, 1971, must comply with the requirements of paragraphs
(b)(1)(ii)(a) (including the financial reporting requirement) and (d)
(relating to an annual information schedule) of this section.
(f) Cessation of taxpayer's liability. If a taxpayer has adopted a
method prescribed in paragraph (b)(1)(ii) of this section, and if in a
taxable year the taxpayer dies, ceases to exist in a transaction other
than one to which section 381(a) applies, or his liability under the
agreement otherwise ends, then so much of the advance payment as was not
includible in his gross income in preceding taxable years shall be
included in his gross income for such taxable year.
(g) Special rule for certain transactions concerning natural
resources. A transaction which is treated as creating a mortgage loan
pursuant to section 636 and the regulations thereunder rather than as a
sale shall not be considered a ``sale or other disposition'' within the
meaning of paragraph (a)(1) of this section. Consequently, any payment
received pursuant to such a transaction, which payment would otherwise
qualify as an ``advance payment'', will not be treated as an ``advance
payment'' for purposes of this section.
[T.D. 7103, 36 FR 5495, Mar. 24, 1971, as amended by T.D. 7397, 41 FR
2641, Jan. 19, 1976; T.D. 8067, 51 FR 393, Jan. 6, 1986; T.D. 8929, 66
FR 2224, Jan. 11, 2001]
Sec. 1.451-6 Election to include crop insurance proceeds in gross income
in the taxable year following the taxable year of destruction or damage.
(a) In general. (1) For taxable years ending after December 30,
1969, a taxpayer reporting gross income on the cash receipts and
disbursements method of accounting may elect to include insurance
proceeds received as a result of the destruction of, or damage to, crops
in gross income for the taxable year following the taxable year of the
destruction or damage, if the taxpayer establishes that, under the
taxpayer's normal business practice, the income from those crops would
have been included in gross income for any taxable year following the
taxable year of the destruction or damage. However, if the taxpayer
receives the insurance proceeds in the taxable year following the
taxable year of the destruction or damage, the taxpayer shall include
the proceeds in gross income for the taxable year of receipt without
having to make an election under section 451(d) and this section. For
the purposes of this section only, federal payments received as a result
of destruction or damage to crops caused by drought, flood, or any other
natural disaster, or the inability to plant crops because of such a
natural disaster, shall be treated as insurance proceeds received as a
result of destruction or damage to crops. The
[[Page 125]]
preceding sentence shall apply to payments that are received by the
taxpayer after December 31, 1973.
(2) In the case of a taxpayer who receives insurance proceeds as a
result of the destruction of, or damage to, two or more specific crops,
if such proceeds may, under section 451(d) and this section, be included
in gross income for the taxable year following the taxable year of such
destruction or damage, and if such taxpayer makes an election under
section 451(d) and this section with respect to any portion of such
proceeds, then such election will be deemed to cover all of such
proceeds which are attributable to crops representing a single trade or
business under section 446(d). A separate election must be made with
respect to insurance proceeds attributable to each crop which represents
a separate trade or business under section 446(d).
(b)(1) Time and manner of making election. The election to include
in gross income insurance proceeds received as a result of destruction
of, or damage to, the taxpayer's crops in the taxable year following the
taxable year of such destruction or damage shall be made by means of a
statement attached to the taxpayer's return (or an amended return) for
the taxable year of destruction or damage. The statement shall include
the name and address of the taxpayer (or his duly authorized
representative), and shall set forth the following information:
(i) A declaration that the taxpayer is making an election under
section 451(d) and this section;
(ii) Identification of the specific crop or crops destroyed or
damaged;
(iii) A declaration that under the taxpayer's normal business
practice the income derived from the crops which were destroyed or
damaged would have been included in this gross income for a taxable year
following the taxable year of such destruction or damage;
(iv) The cause of destruction or damage of crops and the date or
dates on which such destruction or damage occurred;
(v) The total amount of payments received from insurance carriers,
itemized with respect to each specific crop and with respect to the date
each payment was received;
(vi) The name(s) of the insurance carrier or carriers from whom
payments were received.
(2) Scope of election. Once made, an election under section 451(d)
is binding for the taxable year for which made unless the district
director consents to a revocation of such election. Requests for consent
to revoke an election under section 451(d) shall be made by means of a
letter to the district director for the district in which the taxpayer
is required to file his return, setting forth the taxpayer's name,
address, and identification number, the year for which it is desired to
revoke the election, and the reasons therefor.
[T.D. 7097, 36 FR 5215, Mar. 18, 1971, as amended by T.D. 7526, 42 FR
64624, Dec. 27, 1977; T.D. 8429, 57 FR 38595, Aug. 26, 1992]
Sec. 1.451-7 Election relating to livestock sold on account of drought.
(a) In general. Section 451(e) provides that for taxable years
beginning after December 31, 1975, a taxpayer whose principal trade or
business is farming (within the meaning of Sec. 6420 (c)(3)) and who
reports taxable income on the cash receipts and disbursements method of
accounting may elect to defer for one year a certain portion of income.
The income which may be deferred is the amount of gain realized during
the taxable year from the sale or exchange of that number of livestock
sold or exchanged solely on account of a drought which caused an area to
be designated as eligible for assistance by the Federal Government
(regardless of whether the designation is made by the President or by an
agency or department of the Federal Government). That number is equal to
the excess of the number of livestock sold or exchanged over the number
which would have been sold or exchanged had the taxpayer followed its
usual business practices in the absence of such drought. For example, if
in the past it has been a taxpayer's practice to sell or exchange
annually 400 head of beef cattle but due to qualifying drought
conditions 550 head were sold in a given taxable year, only income from
the sale of 150 head may qualify for deferral under this section. The
election is not available with respect to livestock described in section
1231(b)(3) (relating to cattle, horses
[[Page 126]]
(and other livestock) held by the taxpayer for 24 months (12 months) and
used for draft, breeding, dairy, or sporting purposes).
(b) Usual business. The determination of the number of animals which
a taxpayer would have sold if it had followed its usual business
practice in the absence of drought will be made in light of all facts
and circumstances. In the case of taxpayers who have not established a
usual business practice, reliance will be placed upon the usual business
practice of similarly situated taxpayers in the same general region as
the taxpayer.
(c) Special rules--(1) Connection with drought area. To qualify
under section 451(e) and this section, the livestock need not be raised,
and the sale or exchange need not take place, in a drought area.
However, the sale or exchange of the livestock must occur solely on
account of drought conditions, the existence of which affected the
water, grazing, or other requirements of the livestock so as to
necessitate their sale or exchange.
(2) Sale prior to designation of area as eligible for Federal
assistance. The provisions of this section will apply regardless of
whether all or a portion of the excess number of animals were sold or
exchanged before an area becomes eligible for Federal assistance, so
long as the drought which caused such dispositions also caused the area
to be designated as eligible for Federal assistance.
(d) Classifications of livestock with respect to which the election
may be made. The election to have the provisions of section 451(e) apply
must be made separately for each broad generic classification of animals
(e.g., hogs, sheep, cattle) for which the taxpayer wishes the provisions
to apply. Separate elections shall not be made solely by reason of the
animals' age, sex, or breed.
(e) Computation--(1) Determination of amount deferred. The amount of
income which may be deferred for a classification of livestock pursuant
to this section shall be determined in the following manner. The total
amount of income realized from the sale or exchange of all livestock in
the classification during the taxable year shall be divided by the total
number of all such livestock sold. The resulting quotient shall then be
multiplied by the excess number of such livestock sold on account of
drought.
(2) Example. The provisions of this paragraph may be illustrated by
the following example:
Example. A, a calendar year taxpayer, normally sells 100 head of
beef cattle a year. As the result of drought conditions existing during
1976, A sells 135 head during that year. A realizes $35,100 of income
from the sale of the 135 head. On August 9, 1976, as a result of the
drought, the affected area was declared a disaster area thereby eligible
for Federal assistance. The amount of income which A may defer until
1977, presuming the other provisions of this section are met, is
determined as follows:
$35,100 (total income from sales of beef cattle)/135 (total number of
beef cattle sold) x 35 (excess number of beef cattle sold,
i.e. 135 - 100) = $9,100 (amount which A may defer until 1977)
(f) Successive elections. If a taxpayer makes an election under
section 451(e) for successive years, the amount deferred from one year
to the next year shall not be deemed to have been received from the sale
or exchange of livestock during the later year. In addition, in
determining the taxpayer's normal business practice for the later year,
earlier years for which an election under section 451(e) was made shall
not be considered.
(g) Time and manner of making election. The election provided for in
this section must be made by the later of (1) the due date for filing
the income tax return (determined with regard to any extensions of time
granted the taxpayer for filing such return) for the taxable year in
which the early sale of livestock occurs, or (2) (the 90th day after the
date these regulations are published as a Treasury decision in the
Federal Register). The election must be made separately for each taxable
year to which it is to apply. It must be made by attaching a statement
to the return or an amended return for such taxable year. The statement
shall include the name and address of the taxpayer and shall set forth
the following information for each classification of livestock for which
the election is made:
[[Page 127]]
(1) A declaration that the taxpayer is making an election under
section 451(e);
(2) Evidence of the existence of the drought conditions which forced
the early sale or exchange of the livestock and the date, if known, on
which an area was designated as eligible for assistance by the Federal
Government as a result of the drought conditions.
(3) A statement explaining the relationship of the drought area to
the taxpayer's early sale or exchange of the livestock;
(4) The total number of animals sold in each of the three preceding
years;
(5) The number of animals which would have been sold in the taxable
year had the taxpayer followed its normal business practice in the
absence of drought;
(6) The total number of animals sold, and the number sold on account
of drought, during the taxable year; and
(7) A computation, pursuant to paragraph (e) of this section, of the
amount of income to be deferred for each such classification.
(h) Revocation of election. Once an election under this section is
made for a taxable year, it may be revoked only with the approval of the
Commissioner.
(i) Cross reference. For provisions relating to the involuntary
conversion of livestock sold on account of drought see section 1033(e)
and the regulations thereunder.
[T.D. 7526, 42 FR 64624, Dec. 27, 1977]
Sec. Sec. 1.453-1--1.453-2 [Reserved]
Sec. 1.453-3 Purchaser evidences of indebtedness payable on demand
or readily tradable.
(a) In general. A bond or other evidence of indebtedness
(hereinafter in this section referred to as an obligation) issued by any
person and payable on demand shall not be treated as an evidence of
indebtedness of the purchaser in applying section 453(b) to a sale or
other disposition of real property or to a casual sale or other casual
disposition of personal property. In addition, an obligation issued by a
corporation or a government or political subdivision thereof--
(1) With interest coupons attached (whether or not the obligation is
readily tradable in an established securities market),
(2) In registered form (other than an obligation issued in
registered form which the taxpayer establishes will not be readily
tradable in an established securities market), or
(3) In any other form designed to render such obligation readily
tradable in an established securities market shall not be treated as an
evidence of indebtedness of the purchaser in applying section 453(b) to
a sale or other disposition of real property or to a casual sale or
other casual disposition of personal property. For purposes of this
section, an obligation is to be considered in registered form if it is
registered as to principal, interest, or both and if its transfer must
be effected by the surrender of the old instrument and either the
reissuance by the corporation of the old instrument to the new holder or
the issuance by the corporation of a new instrument to the new holder.
(b) Treatment as payment. If under section 453(b)(3) an obligation
is not treated as an evidence of indebtedness of the purchaser, then--
(1) For purposes of determining whether the payments received in the
taxable year of the sale or disposition exceed 30 percent of the selling
price, and
(2) For purposes of returning income on the installment method
during the taxable year of the sale or disposition or in a subsequent
taxable year, the receipt by the seller of such obligation shall be
treated as a payment. The rules stated in this paragraph may be
illustrated by the following examples:
[[Page 128]]
[GRAPHIC] [TIFF OMITTED] TR25SE06.004
Example 1. On July 1, 1970, A, an individual on the cash method of
accounting reporting on a calendar year basis, transferred all of his
stock in corporation X (traded on an established securities market and
having a fair market value of $1 million) to corporation Y in exchange
for 250 of corporation Y's registered bonds (which are traded in an
over-the-counter bond market) each with a principal amount and fair
market value of $1,000 (with interest payable at the rate of 8 percent
per year), and Y's unsecured promissory note, with a principal amount of
$750,000. At the time of such exchange A's basis in the corporation X
stock is $900,000. The promissory note is payable at the rate of $75,000
annually, due on July 1, of each year following 1970, until the
principal balance is paid. The note provides for the payment of interest
at the rate of 10 percent per year also payable on July 1 of each year.
Under the rule stated in subparagraph (1) of this paragraph, the 250
registered bonds of corporation Y are treated as a payment for purposes
of the 30 percent test described in section 453(b)(2)(A)(ii). The
payment on account of the bonds equals 25 percent of the selling price
determined as follows:
Since the payments received in the taxable year of the sale do not
exceed 30 percent of the selling price and the sales price exceeds
$1,000, A may report the income received on the sale of his corporation
X stock on the installment method. A elects to report the income on the
installment method. The gross profit to be realized when the corporation
X stock is fully paid for is 10 percent of the total contract price,
computed as follows: $100,000 gross profit (i.e., $1 million contract
price less $900,000 basis in corporation X stock) over $1 million
contract price. However, since subparagraph (2) of this paragraph also
treats the 250 corporation Y registered bonds as a payment for purposes
of reporting income, A must include $25,000 (i.e., 10 percent times
$250,000) in his gross income for calendar year 1970, the taxable year
of sale.
Example 2. Assume the same facts as in Example 1. Assume further
that on July 1, 1971, corporation Y makes its first installment payment
to A under the terms of the unsecured promissory note with 75 more of
its $1,000 registered bonds. A must include $7,500 (i.e., 10 percent
gross profit percentage times $75,000) in his gross income for calendar
year 1971. In addition, A includes the interest payment made by
corporation Y on July 1, in his gross income for 1971.
(c) Payable on demand. Under section 453(b)(3), an obligation shall
be treated as payable on demand only if the obligation is treated as
payable on demand under applicable state or local law.
(d) Designed to be readily tradable in an established securities
market--(1) In general. Obligations issued by a corporation or
government or political subdivision thereof will be deemed to be in a
form designed to render such obligations readily tradable in an
established securities market if--
(i) Steps necessary to create a market for them are taken at the
time of issuance (or later, if taken pursuant to an expressed or implied
agreement or understanding which existed at the time of issuance),
(ii) If they are treated as readily tradable in an established
securities market under subparagraph (2) of this paragraph, or
(iii) If they are convertible obligations to which paragraph (e) of
this section applies.
(2) Readily tradable in an established securities market. An
obligation will be treated as readily tradable in an established
securities market if--
(i) The obligation is part of an issue or series of issues which are
readily tradable in an established securities market, or
(ii) The corporation issuing the obligation has other obligations of
a comparable character which are described in subdivision (i) of this
subparagraph.
For purposes of subdivision (ii) of this subparagraph, the determination
as to whether there exist obligations of a
[[Page 129]]
comparable character depends upon the particular facts and
circumstances. Factors to be considered in making such determination
include, but are not limited to, substantial similarity with respect to
the presence and nature of security for the obligation, the number of
obligations issued (or to be issued), the number of holders of such
obligation, the principal amount of the obligation, and other relevant
factors.
(3) Readily tradable. For purposes of subparagraph (2)(i) of this
paragraph, an obligation shall be treated as readily tradable if it is
regularly quoted by brokers or dealers making a market in such
obligation or is part of an issue a portion of which is in fact traded
in an established securities market.
(4) Established securities market. For purposes of this paragraph,
the term established securities market includes (i) a national
securities exchange which is registered under section 6 of the
Securities and Exchange Act of 1934 (15 U.S.C. 78f), (ii) an exchange
which is exempted from registration under section 5 of the Securities
Exchange Act of 1935 (15 U.S.C. 78e) because of its limited volume of
transactions, and (iii) any over-the-counter market. For purposes of
this subparagraph, an over-the-counter market is reflected by the
existence of an interdealer quotation system. An interdealer quotation
system is any system of general circulation to brokers and dealers which
regularly disseminates quotations of obligations by identified brokers
or dealers, other than a quotation sheet prepared and distributed by a
broker or dealer in the regular course of his business and containing
only quotations of such broker or dealer.
(5) Examples. The rules stated in this paragraph may be illustrated
by the following examples:
Example 1. On June 1, 1971, 25 individuals owning equal interests in
a tract of land with a fair market value of $1 million sell the land to
corporation Y. The $1 million sales price is represented by 25 bonds
issued by corporation Y each having a face value of $40,000. The bonds
are not in registered form and do not have interest coupons attached,
and, in addition, are payable in 120 equal installments each due on the
first business day of each month. In addition, the bonds are negotiable
and may be assigned by the holder to any other person. However, the
bonds are not quoted by any brokers or dealers who deal in corporate
bonds, and, furthermore, there are no comparable obligations of
corporation Y (determined with reference to the characteristics set
forth in subparagraph (2) of this paragraph) which are so quoted.
Therefore, the bonds are not treated as readily tradable in an
established securities market. In addition, under the particular facts
and circumstances stated, the bonds will not be considered to be in a
form designed to render them readily tradeable in an established
securities market. Since the bonds are not in registered form, do not
have coupons attached, are not in a form designed to render them readily
tradable in an established securities market, the receipt of such bonds
by the holder is not treated as a payment for purposes of section
453(b), notwithstanding that they are freely assignable.
Example 2. On April 1, 1972, corporation M purchases in a casual
sale of personal property a fleet of trucks from corporation N in
exchange for corporation M's negotiable notes, not in registered form
and without coupons attached. The corporation M notes are comparable to
earlier notes issued by corporation M, which notes are quoted in the
Eastern Bond section of the National daily quotation sheet, which is an
interdealer quotation system. Both issues of notes are unsecured, held
by more than 100 holders, have a maturity date of more than 5 years, and
were issued for a comparable principal amount. On the basis of these
similar characteristics it appears that the latest notes will also be
readily tradable. Since an interdealer system reflects an over-the-
counter market, the earlier notes are treated as readily tradable in an
established securities market. Since the later notes are obligations
comparable to the earlier ones, which are treated as readily tradable in
an established securities market, the later notes are also treated as
readily tradable in an established securities market (whether or not
such notes are actually traded).
(e) Special rule for convertible securities--(1) General rule. For
purposes of paragraph (d)(1) of this section, if an obligation contains
a right whereby the holder of such obligation may convert it directly or
indirectly into another obligation which would be treated as a payment
under paragraph (b) of this section or may convert it directly or
indirectly into stock which would be treated as readily tradable or
designed to be readily tradable in an established securities market
under paragraph (d) of this section, the convertible obligation shall be
considered to be in a form designed to render such obligation
[[Page 130]]
readily tradable in an established securities market unless such
obligation is convertible only at a substantial discount. In determining
whether the stock or obligation, into which an obligation is
convertible, is readily tradable or designed to be readily tradable in
an established securities market, the rules stated in paragraph (d) of
this section shall apply, and for purposes of such paragraph (d) if such
obligation is convertible into stock then the term ``stock'' shall be
substituted for the term ``obligation'' wherever it appears in such
paragraph (d).
(2) Substantial discount rule. Whether an obligation is convertible
at a substantial discount depends upon the particular facts and
circumstances. A substantial discount shall be considered to exist if at
the time the convertible obligation is issued, the fair market value of
the stock or obligation into which the obligation is convertible is less
than 80 percent of the fair market value of the obligation (determined
by taking into account all relevant factors, including proper discount
to reflect the fact that the convertible obligation is not readily
tradable in an established securities market and any additional
consideration required to be paid by the taxpayer). Also, if a privilege
to convert an obligation into stock or an obligation which is readily
tradable in an established securities market may not be exercised within
a period of 1 year from the date the obligation is issued, a substantial
discount shall be considered to exist.
(f) Effective date. The provisions of this section shall apply to
sales or other dispositions occurring after May 27, 1969, which are not
made pursuant to a binding written contract entered into on or before
such date. No inference shall be drawn from this section as to any
question of law concerning the application of section 453 to sales or
other dispositions occurring on or before May 27, 1969.
[T.D. 7197, 37 FR 13532, July 11, 1972]
Sec. Sec. 1.453-4--1.453.8 [Reserved]
Sec. 1.453-9 Gain or loss on disposition of installment obligations.
(a) In general. Subject to the exceptions contained in section
453(d)(4) and paragraph (c) of this section, the entire amount of gain
or loss resulting from any disposition or satisfaction of installment
obligations, computed in accordance with section 453(d), is recognized
in the taxable year of such disposition or satisfaction and shall be
considered as resulting from the sale or exchange of the property in
respect of which the installment obligation was received by the
taxpayer.
(b) Computation of gain or loss. (1) The amount of gain or loss
resulting under paragraph (a) of this section is the difference between
the basis of the obligation and (i) the amount realized, in the case of
satisfaction at other than face value or in the case of a sale or
exchange, or (ii) the fair market value of the obligation at the time of
disposition, if such disposition is other than by sale or exchange.
(2) The basis of an installment obligation shall be the excess of
the face value of the obligation over an amount equal to the income
which would be returnable were the obligation satisfied in full.
(3) The application of subparagraphs (1) and (2) of this paragraph
may be illustrated by the following examples:
Example 1. In 1960 the M Corporation sold a piece of unimproved real
estate to B for $20,000. The company acquired the property in 1948 at a
cost of $10,000. During 1960 the company received $5,000 cash and
vendee's notes for the remainder of the selling price, or $15,000,
payable in subsequent years. In 1962, before the vendee made any further
payments, the company sold the notes for $13,000 in cash. The
corporation makes its returns on the calendar year basis. The income to
be reported for 1962 is $5,500, computed as follows:
Proceeds of sale of notes........................... ........ $13,000
Selling price of property........................... $20,000
Cost of property.................................... 10,000
----------
Total profit...................................... 10,000
Total contract price.............................. 20,000
==========
Percent of profit, or proportion of each payment
returnable as income, $10,000 divided by $20,000,
50 percent.
Face value of notes................................. 15,000
[[Page 131]]
Amount of income returnable were the notes satisfied 7,500
in full, 50 percent of $15,000.....................
----------
Basis of obligation--excess of face value of notes 7,500
over amount of income returnable were the notes
satisfied in full..................................
----------
Taxable income to be reported for 1962..................... 5,500
Example 2. Suppose in Example 1 the M Corporation, instead of
selling the notes, distributed them in 1962 to its shareholders as a
dividend, and at the time of such distribution, the fair market value of
the notes was $14,000. The income to be reported for 1962 is $6,500,
computed as follows:
Fair market value of notes.................................... $14,000
Basis of obligation--excess of face value of notes over amount 7,500
of income returnable were the notes satisfied in full
(computed as in Example 1)...................................
=========
Taxable income to be reported for 1962...................... 6,500
(c) Disposition from which no gain or loss is recognized. (1)(i)
Under section 453(d)(4)(A), no gain or loss shall be recognized to a
distributing corporation with respect to the distribution made after
November 13, 1966, of installment obligations if (a) the distribution is
made pursuant to a plan for the complete liquidation of a subsidiary
under section 332, and (b) the basis of the such obligations in the
hands of the distributee is determined under section 334(b)(1).
(ii) Under section 453(d)(4)(B), no gain or loss shall be recognized
to a distributing corporation with respect to the distribution of
installment obligations if the distribution is made, pursuant to a plan
for the complete liquidation of a corporation which meets the
requirements of section 337, under conditions whereby no gain or loss
would have been recognized to the corporation had such installment
obligations been sold or exchanged on the day of the distribution. The
preceding sentence shall not apply to the extent that under section
453(d)(1) gain to the distributing corporation would be considered as
gain to which section 341(f)(2), 617(d)(1), 1245(a)(1), 1250(a)(1),
1251(c)(1), 1252(a)(1), or 1254(a)(1) applies, computed under the
principles of the regulations under such provisions. See paragraph (d)
of Sec. 1.1245-6, paragraph (c)(6) of Sec. 1.1250-1, paragraph (e)(6)
of Sec. 1.1251-1, paragraph (d)(3) of Sec. 1.1252-1, and paragraph (d)
of Sec. 1.1254-1.
(2) Where the Code provides for exceptions to the recognition of
gain or loss in the case of certain dispositions, no gain or loss shall
result under section 453(d) in the case of a disposition of an
installment obligation. Such exceptions include: Certain transfers to
corporations under sections 351 and 361; contributions of property to a
partnership by a partner under section 721; and distributions by a
partnership to a partner under section 731 (except as provided by
section 736 and section 751).
(3) Any amount received by a person in payment or settlement of an
installment obligation acquired in a transaction described in
subparagraphs (1) or (2) of this paragraph (other than an amount
received by a stockholder with respect to an installment obligation
distributed to him pursuant to section 337) shall be considered to have
the character it would have had in the hands of the person from whom
such installment obligation was acquired.
(d) Carryover of installment method. For the treatment of income
derived from installment obligations received in transactions to which
section 381 (a) is applicable, see section 381(c)(8) and the regulations
thereunder.
(e) Installment obligations transmitted at death. Where installment
obligations are transmitted at death, see section 691(a)(4) and the
regulations thereunder for the treatment of amounts considered income in
respect of a decedent.
(f) Losses. See subchapter P (section 1201 and following), chapter 1
of the Code, as to the limitation on capital losses sustained by
corporations and the limitation as to both capital gains and capital
losses of individuals.
(g) Disposition of installment obligations to life insurance
companies. (1) Notwithstanding the provisions of section 453(d)(4) and
paragraph (c) of this section or any provision of subtitle A relating to
the nonrecognition of gain, the entire amount of any gain realized on
the disposition of an installment obligation by any person, other than a
life insurance company (as defined in section 801(a) and paragraph (b)
of Sec. 1.801-3), to a life insurance company or to a partnership of
which a life insurance company is a partner shall be recognized and
treated in accordance
[[Page 132]]
with section 453(d)(1) and paragraphs (a) and (b) of this section. If a
corporation which is a life insurance company for the taxable year was a
corporation which was not a life insurance company for the preceding
taxable year, such corporation shall be treated, for purposes of section
453(d)(1) and this paragraph, as having transferred to a life insurance
company, on the last day of the preceding taxable year, all installment
obligations which it held on such last day. The gain, if any, realized
by reason of the installment obligations being so transferred shall be
recognized and treated in accordance with section 453(d)(1) and
paragraphs (a) and (b) of this section. Similarly, a partnership of
which a life insurance company becomes a partner shall be treated, for
purposes of section 453(d)(1) and this paragraph, as having transferred
to a life insurance company, on the last day of the preceding taxable
year of such partnership, all installment obligations which it holds at
the time such life insurance company becomes a partner. The gain, if
any, realized by reason of the installment obligations being so
transferred shall be recognized and treated in accordance with section
453(d)(1) and paragraphs (a) and (b) of this section.
(2) The provisions of section 453(d)(5) and subparagraph (1) of this
paragraph shall not apply to losses sustained in connection with the
disposition of installment obligations to a life insurance company.
(3) For the effective date of the provisions of section 453(d)(5)
and this paragraph, see paragraph (f) of Sec. 1.453-10.
(4) Application of the provisions of this paragraph may be
illustrated by the following examples:
Example 1. A, an individual, in a transaction to which section 351
applies, transfers in 1961 certain assets, including installment
obligations, to a new corporation, X, which qualifies as a life
insurance company (as defined in section 801(a)) for the year 1961. A
makes his return on the calendar year basis. Section 453(d)(5) provides
that the nonrecognition provisions of section 351 will not apply to the
installment obligations transferred by A to X Corporation. Therefore,
the entire amount of any gain realized by A on the transfer of the
installment obligations shall be recognized in 1961, with the amount of
any such gain computed in accordance with the provisions of section
453(d)(1) and paragraph (b) of this section.
Example 2. The M Corporation did not qualify as a life insurance
company (as defined in section 801(a)) for the taxable year 1958. On
December 31, 1958, it held $60,000 of installment obligations. The M
Corporation qualified as a life insurance company for the taxable year
1959. Accordingly, the M Corporation is treated as having transferred to
a life insurance company, on December 31, 1958, the $60,000 of
installment obligations it held on such date. The gain, if any, realized
by M by reason of such installment obligations being so transferred
shall be recognized in the taxable year 1958, with the amount of any
such gain computed in accordance with the provisions of section
453(d)(1) and paragraph (b) of this section.
Example 3. During its taxable year 1958, none of the partners of the
N partnership qualified as a life insurance company (as defined in
section 801(a)). The N partnership held $30,000 of installment
obligations on December 31, 1958. On July 30, 1959, the O Corporation, a
life insurance company (as defined in section 801(a)), became a partner
in the partnership. The N partnership held $50,000 of installment
obligations on July 30, 1959. Pursuant to section 453(d)(5), the N
partnership is treated as having transferred to a life insurance
company, on December 31, 1958, the $50,000 of installment obligations it
held on July 30, 1959. The gain, if any, realized by the N partnership
by reason of such installment obligations being so transferred shall be
recognized in the taxable year 1958, with the amount of any such gain
computed in accordance with the provisions of section 453(d)(1) and
paragraph (b) of this section.
Example 4. In 1960, the P Corporation, in a reorganization
qualifying under section 368(a), transferred certain assets (including
installment obligations) to the R Corporation, a life insurance company
as defined in section 801(a). P realized a loss upon the transfer of the
installment obligations, which was not recognized under section 361.
Pursuant to subparagraph (2) of paragraph (c) of this section, no loss
with respect to the transfer of these obligations will be recognized to
P under section 453(d)(1).
[T.D. 6500, 25 FR 11718, Nov. 26, 1960, as amended by T.D. 6590, 27 FR
1319, Feb. 13, 1962; T.D. 7084, 36 FR 267, Jan. 8, 1971; T.D. 7418, 41
FR 18812, May 7, 1976; T.D. 8586, 60 FR 2500, Jan. 10, 1995]
Sec. 1.453-10 [Reserved]
Sec. 1.453-11 Installment obligations received
from a liquidating corporation.
(a) In general--(1) Overview. Except as provided in section
453(h)(1)(C) (relating to installment sales of depreciable
[[Page 133]]
property to certain closely related persons), a qualifying shareholder
(as defined in paragraph (b) of this section) who receives a qualifying
installment obligation (as defined in paragraph (c) of this section) in
a liquidation that satisfies section 453(h)(1)(A) treats the receipt of
payments in respect of the obligation, rather than the receipt of the
obligation itself, as a receipt of payment for the shareholder's stock.
The shareholder reports the payments received on the installment method
unless the shareholder elects otherwise in accordance with Sec.
15a.453-1(d) of this chapter.
(2) Coordination with other provisions--(i) Deemed sale of stock for
installment obligation. Except as specifically provided in section
453(h)(1)(C), a qualifying shareholder treats a qualifying installment
obligation, for all purposes of the Internal Revenue Code, as if the
obligation is received by the shareholder from the person issuing the
obligation in exchange for the shareholder's stock in the liquidating
corporation. For example, if the stock of a corporation that is
liquidating is traded on an established securities market, an
installment obligation distributed to a shareholder of the corporation
in exchange for the shareholder's stock does not qualify for installment
reporting pursuant to section 453(k)(2).
(ii) Special rules to account for the qualifying installment
obligation--(A) Issue price. A qualifying installment obligation is
treated by a qualifying shareholder as newly issued on the date of the
distribution. The issue price of the qualifying installment obligation
on that date is equal to the sum of the adjusted issue price of the
obligation on the date of the distribution (as determined under Sec.
1.1275-1(b)) and the amount of any qualified stated interest (as defined
in Sec. 1.1273-1(c)) that has accrued prior to the distribution but
that is not payable until after the distribution. For purposes of the
preceding sentence, if the qualifying installment obligation is subject
to Sec. 1.446-2 (e.g., a debt instrument that has unstated interest
under section 483), the adjusted issue price of the obligation is
determined under Sec. 1.446-2(c) and (d).
(B) Variable rate debt instrument. If the qualifying installment
obligation is a variable rate debt instrument (as defined in Sec.
1.1275-5), the shareholder uses the equivalent fixed rate debt
instrument (within the meaning of Sec. 1.1275-5(e)(3)(ii)) constructed
for the qualifying installment obligation as of the date the obligation
was issued to the liquidating corporation to determine the accruals of
original issue discount, if any, and interest on the obligation.
(3) Liquidating distributions treated as selling price. All amounts
distributed or treated as distributed to a qualifying shareholder
incident to the liquidation, including cash, the issue price of
qualifying installment obligations as determined under paragraph
(a)(2)(ii)(A) of this section, and the fair market value of other
property (including obligations that are not qualifying installment
obligations) are considered as having been received by the shareholder
as the selling price (as defined in Sec. 15a.453-1(b)(2)(ii) of this
chapter) for the shareholder's stock in the liquidating corporation. For
the proper method of reporting liquidating distributions received in
more than one taxable year of a shareholder, see paragraph (d) of this
section. An election not to report on the installment method an
installment obligation received in the liquidation applies to all
distributions received in the liquidation.
(4) Assumption of corporate liability by shareholders. For purposes
of this section, if in the course of a liquidation a shareholder assumes
secured or unsecured liabilities of the liquidating corporation, or
receives property from the corporation subject to such liabilities
(including any tax liabilities incurred by the corporation on the
distribution), the amount of the liabilities is added to the
shareholder's basis in the stock of the liquidating corporation. These
additions to basis do not affect the shareholder's holding period for
the stock. These liabilities do not reduce the amounts received in
computing the selling price.
(5) Examples. The provisions of this paragraph (a) are illustrated
by the following examples. Except as otherwise provided, assume in each
example that A, an individual who is a calendar-year taxpayer, owns all
of the stock of T corporation. A's adjusted tax basis in
[[Page 134]]
that stock is $100,000. On February 1, 1998, T, an accrual method
taxpayer, adopts a plan of complete liquidation that satisfies section
453(h)(1)(A) and immediately sells all of its assets to unrelated B
corporation in a single transaction. The examples are as follows:
Example 1. (i) The stated purchase price for T's assets is
$3,500,000. In consideration for the sale, B makes a down payment of
$500,000 and issues a 10-year installment obligation with a stated
principal amount of $3,000,000. The obligation provides for interest
payments of $150,000 on January 31 of each year, with the total
principal amount due at maturity.
(ii) Assume that for purposes of section 1274, the test rate on
February 1, 1998, is 8 percent, compounded semi-annually. Also assume
that a semi-annual accrual period is used. Under Sec. 1.1274-2, the
issue price of the obligation on February 1, 1998, is $2,368,450.
Accordingly, the obligation has $631,550 of original issue discount
($3,000,000-$2,368,450). Between February 1 and July 31, $19,738 of
original issue discount and $75,000 of qualified stated interest accrue
with respect to the obligation and are taken into account by T.
(iii) On July 31, 1998, T distributes the installment obligation to
A in exchange for A's stock. No other property is ever distributed to A.
On January 31, 1999, A receives the first annual payment of $150,000
from B.
(iv) When the obligation is distributed to A on July 31, 1998, it is
treated as if the obligation is received by A in an installment sale of
shares directly to B on that date. Under Sec. 1.1275-1(b), the adjusted
issue price of the obligation on that date is $2,388,188 (original issue
price of $2,368,450 plus accrued original issue discount of $19,738).
Accordingly, the issue price of the obligation under paragraph
(a)(2)(ii)(A) of this section is $2,463,188, the sum of the adjusted
issue price of the obligation on that date ($2,388,188) and the amount
of accrued but unpaid qualified stated interest ($75,000).
(v) The selling price and contract price of A's stock in T is
$2,463,188, and the gross profit is $2,363,188 ($2,463,188 selling price
less A's adjusted tax basis of $100,000). A's gross profit ratio is thus
96 percent (gross profit of $2,363,188 divided by total contract price
of $2,463,188).
(vi) Under Sec. Sec. 1.446-2(e)(1) and 1.1275-2(a), $98,527 of the
$150,000 payment is treated as a payment of the interest and original
issue discount that accrued on the obligation from July 31, 1998, to
January 31, 1999 ($75,000 of qualified stated interest and $23,527 of
original issue discount). The balance of the payment ($51,473) is
treated as a payment of principal. A's gain recognized in 1999 is
$49,414 (96 percent of $51,473).
Example 2. (i) T owns Blackacre, unimproved real property, with an
adjusted tax basis of $700,000. Blackacre is subject to a mortgage
(underlying mortgage) of $1,100,000. A is not personally liable on the
underlying mortgage and the T shares held by A are not encumbered by the
underlying mortgage. The other assets of T consist of $400,000 of cash
and $600,000 of accounts receivable attributable to sales of inventory
in the ordinary course of business. The unsecured liabilities of T total
$900,000.
(ii) On February 1, 1998, T adopts a plan of complete liquidation
complying with section 453(h)(1)(A), and promptly sells Blackacre to B
for a 4-year mortgage note (bearing adequate stated interest and
otherwise meeting all of the requirements of section 453) in the face
amount of $4 million. Under the agreement between T and B, T (or its
successor) is to continue to make principal and interest payments on the
underlying mortgage. Immediately thereafter, T completes its liquidation
by distributing to A its remaining cash of $400,000 (after payment of
T's tax liabilities), accounts receivable of $600,000, and the $4
million B note. A assumes T's $900,000 of unsecured liabilities and
receives the distributed property subject to the obligation to make
payments on the $1,100,000 underlying mortgage. A receives no payments
from B on the B note during 1998.
(iii) Unless A elects otherwise, the transaction is reported by A on
the installment method. The selling price is $5 million (cash of
$400,000, accounts receivable of $600,000, and the B note of $4
million). The total contract price also is $5 million. A's adjusted tax
basis in the T shares, initially $100,000, is increased by the $900,000
of unsecured T liabilities assumed by A and by the obligation (subject
to which A takes the distributed property) to make payments on the
$1,100,000 underlying mortgage on Blackacre, for an aggregate adjusted
tax basis of $2,100,000. Accordingly, the gross profit is $2,900,000
(selling price of $5 million less aggregate adjusted tax basis of
$2,100,000). The gross profit ratio is 58 percent (gross profit of
$2,900,000 divided by the total contract price of $5 million). The 1998
payments to A are $1 million ($400,000 cash plus $600,000 receivables)
and A recognizes gain in 1998 of $580,000 (58 percent of $1 million).
(iv) In 1999, A receives payment from B on the B note of $1 million
(exclusive of interest). A's gain recognized in 1999 is $580,000 (58
percent of $1 million).
(b) Qualifying shareholder. For purposes of this section, qualifying
shareholder means a shareholder to which,
[[Page 135]]
with respect to the liquidating distribution, section 331 applies. For
example, a creditor that receives a distribution from a liquidating
corporation, in exchange for the creditor's claim, is not a qualifying
shareholder as a result of that distribution regardless of whether the
liquidation satisfies section 453(h)(1)(A).
(c) Qualifying installment obligation--(1) In general. For purposes
of this section, qualifying installment obligation means an installment
obligation (other than an evidence of indebtedness described in Sec.
15a.453-1(e) of this chapter, relating to obligations that are payable
on demand or are readily tradable) acquired in a sale or exchange of
corporate assets by a liquidating corporation during the 12-month period
beginning on the date the plan of liquidation is adopted. See paragraph
(c)(4) of this section for an exception for installment obligations
acquired in respect of certain sales of inventory. Also see paragraph
(c)(5) of this section for an exception for installment obligations
attributable to sales of certain property that do not generally qualify
for installment method treatment.
(2) Corporate assets. Except as provided in section 453(h)(1)(C), in
paragraph (c)(4) of this section (relating to certain sales of
inventory), and in paragraph (c)(5) of this section (relating to certain
tax avoidance transactions), the nature of the assets sold by, and the
tax consequences to, the selling corporation do not affect whether an
installment obligation is a qualifying installment obligation. Thus, for
example, the fact that the fair market value of an asset is less than
the adjusted basis of that asset in the hands of the corporation; or
that the sale of an asset will subject the corporation to depreciation
recapture (e.g., under section 1245 or section 1250); or that the assets
of a trade or business sold by the corporation for an installment
obligation include depreciable property, certain marketable securities,
accounts receivable, installment obligations, or cash; or that the
distribution of assets to the shareholder is or is not taxable to the
corporation under sections 336 and 453B, does not affect whether
installment obligations received in exchange for those assets are
treated as qualifying installment obligations by the shareholder.
However, an obligation received by the corporation in exchange for cash,
in a transaction unrelated to a sale or exchange of noncash assets by
the corporation, is not treated as a qualifying installment obligation.
(3) Installment obligations distributed in liquidations described in
section 453(h)(1)(E)--(i) In general. In the case of a liquidation to
which section 453(h)(1)(E) (relating to certain liquidating subsidiary
corporations) applies, a qualifying installment obligation acquired in
respect of a sale or exchange by the liquidating subsidiary corporation
will be treated as a qualifying installment obligation if distributed by
a controlling corporate shareholder (within the meaning of section
368(c)) to a qualifying shareholder. The preceding sentence is applied
successively to each controlling corporate shareholder, if any, above
the first controlling corporate shareholder.
(ii) Examples. The provisions of this paragraph (c)(3) are
illustrated by the following examples:
Example 1. (i) A, an individual, owns all of the stock of T
corporation, a C corporation. T has an operating division and three
wholly-owned subsidiaries, X, Y, and Z. On February 1, 1998, T, Y, and Z
all adopt plans of complete liquidation.
(ii) On March 1, 1998, the following sales are made to unrelated
purchasers: T sells the assets of its operating division to B for cash
and an installment obligation. T sells the stock of X to C for an
installment obligation. Y sells all of its assets to D for an
installment obligation. Z sells all of its assets to E for cash. The B,
C, and D installment obligations bear adequate stated interest and meet
the requirements of section 453.
(iii) In June 1998, Y and Z completely liquidate, distributing their
respective assets (the D installment obligation and cash) to T. In July
1998, T completely liquidates, distributing to A cash and the
installment obligations respectively issued by B, C, and D. The
liquidation of T is a liquidation to which section 453(h) applies and
the liquidations of Y and Z into T are liquidations to which section 332
applies.
(iv) Because T is in control of Y (within the meaning of section
368(c)), the D obligation acquired by Y is treated as acquired by T
pursuant to section 453(h)(1)(E). A is a qualifying shareholder and the
installment obligations issued by B, C, and D are qualifying installment
obligations. Unless A
[[Page 136]]
elects otherwise, A reports the transaction on the installment method as
if the cash and installment obligations had been received in an
installment sale of the stock of T corporation. Under section 453B(d),
no gain or loss is recognized by Y on the distribution of the D
installment obligation to T. Under sections 453B(a) and 336, T
recognizes gain or loss on the distribution of the B, C, and D
installment obligations to A in exchange for A's stock.
Example 2. (i) A, a cash-method individual taxpayer, owns all of the
stock of P corporation, a C corporation. P owns 30 percent of the stock
of Q corporation. The balance of the Q stock is owned by unrelated
individuals. On February 1, 1998, P adopts a plan of complete
liquidation and sells all of its property, other than its Q stock, to B,
an unrelated purchaser for cash and an installment obligation bearing
adequate stated interest. On March 1, 1998, Q adopts a plan of complete
liquidation and sells all of its property to an unrelated purchaser, C,
for cash and installment obligations. Q immediately distributes the cash
and installment obligations to its shareholders in completion of its
liquidation. Promptly thereafter, P liquidates, distributing to A cash,
the B installment obligation, and a C installment obligation that P
received in the liquidation of Q.
(ii) In the hands of A, the B installment obligation is a qualifying
installment obligation. In the hands of P, the C installment obligation
was a qualifying installment obligation. However, in the hands of A, the
C installment obligation is not treated as a qualifying installment
obligation because P owned only 30 percent of the stock of Q. Because P
did not own the requisite 80 percent stock interest in Q, P was not a
controlling corporate shareholder of Q (within the meaning of section
368(c)) immediately before the liquidation. Therefore, section
453(h)(1)(E) does not apply. Thus, in the hands of A, the C obligation
is considered to be a third-party note (not a purchaser's evidence of
indebtedness) and is treated as a payment to A in the year of
distribution. Accordingly, for 1998, A reports as payment the cash and
the fair market value of the C obligation distributed to A in the
liquidation of P.
(iii) Because P held 30 percent of the stock of Q, section 453B(d)
is inapplicable to P. Under sections 453B(a) and 336, accordingly, Q
recognizes gain or loss on the distribution of the C obligation. P also
recognizes gain or loss on the distribution of the B and C installment
obligations to A in exchange for A's stock. See sections 453B and 336.
(4) Installment obligations attributable to certain sales of
inventory--(i) In general. An installment obligation acquired by a
corporation in a liquidation that satisfies section 453(h)(1)(A) in
respect of a broken lot of inventory is not a qualifying installment
obligation. If an installment obligation is acquired in respect of a
broken lot of inventory and other assets, only the portion of the
installment obligation acquired in respect of the broken lot of
inventory is not a qualifying installment obligation. The portion of the
installment obligation attributable to other assets is a qualifying
installment obligation. For purposes of this section, the term broken
lot of inventory means inventory property that is sold or exchanged
other than in bulk to one person in one transaction involving
substantially all of the inventory property attributable to a trade or
business of the corporation. See paragraph (c)(4)(ii) of this section
for rules for determining what portion of an installment obligation is
not a qualifying installment obligation and paragraph (c)(4)(iii) of
this section for rules determining the application of payments on an
installment obligation only a portion of which is a qualifying
installment obligation.
(ii) Rules for determining nonqualifying portion of an installment
obligation. If a broken lot of inventory is sold to a purchaser together
with other corporate assets for consideration consisting of an
installment obligation and either cash, other property, the assumption
of (or taking property subject to) corporate liabilities by the
purchaser, or some combination thereof, the installment obligation is
treated as having been acquired in respect of a broken lot of inventory
only to the extent that the fair market value of the broken lot of
inventory exceeds the sum of unsecured liabilities assumed by the
purchaser, secured liabilities which encumber the broken lot of
inventory and are assumed by the purchaser or to which the broken lot of
inventory is subject, and the sum of the cash and fair market value of
other property received. This rule applies solely for the purpose of
determining the portion of the installment obligation (if any) that is
attributable to the broken lot of inventory.
(iii) Application of payments. If, by reason of the application of
paragraph (c)(4)(ii) of this section, a portion of an
[[Page 137]]
installment obligation is not a qualifying installment obligation, then
for purposes of determining the amount of gain to be reported by the
shareholder under section 453, payments on the obligation (other than
payments of qualified stated interest) shall be applied first to the
portion of the obligation that is not a qualifying installment
obligation.
(iv) Example. The following example illustrates the provisions of
this paragraph (c)(4). In this example, assume that all obligations bear
adequate stated interest within the meaning of section 1274(c)(2) and
that the fair market value of each nonqualifying installment obligation
equals its face amount. The example is as follows:
Example. (i) P corporation has three operating divisions, X, Y, and
Z, each engaged in a separate trade or business, and a minor amount of
investment assets. On July 1, 1998, P adopts a plan of complete
liquidation that meets the criteria of section 453(h)(1)(A). The
following sales are promptly made to purchasers unrelated to P: P sells
all of the assets of the X division (including all of the inventory
property) to B for $30,000 cash and installment obligations totalling
$200,000. P sells substantially all of the inventory property of the Y
division to C for a $100,000 installment obligation, and sells all of
the other assets of the Y division (excluding cash but including
installment receivables previously acquired in the ordinary course of
the business of the Y division) to D for a $170,000 installment
obligation. P sells \1/3\ of the inventory property of the Z division to
E for $100,000 cash, \1/3\ of the inventory property of the Z division
to F for a $100,000 installment obligation, and all of the other assets
of the Z division (including the remaining \1/3\ of the inventory
property worth $100,000) to G for $60,000 cash, a $240,000 installment
obligation, and the assumption by G of the liabilities of the Z
division. The liabilities assumed by G, which are unsecured liabilities
and liabilities encumbering the inventory property acquired by G,
aggregate $30,000. Thus, the total purchase price G pays is $330,000.
(ii) P immediately completes its liquidation, distributing the cash
and installment obligations, which otherwise meet the requirements of
section 453, to A, an individual cash-method taxpayer who is its sole
shareholder. In 1999, G makes a payment to A of $100,000 (exclusive of
interest) on the $240,000 installment obligation.
(iii) In the hands of A, the installment obligations issued by B, C,
and D are qualifying installment obligations because they were timely
acquired by P in a sale or exchange of its assets. In addition, the
installment obligation issued by C is a qualifying installment
obligation because it arose from a sale to one person in one transaction
of substantially all of the inventory property of the trade or business
engaged in by the Y division.
(iv) The installment obligation issued by F is not a qualifying
installment obligation because it is in respect of a broken lot of
inventory. A portion of the installment obligation issued by G is a
qualifying installment obligation and a portion is not a qualifying
installment obligation, determined as follows: G purchased part of the
inventory property (with a fair market value of $100,000) and all of the
other assets of the Z division by paying cash ($60,000), issuing an
installment obligation ($240,000), and assuming liabilities of the Z
division ($30,000). The assumed liabilities ($30,000) and cash ($60,000)
are attributed first to the inventory property. Therefore, only $10,000
of the $240,000 installment obligation is attributed to inventory
property. Accordingly, in the hands of A, the G installment obligation
is a qualifying installment obligation to the extent of $230,000, but is
not a qualifying installment obligation to the extent of the $10,000
attributable to the inventory property.
(v) In the 1998 liquidation of P, A receives a liquidating
distribution as follows:
------------------------------------------------------------------------
Qualifying Cash and
Item installment other
obligations property
------------------------------------------------------------------------
Cash............................................ ........... $190,000
B note.......................................... $200,000 .........
C note.......................................... $100,000 .........
D note.......................................... $170,000 .........
F note.......................................... ........... $100,000
G note \1\...................................... $230,000 $ 10,000
-----------------------
Total....................................... $700,000 $300,000
------------------------------------------------------------------------
\1\ Face amount $240,000.
(vi) Assume that A's adjusted tax basis in the stock of P is
$100,000. Under the installment method, A's selling price and the
contract price are both $1 million, the gross profit is $900,000
(selling price of $1 million less adjusted tax basis of $100,000), and
the gross profit ratio is 90 percent (gross profit of $900,000 divided
by the contract price of $1 million). Accordingly, in 1998, A reports
gain of $270,000 (90 percent of $300,000 payment in cash and other
property). A's adjusted tax basis in each of the qualifying installment
obligations is an amount equal to 10 percent of the obligation's
respective face amount. A's adjusted tax basis in the F note, a
nonqualifying installment obligation, is $100,000, i.e., the fair market
value of the note when received by A. A's adjusted tax basis in the G
note, a mixed obligation, is $33,000 (10 percent of the $230,000
qualifying installment
[[Page 138]]
obligation portion of the note, plus the $10,000 nonqualifying portion
of the note).
(vii) With respect to the $100,000 payment received from G in 1999,
$10,000 is treated as the recovery of the adjusted tax basis of the
nonqualifying portion of the G installment obligation and $9,000 (10
percent of $90,000) is treated as the recovery of the adjusted tax basis
of the portion of the note that is a qualifying installment obligation.
The remaining $81,000 (90 percent of $90,000) is reported as gain from
the sale of A's stock. See paragraph (c)(4)(iii) of this section.
(5) Installment obligations attributable to sales of certain
property--(i) In general. An installment obligation acquired by a
liquidating corporation, to the extent attributable to the sale of
property described in paragraph (c)(5)(ii) of this section, is not a
qualifying obligation if the corporation is formed or availed of for a
principal purpose of avoiding section 453(b)(2) (relating to dealer
dispositions and certain other dispositions of personal property),
section 453(i) (relating to sales of property subject to recapture), or
section 453(k) (relating to dispositions under a revolving credit plan
and sales of stock or securities traded on an established securities
market) through the use of a party bearing a relationship, either
directly or indirectly, described in section 267(b) to any shareholder
of the corporation.
(ii) Covered property. Property is described in this paragraph
(c)(5)(ii) if, within 12 months before or after the adoption of the plan
of liquidation, the property was owned by any shareholder and--
(A) The shareholder regularly sold or otherwise disposed of personal
property of the same type on the installment plan or the property is
real property that the shareholder held for sale to customers in the
ordinary course of a trade or business (provided the property is not
described in section 453(l)(2) (relating to certain exceptions to the
definition of dealer dispositions));
(B) The sale of the property by the shareholder would result in
recapture income (within the meaning of section 453(i)(2)), but only if
the amount of the recapture income is equal to or greater than 50
percent of the property's fair market value on the date of the sale by
the corporation;
(C) The property is stock or securities that are traded on an
established securities market; or
(D) The sale of the property by the shareholder would have been
under a revolving credit plan.
(iii) Safe harbor. Paragraph (c)(5)(i) of this section will not
apply to the liquidation of a corporation if, on the date the plan of
complete liquidation is adopted and thereafter, less than 15 percent of
the fair market value of the corporation's assets is attributable to
property described in paragraph (c)(5)(ii) of this section.
(iv) Example. The provisions of this paragraph (c)(5) are
illustrated by the following example:
Example. Ten percent of the fair market value of the assets of T is
attributable to stock and securities traded on an established securities
market. T owns no other assets described in paragraph (c)(5)(ii) of this
section. T, after adopting a plan of complete liquidation, sells all of
its stock and securities holdings to C corporation in exchange for an
installment obligation bearing adequate stated interest, sells all of
its other assets to B corporation for cash, and distributes the cash and
installment obligation to its sole shareholder, A, in a complete
liquidation that satisfies section 453(h)(1)(A). Because the C
installment obligation arose from a sale of publicly traded stock and
securities, T cannot report the gain on the sale under the installment
method pursuant to section 453(k)(2). In the hands of A, however, the C
installment obligation is treated as having arisen out of a sale of the
stock of T corporation. In addition, the general rule of paragraph
(c)(5)(i) of this section does not apply, even if a principal purpose of
the liquidation was the avoidance of section 453(k)(2), because the fair
market value of the publicly traded stock and securities is less than 15
percent of the total fair market value of T's assets. Accordingly,
section 453(k)(2) does not apply to A, and A may use the installment
method to report the gain recognized on the payments it receives in
respect of the obligation.
(d) Liquidating distributions received in more than one taxable
year. If a qualifying shareholder receives liquidating distributions to
which this section applies in more than one taxable year, the
shareholder must reasonably estimate the gain attributable to
distributions received in each taxable year. In allocating basis to
calculate the gain for a taxable year, the shareholder
[[Page 139]]
must reasonably estimate the anticipated aggregate distributions. For
this purpose, the shareholder must take into account distributions and
other relevant events or information that the shareholder knows or
reasonably could know up to the date on which the federal income tax
return for that year is filed. If the gain for a taxable year is
properly taken into account on the basis of a reasonable estimate and
the exact amount is subsequently determined the difference, if any, must
be taken into account for the taxable year in which the subsequent
determination is made. However, the shareholder may file an amended
return for the earlier year in lieu of taking the difference into
account for the subsequent taxable year.
(e) Effective date. This section is applicable to distributions of
qualifying installment obligations made on or after January 28, 1998.
[T.D. 8762, 63 FR 4170, Jan. 28, 1998]
Sec. 1.453-12 Allocation of unrecaptured section 1250 gain reported
on the installment method.
(a) General rule. Unrecaptured section 1250 gain, as defined in
section 1(h)(7), is reported on the installment method if that method
otherwise applies under section 453 or 453A and the corresponding
regulations. If gain from an installment sale includes unrecaptured
section 1250 gain and adjusted net capital gain (as defined in section
1(h)(4)), the unrecaptured section 1250 gain is taken into account
before the adjusted net capital gain.
(b) Installment payments from sales before May 7, 1997. The amount
of unrecaptured section 1250 gain in an installment payment that is
properly taken into account after May 6, 1997, from a sale before May 7,
1997, is determined as if, for all payments properly taken into account
after the date of sale but before May 7, 1997, unrecaptured section 1250
gain had been taken into account before adjusted net capital gain.
(c) Installment payments received after May 6, 1997, and on or
before August 23, 1999. If the amount of unrecaptured section 1250 gain
in an installment payment that is properly taken into account after May
6, 1997, and on or before August 23, 1999, is less than the amount that
would have been taken into account under this section, the lesser amount
is used to determine the amount of unrecaptured section 1250 gain that
remains to be taken into account.
(d) Examples. In each example, the taxpayer, an individual whose
taxable year is the calendar year, does not elect out of the installment
method. The installment obligation bears adequate stated interest, and
the property sold is real property held in a trade or business that
qualifies as both section 1231 property and section 1250 property. In
all taxable years, the taxpayer's marginal tax rate on ordinary income
is 28 percent. The following examples illustrate the rules of this
section:
Example 1. General rule. This example illustrates the rule of
paragraph (a) of this section as follows:
(i) In 1999, A sells property for $10,000, to be paid in ten equal
annual installments beginning on December 1, 1999. A originally
purchased the property for $5000, held the property for several years,
and took straight-line depreciation deductions in the amount of $3000.
In each of the years 1999-2008, A has no other capital or section 1231
gains or losses.
(ii) A's adjusted basis at the time of the sale is $2000. Of A's
$8000 of section 1231 gain on the sale of the property, $3000 is
attributable to prior straight-line depreciation deductions and is
unrecaptured section 1250 gain. The gain on each installment payment is
$800.
(iii) As illustrated in the table in this paragraph (iii) of this
Example 1., A takes into account the unrecaptured section 1250 gain
first. Therefore, the gain on A's first three payments, received in
1999, 2000, and 2001, is taxed at 25 percent. Of the $800 of gain on the
fourth payment, received in 2002, $600 is taxed at 25 percent and the
remaining $200 is taxed at 20 percent. The gain on A's remaining six
installment payments is taxed at 20 percent. The table is as follows:
----------------------------------------------------------------------------------------------------------------
Total
1999 2000 2001 2002 2003 2004-2008 gain
----------------------------------------------------------------------------------------------------------------
Installment gain................... 800 800 800 800 800 4000 8000
Taxed at 25%....................... 800 800 800 600 ......... ......... 3000
Taxed at 20%....................... ......... ......... ......... 200 800 4000 5000
[[Page 140]]
Remaining to be taxed at 25%....... 2200 1400 600 ......... ......... ......... .........
----------------------------------------------------------------------------------------------------------------
Example 2. Installment payments from sales prior to May 7, 1997.
This example illustrates the rule of paragraph (b) of this section as
follows:
(i) The facts are the same as in Example 1 except that A sold the
property in 1994, received the first of the ten annual installment
payments on December 1, 1994, and had no other capital or section 1231
gains or losses in the years 1994-2003.
(ii) As in Example 1, of A's $8000 of gain on the sale of the
property, $3000 was attributable to prior straight-line depreciation
deductions and is unrecaptured section 1250 gain.
(iii) As illustrated in the following table, A's first three
payments, in 1994, 1995, and 1996, were received before May 7, 1997, and
taxed at 28 percent. Under the rule described in paragraph (b) of this
section, A determines the allocation of unrecaptured section 1250 gain
for each installment payment after May 6, 1997, by taking unrecaptured
section 1250 gain into account first, treating the general rule of
paragraph (a) of this section as having applied since the time the
property was sold, in 1994. Consequently, of the $800 of gain on the
fourth payment, received in 1997, $600 is taxed at 25 percent and the
remaining $200 is taxed at 20 percent. The gain on A's remaining six
installment payments is taxed at 20 percent. The table is as follows:
----------------------------------------------------------------------------------------------------------------
Total
1994 1995 1996 1997 1998 1999-2003 gain
----------------------------------------------------------------------------------------------------------------
Installment gain................... 800 800 800 800 800 4000 8000
Taxed at 28%....................... 800 800 800 ......... ......... ......... 2400
Taxed at 25%....................... ......... ......... ......... 600 ......... ......... 600
Taxed at 20%....................... ......... ......... ......... 200 800 4000 5000
Remaining to be taxed at 25%....... 2200 1400 600 ......... ......... ......... .........
----------------------------------------------------------------------------------------------------------------
Example 3. Effect of section 1231(c) recapture. This example
illustrates the rule of paragraph (a) of this section when there are
non-recaptured net section 1231 losses, as defined in section
1231(c)(2), from prior years as follows:
(i) The facts are the same as in Example 1, except that in 1999 A
has non-recaptured net section 1231 losses from the previous four years
of $1000.
(ii) As illustrated in the table in paragraph (iv) of this Example
3, in 1999, all of A's $800 installment gain is recaptured as ordinary
income under section 1231(c). Under the rule described in paragraph (a)
of this section, for purposes of determining the amount of unrecaptured
section 1250 gain remaining to be taken into account, the $800
recaptured as ordinary income under section 1231(c) is treated as
reducing unrecaptured section 1250 gain, rather than adjusted net
capital gain. Therefore, A has $2200 of unrecaptured section 1250 gain
remaining to be taken into account.
(iii) In the year 2000, A's installment gain is taxed at two rates.
First, $200 is recaptured as ordinary income under section 1231(c).
Second, the remaining $600 of gain on A's year 2000 installment payment
is taxed at 25 percent. Because the full $800 of gain reduces
unrecaptured section 1250 gain, A has $1400 of unrecaptured section 1250
gain remaining to be taken into account.
(iv) The gain on A's installment payment received in 2001 is taxed
at 25 percent. Of the $800 of gain on the fourth payment, received in
2002, $600 is taxed at 25 percent and the remaining $200 is taxed at 20
percent. The gain on A's remaining six installment payments is taxed at
20 percent. The table is as follows:
----------------------------------------------------------------------------------------------------------------
Total
1999 2000 2001 2002 2003 2004-2008 gain
----------------------------------------------------------------------------------------------------------------
Installment gain................... 800 800 800 800 800 4000 8000
Taxed at ordinary rates under 800 200 ......... ......... ......... ......... 1000
section 1231(c)...................
Taxed at 25%....................... ......... 600 800 600 ......... ......... 2000
Taxed at 20%....................... ......... ......... ......... 200 800 4000 5000
Remaining non-recaptured net 200 ......... ......... ......... ......... ......... .........
section 1231 losses...............
Remaining to be taxed at 25%....... 2200 1400 600 ......... ......... ......... .........
----------------------------------------------------------------------------------------------------------------
[[Page 141]]
Example 4. Effect of a net section 1231 loss. This example
illustrates the application of paragraph (a) of this section when there
is a net section 1231 loss as follows:
(i) The facts are the same as in Example 1 except that A has section
1231 losses of $1000 in 1999.
(ii) In 1999, A's section 1231 installment gain of $800 does not
exceed A's section 1231 losses of $1000. Therefore, A has a net section
1231 loss of $200. As a result, under section 1231(a) all of A's section
1231 gains and losses are treated as ordinary gains and losses. As
illustrated in the following table, A's entire $800 of installment gain
is ordinary gain. Under the rule described in paragraph (a) of this
section, for purposes of determining the amount of unrecaptured section
1250 gain remaining to be taken into account, A's $800 of ordinary
section 1231 installment gain in 1999 is treated as reducing
unrecaptured section 1250 gain. Therefore, A has $2200 of unrecaptured
section 1250 gain remaining to be taken into account.
(iii) In the year 2000, A has $800 of section 1231 installment gain,
resulting in a net section 1231 gain of $800. A also has $200 of non-
recaptured net section 1231 losses. The $800 gain is taxed at two rates.
First, $200 is taxed at ordinary rates under section 1231(c),
recapturing the $200 net section 1231 loss sustained in 1999. Second,
the remaining $600 of gain on A's year 2000 installment payment is taxed
at 25 percent. As in Example 3, the $200 of section 1231(c) gain is
treated as reducing unrecaptured section 1250 gain, rather than adjusted
net capital gain. Therefore, A has $1400 of unrecaptured section 1250
gain remaining to be taken into account.
(iv) The gain on A's installment payment received in 2001 is taxed
at 25 percent, reducing the remaining unrecaptured section 1250 gain to
$600. Of the $800 of gain on the fourth payment, received in 2002, $600
is taxed at 25 percent and the remaining $200 is taxed at 20 percent.
The gain on A's remaining six installment payments is taxed at 20
percent. The table is as follows:
----------------------------------------------------------------------------------------------------------------
Total
1999 2000 2001 2002 2003 2004-2008 gain
----------------------------------------------------------------------------------------------------------------
Installment gain................... 800 800 800 800 800 4000 8000
Ordinary gain under section 1231(a) 800 ......... ......... ......... ......... ......... 800
Taxed at ordinary rates under ......... 200 ......... ......... ......... ......... 200
section 1231(c)...................
Taxed at 25%....................... ......... 600 800 600 ......... ......... 2000
Taxed at 20%....................... ......... ......... ......... 200 800 4000 5000
Net section 1231 loss.............. 200 ......... ......... ......... ......... ......... .........
Remaining to be taxed at 25%....... 2200 1400 600 ......... ......... ......... .........
----------------------------------------------------------------------------------------------------------------
(e) Effective date. This section applies to installment payments
properly taken into account after August 23, 1999.
[T.D. 8836, 64 FR 45875, Aug. 23, 1999]
Sec. 1.453A-0 Table of contents.
This section lists the paragraphs and subparagraphs contained in
Sec. Sec. 1.453A-1 through 1.453A-3.
Sec. 1.453A-1 Installment method of reporting income by dealers in
personal property.
(a) In general.
(b) Effect of security.
(c) Definition of dealer, sale, and sale on the installment plan.
(d) Installment plans.
(1) Traditional installment plans.
(2) Revolving credit plans.
(e) Installment income of dealers in personal property.
(1) In general.
(2) Gross profit and total contract price.
(3) Carrying changes not included in total contract price.
(f) Other accounting methods.
(g) Records.
(h) Effective date.
Sec. 1.453A-3 Requirements for adoption of or change to installment
method by dealers in personal property.
(a) In general.
(b) Time and manner of electing installment method reporting.
(1) Time for election.
(2) Adoption of installation method.
(3) Change to installment method.
(4) Deemed elections.
(c) Consent.
(d) Cut-off method for amounts previously accrued.
(e) Effective date.
[T.D. 8270, 54 FR 46376, Nov. 3, 1989, as amended by T.D. 9849, 84 FR
9235, Mar. 14, 2019]
Sec. 1.453A-1 Installment method of reporting income by dealers
on personal property.
(a) In general. A dealer (as defined in paragraph (c)(1) of this
section) may elect to return the income from the sale of personal
property on the installment method if such sale is a sale on
[[Page 142]]
the installment plan (as defined in paragraphs (c)(3) and (d) of this
section). Under the installment method of accounting, a taxpayer may
return as income from installment sales in any taxable year that
proportion of the installment payments actually received in that year
which the gross profit realized or to be realized when the property is
paid for bears to the total contract price. For this purpose, gross
profit means sales less cost of goods sold. See paragraph (d) of this
section for additional rules relating to the computation of income under
the installment method of accounting.
(b) Effect of security. A dealer may adopt (but is not required to
do so) one of the following four ways of protecting against loss in case
of default by the purchaser:
(1) An agreement that title is to remain in the vendor until
performance of the purchaser's part of the transaction is completed;
(2) A form of contract in which title is conveyed to the purchaser
immediately, but subject to a lien for the unpaid portion of the selling
price;
(3) A present transfer of title to the purchaser, who at the same
time executes a reconveyance in the form of a chattel mortgage to the
vendor; or
(4) A conveyance to a trustee pending performance of the contract
and subject to its provisions.
(c) Definitions of dealer, sale, and sale on the installment plan.
For purposes of the regulations under section 453A--
(1) The term ``dealer'' means a person who regularly sells or
otherwise disposes of personal property on the installment plan;
(2) The term ``sale'' includes sales and other dispositions; and
(3) Except as provided in paragraph (d)(2) of this section, the term
``sale on the installment plan'' means--
(i) A sale of personal property by the taxpayer under any plan for
the sale of personal property, which plan, by its terms and conditions,
contemplates that each sale under the plan will be paid for in two or
more payments; or
(ii) A sale of personal property by the taxpayer under any plan for
the sale of personal property--
(A) Which plan, by its terms and conditions, contemplates that such
sale will be paid for in two or more payments; and
(B) Which sale is in fact paid for in two or more payments.
(d) Installment plans--(1) Traditional installment plans. A
traditional installment plan usually has the following characteristics:
(i) The execution of a separate installment contract for each sale
or disposition of personal property; and
(ii) The retention by the dealer of some type of security interest
in such property.
Normally, a sale under a traditional installment plan meets the
requirements of paragraph (c)(3)(i) of this section.
(2) Revolving credit plans. Sales under a revolving credit plan
(within the meaning of Sec. 1.453A-2(c)(1))--
(i) Are treated, for taxable years beginning on or before December
31, 1986, as sales on the installment plan to the extent provided in
Sec. 1.453A-2, which provides for the application of the requirements
of paragraph (c)(3)(ii) of this section to sales under revolving credit
plans; and
(ii) Are not treated as sales on the installment plan for taxable
years beginning after December 31, 1986.
(e) Installment income of dealers in personal property--(1) In
general. The income from sales on the installment plan of a dealer may
be ascertained by treating as income that proportion of the total
payments received in the taxable year from sales on the installment plan
(such payments being allocated to the year against the sales of which
they apply) which the gross profit realized or to be realized on the
total sales on the installment plan made during each year bears to the
total contract price of all such sales made during that respective year.
However, if the dealer demonstrates to the satisfaction of the district
director that income from sales on the installment plan is clearly
reflected, the income from such sales may be ascertained by treating as
income that proportion of the total payments received in the taxable
year from sales on the installment plan (such payments being allocated
to the year against the sales of which they apply) which either:
(i) The gross profit realized or to be realized on the total credit
sales made
[[Page 143]]
during each year bears to the total contract price of all credit sales
during that respective year, or
(ii) The gross profit realized or to be realized on all sales made
during each year bears to the total contract price of all sales made
during that respective year.
A dealer who desires to compute income by the installment method shall
maintain accounting records in such a manner as to enable an accurate
computation to be made by such method in accordance with the provisions
of this section, section 446, and Sec. 1.446-1.
(2) Gross profit and total contract price. For purposes of paragraph
(e)(1) of this section, in computing the gross profit realized or to be
realized on the total sales on the installment plan, there shall be
included in the total selling price and, thus, in the total contract
price of all such sales.
(i) The amount of carrying charges or interest which is determined
at the time of each sale and is added to the established cash selling
price of such property and is treated as part of the selling price for
customer billing purposes, and
(ii) In the case of sales made in taxable years beginning on or
after January 1, 1960, the amount of carrying charges or interest
determined with respect to such sales which are added contemporaneously
with the sale on the books of account of the seller but are treated as
periodic service charges for customer billing purposes.
Any change in the amount of the carrying charges or interest in a year
subsequent to the sale will not affect the computation of the gross
profit for the year of sale but will be taken into account at the time
the carrying charges or interest are adjusted. The application of this
paragraph (e)(2) to carrying charges or interest described in paragraph
(e)(2)(ii) of this section may be illustrated by the following example:
Example. X Corporation makes sales on the traditional installment
plan. The customer's order specifies that the total price consists of a
cash price plus a ``time price differential'' of 1\1/2\ percent per
month on the outstanding balance in the customer's account, and the
customer is billed in this manner. On its books and for purposes of
reporting to stockholders, X Corporation consistently makes the
following entries each month when it records its sales. A debit entry is
make to accounts receivable (for the total price) and balancing credit
entries are made to sales (for the established selling price) and to a
reserve account for collection expense (for the amount of the time price
differential). In computing the gross profit realized or to be realized
on the total sales on the installment plan, the total selling price and,
thus, the total contract price for purposes of this paragraph (e) would,
with respect to sales made in taxable years beginning on or after
January 1, 1960, include the time price differential.
(3) Carrying charges not included in total contract price. In the
case of sales by dealers in personal property made during taxable years
beginning after December 31, 1963, the income from which is returned on
the installment method, if the carrying charges or interest with respect
to such sales is not included in the total contract price, payments
received with respect to such sales shall be treated as applying first
against such carrying charges or interest.
(f) Other accounting methods. If the vendor chooses as a matter of
consistent practice to return the income from installment sales on an
accrual method (,) such a course is permissible.
(g) Records. In adopting the installment method of accounting the
seller must maintain such records as are necessary to clearly reflect
income in accordance with this section, section 446 and Sec. 1.446-1.
(h) Effective date. This section applies for taxable years beginning
after December 31, 1953, and ending after August 16, 1954, but generally
does not apply to sales made after December 31, 1987, in taxable years
ending after such date. For sales made after December 31, 1987, sales
made by a dealer in personal or real property shall not be treated as
sales on the installment plan. (However, see section 453(l)(2) for
exceptions to this rule.)
[T.D. 8270, 54 FR 46377, Nov. 3, 1989, as amended by T.D. 9849, 84 FR
9235, Mar. 14, 2019]
[[Page 144]]
Sec. 1.453A-2 [Reserved]
Sec. 1.453A-3 Requirements for adoption of or change to installment method
by dealers in personal property.
(a) In general. A dealer (within the meaning of Sec. 1.453A-
1(c)(1)) may adopt or change to the installment method for a type or
types of sales on the installment plan (within the meaning of Sec.
1.453A-1(c)(3) and (d)) in the manner prescribed in this section. This
section applies only to dealers and only with respect to their sales on
the installment plan.
(b) Time and manner of electing installment method reporting--(1)
Time for election. An election to adopt or change to the installment
method for a type or types of sales must be made on an income tax return
for the taxable year of the election, filed on or before the time
specified (including extensions thereof) for filing such return.
(2) Adoption of installment method. A taxpayer who adopts the
installment method for the first taxable year in which sales are made on
an installment plan of any kind must indicate in the income tax return
for that taxable year that the installment method of accounting is being
adopted and specify the type or types of sales included within the
election. If a taxpayer in the year of the initial election made only
one type of sale on the installment plan, but during a subsequent
taxable year makes another type of sale on the installment plan and
adopts the installment method for that other type of sale, the taxpayer
must indicate in the income tax return for the subsequent year that an
election is being made to adopt the installment method of accounting for
the additional type of sale.
(3) Change to installment method. A taxpayer who changes to the
installment method for a particular type or types of sales on the
installment plan in acordance with this section must, for each type of
sale on the installment plan for which the installment method is to be
used, attach a separate statement to the income tax return for the
taxable year with respect to which the change is made. Each statement
must show the method of accounting used in computing taxable income
before the change and the type of sale on the installment plan for which
the installment method is being elected.
(4) Deemed elections. A dealer (including a person who is a dealer
as a result of the recharacterization of transactions as sales) is
deemed to have elected the installment method if the dealer treats a
sale on the installment plan as a transaction other than a sale and
fails to report the full amount of gain in the year of the sale. For
example, if a transaction treated by a dealer as a lease is
recharacterized by the Internal Revenue Service as a sale on the
installment plan, the dealer will be deemed to have elected the
installment method assuming the dealer failed to report the full amount
of gain in the year of the transaction.
(c) Consent. A dealer may adopt or change to the installment method
for sales on the installment plan without the consent of the
Commissioner. However, a dealer may not change from the installment
method to the accrual method of accounting or to any other method of
accounting without the consent of the Commissioner.
(d) Cut-off method for amounts previously accrued. An election to
change to the installment method for a type of sale applies only with
respect to sales made on or after the first day of the taxable year of
change. Thus, payments received in the taxable year of the change, or in
subsequent years, in respect of an installment obligation which arose in
a taxable year prior to the taxable year of change are not taken into
account on the installment method, but rather must be accounted for
under the taxpayer's method of accounting in use in the prior year.
(e) Effective date. This section applies to sales by dealers in
taxable years ending after October 19, 1980, but generally does not
apply to sales made after December 31, 1987. For sales made after
December 31, 1987, sales by a dealer in personal or real property shall
not be treated as sales on the installment plan. (However, see section
453(l)(2) for certain exceptions to this rule.) For rules relating to
sales by dealers in taxable years ending before October 20, 1980, see 26
CFR 1.453-7 and 1.453-8 (rev. as of April 1, 1987).
[T.D. 8269, 54 FR 46375, Nov. 3, 1989]
[[Page 145]]
Sec. 1.454-1 Obligations issued at discount.
(a) Certain non-interest-bearing obligations issued at discount--(1)
Election to include increase in income currently. If a taxpayer owns--
(i) A non-interest-bearing obligation issued at a discount and
redeemable for fixed amounts increasing at stated intervals (other than
an obligation issued by a corporation after May 27, 1969, as to which
ratable inclusion of original issue discount is required under section
1232(a)(3)), or
(ii) An obligation of the United States, other than a current income
obligation, in which he retains his investment in a matured series E
U.S. savings bond, or
(iii) A nontransferable obligation (whether or not a current income
obligation) of the United States for which a series E U.S. savings bond
was exchanged (whether or not at final maturity) in an exchange upon
which gain is not recognized because of section 1037(a) (or so much of
section 1031(b) as relates to section 1037),
and if the increase, if any, in redemption price of such obligation
described in subdivision (i), (ii), or (iii) of this subparagraph during
the taxable year (as described in subparagraph (2) of this paragraph)
does not constitute income for such year under the method of accounting
used in computing his taxable income, then the taxpayer may, at his
election, treat the increase as constituting income for the year in
which such increase occurs. If the election is not made and section 1037
(or so much of section 1031 as relates to section 1037) does not apply,
the taxpayer shall treat the increase as constituting income for the
year in which the obligation is redeemed or disposed of, or finally
matures, whichever is earlier. Any such election must be made in the
taxpayer's return and may be made for any taxable year. If an election
is made with respect to any such obligation described in subdivision
(i), (ii), or (iii) of this subparagraph, it shall apply also to all
other obligations of the type described in such subdivisions owned by
the taxpayer at the beginning of the first taxable year to which the
election applies, and to those thereafter acquired by him, and shall be
binding for the taxable year for which the return is filed and for all
subsequent taxable years, unless the Commissioner permits the taxpayer
to change to a different method of reporting income from such
obligations. See section 446(e) and paragraph (e) of Sec. 1.446-1,
relating to requirement respecting a change of accounting method.
Although the election once made is binding upon the taxpayer, it does
not apply to a transferee of the taxpayer.
(2) Amount of increase in case of non-interest-bearing obligations.
In any case in which an election is made under section 454, the amount
which accrues in any taxable year to which the election applies is
measured by the actual increase in the redemption price occurring in
that year. This amount does not accrue ratably between the dates on
which the redemption price changes. For example, if two dates on which
the redemption price increases (February 1 and August 1) fall within a
taxable year and if the redemption price increases in the amount of 50
cents on each such date, the amount accruing in that year would be $1
($0.50 on February 1 and $0.50 on August 1). If the taxpayer owns a non-
interest-bearing obligation of the character described in subdivision
(i), (ii), or (iii) of subparagraph (1) of this paragraph acquired prior
to the first taxable year to which his election applies, he must also
include in gross income for such first taxable year (i) the increase in
the redemption price of such obligation occurring between the date of
acquisition of the obligation and the first day of such first taxable
year and (ii), in a case where a series E bond was exchanged for such
obligation, the increase in the redemption price of such series E bond
occurring between the date of acquisition of such series E bond and the
date of the exchange.
(3) Amount of increase in case of current income obligations. If an
election is made under section 454 and the taxpayer owns, at the
beginning of the first taxable year to which the election applies, a
current income obligation of the character described in subparagraph
(1)(iii) of this paragraph acquired prior to such taxable year, he must
also include in gross income for such first taxable year the increase in
the
[[Page 146]]
redemption price of the series E bond which was surrendered to the
United States in exchange for such current income obligation; the amount
of the increase is that occurring between the date of acquisition of the
series E bond and the date of the exchange.
(4) Illustrations. The application of this paragraph may be
illustrated by the following examples:
Example 1. Throughout the calendar year 1954, a taxpayer who uses
the cash receipts and disbursements method of accounting holds series E
U.S. savings bonds having a maturity value of $5,000 and a redemption
value at the beginning of the year 1954 of $4,050 and at the end of the
year 1954 of $4,150. He purchased the bonds on January 1, 1949, for
$3,750, and holds no other obligation of the type described in this
section. If the taxpayer exercises the election in his return for the
calendar year 1954, he is required to include $400 in taxable income
with respect to such bonds. Of this amount, $300 represents the increase
in the redemption price before 1954 and $100 represents the increase in
the redemption price in 1954. The increases in redemption value
occurring in subsequent taxable years are includible in gross income for
such taxable years.
Example 2. In 1958 B, a taxpayer who uses the cash receipts and
disbursements method of accounting and the calendar year as his taxable
year, purchased for $7,500 a series E United States savings bond with a
face value of $10,000. In 1965, when the stated redemption value of the
series E bond is $9,760, B surrenders it to the United States in
exchange solely for a $10,000 series H U.S. current income savings bond
in an exchange qualifying under section 1037(a), after paying $240
additional consideration. On the exchange of the series E bond for the
series H bond in 1965, B realizes a gain of $2,260 ($9,760 less $7,500),
none of which is recognized for that year by reason of section 1037(a).
B retains the series H bond and redeems it at maturity in 1975 for
$10,000, but in 1966 he exercises the election under section 454(a) in
his return for that year with respect to five series E bonds he
purchased in 1960. B is required to include in gross income for 1966 the
increase in redemption price occurring before 1966 and in 1966 with
respect to the series E bonds purchased in 1960; he is also required to
include in gross income for 1966 the $2,260 increase in redemption price
of the series E bond which was exchanged in 1965 for the series H bond.
(b) Short-term obligations issued on a discount basis. In the case
of obligations of the United States or any of its possessions, or of a
State, or Territory, or any political subdivision thereof, or of the
District of Columbia, issued on a discount basis and payable without
interest at a fixed maturity date not exceeding one year from the date
of issue, the amount of discount at which such obligation originally
sold does not accrue until the date on which such obligation is
redeemed, sold, or otherwise disposed of. This rule applies regardless
of the method of accounting used by the taxpayer. For examples
illustrating rules for computation of income from sale or other
disposition of certain obligations of the type described in this
paragraph, see section 1221 and the regulations thereunder.
(c) Matured U.S. savings bonds--(1) Inclusion of increase in income
upon redemption or final maturity. If a taxpayer (other than a
corporation) holds--
(i) A matured series E U.S. savings bond,
(ii) An obligation of the United States, other than a current income
obligation, in which he retains his investment in a matured series E
U.S. savings bond, or
(iii) A nontransferable obligation (whether or not a current income
obligation) of the United States for which a series E U.S. savings bond
was exchanged (whether or not at final maturity) in an exchange upon
which gain is not recognized because of section 1037(a) (or so much of
section 1031(b) as relates to section 1037(a)),
the increase in redemption price of the series E bond in excess of the
amount paid for such series E bond shall be included in the gross income
of such taxpayer for the taxable year in which the obligation described
in subdivision (i), (ii), or (iii) of this subparagraph is redeemed or
disposed of, or finally matures, whichever is earlier, but only to the
extent such increase has not previously been includible in the gross
income of such taxpayer or any other taxpayer. If such obligation is
partially redeemed before final maturity, or partially disposed of by
being partially reissued to another owner, such increase in redemption
price shall be included in the gross income of such taxpayer for such
taxable year on a basis proportional to the total denomination of
obligations redeemed or disposed of. The provisions of section 454 (c)
and of this subparagraph shall not apply in the
[[Page 147]]
case of any taxable year for which the taxpayer's taxable income is
computed under an accrual method of accounting or for a taxable year for
which an election made by the taxpayer under section 454(a) and
paragraph (a) of this section applies. For rules respecting the
character of the gain realized upon the disposition or redemption of an
obligation described in subdivision (iii) of this subparagraph, see
paragraph (b) of Sec. 1.1037-1.
(2) Illustrations. The application of this paragraph may be
illustrated by the following examples, in which it is assumed that the
taxpayer uses the cash receipts and disbursements method of accounting
and the calendar year as his taxable year:
Example 1. On June 1, 1941, A purchased for $375 a series E U.S.
savings bond which was redeemable at maturity (10 years from issue date)
for $500. At maturity of the bond, A exercised the option of retaining
the matured series E bond for the 10-year extended maturity period. On
June 2, 1961, A redeemed the series E bond, at which time the stated
redemption value was $674.60. A never elected under section 454(a) to
include the annual increase in redemption price in gross income
currently. Under section 454(c), A is required to include $299.60
($674.60 less $375) in gross income for 1961 by reason of his redemption
of the bond.
Example 2. The facts are the same as in Example 2 in paragraph
(a)(4) of this section. On redemption of the series H bond received in
the exchange qualifying under section 1037(a), B realizes a gain of
$2,260, determined as provided in Example 5 in paragraph (b)(4) of Sec.
1.1037-1. None of this amount is includible in B's gross income for
1975, such amount having already been includible in his gross income for
1966 because of his election under section 454(a).
Example 3. C, who had elected under section 454(a) to include the
annual increase in the redemption price of his non-interest-bearing
obligations in gross income currently, owned a $1,000 series E U.S.
savings bond, which was purchased on October 1, 1949, for $750, C died
on February 1, 1955, when the redemption value of the bond was $820. The
bond was immediately reissued to D, his only heir, who has not made an
election under section 454(a). On January 15, 1960, when the redemption
value of the bond is $1,000, D surrenders it to the United States in
exchange solely for a $1,000 series H U.S. savings bond in an exchange
qualifying under the provisions of section 1037(a). For 1960 D properly
does not return any income from the exchange of bonds, although he
returns the interest payments on the series H bond for the taxable years
in which they are received. On September 1, 1964, prior to maturity of
the series H bond, D redeems it for $1,000. For 1964, D must include
$180 in gross income under section 454(c) from the redemption of the
series H bond, that is, the amount of the increase in the redemption
price of the series E bond ($1,000 less $820) occurring between February
1, 1955, and January 15, 1960, the period during which he owned the
series E bond.
[T.D. 6500, 25 FR 11719, Nov. 26, 1960, as amended by T.D. 6935, 32 FR
15820, Nov. 17, 1967; T.D. 7154, 36 FR 24997, Dec. 28, 1971]
Sec. 1.455-1 Treatment of prepaid subscription income.
Effective with respect to taxable years beginning after December 31,
1957, section 455 permits certain taxpayers to elect with respect to a
trade or business in connection with which prepaid subscription income
is received, to include such income in gross income for the taxable
years during which a liability exists to furnish or deliver a newspaper,
magazine, or other periodical. If a taxpayer does not elect to treat
prepaid subscription income under the provisions of section 455, such
income is includible in gross income for the taxable year in which
received by the taxpayer, unless under the method or practice of
accounting used in computing taxable income such amount is to be
properly accounted for as of a different period.
[T.D. 6591, 27 FR 1798, Feb. 27, 1962]
Sec. 1.455-2 Scope of election under section 455.
(a) If a taxpayer makes an election under section 455 and Sec.
1.455-6 with respect to a trade or business, all prepaid subscription
income from such trade or business shall be included in gross income for
the taxable years during which the liability exists to furnish or
deliver a newspaper, magazine, or other periodical. Such election shall
be applicable to all prepaid subscription income received in connection
with the trade or business for which the election is made; except that
the taxpayer may further elect to include in gross income for the
taxable year of receipt (as described in section 455(d)(3) and paragraph
(c) of Sec. 1.455-5) the entire amount of any prepaid subscription
income if the liability from which it arose is to end within 12 months
after the date of
[[Page 148]]
receipt, hereinafter sometimes referred to as ``within 12 months''
election.
(b) If the taxpayer is engaged in more than one trade or business in
which a liability is incurred to furnish or deliver a newspaper,
magazine, or other periodical, a separate election 455 with respect to
each such trade or business. In addition, a taxpayer may make a separate
``within 12 months'' election for each separate trade or business for
which it has made an election under section 455.
(c) An election made under section 455 shall be binding for the
first taxable year for which the election is made and for all subsequent
taxable years, unless the taxpayer secures the consent of the
Commissioner to the revocation of such election. Thus, in any case where
the taxpayer has elected a method prescribed by section 455 for the
inclusion of prepaid subscription income in gross income, such method of
reporting income may not be changed without the prior approval of the
Commissioner. In order to secure the Commissioner's consent to the
revocation of such election, an application must be filed with the
Commissioner in accordance with section 446(e) and the regulations
thereunder. For purposes of subtitle A of the Code, the computation of
taxable income under an election made under section 455 shall be treated
as a method of accounting. For adjustments required by changes in method
of accounting, see section 481 and the regulations thereunder.
(d) An election made under section 455 shall not apply to any
prepaid subscription income received before the first taxable year to
which the election applies. For example, Corporation M, which computes
its taxable income under an accrual method of accounting and files its
income tax returns on the calendar year basis, publishes a monthly
magazine and customarily sells subscriptions on a 3-year basis. In 1958
it received $135,000 of 3-year prepaid subscription income for
subscriptions beginning during 1958, and in 1959 it received $142,000 of
prepaid subscription income for subscriptions beginning after December
31, 1958. In February 1959 it elected, with the consent of the
Commissioner, to report its prepaid subscription income under the
provisions of section 455 for the year 1959 and subsequent taxable
years. The $135,000 received in 1958 from prepaid subscriptions must be
included in gross income in full in that year, and no part of such 1958
income shall be allocated to the years 1959, 1960, and 1961 during which
M was under a liability to deliver its magazine. The $142,000 received
in 1959 from prepaid subscriptions shall be allocated to the years 1959,
1960, 1961, and 1962.
(e) No election may be made under section 455 with respect to a
trade or business if, in computing taxable income, the cash receipts and
disbursements method of accounting is used with respect to such trade or
business. However, if the taxpayer is on a ``combination'' method of
accounting under section 446(c)(4) and the regulations thereunder, it
may elect the benefits of section 455 if it uses an accrual method of
accounting for subscription income
[T.D. 6591, 27 FR 1798, Feb. 27, 1962]
Sec. 1.455-3 Method of allocation.
(a) Prepaid subscription income to which section 455 applies shall
be included in gross income for the taxable years during which the
liability to which the income relates is discharged or is deemed to be
discharged on the basis of the taxpayer's experience.
(b) For purposes of determining the period or periods over which the
liability of the taxpayer extends, and for purposes of allocating
prepaid subscription income to such periods, the taxpayer may aggregate
similar transactions during the taxable year in any reasonable manner,
provided the method of aggregation and allocation is consistently
followed.
[T.D. 6591, 27 FR 1798, Feb. 27, 1962]
Sec. 1.455-4 Cessation of taxpayer's liability.
(a) If a taxpayer has elected to apply the provisions of section 455
to a trade or business in connection with which prepaid subscription
income is received, and if its liability to furnish or deliver a
newspaper, magazine, or other periodical ends for any reason, then so
much of the prepaid subscription income attributable to such liability
as was not includible in its gross income
[[Page 149]]
under section 455 for preceding taxable years shall be included in its
gross income for the taxable year in which such liability ends. A
taxpayer's liability may end, for example, because of the cancellation
of a subscription. See section 381(c)(4) and the regulations thereunder
for the treatment of prepaid subscription income in a transaction to
which section 381(a) applies.
(b) If a taxpayer who has elected to apply the provisions of section
455 to a trade or business dies or ceases to exist, then so much of the
prepaid subscription income attributable to such trade or business which
was not includible in its gross income under section 455 for preceding
taxable years shall be included in its gross income for the taxable year
in which such death or cessation of existence occurs. See section
381(c)(4) and the regulations thereunder for the treatment of prepaid
subscription income in a transaction to which section 381(a) applies.
[T.D. 6591, 27 FR 1799, Feb. 27, 1962]
Sec. 1.455-5 Definitions and other rules.
(a) Prepaid subscription income. (1) The term ``prepaid subscription
income'' means any amount includible in gross income which is received
in connection with, and is directly attributable to, a liability of the
taxpayer which extends beyond the close of the taxable year in which
such amount is received and which is income from a newspaper, magazine,
or other periodical. For example where Corporation X, a publisher of
newspapers, magazines, and other periodicals makes sales on a
subscription basis and the purchaser pays the subscription price in
advance, prepaid subscription income would include the amounts actually
received by X in connection with its liability to furnish or deliver the
newspaper, magazine, or other periodical.
(2) For purposes of section 455, prepaid subscription income does
not include amounts received by a taxpayer in connection with sales of
subscriptions on a prepaid basis where such taxpayer does not have the
liability to furnish or deliver a newspaper, magazine, or other
periodical. The provisions of this subparagraph may be illustrated by
the following example. Corporation D has a contract with each of several
large publishers which grants it the right to sell subscriptions to
their periodicals. Corporation D collects the subscription price from
the subscribers, retains a portion thereof as its commission and remits
the balance to the publishers. The amount retained by Corporation D
represents commissions on the sale of subscriptions, and is not prepaid
subscription income for purposes of section 455 since the commissions
represent compensation for services rendered and are not directly
attributable to a liability of Corporation D to furnish or deliver a
newspaper, magazine, or other periodical.
(b) Liability. The term ``liability'' means a liability of the
taxpayer to furnish or deliver a newspaper, magazine, or other
periodical.
(c) Receipt of prepaid subscription income. For purposes of section
455, prepaid subscription income shall be treated as received during the
taxable year for which it is includible in gross income under section
451, relating to general rule for taxable year of inclusion, without
regard to section 455.
(d) Treatment of prepaid subscription income under an established
accounting method. Notwithstanding the provisions of section 455 and
Sec. 1.455-1, any taxpayer who, for taxable years beginning before
January 1, 1958, has reported prepaid subscription income for income tax
purposes under an established and consistent method or practice of
deferring such income may continue to report such income in accordance
with such method or practice for all subsequent taxable years to which
section 455 applies without making an election under section 455.
[T.D. 6591, 27 FR 1799, Feb. 27, 1962]
Sec. 1.455-6 Time and manner of making election.
(a) Election without consent. (1) A taxpayer may, without consent,
elect to treat prepaid subscription income of a trade or business under
section 455 for the first taxable year--
(i) Which begins after December 31, 1957, and
(ii) In which there is received prepaid subscription income from the
trade or business for which the election is made. Such an election shall
be made
[[Page 150]]
not later than the time prescribed by law for filing the income tax
return for such year (including extensions thereof), and shall be made
by means of a statement attached to such return.
(2) The statement shall indicate that the taxpayer is electing to
apply the provisions of section 455 to his trade or business, and shall
contain the following information:
(i) The name and a description of the taxpayer's trade or business
to which the election is to apply;
(ii) The method of accounting used in such trade or business;
(iii) The total amount of prepaid subscription income from such
trade or business for the taxable year;
(iv) The period or periods over which the liability of the taxpayer
to furnish or deliver a newspaper, magazine, or other periodical
extends;
(v) The amount of prepaid subscription income applicable to each
such period; and
(vi) A description of the method used in allocating the prepaid
subscription income to each such period.
In any case in which prepaid subscription income is received from more
than one trade or business, the statement shall set forth the required
information with respect to each trade or business subject to the
election.
(3) See paragraph (c) of this section for additional information
required to be submitted with the statement if the taxpayer also elects
to include in gross income for the taxable year of receipt the entire
amount of prepaid subscription income attributable to a liability which
is to end within 12 months after the date of receipt.
(b) Election with consent. A taxpayer may, with the consent of the
Commissioner, elect at any time to apply the provisions of section 455
to any trade or business in which it receives prepaid subscription
income. The request for such consent shall be in writing, signed by the
taxpayer or its authorized representative, and shall be addressed to the
Commissioner of Internal Revenue, Attention: T:R:C, Washington, D.C.
20224. The request must be filed on or before the later of the following
dates:
(1) 90 days after the beginning of the first taxable year to which
the election is to apply or
(2) May 28, 1962, and must contain the information described in
paragraph (a)(2) of this section.
See paragraph (c) of this section for additional information required to
be submitted with the request if the taxpayer also elects to include in
gross income for the taxable year of receipt the entire amount of
prepaid subscription income attributable to a liability which is to end
within 12 months after the date of receipt.
(c) ``Within 12 months'' election. (1) A taxpayer who elects to
apply the provisions of section 455 to any trade or business may also
elect to include in gross income for the taxable year of receipt (as
described in section 455(d)(3) and paragraph (c) of Sec. 1.455-5) the
entire amount of any prepaid subscription income from such trade or
business if the liability from which it arose is to end within 12 months
after the date of receipt. Any such election is binding for the first
taxable year for which it is effective and for all subsequent taxable
years, unless the taxpayer secures permission from the Commissioner to
treat such income differently. Application to revoke or change a
``within 12 months'' election shall be made in accordance with the
provisions of section 446(e) and the regulations thereunder.
(2) The ``within 12 months'' election shall be made by including in
the statement required by paragraph (a) of this section or the request
described in paragraph (b) of this section, whichever is applicable, a
declaration that the taxpayer elects to include such income in gross
income in the taxable year of receipt, and the amount of such income. If
the taxpayer is engaged in more than one trade or business for which the
election under section 455 is made, it must include, in such statement
or request, a declaration for each trade or business for which it makes
the ``within 12 months'' election. See also paragraph (e) of Sec.
1.455-2.
(3) If the taxpayer does not make the ``within 12 months'' election
for its trade or business at the time prescribed for making the election
to include prepaid subscription income in gross income for the taxable
years during which its liability to furnish or deliver a newspaper,
magazine, or other
[[Page 151]]
periodical exists for such trade or business, but later wishes to make
such election, it must apply for permission from the Commissioner. Such
application shall be made in accordance with the provisions of section
446(e) and the regulations thereunder.
[T.D. 6591, 27 FR 1799, Feb. 27, 1962]
Sec. 1.456-1 Treatment of prepaid dues income.
Effective for taxable years beginning after December 31, 1960, a
taxpayer which is a membership organization (as described in paragraph
(c) of Sec. 1.456-5) and which receives prepaid dues income as
described in paragraph (a) of Sec. 1.456-5 in connection with its trade
or business of rendering services or making available membership
privileges may elect under section 456 to include such income in gross
income ratably over the taxable years during which its liability (as
described in paragraph (b) of Sec. 1.456-5) to render such services or
extend such privileges exists, if such liability does not extend over a
period of time in excess of 36 months. If the taxpayer does not elect to
treat prepaid dues income under section 456, or if such income may not
be reported under section 456, as for example, where the income relates
to a liability to render services or make available membership
privileges which extends beyond 36 months, then such income is
includible in gross income for the taxable year in which it is received
(as described in paragraph (d) of Sec. 1.456-5).
[T.D. 6937, 32 FR 16394, Nov. 30, 1967]
Sec. 1.456-2 Scope of election under section 456.
(a) An election made under section 456 and Sec. 1.456-6, shall be
applicable to all prepaid dues income received in connection with the
trade or business for which the election is made. However, the taxpayer
may further elect to include in gross income for the taxable year of
receipt the entire amount of any prepaid dues income attributable to a
liability extending beyond the close of the taxable year but ending
within 12 months after the date of receipt, hereinafter referred to as
the ``within 12 months'' election.
(b) If the taxpayer is engaged in more than one trade or business in
connection with which prepaid dues income is received, a separate
election may be made under section 456 with respect to each such trade
or business. In addition, a taxpayer may make a separate ``within 12
months'' election for each separate trade or business for which it has
made an election under section 456.
(c) A section 456 election and a ``within 12 months'' election shall
be binding for the first taxable year for which the election is made and
for all subsequent taxable years, unless the taxpayer secures the
consent of the Commissioner to the revocation of either election. In
order to secure the Commissioner's consent to the revocation of the
section 456 election or the ``within 12 months'' election, an
application must be filed with the Commissioner in accordance with
section 446(e) and the regulations thereunder. However, an application
for consent to revoke the section 456 election or the ``within 12
months'' election in the case of all taxable years which end before
November 30, 1967 must be filed on or before February 28, 1968. For
purposes of Subtitle A of the Code, the computation of taxable income
under an election made under section 456 or under the ``within 12
months'' election shall be treated as a method of accounting. For
adjustments required by changes in method of accounting, see section 481
and the regulations thereunder.
(d) Except as provided in section 456(d) and Sec. 1.456-7, an
election made under section 456 shall not apply to any prepaid dues
income received before the first taxable year to which the election
applies. For example, Corporation X, a membership organization which
files its income tax returns on a calendar year basis, customarily sells
3-year memberships, payable in advance. In 1961 it received $160,000 of
prepaid dues income for 3-year memberships beginning during 1961, and in
1962 it received $185,000 of prepaid dues income for 3-year memberships
beginning on January 1, 1962. In March 1962 it elected, with the consent
of the Commissioner, to report its prepaid dues income under the
provisions of section 456 for the year 1962 and subsequent
[[Page 152]]
taxable years. The $160,000 received in 1961 from prepaid dues must be
included in gross income in full in that year, and except as provided in
section 456(d) and Sec. 1.456-7, no part of such income shall be
allocated to the taxable years 1962, 1963, and 1964 during which X was
under a liability to make available its membership privileges. The
$185,000 received in 1962 from prepaid dues income shall be allocated to
the years 1962, 1963, and 1964.
(e) No election may be made under section 456 with respect to a
trade or business if, in computing taxable income, the cash receipts and
disbursements method (or a hybrid thereof) of accounting is used with
respect to such trade or business, unless the combination of the section
456 election and the taxpayer's hybrid method of accounting does not
result in a material distortion of income.
[T.D. 6937, 32 FR 16394, Nov. 30, 1967; 32 FR 17479, Dec. 6, 1967]
Sec. 1.456-3 Method of allocation.
(a) Prepaid dues income for which an election has been made under
section 456 shall be included in gross income over the period of time
during which the liability to render services or make available
membership privileges exists. The liability to render the services or
make available the membership privileges shall be deemed to exist
ratably over the period of time such services are required to be
rendered, or such membership privileges are required to be made
available. Thus, the prepaid dues income shall be included in gross
income ratably over the period of the membership contract. For example,
Corporation X, a membership organization, which files its income tax
returns on a calendar year basis, elects, for its taxable year beginning
January 1, 1961, to report its prepaid dues income in accordance with
the provisions of section 456. On March 31, 1961, it sells a 2-year
membership for $48 payable in advance, the membership to extend from May
1, 1961, to April 30, 1963. X shall include in its gross income for the
taxable year 1961 \8/24\ of the $48, or $16, and for the taxable year
1962 \12/24\ of the $48, or $24, and for the taxable year 1963 \4/24\ of
the $48, or $8.
(b) For purposes of determining the period or periods over which the
liability of the taxpayer exists, and for purposes of allocating prepaid
dues income to such periods, the taxpayer may aggregate similar
transactions during the taxable year in any reasonable manner, provided
the method of aggregation and allocation is consistently followed.
[T.D. 6937, 32 FR 16395, Nov. 30, 1967]
Sec. 1.456-4 Cessation of liability or existence.
(a) If a taxpayer has elected to apply the provisions of section 456
to a trade or business in connection with which prepaid dues income is
received, and if the taxpayer's liability to render services or make
available membership privileges ends for any reason, as for example,
because of the cancellation of a membership then so much of the prepaid
dues income attributable to such liability as was not includible in the
taxpayer's gross income under section 456 for preceding taxable years
shall be included in gross income for the taxable year in which such
liability ends. This paragraph shall not apply to amounts includible in
gross income under Sec. 1.456-7.
(b) If a taxpayer which has elected to apply the provisions of
section 456 ceases to exist, then the prepaid dues income which was not
includible in gross income under section 456 for preceding taxable years
shall be included in the taxpayer's gross income for the taxable year in
which such cessation of existence occurs. This paragraph shall not apply
to amounts includible in gross income under Sec. 1.456-7.
(c) If a taxpayer is a party to a transaction to which section
381(a) applies and the taxpayer's method of accounting with respect to
prepaid dues income is used by the acquiring corporation under the
provisions of section 381(c)(4), then neither the liability nor the
existence of the taxpayer shall be deemed to have ended or ceased. In
such cases see section 381(c)(4) and the regulations thereunder for the
treatment of the portion of prepaid dues income which was not included
in gross income under section 456 for preceding taxable years.
[T.D. 6937, 32 FR 16395, Nov. 30, 1967]
[[Page 153]]
Sec. 1.456-5 Definitions and other rules.
(a) Prepaid dues income. (1) The term ``prepaid dues income'' means
any amount for membership dues includible in gross income which is
received by a membership organization in connection with, and is
directly attributable to, a liability of the taxpayer to render services
or make available membership privileges over a period of time which
extends beyond the close of the taxable year in which such amount is
received.
(2) For purposes of section 456, prepaid dues income does not
include amounts received by a taxpayer in connection with sales of
memberships on a prepaid basis where the taxpayer does not have the
liability to furnish the services or make available the membership
privileges. For example, where a taxpayer has a contract with several
membership organizations to sell memberships in such organizations and
retains a portion of the amounts received from the sale of such
memberships and remits the balance to the membership organizations, the
amounts retained by such taxpayer represent commissions and do not
constitute prepaid dues income for purposes of section 456.
(b) Liability. The term ``liability'' means a liability of the
taxpayer to render services or make available membership privileges over
a period of time which does not exceed 36 months. Thus, if during the
taxable year a taxpayer sells memberships for more than 36 months and
also memberships for 36 months or less, section 456 does not apply to
the income from the sale of memberships for more than 36 months. For the
purpose of determining the duration of a liability, a bona fide renewal
of a membership shall not be considered to be a part of the existing
membership.
(c) Membership organization. (1) The term ``membership
organization'' means a corporation, association, federation, or other
similar organization meeting the following requirements:
(i) It is organized without capital stock of any kind.
(ii) Its charter, bylaws, or other written agreement or contract
expressly prohibits the distribution of any part of the net earnings
directly or indirectly, in money, property, or services, to any member,
and
(iii) No part of the net earnings of which is in fact distributed to
any member either directly or indirectly, in money, property, or
services.
(2) For purposes of this paragraph an increase in services or
reduction in dues to all members shall generally not be considered
distributions of net earnings.
(3) If a corporation, association, federation, or other similar
organization subsequent to the time it elects to report its prepaid dues
income in accordance with the provisions of section 456, (i) issues any
kind of capital stock either to any member or nonmember, (ii) amends its
charter, bylaws, or other written agreement or contract to permit
distributions of its net earnings to any member or, (iii) in fact,
distributes any part of its net earnings either in money, property, or
services to any member, then immediately after such event the
organization shall not be considered a membership organization within
the meaning of section 456(e)(3).
(d) Receipt of prepaid dues income. For purposes of section 456,
prepaid dues income shall be treated as received during the taxable year
for which it is includible in gross income under section 451, relating
to the general rule for taxable year of inclusion, without regard to
section 456.
[T.D. 6937, 32 FR 16395, Nov. 30, 1967]
Sec. 1.456-6 Time and manner of making election.
(a) Election without consent. A taxpayer may make an election under
section 456 without the consent of the Commissioner for the first
taxable year beginning after December 31, 1960, in which it receives
prepaid dues income in the trade or business for which such election is
made. The election must be made not later than the time prescribed by
law for filing the income tax return for such year (including extensions
thereof). The election must be made by means of a statement attached to
such return. In addition, there should be attached a copy of a typical
membership contract used by the organization and a copy of its charter,
bylaws, or other written agreement or contract of organization or
association. The statement shall indicate that the taxpayer is electing
to apply
[[Page 154]]
the provisions of section 456 to the trade or business, and shall
contain the following information:
(1) The taxpayer's name and a description of the trade or business
to which the election is to apply.
(2) The method of accounting used for prepaid dues income in the
trade or business during the first taxable year for which the election
is to be effective and during each of 3 preceding taxable years, and if
there was a change in the method of accounting for prepaid dues income
during such 3-year period, a detailed explanation of such change
including the adjustments necessary to prevent duplications or omissions
of income.
(3) Whether any type of deferral method for prepaid dues income has
been used during any of the 3 taxable years preceding the first taxable
year for which the election is effective. Where any type of such
deferral method has been used during this period, an explanation of the
method and a schedule showing the amounts received in each such year and
the amounts deferred to each succeeding year.
(4) A schedule with appropriate explanations showing:
(i) The total amount of prepaid dues income received in the trade or
business in the first taxable year for which the election is effective
and the amount of such income to be included in each taxable year in
accordance with the election,
(ii) The total amount, if any, of prepayments of dues received in
the first taxable year for which the election is effective which are
directly attributable to a liability of the taxpayer to render services
or make available membership privileges over a period of time in excess
of 36 months, and
(iii) The total amount, if any, of prepaid dues income received in
the trade or business in--
(a) The taxable year preceding the first taxable year for which the
election is effective if all memberships sold by the taxpayer are for
periods of 1 year or less,
(b) Each of the 2 taxable years preceding the first taxable year for
which the election is effective if any memberships are sold for periods
in excess of 1 year but none are sold for periods in excess of 2 years,
or
(c) Each of the 3 taxable years preceding the first taxable year for
which the election is effective if any memberships are sold for periods
in excess of 2 years.
In each case there shall be set forth the amount of such income which
would have been includible in each taxable year had the election been
effective for the years for which the information is required.
In any case in which prepaid dues income is received from more than one
trade or business, the statement shall set forth separately the required
information with respect to each trade or business for which the
election is made. See paragraph (c) of this section for additional
information required to be submitted with the statement if the taxpayer
also elects to include in gross income for the taxable year of receipt
the entire amount of prepaid dues income attributable to a liability
which is to end within 12 months after the date of receipt.
(b) Election with consent. A taxpayer may elect with the consent of
the Commissioner, to apply the provisions of section 456 to any trade or
business in which it receives prepaid dues income. The request for such
consent shall be in writing, signed by the taxpayer or its authorized
representative, and shall be addressed to the Commissioner of Internal
Revenue, Washington, D.C. 20224. The request must be filed on or before
the later of the following dates:
(1) 90 days after the beginning of the first taxable year to which
the election is to apply, or
(2) February 28, 1968 and should contain the information described
in paragraph (a) of this section.
See paragraph (c) of this section for additional information required to
be submitted with the request if the taxpayer also elects to include in
gross income for the taxable year of receipt the entire amount of
prepaid dues income attributable to a liability which is to end within
12 months after the date of receipt.
(c) ``Within 12 months'' election. (1) The ``within 12 months''
election shall be made by including in the statement
[[Page 155]]
required by paragraph (a) of this section or the request described in
paragraph (b) of this section, whichever is applicable, a declaration
that the taxpayer elects to include such income in gross income in the
taxable year of receipt, and the amount of such income for each taxable
year to which the election is to apply which has ended prior to the time
such statement or request is filed. If the taxpayer is engaged in more
than one trade or business for which the election under section 456 is
made, it must include, in such statement or request, a declaration for
each trade or business for which it wishes to make the ``within 12
months'' election.
(2) If the taxpayer does not make the ``within 12 months'' election
for a trade or business at the time it makes the election under
paragraph (a) or (b) of this section, but later wishes to make such
election, it must apply for permission from the Commissioner. Such
application shall be made in accordance with the provisions of section
446(e).
[T.D. 6937, 32 FR 16395, Nov. 30, 1967; 32 FR 17479, Dec. 6, 1967]
Sec. 1.456-7 Transitional rule.
(a) Under section 456(d)(1), a taxpayer making an election under
section 456 shall include in its gross income for the first taxable year
to which the election applies and for each of the 2 succeeding taxable
years not only that portion of prepaid dues income which is includible
in gross income for each such taxable year under section 456(a), but
also an additional amount equal to that portion of the total prepaid
dues income received in each of the 3 taxable years preceding the first
taxable year to which the election applies which would have been
includible in gross income for such first taxable year and such 2
succeeding taxable years had the election under section 456 been
effective during such 3 preceding taxable years. In computing such
additional amounts--
(1) In the case of taxpayers who did not include in gross income for
the taxable year preceding the first taxable year for which the election
is effective, that portion of the prepaid dues income received in such
year attributable to a liability which is to end within 12 months after
the date of receipt, no effect shall be given to a ``within 12 months''
election made under paragraph (c) of Sec. 1.456-6, and
(2) There shall be taken into account only prepaid dues income
arising from a trade or business with respect to which an election is
made under section 456 and Sec. 1.456-6.
Section 481 and the regulations thereunder shall have no application to
the additional amounts includible in gross income under section 456(d)
and this section, but section 481 and the regulations thereunder shall
apply to prevent other amounts from being duplicated or omitted.
(b) A taxpayer who makes an election with respect to prepaid dues
income, and who includes in gross income for any taxable year to which
the election applies an additional amount computed under section
456(d)(1) and paragraph (a) of this section, shall be permitted under
section 456(d)(2) to deduct for such taxable year and for each of the 4
succeeding taxable years an amount equal to one-fifth of such additional
amount, but only to the extent that such additional amount was also
included in the taxpayer's gross income for any of the 3 taxable years
preceding the first taxable year to which such election applies. The
taxpayer shall maintain books and records in sufficient detail to enable
the district director to determine upon audit that the additional
amounts were included in the taxpayer's gross income for any of the 3
taxable years preceding such first taxable year. If, however, the
taxpayer ceases to exist, as described in paragraph (b) of Sec. 1.456-
4, and there is included in gross income, under such paragraph, of the
year of cessation the entire portion of prepaid dues income not
previously includible in gross income under section 456 for preceding
taxable years (other than for amounts received prior to the first year
for which an election was made), all the amounts not previously deducted
under this paragraph shall be permitted as a deduction in the year of
cessation of existence.
(c) The provisions of this section may be illustrated by the
following example:
Example. (1) Assume that X Corporation, a membership organization
qualified to make
[[Page 156]]
the election under section 456, elects to report its prepaid dues income
in accordance with the provisions of section 456 for its taxable year
ending December 31, 1961. Assume further that X Corporation receives in
the middle of each taxable year $3,000 of prepaid dues income in
connection with a liability to render services over a 3-year period
beginning with the date of receipt. Under section 456(a), X Corporation
will report income received in 1961 and subsequent years as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total
Year of receipt receipts 1961 1962 1963 1964 1965 1966 1967 1968
--------------------------------------------------------------------------------------------------------------------------------------------------------
1961.......................................................... $3,000 $500 $1,000 $1,000 $500 ........ ........ ........ ........
1962.......................................................... 3,000 ........ 500 1,000 1,000 $500 ........ ........ ........
1963.......................................................... 3,000 ........ ........ 500 1,000 1,000 $500 ........ ........
1964.......................................................... 3,000 ........ ........ ........ 500 1,000 1,000 $500 ........
1965.......................................................... 3,000 ........ ........ ........ ........ 500 1,000 1,000 $500
1966.......................................................... 3,000 ........ ........ ........ ........ ........ 500 1,000 1,000
1967.......................................................... 3,000 ........ ........ ........ ........ ........ ........ 500 1,000
1968.......................................................... 3,000 ........ ........ ........ ........ ........ ........ ........ 500
--------------------------------------------------------------------------------------------------------------------------------------------------------
Total reportable under section 456(a)................................. 500 1,500 2,500 3,000 3,000 3,000 3,000 3,000
--------------------------------------------------------------------------------------------------------------------------------------------------------
(2) Under section 456(d) (1), X Corporation must include in its
gross income for the first taxable year to which the election applies
and for each of the 2 succeeding taxable years, the amounts which would
have been included in those years had the election been effective 3
years earlier. If the election had been effective in 1958, the following
amounts received in 1958, 1959, and 1960 would have been reported in
1961 and subsequent years:
----------------------------------------------------------------------------------------------------------------
Years of including additional
Amount amounts
Year of receipt received -----------------------------------
1961 1962 1963
----------------------------------------------------------------------------------------------------------------
1958............................................................ $3,000 $500 .......... ..........
1959............................................................ 3,000 1,000 $500 ..........
1960............................................................ 3,000 1,000 1,000 $500
----------------------------------------------------------------------------------------------------------------
Total additional amounts to be included under section 456(d)(1) 2,500 1,500 500
----------------------------------------------------------------------------------------------------------------
(3) Having included the additional amounts as required by section
456(d)(1), and assuming such amounts were actually included in gross
income in the 3 taxable years preceding the first taxable year for which
the election is effective, X Corporation is entitled to deduct under
section 456(d)(2) in the year of inclusion and in each of the succeeding
4 years an amount equal to one-fifth of the amounts included, as
follows:
----------------------------------------------------------------------------------------------------------------
Years of deduction
Year of inclusion Amount --------------------------------------------------------------
1961 1962 1963 1964 1965 1966 1967
----------------------------------------------------------------------------------------------------------------
1961................................... $2,500 $500 $500 $500 $500 $500 ....... .......
1962................................... 1,500 ....... 300 300 300 300 $300 .......
1963................................... 500 ....... ....... 100 100 100 100 $10
-----------
Total amount deductible under section 500 800 900 900 900 400 100
456(d)(2)...........................
----------------------------------------------------------------------------------------------------------------
(4) The net result of the inclusions under section 456(d)(1) and the
deductions under section 456(d)(2) may be summarized as follows:
----------------------------------------------------------------------------------------------------------------
1961 1962 1963 1964 1965 1966 1967 1968
----------------------------------------------------------------------------------------------------------------
Amount includible under section 456(a).. $500 $1,500 $2,500 $3,000 $3,000 $3,000 $3,000 $3,000
Amount includible under section 2,500 1,500 500 ....... ....... ....... ....... .......
456(d)(1)..............................
-----------------------------------------------------------------------
Total................................ 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000
Amount deductible under section 500 800 900 900 900 400 100 .......
456(d)(2)..............................
-----------------------------------------------------------------------
Net amount reportable under section 2,500 2,200 2,100 2,100 2,100 2,600 2,900 3,000
456..................................
----------------------------------------------------------------------------------------------------------------
[[Page 157]]
[T.D. 6937, 32 FR 16396, Nov. 30, 1967]
Sec. 1.457-1 General overviews of section 457.
Section 457 provides rules for nonqualified deferred compensation
plans established by eligible employers as defined under Sec. 1.457-
2(d). Eligible employers can establish either deferred compensation
plans that are eligible plans and that meet the requirements of section
457(b) and Sec. Sec. 1.457-3 through 1.457-10, or deferred compensation
plans or arrangements that do not meet the requirements of section
457(b) and Sec. Sec. 1.457-3 through 1.457-10 and that are subject to
tax treatment under section 457(f) and Sec. 1.457-11.
[T.D. 9075, 68 FR 41234, July 11, 2003]
Sec. 1.457-2 Definitions.
This section sets forth the definitions that are used under
Sec. Sec. 1.457-1 through 1.457-11.
(a) Amount(s) deferred. Amount(s) deferred means the total annual
deferrals under an eligible plan in the current and prior years,
adjusted for gain or loss. Except as provided at Sec. Sec. 1.457-
4(c)(1)(iii) and 1.457-6(a), amount(s) deferred includes any rollover
amount held by an eligible plan as provided under Sec. 1.457-10(e).
(b) Annual deferral(s)--(1) Annual deferral(s) means, with respect
to a taxable year, the amount of compensation deferred under an eligible
plan, whether by salary reduction or by nonelective employer
contribution. The amount of compensation deferred under an eligible plan
is taken into account as an annual deferral in the taxable year of the
participant in which deferred, or, if later, the year in which the
amount of compensation deferred is no longer subject to a substantial
risk of forfeiture.
(2) If the amount of compensation deferred under the plan during a
taxable year is not subject to a substantial risk of forfeiture, the
amount taken into account as an annual deferral is not adjusted to
reflect gain or loss allocable to the compensation deferred. If,
however, the amount of compensation deferred under the plan during the
taxable year is subject to a substantial risk of forfeiture, the amount
of compensation deferred that is taken into account as an annual
deferral in the taxable year in which the substantial risk of forfeiture
lapses must be adjusted to reflect gain or loss allocable to the
compensation deferred until the substantial risk of forfeiture lapses.
(3) If the eligible plan is a defined benefit plan within the
meaning of section 414(j), the annual deferral for a taxable year is the
present value of the increase during the taxable year of the
participant's accrued benefit that is not subject to a substantial risk
of forfeiture (disregarding any such increase attributable to prior
annual deferrals). For this purpose, present value must be determined
using actuarial assumptions and methods that are reasonable (both
individually and in the aggregate), as determined by the Commissioner.
(4) For purposes solely of applying Sec. 1.457-4 to determine the
maximum amount of the annual deferral for a participant for a taxable
year under an eligible plan, the maximum amount is reduced by the amount
of any deferral for the participant under a plan described at paragraph
(k)(4)(i) of this section (relating to certain plans in existence before
January 1, 1987) as if that deferral were an annual deferral under
another eligible plan of the employer.
(c) Beneficiary. Beneficiary means a person who is entitled to
benefits in respect of a participant following the participant's death
or an alternate payee as described in Sec. 1.457-10(c).
(d) Catch-up. Catch-up amount or catch-up limitation for a
participant for a taxable year means the annual deferral permitted under
section 414(v) (as described in Sec. 1.457-4(c)(2)) or section
457(b)(3) (as described in Sec. 1.457-4(c)(3)) to the extent the amount
of the annual deferral for the participant for the taxable year is
permitted to exceed the plan ceiling applicable under section 457(b)(2)
(as described in Sec. 1.457-4(c)(1)).
(e) Eligible employer. Eligible employer means an entity that is a
State that
[[Page 158]]
establishes a plan or a tax-exempt entity that establishes a plan. The
performance of services as an independent contractor for a State or
local government or a tax-exempt entity is treated as the performance of
services for an eligible employer. The term eligible employer does not
include a church as defined in section 3121(w)(3)(A), a qualified
church-controlled organization as defined in section 3121(w)(3)(B), or
the Federal government or any agency or instrumentality thereof. Thus,
for example, a nursing home which is associated with a church, but which
is not itself a church (as defined in section 3121(w)(3)(A)) or a
qualified church-controlled organization as defined in section
3121(w)(3)(B)), would be an eligible employer if it is a tax-exempt
entity as defined in paragraph (m) of this section.
(f) Eligible plan. An eligible plan is a plan that meets the
requirements of Sec. Sec. 1.457-3 through 1.457-10 that is established
and maintained by an eligible employer. An eligible governmental plan is
an eligible plan that is established and maintained by an eligible
employer as defined in paragraph (l) of this section. An arrangement
does not fail to constitute a single eligible governmental plan merely
because the arrangement is funded through more than one trustee,
custodian, or insurance carrier. An eligible plan of a tax-exempt entity
is an eligible plan that is established and maintained by an eligible
employer as defined in paragraph (m) of this section.
(g) Includible compensation. Includible compensation of a
participant means, with respect to a taxable year, the participant's
compensation, as defined in section 415(c)(3), for services performed
for the eligible employer. The amount of includible compensation is
determined without regard to any community property laws.
(h) Ineligible plan. Ineligible plan means a plan established and
maintained by an eligible employer that is not maintained in accordance
with Sec. Sec. 1.457-3 through 1.457-10. A plan that is not established
by an eligible employer as defined in paragraph (e) of this section is
neither an eligible nor an ineligible plan.
(i) Nonelective employer contribution. A nonelective employer
contribution is a contribution made by an eligible employer for the
participant with respect to which the participant does not have the
choice to receive the contribution in cash or property. Solely for
purposes of section 457 and Sec. Sec. 1.457-2 through 1.457-11, the
term nonelective employer contribution includes employer contributions
that would be described in section 401(m) if they were contributions to
a qualified plan.
(j) Participant. Participant in an eligible plan means an individual
who is currently deferring compensation, or who has previously deferred
compensation under the plan by salary reduction or by nonelective
employer contribution and who has not received a distribution of his or
her entire benefit under the eligible plan. Only individuals who perform
services for the eligible employer, either as an employee or as an
independent contractor, may defer compensation under the eligible plan.
(k) Plan. Plan includes any agreement or arrangement between an
eligible employer and a participant or participants (including an
individual employment agreement) under which the payment of compensation
is deferred (whether by salary reduction or by nonelective employer
contribution). The following types of plans are not treated as
agreements or arrangements under which compensation is deferred: a bona
fide vacation leave, sick leave, compensatory time, severance pay,
disability pay, or death benefit plan described in section
457(e)(11)(A)(i) and any plan paying length of service awards to bona
fide volunteers (and their beneficiaries) on account of qualified
services performed by such volunteers as described in section
457(e)(11)(A)(ii). Further, the term plan does not include any of the
following (and section 457 and Sec. Sec. 1.457-2 through 1.457-11 do
not apply to any of the following)--
(1) Any nonelective deferred compensation under which all
individuals (other than those who have not satisfied any applicable
initial service requirement) with the same relationship with the
eligible employer are covered under the same plan with no individual
[[Page 159]]
variations or options under the plan as described in section 457(e)(12),
but only to the extent the compensation is attributable to services
performed as an independent contractor;
(2) An agreement or arrangement described in Sec. 1.457-11(b);
(3) Any plan satisfying the conditions in section 1107(c)(4) of the
Tax Reform Act of 1986 (100 Stat. 2494) (TRA '86) (relating to certain
plans for State judges); and
(4) Any of the following plans or arrangements (to which specific
transitional statutory exclusions apply)--
(i) A plan or arrangement of a tax-exempt entity in existence prior
to January 1, 1987, if the conditions of section 1107(c)(3)(B) of the
TRA '86, as amended by section 1011(e)(6) of the Technical and
Miscellaneous Revenue Act of 1988 (102 Stat. 3700) (TAMRA), are
satisfied (see Sec. 1.457-2(b)(4) for a special rule regarding such
plan);
(ii) A collectively bargained nonelective deferred compensation plan
in effect on December 31, 1987, if the conditions of section 6064(d)(2)
of TAMRA are satisfied;
(iii) Amounts described in section 6064(d)(3) of TAMRA (relating to
certain nonelective deferred compensation arrangements in effect before
1989); and
(iv) Any plan satisfying the conditions in section 1107(c)(4) or (5)
of TRA '86 (relating to certain plans for certain individuals with
respect to which the Service issued guidance before 1977).
(l) State. State means a State (treating the District of Columbia as
a State as provided under section 7701(a)(10)), a political subdivision
of a State, and any agency or instrumentality of a State.
(m) Tax-exempt entity. Tax-exempt entity includes any organization
exempt from tax under subtitle A of the Internal Revenue Code, except
that a governmental unit (including an international governmental
organization) is not a tax-exempt entity.
(n) Trust. Trust means a trust described under section 457(g) and
Sec. 1.457-8. Custodial accounts and contracts described in section
401(f) are treated as trusts under the rules described in Sec. 1.457-
8(a)(2).
[T.D. 9075, 68 FR 41234, July 11, 2003; 68 FR 51446, Aug. 27, 2003]
Sec. 1.457-3 General introduction to eligible plans.
(a) Compliance in form and operation. An eligible plan is a written
plan established and maintained by an eligible employer that is
maintained, in both form and operation, in accordance with the
requirements of Sec. Sec. 1.457-4 through 1.457-10. An eligible plan
must contain all the material terms and conditions for benefits under
the plan. An eligible plan may contain certain optional features not
required for plan eligibility under section 457(b), such as
distributions for unforeseeable emergencies, loans, plan-to-plan
transfers, additional deferral elections, acceptance of rollovers to the
plan, and distributions of smaller accounts to eligible participants.
However, except as otherwise specifically provided in Sec. Sec. 1.457-4
through 1.457-10, if an eligible plan contains any optional provisions,
the optional provisions must meet, in both form and operation, the
relevant requirements under section 457 and Sec. Sec. 1.457-2 through
1.457-10.
(b) Treatment as single plan. In any case in which multiple plans
are used to avoid or evade the requirements of Sec. Sec. 1.457-4
through 1.457-10, the Commissioner may apply the rules under Sec. Sec.
1.457-4 through 1.457-10 as if the plans were a single plan. See also
Sec. 1.457-4(c)(3)(v) (requiring an eligible employer to have no more
than one normal retirement age for each participant under all of the
eligible plans it sponsors), the second sentence of Sec. 1.457-4(e)(2)
(treating deferrals under all eligible plans under which an individual
participates by virtue of his or her relationship with a single employer
as a single plan for purposes of determining excess deferrals), and
Sec. 1.457-5 (combining annual deferrals under all eligible plans).
[T.D. 9075, 68 FR 41234, July 11, 2003]
Sec. 1.457-4 Annual deferrals, deferral limitations, and deferral agreements
under eligible plans.
(a) Taxation of annual deferrals. Annual deferrals that satisfy the
requirements of paragraphs (b) and (c) of this section are excluded from
the gross income of a participant in the year deferred or contributed
and are not includible in gross income until paid to
[[Page 160]]
the participant in the case of an eligible governmental plan, or until
paid or otherwise made available to the participant in the case of an
eligible plan of a tax-exempt entity. See Sec. 1.457-7.
(b) Agreement for deferral. In order to be an eligible plan, the
plan must provide that compensation may be deferred for any calendar
month by salary reduction only if an agreement providing for the
deferral has been entered into before the first day of the month in
which the compensation is paid or made available. A new employee may
defer compensation payable in the calendar month during which the
participant first becomes an employee if an agreement providing for the
deferral is entered into on or before the first day on which the
participant performs services for the eligible employer. An eligible
plan may provide that if a participant enters into an agreement
providing for deferral by salary reduction under the plan, the agreement
will remain in effect until the participant revokes or alters the terms
of the agreement. Nonelective employer contributions are treated as
being made under an agreement entered into before the first day of the
calendar month.
(c) Maximum deferral limitations--(1) Basic annual limitation. (i)
Except as described in paragraphs (c)(2) and (3) of this section, in
order to be an eligible plan, the plan must provide that the annual
deferral amount for a taxable year (the plan ceiling) may not exceed the
lesser of--
(A) The applicable annual dollar amount specified in section
457(e)(15): $11,000 for 2002; $12,000 for 2003; $13,000 for 2004;
$14,000 for 2005; and $15,000 for 2006 and thereafter. After 2006, the
$15,000 amount is adjusted for cost-of-living in the manner described in
paragraph (c)(4) of this section; or
(B) 100 percent of the participant's includible compensation for the
taxable year.
(ii) The amount of annual deferrals permitted by the 100 percent of
includible compensation limitation under paragraph (c)(1)(i)(B) of this
section is determined under section 457(e)(5) and Sec. 1.457-2(g).
(iii) For purposes of determining the plan ceiling under this
paragraph (c), the annual deferral amount does not include any rollover
amounts received by the eligible plan under Sec. 1.457-10(e).
(iv) The provisions of this paragraph (c)(1) are illustrated by the
following examples:
Example 1. (i) Facts. Participant A, who earns $14,000 a year,
enters into a salary reduction agreement in 2006 with A's eligible
employer and elects to defer $13,000 of A's compensation for that year.
A is not eligible for the catch-up described in paragraph (c)(2) or (3)
of this section, participates in no other retirement plan, and has no
other income exclusions taken into account in computing includible
compensation.
(ii) Conclusion. The annual deferral limit for A in 2006 is the
lesser of $15,000 or 100 percent of includible compensation, $14,000.
A's annual deferral of $13,000 is permitted under the plan because it is
not in excess of $14,000 and thus does not exceed 100 percent of A's
includible compensation.
Example 2. (i) Facts. Assume the same facts as in Example 1, except
that A's eligible employer provides an immediately vested, matching
employer contribution under the plan for participants who make salary
reduction deferrals under A's eligible plan. The matching contribution
is equal to 100 percent of elective contributions, but not in excess of
10 percent of compensation (in A's case, $1,400).
(ii) Conclusion. Participant A's annual deferral exceeds the
limitations of this paragraph (c)(1). A's maximum deferral limitation in
2006 is $14,000. A's salary reduction deferral of $13,000 combined with
A's eligible employer's nonelective employer contribution of $1,400
exceeds the basic annual limitation of this paragraph (c)(1) because A's
annual deferrals total $14,400. A has an excess deferral for the taxable
year of $400, the amount exceeding A's permitted annual deferral
limitation. The $400 excess deferral is treated as described in
paragraph (e) of this section.
Example 3. (i) Facts. Beginning in year 2002, Eligible Employer X
contributes $3,000 per year for five years to B's eligible plan account.
B's interest in the account vests in 2006. B has annual compensation of
$50,000 in each of the five years 2002 through 2006. B is 41 years old.
B is not eligible for the catch-up described in paragraph (c)(2) or (3)
of this section, participates in no other retirement plan, and has no
other income exclusions taken into account in computing includible
compensation. Adjusted for gain or loss, the value of B's benefit when
B's interest in the account vests in 2006 is $17,000.
(ii) Conclusion. Under this vesting schedule, $17,000 is taken into
account as an annual deferral in 2006. B's annual deferrals under the
plan are limited to a maximum of $15,000 in 2006. Thus, the aggregate of
the amounts deferred, $17,000, is in excess of B's maximum
[[Page 161]]
deferral limitation by $2,000. The $2,000 is treated as an excess
deferral described in paragraph (e) of this section.
(2) Age 50 catch-up--(i) In general. In accordance with section
414(v) and the regulations thereunder, an eligible governmental plan may
provide for catch-up contributions for a participant who is age 50 by
the end of the year, provided that such age 50 catch-up contributions do
not exceed the catch-up limit under section 414(v)(2) for the taxable
year. The maximum amount of age 50 catch-up contributions for a taxable
year under section 414(v) is as follows: $1,000 for 2002; $2,000 for
2003; $3,000 for 2004; $4,000 for 2005; and $5,000 for 2006 and
thereafter. After 2006, the $5,000 amount is adjusted for cost-of-
living. For additional guidance, see regulations under section 414(v).
(ii) Coordination with special section 457 catch-up. In accordance
with sections 414(v)(6)(C) and 457(e)(18), the age 50 catch-up described
in this paragraph (c)(2) does not apply for any taxable year for which a
higher limitation applies under the special section 457 catch-up under
paragraph (c)(3) of this section. Thus, for purposes of this paragraph
(c)(2)(ii) and paragraph (c)(3) of this section, the special section 457
catch-up under paragraph (c)(3) of this section applies for any taxable
year if and only if the plan ceiling taking into account paragraph
(c)(1) of this section and the special section 457 catch-up described in
paragraph (c)(3) of this section (and disregarding the age 50 catch-up
described in this paragraph (c)(2)) is larger than the plan ceiling
taking into account paragraph (c)(1) of this section and the age 50
catch-up described in this paragraph (c)(2) (and disregarding the
special section 457 catch-up described in paragraph (c)(3) of this
section). Thus, if a plan so provides, a participant who is eligible for
the age 50 catch-up for a year and for whom the year is also one of the
participant's last three taxable years ending before the participant
attains normal retirement age is eligible for the larger of--
(A) The plan ceiling under paragraph (c)(1) of this section and the
age 50 catch-up described in this paragraph (c)(2) (and disregarding the
special section 457 catch-up described in paragraph (c)(3) of this
section) or
(B) The plan ceiling under paragraph (c)(1) of this section and the
special section 457 catch-up described in paragraph (c)(3) of this
section (and disregarding the age 50 catch-up described in this
paragraph (c)(2)).
(iii) Examples. The provisions of this paragraph (c)(2) are
illustrated by the following examples:
Example 1. (i) Facts. Participant C, who is 55, is eligible to
participate in an eligible governmental plan in 2006. The plan provides
a normal retirement age of 65. The plan provides limitations on annual
deferrals up to the maximum permitted under paragraphs (c)(1) and (3) of
this section and the age 50 catch-up described in this paragraph (c)(2).
For 2006, C will receive compensation of $40,000 from the eligible
employer. C desires to defer the maximum amount possible in 2006. The
applicable basic dollar limit of paragraph (c)(1)(i)(A) of this section
is $15,000 for 2006 and the additional dollar amount permitted under the
age 50 catch-up is $5,000 for 2006.
(ii) Conclusion. C is eligible for the age 50 catch-up in 2006
because C is 55 in 2006. However, C is not eligible for the special
section 457 catch-up under paragraph (c)(3) of this section in 2006
because 2006 is not one of the last three taxable years ending before C
attains normal retirement age. Accordingly, the maximum that C may defer
for 2006 is $20,000.
Example 2. (i) Facts. The facts are the same as in Example 1, except
that, in 2006, C will attain age 62. The maximum amount that C can elect
under the special section 457 catch-up under paragraph (c)(3) of this
section is $2,000 for 2006.
(ii) Conclusion. The maximum that C may defer for 2006 is $20,000.
This is the sum of the basic plan ceiling under paragraph (c)(1) of this
section equal to $15,000 and the age 50 catch-up equal to $5,000. The
special section 457 catch-up under paragraph (c)(3) of this section is
not applicable since it provides a smaller plan ceiling.
Example 3. (i) Facts. The facts are the same as in Example 2, except
that the maximum additional amount that C can elect under the special
section 457 catch-up under paragraph (c)(3) of this section is $7,000
for 2006.
(ii) Conclusion. The maximum that C may defer for 2006 is $22,000.
This is the sum of the basic plan ceiling under paragraph (c)(1) of this
section equal to $15,000, plus the additional special section 457 catch-
up under paragraph (c)(3) of this section equal to $7,000. The
additional dollar amount permitted under the age 50 catch-up is not
applicable to C for 2006 because it provides a smaller plan ceiling.
[[Page 162]]
(3) Special section 457 catch-up--(i) In general. Except as provided
in paragraph (c)(2)(ii) of this section, an eligible plan may provide
that, for one or more of the participant's last three taxable years
ending before the participant attains normal retirement age, the plan
ceiling is an amount not in excess of the lesser of--
(A) Twice the dollar amount in effect under paragraph (c)(1)(i)(A)
of this section; or
(B) The underutilized limitation determined under paragraph
(c)(3)(ii) of this section.
(ii) Underutilized limitation. The underutilized amount determined
under this paragraph (c)(3)(ii) is the sum of--
(A) The plan ceiling established under paragraph (c)(1) of this
section for the taxable year; plus
(B) The plan ceiling established under paragraph (c)(1) of this
section (or under section 457(b)(2) for any year before the
applicability date of this section) for any prior taxable year or years,
less the amount of annual deferrals under the plan for such prior
taxable year or years (disregarding any annual deferrals under the plan
permitted under the age 50 catch-up under paragraph (c)(2) of this
section).
(iii) Determining underutilized limitation under paragraph
(c)(3)(ii)(B) of this section. A prior taxable year is taken into
account under paragraph (c)(3)(ii)(B) of this section only if it is a
year beginning after December 31, 1978, in which the participant was
eligible to participate in the plan, and in which compensation deferred
(if any) under the plan during the year was subject to a plan ceiling
established under paragraph (c)(1) of this section. This paragraph
(c)(3)(iii) is subject to the special rules in paragraph (c)(3)(iv) of
this section.
(iv) Special rules concerning application of the coordination limit
for years prior to 2002 for purposes of determining the underutilized
limitation--(A) General rule. For purposes of determining the
underutilized limitation for years prior to 2002, participants remain
subject to the rules in effect prior to the repeal of the coordination
limitation under section 457(c)(2). Thus, the applicable basic annual
limitation under paragraph (c)(1) of this section and the special
section 457 catch-up under this paragraph (c)(3) for years in effect
prior to 2002 are reduced, for purposes of determining a participant's
underutilized amount under a plan, by amounts excluded from the
participant's income for any prior taxable year by reason of a
nonelective employer contribution, salary reduction or elective
contribution under any other eligible section 457(b) plan, or a salary
reduction or elective contribution under any 401(k) qualified cash or
deferred arrangement, section 402(h)(1)(B) simplified employee pension
(SARSEP), section 403(b) annuity contract, and section 408(p) simple
retirement account, or under any plan for which a deduction is allowed
because of a contribution to an organization described in section
501(c)(18) (pre-2002 coordination plans). Similarly, in applying the
section 457(b)(2)(B) limitation for includible compensation for years
prior to 2002, the limitation is 33\1/3\ percent of the participant's
compensation includible in gross income.
(B) Coordination limitation applied to participant. For purposes of
determining the underutilized limitation for years prior to 2002, the
coordination limitation applies to pre-2002 coordination plans of all
employers for whom a participant has performed services, whether or not
those are plans of the participant's current eligible employer. Thus,
for purposes of determining the amount excluded from a participant's
gross income in any prior taxable year under paragraph (c)(3)(ii)(B) of
this section, the participant's annual deferrals under an eligible plan,
and salary reduction or elective deferrals under all other pre-2002
coordination plans, must be determined on an aggregate basis. To the
extent that the combined deferrals for years prior to 2002 exceeded the
maximum deferral limitations, the amount is treated as an excess
deferral under paragraph (e) of this section for those prior years.
(C) Special rule where no annual deferrals under the eligible plan.
A participant who, although eligible, did not defer any compensation
under the eligible plan in any year before 2002 is not subject to the
coordinated deferral limit, even though the participant may have
deferred compensation under one
[[Page 163]]
of the other pre-2002 coordination plans. An individual is treated as
not having deferred compensation under an eligible plan for a prior
taxable year if all annual deferrals under the plan are distributed in
accordance with paragraph (e) of this section. Thus, to the extent that
a participant participated solely in one or more of the other pre-2002
coordination plans during a prior taxable year (and not the eligible
plan), the participant is not subject to the coordinated limitation for
that prior taxable year. However, the participant is treated as having
deferred an amount in a prior taxable year, for purposes of determining
the underutilized limitation for that prior taxable year under this
paragraph (c)(3)(iv)(C), to the extent of the participant's aggregate
salary reduction contributions and elective deferrals under all pre-2002
coordination plans up to the maximum deferral limitations in effect
under section 457(b) for that prior taxable year. To the extent an
employer did not offer an eligible plan to an individual in a prior
given year, no underutilized limitation is available to the individual
for that prior year, even if the employee subsequently becomes eligible
to participate in an eligible plan of the employer.
(D) Examples. The provisions of this paragraph (c)(3)(iv) are
illustrated by the following examples:
Example 1. (i) Facts. In 2001 and in years prior to 2001,
Participant D earned $50,000 a year and was eligible to participate in
both an eligible plan and a section 401(k) plan. However, D had always
participated only in the section 401(k) plan and had always deferred the
maximum amount possible. For each year before 2002, the maximum amount
permitted under section 401(k) exceeded the limitation of paragraph
(c)(3)(i) of this section. In 2002, D is in the 3-year period prior to
D's attainment of the eligible plan's normal retirement age of 65, and D
now wants to participate in the eligible plan and make annual deferrals
of up to $30,000 under the plan's special section 457 catch-up
provisions.
(ii) Conclusion. Participant D is treated as having no underutilized
amount under paragraph (c)(3)(ii)(B) of this section for 2002 for
purposes of the catch-up limitation under section 457(b)(3) and
paragraph (c)(3) of this section because, in each of the years before
2002, D has deferred an amount equal to or in excess of the limitation
of paragraph (c)(3)(i) of this section under all of D's coordinated
plans.
Example 2. (i) Facts. Assume the same facts as in Example 1, except
that D only deferred $2,500 per year under the section 401(k) plan for
one year before 2002.
(ii) Conclusion. D is treated as having an underutilized amount
under paragraph (c)(3)(ii)(B) of this section for 2002 for purposes of
the special section 457 catch-up limitation. This is because D has
deferred an amount for prior years that is less than the limitation of
paragraph (c)(1)(i) of this section under all of D's coordinated plans.
Example 3. (i) Facts. Participant E, who earned $15,000 for 2000,
entered into a salary reduction agreement in 2000 with E's eligible
employer and elected to defer $3,000 for that year under E's eligible
plan. For 2000, E's eligible employer provided an immediately vested,
matching employer contribution under the plan for participants who make
salary reduction deferrals under E's eligible plan. The matching
contribution was equal to 67 percent of elective contributions, but not
in excess of 10 percent of compensation before salary reduction
deferrals (in E's case, $1,000). For 2000, E was not eligible for any
catch-up contribution, participated in no other retirement plan, and had
no other income exclusions taken into account in computing taxable
compensation.
(ii) Conclusion. Participant E's annual deferral equaled the maximum
limitation of section 457(b) for 2000. E's maximum deferral limitation
in 2000 was $4,000 because E's includible compensation was $12,000
($15,000 minus the deferral of $3,000) and the applicable limitation for
2000 was one third of the individual's includible compensation (one-
third of $12,000 equals $4,000). E's salary reduction deferral of $3,000
combined with E's eligible employer's matching contribution of $1,000
equals the limitation of section 457(b) for 2000 because E's annual
deferrals totaled $4,000. E's underutilized amount for 2000 is zero.
(v) Normal retirement age--(A) General rule. For purposes of the
special section 457 catch-up in this paragraph (c)(3), a plan must
specify the normal retirement age under the plan. A plan may define
normal retirement age as any age that is on or after the earlier of age
65 or the age at which participants have the right to retire and
receive, under the basic defined benefit pension plan of the State or
tax-exempt entity (or a money purchase pension plan in which the
participant also participates if the participant is not eligible to
participate in a defined benefit plan), immediate retirement benefits
without actuarial or similar reduction because
[[Page 164]]
of retirement before some later specified age, and that is not later
than age 70\1/2\. Alternatively, a plan may provide that a participant
is allowed to designate a normal retirement age within these ages. For
purposes of the special section 457 catch-up in this paragraph (c)(3),
an entity sponsoring more than one eligible plan may not permit a
participant to have more than one normal retirement age under the
eligible plans it sponsors.
(B) Special rule for eligible plans of qualified police or
firefighters. An eligible plan with participants that include qualified
police or firefighters as defined under section 415(b)(2)(H)(ii)(I) may
designate a normal retirement age for such qualified police or
firefighters that is earlier than the earliest normal retirement age
designated under the general rule of paragraph (c)(3)(i)(A) of this
section, but in no event may the normal retirement age be earlier than
age 40. Alternatively, a plan may allow a qualified police or
firefighter participant to designate a normal retirement age that is
between age 40 and age 70\1/2\.
(vi) Examples. The provisions of this paragraph (c)(3) are
illustrated by the following examples:
Example 1. (i) Facts. Participant F, who will turn 61 on April 1,
2006, becomes eligible to participate in an eligible plan on January 1,
2006. The plan provides a normal retirement age of 65. The plan provides
limitations on annual deferrals up to the maximum permitted under
paragraphs (c)(1) through (3) of this section. For 2006, F will receive
compensation of $40,000 from the eligible employer. F desires to defer
the maximum amount possible in 2006. The applicable basic dollar limit
of paragraph (c)(1)(i)(A) of this section is $15,000 for 2006 and the
additional dollar amount permitted under the age 50 catch-up in
paragraph (c)(2) of this section for an individual who is at least age
50 is $5,000 for 2006.
(ii) Conclusion. F is not eligible for the special section 457
catch-up under paragraph (c)(3) of this section in 2006 because 2006 is
not one of the last three taxable years ending before F attains normal
retirement age. Accordingly, the maximum that F may defer for 2006 is
$20,000. See also paragraph (c)(2)(iii) Example 1 of this section.
Example 2. (i) Facts. The facts are the same as in Example 1 except
that, in 2006, F elects to defer only $2,000 under the plan (rather than
the maximum permitted amount of $20,000). In addition, assume that the
applicable basic dollar limit of paragraph (c)(1)(i)(A) of this section
continues to be $15,000 for 2007 and the additional dollar amount
permitted under the age 50 catch-up in paragraph (c)(2) of this section
for an individual who is at least age 50 continues to be $5,000 for
2007. In F's taxable year 2007, which is one of the last three taxable
years ending before F attains the plan's normal retirement age of 65, F
again receives a salary of $40,000 and elects to defer the maximum
amount permissible under the plan's catch-up provisions prescribed under
paragraph (c) of this section.
(ii) Conclusion. For 2007, which is one of the last three taxable
years ending before F attains the plan's normal retirement age of 65,
the applicable limit on deferrals for F is the larger of the amount
under the special section 457 catch-up or $20,000, which is the basic
annual limitation ($15,000) and the age 50 catch-up limit of section
414(v) ($5,000). For 2007, F's special section 457 catch-up amount is
the lesser of two times the basic annual limitation ($30,000) or the sum
of the basic annual limitation ($15,000) plus the $13,000 underutilized
limitation under paragraph (c)(3)(ii) of this section (the $15,000 plan
ceiling in 2006, minus the $2,000 contributed for F in 2006), or
$28,000. Thus, the maximum amount that F may defer in 2007 is $28,000.
Example 3. (i) Facts. The facts are the same as in Examples 1 and 2,
except that F does not make any contributions to the plan before 2010.
In addition, assume that the applicable basic dollar limitation of
paragraph (c)(1)(i)(A) of this section continues to be $15,000 for 2010
and the additional dollar amount permitted under the age 50 catch-up in
paragraph (c)(2) of this section for an individual who is at least age
50 continues to be $5,000 for 2010. In F's taxable year 2010, the year
in which F attains age 65 (which is the normal retirement age under the
plan), F desires to defer the maximum amount possible under the plan.
F's compensation for 2010 is again $40,000.
(ii) Conclusion. For 2010, the maximum amount that F may defer is
$20,000. The special section 457 catch-up provisions under paragraph
(c)(3) of this section are not applicable because 2010 is not a taxable
year ending before the year in which F attains normal retirement age.
(4) Cost-of-living adjustment. For years beginning after December
31, 2006, the $15,000 dollar limitation in paragraph (c)(1)(i)(A) of
this section will be adjusted to take into account increases in the
cost-of-living. The adjustment in the dollar limitation is made at the
same time and in the same manner as under section 415(d) (relating to
qualified plans under section 401(a)), except that the base period is
the calendar quarter beginning July 1, 2005 and any
[[Page 165]]
increase which is not a multiple of $500 will be rounded to the next
lowest multiple of $500.
(d) Deferrals after severance from employment, including sick,
vacation, and back pay under an eligible plan--(1) In general. An
eligible plan may provide that a participant who has not had a severance
from employment may elect to defer accumulated sick pay, accumulated
vacation pay, and back pay under an eligible plan if the requirements of
section 457(b) are satisfied. For example, the plan must provide, in
accordance with paragraph (b) of this section, that these amounts may be
deferred for any calendar month only if an agreement providing for the
deferral is entered into before the beginning of the month in which the
amounts would otherwise be paid or made available and the participant is
an employee on the date the amounts would otherwise be paid or made
available. For purposes of section 457, compensation that would
otherwise be paid for a payroll period that begins before severance from
employment is treated as an amount that would otherwise be paid or made
available before an employee has a severance from employment. In
addition, deferrals may be made for former employees with respect to
compensation described in Sec. 1.415(c)-2(e)(3)(i) (relating to certain
compensation paid by the later of 2\1/2\ months after severance from
employment or the end of the limitation year that includes the date of
severance from employment). For this purpose, the calendar year is
substituted for the limitation year. In addition, compensation described
in Sec. 1.415(c)-2(e)(4), (g)(4), or (g)(7) (relating to compensation
paid to participants who are permanently and totally disabled or
compensation relating to qualified military service under section
414(u)), provided those amounts represent compensation described in
Sec. 1.415(c)-2(e)(3)(i).
(2) Examples. The provisions of this paragraph (d) are illustrated
by the following examples:
Example 1. (i) Facts. Participant G, who is age 62 in year 2007, is
an employee who participates in an eligible plan providing a normal
retirement age of 65 and a bona fide sick leave and vacation pay program
of the eligible employer. Under the terms of G's employer's eligible
plan and the sick leave and vacation pay program, G is permitted to make
a one-time election to contribute amounts representing accumulated sick
pay to the eligible plan. G has a severance from employment on January
12, 2008, at which time G's accumulated sick and vacation pay that is
payable on March 15, 2008, totals $12,000. G elects, on February 4,
2008, to have the $12,000 of accumulated sick and vacation pay
contributed to the eligible plan.
(ii) Conclusion. Under the terms of the eligible plan and the sick
and vacation pay program, G may elect before March 1, 2008, to defer the
accumulated sick and vacation pay because the agreement providing for
the deferral is entered into before the beginning of the month in which
the amount is currently available and the amount is bona fide
accumulated sick and vacation pay, as described in Sec. 1.415(c)-
2(e)(3)(ii), and that is payable by the later of 2\1/2\ months after
severance from employment or the end of the calendar year that includes
the date of severance from employment by G. Thus, under this section and
Sec. 1.415(c)-2(e)(3)(ii), the $12,000 is included in G's includible
compensation for purposes of determining G's includible compensation in
year 2008.
Example 2. (i) Facts. Same facts as in Example 1, except that G's
severance from employment is on May 31, 2008, G's $12,000 of accumulated
sick and vacation pay is payable on September 15, 2008 (which is by the
later of 2\1/2\ months after severance from employment or the end of the
calendar year that includes the date of severance from employment by G),
and G's election to defer the accumulated sick and vacation pay is made
before May 1, 2008.
(ii) Conclusion. Under this section and Sec. 1.415(c)-2(e)(3)(ii),
the $12,000 is included in G's includible compensation for purposes of
determining G's includible compensation in year 2008.
Example 3. (i) Facts. Employer X maintains an eligible plan and a
vacation leave plan. Under the terms of the vacation leave plan,
employees generally accrue three weeks of vacation per year. Up to one
week's unused vacation may be carried over from one year to the next, so
that in any single year an employee may have a maximum of four weeks'
vacation time. At the beginning of each calendar year, under the terms
of the eligible plan (which constitutes an agreement providing for the
deferral), the value of any unused vacation time from the prior year in
excess of one week is automatically contributed to the eligible plan, to
the extent of the employee's maximum deferral limitations. Amounts in
excess of the maximum deferral limitations are forfeited.
(ii) Conclusion. The value of the unused vacation pay contributed to
X's eligible plan pursuant to the terms of the plan and the terms of the
vacation leave plan is treated as
[[Page 166]]
an annual deferral to the eligible plan for January of the calendar
year. No amounts contributed to the eligible plan will be considered
made available to a participant in X's eligible plan.
(e) Excess deferrals under an eligible plan--(1) In general. Any
amount deferred under an eligible plan for the taxable year of a
participant that exceeds the maximum deferral limitations set forth in
paragraphs (c)(1) through (3) of this section, and any amount that
exceeds the individual limitation under Sec. 1.457-5, constitutes an
excess deferral that is taxable in accordance with Sec. 1.457-11 for
that taxable year. Thus, an excess deferral is includible in gross
income in the taxable year deferred or, if later, the first taxable year
in which there is no substantial risk of forfeiture.
(2) Excess deferrals under an eligible governmental plan other than
as a result of the individual limitation. In order to be an eligible
governmental plan, the plan must provide that any excess deferral
resulting from a failure of a plan to apply the limitations of
paragraphs (c)(1) through (3) of this section to amounts deferred under
the eligible plan (computed without regard to the individual limitation
under Sec. 1.457-5) will be distributed to the participant, with
allocable net income, as soon as administratively practicable after the
plan determines that the amount is an excess deferral. For purposes of
determining whether there is an excess deferral resulting from a failure
of a plan to apply the limitations of paragraphs (c)(1) through (3) of
this section, all plans under which an individual participates by virtue
of his or her relationship with a single employer are treated as a
single plan (without regard to any differences in funding). An eligible
governmental plan does not fail to satisfy the requirements of
paragraphs (a) through (d) of this section or Sec. Sec. 1.457-6 through
1.457-10 (including the distribution rules under Sec. 1.457-6 and the
funding rules under Sec. 1.457-8) solely by reason of a distribution
made under this paragraph (e)(2). If such excess deferrals are not
corrected by distribution under this paragraph (e)(2), the plan will be
an ineligible plan under which benefits are taxable in accordance with
Sec. 1.457-11.
(3) Excess deferrals under an eligible plan of a tax-exempt employer
other than as a result of the individual limitation. If a plan of a tax-
exempt employer fails to comply with the limitations of paragraphs
(c)(1) through (3) of this section, the plan will be an ineligible plan
under which benefits are taxable in accordance with Sec. 1.457-11.
However, a plan may distribute to a participant any excess deferrals
(and any income allocable to such amount) not later than the first April
15 following the close of the taxable year of the excess deferrals. In
such a case, the plan will continue to be treated as an eligible plan.
However, any excess deferral is included in the gross income of a
participant for the taxable year of the excess deferral. If the excess
deferrals are not corrected by distribution under this paragraph (e)(3),
the plan is an ineligible plan under which benefits are taxable in
accordance with Sec. 1.457-11. For purposes of determining whether
there is an excess deferral resulting from a failure of a plan to apply
the limitations of paragraphs (c)(1) through (3) of this section, all
eligible plans under which an individual participates by virtue of his
or her relationship with a single employer are treated as a single plan.
(4) Excess deferrals arising from application of the individual
limitation. An eligible plan may provide that an excess deferral that is
a result solely of a failure to comply with the individual limitation
under Sec. 1.457-5 for a taxable year may be distributed to the
participant, with allocable net income, as soon as administratively
practicable after the plan determines that the amount is an excess
deferral. An eligible plan does not fail to satisfy the requirements of
paragraphs (a) through (d) of this section or Sec. Sec. 1.457-6 through
1.457-10 (including the distribution rules under Sec. 1.457-6 and the
funding rules under Sec. 1.457-8) solely by reason of a distribution
made under this paragraph (e)(4). Although a plan will still maintain
eligible status if excess deferrals are not distributed under this
paragraph (e)(4), a participant must include the excess amounts in
income as provided in paragraph (e)(1) of this section.
[[Page 167]]
(5) Examples. The provisions of this paragraph (e) are illustrated
by the following examples:
Example 1. (i) Facts. In 2006, the eligible plan of State Employer X
in which Participant H participates permits a maximum deferral of the
lesser of $15,000 or 100 percent of includible compensation. In 2006, H,
who has compensation of $28,000, nevertheless defers $16,000 under the
eligible plan. Participant H is age 45 and normal retirement age under
the plan is age 65. For 2006, the applicable dollar limit under
paragraph (c)(1)(i)(A) of this section is $15,000. Employer X discovers
the error in January of 2007 when it completes H's 2006 Form W-2 and
promptly distributes $1,022 to H (which is the sum of the $1,000 excess
and $22 of allocable net income).
(ii) Conclusion. Participant H has deferred $1,000 in excess of the
$15,000 limitation provided for under the plan for 2006. The $1,000
excess must be included by H in H's income for 2006. In order to correct
the failure and still be an eligible plan, the plan must distribute the
excess deferral, with allocable net income, as soon as administratively
practicable after determining that the amount exceeds the plan deferral
limitations. In this case, $22 of the distribution of $1,022 is included
in H's gross income for 2007 (and is not an eligible rollover
distribution). If the excess deferral were not distributed, the plan
would be an ineligible plan with respect to which benefits are taxable
in accordance with Sec. 1.457-11.
Example 2. (i) Facts. The facts are the same as in Example 1, except
that X uses a number of separate arrangements with different trustees
and annuity insurers to permit employees to defer and H elects deferrals
under several of the funding arrangements none of which exceeds $15,000
for any individual funding arrangement, but which total $16,000.
(ii) Conclusion. The conclusion is the same as in Example 1.
Example 3. (i) Facts. The facts are the same as in Example 1, except
that H's deferral under the eligible plan is limited to $11,000 and H
also makes a salary reduction contribution of $5,000 to an annuity
contract under section 403(b) with the same Employer X.
(ii) Conclusion. H's deferrals are within the plan deferral
limitations of Employer X. Because of the repeal of the application of
the coordination limitation under former paragraph (2) of section
457(c), H's salary reduction deferrals under the annuity contract are no
longer considered in determining H's applicable deferral limits under
paragraphs (c)(1) through (3) of this section.
Example 4. (i) Facts. The facts are the same as in Example 1, except
that H's deferral under the eligible governmental plan is limited to
$14,000 and H also makes a deferral of $4,000 to an eligible
governmental plan of a different employer. Participant H is age 45 and
normal retirement age under both eligible plans is age 65.
(ii) Conclusion. Because of the application of the individual
limitation under Sec. 1.457-5, H has an excess deferral of $3,000 (the
sum of $14,000 plus $4,000 equals $18,000, which is $3,000 in excess of
the dollar limitation of $15,000). The $3,000 excess deferral, with
allocable net income, may be distributed from either plan as soon as
administratively practicable after determining that the combined amount
exceeds the deferral limitations. If the $3,000 excess deferral is not
distributed to H, each plan will continue to be an eligible plan, but
the $3,000 must be included by H in H's income for 2006.
Example 5. (i) Facts. Assume the same facts as in Example 3, except
that H's deferral under the eligible governmental plan is limited to
$14,000 and H also makes a deferral of $4,000 to an eligible plan of
Employer Y, a tax-exempt entity.
(ii) Conclusion. The results are the same as in Example 3, namely,
because of the application of the individual limitation under Sec.
1.457-5, H has an excess deferral of $3,000. If the $3,000 excess
deferral is not distributed to H, each plan will continue to be an
eligible plan, but the $3,000 must be included by H in H's income for
2006.
Example 6. (i) Facts. Assume the same facts as in Example 5, except
that X is a tax-exempt entity and thus its plan is an eligible plan of a
tax-exempt entity.
(ii) Conclusion. The results are the same as in Example 5, namely,
because of the application of the individual limitation under Sec.
1.457-5, H has an excess deferral of $3,000. If the $3,000 excess
deferral is not distributed to H, each plan will continue to be an
eligible plan, but the $3,000 must be included by H into H's income for
2006.
[T.D. 9075, 68 FR 41234, July 11, 2003; 68 FR 51446, Aug. 27, 2003; T.D.
9319, 72 FR 16930, Apr. 5, 2007]
Sec. 1.457-5 Individual limitation for combined annual deferrals
under multiple eligible plans
(a) General rule. The individual limitation under section 457(c) and
this section equals the basic annual deferral limitation under Sec.
1.457-4(c)(1)(i)(A), plus either the age 50 catch-up amount under Sec.
1.457-4(c)(2), or the special section 457 catch-up amount under Sec.
1.457-4(c)(3), applied by taking into account the combined annual
deferral for the participant for any taxable year under all eligible
plans. While an eligible plan may include provisions under which it will
limit deferrals to meet the individual limitation under section 457(c)
[[Page 168]]
and this section, annual deferrals by a participant that exceed the
individual limit under section 457(c) and this section (but do not
exceed the limits under Sec. 1.457-4(c)) will not cause a plan to lose
its eligible status. However, to the extent the combined annual
deferrals for a participant for any taxable year exceed the individual
limitation under section 457(c) and this section for that year, the
amounts are treated as excess deferrals as described in Sec. 1.457-
4(e).
(b) Limitation applied to participant. The individual limitation in
this section applies to eligible plans of all employers for whom a
participant has performed services, including both eligible governmental
plans and eligible plans of a tax-exempt entity and both eligible plans
of the employer and eligible plans of other employers. Thus, for
purposes of determining the amount excluded from a participant's gross
income in any taxable year (including the underutilized limitation under
Sec. 1.457-4 (c)(3)(ii)(B)), the participant's annual deferral under an
eligible plan, and the participant's annual deferrals under all other
eligible plans, must be determined on an aggregate basis. To the extent
that the combined annual deferral amount exceeds the maximum deferral
limitation applicable under Sec. 1.457-4 (c)(1)(i)(A), (c)(2), or
(c)(3), the amount is treated as an excess deferral under Sec. 1.457-
4(e).
(c) Special rules for catch-up amounts under multiple eligible
plans. For purposes of applying section 457(c) and this section, the
special section 457 catch-up under Sec. 1.457-4 (c)(3) is taken into
account only to the extent that an annual deferral is made for a
participant under an eligible plan as a result of plan provisions
permitted under Sec. 1.457-4 (c)(3). In addition, if a participant has
annual deferrals under more than one eligible plan and the applicable
catch-up amount under Sec. 1.457-4 (c)(2) or (3) is not the same for
each such eligible plan for the taxable year, section 457(c) and this
section are applied using the catch-up amount under whichever plan has
the largest catch-up amount applicable to the participant.
(d) Examples. The provisions of this section are illustrated by the
following examples:
Example 1. (i) Facts. Participant F is age 62 in 2006 and
participates in two eligible plans during 2006, Plans J and K, which are
each eligible plans of two different governmental entities. Each plan
includes provisions allowing the maximum annual deferral permitted under
Sec. 1.457-4(c)(1) through (3). For 2006, the underutilized amount
under Sec. 1.457-4 (c)(3)(ii)(B) is $20,000 under Plan J and is $40,000
under Plan K. Normal retirement age is age 65 under both plans.
Participant F defers $15,000 under each plan. Participant F's includible
compensation is in each case in excess of the deferral. Neither plan
designates the $15,000 contribution as a catch-up permitted under each
plan's special section 457 catch-up provisions.
(ii) Conclusion. For purposes of applying this section to
Participant F for 2006, the maximum exclusion is $20,000. This is equal
to the sum of $15,000 plus $5,000, which is the age 50 catch-up amount.
Thus, F has an excess amount of $10,000 which is treated as an excess
deferral for Participant F for 2006 under Sec. 1.457-4(e).
Example 2. (i) Facts. Participant E, who will turn 63 on April 1,
2006, participates in four eligible plans during year 2006: Plan W which
is an eligible governmental plan; and Plans X, Y, and Z which are each
eligible plans of three different tax-exempt entities. For year 2006,
the limitation that applies to Participant E under all four plans under
Sec. 1.457-4(c)(1)(i)(A) is $15,000. For year 2006, the additional age
50 catch-up limitation that applies to Participant E under all four
plans under Sec. 1.457-4(c)(2) is $5,000. Further, for year 2006,
different limitations under Sec. 1.457-4(c)(3) and (c)(3)(ii)(B) apply
to Participant E under each of these plans, as follows: under Plan W,
the underutilized limitation under Sec. 1.457-4(c)(3)(ii)(B) is $7,000;
under Plan X, the underutilized limitation under Sec. 1.457-
4(c)(3)(ii)(B) is $2,000; under Plan Y, the underutilized limitation
under Sec. 1.457-4(c)(3)(ii)(B) is $8,000; and under Plan Z, Sec.
1.457-4(c)(3) is not applicable since normal retirement age is 62 under
Plan Z. Participant E's includible compensation is in each case in
excess of any applicable deferral.
(ii) Conclusion. For purposes of applying this section to
Participant E for year 2006, Participant E could elect to defer $23,000
under Plan Y, which is the maximum deferral limitation under Sec.
1.457-4(c)(1) through (3), and to defer no amount under Plans W, X, and
Z. The $23,000 maximum amount is equal to the sum of $15,000 plus
$8,000, which is the catch-up amount applicable to Participant E under
Plan Y and which is the largest catch-up amount applicable to
Participant E under any of the four plans for year 2006. Alternatively,
Participant E could instead elect to defer the following combination of
amounts: An aggregate total of $15,000 to Plans X, Y, and Z, if no
contribution is made to Plan W; an aggregate total of $20,000 to
[[Page 169]]
any of the four plans, assuming at least $5,000 is contributed to Plan
W; or $22,000 to Plan W and none to any of the other three plans.
(iii) If the underutilized amount under Plans W, X, and Y for year
2006 were in each case zero (because E had always contributed the
maximum amount or E was a new participant) or an amount not in excess of
$5,000, the maximum exclusion under this section would be $20,000 for
Participant E for year 2006 ($15,000 plus the $5,000 age 50 catch-up
amount), which Participant E could contribute to any of the plans
assuming at least $5,000 is contributed to Plan W.
[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51446, Aug. 26, 2003; T.D.
9319, 72 FR 16930, Apr. 5, 2007; 72 FR 28854, May 23, 2007]
Sec. 1.457-6 Timing of distributions under eligible plans.
(a) In general. Except as provided in paragraph (c) of this section
(relating to distributions on account of an unforeseeable emergency),
paragraph (e) of this section (relating to distributions of small
accounts), Sec. 1.457-10(a) (relating to plan terminations), or Sec.
1.457-10(c) (relating to domestic relations orders), amounts deferred
under an eligible plan may not be paid to a participant or beneficiary
before the participant has a severance from employment with the eligible
employer or when the participant attains age 70\1/2\, if earlier. For
rules relating to loans, see paragraph (f) of this section. This section
does not apply to distributions of excess amounts under Sec. 1.457-
4(e). However, except to the extent set forth by the Commissioner in
revenue rulings, notices, and other guidance published in the Internal
Revenue Bulletin (see Sec. 601.601(d) of this chapter), this section
applies to amounts held in a separate account for eligible rollover
distributions maintained by an eligible governmental plan as described
in Sec. 1.457-10(e)(2).
(b) Severance from employment--(1) Employees. An employee has a
severance from employment with the eligible employer if the employee
dies, retires, or otherwise has a severance from employment with the
eligible employer. See regulations under section 401(k) for additional
guidance concerning severance from employment.
(2) Independent contractors--(i) In general. An independent
contractor is considered to have a severance from employment with the
eligible employer upon the expiration of the contract (or in the case of
more than one contract, all contracts) under which services are
performed for the eligible employer if the expiration constitutes a
good-faith and complete termination of the contractual relationship. An
expiration does not constitute a good faith and complete termination of
the contractual relationship if the eligible employer anticipates a
renewal of a contractual relationship or the independent contractor
becoming an employee. For this purpose, an eligible employer is
considered to anticipate the renewal of the contractual relationship
with an independent contractor if it intends to contract again for the
services provided under the expired contract, and neither the eligible
employer nor the independent contractor has eliminated the independent
contractor as a possible provider of services under any such new
contract. Further, an eligible employer is considered to intend to
contract again for the services provided under an expired contract if
the eligible employer's doing so is conditioned only upon incurring a
need for the services, the availability of funds, or both.
(ii) Special rule. Notwithstanding paragraph (b)(2)(i) of this
section, the plan is considered to satisfy the requirement described in
paragraph (a) of this section that no amounts deferred under the plan be
paid or made available to the participant before the participant has a
severance from employment with the eligible employer if, with respect to
amounts payable to a participant who is an independent contractor, an
eligible plan provides that--
(A) No amount will be paid to the participant before a date at least
12 months after the day on which the contract expires under which
services are performed for the eligible employer (or, in the case of
more than one contract, all such contracts expire); and
(B) No amount payable to the participant on that date will be paid
to the participant if, after the expiration of the contract (or
contracts) and before that date, the participant performs services for
the eligible employer as an independent contractor or an employee.
[[Page 170]]
(c) Rules applicable to distributions for unforeseeable
emergencies--(1) In general. An eligible plan may permit a distribution
to a participant or beneficiary for an unforeseeable emergency. The
distribution must satisfy the requirements of paragraph (c)(2) of this
section.
(2) Requirements--(i) Unforeseeable emergency defined. An
unforeseeable emergency must be defined in the plan as a severe
financial hardship of the participant or beneficiary resulting from an
illness or accident of the participant or beneficiary, the participant's
or beneficiary's spouse, or the participant's or beneficiary's dependent
(as defined in section 152, and, for taxable years beginning on or after
January 1, 2005, without regard to section 152(b)(1), (b)(2), and
(d)(1)(B)); loss of the participant's or beneficiary's property due to
casualty (including the need to rebuild a home following damage to a
home not otherwise covered by homeowner's insurance, such as damage that
is the result of a natural disaster); or other similar extraordinary and
unforeseeable circumstances arising as a result of events beyond the
control of the participant or the beneficiary. For example, the imminent
foreclosure of or eviction from the participant's or beneficiary's
primary residence may constitute an unforeseeable emergency. In
addition, the need to pay for medical expenses, including non-refundable
deductibles, as well as for the cost of prescription drug medication,
may constitute an unforeseeable emergency. Finally, the need to pay for
the funeral expenses of a spouse or a dependent (as defined in section
152, and, for taxable years beginning on or after January 1, 2005,
without regard to section 152(b)(1), (b)(2), and (d)(1)(B)) of a
participant or beneficiary may also constitute an unforeseeable
emergency. Except as otherwise specifically provided in this paragraph
(c)(2)(i), the purchase of a home and the payment of college tuition are
not unforeseeable emergencies under this paragraph (c)(2)(i).
(ii) Unforeseeable emergency distribution standard. Whether a
participant or beneficiary is faced with an unforeseeable emergency
permitting a distribution under this paragraph (c) is to be determined
based on the relevant facts and circumstances of each case, but, in any
case, a distribution on account of unforeseeable emergency may not be
made to the extent that such emergency is or may be relieved through
reimbursement or compensation from insurance or otherwise, by
liquidation of the participant's assets, to the extent the liquidation
of such assets would not itself cause severe financial hardship, or by
cessation of deferrals under the plan.
(iii) Distribution necessary to satisfy emergency need.
Distributions because of an unforeseeable emergency must be limited to
the amount reasonably necessary to satisfy the emergency need (which may
include any amounts necessary to pay for any federal, state, or local
income taxes or penalties reasonably anticipated to result from the
distribution).
(d) Minimum required distributions for eligible plans. In order to
be an eligible plan, a plan must meet the distribution requirements of
section 457(d)(1) and (2). Under section 457(d)(2), a plan must meet the
minimum distribution requirements of section 401(a)(9). See section
401(a)(9) and the regulations thereunder for these requirements. Section
401(a)(9) requires that a plan begin lifetime distributions to a
participant no later than April 1 of the calendar year following the
later of the calendar year in which the participant attains age 70\1/2\
or the calendar year in which the participant retires.
(e) Distributions of smaller accounts--(1) In general. An eligible
plan may provide for a distribution of all or a portion of a
participant's benefit if this paragraph (e)(1) is satisfied. This
paragraph (e)(1) is satisfied if the participant's total amount deferred
(the participant's total account balance) which is not attributable to
rollover contributions (as defined in section 411(a)(11)(D)) is not in
excess of the dollar limit under section 411(a)(11)(A), no amount has
been deferred under the plan by or for the participant during the two-
year period ending on the date of the distribution, and there has been
no prior distribution under the plan to the participant under this
paragraph (e). An eligible plan is not required to
[[Page 171]]
permit distributions under this paragraph (e).
(2) Alternative provisions possible. Consistent with the provisions
of paragraph (e)(1) of this section, a plan may provide that the total
amount deferred for a participant or beneficiary will be distributed
automatically to the participant or beneficiary if the requirements of
paragraph (e)(1) of this section are met. Alternatively, if the
requirements of paragraph (e)(1) of this section are met, the plan may
provide for the total amount deferred for a participant or beneficiary
to be distributed to the participant or beneficiary only if the
participant or beneficiary so elects. The plan is permitted to
substitute a specified dollar amount that is less than the total amount
deferred. In addition, these two alternatives can be combined; for
example, a plan could provide for automatic distributions for up to
$500, but allow a participant or beneficiary to elect a distribution if
the total account balance is above $500.
(f) Loans from eligible plans--(1) Eligible plans of tax-exempt
entities. If a participant or beneficiary receives (directly or
indirectly) any amount deferred as a loan from an eligible plan of a
tax-exempt entity, that amount will be treated as having been paid or
made available to the individual as a distribution under the plan, in
violation of the distribution requirements of section 457(d).
(2) Eligible governmental plans. The determination of whether the
availability of a loan, the making of a loan, or a failure to repay a
loan made from a trustee (or a person treated as a trustee under section
457(g)) of an eligible governmental plan to a participant or beneficiary
is treated as a distribution (directly or indirectly) for purposes of
this section, and the determination of whether the availability of the
loan, the making of the loan, or a failure to repay the loan is in any
other respect a violation of the requirements of section 457(b) and the
regulations, depends on the facts and circumstances. Among the facts and
circumstances are whether the loan has a fixed repayment schedule and
bears a reasonable rate of interest, and whether there are repayment
safeguards to which a prudent lender would adhere. Thus, for example, a
loan must bear a reasonable rate of interest in order to satisfy the
exclusive benefit requirement of section 457(g)(1) and Sec. 1.457-
8(a)(1). See also Sec. 1.457-7(b)(3) relating to the application of
section 72(p) with respect to the taxation of a loan made under an
eligible governmental plan, and Sec. 1.72(p)-1 relating to section
72(p)(2).
(3) Example. The provisions of paragraph (f)(2) of this section are
illustrated by the following example:
Example. (i) Facts. Eligible Plan X of State Y is funded through
Trust Z. Plan X permits an employee's account balance under Plan X to be
paid in a single sum at severance from employment with State Y. Plan X
includes a loan program under which any active employee with a vested
account balance may receive a loan from Trust Z. Loans are made pursuant
to plan provisions regarding loans that are set forth in the plan under
which loans bear a reasonable rate of interest and are secured by the
employee's account balance. In order to avoid taxation under Sec.
1.457-7(b)(3) and section 72(p)(1), the plan provisions limit the amount
of loans and require loans to be repaid in level installments as
required under section 72(p)(2). Participant J's vested account balance
under Plan X is $50,000. J receives a loan from Trust Z in the amount of
$5,000 on December 1, 2003, to be repaid in level installments made
quarterly over the 5-year period ending on November 30, 2008.
Participant J makes the required repayments until J has a severance from
employment from State Y in 2005 and subsequently fails to repay the
outstanding loan balance of $2,250. The $2,250 loan balance is offset
against J's $80,000 account balance benefit under Plan X, and J elects
to be paid the remaining $77,750 in 2005.
(ii) Conclusion. The making of the loan to J will not be treated as
a violation of the requirements of section 457(b) or the regulations.
The cancellation of the loan at severance from employment does not cause
Plan X to fail to satisfy the requirements for plan eligibility under
section 457. In addition, because the loan satisfies the maximum amount
and repayment requirements of section 72(p)(2), J is not required to
include any amount in income as a result of the loan until 2005, when J
has income of $2,250 as a result of the offset (which is a permissible
distribution under this section) and income of $77,750 as a result of
the distribution made in 2005.
[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51446, Aug. 27, 2003; T.D.
9319, 72 FR 16930, Apr. 5, 2007]
[[Page 172]]
Sec. 1.457-7 Taxation of Distributions Under Eligible Plans.
(a) General rules for when amounts are included in gross income. The
rules for determining when an amount deferred under an eligible plan is
includible in the gross income of a participant or beneficiary depend on
whether the plan is an eligible governmental plan or an eligible plan of
a tax-exempt entity. Paragraph (b) of this section sets forth the rules
for an eligible governmental plan. Paragraph (c) of this section sets
forth the rules for an eligible plan of a tax-exempt entity.
(b) Amounts included in gross income under an eligible governmental
plan--(1) Amounts included in gross income in year paid under an
eligible governmental plan. Except as provided in paragraphs (b)(2) and
(3) of this section (or in Sec. 1.457-10(c) relating to payments to a
spouse or former spouse pursuant to a qualified domestic relations
order), amounts deferred under an eligible governmental plan are
includible in the gross income of a participant or beneficiary for the
taxable year in which paid to the participant or beneficiary under the
plan.
(2) Rollovers to individual retirement arrangements and other
eligible retirement plans. A trustee-to-trustee transfer in accordance
with section 401(a)(31) (generally referred to as a direct rollover)
from an eligible government plan is not includible in gross income of a
participant or beneficiary in the year transferred. In addition, any
payment made from an eligible government plan in the form of an eligible
rollover distribution (as defined in section 402(c)(4)) is not
includible in gross income in the year paid to the extent the payment is
transferred to an eligible retirement plan (as defined in section
402(c)(8)(B)) within 60 days, including the transfer to the eligible
retirement plan of any property distributed from the eligible
governmental plan. For this purpose, the rules of section 402(c)(2)
through (7) and (9) apply. Any trustee-to-trustee transfer under this
paragraph (b)(2) from an eligible government plan is a distribution that
is subject to the distribution requirements of Sec. 1.457-6.
(3) Amounts taxable under section 72(p)(1). In accordance with
section 72(p), the amount of any loan from an eligible governmental plan
to a participant or beneficiary (including any pledge or assignment
treated as a loan under section 72(p)(1)(B)) is treated as having been
received as a distribution from the plan under section 72(p)(1), except
to the extent set forth in section 72(p)(2) (relating to loans that do
not exceed a maximum amount and that are repayable in accordance with
certain terms) and Sec. 1.72(p)-1. Thus, except to the extent a loan
satisfies section 72(p)(2), any amount loaned from an eligible
governmental plan to a participant or beneficiary (including any pledge
or assignment treated as a loan under section 72(p)(1)(B)) is includible
in the gross income of the participant or beneficiary for the taxable
year in which the loan is made. See generally Sec. 1.72(p)-1.
(4) Examples. The provisions of this paragraph (b) are illustrated
by the following examples:
Example 1. (i) Facts. Eligible Plan G of a governmental entity
permits distribution of benefits in a single sum or in installments of
up to 20 years, with such benefits to commence at any date that is after
severance from employment (up to the later of severance from employment
or the plan's normal retirement age of 65). Effective for participants
who have a severance from employment after December 31, 2001, Plan X
allows an election--as to both the date on which payments are to begin
and the form in which payments are to be made--to be made by the
participant at any time that is before the commencement date selected.
However, Plan X chooses to require elections to be filed at least 30
days before the commencement date selected in order for Plan X to have
enough time to be able to effectuate the election.
(ii) Conclusion. No amounts are included in gross income before
actual payments begin. If installment payments begin (and the
installment payments are payable over at least 10 years so as not to be
eligible rollover distributions), the amount included in gross income
for any year is equal to the amount of the installment payment paid
during the year.
Example 2. (i) Facts. Same facts as in Example 1, except that the
same rules are extended to participants who had a severance from
employment before January 1, 2002.
(ii) Conclusion. For all participants (that is, both those who have
a severance from employment after December 31, 2001, and those who have
a severance from employment before January 1, 2002, including those
whose benefit payments have commenced before January 1, 2002), no
amounts are included in
[[Page 173]]
gross income before actual payments begin. If installment payments begin
(and the installment payments are payable over at least 10 years so as
not to be eligible rollover distributions), the amount included in gross
income for any year is equal to the amount of the installment payment
paid during the year.
(c) Amounts included in gross income under an eligible plan of a
tax-exempt entity--(1) Amounts included in gross income in year paid or
made available under an eligible plan of a tax-exempt entity. Amounts
deferred under an eligible plan of a tax-exempt entity are includible in
the gross income of a participant or beneficiary for the taxable year in
which paid or otherwise made available to the participant or beneficiary
under the plan. Thus, amounts deferred under an eligible plan of a tax-
exempt entity are includible in the gross income of the participant or
beneficiary in the year the amounts are first made available under the
terms of the plan, even if the plan has not distributed the amounts
deferred. Amounts deferred under an eligible plan of a tax-exempt entity
are not considered made available to the participant or beneficiary
solely because the participant or beneficiary is permitted to choose
among various investments under the plan.
(2) When amounts deferred are considered to be made available under
an eligible plan of a tax-exempt entity--(i) General rule. Except as
provided in paragraphs (c)(2)(ii) through (iv) of this section, amounts
deferred under an eligible plan of a tax-exempt entity are considered
made available (and, thus, are includible in the gross income of the
participant or beneficiary under this paragraph (c)) at the earliest
date, on or after severance from employment, on which the plan allows
distributions to commence, but in no event later than the date on which
distributions must commence pursuant to section 401(a)(9). For example,
in the case of a plan that permits distribution to commence on the date
that is 60 days after the close of the plan year in which the
participant has a severance from employment with the eligible employer,
amounts deferred are considered to be made available on that date.
However, distributions deferred in accordance with paragraphs (c)(2)(ii)
through (iv) of this section are not considered made available prior to
the applicable date under paragraphs (c)(2)(ii) through (iv) of this
section. In addition, no portion of a participant or beneficiary's
account is treated as made available (and thus currently includible in
income) under an eligible plan of a tax-exempt entity merely because the
participant or beneficiary under the plan may elect to receive a
distribution in any of the following circumstances:
(A) A distribution in the event of an unforeseeable emergency to the
extent the distribution is permitted under Sec. 1.457-6(c).
(B) A distribution from an account for which the total amount
deferred is not in excess of the dollar limit under section
411(a)(11)(A) to the extent the distribution is permitted under Sec.
1.457-6(e).
(ii) Initial election to defer commencement of distributions--(A) In
general. An eligible plan of a tax-exempt entity may provide a period
for making an initial election during which the participant or
beneficiary may elect, in accordance with the terms of the plan, to
defer the payment of some or all of the amounts deferred to a fixed or
determinable future time. The period for making this initial election
must expire prior to the first time that any such amounts would be
considered made available under the plan under paragraph (c)(2)(i) of
this section.
(B) Failure to make initial election to defer commencement of
distributions. Generally, if no initial election is made by a
participant or beneficiary under this paragraph (c)(2)(ii), then the
amounts deferred under an eligible plan of a tax-exempt entity are
considered made available and taxable to the participant or beneficiary
in accordance with paragraph (c)(2)(i) of this section at the earliest
time, on or after severance from employment (but in no event later than
the date on which distributions must commence pursuant to section
401(a)(9)), that distribution is permitted to commence under the terms
of the plan. However, the plan may provide for a default payment
schedule that applies if no election is made. If the plan provides for a
default payment schedule, the amounts deferred are includible in the
gross income of the participant or beneficiary
[[Page 174]]
in the year the amounts deferred are first made available under the
terms of the default payment schedule.
(iii) Additional election to defer commencement of distribution. An
eligible plan of a tax-exempt entity is permitted to provide that a
participant or beneficiary who has made an initial election under
paragraph (c)(2)(ii)(A) of this section may make one additional election
to defer (but not accelerate) commencement of distributions under the
plan before distributions have commenced in accordance with the initial
deferral election under paragraph (c)(2)(ii)(A) of this section. Amounts
payable to a participant or beneficiary under an eligible plan of a tax-
exempt entity are not treated as made available merely because the plan
allows the participant to make an additional election under this
paragraph (c)(2)(iii). A participant or beneficiary is not precluded
from making an additional election to defer commencement of
distributions merely because the participant or beneficiary has
previously received a distribution under Sec. 1.457-6(c) because of an
unforeseeable emergency, has received a distribution of smaller amounts
under Sec. 1.457-6(e), has made (and revoked) other deferral or method
of payment elections within the initial election period, or is subject
to a default payment schedule under which the commencement of benefits
is deferred (for example, until a participant is age 65).
(iv) Election as to method of payment. An eligible plan of a tax-
exempt entity may provide that an election as to the method of payment
under the plan may be made at any time prior to the time the amounts are
distributed in accordance with the participant or beneficiary's initial
or additional election to defer commencement of distributions under
paragraph (c)(2)(ii) or (iii) of this section. Where no method of
payment is elected, the entire amount deferred will be includible in the
gross income of the participant or beneficiary when the amounts first
become made available in accordance with a participant's initial or
additional elections to defer under paragraphs (c)(2)(ii) and (iii) of
this section, unless the eligible plan provides for a default method of
payment (in which case amounts are considered made available and taxable
when paid under the terms of the default payment schedule). A method of
payment means a distribution or a series of periodic distributions
commencing on a date determined in accordance with paragraph (c)(2)(ii)
or (iii) of this section.
(3) Examples. The provisions of this paragraph (c) are illustrated
by the following examples:
Example 1. (i) Facts. Eligible Plan X of a tax-exempt entity
provides that a participant's total account balance, representing all
amounts deferred under the plan, is payable to a participant in a single
sum 60 days after severance from employment throughout these examples,
unless, during a 30-day period immediately following the severance, the
participant elects to receive the single sum payment at a later date
(that is not later than the plan's normal retirement age of 65) or
elects to receive distribution in 10 annual installments to begin 60
days after severance from employment (or at a later date, if so elected,
that is not later than the plan's normal retirement age of 65). On
November 13, 2004, K, a calendar year taxpayer, has a severance from
employment with the eligible employer. K does not, within the 30-day
window period, elect to postpone distributions to a later date or to
receive payment in 10 fixed annual installments.
(ii) Conclusion. The single sum payment is payable to K 60 days
after the date K has a severance from employment (January 12, 2005), and
is includible in the gross income of K in 2005 under section 457(a).
Example 2. (i) Facts. The terms of eligible Plan X are the same as
described in Example 1. Participant L participates in eligible Plan X.
On November 11, 2003, L has a severance from the employment of the
eligible employer. On November 24, 2003, L makes an initial deferral
election not to receive the single-sum payment payable 60 days after the
severance, and instead elects to receive the amounts in 10 annual
installments to begin 60 days after severance from employment.
(ii) Conclusion. No portion of L's account is considered made
available in 2003 or 2004 before a payment is made and no amount is
includible in the gross income of L until distributions commence. The
annual installment payable in 2004 will be includible in L's gross
income in 2004.
Example 3. (i) Facts. The facts are the same as in Example 1, except
that eligible Plan X also provides that those participants who are
receiving distributions in 10 annual installments may, at any time and
without restriction, elect to receive a cash out of all remaining
installments. Participant M elects
[[Page 175]]
to receive a distribution in 10 annual installments commencing in 2004.
(ii) Conclusion. M's total account balance, representing the total
of the amounts deferred under the plan, is considered made available and
is includible in M's gross income in 2004.
Example 4. (i) Facts. The facts are the same as in Example 3, except
that, instead of providing for an unrestricted cashout of remaining
payments, the plan provides that participants or beneficiaries who are
receiving distributions in 10 annual installments may accelerate the
payment of the amount remaining payable to the participant upon the
occurrence of an unforeseeable emergency as described in Sec. 1.457-
6(c)(1) in an amount not exceeding that described in Sec. 1.457-
6(c)(2).
(ii) Conclusion. No amount is considered made available to
participant M on account of M's right to accelerate payments upon the
occurrence of an unforeseeable emergency.
Example 5. (i) Facts. Eligible Plan Y of a tax-exempt entity
provides that distributions will commence 60 days after a participant's
severance from employment unless the participant elects, within a 30-day
window period following severance from employment, to defer
distributions to a later date (but no later than the year following the
calendar year the participant attains age 70\1/2\). The plan provides
that a participant who has elected to defer distributions to a later
date may make an election as to form of distribution at any time prior
to the 30th day before distributions are to commence.
(ii) Conclusion. No amount is considered made available prior to the
date distributions are to commence by reason of a participant's right to
defer or make an election as to the form of distribution.
Example 6. (i) Facts. The facts are the same as in Example 1, except
that the plan also permits participants who have made an initial
election to defer distribution to make one additional deferral election
at any time prior to the date distributions are scheduled to commence.
Participant N has a severance from employment at age 50. The next day,
during the 30-day period provided in the plan, N elects to receive
distribution in the form of 10 annual installment payments beginning at
age 55. Two weeks later, within the 30-day window period, N makes a new
election permitted under the plan to receive 10 annual installment
payments beginning at age 60 (instead of age 55). When N is age 59, N
elects under the additional deferral election provisions, to defer
distributions until age 65.
(ii) Conclusion. In this example, N's election to defer
distributions until age 65 is a valid election. The two elections N
makes during the 30-day window period are not additional deferral
elections described in paragraph (c)(2)(iii) of this section because
they are made before the first permissible payout date under the plan.
Therefore, the plan is not precluded from allowing N to make the
additional deferral election. However, N can make no further election to
defer distributions beyond age 65 (or accelerate distribution before age
65) because this additional deferral election can only be made once.
[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]
Sec. 1.457-8 Funding rules for eligible plans.
(a) Eligible governmental plans--(1) In general. In order to be an
eligible governmental plan, all amounts deferred under the plan, all
property and rights purchased with such amounts, and all income
attributable to such amounts, property, or rights, must be held in trust
for the exclusive benefit of participants and their beneficiaries. A
trust described in this paragraph (a) that also meets the requirements
of Sec. Sec. 1.457-3 through 1.457-10 is treated as an organization
exempt from tax under section 501(a), and a participant's or
beneficiary's interest in amounts in the trust is includible in the
gross income of the participants and beneficiaries only to the extent,
and at the time, provided for in section 457(a) and Sec. Sec. 1.457-4
through 1.457-10.
(2) Trust requirement. (i) A trust described in this paragraph (a)
must be established pursuant to a written agreement that constitutes a
valid trust under State law. The terms of the trust must make it
impossible, prior to the satisfaction of all liabilities with respect to
participants and their beneficiaries, for any part of the assets and
income of the trust to be used for, or diverted to, purposes other than
for the exclusive benefit of participants and their beneficiaries.
(ii) Amounts deferred under an eligible governmental plan must be
transferred to a trust within a period that is not longer than is
reasonable for the proper administration of the participant accounts (if
any). For purposes of this requirement, the plan may provide for amounts
deferred for a participant under the plan to be transferred to the trust
within a specified period after the date the amounts would otherwise
have been paid to the participant. For example, the plan could provide
for amounts deferred under the plan at the election of the participant
to be contributed to
[[Page 176]]
the trust within 15 business days following the month in which these
amounts would otherwise have been paid to the participant.
(3) Custodial accounts and annuity contracts treated as trusts--(i)
In general. For purposes of the trust requirement of this paragraph (a),
custodial accounts and annuity contracts described in section 401(f)
that satisfy the requirements of this paragraph (a)(3) are treated as
trusts under rules similar to the rules of section 401(f). Therefore,
the provisions of Sec. 1.401(f)-1(b) will generally apply to determine
whether a custodial account or an annuity contract is treated as a
trust. The use of a custodial account or annuity contract as part of an
eligible governmental plan does not preclude the use of a trust or
another custodial account or annuity contract as part of the same plan,
provided that all such vehicles satisfy the requirements of section
457(g)(1) and (3) and paragraphs (a)(1) and (2) of this section and that
all assets and income of the plan are held in such vehicles.
(ii) Custodial accounts--(A) In general. A custodial account is
treated as a trust, for purposes of section 457(g)(1) and paragraphs
(a)(1) and (2) of this section, if the custodian is a bank, as described
in section 408(n), or a person who meets the nonbank trustee
requirements of paragraph (a)(3)(ii)(B) of this section, and the account
meets the requirements of paragraphs (a)(1) and (2) of this section,
other than the requirement that it be a trust.
(B) Nonbank trustee status. The custodian of a custodial account may
be a person other than a bank only if the person demonstrates to the
satisfaction of the Commissioner that the manner in which the person
will administer the custodial account will be consistent with the
requirements of section 457(g)(1) and (3). To do so, the person must
demonstrate that the requirements of Sec. 1.408-2(e)(2) through (6)
(relating to nonbank trustees) are met. The written application must be
sent to the address prescribed by the Commissioner in the same manner as
prescribed under Sec. 1.408-2(e). To the extent that a person has
already demonstrated to the satisfaction of the Commissioner that the
person satisfies the requirements of Sec. 1.408-2(e) in connection with
a qualified trust (or custodial account or annuity contract) under
section 401(a), that person is deemed to satisfy the requirements of
this paragraph (a)(3)(ii)(B).
(iii) Annuity contracts. An annuity contract is treated as a trust
for purposes of section 457(g)(1) and paragraph (a)(1) of this section
if the contract is an annuity contract, as defined in section 401(g),
that has been issued by an insurance company qualified to do business in
the State, and the contract meets the requirements of paragraphs (a)(1)
and (2) of this section, other than the requirement that it be a trust.
An annuity contract does not include a life, health or accident,
property, casualty, or liability insurance contract.
(4) Combining assets. [Reserved]
(b) Eligible plans maintained by tax-exempt entity--(1) General
rule. In order to be an eligible plan of a tax-exempt entity, the plan
must be unfunded and plan assets must not be set aside for participants
or their beneficiaries. Under section 457(b)(6) and this paragraph (b),
an eligible plan of a tax-exempt entity must provide that all amounts
deferred under the plan, all property and rights to property (including
rights as a beneficiary of a contract providing life insurance
protection) purchased with such amounts, and all income attributable to
such amounts, property, or rights, must remain (until paid or made
available to the participant or beneficiary) solely the property and
rights of the eligible employer (without being restricted to the
provision of benefits under the plan), subject only to the claims of the
eligible employer's general creditors.
(2) Additional requirements. For purposes of paragraph (b)(1) of
this section, the plan must be unfunded regardless of whether or not the
amounts were deferred pursuant to a salary reduction agreement between
the eligible employer and the participant. Any funding arrangement under
an eligible plan of a tax-exempt entity that sets aside assets for the
exclusive benefit of participants violates this requirement, and amounts
deferred are generally immediately includible in the gross income of
plan participants and beneficiaries. Nothing in this paragraph (b)
[[Page 177]]
prohibits an eligible plan from permitting participants and their
beneficiaries to make an election among different investment options
available under the plan, such as an election affecting the investment
of the amounts described in paragraph (b)(1) of this section.
[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]
Sec. 1.457-9 Effect on eligible plans when not administered in accordance
with eligibility requirements.
(a) Eligible governmental plans. A plan of a State ceases to be an
eligible governmental plan on the first day of the first plan year
beginning more than 180 days after the date on which the Commissioner
notifies the State in writing that the plan is being administered in a
manner that is inconsistent with one or more of the requirements of
Sec. Sec. 1.457-3 through 1.457-8 or 1.447-10. However, the plan may
correct the plan inconsistencies specified in the written notification
before the first day of that plan year and continue to maintain plan
eligibility. If a plan ceases to be an eligible governmental plan,
amounts subsequently deferred by participants will be includible in
income when deferred, or, if later, when the amounts deferred cease to
be subject to a substantial risk of forfeiture, as provided at Sec.
1.457-11. Amounts deferred before the date on which the plan ceases to
be an eligible governmental plan, and any earnings thereon, will be
treated as if the plan continues to be an eligible governmental plan and
will not be includible in participant's or beneficiary's gross income
until paid to the participant or beneficiary.
(b) Eligible plans of tax-exempt entities. A plan of a tax-exempt
entity ceases to be an eligible plan on the first day that the plan
fails to satisfy one or more of the requirements of Sec. Sec. 1.457-3
through 1.457-8, or Sec. 1.457-10. See Sec. 1.457-11 for rules
regarding the treatment of an ineligible plan.
[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003]
Sec. 1.457-10 Miscellaneous provisions.
(a) Plan terminations and frozen plans--(1) In general. An eligible
employer may amend its plan to eliminate future deferrals for existing
participants or to limit participation to existing participants and
employees. An eligible plan may also contain provisions that permit plan
termination and permit amounts deferred to be distributed on
termination. In order for a plan to be considered terminated, amounts
deferred under an eligible plan must be distributed to all plan
participants and beneficiaries as soon as administratively practicable
after termination of the eligible plan. The mere provision for, and
making of, distributions to participants or beneficiaries upon a plan
termination will not cause an eligible plan to cease to satisfy the
requirements of section 457(b) or the regulations.
(2) Employers that cease to be eligible employers--(i) Plan not
terminated. An eligible employer that ceases to be an eligible employer
may no longer maintain an eligible plan. If the employer was a tax-
exempt entity and the plan is not terminated as permitted under
paragraph (a)(2)(ii) of this section, the tax consequences to
participants and beneficiaries in the previously eligible (unfunded)
plan of an ineligible employer are determined in accordance with either
section 451 if the employer becomes an entity other than a State or
Sec. 1.457-11 if the employer becomes a State. If the employer was a
State and the plan is neither terminated as permitted under paragraph
(a)(2)(ii) of this section nor transferred to another eligible plan of
that State as permitted under paragraph (b) of this section, the tax
consequences to participants in the previously eligible governmental
plan of an ineligible employer, the assets of which are held in trust
pursuant to Sec. 1.457-8(a), are determined in accordance with section
402(b) (section 403(c) in the case of an annuity contract) and the trust
is no longer to be treated as a trust that is exempt from tax under
section 501(a).
(ii) Plan termination. As an alternative to determining the tax
consequences to the plan and participants under paragraph (a)(2)(i) of
this section, the employer may terminate the plan and distribute the
amounts deferred (and all plan assets) to all plan participants as soon
as administratively practicable in accordance with
[[Page 178]]
paragraph (a)(1) of this section. Such distribution may include eligible
rollover distributions in the case of a plan that was an eligible
governmental plan. In addition, if the employer is a State, another
alternative to determining the tax consequences under paragraph
(a)(2)(i) of this section is to transfer the assets of the eligible
governmental plan to an eligible governmental plan of another eligible
employer within the same State under the plan-to-plan transfer rules of
paragraph (b) of this section.
(3) Examples. The provisions of this paragraph (a) are illustrated
by the following examples:
Example 1. (i) Facts. Employer Y, a corporation that owns a State
hospital, sponsors an eligible governmental plan funded through a trust.
Employer Y is acquired by a for-profit hospital and Employer Y ceases to
be an eligible employer under section 457(e)(1) or Sec. 1.457-2(e).
Employer Y terminates the plan and, during the next 6 months,
distributes to participants and beneficiaries all amounts deferred that
were under the plan.
(ii) Conclusion. The termination and distribution does not cause the
plan to fail to be an eligible governmental plan. Amounts that are
distributed as eligible rollover distributions may be rolled over to an
eligible retirement plan described in section 402(c)(8)(B).
Example 2. (i) Facts. The facts are the same as in Example 1, except
that Employer Y decides to continue to maintain the plan.
(ii) Conclusion. If Employer Y continues to maintain the plan, the
tax consequences to participants and beneficiaries will be determined in
accordance with either section 402(b) if the compensation deferred is
funded through a trust, section 403(c) if the compensation deferred is
funded through annuity contracts, or Sec. 1.457-11 if the compensation
deferred is not funded through a trust or annuity contract. In addition,
if Employer Y continues to maintain the plan, the trust will no longer
be treated as exempt from tax under section 501(a).
Example 3. (i) Facts. Employer Z, a corporation that owns a tax-
exempt hospital, sponsors an unfunded eligible plan. Employer Z is
acquired by a for-profit hospital and is no longer an eligible employer
under section 457(e)(1) or Sec. 1.457-2(e). Employer Z terminates the
plan and distributes all amounts deferred under the eligible plan to
participants and beneficiaries within a one-year period.
(ii) Conclusion. Distributions under the plan are treated as made
under an eligible plan of a tax-exempt entity and the distributions of
the amounts deferred are includible in the gross income of the
participant or beneficiary in the year distributed.
Example 4. (i) Facts. The facts are the same as in Example 3, except
that Employer Z decides to maintain instead of terminate the plan.
(ii) Conclusion. If Employer Z maintains the plan, the tax
consequences to participants and beneficiaries in the plan will
thereafter be determined in accordance with section 451.
(b) Plan-to-plan transfers--(1) General rule. An eligible
governmental plan may provide for the transfer of amounts deferred by a
participant or beneficiary to another eligible governmental plan if the
conditions in paragraphs (b)(2), (3), or (4) of this section are met. An
eligible plan of a tax-exempt entity may provide for transfers of
amounts deferred by a participant to another eligible plan of a tax-
exempt entity if the conditions in paragraph (b)(5) of this section are
met. In addition, an eligible governmental plan may accept transfers
from another eligible governmental plan as described in the first
sentence of this paragraph (b)(1), and an eligible plan of a tax-exempt
entity may accept transfers from another eligible plan of a tax-exempt
entity as described in the preceding sentence. However, a State may not
transfer the assets of its eligible governmental plan to a tax-exempt
entity's eligible plan and the plan of a tax-exempt entity may not
accept such a transfer. Similarly, a tax-exempt entity may not transfer
the assets of its eligible plan to an eligible governmental plan and an
eligible governmental plan may not accept such a transfer. In addition,
if the conditions in paragraph (b)(4) of this section (relating to
permissive past service credit and repayments under section 415) are
met, an eligible governmental plan of a State may provide for the
transfer of amounts deferred by a participant or beneficiary to a
qualified plan (under section 401(a)) maintained by a State. However, a
qualified plan may not transfer assets to an eligible governmental plan
or to an eligible plan of a tax-exempt entity, and an eligible
governmental plan or the plan of a tax-exempt entity may not accept such
a transfer.
[[Page 179]]
(2) Requirements for post-severance plan-to-plan transfers among
eligible governmental plans. A transfer under paragraph (b)(1) of this
section from an eligible governmental plan to another eligible
governmental plan is permitted if the following conditions are met--
(i) The transferor plan provides for transfers;
(ii) The receiving plan provides for the receipt of transfers;
(iii) The participant or beneficiary whose amounts deferred are
being transferred will have an amount deferred immediately after the
transfer at least equal to the amount deferred with respect to that
participant or beneficiary immediately before the transfer; and
(iv) In the case of a transfer for a participant, the participant
has had a severance from employment with the transferring employer and
is performing services for the entity maintaining the receiving plan.
(3) Requirements for plan-to-plan transfers of all plan assets of
eligible governmental plan. A transfer under paragraph (b)(1) of this
section from an eligible governmental plan to another eligible
governmental plan is permitted if the following conditions are met--
(i) The transfer is from an eligible governmental plan to another
eligible governmental plan within the same State;
(ii) All of the assets held by the transferor plan are transferred;
(iii) The transferor plan provides for transfers;
(iv) The receiving plan provides for the receipt of transfers;
(v) The participant or beneficiary whose amounts deferred are being
transferred will have an amount deferred immediately after the transfer
at least equal to the amount deferred with respect to that participant
or beneficiary immediately before the transfer; and
(vi) The participants or beneficiaries whose deferred amounts are
being transferred are not eligible for additional annual deferrals in
the receiving plan unless they are performing services for the entity
maintaining the receiving plan.
(4) Requirements for plan-to-plan transfers among eligible
governmental plans of the same employer. A transfer under paragraph
(b)(1) of this section from an eligible governmental plan to another
eligible governmental plan is permitted if the following conditions are
met--
(i) The transfer is from an eligible governmental plan to another
eligible governmental plan of the same employer (and, for this purpose,
the employer is not treated as the same employer if the participant's
compensation is paid by a different entity);
(ii) The transferor plan provides for transfers;
(iii) The receiving plan provides for the receipt of transfers;
(iv) The participant or beneficiary whose amounts deferred are being
transferred will have an amount deferred immediately after the transfer
at least equal to the amount deferred with respect to that participant
or beneficiary immediately before the transfer; and
(v) The participant or beneficiary whose deferred amounts are being
transferred is not eligible for additional annual deferrals in the
receiving plan unless the participant or beneficiary is performing
services for the entity maintaining the receiving plan.
(5) Requirements for post-severance plan-to-plan transfers among
eligible plans of tax-exempt entities. A transfer under paragraph (b)(1)
of this section from an eligible plan of a tax-exempt employer to
another eligible plan of a tax-exempt employer is permitted if the
following conditions are met--
(i) The transferor plan provides for transfers;
(ii) The receiving plan provides for the receipt of transfers;
(iii) The participant or beneficiary whose amounts deferred are
being transferred will have an amount deferred immediately after the
transfer at least equal to the amount deferred with respect to that
participant or beneficiary immediately before the transfer; and
(iv) In the case of a transfer for a participant, the participant
has had a severance from employment with the transferring employer and
is performing services for the entity maintaining the receiving plan.
[[Page 180]]
(6) Treatment of amount transferred following a plan-to-plan
transfer between eligible plans. Following a transfer of any amount
between eligible plans under paragraphs (b)(1) through (b)(5) of this
section--
(i) The transferred amount is subject to the restrictions of Sec.
1.457-6 (relating to when distributions are permitted to be made to a
participant under an eligible plan) in the receiving plan in the same
manner as if the transferred amount had been originally been deferred
under the receiving plan if the participant is performing services for
the entity maintaining the receiving plan, and
(ii) In the case of a transfer between eligible plans of tax-exempt
entities, except as otherwise determined by the Commissioner, the
transferred amount is subject to Sec. 1.457-7(c)(2) (relating to when
amounts are considered to be made available under an eligible plan of a
tax-exempt entity) in the same manner as if the elections made by the
participant or beneficiary under the transferor plan had been made under
the receiving plan.
(7) Examples. The provisions of paragraphs (b)(1) through (6) of
this section are illustrated by the following examples:
Example 1. (i) Facts. Participant A, the president of City X's
hospital, has accepted a position with another hospital which is a tax-
exempt entity. A participates in the eligible governmental plan of City
X. A would like to transfer the amounts deferred under City X's eligible
governmental plan to the eligible plan of the tax-exempt hospital.
(ii) Conclusion. City X's plan may not transfer A's amounts deferred
to the tax-exempt employer's eligible plan. In addition, because the
amounts deferred would no longer be held in trust for the exclusive
benefit of participants and their beneficiaries, the transfer would
violate the exclusive benefit rule of section 457(g) and Sec. 1.457-
8(a).
Example 2. (i) Facts. County M, located in State S, operates several
health clinics and maintains an eligible governmental plan for employees
of those clinics. One of the clinics operated by County M is being
acquired by a hospital operated by State S, and employees of that clinic
will become employees of State S. County M permits those employees to
transfer their balances under County M's eligible governmental plan to
the eligible governmental plan of State S.
(ii) Conclusion. If the eligible governmental plans of County M and
State S provide for the transfer and acceptance of the transfer (and the
other requirements of paragraph (b)(1) of this section are satisfied),
then the requirements of paragraph (b)(2) of this section are satisfied
and, thus, the transfer will not cause either plan to violate the
requirements of section 457 or these regulations.
Example 3. (i) Facts. City Employer Z, a hospital, sponsors an
eligible governmental plan. City Employer Z is located in State B. All
of the assets of City Employer Z are being acquired by a tax-exempt
hospital. City Employer Z, in accordance with the plan-to-plan transfer
rules of paragraph (b) of this section, would like to transfer the total
amount of assets deferred under City Employer Z's eligible governmental
plan to the acquiring tax-exempt entity's eligible plan.
(ii) Conclusion. City Employer Z may not permit participants to
transfer the amounts to the eligible plan of the tax-exempt entity. In
addition, because the amounts deferred would no longer be held in trust
for the exclusive benefit of participants and their beneficiaries, the
transfer would violate the exclusive benefit rule of section 457(g) and
Sec. 1.457-8(a).
Example 4. (i) Facts. The facts are the same as in Example 3, except
that City Employer Z, instead of transferring all of its assets to the
eligible plan of the tax-exempt entity, decides to transfer all of the
amounts deferred under City Z's eligible governmental plan to the
eligible governmental plan of County B in which City Z is located.
County B's eligible plan does not cover employees of City Z, but is
willing to allow the assets of City Z's plan to be transferred to County
B's plan, a related state government entity, also located in State B.
(ii) Conclusion. If City Employer Z's (transferor) eligible
governmental plan provides for such transfer and the eligible
governmental plan of County B permits the acceptance of such a transfer
(and the other requirements of paragraph (b)(1) of this section are
satisfied), then the requirements of paragraph (b)(3) of this section
are satisfied and, thus, City Employer Z may transfer the total amounts
deferred under its eligible governmental plan, prior to termination of
that plan, to the eligible governmental plan maintained by County B.
However, the participants of City Employer Z whose deferred amounts are
being transferred are not eligible to participate in the eligible
governmental plan of County B, the receiving plan, unless they are
performing services for County B.
Example 5. (i) Facts. State C has an eligible governmental plan.
Employees of City U in State C are among the eligible employees for
State C's plan and City U decides to adopt another eligible governmental
plan only for its employees. State C decides to allow employees to elect
to transfer all of the
[[Page 181]]
amounts deferred for an employee under State C's eligible governmental
plan to City U's eligible governmental plan.
(ii) Conclusion. If State C's (transferor) eligible governmental
plan provides for such transfer and the eligible governmental plan of
City U permits the acceptance of such a transfer (and the other
requirements of paragraph (b)(1) of this section are satisfied), then
the requirements of paragraph (b)(4) of this section are satisfied and,
thus, State C may transfer the total amounts deferred under its eligible
governmental plan to the eligible governmental plan maintained by City
U.
(8) Purchase of permissive service credit by plan-to-plan transfers
from an eligible governmental plan to a qualified plan--(i) General
rule. An eligible governmental plan of a State may provide for the
transfer of amounts deferred by a participant or beneficiary to a
defined benefit governmental plan (as defined in section 414(d)), and no
amount shall be includible in gross income by reason of the transfer, if
the conditions in paragraph (b)(8)(ii) of this section are met. A
transfer under this paragraph (b)(8) is not treated as a distribution
for purposes of Sec. 1.457-6. Therefore, such a transfer may be made
before severance from employment.
(ii) Conditions for plan-to-plan transfers from an eligible
governmental plan to a qualified plan. A transfer may be made under this
paragraph (b)(8) only if the transfer is either--
(A) For the purchase of permissive service credit (as defined in
section 415(n)(3)(A)) under the receiving defined benefit governmental
plan; or
(B) A repayment to which section 415 does not apply by reason of
section 415(k)(3).
(iii) Example. The provisions of this paragraph (b)(8) are
illustrated by the following example:
Example. (i) Facts. Plan X is an eligible governmental plan
maintained by County Y for its employees. Plan X provides for
distributions only in the event of death, an unforeseeable emergency, or
severance from employment with County Y (including retirement from
County Y). Plan S is a qualified defined benefit plan maintained by
State T for its employees. County Y is within State T. Employee A is an
employee of County Y and is a participant in Plan X. Employee A
previously was an employee of State T and is still entitled to benefits
under Plan S. Plan S includes provisions allowing participants in
certain plans, including Plan X, to transfer assets to Plan S for the
purchase of service credit under Plan S and does not permit the amount
transferred to exceed the amount necessary to fund the benefit resulting
from the service credit. Although not required to do so, Plan X allows
Employee A to transfer assets to Plan S to provide a service benefit
under Plan S.
(ii) Conclusion. The transfer is permitted under this paragraph
(b)(8).
(c) Qualified domestic relations orders under eligible plans--(1)
General rule. An eligible plan does not become an ineligible plan
described in section 457(f) solely because its administrator or sponsor
complies with a qualified domestic relations order as defined in section
414(p), including an order requiring the distribution of the benefits of
a participant to an alternate payee in advance of the general rules for
eligible plan distributions under Sec. 1.457-6. If a distribution or
payment is made from an eligible plan to an alternate payee pursuant to
a qualified domestic relations order, rules similar to the rules of
section 402(e)(1)(A) shall apply to the distribution or payment.
(2) Examples. The provisions of this paragraph (c) are illustrated
by the following examples:
Example 1. (i) Facts. Participant C and C's spouse D are divorcing.
C is employed by State S and is a participant in an eligible plan
maintained by State S. C has an account valued at $100,000 under the
plan. Pursuant to the divorce, a court issues a qualified domestic
relations order on September 1, 2003 that allocates 50 percent of C's
$100,000 plan account to D and specifically provides for an immediate
distribution to D of D's share within 6 months of the order. Payment is
made to D in January of 2004.
(ii) Conclusion. State S's eligible plan does not become an
ineligible plan described in section 457(f) and Sec. 1.457-11 solely
because its administrator or sponsor complies with the qualified
domestic relations order requiring the immediate distribution to D in
advance of the general rules for eligible plan distributions under Sec.
1.457-6. In accordance with section 402(e)(1)(A), D (not C) must include
the distribution in gross income. The distribution is includible in D's
gross income in 2004. If the qualified domestic relations order were to
provide for distribution to D at a future date, amounts deferred
attributable to D's share will be includible in D's gross income when
paid to D.
Example 2. (i) Facts. The facts are the same as in Example 1, except
that S is a tax-exempt entity, instead of a State.
[[Page 182]]
(ii) Conclusion. State S's eligible plan does not become an
ineligible plan described in section 457(f) and Sec. 1.457-11 solely
because its administrator or sponsor complies with the qualified
domestic relations order requiring the immediate distribution to D in
advance of the general rules for eligible plan distributions under Sec.
1.457-6. In accordance with section 402(e)(1)(A), D (not C) must include
the distribution in gross income. The distribution is includible in D's
gross income in 2004, assuming that the plan did not make the
distribution available to D in 2003. If the qualified domestic relations
order were to provide for distribution to D at a future date, amounts
deferred attributable to D's share would be includible in D's gross
income when paid or made available to D.
(d) Death benefits and life insurance proceeds. A death benefit plan
under section 457(e)(11) is not an eligible plan. In addition, no amount
paid or made available under an eligible plan as death benefits or life
insurance proceeds is excludable from gross income under section 101.
(e) Rollovers to eligible governmental plans--(1) General rule. An
eligible governmental plan may accept contributions that are eligible
rollover distributions (as defined in section 402(c)(4)) made from
another eligible retirement plan (as defined in section 402(c)(8)(B)) if
the conditions in paragraph (e)(2) of this section are met. Amounts
contributed to an eligible governmental plan as eligible rollover
distributions are not taken into account for purposes of the annual
limit on annual deferrals by a participant in Sec. 1.457-4(c) or Sec.
1.457-5, but are otherwise treated in the same manner as amounts
deferred under section 457 for purposes of Sec. Sec. 1.457-3 through
1.457-9 and this section.
(2) Conditions for rollovers to an eligible governmental plan. An
eligible governmental plan that permits eligible rollover distributions
made from another eligible retirement plan to be paid into the eligible
governmental plan is required under this paragraph (e)(2) to provide
that it will separately account for any eligible rollover distributions
it receives. A plan does not fail to satisfy this requirement if it
separately accounts for particular types of eligible rollover
distributions (for example, if it maintains a separate account for
eligible rollover distributions attributable to annual deferrals that
were made under other eligible governmental plans and a separate account
for amounts attributable to other eligible rollover distributions), but
this requirement is not satisfied if any such separate account includes
any amount that is not attributable to an eligible rollover
distribution.
(3) Example. The provisions of this paragraph (e) are illustrated by
the following example:
Example. (i) Facts. Plan T is an eligible governmental plan that
provides that employees who are eligible to participate in Plan T may
make rollover contributions to Plan T from amounts distributed to an
employee from an eligible retirement plan. An eligible retirement plan
is defined in Plan T as another eligible governmental plan, a qualified
section 401(a) or 403(a) plan, or a section 403(b) contract, or an
individual retirement arrangement (IRA) that holds such amounts. Plan T
requires rollover contributions to be paid by the eligible retirement
plan directly to Plan T (a direct rollover) or to be paid by the
participant within 60 days after the date on which the participant
received the amount from the other eligible retirement plan. Plan T does
not take rollover contributions into account for purposes of the plan's
limits on amounts deferred that conform to Sec. 1.457-4(c). Rollover
contributions paid to Plan T are invested in the trust in the same
manner as amounts deferred under Plan T and rollover contributions (and
earnings thereon) are available for distribution to the participant at
the same time and in the same manner as amounts deferred under Plan T.
In addition, Plan T provides that, for each participant who makes a
rollover contribution to Plan T, the Plan T record-keeper is to
establish a separate account for the participant's rollover
contributions. The record-keeper calculates earnings and losses for
investments held in the rollover account separately from earnings and
losses on other amounts held under the plan and calculates disbursements
from and payments made to the rollover account separately from
disbursements from and payments made to other amounts held under the
plan.
(ii) Conclusion. Plan T does not lose its status as an eligible
governmental plan as a result of the receipt of rollover contributions.
The conclusion would not be different if the Plan T record-keeper were
to establish two separate accounts, one of which is for the
participant's rollover contributions attributable to annual deferrals
that were made under an eligible governmental plan and the other of
which is for other rollover contributions.
[[Page 183]]
(f) Deemed IRAs under eligible governmental plans. See regulations
under section 408(q) for guidance regarding the treatment of separate
accounts or annuities as individual retirement plans (IRAs).
[T.D. 9075, 68 FR 41240, July 11, 2003; 68 FR 51447, Aug. 27, 2003; T.D.
9319, 72 FR 16931, Apr. 5, 2007]
Sec. 1.457-11 Tax treatment of participants if plan is not an eligible plan.
(a) In general. Under section 457(f), if an eligible employer
provides for a deferral of compensation under any agreement or
arrangement that is an ineligible plan--
(1) Compensation deferred under the agreement or arrangement is
includible in the gross income of the participant or beneficiary for the
first taxable year in which there is no substantial risk of forfeiture
(within the meaning of section 457(f)(3)(B)) of the rights to such
compensation;
(2) If the compensation deferred is subject to a substantial risk of
forfeiture, the amount includible in gross income for the first taxable
year in which there is no substantial risk of forfeiture includes
earnings thereon to the date on which there is no substantial risk of
forfeiture;
(3) Earnings credited on the compensation deferred under the
agreement or arrangement that are not includible in gross income under
paragraph (a)(2) of this section are includible in the gross income of
the participant or beneficiary only when paid or made available to the
participant or beneficiary, provided that the interest of the
participant or beneficiary in any assets (including amounts deferred
under the plan) of the entity sponsoring the agreement or arrangement is
not senior to the entity's general creditors; and
(4) Amounts paid or made available to a participant or beneficiary
under the agreement or arrangement are includible in the gross income of
the participant or beneficiary under section 72, relating to annuities.
(b) Exceptions. Paragraph (a) of this section does not apply with
respect to--
(1) A plan described in section 401(a) which includes a trust exempt
from tax under section 501(a);
(2) An annuity plan or contract described in section 403;
(3) That portion of any plan which consists of a transfer of
property described in section 83;
(4) That portion of any plan which consists of a trust to which
section 402(b) applies; or
(5) A qualified governmental excess benefit arrangement described in
section 415(m).
(c) Amount included in income. The amount included in gross income
on the applicable date under paragraphs (a)(1) and (a)(2) of this
section is equal to the present value of the compensation (including
earnings to the extent provided in paragraph (a)(2) of this section) on
that date. For purposes of applying section 72 on the applicable date
under paragraphs (a)(3) and (4) of this section, the participant is
treated as having paid investment in the contract (or basis) to the
extent that the deferred compensation has been taken into account by the
participant in accordance with paragraphs (a)(1) and (a)(2) of this
section.
(d) Coordination of section 457(f) with section 83--(1) General
rules. Under paragraph (b)(3) of this section, section 457(f) and
paragraph (a) of this section do not apply to that portion of any plan
which consists of a transfer of property described in section 83. For
this purpose, a transfer of property described in section 83 means a
transfer of property to which section 83 applies. Section 457(f) and
paragraph (a) of this section do not apply if the date on which there is
no substantial risk of forfeiture with respect to compensation deferred
under an agreement or arrangement that is not an eligible plan is on or
after the date on which there is a transfer of property to which section
83 applies. However, section 457(f) and paragraph (a) of this section
apply if the date on which there is no substantial risk of forfeiture
with respect to compensation deferred under an agreement or arrangement
that is not an eligible plan precedes the date on which there is a
transfer of property to which section 83 applies. If deferred
compensation payable in property is
[[Page 184]]
includible in gross income under section 457(f), then, as provided in
section 72, the amount includible in gross income when that property is
later transferred or made available to the service provider is the
excess of the value of the property at that time over the amount
previously included in gross income under section 457(f).
(2) Examples. The provisions of this paragraph (d) are illustrated
in the following examples:
Example 1. (i) Facts. As part of an arrangement for the deferral of
compensation, an eligible employer agrees on December 1, 2002 to pay an
individual rendering services for the eligible employer a specified
dollar amount on January 15, 2005. The arrangement provides for the
payment to be made in the form of property having a fair market value
equal to the specified dollar amount. The individual's rights to the
payment are not subject to a substantial risk of forfeiture (within the
meaning of section 457(f)(3)(B)).
(ii) Conclusion. In this Example 1, because there is no substantial
risk of forfeiture with respect to the agreement to transfer property in
2005, the present value (as of December 1, 2002) of the payment is
includible in the individual's gross income for 2002. Under paragraph
(a)(4) of this section, when the payment is made on January 15, 2005,
the amount includible in the individual's gross income is equal to the
excess of the fair market value of the property when paid, over the
amount that was includible in gross income for 2002 (which is the basis
allocable to that payment).
Example 2. (i) Facts. As part of an arrangement for the deferral of
compensation, individuals A and B rendering services for a tax-exempt
entity each receive in 2010 property that is subject to a substantial
risk of forfeiture (within the meaning of section 457(f)(3)(B) and
within the meaning of section 83(c)(1)). Individual A makes an election
to include the fair market value of the property in gross income under
section 83(b) and individual B does not make this election. The
substantial risk of forfeiture for the property transferred to
individual A lapses in 2012 and the substantial risk of forfeiture for
the property transferred to individual B also lapses in 2012. Thus, the
property transferred to individual A is included in A's gross income for
2010 when A makes a section 83(b) election and the property transferred
to individual B is included in B's gross income for 2012 when the
substantial risk of forfeiture for the property lapses.
(ii) Conclusion. In this Example 2, in each case, the compensation
deferred is not subject to section 457(f) or this section because
section 83 applies to the transfer of property on or before the date on
which there is no substantial risk of forfeiture with respect to
compensation deferred under the arrangement.
Example 3. (i) Facts. In 2004, Z, a tax-exempt entity, grants an
option to acquire property to employee C. The option lacks a readily
ascertainable fair market value, within the meaning of section 83(e)(3),
has a value on the date of grant equal to $100,000, and is not subject
to a substantial risk of forfeiture (within the meaning of section
457(f)(3)(B) and within the meaning of section 83(c)(1)). Z exercises
the option in 2012 by paying an exercise price of $75,000 and receives
property that has a fair market value (for purposes of section 83) equal
to $300,000.
(ii) Conclusion. In this Example 3, under section 83(e)(3), section
83 does not apply to the grant of the option. Accordingly, C has income
of $100,000 in 2004 under section 457(f). In 2012, C has income of
$125,000, which is the value of the property transferred in 2012, minus
the allocable portion of the basis that results from the $100,000 of
income in 2004 and the $75,000 exercise price.
Example 4. (i) Facts. In 2010, X, a tax-exempt entity, agrees to pay
deferred compensation to employee D. The amount payable is $100,000 to
be paid 10 years later in 2020. The commitment to make the $100,000
payment is not subject to a substantial risk of forfeiture. In 2010, the
present value of the $100,000 is $50,000. In 2018, X transfers to D
property having a fair market value (for purposes of section 83) equal
to $70,000. The transfer is in partial settlement of the commitment made
in 2010 and, at the time of the transfer in 2018, the present value of
the commitment is $80,000. In 2020, X pays D the $12,500 that remains
due.
(ii) Conclusion. In this Example 4, D has income of $50,000 in 2010.
In 2018, D has income of $30,000, which is the amount transferred in
2018, minus the allocable portion of the basis that results from the
$50,000 of income in 2010. (Under section 72(e)(2)(B), income is
allocated first. The income is equal to $30,000 ($80,000 minus the
$50,000 basis), with the result that the allocable portion of the basis
is equal to $40,000 ($70,000 minus the $30,000 of income).) In 2020, D
has income of $2,500 ($12,500 minus $10,000, which is the excess of the
original $50,000 basis over the $40,000 basis allocated to the transfer
made in 2018).
[T.D. 9075, 68 FR 41240, July 11, 2003]
Sec. 1.457-12 Effective dates.
(a) General effective date. Except as otherwise provided in this
section, Sec. Sec. 1.457-1 through 1.457-11 apply for taxable years
beginning after December 31, 2001.
(b) Transition period for eligible plans to comply with EGTRRA. For
taxable years beginning after December 31,
[[Page 185]]
2001, and before January 1, 2004, a plan does not fail to be an eligible
plan as a result of requirements imposed by the Economic Growth and Tax
Relief Reconciliation Act of 2001 (115 Stat. 385) (EGTRRA) (Public Law
107-16) June 7, 2001, if it is operated in accordance with a reasonable,
good faith interpretation of EGTRRA.
(c) Special rule for distributions from rollover accounts. The last
sentence of Sec. 1.457-6(a) (relating to distributions of amounts held
in a separate account for eligible rollover distributions) applies for
taxable years beginning after December 31, 2003.
(d) Special rule for options. Section 1.457-11(d) does not apply
with respect to an option without a readily ascertainable fair market
value (within the meaning of section 83(e)(3)) that was granted on or
before May 8, 2002.
(e) Special rule for qualified domestic relations orders. Section
1.457-10(c) (relating to qualified domestic relations orders) applies
for transfers, distributions, and payments made after December 31, 2001.
[T.D. 9075, 68 FR 41240, July 11, 2003]
Sec. 1.458-1 Exclusion for certain returned magazines, paperbacks,
or records.
(a) In general--(1) Introduction. For taxable years beginning after
September 30, 1979, section 458 allows accrual basis taxpayers to elect
to use a method of accounting that excludes from gross income some or
all of the income attributable to qualified sales during the taxable
year of magazines, paperbacks, or records, that are returned before the
close of the applicable merchandise return period for that taxable year.
Any amount so excluded cannot be excluded or deducted from gross income
for the taxable year in which the merchandise is returned to the
taxpayer. For the taxable year in which the taxpayer first uses this
method of accounting, the taxpayer is not allowed to exclude from gross
income amounts attributable to merchandise returns received during the
taxable year that would have been excluded from gross income for the
prior taxable year had the taxpayer used this method of accounting for
that prior year. (See paragraph (e) of this section for rules describing
how this amount should be taken into account.) The election to use this
method of accounting shall be made in accordance with the rules
contained in section 458(c) and in Sec. 1.458-2 and this section. A
taxpayer that does not elect to use this method of accounting can reduce
income for returned merchandise only for the taxable year in which the
merchandise is actually returned unsold by the purchaser.
(2) Effective date. While this section is generally effective only
for taxable years beginning after August 31, 1984, taxpayers may rely on
the provisions of paragraphs (a) through (f) of this section in taxable
years beginning after September 30, 1979.
(b) Definitions--(1) Magazine. ``Magazine'' means a publication,
usually paper-backed and sometimes illustrated, that is issued at
regular intervals and contains stories, poems, articles, features, etc.
This term includes periodicals, but does not include newspapers or
volumes of a single publication issued at various intervals. However,
volumes of a single publication that are issued at least annually, are
related by title or subject matter to a magazine, and would otherwise
qualify as a magazine, will be treated as a magazine.
(2) Paperback. ``Paperback'' means a paperback book other than a
magazine. Unlike a hardback book, which usually has stiff front and back
covers that enclose pages bound to a separate spine, a paperback book is
characterized by a flexible outer cover to which the pages of the book
are directly affixed.
(3) Record. ``Record'' means a disc, tape, or similar item on which
music, spoken or other sounds are recorded. However, the term does not
include blank records, tapes, etc., on which it is expected the ultimate
purchaser will record. The following items, provided they carry pre-
recorded sound, are examples of ``records'': audio and video cassettes,
eight-track tapes, reel-to-reel tapes, cylinders, and flat, compact, and
laser discs.
(4) Qualified sale. In order for a sale to be considered a qualified
sale, both of the following conditions must be met:
[[Page 186]]
(i) The taxpayer must be under a legal obligation (as determined by
applicable State law), at the time of sale, to adjust the sales price of
the magazine, paperback, or record on account of the purchaser's failure
to resell it; and
(ii) The taxpayer must actually adjust the sales price of the
magazine, paperback, or record to reflect the purchaser's failure to
resell the merchandise. The following are examples of adjustments to the
sales price of unsold merchandise: Cash refunds, credits to the account
of the purchaser, and repurchases of the merchandise. The adjustment
need not be equal to the full amount of the sales price of the item.
However, a markdown of the sales price under an agreement whereby the
purchaser continues to hold the merchandise for sale or other
disposition (other than solely for scrap) does not constitute an
adjustment resulting from a failure to resell.
(5) Merchandise return period--(i) In general. Unless the taxpayer
elects a shorter period, the ``merchandise return period'' is the period
that ends 2 months and 15 days after the close of the taxable year for
sales of magazines and 4 months and 15 days after the close of the
taxable year for sales of paperbacks and records.
(ii) Election to use shorter period. The taxpayer may select a
shorter merchandise return period than the applicable period set forth
in paragraph (b)(5)(i) of this section.
(iii) Change in merchandise return period. Any change in the
merchandise return period after its initial establishment will be
treated as a change in method of accounting.
(c) Amount of the exclusion--(1) In general. Except as otherwise
provided in paragraph (g) of this section, the amount of the gross
income exclusion with respect to any qualified sale is equal to the
lesser of--
(i) The amount covered by the legal obligation referred to in
paragraph (b)(4)(i) of this section; or
(ii) The amount of the adjustment agreed to by the taxpayer before
the close of the merchandise return period.
(2) Price adjustment in excess of legal obligation. The excess, if
any, of the amount described in paragraph (c)(1)(ii) of this section
over the amount described in paragraph (c)(1)(i) of this section should
be excluded in the taxable year in which it is properly accruable under
section 461.
(d) Return of the merchandise--(1) In general. (i) The exclusion
from gross income allowed by section 458 applies with respect to a
qualified sale of merchandise only if the seller receives, before the
close of the merchandise return period, either--
(A) The physical return of the merchandise; or
(B) Satisfactory evidence that the merchandise has not been and will
not be resold (as defined in paragraph (d)(2) of this section).
(ii) For purposes of this paragraph (d), evidence of a return
received by an agent of the seller (other than the purchaser who
purchased the merchandise from the seller) will be considered to be
received by the seller at the time the agent receives the merchandise or
evidence.
(2) Satisfactory evidence. Evidence that merchandise has not been
and will not be resold is satisfactory only if the seller receives--
(i) Physical return of some portion of the merchandise (e.g.,
covers) provided under either the agreement between the seller and the
purchaser or industry practice (such return evidencing the fact that the
purchaser has not and will not resell the merchandise); or
(ii) A written statement from the purchaser specifying the
quantities of each title not resold, provided either--
(A) The statement contains a representation that the items specified
will not be resold by the purchaser; or
(B) The past dealings, if any, between the parties and industry
practice indicate that such statement constitutes a promise by the
purchaser not to resell the items.
(3) Retention of evidence. In the case of a return of merchandise
(described in paragraph (d)(1)(i)(A) of this section) or portion thereof
(described in paragraph (d)(2)(i) of this section), the seller has no
obligation to retain physical evidence of the returned merchandise or
portion thereof, provided the seller maintains documentary evidence that
describes the quantity of physical
[[Page 187]]
items returned to the seller and indicates that the items were returned
before the close of the merchandise return period.
(e) Transitional adjustment--(1) In general. An election to change
from some other method of accounting for the return of magazines,
paperbacks, or records to the method of accounting described in section
458 is a change in method of accounting that requires a transitional
adjustment. Section 458 provides special rules for transitional
adjustments that must be taken into account as a result of this change.
See paragraph (e)(2) of this section for special rules applicable to
magazines and paragraphs (e) (3) and (4) of this section for special
rules applicable to paperbacks and records.
(2) Magazines: 5-year spread of decrease in taxable income. For
taxpayers who have elected to use the method of accounting described in
section 458 to account for returned magazines for a taxable year,
section 458(d) and this paragraph (e)(2) provide a special rule for
taking into account any decrease in taxable income resulting from the
adjustment required by section 481(a)(2). Under these provisions, one-
fifth of the transitional adjustment must be taken into account in the
taxable year of the change and in each of the 4 succeeding taxable
years. For example, if the application of section 481(a)(2) would
produce a decrease in taxable income of $50 for 1980, the year of
change, then $10 (one-fifth of $50) must be taken into account as a
decrease in taxable income for 1980, 1981, 1982, 1983, and 1984.
(3) Suspense account for paperbacks and records--(i) In general. For
taxpayers who have elected to use the method of accounting described in
section 458 to account for returned paperbacks and records for a taxable
year, section 458(e) provides that, in lieu of applying section 481, an
electing taxpayer must establish a separate suspense account for its
paperback business and its record business. The initial opening balance
of the suspense account is described in paragraph (e)(3)(ii)(A) of this
section. An initial adjustment to gross income for the year of election
is described in paragraph (e)(3)(ii)(B) of this section. Annual
adjustments to the suspense account are described in paragraph
(e)(3)(iii)(A) of this section. Gross income adjustments are described
in paragraph (e)(3)(iii)(B) of this section. Examples are provided in
paragraph (e)(4) of this section. The effect of the suspense account is
to defer all, or some part, of the deduction of the transitional
adjustment until the taxpayer is no longer engaged in the trade or
business of selling paperbacks or records, whichever is applicable.
(ii) Establishing a suspense account--(A) Initial opening balance.
To compute the initial opening balance of the suspense account for the
first taxable year for which an election is effective, the taxpayer must
determine the section 458 amount (as defined in paragraph (e)(3)(ii)(C)
of this section) for each of the three preceding taxable years. The
initial opening balance of the account is the largest of the section 458
amounts.
(B) Initial year adjustment. If the initial opening balance in the
suspense account exceeds the section 458 amount (as defined in paragraph
(e)(3)(ii)(C) of this section) for the taxable year immediately
preceding the year of election, the excess is included in the taxpayer's
gross income for the first taxable year for which the election was made.
(C) Section 458 amount. For purposes of paragraph (e)(3)(ii) of this
section, the section 458 amount for a taxable year is the dollar amount
of merchandise returns that would have been excluded from gross income
under section 458(a) for that taxable year if the section 458 election
had been in effect for that taxable year.
(iii) Annual adjustments--(A) Adjustment to the suspense account.
Adjustments are made to the suspense account each year to account for
fluctuations in merchandise returns. To compute the annual adjustment,
the taxpayer must determine the amount to be excluded under the election
from gross income under section 458(a) for the taxable year. If the
amount is less than the opening balance in the suspense account for the
taxable year, the balance in the suspense account is reduced by the
difference. Conversely, if the amount is greater than the opening
balance in the suspense account for the
[[Page 188]]
taxable year, the account is increased by the difference, but not to an
amount in excess of the initial opening balance described in paragraph
(e)(3)(ii)(A) of this section. Therefore, the balance in the suspense
account will never be greater than the initial opening balance in the
suspense account determined in paragraph (e)(3)(ii)(A) of this section.
However, the balance in the suspense account after adjustments may be
less than this initial opening balance in the suspense account.
(B) Gross income adjustments. Adjustments to the suspense account
for years subsequent to the year of election also produce adjustments in
the taxpayer's gross income. Adjustments which reduce the balance in the
suspense account reduce gross income for the year in which the
adjustment to the suspense account is made. Adjustments which increase
the balance in the suspense account increase gross income for the year
in which the adjustment to the suspense account is made.
(4) Example. The provisions of paragraph (e)(3) of this section may
be illustrated by the following example:
Example: (i) X corporation, a paperback distributor, makes a timely
section 458 election for its taxable year ending December 31, 1980. If
the election had been in effect for the taxable years ending on December
31, 1977, 1978, and 1979, the dollar amounts of the qualifying returns
would have been $5, $8, and $6, respectively. The initial opening
balance of X's suspense account on January 1, 1980, is $8, the largest
of these amounts. Since the initial opening balance ($8), is larger than
the qualifying returns for 1979 ($6), the initial adjustment to gross
income for 1980 is $2 ($8-$6).
(ii) X has $5 in qualifying returns for its taxable year ending
December 31, 1980. X must reduce its suspense account by $3, which is
the excess of the opening balance ($8) over the amount of qualifying
returns for the 1980 taxable year ($5). X also reduces its gross income
for 1980 by $3. Thus, the net amount excludable from gross income for
the 1980 taxable year after taking into account the qualifying returns,
the gross income adjustment, and the initial year adjustment is $6 ($3 +
$5-$2).
(iii) X has qualifying returns of $7 for its taxable year ending
December 31, 1981. X must increase its suspense account balance by $2,
which is the excess of the amount of qualifying returns for 1981 ($7)
over X's opening balance in the suspense account ($5). X must also
increase its gross income by $2. Thus, the net income excludable from
gross income for the 1981 taxable year after taking into account the
qualifying returns and the gross income adjustment is $5 ($7-$2).
(iv) X has qualifying returns of $10 for its taxable year ending
December 31, 1982. The opening balance in X's suspense account of $7
will not be increased in excess of the initial opening balance ($8). X
must also increase gross income by $1. Thus, the net amount excludable
from gross income for the 1982 taxable year is $9 ($10-$1).
(v) This example is summarized by the following table:
----------------------------------------------------------------------------------------------------------------
Years Ending December 31
-----------------------------------------------------------------------------
1977 1978 1979 1980 \1\ 1981 1982
----------------------------------------------------------------------------------------------------------------
Facts:
Qualifying returns during $5 $8 $6 $5 $7 $10
merchandise return period for
the taxable year.............
=============================================================================
Adjustment to suspense account:
Opening balance............... ........... ........... ........... $8 $5 $7
Addition to account \2\....... ........... ........... ........... ........... 2 1
Reduction to account \3\...... ........... ........... ........... (3)
-----------------------------------------------------------------------------
Opening balance for next ........... ........... ........... $5 $7 $8
year.......................
=============================================================================
Amount excludable from income:
Initial year adjustment....... ........... ........... ........... $(2)
Amount excludable as ........... ........... ........... 5 $7 $10
qualifying returns in
merchandise return period....
Adjustment for increase in ........... ........... ........... ........... (2) (1)
suspense account.............
Adjustment for decrease in ........... ........... ........... 3
suspense account.............
-----------------------------------------------------------------------------
[[Page 189]]
Net amount excludable for ........... ........... ........... $6 $5 $9
the year...................
----------------------------------------------------------------------------------------------------------------
\1\ Year of Change.
\2\ Applies when qualifying returns during the merchandise return period exceed the opening balance; the
addition is not to cause the suspense account to exceed the initial opening balance.
\3\ Applies when qualifying returns during the merchandise return period are less than the opening balance.
(f) Subchapter C transactions--(1) General rule. If a transfer of
substantially all the assets of a trade or business in which paperbacks
or records are sold is made to an acquiring corporation, and if the
acquiring corporation determines its basis in these assets, in whole or
part, with reference to the basis of these assets in the hands of the
transferor, then for the purposes of section 458(e) the principles of
section 381 and Sec. 1.381(c)(4)-1 will apply. The application of this
rule is not limited to the transactions described in section 381(a).
Thus, the rule also applies, for example, to transactions described in
section 351.
(2) Special rules. If, in the case of a transaction described in
paragraph (f)(1) of this section, an acquiring corporation acquires
assets that were used in a trade or business that was not subject to a
section 458 election from a transferor that is owned or controlled
directly (or indirectly through a chain of corporations) by the same
interests, and if the acquiring corporation uses the acquired assets in
a trade or business for which the acquiring corporation later makes an
election to use section 458, then the acquiring corporation must
establish a suspense account by taking into account not only its own
experience but also the transferor's experience when the transferor held
the assets in its trade or business. Furthermore, the transferor is not
allowed a deduction or exclusion for merchandise returned after the date
of the transfer attributable to sales made by the transferor before the
date of the transfer. Such returns shall be considered to be received by
the acquiring corporation.
(3) Example. The provisions of paragraph (f)(2) of this section may
be illustrated by the following example.
Example. Corporation S, a calendar year taxpayer, is a wholly owned
subsidiary of Corporation P, a calendar year taxpayer. On December 31,
1982, S acquires from P substantially all of the assets used in a trade
or business in which records are sold. P had not made an election under
section 458 with respect to the qualified sale of records made in
connection with that trade or business. S makes an election to use
section 458 for its taxable year ending December 31, 1983, for the trade
or business in which the acquired assets are used. P's qualified record
returns within the 4 month and 15 day merchandise return period
following the 1980 and 1981 taxable years were $150 and $170,
respectively. S's qualified record returns during the merchandise return
period following 1982 were $160. S must establish a suspense account by
taking into account both P's and S's experience for the 3 immediately
preceding taxable years. Thus, the initial opening balance of S's
suspense account is $170. S must also make an initial year adjustment of
$10 ($170--$160), which S must include in income for S's taxable year
ending December 31, 1983. P is not entitled to a deduction or exclusion
for merchandise received after the date of the transfer (December 31,
1982) attributable to sales made by the transferor before the date of
transfer. Thus, P is not entitled to a deduction or exclusion for the
$160 of merchandise received by S during the first 4 months and 15 days
of 1983.
(g) Adjustment to inventory and cost of goods sold. (1) If a
taxpayer makes adjustments to gross receipts for a taxable year under
the method of accounting described in section 458, the taxpayer, in
determining excludable gross income, is also required to make
appropriate correlative adjustments to purchases or closing inventory
and to cost of goods sold for the same taxable year. Adjustments are
appropriate, for example, where the taxpayer holds the merchandise
returned for resale or where the taxpayer is entitled to receive a price
adjustment from the person or entity that sold the merchandise to the
taxpayer. Cost of goods sold must be properly adjusted in accordance
with
[[Page 190]]
the provisions of Sec. 1.61-3 which provides, in pertinent part, that
gross income derived from a manufacturing or merchandising business
equals total sales less cost of goods sold.
(2) The provisions of this paragraph (g) may be illustrated by the
following examples. These examples do not, however, reflect any required
adjustments under paragraph (e)(3) of this section.
Example 1. (i) In 1986, P, a publisher, properly elects under
section 458 of the Code not to include in its gross income in the year
of sale, income attributable to qualified sales of paperback books
returned within the specified statutory merchandise return period of 4
months and 15 days. P and D, a distributor, agree that P shall provide D
with a full refund for paperback books that D purchases from P and is
unable to resell, provided the merchandise is returned to P within four
months following the original sale. The agreement constitutes a legal
obligation. The agreement provides that D's return of the covers of
paperback books within the first four months following their sale
constitutes satisfactory evidence that D has not resold and will not
resell the paperback books. During P's 1989 taxable year, pursuant to
the agreement, P sells D 500 paperback books for $1 each. In 1990,
during the merchandise return period, D returns covers from 100 unsold
paperback books representing $100 of P's 1989 sales of paperback books.
P's cost attributable to the returned books is $25. No adjustment to
cost of goods sold is required under paragraph (g)(1) of this section
because P is not holding returned merchandise for resale. P's proper
amount excluded from its 1989 gross income under section 458 is $100.
(ii) If D returns the paperback books, rather than the covers, to P
and these same books are then held by P for resale to other customers,
paragraph (g)(1) of this section applies. Under paragraph (g)(1), P is
required to decrease its cost of goods sold by $25, the amount of P's
cost attributable to the returned merchandise. The proper amount
excluded from P's 1989 gross income under section 458 is $75, resulting
from adjustments to sales and cost of sales [(100 x $1)--$25].
Example 2. (i) In 1986, D, a distributor, properly elects under
section 458 of the Code not to include in its gross income in the year
of sale, income attributable to qualified sales of paperback books
returned within the specified statutory merchandise return period of
four months and 15 days. D and R, a retailer, agree that D shall provide
a full refund for paperback books that R purchases from it and is unable
to resell. D and R also have agreed that the merchandise must be
returned to D within four months following the original sale. The
agreement constitutes a legal obligation. D is similarly entitled to a
full refund from P, the publisher, for the same paperback books. In
1990, during the merchandise return period, R returns paperback books to
D representing $100 of 1989 sales. D's cost relating to these sales is
$50. Under paragraph (g)(1) of this section, D must decrease its costs
of goods sold by $50. D's proper amount excluded from its 1989 gross
income under section 458 is $50 resulting from adjustments to sales and
costs of sales ($100--$50).
(ii) If D is instead only entitled to a 50 percent refund from P, D
is required under paragraph (g)(1) of this section to decrease its costs
of goods sold by $25, the amount of refund from P. D's proper amount
excluded from its 1989 gross income under section 458 is $75, resulting
from adjustments to sales and cost of sales ($100--$25).
[T.D. 8426, 57 FR 38596, Aug. 26, 1992; 57 FR 45879, Oct. 5, 1992]
Sec. 1.458-2 Manner of and time for making election.
(a) Scope. For taxable years beginning after September 30, 1979,
section 458 provides a special method of accounting for taxpayers who
account for sales of magazines, paperbacks, or records using an accrual
method of accounting. In order to use the special method of accounting
under section 458, a taxpayer must make an election in the manner
prescribed in this section. The election does not require the prior
consent of the Internal Revenue Service. The election is effective for
the taxable year for which it is made and for all subsequent taxable
years, unless the taxpayer secures the prior consent of the Internal
Revenue Service to revoke such election.
(b) Separate election for each trade or business. An election is
made with respect to each trade or business of a taxpayer in connection
with which qualified sales (as defined in section 458(b)(5)) of a
category of merchandise were made. Magazines, paperbacks, and records
are each treated as a separate category of merchandise. If qualified
sales of two or more categories of merchandise are made in connection
with the same trade or business, then solely for purposes of section
458, each category is treated as a separate trade or business. For
example, if a taxpayer makes qualified sales of both magazines and
paperbacks in the same trade or business, then solely for purposes of
[[Page 191]]
section 458, the qualified sales relating to magazines are considered
one trade or business and the qualified sales relating to paperbacks are
considered a separate trade or business. Thus, if the taxpayer wishes to
account under section 458 for the qualified sales of both magazines and
paperbacks, such taxpayer must make a separate election for each
category.
(c) Manner of, and time for, making election. An election is made
under section 458 and this section by filing a statement of election
containing the information described in paragraph (d) of this section
with the taxpayer's income tax return for first taxable year for which
the election is made. The election must be made no later than the time
prescribed by law (including extensions) for filing the income tax
return for the first taxable year for which the election is made. Thus,
the election may not be filed with an amended income tax return after
the prescribed date (including extensions) for filing the original
return for such year.
(d) Required information. The statement of election required by
paragraph (c) of this section must indicate that an election is being
made under section 458(c) and must set forth the following information:
(1) The taxpayer's name, address, and identification number;
(2) A description of each trade or business for which an election is
made;
(3) The first taxable year for which an election is made for each
trade or business;
(4) The merchandise return period (as defined in section 458(b)(7))
for each trade or business for which an election is made;
(5) With respect to an election that applies to magazines, the
amount of the adjustment computed under section 481(a) resulting from
the change to the method of accounting described in section 458; and
(6) With respect to an election that applies to paperbacks or
records, the initial opening balance (computed in accordance with
section 458(e)) in the suspense account for each trade or business for
which an election is made.
The statement of election should be made on a Form 3115 which need
contain no information other than that required by this paragraph.
[T.D. 7628, 44 FR 33398, June 11, 1979. Redesignated by T.D. 8426, 57 FR
38599, Aug. 26, 1992]
Sec. 1.460-0 Outline of regulations under section 460.
This section lists the paragraphs contained in Sec. 1.460-1 through
Sec. 1.460-6.
Sec. 1.460-1 Long-term contracts.
(a) Overview.
(1) In general.
(2) Exceptions to required use of PCM.
(i) Exempt construction contract.
(ii) Qualified ship or residential construction contract.
(b) Terms.
(1) Long-term contract.
(2) Contract for the manufacture, building, installation, or
construction of property.
(i) In general.
(ii) De minimis construction activities.
(3) Allocable contract costs.
(4) Related party.
(5) Contracting year.
(6) Completion year.
(7) Contract commencement date.
(8) Incurred.
(9) Independent research and development expenses.
(10) Long-term contract methods of accounting.
(c) Entering into and completing long-term contracts.
(1) In general.
(2) Date contract entered into.
(i) In general.
(ii) Options and change orders.
(3) Date contract completed.
(i) In general.
(ii) Secondary items.
(iii) Subcontracts.
(iv) Final completion and acceptance.
(A) In general.
(B) Contingent compensation.
(C) Assembly or installation.
(D) Disputes.
(d) Allocation among activities.
(1) In general.
(2) Non-long-term contract activity.
(e) Severing and aggregating contracts.
(1) In general.
(2) Facts and circumstances.
(i) Pricing.
(ii) Separate delivery or acceptance.
(iii) Reasonable businessperson.
(3) Exceptions.
(i) Severance for PCM.
(ii) Options and change orders.
(4) Statement with return.
(f) Classifying contracts.
(1) In general.
(2) Hybrid contracts.
(i) In general.
[[Page 192]]
(ii) Elections.
(3) Method of accounting.
(4) Use of estimates.
(i) Estimating length of contract.
(ii) Estimating allocable contract costs.
(g) Special rules for activities benefitting long-term contracts of
a related party.
(1) Related party use of PCM.
(i) In general.
(ii) Exception for components and subassemblies.
(2) Total contract price.
(3) Completion factor.
(h) Effective date.
(1) In general.
(2) Change in method of accounting.
(i) [Reserved]
(j) Examples.
Sec. 1.460-2 Long-term manufacturing contracts.
(a) In general.
(b) Unique.
(1) In general.
(2) Safe harbors.
(i) Short production period.
(ii) Customized item.
(iii) Inventoried item.
(c) Normal time to complete.
(1) In general.
(2) Production by related parties.
(d) Qualified ship contracts.
(e) Examples.
Sec. 1.460-3 Long-term construction contracts.
(a) In general.
(b) Exempt construction contracts.
(1) In general.
(2) Home construction contract.
(i) In general.
(ii) Townhouses and rowhouses.
(iii) Common improvements.
(iv) Mixed use costs.
(3) $10,000,000 gross receipts test.
(i) In general.
(ii) Single employer.
(iii) Attribution of gross receipts.
(c) Residential construction contracts.
Sec. 1.460-4 Methods of accounting for long-term contracts.
(a) Overview.
(b) Percentage-of-completion method.
(1) In general.
(2) Computations.
(3) Post-completion-year income.
(4) Total contract price.
(i) In general.
(A) Definition.
(B) Contingent compensation.
(C) Non-long-term contract activities.
(ii) Estimating total contract price.
(5) Completion factor.
(i) Allocable contract costs.
(ii) Cumulative allocable contract costs.
(iii) Estimating total allocable contract costs.
(iv) Pre-contracting-year costs.
(v) Post-completion-year costs.
(6) 10-percent method.
(i) In general.
(ii) Election.
(7) Terminated contract.
(i) Reversal of income.
(ii) Adjusted basis.
(iii) Look-back method.
(c) Exempt contract methods.
(1) In general.
(2) Exempt-contract percentage-of-completion method.
(i) In general.
(ii) Determination of work performed.
(d) Completed-contract method.
(1) In general.
(2) Post-completion-year income and costs.
(3) Gross contract price.
(4) Contracts with disputed claims.
(i) In general.
(ii) Taxpayer assured of profit or loss.
(iii) Taxpayer unable to determine profit or loss.
(iv) Dispute resolved.
(e) Percentage-of-completion/capitalized-cost method.
(f) Alternative minimum taxable income.
(1) In general.
(2) Election to use regular completion factors.
(g) Method of accounting.
(h) Examples.
(i) [Reserved]
(j) Consolidated groups and controlled groups.
(1) Intercompany transactions.
(i) In general.
(ii) Definitions and nomenclature.
(2) Example.
(3) Effective dates.
(i) In general.
(ii) Prior law.
(4) Consent to change method of accounting.
(k) Mid-contract change in taxpayer.
(1) In general.
(2) Constructive completion transactions.
(i) Scope.
(ii) Old taxpayer.
(iii) New taxpayer.
(iv) Special rules relating to distributions of certain contracts by
a partnership.
(A) In general.
(B) Old taxpayer.
(C) New taxpayer.
(D) Basis rules.
(E) Section 751.
(1) In general.
(2) Ordering rules.
(3) Step-in-the-shoes transactions.
(i) Scope.
(ii) Old taxpayer.
(A) In general.
(B) Gain realized on the transaction.
(iii) New taxpayer.
(A) Method of accounting.
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(B) Contract price.
(C) Contract costs.
(iv) Special rules related to certain corporate and partnership
transactions.
(A) Old taxpayer--basis adjustment.
(1) In general.
(2) Basis adjustment in excess of stock or partnership interest
basis.
(3) Subsequent dispositions of certain contracts.
(B) New taxpayer.
(1) Contract price adjustment.
(2) Basis in contract.
(C) Definition of old taxpayer and new taxpayer for certain
partnership transactions.
(D) Exceptions to step-in-the-shoes rules for S corporations.
(v) Special rules relating to certain partnership transactions.
(A) Section 704(c).
(1) Contributions of contracts.
(2) Revaluations of partnership property.
(3) Allocation methods.
(B) Basis adjustments under sections 743(b) and 734(b).
(C) Cross reference.
(D) Exceptions to step-in-the-shoes rules.
(4) Anti-abuse rule.
(5) Examples.
(6) Effective date.
Sec. 1.460-5 Cost allocation rules.
(a) Overview.
(b) Cost allocation method for contracts subject to PCM.
(1) In general.
(2) Special rules.
(i) Direct material costs.
(ii) Components and subassemblies.
(iii) Simplified production methods.
(iv) Costs identified under cost-plus long-term contracts and
federal long-term contracts.
(v) Interest.
(A) In general.
(B) Production period.
(C) Application of section 263A(f).
(vi) Research and experimental expenses.
(vii) Service costs.
(A) Simplified service cost method.
(1) In general.
(2) Example.
(B) Jobsite costs.
(C) Limitation on other reasonable cost allocation methods.
(c) Simplified cost-to-cost method for contracts subject to the PCM.
(1) In general.
(2) Election.
(d) Cost allocation rules for exempt construction contracts reported
using CCM.
(1) In general.
(2) Indirect costs.
(i) Indirect costs allocable to exempt construction contracts.
(ii) Indirect costs not allocable to exempt construction contracts.
(3) Large homebuilders.
(e) Cost allocation rules for contracts subject to the PCCM.
(f) Special rules applicable to costs allocated under this section.
(1) Nondeductible costs.
(2) Costs incurred for non-long-term contract activities.
(g) Method of accounting.
Sec. 1.460-6 Look-back method.
(a) In general.
(1) Introduction.
(2) Overview.
(b) Scope of look-back method.
(1) In general.
(2) Exceptions from section 460.
(3) De minimis exception.
(4) Alternative minimum tax.
(5) Effective date.
(c) Operation of the look-back method.
(1) Overview.
(i) In general.
(ii) Post-completion revenue and expenses.
(A) In general.
(B) Completion.
(C) Discounting of contract price and contract cost adjustments
subsequent to completion; election not to discount.
(1) General rule.
(2) Election not to discount.
(3) Year-end discounting convention.
(D) Revenue acceleration rule.
(2) Look-back Step One.
(i) Hypothetical reallocation of income among prior tax years.
(ii) Treatment of estimated future costs in year of completion.
(iii) Interim reestimates not considered.
(iv) Tax years in which income is affected.
(v) Costs incurred prior to contract execution; 10-percent method.
(A) General rule.
(B) Example.
(vi) Amount treated as contract price.
(A) General rule.
(B) Contingencies.
(C) Change orders.
(3) Look-back Step Two: Computation of hypothetical overpayment or
underpayment of tax.
(i) In general.
(ii) Redetermination of tax liability.
(iii) Hypothetical underpayment or overpayment.
(iv) Cumulative determination of tax liability.
(v) Years affected by look-back only.
(vi) Definition of tax liability.
(4) Look-back Step Three: Calculation of interest on underpayment or
overpayment.
(i) In general.
(ii) Changes in the amount of a loss or credit carryback or
carryover.
(iii) Changes in the amount of tax liability that generated a
subsequent refund.
(d) Simplified marginal impact method.
[[Page 194]]
(1) Introduction.
(2) Operation.
(i) In general.
(ii) Applicable tax rate.
(iii) Overpayment ceiling.
(iv) Example.
(3) Anti-abuse rule.
(4) Application.
(i) Required use by certain pass-through entities.
(A) General rule.
(B) Closely held.
(C) Examples.
(D) Domestic contracts.
(1) General rule.
(2) Portion of contract income sourced.
(E) Application to foreign contracts.
(F) Effective date.
(ii) Elective use.
(A) General rule.
(B) Election requirements.
(C) Consolidated group consistency rule.
(e) Delayed reapplication method.
(1) In general.
(2) Time and manner of making election.
(3) Examples.
(f) Look-back reporting.
(1) Procedure.
(2) Treatment of interest on return.
(i) General rule.
(ii) Timing of look-back interest.
(3) Statutes of limitations and compounding of interest on look-back
interest.
(g) Mid-contract change in taxpayer.
(1) In general.
(2) Constructive completion transactions.
(3) Step-in-the-shoes transactions.
(i) General rules.
(ii) Application of look-back method to pre-transaction period.
(A) Contract price
(B) Method.
(C) Interest accrual period.
(D) Information old taxpayer must provide.
(1) In general.
(2) Special rules for certain pass-through entity transactions.
(iii) Application of look-back method to post-transaction years.
(iv) S corporation elections.
(4) Effective date.
(h) Examples.
(1) Overview.
(2) Step One.
(3) Step Two.
(4) Post-completion adjustments.
(5) Alternative minimum tax.
(6) Credit carryovers.
(7) Net operating losses.
(8) Alternative minimum tax credit.
(9) Period for interest.
(i) [Reserved]
(j) Election not to apply look-back method in de minimis cases.
[T.D. 9315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8597, 60 FR
36683, July 18, 1995; T.D. 8756, 63 FR 1918, Jan. 13, 1998; T.D. 8775,
63 FR 36181, July 2, 1998; T.D. 8929, 66 FR 2224, Jan. 11, 2001; T.D.
8995, 67 FR 34605, May 15, 2002; T.D. 9137, 69 FR 42553, July 16, 2004]
Sec. 1.460-1 Long-term contracts.
(a) Overview--(1) In general. This section provides rules for
determining whether a contract for the manufacture, building,
installation, or construction of property is a long-term contract under
section 460 and what activities must be accounted for as a single long-
term contract. Specific rules for long-term manufacturing and
construction contracts are provided in Sec. Sec. 1.460-2 and 1.460-3,
respectively. A taxpayer generally must determine the income from a
long-term contract using the percentage-of-completion method described
in Sec. 1.460-4(b) (PCM) and the cost allocation rules described in
Sec. 1.460-5(b) or (c). In addition, after a contract subject to the
PCM is completed, a taxpayer generally must apply the look-back method
described in Sec. 1.460-6 to determine the amount of interest owed on
any hypothetical underpayment of tax, or earned on any hypothetical
overpayment of tax, attributable to accounting for the long-term
contract under the PCM.
(2) Exceptions to required use of PCM--(i) Exempt construction
contract. The requirement to use the PCM does not apply to any exempt
construction contract described in Sec. 1.460-3(b). Thus, a taxpayer
may determine the income from an exempt construction contract using any
accounting method permitted by Sec. 1.460-4(c) and, for contracts
accounted for using the completed-contract method (CCM), any cost
allocation method permitted by Sec. 1.460-5(d). Exempt construction
contracts that are not subject to the PCM or CCM are not subject to the
cost allocation rules of Sec. 1.460-5 except for the production-period
interest rules of Sec. 1.460-5(b)(2)(v). Exempt construction
contractors that are large homebuilders described in Sec. 1.460-5(d)(3)
must capitalize costs under section 263A. All other exempt construction
contractors must account for the cost of construction using the
appropriate rules contained in other
[[Page 195]]
sections of the Internal Revenue Code or regulations.
(ii) Qualified ship or residential construction contract. The
requirement to use the PCM applies only to a portion of a qualified ship
contract described in Sec. 1.460-2(d) or residential construction
contract described in Sec. 1.460-3(c). A taxpayer generally may
determine the income from a qualified ship contract or residential
construction contract using the percentage-of-completion/capitalized-
cost method (PCCM) described in Sec. 1.460-4(e), but must use a cost
allocation method described in Sec. 1.460-5(b) for the entire contract.
(b) Terms--(1) Long-term contract. A long-term contract generally is
any contract for the manufacture, building, installation, or
construction of property if the contract is not completed within the
contracting year, as defined in paragraph (b)(5) of this section.
However, a contract for the manufacture of property is a long-term
contract only if it also satisfies either the unique item or 12-month
requirements described in Sec. 1.460-2. A contract for the manufacture
of personal property is a manufacturing contract. In contrast, a
contract for the building, installation, or construction of real
property is a construction contract.
(2) Contract for the manufacture, building, installation, or
construction of property--(i) In general. A contract is a contract for
the manufacture, building, installation, or construction of property if
the manufacture, building, installation, or construction of property is
necessary for the taxpayer's contractual obligations to be fulfilled and
if the manufacture, building, installation, or construction of that
property has not been completed when the parties enter into the
contract. If a taxpayer has to manufacture or construct an item to
fulfill its obligations under the contract, the fact that the taxpayer
is not required to deliver that item to the customer is not relevant.
Whether the customer has title to, control over, or bears the risk of
loss from, the property manufactured or constructed by the taxpayer also
is not relevant. Furthermore, how the parties characterize their
agreement (e.g., as a contract for the sale of property) is not
relevant.
(ii) De minimis construction activities. Notwithstanding paragraph
(b)(2)(i) of this section, a contract is not a construction contract
under section 460 if the contract includes the provision of land by the
taxpayer and the estimated total allocable contract costs, as defined in
paragraph (b)(3) of this section, attributable to the taxpayer's
construction activities are less than 10 percent of the contract's total
contract price, as defined in Sec. 1.460-4(b)(4)(i). For the purposes
of this paragraph (b)(2)(ii), the allocable contract costs attributable
to the taxpayer's construction activities do not include the cost of the
land provided to the customer. In addition, a contract's estimated total
allocable contract costs include a proportionate share of the estimated
cost of any common improvement that benefits the subject matter of the
contract if the taxpayer is contractually obligated, or required by law,
to construct the common improvement.
(3) Allocable contract costs. Allocable contract costs are costs
that are allocable to a long-term contract under Sec. 1.460-5.
(4) Related party. A related party is a person whose relationship to
a taxpayer is described in section 707(b) or 267(b), determined without
regard to section 267(f)(1)(A) and determined by replacing ``at least 80
percent'' with ``more than 50 percent'' for the purposes of determining
the ownership of the stock of a corporation in sections 267(b)(2), (8),
(10)(A), and (12).
(5) Contracting year. The contracting year is the taxable year in
which a taxpayer enters into a contract as described in paragraph (c)(2)
of this section.
(6) Completion year. The completion year is the taxable year in
which a taxpayer completes a contract as described in paragraph (c)(3)
of this section.
(7) Contract commencement date. The contract commencement date is
the date that a taxpayer or related party first incurs any allocable
contract costs, such as design and engineering costs, other than
expenses attributable to bidding and negotiating activities. Generally,
the contract commencement date is relevant in applying
[[Page 196]]
Sec. 1.460-6(b)(3) (concerning the de minimis exception to the look-
back method under section 460(b)(3)(B)); Sec. 1.460-5(b)(2)(v)(B)(1)(i)
(concerning the production period subject to interest allocation); Sec.
1.460-2(d) (concerning qualified ship contracts); and Sec. 1.460-
3(b)(1)(ii) (concerning the construction period for exempt construction
contracts).
(8) Incurred. Incurred has the meaning given in Sec. 1.461-1(a)(2)
(concerning the taxable year a liability is incurred under the accrual
method of accounting), regardless of a taxpayer's overall method of
accounting. See Sec. 1.461-4(d)(2)(ii) for economic performance rules
concerning the PCM.
(9) Independent research and development expenses. Independent
research and development expenses are any expenses incurred in the
performance of research or development, except that this term does not
include any expenses that are directly attributable to a particular
long-term contract in existence when the expenses are incurred and this
term does not include any expenses under an agreement to perform
research or development.
(10) Long-term contract methods of accounting. Long-term contract
methods of accounting, which include the PCM, the CCM, the PCCM, and the
exempt-contract percentage-of-completion method (EPCM), are methods of
accounting that may be used only for long-term contracts.
(c) Entering into and completing long-term contracts--(1) In
general. To determine when a contract is entered into under paragraph
(c)(2) of this section and completed under paragraph (c)(3) of this
section, a taxpayer must consider all relevant allocable contract costs
incurred and activities performed by itself, by related parties on its
behalf, and by the customer, that are incident to or necessary for the
long-term contract. In addition, to determine whether a contract is
completed in the contracting year, the taxpayer may not consider when it
expects to complete the contract.
(2) Date contract entered into--(i) In general. A taxpayer enters
into a contract on the date that the contract binds both the taxpayer
and the customer under applicable law, even if the contract is subject
to unsatisfied conditions not within the taxpayer's control (such as
obtaining financing). If a taxpayer delays entering into a contract for
a principal purpose of avoiding section 460, however, the taxpayer will
be treated as having entered into a contract not later than the contract
commencement date.
(ii) Options and change orders. A taxpayer enters into a new
contract on the date that the customer exercises an option or similar
provision in a contract if that option or similar provision must be
severed from the contract under paragraph (e) of this section.
Similarly, a taxpayer enters into a new contract on the date that it
accepts a change order or other similar agreement if the change order or
other similar agreement must be severed from the contract under
paragraph (e) of this section.
(3) Date contract completed--(i) In general. A taxpayer's contract
is completed upon the earlier of--
(A) Use of the subject matter of the contract by the customer for
its intended purpose (other than for testing) and at least 95 percent of
the total allocable contract costs attributable to the subject matter
have been incurred by the taxpayer; or
(B) Final completion and acceptance of the subject matter of the
contract.
(ii) Secondary items. The date a contract accounted for using the
CCM is completed is determined without regard to whether one or more
secondary items have been used or finally completed and accepted. If any
secondary items are incomplete at the end of the taxable year in which
the primary subject matter of a contract is completed, the taxpayer must
separate the portion of the gross contract price and the allocable
contract costs attributable to the incomplete secondary item(s) from the
completed contract and account for them using a permissible method of
accounting. A permissible method of accounting includes a long-term
contract method of accounting only if a separate contract for the
secondary item(s) would be a long-term contract, as defined in paragraph
(b)(1) of this section.
(iii) Subcontracts. In the case of a subcontract, a subcontractor's
customer is
[[Page 197]]
the general contractor. Thus, the subject matter of the subcontract is
the relevant subject matter under paragraph (c)(3)(i) of this section.
(iv) Final completion and acceptance--(A) In general. Except as
otherwise provided in this paragraph (c)(3)(iv), to determine whether
final completion and acceptance of the subject matter of a contract have
occurred, a taxpayer must consider all relevant facts and circumstances.
Nevertheless, a taxpayer may not delay the completion of a contract for
the principal purpose of deferring federal income tax.
(B) Contingent compensation. Final completion and acceptance is
determined without regard to any contractual term that provides for
additional compensation that is contingent on the successful performance
of the subject matter of the contract. A taxpayer must account for all
contingent compensation that is not includible in total contract price
under Sec. 1.460-4(b)(4)(i), or in gross contract price under Sec.
1.460-4(d)(3), using a permissible method of accounting. For application
of the look-back method for contracts accounted for using the PCM, see
Sec. 1.460-6(c)(1)(ii) and (2)(vi).
(C) Assembly or installation. Final completion and acceptance is
determined without regard to whether the taxpayer has an obligation to
assist or supervise assembly or installation of the subject matter of
the contract where the assembly or installation is not performed by the
taxpayer or a related party. A taxpayer must account for the gross
receipts and costs attributable to such an obligation using a
permissible method of accounting, other than a long-term contract
method.
(D) Disputes. Final completion and acceptance is determined without
regard to whether a dispute exists at the time the taxpayer tenders the
subject matter of the contract to the customer. For contracts accounted
for using the CCM, see Sec. 1.460-4(d)(4). For application of the look-
back method for contracts accounted for using the PCM, see Sec. 1.460-
6(c)(1)(ii) and (2)(vi).
(d) Allocation among activities--(1) In general. Long-term contract
methods of accounting apply only to the gross receipts and costs
attributable to long-term contract activities. Gross receipts and costs
attributable to long-term contract activities means amounts included in
total contract price or gross contract price, whichever is applicable,
as determined under Sec. 1.460-4, and costs allocable to the contract,
as determined under Sec. 1.460-5. Gross receipts and costs attributable
to non-long-term contract activities (as defined in paragraph (d)(2) of
this section) generally must be taken into account using a permissible
method of accounting other than a long-term contract method. See section
446(c) and Sec. 1.446-1(c). However, if the performance of a non-long-
term contract activity is incident to or necessary for the manufacture,
building, installation, or construction of the subject matter of one or
more of the taxpayer's long-term contracts, the gross receipts and costs
attributable to that activity must be allocated to the long-term
contract(s) benefitted as provided in Sec. Sec. 1.460-4(b)(4)(i) and
1.460-5(f)(2), respectively. Similarly, if a single long-term contract
requires a taxpayer to perform a non-long-term contract activity that is
not incident to or necessary for the manufacture, building,
installation, or construction of the subject matter of the long-term
contract, the gross receipts and costs attributable to that non-long-
term contract activity must be separated from the contract and accounted
for using a permissible method of accounting other than a long-term
contract method. But see paragraph (g) of this section for related party
rules.
(2) Non-long-term contract activity. Non-long-term contract activity
means the performance of an activity other than manufacturing, building,
installation, or construction, such as the provision of architectural,
design, engineering, and construction management services, and the
development or implementation of computer software. In addition,
performance under a guaranty, warranty, or maintenance agreement is a
non-long-term contract activity that is never incident to or necessary
for the manufacture or construction of property under a long-term
contract.
(e) Severing and aggregating contracts--(1) In general. After
application of the allocation rules of paragraph (d)
[[Page 198]]
of this section, the severing and aggregating rules of this paragraph
(e) may be applied by the Commissioner or the taxpayer as necessary to
clearly reflect income (e.g., to prevent the unreasonable deferral (or
acceleration) of income or the premature recognition (or deferral) of
loss). Under the severing and aggregating rules, one agreement may be
treated as two or more contracts, and two or more agreements may be
treated as one contract. Except as provided in paragraph (e)(3)(ii) of
this section, a taxpayer must determine whether to sever an agreement or
to aggregate two or more agreements based on the facts and circumstances
known at the end of the contracting year.
(2) Facts and circumstances. Whether an agreement should be severed,
or two or more agreements should be aggregated, depends on the following
factors:
(i) Pricing. Independent pricing of items in an agreement is
necessary for the agreement to be severed into two or more contracts. In
the case of an agreement for similar items, if the price to be paid for
the items is determined under different terms or formulas (e.g., if some
items are priced under a cost-plus incentive fee arrangement and later
items are to be priced under a fixed-price arrangement), then the
difference in the pricing terms or formulas indicates that the items are
independently priced. Similarly, interdependent pricing of items in
separate agreements is necessary for two or more agreements to be
aggregated into one contract. A single price negotiation for similar
items ordered under one or more agreements indicates that the items are
interdependently priced.
(ii) Separate delivery or acceptance. An agreement may not be
severed into two or more contracts unless it provides for separate
delivery or separate acceptance of items that are the subject matter of
the agreement. However, the separate delivery or separate acceptance of
items by itself does not necessarily require an agreement to be severed.
(iii) Reasonable businessperson. Two or more agreements to perform
manufacturing or construction activities may not be aggregated into one
contract unless a reasonable businessperson would not have entered into
one of the agreements for the terms agreed upon without also entering
into the other agreement(s). Similarly, an agreement to perform
manufacturing or construction activities may not be severed into two or
more contracts if a reasonable businessperson would not have entered
into separate agreements containing terms allocable to each severed
contract. Analyzing the reasonable businessperson standard requires an
analysis of all the facts and circumstances of the business arrangement
between the taxpayer and the customer. For purposes of this paragraph
(e)(2)(iii), a taxpayer's expectation that the parties would enter into
another agreement, when agreeing to the terms contained in the first
agreement, is not relevant.
(3) Exceptions--(i) Severance for PCM. A taxpayer may not sever
under this paragraph (e) a long-term contract that would be subject to
the PCM without obtaining the Commissioner's prior written consent.
(ii) Options and change orders. Except as provided in paragraph
(e)(3)(i) of this section, a taxpayer must sever an agreement that
increases the number of units to be supplied to the customer, such as
through the exercise of an option or the acceptance of a change order,
if the agreement provides for separate delivery or separate acceptance
of the additional units.
(4) Statement with return. If a taxpayer severs an agreement or
aggregates two or more agreements under this paragraph (e) during the
taxable year, the taxpayer must attach a statement to its original
federal income tax return for that year. This statement must contain the
following information--
(i) The legend NOTIFICATION OF SEVERANCE OR AGGREGATION UNDER SEC.
1.460-1(e);
(ii) The taxpayer's name; and
(iii) The taxpayer's employer identification number or social
security number.
(f) Classifying contracts--(1) In general. After applying the
severing and aggregating rules of paragraph (e) of this section, a
taxpayer must determine the classification of a contract (e.g., as a
long-term manufacturing contract, long-term construction contract, non-
[[Page 199]]
long-term contract) based on all the facts and circumstances known no
later than the end of the contracting year. Classification is determined
on a contract-by-contract basis. Consequently, a requirement to
manufacture a single unique item under a long-term contract will subject
all other items in that contract to section 460.
(2) Hybrid contracts--(i) In general. A long-term contract that
requires a taxpayer to perform both manufacturing and construction
activities (hybrid contract) generally must be classified as two
contracts, a manufacturing contract and a construction contract. A
taxpayer may elect, on a contract-by-contract basis, to classify a
hybrid contract as a long-term construction contract if at least 95
percent of the estimated total allocable contract costs are reasonably
allocable to construction activities. In addition, a taxpayer may elect,
on a contract-by-contract basis, to classify a hybrid contract as a
long-term manufacturing contract subject to the PCM.
(ii) Elections. A taxpayer makes an election under this paragraph
(f)(2) by using its method of accounting for similar construction
contracts or for manufacturing contracts, whichever is applicable, to
account for a hybrid contract entered into during the taxable year of
the election on its original federal income tax return for the election
year. If an electing taxpayer's method is the PCM, the taxpayer also
must use the PCM to apply the look-back method under Sec. 1.460-6 and
to determine alternative minimum taxable income under Sec. 1.460-4(f).
(3) Method of accounting. Except as provided in paragraph (f)(2)(ii)
of this section, a taxpayer's method of classifying contracts is a
method of accounting under section 446 and, thus, may not be changed
without the Commissioner's consent. If a taxpayer's method of
classifying contracts is unreasonable, that classification method is an
impermissible accounting method.
(4) Use of estimates--(i) Estimating length of contract. A taxpayer
must use a reasonable estimate of the time required to complete a
contract when necessary to classify the contract (e.g., to determine
whether the five-year completion rule for qualified ship contracts under
Sec. 1.460-2(d), or the two-year completion rule for exempt
construction contracts under Sec. 1.460-3(b), is satisfied, but not to
determine whether a contract is completed within the contracting year
under paragraph (b)(1) of this section). To be considered reasonable, an
estimate of the time required to complete the contract must include
anticipated time for delay, rework, change orders, technology or design
problems, or other problems that reasonably can be anticipated
considering the nature of the contract and prior experience. A contract
term that specifies an expected completion or delivery date may be
considered evidence that the taxpayer reasonably expects to complete or
deliver the subject matter of the contract on or about the date
specified, especially if the contract provides bona fide penalties for
failing to meet the specified date. If a taxpayer classifies a contract
based on a reasonable estimate of completion time, the contract will not
be reclassified based on the actual (or another reasonable estimate of)
completion time. A taxpayer's estimate of completion time will not be
considered unreasonable if a contract is not completed within the
estimated time primarily because of unforeseeable factors not within the
taxpayer's control, such as third-party litigation, extreme weather
conditions, strikes, or delays in securing permits or licenses.
(ii) Estimating allocable contract costs. A taxpayer must use a
reasonable estimate of total allocable contract costs when necessary to
classify the contract (e.g., to determine whether a contract is a home
construction contract under Sec. 1.460-(3)(b)(2)). If a taxpayer
classifies a contract based on a reasonable estimate of total allocable
contract costs, the contract will not be reclassified based on the
actual (or another reasonable estimate of) total allocable contract
costs.
(g) Special rules for activities benefitting long-term contracts of
a related party--(1) Related party use of PCM--(i) In general. Except as
provided in paragraph (g)(1)(ii) of this section, if a related party and
its customer enter into a long-term contract subject to the
[[Page 200]]
PCM, and a taxpayer performs any activity that is incident to or
necessary for the related party's long-term contract, the taxpayer must
account for the gross receipts and costs attributable to this activity
using the PCM, even if this activity is not otherwise subject to section
460(a). This type of activity may include, for example, the performance
of engineering and design services, and the production of components and
subassemblies that are reasonably expected to be used in the production
of the subject matter of the related party's contract.
(ii) Exception for components and subassemblies. A taxpayer is not
required to use the PCM under this paragraph (g) to account for a
component or subassembly that benefits a related party's long-term
contract if more than 50 percent of the average annual gross receipts
attributable to the sale of this item for the 3-taxable-year-period
ending with the contracting year comes from unrelated parties.
(2) Total contract price. If a taxpayer is required to use the PCM
under paragraph (g)(1)(i) of this section, the total contract price (as
defined in Sec. 1.460-4(b)(4)(i)) is the fair market value of the
taxpayer's activity that is incident to or necessary for the performance
of the related party's long-term contract. The related party also must
use the fair market value of the taxpayer's activity as the cost it
incurs for the activity. The fair market value of the taxpayer's
activity may or may not be the same as the amount the related party pays
the taxpayer for that activity.
(3) Completion factor. To compute a contract's completion factor (as
described in Sec. 1.460-4(b)(5)), the related party must take into
account the fair market value of the taxpayer's activity that is
incident to or necessary for the performance of the related party's
long-term contract when the related party incurs the liability to the
taxpayer for the activity, rather than when the taxpayer incurs the
costs to perform the activity.
(h) Effective date--(1) In general. Except as otherwise provided,
this section and Sec. Sec. 1.460-2 through 1.460-5 are applicable for
contracts entered into on or after January 11, 2001.
(2) Change in method of accounting. Any change in a taxpayer's
method of accounting necessary to comply with this section and
Sec. Sec. 1.460-2 through 1.460-5 is a change in method of accounting
to which the provisions of section 446 and the regulations thereunder
apply. For the first taxable year that includes January 11, 2001, a
taxpayer is granted the consent of the Commissioner to change its method
of accounting to comply with the provisions of this section and
Sec. Sec. 1.460-2 through 1.460-5 for long-term contracts entered into
on or after January 11, 2001. A taxpayer that wants to change its method
of accounting under this paragraph (h)(2) must follow the automatic
consent procedures in Rev. Proc. 99-49 (1999-52 I.R.B. 725) (see Sec.
601.601(d)(2) of this chapter), except that the scope limitations in
section 4.02 of Rev. Proc. 99-49 do not apply. Because a change under
this paragraph (h)(2) is made on a cut-off basis, a section 481(a)
adjustment is not permitted or required. Moreover, the taxpayer does not
receive audit protection under section 7 of Rev. Proc. 99-49 for a
change in method of accounting under this paragraph (h)(2). A taxpayer
that wants to change its exempt-contract method of accounting is not
granted the consent of the Commissioner under this paragraph (h)(2) and
must file a Form 3115, ``Application for Change in Accounting Method,''
to obtain consent. See Rev. Proc. 97-27 (1997-1 C.B. 680) (see Sec.
601.601(d)(2) of this chapter).
(i) [Reserved]
(j) Examples. The following examples illustrate the rules of this
section:
Example 1. Contract for manufacture of property. B notifies C, an
aircraft manufacturer, that it wants to purchase an aircraft of a
particular type. At the time C receives the order, C has on hand several
partially completed aircraft of this type; however, C does not have any
completed aircraft of this type on hand. C and B agree that B will
purchase one of these aircraft after it has been completed. C retains
title to and risk of loss with respect to the aircraft until the sale
takes place. The agreement between C and B is a contract for the
manufacture of property under paragraph (b)(2)(i) of this section, even
if labeled as a contract for the sale of property, because the
manufacture of the aircraft is necessary for C's obligations under the
[[Page 201]]
agreement to be fulfilled and the manufacturing was not complete when B
and C entered into the agreement.
Example 2. De minimis construction activity. C, a master developer
whose taxable year ends December 31, owns 5,000 acres of undeveloped
land with a cost basis of $5,000,000 and a fair market value of
$50,000,000. To obtain permission from the local county government to
improve this land, a service road must be constructed on this land to
benefit all 5,000 acres. In 2001, C enters into a contract to sell a
1,000-acre parcel of undeveloped land to B, a residential developer, for
its fair market value, $10,000,000. In this contract, C agrees to
construct a service road running through the land that C is selling to B
and through the 4,000 adjacent acres of undeveloped land that C has sold
or will sell to other residential developers for its fair market value,
$40,000,000. C reasonably estimates that it will incur allocable
contract costs of $50,000 (excluding the cost of the land) to construct
this service road, which will be owned and maintained by the county. C
must reasonably allocate the cost of the service road among the
benefitted parcels. The portion of the estimated total allocable
contract costs that C allocates to the 1,000-acre parcel being sold to B
(based upon its fair market value) is $10,000 ($50,000 x ($10,000,000 /
$50,000,000)). Construction of the service road is finished in 2002.
Because the estimated total allocable contract costs attributable to C's
construction activities, $10,000, are less than 10 percent of the
contract's total contract price, $10,000,000, C's contract with B is not
a construction contract under paragraph (b)(2)(ii) of this section.
Thus, C's contract with B is not a long-term contract under paragraph
(b)(2)(i) of this section, notwithstanding that construction of the
service road is not completed in 2001.
Example 3. Completion--customer use. In 2002, C, whose taxable year
ends December 31, enters into a contract to construct a building for B.
In November of 2003, the building is completed in every respect
necessary for its intended use, and B occupies the building. In early
December of 2003, B notifies C of some minor deficiencies that need to
be corrected, and C agrees to correct them in January 2004. C reasonably
estimates that the cost of correcting these deficiencies will be less
than five percent of the total allocable contract costs. C's contract is
complete under paragraph (c)(3)(i)(A) of this section in 2003 because in
that year, B used the building and C had incurred at least 95 percent of
the total allocable contract costs attributable to the building. C must
use a permissible method of accounting for any deficiency-related costs
incurred after 2003.
Example 4. Completion--customer use. In 2001, C, whose taxable year
ends December 31, agrees to construct a shopping center, which includes
an adjoining parking lot, for B. By October 2002, C has finished
constructing the retail portion of the shopping center. By December
2002, C has graded the entire parking lot, but has paved only one-fourth
of it because inclement weather conditions prevented C from laying
asphalt on the remaining three-fourths. In December 2002, B opens the
retail portion of the shopping center and the paved portion of the
parking lot to the general public. C reasonably estimates that the cost
of paving the remaining three-fourths of the parking lot when weather
permits will exceed five percent of C's total allocable contract costs.
Even though B is using the subject matter of the contract, C's contract
is not completed in December 2002 under paragraph (c)(3)(i)(A) of this
section because C has not incurred at least 95 percent of the total
allocable contract costs attributable to the subject matter.
Example 5. Completion--customer use. In 2001, C, whose taxable year
ends December 31, agrees to manufacture 100 machines for B. By December
31, 2002, C has delivered 99 of the machines to B. C reasonably
estimates that the cost of finishing the related work on the contract
will be less than five percent of the total allocable contract costs.
C's contract is not complete under paragraph (c)(3)(i)(A) of this
section in 2002 because in that year, B is not using the subject matter
of the contract (all 100 machines) for its intended purpose.
Example 6. Non-long-term contract activity. On January 1, 2001, C,
whose taxable year ends December 31, enters into a single long-term
contract to design and manufacture a satellite and to develop computer
software enabling B to operate the satellite. At the end of 2001, C has
not finished manufacturing the satellite. Designing the satellite and
developing the computer software are non-long-term contract activities
that are incident to and necessary for the taxpayer's manufacturing of
the subject matter of a long-term contract because the satellite could
not be manufactured without the design and would not operate without the
software. Thus, under paragraph (d)(1) of this section, C must allocate
these non-long-term contract activities to the long-term contract and
account for the gross receipts and costs attributable to designing the
satellite and developing computer software using the PCM.
Example 7. Non-long-term contract activity. C agrees to manufacture
equipment for B under a long-term contract. In a separate contract, C
agrees to design the equipment being manufactured for B under the long-
term contract. Under paragraph (d)(1) of this section, C must allocate
the gross receipts and costs related to the design to the long-term
contract because designing the equipment is a non-long-term contract
activity that is incident to and necessary for the
[[Page 202]]
manufacture of the subject matter of the long-term contract.
Example 8. Severance. On January 1, 2001, C, a construction
contractor, and B, a real estate investor, enter into an agreement
requiring C to build two office buildings in different areas of a large
city. The agreement provides that the two office buildings will be
completed by C and accepted by B in 2002 and 2003, respectively, and
that C will be paid $1,000,000 and $1,500,000 for the two office
buildings, respectively. The agreement will provide C with a reasonable
profit from the construction of each building. Unless C is required to
use the PCM to account for the contract, C is required to sever this
contract under paragraph (e)(2) of this section because the buildings
are independently priced, the agreement provides for separate delivery
and acceptance of the buildings, and, as each building will generate a
reasonable profit, a reasonable businessperson would have entered into
separate agreements for the terms agreed upon for each building.
Example 9. Severance. C, a large construction contractor whose
taxable year ends December 31, accounts for its construction contracts
using the PCM and has elected to use the 10-percent method described in
Sec. 1.460-4(b)(6). In September 2001, C enters into an agreement to
construct four buildings in four different cities. The buildings are
independently priced and the contract provides a reasonable profit for
each of the buildings. In addition, the agreement requires C to complete
one building per year in 2002, 2003, 2004, and 2005. As of December 31,
2001, C has incurred 25 percent of the estimated total allocable
contract costs attributable to one of the buildings, but only five
percent of the estimated total allocable contract costs attributable to
all four buildings included in the agreement. C does not request the
Commissioner's consent to sever this contract. Using the 10-percent
method, C does not take into account any portion of the total contract
price or any incurred allocable contract costs attributable to this
agreement in 2001. Upon examination of C's 2001 tax return, the
Commissioner determines that C entered into one agreement for four
buildings rather than four separate agreements each for one building
solely to take advantage of the deferral obtained under the 10-percent
method. Consequently, to clearly reflect the taxpayer's income, the
Commissioner may require C to sever the agreement into four separate
contracts under paragraph (e)(2) of this section because the buildings
are independently priced, the agreement provides for separate delivery
and acceptance of the buildings, and a reasonable businessperson would
have entered into separate agreements for these buildings.
Example 10. Aggregation. In 2001, C, a shipbuilder, enters into two
agreements with the Department of the Navy as the result of a single
negotiation. Each agreement obligates C to manufacture a submarine.
Because the submarines are of the same class, their specifications are
similar. Because C has never manufactured submarines of this class,
however, C anticipates that it will incur substantially higher costs to
manufacture the first submarine, to be delivered in 2007, than to
manufacture the second submarine, to be delivered in 2010. If the
agreements are treated as separate contracts, the first contract
probably will produce a substantial loss, while the second contract
probably will produce substantial profit. Based upon these facts,
aggregation is required under paragraph (e)(2) of this section because
the submarines are interdependently priced and a reasonable
businessperson would not have entered the first agreement without also
entering into the second.
Example 11. Aggregation. In 2001, C, a manufacturer of aircraft and
related equipment, agrees to manufacture 10 military aircraft for
foreign government B and to deliver the aircraft by the end of 2003.
When entering into the agreement, C anticipates that it might receive
production orders from B over the next 20 years for as many as 300 more
of these aircraft. The negotiated contract price reflects C's and B's
consideration of the expected total cost of manufacturing the 10
aircraft, the risks and opportunities associated with the agreement, and
the additional factors the parties considered relevant. The negotiated
price provides a profit on the sale of the 10 aircraft even if C does
not receive any additional production orders from B. It is unlikely,
however, that C actually would have wanted to manufacture the 10
aircraft but for the expectation that it would receive additional
production orders from B. In 2003, B accepts delivery of the 10
aircraft. At that time, B orders an additional 20 aircraft of the same
type for delivery in 2007. When negotiating the price for the additional
20 aircraft, C and B consider the fact that the expected unit cost for
this production run of 20 aircraft will be lower than the unit cost of
the 10 aircraft completed and accepted in 2003, but substantially higher
than the expected unit cost of future production runs. Based upon these
facts, aggregation is not permitted under paragraph (e)(2) of this
section. Because the parties negotiated the prices of both agreements
considering only the expected production costs and risks for each
agreement standing alone, the terms and conditions agreed upon for the
first agreement are independent of the terms and conditions agreed upon
for the second agreement. The fact that the agreement to manufacture 10
aircraft provides a profit for C indicates that a reasonable
businessperson would have entered into that agreement without entering
into the agreement to manufacture the additional 20 aircraft.
[[Page 203]]
Example 12. Classification and completion. In 2001, C, whose taxable
year ends December 31, agrees to manufacture and install an industrial
machine for B. C elects under paragraph (f) of this section to classify
the agreement as a long-term manufacturing contract and to account for
it using the PCM. The agreement requires C to deliver the machine in
August 2003 and to install and test the machine in B's factory. In
addition, the agreement requires B to accept the machine when the tests
prove that the machine's performance will satisfy the environmental
standards set by the Environmental Protection Agency (EPA), even if B
has not obtained the required operating permit. Because of technical
difficulties, C cannot deliver the machine until December 2003, when B
conditionally accepts delivery. C installs the machine in December 2003
and then tests it through February 2004. B accepts the machine in
February 2004, but does not obtain the operating permit from the EPA
until January 2005. Under paragraph (c)(3)(i)(B) of this section, C's
contract is finally completed and accepted in February 2004, even though
B does not obtain the operating permit until January 2005, because C
completed all its obligations under the contract and B accepted the
machine in February 2004.
[T.D. 8929, 66 FR 2225, Jan. 11, 2001; 66 FR 18357, Apr. 6, 2001]
Sec. 1.460-2 Long-term manufacturing contracts.
(a) In general. Section 460 generally requires a taxpayer to
determine the income from a long-term manufacturing contract using the
percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A
contract not completed in the contracting year is a long-term
manufacturing contract if it involves the manufacture of personal
property that is--
(1) A unique item of a type that is not normally carried in the
finished goods inventory of the taxpayer; or
(2) An item that normally requires more than 12 calendar months to
complete (regardless of the duration of the contract or the time to
complete a deliverable quantity of the item).
(b) Unique--(1) In general. Unique means designed for the needs of a
specific customer. To determine whether an item is designed for the
needs of a specific customer, a taxpayer must consider the extent to
which research, development, design, engineering, retooling, and similar
activities (customizing activities) are required to manufacture the item
and whether the item could be sold to other customers with little or no
modification. A contract may require the taxpayer to manufacture more
than one unit of a unique item. If a contract requires a taxpayer to
manufacture more than one unit of the same item, the taxpayer must
determine whether that item is unique by considering the customizing
activities that would be needed to produce only the first unit. For the
purposes of this paragraph (b), a taxpayer must consider the activities
performed on its behalf by a subcontractor.
(2) Safe harbors. Notwithstanding paragraph (b)(1) of this section,
an item is not unique if it satisfies one or more of the safe harbors in
this paragraph (b)(2). If an item does not satisfy one or more safe
harbors, the determination of uniqueness will depend on the facts and
circumstances. The safe harbors are:
(i) Short production period. An item is not unique if it normally
requires 90 days or less to complete. In the case of a contract for
multiple units of an item, the item is not unique only if it normally
requires 90 days or less to complete each unit of the item in the
contract.
(ii) Customized item. An item is not unique if the total allocable
contract costs attributable to customizing activities that are incident
to or necessary for the manufacture of the item do not exceed 10 percent
of the estimated total allocable contract costs allocable to the item.
In the case of a contract for multiple units of an item, this comparison
must be performed on the first unit of the item, and the total allocable
contract costs attributable to customizing activities that are incident
to or necessary for the manufacture of the first unit of the item must
be allocated to that first unit.
(iii) Inventoried item. A unique item ceases to be unique no later
than when the taxpayer normally includes similar items in its finished
goods inventory.
(c) Normal time to complete--(1) In general. The amount of time
normally required to complete an item is the item's reasonably expected
production period, as described in Sec. 1.263A-12, determined at the
end of the contracting year. Thus, in general, the expected
[[Page 204]]
production period for an item begins when a taxpayer incurs at least
five percent of the costs that would be allocable to the item under
Sec. 1.460-5 and ends when the item is ready to be held for sale and
all reasonably expected production activities are complete. In the case
of components that are assembled or reassembled into an item or unit at
the customer's facility by the taxpayer's employees or agents, the
production period ends when the components are assembled or reassembled
into an operable item or unit. To the extent that several distinct
activities related to the production of the item are expected to occur
simultaneously, the period during which these distinct activities occur
is not counted more than once. Furthermore, when determining the normal
time to complete an item, a taxpayer is not required to consider
activities performed or costs incurred that would not be allocable
contract costs under section 460 (e.g., independent research and
development expenses (as defined in Sec. 1.460-1(b)(9)) and marketing
expenses). Moreover, the time normally required to design and
manufacture the first unit of an item for which the taxpayer intends to
produce multiple units generally does not indicate the normal time to
complete the item.
(2) Production by related parties. To determine the time normally
required to complete an item, a taxpayer must consider all relevant
production activities performed and costs incurred by itself and by
related parties, as defined in Sec. 1.460-1(b)(4). For example, if a
taxpayer's item requires a component or subassembly manufactured by a
related party, the taxpayer must consider the time the related party
takes to complete the component or subassembly and, for purposes of
determining the beginning of an item's production period, the costs
incurred by the related party that are allocable to the component or
subassembly. However, if both requirements of the exception for
components and subassemblies under Sec. 1.460-1(g)(1)(ii) are
satisfied, a taxpayer does not consider the activities performed or the
costs incurred by a related party when determining the normal time to
complete an item.
(d) Qualified ship contracts. A taxpayer may determine the income
from a long-term manufacturing contract that is a qualified ship
contract using either the PCM or the percentage-of-completion/
capitalized-cost method (PCCM) of accounting described in Sec. 1.460-
4(e). A qualified ship contract is any contract entered into after
February 28, 1986, to manufacture in the United States not more than 5
seagoing vessels if the vessels will not be manufactured directly or
indirectly for the United States Government and if the taxpayer
reasonably expects to complete the contract within 5 years of the
contract commencement date. Under Sec. 1.460-1(e)(3)(i), a contract to
produce more than 5 vessels for which the PCM would be required cannot
be severed in order to be classified as a qualified ship contract.
(e) Examples. The following examples illustrate the rules of this
section:
Example 1. Unique item and classification. In December 2001, C
enters into a contract with B to design and manufacture a new type of
industrial equipment. C reasonably expects the normal production period
for this type of equipment to be eight months. Because the new type of
industrial equipment requires a substantial amount of research, design,
and engineering to produce, C determines that the equipment is a unique
item and its contract with B is a long-term contract. After delivering
the equipment to B in September 2002, C contracts with B to produce five
additional units of that industrial equipment with certain different
specifications. These additional units, which also are expected to take
eight months to produce, will be delivered to B in 2003. C determines
that the research, design, engineering, retooling, and similar
customizing costs necessary to produce the five additional units of
equipment does not exceed 10 percent of the first unit's share of
estimated total allocable contract costs. Consequently, the additional
units of equipment satisfy the safe harbor in paragraph (b)(2)(ii) of
this section and are not unique items. Although C's contract with B to
produce the five additional units is not completed within the
contracting year, the contract is not a long-term contract since the
additional units of equipment are not unique items and do not normally
require more than 12 months to produce. C must classify its second
contract with B as a non-long term contract, notwithstanding that it
classified the previous contract with B for a similar item as a long-
term contract, because the determination of whether a contract is a
long-term contract is made on a
[[Page 205]]
contract-by-contract basis. A change in classification is not a change
in method of accounting because the change in classification results
from a change in underlying facts.
Example 2. 12-month rule--related party. C manufactures cranes. C
purchases one of the crane's components from R, a related party under
Sec. 1.460-1(b)(4). Less than 50 percent of R's gross receipts
attributable to the sale of this component comes from sales to unrelated
parties; thus, the exception for components and subassemblies under
Sec. 1.460-1(g)(1)(ii) is not satisfied. Consequently, C must consider
the activities of R as R incurs costs and performs the activities rather
than as C incurs a liability to R. The normal time period between the
time that both C and R incur five percent of the costs allocable to the
crane and the time that R completes the component is five months. C
normally requires an additional eight months to complete production of
the crane after receiving the integral component from R. C's crane is an
item of a type that normally requires more than 12 months to complete
under paragraph (c) of this section because the production period from
the time that both C and R incur five percent of the costs allocable to
the crane until the time that production of the crane is complete is
normally 13 months.
Example 3. 12-month rule--duration of contract. The facts are the
same as in Example 2, except that C enters into a sales contract with B
on December 31, 2001 (the last day of C's taxable year), and delivers a
completed crane to B on February 1, 2002. C's contract with B is a long-
term contract under paragraph (a)(2) of this section because the
contract is not completed in the contracting year, 2001, and the crane
is an item that normally requires more than 12 calendar months to
complete (regardless of the duration of the contract).
Example 4. 12-month rule--normal time to complete. The facts are the
same as in Example 2, except that C (and R) actually complete B's crane
in only 10 calendar months. The contract is a long-term contract because
the normal time to complete a crane, not the actual time to complete a
crane, is the relevant criterion for determining whether an item is
subject to paragraph (a)(2) of this section.
Example 5. Normal time to complete. C enters into a multi-unit
contract to produce four units of an item. C does not anticipate
producing any additional units of the item. C expects to perform the
research, design, and development that are directly allocable to the
particular item and to produce the first unit in the first 24 months. C
reasonably expects the production period for each of the three remaining
units will be 3 months. This contract is not a contract that involves
the manufacture of an item that normally requires more than 12 months to
complete because the normal time to complete the item is 3 months.
However, the contract does not satisfy the 90-day safe harbor for unique
items because the normal time to complete the first unit of this item
exceeds 90 days. Thus, the contract might involve the manufacture of a
unique item depending on the facts and circumstances.
[T.D. 8929, 66 FR 2230, Jan. 11, 2001; 66 FR 18191, Apr. 6, 2001]
Sec. 1.460-3 Long-term construction contracts.
(a) In general. Section 460 generally requires a taxpayer to
determine the income from a long-term construction contract using the
percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A
contract not completed in the contracting year is a long-term
construction contract if it involves the building, construction,
reconstruction, or rehabilitation of real property; the installation of
an integral component to real property; or the improvement of real
property (collectively referred to as construction). Real property means
land, buildings, and inherently permanent structures, as defined in
Sec. 1.263A-8(c)(3), such as roadways, dams, and bridges. Real property
does not include vessels, offshore drilling platforms, or unsevered
natural products of land. An integral component to real property
includes property not produced at the site of the real property but
intended to be permanently affixed to the real property, such as
elevators and central heating and cooling systems. Thus, for example, a
contract to install an elevator in a building is a construction contract
because a building is real property, but a contract to install an
elevator in a ship is not a construction contract because a ship is not
real property.
(b) Exempt construction contracts--(1) In general. The general
requirement to use the PCM and the cost allocation rules described in
Sec. 1.460-5(b) or (c) does not apply to any long-term construction
contract described in this paragraph (b) (exempt construction contract).
Exempt construction contract means any--
(i) Home construction contract; and
(ii) Other construction contract that a taxpayer estimates (when
entering into the contract) will be completed
[[Page 206]]
within 2 years of the contract commencement date, provided the taxpayer
satisfies the $10,000,000 gross receipts test described in paragraph
(b)(3) of this section.
(2) Home construction contract--(i) In general. A long-term
construction contract is a home construction contract if a taxpayer
(including a subcontractor working for a general contractor) reasonably
expects to attribute 80 percent or more of the estimated total allocable
contract costs (including the cost of land, materials, and services),
determined as of the close of the contracting year, to the construction
of--
(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I),
contained in buildings containing 4 or fewer dwelling units (including
buildings with 4 or fewer dwelling units that also have commercial
units); and
(B) Improvements to real property directly related to, and located
at the site of, the dwelling units.
(ii) Townhouses and rowhouses. Each townhouse or rowhouse is a
separate building.
(iii) Common improvements. A taxpayer includes in the cost of the
dwelling units their allocable share of the cost that the taxpayer
reasonably expects to incur for any common improvements (e.g., sewers,
roads, clubhouses) that benefit the dwelling units and that the taxpayer
is contractually obligated, or required by law, to construct within the
tract or tracts of land that contain the dwelling units.
(iv) Mixed use costs. If a contract involves the construction of
both commercial units and dwelling units within the same building, a
taxpayer must allocate the costs among the commercial units and dwelling
units using a reasonable method or combination of reasonable methods,
such as specific identification, square footage, or fair market value.
(3) $10,000,000 gross receipts test--(i) In general. Except as
otherwise provided in paragraphs (b)(3)(ii) and (iii) of this section,
the $10,000,000 gross receipts test is satisfied if a taxpayer's (or
predecessor's) average annual gross receipts for the 3 taxable years
preceding the contracting year do not exceed $10,000,000, as determined
using the principles of the gross receipts test for small resellers
under Sec. 1.263A-3(b).
(ii) Single employer. To apply the gross receipts test, a taxpayer
is not required to aggregate the gross receipts of persons treated as a
single employer solely under section 414(m) and any regulations
prescribed under section 414.
(iii) Attribution of gross receipts. A taxpayer must aggregate a
proportionate share of the construction-related gross receipts of any
person that has a five percent or greater interest in the taxpayer. In
addition, a taxpayer must aggregate a proportionate share of the
construction-related gross receipts of any person in which the taxpayer
has a five percent or greater interest. For this purpose, a taxpayer
must determine ownership interests as of the first day of the taxpayer's
contracting year and must include indirect interests in any corporation,
partnership, estate, trust, or sole proprietorship according to
principles similar to the constructive ownership rules under sections
1563(e), (f)(2), and (f)(3)(A). However, a taxpayer is not required to
aggregate under this paragraph (b)(3)(iii) any construction-related
gross receipts required to be aggregated under paragraph (b)(3)(i) of
this section.
(c) Residential construction contracts. A taxpayer may determine the
income from a long-term construction contract that is a residential
construction contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in
Sec. 1.460-4(e). A residential construction contract is a home
construction contract, as defined in paragraph (b)(2) of this section,
except that the building or buildings being constructed contain more
than 4 dwelling units.
[T.D. 8929, 66 FR 2231, Jan. 11, 2001]
Sec. 1.460-4 Methods of accounting for long-term contracts.
(a) Overview. This section prescribes permissible methods of
accounting for long-term contracts. Paragraph (b) of this section
describes the percentage-of-completion method under section 460(b) (PCM)
that a taxpayer generally must use to determine the income from a long-
term contract. Paragraph (c) of this section lists permissible methods
[[Page 207]]
of accounting for exempt construction contracts described in Sec.
1.460-3(b)(1) and describes the exempt-contract percentage-of-completion
method (EPCM). Paragraph (d) of this section describes the completed-
contract method (CCM), which is one of the permissible methods of
accounting for exempt construction contracts. Paragraph (e) of this
section describes the percentage-of-completion/capitalized-cost method
(PCCM), which is a permissible method of accounting for qualified ship
contracts described in Sec. 1.460-2(d) and residential construction
contracts described in Sec. 1.460-3(c). Paragraph (f) of this section
provides rules for determining the alternative minimum taxable income
(AMTI) from long-term contracts that are not exempted under section 56.
Paragraph (g) of this section provides rules concerning consistency in
methods of accounting for long-term contracts. Paragraph (h) of this
section provides examples illustrating the principles of this section.
Paragraph (j) of this section provides rules for taxpayers that file
consolidated tax returns. Finally, paragraph (k) of this section
provides rules relating to a mid-contract change in taxpayer of a
contract accounted for using a long-term contract method of accounting.
(b) Percentage-of-completion method--(1) In general. Under the PCM,
a taxpayer generally must include in income the portion of the total
contract price, as defined in paragraph (b)(4)(i) of this section, that
corresponds to the percentage of the entire contract that the taxpayer
has completed during the taxable year. The percentage of completion must
be determined by comparing allocable contract costs incurred with
estimated total allocable contract costs. Thus, the taxpayer includes a
portion of the total contract price in gross income as the taxpayer
incurs allocable contract costs.
(2) Computations. To determine the income from a long-term contract,
a taxpayer--
(i) Computes the completion factor for the contract, which is the
ratio of the cumulative allocable contract costs that the taxpayer has
incurred through the end of the taxable year to the estimated total
allocable contract costs that the taxpayer reasonably expects to incur
under the contract;
(ii) Computes the amount of cumulative gross receipts from the
contract by multiplying the completion factor by the total contract
price;
(iii) Computes the amount of current-year gross receipts, which is
the difference between the amount of cumulative gross receipts for the
current taxable year and the amount of cumulative gross receipts for the
immediately preceding taxable year (the difference can be a positive or
negative number); and
(iv) Takes both the current-year gross receipts and the allocable
contract costs incurred during the current year into account in
computing taxable income.
(3) Post-completion-year income. If a taxpayer has not included the
total contract price in gross income by the completion year, as defined
in Sec. 1.460-1(b)(6), the taxpayer must include the remaining portion
of the total contract price in gross income for the taxable year
following the completion year. For the treatment of post-completion-year
costs, see paragraph (b)(5)(v) of this section. See Sec. 1.460-
6(c)(1)(ii) for application of the look-back method as a result of
adjustments to total contract price.
(4) Total contract price--(i) In general--(A) Definition. Total
contract price means the amount that a taxpayer reasonably expects to
receive under a long-term contract, including holdbacks, retainages, and
cost reimbursements. See Sec. 1.460-6(c)(1)(ii) and (2)(vi) for
application of the look-back method as a result of changes in total
contract price.
(B) Contingent compensation. Any amount related to a contingent
right under a contract, such as a bonus, award, incentive payment, and
amount in dispute, is included in total contract price as soon as the
taxpayer can reasonably predict that the amount will be earned, even if
the all events test has not yet been met. For example, if a bonus is
payable to a taxpayer for meeting an early completion date, the bonus is
includible in total contract price at the time and to the extent
[[Page 208]]
that the taxpayer can reasonably predict the achievement of the
corresponding objective. Similarly, a portion of the contract price that
is in dispute is includible in total contract price at the time and to
the extent that the taxpayer can reasonably predict that the dispute
will be resolved in the taxpayer's favor (regardless of when the
taxpayer actually receives payment or when the dispute is finally
resolved). Total contract price does not include compensation that might
be earned under any other agreement that the taxpayer expects to obtain
from the same customer (e.g., exercised option or follow-on contract) if
that other agreement is not aggregated under Sec. 1.460-1(e). For the
purposes of this paragraph (b)(4)(i)(B), a taxpayer can reasonably
predict that an amount of contingent income will be earned not later
than when the taxpayer includes that amount in income for financial
reporting purposes under generally accepted accounting principles. If a
taxpayer has not included an amount of contingent compensation in total
contract price under this paragraph (b)(4)(i) by the taxable year
following the completion year, the taxpayer must account for that amount
of contingent compensation using a permissible method of accounting. If
it is determined after the taxable year following the completion year
that an amount included in total contract price will not be earned, the
taxpayer should deduct that amount in the year of the determination.
(C) Non-long-term contract activities. Total contract price includes
an allocable share of the gross receipts attributable to a non-long-term
contract activity, as defined in Sec. 1.460-1(d)(2), if the activity is
incident to or necessary for the manufacture, building, installation, or
construction of the subject matter of the long-term contract. Total
contract price also includes amounts reimbursed for independent research
and development expenses (as defined in Sec. 1.460-1(b)(9)), or for
bidding and proposal costs, under a federal or cost-plus long-term
contract (as defined in section 460(d)), regardless of whether the
research and development, or bidding and proposal, activities are
incident to or necessary for the performance of that long-term contract.
(ii) Estimating total contract price. A taxpayer must estimate the
total contract price based upon all the facts and circumstances known as
of the last day of the taxable year. For this purpose, an event that
occurs after the end of the taxable year must be taken into account if
its occurrence was reasonably predictable and its income was subject to
reasonable estimation as of the last day of that taxable year.
(5) Completion factor--(i) Allocable contract costs. A taxpayer must
use a cost allocation method permitted under either Sec. 1.460-5(b) or
(c) to determine the amount of cumulative allocable contract costs and
estimated total allocable contract costs that are used to determine a
contract's completion factor. Allocable contract costs include a
reimbursable cost that is allocable to the contract.
(ii) Cumulative allocable contract costs. To determine a contract's
completion factor for a taxable year, a taxpayer must take into account
the cumulative allocable contract costs that have been incurred, as
defined in Sec. 1.460-1(b)(8), through the end of the taxable year.
(iii) Estimating total allocable contract costs. A taxpayer must
estimate total allocable contract costs for each long-term contract
based upon all the facts and circumstances known as of the last day of
the taxable year. For this purpose, an event that occurs after the end
of the taxable year must be taken into account if its occurrence was
reasonably predictable and its cost was subject to reasonable estimation
as of the last day of that taxable year. To be considered reasonable, an
estimate of total allocable contract costs must include costs
attributable to delay, rework, change orders, technology or design
problems, or other problems that reasonably can be predicted considering
the nature of the contract and prior experience. However, estimated
total allocable contract costs do not include any contingency allowance
for costs that, as of the end of the taxable year, are not reasonably
predicted to be incurred in the performance of the contract. For
example, estimated total allocable contract costs do not include any
costs attributable to factors not
[[Page 209]]
reasonably predictable at the end of the taxable year, such as third-
party litigation, extreme weather conditions, strikes, and delays in
securing required permits and licenses. In addition, the estimated costs
of performing other agreements that are not aggregated with the contract
under Sec. 1.460-1(e) that the taxpayer expects to incur with the same
customer (e.g., follow-on contracts) are not included in estimated total
allocable contract costs for the initial contract.
(iv) Pre-contracting-year costs. If a taxpayer reasonably expects to
enter into a long-term contract in a future taxable year, the taxpayer
must capitalize all costs incurred prior to entering into the contract
that will be allocable to that contract (e.g., bidding and proposal
costs). A taxpayer is not required to compute a completion factor, or to
include in gross income any amount, related to allocable contract costs
for any taxable year ending before the contracting year or, if
applicable, the 10-percent year defined in paragraph (b)(6)(i) of this
section. In that year, the taxpayer is required to compute a completion
factor that includes all allocable contract costs that have been
incurred as of the end of that taxable year (whether previously
capitalized or deducted) and to take into account in computing taxable
income the related gross receipts and the previously capitalized
allocable contract costs. If, however, a taxpayer determines in a
subsequent year that it will not enter into the long-term contract, the
taxpayer must account for these pre-contracting-year costs in that year
(e.g., as a deduction or an inventoriable cost) using the appropriate
rules contained in other sections of the Code or regulations.
(v) Post-completion-year costs. If a taxpayer incurs an allocable
contract cost after the completion year, the taxpayer must account for
that cost using a permissible method of accounting. See Sec. 1.460-
6(c)(1)(ii) for application of the look-back method as a result of
adjustments to allocable contract costs.
(6) 10-percent method--(i) In general. Instead of determining the
income from a long-term contract beginning with the contracting year, a
taxpayer may elect to use the 10-percent method under section 460(b)(5).
Under the 10-percent method, a taxpayer does not include in gross income
any amount related to allocable contract costs until the taxable year in
which the taxpayer has incurred at least 10 percent of the estimated
total allocable contract costs (10-percent year). A taxpayer must treat
costs incurred before the 10-percent year as pre-contracting-year costs
described in paragraph (b)(5)(iv) of this section.
(ii) Election. A taxpayer makes an election under this paragraph
(b)(6) by using the 10-percent method for all long-term contracts
entered into during the taxable year of the election on its original
federal income tax return for the election year. This election is a
method of accounting and, thus, applies to all long-term contracts
entered into during and after the taxable year of the election. An
electing taxpayer must use the 10-percent method to apply the look-back
method under Sec. 1.460-6 and to determine alternative minimum taxable
income under paragraph (f) of this section. This election is not
available if a taxpayer uses the simplified cost-to-cost method
described in Sec. 1.460-5(c) to compute the completion factor of a
long-term contract.
(7) Terminated contract--(i) Reversal of income. If a long-term
contract is terminated before completion and, as a result, the taxpayer
retains ownership of the property that is the subject matter of that
contract, the taxpayer must reverse the transaction in the taxable year
of termination. To reverse the transaction, the taxpayer reports a loss
(or gain) equal to the cumulative allocable contract costs reported
under the contract in all prior taxable years less the cumulative gross
receipts reported under the contract in all prior taxable years.
(ii) Adjusted basis. As a result of reversing the transaction under
paragraph (b)(7)(i) of this section, a taxpayer will have an adjusted
basis in the retained property equal to the cumulative allocable
contract costs reported under the contract in all prior taxable years.
However, if the taxpayer received and retains any consideration or
compensation from the customer, the taxpayer must reduce the adjusted
[[Page 210]]
basis in the retained property (but not below zero) by the fair market
value of that consideration or compensation. To the extent that the
amount of the consideration or compensation described in the preceding
sentence exceeds the adjusted basis in the retained property, the
taxpayer must include the excess in gross income for the taxable year of
termination.
(iii) Look-back method. The look-back method does not apply to a
terminated contract that is subject to this paragraph (b)(7).
(c) Exempt contract methods--(1) In general. An exempt contract
method means the method of accounting that a taxpayer must use to
account for all its long-term contracts (and any portion of a long-term
contract) that are exempt from the requirements of section 460(a). Thus,
an exempt contract method applies to exempt construction contracts, as
defined in Sec. 1.460-3(b); the non-PCM portion of a qualified ship
contract, as defined in Sec. 1.460-2(d); and the non-PCM portion of a
residential construction contract, as defined in Sec. 1.460-3(c).
Permissible exempt contract methods include the PCM, the EPCM described
in paragraph (c)(2) of this section, the CCM described in paragraph (d)
of this section, or any other permissible method. See section 446.
(2) Exempt-contract percentage-of-completion method--(i) In general.
Similar to the PCM described in paragraph (b) of this section, a
taxpayer using the EPCM generally must include in income the portion of
the total contract price, as described in paragraph (b)(4) of this
section, that corresponds to the percentage of the entire contract that
the taxpayer has completed during the taxable year. However, under the
EPCM, the percentage of completion may be determined as of the end of
the taxable year by using any method of cost comparison (such as
comparing direct labor costs incurred to date to estimated total direct
labor costs) or by comparing the work performed on the contract with the
estimated total work to be performed, rather than by using the cost-to-
cost comparison required by paragraphs (b)(2)(i) and (5) of this
section, provided such method is used consistently and clearly reflects
income. In addition, paragraph (b)(3) of this section (regarding post-
completion-year income), paragraph (b)(6) of this section (regarding the
10-percent method) and Sec. 1.460-6 (regarding the look-back method) do
not apply to the EPCM.
(ii) Determination of work performed. For purposes of the EPCM, the
criteria used to compare the work performed on a contract as of the end
of the taxable year with the estimated total work to be performed must
clearly reflect the earning of income with respect to the contract. For
example, in the case of a roadbuilder, a standard of completion solely
based on miles of roadway completed in a case where the terrain is
substantially different may not clearly reflect the earning of income
with respect to the contract.
(d) Completed-contract method--(1) In general. Except as otherwise
provided in paragraph (d)(4) of this section, a taxpayer using the CCM
to account for a long-term contract must take into account in the
contract's completion year, as defined in Sec. 1.460-1(b)(6), the gross
contract price and all allocable contract costs incurred by the
completion year. A taxpayer may not treat the cost of any materials and
supplies that are allocated to a contract, but actually remain on hand
when the contract is completed, as an allocable contract cost.
(2) Post-completion-year income and costs. If a taxpayer has not
included an item of contingent compensation (i.e., amounts for which the
all events test has not been satisfied) in gross contract price under
paragraph (d)(3) of this section by the completion year, the taxpayer
must account for this item of contingent compensation using a
permissible method of accounting. If a taxpayer incurs an allocable
contract cost after the completion year, the taxpayer must account for
that cost using a permissible method of accounting.
(3) Gross contract price. Gross contract price includes all amounts
(including holdbacks, retainages, and reimbursements) that a taxpayer is
entitled by law or contract to receive, whether or not the amounts are
due or have been paid. In addition, gross contract price includes all
bonuses, awards, and incentive payments, such as a bonus for
[[Page 211]]
meeting an early completion date, to the extent the all events test is
satisfied. If a taxpayer performs a non-long-term contract activity, as
defined in Sec. 1.460-1(d)(2), that is incident to or necessary for the
manufacture, building, installation, or construction of the subject
matter of one or more of the taxpayer's long-term contracts, the
taxpayer must include an allocable share of the gross receipts
attributable to that activity in the gross contract price of the
contract(s) benefitted by that activity. Gross contract price also
includes amounts reimbursed for independent research and development
expenses (as defined in Sec. 1.460-1(b)(9)), or bidding and proposal
costs, under a federal or cost-plus long-term contract (as defined in
section 460(d)), regardless of whether the research and development, or
bidding and proposal, activities are incident to or necessary for the
performance of that long-term contract.
(4) Contracts with disputed claims--(i) In general. The special
rules in this paragraph (d)(4) apply to a long-term contract accounted
for using the CCM with a dispute caused by a customer's requesting a
reduction of the gross contract price or the performance of additional
work under the contract or by a taxpayer's requesting an increase in
gross contract price, or both, on or after the date a taxpayer has
tendered the subject matter of the contract to the customer.
(ii) Taxpayer assured of profit or loss. If the disputed amount
relates to a customer's claim for either a reduction in price or
additional work and the taxpayer is assured of either a profit or a loss
on a long-term contract regardless of the outcome of the dispute, the
gross contract price, reduced (but not below zero) by the amount
reasonably in dispute, must be taken into account in the completion
year. If the disputed amount relates to a taxpayer's claim for an
increase in price and the taxpayer is assured of either a profit or a
loss on a long-term contract regardless of the outcome of the dispute,
the gross contract price must be taken into account in the completion
year. If the taxpayer is assured a profit on the contract, all allocable
contract costs incurred by the end of the completion year are taken into
account in that year. If the taxpayer is assured a loss on the contract,
all allocable contract costs incurred by the end of the completion year,
reduced by the amount reasonably in dispute, are taken into account in
the completion year.
(iii) Taxpayer unable to determine profit or loss. If the amount
reasonably in dispute affects so much of the gross contract price or
allocable contract costs that a taxpayer cannot determine whether a
profit or loss ultimately will be realized from a long-term contract,
the taxpayer may not take any of the gross contract price or allocable
contract costs into account in the completion year.
(iv) Dispute resolved. Any part of the gross contract price and any
allocable contract costs that have not been taken into account because
of the principles described in paragraph (d)(4)(i), (ii), or (iii) of
this section must be taken into account in the taxable year in which the
dispute is resolved. If a taxpayer performs additional work under the
contract because of the dispute, the term taxable year in which the
dispute is resolved means the taxable year the additional work is
completed, rather than the taxable year in which the outcome of the
dispute is determined by agreement, decision, or otherwise.
(e) Percentage-of-completion/capitalized-cost method. Under the
PCCM, a taxpayer must determine the income from a long-term contract
using the PCM for the applicable percentage of the contract and its
exempt contract method, as defined in paragraph (c) of this section, for
the remaining percentage of the contract. For residential construction
contracts described in Sec. 1.460-3(c), the applicable percentage is 70
percent, and the remaining percentage is 30 percent. For qualified ship
contracts described in Sec. 1.460-2(d), the applicable percentage is 40
percent, and the remaining percentage is 60 percent.
(f) Alternative minimum taxable income--(1) In general. Under
section 56(a)(3), a taxpayer (not exempt from the AMT under section
55(e)) must use the PCM to determine its AMTI from any long-term
contract entered into on or after March 1, 1986, that is not a home
construction contract, as defined in Sec. 1.460-3(b)(2). For AMTI
purposes,
[[Page 212]]
the PCM must include any election under paragraph (b)(6) of this section
(concerning the 10-percent method) or under Sec. 1.460-5(c) (concerning
the simplified cost-to-cost method) that the taxpayer has made for
regular tax purposes. For exempt construction contracts described in
Sec. 1.460-3(b)(1)(ii), a taxpayer must use the simplified cost-to-cost
method to determine the completion factor for AMTI purposes. Except as
provided in paragraph (f)(2) of this section, a taxpayer must use AMTI
costs and AMTI methods, such as the depreciation method described in
section 56(a)(1), to determine the completion factor of a long-term
contract (except a home construction contract) for AMTI purposes.
(2) Election to use regular completion factors. Under this paragraph
(f)(2), a taxpayer may elect for AMTI purposes to determine the
completion factors of all of its long-term contracts using the methods
of accounting and allocable contract costs used for regular federal
income tax purposes. A taxpayer makes this election by using regular
methods and regular costs to compute the completion factors of all long-
term contracts entered into during the taxable year of the election for
AMTI purposes on its original federal income tax return for the election
year. This election is a method of accounting and, thus, applies to all
long-term contracts entered into during and after the taxable year of
the election. Although a taxpayer may elect to compute the completion
factor of its long-term contracts using regular methods and regular
costs, an election under this paragraph (f)(2) does not eliminate a
taxpayer's obligation to comply with the requirements of section 55 when
computing AMTI. For example, although a taxpayer may elect to use the
depreciation methods used for regular tax purposes to compute the
completion factor of its long-term contracts for AMTI purposes, the
taxpayer must use the depreciation methods permitted by section 56 to
compute AMTI.
(g) Method of accounting. A taxpayer that uses the PCM, EPCM, CCM,
or PCCM, or elects the 10-percent method or special AMTI method (or
changes to another method of accounting with the Commissioner's consent)
must apply the method(s) consistently for all similarly classified long-
term contracts, until the taxpayer obtains the Commissioner's consent
under section 446(e) to change to another method of accounting. A
taxpayer-initiated change in method of accounting will be permitted only
on a cut-off basis (i.e., for contracts entered into on or after the
year of change), and thus, a section 481(a) adjustment will not be
permitted or required.
(h) Examples. The following examples illustrate the rules of this
section:
Example 1. PCM--estimating total contract price. C, whose taxable
year ends December 31, determines the income from long-term contracts
using the PCM. On January 1, 2001, C enters into a contract to design
and manufacture a satellite (a unique item). The contract provides that
C will be paid $10,000,000 for delivering the completed satellite by
December 1, 2002. The contract also provides that C will receive a
$3,000,000 bonus for delivering the satellite by July 1, 2002, and an
additional $4,000,000 bonus if the satellite successfully performs its
mission for five years. C is unable to reasonably predict if the
satellite will successfully perform its mission for five years. If on
December 31, 2001, C should reasonably expect to deliver the satellite
by July 1, 2002, the estimated total contract price is $13,000,000
($10,000,000 unit price + $3,000,000 production-related bonus).
Otherwise, the estimated total contract price is $10,000,000. In either
event, the $4,000,000 bonus is not includible in the estimated total
contract price as of December 31, 2001, because C is unable to
reasonably predict that the satellite will successfully perform its
mission for five years.
Example 2. PCM--computing income. (i) C, whose taxable year ends
December 31, determines the income from long-term contracts using the
PCM. During 2001, C agrees to manufacture for the customer, B, a unique
item for a total contract price of $1,000,000. Under C's contract, B is
entitled to retain 10 percent of the total contract price until it
accepts the item. By the end of 2001, C has incurred $200,000 of
allocable contract costs and estimates that the total allocable contract
costs will be $800,000. By the end of 2002, C has incurred $600,000 of
allocable contract costs and estimates that the total allocable contract
costs will be $900,000. In 2003, after completing the contract, C
determines that the actual cost to manufacture the item was $750,000.
(ii) For each of the taxable years, C's income from the contract is
computed as follows:
[[Page 213]]
------------------------------------------------------------------------
Taxable Year
-----------------------------------------
2001 2002 2003
------------------------------------------------------------------------
(A) Cumulative incurred costs. $200,000 $600,000 $750,000
(B) Estimated total costs..... 800,000 900,000 750,000
-----------------------------------------
(C) Completion factor: (A) / 25.00% 66.67% 100.00%
(B)..........................
-----------------------------------------
(D) Total contract price...... 1,000,000 1,000,000 1,000,000
-----------------------------------------
(E) Cumulative gross receipts: 250,000 666,667 1,000,000
(C) x (D)....................
(F) Cumulative gross receipts (0) (250,000) (666,667)
(prior year).................
-----------------------------------------
(G) Current-year gross 250,000 416,667 333,333
receipts.....................
-----------------------------------------
(H) Cumulative incurred costs. 200,000 600,000 750,000
(I) Cumulative incurred costs (0) (200,000) (600,000)
(prior year).................
-----------------------------------------
(J) Current-year costs........ 200,000 400,000 150,000
-----------------------------------------
(K) Gross income: (G) - (J)... $50,000 $16,667 $183,333
------------------------------------------------------------------------
Example 3. PCM--computing income with cost sharing. (i) C, whose
taxable year ends December 31, determines the income from long-term
contracts using the PCM. During 2001, C enters into a contract to
manufacture a unique item. The contract specifies a target price of
$1,000,000, a target cost of $600,000, and a target profit of $400,000.
C and B will share the savings of any cost underrun (actual total
incurred cost is less than target cost) and the additional cost of any
cost overrun (actual total incurred cost is greater than target cost) as
follows: 30 percent to C and 70 percent to B. By the end of 2001, C has
incurred $200,000 of allocable contract costs and estimates that the
total allocable contract costs will be $600,000. By the end of 2002, C
has incurred $300,000 of allocable contract costs and estimates that the
total allocable contract costs will be $400,000. In 2003, after
completing the contract, C determines that the actual cost to
manufacture the item was $700,000.
(ii) For each of the taxable years, C's income from the contract is
computed as follows (note that the sharing of any cost underrun or cost
overrun is reflected as an adjustment to C's target price under
paragraph (b)(4)(i) of this section):
------------------------------------------------------------------------
Taxable Year
-----------------------------------------
2001 2002 2003
------------------------------------------------------------------------
(A) Cumulative incurred costs. $200,000 $300,000 $700,000
(B) Estimated total costs..... 600,000 400,000 700,000
-----------------------------------------
(C) Completion factor: (A) / 33.33% 75.00% 100.00%
(B)..........................
=========================================
(D) Target price.............. $1,000,000 $1,000,000 $1,000,000
-----------------------------------------
(E) Estimated total costs..... 600,000 400,000 700,000
(F) Target costs.............. 600,000 600,000 600,000
-----------------------------------------
(G) Cost (underrun)/overrun: 0 (200,000) 100,000
(E) - (F)....................
(H) Adjustment rate........... 70% 70% 70%
-----------------------------------------
(I) Target price adjustment... 0 (140,000) 70,000
-----------------------------------------
(J) Total contract price: (D) $1,000,000 $860,000 $1,070,000
+ (I)........................
=========================================
(K) Cumulative gross receipts: $333,333 $645,000 $1,070,000
(C) x (J)....................
(L) Cumulative gross receipts (0) (333,333) (645,000)
(prior year):................
-----------------------------------------
(M) Current-year gross 333,333 311,667 425,000
receipts.....................
-----------------------------------------
(N) Cumulative incurred costs. 200,000 300,000 700,000
(O) Cumulative incurred costs (0) (200,000) (300,000)
(prior year):................
-----------------------------------------
(P) Current-year costs........ 200,000 100,000 400,000
-----------------------------------------
(Q) Gross income: (M) - (P)... $133,333 $211,667 $25,000
------------------------------------------------------------------------
[[Page 214]]
Example 4. PCM--10 percent method. (i) C, whose taxable year ends
December 31, determines the income from long-term contracts using the
PCM. In November 2001, C agrees to manufacture a unique item for
$1,000,000. C reasonably estimates that the total allocable contract
costs will be $600,000. By December 31, 2001, C has received $50,000 in
progress payments and incurred $40,000 of costs. C elects to use the 10
percent method effective for 2001 and all subsequent taxable years.
During 2002, C receives $500,000 in progress payments and incurs
$260,000 of costs. In 2003, C incurs an additional $300,000 of costs, C
finishes manufacturing the item, and receives the final $450,000
payment.
(ii) For each of the taxable years, C's income from the contract is
computed as follows:
------------------------------------------------------------------------
Taxable Year
-----------------------------------------
2001 2002 2003
------------------------------------------------------------------------
(A) Cumulative incurred costs. $40,000 $300,000 $600,000
(B) Estimated total costs..... 600,000 600,000 600,000
-----------------------------------------
(C) Completion factor (A) / 6.67% 50.00% 100.00%
(B)..........................
-----------------------------------------
(D) Total contract price...... 1,000,000 1,000,000 1,000,000
-----------------------------------------
(E) Cumulative gross receipts: 0 500,000 1,000,000
(C) x (D)*...................
(F) Cumulative gross receipts (0) (0) (500,000)
(prior year):................
-----------------------------------------
(G) Current-year gross 0 500,000 500,000
receipts.....................
-----------------------------------------
(H) Cumulative incurred costs. 0 300,000 600,000
(I) Cumulative incurred costs (0) (0) (300,000)
(prior year):................
-----------------------------------------
(J) Current-year costs........ 0 300,000 300,000
-----------------------------------------
(K) Gross income: (G) - (J)... $0 $200,000 $200,000
------------------------------------------------------------------------
*Unless (C) <10 percent.
Example 5. PCM--contract terminated. C, whose taxable year ends
December 31, determines the income from long-term contracts using the
PCM. During 2001, C buys land and begins constructing a building that
will contain 50 condominium units on that land. C enters into a contract
to sell one unit in this condominium to B for $240,000. B gives C a
$5,000 deposit toward the purchase price. By the end of 2001, C has
incurred $50,000 of allocable contract costs on B's unit and estimates
that the total allocable contract costs on B's unit will be $150,000.
Thus, for 2001, C reports gross receipts of $80,000 ($50,000 / $150,000
x $240,000), current-year costs of $50,000, and gross income of $30,000
($80,000 - $50,000). In 2002, after C has incurred an additional $25,000
of allocable contract costs on B's unit, B files for bankruptcy
protection and defaults on the contract with C, who is permitted to keep
B's $5,000 deposit as liquidated damages. In 2002, C reverses the
transaction with B under paragraph (b)(7) of this section and reports a
loss of $30,000 ($50,000-$80,000). In addition, C obtains an adjusted
basis in the unit sold to B of $70,000 ($50,000 (current-year costs
deducted in 2001)- $5,000 (B's forfeited deposit) + $25,000 (current-
year costs incurred in 2002). C may not apply the look-back method to
this contract in 2002.
Example 6. CCM--contracts with disputes from customer claims. In
2001, C, whose taxable year ends December 31, uses the CCM to account
for exempt construction contracts. C enters into a contract to construct
a bridge for B. The terms of the contract provide for a $1,000,000 gross
contract price. C finishes the bridge in 2002 at a cost of $950,000.
When B examines the bridge, B insists that C either repaint several
girders or reduce the contract price. The amount reasonably in dispute
is $10,000. In 2003, C and B resolve their dispute, C repaints the
girders at a cost of $6,000, and C and B agree that the contract price
is not to be reduced. Because C is assured a profit of $40,000
($1,000,000 - $10,000 - $950,000) in 2002 even if the dispute is
resolved in B's favor, C must take this $40,000 into account in 2002. In
2003, C will earn an additional $4,000 profit ($1,000,000 - $956,000 -
$40,000) from the contract with B. Thus, C must take into account an
additional $10,000 of gross contract price and $6,000 of additional
contract costs in 2003.
Example 7. CCM--contracts with disputes from taxpayer claims. In
2003, C, whose taxable year ends December 31, uses the CCM to account
for exempt construction contracts. C enters into a contract to construct
a building for B. The terms of the contract provide for a $1,000,000
gross contract price. C finishes the building in 2004 at a cost of
$1,005,000. B examines the building in 2004 and agrees that it meets the
contract's specifications; however, at the end of 2004, C and
[[Page 215]]
B are unable to agree on the merits of C's claim for an additional
$10,000 for items that C alleges are changes in contract specifications
and B alleges are within the scope of the contract's original
specifications. In 2005, B agrees to pay C an additional $2,000 to
satisfy C's claims under the contract. Because the amount in dispute
affects so much of the gross contract price that C cannot determine in
2004 whether a profit or loss will ultimately be realized, C may not
taken any of the gross contract price or allocable contract costs into
account in 2004. C must take into account $1,002,000 of gross contract
price and $1,005,000 of allocable contract costs in 2005.
Example 8. CCM--contracts with disputes from taxpayer and customer
claims. C, whose taxable year ends December 31, uses the CCM to account
for exempt construction contracts. C constructs a factory for B pursuant
to a long-term contract. Under the terms of the contract, B agrees to
pay C a total of $1,000,000 for construction of the factory. C finishes
construction of the factory in 2002 at a cost of $1,020,000. When B
takes possession of the factory and begins operations in December 2002,
B is dissatisfied with the location and workmanship of certain heating
ducts. As of the end of 2002, C contends that the heating ducts are
constructed in accordance with contract specifications. The amount of
the gross contract price reasonably in dispute with respect to the
heating ducts is $6,000. As of this time, C is claiming $14,000 in
addition to the original contract price for certain changes in contract
specifications which C alleges have increased his costs. B denies that
these changes have increased C's costs. In 2003, the disputes between C
and B are resolved by performance of additional work by C at a cost of
$1,000 and by an agreement that the contract price would be revised
downward to $996,000. Under these circumstances, C must include in his
gross income for 2002, $994,000 (the gross contract price less the
amount reasonably in dispute because of B's claim, or $1,000,000 -
$6,000). In 2002, C must also take into account $1,000,000 of allocable
contract costs (costs incurred less the amounts in dispute attributable
to both B's and C's claims, or $1,020,000 - $6,000 - $14,000). In 2003,
C must take into account an additional $2,000 of gross contract price
($996,000 - $994,000) and $21,000 of allocable contract costs
($1,021,000 - $1,000,000).
(i) [Reserved]
(j) Consolidated groups and controlled groups--(1) Intercompany
transactions--(i) In general. Section 1.1502-13 does not apply to the
income, gain, deduction, or loss from an intercompany transaction
between members of a consolidated group, and section 267(f) does not
apply to these items from an intercompany sale between members of a
controlled group, to the extent--
(A) The transaction or sale directly or indirectly benefits, or is
intended to benefit, another member's long-term contract with a
nonmember;
(B) The selling member is required under section 460 to determine
any part of its gross income from the transaction or sale under the
percentage-of-completion method (PCM); and
(C) The member with the long-term contract is required under section
460 to determine any part of its gross income from the long-term
contract under the PCM.
(ii) Definitions and nomenclature. The definitions and nomenclature
under Sec. 1.1502-13 and Sec. 1.267(f)-1 apply for purposes of this
paragraph (j).
(2) Example. The following example illustrates the principles of
paragraph (j)(1) of this section.
Example. Corporations P, S, and B file consolidated returns on a
calendar-year basis. In 1996, B enters into a long-term contract with X,
a nonmember, to manufacture 5 airplanes for $500 million, with delivery
scheduled for 1999. Section 460 requires B to determine the gross income
from its contract with X under the PCM. S enters into a contract with B
to manufacture for $50 million the engines that B will install on X's
airplanes. Section 460 requires S to determine the gross income from its
contract with B under the PCM. S estimates that it will incur $40
million of total contract costs during 1997 and 1998 to manufacture the
engines. S incurs $10 million of contract costs in 1997 and $30 million
in 1998. Under paragraph (j) of this section, S determines its gross
income from the long-term contract under the PCM rather than taking its
income or loss into account under section 267(f) or Sec. 1.1502-13.
Thus, S includes $12.5 million of gross receipts and $10 million of
contract costs in gross income in 1997 and includes $37.5 million of
gross receipts and $30 million of contract costs in gross income in
1998.
(3) Effective dates--(i) In general. This paragraph (j) applies with
respect to transactions and sales occurring pursuant to contracts
entered into in years beginning on or after July 12, 1995.
(ii) Prior law. For transactions and sales occurring pursuant to
contracts entered into in years beginning before July 12, 1995, see the
applicable regulations issued under sections 267(f) and 1502, including
Sec. Sec. 1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) (as contained in
the 26
[[Page 216]]
CFR part 1 edition revised as of April 1, 1995).
(4) Consent to change method of accounting. For transactions and
sales to which this paragraph (j) applies, the Commissioner's consent
under section 446(e) is hereby granted to the extent any changes in
method of accounting are necessary solely to comply with this section,
provided the changes are made in the first taxable year of the taxpayer
to which the rules of this paragraph (j) apply. Changes in method of
accounting for these transactions are to be effected on a cut-off basis.
(k) Mid-contract change in taxpayer--(1) In general. The rules in
this paragraph (k) apply if prior to the completion of a long-term
contract accounted for using a long-term contract method by a taxpayer
(old taxpayer), there is a transaction that makes another taxpayer (new
taxpayer) responsible for accounting for income from the same contract.
For purposes of this paragraph (k) and Sec. 1.460-6(g), an old taxpayer
also includes any old taxpayer(s) (e.g., predecessors) of the old
taxpayer. In addition, a change in status from taxable to tax exempt or
from domestic to foreign, or vice versa, will be considered a change in
taxpayer. Finally, a contract will be treated as the same contract if
the terms of the contract are not substantially changed in connection
with the transaction, whether or not the customer agrees to release the
old taxpayer from any or all of its obligations under the contract. The
rules governing constructive completion transactions are provided in
paragraph (k)(2) of this section, while the rules governing step-in-the-
shoes transactions are provided in paragraph (k)(3) of this section.
Special rules relating to the treatment of certain partnership
transactions are provided in paragraphs (k)(2)(iv) and (k)(3)(v) of this
section. For application of the look-back method to mid-contract changes
in taxpayers for contracts accounted for using the PCM, see Sec. 1.460-
6(g).
(2) Constructive completion transactions--(i) Scope. The
constructive completion rules in this paragraph (k)(2) apply to
transactions (constructive completion transactions) that result in a
change in the taxpayer responsible for reporting income from a contract
and that are not described in paragraph (k)(3)(i) of this section.
Constructive completion transactions generally include, for example,
taxable sales under section 1001 and deemed asset sales under section
338.
(ii) Old taxpayer. The old taxpayer is treated as completing the
contract on the date of the transaction. The total contract price (or,
gross contract price in the case of a long-term contract accounted for
under the CCM) for the old taxpayer is the sum of any amounts realized
from the transaction that are allocable to the contract and any amounts
the old taxpayer has received or reasonably expects to receive under the
contract. Total contract price (or gross contract price) is reduced by
any amount paid by the old taxpayer to the new taxpayer, and by any
transaction costs, that are allocable to the contract. Thus, the old
taxpayer's allocable contract costs determined under paragraph (b)(5) of
this section do not include any consideration paid, or costs incurred,
as a result of the transaction that are allocable to the contract. In
the case of a transaction subject to section 338 or 1060, the amount
realized from the transaction allocable to the contract is determined by
using the residual method under Sec. Sec. 1.338-6 and 1.338-7.
(iii) New taxpayer. The new taxpayer is treated as entering into a
new contract on the date of the transaction. The new taxpayer must
evaluate whether the new contract should be classified as a long-term
contract within the meaning of Sec. 1.460-1(b) and account for the
contract under a permissible method of accounting. For a new taxpayer
who accounts for a contract using the PCM, the total contract price is
any amount the new taxpayer reasonably expects to receive under the
contract consistent with paragraph (b)(4) of this section. Total
contract price is reduced by the amount of any consideration paid by the
new taxpayer as a result of the transaction, and by any transaction
costs, that are allocable to the contract and is increased by the amount
of any consideration received by the new taxpayer as a result of the
transaction that is allocable to
[[Page 217]]
the contract. Similarly, the gross contract price for a contract
accounted for using the CCM is all amounts the new taxpayer is entitled
by law or contract to receive consistent with paragraph (d)(3) of this
section, adjusted for any consideration paid (or received) by the new
taxpayer as a result of the transaction, and for any transaction costs,
that are allocable to the contract. Thus, the new taxpayer's allocable
contract costs determined under paragraph (b)(5) of this section do not
include any consideration paid, or costs incurred, as a result of the
transaction that are allocable to the contract. In the case of a
transaction subject to sections 338 or 1060, the amount of consideration
paid that is allocable to the contract is determined by using the
residual method under Sec. Sec. 1.338-6 and 1.338-7.
(iv) Special rules relating to distributions of certain contracts by
a partnership--(A) In general. The constructive completion rules of
paragraph (k)(2) of this section apply both to the distribution of a
contract accounted for under a long-term contract method of accounting
by a partnership to a partner and to the distribution of an interest in
a partnership (lower-tier partnership) holding (either directly or
through other partnerships) one or more contracts accounted for under a
long-term contract method of accounting by another partnership (upper-
tier partnership). Notwithstanding the previous sentence, the
constructive completion rules of paragraph (k)(2) of this section do not
apply to a transfer by a partnership (transferor partnership) of all of
its assets and liabilities to a second partnership (transferee
partnership) in an exchange described in section 721, followed by a
distribution of the interest in the transferee partnership in
liquidation of the transferor partnership, under Sec. 1.708-1(b)(4)
(relating to terminations under section 708(b)(1)(B)) or Sec. 1.708-
1(c)(3)(i) (relating to certain partnership mergers). If a partnership
that holds a contract accounted for under a long-term contract method of
accounting terminates under section 708(b)(1)(A) because the number of
its owners is reduced to one, the entire contract will be treated as
being distributed from the partnership for purposes of the constructive
completion rules, and the partnership must apply paragraph (k)(2) of
this section immediately prior to the transaction or transactions
resulting in the termination of the partnership.
(B) Old taxpayer. The partnership that distributes the contract is
treated as the old taxpayer for purposes of paragraph (k)(2)(ii) of this
section. For purposes of determining the total contract price (or gross
contract price) under paragraph (k)(2)(ii) of this section, the fair
market value of the contract is treated as the amount realized from the
transaction. For purposes of determining each partner's distributive
share of partnership items, any income or loss resulting from the
constructive completion must be allocated among the partners of the old
taxpayer as though the partnership closed its books on the date of the
distribution.
(C) New taxpayer. The partner receiving the distributed contract is
treated as the new taxpayer for purposes of paragraph (k)(2)(iii) of
this section. For purposes of determining the total contract price (or
gross contract price) under paragraph (k)(2)(iii) of this section, the
new taxpayer's basis in the contract (including the uncompleted
property, if applicable) after the distribution (as determined under
section 732) is treated as consideration paid by the new taxpayer that
is allocable to the contract. Thus, the total contract price (or gross
contract price) of the new contract is reduced by the partner's basis in
the contract (including the uncompleted property, if applicable)
immediately after the distribution.
(D) Basis rules. For purposes of determining the new taxpayer's
basis in the contract (including the uncompleted property, if
applicable) under section 732, and the amount of any basis adjustment
under section 734(b), the partnership's basis in the contract (including
the uncompleted property, if applicable) immediately prior to the
distribution is equal to--
(1) The partnership's allocable contract costs (including
transaction costs);
(2) Increased (or decreased) by the amount of cumulative taxable
income (or loss) recognized by the partnership
[[Page 218]]
on the contract through the date of the distribution (including amounts
recognized as a result of the constructive completion); and
(3) Decreased by the amounts that the partnership has received or
reasonably expects to receive under the contract.
(E) Section 751--(1) In general. Contracts accounted for under a
long-term contract method of accounting are unrealized receivables
within the meaning of section 751(c). For purposes of section 751, the
amount of ordinary income or loss attributable to a contract accounted
for under a long-term contract method of accounting is the amount of
income or loss that the partnership would take into account under the
constructive completion rules of paragraph (k)(2) of this section if the
contract were disposed of for its fair market value in a constructive
completion transaction, adjusted to account for any income or loss from
the contract that is allocated under section 706 to that portion of the
taxable year of the partnership ending on the date of the distribution,
sale, or exchange.
(2) Ordering rules. Because the distribution of a contract accounted
for under a long-term contract method of accounting is the distribution
of an unrealized receivable, section 751(b) may apply to the
distribution. A partnership that distributes a contract accounted for
under a long-term contract method of accounting must apply paragraph
(k)(2)(ii) of this section before applying the rules of section 751(b)
to the distribution.
(3) Step-in-the-shoes transactions--(i) Scope. Except as otherwise
provided in paragraph (k)(3)(v)(D) of this section, the step-in-the-
shoes rules in this paragraph (k)(3) apply to the following transactions
that result in a change in the taxpayer responsible for reporting income
from a contract accounted for using a long-term contract method of
accounting (step-in-the-shoes transactions)--
(A) Transfers to which section 361 applies if the transfer is in
connection with a reorganization described in section 368(a)(1)(A), (C)
or (F);
(B) Transfers to which section 361 applies if the transfer is in
connection with a reorganization described in section 368(a)(1)(D) or
(G), provided the requirements of section 354(b)(1)(A) and (B) are met;
(C) Distributions to which section 332 applies, provided the
contract is transferred to an 80-percent distributee;
(D) Transfers described in section 351;
(E) Transfers to which section 361 applies if the transfer is in
connection with a reorganization described in section 368(a)(1)(D) with
respect to which the requirements of section 355 (or so much of section
356 as relates to section 355) are met;
(F) Transfers (e.g., sales) of S corporation stock;
(G) Conversion to or from an S corporation;
(H) Members joining or leaving a consolidated group;
(I) Contributions of contracts accounted for under a long-term
contract method of accounting to which section 721(a) applies;
(J) Contributions of property (other than contracts accounted for
under a long-term contract method of accounting) to a partnership that
holds a contract accounted for under a long-term contract method of
accounting;
(K) Transfers of partnership interests (other than transfers which
cause the partnership to terminate under section 708(b)(1)(A));
(L) Distributions to which section 731 applies (other than the
distribution of the contract); and
(M) Any other transaction designated in the Internal Revenue
Bulletin by the Internal Revenue Service. See Sec. 601.601(d)(2)(ii) of
this chapter.
(ii) Old taxpayer--(A) In general. The new taxpayer will ``step into
the shoes'' of the old taxpayer with respect to the contract. Thus, the
old taxpayer's obligation to account for the contract terminates on the
date of the transaction and is assumed by the new taxpayer, as set forth
in paragraph (k)(3)(iii) of this section. As a result, an old taxpayer
using the PCM is required to recognize income from the contract based on
the cumulative allocable contract costs incurred as of the date of the
transaction. Similarly, an old taxpayer using the CCM is not required to
recognize any revenue and may not deduct allocable contract costs
incurred with respect to the contract.
[[Page 219]]
(B) Gain realized on the transaction. The amount of gain the old
taxpayer realizes on the transfer of a contract in a step-in-the-shoes
transaction must be determined after application of paragraph
(k)(3)(ii)(A) of this section using the rules of paragraph (k)(2) of
this section that apply to constructive completion transactions. (The
amount of gain realized on a transfer of a contract is relevant, for
example, in determining the amount of gain recognized with respect to
the contract in a section 351 transaction in which the old taxpayer
receives from the new taxpayer money or property other than stock of the
transferee.)
(iii) New taxpayer--(A) Method of accounting. Beginning on the date
of the transaction, the new taxpayer must account for the long-term
contract by using the same method of accounting used by the old taxpayer
prior to the transaction. The same method of accounting must be used for
such contract regardless of whether the old taxpayer's method is the new
taxpayer's principal method of accounting under Sec. 1.381(c)(4)-
1(b)(3) or whether the new taxpayer is otherwise eligible to use the old
taxpayer's method. Thus, if the old taxpayer uses the PCM to account for
the contract, the new taxpayer steps into the shoes of the old taxpayer
with respect to its completion factor and percentage of completion
methods (such as the 10-percent method), even if the new taxpayer has
not elected such methods for similarly classified contracts. Similarly,
if the old taxpayer uses the CCM, the new taxpayer steps into the shoes
of the old taxpayer with respect to the CCM, even if the new taxpayer is
not otherwise eligible to use the CCM. However, the new taxpayer is not
necessarily bound by the old taxpayer's method for similarly classified
contracts entered into by the new taxpayer subsequent to the transaction
and must apply general tax principles, including section 381, to
determine the appropriate method to account for these subsequent
contracts. To the extent that general tax principles allow the taxpayer
to account for similarly classified contracts using a method other than
the old taxpayer's method, the taxpayer is not required to obtain the
consent of the Commissioner to begin using such other method.
(B) Contract price. In the case of a long-term contract that has
been accounted for under PCM, the total contract price for the new
taxpayer is the sum of any amounts the old taxpayer or the new taxpayer
has received or reasonably expects to receive under the contract
consistent with paragraph (b)(4) of this section. Similarly, the gross
contract price in the case of a long-term contract accounted for under
the CCM includes all amounts the old taxpayer or the new taxpayer is
entitled by law or by contract to receive consistent with paragraph
(d)(3) of this section.
(C) Contract costs. Total allocable contract costs for the new
taxpayer are the allocable contract costs as defined under paragraph
(b)(5) of this section incurred by either the old taxpayer prior to, or
the new taxpayer after, the transaction. Thus, any payments between the
old taxpayer and the new taxpayer with respect to the contract in
connection with the transaction are not treated as allocable contract
costs.
(iv) Special rules related to certain corporate and partnership
transactions--(A) Old taxpayer--basis adjustment--(1) In general. Except
as provided in paragraph (k)(3)(iv)(A)(2) of this section, in the case
of a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of
this section, the old taxpayer must adjust its basis in the stock or
partnership interest of the new taxpayer by--
(i) Increasing such basis by the amount of gross receipts the old
taxpayer has recognized under the contract; and
(ii) Reducing such basis by the amount of gross receipts the old
taxpayer has received or reasonably expects to receive under the
contract (except to the extent such gross receipts give rise to a
liability other than a liability described in section 357(c)(3)).
(2) Basis adjustment in excess of stock or partnership interest
basis. If the old and new taxpayer do not join in the filing of a
consolidated Federal income tax return, the old taxpayer may not adjust
its basis in the stock or partnership interest of the new taxpayer under
paragraph (k)(3)(iv)(A)(1) of this section below zero and the old
taxpayer
[[Page 220]]
must recognize ordinary income to the extent the basis in the stock or
partnership interest of the new taxpayer otherwise would be adjusted
below zero. If the old and new taxpayer join in the filing of a
consolidated Federal income tax return, the old taxpayer must create an
(or increase an existing) excess loss account to the extent the basis in
the stock of the new taxpayer otherwise would be adjusted below zero
under paragraph (k)(3)(iv)(A)(1) of this section. See Sec. 1.1502-19
and 1.1502-32(a)(3)(ii).
(3) Subsequent dispositions of certain contracts. If the old
taxpayer disposes of a contract in a transaction described in paragraph
(k)(3)(i)(D), (E), or (I) of this section that the old taxpayer acquired
in a transaction described in paragraph (k)(3)(i)(D), (E), or (I) of
this section, the basis adjustment rule of this paragraph (k)(3)(iv)(A)
is applied by treating the old taxpayer as having recognized the amount
of gross receipts recognized by the previous old taxpayer under the
contract and any amount recognized by the previous old taxpayer with
respect to the contract in connection with the transaction in which the
old taxpayer acquired the contract. In addition, the old taxpayer is
treated as having received or as reasonably expecting to receive under
the contract any amount the previous old taxpayer received or reasonably
expects to receive under the contract. Similar principles will apply in
the case of multiple successive transfers described in paragraph
(k)(3)(i)(D), (E), or (I) of this section involving the contract.
(B) New taxpayer--(1) Contract price adjustment. Generally, payments
between the old taxpayer and the new taxpayer with respect to the
contract in connection with the transaction do not affect the contract
price. Notwithstanding the preceding sentence and paragraph
(k)(3)(iii)(B) of this section, however, in the case of transactions
described in paragraph (k)(3)(i)(B), (D), (E), or (I) of this section,
the total contract price (or gross contract price) must be reduced to
the extent of any amount recognized by the old taxpayer with respect to
the contract in connection with the transaction (e.g., any amount
recognized under section 351(b) or section 357 that is attributable to
the contract and any income recognized by the old taxpayer pursuant to
the basis adjustment rule of paragraph (k)(3)(iv)(A) of this section).
(2) Basis in contract. The new taxpayer's basis in a contract
(including the uncompleted property, if applicable) acquired in a
transaction described in paragraphs (k)(3)(i)(A) through (E) or
paragraph (k)(3)(i)(I) of this section will be computed under section
362, section 334, or section 723, as applicable. Upon a new taxpayer's
completion (actual or constructive) of a CCM or a PCM contract acquired
in a transaction described in paragraphs (k)(3)(i)(A) through (E) or
paragraph (k)(3)(i)(I) of this section, the new taxpayer's basis in the
contract (including the uncompleted property, if applicable) is reduced
to zero. The new taxpayer is not entitled to a deduction or loss in
connection with any basis reduction pursuant to this paragraph
(k)(3)(iv)(B)(2).
(C) Definition of old taxpayer and new taxpayer for certain
partnership transactions. For purposes of paragraphs (k)(3)(ii), (iii)
and (iv) of this section, in the case of a transaction described in
paragraph (k)(3)(i)(I) of this section, the partner contributing the
contract to the partnership is treated as the old taxpayer, and the
partnership receiving the contract from the partner is treated as the
new taxpayer.
(D) Exceptions to step-in-the-shoes rules for S corporations. Upon a
transfer described in paragraph (k)(3)(i)(F) of this section or a
conversion described in paragraph (k)(3)(i)(G) of this section,
paragraphs (k)(3)(ii) and (iii) of this section apply to a contract
accounted for under a long-term contract method of accounting only if
the S corporation's books are closed under section 1362(e)(3), section
1362(e)(6)(C), section 1362(e)(6)(D), section 1377(a)(2), or Sec.
1.1502-76 on the date of the transfer or conversion. In these cases, the
corporation is treated as both the old taxpayer and the new taxpayer for
purposes of paragraphs (k)(3)(ii) and (iii) of this section. In all
other cases involving these transfers, the corporation shall compute its
income or loss from each contract accounted for under a long-term
contract method of accounting
[[Page 221]]
for the period that includes the date of the transaction as though no
change in taxpayer had occurred with respect to the contract, and must
allocate the income or loss from the contract for that period in
accordance with the rules generally applicable to transfers of S
corporation stock and conversions to or from S corporation status. This
paragraph (k)(3)(iv)(D) is applicable for transactions on or after July
16, 2004. In addition, this paragraph (k)(3)(iv)(D) may be relied upon
for transactions on or after May 15, 2002.
(v) Special rules relating to certain partnership transactions--(A)
Section 704(c)--(1) Contributions of contracts. The principles of
section 704(c)(1)(A), section 737, and the regulations thereunder apply
to income or loss with respect to a contract accounted for under a long-
term contract method of accounting that is contributed to a partnership.
The amount of built-in income or built-in loss attributable to a
contributed contract that is subject to section 704(c)(1)(A) is
determined as follows. First, the contributing partner must take into
account any income or loss required under paragraph (k)(3)(ii)(A) of
this section for the period ending on the date of the contribution.
Second, the partnership must determine the amount of income or loss that
the contributing partner would take into account if the contract were
disposed of for its fair market value in a constructive completion
transaction. This calculation is treated as occurring immediately after
the partner has applied paragraph (k)(3)(ii)(A) of this section, but
before the contribution to the partnership. Finally, this amount is
reduced by the amount of income, if any, that the contributing partner
is required to recognize as a result of the contribution.
(2) Revaluations of partnership property. The principles of section
704(c) and Sec. 1.704-3 apply to allocations of income or loss with
respect to a long-term contract that is revalued by a partnership under
Sec. 1.704-1(b)(2)(iv)(f). The amount of built-in income or built-in
loss attributable to such a contract is equal to the amount of income or
loss that would be taken into account if, at the time of the
revaluation, the contract were disposed of for its fair market value in
a constructive completion transaction.
(3) Allocation methods. In the case of a contract accounted for
under the CCM, any built-in income or loss under section 704(c) is taken
into account in the year the contract is completed. In the case of a
contract accounted for under a long-term contract method of accounting
other than the CCM, any built-in income or loss under section 704(c)
must be taken into account in a manner that reasonably accounts for the
section 704(c) income or loss over the remaining term of the contract.
(B) Basis adjustments under sections 743(b) and 734(b). For purposes
of Sec. Sec. 1.743-1(d), 1.755-1(b), and 1.755-1(c), the amount of
ordinary income or loss attributable to a contract accounted for under a
long-term contract method of accounting is the amount of income or loss
that the partnership would take into account under the constructive
completion rules of paragraph (k)(2) of this section if, at the time of
the sale of a partnership interest or the distribution to a partner, the
partnership disposed of the contract for its fair market value in a
constructive completion transaction. If all or part of the transferee's
basis adjustment under section 743(b) or the partnership's basis
adjustment under section 734(b) is allocated to a contract accounted for
under a long-term contract method of accounting, the basis adjustment
shall reduce or increase, as the case may be, the affected party's
income or loss from the contract. In the case of a contract accounted
for under the CCM, the basis adjustment is taken into account in the
year in which the contract is completed. In the case of a contract
accounted for under a long-term contract method of accounting other than
the CCM, the portion of that basis adjustment that is recovered in each
taxable year of the partnership must be determined by the partnership in
a manner that reasonably accounts for the adjustment over the remaining
term of the contract.
(C) Cross reference. See paragraph (k)(2)(iv)(E) of this section for
rules relating to the application of section 751 to the transfer of an
interest in a partnership holding a contract accounted
[[Page 222]]
for under a long-term contract method of accounting.
(D) Exceptions to step-in-the-shoes rules. Upon a contribution
described in paragraph (k)(3)(i)(J) of this section, a transfer
described in paragraph (k)(3)(i)(K) of this section, or a distribution
described in paragraph (k)(3)(i)(L) of this section, paragraphs
(k)(3)(ii) and (iii) of this section apply to a contract accounted for
under a long-term contract method of accounting only if the
partnership's books are properly closed with respect to that contract
under section 706. In these cases, the partnership is treated as both
the old taxpayer and the new taxpayer for purposes of paragraphs
(k)(3)(ii) and (iii) of this section. In all other cases involving these
transactions, the partnership shall compute its income or loss from each
contract accounted for under a long-term contract method of accounting
for the period that includes the date of the transaction as though no
change in taxpayer had occurred with respect to the contract, and must
allocate the income or loss from the contract for that period under a
reasonable method complying with section 706.
(4) Anti-abuse rule. Notwithstanding this paragraph (k), in the case
of a transaction entered into with a principal purpose of shifting the
tax consequences associated with a long-term contract in a manner that
substantially reduces the aggregate U.S. Federal income tax liability of
the parties with respect to that contract, the Commissioner may allocate
to the old (or new) taxpayer the income from that contract properly
allocable to the old (or new) taxpayer. For example, the Commissioner
may reallocate income from a long-term contract in a transaction in
which a contract accounted for using the CCM, or using the PCM where the
old taxpayer has received advance payments in excess of its contribution
to the contract, is transferred to a tax indifferent party (e.g., a
foreign person not subject to U.S. Federal income tax).
(5) Examples. The following examples illustrate the rules of this
paragraph (k). For purposes of these examples, it is assumed that the
contract is a long-term construction contract accounted for using the
PCM prior to the transaction unless stated otherwise and the contract is
not transferred with a principal purpose of shifting the tax
consequences associated with a long-term contract in a manner that
substantially reduces the aggregate U.S. Federal income tax liability of
the parties with respect to that contract. The examples are as follows:
Example 1. Constructive completion--PCM. (i) Facts. In Year 1, X
enters into a contract. The total contract price is $1,000,000 and the
estimated total allocable contract costs are $800,000. In Year 1, X
incurs costs of $200,000. In Year 2, X incurs additional costs of
$400,000 before selling the contract as part of a taxable sale of its
business in Year 2 to Y, an unrelated party. At the time of sale, X has
received $650,000 in progress payments under the contract. The
consideration allocable to the contract under section 1060 is $150,000.
Pursuant to the sale, the new taxpayer Y immediately assumes X's
contract obligations and rights. Y is required to account for the
contract using the PCM. In Year 2, Y incurs additional allocable
contract costs of $50,000. Y correctly estimates at the end of Year 2
that it will have to incur an additional $75,000 of allocable contract
costs in Year 3 to complete the contract.
(ii) Old taxpayer. For Year 1, X reports receipts of $250,000 (the
completion factor multiplied by total contract price ($200,000/$800,000
x $1,000,000)) and costs of $200,000, for a profit of $50,000. X is
treated as completing the contract in Year 2 because it sold the
contract. For purposes of applying the PCM in Year 2, the total contract
price is $800,000 (the sum of the amounts received under the contract
and the amount realized in the sale ($650,000 + $150,000)) and the total
allocable contract costs are $600,000 (the sum of the costs incurred in
Year 1 and Year 2 ($200,000 + $400,000)). Thus, in Year 2, X reports
receipts of $550,000 (total contract price minus receipts already
reported ($800,000 - $250,000)) and costs incurred in year 2 of
$400,000, for a profit of $150,000.
(iii) New taxpayer. Y is treated as entering into a new contract in
Year 2. The total contract price is $200,000 (the amount remaining to be
paid under the terms of the contract less the consideration paid
allocable to the contract ($1,000,000 - $650,000 - $150,000)). The
estimated total allocable contract costs at the end of Year 2 are
$125,000 (the allocable contract costs that Y reasonably expects to
incur to complete the contract ($50,000 + $75,000)). In Year 2, Y
reports receipts of $80,000 (the completion factor multiplied by the
total contract price [($50,000/$125,000) x $200,000] and costs of
$50,000 (the costs incurred after the purchase), for a profit of
$30,000. For Year 3, Y reports receipts of
[[Page 223]]
$120,000 (total contract price minus receipts already reported ($200,000
- $80,000)) and costs of $75,000, for a profit of $45,000.
Example 2. Constructive completion--CCM. (i) Facts. The facts are
the same as in Example 1, except that X and Y properly account for the
contract under the CCM.
(ii) Old taxpayer. X does not report any income or costs from the
contract in Year 1. In Year 2, the contract is deemed complete for X,
and X reports its gross contract price of $800,000 (the sum of the
amounts received under the contract and the amount realized in the sale
($650,000 + $150,000)) and its total allocable contract costs of
$600,000 (the sum of the costs incurred in Year 1 and Year 2 ($200,000 +
$400,000)) in that year, for a profit of $200,000.
(iii) New taxpayer. Y is treated as entering into a new contract in
Year 2. Under the CCM, Y reports no gross receipts or costs in Year 2. Y
reports its gross contract price of $200,000 (the amount remaining to be
paid under the terms of the contract less the consideration paid
allocable to the contract ($1,000,000 - $650,000 - $150,000)) and its
total allocable contract costs of $125,000 (the allocable contract costs
that Y incurred to complete the contract ($50,000 + $75,000)) in Year 3,
the completion year, for a profit of $75,000.
Example 3. Step-in-the-shoes--PCM. (i) Facts. The facts are the same
as in Example 1, except that X transfers the contract (including the
uncompleted property) to Y in exchange for stock of Y in a transaction
that qualifies as a statutory merger described in section 368(a)(1)(A)
and does not result in gain or loss to X under section 361(a).
(ii) Old taxpayer. For Year 1, X reports receipts of $250,000 (the
completion factor multiplied by total contract price ($200,000/$800,000
x $1,000,000)) and costs of $200,000, for a profit of $50,000. Because
the mid-contract change in taxpayer results from a transaction described
in paragraph (k)(3)(i) of this section, X is not treated as completing
the contract in Year 2. In Year 2, X reports receipts of $500,000 (the
completion factor multiplied by the total contract price and minus the
Year 1 gross receipts [($600,000/$800,000 x $1,000,000)-$250,000]) and
costs of $400,000, for a profit of $100,000.
(iii) New taxpayer. Because the mid-contract change in taxpayer
results from a step-in-the-shoes transaction, Y must account for the
contract using the same methods of accounting used by X prior to the
transaction. Total contract price is the sum of any amounts that X and Y
have received or reasonably expect to receive under the contract, and
total allocable contract costs are the allocable contract costs of X and
Y. Thus, the estimated total allocable contract costs at the end of Year
2 are $725,000 (the cumulative allocable contract costs of X and the
estimated total allocable contract costs of Y ($200,000 + $400,000 +
$50,000 + $75,000)). In Year 2, Y reports receipts of $146,552 (the
completion factor multiplied by the total contract price minus receipts
reported by the old taxpayer ([($650,000/$725,000) x $1,000,000]-
$750,000) and costs of $50,000, for a profit of $96,552. For Year 3, Y
reports receipts of $103,448 (the total contract price minus prior year
receipts ($1,000,000-$896,552)) and costs of $75,000, for a profit of
$28,448.
Example 4. Step-in-the-shoes--CCM (i) Facts. The facts are the same
as in Example 3, except that X properly accounts for the contract under
the CCM.
(ii) Old taxpayer. X reports no income or costs from the contract in
Years 1, 2 or 3.
(iii) New taxpayer. Because the mid-contract change in taxpayer
results from a step-in-the-shoes transaction, Y must account for the
contract using the same method of accounting used by X prior to the
transaction. Thus, in Year 3, the completion year, Y reports receipts of
$1,000,000 and total contract costs of $725,000, for a profit of
$275,000.
Example 5. Step in the shoes--PCM--basis adjustment. The facts are
the same as in Example 3, except that X transfers the contract
(including the uncompleted property) with a basis of $0 and $125,000 of
cash to a new corporation, Z, in exchange for all of the stock of Z in a
section 351 transaction. Thus, under section 358(a), X's basis in the Z
stock is $125,000. Pursuant to paragraph (k)(3)(iv)(A)(1) of this
section, X must increase its basis in the Z stock by the amount of gross
receipts X recognized under the contract, $750,000 ($250,000 receipts in
Year 1 + $500,000 receipts in Year 2), and reduce its basis by the
amount of gross receipts X received under the contract, the $650,000 in
progress payments. Accordingly, X's basis in the Z stock is $225,000.
All other results are the same.
Example 6. Step in the shoes--CCM--basis adjustment. (i) Facts. The
facts are the same as in Example 4, except that X receives progress
payments of $800,000 (rather than $650,000) and transfers the contract
(including the uncompleted property) with a basis of $600,000 and
$125,000 of cash to a new corporation, Z, in exchange for all of the
stock of Z in a section 351 transaction. X and Z do not join in filing a
consolidated Federal income tax return.
(ii) Old taxpayer. X reports no income or costs under the contract
in Years 1, 2, or 3. Under section 358(a), X's basis in Z is $725,000.
Pursuant to paragraph (k)(3)(iv)(A)(1), X must reduce its basis in the
stock of Z by $800,000, the progress payments received by X. However, X
may not reduce its basis in the Z stock below zero pursuant paragraph
(k)(3)(iv)(A)(2) of this section. Accordingly, X's basis in the Z stock
is reduced by $725,000 to zero and X must recognize ordinary income of
$75,000.
(iii) New taxpayer. Upon completion of the contract in Year 3, Z
reports gross receipts
[[Page 224]]
of $925,000 ($1,000,000 original contract price--$75,000 income
recognized by the old taxpayer pursuant to the basis adjustment rule of
paragraph (k)(3)(iv)(A)) and total contract costs of $725,000, for a
profit of $200,000.
Example 7. Step in the shoes--PCM--gain recognized in transaction.
(i) Facts. The facts are the same as in Example 3, except that X
transfers the contract (including the uncompleted property) with a basis
of $0 and an unrelated capital asset with a value of $100,000 and a
basis of $0 to a new corporation, Z, in exchange for stock of Z with a
value of $200,000 and $50,000 of cash in a section 351 transaction.
(ii) Old taxpayer. For year 1, X reports receipts of $250,000
($200,000/$800,000 x $1,000,000) and costs of $200,000, for a profit of
$50,000. X is not treated as completing the contract in Year 2. In Year
2, X reports receipts of $500,000 (($600,000/$800,000 x $1,000,000 =
$750,000 cumulative gross receipts)--$250,000 prior year cumulative
gross receipts) and costs of $400,000, for a profit of $100,000. Under
paragraph (k)(3)(ii)(B) of this section, X determines that the gain
realized on the transfer of the contract to Z under the constructive
completion rules of paragraph (k)(2)(ii) of this section is $50,000
(total contract price of $800,000 ($150,000 value allocable to the
contract + $650,000 progress payments)--$750,000 previously recognized
cumulative gross receipts--$0 costs incurred but not recognized). The
gain realized on the transfer of the unrelated capital asset to Z is
$100,000. The amount of gain X must recognize due to the receipt of
$50,000 cash in the exchange is $50,000, of which $30,000 is allocated
to the contract ($150,000 value of contract/$250,000 total value of
property transferred to Z x $50,000) and is treated as ordinary income,
and $20,000 is allocated to the unrelated capital asset ($100,000 value
of capital asset/$250,000 total value of property transferred to Z x
$50,000). Under section 358(a), X's basis in the Z stock is $0. However,
pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X must increase
its basis in the Z stock by $750,000, the amount of gross receipts
recognized under the contract, and must reduce its basis in the Z stock
by $650,000, the amount of gross receipts X received under the contract.
Therefore, X's basis in the Z stock is $100,000.
(iii) New taxpayer. Z must account for the contract using the same
PCM method used by X prior to the transaction. Pursuant to paragraph
(k)(3)(iv)(B)(1) of this section, the total contract price is $970,000
($1,000,000 amount X and Z have received or reasonably expect to receive
under the contract--$30,000 income recognized by X with respect to the
contract as a result of the receipt of $50,000 cash in the transaction).
In Year 2, Z reports gross receipts of $119,655 ($650,000/$725,000 x
$970,000 = $869,655 current year cumulative gross receipts--$750,000
cumulative gross receipts reported by the old taxpayer) and costs of
$50,000, for a profit of $69,655. In Year 3, Z reports gross receipts of
$100,345 ($970,000-$869,655) and costs of $75,000, for a profit of
$25,345.
Example 8. Step in the shoes--CCM--gain recognized in transaction.
(i) Facts. The facts are the same as in Example 4, except that X
transfers the contract (including the uncompleted property) with a basis
of $600,000 and an unrelated capital asset with a value of $125,000 and
a basis of $0 to a new corporation, Z, in exchange for all the stock of
Z with a value of $175,000 and $100,000 of cash in a section 351
transaction. X and Z do not join in filing a consolidated Federal income
tax return.
(ii) Old taxpayer. X reports no income or costs under the contract
in Years 1, 2, or 3. Under paragraph (k)(3)(ii)(B), X determines that
the gain realized on the transfer of the contract to Z under the
constructive completion rules of paragraph (k)(2)(ii) of this section is
$200,000 ($800,000 total contract price ($150,000 value allocable to the
contract + $650,000 progress payments)--$600,000 costs incurred but not
recognized). The gain realized on the transfer of the unrelated capital
asset to Z is $125,000. The amount of gain X must recognize due to the
receipt of $100,000 of cash in the exchange is $100,000, of which
$54,545 is allocated to the contract ($150,000 value of the contract/
$275,000 total value of property transferred to Z x $100,000) and is
treated as ordinary income, and $45,455 is allocated to the unrelated
capital asset ($125,000 value of capital asset/$275,000 total value of
property transferred to Z x $100,000). Under section 358(a), X's basis
in the Z stock is $600,000 ($600,000 basis in the contract and unrelated
capital asset transferred--$100,000 cash received + $100,000 gain
recognized). Pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X
must reduce its basis in the stock of Z by $650,000, the progress
payments received under the contract. However, X may not reduce its
basis in the Z stock below zero pursuant to paragraph (k)(3)(iv)(A)(2)
of this section. Accordingly, X's basis in the Z stock is reduced by
$600,000 to zero and X must recognize income of $50,000.
(iii) New taxpayer. Z must account for the contract using the same
CCM used by X prior to the transaction. Pursuant to paragraph
(k)(3)(iv)(B)(1) of this section, the total contract price is $895,455
($1,000,000 original contract price--$54,545 income recognized by old
taxpayer with respect to the contract as a result of the receipt of cash
in the transaction--$50,000 income recognized by the old taxpayer
pursuant to the basis adjustment rule of paragraph (k)(3)(iv)(A)).
Accordingly, upon completion of the contract in Year 3, Z reports gross
receipts of $895,455 and total contract costs of $725,000, for a profit
of $170,455.
Example 9. Constructive completion--PCM--distribution of contract by
partnership. (i)
[[Page 225]]
Facts. In Year 1, W, X, Y, and Z each contribute $100,000 to form equal
partnership PRS. In Year 1, PRS enters into a contract. The total
contract price is $1,000,000 and the estimated total allocable contract
costs are $800,000. In Year 1, PRS incurs costs of $600,000 and receives
$650,000 in progress payments under the contract. Under the contract,
PRS performed all of the services required in order to be entitled to
receive the progress payments, and there was no obligation to return the
payments or perform any additional services in order to retain the
payments. PRS properly accounts for the contract under the PCM. In Year
2, PRS distributes the contract to X in liquidation of X's interest. PRS
incurs no costs and receives no progress payments in Year 2 prior to the
distribution. At the time of the distribution, PRS's only asset other
than the long-term contract and the partially constructed property is
$450,000 cash ($400,000 initially contributed and $50,000 in excess
progress payments). The fair market value of the contract is $150,000.
Pursuant to the distribution, X assumes PRS's contract obligations and
rights. In Year 2, X incurs additional allocable contract costs of
$50,000. X correctly estimates at the end of Year 2 that X will have to
incur an additional $75,000 of allocable contract costs in Year 3 to
complete the contract (rather than $150,000 as originally estimated by
PRS). Assume that X properly accounts for the contract under the PCM,
that PRS has no income or loss other than income or loss from the
contract, and that PRS has an election under section 754 in effect in
Year 2.
(ii) Tax consequences to PRS. For Year 1, PRS reports receipts of
$750,000 (the completion factor multiplied by total contract price
($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of
$150,000, which is allocated equally among W, X, Y, and Z ($37,500
each). Immediately prior to the distribution of the contract to X in
Year 2, the contract is deemed completed. Under paragraph (k)(2)(iv)(B)
of this section, the fair market value of the contract ($150,000) is
treated as the amount realized from the transaction. For purposes of
applying the PCM in Year 2, the total contract price is $800,000 (the
sum of the amounts received under the contract and the amount treated as
realized from the transaction ($650,000 + $150,000)) and the total
allocable contract costs are $600,000. Thus, in Year 2 PRS reports
receipts of $50,000 (total contract price minus receipts already
reported ($800,000 - $750,000)), and costs incurred in Year 2 of $0, for
a profit of $50,000. Under paragraph (k)(2)(iv)(B) of this section, this
profit must be allocated among W, X, Y, and Z as though the partnership
closed its books on the date of the distribution. Accordingly, each
partner's distributive share of this income is $12,500.
(iii) Tax consequences to X. X's basis in its interest in PRS
immediately prior to the distribution is $150,000 (X's $100,000 initial
contribution, increased by $37,500, X's distributive share of Year 1
income, and $12,500, X's distributive share of Year 2 income). Under
paragraph (k)(2)(iv)(D) of this section, PRS's basis in the contract
(including the uncompleted property, if applicable) immediately prior to
the distribution is equal to $150,000 (the partnership's allocable
contract costs, $600,000, increased by the amount of income recognized
by PRS on the contract through the date of the distribution (including
amounts recognized as a result of the constructive completion),
$200,000, decreased by the amounts that the partnership has received or
reasonably expects to receive under the contract, $650,000). Under
section 732, X's basis in the contract (including the uncompleted
property) after the distribution is $150,000. Under paragraph
(k)(2)(iv)(C) of this section, X's basis in the contract (including the
uncompleted property) is treated as consideration paid by X that is
allocable to the contract. X's total contract price is $200,000 (the
amount remaining to be paid under the terms of the contract less the
consideration allocable to the contract ($350,000-$150,000)). For Year
2, X reports receipts of $80,000 (the completion factor multiplied by
the total contract price [($50,000/$125,000) x $200,000]) and costs of
$50,000 (the costs incurred after the distribution of the contract), for
a profit of $30,000. For Year 3, X reports receipts of $120,000 (the
total contract price minus receipts already reported ($200,000 -
$80,000)) and costs of $75,000, for a profit of $45,000.
(iv) Section 734(b). Because X's basis in the contract (including
the uncompleted property) immediately after the distribution, $150,000,
is equal to PRS's basis in the contract (including the uncompleted
property) immediately prior to the distribution, there is no basis
adjustment under section 734(b).
Example 10. Constructive completion--CCM--distribution of contract
by partnership. (i) Facts. The facts are the same as in Example 9,
except that PRS and X properly account for the contract under the CCM.
(ii) Tax consequences to PRS. PRS reports no income or costs from
the contract in Year 1. Immediately prior to the distribution of the
contract to X in Year 2, the contract is deemed completed. Under
paragraph (k)(2)(iv)(B) of this section, the fair market value of the
contract ($150,000) is treated as the amount realized from the
transaction. For purposes of applying the CCM in Year 2, the gross
contract price is $800,000 (the sum of the amounts received under the
contract and the amount treated as realized from the transaction
($650,000 + $150,000)) and the total allocable contract costs are
$600,000. Thus, in Year 2 PRS reports profits of $200,000
[[Page 226]]
($800,000 - $600,000). This profit must be allocated among W, X, Y, and
Z as though the partnership closed its books on the date of the
distribution. Accordingly, each partner's distributive share of this
income is $50,000.
(iii) Tax consequences to X. X's basis in its interest in PRS
immediately prior to the distribution is $150,000 ($100,000 initial
contribution, increased by $50,000, X's distributive share of Year 2
income). Under paragraph (k)(2)(iv)(D) of this section, PRS's basis in
the contract (including the uncompleted property, if applicable)
immediately prior to the distribution is equal to $150,000 (the
partnership's allocable contract costs, $600,000, increased by the
amount of cumulative taxable income recognized by PRS on the contract
through the date of the distribution (including amounts recognized as a
result of the constructive completion), $200,000, decreased by the
amounts that the partnership has received or reasonably expects to
receive under the contract, $650,000). Under section 732, X's basis in
the contract (including the uncompleted property) after the distribution
is $150,000. Under paragraph (k)(2)(iv)(C) of this section, X's basis in
the contract is treated as consideration paid by X that is allocable to
the contract. Under the CCM, X reports no gross receipts or costs in
Year 2. For Year 3, the completion year, X reports its gross contract
price of $200,000 (the amount remaining to be paid under the terms of
the contract less the consideration allocable to the contract ($350,000
- $150,000)) and its total allocable contract costs of $125,000 (the
allocable contract costs that X incurred to complete the contract
($50,000 + $75,000)), for a profit of $75,000.
(iv) Section 734(b). The results under section 734(b) are the same
as in Example 9.
Example 11. Step-in-the-shoes--PCM--contribution of contract to
partnership. (i) Facts. In Year 1, X enters into a contract that X
properly accounts for under the PCM. The total contract price is
$1,000,000 and the estimated total allocable contract costs are
$800,000. In Year 1, X incurs costs of $600,000 and receives $650,000 in
progress payments under the contract. Under the contract, X performed
all of the services required in order to be entitled to receive the
progress payments, and there was no obligation to return the payments or
perform any additional services in order to retain the payments. In Year
2, X contributes the contract (including the uncompleted property) with
a basis of $0 and $125,000 of cash to partnership PRS in exchange for a
one-fourth partnership interest. X incurs costs of $10,000, and receives
no progress payments in Year 2 prior to the contribution of the
contract. X and the other three partners of PRS share equally in its
capital, profits, and losses. The parties determine that, at the time of
the contribution, the fair market value of the contract is $160,000.
Following the contribution in Year 2, PRS incurs additional allocable
contract costs of $40,000. PRS correctly estimates at the end of Year 2
that it will have to incur an additional $75,000 of allocable contract
costs in Year 3 to complete the contract (rather than $150,000 as
originally estimated by PRS).
(ii) Tax consequences to X. For Year 1, X reports receipts of
$750,000 (the completion factor multiplied by the total contract price
($600,000/$800,000 x $1,000,000)) and costs of $600,000, for a profit of
$150,000. Because the mid-contract change in taxpayer results from a
transaction described in paragraph (k)(3)(i)(I) of this section, X is
not treated as completing the contract in Year 2. Under paragraph
(k)(3)(ii)(A) of this section, for Year 2, X reports receipts of $12,500
(the completion factor multiplied by the total contract price ($610,000/
$800,000 x $1,000,000, or $762,500), decreased by receipts already
reported, $750,000) and costs of $10,000, for a profit of $2,500. Under
section 722, X's initial basis in its interest in PRS is $125,000.
Pursuant to paragraph (k)(3)(iv)(A)(1) of this section, X must increase
its basis in its interest in PRS by the amount of gross receipts X
recognized under the contract, $762,500, and reduce its basis by the
amount of gross receipts X received under the contract, the $650,000 in
progress payments. Accordingly, X's basis in its interest in PRS is
$237,500.
(iii) Tax consequences to PRS. Because the mid-contract change in
taxpayer results from a step-in-the-shoes transaction, PRS must account
for the contract using the same methods of accounting used by X prior to
the transaction. The total contract price is the sum of any amounts that
X and PRS have received or reasonably expect to receive under the
contract, and total allocable contract costs are the allocable contract
costs of X and PRS. For Year 2, PRS reports receipts of $134,052 (the
completion factor multiplied by the total contract price [($650,000/
$725,000) - $1,000,000], $896,552, decreased by receipts reported by X,
$762,500) and costs of $40,000, for a profit of $94,052. For Year 3, PRS
reports receipts of $103,448 (the total contract price minus prior year
receipts ($1,000,000 x $896,552)) and costs of $75,000, for a profit of
$28,448.
(iv) Section 704(c). The principles of section 704(c) and Sec.
1.704-3 apply to allocations of income or loss with respect to the
contract contributed by X. In this case, the amount of built-in income
that is subject to section 704(c) is the amount of income or loss that
the contributing partner would take into account if the contract were
disposed of for its fair market value in a constructive completion
transaction. This calculation is treated as occurring immediately after
the partner has applied paragraph (k)(3)(ii)(A) of this section, but
before the contribution to the partnership. In a constructive completion
transaction, the total contract price would
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be $810,000 (the sum of the amounts received under the contract and the
amount realized in the deemed sale ($650,000 + $160,000)). X would
report receipts of $47,500 (total contract price minus receipts already
reported ($810,000 - $762,500)) and costs of $0, for a profit of
$47,500. Thus, the amount of built-in income that is subject to section
704(c) is $47,500. The partnership must apply section 704(c) to this
income in a manner that reasonably accounts for the income over the
remaining term of the contract. For example, in Year 2, PRS could
allocate $26,810 to X under section 704(c) (the amount of built-in
income, $47,500, multiplied by a fraction, the numerator of which is the
completion factor for the year, $650,000/725,000, less the completion
factor for the prior year, $610,000/$800,000, and the denominator of
which is 100 percent reduced by the completion factor for the taxable
year preceding the event creating the section 704(c) income or loss,
$610,000/$800,000). The remaining $67,242 would be allocated equally
among all of the partners. In Year 3, the completion year, PRS could
allocate $20,690 to X under section 704(c) ($47,500 x [($725,000/
$725,000 -$650,000/$725,000) / (100 percent - $610,000/$800,000)]). The
remaining $7,758 would be allocated equally among all the partners.
Example 12. Step-in-the-shoes--CCM--contribution of contract to
partnership. (i) Facts. The facts are the same as in Example 11, except
that X and PRS properly account for the contract under the CCM, and X
has a basis of $610,000 in the contract (including the uncompleted
property).
(ii) Tax consequences to X. X reports no income or costs from the
contract in Years 1 or 2. X is not treated as completing the contract in
Year 2. Under section 722, X's initial basis in its interest in PRS is
$735,000 (the sum of $125,000 cash and X's basis of $610,000 in the
contract (including the uncompleted property)). Pursuant to paragraph
(k)(3)(iv)(A)(1)(ii) of this section, X must reduce its basis in its
interest in PRS by the amount of gross receipts X received under the
contract, or $650,000. Accordingly, X's basis in its interest in PRS is
$85,000.
(iii) Tax consequences to PRS. PRS must account for the contract
using the same methods of accounting used by X prior to the transaction.
Under the CCM, PRS reports no gross receipts or costs in Year 2. For
Year 3, the completion year, PRS reports its gross contract price of
$1,000,000 (the sum of any amounts that X and PRS have received or
reasonably expect to receive under the contract), and total allocable
contract costs of $725,000 (the allocable contract costs of X and PRS),
for a profit of $275,000.
(iv) Section 704(c). In this case, the amount of built-in income
that is subject to section 704(c) is the amount of income or loss that
the contributing partner would take into account if the contract were
disposed of for its fair market value in a constructive completion
transaction. This calculation is treated as occurring immediately after
the partner has applied paragraph (k)(3)(ii)(A) of this section, but
before the contribution to the partnership. In a constructive completion
transaction, X would report its gross contract price of $810,000 (the
sum of the amounts received under the contract and the amount realized
in the deemed sale ($650,000 + $160,000)) and its total allocable
contract costs of $610,000, for a profit of $200,000. Thus, the amount
of built-in income that is subject to section 704(c) is $200,000. Out of
PRS's income of $275,000, in Year 3, $200,000 must be allocated to X
under section 704(c), and the remaining $75,000 is allocated equally
among all of the partners.
Example 13. Step-in-the-shoes--PCM--transfer of a partnership
interest. (i) Facts. In Year 1, W, X, Y, and Z each contribute $100,000
to form equal partnership PRS. In Year 1, PRS enters into a contract.
The total contract price is $1,000,000 and the estimated total allocable
contract costs are $800,000. In Year 1, PRS incurs costs of $600,000 and
receives $650,000 in progress payments under the contract. Under the
contract, PRS performed all of the services required in order to be
entitled to receive the progress payments, and there was no obligation
to return the payment or perform any additional services in order to
retain the payments. PRS properly accounts for the contract under the
PCM. In Year 2, W transfers W's interest in PRS to T for $150,000.
Assume that $10,000 of PRS's Year 2 costs are incurred prior to the
transfer, $40,000 are incurred after the transfer; and that PRS receives
no progress payments in Year 2. Also assume that the fair market value
of the contract on the date of the transfer is $160,000, that PRS closes
its books with respect to the contract under section 706 on the date of
the transfer, and that PRS correctly estimates at the end of Year 2 that
it will have to incur an additional $75,000 of allocable contract costs
in Year 3 to complete the contract (rather than $150,000 as originally
estimated by PRS).
(ii) Income reporting for period ending on date of transfer. For
Year 1, PRS reports receipts of $750,000 (the completion factor
multiplied by total contract price ($600,000/$800,000 x $1,000,000)) and
costs of $600,000, for a profit of $150,000. This profit is allocated
equally among W, X, Y, and Z ($37,500 each). Under paragraph
(k)(3)(ii)(A) of this section, for the part of Year 2 ending on the date
of the transfer of W's interest, PRS reports receipts of $12,500 (the
completion factor multiplied by the total contract price ($610,000/
$800,000 x $1,000,000) minus receipts already reported ($750,000)) and
costs of $10,000 for a profit of $2,500. This profit is allocated
equally among W, X, Y, and Z ($625 each).
(iii) Income reporting for period after transfer. PRS must continue
to use the PCM. For
[[Page 228]]
the part of Year 2 beginning on the day after the transfer, PRS reports
receipts of $134,052 (the completion factor multiplied by the total
contract price decreased by receipts reported by PRS for the period
ending on the date of the transfer [($650,000/$725,000 x $1,000,000)--
$762,500]) and costs of $40,000, for a profit of $94,052. This profit is
shared equally among T, X, Y, and Z ($23,513 each). For Year 3, PRS
reports receipts of $103,448 (the total contract price minus prior year
receipts ($1,000,000 - $896,552)) and costs of $75,000, for a profit of
$28,448. The profit for Year 3 is shared equally among T, X, Y, and Z
($7,112 each).
(iv) Tax Consequences to W. W's amount realized is $150,000. W's
adjusted basis in its interest in PRS is $138,125 ($100,000 originally
contributed, plus $37,500, W's distributive share of PRS's Year 1
income, and $625, W's distributive share of PRS's Year 2 income prior to
the transfer). Accordingly, W's income from the sale of W's interest in
PRS is $11,875. Under paragraph (k)(2)(iv)(E) of this section, for
purposes of section 751(a), the amount of ordinary income attributable
to the contract is determined as follows. First, the partnership must
determine the amount of income or loss from the contract that is
allocated under section 706 to the period ending on the date of the sale
($625). Second, the partnership must determine the amount of income or
loss that the partnership would take into account under the constructive
completion rules of paragraph (k)(2) of this section if the contract
were disposed of for its fair market value in a constructive completion
transaction. Because PRS closed its books under section 706 with respect
to the contract on the date of the sale, this calculation is treated as
occurring immediately after the partnership has applied paragraph
(k)(3)(ii)(A) of this section on the date of the sale. In a constructive
completion transaction, the total contract price would be $810,000 (the
sum of the amounts received under the contract and the amount realized
in the deemed sale ($650,000 + $160,000)). PRS would report receipts of
$47,500 (total contract price minus receipts already reported ($810,000
- $762,500)) and costs of $0, for a profit of $47,500. Thus, the amount
of ordinary income attributable to the contract is $47,500, and W's
share of that income is $11,875. Thus, under Sec. 1.751-1(a), all of
W's $11,875 of income from the sale of W's interest in PRS is ordinary
income.
(v) Tax Consequences to T. T's adjusted basis for its interest in
PRS is $150,000. Under Sec. 1.743-1(d)(2), the amount of income that
would be allocated to T if the contract were disposed of for its fair
market value (adjusted to account for income from the contract for the
portion of PRS's taxable year that ends on the date of the transfer) is
$11,875. Under Sec. 1.743-1(b), the amount of T's basis adjustment
under section 743(b) is $11,875. Under paragraph (k)(3)(v)(B) of this
section, the portion of T's basis adjustment that is recovered in Year 2
and Year 3 must be determined by PRS in a manner that reasonably
accounts for the adjustment over the remaining term of the contract. For
example, PRS could recover $6,703 of the adjustment in Year 2 (the
amount of the basis adjustment, $11,875, multiplied by a fraction, the
numerator of which is the excess of the completion factor for the year,
$650,000/$725,000, less the completion factor for the prior year,
$610,000/$800,000, and the denominator of which is 100 percent reduced
by the completion factor for the taxable year preceding the transfer,
$610,000/$800,000). T's distributive share of income in Year 2 from the
contract would be adjusted from $23,513 to $16,810 as a result of the
basis adjustment. In Year 3, the completion year, PRS could recover
$5,172 of the adjustment ($11,875 x [($725,000/$725,000 -$650,000/
$725,000) / (100 percent - $610,000/$800,000)]). T's distributive share
of income in Year 3, the completion year, from the contract would be
adjusted from $7,112 to $1,940 as a result of the basis adjustment.
(6) Effective date. Except as provided in paragraph (k)(3)(iv)(D) of
this section, this paragraph (k) is applicable for transactions on or
after May 15, 2002. Application of the rules of this paragraph (k) to a
transaction that occurs on or after May 15, 2002 is not a change in
method of accounting.
[T.D. 8597, 60 FR 36684, July 18, 1995, as amended by T.D. 8929, 66 FR
2232, Jan. 11, 2001; 66 FR 18191, Apr. 6, 2001; T.D. 8995, 67 FR 34605,
May 15, 2002; T.D. 9137, 69 FR 42553, July 16, 2004]
Sec. 1.460-5 Cost allocation rules.
(a) Overview. This section prescribes methods of allocating costs to
long-term contracts accounted for using the percentage-of-completion
method described in Sec. 1.460-4(b) (PCM), the completed-contract
method described in Sec. 1.460-4(d) (CCM), or the percentage-of-
completion/capitalized-cost method described in Sec. 1.460-4(e) (PCCM).
Exempt construction contracts described in Sec. 1.460-3(b) accounted
for using a method other than the PCM or CCM are not subject to the cost
allocation rules of this section (other than the requirement to allocate
production-period interest under paragraph (b)(2)(v) of this section).
Paragraph (b) of this section describes the regular cost allocation
methods for contracts subject to the
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PCM. Paragraph (c) of this section describes an elective simplified cost
allocation method for contracts subject to the PCM. Paragraph (d) of
this section describes the cost allocation methods for exempt
construction contracts reported using the CCM. Paragraph (e) of this
section describes the cost allocation rules for contracts subject to the
PCCM. Paragraph (f) of this section describes additional rules
applicable to the cost allocation methods described in this section.
Paragraph (g) of this section provides rules concerning consistency in
method of allocating costs to long-term contracts.
(b) Cost allocation method for contracts subject to PCM--(1) In
general. Except as otherwise provided in paragraph (b)(2) of this
section, a taxpayer must allocate costs to each long-term contract
subject to the PCM in the same manner that direct and indirect costs are
capitalized to property produced by a taxpayer under Sec. 1.263A-1(e)
through (h). Thus, a taxpayer must allocate to each long-term contract
subject to the PCM all direct costs and certain indirect costs properly
allocable to the long-term contract (i.e., all costs that directly
benefit or are incurred by reason of the performance of the long-term
contract). However, see paragraph (c) of this section concerning an
election to allocate contract costs using the simplified cost-to-cost
method. As in section 263A, the use of the practical capacity concept is
not permitted. See Sec. 1.263A-2(a)(4).
(2) Special rules--(i) Direct material costs. The costs of direct
materials must be allocated to a long-term contract when dedicated to
the contract under principles similar to those in Sec. 1.263A-11(b)(2).
Thus, a taxpayer dedicates direct materials by associating them with a
specific contract, including by purchase order, entry on books and
records, or shipping instructions. A taxpayer maintaining inventories
under Sec. 1.471-1 must determine allocable contract costs attributable
to direct materials using its method of accounting for those inventories
(e.g., FIFO, LIFO, specific identification).
(ii) Components and subassemblies. The costs of a component or
subassembly (component) produced by the taxpayer must be allocated to a
long-term contract as the taxpayer incurs costs to produce the component
if the taxpayer reasonably expects to incorporate the component into the
subject matter of the contract. Similarly, the cost of a purchased
component (including a component purchased from a related party) must be
allocated to a long-term contract as the taxpayer incurs the cost to
purchase the component if the taxpayer reasonably expects to incorporate
the component into the subject matter of the contract. In all other
cases, the cost of a component must be allocated to a long-term contract
when the component is dedicated, under principles similar to those in
Sec. 1.263A-11(b)(2). A taxpayer maintaining inventories under Sec.
1.471-1 must determine allocable contract costs attributable to
components using its method of accounting for those inventories (e.g.,
FIFO, LIFO, specific identification).
(iii) Simplified production methods. A taxpayer may not determine
allocable contract costs using the simplified production methods
described in Sec. 1.263A-2(b) and (c).
(iv) Costs identified under cost-plus long-term contracts and
federal long-term contracts. To the extent not otherwise allocated to
the contract under this paragraph (b), a taxpayer must allocate any
identified costs to a cost-plus long-term contract or federal long-term
contract (as defined in section 460(d)). Identified cost means any cost,
including a charge representing the time-value of money, identified by
the taxpayer or related person as being attributable to the taxpayer's
cost-plus long-term contract or federal long-term contract under the
terms of the contract itself or under federal, state, or local law or
regulation.
(v) Interest--(A) In general. If property produced under a long-term
contract is designated property, as defined in Sec. 1.263A-8(b)
(without regard to the exclusion for long-term contracts under Sec.
1.263A-8(d)(2)(v)), a taxpayer must allocate interest incurred during
the production period to the long-term contract in the same manner as
interest is allocated to property produced by a taxpayer under section
263A(f). See Sec. Sec. 1.263A-8 to 1.263A-12 generally.
[[Page 230]]
(B) Production period. Notwithstanding Sec. 1.263A-12(c) and (d),
for purposes of this paragraph (b)(2)(v), the production period of a
long-term contract--
(1) Begins on the later of--
(i) The contract commencement date, as defined in Sec. 1.460-
1(b)(7); or
(ii) For a taxpayer using the accrual method of accounting for long-
term contracts, the date by which 5 percent or more of the total
estimated costs, including design and planning costs, under the contract
have been incurred; and
(2) Ends on the date that the contract is completed, as defined in
Sec. 1.460-1(c)(3).
(C) Application of section 263A(f). For purposes of this paragraph
(b)(2)(v), section 263A(f)(1)(B)(iii) (regarding an estimated production
period exceeding 1 year and a cost exceeding $1,000,000) must be applied
on a contract-by-contract basis; except that, in the case of a taxpayer
using an accrual method of accounting, that section must be applied on a
property-by-property basis.
(vi) Research and experimental expenses. Notwithstanding Sec.
1.263A-1(e)(3)(ii)(P) and (iii)(B), a taxpayer must allocate research
and experimental expenses, other than independent research and
development expenses (as defined in Sec. 1.460-1(b)(9)), to its long-
term contracts.
(vii) Service costs--(A) Simplified service cost method--(1) In
general. To use the simplified service cost method under Sec. 1.263A-
1(h), a taxpayer must allocate the otherwise capitalizable mixed service
costs among its long-term contracts using a reasonable method. For
example, otherwise capitalizable mixed service costs may be allocated to
each long-term contract based on labor hours or contract costs allocable
to the contract. To be considered reasonable, an allocation method must
be applied consistently and must not disproportionately allocate service
costs to contracts expected to be completed in the near future.
(2) Example. The following example illustrates the rule of this
paragraph (b)(2)(vii)(A):
Example. Simplified service cost method. During 2001, C, whose
taxable year ends December 31, produces electronic equipment for
inventory and enters into long-term contracts to manufacture specialized
electronic equipment. C's method of allocating mixed service costs to
the property it produces is the labor-based, simplified service cost
method described in Sec. 1.263A-1(h)(4). For 2001, C's total mixed
service costs are $100,000, C's section 263A labor costs are $500,000,
C's section 460 labor costs (i.e., labor costs allocable to C's long-
term contracts) are $250,000, and C's total labor costs are $1,000,000.
To determine the amount of mixed service costs capitalizable under
section 263A for 2001, C multiplies its total mixed service costs by its
section 263A allocation ratio (section 263A labor costs / total labor
costs). Thus, C's capitalizable mixed service costs for 2001 are $50,000
($100,000 x $500,000 / $1,000,000). Thereafter, C allocates its
capitalizable mixed service costs to produced property remaining in
ending inventory using its 263A allocation method (e.g., burden rate,
simplified production). Similarly, to determine the amount of mixed
service costs that are allocable to C's long-term contracts for 2001, C
multiplies its total mixed service costs by its section 460 allocation
ratio (section 460 labor / total labor costs). Thus, C's allocable mixed
service contract costs for 2001 are $25,000 ($100,000 x $250,000 /
$1,000,000). Thereafter, C allocates its allocable mixed service costs
to its long-term contracts proportionately based on its section 460
labor costs allocable to each long-term contract.
(B) Jobsite costs. If an administrative, service, or support
function is performed solely at the jobsite for a specific long-term
contract, the taxpayer may allocate all the direct and indirect costs of
that administrative, service, or support function to that long-term
contract. Similarly, if an administrative, service, or support function
is performed at the jobsite solely for the taxpayer's long-term contract
activities, the taxpayer may allocate all the direct and indirect costs
of that administrative, service, or support function among all the long-
term contracts performed at that jobsite. For this purpose, jobsite
means a production plant or a construction site.
(C) Limitation on other reasonable cost allocation methods. A
taxpayer may use any other reasonable method of allocating service
costs, as provided in Sec. 1.263A-1(f)(4), if, for the taxpayer's long-
term contracts considered as a whole, the--
(1) Total amount of service costs allocated to the contracts does
not differ significantly from the total amount of
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service costs that would have been allocated to the contracts under
Sec. 1.263A-1(f)(2) or (3);
(2) Service costs are not allocated disproportionately to contracts
expected to be completed in the near future because of the taxpayer's
cost allocation method; and
(3) Taxpayer's cost allocation method is applied consistently.
(c) Simplified cost-to-cost method for contracts subject to the
PCM--(1) In general. Instead of using the cost allocation method
prescribed in paragraph (b) of this section, a taxpayer may elect to use
the simplified cost-to-cost method, which is authorized under section
460(b)(3)(A), to allocate costs to a long-term contract subject to the
PCM. Under the simplified cost-to-cost method, a taxpayer determines a
contract's completion factor based upon only direct material costs;
direct labor costs; and depreciation, amortization, and cost recovery
allowances on equipment and facilities directly used to manufacture or
construct the subject matter of the contract. For this purpose, the
costs associated with any manufacturing or construction activities
performed by a subcontractor are considered either direct material or
direct labor costs, as appropriate, and therefore must be allocated to
the contract under the simplified cost-to-cost method. An electing
taxpayer must use the simplified cost-to-cost method to apply the look-
back method under Sec. 1.460-6 and to determine alternative minimum
taxable income under Sec. 1.460-4(f).
(2) Election. A taxpayer makes an election under this paragraph (c)
by using the simplified cost-to-cost method for all long-term contracts
entered into during the taxable year of the election on its original
federal income tax return for the election year. This election is a
method of accounting and, thus, applies to all long-term contracts
entered into during and after the taxable year of the election. This
election is not available if a taxpayer does not use the PCM to account
for all long-term contracts or if a taxpayer elects to use the 10-
percent method described in Sec. 1.460-4(b)(6).
(d) Cost allocation rules for exempt construction contracts reported
using the CCM--(1) In general. For exempt construction contracts
reported using the CCM, other than contracts described in paragraph
(d)(3) of this section (concerning contracts of homebuilders that do not
satisfy the $10,000,000 gross receipts test described in Sec. 1.460-
3(b)(3) or will not be completed within two years of the contract
commencement date), a taxpayer must annually allocate the cost of any
activity that is incident to or necessary for the taxpayer's performance
under a long-term contract. A taxpayer must allocate to each exempt
construction contract all direct costs as defined in Sec. 1.263A-
1(e)(2)(i) and all indirect costs either as provided in Sec. 1.263A-
1(e)(3) or as provided in paragraph (d)(2) of this section.
(2) Indirect costs--(i) Indirect costs allocable to exempt
construction contracts. A taxpayer allocating costs under this paragraph
(d)(2) must allocate the following costs to an exempt construction
contract, other than a contract described in paragraph (d)(3) of this
section, to the extent incurred in the performance of that contract--
(A) Repair of equipment or facilities;
(B) Maintenance of equipment or facilities;
(C) Utilities, such as heat, light, and power, allocable to
equipment or facilities;
(D) Rent of equipment or facilities;
(E) Indirect labor and contract supervisory wages, including basic
compensation, overtime pay, vacation and holiday pay, sick leave pay
(other than payments pursuant to a wage continuation plan under section
105(d) as it existed prior to its repeal in 1983), shift differential,
payroll taxes, and contributions to a supplemental unemployment benefits
plan;
(F) Indirect materials and supplies;
(G) Noncapitalized tools and equipment;
(H) Quality control and inspection;
(I) Taxes otherwise allowable as a deduction under section 164,
other than state, local, and foreign income taxes, to the extent
attributable to labor, materials, supplies, equipment, or facilities;
(J) Depreciation, amortization, and cost-recovery allowances
reported for the taxable year for financial purposes
[[Page 232]]
on equipment and facilities to the extent allowable as deductions under
chapter 1 of the Internal Revenue Code;
(K) Cost depletion;
(L) Administrative costs other than the cost of selling or any
return on capital;
(M) Compensation paid to officers other than for incidental or
occasional services;
(N) Insurance, such as liability insurance on machinery and
equipment; and
(O) Interest, as required under paragraph (b)(2)(v) of this section.
(ii) Indirect costs not allocable to exempt construction contracts.
A taxpayer allocating costs under this paragraph (d)(2) is not required
to allocate the following costs to an exempt construction contract
reported using the CCM--
(A) Marketing and selling expenses, including bidding expenses;
(B) Advertising expenses;
(C) Other distribution expenses;
(D) General and administrative expenses attributable to the
performance of services that benefit the taxpayer's activities as a
whole (e.g., payroll expenses, legal and accounting expenses);
(E) Research and experimental expenses (described in section 174 and
the regulations thereunder);
(F) Losses under section 165 and the regulations thereunder;
(G) Percentage of depletion in excess of cost depletion;
(H) Depreciation, amortization, and cost recovery allowances on
equipment and facilities that have been placed in service but are
temporarily idle (for this purpose, an asset is not considered to be
temporarily idle on non-working days, and an asset used in construction
is considered to be idle when it is neither en route to nor located at a
job-site), and depreciation, amortization and cost recovery allowances
under chapter 1 of the Internal Revenue Code in excess of depreciation,
amortization, and cost recovery allowances reported by the taxpayer in
the taxpayer's financial reports;
(I) Income taxes attributable to income received from long-term
contracts;
(J) Contributions paid to or under a stock bonus, pension, profit-
sharing, or annuity plan or other plan deferring the receipt of
compensation whether or not the plan qualifies under section 401(a), and
other employee benefit expenses paid or accrued on behalf of labor, to
the extent the contributions or expenses are otherwise allowable as
deductions under chapter 1 of the Internal Revenue Code. Other employee
benefit expenses include (but are not limited to): Worker's
compensation; amounts deductible or for whose payment reduction in
earnings and profits is allowed under section 404A and the regulations
thereunder; payments pursuant to a wage continuation plan under section
105(d) as it existed prior to its repeal in 1983; amounts includible in
the gross income of employees under a method or arrangement of employer
contributions or compensation which has the effect of a stock bonus,
pension, profit-sharing, or annuity plan, or other plan deferring the
receipt of compensation or providing deferred benefits; premiums on life
and health insurance; and miscellaneous benefits provided for employees
such as safety, medical treatment, recreational and eating facilities,
membership dues, etc.;
(K) Cost attributable to strikes, rework labor, scrap and spoilage;
and
(L) Compensation paid to officers attributable to the performance of
services that benefit the taxpayer's activities as a whole.
(3) Large homebuilders. A taxpayer must capitalize the costs of home
construction contracts under section 263A and the regulations
thereunder, unless the contract will be completed within two years of
the contract commencement date and the taxpayer satisfies the
$10,000,000 gross receipts test described in Sec. 1.460-3(b)(3).
(e) Cost allocation rules for contracts subject to the PCCM. A
taxpayer must use the cost allocation rules described in paragraph (b)
of this section to determine the costs allocable to the entire qualified
ship contract or residential construction contract accounted for using
the PCCM and may not use the simplified cost-to-cost method described in
paragraph (c) of this section.
(f) Special rules applicable to costs allocated under this section--
(1) Nondeductible costs. A taxpayer may not allocate any otherwise
allocable contract cost to a long-term contract if any section
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of the Internal Revenue Code disallows a deduction for that type of
payment or expenditure (e.g., an illegal bribe described in section
162(c)).
(2) Costs incurred for non-long-term contract activities. If a
taxpayer performs a non-long-term contract activity, as defined in Sec.
1.460-1(d)(2), that is incident to or necessary for the manufacture,
building, installation, or construction of the subject matter of one or
more of the taxpayer's long-term contracts, the taxpayer must allocate
the costs attributable to that activity to such contract(s).
(g) Method of accounting. A taxpayer that adopts or elects a cost
allocation method of accounting (or changes to another cost allocation
method of accounting with the Commissioner's consent) must apply that
method consistently for all similarly classified contracts, until the
taxpayer obtains the Commissioner's consent under section 446(e) to
change to another cost allocation method. A taxpayer-initiated change in
cost allocation method will be permitted only on a cut-off basis (i.e.,
for contracts entered into on or after the year of change) and thus, a
section 481(a) adjustment will not be permitted or required.
[T.D. 8929, 66 FR 2237, Jan. 11, 2001]
Sec. 1.460-6 Look-back method.
(a) In general--(1) Introduction. With respect to income from any
long-term contract reported under the percentage of completion method, a
taxpayer is required to pay or is entitled to receive interest under
section 460(b) on the amount of tax liability that is deferred or
accelerated as a result of overestimating or underestimating total
contract price or contract costs. Under this look-back method, taxpayers
are required to pay interest for any deferral of tax liability resulting
from the underestimation of the total contract price or the
overestimation of total contract costs. Conversely, if the total
contract price is overestimated or the total contract costs are
underestimated, taxpayers are entitled to receive interest for any
resulting acceleration of tax liability. The computation of the amount
of deferred or accelerated tax liability under the look-back method is
hypothetical; application of the look-back method does not result in an
adjustment to the taxpayer's tax liability as originally reported, as
reported on an amended return, or as adjusted on examination. Thus, the
look-back method does not correct for differences in tax liability that
result from over- or under-estimation of contract price and costs and
that are permanent because, for example, tax rates change during the
term of the contract.
(2) Overview. Paragraph (b) explains which situations require
application of the look-back method to income from a long-term contract.
Paragraph (c) explains the operation of the three computational steps
for applying the look-back method. Paragraph (d) provides guidance
concerning the simplified marginal impact method. Paragraph (e) provides
an elective method to minimize the number of times the look-back method
must be reapplied to a single long-term contract. Paragraph (f)
describes the reporting requirements for the look-back method and the
tax treatment of look-back interest. Paragraph (g) provides rules for
applying the look-back method when there is a transaction that changes
the taxpayer that reports income from a long-term contract prior to the
completion of a contract. Paragraph (h) provides examples illustrating
the three computational steps for applying the look-back method.
Paragraph (j) of this section provides guidance concerning the election
not to apply the look-back method in de minimis cases.
(b) Scope of look-back method--(1) In general. The look-back method
applies to any income from a long-term contract within the meaning of
section 460(f) that is required to be reported under the percentage of
completion method (as modified by section 460) for regular income tax
purposes or for alternative minimum tax purposes. If a taxpayer uses the
percentage of completion-capitalized cost method for long-term
contracts, the look-back method applies for regular tax purposes only to
the portion (40, 70, or 90 percent, whichever applies) of the income
from the contract that is reported under the percentage of completion
[[Page 234]]
method. To the extent that the percentage-of-completion method is
required to be used under Sec. 1.460-1(g) with respect to income and
expenses that are attributable to activities that benefit a related
party's long-term contract, the look-back method also applies to these
amounts, even if those activities are not performed under a contract
entered into directly by the taxpayer.
(2) Exceptions from section 460. The look-back method generally does
not apply to the regular taxable income from any long-term construction
contract within the meaning of section 460(e)(4) that:
(i) Is a home construction contract within the meaning of section
460(e)(1)(A), or
(ii) Is not a home construction contract but is estimated to be
completed within a 2-year period by a taxpayer whose average annual
gross receipts for the 3 tax years preceding the tax year the contract
is entered into do not exceed $10,000,000 (as provided in section
460(e)(1)(B)). These contracts are not subject to the look-back method
for regular tax purposes, even if the taxpayer uses a version of the
percentage of completion method permitted under Sec. 1.451-3, unless
the taxpayer has properly changed its method of accounting for these
contracts to the percentage of completion method as modified by section
460(b). The look-back method, however, applies to the alternative
minimum taxable income from a contract of this type, unless it is exempt
from the required use of the percentage of completion method under
section 56(a)(3).
(3) De minimis exception. Notwithstanding that the percentage of
completion method is otherwise required to be used, the look-back method
does not apply to any long-term contract that:
(i) Is completed within 2 years of the contract commencement date,
and
(ii) Has a gross contract price (as of the completion of the
contract) that does not exceed the lesser of $1,000,000 or 1 percent of
the average annual gross receipts of the taxpayer for the 3 tax years
preceding the tax year in which the contract is completed.
This de minimis exception is mandatory and, therefore, precludes
application of the look-back method to any contract that meets the
requirements of the exception. The de minimis exception applies for
purposes of computing both regular taxable income and alternative
minimum taxable income. Solely for this purpose, the determination of
whether a long-term contract meets the gross receipts test for both
alternative minimum tax and regular tax purposes is made based only on
the taxpayer's regular taxable income.
(4) Alternative minimum tax. For purposes of computing alternative
minimum taxable income, section 56(a)(3) generally requires long-term
contracts within the meaning of section 460(f) (generally without regard
to the exceptions in section 460(e)) to be accounted for using only the
percentage of completion method as defined in section 460(b), including
the look-back method of section 460(b), with respect to tax years
beginning after December 31, 1986. However, section 56(a)(3) (and thus
the look-back method) does not apply to any long-term contract entered
into after June 20, 1988, and before the beginning of the first tax year
that begins after September 30, 1990, that meets the conditions of both
section 460(e)(1)(A) and clauses (i) and (ii) of section 460(e)(1)(B),
and does not apply to any long-term contract entered into in a tax year
that begins after September 30, 1990, that meets the conditions of
section 460(e)(1)(A). A taxpayer that applies the percentage of
completion method (and thus the look-back method) to income from a long-
term contract only for purposes of determining alternative minimum
taxable income, and not regular taxable income, must apply the look-back
method to the alternative minimum taxable income in the year of contract
completion and other filing years whether or not the taxpayer was liable
for the alternative minimum tax for the filing year or for any prior
year. Interest is computed under the look-back method to the extent that
the taxpayer's total tax liability (including the alternative minimum
tax liability) would have differed if the percentage of completion
method had been applied using actual, rather than estimated, contract
price and contract costs.
[[Page 235]]
(5) Effective date. The look-back method, including the de minimis
exception, applies to long-term contracts entered into after February
28, 1986. With respect to activities that are subject to section 460
solely because they benefit a long-term contract of a related party, the
look-back method generally applies only if the related party's long-term
contract was entered into after June 20, 1988, unless a principal
purpose of the related-party arrangement is to avoid the requirements of
section 460.
(c) Operation of the look-back method--(1) Overview--(i) In general.
The amount of interest charged or credited to a taxpayer under the look-
back method is computed in three steps. This paragraph (c) describes the
three steps for applying the look-back method. These steps are
illustrated by the examples in paragraph (h). The first step is to
hypothetically reapply the percentage of completion method to all long-
term contracts that are completed or adjusted in the current year (the
``filing year''), using the actual, rather than estimated, total
contract price and contract costs. Based on this reapplication, the
taxpayer determines the amount of taxable income (and alternative
minimum taxable income) that would have been reported for each year
prior to the filing year that is affected by contracts completed or
adjusted in the filing year if the actual, rather than estimated, total
contract price and costs had been used in applying the percentage of
completion method to these contracts, and to any other contracts
completed or adjusted in a year preceding the filing year. If the
percentage of completion method only applies to alternative minimum
taxable income for contracts completed or adjusted in the filing year,
only alternative minimum taxable income is recomputed in the first step.
The second step is to compare what the tax liability would have been
under the percentage of completion method (as reapplied in the first
step) for each tax year for which the tax liability is affected by
income from contracts completed or adjusted in the filing year (a
``redetermination year'') with the most recent determination of tax
liability for that year to produce a hypothetical underpayments or
overpayment of tax. The third step is to apply the rate of interest on
overpayments designated under section 6621 of the Code, compounded
daily, to the hypothetical underpayment or overpayment of tax for each
redetermination year to compute interest that runs, generally, from the
due date (determined without regard to extensions) of the return for the
redetermination year to the due date (determined without regard to
extensions) of the return for the filing year. The net amount of
interest computed under the third step is paid by or credited to the
taxpayer for the filing year. Paragraph (d) provides a simplified
marginal impact method that simplifies the second step--the computation
of hypothetical underpayments or overpayments of tax liability for
redetermination years--and, in some cases, the third step--the
determination of the time period for computing interest.
(ii) Post-completion revenue and expenses--(A) In general. Except as
otherwise provided in section 460(b)(6) (see Sec. 1.460-6(j) for method
of electing) or Sec. 1.460-6(e), a taxpayer must apply the look-back
method to a long-term contract in the completion year and in any post-
completion year for which the taxpayer must adjust total contract price
or total allocable contract costs, or both, under the PCM. Any year in
which the look-back method must be reapplied is treated as a filing
year. See Example 3 of paragraph (h)(4) for an illustration of how the
look-back method is applied to post-completion adjustments.
(B) Completion. A contract is considered to be completed for
purposes of the look-back method in the year in which final completion
and acceptance within the meaning of Sec. 1.460-1(c)(3) have occurred.
(C) Discounting of contract price and contract cost adjustments
subsequent to completion; election not to discount--(1) General rule.
The amount of any post-completion adjustment to the total contract price
or contract costs is discounted, solely for purposes of applying the
look-back method, from its value at the time the amount is taken into
account in computing taxable income to its value at the completion of
the contract. The discount rate for this
[[Page 236]]
purpose is the Federal mid-term rate under section 1274(d) in effect at
the time the amount is properly taken into account. For purposes of
applying the look-back method for the completion year, no amounts are
discounted, even if they are received after the completion year.
(2) Election not to discount. Notwithstanding the general
requirement to discount post-completion adjustments, a taxpayer may
elect not to discount contract price and contract cost adjustments with
respect to any contract. The election not to discount is to be made on a
contract-by-contract basis and is binding with respect to all post-
completion adjustments that arise with respect to a contract for which
an election has been made. An election not to discount with respect to
any contract is made by stating that an election is being made on the
taxpayer's timely filed Federal income tax return (determined with
regard to extensions) for the first tax year after completion in which
the taxpayer takes into account (i.e., includes in income or deducts)
any adjustment to the contract price or contract costs. See Sec.
301.9100-8 of this chapter.
(3) Year-end discounting convention. In the absence of an election
not to discount, any revisions to the contract price and contract costs
must be discounted to their value as of the completion of the contract
in reapplying the look-back method. For this purpose, the period of
discounting is the period between the completion date of the contract
and the date that any adjustment is taken into account in computing
taxable income. Although taxpayers may use the period between the months
in which these two events actually occur, in many cases, these dates may
not be readily identifiable. Therefore, for administrative convenience,
taxpayers are permitted to use the period between the end of the tax
years in which these events occur as the period of discounting provided
that the convention is used consistently with respect to all post-
completion adjustments for all contracts of the taxpayer the adjustments
to which are discounted. In that case, the taxpayer must use as the
discount rate the Federal mid-term rate under section 1274(d) as of the
end of the tax year in which any revision is taken into account in
computing taxable income.
(D) Revenue acceleration rule. Section 460(b)(1) imposes a special
rule that requires a taxpayer to include in gross income, for the tax
year immediately following the year of completion, any previously
unreported portion of the total contract price (including amounts that
the taxpayer expects to receive in the future) determined as of that
year, even if the percentage of completion ratio is less than 100
percent because the taxpayer expects to incur additional allocable
contract costs in a later year. At the time any remaining portion of the
contract price is includible in income under this rule, no offset
against this income is permitted for estimated future contract costs. To
achieve the requirement to report all remaining contract revenue without
regard to additional estimated costs, a taxpayer must include only costs
actually incurred through the end of the tax year in the denominator of
the percentage of completion ratio in applying the percentage of
completion method for any tax years after the year of completion. The
look-back method also must be reapplied for the year immediately
following the year of completion if any portion of the contract price is
includible in income in that year by reason of section 460(b)(1). For
purposes of reapplying the look-back method as a result of this
inclusion in income, the taxpayer must only include in the denominator
of the percentage of completion ratio the actual contract costs incurred
as of the end of the year, even if the taxpayer reasonably expects to
incur additional allocable contract costs. To the extent that costs are
incurred in a subsequent tax year, the look-back method is reapplied in
that year (or a later year if the delayed reapplication method is used),
and the taxpayer is entitled to receive interest for the post-completion
adjustment to contract costs. Because this reapplication occurs
subsequent to the completion year, only the cumulative costs incurred as
of the end of the reapplication year are includible in the denominator
of the percentage of completion ratio.
[[Page 237]]
(2) Look-back Step One--(i) Hypothetical reallocation of income
among prior tax years. For each filing year, a taxpayer must allocate
total contract income among prior tax years, by hypothetically applying
the percentage of completion method to all contracts that are completed
or adjusted in the filing year using the rules of this paragraph (c)(2).
The taxpayer must reallocate income from those contracts among all years
preceding the filing year that are affected by those contracts using the
total contract price and contract costs, as determined as of the end of
the filing year (``actual contract price and costs''), rather than the
estimated contract price and contract costs. The taxpayer then must
determine the amount of taxable income and the amount of alternative
minimum taxable income that would have been reported for each affected
tax year preceding the filing year if the percentage of completion
method had been applied on the basis of actual contract price and
contract costs in reporting income from all contracts completed or
adjusted in the filing year and in any preceding year. If the percentage
of completion method only applies to alternative minimum taxable income
from the contract, only alternative minimum taxable income is recomputed
in the first step. For purposes of reallocating income (and costs if the
10-percent year changes for a taxpayer using the 10-percent method of
section 460(b)(5)) under the look-back method, the method of computing
the percentage of completion ratio is the same method used to report
income from the contract on the taxpayer's return. (Thus, an election to
use the 10-percent method or the simplified cost-to-cost method is taken
into account). See Example 1 of paragraph (h)(2) for an illustration of
Step One.
(ii) Treatment of estimated future costs in year of completion. If a
taxpayer reasonably expects to incur additional allocable contract costs
in a tax year subsequent to the year in which the contract is completed,
the taxpayer includes the actual costs incurred as of the end of the
completion year plus the additional allocable contract costs that are
reasonably expected to be incurred (to the extent includible under the
taxpayer's percentage of completion method) in the denominator of the
percentage of completion ratio. The completion year is the only filing
year for which the taxpayer may include additional estimated costs in
the denominator of the percentage of completion ratio in applying the
look-back method. If the look-back method is reapplied in any year after
the completion year, only the cumulative costs incurred as of the end of
the year of reapplication are includible in the denominator of the
percentage of completion ratio in reapplying the look-back method.
(iii) Interim reestimates not considered. The look-back method
cannot be applied to a contract before it is completed. Accordingly, for
purposes of applying Step One, the actual total contract price and
contract costs are substituted for the previous estimates of total
contract price and contract costs only with respect to contracts that
have been completed in the filing year and in a tax year preceding the
filing year. No adjustments are made under Step One for contracts that
have not been completed prior to the end of the current filing year,
even if, as of the end of this year, the estimated total contract price
or contract costs for these uncompleted contracts is different from the
estimated amount that was used during any tax year for which taxable
income is recomputed with respect to completed contracts under the look-
back method for the current filing year.
(iv) Tax years in which income is affected. In general, because
income under the percentage of completion method is generally reported
as costs are incurred, the taxable income and alternative minimum
taxable income are recomputed only for each year in which allocable
contract costs were incurred. However, there will be exceptions to this
general rule. For example, a taxpayer may be required to cumulatively
adjust the income from a contract in a year in which no allocable
contract costs are incurred if the estimated total contract price or
contract costs was revised in that year. However, in applying the look-
back method, no contract income is allocated to
[[Page 238]]
that year. Thus, there may be a difference between the amount of
contract income originally reported for that year and the amount of
contract income as reallocated. Similarly, because of the revenue
acceleration rule of section 460(b)(1), income may be reported in the
year immediately following the completion year even though no costs were
incurred during that year and, in applying the look-back method in that
year or another year, if additional costs are incurred or the contract
price is adjusted in a later year, no income is allocated to the year
immediately following the completion year.
(v) Costs incurred prior to contract execution; 10-percent method--
(A) General rule. The look-back method does not require allocation of
contract income to tax years before the contract was entered into. Costs
incurred prior to the year a contract is entered into are first taken
into account in the numerator of the percentage of completion ratio in
the year the contract is entered into. A taxpayer using the 10-percent
method must also use the 10-percent method in applying the look-back
method, using actual total contract costs to determine the 10-percent
year. Thus, contract income is never reallocated to a year before the
10-percent year as determined on the basis of actual contract costs. If
the 10-percent year is earlier as a result of applying Step One of the
look-back method, contract costs incurred up to and including the new
10-percent year (as determined based on actual contract costs), are
reallocated from the original 10-percent year to the new 10-percent, and
costs incurred in later years but before the old 10-percent year are
reallocated to those years. If the 10-percent year is later as a result
of applying Step One of the look-back method, contract costs incurred up
to and including the new 10-percent year are reallocated from all prior
years to the new 10-percent year. This is the only case in which costs
are reallocated under the look-back method.
(B) Example. The application of the look-back method by a taxpayer
using the 10-percent method is illustrated by the following example:
Example. Z elected to use the 10-percent method of section 460(b)(5)
for reporting income under the percentage of completion method. Z
entered into a contract in 1990 for a fixed price of $1,000x. During
1990, Z incurred allocable contract costs of $80x and estimated that it
would incur a total of $900x for the entire contract. Since $80x is less
than 10 percent of total estimated contract costs, Z reported no revenue
from the contract in 1990 and deferred the $80x of costs incurred. In
1991, Z incurred an additional $620x of contract costs, and completed
the contract. Accordingly, in its 1991 return, Z reported the entire
contract price of $l,000x, and deducted the $620x of costs incurred in
1991 and the $80x of costs incurred in 1990.
Under section 460(b)(5), the 10-percent method applies both for
reporting contract income and the look-back method. Under the look-back
method, since the costs incurred in 1990 ($80x) exceed 10 percent of the
actual total contract costs ($700x), Z is required to allocate $114x of
contract revenue ($80x/$700x x $1,000x) and the $80x of costs incurred
to 1990. Thus, application of the 1ook-back method results in a net
increase in taxable income for 1990 of $34x, solely for purposes of the
look-back method.
(vi) Amount treated as contract price--(A) General rule. The amount
that is treated as total contract price for purposes of applying the
percentage of completion method and reapplying the percentage of
completion method under the look-back method under Step One includes all
amounts that the taxpayer expects to receive from the customer. Thus,
amounts are treated as part of the contract price as soon as it is
reasonably estimated that they will be received, even if the all-events
test has not yet been met.
(B) Contingencies. Any amounts related to contingent rights or
obligations, such as incentive fees or amounts in dispute, are not
separated from the contract and accounted for under a non-long-term
contract method of accounting, notwithstanding any provision in Sec.
1.460-4(b)(4)(i), to the contrary. Instead, those amounts are treated as
part of the total contract price in applying the look-back method. For
example, if an incentive fee under a contract to manufacture a satellite
is payable to the taxpayer after a specified period of successful
performance, the incentive fee is includible in the total contract price
at the time and to the extent that it can reasonably be predicted that
the performance
[[Page 239]]
objectives will be met, . A portion of the contract price that is in
dispute is included in the total contract price at the time and to the
extent that the taxpayer can reasonably expect the dispute will be
resolved in the taxpayer's favor (without regard to when the taxpayer
receives payment for the amount in dispute or when the dispute is
finally resolved).
(C) Change orders. In applying the look-back method, a change order
with respect to a contract is not treated as a separate contract unless
the change order would be treated as a separate contract under the rules
for severing and aggregating contracts provided in Sec. 1.460-1(e).
Thus, if a change order is not treated as a separate contract, the
contract price and contract costs attributable to the change order must
be taken into account in allocating contract income to all tax years
affected by the underlying contract.
(3) Look-back Step Two: Computation of hypothetical overpayment or
underpayment of tax--(i) In general. Step Two involves the computation
of a hypothetical overpayment or underpayment of tax for each year in
which the tax liability is affected by income from contracts that are
completed or adjusted in the filing year (a ``redetermination year'').
The application of Step Two depends on whether the taxpayer uses the
simplified marginal impact method contained in paragraph (d) or the
actual method described in this paragraph (c)(3). The remainder of this
paragraph (c)(3) does not apply if a taxpayer uses the simplified
marginal impact method.
(ii) Redetermination of tax liability. Under the method described in
this paragraph (c)(3) (the ``actual method''), a taxpayer, first, must
determine what its regular and alternative minimum tax liability would
have been for each redetermination year if the amounts of contract
income allocated in Step One for all contracts completed or adjusted in
the filing year and in any prior year were substituted for the amounts
of contract income reported under the percentage of completion method on
the taxpayer's original return (or as subsequently adjusted on
examination, or by amended return). See Example 2 of paragraph (h)(3)
for an illustration of Step Two.
(iii) Hypothetical underpayment or overpayment. After redetermining
the income tax liability for each tax year affected by the reallocation
of contract income, the taxpayer then determines the amount, if any, of
the hypothetical underpayment or overpayment of tax for each of these
redetermination years. The hypothetical underpayment or overpayment for
each affected year is the difference between the tax liability as
redetermined under the look-back method for that year and the amount of
tax liability determined as of the latest of the following:
(A) The original return date;
(B) The date of a subsequently amended or adjusted return (if,
however, the amended return is due to a carryback described in section
6611(f), see paragraph (c)(4)(iii)); or,
(C) The last previous application of the look-back method (in which
case, the previous hypothetical tax liability is used).
(iv) Cumulative determination of tax liability. The redetermination
of tax liability resulting from previous applications of the look-back
method is cumulative. Thus, for example, in computing the amount of a
hypothetical overpayment or underpayment of tax for a redetermination
year, the current hypothetical tax liability is compared to the
hypothetical tax liability for that year determined as of the last
previous application of the look-back method.
(v) Years affected by look-back only. A redetermination of income
tax liability under Step Two is required for every tax year for which
the tax liability would have been affected by a change in the amount of
income or loss for any other year for which a redetermination is
required. For example, if the allocation of contract income under Step
One changed the amount of a net operating loss that was carried back to
a year preceding the year the taxpayer entered into the contract, the
tax liability for the earlier year must be redetermined.
(vi) Definition of tax liability. For purposes of Step Two, the
income tax liability must be redetermined by taking into account all
applicable additions to tax, credits, and net operating loss
[[Page 240]]
carrybacks and carryovers. Thus, the tax, if any, imposed under section
55 (relating to alternative minimum tax) must be taken into account. For
example, if the taxpayer did not pay alternative minimum tax, but would
have paid alternative minimum tax for that year if actual rather than
estimated contract price and costs had been used in determining contract
income for the year, the amount of any hypothetical overpayment or
underpayment of tax must be determined by comparing the hypothetical
total tax liability (including hypothetical alternative minimum tax
liability) with the actual tax liability for that year. The effect of
taking these items into account in applying the look-back method is
illustrated in Examples (4) through (7) of paragraphs (h)(5) through
(h)(8) below.
(4) Look-back Step Three: Calculation of interest on underpayment or
overpayment--(i) In general. After determining a hypothetical
underpayment or overpayment of tax for each redetermination year, the
taxpayer must determine the interest charged or credited on each of
these amounts. Interest on the amount determined under Step Two is
determined by applying the overpayment rate designated under section
6621, compounded daily. In general, the time period over which interest
is charged on hypothetical underpayments or credited on hypothetical
overpayments begins at the due date (not including extensions) of the
return for the redetermination year for which the hypothetical
underpayment or overpayment determined in Step Two is computed. This
time period generally ends on the earlier of:
(A) The due date (not including extensions) of the return for the
filing year, and
(B) The date both
(1) The income tax return for the filing year is filed, and
(2) The tax for that year has been paid in full. If a taxpayer uses
the simplified marginal impact method contained in paragraph (d), the
remainder of this paragraph (c)(4) does not apply.
(ii) Changes in the amount of a loss or credit carryback or
carryover. The time period for determining interest may be different in
cases involving loss or credit carrybacks or carryovers in order to
properly reflect the time period during which the taxpayer (in the case
of an underpayment) or the Government (in the case of an overpayment)
had the use of the amount determined to be a hypothetical underpayment
or overpayment. Thus, if a reallocation of contract income under Step
One results in an increase or decrease to a net operating loss carryback
(but not a carryforward), the interest due or to be refunded must be
computed on the increase or decrease in tax attributable to the change
to the carryback only from the due date (not including extensions) of
the return for the redetermination year that generated the carryback and
not from the due date of the return for the redetermination year in
which the carryback was absorbed. In the case of a change in the amount
of a carryover as a result of applying the lookback method, interest is
computed from the due date of the return for the year in which the
carryover was absorbed. See Examples (8) and (9) of paragraph (h)(9) for
an illustration of these rules.
(iii) Changes in the amount of tax liability that generated a
subsequent refund. If the amount of tax liability for a redetermination
year (as reported on the taxpayer's original return, as subsequently
adjusted on examination, as adjusted by amended return, or as
redetermined by the last previous application of the look-back method)
is decreased by the application of the look-back method, and any portion
of the redetermination year tax liability was absorbed by a loss or
credit carryback arising in a year subsequent to the redetermination
year, the look-back method applies as follows to properly reflect the
time period of the use of the tax overpayment. To the extent the amount
of tax absorbed because of the carryback exceeds the total hypothetical
tax liability for the year (as redetermined under the look-back method)
the taxpayer is entitled to receive interest only until the due date
(not including extensions) of the return for the year in which the
carryback arose.
Example. Upon the completion of a long-term contract in 1990, the
taxpayer redetermines its tax liability for 1988 under the
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look-back method. This redetermination results in a hypothetical
reduction of tax liability from $1,500x (actual liability originally
reported) to $1,200x (hypothetical liability). In addition, the taxpayer
had already received a refund of some or all of the actual 1988 tax by
carrying back a net operating loss (NOL) that arose in 1989. The time
period over which interest would be computed on the hypothetical
overpayment of $300x for 1988 would depend on the amount of the refund
generated by the carryback, as illustrated by the following three
alternative situations:
(A) If the amount refunded because of the NOL is $1,500x: interest
is credited to the taxpayer on the entire hypothetical overpayment of
$300x from the due date of the 1988 return, when the hypothetical
overpayment occurred, until the due date of the 1989 return, when the
taxpayer received a refund for the entire amount of the 1988 tax,
including the hypothetical overpayment.
(B) If the amount refunded because of the NOL is $1,000x: interest
is credited to the taxpayer on the entire amount of the hypothetical
overpayment of $300x from the due date of the 1988 return, when the
hypothetical overpayment occurred, until the due date of the 1990
return. In this situation interest is credited until the due date of the
return for the completion year of the contract, rather than the due date
of the return for the year in which the carryback arose, because the
amount refunded was less than the redetermined tax liability. Therefore,
no portion of the hypothetical overpayment is treated as having been
refunded to the taxpayer before the filing year.
(C) If the amount refunded because of the NOL is $1,300x-: interest
is credited to the taxpayer on $100x ($1,300x-$1,200x) from the due date
of the 1988 return until the due date of the 1989 return because only
this portion of the total hypothetical overpayment is treated as having
been refunded to the taxpayer before the filing year. However, the
taxpayer did not receive a refund for the remaining $200x of the
overpayment at that time and, therefore, is credited with interest on
$200x through the due date of the tax return for 1990, the filing year.
See Examples (10) and (11) of paragraph (h)(9) for a further
illustration of this rule.
(d) Simplified marginal impact method--(1) Introduction. This
paragraph (d) provides a simplified method for calculating look-back
interest. Any taxpayer may elect this simplified marginal impact method,
except that pass-through entities described in paragraph (d)(4) of this
section are required to apply the simplified marginal impact method at
the entity level with respect to domestic contracts and the owners of
those entities do not apply the look-back method to those contracts.
Under the simplified marginal impact method, a taxpayer calculates the
hypothetical underpayments or overpayments of tax for a prior year based
on an assumed marginal tax rate. A taxpayer electing to use the
simplified marginal impact method must use the method for each long-term
contract for which it reports income (except with respect to domestic
contracts if the taxpayer is an owner in a widely held pass-through
entity that is required to use the simplified marginal impact method at
the entity level for those contracts).
(2) Operation--(i) In general. Under the simplified marginal impact
method, income from those contracts that are completed or adjusted in
the filing year is first reallocated in accordance with the procedures
of Step One contained in paragraph (c)(2) of this section. Step Two is
modified in the following manner. The hypothetical underpayment or
overpayment of tax for each year of the contract (a ``redetermination
year'') is determined by multiplying the applicable regular tax rate (as
defined in paragraph (d)(2)(iii)) by the increase or decrease in regular
taxable income (or, if it produces a greater amount, by multiplying the
applicable alternative minimum tax rate by the increase or decrease in
alternative minimum taxable income, whether or not the taxpayer would
have been subject to the alternative minimum tax) that results from
reallocating income to the tax year under Step One. Generally, the
product of the alternative minimum tax rate and the increase or decrease
in alternative minimum taxable income will be the greater of the two
amounts described in the preceding sentence only with respect to
contracts for which a taxpayer uses the full percentage of completion
method only for alternative minimum tax purposes and uses the completed
contract method, or the percentage of completion-capitalized cost
method, for regular tax purposes. Step Three is then applied. Interest
is credited to the taxpayer on the net overpayment and is charged to the
taxpayer on the net underpayment for each redetermination year from the
due date (determined without regard to
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extensions) of the return for the redetermination year until the earlier
of
(A) The due date (determined without regard to extensions) of the
return for the filing year, and
(B) The first date by which both the return is filed and the tax is
fully paid.
(ii) Applicable tax rate. For purposes of determining hypothetical
underpayments or overpayments of tax under the simplified marginal
impact method, the applicable regular tax rate is the highest rate of
tax in effect for the redetermination year under section 1 in the case
of an individual and under section 11 in the case of a corporation. The
applicable alternative minimum tax rate is the rate of tax in effect for
the taxpayer under section 55(b)(1). The highest rate is determined
without regard to the taxpayer's actual rate bracket and without regard
to any additional surtax imposed for the purpose of phasing out multiple
tax brackets or exemptions.
(iii) Overpayment ceiling. The net hypothetical overpayment of tax
for any redetermination year is limited to the taxpayer's total federal
income tax liability for the redetermination year reduced by the
cumulative amount of net hypothetical overpayments of tax for that
redetermination year resulting from earlier applications of the look-
back method. If the reallocation of contract income results in a net
overpayment of tax and this amount exceeds the actual tax liability (as
of the filing year) for the redetermination year, as adjusted for past
applications of the look-back method and taking into account net
operating loss, capital loss, or credit carryovers and carrybacks to
that year, the actual tax so adjusted is treated as the overpayment for
the redetermination year. This overpayment ceiling does not apply when
the simplified marginal impact method is applied at the entity level by
a widely held pass-through entity in accordance with paragraph (d)(4) of
this section.
(iv) Example. The application of the simplified marginal impact
method is illustrated by the following example:
Example. Corporation X, a calendar-year taxpayer, reports income
from long-term contracts and elected the simplified marginal impact
method when it filed its income tax return for 1989. X uses only the
percentage of completion method for both regular taxable income and
alternative minimum taxable income. X completed contracts A, B, and C in
1989 and, therefore, was required to apply the look-back method in 1989.
Income was actually reported for these contracts in 1987, 1988, and
1989. X's applicable tax rate, as determined under section 11, for the
redetermination years 1987 and 1988 was 40 percent and 34 percent,
respectively. The amount of contract income originally reported and
reallocated for contracts A, B, and C, and the net overpayments and
underpayments for the redetermination years are as follows:
------------------------------------------------------------------------
1987 1988
------------------------------------------------------------------------
Contract A:
Originally reported........................... $5,000x $4,000x
Reallocated................................... 3,000x 5,000x
Increase/(Decrease)........................... (2,000x) 1,000x
Contract B:
Originally reported........................... 6,000x 2,000x
Reallocated................................... 7,000x 1,500x
Increase/(Decrease)........................... 1,000x (500x)
Contract C:
Originally reported........................... 8,000x 5,000x
Reallocated................................... 4,000x 7,000x
Increase/(Decrease)........................... (4,000x) 2,000x
Net Increase/(Decrease)......................... (5,000x) 2,500x
Tentative (Underpayment)/Overpayment:
@ .40....................................... 2,000x ..........
@ .34....................................... .......... (850x)
Ceiling:
Actual Tax Liability (After Carryovers and 1,500x 500x
Carrybacks)..................................
Final (Underpayment)/Overpayment................ 1,500x (850x)
------------------------------------------------------------------------
Under the simplified marginal impact method, X determined a
tentative hypothetical net overpayment for 1987 and a net underpayment
for 1988. X determined these amounts by first aggregating the difference
for contracts A, B, and C between the amount of contract price
originally reported and the amount of contract price as reallocated and,
then, applying the highest regular tax rate to the aggregate decrease in
income for 1987 and the aggregate increase in income for 1988.
However, X's overpayment for 1987 is subject to a ceiling based on
X's total tax liability. Because the tentative net overpayment of tax
for 1987 exceeds the actual tax liability for that year after taking
into account carryovers and carrybacks to that year, the final
overpayment under the simplified marginal impact method is the amount of
tax liability paid instead of the tentative net overpayment. Since
application of the look-back method for 1988 results in a tentative
underpayment of tax, it is not subject to a ceiling. If the look-back
method is applied in 1991, the ceiling amount for 1987 will be zero and
the ceiling amount for 1988 will be $1,350.
X is entitled to receive interest on the hypothetical overpayment
from March 15, 1988,
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to March 15, 1990. X is required to pay interest on the underpayment
from March 15, 1989, to March 15, 1990.
(3) Anti-abuse rule. If the simplified marginal impact method is
used with respect to any long-term contract (including a contract of a
widely held pass-through entity), the district director may recompute
interest for the contract (including domestic contracts of widely held
pass-through entities) under the look-back method using the actual
method (and without regard to the simplified marginal impact method).
The district director may make such a recomputation only if the amount
of income originally reported with respect to the contract for any
redetermination year exceeds the amount of income reallocated under the
look-back method with respect to that contract for that year (using
actual contract price and contract costs) by the lesser of $1,000,000 or
20 percent of the amount of income as reallocated (i.e., based on actual
contract price and contract costs) under the look-back method with
respect to that contract for that year. In determining whether to
exercise this authority upon examination of the Form 8697, the district
director may take into account whether the taxpayer overreported income
for a purpose of receiving interest under the look-back method on a
hypothetical overpayment determined at the applicable tax rate. The
district director also may take into account whether the taxpayer
underreported income for the year in question with respect to other
contracts. Notwithstanding the look-back method, the district director
may require an adjustment to the tax liability for any open tax year if
the taxpayer did not apply the percentage of completion method properly
on its original return.
(4) Application--(i) Required use by certain pass-through entities--
(A) General rule. The simplified marginal impact method is required to
be used with respect to income reported from domestic contracts by a
pass-through entity that is either a partnership, an S corporation, or a
trust, and that is not closely held. With respect to contracts described
in the preceding sentence, the simplified marginal impact method is
applied by the pass-through entity at the entity level. For determining
the amount of any hypothetical underpayment or overpayment, the
applicable regular and alternative minimum tax rates, respectively, are
generally the highest rates of tax in effect for corporations under
section 11 and section 55 (b)(1). However, the applicable regular and
alternative minimum tax rates are the highest rates of tax imposed on
individuals under section 1 and section 55 (b)(1) if, at all times
during the redetermination year involved (i.e., the year in which the
hypothetical increase or decrease in income arises), more than 50
percent of the interests in the entity were held by individuals directly
or through 1 or more pass-through entities.
(B) Closely held. A pass-through entity is closely held if, at any
time during any redetermination year, 50 percent of more (by value) of
the beneficial interests in that entity are held (directly or
indirectly) by or for 5 or fewer persons. For this purpose, the term
``person'' has the same meaning as in section 7701(a)(1), except that a
pass-through entity is not treated as a person. In addition, the
constructive ownership rules of section 1563(e) apply by substituting
the term ``beneficial interest'' for the term ``stock'' and by
substituting the term ``pass-through entity'' for the term,
``corporation'' used in that section, as appropriate, for purposes of
determining whether a beneficial interest in a pass-through entity is
indirectly owned by any person.
(C) Examples. The following examples illustrate the application of
the rules of paragraph (d)(4)(i):
Example 1. P, a partnership, began a long-term contract on March 1,
1986, and completed this contract in its tax year ending December 31,
1989. P used the percentage of completion method for all contract
income. Substantially all of the income from the contract arose from
U.S. sources. At all times during all of the years for which income was
required to be reported under the contract, exactly 25 percent of the
value of P's interests was owned by Corporation M. The remaining 75
percent of the value of P's interests was owned in equal shares by 15
unrelated individuals, who are also unrelated to Corporation M. M's
ownership of P represents less than 50 percent of the value of the
beneficial interests in P, and, therefore, viewed alone, is insufficient
to make P a
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closely held partnership. In addition, because no 4 of the individual
owners together own 25 percent or more of the remaining value of P's
beneficial interests, there is no group of 5 owners that together own,
directly or indirectly, 50 percent or more by value of the beneficial
interests in P. Therefore, P is not closely held pass-through entity.
Because P is not a closely held pass-through entity, and because P
completed the contract after the effective date of section 460(b)(4), P
is required to use the simplified marginal impact method. Any interest
computed under the look-back method will be paid to, or collected from,
P, rather than its partners, and must be reported to each of the
partners on Form 1065 as interest income or expense. Further, assume
that, for the redetermination years, Corporation M is subject to
alternative minimum tax at the rate of 20 percent and 3 of the
individuals who own interests in P are subject to the highest marginal
tax rate of 33 percent in 1988. Regardless of the actual marginal tax
rates of its partners, P is required to determine the underpayment or
overpayment of tax for each redetermination year at the entity level by
applying a single rate to the increase or decrease in income resulting
from the reallocation of contract income under the look-back method.
Because more than 50 percent of the interests in P are held by
individuals, P must use the highest rate specified in section 1 for each
redetermination year. Thus, the rate applied by P is 50 percent for
1986, 38.5 percent for 1987, and 28 percent for 1988.
Example 2. Assume the same facts as in Example 1, except that one of
the individuals, Individual I, who directly owns 5 percent of the value
of the interests of P, also owns 100 percent of the stock of Corporation
M. Section 1563(e)(4) of the Code provides that stock owned directly or
indirectly by or for a corporation is considered to be owned by any
person who owns 5 percent or more in value of its stock in that
proportion which the value of the stock which that person so owns bears
to the value of all the stock in that corporation. Because section
460(b)(4)(C)(iii) and this paragraph (d)(4) provide that rules similar
to the constructive ownership rules of section 1563(e) apply in
determining whether a pass-through entity is closely held, all of M's
interest in P is attributed to I because I owns 100 percent of the value
of the stock in M. Accordingly, because I's direct 5 percent and
constructive 25 percent ownership of P, plus the interests owned by any
4 other individual partners, equals 50 percent or more of the value of
the beneficial interests of P, P is a closely held pass-through entity
within the meaning of section 460(b)(4)(C)(iii). Therefore, P cannot use
the simplified marginal impact method at the entity level. Accordingly,
each of the partners of P must separately apply the look-back method to
their respective interests in the income and expenses attributable to
the contract, but each partner may elect to use the simplified marginal
impact method with respect to the partner's share of income from the
contract.
(D) Domestic contracts--(1) General rule. A domestic contract is any
contract substantially all of the income of which is from sources in the
United States. For this purpose, ``substantially all'' of the income
from a long-term contract is considered to be from United States sources
if 95 percent or more of the gross income from the contract is from
sources within the United States as determined under the rules in
sections 861 through 865.
(2) Portion of contract income sourced. In determining whether
substantially all of the gross income from a long-term contract is from
United States sources, taxpayers must apply the allocation and
apportionment principles of sections 861 through 865 only to the portion
of the contract accounted for under the percentage of completion method.
Under the percentage of completion method, gross income from a long-term
contract includes all payments to be received under the contract (i.e.,
any amounts treated as contract price). Similarly, all costs taken into
account in the computation of taxable income under the percentage of
completion method are deducted from gross income rather than added to a
cost of goods sold account that reduces gross income. Therefore,
allocable contract costs are not considered in determining whether a
long-term contract is a domestic contract or a foreign contract, even
if, under the taxpayer's facts, the allocation of contract costs to any
portion of a contract not accounted for under the percentage of
completion method would affect the relative percentages of United States
and foreign source gross income from the entire contract if this portion
of the contract were taken into account in applying the 95-percent test.
(E) Application to foreign contracts. If a widely held pass-through
entity has some foreign contracts and some domestic contracts, the
owners of the pass-through entity each apply the look-back method
(using, if they elect,
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the simplified marginal impact method) to their respective share of the
income and expense from foreign contracts. Moreover, in applying the
look-back method to foreign contracts at the owner level, the owners do
not take into account their share of increases or decreases in contract
income resulting from the application of the simplified marginal impact
method with respect to domestic contracts at the entity level.
(F) Effective date. The simplified marginal impact method must be
applied to pass-through entities described in paragraph (d)(4)(i) of
this section with respect to domestic contracts completed or adjusted in
tax years for which the due date of the return (determined with regard
to extensions) of the pass-through entity is after November 9, 1988.
(ii) Elective use--(A) General rule. As provided in paragraph
(d)(4)(i) of this section, the simplified marginal impact method must be
used by certain pass-through entities with respect to domestic
contracts. C corporations, individuals, and owners of closely held pass-
through entities may elect the simplified marginal impact method. Owners
of other pass-through entities may also elect the simplified marginal
impact method with respect to all contracts other than those for which
the simplified marginal impact method is required to be applied at the
entity level. This rule applies to foreign contracts of widely held
pass-through entities. In the case of an electing owner in a pass-
through entity, the simplified marginal impact method is applied at the
owner level, instead of at the entity level, with respect to the owner's
share of the long-term contract income and expense reported by the pass-
through entity.
(B) Election requirements. A taxpayer elects the simplified marginal
impact method by stating that the election is being made on a timely
filed income tax return (determined with regard to extensions) for the
first tax year the election is to apply. An election to use the
simplified marginal impact method applies to all applications of the
look-back method to all eligible long-term contracts for the tax year
for which the election is made and for any subsequent tax year. The
election may not be revoked without the consent of the Commissioner.
(C) Consolidated group consistency rule. In the case of a
consolidated group of corporations as defined in Sec. 1.1502-1(h), an
election to use the simplified marginal impact method is made by the
common parent of the group. The election is binding on all other
affected members of the group (including members that join the group
after the election is made with respect to all applications of the look-
back method after joining). If a member subsequently leaves the group,
the election remains binding as to that member unless the Commissioner
consents to a revocation of the election. If a corporation using the
simplified marginal impact method joins a group that does not use the
method, the election is automatically revoked with respect to all
applications of the look-back method after it joins the group.
(e) Delayed reapplication method--(1) In general. For purposes of
reapplying the look-back method after the year of contract completion, a
taxpayer may elect the delayed reapplication method to minimize the
number of required reapplications of the look-back method. Under this
method, the look-back method is reapplied after the year of completion
of a contract (or after a subsequent application of the look-back
method) only when the first one of the following conditions is met with
respect to the contract:
(i) The net undiscounted value of increases or decreases in the
contract price occurring since the time of the last application of the
look-back method exceeds the lesser of $1,000,000 or 10 percent of the
total contract price as of that time,
(ii) The net undiscounted value of increases or decreases in the
contract costs occurring since the time of the last application of the
look-back method exceeds the lesser of $1,000,000 or 10 percent of the
total contract price as of that time,
(iii) The taxpayer goes out of existence,
(iv) The taxpayer reasonably believes the contract is finally
settled and closed, or
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(v) Neither condition (e)(1) (i), (ii), (iii), nor (iv) above is met
by the end of the fifth tax year that begins after the last previous
application of the look-back method.
(2) Time and manner of making election. An election to use the
delayed reapplication method may be made for any filing year for which
the due date of the return (determined with regard to extensions) is
after June 12, 1990. The election is made by a statement to that effect
on the taxpayer's timely filed Federal income tax return (determined
with regard to extensions) for the first tax year the election is to be
effective. An election to use the delayed reapplication method is
binding with respect to all long-term contracts for which the look-back
method would be reapplied without regard to the election in the year of
election and any subsequent year unless the Commissioner consents to a
revocation of the election. In the case of a consolidated group of
corporations as defined in Sec. 1.1502-1(h), an election to use the
delayed reapplication method is made by the common parent of the group.
The election is binding on all other affected members of the group
(including members that join the group after the election is made with
respect to contracts adjusted after joining). If a member subsequently
leaves the group, the election remains binding as to that member unless
the Commissioner consents to a revocation of the election. If a
corporation that has made the election joins a consolidated group that
has not made the election, the election is treated as revoked with
respect to contracts adjusted after joining.
(3) Examples. The operation of this delayed reapplication method is
illustrated by the following examples:
Example 1. X completes a contract in 1987, and applies the look-back
method when its return for 1987 is filed. X properly uses $600,000 as
the actual contract price in applying the look-back method. In 1990, as
a result of the settlement of a dispute with its customer, X
redetermines total contract price to be $640,000, and includes $40,000
in gross income. On its return for 1990, X states it is electing the
delayed reapplication method. X is not required to reapply the look-back
method at that time, because $40,000 does not exceed the lesser of
$1,000,000 or 10 percent of the unadjusted contract price of $600,000,
and 5 years have not passed since the last application of the look-back
method.
Example 2. Assume the same facts as in Example 1, except that at the
end of 1992, the fifth year after completion of the contract, no other
adjustments to contract price or contract costs have occurred. X is
required to reapply the look-back method in 1992 and, accordingly,
redetermine its tax liability for each redetermination year. After
redetermining the underpayment of tax for those years, X must compute
the amount of interest charged on the underpayments. Although 1992 is
the filing year, interest is due on the amount of each underpayment
resulting from the adjustment only from the due date of the return for
each redetermination year to the due date of the return for 1990 because
the tax liability for the adjustment was fully paid in 1990. However,
from the due of the 1990 return until the due date of the 1992 return,
when the look-back method is reapplied for the adjustment, interest is
due on the amount of interest attributable to the underpayments.
(f) Look-back reporting--(1) Procedure. The amount of any interest
due from, or payable to, a taxpayer as a result of applying the look-
back method is computed on Form 8697 for any filing year. In general,
the look-back method is applied by the taxpayer that reports income from
a long-term contract. See paragraph (g) of this section to determine who
is responsible for applying the look-back method when, prior to the
completion of a long-term contract, there is a transaction that changes
the taxpayer that reports income from the contract.
(2) Treatment of interest on return--(i) General rule. The amount of
interest required to be paid by a taxpayer is treated as an income tax
under subtitle A, but only for purposes of subtitle F of the Code (other
than sections 6654 and 6655), which addresses tax procedures and
administration. Thus, a taxpayer that fails to pay the amount of
interest due is subject to any applicable penalties under subtitle F,
including, for example, an underpayment penalty under section 6651, and
the taxpayer also is liable for underpayment interest under section
6601. However, interest required to be paid under the look-back method
is treated as interest expense for purposes of computing taxable income
under subtitle A, even though it is treated as income tax liability for
subtitle F purposes. Interest received under the look-back method is
treated
[[Page 247]]
as taxable interest income for all purposes, and is not treated as a
reduction in tax liability or a tax refund. The determination of whether
or not interest computed under the look-back method is treated as tax is
determined on a ``net'' basis for each filing year. Thus, if a taxpayer
computes for the current filing year both hypothetical overpayments and
hypothetical underpayments for prior years, the taxpayer has an increase
in tax only if the interest computed on the underpayments for all those
prior years exceeds the interest computed on the overpayments for all
those prior years, for all contracts completed or adjusted for the year.
(ii) Timing of look-back interest. For purposes of determining
taxable income under subtitle A of the Code, any amount of interest
payable to the taxpayer under the look-back method is includible in
gross income as interest income in the tax year it is properly taken
into account under the taxpayer's method of accounting for interest
income. Any amount of interest required to be paid is taken into account
as interest expense arising from an underpayment of income tax in the
tax year it is properly taken into account under the taxpayer's method
of accounting for interest expense. Thus, look-back interest required to
be paid by an individual, or by a pass-through entity on behalf of an
individual owner (or beneficiary) under the simplified marginal impact
method, is personal interest and, therefore, is disallowed in accordance
with Sec. 1.163-9T(b)(2). Interest determined at the entity level under
the simplified marginal impact method is allocated among the owners (or
beneficiaries) for reporting purposes in the same manner that interest
income and interest expense are allocated to owners (or beneficiaries)
and subject to the requirements of section 704 and any other applicable
rules.
(3) Statute of limitations and compounding of interest on look-back
interest. For guidance on the statute of limitations applicable to the
assessment and collection of look-back interest owed by a taxpayer, see
sections 6501 and 6502. A taxpayer's claim for credit or refund of look-
back interest previously paid by or collected from a taxpayer is a claim
for credit or refund of an overpayment of tax and is subject to the
statute of limitations provided in section 6511. A taxpayer's claim for
look-back interest (or interest payable on look-back interest) that is
not attributable to an amount previously paid by or collected from a
taxpayer is a general, non-tax claim against the federal government. For
guidance on the statute of limitations that applies to general, non-tax
claims against the federal government, see 28 U.S.C. sections 2401 and
2501. For guidance applicable to the compounding of interest when the
look-back interest is not paid, see sections 6601 to 6622.
(g) Mid-contract change in taxpayer--(1) In general. The rules in
this paragraph (g) apply if, as described in Sec. 1.460-4(k), prior to
the completion of a long-term contract accounted for using the PCM or
the PCCM by a taxpayer (old taxpayer), there is a transaction that makes
another taxpayer (new taxpayer) responsible for accounting for income
from the same contract. The rules governing constructive completion
transactions are provided in paragraph (g)(2) of this section, while the
rules governing step-in-the-shoes transactions are provided in paragraph
(g)(3) of this section. For purposes of this paragraph, pre-transaction
years are all taxable years of the old taxpayer in which the old
taxpayer accounted for (or should have accounted for) gross receipts
from the contract, and post-transaction years are all taxable years of
the new taxpayer in which the new taxpayer accounted for (or should have
accounted for) gross receipts from the contract.
(2) Constructive completion transactions. In the case of a
transaction described in Sec. 1.460-4(k)(2)(i) (constructive completion
transaction), the look-back method is applied by the old taxpayer with
respect to pre-transaction years upon the date of the transaction and,
if the new taxpayer uses the PCM or the PCCM to account for the
contract, by the new taxpayer with respect to post-transaction years
upon completion of the contract. The contract price and allocable
contract costs to be taken into account by the old taxpayer or the new
taxpayer in applying the look-back method are described in Sec. 1.460-
4(k)(2).
[[Page 248]]
(3) Step-in-the-shoes transactions--(i) General rules. In the case
of a transaction described in Sec. 1.460-4(k)(3)(i) (step-in-the-shoes
transaction), the look-back method is not applied at the time of the
transaction, but is instead applied for the first time when the contract
is completed by the new taxpayer. Upon completion of the contract, the
look-back method is applied by the new taxpayer with respect to both
pre-transaction years and post-transaction years, taking into account
all amounts reasonably expected to be received by either the old or new
taxpayer and all allocable contract costs incurred during both periods
as described in Sec. 1.460-4(k)(3). The new taxpayer is liable for
filing the Form 8697 and for interest computed on hypothetical
underpayments of tax, and is entitled to receive interest with respect
to hypothetical overpayments of tax, for both pre- and post-transaction
years. The old taxpayer will be secondarily liable for any interest
required to be paid with respect to pre-transaction years reduced by any
interest on pre-transaction overpayments.
(ii) Application of look-back method to pre-transaction period--(A)
Contract price. The actual contract price for pre-transaction taxable
years must be determined by the new taxpayer without regard to any
contract price adjustment described in paragraph (k)(3)(iv)(B)(1) of
this section.
(B) Method. The new taxpayer may apply the look-back method to each
pre-transaction taxable year that is a redetermination year using the
simplified marginal impact method described in paragraph (d) of this
section (regardless of whether or not the old taxpayer would have
actually used that method and without regard to the tax liability
ceiling). But see paragraph (d)(4) of this section, which requires use
of the simplified marginal impact method by certain pass-through
entities.
(C) Interest accrual period. With respect to any hypothetical
underpayment or overpayment of tax for a pre-transaction taxable year,
interest accrues from the due date of the old taxpayer's tax return (not
including extensions) for the taxable year of the underpayment or
overpayment until the due date of the new taxpayer's return (not
including extensions) for the completion year or the year of a post-
completion adjustment, whichever is applicable.
(D) Information old taxpayer must provide--(1) In general. Except as
provided in paragraph (g)(3)(ii)(D)(2) of this section, in order to help
the new taxpayer to apply the look-back method with respect to pre-
transaction taxable years, any old taxpayer that accounted for income
from a long-term contract under the PCM or PCCM for either regular or
alternative minimum tax purposes is required to provide the information
described in this paragraph to the new taxpayer by the due date (not
including extensions) of the old taxpayer's income tax return for the
first taxable year ending on or after a step-in-the-shoes transaction
described in Sec. 1.460-4(k)(3)(i). The required information is as
follows--
(i) The portion of the contract reported by the old taxpayer under
PCM for regular and alternative minimum tax purposes (i.e., whether the
old taxpayer used PCM, the 40/60 PCCM method, or the 70/30 PCCM method);
(ii) Any submethods used in the application of PCM (e.g., the
simplified cost-to-cost method or the 10-percent method);
(iii) The amount of total contract price reported by year;
(iv) The numerator and the denominator of the completion factor by
year;
(v) The due date (not including extensions) of the old taxpayer's
income tax returns for each taxable year in which income was required to
be reported;
(vi) Whether the old taxpayer was a corporate or a noncorporate
taxpayer by year; and
(vii) Any other information required by the Commissioner by
administrative pronouncement.
(2) Special rules for certain pass-through entity transactions. For
purposes of paragraph (g)(3)(ii)(D)(1) of this section, in the case of a
transaction described in Sec. 1.460-4(k)(3)(i)(I), the contributing
partner is treated as the old taxpayer, and the partnership is treated
as the new taxpayer. In the case of transactions described in Sec.
1.460-4(k)(3)(i)(F), (G), (J), (K), or (L), the old taxpayer is not
required to provide the
[[Page 249]]
information described in paragraph (g)(3)(ii)(D)(1) of this section,
because information necessary for the new taxpayer to apply the look-
back method is provided by the pass-through entity. This paragraph
(g)(3)(ii)(D) is applicable for transactions on or after August 6, 2003.
(iii) Application of look-back method to post-transaction years.
With respect to post-transaction taxable years, the new taxpayer must
use the same look-back method it uses for other contacts (i.e., the
simplified marginal impact method or the acutal method) to determine the
amount of any hypothetical overpayment or underpayment of tax and the
time period for computing interest on these amounts.
(iv) S corporation elections. Following the conversion of a C
corporation into an S corporation, the look-back method is applied at
the entity level with respect to contracts entered into prior to the
conversion, notwithstanding section 460(b)(4)(B)(i).
(4) Effective date. Except as provided in paragraph (g)(3)(ii)(D) of
this section, this paragraph (g) is applicable for transactions on or
after May 15, 2002.
(h) Examples--(1) Overview. This paragraph provides computational
examples of the rules of this section. Except as otherwise noted, the
examples involve calendar-year taxpayers and involve long-term contracts
subject to section 460 that are accounted for using the percentage of
completion method, rather than the percentage of completion-capitalized
cost method. If the percentage of completion-capitalized cost method
were used by a taxpayer described in the examples, the amounts of
contract income and expenses shown in the examples would be reduced, for
purposes of determining regular taxable income, to the appropriate
fraction (40, 70, or 90 percent) of contract items accounted for under
the percentage of completion method. Tens of thousands of dollars ($
00,000's) are omitted from the figures in the examples. The contracts
described in the examples are assumed to be the taxpayers' only
contracts that are subject to the look-back method of section 460.
Except as otherwise stated, the examples assume that the taxpayer has no
adjustments and preferences for purposes of section 55, so that
alternative minimum taxable income is the same as taxable income, and no
alternative minimum tax is imposed for the years involved. The examples
assume that the taxpayer does not elect the 10-percent method, the
simplified marginal impact method, or the delayed reapplication method.
(2) Step One. The following example illustrates the application of
paragraph (c)(2):
Example 1. In 1989, W completes three long-term contracts, A, B, and
C, entered into on January 1 of 1986, 1987, and 1988, respectively. For
Contract A, W used the completed contract method of accounting. For
Contract B, W used the percentage of completion-capitalized cost method
of accounting, taking into account 60 percent of contract income under
W's normal method of accounting, which was the completed contract
method. For Contract C, W used the percentage of completion method of
accounting. The total price for each contract was $1,000. In computing
alternative minimum taxable income, W is required to use the percentage
of completion method for Contracts B and C. W used regular tax costs for
purposes of determining the degree of contract completion under the
alternative minimum tax.
Contract A is not taken into account for purposes of applying the
look-back method, because it is subject to neither section 460 nor
section 56(a)(3). Thus, even if W had used the percentage of completion
method as permitted under Sec. 1.451-3, instead of the completed
contract method, the look-back method would not be applicable because
the Contract A was entered into before the effective date of section
460.
The actual costs allocated to Contracts B and C under section 460(c)
and incurred in each year of the contract were as follows:
------------------------------------------------------------------------
Contract 1987 1988 1989 Total
------------------------------------------------------------------------
B......................................... $200 $400 $200 $800
C......................................... 100 300 400 800
------------------------------------------------------------------------
In applying the look-back method, the first step is to allocate the
contract price among tax years preceding and including the completion
year. That allocation would produce the following amounts of gross
income for purposes of the regular tax. Note that no income from
Contract C is allocated to 1987, the year before the contract was
entered into, even though contract costs were incurred in 1987:
[[Page 250]]
----------------------------------------------------------------------------------------------------------------
Contract 1987 1988 1989
----------------------------------------------------------------------------------------------------------------
B.................................. $100 $200 $700
(40%X$200/$800X$1000) ((40%X$600/$800X$1000)-$100) .......
C.................................. 0 500 500
............................ ($400/$800X$1000) .......
----------------------------------------------------------------------------------------------------------------
Because the percentage of completion-capitalized cost method may not
be used for alternative minimum tax purposes, the allocation of contract
income would produce the following amounts of gross income for purposes
of computing alternative minimum taxable income:
----------------------------------------------------------------------------------------------------------------
Contract 1987 1988 1989
----------------------------------------------------------------------------------------------------------------
B................................................. $250 $500 $250
($200/$800X$1000) (($600/$800X$1000)-$250) .......
C................................................. 0 500 500
----------------------------------------------------------------------------------------------------------------
(3) Step Two. The following example illustrates the application of
paragraph (c)(3):
Example 2. (i) X enters into two long-term contracts (D and E) in
1988. X determines its tax liability for 1988 as follows:
e = estimate
a = amount originally reported (actual)
h = hypothetical
------------------------------------------------------------------------
1988
------------------------ Total
D E
------------------------------------------------------------------------
1988 contract costs................. $3,000a $2,000a ..........
Total contract costs................ 8,000e 8,000e ..........
Total contract price................ 10,000e 10,000e ..........
1988 completion %................... 37.5e 25e ..........
1988 gross income................... 3,750a 2,500a ..........
Less, 1988 costs.................... (3,000a) (2,000a) ..........
-----------------------------------
1988 net contract income...... 750a 500a $1,250a
Other 1988 net income (loss)........ .......... .......... (2,000a)
-----------------------------------
Taxable income (NOL).......... .......... .......... (750a)
-----------------------------------
Tax........................... .......... .......... 0a
Refund from NOL carryback fully .......... .......... 345a
absorbed in 1985, at 46%...........
------------------------------------------------------------------------
(ii) X completes Contract D during 1989. X determines its taxable
income for 1989 as follows:
------------------------------------------------------------------------
1989
------------------------ Total
D E
------------------------------------------------------------------------
1989 contract costs................. $3,000a 0a ..........
Total contract costs................ 6,000a $9,000e ..........
Total contract price................ 10,000a 10,000e ..........
1989 completion %................... 100a 22.2e ..........
1989 gross income/(loss)............ 6,250a (278a) ..........
Less, 1989 costs.................... (3,000a) 0a ..........
-----------------------------------
1989 net contract income...... 3,250a (278a) $2,972a
Other 1989 net income (loss)........ .......... .......... 0a
-----------------------------------
Taxable income (NOL).......... .......... .......... 2,972a
Tax at 34%.......................... .......... .......... 1,011a
------------------------------------------------------------------------
[[Page 251]]
(iii) For purposes of the look-back method, X must reallocate the
actual total contract D price between 1988 and 1989 based on the actual
total contract D costs. This results in the following hypothetical
underpayment of tax for 1988 for purposes of the look-back method. Note
that X does not reallocate the contract E price in applying the look-
back method in 1989 because contract E has not been completed, even
though X's estimate of contract E costs has changed. The following
computation is only for purposes of applying the look-back method, and
does not result in the assessment of a tax deficiency.
------------------------------------------------------------------------
1988
------------------------ Total
D E
------------------------------------------------------------------------
1988 contract costs................. $3,000a $2,000a ..........
Total contract costs................ 6,000a 8,000e ..........
Total contract price................ 10,000a 10,000e ..........
1988 completion %................... 50a 25e ..........
1988 gross income................... 5,000h 2,500a ..........
Less, 1988 costs.................... (3,000a) (2,000a) ..........
-----------------------------------
1988 net contract income...... 2,000h 500a $2,500h
Other 1988 net income (loss)........ .......... .......... (2,000a)
-----------------------------------
Taxable income (NOL).......... .......... .......... 500h
Tax at 34%.......................... .......... .......... 170h
Less, previously computed tax....... .......... .......... -0a
Underpayment of 1988 tax............ .......... .......... 170h
Underpayment of 1985 tax from NOL .......... .......... 345h
carryback refund in 1988...........
-----------------------------------
Total underpayment of tax..... .......... .......... 515h
------------------------------------------------------------------------
For purposes of any subsequent application of the look-back method
for which 1989 is a redetermination year, because the reallocation of
contract income and redetermination of tax liability are cumulative, X
will use for 1989 the amount of contract D income and the amount of tax
liability that would have been reported in 1989 if X had used actual
contract costs instead of the amounts that were originally reported
using the estimate of $8,000. Assuming no subsequent revisions (due to,
for example, adjustments to contract D price and costs determined after
the end of 1989), this amount would be determined as follows:
------------------------------------------------------------------------
1989
------------------------ Total
D E
------------------------------------------------------------------------
1989 contract costs................. $3,000a 0a ..........
Total contract costs................ 6,000a $9,000e ..........
Total contract price................ 10,000a 10,000e ..........
1989 completion %................... 100a 22.2e ..........
1989 gross income................... 5,000h (278a) ..........
Less, 1989 costs.................... (3,000a) 0a ..........
-----------------------------------
1989 net contract income...... 2,000h (278a) $1,722h
Other 1989 net income (loss)........ .......... .......... 0a
-----------------------------------
Taxable income (NOL).......... .......... .......... 1,722h
Tax at 34%.......................... .......... .......... 585h
------------------------------------------------------------------------
(iv) X completes contract E during 1990. X determines its taxable
income for 1990 as follows:
------------------------------------------------------------------------
1990
------------------------ Total
D E
------------------------------------------------------------------------
1990 contract costs................. .......... $7,000a ..........
Total contract costs................ .......... 9,000a ..........
Total contract price................ .......... 10,000a ..........
1990 completion %................... .......... 100a ..........
1990 gross income................... .......... 7,778a ..........
[[Page 252]]
Less, 1990 costs.................... .......... (7,000a) ..........
-----------------------------------
1990 net contract income...... .......... 778a $778a
Other 1990 net income (loss)........ .......... .......... 0a
-----------------------------------
Taxable income (NOL).......... .......... .......... 778a
Tax at 34%.......................... .......... .......... 265a
------------------------------------------------------------------------
(v) For purposes of the look-back method, X must reallocate the
actual total contract E price between the 1988, 1989, and 1990, based on
the actual total contract E costs.
This results in the following hypothetical overpayment of tax for 1988.
Note that X uses the amount of income for contract D determined in the
last previous application of the look-back method, and not the amount of
income actually reported:
------------------------------------------------------------------------
1988
------------------------ Total
D E
------------------------------------------------------------------------
1988 contract costs................. $3,000a $2,000a ..........
Total contract costs................ $6,000a $9,000a ..........
Total contract price................ $10,000a $10,000a ..........
1988 completion (%)................. 50a 22.2a ..........
1988 gross income................... $5,000h $2,222h ..........
Less, 1988 costs.................... ($3,000a) ($2,000a) ..........
-----------------------------------
1988 net contract income...... $2,000h $222h $2,222h
Other 1988 net income (loss)........ .......... .......... ($2,000a)
-----------------------------------
Taxable income (NOL).......... .......... .......... $222h
-----------------------------------
Tax at 34%.................... .......... .......... $75h
Less, previously computed tax (based .......... .......... $170h
on most recent application of the
look-back method)..................
-----------------------------------
Overpayment of 1988 tax....... .......... .......... ($95h)
------------------------------------------------------------------------
In applying the look-back method to 1989, X again uses the amounts
substituted as of the last previous application of the look-back method
with respect to contract D. Thus, X computes its hypothetical
underpayment for 1989 as follows:
------------------------------------------------------------------------
1989
------------------------ Total
D E
------------------------------------------------------------------------
1989 contract costs................. $3,000a 0a ..........
Total contract costs................ $6,000a $9,000a ..........
Total contract price................ $10,000a $10,000a ..........
1989 completion (%)................. 100a 22.2a ..........
1989 gross income................... $5,000h $0h ..........
Less, 1989 costs.................... ($3,000a) ($0a) ..........
-----------------------------------
1989 net contract income...... $2,000h 0a $2,000h
Other 1989 net income (loss)........ .......... .......... ($0a)
-----------------------------------
Taxable income (NOL)................ .......... .......... $2,000h
Tax at 34%.......................... .......... .......... $680h
Less, previously computed tax....... .......... .......... $585h
-----------------------------------
Underpayment of 1989 tax...... .......... .......... $95h
------------------------------------------------------------------------
For purposes of any subsequent application of the look-back method
for which 1990 is a redetermination year, X will use for 1990 the amount
of Contract E income, and the amount of tax liability, that was
originally reported in 1990 because X's estimate of the total contract
costs from $8,000 to $9,000 did not change after 1989. Without regard to
any
[[Page 253]]
subsequent revisions, these amounts are the same as in the table in
paragraph (h)(3)(iv) above.
(4) Post-completion adjustments. The following example illustrates
the application of paragraph (c)(1)(ii):
Example 3. The facts are the same as in Example 2. In 1991, X
settles a lawsuit against its customer in Contract E. The customer pays
X an additional $3,000, without interest, in 1991. Applying the Federal
mid-term rate then in effect, this $3,000 has a discounted value at the
time of contract completion in 1990 of $2,700. X is required to apply
the look-back method for 1991 even though no contract was completed in
1991. X must include the full $3,000 adjustment (which was not
previously includible in total contract price) in gross income for 1991.
X does not elect not to discount adjustments to the contract price or
costs. Thus, X adjusts the contract price by the discounted amount of
the adjustment and, therefore, uses $12,700 (not $13,000) for total
Contract E price, rather than $10,000, which was used when the look-back
method was first applied with respect to Contract E.
For purposes of the look-back method, X must allocate the revised
total Contract E price of $12,700 between 1988, 1989 and 1990 based on
the actual total Contract E costs, and compare the resulting revised tax
liability with the tax liability determined for the last previous
application of the look-back method involving those years. This results
in the following hypothetical underpayments of tax for purposes of the
look-back method:
r = revised
------------------------------------------------------------------------
1988
------------------------- Total
D E
------------------------------------------------------------------------
1988 contract costs................ $3,000a $2,000a ..........
Total contract costs............... $6,000a $9,000a ..........
Total contract price............... $10,000a $12,700r ..........
1988 completion (%)................ 50a 22.2a ..........
1988 gross income.................. $5,000h $2,822rh ..........
Less, 1988 costs................... ($3,000a) ($2,000a) ..........
------------------------------------
1988 net contract income..... $2,000h 822rh $2,222rh
Other 1988 net income (loss)....... .......... ........... ($2,000a)
------------------------------------
Taxable income............... .......... ........... $822rh
Tax at 34%................... .......... ........... $279rh
Less, previously computed tax...... .......... ........... $75h
Underpayment of 1988 tax..... .......... ........... $204rh
------------------------------------------------------------------------
No Contract E costs were incurred in 1989, and there is no
hypothetical underpayment for 1989.
------------------------------------------------------------------------
1990
--------------------------------------
D E Total
------------------------------------------------------------------------
1990 contract costs.............. ........... $7,000a ...........
Total contract costs............. ........... $9,000a ...........
Total contract price............. ........... $12,700r ...........
1990 completion (%).............. ........... 100a ...........
1990 gross income................ ........... $9,878rh ...........
Less 1990 costs.................. ........... ($7,000a) ...........
--------------------------------------
1990 net contract income... ........... $2,878rh $2,878rh
Other 1990 net income (loss)..... ........... ........... 0a
--------------------------------------
Taxable income (NOL)............. ........... ........... $2,878rh
Tax at 34%....................... ........... ........... $978rh
Less, previously computed tax.... ........... ........... $265h
--------------
Underpayment of 1990 tax... ........... ........... $713rh
------------------------------------------------------------------------
In 1992, X incurs an additional cost of $1,000 allocable to the
contract, which was not previously includible in total contract costs.
Applying the Federal mid-term rate then in effect, the $1,000 has a
discounted value at the time of contract completion of $800. X deducts
this additional $1,000 in expenses in 1992. Based on this increase to
contract
[[Page 254]]
costs, X reapplies the look-back method, and determines the following
hypothetical underpayments for 1988, 1989 and 1990 for purposes of the
look-back method:
------------------------------------------------------------------------
1988
-------------------------- Total
D E
------------------------------------------------------------------------
1988 contract costs.............. $3,000a $2,000a ...........
Total contract costs............. $6,000a $9,800r ...........
Total contract price............. $10,000a $12,700r ...........
1988 completion (%).............. 50a 20.4r ...........
1988 gross income................ $5,000h $2,592rh ...........
Less, 1988 costs................. ($3,000a) ($2,000a) ...........
--------------------------------------
1988 net contract income... $2,000h 592rh $2,592rh
Other 1988 net income (loss)..... ........... ........... ($2,000a)
--------------------------------------
Taxable income (NOL)....... ........... ........... $592rh
Tax at 34%....................... ........... ........... $201rh
Less, previously computed tax.... ........... ........... $279rh
--------------------------------------
Overpayment of 1988 tax.... ........... ........... ($78rh)
------------------------------------------------------------------------
No Contract E costs were incured in 1989, and there is no
hypothetical underpayment for 1989.
------------------------------------------------------------------------
1990
------------------------- Total
D E
------------------------------------------------------------------------
1990 contract costs............... .......... ........... $7,000a
Total contract costs.............. .......... 9,800r ...........
Total contract price.............. .......... 12,700r ...........
1990 completion (%)............... .......... 92a ...........
1990 gross income................. .......... 9,071rh ...........
Less, 1990 costs.................. .......... (7,000a) ...........
-------------------------------------
1990 Net contract income.......... .......... 2,071rh $2,071rh
Other 1990 net income (loss)...... .......... ........... 0a
-------------------------------------
Taxable income (NOL)........ .......... ........... 2,071rh
Tax at 34%........................ .......... ........... 704rh
Less, previously computed tax..... .......... ........... 978rh
-------------------------------------
Overpayment of 1990 tax..... .......... ........... (274rh)
------------------------------------------------------------------------
(5) Alternative minimum tax. The operation of the look-back method
in the case of a taxpayer liable for the alternative minimum tax as
provided in paragraph (c)(3)(vi) is illustrated by the following
examples:
Example 4. Y enters into a long-term contract in 1988 that is
completed in 1989. Y used regular tax costs for purposes of determining
the degree of contract completion under the alternative minimum tax.
(i) Y determines its tax liability for 1988 as follows:
1988 contract costs........................................ $4,000a
Total contract costs....................................... $8,000e
Total contract price....................................... $20,000e
1988 completion (%)........................................ 50e
1988 gross income.......................................... $10,000a
Less, 1988 contract costs.................................. ($4,000a
------------
1988 net contract income............................. $6,000a
Other 1988 net income/(loss)............................... ($3,400a)
Taxable income............................................. $2,600a
Regular tax at 34%......................................... 884a
Adjustments and preferences to produce alternative minimum $600a
taxable income............................................
Alternative minimum taxable income......................... $3,200a
Tentative minimum tax at 20%............................... 640a
Tax liability.............................................. $884a
In 1989, Y determines the following amounts:
1989 contract costs.......................................... $6,000a
Total contract costs......................................... $10,000a
Total contract price......................................... $20,000a
(ii) For purposes of applying the look-back method, Y redetermines
its tax liability for 1988, which results in a hypothetical overpayment
of tax. This hypothetical overpayment is determined by comparing Y's
original regular tax liability for 1988 with the hypothetical total tax
liability (including alternative minimum tax liability) for that
[[Page 255]]
year because Y would have paid the alternative minimum tax if Y had used
its actual contract costs to report income:
1988 contract costs......................................... $4,000a
Total contract costs........................................ $10,000a
Total contract price........................................ $20,000a
1988 completion(%).......................................... 40a
1988 gross income........................................... $8,000h
less, 1988 contract costs................................... ($4,000a)
1988 net contract income.................................... $4,000h
Other 1988 net income/(loss)................................ ($3,400a)
Taxable income.............................................. $600h
Regular tax at 34%.......................................... $204h
Adjustments and preferences to produce alternative minimum $600a
taxable income.............................................
Alternative minimum taxable income.......................... $1,200h
Tentative minimum tax at 20%................................ 240h
Alternative minimum tax..................................... $36h
Total tax liability......................................... $240h
less, previously computed tax............................... $884a
Underpayment/(overpayment).................................. ($644h)
(6) Credit carryovers. The operation of the look-back method in the
case of credit carryovers as provided in paragraph (c)(3)(v) is
illustrated by the following example:
Example 5. Z enters into a contract in 1986 that is completed in
1987. Z determines its tax liability for 1986 as follows:
1986 contract costs.......................................... $400a
Total contract costs......................................... $1,000e
Total contract price......................................... $2,000e
1986 completion (%).......................................... 40e
1986 gross income............................................ $800a
Less, 1986 costs............................................. ($400a)
1986 net contract income..................................... $400a
Other 1986 net income........................................ $0a
Taxable income............................................... $400a
Tax at 46%................................................... $184a
Unused tax credits carried forward from 1985 allowable in $350a
1986........................................................
Net tax due.................................................. $0a
Z determines the following amounts for 1987:
1987 contract costs.......................................... $400a
Total contract price......................................... $2,000a
Total contract costs......................................... $800a
If Z had used actual rather than estimated contract costs in
determining gross income for 1986, Z would have reported tax liability
of $276 (46%x$600) rather than $184. However, Z would have paid no
additional tax for 1986 because its unused tax credits carried forward
from 1985 would have been sufficient to offset this increased tax
liability. Therefore, there is no hypothetical underpayment for 1986 for
purposes of the look-back method. However, this hypothetical earlier use
of the credit may increase the hypothetical tax liability for 1987 (or
another subsequent year) for purposes of subsequent applications of the
look-back method.
(7) Net operating losses. The operation of the look-back method in
the case of net operating loss (``NOL'') carryovers as provided in
paragraph (c)(3)(v) is illustrated by the following example:
Example 6. A entered into a long-term contract in 1986, which was
completed in 1987. A determined its tax liability for 1986 as follows:
1986 contract costs......................................... $400a
Total contract costs........................................ $1,000e
Total contract price........................................ $2,000e
1986 completion (%)......................................... 40e
1986 gross income........................................... $800a
Less, 1986 costs............................................ ($400a)
1986 net contract income.................................... $400a
Other 1986 net income/(loss)................................ ($1,000a)
Taxable income/(NOL)........................................ ($600a)
Tax......................................................... $0a
A elected to carry this loss forward to 1987 pursuant to section
172(b)(3)(C).
For 1987, A determined the following amounts:
1987 contract costs........................................... $400a
Total contract costs.......................................... $800a
Total contract price.......................................... $2,000a
If actual rather than estimated contract costs had been used in
determining gross income for 1986, A would have reported $1,000 of gross
income from the contract rather than $800, and thus would have reported
a loss of $400 rather than $600. However, since A would have paid no tax
for 1986 regardless of whether actual or estimated contract costs had
been used, A does not have an underpayment for 1986 for purposes of the
look-back method. If A had, instead, carried back the 1986 NOL, and this
NOL had been absorbed in the tax years 1983 through 1985, it would have
resulted in refunds of tax for those years in 1986. When A applies the
look-back method, a hypothetical underpayment of tax would have resulted
for those years due to a hypothetical reduction in the amount that would
have been refunded if income had been reported on the basis of actual
contract costs. See Example 2(iii).
(8) Alternative minimum tax credit. The following example
illustrates the application of the look-back method if affected by the
alternative minimum tax credit as provided in paragraph (c)(3)(vi):
(i) Example 4, above illustrates that the reallocation of contract
income under the look-back method can result in a hypothetical
underpayment or overpayment determined using the alternative minimum tax
rate, even though the taxpayer actually paid only the regular tax for
that year. However, application of the look-back method had no effect on
the difference between the amount of alternative minimum taxable income
and the amount of regular taxable income taken into account in that year
because the taxpayer was
[[Page 256]]
required to use the percentage of completion method for both regular and
alternative minimum tax purposes and used the same version of the
percentage of completion method for both regular and alternative minimum
tax purposes (i.e., the taxpayer had made an election to use regular tax
costs in determining the percentage of completion for purposes of
computing alternative minimum taxable income).
(ii) The following example illustrates the application of the look-
back method in the case of a taxpayer that does not use the percentage
of completion method of accounting for long-term contracts in computing
taxable income for regular tax purposes and thus must make an adjustment
to taxable income to determine alternative minimum taxable income. The
example also shows how interest is computed under the look-back method
when the taxpayer is entitled to a credit under section 53 for minimum
tax paid because of this adjustment.
Example 7. X is a taxpayer engaged in the construction of real
property under contracts that are completed within a 24-month period and
whose average annual gross receipts do not exceed $10,000,000. As
permitted by section 460(e)(1)(B), X uses the completed contract method
(``CCM'') for regular tax purposes. However, X is engaged in the
construction of commercial real property and, therefore, is required to
use the percentage of completion method (``PCM'') for alternative
minimum tax (``AMT'') purposes.
Assume that for 1988, 1989, and 1990, X has only one long-term
contract, which is entered into in 1988 and completed in 1990. Assume
further that X estimates gross income from the contract to be $2,000,
total contract costs to be $1,000, and that the contract is 25 percent
complete in 1988 and 75 percent complete in 1989. In 1990, the year of
completion, the percentage of completion does not change but, upon
completion, gross income from the contract is actually $3,000, instead
of $2,000, and costs are actually $1,000.
For 1988, 1989, and 1990, X's income and tax liability using
estimated contract price and costs are as follows:
------------------------------------------------------------------------
Estimates 1988 1989 1990
------------------------------------------------------------------------
Regular tax:
Long-term:
Contract-CCM............. 0 0 $2,000
Other Income............. 0 $5,000 0
Total Income......... 0 $5,000 $2,000
Tax @ 34%........................ 0 $1,700 $680
AMT
Gross Income................. $500 $1,000 $1,500
Deductions................... $(250) $(500) $(250)
Total long-term:
Contract-PCM............. $250 $500 $1,250
Other Income............. 0 $5,000 0
Total Income......... $250 $5,500 $1,250
Tax @ 20%........................ $50 $1,100 $250
Tentative Minimum Tax............ $50 $1,100 $250
Regular Tax...................... 0 $1,700 $680
Minimum Tax Credit............... 0 $(50) 0
Net Tax Liability............ $50 $1,650 $680
------------------------------------------------------------------------
When X files its tax return for 1990, X applies the look-back method
to the contract. For 1988, 1989, and 1990, X's income and tax liability
using actual contract price and costs are as follows:
------------------------------------------------------------------------
Actual 1988 1989 1990
------------------------------------------------------------------------
Regular tax:
Long-term:
Contract-CCM............. 0 0 $2,000
Other Income............. 0 $5,000 0
Total Income......... 0 $5,000 $2,000
Tax @ 34%........................ 0 $1,700 $680
AMT
Gross Income................. $750 $1,500 $750
Deductions................... $(250) $(500) $(250)
Total long-term:
Contract-PCM............. $500 $1,000 $500
Other Income............. 0 $5,000 0
[[Page 257]]
Total Income......... $500 $6,000 $500
Tax @ 20%........................ $100 $1,200 $100
Tentative Minimum Tax............ $100 $1,200 $100
Regular Tax...................... 0 $1,700 $680
Minimum Tax Credit............... 0 $(100) 0
Net Tax Liability............ $100 $1,600 $680
Underpayment..................... $50
Overpayment...................... ........... $50
------------------------------------------------------------------------
As shown above, application of the look-back method results in a
hypothetical underpayment of $50 for 1988 because X was subject to the
alternative minimum tax for that year. Interest is charged to X on this
$50 underpayment from the due date of X's 1988 return until the due date
of X's 1990 return.
In 1989, although X was required to compute alternative minimum
taxable income using the percentage of completion method, X was not
required to pay alternative minimum tax. Nevertheless, the look-back
method must be applied to 1989 because use of actual rather than
estimated contract price in computing alternative minimum taxable income
for 1988 would have changed the amount of the alternative minimum tax
credit carried to 1989. Interest is paid to X on the resulting $50
overpayment from the due date of X's 1989 return until the due date of
X's 1990 return.
(9) Period for interest. The following Examples (8) through (11)
illustrate how to determine the period for computing interest as
provided in paragraph (c)(4):
Example 8. The facts are the same as in Example 6, except that the
contract is completed in 1988, and A determined the following amounts
for 1987 and 1988:
For 1987:
1987 contract costs....................................... 0
Total contract costs...................................... $1,000e
Total contract price...................................... $2,000e
1987 completion (%)....................................... $40e
1987 gross income......................................... 0a
Less, 1987 costs.......................................... 0a
Other 1987 net income..................................... $600a
Net operating loss carryforward from 1986................. $(600a)
Taxable income............................................ 0a
Tax....................................................... 0a
For 1988:
1988 contract costs....................................... $400a
Total contract costs...................................... $800a
Total contract price...................................... $2,000a
If actual rather than estimated contract costs had been used in
determining gross income for 1986, A would have reported $1,000 of gross
income from the contract for 1986 rather than $800, and would have
reported a net operating loss carryforward to 1987 of $400 rather than
$600. Therefore, A would have reported taxable income of $200, and would
have paid tax of $80 (i.e., $200 x 40%) for 1987. The due date for
filing A's Federal income tax return for its 1988 taxable year is March
15. A obtains an extension and files its 1988 return on September 15,
1989. Under the look-back method, A is required to pay interest on the
amount of this hypothetical underpayment ($80) computed from the due
date (determined without regard to extensions) for A's return for 1987
(not 1986, even though 1986 was the year in which the net operating loss
arose) until March 15 (not September 15), the due date (without regard
to extensions) of A's return for 1988. A is required to pay additional
interest from March 15 until September 15 on the amount of interest
outstanding as of March 15 with respect to the hypothetical underpayment
of $80.
Example 9. The facts are the same as in Example 6, except that A
carries the net operating loss of $600 back to 1983 rather than forward
to 1987, and receives a refund of $276 ($600 reduction in 1983 taxable
income x 46% rate in effect in 1983). As in Example 6, if actual
contract costs had been used, A would have reported a loss for 1986 of
$400 rather than $600. Thus, A would have received a refund of 1983 tax
of $184 ($400 x 46%) rather than $276. Under the look-back method A is
required to pay interest on the difference in these two amounts ($92)
computed from the due date (determined without regard to extensions) of
A's return for 1986 (the year in which the carryback arose rather than
1983, the year in which it was used) until the due date of A's return
for 1988.
Example 10. B enters into a long-term contract in 1986 that is
completed in 1988. B determines its 1986 tax liability as follows:
1986 contract costs.......................................... $400a
Total contract costs......................................... $1,000e
Total contract price......................................... $2,000e
1986 completion (%).......................................... 40e
1986 gross income............................................ $800a
Less, 1986 costs............................................. ($400a)
1986 net contract income..................................... $400a
Other 1986 net income........................................ $2,000a
Taxable income............................................... $2,400a
Tax at 46%................................................... $1,104a
B determines its tax liability for 1987 as follows:
1987 contract costs.......................................... $400a
Total contract costs......................................... $1,600e
Total contract price......................................... $2,000e
1987 completion (%).......................................... 50e
1987 gross income............................................ $200a
( = (50% x $2,000)-$800 previously reported) less, 1987 costs ($400a)
1987 net contract income..................................... ($200a)
Other 1987 net income/(loss)................................. ($2,200a)
Taxable income (NOL)......................................... ($2,400a)
[[Page 258]]
Tax.......................................................... 0a
Assume that B had no taxable income in either 1984 or 1985, so that
the entire amount of the $2,400 net operating loss is carried back to
1986, and B receives a refund, with interest from the due date of B's
1987 return, of the entire $1,104 in tax that it paid for 1986.
In 1988, B determines the following amounts:
1988 contract costs........................................... $800a
Total contract costs.......................................... $1,600a
Total contract price.......................................... $2,000a
If B had used actual contract costs rather than estimated costs in
determining its gross income for 1986, B would have had gross income
from the contract of $500 rather than $800, and thus would have had
taxable income of $2,100 rather than $2,400, and would have paid tax of
$966 rather than $1,104. B is entitled to receive interest on the
difference between these two amounts, the hypothetical overpayment of
tax of $138. Interest is computed from the due date (without regard to
extensions) of B's return for 1986 until the due date for B's return for
1987. Interest stops running at this date, because B's hypothetical
overpayment of tax ended when B filed its original 1987 return and
received a refund for the carryback to 1986, and interest on this refund
began to run only from the due date of B's 1987 return. See section
6611(f).
Example 11. C enters into a long-term contract in 1986, its first
year in business, which is completed in 1988. C determines its tax
liability for 1986 as follows:
1986 contract costs......................................... $400a
Total contract costs........................................ $1,000e
Total contract price........................................ $2,000e
1986 completion (%)......................................... 40e
1986 gross income........................................... $800a
less, 1986 costs............................................ ($400a)
1986 net contract income.................................... $400a
Other 1986 net income....................................... $2,000a
Taxable income (NOL)........................................ $2,400a
Tax at 46%.................................................. $1,104a
C determines its tax liability for 1987 as follows:
1987 contract costs......................................... $400a
Total contract costs........................................ $1,066e
Total contract price........................................ $2,000e
1987 completion (%)......................................... 75e
1987 gross income........................................... $700a
Less, 1987 costs............................................ ($400a)
1987 net contract income.................................... $300a
Other 1987 net income....................................... ($2,450a)
Taxable income (NOL)........................................ ($2,150a)
Tax......................................................... $10a
C carries back the net operating loss to 1986, and files an amended
return for 1986, showing taxable income of $250, and receives a refund
of $989 (46% x $2,150). Interest on this refund begins to run only as of
the due date of C's 1987 return. See section 6611(f).
In 1988, when the contract is completed, C determines the following
amounts:
1988 contract costs......................................... $800a
Total contract costs........................................ $1,600a
Total contract price........................................ $2,000a
If C had used actual contract price and contract costs in
determining gross income for 1986, it would have reported gross income
from the contract of $500 rather than $800, taxable income of $2,100
rather than $2,400, and tax liability of $966 rather than $1,104.
If C had used actual contract price and contract costs in
determining gross income for 1987, it would have reported gross income
from the contract of $500 rather than $700, and would have reported a
net operating loss of $2,350, rather than $2,150, which would have been
carried back to 1986.
Under the look-back method, C receives interest with respect to a
total 1986 hypothetical overpayment of $138 ($1,104 minus $966). C is
credited with interest on $23 of this amount only from the due date of
C's 1986 return until the due date of C's 1987 tax return, because this
portion of C's total hypothetical overpayment for 1986 was refunded to C
with interest computed from the due date of C's 1987 return and,
therefore, was no longer held by the government. However, because the
remainder of the total hypothetical overpayment of $115 was not refunded
to C, C is credited with interest on this amount from the due date of
C's 1986 return until the due date of C's 1988 tax return.
Under the look-back method, C receives no interest with respect to
1987, because C had no tax liability for 1987 using either estimated or
actual contract price and costs.
(i) [Reserved]
(j) Election not to apply look-back method in de minimis cases.
Section 460(b)(6) provides taxpayers with an election not to apply the
look-back method to long-term contracts in de minimis cases, effective
for contracts completed in taxable years ending after August 5, 1997. To
make an election, a taxpayer must attach a statement to its timely filed
original federal income tax return (including extensions) for the
taxable year the election is to become effective or to an amended return
for that year, provided the amended return is filed on or before March
31, 998. This statement must have the legend ``NOTIFICATION OF ELECTION
UNDER SECTION 460(b)(6)''; provide the taxpayer's name and identifying
number and the effective date of the election; and identify the trades
or businesses that involve long-term contracts. An election applies to
all long-term contracts completed during and after the taxable
[[Page 259]]
year for which the election is effective. An election may not be revoked
without the Commissioner's consent. For taxpayers who elected to use the
delayed reapplication method under paragraph (e) of this section, an
election under this paragraph (j) automatically revokes the election to
use the delayed reapplication method for contracts subject to section
460(b)(6). A consolidated group of corporations, as defined in Sec.
1.1502-1(h), is subject to consistency rules analogous to those in
paragraph (e)(2) of this section and in paragraph (d)(4)(ii)(C) of this
section (concerning election to use simplified marginal impact method).
[T.D. 8315, 55 FR 41670, Oct. 15, 1990, as amended by T.D. 8775, 63 FR
36181, July 2, 1998; T.D. 8929, 66 FR 2240, Jan. 11, 2001; T.D. 8995, 67
FR 34609, May 15, 2002; T.D. 9137, 69 FR 42558, July 16, 2004]
taxable year for which deductions taken
Sec. 1.461-0 Table of contents.
This section lists the captions that appear in the regulations under
section 461 of the Internal Revenue Code.
Sec. 1.461-1 General rule for taxable year of deduction.
(a) General rule.
(1) Taxpayer using cash receipts and disbursements method.
(2) Taxpayer using an accrual method.
(3) Effect in current taxable year of improperly accounting for a
liability in a prior taxable year.
(4) Deductions attributable to certain foreign income.
(b) Special rule in case of death.
(c) Accrual of real property taxes.
(1) In general.
(2) Special rules.
(3) When election may be made.
(4) Binding effect of election.
(5) Apportionment of taxes on real property between seller and
purchaser.
(6) Examples.
(d) Limitation on acceleration of accrual of taxes.
(e) Dividends or interest paid by certain savings institutions on
certain deposits or withdrawable accounts.
(1) Deduction not allowable.
(2) Computation of amounts not allowed as a deduction.
(3) When amounts allowable.
Sec. 1.461-2 Contested liabilities.
(a) General rule.
(1) Taxable year of deduction.
(2) Exception.
(3) Refunds includible in gross income.
(4) Examples.
(5) Liabilities described in paragraph (g) of Sec. 1.461-4.
[Reserved]
(b) Contest of asserted liability.
(1) Asserted liability.
(2) Definition of the term ``contest.''
(3) Example.
(c) Transfer to provide for the satisfaction of an asserted
liability.
(1) In general.
(2) Examples.
(d) Contest exists after transfer.
(e) Deduction otherwise allowed.
(1) In general.
(2) Example.
(f) Treatment of money or property transferred to an escrowee,
trustee, or court and treatment of any income attributable thereto.
[Reserved]
(g) Effective dates.
Sec. 1.461-3 Prepaid interest. [Reserved]
Sec. 1.461-4 Economic performance.
(a) Introduction.
(1) In general.
(2) Overview.
(b) Exceptions to the economic performance requirement.
(c) Definitions.
(1) Liability.
(2) Payment.
(d) Liabilities arising out of the provision of services, property,
or the use of property.
(1) In general.
(2) Services or property provided to the taxpayer.
(3) Use of property provided to the taxpayer.
(4) Services or property provided by the taxpayer.
(5) Liabilities that are assumed in connection with the sale of a
trade or business.
(6) Rules relating to the provision of services or property to a
taxpayer.
(7) Examples.
(e) Interest.
(f) Timing of deductions from notional principal contracts.
(g) Certain liabilities for which payment is economic performance.
(1) In general.
(2) Liabilities arising under a workers compensation act or out of
any tort, breach of contract, or violation of law.
(3) Rebates and refunds.
(4) Awards, prizes, and jackpots.
(5) Insurance, warranty, and service contracts.
(6) Taxes.
(7) Other liabilities.
(8) Examples.
(h) Liabilities arising under the Nuclear Waste Policy Act of 1982.
[[Page 260]]
(i) [Reserved]
(j) Contingent liabilities. [Reserved]
(k) Special effective dates.
(1) In general.
(2) Long-term contracts.
(3) Payment liabilities.
(l) [Reserved]
(m) Change in method of accounting required by this section.
(1) In general.
(2) Change in method of accounting for long-term contracts and
payment liabilities.
Sec. 1.461-5 Recurring item exception.
(a) In general.
(b) Requirements for use of the exception.
(1) General rule.
(2) Amended returns.
(3) Liabilities that are recurring in nature.
(4) Materiality requirement.
(5) Matching requirement.
(c) Types of liabilities not eligible for treatment under the
recurring item exception.
(d) Time and manner of adopting the recurring item exception.
(1) In general.
(2) Change to the recurring item exception method for the first
taxable year beginning after December 31, 1991.
(3) Retroactive change to the recurring item exception method.
(e) Examples.
Sec. 1.461-6 Economic performance when certain liabilities are assigned
or are extinguished by the establishment of a fund.
(a) Qualified assignments of certain personal injury liabilities
under section 130.
(b) Section 468B.
(c) Payments to other funds or persons that constitute economic
performance. [Reserved]
(d) Effective dates.
[T.D. 8408, 57 FR 12420, Apr. 10, 1992, as amended by T.D. 8593, 60 FR
18743, Apr. 13, 1995]
Sec. 1.461-1 General rule for taxable year of deduction.
(a) General rule--(1) Taxpayer using cash receipts and disbursements
method. Under the cash receipts and disbursements method of accounting,
amounts representing allowable deductions shall, as a general rule, be
taken into account for the taxable year in which paid. Further, a
taxpayer using this method may also be entitled to certain deductions in
the computation of taxable income which do not involve cash
disbursements during the taxable year, such as the deductions for
depreciation, depletion, and losses under sections 167, 611, and 165,
respectively. If an expenditure results in the creation of an asset
having a useful life which extends substantially beyond the close of the
taxable year, such an expenditure may not be deductible, or may be
deductible only in part, for the taxable year in which made. An example
is an expenditure for the construction of improvements by the lessee on
leased property where the estimated life of the improvements is in
excess of the remaining period of the lease. In such a case, in lieu of
the allowance for depreciation provided by section 167, the basis shall
be amortized ratably over the remaining period of the lease. See section
178 and the regulations thereunder for rules governing the effect to be
given renewal options in determining whether the useful life of the
improvements exceeds the remaining term of the lease where a lessee
begins improvements on leased property after July 28, 1958, other than
improvements which on such date and at all times thereafter, the lessee
was under a binding legal obligation to make. See section 263 and the
regulations thereunder for rules relating to capital expenditures. See
section 467 and the regulations thereunder for rules under which a
liability arising out of the use of property pursuant to a section 467
rental agreement is taken into account.
(2) Taxpayer using an accrual method--(i) In general. Under an
accrual method of accounting, a liability (as defined in Sec. 1.446-
1(c)(1)(ii)(B)) is incurred, and generally is taken into account for
Federal income tax purposes, in the taxable year in which all the events
have occurred that establish the fact of the liability, the amount of
the liability can be determined with reasonable accuracy, and economic
performance has occurred with respect to the liability. (See paragraph
(a)(2)(iii)(A) of this section for examples of liabilities that may not
be taken into account until a taxable year subsequent to the taxable
year incurred, and see Sec. Sec. 1.461-4 through 1.461-6 for rules
relating to economic performance.) Applicable provisions of the Code,
the Income Tax Regulations, and other guidance published by the
Secretary prescribe the manner in
[[Page 261]]
which a liability that has been incurred is taken into account. For
example, section 162 provides that the deductible liability generally is
taken into account in the taxable year incurred through a deduction from
gross income. As a further example, under section 263 or 263A, a
liability that relates to the creation of an asset having a useful life
extending substantially beyond the close of the taxable year is taken
into account in the taxable year incurred through capitalization (within
the meaning of Sec. 1.263A-1(c)(3)), and may later affect the
computation of taxable income through depreciation or otherwise over a
period including subsequent taxable years, in accordance with applicable
Internal Revenue Code sections and guidance published by the Secretary.
The principles of this paragraph (a)(2) also apply in the calculation of
earnings and profits and accumulated earnings and profits.
(ii) Uncertainty as to the amount of a liability. While no liability
shall be taken into account before economic performance and all of the
events that fix the liability have occurred, the fact that the exact
amount of the liability cannot be determined does not prevent a taxpayer
from taking into account that portion of the amount of the liability
which can be computed with reasonable accuracy within the taxable year.
For example, A renders services to B during the taxable year for which A
charges $10,000. B admits a liability to A for $6,000 but contests the
remainder. B may take into account only $6,000 as an expense for the
taxable year in which the services were rendered.
(iii) Alternative timing rules. (A) If any provision of the Code
requires a liability to be taken into account in a taxable year later
than the taxable year provided in paragraph (a)(2)(i) of this section,
the liability is taken into account as prescribed in that Code
provision. See, for example, section 267 (transactions between related
parties) and section 464 (farming syndicates).
(B) If the liability of a taxpayer is subject to section 170
(charitable contributions), section 192 (black lung benefit trusts),
section 194A (employer liability trusts), section 468 (mining and solid
waste disposal reclamation and closing costs), or section 468A (certain
nuclear decommissioning costs), the liability is taken into account as
determined under that section and not under section 461 or the
regulations thereunder. For special rules relating to certain loss
deductions, see sections 165(e), 165(i), and 165(l), relating to theft
losses, disaster losses, and losses from certain deposits in qualified
financial institutions.
(C) Section 461 and the regulations thereunder do not apply to any
amount allowable under a provision of the Code as a deduction for a
reserve for estimated expenses.
(D) Except as otherwise provided in any Internal Revenue
regulations, revenue procedure, or revenue ruling, the economic
performance requirement of section 461(h) and the regulations thereunder
is satisfied to the extent that any amount is otherwise deductible under
section 404 (employer contributions to a plan of deferred compensation),
section 404A (certain foreign deferred compensation plans), or section
419 (welfare benefit funds). See Sec. 1.461-4(d)(2)(iii).
(E) Except as otherwise provided by regulations or other published
guidance issued by the Commissioner (See Sec. 601.601(b)(2) of this
chapter), in the case of a liability arising out of the use of property
pursuant to a section 467 rental agreement, the all events test
(including economic performance) is considered met in the taxable year
in which the liability is to be taken into account under section 467 and
the regulations thereunder.
(3) Effect in current taxable year of improperly accounting for a
liability in a prior taxable year. Each year's return should be complete
in itself, and taxpayers shall ascertain the facts necessary to make a
correct return. The expenses, liabilities, or loss of one year generally
cannot be used to reduce the income of a subsequent year. A taxpayer may
not take into account in a return for a subsequent taxable year
liabilities that, under the taxpayer's method of accounting, should have
been taken into account in a prior taxable year. If a taxpayer
ascertains that a liability should have been taken into account in a
prior taxable year, the taxpayer should, if within the period of
[[Page 262]]
limitation, file a claim for credit or refund of any overpayment of tax
arising therefrom. Similarly, if a taxpayer ascertains that a liability
was improperly taken into account in a prior taxable year, the taxpayer
should, if within the period of limitation, file an amended return and
pay any additional tax due. However, except as provided in section
905(c) and the regulations thereunder, if a liability is properly taken
into account in an amount based on a computation made with reasonable
accuracy and the exact amount of the liability is subsequently
determined in a later taxable year, the difference, if any, between such
amounts shall be taken into account for the later taxable year.
(4) Deductions attributable to certain foreign income. In any case
in which, owing to monetary, exchange, or other restrictions imposed by
a foreign country, an amount otherwise constituting gross income for the
taxable year from sources without the United States is not includible in
gross income of the taxpayer for that year, the deductions and credits
properly chargeable against the amount so restricted shall not be
deductible in such year but shall be deductible proportionately in any
subsequent taxable year in which such amount or portion thereof is
includible in gross income. See paragraph (b) of Sec. 1.905-1 for rules
relating to credit for foreign income taxes when foreign income is
subject to exchange controls.
(b) Special rule in case of death. A taxpayer's taxable year ends on
the date of his death. See section 443(a)(2) and paragraph (a)(2) of
Sec. 1.443-1. In computing taxable income for such year, there shall be
deducted only amounts properly deductible under the method of accounting
used by the taxpayer. However, if the taxpayer used an accrual method of
accounting, no deduction shall be allowed for amounts accrued only by
reason of his death. For rules relating to the inclusion of items of
partnership deduction, loss, or credit in the return of a decedent
partner, see subchapter K, chapter 1 of the Code, and the regulations
thereunder.
(c) Accrual of real property taxes--(1) In general. If the accrual
of real property taxes is proper in connection with one of the methods
of accounting described in section 446(c), any taxpayer using such a
method of accounting may elect to accrue any real property tax, which is
related to a definite period of time, ratably over that period in the
manner described in this paragraph. For example, assume that such an
election is made by a calendar-year taxpayer whose real property taxes,
applicable to the period from July 1, 1955, to June 30, 1956, amount to
$1,200. Under section 461(c), $600 of such taxes accrue in the calendar
year 1955, and the balance accrues in 1956. For special rule in the case
of certain contested real property taxes in respect of which the
taxpayer transfers money or other property to provide for the
satisfaction of the contested tax, see Sec. 1.461-2. For general rules
relating to deductions for taxes, see section 164 and the regulations
thereunder.
(2) Special rules--(i) Effective date. Section 461(c) and this
paragraph do not apply to any real property tax allowable as a deduction
under the Internal Revenue Code of 1939 for any taxable year beginning
before January 1, 1954.
(ii) If real property taxes which relate to a period prior to the
taxpayer's first taxable year beginning on or after January 1, 1954,
would, but for section 461(c), be deductible in such first taxable year,
the portion of such taxes which applies to the prior period is
deductible in such first taxable year (in addition to the amount
allowable under section 461(c)(1)).
(3) When election may be made--(i) Without consent. A taxpayer may
elect to accrue real property taxes ratably in accordance with section
461(c) and this paragraph without the consent of the Commissioner for
his first taxable year beginning after December 31, 1953, and ending
after August 16, 1954, in which the taxpayer incurs real property taxes.
Such election must be made not later than the time prescribed by law for
filing the return for such year (including extensions thereof). An
election may be made by the taxpayer for each separate trade or business
(and for nonbusiness activities, if accounted for separately). Such an
election shall apply to all real property taxes of the trade, business,
or nonbusiness activity for which the election is made. The
[[Page 263]]
election shall be made in a statement submitted with the taxpayer's
return for the first taxable year to which the election is applicable.
The statement should set forth:
(a) The trades or businesses, or nonbusiness activity, to which the
election is to apply, and the method of accounting used therein;
(b) The period of time to which the taxes are related; and
(c) The computation of the deduction for real property taxes for the
first year of the election (or a summary of such computation).
(ii) With consent. A taxpayer may elect with the consent of the
Commissioner to accrue real property taxes ratably in accordance with
section 461 (c) and this paragraph. A written request for permission to
make such an election shall be submitted to the Commissioner of Internal
Revenue, Washington, D.C. 20224, within 90 days after the beginning of
the taxable year to which the election is first applicable, or before
March 26, 1958, whichever date is later. The request for permission
shall state:
(a) The name and address of the taxpayer;
(b) The trades or businesses, or nonbusiness activity, to which the
election is to apply, and the method of accounting used therein;
(c) The taxable year to which the election first applies;
(d) The period to which the real property tax relate;
(e) The computation of the deduction for real property taxes for the
first year of election (or a summary of such computation); and
(f) An adequate description of the manner in which all real property
taxes were deducted in the year prior to the year of election.
(4) Binding effect of election. An election to accrue real property
taxes ratably under section 461(c) is binding upon the taxpayer unless
the consent of the Commissioner is obtained under section 446(e) and
paragraph (e) of Sec. 1.446-1 to change such method of deducting real
property taxes. If the last day prescribed by law for filing a return
for any taxable year (including extensions thereof) to which section
461(c) is applicable falls before March 25, 1958, consent is hereby
given for the taxpayer to revoke an election previously made to accrue
real property taxes in the manner prescribed by section 461(c). If the
taxpayer revokes his election under the preceding sentence, he must, on
or before March 25, 1958, notify the district director for the district
in which the return was filed of such revocation. For any taxable year
for which such revocation is applicable, an amended return reflecting
such revocation shall be filed on or before March 25, 1958.
(5) Apportionment of taxes on real property between seller and
purchaser. For apportionment of taxes on real property between seller
and purchaser, see section 164(d) and the regulations thereunder.
(6) Examples. The provisions of this paragraph are illustrated by
the following examples:
Example 1. A taxpayer on an accrual method reports his taxable
income for the taxable year ending June 30. He elects to accrue real
property taxes ratably for the taxable year ending June 30, 1955 (which
is his first taxable year beginning on or after January 1, 1954). In the
absence of an election under section 461(c), such taxes would accrue on
January 1 of the calendar year to which they are related. The real
property taxes are $1,200 for 1954; $1,600 for 1955; and $1,800 for
1956. Deductions for such taxes for the fiscal years ending June 30,
1955, and June 30, 1956, are computed as follows:
Fiscal year ending June 30, 1955
July through December 1954..................................... \1\
None
January through June 1955 (\6/12\ of $1,600)................... $800
Deduction for fiscal year ending June 30, 1955............... 800
\1\ The taxes for 1954 were deductible in the fiscal year ending June
30, 1954, since such taxes accrued on January 1, 1954.
Fiscal year ending June 30, 1956
July through December 1955 (\6/12\ of $1,600).................. $800
January through June 1956 (\6/12\ of $1,800)................... 900
--------
Deduction for fiscal year ending June 30, 1956............... 1,700
Example 2. A calendar-year taxpayer on an accrual method elects to
accrue real property taxes ratably for 1954. In the absence of an
election under section 461(c), such taxes would accrue on July 1 and are
assessed for the 12-month period beginning on that date. The real
property taxes assessed for the year ending June 30, 1954, are $1,200;
$1,600 for the year ending June 30, 1955; and $1,800 for the year ending
June 30, 1956. Deductions for such taxes for the calendar years 1954 and
1955 are computed as follows:
[[Page 264]]
Year ending December 31, 1954
January through June 1954...................................... \1\
None
July through December 1954 (\6/12\ of $1,600).................. $800
--------
Deduction for year ending December 31, 1954.................. 800
\1\ The entire tax of $1,200 for the year ended June 30, 1954, was
deductible in the return for 1953, since such tax accrued on July 1,
1953.
Year ending December 31, 1955
January through June 1955 (\6/12\ of $1,600)................... $800
July through December 1955 (\6/12\ of $1,800).................. 900
--------
Deduction for year ending December 31, 1955.................. 1,700
Example 3. A calendar-year taxpayer on an accrual method elects to
accrue real property taxes ratably for 1954. In the absence of an
election under section 461(c), such taxes, which relate to the calendar
year 1954, are accruable on December 1 of the preceding calendar year.
No deduction for real property taxes is allowable for the taxable year
1954 since such taxes accrued in the taxable year 1953 under section
23(c) of the Internal Revenue Code of 1939.
Example 4. A taxpayer on an accrual method reports his taxable
income for the taxable year ending March 31. He elects to accrue real
property taxes ratably for the taxable year ending March 31, 1955. In
the absence of an election under section 461(c), such taxes are
accruable on June 1 of the calendar year to which they relate. The real
property taxes are $1,200 for 1954; $1,600 for 1955; and $1,800 for
1956. Deductions for such taxes for the taxable years ending March 31,
1955, and March 31, 1956, are computed as follows:
Fiscal year ending March 31, 1955
April through December 1954 (\9/12\ of $1,200)................. $900
January through March 1955 (\3/12\ of $1,600).................. 400
--------
Taxes accrued ratably in fiscal year ending March 31, 1955... 1,800
Tax relating to period January through March 1954, paid in June 300
1954, and not deductible in prior taxable year (\9/12\ of
$1,200).......................................................
--------
Deduction for fiscal year ending March 31, 1955.............. 1,600
========
Fiscal year ending March 31, 1956
April through December 1955 (\9/12\ of $1,600)................. $1,200
January through March 1956 (\3/12\ of $1,800).................. 450
--------
Deduction for fiscal year ending March 31, 1956.............. 1,650
Example 5. The facts are the same as in Example 4 except that in
June 1955, when the taxpayer pays his $1,600 real property taxes for
1955, he pays $400 of such amount under protest. Deductions for taxes
for the taxable years ending March 31, 1955, and March 31, 1956, are
computed as follows:
Fiscal year ending March 31, 1955
April through December 1954 (\9/12\ of $1,200)................. $900
January through March 1955 (\3/12\ of $1,200, that is, $1,600 300
minus $400 (the contested portion which is not properly
accruable))...................................................
--------
Taxes accrued ratably in fiscal year ending March 31, 1955... 1,200
Tax relating to period January through March 1954, paid in June 300
1954, and not deductible in prior taxable years (\3/12\ of
$1,200).......................................................
--------
Deduction for fiscal year ending March 31, 1955.............. 1,500
========
Fiscal year ending March 31, 1956
April through December 1955 (\9/12\ of $1,200)................. $900
January through March 1956 (\3/12\ of $1,800).................. 450
--------
Taxes accrued ratably in fiscal year ending March 31, 1956... 1,350
Contested portion of tax relating to period January through 400
December 1955, paid in June 1955, and deductible, under
section 461(f), for taxpayer's fiscal year ending March 31,
1956..........................................................
--------
Deduction for fiscal year ending March 31, 1956.............. 1,750
========
(d) Limitation on acceleration of accrual of taxes. (1) Section
461(d)(1) provides that, in the case of a taxpayer whose taxable income
is computed under an accrual method of accounting, to the extent that
the time for accruing taxes is earlier than it would be but for any
action of any taxing jurisdiction taken after December 31, 1960, such
taxes are to be treated as accruing at the time they would have accrued
but for such action. Any such action which, but for the provisions of
section 461(d) and this paragraph, would accelerate the time for
accruing a tax is to be disregarded in determining the time for accruing
such tax for purposes of the deduction allowed for such tax. Such action
is to be disregarded not only with respect to a taxpayer (whose taxable
income is computed under an accrual method of accounting) upon whom the
tax is imposed at the time of the action, but also with respect to such
a taxpayer upon whom the tax is imposed at any time subsequent to such
action. Thus, in the case of a tax imposed on property, the acceleration
of the time for accruing taxes is to be disregarded not only with
respect to the taxpayer who owned the property at the time of such
acceleration, but also with respect to any subsequent owner of the
property
[[Page 265]]
whose taxable income is computed under an accrual method of accounting.
Similarly, such action is to be disregarded with respect to all property
subject to such tax, even if such property is acquired after the action.
Whenever the time for accruing taxes is to be disregarded in accordance
with the provisions of this paragraph, the taxpayer shall accrue the tax
at the time (original accrual date) the tax would have accrued but for
such action, and shall, in the absence of any action of the taxing
jurisdiction placing the time for accruing such tax at a time subsequent
to the original accrual date, continue to accrue the tax as of the
original accrual date for all future taxable years.
(2) For purposes of this paragraph--
(i) The term ``a taxpayer whose taxable income is computed under an
accrual method of accounting'' means a taxpayer who, for Federal income
tax purposes, accounts for any tax which is the subject of ``any
action'' (as defined in subdivision (iii) of this subparagraph) under an
accrual method of accounting. See section 446 and the regulations
thereunder. If a taxpayer uses an accrual method as his overall method
of accounting, it shall be presumed that he is ``a taxpayer whose
taxable income is computed under an accrual method of accounting.''
However, if the taxpayer establishes to the satisfaction of the district
director that he has, for Federal income tax purposes, consistently
accounted for such tax under the cash method of accounting, he shall be
considered not to be ``a taxpayer whose taxable income is computed under
an accrual method of accounting.''
(ii) The time for accruing taxes shall be determined under section
461 and the regulations in this section.
(iii) The term ``any action'' includes the enactment or reenactment
of legislation, the adoption of an ordinance, the exercise of any taxing
or administrative authority, or the taking of any other step, the result
of which is an acceleration of the accrual event of any tax. The term
also applies to the substitution of a substantially similar tax by
either the original taxing jurisdiction or a substitute jurisdiction.
However, the term does not include either a judicial interpretation, or
an administrative determination by the Internal Revenue Service, as to
the event which fixes the accrual date for the tax.
(iv) The term ``any taxing jurisdiction'' includes the District of
Columbia, any State, possession of the United States, city, county,
municipality, school district, or other political subdivision or
authority, other than the United States, which imposes, assesses, or
collects a tax.
(3) The provisions of this paragraph may be illustrated by the
following examples:
Example 1. State X imposes a tax on intangible and tangible personal
property used in a trade or business conducted in the State. The tax is
assessed as of July 1, and becomes a lien as of that date. As a result
of administrative and judicial decisions, July 1 is recognized as the
proper date on which accrual method taxpayers may accrue their personal
property tax for Federal income tax purposes. In 1961 State X, by
legislative action, changes the assessment and lien dates from July 1,
1962, to December 31, 1961, for the property tax year 1962. The action
taken by State X is considered to be ``any action'' of a taxing
jurisdiction which results in the time for accruing taxes being earlier
than it would have been but for that action. Therefore, for purposes of
the deduction allowed for such tax, the personal property tax imposed by
State X, for the property tax year 1962, shall be treated as though it
accrued on July 1, 1962.
Example 2. Assume the same facts as in Example 1 except that State X
repeals the personal property tax and in lieu thereof enacts a franchise
tax which is imposed on the privilege of conducting a trade or business
within State X, and is based on the value of intangible and tangible
personal property used in the trade or business. The franchise tax is to
be assessed and will become a lien as of December 31, 1961, for the
franchise tax year 1962, and on December 31 for all subsequent franchise
tax years. Since the franchise tax is substantially similar to the
former personal property tax and since the enactment of the franchise
tax has the effect of accelerating the accrual date of the personal
property tax from July 1, 1962, to December 31, 1961, the action taken
by State X is considered to be ``any action'' of a taxing jurisdiction
which results in the time for accruing taxes being earlier than it would
have been but for that action. Therefore, for purposes of the deduction
allowed for such tax, the franchise tax imposed by State X shall be
treated as though it accrued on July 1, 1962, for the franchise tax year
1962, and on July 1 for all subsequent franchise tax years.
[[Page 266]]
Example 3. Assume the same facts as in Example 1 except that State X
repealed the personal property tax and empowered the counties within the
State to impose a personal property tax. Assuming the counties in State
X subsequently imposed a personal property tax and chose December 31 of
the preceding year as the assessment and lien date, the action of each
of the counties would be considered to be ``any action'' of a taxing
jurisdiction which results in the time for accruing taxes being earlier
than it would have been but for that action since it is immaterial
whether the original taxing jurisdiction or a substitute jurisdiction
took the action.
(4) Section 461(d)(1) shall not be applicable to the extent that it
would prevent the taxpayer and all other persons, including successors
in interest, from ever taking into account, for Federal income tax
purposes, any tax to which that section would otherwise apply. For
example, assume that State Y imposes a personal property tax on tangible
personal property used in a trade or business conducted in the State
during a calendar year. The tax is assessed as of February 1 of the year
following the personal property tax year, and becomes a lien as of that
date. As a result of administrative and judicial decisions, February 1
of the following year is recognized as the proper date on which accrual
method taxpayers may accrue the personal property tax for Federal income
tax purposes. In 1962 State Y, by legislative action, changes the
assessment and lien dates for the personal property tax year 1962 from
February 1, 1963, to December 1, 1962, and to December 1 of the personal
property tax year for all subsequent years. Corporation A, an accrual
method taxpayer which uses the calendar year as its taxable year, pays
the tax for 1962 on December 10, 1962. On December 15, 1962, the
property which was taxed is completely destroyed and, on December 20,
1962, corporation A transfers all of its remaining assets to its
shareholders, and is dissolved. Since corporation A is not in existence
in 1963, and therefore could not take the personal property tax into
account in computing its 1963 Federal income tax if February 1, 1963, is
considered to be the time for accruing the tax, and no other person
could ever take such tax into account in computing his Federal income
tax, such tax shall be treated as accruing as of December 1, 1962. To
the extent that any person other than the taxpayer may at any time take
such tax into account in computing his taxable income, the provisions of
section 461(d)(1) shall apply. Thus, upon the dissolution of a
corporation or the termination of a partnership between the time which,
but for the provisions of section 461(d)(1) and this paragraph, would be
the time for accruing any tax which was the subject of ``any action''
(as defined in subdivision (iii) of subparagraph (2)), and the original
accrual date, the corporation or the partnership would be entitled to a
deduction for only that portion, if any, of such tax with respect to
which it can establish, to the satisfaction of the district director,
that no other taxpayer can properly take into account in computing his
taxable income. However, to the extent that the corporation or
partnership cannot establish, at the time of its dissolution or
termination, as the case may be, that no other taxpayer would be
entitled to take such tax into account in computing his taxable income,
and it is subsequently determined that no other taxpayer is entitled to
take such tax into account in computing his taxable income, the
corporation or partnership may file a claim for refund for the year of
its dissolution or termination (subject to the limitations prescribed in
section 6511) and claim as a deduction therein the portion of such tax
determined to be not deductible by any other taxpayer.
(5) Section 461(d) and this paragraph shall apply to taxable years
ending after December 31, 1960.
(e) Dividends or interest paid by certain savings institutions on
certain deposits or withdrawable accounts--(1) Deduction not allowable--
(i) In general. Except as otherwise provided in this paragraph, pursuant
to section 461(e) amounts paid to, or credited to the accounts of,
depositors or holders of accounts as dividends or interest on their
deposits or withdrawable accounts (if such amounts paid or credited are
withdrawable on demand subject only to customary notice to withdraw) by
a mutual savings bank not having capital stock represented by shares, a
domestic building and loan association,
[[Page 267]]
or a cooperative bank shall not be allowed as a deduction for the
taxable year to the extent such amounts are paid or credited for periods
representing more than 12 months. The provisions of section 461(e) are
applicable with respect to taxable years ending after December 31, 1962.
Whether amounts are paid or credited for periods representing more than
12 months depends upon all the facts and circumstances in each case. For
example, payments or credits which under all the facts and circumstances
are in the nature of bona fide bonus interest or dividends paid or
credited because a shareholder or depositor maintained a certain balance
for more than 12 months, will not be considered made for more than 12
months, providing the regular payments or credits represent a period of
12 months or less. The nonallowance of a deduction to the taxpayer under
section 461(e) and this subparagraph has no effect either on the proper
time for reporting dividends or interest by a depositor or holder of a
withdrawable account, or on the obligation of the taxpayer to make a
return setting forth, among other things, the aggregate amounts paid to
a depositor or shareholder under section 6049 (relating to returns
regarding payments of interest) and the regulations thereunder. With
respect to a short period (a taxable year consisting of a period of less
than 12 months), amounts of dividends or interest paid or credited shall
not be allowed as a deduction to the extent that such amounts are paid
or credited for a period representing more than the number of months in
such short period. In such a case, the rules contained in section 461(e)
and this paragraph apply to the short period in a manner consistent with
the application of such rules to a 12-month taxable year. Subparagraph
(2) of this paragraph provides rules for computing amounts not allowed
in the taxable year and subparagraph (3) provides rules for determining
when such amounts are allowed. See section 7701(a) (19) and (32) and the
regulations thereunder for the definitions of domestic building and loan
association and cooperative bank.
(ii) Exceptions. The rule of nonallowance set forth in subdivision
(i) of this subparagraph is not applicable to a taxpayer in the year in
which it liquidates (other than following, or as part of, an acquisition
of its assets in which the acquiring corporation, pursuant to section
381(a), takes into account certain items of the taxpayer, which for
purposes of this paragraph shall be referred to as an acquisition
described in section 381(a)). In addition, such rule of nonallowance is
not applicable to a taxpayer which pays or credits grace interest or
dividends to terminating depositors or shareholders, provided the total
amount of the grace interest or dividends paid or credited during the
payment or crediting period (for example, a quarterly or semiannual
period) does not exceed 10 percent of the total amount of the interest
or dividends paid or credited during such period, computed without
regard to the grace interest or dividends. For example, providing the 10
percent limitation is met, the rule of nonallowance does not apply in a
case in which a calendar year taxpayer, with regular interest payment
dates of January 1, April 1, July 1, and October 1, pays grace interest
for the period beginning October 1 to a depositor who terminates his
account on December 10.
(2) Computation of amounts not allowed as a deduction--(i) Method of
computation. The amount of the dividends or interest to which
subparagraph (1) of this paragraph applies, which is not allowed as a
deduction, shall be computed under the rules of this subparagraph. The
amount which is not allowed as a deduction is the difference between the
total amount of dividends or interest paid or credited to that class of
accounts with respect to which a deduction is not allowed under
subparagraph (1) of this paragraph during the taxable year (or short
period, if applicable) and an amount which bears the same ratio to such
total as the number 12 (or number of months in the short period) bears
to the number of months with respect to which such amounts of dividends
or interest are paid or credited.
(ii) Examples. The provisions of subdivision (i) of this
subparagraph may be illustrated by the following examples:
Example 1. X Association, a domestic building and loan association
filing its return on
[[Page 268]]
the basis of a calendar year, regularly credits dividends on its
withdrawable accounts quarterly on the first day of the quarter
following the quarter with respect to which they are earned. X changes
the time of crediting dividends commencing with the credit for the
fourth quarter of 1964. Such credit and all subsequent credits are made
on the last day of the quarter with respect to which they are earned. As
a result of this change X's credits for the year 1964 are as follows:
------------------------------------------------------------------------
Period with respect to which earned Date credited in 1964 Amt.
------------------------------------------------------------------------
4th quarter, 1963..................... Jan. 1 $250,000
1st quarter, 1964..................... Apr. 1 300,000
2d quarter, 1964...................... July 1 300,000
3d quarter, 1964...................... Oct. 1 300,000
4th quarter, 1964..................... Dec. 31 350,000
---------------------------------
Total dividends credited........... ..................... 1,500,000
------------------------------------------------------------------------
Since the change in the time of crediting dividends results in the
crediting in 1964 of amounts of dividends representing periods totaling
15 months (October 1963 through December 1964), amounts shall not be
allowed as a deduction in 1964 which are in excess of $1,200,000, which
is the amount which bears the same ratio to the amounts of dividends
credited during the year ($1,500,000) as the number 12 bears to the
number of months (15) with respect to which such dividends are credited.
Thus, $300,000 ($1,500,000 minus $1,200,000) is not allowed as a
deduction in 1964.
Example 2. Y Association, a domestic building and loan association
filing its return on the basis of a calendar year, regularly credits
dividends on its withdrawable accounts on the basis of a semiannual
period on March 31 and September 30 of each year. Y changes the period
with respect to which credits are made from the semiannual period to the
quarterly basis, commencing with the last quarter in 1964. The credit
for this last quarter and all subsequent credits are made on the last
day of the quarter with respect to which they are earned. As a result of
this change, Y's credits for the year 1964 are as follows:
------------------------------------------------------------------------
Period with respect to which earned Date credited in 1964 Amt.
------------------------------------------------------------------------
6-month period ending Mar. 31, 1964... Mar. 31 $300,000
6-month period ending Sept. 30, 1964.. Sept. 30 400,000
4th quarter, 1964..................... Dec. 31 200,000
Total dividends credited........... ..................... 900,000
------------------------------------------------------------------------
Since the change in the basis of crediting dividends results in a
crediting in 1964 of dividends representing periods totaling 15 months
(October 1963 through December 1964), amounts shall not be allowed as a
deduction in 1964 which are in excess of $720,000, which is the amount
which bears the same ratio to the amounts of dividends credited during
the year ($900,000) as the number 12 bears to the number of months (15)
with respect to which such dividends are credited. Thus, $180,000
($900,000 minus $720,000) is not allowed as a deduction in 1964.
Example 3. Z Association, a domestic building and loan association
regularly files its return on the basis of a fiscal year ending on the
last day of February and regularly credits dividends on its withdrawable
accounts quarterly on the last day of the quarter with respect to which
they are earned. Z receives approval from the Commissioner of Internal
Revenue to change its accounting period to a calendar year and effects
the change by filing a return for a short period ending on December 31,
1964. Dividend credits for the short period beginning on March 1 and
ending on December 31, 1964, are as follows:
------------------------------------------------------------------------
Period with respect to which earned Date credited in 1964 Amt.
------------------------------------------------------------------------
January-March 1964.................... Mar. 31 $250,000
April-June 1964....................... June 30 300,000
July-September 1964................... Sept. 30 300,000
October-December 1964................. Dec. 31 350,000
Total dividends credited........... ..................... 1,200,000
------------------------------------------------------------------------
Since the change of accounting period results in amounts of dividends
credited ($1,200,000) representing periods totaling 12 months (January
through December 1964), and such periods represent more than the number
of months (10) in the short period, an amount shall not be allowed as a
deduction in such short period which is in excess of $1,000,000, which
is the amount which bears the same ratio to the amount of dividends
credited in the short period ($1,200,000) as the number of months (10)
in the short period bears to the number of months (12) with respect to
which such dividends are credited. Thus, $200,000 ($1,200,000 minus
$1,000,000) is not allowed as a deduction in the short period.
(3) When amounts allowable. The amount of dividends or interest not
allowed as a deduction under subparagraph (1) of this paragraph shall be
allowed as follows (subject to the limitation that the total of the
amounts so allowed shall not exceed the amount not allowed under
subparagraph (1)):
(i) Such amount shall be allowed as a deduction in a later taxable
year or years subject to the limitation that, when taken together with
the deductions otherwise allowable in the later taxable year or years,
it does not bring the deductions for any later taxable year to a total
representing a period of more than 12 months (or number of
[[Page 269]]
months in the short period, if applicable). However, in any event, an
amount otherwise allowable under subdivision (ii) of this subparagraph
shall be allowed notwithstanding the fact that it may bring the
deductions allowable to a total representing a period of more than 12
months (or number of months in the short period, if applicable).
(ii) In any case in which it is established to the satisfaction of
the Commissioner that the taxpayer does not intend to avoid taxes, one-
tenth of such amount shall be allowed as a deduction in each of the 10
succeeding taxable years--
(a) Commencing with the taxable year for which such amount is not
allowed as a deduction under subparagraph (1), or
(b) In the case of such amount not allowed for a taxable year ending
before July 1, 1964, commencing with either the first or second taxable
year after the taxable year for which such amount is not allowed as a
deduction under subparagraph (1) if the taxpayer has not taken a
deduction on his return, or filed a claim for credit or refund, in
respect of such amount under (a).
Normally, if the deduction not allowed under subparagraph (1) is a
result of a change, not requested by the taxpayer, in the taxpayer's
annual accounting period or dividend or interest payment or crediting
dates solely as a consequence of a requirement of a Federal or State
regulatory authority, or if the deduction is not allowed solely as a
result of the taxpayer being a party to an acquisition to which section
381(a) applies, the Commissioner will permit the allowance of the amount
not allowed in the manner provided in this subdivision. Nothing set
forth in this subdivision shall be construed as permitting the allowance
of a credit or refund for any year which is barred by the limitations on
credit or refund provided by section 6511.
(iii) If the total of the amounts, if any, allowed under
subdivisions (i) and (ii) of this subparagraph before the taxable year
in which the taxpayer liquidates or otherwise ceases to engage in trade
or business is less than the amount not allowed under subparagraph (1),
there shall be allowed a deduction in such taxable year for the
difference between the amount not allowed under subparagraph (1) and the
amounts allowed, if any, as deductions under subdivisions (i) and (ii)
unless the circumstances under which the taxpayer ceased to do business
constitute an acquisition described in section 381(a) (relating to
carryovers in certain corporate acquisitions). If the circumstances
under which the taxpayer ceased to do business constitute an acquisition
described in section 381(a), the acquiring corporation shall succeed to
and take into account the balance of the amounts not allowed on the same
basis as the taxpayer, had it not ceased to engage in business.
[T.D. 6500, 25 FR 11720, Nov. 26, 1960]
Editorial Note: For Federal Register citations affecting Sec.
1.461-1, see the List of CFR Sections Affected, which appears in the
Finding Aids section of the printed volume and at www.govinfo.gov.
Sec. 1.461-2 Contested liabilities.
(a) General rule--(1) Taxable year of deduction. If--
(i) The taxpayer contests an asserted liability,
(ii) The taxpayer transfers money or other property to provide for
the satisfaction of the asserted liability,
(iii) The contest with respect to the asserted liability exists
after the time of the transfer, and
(iv) But for the fact that the asserted liability is contested, a
deduction would be allowed for the taxable year of the transfer (or, in
the case of an accrual method taxpayer, for an earlier taxable year for
which such amount would be accruable),
then the deduction with respect to the contested amount shall be allowed
for the taxable year of the transfer.
(2) Exception. Subparagraph (1) of this paragraph shall not apply in
respect of the deduction for income, war profits, and excess profits
taxes imposed by the authority of any foreign country or possession of
the United States, including a tax paid in lieu of a tax on income, war
profits, or excess profits otherwise generally imposed by any foreign
country or by any possession of the United States.
(3) Refunds includible in gross income. If any portion of the
contested amount
[[Page 270]]
which is deducted under subparagraph (1) of this paragraph for the
taxable year of transfer is refunded when the contest is settled, such
portion is includible in gross income except as provided in Sec. 1.111-
1, relating to recovery of certain items previously deducted or
credited. Such refunded amount is includible in gross income for the
taxable year of receipt, or for an earlier taxable year if properly
accruable for such earlier year.
(4) Examples. The provisions of this paragraph are illustrated by
the following examples:
Example 1. X Corporation, which uses an accrual method of
accounting, in 1964 contests $20 of a $100 asserted real property tax
liability but pays the entire $100 to the taxing authority. In 1968, the
contest is settled and X receives a refund of $5. X deducts $100 for the
taxable year 1964, and includes $5 in gross income for the taxable year
1968 (assuming Sec. 1.111-1 does not apply to such amount). If in 1964
X pays only $80 to the taxing authority, X deducts only $80 for 1964.
The result would be the same if X Corporation used the cash method of
accounting.
Example 2. Y Corporation makes its return on the basis of a calendar
year and uses an accrual method of accounting. Y's real property taxes
are assessed and become a lien on December 1, but are not payable until
March 1 of the following year. On December 10, 1964, Y contests $20 of
the $100 asserted real property tax which was assessed and became a lien
on December 1, 1964. On March 1, 1965, Y pays the entire $100 to the
taxing authority. In 1968, the contest is settled and Y receives a
refund of $5. Y deducts $80 for the taxable year 1964, deducts $20 for
the taxable year 1965, and includes $5 in gross income for the taxable
year 1968 (assuming Sec. 1.111-1 does not apply to such amount).
(b) Production costs--(1) In general; asserted liability. For
purposes of paragraph (a)(1) of this section, the term ``asserted
liability'' means an item with respect to which, but for the existence
of any contest in respect of such item, a deduction would be allowable
under an accrual method of accounting. For example, a notice of a local
real estate tax assessment and a bill received for services may
represent asserted liabilities.
(2) Definition of the term ``contest''. Any contest which would
prevent accrual of a liability under section 461(a) shall be considered
to be a contest in determining whether the taxpayer satisfies paragraph
(a)(1)(i) of this section. A contest arises when there is a bona fide
dispute as to the proper evaluation of the law or the facts necessary to
determine the existence or correctness of the amount of an asserted
liability. It is not necessary to institute suit in a court of law in
order to contest an asserted liability. An affirmative act denying the
validity or accuracy, or both, of an asserted liability to the person
who is asserting such liability, such as including a written protest
with payment of the asserted liability, is sufficient to commence a
contest. Thus, lodging a protest in accordance with local law is
sufficient to contest an asserted liability for taxes. It is not
necessary that the affirmative act denying the validity or accuracy, or
both, of an asserted liability be in writing if, upon examination of all
the facts and circumstances, it can be established to the satisfaction
of the Commissioner that a liability has been asserted and contested.
(3) Example. The provisions of this paragraph are illustrated by the
following example:
Example: O Corporation makes its return on the basis of a calendar
year and uses an accrual method of accounting. O receives a large
shipment of typewriter ribbons from S Company on January 30, 1964, which
O pays for in full on February 10, 1964. Subsequent to their receipt,
several of the ribbons prove defective because of inferior materials
used by the manufacturer. On August 9, 1964, O orally notifies S and
demands refund of the full purchase price of the ribbons. After
negotiations prove futile and a written demand is rejected by S, O
institutes an action for the full purchase price. For purposes of
paragraph (a)(1)(i) of this section, S has asserted a liability against
O which O contests on August 9, 1964. O deducts the contested amount for
1964.
(c) Transfer to provide for the satisfaction of an asserted
liability--(1) In general. (i) A taxpayer may provide for the
satisfaction of an asserted liability by transferring money or other
property beyond his control to--
(A) The person who is asserting the liability;
(B) An escrowee or trustee pursuant to a written agreement (among
the escrowee or trustee, the taxpayer, and the person who is asserting
the liability) that the money or other property
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be delivered in accordance with the settlement of the contest;
(C) An escrowee or trustee pursuant to an order of the United States
or of any State or political subdivision thereof or any agency or
instrumentality of the foregoing, or of a court, that the money or other
property be delivered in accordance with the settlement of the contest;
or
(D) A court with jurisdiction over the contest.
(ii) In order for money or other property to be beyond the control
of a taxpayer, the taxpayer must relinquish all authority over the money
or other property.
(iii) The following are not transfers to provide for the
satisfaction of an asserted liability--
(A) Purchasing a bond to guarantee payment of the asserted
liability;
(B) An entry on the taxpayer's books of account;
(C) A transfer to an account that is within the control of the
taxpayer;
(D) A transfer of any indebtedness of the taxpayer or of any promise
by the taxpayer to provide services or property in the future; and
(E) A transfer to a person (other than the person asserting the
liability) of any stock of the taxpayer or of any stock or indebtedness
of a person related to the taxpayer (as defined in section 267(b)).
(2) Examples. The provisions of this paragraph are illustrated by
the following examples:
Example 1. M Corporation contests a $5,000 liability asserted
against it by L Company for services rendered. To provide for the
contingency that it might have to pay the liability, M establishes a
separate bank account in its own name. M then transfers $5,000 from its
general account to such separate account. Such transfer does not qualify
as a transfer to provide for the satisfaction of an asserted liability
because M has not transferred the money beyond its control.
Example 2. M Corporation contests a $5,000 liability asserted
against it by L Company for services rendered. To provide for the
contingency that it might have to pay the liability, M transfers $5,000
to an irrevocable trust pursuant to a written agreement among the
trustee, M (the taxpayer), and L (the person who is asserting the
liability) that the money shall be held until the contest is settled and
then disbursed in accordance with the settlement. Such transfer
qualifies as a transfer to provide for the satisfaction of an asserted
liability.
(d) Contest exists after transfer. In order for a contest with
respect to an asserted liability to exist after the time of transfer,
such contest must be pursued subsequent to such time. Thus, the contest
must have been neither settled nor abandoned at the time of the
transfer. A contest may be settled by a decision, judgment, decree, or
other order of any court of competent jurisdiction which has become
final, or by written or oral agreement between the parties. For example,
Z Corporation, which uses an accrual method of accounting, in 1964
contests a $100 asserted liability. In 1967 the contested liability is
settled as being $80 which Z accrues and deducts for such year. In 1968
Z pays the $80. Section 461(f) does not apply to Z with respect to the
transfer because a contest did not exist after the time of such
transfer.
(e) Deduction otherwise allowed--(1) In general. The existence of
the contest with respect to an asserted liability must prevent (without
regard to section 461(f)) and be the only factor preventing a deduction
for the taxable year of the transfer (or, in the case of an accrual
method taxpayer, for an earlier taxable year for which such amount would
be accruable) to provide for the satisfaction of such liability. Nothing
in section 461(f) or this section shall be construed to give rise to a
deduction since section 461(f) and this section relate only to the
timing of deductions which are otherwise allowable under the Code.
(2) Application of economic performance rules to transfers under
section 461(f). (i) A taxpayer using an accrual method of accounting is
not allowed a deduction under section 461(f) in the taxable year of the
transfer unless economic performance has occurred.
(ii) Economic performance occurs for liabilities requiring payment
to another person arising out of any workers compensation act or any
tort, or any other liability designated in Sec. 1.461-4(g), as payments
are made to the person to which the liability is owed. Except as
provided in section 468B or the regulations thereunder, economic
performance does not occur when a taxpayer transfers money or other
property to a
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trust, an escrow account, or a court to provide for the satisfaction of
an asserted workers compensation, tort, or other liability designated
under Sec. 1.461-4(g) that the taxpayer is contesting unless the trust,
escrow account, or court is the person to which the liability is owed or
the taxpayer's payment to the trust, escrow account, or court discharges
the taxpayer's liability to the claimant. Rather, economic performance
occurs in the taxable year the taxpayer transfers money or other
property to the person that is asserting the workers compensation, tort,
or other liability designated under Sec. 1.461-4(g) that the taxpayer
is contesting or in the taxable year that payment is made from a trust,
an escrow account, or a court registry funded by the taxpayer to the
person to which the liability is owed.
(3) Examples. The provisions of this paragraph are illustrated by
the following examples:
Example 1. A, an individual, makes a gift of certain property to B,
an individual. A pays the entire amount of gift tax assessed against him
but contests his liability for the tax. Section 275(a)(3) provides that
gift taxes are not deductible. A does not satisfy the requirement of
paragraph (a)(1)(iv) of this section because a deduction would not be
allowed for the taxable year of the transfer even if A did not contest
his liability to the tax.
Example 2. Corporation X is a defendant in a class action suit for
tort liabilities. In 2002, X establishes a trust for the purpose of
satisfying the asserted liability and transfers $10,000,000 to the
trust. The trust does not satisfy the requirements of section 468B or
the regulations thereunder. In 2004, the trustee pays $10,000,000 to the
plaintiffs in settlement of the litigation. Under paragraph (e)(2) of
this section, economic performance with respect to X's liability to the
plaintiffs occurs in 2004. X may deduct the $10,000,000 payment to the
plaintiffs in 2004.
(f) Treatment of money or property transferred to an escrowee,
trustee, or court and treatment of any income attributable thereto.
[Reserved]
(g) Effective dates. (1) Except as otherwise provided, this section
applies to transfers of money or other property in taxable years
beginning after December 31, 1953, and ending after August 16, 1954.
(2) Paragraph (c)(1)(iii)(E) of this section applies to transfers of
any stock of the taxpayer or any stock or indebtedness of a person
related to the taxpayer on or after November 19, 2003.
(3) Paragraph (e)(2)(i) of this section applies to transfers of
money or other property after July 18, 1984.
(4) Paragraph (e)(2)(ii) and paragraph (e)(3) Example 2 of this
section apply to--
(i) Transfers after July 18, 1984, of money or other property to
provide for the satisfaction of an asserted workers compensation or tort
liability; and
(ii) Transfers in taxable years beginning after December 31, 1991,
of money or other property to provide for the satisfaction of asserted
liabilities designated in Sec. 1.461-4(g) (other than liabilities for
workers compensation or tort).
[T.D. 6772, 29 FR 15753, Nov. 24, 1964, as amended by T.D. 8408, 57 FR
12421, Apr. 10, 1992; T.D. 9095, 68 FR 65636, Nov. 21, 2003; T.D. 9140,
69 FR 43303, July 20, 2004]
Sec. 1.461-3 Prepaid interest. [Reserved]
Sec. 1.461-4 Economic performance.
(a) Introduction--(1) In general. For purposes of determining
whether an accrual basis taxpayer can treat the amount of any liability
(as defined in Sec. 1.446-1(c)(1)(ii)(B)) as incurred, the all events
test is not treated as met any earlier than the taxable year in which
economic performance occurs with respect to the liability.
(2) Overview. Paragraph (b) of this section lists exceptions to the
economic performance requirement. Paragraph (c) of this section provides
cross-references to the definitions of certain terms for purposes of
section 461 (h) and the regulations thereunder. Paragraphs (d) through
(m) of this section and Sec. 1.461-6 provide rules for determining when
economic performance occurs. Section 1.461-5 provides rules relating to
an exception under which certain recurring items may be incurred for the
taxable year before the year during which economic performance occurs.
(b) Exceptions to the economic performance requirement. Paragraph
(a)(2)(iii)(B) of Sec. 1.461-1 provides examples of liabilities that
are taken into
[[Page 273]]
account under rules that operate without regard to the all events test
(including economic performance).
(c) Definitions. The following cross-references identify certain
terms defined for purposes of section 461(h) and the regulations
thereunder:
(1) Liability. See paragraph (c)(1)(ii)(B)d of Sec. 1.446-1 for the
definition of ``liability.''
(2) Payment. See paragraph (g)(1)(ii) of this section for the
definition of ``payment.''
(d) Liabilities arising out of the provision of services, property,
or the use of property--(1) In general. The principles of this paragraph
(d) determine when economic performance occurs with respect to
liabilities arising out of the performance of services, the transfer of
property, or the use of property. This paragraph (d) does not apply to
liabilities described in paragraph (e) (relating to interest expense) or
paragraph (g) (relating to breach of contract, workers compensation,
tort, etc.) of this section. In addition, except as otherwise provided
in Internal Revenue regulations, revenue procedures, or revenue rulings
this paragraph (d) does not apply to amounts paid pursuant to a notional
principal contract. The Commissioner may provide additional rules in
regulations, revenue procedures, or revenue rulings concerning the time
at which economic performance occurs for items described in this
paragraph (d).
(2) Services or property provided to the Taxpayer--(i) In general.
Except as otherwise provided in paragraph (d)(5) of this section, if the
liability of a taxpayer arises out of the providing of services or
property to the taxpayer by another person, economic performance occurs
as the services or property is provided.
(ii) Long-term contracts. In the case of any liability of a taxpayer
described in paragraph (d)(2)(i) of this section that is an expense
attributable to a long-term contract with respect to which the taxpayer
uses the percentage of completion method, economic performance occurs--
(A) As the services or property is provided; or, if earlier,
(B) As the taxpayer makes payment (as defined in paragraph
(g)(1)(ii) of this section) in satisfaction of the liability to the
person providing the services or property. See paragraph (k)(2) of this
section for the effective date of this paragraph (d)(2)(ii).
(iii) Employee benefits--(A) In general. Except as otherwise
provided in any Internal Revenue regulation, revenue procedure, or
revenue ruling, the economic performance requirement is satisfied to the
extent that any amount is otherwise deductible under section 404
(employer contributions to a plan of deferred compensation), section
404A (certain foreign deferred compensation plans), and section 419
(welfare benefit funds). See Sec. 1.461-1(a)(2)(iii)(D).
(B) Property transferred in connection with performance of services.
[Reserved]
(iv) Cross-references. See Examples 4 through 6 of paragraph (d)(7)
of this section. See paragraph (d)(6) of this section for rules relating
to when a taxpayer may treat services or property as provided to the
taxpayer.
(3) Use of property provided to the taxpayer--(i) In general. Except
as otherwise provided in this paragraph (d)(3)d and paragraph (d)(5) of
this section, if the liability of a taxpayer arises out of the use of
property by the taxpayer, economic performance occurs ratably over the
period of time the taxpayer is entitled to the use of the property
(taking into account any reasonably expected renewal periods when
necessary to carry out the purposes of section 461(h)). See Examples 6
through 9 of paragraph (d)(7) of this section.
(ii) Exceptions--(A) Volume, frequency of use, or income. If the
liability of a taxpayer arises out of the use of property by the
taxpayer and all or a portion of the liability is determined by
reference to the frequency or volume of use of the property or the
income from the property, economic performance occurs for the portion of
the liability determined by reference to the frequency or volume of use
of the property or the income from the property as the taxpayer uses the
property or includes income from the property. See Examples 8 and 9 of
paragraph (d)(7) of this section. This paragraph (d)(3)(ii) shall not
apply if the District Director determines, that based on the substance
of the transaction, the liability of the taxpayer for use of the
property
[[Page 274]]
is more appropriately measured ratably over the period of time the
taxpayer is entitled to the use of the property.
(B) Section 467 rental agreements. In the case of a liability
arising out of the use of property pursuant to a section 467 rental
agreement, economic performance occurs as provided in Sec. 1.461-
1(a)(2)(iii)(E).
(4) Services or property provided by the taxpayer--(i) In general.
Except as otherwise provided in paragraph (d)(5) of this section, if the
liability of a taxpayer requires the taxpayer to provide services or
property to another person, economic performance occurs as the taxpayer
incurs costs (within the meaning of Sec. 1.446-1(c)(1)(ii)) in
connection with the satisfaction of the liability. See Examples 1
through 3 of paragraph (d)(7) of this section.
(ii) Barter transactions. If the liability of a taxpayer requires
the taxpayer to provide services, property, or the use of property, and
arises out of the use of property by the taxpayer, or out of the
provision of services or property to the taxpayer by another person,
economic performance occurs to the extent of the lesser of--
(A) The cumulative extent to which the taxpayer incurs costs (within
the meaning of Sec. 1.446-1(c)(1)(ii)) in connection with its liability
to provide the services of property; or
(B) The cumulative extent to which the services or property is
provided to the taxpayer.
(5) Liabilities that are assumed in connection with the sale of a
trade or business--(i) In general. If, in connection with the sale or
exchange of a trade or business by a taxpayer, the purchaser expressly
assumes a liability arising out of the trade or business that the
taxpayer but for the economic performance requirement would have been
entitled to incur as of the date of the sale, economic performance with
respect to that liability occurs as the amount of the liability is
properly included in the amount realized on the transaction by the
taxpayer. See Sec. 1.1001-2 for rules relating to the inclusion in
amount realized from a discharge of liabilities resulting from a sale or
exchange.
(ii) Trade or business. For purposes of this paragraph (d)(5), a
trade or business is a specific group of activities carried on by the
taxpayer for the purpose of earning income or profit if every operation
that is necessary to the process of earning income or profit is included
in the group. Thus, for example, the group of activities generally must
include the collection of income and the payment of expenses.
(iii) Tax avoidance. This paragraph (d)(5) does not apply if the
District Director determines that tax avoidance is one of the taxpayer's
principal purposes for the sale or exchange.
(6) Rules relating to the provision of services or property to a
taxpayer. The following rules apply for purposes of this paragraph (d):
(i) Services or property provided to a taxpayer include services or
property provided to another person at the direction of the taxpayer.
(ii) A taxpayer is permitted to treat services or property as
provided to the taxpayer as the taxpayer makes payment to the person
providing the services or property (as defined in paragraph (g)(1)(ii)
of this section), if the taxpayer can reasonably expect the person to
provide the services or property within 3\1/2\ months after the date of
payment.
(iii) A taxpayer is permitted to treat property as provided to the
taxpayer when the property is delivered or accepted, or when title to
the property passes. The method used by the taxpayer to determine when
property is provided is a method of accounting that must comply with the
rules of Sec. 1.446-1(e). Thus, the method of determining when property
is provided must be used consistently from year to year, and cannot be
changed without the consent of the Commissioner.
(iv) If different services or items of property are required to be
provided to a taxpayer under a single contract or agreement, economic
performance generally occurs over the time each service is provided and
as each item of property is provided. However, if a service or item of
property to be provided to the taxpayer is incidental to other services
or property to be provided under a contract or agreement, the taxpayer
is not required to allocate
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any portion of the total contract price to the incidental service or
property. For purposes of this paragraph (d)(6)(iv), services or
property is treated as incidental only if--
(A) The cost of the services or property is treated on the
taxpayer's books and records as part of the cost of the other services
or property provided under the contract; and
(B) The aggregate cost of the services or property does not exceed
10 percent of the total contract price.
(7) Examples. The following examples illustrate the principles of
this paragraph (d). For purposes of these examples, it is assumed that
the requirements of the all events test other than economic performance
have been met, and that the recurring item exception is not used. Assume
further that the examples do not involve section 467 rental agreements
and, therefore, section 467 is not applicable. The examples are as
follows:
Example 1. Services or property provided by the taxpayer. (i) X
corporation, a calendar year, accrual method taxpayer, is an oil
company. During March 1990, X enters into an oil and gas lease with Y.
In November 1990, X installs a platform and commences drilling. The
lease obligates X to remove its offshore platform and well fixtures upon
abandonment of the well or termination of the lease. During 1998, X
removes the platform and well fixtures at a cost of $200,000.
(ii) Under paragraph (d)(4)(i) of this section, economic performance
with respect to X's liability to remove the offshore platform and well
fixtures occurs as X incurs costs in connection with that liability. X
incurs these costs in 1998 as, for example, X's employees provide X with
removal services (see paragraph (d)(2) of this section). Consequently, X
incurs $200,000 for the 1998 taxable year. Alternatively, assume that
during 1990 X pays Z $130,000 to remove the platform and fixtures, and
that Z performs these removal services in 1998. Under paragraph (d)(2)
of this section, X does not incur this cost until Z performs the
services. Thus, economic performance with respect to the $130,000 X pays
Z occurs in 1998.
Example 2. Services or property provided by the taxpayer. (i) W
corporation, a calendar year, accrual method taxpayer, sells tractors
under a three-year warranty that obligates W to make any reasonable
repairs to each tractor it sells. During 1990, W sells ten tractors. In
1992 W repairs, at a cost of $5,000, two tractors sold during 1990.
(ii) Under paragraph (d)(4)(i) of this section, economic performance
with respect to W's liability to perform services under the warranty
occurs as W incurs costs in connection with that liability. W incurs
these costs in 1992 as, for example, replacement parts are provided to W
(see paragraph (d)(2) of this section). Consequently, $5,000 is incurred
by W for the 1992 taxable year.
Example 3. Services or property provided by the taxpayer; Long-term
contracts. (i) W corporation, a calendar year, accrual method taxpayer,
manufactures machine tool equipment. In November 1992, W contracts to
provide X corporation with certain equipment. The contract is not a
long-term contract under section 460 or Sec. 1.451-3. In 1992, W pays Z
corporation $50,000 to lease from Z, for the one-year period beginning
on January 1, 1993, testing equipment to perform quality control tests
required by the agreement with X. In 1992, pursuant to the terms of a
contract, W pays Y corporation $100,000 for certain parts necessary to
manufacture the equipment. The parts are provided to W in 1993. W's
employees provide W with services necessary to manufacture the equipment
during 1993, for which W pays $150,000 in 1993.
(ii) Under paragraph (d)(4) of this section, economic performance
with respect to W's liability to provide the equipment to X occurs as W
incurs costs in connection with that liability. W incurs these costs
during 1993, as services, property, and the use of property necessary to
manufacture the equipment are provided to W (see paragraphs (d)(2) and
(d)(3) of this section). Thus, $300,000 is incurred by W for the 1993
taxable year. See section 263A and the regulations thereunder for rules
relating to the capitalization and inclusion in inventory of these
incurred costs.
(iii) Alternatively, assume that the agreement with X is a long-term
contract as defined in section 460(f), and that W takes into account all
items with respect to such contracts under the percentage of completion
method as described in section 460(b)(1). Under paragraph (d)(2)(ii) of
this section, the $100,000 W pays in 1992 for parts is incurred for the
1992 taxable year, for purposes of determining the percentage of
completion under section 460(b)(1)(A). W's other costs under the
agreement are incurred for the 1993 taxable year for this purpose.
Example 4. Services or property provided to the taxpayers. (i) LP1,
a calendar year, accrual method limited partnership, owns the working
interest in a parcel of property containing oil and gas. During December
1990, LP1 enters into a turnkey contract with Z corporation pursuant to
which LP1 pays Z $200,000 and Z is required to provide a completed well
by the close of 1992. In May 1992, Z commences drilling the well, and,
in December 1992, the well is completed.
(ii) Under paragraph (d)(2) of this section, economic performance
with respect to LP1's
[[Page 276]]
liability for drilling and development services provided to LP1 by Z
occurs as the services are provided. Consequently, $200,000 is incurred
by LP1 for the 1992 taxable year.
Example 5. Services or property provided to the taxpayer. (i) X
corporation, a calendar year, accrual method taxpayer, is an automobile
dealer. On Jaunary 15, 1990, X agrees to pay an additional $10 to Y, the
manufacturer of the automobiles, for each automobile purchased by X from
Y. Y agrees to provide advertising and promotional activities to X.
(ii) During 1990, X purchases from Y 1,000 new automobiles and pays
to Y an additional $10,000 as provided in the agreement. Y, in turn,
uses this $10,000 to provide advertising and promotional activities
during 1992.
(iii) Under paragraph (d)(2) of this section, economic performance
with respect to X's liability for advertising and promotional services
provided to X by Y occurs as the services are provided. Consequently,
$10,000 is incurred by X for the 1992 taxable year.
Example 6. Use of property provided to the taxpayer; services or
property provided to the taxpayer. (i) V corporation, a calendar year,
accrual method taxpayer, charters aircrafts. On December 20, 1990, V
leases a jet aircraft from L for the four-year period that begins on
January 1, 1991. The lease obligates V to pay L a base rental of
$500,000 per year. In addition, the lease requires V to pay $25 to an
escrow account for each hour that the aircraft is flown. The escrow
account funds are held by V and are to be used by L to make necessary
repairs to the aircraft. Any amount remaining in the escrow account upon
termination of the lease is payable to V. During 1991, the aircraft is
flown 1,000 hours and V pays $25,000 to the escrow account. The aircraft
is repaired by L in 1993. In 1994, $20,000 is released from the escrow
account to pay L for the repairs.
(ii) Under paragraph (d)(3)(i) of this section, economic performance
with respect to V's base rental liability occurs ratably over the period
of time V is entitled to use the jet aircraft. Consequently, the
$500,000 rent is incurred by V for the 1991 taxable year and for each of
the next three taxable years. Under paragraph (d)(2) of this section,
economic performance with respect to the liability to place amounts in
escrow occurs as the aircraft is repaired. Consequently, V incurs $20,00
for the 1993 taxable year.
Example 7. Use of property provided to the taxpayer. (i) X
corporation, a calendar year, accrual method taxpayer, manufactures and
sells electronic circuitry. On November 15, 1990, X enters into a
contract with Y that entitles X to the exclusive use of a product owned
by Y for the five-year period beginning on January 1, 1991. Pursuant to
the contract, X pays Y $100,000 on December 30, 1990.
(ii) Under paragraph (d)(3)(i) of this section, economic performance
with respect to X's liability for the use of property occurs ratably
over the period of time X is entitled to use the product. Consequently,
$20,000 is incurred by X for 1991 and for each of the succeeding four
taxable years.
Example 8. Use of property provided to the taxpayer. (i) Y
corporation, a calendar year, accrual method taxpayer, enters into a
five-year lease with Z for the use of a copy machine on July 1, 1991. Y
also receives elivery of the copy machine on July 1, 1991. The lease
obligates Y to pay Z a base rental payment of $6,000 per year at the
beginning of each lease year and an additional charge of 5 cents per
copy 30 days after the end of each lease year. The machine is used to
make 50,000 copies during the first lease year: 20,000 copies in 1991
and 30,000 copies from January 1, 1992, to July 1, 1992. Y pays the
$6,000 base rental payment to Z on July 1, 1991, and the $2,500 variable
use payment on July 30, 1992.
(ii) under paragraph (d)(3)(i) of this section, economic performance
with respect to Y's base rental liability occurs ratably over the period
of time Y is entitled to use the copy machine. Consequently, $3,000 rent
is incurred by Y for the 1991 taxable year. Under paragraph (d)(3)(ii)
of this section, economic performance with respect to Y's variable use
portion of the liability occurs as Y uses the machine. Thus, the $1,000
of the $2,500 variable-use liability that relates to the 20,000 copies
made in 1991 is incurred by Y for the 1991 taxable year.
Example 9. Use of property provided to the taxpayer. (i) X
corporation, a calendar year, accrual method taxpayer, enters into a
five-year product distribution agreement with Y, on January 1, 1992. The
agreement provides for a payment of $100,000 on January 1, 1992, plus 10
percent of the gross profits earned by X from distribution of the
product. The variable income portion of X's liability is payable on
April 1 of each subsequent year. On January 1, 1992, X pays Y $100,000.
On April 1, 1993, X pays Y $3 million representing 10 percent of X's
gross profits from January 1 through December 31, 1992.
(ii) Under paragraph (d)(3)(i) of this section, economic performance
with respect to X's $100,000 payment occurs ratably over the period of
time X is entitled to use the product. Consequently, $20,000 is incurred
by X for each year of the agreement beginning with 1992. Under paragraph
(d)(3)(ii) of this section, economic performance with respect to X's
variable income portion of the liability occurs as the income is earned
by X. Thus, the $3 million variable-income liability is incurred by X
for the 1992 taxable year.
(e) Interest. In the case of interest, economic performance occurs
as the interest cost economically accrues, in accordance with the
principles of relevant provisions of the Code.
[[Page 277]]
(f) Timing of deductions from notional principal contracts. Economic
performance on a notional principal contract occurs as provided under
Sec. 1.446-3.
(g) Certain liabilities for which payment is economic performance--
(1) In general--(i) Person to which payment must be made. In the case of
liabilities described in paragraphs (g) (2) through (7) of this section,
economic performance occurs when, and to the extent that, payment is
made to the person to which the liability is owed. Thus, except as
otherwise provided in paragraph (g)(1)(iv) of this section and Sec.
1.461-6, economic performance does not occur as a taxpayer makes
payments in connection with such a liability to any other person,
including a trust, escrow account, court-administered fund, or any
similar arrangement, unless the payments constitute payment to the
person to which the liability is owed under paragraph (g)(1)(ii)(B) of
this section. Instead, economic performance occurs as payments are made
from that other person or fund to the person to which the liability is
owed. The amount of economic performance that occurs as payment is made
from the other person or fund to the person to which the liability is
owed may not exceed the amount the taxpayer transferred to the other
person or fund. For special rules relating to the taxation of amounts
transferred to ``qualified settlement funds,'' see section 468B and the
regulations thereunder. The Commissioner may provide additional rules in
regulations, revenue procedures, and revenue rulings concerning the time
at which economic performance occurs for items described in this
paragraph (g).
(ii) Payment to person to which liability is owed. Paragraph (d)(6)
of this section provides that for purposes of paragraph (d) of this
section (relating to the provision of services or property to the
taxpayer) in certain cases a taxpayer may treat services or property as
provided to the taxpayer as the taxpayer makes payments to the person
providing the services or property. In addition, this paragraph (g)
provides that in the case of certain liabilities of a taxpayer, economic
performance occurs as the taxpayer makes payment to persons specified
therein. For these and all other purposes of section 461(h) and the
regulations thereunder:
(A) Payment. The term payment has the same meaning as is used when
determining whether a taxpayer using the cash receipts and disbursements
method of accounting has made a payment. Thus, for example, payment
includes the furnishing of cash or cash equivalents and the netting of
offsetting accounts. Payment does not include the furnishing of a note
or other evidence of indebtedness of the taxpayer, whether or not the
evidence is guaranteed by any other instrument (including a standby
letter of credit) or by any third party (including a government agency).
As a further example, payment does not include a promise of the taxpayer
to provide services or property in the future (whether or not the
promise is evidenced by a contract or other witten agreement). In
addition, payment does not include an amount transferred as a loan,
refundable deposit, or contingent payment.
(B) Person to which payment is made. Payment to a particular person
is accomplished if paragraph (g)(1)(ii)(A) of this section is satisfied
and a cash basis taxpayer in the position of that person would be
treated as having actually or constructively received the amount of the
payment as gross income under the principles of section 451 (without
regard to section 104(a) or any other provision that specifically
excludes the amount from gross income). Thus, for example, the purchase
of an annuity contract or any other asset generally does not constitute
payment to the person to which a liability is owed unless the ownership
of the contract or other asset is transferred to that person.
(C) Liabilities that are assumed in connection with the sale of a
trade or business. Paragraph (d)(5) of this section provides rules that
determine when economic performance occurs in the case of liabilities
that are assumed in connection with the sale of a trade or business. The
provisions of paragraph (d)(5) of this section also apply to any
liability described in paragraph (g) (2) through (7) of this section
that the purchaser expressly assumes in connection with the sale or
exchange of a trade or business by a taxpayer, provided the
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taxpayer (but for the economic performance requirement) would have been
entitled to incur the liability as of the date of the sale.
(iii) Person. For purposes of this paragraph (g), ``person'' has the
same meaning as in section 7701(a)(1), except that it also includes any
foreign state, the United States, any State or political subdivision
thereof, any possession of the United States, and any agency or
instrumentality of any of the foregoing.
(iv) Assignments. If a person that has a right to receive payment in
satisfaction of a liability described in paragraphs (g) (2) through (7)
of this section makes a valid assignment of that right to a second
person, or if the right is assigned to the second person through
operation of law, then payment to the second person in satisfaction of
that liability constitutes payment to the person to which the liability
is owed.
(2) Liabilities arising under a workers compensation act or out of
any tort, breach of contract, or violation of law. If the liability of a
taxpayer requires a payment or series of payments to another person and
arises under any workers compensation act or out of any tort, breach of
contract, or violation of law, economic performance occurs as payment is
made to the person to which the liability is owed. See Example 1 of
paragraph (g)(8) of this section. For purposes of this paragraph
(g)(2)--
(i) A liability to make payments for services, property, or other
consideration provided under a contract is not a liability arising out
of a breach of that contract unless the payments are in the nature of
incidental, consequential, or liquidated damages; and
(ii) A liability arising out of a tort, breach of contract, or
violation of law includes a liability arising out of the settlement of a
dispute in which a tort, breach of contract, or violation of law,
respectively, is alleged.
(3) Rebates and refunds. If the liability of a taxpayer is to pay a
rebate, refund, or similar payment to another person (whether paid in
property, money, or as a reduction in the price of goods or services to
be provided in the future by the taxpayer), economic performance occurs
as payment is made to the person to which the liability is owed. This
paragraph (g)(3) applies to all rebates, refunds, and payments or
transfers in the nature of a rebate or refund regardless of whether they
are characterized as a deduction from gross income, an adjustment to
gross receipts or total sales, or an adjustment or addition to cost of
goods sold. In the case of a rebate or refund made as a reduction in the
price of goods or services to be provided in the future by the taxpayer,
``payment'' is deemed to occur as the taxpayer would otherwise be
required to recognize income resulting from a disposition at an
unreduced price. See Example 2 of paragraph (g)(8) of this section. For
purposes of determining whether the recurring item exception of Sec.
1.461-5 applies, a liability that arises out of a tort, breach of
contract, or violation of law is not considered a rebate or refund.
(4) Awards, prizes, and jackpots. If the liability of a taxpayer is
to provide an award, prize, jackpot, or other similar payment to another
person, economic performance occurs as payment is made to the person to
which the liability is owed. See Examples 3 and 4 of paragraph (g)(8) of
this section.
(5) Insurance, warranty, and service contracts. If the liability of
a taxpayer arises out of the provision to the taxpayer of insurance, or
a warranty or service contract, economic performance occurs as payment
is made to the person to which the liability is owed. See Examples 5
through 7 of paragraph (g)(8) of this section. For purposes of this
paragraph (g)(5)--
(i) A warranty or service contract is a contract that a taxpayer
enters into in connection with property bought or leased by the
taxpayer, pursuant to which the other party to the contract promises to
replace or repair the property under specified circumstances.
(ii) The term ``insurance'' has the same meaning as is used when
determining the deductibility of amounts paid or incurred for insurance
under section 162.
(6) Taxes--(i) In general. Except as otherwise provided in this
paragraph (g)(6), if the liability of a taxpayer is to pay a tax,
economic performance occurs as the tax is paid to the governmental
authority that imposed the tax.
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For purposes of this paragraph (g)(6), payment includes payments of
estimated income tax and payments of tax where the taxpayer subsequently
files a claim for credit or refund. In addition, for purposes of this
paragraph (g)(6), a tax does not include a charge collected by a
governmental authority for specific extraordinary services or property
provided to a taxpayer by the governmental authority. Examples of such a
charge include the purchase price of a parcel of land sold to a taxpayer
by a governmental authority and a charge for labor engaged in by
government employees to improve that parcel. In certain cases, a
liability to pay a tax is permitted to be taken into account in the
taxable year before the taxable year during which economic performance
occurs under the recurring item exception of Sec. 1.461-5. See Example
8 of paragraph (g)(8) of this section.
(ii) Licensing fees. If the liability of a taxpayer is to pay a
licensing or permit fee required by a governmental authority, economic
performance occurs as the fee is paid to the governmental authority, or
as payment is made to any other person at the direction of the
governmental authority.
(iii) Exceptions--(A) Real property taxes. If a taxpayer has made a
valid election under section 461 (c), the taxpayer's accrual for real
property taxes is determined under section 461 (c). Otherwise, economic
performance with respect to a property tax liability occurs as the tax
is paid, as specified in paragraph (g)(6)(i) of this section.
(B) Certain foreign taxes. If the liability of a taxpayer is to pay
an income, war profits, or excess profits tax that is imposed by the
authority of any foreign country or possession of the United States and
is creditable under section 901 (including a creditable tax described in
section 903 that is paid in lieu of such a tax), economic performance
occurs when the requirements of the all events test (as described in
Sec. 1.446-1 (c)(1)(ii)) other than economic performance are met,
whether or not the taxpayer elects to credit such taxes under section
901 (a).
(7) Other liabilities. In the case of a taxpayer's liability for
which economic perfomance rules are not provided elsewhere in this
section or in any other Internal Revenue regulation, revenue ruling or
revenue procedure, economic performance occurs as the taxpayer makes
payments in satisfaction of the liability to the person to which the
liability is owed. This paragraph (g)(7) applies only if the liability
cannot properly be characterized as a liability covered by rules
provided elsewhere in this section. If a liability may properly be
characterized as, for example, a liability arising from the provision of
services or property to, or by, a taxpayer, the determination as to when
economic performance occurs with respect to that liability is made under
paragraph (d) of this section and not under this paragraph (g)(7).
(8) Examples. The following examples illustrate the principles of
this paragraph (g). For purposes of these examples, it is assumed that
the requirements of the all events test other than economic performance
have been met and, except as otherwise provided, that the recurring item
exception is not used.
Example 1. Liabilities arising out of a tort. (i) During the period
1970 through 1975, Z corporation, a calendar year, accrual method
taxpayer, manufactured and distributed industrial products that
contained carcinogenic substances. In 1992, a number of lawsuits are
filed against Z alleging damages due to exposure to these products. In
settlement of a lawsuit maintained by A, Z agrees to purchase an annuity
contract that will provide annual payments to A of $50,000 for a period
of 25 years. On December 15, 1992, Z pays W, an unrelated life insurance
company, $491,129 for such an annuity contract. Z retains ownership of
the annuity contract.
(ii) Under paragraph (g)(2) of this section, economic performance
with respect to Z's liability to A occurs as each payment is made to A.
Consequently, $50,000 is incurred by Z for each taxable year that a
payment is made to A under the annuity contract. (Z must also include in
income a portion of amounts paid under the annuity, pursuant to section
72.) The result is the same if in 1992 Z secures its obligation with a
standby letter of credit.
(iii) If Z later transfers ownership of the annuity contract to A,
an amount equal to the fair market value of the annuity on the date of
transfer is incurred by Z in the taxable year of the transfer (see
paragraph (g)(1)(ii)(B) of this section). In addition, the transfer
constitutes a transaction to which section 1001 applies.
Example 2. Rebates and refunds. (i) X corporation, a calendar year,
accrual method
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taxpayer, manufactures and sells hardware products. X enters into
agreements that entitle each of its distributors to a rebate (or
discount on future purchases) from X based on the amount of purchases
made by the distributor from X during any calendar year. During the 1992
calendar year, X becomes liable to pay a $2,000 rebate to distributor A.
X pays A $1,200 of the rebate on January 15, 1993, and the remaining
$800 on October 15, 1993. Assume the rebate is deductible (or allowable
as an adjustment to gross receipts or cost of goods sold) when incurred.
(ii) If X does not adopt the recurring item exception described in
Sec. 1.461-5 with respect to rebates and refunds, then under paragraph
(g)(3) of this section, economic performance with respect to the $2,000
rebate liability occurs in 1993. However, if X has made a proper
election under Sec. 1.461-5, and as of December 31, 1992, all events
have occurred that determine the fact of the rebate liability, X incurs
$1,200 for the 1992 taxable year. Because economic performance (payment)
with respect to the remaining $800 does not occur until October 15, 1993
(more than 8\1/2\ months after the end of 1992), X cannot use the
recurring item exception for this portion of the liability (see Sec.
1.461-5). Thus, the $800 is not incurred by X until the 1993 taxable
year. If, instead of making the cash payments to A during 1993, X
adjusts the price of hardware purchased by A that is delivered to A
during 1993, X's ``payment'' occurs as X would otherwise be required to
recognize income resulting from a disposition at an unreduced price.
Example 3. Awards, prizes, and jackpots. (i) W corporation, a
calendar year, accrual method taxpayer, produces and sells breakfast
cereal. W conducts a contest pursuant to which the winner is entitled to
$10,000 per year for a period of 20 years. On December 1, 1992, A is
declared the winner of the contest and is paid $10,000 by W. In
addition, on December 1 of each of the next nineteen years, W pays
$10,000 to A.
(ii) Under paragraph (g)(4) of this section, economic performance
with respect to the $200,000 contest liability occurs as each of the
$10,000 payments is made by W to A. Consequently, $10,000 is incurred by
W for the 1992 taxable year and for each of the succeeding nineteen
taxable years.
Example 4. Awards, prizes, and jackpots. (i) Y corporation, a
calendar year, accrual method taxpayer, owns a casino that contains
progressive slot machines. A progressive slot machine provides a
guaranteed jackpot amount that increases as money is gambled through the
machine until the jackpot is won or until a maximum predetermined amount
is reached. On July 1, 1993, the guaranteed jackpot amount on one of Y's
slot machines reaches the maximum predetermined amount of $50,000. On
October 1, 1994, the $50,000 jackpot is paid to B.
(ii) Under paragraph (g)(4) of this section, economic performance
with respect to the $50,000 jackpot liability occurs on the date the
jackpot is paid to B. Consequently, $50,000 is incurred by Y for the
1994 taxable year.
Example 5. Insurance, warranty, and service contracts. (i) V
corporation, a calendar year, accrual method taxpayer, manufactures
toys. V enters into a contract with W, an unrelated insurance company,
on December 15, 1992. The contract obligates V to pay W a premium of
$500,000 before the end of 1995. The contract obligates W to satisfy any
liability of V resulting from claims made during 1993 or 1994 against V
by any third party for damages attributable to defects in toys
manufactured by V. Pursuant to the contract, V pays W a premium of
$500,000 on October 1, 1995.
(ii) Assuming the arrangement constitutes insurance, under paragraph
(g)(5) of this section economic performance occurs as the premium is
paid. Thus, $500,000 is incurred by V for the 1995 taxable year.
Example 6. Insurance, warranty, and service contracts. (i) Y
corporation, a calendar year, accrual method taxpayer, is a common
carrier. On December 15, 1992, Y enters into a contract with Z, an
unrelated insurance company, under which Z must satisfy any liability of
Y that arises during the succeeding 5 years for damages under a workers
compensation act or out of any tort, provided the event that causes the
damages occurs during 1993 or 1994. Under the contract, Y pays $360,000
to Z on December 31, 1993.
(ii) Assuming the arrangement constitutes insurance, under paragraph
(g)(5) of this section economic performance occurs as the premium is
paid. Consequently, $360,000 is incurred by Y for the 1993 taxable year.
The period for which the $360,000 amount is permitted to be taken into
account is determined under the capitalization rules because the
insurance contract is an asset having a useful life extending
substantially beyond the close of the taxable year.
Example 7. Insurance, warranty, and service contracts. Assume the
same facts as in Example 6, except that Y is obligated to pay the first
$5,000 of any damages covered by the arrangement with Z. Y is, in
effect, self-insured to the extent of this $5,000 ``deductible.'' Thus,
under paragraph (g)(2) of this section, economic performance with
respect to the $5,000 liability does not occur until the amount is paid
to the person to which the tort or workers compensation liability is
owed.
Example 8. Taxes. (i) The laws of State A provide that every person
owning personal property located in State A on the first day of January
shall be liable for tax thereon and that a lien for the tax shall attach
as of that date. In addition, the laws of State A provide that 60% of
the tax is due on the first day of
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December following the lien date and the remaining 40% is due on the
first day of July of the succeeding year. On January 1, 1992, X
corporation, a calendar year, accrual method taxpayer, owns personal
property located in State A. State A imposes a $10,000 tax on S with
respect to that property on January 1, 1992. X pays State A $6,000 of
the tax on December 1, 1992, and the remaining $4,000 on July 1, 1993.
(ii) Under paragraph (g)(6) of this section, economic performance
with respect to $6,000 of the tax liability occurs on December 1, 1992.
Consequently, $6,000 is incurred by X for the 1992 taxable year.
Economic performance with respect to the remaining $4,000 of the tax
liability occurs on July 1, 1993. If X has adopted the recurring item
exception described in Sec. 1.461-5 as a method of accounting for
taxes, and as of December 31, 1992, all events have occurred that
determine the liability of X for the remaining $4,000, X also incurs
$4,000 for the 1992 taxable year. If X does not adopt the recurring item
exception method, the $4,000 is not incurred by X until the 1993 taxable
year.
(h) Liabilities arising under the Nuclear Waste Policy Act of 1982.
Notwithstanding the principles of paragraph (d) of this section,
economic performance with respect to the liability of an owner or
generator of nuclear waste to make payments to the Department of Energy
(``DOE'') pursuant to a contract required by the Nuclear Waste Policy
Act of 1982 (Pub. L. 97-425, 42 U.S.C. 10101-10226 (1982)) occurs as
each payment under the contract is made to DOE and not when DOE
satisfies its obligations under the contract. This rule applies to the
continuing fee required by 42 U.S.C. 10222(a)(2) (1982), as well as the
one-time fee required by 42 U.S.C. 10222 (a)(3) (1982). For rules
relating to when economic performance occurs with respect to interest,
see paragraph (e) of this section.
(i) [Reserved]
(j) Contingent liabilities. [Reserved]
(k) Special effective dates--(1) In general. Except as otherwise
provided in this paragraph (k), section 461(h) and this section apply to
liabilities that would, under the law in effect before the enactment of
section 461(h), be allowable as a deduction or otherwise incurred after
July 18, 1984. For example, the economic performance requirement applies
to all liabilities arising under a workers compensation act or out of
any tort that would, under the law in effect before the enactment of
section 461(h), be incurred after July 18, 1984. For taxable years
ending before April 7, 1995, see Q&A-2 of Sec. 1.461-7T (as it appears
in 26 CFR part 1 revised April 1, 1995), which provides an election to
make this change in method of accounting applicable to either the
portion of the first taxable year that occurs after July 18, 1984 (part-
year change method), or the entire first taxable year ending after July
18, 1984 (full-year change method). With respect to the effective date
rules for interest, section 461(h) applies to interest accruing under
any obligation (whether or not evidenced by a debt instrument) if the
obligation is incurred in any transaction occurring after June 8, 1984,
and is not incurred under a written contract which was binding on March
1, 1984, and at all times thereafter until the obligation is incurred.
Interest accruing under an obligation described in the preceding
sentence is subject to section 461(h) even if the interest accrues
before July 19, 1984. Similarly, interest accruing under any obligation
incurred in a transaction occurring before June 9, 1984, (or under a
written contract which was binding on March 1, 1984, and at all times
thereafter until the obligation is incurred) is not subject to section
461(h) even to the extent the interest accrues after July 18, 1984.
(2) Long-term contracts. Except as otherwise provided in paragraph
(M)(2) of this section, in the case of liabilities described in
paragraph (d)(2)(ii) of this section (relating to long-term contracts),
paragraph (d)(2)(ii) of this section applies to liabilities that would,
but for the enactment of section 461(h), be allowable as a deduction or
otherwise incurred for taxable years beginning after December 31, 1991.
(3) Payment liabilities. Except as otherwise provided in paragraph
(m)(2) of this section, in the case of liabilities described in
paragraph (g) of this section (other than liabilities arising under a
workers compensation act or out of any tort described in paragraph
(g)(2) of this section), paragraph (g) of this section applies to
liabilities that would, but for the enactment of section 461(h), be
allowable as a deduction or otherwise incurred for taxable years
beginning after December 31, 1991.
[[Page 282]]
(l) [Reserved]
(m) Change in method of accounting required by this section--(1) In
general. For the first taxable year ending after July 18, 1984, a
taxpayer is granted the consent of the Commissioner to change its method
of accounting for liabilities to comply with the provisions of this
section pursuant to any of the following procedures:
(i) For taxable years ending before April 7, 1995, the part-year
change in method election described in Q&A-2 through Q&A-6 and Q&A-8
through Q&A-10 of Sec. 1.461-7T (as it appears in 26 CFR part 1 revised
April 1, 1995);
(ii) For taxable years ending before April 7, 1995, the full-year
change in method election described in Q&A-2 through Q&A-6 and Q&A-8
through Q&A-10 of Sec. 1.461-7T (as it appears in 26 CFR part 1 revised
April 1, 1995); or
(iii) For taxable years ending before April 7, 1995, if no election
is made, the cut-off method described in Q&A-1 and Q&A-11 of Sec.
1.461-7T (as it appears in 26 CFR part 1 revised April 1, 1995).
(2) Change in method of accounting for long-term contracts and
payment liabilities--(i) First taxable year beginning after December 31,
1991. For the first taxable year beginning after December 31, 1991, a
taxpayer is granted the consent of the Commissioner to change its method
of accounting for long-term contract liabilities described in paragraph
(D)(2)(ii) of this section and payment liabilities described in
paragraph (g) of this section (other than liabilities arising under a
workers compensation act or out of any tort described in paragraph
(g)(2) of this section) to comply with the provisions of this section.
The change must be made in accordance with paragraph (m)(1)(ii) or
(m)(1)(iii) of this section, except the effective date is the first day
of the first taxable year beginning December 31, 1991.
(ii) Retroactive change in method of accounting for long-term
contracts and payment liabilities. For the first taxable year beginning
after December 31, 1989, or the first taxable year beginning after
December 31, 1990, a taxpayer is granted the consent of the Commissioner
to change its method of accounting for long-term contract liabilities
described in paragraph (d)(2)(ii) of this section and payment
liabilities described in paragraph (g) of this section (other than
liabilities arising under a workers compensation act or out of any tort
described in paragraph (g)(2) of this section) to comply with the
provisions of this section. The change must be made in accordance with
paragraph (m)(1)(ii) or (m)(1)(iii) of this section, except the
effective date is the first day of the first taxable year beginning
after December 31, 1989, or the first day of the first taxable year
beginning after December 31, 1990. For taxable years ending before April
7, 1995, the taxpayer may make the change in method of accounting,
including a full-year change in method election under paragraph
(m)(1)(ii) of this section and Q&A-5 of Sec. 1.461-7T (as it appears in
26 CFR part 1 revised April 1, 1995), by filing an amended return for
such year, provided the amended return is filed on or before October 7,
1992.
[T.D. 8408, 57 FR 12421, Apr. 10, 1992, as amended by T.D. 8491, 58 FR
53135, Oct. 14, 1993; T.D. 8593, 60 FR 18743, Apr. 13, 1995; T.D. 8820,
64 FR 26851, May 18, 1999; T.D. 8408, 69 FR 44597, July 27, 2004]
Sec. 1.461-5 Recurring item exception.
(a) In general. Except as otherwise provided in paragraph (c) of
this section, a taxpayer using an accrual method of accounting may adopt
the recurring item exception described in paragraph (b) of this section
as method of accounting for one or more types of recurring items
incurred by the taxpayer. In the case of the ``other payment
liabilities'' described in Sec. 1.461-4(g)(7), the Commissioner may
provide for the application of the recurring item exception by
regulation, revenue procedure or revenue ruling.
(b) Requirements for use of the exception--(1) General rule. Under
the recurring item exception, a liability is treated as incurred for a
taxable year if--
(i) As of the end of that taxable year, all events have occurred
that establish the fact of the liability and the amount of the liability
can be determined with reasonable accuracy;
(ii) Economic performance with respect to the liability occurs on or
before the earlier of--
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(A) The date the taxpayer files a timely (including extensions)
return for that taxable year; or
(B) The 15th day of the 9th calendar month after the close of that
taxable year;
(iii) The liability is recurring in nature; and
(iv) Either--
(A) The amount of the liability is not material; or
(B) The accrual of the liability for that taxable year results in a
better matching of the liability with the income to which it relates
than would result from accruing the liability for the taxable year in
which economic performance occurs.
(2) Amended returns. A taxpayer may file an amended return treating
a liability as incurred under the recurring item exception for a taxable
year if economic performance with respect to the liability occurs after
the taxpayer files a return for that year, but within 8\1/2\ months
after the close of that year.
(3) Liabilities that are recurring in nature. A liability is
recurring if it can generally be expected to be incurred from one
taxable year to the next. However, a taxpayer may treat such a liability
as recurring in nature even if it is not incurred by the taxpayer in
each taxable year. In addition, a liability that has never previously
been incurred by a taxpayer may be treated as recurring if it is
reasonable to expect that the liability will be incurred on a recurring
basis in the future.
(4) Materiality requirement. For purposes of this paragraph (b):
(i) In determining whether a liability is material, consideration
shall be given to the amount of the liability in absolute terms and in
relation to the amount of other items of income and expense attributable
to the same activity.
(ii) A liability is material if it is material for financial
statement purposes under generally acepted accounting principles.
(iii) A liability that is immaterial for financial statement
purposes under generally accepted accounting principles may be material
for purposes of this paragraph (b).
(5) Matching requirement. (i) In determining whether the matching
requirement of paragraph (b)(1)(iv)(B) of this section is satisfied,
generally accepted accounting principles are an important factor, but
are not dispositive.
(ii) In the case of a liability described in paragraph (g)(3)
(rebates and refunds), paragraph (g)(4) (awards, prizes, and jackpots),
paragraph (g)(5) (insurance, warranty, and service contracts), paragraph
(g)(6) (taxes), or paragraph (h) (continuing fees under the Nuclear
Waste Policy Act of 1982) of Sec. 1.461-4, the matching requirement of
paragraph (b)(1)(iv)(B) of this section shall be deemed satisfied.
(c) Types of liabilities not eligible for treatment under the
recurring item exception. The recurring item exception does not apply to
any liability of a taxpayer described in paragraph (e) (interest),
paragraph (g)(2) (workers compensation, tort, breach of contract, and
violation of law), or paragraph (g)(7) (other liabilities) of Sec.
1.461-4. Moreover, the recurring item exception does not apply to any
liability incurred by a tax shelter, as defined in section 461(i) and
Sec. 1.448-1T(b).
(d) Time and manner of adopting the recurring item exception--(1) In
general. The recurring item exception is a method of accounting that
must be consistently applied with respect to a type of item, or for all
items, from one taxable year to the next in order to clearly reflect
income. A taxpayer is permitted to adopt the recurring item exception as
part of its method of accounting for any type of item for the first
taxable year in which that type of item is incurred. Except as otherwise
provided, the rules of section 446(e) and Sec. 1.446-1(e) apply to
changes to or from the recurring item exception as a method of
accounting. For taxable years ending before April 7, 1995, see Q&A-7 of
Sec. 1.461-7T (as it appears in 26 CFR part 1 revised April 1, 1995)
for rules concerning the time and manner of adopting the recurring item
exception for taxable years that include July 19, 1984. For purposes of
this section, items are to be classified by type in a manner that
results in classifications that are no less inclusive than the
classifications of production costs provided in the full-absorption
regulations of Sec. 1.471-11(b) and(c), whether or not the
[[Page 284]]
taxpayer is required to maintain inventories.
(2) Change to the recurring item exception method for the first
taxable year beginning after December 31, 1991--(i) In general. For the
first taxable year beginning after December 31, 1991, a taxpayer is
granted the consent of the Commissioner to change to the recurring item
exception method of accounting. A taxpayer is also granted the consent
of the Commissioner to expand or modify its use of the recurring item
exception method for the first taxable year beginning after December 31,
1991. For each trade or business for which a taxpayer elects to use the
recurring item exception method, the taxpayer must use the same method
of change (cut-off or full-year change) it is using for that trade or
business under Sec. 1.461-4(m). For taxable year sending before April
7, 1995, see Q&A-11 of Sec. 1.461-7T (as it appears in 26 CFR part 1
revised April 1, 1995) for an explanation of how amounts are taken into
account under the cut-off method (except that, for purposes of this
paragraph (d)(2), the change applies to all amounts otherwise incurred
on or after the first day of the first taxable year beginning after
December 31, 1991). For taxable years ending before April 7, 1995, see
Q&A-6 of Sec. 1.461-7T (as it appears in 26 CFR part 1 revised April 1,
1995) for an explanation of how amounts are taken into account under the
full-year change method (except that the change in method occurs on the
first day of the first taxable year beginning after December 31, 1991).
For taxable years ending before April 7, 1995, the full-year change in
method may result in a section 481(a) adjustment that must be taken into
account in the manner described in Q&A-8 and Q&A-9 of Sec. 1.461-7T (as
it appears in 26 CFR part 1 revised April 1, 1995) (except that the
taxable year of change is the first taxable year beginning after
December 31, 1991).
(ii) Manner of changing to the recurring item exception method. For
the first taxable year beginning after December 31, 1991, a taxpayer may
change to the recurring item exception method by accounting for the item
on its timely filed original return for such taxable year (including
extensions). For taxable years ending before April 7, 1995, the
automatic consent of the Commissioner is limited to those items
accounted for under the recurring item exception method on the timely
filed return, unless the taxpayer indicates a wider scope of change by
filing the statement provided in Q&A-7(b)(2) of Sec. 1.461-7T (as it
appears in 26 CFR part 1 revised April 1, 1995).
(3) Retroactive change to the recurring item exception method. For
the first taxable year beginning after December 31, 1989, or December
31, 1990, a taxpayer is granted consent of the Commissioner to change to
the recurring item exception method of accounting, provided the taxpayer
complies with paragraph (d)(2) of this section on either the original
return for such year or on an amended return for such year filed on or
before October 7, 1991. For this purpose the effective date is the first
day of the first taxable year beginning after December 31, 1989, or the
first day of the first taxable year beginning after December 31, 1990. A
taxpayer is also granted the consent of the Commissioner to expand or
modify its use of the recurring item exception method for the first
taxable year beginning after December 31, 1989, December 31, 1990, or
December 31, 1991.
(e) Examples. The following examples illustrate the principles of
this section:
Example 1. Requirements for use of the recurring item exception. (i)
Y corporation, a calendar year, accrual method taxpayer, manufactures
and distributes video cassette recorders. Y timely files its federal
income tax return for each taxable year on the extended due date for the
return (September 15, of the following taxable year). Y offers to refund
the price of a recorder to any purchaser not satisfied with the
recorder. During 1992, 100 purchasers request a refund of the $500
purchase price. Y refunds $30,000 on or before September 15, 1993, and
the remaining $20,000 after such date but before the end of 1993.
(ii) Under paragraph (g)(3) of Sec. 1.461-4, economic performance
with respect to $30,000 of the refund liability occurs on September 15,
1993. Assume the refund is deductible (or allowable as an adjustment to
gross receipts or cost of goods sold) when incurred. If Y does not adopt
the recurring item exception with respect to rebates and refunds, the
$30,000 refund is incurred by Y for the 1993 taxable year. However, if Y
has properly adopted the recurring item exception method of accounting
under this section, and as of December
[[Page 285]]
31, 1992, all events have occurred that determine the fact of the
liability for the $30,000 refund, Y incurs that amount for the 1992
taxable year. Because economic performance (payment) with respect to the
remaining $20,000 occurs after September 15, 1993 (more than 8\1/2\
months after the end of 1992), that amount is not eligible for recurring
item treatment under this section. Thus, the $20,000 amount is not
incurred by Y until the 1993 taxable year.
Example 2. Requirements for use of the recurring item exception;
amended returns. The facts are the same as in Example 2, except that Y
files its income tax return for 1992 on March 15, 1993, and Y does not
refund the price of any recorder before that date. Under paragraph
(b)(1) of this section, the refund liability is not eligible for the
recurring item exception because economic performance with respect to
the refund does not occur before Y files a return for the taxable year
for which the item would have been incurred under the exception.
However, since economic performance occurs within 8\1/2\ months after
1992, Y may file an amended return claiming the $30,000 as incurred for
its 1992 taxable year (see paragraph (b)(2) of this section).
[T.D. 8408, 57 FR 12427, Apr. 10, 1992, as amended by T.D. 8593, 60 FR
18743, Apr. 13, 1995]
Sec. 1.461-6 Economic performance when certain liabilities are assigned
or are extinguished by the establishment of a fund.
(a) Qualified assignments of certain personal injury liabilities
under section 130. In the case of a qualified assignment (within the
meaning of section 130(c)), economic performance occurs as a taxpayer-
assignor makes payments that are excludible from the income of the
assignee under section 130(a).
(b) Section 468B. Economic performance occurs as a taxpayer makes
qualified payments to a designated settlement fund under section 468B,
relating to special rules for designated settlement funds.
(c) Payments to other funds or persons that constitute economic
performance. [Reserved]
(d) Effective dates. The rules in paragraph (a) of this section
apply to payments after July 18, 1984.
[T.D. 8408, 57 FR 12428, Apr. 10, 1992]
Sec. 1.465-1T Aggregation of certain activities (temporary).
(a) General rule. A partner in a partnership or an S corporation
shareholder may aggregate and treat as a single activity--
(1) The holding, production, or distribution of more than one motion
picture film or video tape by the partnership or S corporation,
(2) The farming (as defined in section 464 (e)) of more than one
farm by the partnership or S corporation,
(3) The exploration for, or exploitation of, oil and gas resources
with respect to more than one oil and gas property by the partnership or
S corporation, or
(4) The exploration for, or exploitation of, geothermal deposits
(within the meaning of section 613(e)(3)) with respect to more than one
geothermal property by the partnership or S corporation.
Thus, for example, if a partnership or S corporation is engaged in the
activity of exploring for, or exploiting, oil and gas resources with
respect to 10 oil and gas properties, a partner or S corporation
shareholder may aggregate those properties and treat the aggregated oil
and gas activities as a single activity. If that partnership or S
corporation also is engaged in the activity of farming with respect to
two farms, the partner or shareholder may aggregate the farms and treat
the aggregated farming activities as a single separate activity. Except
as provided in section 465(c)(2)(B)(ii), the partner or shareholder
cannot aggregate the farming activity with the oil and gas activity.
(b) Effective date. This section shall apply to taxable years
beginning after December 31, 1983 and before January 1, 1985.
(Secs. 465(c)(2)(B) and 7805 of the Internal Revenue Code of 1954 (98
Stat. 814, 68A Stat. 917; 26 U.S.C. 465(c)(2)(B) and 7805))
[T.D. 8012, 50 FR 9614, Mar. 11, 1985]
Sec. 1.465-8 General rules; interest other than that of a creditor.
(a) In general--(1) Amounts borrowed. This section applies to
amounts borrowed for use in an activity described in section 465(c)(1)
or (c)(3)(A). Amounts borrowed with respect to an activity will not
increase the borrower's amount at risk in the activity if the lender has
an interest in the activity other than that of a creditor or
[[Page 286]]
is related to a person (other than the borrower) who has an interest in
the activity other than that of a creditor. This rule applies even if
the borrower is personally liable for the repayment of the loan or the
loan is secured by property not used in the activity. For additional
rules relating to the treatment of amounts borrowed from these persons,
see Sec. 1.465-20.
(2) Certain borrowed amounts excepted. (i) For purposes of
determining a corporation's amount at risk, an interest in the
corporation as a shareholder is not an interest in any activity of the
corporation. Thus, amounts borrowed by a corporation from a shareholder
may increase the corporation's amount at risk.
(ii) For purposes of determining a taxpayer's amount at risk in an
activity of holding real property, paragraph (a)(1) of this section does
not apply to financing that is secured by real property used in the
activity and is either--
(A) Qualified nonrecourse financing described in section
465(b)(6)(B); or
(B) Financing that, if it were nonrecourse, would be financing
described in section 465(b)(6)(B).
(b) Loans for which the borrower is personally liable for
repayment--(1) General rule. If a borrower is personally liable for the
repayment of a loan for use in an activity, a person shall be considered
a person with an interest in the activity other than that of a creditor
only if the person has either a capital interest in the activity or an
interest in the net profits of the activity.
(2) Capital interest. For the purposes of this section a capital
interest in an activity means an interest in the assets of the activity
which is distributable to the owner of the capital interest upon the
liquidation of the activity. The partners of a partnership and the
shareholders of an S corporation are considered to have capital
interests in the activities conducted by the partnership or S
corporation.
(3) Interest in net profits. For the purposes of this section it is
not necessary for a person to have any incidents of ownership in the
activity in order to have an interest in the net profits of the
activity. For example, an employee or independent contractor any part of
whose compensation is determined with reference to the net profits of
the activity will be considered to have an interest in the net profits
of the activity.
(4) Examples. The provisions of this paragraph may be illustrated by
the following examples:
Example 1. A, the owner of a herd of cattle sells the herd to
partnership BCD. BCD pays A $10,000 in cash and executes a note for
$30,000 payable to A. Each of the three partners, B, C, and D, assumes
personal liability for repayment of the amount owed A. In addition, BCD
enters into an agreement with A under which A is to take care of the
cattle for BCD in return for compensation equal to 6 percent of BCD's
net profits from the activity. Because A has an interest in the net
profits of BCD's farming activity, A is considered to have an interest
in the activity other than that of a creditor. Accordingly, amounts
payable to A for use in that activity do not increase the partners'
amount at risk even though the partners assume personal liability for
repayment.
Example 2. Assume the same facts as in Example 1 except that instead
of receiving compensation equal to 6 percent of BCD's net profits from
the activity, A instead receives compensation equal to 1 percent of the
gross receipts from the activity. A does not have a capital interest in
BCD. A's interest in the gross receipts is not considered an interest in
the net profits. Because B, C, and D assumed personal liability for the
amounts payable to A, and A has neither a capital interest nor an
interest in the net profits of the activity, A is not considered to have
an interest in the activity other than that of a creditor with respect
to the $30,000 loan. Accordingly, B, C, and D are at risk for their
share of the loan if the other provisions of section 465 are met.
Example 3. Assume the same facts as in Example 1 except that instead
of receiving compensation equal to 6 percent of BCD's net profits from
the activity, A instead receives compensation equal to 6 percent of the
net profits from the activity or $15,000, whichever is greater. A is
considered to have an interest in the net profits from the activity and
accordingly will be treated as a person with an interest in the activity
other than that of a creditor.
(c) Nonrecourse loans secured by assets with a readily ascertainable
fair market value--(1) General rule. This paragraph shall apply in the
case of a nonrecourse loan for use in an activity where the loan is
secured by property which has a readily ascertainable fair market value.
In the case of such a loan a person shall be considered a person with
[[Page 287]]
an interest in the activity other than that of a creditor only if the
person has either a capital interest in the activity or an interest in
the net profits of the activity.
(2) Example. The provisions of this paragraph (c) may be illustrated
by the following example:
Example. X is an investor in an activity described in section
465(c)(1). In order to raise money for the investment, X borrows money
from A, the promoter (the person who brought X together with other
taxpayers for the purpose of investing in the activity). The loan is
secured by stock unrelated to the activity which is listed on a national
securities exchange. X's stock has a readily ascertainable fair market
value. A does not have a capital interest in the activity or an interest
in its net profits. Accordingly, with respect to the loan secured by X's
stock, A does not have an interest in the activity other than that of a
creditor.
(d) Nonrecourse loans secured by assets without a readily
ascertainable fair market value--(1) General rule. This paragraph shall
apply in the case of a nonrecourse loan for use in an activity where the
loan is secured by property which does not have a readily ascertainable
fair market value. In the case of such a loan a person shall be
considered a person with an interest in the activity other than that of
a creditor if the person stands to receive financial gain (other than
interest) from the activity or from the sale of interests in the
activity. For the purposes of this section persons who stand to receive
financial gain from the activity include persons who receive
compensation for services rendered in connection with the organization
or operation of the activity or for the sale of interests in the
activity. Such a person will generally include the promoter of the
activity who organizes the activity or solicits potential investors in
the activity.
(2) Example. The provisions of this paragraph (d) may be illustrated
by the following example:
Example. A is the promoter of an activity described in section
465(c)(1). As the promoter, A organizes the activity and solicits
potential investors. For these services A is paid a flat fee of $130x.
This fee is paid out of the amounts contributed by the investors to the
activity. X, one of the investors in the activity, borrows money from A
for use in the activity. X is not personally liable for repayment to A
of the amount borrowed. As security for the loan, X pledges an asset
which does not have a readily ascertainable fair market value. A is
considered a person with an interest in the activity other than that of
a creditor with respect to this loan because the asset pledged as
security does not have a readily ascertainable fair market value, X is
not personally liable for repayment of the loan, and A received
financial gain from the activity. Accordingly, X's amount at risk in the
activity is not increased despite the fact that property was pledged as
security.
(e) Effective date. This section applies to amounts borrowed after
May 3, 2004.
[T.D. 9124, 69 FR 24079, May 3, 2004; 69 FR 26305, May 12, 2004]
Sec. 1.465-20 Treatment of amounts borrowed from certain persons
and amounts protected against loss.
(a) General rule. The following amounts are treated in the same
manner as borrowed amounts for which the taxpayer has no personal
liability and for which no security is pledged--
(1) Amounts that do not increase the taxpayer's amount at risk
because they are borrowed from a person who has an interest in the
activity other than that of a creditor or from a person who is related
to a person (other than the taxpayer) who has an interest in the
activity other than that of a creditor; and
(2) Amounts (whether or not borrowed) that are protected against
loss.
(b) Interest other than that of a creditor; cross reference. See
Sec. 1.465-8 for additional rules relating to amounts borrowed from a
person who has an interest in the activity other than that of a creditor
or is related to a person (other than the taxpayer) who has an interest
in the activity other than that of a creditor.
(c) Amounts protected against loss; cross reference. See Sec.
1.465-6 for rules relating to amounts protected against loss.
(d) Effective date. This section applies to amounts borrowed after
May 3, 2004.
[T.D. 9124, 69 FR 24079, May 3, 2004]
[[Page 288]]
Sec. 1.465-27 Qualified nonrecourse financing.
(a) In general. Notwithstanding any provision of section 465(b) or
the regulations under section 465(b), for an activity of holding real
property, a taxpayer is considered at risk for the taxpayer's share of
any qualified nonrecourse financing which is secured by real property
used in such activity.
(b) Qualified nonrecourse financing secured by real property--(1) In
general. For purposes of section 465(b)(6) and this section, the term
qualified nonrecourse financing means any financing--
(i) Which is borrowed by the taxpayer with respect to the activity
of holding real property;
(ii) Which is borrowed by the taxpayer from a qualified person or
represents a loan from any federal, state, or local government or
instrumentality thereof, or is guaranteed by any federal, state, or
local government;
(iii) For which no person is personally liable for repayment, taking
into account paragraphs (b)(3), (4), and (5) of this section; and
(iv) Which is not convertible debt.
(2) Security for qualified nonrecourse financing--(i) Types of
property. For a taxpayer to be considered at risk under section
465(b)(6), qualified nonrecourse financing must be secured only by real
property used in the activity of holding real property. For this
purpose, however, property that is incidental to the activity of holding
real property will be disregarded. In addition, for this purpose,
property that is neither real property used in the activity of holding
real property nor incidental property will be disregarded if the
aggregate gross fair market value of such property is less than 10
percent of the aggregate gross fair market value of all the property
securing the financing.
(ii) Look-through rule for partnerships. For purposes of paragraph
(b)(2)(i) of this section, a borrower shall be treated as owning
directly its proportional share of the assets in a partnership in which
the borrower owns (directly or indirectly through a chain of
partnerships) an equity interest.
(3) Personal liability; partial liability. If one or more persons
are personally liable for repayment of a portion of a financing, the
portion of the financing for which no person is personally liable may
qualify as qualified nonrecourse financing.
(4) Partnership liability. For purposes of section 465(b)(6) and
this paragraph (b), the personal liability of any partnership for
repayment of a financing is disregarded and, provided the requirements
contained in paragraphs (b)(1)(i), (ii), and (iv) of this section are
satisfied, the financing will be treated as qualified nonrecourse
financing secured by real property if--
(i) The only persons personally liable to repay the financing are
partnerships;
(ii) Each partnership with personal liability holds only property
described in paragraph (b)(2)(i) of this section (applying the
principles of paragraph (b)(2)(ii) of this section in determining the
property held by each partnership); and
(iii) In exercising its remedies to collect on the financing in a
default or default-like situation, the lender may proceed only against
property that is described in paragraph (b)(2)(i) of this section and
that is held by the partnership or partnerships (applying the principles
of paragraph (b)(2)(ii) of this section in determining the property held
by the partnership or partnerships).
(5) Disregarded entities. Principles similar to those described in
paragraph (b)(4) of this section shall apply in determining whether a
financing of an entity that is disregarded for federal tax purposes
under Sec. 301.7701-3 of this chapter is treated as qualified
nonrecourse financing secured by real property.
(6) Examples. The following examples illustrate the rules of this
section:
Example 1. Personal liability of a partnership; incidental property.
(i) X is a limited liability company that is classified as a partnership
for federal tax purposes. X engages only in the activity of holding real
property. In addition to real property used in the activity of holding
real property, X owns office equipment, a truck, and maintenance
equipment that it uses to support the activity of holding real property.
X borrows $500 to use in the activity. X is personally liable on the
financing, but no member of X and no other person is liable for
repayment of the financing under local law. The lender may proceed
[[Page 289]]
against all of X's assets if X defaults on the financing.
(ii) Under paragraph (b)(2)(i) of this section, the personal
property is disregarded as incidental property used in the activity of
holding real property. Under paragraph (b)(4) of this section, the
personal liability of X for repayment of the financing is disregarded
and, provided the requirements contained in paragraphs (b)(1)(i), (ii),
and (iv) of this section are satisfied, the financing will be treated as
qualified nonrecourse financing secured by real property.
Example 2. Bifurcation of a financing. The facts are the same as in
Example 1, except that A, a member of X, is personally liable for
repayment of $100 of the financing. If the requirements contained in
paragraphs (b)(1)(i), (ii), and (iv) of this section are satisfied, then
under paragraph (b)(3) of this section, the portion of the financing for
which A is not personally liable for repayment ($400) will be treated as
qualified nonrecourse financing secured by real property.
Example 3. Personal liability; tiered partnerships. (i) UTP1 and
UTP2, both limited liability companies classified as partnerships, are
the only general partners in Y, a limited partnership. Y borrows $500
with respect to the activity of holding real property. The financing is
a general obligation of Y. UTP1 and UTP2, therefore, are personally
liable to repay the financing. Under section 752, UTP1's share of the
financing is $300, and UTP2's share is $200. No person other than Y,
UTP1, and UTP2 is personally liable to repay the financing. Y, UTP1, and
UTP2 each hold only real property.
(ii) Under paragraph (b)(4) of this section, the personal liability
of Y, UTP1, and UTP2 to repay the financing is disregarded and, provided
the requirements of paragraphs (b)(1)(i), (ii), and (iv) of this section
are satisfied, UTP1's $300 share of the financing and UTP2's $200 share
of the financing will be treated as qualified nonrecourse financing
secured by real property.
Example 4. Personal liability; tiered partnerships. The facts are
the same as in Example 3, except that Y's general partners are UTP1 and
B, an individual. Because B, an individual, is also personally liable to
repay the $500 financing, the entire financing fails to satisfy the
requirement in paragraph (b)(1)(iii) of this section. Accordingly,
UTP1's $300 share of the financing will not be treated as qualified
nonrecourse financing secured by real property.
Example 5. Personal liability; tiered partnerships. The facts are
the same as in Example 3, except that Y is a limited liability company
and UTP1 and UTP2 are not personally liable for the debt. However, UTP1
and UTP2 each pledge property as security for the loan that is other
than real property used in the activity of holding real property and
other than property that is incidental to the activity of holding real
property. The fair market value of the property pledged by UTP1 and UTP2
is greater than 10 percent of the sum of the aggregate gross fair market
value of the property held by Y and the aggregate gross fair market
value of the property pledged by UTP1 and UTP2. Accordingly, the
financing fails to satisfy the requirement in paragraph (b)(1)(iii) of
this section by virtue of its failure to satisfy paragraph (b)(4)(iii)
of this section. Therefore, the financing is not qualified nonrecourse
financing secured by real property.
Example 6. Personal liability; Disregarded entity. (i) X is a single
member limited liability company that is disregarded as an entity
separate from its owner for federal tax purposes under Sec. 301.7701-3
of this chapter. X owns certain real property and property that is
incidental to the activity of holding the real property. X does not own
any other property. For federal tax purposes, A, the sole member of X,
is considered to own all of the property held by X and is engaged in the
activity of holding real property through X. X borrows $500 and uses the
proceeds to purchase additional real property that is used in the
activity of holding real property. X is personally liable to repay the
financing, but A is not personally liable for repayment of the financing
under local law. The lender may proceed against all of X's assets if X
defaults on the financing.
(ii) X is disregarded so that the assets and liabilities of X are
treated as the assets and liabilities of A. However, A is not personally
liable for the $500 liability. Provided that the requirements contained
in paragraphs (b)(1)(i), (ii), and (iv) of this section are satisfied,
the financing will be treated as qualified nonrecourse financing secured
by real property with respect to A.
(c) Effective date. This section is effective for any financing
incurred on or after August 4, 1998. Taxpayers, however, may apply this
section retroactively for financing incurred before August 4, 1998.
[T.D. 8777, 63 FR 41421, Aug. 4, 1998]
Sec. 1.466-1 Method of accounting for the redemption cost
of qualified discount coupons.
(a) Introduction. Section 466 permits taxpayers who elect to use the
method of accounting description in section 466 to deduct the redemption
cost (as defined in paragraph (b) of this section) of qualified discount
coupons (as defined in paragraph (c) of this section) outstanding at the
end of the taxable year and redeemed during the redemption period
(within the meaning of
[[Page 290]]
paragraph (d)(2) of this section) in addition to the redemption cost of
qualified discount coupons redeemed during the taxable year which were
not deducted for a prior taxable year. For the taxable year in which the
taxpayer first uses this method of accounting, the taxpayer is not
allowed to deduct the redemption costs of qualified discount coupons
redeemed during the taxable year that would have been deductible for the
prior taxable year had the taxpayer used this method of accounting for
such prior year. (See paragraph (e) of this section for rules describing
how this amount should be taken into account.) A taxpayer must use the
accrual method of accounting for any trade or business for which an
election is made under section 466. Furthermore, the taxpayer must make
an election in accordance with the rules in section 466(d) and Sec.
1.466-3 for that trade or business. The method of accounting in section
466 is applicable only to the taxpayer's redemption of qualified
discount coupons. Section 466 does not apply to trading stamps or
premium coupons, which are subject to the method of accounting in Sec.
1.451-4, or to discount coupons that are not qualified discount coupons.
(b) Redemption costs--(1) Costs deductible under section 466. The
deduction allowed by section 466 applies only to the redemption cost of
qualified discount coupons. The term ``redemption cost'' means an amount
equal to:
(i) The lesser of:
(A) The amount of the discount stated on the coupon, or
(B) The cost incurred by the taxpayer for paying the discount; plus
(ii) The amount payable to the retailer (or other person redeeming
the coupon from the person receiving the price discount) for services in
redeeming the coupon.
The amount payable to the retailer or other person for services in
redeeming the coupon is allowed only if the amount payable is stated on
the coupon.
(2) Costs not deductible under section 466. The term ``redemption
cost'' includes only the amounts stated in paragraph (b)(1) of this
section. Amounts other than those mentioned in paragraph (b)(1) of this
section cannot be deducted under the method of accounting described in
section 466 even though such amounts are incurred in relation to the
redemption of qualified discount coupons. Therefore, those amounts must
be taken into account as if section 466 did not apply. Examples of such
amounts are fees paid to the redemption center or clearinghouse and
amounts payable to the retailer in excess of the amount stated on the
coupon.
(c) Qualified discount coupons--(1) General rule. In order for a
discount coupon (as defined in paragraph (c)(2)(i) of this section) to
be considered a qualified discount coupon, all of the following
requirements must be met:
(i) The coupon must have been issued by and must be redeemable by
the taxpayer;
(ii) The coupon must allow a discount on the purchase price of
merchandise or other tangible personal property;
(iii) The face amount of the coupon must not exceed five dollars;
(iv) The coupon, by its terms, may not be used with other coupons to
bring about a price discount reimbursable by the issuer of more than
five dollars with respect to any item; and
(v) There must exist a redemption chain (as defined in paragraph
(c)(2)(ii) of this section) with respect to the coupon.
(2) Definitions--(i) Discount coupon. A discount coupon is a sales
promotion device used to encourage the purchase of a specific product by
allowing a purchaser of that product to receive a discount on its
purchase price. The term ``discount coupon'' does not include trading
stamps or premium coupons, which are subject to the method of accounting
in Sec. 1.451-4. A discount coupon may or may not be issued as part of
a prior purchase. A discount coupon normally entitles its holders to
receive nothing more than a reduction in the sales price of one of the
issuer's products. The discount may be stated in terms of a cash amount,
a percentage or fraction of the purchase price, a ``two for the price of
one'' deal, or any other similar provision. A discount coupon need not
be printed on paper in the form usually associated with coupons; it may
be a token or other object so long as it functions as a coupon.
[[Page 291]]
(ii) Redemption chain. A redemption chain exists when the issuer
redeems the coupon from some person other than the customer who used the
coupon to receive the price discount. Thus, in order to be treated as a
qualified discount coupon, the coupon must not be issued by the person
that initially redeems the coupon from the customer. For purposes of
determining whether a redemption chain exists, corporations that are
members of the same controlled group of corporations (as defined in
section 1563(a)) as the issuer of the coupon shall be treated as the
issuer. Thus, if the issuer of the coupon and the retailer that
initially redeems the coupon from the customer are members of the same
controlled group of corporations, the coupon shall not be treated as a
qualified discount coupon.
(d) Deduction for coupons redeemed during the redemption period--(1)
General rule. Two special conditions must be met before the cost of
redeeming qualified discount coupons during the redemption period can be
deducted from the taxpayer's gross income for the taxable year preceding
the redemption period. First, the qualified discount coupons must have
been outstanding at the close of such taxable year. Second, the
qualified discount coupons must have been received by the taxpayer
before the close of the redemption period for that taxable year.
(2) Redemption period. The taxpayer can select any redemption period
so long as the period does not extend longer than 6 months after the
close of the taxapayer's taxable year. A change in the redemption period
so selected shall be treated as a change in method of accounting.
(3) Coupons received. The deduction provided for in section
466(a)(1) is limited to the redemption costs associated with coupons
that are actually received by the taxpayer within the redemption period.
For purposes of this paragraph, if the issuer uses a redemption agent or
clearinghouse to group, count, and verify coupons after they have been
redeemed by a retailer, the coupons received by the redemption agent or
clearinghouse will be
considered to have been received by the issuer. Nothing in section 466,
however, allows deductions to be made on the basis of estimated
redemptions, whether such estimates are made by either the issuer or
some other party.
(e) Transitional adjustment--(1) In general. An election to change
from some other method of accounting for the redemption of discount
coupons to the method of accounting described in section 466 is a change
in method of accounting that requires a transitional adjustment. Unless
the taxpayer can qualify for a waiver of the suspense account
requirement as provided for in section 373(c) of the Revenue Act of 1978
(92 Stat. 2865), the taxpayer should compute the transitional adjustment
described in section 481(a)(2) according to the rules contained in this
section. This adjustment should be taken into account according to the
special rules in subsections (e) and (f) of section 466.
(2) Net increase in taxable income. In the case of a transitional
adjustment that would result in a net increase in taxable income under
section 481(a)(2) for the year of change, that increase should be taken
into income over a ten-year period consisting of the year of change and
the immediately succeeding nine taxable years. For example, assume that
A, a calendar year taxpayer, makes an election to use the method of
accounting described in section 466 for the year 1980 and for subsequent
years. Assume further that the amount of the transitional adjustment
computed under section 481(a)(2) would result in a net increase in
taxable income of $100 for 1980. Under these facts, A should increase
taxable income for 1980 and each of the next nine taxable years by $10.
(3) Suspense account--(i) In general. In the case of a transitional
adjustment that would result in a net decrease in taxable income under
section 481(a)(2) for the year of change, in lieu of applying section
481, the taxpayer must establish a separate suspense account for each
trade or business for which the taxpayer has made an election to use
section 466. The computation of the initial opening balance in the
suspense account is described in paragraph (e)(3)(ii)(A) of this
section. An initial adjustment to gross income for the
[[Page 292]]
year of election is described in paragraph (e)(3)(ii)(B) of this
section. Annual adjustments to the suspense account are described in
paragraph (e)(3)(iii)(A) of this section, and gross income adjustments
are described in paragraph (e)(3)(iii)(B) of this section. Examples are
provided in paragraph (e)(4) of this section. The effect of the suspense
account is to defer some part of, or all of, the deduction of the
transitional adjustment until the taxpayer no longer redeems discount
coupons in connection with the trade or business to which the suspense
account relates.
(ii) Establishing a suspense account--(A) Initial opening balance.
To compute the initial opening balance of the suspense account for the
first taxable year for which the election to use section 466 is
effective, the taxpayer must determine the dollar amount of the
deduction that would have been allowed for qualified discount coupon
redemption costs during the redemption period for each of the three
immediately preceding taxable years had the election to use section 466
been in effect for those years. The initial opening balance of the
suspense account is the largest such dollar amount reduced by the sum of
the adjustments attributable to the change in method of accounting that
increase income for the year of change.
(B) Initial year adjustment. If, in computing the initial opening
balance, the largest dollar amount of deduction that would have been
allowed in any of the three prior years exceeds the actual cost of
redeeming qualified discount coupons received during the redemption
period following the close of the year immediately preceding the year of
election, the excess is included in income in the year of election.
Section 481(b) does not apply to this increase in gross income.
(iii) Annual adjustments--(A) Adjustment to the suspense account.
Adjustments are made to the suspense account each year to account for
fluctuations in coupon redemptions. To compute the annual adjustment,
the taxpayer must determine the amount to be deducted under section
466(a)(1) for the taxable year. If the amount is less than the opening
balance in the suspense account for the taxable year, the balance in the
suspense account is reduced by the difference. Conversely, if such
amount is greater than the opening balance in the suspense account for
the taxable year, the account is increased by the difference (but not to
an amount in excess of the initial opening balance described in
paragraph (e)(3)(ii) of this section). Therefore, the balance in the
suspense account will never be greater than the initial opening balance
in the suspense account determined in paragraph (e)(3)(ii) of this
section. However, the balance in the suspense account after adjustments
may be less than this initial opening balance in the suspense account.
(B) Gross income adjustments. Adjustments to the suspense account
for years subsequent to the year of the election also produce
adjustments in the taxpayer's gross income. Adjustments which reduce the
balance in the suspense account reduce gross income for the year in
which the adjustment to the suspense account is made. Adjustments which
increase the balance in the suspense account increase gross income for
the year in which the adjustment to the suspense account is made.
(4) Examples. (i) The provisions of paragraph (e)(3) of this section
may be illustrated by the following examples:
Example 1. Assume that the issuer of qualified discount coupons
makes a timely election under section 466 for its taxable year ending
December 31, 1979, and does not select a coupon redemption period
shorter than the statutory period of 6 months. Assume further that the
taxpayer's qualified discount coupon redemption costs in the first 6
months of 1977, 1978, and 1979 were $7, $13, and $8 respectively, and
that the accounting change adjustments that increase income for 1979 are
$10. Since the accounting change adjustment that increases income for
1979, ($10), is greater than the taxpayer's discount coupon redemptions
during the first 6 months of 1979 ($8), the net section 481(a)(2)
adjustment for the year of change results in a positive adjustment.
Because of this, a suspense account is not required. The taxpayer should
instead follow the rules in section 466(f) and in paragraph (e)(2) of
this section in order to take this positive transitional adjustment into
account.
Example 2. Assume the same facts as in Example 1, except that the
sum of the accounting change adjustments that increase income for 1979
is equal to $2. Under these facts the initial opening balance in the
suspense account on January 1, 1979 would be $11 (that
[[Page 293]]
is, the largest dollar amount of qualified coupon redemption costs in
the pertinent years ($13), reduced by the sum of the accounting change
adjustments that increase income in the year of change ($2)). Since the
coupon redemption costs taken into account in determining the initial
opening balance ($13 in 1979) exceed the actual redemption costs in the
first 6 months of the taxable year for which the election is first
effective ($8 in 1979), the excess of $5 is added to gross income for
the year of election (1979).
Example 3. Assume, in addition to the facts of Example 2, that
coupon redemption costs during the redemption period for the 1979
taxable year are $7. Since the qualifying redemption costs ($7) during
the redemption period for the taxable year are less than the opening
balance in the suspense account ($11) the taxpayer must reduce the
suspense account balance by the difference ($4). The taxpayer is also
allowed to take a deduction equal to the amount of this adjustment to
the suspense account. Thus, the net amount deductible for the 1979
taxable year after taking into account the coupon redemptions during the
redemption period, the amount deductible because of the decrease in the
suspense account, and the initial year adjustment determined in Example
2 is $6 ($7 + $4-$5).
Example 4. Assume, in addition to the facts of Example 3, that
coupon redemption costs during the redemption period for the 1980
taxable year are $10. Since the qualifying redemption costs during the
redemption period for the taxable year ($10) exceed the opening balance
of the suspense account at the beginning of the taxable year ($7), the
suspense account must be increased by the difference ($3). The taxpayer
must also include $3 in gross income for the taxable year. Thus, the net
amount deductible for the 1980 taxable year is $7 ($10-$3).
Example 5. Assume, in addition to the facts of Example 4, that
coupon redemption costs during the redemption period for the 1981
taxable year are $12. Since the qualifying redemption costs for the 1961
taxable year ($12) exceed the opening balance of the suspense account at
the beginning of the taxable year ($10), the suspense account must be
increased by the difference ($2) but not above the initial opening
balance ($11). Thus, the taxpayer will increase the balance by $1. The
taxpayer must also include $1 in gross income for the taxable year.
Thus, the net amount deductible for the 1981 taxable year is $11 ($12-
$1).
(ii) The following table summarizes examples (2) through (5):
------------------------------------------------------------------------
Years ending Dec. 31--
-----------------------------------------
1977 1978 1979 1980 1981 1982
------------------------------------------------------------------------
Facts:
Actual coupon redemption $7 $13 $8 $7 $10 $12
costs in first six months
Accounting change ..... ..... 2 ..... ..... .....
adjustments that increase
income in year of change.
-----------------------------------------
Net adjustment decreasing ..... ..... 6 ..... ..... .....
income in year of change
under sec. 481(a)(2).....
-----------------------------------------
Adjustment to suspense
account:
Opening balance........... ..... ..... 11 7 10 11
Addition to account....... ..... ..... ..... 3 1 .....
Reduction to account...... ..... ..... (4) ..... ..... .....
-----------------------------------------
Opening balance for ..... ..... 7 10 11 .....
next year............
-----------------------------------------
Amount deductible:
Initial year adjustment... ..... ..... (5) ..... ..... .....
Amount of deductible as ..... ..... 7 10 12 .....
actual coupon redemptions
during redemption period.
Adjustment for increase in ..... ..... ..... (3) (1) .....
suspense account.........
Adjustment for decrease in ..... ..... 4 ..... ..... .....
suspense account.........
-----------------------------------------
Net amount deductible ..... ..... 6 7 11 .....
for the year for
coupons redeemed
during the redemption
period...............
------------------------------------------------------------------------
(f) Subchapter C transactions--(1) General rule. If a transfer of
substantially all the assets of a trade or business in which discount
coupons are redeemed is made to an acquiring corporation, and if the
acquiring corporation determines its bases in these assets, in whole or
part, with reference to the basis of these assets in the hands of the
transferor, then for the purposes of section 466(e) the principles of
section 381 and Sec. 1.381(c)(4)-1 will apply. The application of this
rule is not limited to the transactions described in section 381(a).
[[Page 294]]
Thus, the rule also applies, for example, to transactions described in
section 351.
(2) Special rules. If, in the case of a transaction described in
paragraph (f)(1) of this section, an acquiring corporation acquires
assets that were used in a trade or business that was not subject to a
section 466 election from a transferor that is owned or controlled
directly (or indirectly through a chain of corporations) by the same
interests, and if the acquiring corporation uses the acquired assets in
a trade or business for which the acquiring corporation later makes an
election to use section 466, then the acquiring corporation must
establish a suspense account by taking into account not only its own
experience but also the transferor's experience when the transferor held
the assets in its trade or business. Furthermore, the transferor is not
allowed a deduction for qualified discount coupons redeemed after the
date of the transfer attributable to discount coupons issued by the
transferor before the date of the transfer. Such redemptions shall be
considered to be made by the acquiring corporation.
(3) Example. The provisions of paragraph (f)(2) of this section may
be illustrated by the following example:
Example. Corporation S, a calendar year taxpayer, is a wholly owned
subsidiary of Corporation P, a calendar year taxpayer. On December 31,
1982, S acquires from P sustantially all of the assets used in a trade
or business in which qualified disount coupons are redeemed. P had not
made an election under section 466 with respect to the redemption costs
of the qualified discount coupons issued in connection with that trade
or business. S makes an election to use section 466 for its taxable year
ending December 31, 1983, for the trade or business in which the
acquired assets are used, and selects a redemption period of 6 months.
Assume that P's qualified discount coupon redemption costs in the first
6 months of 1981 and 1982 were $120 and $140 respectively. Assume
further that S's qualified discount coupon redemption costs in the first
6 months of 1983 were $130, and that there are no accounting change
adjustments that increase income with respect to the election. S must
establish a suspense account by taking into account the largest dollar
amount of deductions that would have been allowed under section
466(a)(1) for the 3 immediately preceding taxable years of P, including
both P's and S's experience with respect to costs actually incurred
during the redemption periods relating to those years. Thus, the initial
opening balance of S's suspense account is $140. S must also make an
initial year adjustment of $10 ($140-$130), which S must include in
income for S's taxable year ending December 31, 1983. P may not take a
deduction for the qualified coupon redemptions made after December 31,
1982, that are attributable to coupons issued by P before December 31,
1982. Thus, none of the $130 qualified discount coupon redemption costs
incurred by S during the first six months of 1983 may be deducted by P.
[T.D. 8022, 50 FR 18474, May 1, 1985, as amended at 50 FR 21046, May 22,
1985]
Sec. 1.466-2 Special protective election for certain taxpayers.
(a) General rule. Section 373(c) of the Revenue Act of 1978 (92
Stat. 2865) allows certain taxpayers, who in prior years have accounted
for discount coupons under a method of accounting reasonably similar to
the method described in Sec. 1.451-4, to elect to treat that method of
accounting as a proper one for those prior years. There are several
differences between this protective election and the section 466(d)
election. First, the protective election applies only to a single
continuous period of taxable years the last year of which ends before
January 1, 1979. Second, an otherwise qualifying protective election may
apply to coupons which are discount coupons but which would not be
treated as qualified discount coupons under Code section 466. Third,
certain expenses such as the cost of redemption center service fees, and
amounts that are payable to the retailer (or other person redeeming the
coupons from the person receiving the price discount) for services in
redeeming the coupons but that are not stated on the coupon, can be
subtracted from gross receipts for prior years covered by a protective
election (if treated as deductible under the accounting method for such
years), even though such expenses would not be deductible under Code
section 466.
(b) Requirements. In order to qualify for this special protective
election, the following conditions must be met:
(1) For a continuous period of one or more prior taxable years, (the
last year of which ends before Jan. 1, 1979), the taxpayer must have
used a method of accounting for discount coupons that is
[[Page 295]]
reasonably similar to the method provided in Sec. 1.451-4 or its
predecessors under the Internal Revenue Code of 1954;
(2) The taxpayer must make an election under section 466 of the
Internal Revenue Code of 1954 according to the rules contained in Sec.
1.466-3 for its first taxable year ending after December 31, 1978; and
(3) The taxpayer must make an election under section 373(c) of the
Revenue Act of 1978 according to the rules contained in Sec. 1.466-4
for its first taxable year ending after December 31, 1978.
(c) Amount to be subtracted from gross receipts. The amount the
taxpayer may subtract under this section for the redemption costs of
coupons shall include only:
(1) Costs of the type permitted by Sec. 1.451-4 to be included in
the estimated average cost of redeeming coupons, plus
(2) Any amount designated or referred to on the coupon payable by
the taxpayer to the person who allowed the discount on a sale by such
person to the user of the coupon.
Nothing in this paragraph shall allow an item to be deducted more than
once.
(d) Right to amend prior tax returns. This paragraph applies only to
those taxpayers who have agreed in a prior year to discontinue the use
of the method of accounting described in Sec. 1.451-4 for discount
coupon redemptions. If the taxpayer used such method of accounting on
the original return filed for the prior taxable year, and if any such
year is not closed under the statute of limitations or by reason of a
closing agreement with the Internal Revenue Service, a taxpayer who has
made a protective election may file an amended return and a claim for
refund for such years. In this amended return, the taxpayer should
account for its discount coupon redemptions, according to the method of
accounting described in Sec. 1.451-4. This is not to be construed,
however, to abrogate in any way the rules regarding the close of taxable
years due to the statute of limitations or a binding closing agreement
between the Internal Revenue Service and the taxpayer.
(e) Suspense account not required. If the following three conditions
are satisfied, the taxpayer need not establish the suspense account
otherwise required by section 466(e). First, the taxpayer must make a
timely election under these rules to protect prior years. Second, the
method of accounting used in those years must have been used for all
discount coupons issued by the taxpayer in those years in all the
taxpayer's separate trades or
businesses in which coupons were issued. Third, either before or after
an amendment to the taxpayer's tax returns as described in paragraph (d)
of this section, a method of accounting reasonably similar to the method
of accounting described in Sec. 1.451-4 must have been used for the
taxable year ending on or before December 31, 1978. If these conditions
are met, the taxpayer will treat the election of the method under
section 466 as a change in method of accounting to which the rules in
section 481 and the regulations thereunder apply.
(f) Definition: reasonably similar. For purposes of paragraphs
(b)(1) and (e) of this section, a taxpayer will be considered to have
used a method of accounting for discount coupons that is ``reasonably
similar'' to the method of accounting provided in Sec. 1.451-4 if the
taxpayer followed the method of accounting described in Sec. 1.451-4 as
if that method were a valid method of accounting for discount coupon
redemptions.
[T.D. 8022, 50 FR 18476, May 1, 1985]
Sec. 1.466-3 Manner of and time for making election under section 466.
(a) In general. Section 466 provides a special method of accounting
for accrual basis taxpayers who issue qualified discount coupons (as
defined in section 466(b)). In order to use the special method under
section 466, a taxpayer must make an election with respect to the trade
or business in connection with which the qualified discount coupons are
issued. If a taxpayer issues qualified discount coupons in connection
with more than one trade or business, the taxpayer may use the special
method of accounting under section 466 only with respect to the
qualified discount coupons issued in
[[Page 296]]
connection with a trade or business for which an election is made. The
election must be made in the manner prescribed in this section. The
election does not require the prior consent of the Internal Revenue
Service. An election under section 466 is effective for the taxable year
for which it is made and for all subsequent taxable years, unless the
taxpayer secures the prior consent of the Internal Revenue Service to
revoke such election.
(b) Manner of and time for making election--(1) General rule. Except
as provided in paragraph (b)(2) of this section, an election is made
under section 466 and this section by filing a statement of election
containing the information described in paragraph (c) of this section
with the taxpayer's income tax return for the taxpayer's first taxable
year for which the election is made. The election must be made not later
than the time prescribed by law (including extensions thereof) for
filing the income tax return for the first taxable year for which the
election is made. Thus, the election may not be made for a taxable year
by filing an amended income tax return after the time prescribed
(including extensions) for filing the original return for such year.
(2) Transitional rule. If the last day of the time prescribed by law
(including extensions thereof) for filing a taxpayer's income tax return
for the taxpayer's first taxable year ending after December 31, 1978,
falls before December 3, 1979, and the taxpayer does not make an
election under section 466 with respect to such taxable year in the
manner prescribed by paragraph (b)(1) of this section, an election is
made under section 466 and this section with respect to such taxable
year if--
(i) Within the time prescribed by law (including extensions thereof)
for filing the taxpayer's income tax return for such taxable year, the
taxpayer has made a reasonable effort to notify the Commissioner of the
taxpayer's intent to make an election under section 466 with respect to
such taxable year, and
(ii) Before January 2, 1980, the taxpayer files a statement of
election
containing the information described in paragraph (c) of this section to
be associated with the taxpayer's income tax return for such taxable
year.
For purposes of paragraph (b)(2)(i) of this section, a reasonable effort
to notify the Commissioner of an intent to make an election under
section 466 with respect to a taxable year includes the timely filing of
an income tax return for such taxable year if the taxable income
reported on the return reflects a deduction for the redemption costs of
qualified discount coupons as determined under section 466(a).
(c) Required information. The statement of election required by
paragraph (b) of this section must indicate that the taxpayer
(identified by name, address, and taxpayer identification number) is
making an election under section 466 and must set forth the following
information:
(1) A description of each trade or business for which the election
is made;
(2) The first taxable year for which the election is made;
(3) The redemption period (as defined in section 466(c)(2)) for each
trade or business for which the election is made;
(4) If the taxpayer is required to establish a suspense account
under section 466(e) for a trade or business for which the election is
made, the initial opening balance of such account (as defined in section
466(e)(2)) for each such trade or business; and
(5) In the case of an election under section 466 that results in a
net increase in taxable income under section 481(a)(2), the amount of
such net increase.
The statement of election should be made on a Form 3115, which need
contain no information other than that required by this paragraph or
paragraph (c) of Sec. 1.466-4.
[T.D. 8022, 50 FR 18477, May 1, 1985]
Sec. 1.466-4 Manner of and time for making election under section 373(c)
of the Revenue Act of 1978.
(a) In general. Section 373(c)(2) of the Revenue Act of 1978 (92
Stat. 2865) provides an election for taxpayers who satisfy the
requirements of section 373(c)(2)(A) (i) and (ii) of the Act. The
election is made with respect to a
[[Page 297]]
method of accounting for the redemption costs of discount coupons used
by the electing taxpayer in a continuous period of one or more taxable
years ending before January 1, 1979. The election must be made in the
manner prescribed by this section. The election does not require the
prior consent of the Internal Revenue Service.
(b) Manner of and time for making election--(1) General rule. Except
as provided in paragraph (b)(2) of this section, the election under
section 373(c) of the Revenue Act of 1978 is made by filing a statement
of election containing the information described in paragraph (c) of
this section with the taxpayer's income tax return for the taxpayer's
first taxable year ending after December 31, 1978. The election must be
made not later than the time prescribed by law (including extensions
thereof) for filing the income tax return for the taxpayer's first
taxable year ending after December 31, 1978. Thus, the election may not
be made with an amended income tax return for such year filed after the
time prescribed (including extensions) for filing the original return.
(2) Transitional rule. If the last day of the time prescribed by law
(including extensions thereof) for filing a taxpayer's income tax return
for the taxpayer's first taxable year ending after December 31, 1978,
falls before December 3, 1979, and the taxpayer does not make an
election in the manner prescribed by paragraph (b)(1) of this section,
an election is made under section 373(c) of the Act and this section
with respect to a continuous period if--
(i) Within the time prescribed by law (including extensions thereof)
for filing the taxpayer's income tax return for the taxpayer's first
taxable year ending after December 31, 1978, the taxpayer has made a
reasonable effort to notify the Commissioner of the taxpayer's intent to
make election under section 373(c) of the Act with respect to the
continuous period, and
(ii) Before January 2, 1980, the taxpayer files a statement of
election containing the information described in paragraph (c) of this
section to be associated with the taxpayer's income tax return for the
taxpayer's first taxable year ending after December 31, 1978.
(c) Required information. The statement of election required by
paragraph (b) of this section must indicate that the taxpayer
(identified by name, address, and taxpayer identification number) is
making an election under section 373(c) of the Revenue Act of 1978 and
must set forth the taxable years in the continuous period for which the
election is made. The statement of election should be made on the same
form 3115 on which the taxpayer has made a statement of election under
section 466. The Form 3115 need contain no information other than that
required by this paragraph or paragraph (c) of Sec. 1466-3.
[T.D. 8022, 50 FR 18478, May 1, 1985]
Sec. 1.467-0 Table of contents.
This section lists the captions that appear in Sec. Sec. 1.467-1
through 1.467-9.
Sec. 1.467-1 Treatment of lessors and lessees generally.
(a) Overview.
(1) In general.
(2) Cases in which rules are inapplicable.
(3) Summary of rules.
(i) Basic rules.
(ii) Special rules.
(4) Scope of rules.
(5) Application of other authorities.
(b) Method of accounting for section 467 rental agreements.
(c) Section 467 rental agreements.
(1) In general.
(2) Increasing or decreasing rent.
(i) Fixed rent.
(A) In general.
(B) Certain rent holidays disregarded.
(ii) Fixed rent allocated to a rental period.
(A) Specific allocation.
(1) In general.
(2) Rental agreements specifically allocating fixed rent.
(B) No specific allocation.
(iii) Contingent rent.
(A) In general.
(B) Certain contingent rent disregarded.
(3) Deferred or prepaid rent.
(i) Deferred rent.
(ii) Prepaid rent.
(iii) Rent allocated to a calendar year.
(iv) Examples.
(4) Rental agreements involving total payments of $250,000 or less.
(i) In general.
(ii) Special rules in computing amount described in paragraph
(c)(4)(i) of this section.
(d) Section 467 rent.
(1) In general.
(2) Fixed rent for a rental period.
[[Page 298]]
(i) Constant rental accrual.
(ii) Proportional rental accrual.
(iii) Section 467 rental agreement accrual.
(e) Section 467 interest.
(1) In general.
(2) Interest on fixed rent for a rental period.
(i) In general.
(ii) Section 467 rental agreements with adequate interest.
(3) Treatment of interest.
(f) Substantial modification of a rental agreement.
(1) Treatment as new agreement.
(i) In general.
(ii) Limitation.
(2) Post-modification agreement; in general.
(3) Other effects of a modification.
(4) Special rules.
(i) Carryover of character; leasebacks.
(ii) Carryover of character; long-term agreements.
(iii) Carryover of character; disqualified agreements.
(iv) Allocation of rent.
(v) Difference between aggregate rent and interest and aggregate
payments.
(A) In general.
(B) Constant rental accrual prior to the modification.
(C) Agreements described in this paragraph (f)(4)(v)(C).
(vi) Principal purpose of tax avoidance.
(5) Definitions.
(6) Safe harbors.
(7) Special rules for certain transfers.
(i) In general.
(ii) Exception.
(g) Treatment of amounts payable by lessor to lessee.
(1) Interest.
(2) Other amounts. [Reserved]
(h) Meaning of terms.
(i) [Reserved]
(j) Computational rules.
(1) Counting conventions.
(2) Conventions regarding timing of rent and payments.
(i) In general.
(ii) Time amount is payable.
(3) Annualized fixed rent.
(4) Allocation of fixed rent within a period.
(5) Rental period length.
Sec. 1.467-2 Rent accrual for section 467 rental agreements without
adequate interest.
(a) Section 467 rental agreements for which proportional rental
accrual is required.
(b) Adequate interest on fixed rent.
(1) In general.
(2) Section 467 rental agreements that provide for a variable rate
of interest.
(3) Agreements with both deferred and prepaid rent.
(c) Computation of proportional rental amount.
(1) In general.
(2) Section 467 rental agreements that provide for a variable rate
of interest.
(d) Present value.
(e) Applicable Federal rate.
(1) In general.
(2) Source of applicable Federal rates.
(3) 110 percent of applicable Federal rate.
(4) Term of the section 467 rental agreement.
(i) In general.
(ii) Section 467 rental agreements with variable interest.
(f) Examples.
Sec. 1.467-3 Disqualified leasebacks and long-term agreements.
(a) General rule.
(b) Disqualified leaseback or long-term agreement.
(1) In general.
(2) Leaseback.
(3) Long-term agreement.
(i) In general.
(ii) Statutory recovery period.
(A) In general.
(B) Special rule for rental agreements relating to properties having
different statutory recovery periods.
(c) Tax avoidance as principal purpose for increasing or decreasing
rent.
(1) In general.
(2) Tax avoidance.
(i) In general.
(ii) Significant difference in tax rates.
(iii) Special circumstances.
(3) Safe harbors.
(4) Uneven rent test.
(i) In general.
(ii) Special rule for real estate.
(iii) Operating rules.
(d) Calculating constant rental amount.
(1) In general.
(2) Initial or final short periods.
(3) Method to determine constant rental amount; no short periods.
(i) Step 1.
(ii) Step 2.
(iii) Step 3.
(e) Examples.
Sec. 1.467-4 Section 467 loan.
(a) In general.
(1) Overview.
(2) No section 467 loan in the case of certain section 467 rental
agreements.
(3) Rental agreements subject to constant rental accrual.
(4) Special rule in applying the provisions of Sec. 1.467-7 (e),
(f), or (g).
(b) Principal balance.
(1) In general.
(2) Section 467 rental agreements that provide for prepaid fixed
rent and adequate interest.
(3) Timing of payments.
[[Page 299]]
(c) Yield.
(1) In general.
(i) Method of determining yield.
(ii) Method of stating yield.
(iii) Rounding adjustments.
(2) Yield of section 467 rental agreements for which constant rental
amount or proportional rental amount is computed.
(3) Yield for purposes of applying paragraph (a)(4) of this section.
(4) Determination of present values.
(d) Contingent payments.
(e) Section 467 rental agreements that call for payments before or
after the lease term.
(f) Examples.
Sec. 1.467-5 Section 467 rental agreements with variable interest.
(a) Variable interest on deferred or prepaid rent.
(1) In general.
(2) Exceptions.
(b) Variable rate treated as fixed.
(1) In general.
(2) Variable interest adjustment amount.
(i) In general.
(ii) Positive or negative adjustment.
(3) Section 467 loan balance.
(c) Examples.
Sec. 1.467-6 Section 467 rental agreements with contingent payments.
[Reserved]
Sec. 1.467-7 Section 467 recapture and other rules relating to
dispositions and modifications.
(a) Section 467 recapture.
(b) Recapture amount.
(1) In general.
(2) Prior understated inclusion.
(3) Section 467 gain.
(i) In general.
(ii) Certain dispositions.
(c) Special rules.
(1) Gifts.
(2) Dispositions at death.
(3) Certain tax-free exchanges.
(i) In general.
(ii) Dispositions covered.
(A) In general.
(B) Transfers to certain tax-exempt organizations.
(4) Dispositions by transferee.
(5) Like-kind exchanges and involuntary conversions.
(6) Installment sales.
(7) Dispositions covered by section 170(e), 341(e)(12), or 751(c).
(d) Examples.
(e) Other rules relating to dispositions.
(1) In general.
(2) Treatment of section 467 loan.
(3) [Reserved]
(4) Examples.
(f) Treatment of assignments by lessee and lessee-financed renewals.
(1) Substitute lessee use.
(2) Treatment of section 467 loan.
(3) Lessor use.
(4) Examples.
(g) Application of section 467 following a rental agreement
modification.
(1) Substantial modifications.
(i) Treatment of pre-modification items.
(ii) Computations with respect to post-modification items.
(iii) Adjustments.
(A) Adjustment relating to certain prepayments.
(B) Adjustment relating to retroactive beginning of lease term.
(iv) Coordination with rules relating to dispositions and
assignments.
(A) Dispositions.
(B) Assignments.
(2) Other modifications.
(i) Computation of section 467 loan for modified agreement.
(ii) Change in balance of section 467 loan.
(iii) Section 467 rent and interest after the modification.
(iv) Applicable Federal rate.
(v) Modification effective within a rental period.
(vi) Other adjustments.
(vii) Coordination with rules relating to dispositions and
assignments.
(viii) Exception for agreements entered into prior to effective date
of section 467.
(3) Adjustment by Commissioner.
(4) Effective date of modification.
(5) Examples.
(h) Omissions or duplications.
(1) In general.
(2) Example.
Sec. 1.467-8 Automatic consent to change to constant rental accrual for
certain rental agreements.
(a) General rule.
(b) Agreements to which automatic consent applies.
Sec. 1.467-9 Effective dates and automatic method changes for certain
agreements.
(a) In general.
(b) Automatic consent for certain rental agreements.
(c) Application of regulation project IA-292-84 to certain
leasebacks and long-term agreements.
(d) Entered into.
(e) Change in method of accounting.
(1) In general.
(2) Application of regulation project IA-292-84.
(3) Automatic change procedures.
[T.D. 8820, 64 FR 26851, May 18, 1999, as amended by T.D. 8917, 66 FR
1039, Jan. 5, 2001]
Sec. 1.467-1 Treatment of lessors and lessees generally.
(a) Overview--(1) In general. When applicable, section 467 requires
a lessor
[[Page 300]]
and lessee of tangible property to treat rents consistently and to use
the accrual method of accounting (and time value of money principles)
regardless of their overall method of accounting. In addition, in
certain cases involving tax avoidance, the lessor and lessee must take
rent and stated or imputed interest into account under a constant rental
accrual method, pursuant to which the rent is treated as accruing
ratably over the entire lease term.
(2) Cases in which rules are inapplicable. Section 467 applies only
to leases (or other similar arrangements) that constitute section 467
rental agreements as defined in paragraph (c) of this section. For
example, a rental agreement is not a section 467 rental agreement, and,
therefore, is not subject to the provisions of this section and
Sec. Sec. 1.467-2 through 1.467-9 (the section 467 regulations), if it
specifies equal amounts of rent for each month throughout the lease term
and all payments of rent are due in the calendar year to which the rent
relates (or in the preceding or succeeding calendar year). In addition,
the section 467 regulations do not apply to a rental agreement that
requires total rents of $250,000 or less. For purposes of determining
whether the agreement has total rents of $250,000 or less, certain
specified contingent rent is disregarded.
(3) Summary of rules--(i) Basic rules. Paragraph (c) of this section
provides rules for determining whether a rental agreement is a section
467 rental agreement. Paragraphs (d) and (e) of this section provide
rules for determining the amount of rent and interest, respectively,
required to be taken into account by a lessor and lessee under a section
467 rental agreement. Paragraphs (f) through (h) and (j) of this section
provide various definitions and special rules relating to the
application of the section 467 regulations. Paragraph (i) of this
section is reserved.
(ii) Special rules. Section 1.467-2 provides rules for section 467
rental agreements that have deferred or prepaid rents without providing
for adequate interest. Section 1.467-3 provides rules for application of
the constant rental accrual method, including criteria for determining
whether an agreement is subject to this method. Section 1.467-4 provides
rules for establishing and adjusting a section 467 loan (the amount that
a lessor is deemed to have loaned to the lessee, or vice versa, pursuant
to the application of the section 467 regulations). Section 1.467-5
provides rules for applying the section 467 regulations where a rental
agreement requires payments of interest at a variable rate. Section
1.467-6, relating to the treatment of certain section 467 rental
agreements with contingent payments, is reserved. Section 1.467-7
provides rules for the treatment of dispositions by a lessor of property
subject to a section 467 rental agreement and the treatment of
assignments by lessees and certain lessee-financed renewals of a section
467 rental agreement. Section 1.467-7 also provides rules for the
treatment of modified rental agreements. Section 1.467-8 provides
special transitional rules relating to the method of accounting for
certain rental agreements entered into on or before May 18, 1999.
Finally, Sec. 1.467-9 provides the effective date rules for the section
467 regulations.
(4) Scope of rules. No inference should be drawn from any provision
of this section or Sec. Sec. 1.467-2 through 1.467-9 concerning
whether--
(i) For Federal tax purposes, an arrangement constitutes a lease; or
(ii) For Federal tax purposes, any obligation of the lessee under a
rental agreement is treated as rent.
(5) Application of other authorities. Notwithstanding section 467
and the regulations thereunder, other authorities such as section 446(b)
clear-reflection-of-income principles, section 482, and the substance-
over-form doctrine, may be applied by the Commissioner to determine the
income and expense from a rental agreement (including the proper
allocation of fixed rent under a rental agreement).
(b) Method of accounting for section 467 rental agreements. If a
rental agreement is a section 467 rental agreement, as described in
paragraph (c) of this section, the lessor and lessee must each take into
account for any taxable year the sum of--
[[Page 301]]
(1) The section 467 rent for the taxable year (as defined in
paragraph (d) of this section); and
(2) The section 467 interest for the taxable year (as defined in
paragraph (e) of this section).
(c) Section 467 rental agreements--(1) In general. Except as
otherwise provided in paragraph (c)(4) of this section, the term section
467 rental agreement means a rental agreement, as defined in paragraph
(h)(12) of this section, that has increasing or decreasing rents (as
described in paragraph (c)(2) of this section), or deferred or prepaid
rents (as described in paragraph (c)(3) of this section).
(2) Increasing or decreasing rent--(i) Fixed rent--(A) In general. A
rental agreement has increasing or decreasing rent if the annualized
fixed rent, as described in paragraph (j)(3) of this section, allocated
to any rental period exceeds the annualized fixed rent allocated to any
other rental period in the lease term.
(B) Certain rent holidays disregarded. Notwithstanding the
provisions of paragraph (c)(2)(i)(A) of this section, a rental agreement
does not have increasing or decreasing rent if the increasing or
decreasing rent is solely attributable to a rent holiday provision
allowing reduced rent (or no rent) for a period of three months or less
at the beginning of the lease term.
(ii) Fixed rent allocated to a rental period--(A) Specific
allocation--(1) In general. If a rental agreement provides a specific
allocation of fixed rent, as described in paragraph (c)(2)(ii)(A)(2) of
this section, the amount of fixed rent allocated to each rental period
during the lease term is the amount of fixed rent allocated to that
period by the rental agreement.
(2) Rental agreements specifically allocating fixed rent. A rental
agreement specifically allocates fixed rent if the rental agreement
unambiguously specifies, for periods no longer than a year, a fixed
amount of rent for which the lessee becomes liable on account of the use
of the property during that period, and the total amount of fixed rent
specified is equal to the total amount of fixed rent payable under the
lease. For example, a rental agreement providing that rent is $100,000
per calendar year, and providing for total payments of fixed rent equal
to the total amount specified, specifically allocates rent. A rental
agreement stating only when rent is payable does not specifically
allocate rent.
(B) No specific allocation. If a rental agreement does not provide a
specific allocation of fixed rent (for example, because the total amount
of fixed rent specified is not equal to the total amount of fixed rent
payable under the lease), the amount of fixed rent allocated to a rental
period is the amount of fixed rent payable during that rental period. If
an amount of fixed rent is payable before the beginning of the lease
term, it is allocated to the first rental period in the lease term. If
an amount of fixed rent is payable after the end of the lease term, it
is allocated to the last rental period in the lease term.
(iii) Contingent rent--(A) In general. A rental agreement has
increasing or decreasing rent if it requires (or may require) the
payment of contingent rent (as defined in paragraph (h)(2) of this
section), other than contingent rent described in paragraph
(c)(2)(iii)(B) of this section.
(B) Certain contingent rent disregarded. For purposes of this
paragraph (c)(2)(iii), rent is disregarded to the extent it is
contingent as the result of one or more of the following provisions--
(1) A qualified percentage rents provision, as defined in paragraph
(h)(8) of this section;
(2) An adjustment based on a reasonable price index, as defined in
paragraph (h)(10) of this section;
(3) A provision requiring the lessee to pay third-party costs, as
defined in paragraph (h)(15) of this section;
(4) A provision requiring the payment of late payment charges, as
defined in paragraph (h)(4) of this section;
(5) A loss payment provision, as defined in paragraph (h)(7) of this
section;
(6) A qualified TRAC provision, as defined in paragraph (h)(9) of
this section;
(7) A residual condition provision, as defined in paragraph (h)(13)
of this section;
(8) A tax indemnity provision, as defined in paragraph (h)(14) of
this section;
[[Page 302]]
(9) A variable interest rate provision, as defined in paragraph
(h)(16) of this section; or
(10) Any other provision provided in regulations or other published
guidance issued by the Commissioner, but only if the provision is
designated as contingent rent to be disregarded for purposes of this
paragraph (c)(2)(iii).
(3) Deferred or prepaid rent--(i) Deferred rent. A rental agreement
has deferred rent under this paragraph (c)(3) if the cumulative amount
of rent allocated as of the close of a calendar year (determined under
paragraph (c)(3)(iii) of this section) exceeds the cumulative amount of
rent payable as of the close of the succeeding calendar year.
(ii) Prepaid rent. A rental agreement has prepaid rent under this
paragraph (c)(3) if the cumulative amount of rent payable as of the
close of a calendar year exceeds the cumulative amount of rent allocated
as of the close of the succeeding calendar year (determined under
paragraph (c)(3)(iii) of this section).
(iii) Rent allocated to a calendar year. For purposes of this
paragraph (c)(3), the rent allocated to a calendar year is the sum of--
(A) The fixed rent allocated to any rental period (determined under
paragraph (c)(2)(ii) of this section) that begins and ends in the
calendar year;
(B) A ratable portion of the fixed rent allocated to any other
rental period that begins or ends in the calendar year; and (C) Any
contingent rent that accrues during the calendar year.
(iv) Examples. The following examples illustrate the application of
this paragraph (c)(3):
Example 1. (i) A and B enter into a rental agreement that provides
for the lease of property to begin on January 1, 2000, and end on
December 31, 2003. The rental agreement provides that rent of $100,000
accrues during each year of the lease term. Under the rental agreement,
no rent is payable during calendar year 2000, a payment of $100,000 is
to be made on December 31, 2001, and December 31, 2002, and a payment of
$200,000 is to be made on December 31, 2003. A and B both select the
calendar year as their rental period. Thus, the amount of rent allocated
to each rental period under paragraph (c)(2)(ii) of this section is
$100,000. Therefore, the rental agreement does not have increasing or
decreasing rent as described in paragraph (c)(2)(i) of this section.
(ii) Under paragraph (c)(3)(i) of this section, a rental agreement
has deferred rent if, at the close of a calendar year, the cumulative
amount of rent allocated under paragraph (c)(3)(iii) of this section
exceeds the cumulative amount of rent payable as of the close of the
succeeding year. In this example, there is no deferred rent: the rent
allocated to 2000 ($100,000) does not exceed the cumulative rent payable
as of December 31, 2001 ($100,000); the rent allocated to 2001 and
preceding years ($200,000) does not exceed the cumulative rent payable
as of December 31, 2002 ($200,000); the rent allocated to 2002 and
preceding years ($300,000) does not exceed the cumulative rent payable
as of December 31, 2003 ($400,000); and the rent allocated to 2003 and
preceding years ($400,000) does not exceed the cumulative rent payable
as of December 31, 2004 ($400,000). Therefore, because the rental
agreement does not have increasing or decreasing rent and does not have
deferred or prepaid rent, the rental agreement is not a section 467
rental agreement.
Example 2. (i) A and B enter into a rental agreement that provides
for a 10-year lease of personal property, beginning on January 1, 2000,
and ending on December 31, 2009. The rental agreement provides for
accruals of rent of $10,000 during each month of the lease term. Under
paragraph (c)(3)(iii) of this section, $120,000 is allocated to each
calendar year. The rental agreement provides for a $1,200,000 payment on
December 31, 2000.
(ii) The rental agreement does not have increasing or decreasing
rent as described in paragraph (c)(2)(i) of this section. The rental
agreement, however, provides prepaid rent under paragraph (c)(3)(ii) of
this section because the cumulative amount of rent payable as of the
close of a calendar year exceeds the cumulative amount of rent allocated
as of the close of the succeeding calendar year. For example, the
cumulative amount of rent payable as of the close of 2000 ($1,200,000 is
payable on December 31, 2000) exceeds the cumulative amount of rent
allocated as of the close of 2001, the succeeding calendar year
($240,000). Accordingly, the rental agreement is a section 467 rental
agreement.
(4) Rental agreements involving total payments of $250,000 or less--
(i) In general. A rental agreement is not a section 467 rental agreement
if, as of the agreement date (as defined in paragraph (h)(1) of this
section), it is not reasonably expected that the sum of the aggregate
amount of rental payments under the rental agreement and the aggregate
value of all other consideration to be received for the use of property
(taking into account any payments of contingent rent, and any
[[Page 303]]
other contingent consideration) will exceed $250,000.
(ii) Special rules in computing amount described in paragraph
(c)(4)(i) of this section of this section. The following rules apply in
determining the amount described in paragraph (c)(4)(i) of this section:
(A) Stated interest on deferred rent is not taken into account.
However, the Commissioner may recharacterize a portion of stated
interest as additional rent if a rental agreement provides for interest
on deferred rent at a rate that, in light of all of the facts and
circumstances, is clearly greater than the arm's-length rate of interest
that would have been charged in a lending transaction between the lessor
and lessee.
(B) Consideration that does not involve a cash payment is taken into
account at its fair market value. A liability that is either assumed or
secured by property acquired subject to the liability is taken into
account at the sum of its remaining principal amount and accrued
interest (if any) thereon or, in the case of an obligation originally
issued at a discount, at the sum of its adjusted issue price and accrued
qualified stated interest (if any), within the meaning of Sec. 1.1273-
1(c)(1).
(C) All rental agreements that are part of the same transaction or a
series of related transactions involving the same lessee (or any related
person) and the same lessor (or any related person) are treated as a
single rental agreement. Whether two or more rental agreements are part
of the same transaction or a series of related transactions depends on
all the facts and circumstances.
(D) If an agreement includes a provision increasing or decreasing
rent payable solely as a result of an adjustment based on a reasonable
price index, the amount described in paragraph (c)(4)(i) of this section
must be determined as if the applicable price index did not change
during the lease term.
(E) If an agreement includes a variable interest rate provision (as
defined in paragraph (h)(16) of this section), the amount described in
paragraph (c)(4)(i) of this section must be determined by using fixed
rate substitutes (determined in the same manner as under Sec. 1.1275-
5(e), treating the agreement date as the issue date) for the variable
rates of interest applicable to the lessor's indebtedness.
(F) Contingent rent described in paragraphs (c)(2)(iii)(B)(3)
through (8) of this section is not taken into account.
(d) Section 467 rent--(1) In general. The section 467 rent for a
taxable year is the sum of--
(i) The fixed rent for any rental period (determined under paragraph
(d)(2) of this section) that begins and ends in the taxable year;
(ii) A ratable portion of the fixed rent for any other rental period
beginning or ending in the taxable year; and
(iii) In the case of a section 467 rental agreement that provides
for contingent rent, the contingent rent that accrues during the taxable
year.
(2) Fixed rent for a rental period--(i) Constant rental accrual. In
the case of a section 467 rental agreement that is a disqualified
leaseback or long-term agreement (as described in Sec. 1.467-3(b)), the
fixed rent for a rental period is the constant rental amount (as
determined under Sec. 1.467-3(d)).
(ii) Proportional rental accrual. In the case of a section 467
rental agreement that is not described in paragraph (d)(2)(i) of this
section, and does not provide adequate interest on fixed rent (as
determined under Sec. 1.467-2(b)), the fixed rent for a rental period
is the proportional rental amount (as determined under Sec. 1.467-
2(c)).
(iii) Section 467 rental agreement accrual. In the case of a section
467 rental agreement that is not described in either paragraph (d)(2)(i)
or (ii) of this section, the fixed rent for a rental period is the
amount of fixed rent allocated to the rental period under the rental
agreement, as determined under paragraph (c)(2)(ii) of this section.
(e) Section 467 interest--(1) In general. The section 467 interest
for a taxable year is the sum of--
(i) The interest on fixed rent for any rental period that begins and
ends in the taxable year;
(ii) A ratable portion of the interest on fixed rent for any other
rental period beginning or ending in the taxable year; and
[[Page 304]]
(iii) In the case of a section 467 rental agreement that provides
for contingent rent, any interest that accrues on the contingent rent
during the taxable year.
(2) Interest on fixed rent for a rental period--(i) In general.
Except as provided in paragraph (e)(2)(ii) of this section and Sec.
1.467-5(b)(1)(ii), the interest on fixed rent for a rental period is
equal to the product of--
(A) The principal balance of the section 467 loan (as described in
Sec. 1.467-4(b)) at the beginning of the rental period; and
(B) The yield of the section 467 loan (as described in Sec. 1.467-
4(c)).
(ii) Section 467 rental agreements with adequate interest. Except in
the case of a section 467 rental agreement that is a disqualified
leaseback or long-term agreement, if a section 467 rental agreement
provides adequate interest under Sec. 1.467-2(b)(1)(i) (agreements with
no deferred or prepaid rent) or Sec. 1.467-2(b)(1)(ii) (agreements with
adequate interest stated at a single fixed rate), the interest on fixed
rent for a rental period is the amount of interest provided in the
rental agreement for the period.
(3) Treatment of interest. If the section 467 interest for a rental
period is a positive amount, the lessor has interest income and the
lessee has an interest expense. If the section 467 interest for a rental
period is a negative amount, the lessee has interest income and the
lessor has an interest expense. Section 467 interest is treated as
interest for all purposes of the Internal Revenue Code.
(f) Substantial modification of a rental agreement--(1) Treatment as
new agreement--(i) In general. If a substantial modification of a rental
agreement occurs after June 3, 1996, the post-modification agreement is
treated as a new agreement and the date on which the modification occurs
is treated as the agreement date in applying section 467 and the
regulations thereunder to the post-modification agreement. Thus, for
example, the post-modification agreement is treated as a new agreement
entered into on the date the modification occurs for purposes of
determining whether it is a section 467 rental agreement under this
section, whether it is a disqualified leaseback or long-term agreement
under Sec. 1.467-3, and whether it is entered into after the applicable
effective date in Sec. 1.467-9.
(ii) Limitation. In the case of a substantial modification of a
rental agreement occurring on or before May 18, 1999, this paragraph (f)
applies only if--
(A) The rental agreement was a disqualified leaseback or long-term
agreement before the modification and the agreement date, determined
without regard to the modification, is after June 3, 1996; or
(B) The post-modification agreement would, after application of the
rules in this paragraph (f) (other than the special rule for
disqualified agreements in paragraph (f)(4)(iii) of this section), be a
disqualified leaseback or long-term agreement.
(2) Post-modification agreement; in general. For purposes of
determining whether a post-modification agreement is a section 467
rental agreement or a disqualified leaseback or long-term agreement
under paragraph (f)(1) of this section, the terms of the post-
modification agreement are, except as provided in paragraph (f)(4) of
this section, only those terms that provide for rights and obligations
relating to post-modification items (within the meaning of paragraph
(f)(5)(iv) of this section).
(3) Other effects of a modification. For rules relating to amounts
that must be taken into account following certain modifications, see
Sec. 1.467-7(g).
(4) Special rules--(i) Carryover of character; leasebacks. If an
agreement is a leaseback prior to its modification and the lessee prior
to the modification (or a related person) is the lessee after the
modification, the post-modification agreement is a leaseback even if the
post-modification lessee did not have an interest in the property at any
time during the two-year period ending on the date on which the
modification occurs.
(ii) Carryover of character; long-term agreements. If an agreement
is a long-term agreement prior to its modification and the entire
agreement (as modified) would be a long-term agreement, the post-
modification agreement is a long-term agreement.
[[Page 305]]
(iii) Carryover of character; disqualified agreements. If an
agreement (as in effect before its modification) is a disqualified
leaseback or long-term agreement as the result of a determination
(whether occurring before or after the modification) under Sec. 1.467-
3(b)(1)(ii) and the post-modification agreement is a section 467 rental
agreement (or the entire agreement (as modified) would be a section 467
rental agreement), the post-modification agreement will, notwithstanding
its treatment as a new agreement under paragraph (f)(1)(i) of this
section, be subject to constant rental accrual unless the Commissioner
determines that, because of the absence of tax avoidance potential, the
post-modification agreement should not be treated as a disqualified
leaseback or long-term agreement.
(iv) Allocation of rent. If the entire agreement (as modified)
provides a specific allocation of fixed rent, as described in paragraph
(c)(2)(ii)(A)(2) of this section, the post-modification agreement is
treated as an agreement that provides a specific allocation of fixed
rent. If the entire agreement (as modified) does not provide a specific
allocation of fixed rent, the fixed rent allocated to rental periods
during the lease term of the post-modification agreement is determined
by applying the rules of paragraph (c)(2)(ii)(B) of this section to the
entire agreement (as modified).
(v) Difference between aggregate rent and interest and aggregate
payments--(A) In general. Except as provided in paragraph (f)(4)(v)(B)
of this section, a post-modification agreement described in paragraph
(f)(4)(v)(C) of this section is treated as a section 467 rental
agreement subject to proportional rental accrual (determined under Sec.
1.467-2(c)).
(B) Constant rental accrual prior to the modification. A post-
modification agreement described in paragraph (f)(4)(v)(C) of this
section is treated as a section 467 rental agreement subject to constant
rental accrual if--
(1) Constant rental accrual is required under paragraph (f)(4)(iii)
of this section; or
(2) The post-modification agreement involves total payments of more
than $250,000 (as described in paragraph (c)(4) of this section), and
the Commissioner determines that the post-modification agreement is a
disqualified leaseback or long-term agreement.
(C) Agreements described in this paragraph (f)(4)(v)(C). A post-
modification agreement is described in this paragraph (f)(4)(v)(C) if
the aggregate amount of fixed rent and stated interest treated as post-
modification items does not equal the aggregate amount of payments
treated as post-modification items.
(vi) Principal purpose of tax avoidance. If a principal purpose of a
substantial modification is to avoid the purpose or intent of section
467 or the regulations thereunder, the Commissioner may treat the entire
agreement (as modified) as a single agreement for purposes of section
467 and the regulations thereunder.
(5) Definitions. The following definitions apply for purposes of
this paragraph (f) and Sec. 1.467-7(g):
(i) A modification of a rental agreement is any alteration,
including any deletion or addition, in whole or in part, of a legal
right or obligation of the lessor or lessee thereunder, whether the
alteration is evidenced by an express agreement (oral or written),
conduct of the parties, or otherwise.
(ii) A modification is substantial only if, based on all of the
facts and circumstances, the legal rights or obligations that are
altered and the degree to which they are altered are economically
substantial. A modification of a rental agreement will not be treated as
substantial solely because it is not described in paragraph (f)(6) of
this section.
(iii) A modification occurs on the earlier of the first date on
which there is a binding contract that substantially sets forth the
terms of the modification or the date on which agreement to such terms
is otherwise evidenced.
(iv) Post-modification items with respect to any modification of a
rental agreement are all items (other than pre-modification items)
provided under the terms of the entire agreement (as modified).
(v) Pre-modification items with respect to any modification of a
rental agreement are pre-modification rent, interest thereon, and
payments allocable thereto (whether payable before or
[[Page 306]]
after the modification.) For this purpose--
(A) Pre-modification rent is rent allocable to periods before the
effective date of the modification, but only to the extent such rent is
payable under the entire agreement (as modified) at the time such rent
was due under the agreement in effect before the modification; and
(B) Pre-modification items are identified by applying payments, in
the order payable under the entire agreement (as modified) unless the
agreement specifies otherwise, to rent and interest thereon in the order
in which amounts accrue.
(vi) The entire agreement (as modified) with respect to any
modification is the agreement consisting of pre-modification terms
providing for rights and obligations that are not affected by the
modification and post-modification terms providing for rights and
obligations that differ from the rights and obligations under the
agreement in effect before the modification. For example, if a 10-year
rental agreement that provides for rent of $25,000 per year is modified
at the end of the 5th year to provide for rent of $30,000 per year in
subsequent years, the entire agreement (as modified) provides for a 10-
year lease term and provides for rent of $25,000 per year in years 1
through 5 and rent of $30,000 per year in years 6 through 10. The result
would be the same if the modification provided for both the increase in
rent and the substitution of a new lessee.
(6) Safe harbors. Notwithstanding the provisions of paragraph (f)(5)
of this section, a modification of a rental agreement is not a
substantial modification if the modification occurs solely as the result
of one or more of the following--
(i) The refinancing of any indebtedness incurred by the lessor to
acquire the property subject to the rental agreement and secured by such
property (or any refinancing thereof) but only if all of the following
conditions are met--
(A) Neither the amount, nor the time for payment, of the principal
amount of the new indebtedness differs from the amount and time for
payment of the remaining principal amount of the refinanced
indebtedness, except for de minimis changes;
(B) For each of the remaining rental periods, the rent allocation
schedule, the payments of rent and interest, and the amount accrued
under section 467 are changed only to the extent necessary to take into
account the change in financing costs, and such changes are made
pursuant to the terms of the rental agreement in effect before the
modification;
(C) The lessor and the lessee are not related persons to each other
or to any lender to the lessor with respect to the property (whether
under the refinanced indebtedness or the new indebtedness); and
(D) With respect to the indebtedness being refinanced, the lessor
was granted a unilateral option (within the meaning of Sec. 1.1001-
3(c)(3)) by the creditor to repay the refinanced indebtedness,
exercisable with or without the lessee's consent;
(ii) A change in the obligation of the lessee to make any of the
contingent payments described in paragraphs (c)(2)(iii)(B)(3) through
(8) of this section; or
(iii) A change in the amount of fixed rent allocated to a rental
period that, when combined with all previous changes in the amount of
fixed rent allocated to the rental period, does not exceed one percent
of the fixed rent allocated to that rental period prior to the
modification.
(7) Special rules for certain transfers--(i) In general. For
purposes of this paragraph (f), a substitution of a new lessee or a
sale, exchange, or other disposition by a lessor of property subject to
a rental agreement will not, by itself, be treated as a substantial
modification unless a principal purpose of the transaction giving rise
to the modification is the avoidance of Federal income tax. In
determining whether a principal purpose of the transaction giving rise
to the modification is the avoidance of Federal income tax--
(A) The safe harbors and other principles of Sec. 1.467-3(c) are
taken into account; and
(B) The Commissioner may treat the post-modification agreement as a
new
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agreement or treat the entire agreement (as modified) as a single
agreement.
(ii) Exception. Notwithstanding the provisions of paragraph
(f)(7)(i) of this section, the continuing lessor and the new lessee (in
the case of a substitution of a new lessee) or the new lessor and the
continuing lessee (in the case of a sale, exchange, or other disposition
by a lessor of property subject to a rental agreement) may, in
appropriate cases, request the Commissioner to treat the transaction as
if it were a substantial modification in order to have the provisions of
paragraph (f)(4)(iii) of this section and Sec. 1.467-7(g)(1) apply to
the transaction.
(g) Treatment of amounts payable by lessor to lessee--(1) Interest.
For purposes of determining present value, any amounts payable by the
lessor to the lessee as interest on prepaid rent are treated as negative
amounts.
(2) Other amounts. [Reserved]
(h) Meaning of terms. The following meanings apply for purposes of
this section and Sec. Sec. 1.467-2 through 1.467-9:
(1) Agreement date means the earlier of the lease date or the first
date on which there is a binding written contract that substantially
sets forth the terms under which the property will be leased.
(2) Contingent rent means any rent that is not fixed rent, including
any amount reflecting an adjustment based on a reasonable price index
(as defined in paragraph (h)(10) of this section) or a variable interest
rate provision (as defined in paragraph (h)(16) of this section).
(3) Fixed rent means any rent to the extent its amount and the time
at which it is required to be paid are fixed and determinable under the
terms of the rental agreement as of the lease date. The following rules
apply for the purpose of determining the extent to which rent is fixed
rent:
(i) The possibility of a breach, default, or other early termination
of the rental agreement and any adjustments based on a reasonable price
index or a variable interest rate provision are disregarded.
(ii) Rent will not fail to be treated as fixed rent merely because
of the possibility of impairment by insolvency, bankruptcy, or other
similar circumstances.
(iii) If the lease term (as defined in paragraph (h)(6) of this
section) includes one or more periods as to which either the lessor or
the lessee has an option to renew or extend the term of the agreement,
rent will not fail to be treated as fixed rent merely because the option
has not been exercised.
(iv) If the lease term includes one or more periods during which a
substitute lessee or lessor may have use of the property, rent will not
fail to be treated as fixed rent merely because the contingencies
relating to the obligation of the lessee (or a related person) to make
payments in the nature of rent have not occurred.
(v) If either the lessor or the lessee has an unconditional option
or options, exercisable on one or more dates during the lease term,
that, if exercised, require payments of rent to be made under an
alternative payment schedule or schedules, the amount of fixed rent and
the dates on which such rent is required to be paid are determined on
the basis of the payment schedule that, as of the agreement date, is
most likely to occur. If payments of rent are made under an alternative
payment schedule that differs from the payment schedule assumed in
applying the preceding sentence, then, for purposes of paragraph (f) of
this section, the rental agreement is treated as having been modified at
the time the option to make payments on such alternative schedule is
exercised.
(4) Late payment charge means any amount required to be paid by the
lessee to the lessor as additional compensation for the lessee's failure
to make any payment of rent under a rental agreement when due.
(5) Lease date means the date on which the lessee first has the
right to use of the property that is the subject of the rental
agreement.
(6) Lease term means the period during which the lessee has use of
the property subject to the rental agreement, including any option of
the lessor to renew or extend the term of the agreement. An option of
the lessee to renew or extend the term of the agreement is included in
the lease term only if it is expected, as of the agreement
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date, that the option will be exercised. For this purpose, a lessee is
generally expected to exercise an option if, for example, as of the
agreement date the rent for the option period is less than the expected
fair market value rental for such period. The lessor's or lessee's
determination that an option period is either included in or excluded
from the lease term is not binding on the Commissioner. If the lessee
(or a related person) agrees that one or both of them will or could be
obligated to make payments in the nature of rent (within the meaning of
Sec. 1.168(i)-2(b)(2)) for a period when another lessee (the substitute
lessee) or the lessor will have use of the property subject to the
rental agreement, the Commissioner may, in appropriate cases, treat the
period when the substitute lessee or lessor will have use of the
property as part of the lease term. See Sec. 1.467-7(f) for special
rules applicable to the lessee, substitute lessee, and lessor. This
paragraph (h)(6) applies to section 467 rental agreements entered into
after March 6, 2001. However, taxpayers may choose to apply this
paragraph (h)(6) to any rental agreement that is described in Sec.
1.467-9(a) and is entered into on or before March 6, 2001.
(7) A loss payment provision means a provision that requires the
lessee to pay the lessor a sum of money (which may be either a
stipulated amount or an amount determined by reference to a formula or
other objective measure) if the property subject to the rental agreement
is lost, stolen, damaged or destroyed, or otherwise rendered unsuitable
for any use (other than for scrap purposes).
(8) A qualified percentage rents provision means a provision
pursuant to which the rent is equal to a fixed percentage of the
lessee's receipts or sales (whether or not receipts or sales are
adjusted for returned merchandise or Federal, state, or local sales
taxes), but only if the percentage does not vary throughout the lease
term. A provision will not fail to be treated as a qualified percentage
rents provision solely by reason of one or more of the following
additional terms:
(i) Differing percentages of receipts or sales apply to different
departments or separate floors of a retail store, but only if the
percentage applicable to a particular department or floor does not vary
throughout the lease term.
(ii) The percentage is applied to receipts or sales in excess of
determinable dollar amounts, but only if the determinable dollar amounts
are fixed and do not vary throughout the lease term.
(9) A qualified TRAC provision means a terminal rental adjustment
clause (as defined in section 7701(h)(3)) contained in a qualified motor
vehicle operating agreement (as defined in section 7701(h)(2)), but only
if the adjustment to the rental price is based on a reasonable estimate,
determined as of any date between the agreement date and the lease date
(or, in the event the agreement date is the same as or later than the
lease date, determined as of the agreement date), of the fair market
value of the motor vehicle (including any trailer) at the end of the
lease term.
(10) An adjustment is based on a reasonable price index if the
adjustment reflects inflation or deflation occurring over a period
during the lease term and is determined consistently under a generally
recognized index for measuring inflation or deflation (for example, the
non-seasonally adjusted U.S. City Average All Items Consumer Price Index
for All Urban Consumers (CPI-U), which is published by the Bureau of
Labor Statistics of the Department of Labor). An adjustment will not
fail to be treated as one that is based on a reasonable price index
merely because the adjustment may be limited to a fixed percentage, but
only if the parties reasonably expect, as of any date between the
agreement date and the lease date (or, in the event the agreement date
is the same as the lease date, as of such date), that the fixed
percentage will actually limit the amount of the rent payable during
less than 50 percent of the lease term.
(11) For purposes of determining whether a section 467 rental
agreement is a leaseback within the meaning of Sec. 1.467-3(b)(2), two
persons are related persons if they are related persons within the
meaning of section 465(b)(3)(C). In all other cases, two persons are
related persons if they either have a relationship to each other that
[[Page 309]]
is specified in section 267(b) or section 707(b)(1) or are related
entities within the meaning of sections 168(h)(4)(A), (B), or (C).
(12) Rental agreement includes any agreement, whether written or
oral, that provides for the use of tangible property and is treated as a
lease for Federal income tax purposes.
(13) A residual condition provision means a provision in a rental
agreement that requires a payment to be made by either the lessor or the
lessee to the other party based on the difference between the actual
condition of the property subject to the agreement, determined as of the
expiration of the lease term, and the expected condition of the property
at the expiration of the lease term, as set forth in the rental
agreement. The amount of any such payment may be determined by reference
to any objective measure relating to the use or condition of the
property, such as miles, hours or other duration of use, units of
production, or similar measure. A provision will be treated as a
residual condition provision only if the payment represents compensation
for the use of, or wear and tear on, the property in excess of, or
below, a standard set forth in the rental agreement, and the standard is
reasonably expected, as of any date between the agreement date and the
lease date (or, in the event the agreement date is the same as or later
than the lease date, as of the agreement date), to be met at the
expiration of the lease term.
(14) A tax indemnity provision means a provision in a rental
agreement that may require the lessee to make one or more payments to
the lessor in the event that the Federal, foreign, state, or local
income tax consequences actually realized by a lessor from owning the
property subject to the rental agreement and leasing it to the lessee
differ from the consequences reasonably expected by the lessor, but only
if the differences in such consequences result from a misrepresentation,
act, or failure to act on the part of the lessee, or any other factor
not within the control of the lessor or any related person.
(15) Third-party costs include any real estate taxes, insurance
premiums, maintenance costs, and any other costs (excluding a debt
service cost) that relate to the leased property and are not within the
control of the lessor or lessee or any person related to the lessor or
lessee.
(16) A variable interest rate provision means a provision in a
rental agreement that requires the rent payable by the lessee to the
lessor to be adjusted by the dollar amount of changes in the amount of
interest payable by the lessor on any indebtedness that was incurred to
acquire the property subject to the rental agreement (or any refinancing
thereof), but--
(i) Only to the extent the changes are attributable to changes in
the interest rate; and
(ii) Only if the indebtedness provides for interest at one or more
qualified floating rates (within the meaning of Sec. 1.1275-5(b)), or
the changes are attributable to a refinancing at a fixed rate or one or
more qualified floating rates.
(i) [Reserved]
(j) Computational rules. For purposes of this section and Sec. Sec.
1.467-2 through 1.467-9, the following rules apply--
(1) Counting conventions. Any reasonable counting convention may be
used (for example, 30 days per month/360 days per year) to determine the
length of a rental period or to perform any computation. Rental periods
of the same descriptive length, for example annual, semiannual,
quarterly, or monthly, may be treated as being of equal length.
(2) Conventions regarding timing of rent and payments--(i) In
general. For purposes of determining present values and yield only,
except as otherwise provided in this section and Sec. Sec. 1.467-2
through 1.467-8--
(A) The rent allocated to a rental period is taken into account on
the last day of the rental period;
(B) Any amount payable during the first half of the first rental
period is treated as payable on the first day of that rental period;
(C) Any amount payable during the first half of any other rental
period is treated as payable on the last day of the preceding rental
period;
(D) Any amount payable during the second half of a rental period is
treated
[[Page 310]]
as payable on the last day of the rental period; and
(E) Any amount payable at the midpoint of a rental period is
treated, in applying this paragraph (j)(2), as an amount payable during
the first half of the rental period.
(ii) Time amount is payable. For purposes of this section and
Sec. Sec. 1.467-2 through 1.467-9, an amount is payable on the last day
for timely payment (that is, the last day such amount may be paid
without incurring interest, computed at an arm's-length rate, a
substantial penalty, or other substantial detriment (such as giving the
lessor the right to terminate the agreement, bring an action to enforce
payment, or exercise other similar remedies under the terms of the
agreement or applicable law)). This paragraph (j)(2)(ii) applies to
section 467 rental agreements entered into after March 6, 2001. However,
taxpayers may choose to apply this paragraph (j)(2)(ii) to any rental
agreement that is described in Sec. 1.467-9(a) and is entered into on
or before March 6, 2001.
(3) Annualized fixed rent. Annualized fixed rent is determined by
multiplying the fixed rent allocated to the rental period under
paragraph (c)(2)(ii) of this section by the number of periods of the
rental period's length in a calendar year. Thus, if the fixed rent
allocated to a rental period is $10,000 and the rental period is one
month, the annualized fixed rent for that rental period is $120,000
($10,000 times 12).
(4) Allocation of fixed rent within a period. A rental agreement
that allocates fixed rent to any period is treated as allocating fixed
rent ratably within that period. Thus, if a rental agreement provides
that $120,000 is allocated to each calendar year in the lease term,
$10,000 of rent is allocated to each calendar month.
(5) Rental period length. Except as provided in Sec. 1.467-3(d)(1)
(relating to agreements for which constant rental accrual is required),
rental periods may be of any length, may vary in length, and may be
different as between the lessor and the lessee as long as--
(i) The rental periods are one year or less, cover the entire lease
term, and do not overlap;
(ii) Each scheduled payment under the rental agreement (other than a
payment scheduled to occur before or after the lease term) occurs within
30 days of the beginning or end of a rental period; and
(iii) In the case of a rental agreement that does not provide a
specific allocation of fixed rent, the rental periods selected do not
cause the agreement to be treated as a section 467 rental agreement
unless all alternative rental period schedules would result in such
treatment.
[T.D. 8820, 64 FR 26853, May 18, 1999, as amended by T.D. 8917, 66 FR
1039, Jan. 5, 2001]
Sec. 1.467-2 Rent accrual for section 467 rental agreements
without adequate interest.
(a) Section 467 rental agreements for which proportional rental
accrual is required. Under Sec. 1.467-1(d)(2)(ii), the fixed rent for
each rental period is the proportional rental amount, computed under
paragraph (c) of this section, if--
(1) The section 467 rental agreement is not a disqualified leaseback
or long-term agreement under Sec. 1.467-3(b); and
(2) The section 467 rental agreement does not provide adequate
interest on fixed rent under paragraph (b) of this section.
(b) Adequate interest on fixed rent--(1) In general. A section 467
rental agreement provides adequate interest on fixed rent if,
disregarding any contingent rent--
(i) The rental agreement has no deferred or prepaid rent as
described in Sec. 1.467-1(c)(3);
(ii) The rental agreement has deferred or prepaid rent, and--
(A) The rental agreement provides interest (the stated rate of
interest) on deferred or prepaid fixed rent at a single fixed rate (as
defined in Sec. 1.1273-1(c)(1)(iii));
(B) The stated rate of interest on fixed rent is no lower than 110
percent of the applicable Federal rate (as defined in paragraph (e)(3)
of this section);
(C) The amount of deferred or prepaid fixed rent on which interest
is charged is adjusted at least annually to reflect the amount of
deferred or prepaid fixed rent as of a date no earlier than the date of
the preceding adjustment and
[[Page 311]]
no later than the date of the succeeding adjustment; and
(D) The rental agreement requires interest to be paid or compounded
at least annually;
(iii) The rental agreement provides for deferred rent but no prepaid
rent, and the sum of the present values (within the meaning of paragraph
(d) of this section) of all amounts payable by the lessee as fixed rent
(and interest, if any, thereon) is equal to or greater than the sum of
the present values of the fixed rent allocated to each rental period; or
(iv) The rental agreement provides for prepaid rent but no deferred
rent, and the sum of the present values of all amounts payable by the
lessee as fixed rent, plus the sum of the negative present values of all
amounts payable by the lessor as interest, if any, on prepaid fixed
rent, is equal to or less than the sum of the present values of the
fixed rent allocated to each rental period.
(2) Section 467 rental agreements that provide for a variable rate
of interest. For purposes of the adequate interest test under paragraph
(b)(1) of this section, if a section 467 rental agreement provides for
variable interest, the rental agreement is treated as providing for
fixed rates of interest on deferred or prepaid fixed rent equal to the
fixed rate substitutes (determined in the same manner as under Sec.
1.1275-5(e), treating the agreement date as the issue date) for the
variable rates called for by the rental agreement. For purposes of this
section, a rental agreement provides for variable interest if all stated
interest provided by the agreement is paid or compounded at least
annually at a rate or rates that meet the requirements of Sec. 1.1275-
5(a)(3)(i)(A) or (B) and (a)(4).
(3) Agreements with both deferred and prepaid rent. If an agreement
has both deferred and prepaid rent, the agreement provides adequate
interest under paragraph (b)(1) of this section if the conditions set
forth in paragraph (b)(1)(ii)(A) through (D) of this section are met for
both the prepaid and the deferred rent. For purposes of this paragraph
(b)(3), an agreement will be considered to meet the condition set forth
in paragraph (b)(1)(ii)(A) of this section if the agreement provides a
single fixed rate of interest on the deferred rent and a single fixed
rate of interest on the prepaid rent, even if those rates are not the
same. This paragraph (b)(3) applies to section 467 rental agreements
entered into after March 6, 2001. However, taxpayers may choose to apply
this paragraph (b)(3) to any rental agreement that is described in Sec.
1.467-9(a) and is entered into on or before March 6, 2001.
(c) Computation of proportional rental amount--(1) In general. The
proportional rental amount for a rental period is the amount of fixed
rent allocated to the rental period under Sec. 1.467-1(c)(2)(ii),
multiplied by a fraction. The numerator of the fraction is the sum of
the present values of the amounts payable under the terms of the section
467 rental agreement as fixed rent and interest thereon. The denominator
of the fraction is the sum of the present values of the fixed rent
allocated to each rental period under the rental agreement.
(2) Section 467 rental agreements that provide for a variable rate
of interest. To calculate the proportional rental amount for a section
467 rental agreement that provides for a variable rate of interest, see
Sec. 1.467-5.
(d) Present value. For purposes of determining adequate interest
under paragraph (b) of this section or the proportional rental amount
under paragraph (c) of this section, the present value of any amount is
determined using a discount rate equal to 110 percent of the applicable
Federal rate. In general, present values are determined as of the first
day of the first rental period in the lease term. However, if a section
467 rental agreement calls for payments of fixed rent prior to the lease
term, present values are determined as of the first day a fixed rent
payment is called for by the agreement. For purposes of the present
value determination under paragraph (b)(1)(iv) of this section, the
fixed rent allocated to a rental period must be discounted from the
first day of the rental period. For other conventions and rules relating
to the determination of present value, see Sec. 1.467-1(g) and (j).
(e) Applicable Federal rate--(1) In general. The applicable Federal
rate for a
[[Page 312]]
section 467 rental agreement is the applicable Federal rate in effect on
the agreement date. The applicable Federal rate for a rental agreement
means--
(i) The Federal short-term rate if the term of the rental agreement
is not over 3 years;
(ii) The Federal mid-term rate if the term of the rental agreement
is over 3 years but not over 9 years; and
(iii) The Federal long-term rate if the term of the rental agreement
is over 9 years.
(2) Source of applicable Federal rates. The Internal Revenue Service
publishes the applicable Federal rates, based on annual, semiannual,
quarterly, and monthly compounding, each month in the Internal Revenue
Bulletin (see Sec. 601.601(d) of this chapter). However, the applicable
Federal rates may be based on any compounding assumption. To convert a
rate based on one compounding assumption to an equivalent rate based on
a different compounding assumption, see Sec. 1.1272-1(j), Example 1.
(3) 110 percent of applicable Federal rate. For purposes of Sec.
1.467-1, this section and Sec. Sec. 1.467-3 through 1.467-9, 110
percent of the applicable Federal rate means 110 percent of the
applicable Federal rate based on semiannual compounding or any rate
based on a different compounding assumption that is equivalent to 110
percent of the applicable Federal rate based on semiannual compounding.
The Internal Revenue Service publishes 110 percent of the applicable
Federal rates, based on annual, semiannual, quarterly, and monthly
compounding, each month in the Internal Revenue Bulletin (see Sec.
601.601(d)(2) of this chapter).
(4) Term of the section 467 rental agreement--(i) In general. For
purposes of determining the applicable Federal rate under this paragraph
(e), the term of the section 467 rental agreement includes the lease
term, any period before the lease term beginning with the first day an
amount of fixed rent is payable under the terms of the rental agreement,
and any period after the lease term ending with the last day an amount
of fixed rent or interest thereon is payable under the rental agreement.
(ii) Section 467 rental agreements with variable interest. If a
section 467 rental agreement provides variable interest on deferred or
prepaid fixed rent, the term of the rental agreement for purposes of
calculating the applicable Federal rate is the longest period between
interest rate adjustment dates, or, if the rental agreement provides an
initial fixed rate of interest on deferred or prepaid fixed rent, the
period between the agreement date and the last day the fixed rate
applies, if this period is longer. If, as described in Sec. 1.1274-
4(c)(2)(ii), the rental agreement provides for a qualified floating rate
(as defined in Sec. 1.1275-5(b)) that in substance resembles a fixed
rate, the applicable Federal rate is determined by reference to the
lease term.
(f) Examples. The following examples illustrate the application of
this section. In each of these examples it is assumed that the rental
agreement is not a disqualified leaseback or long-term agreement subject
to constant rental accrual. The examples are as follows:
Example 1. (i) C agrees to lease property from D for five years
beginning on January 1, 2000, and ending on December 31, 2004. The
section 467 rental agreement provides that rent of $100,000 accrues in
each calendar year in the lease term and that rent of $500,000 plus
$120,000 of interest is payable on December 31, 2004. Assume that the
parties select the calendar year as the rental period and that 110
percent of the applicable Federal rate is 10 percent, compounded
annually.
(ii) The rental agreement has deferred rent under Sec. 1.467-
1(c)(3)(i) because the fixed rent allocated to calendar years 2000,
2001, and 2002 is not paid until 2004. In addition, because the rental
agreement does not state an interest rate, the rental agreement does not
satisfy the requirements of paragraph (b)(1)(ii) of this section.
(iii)(A) Because the rental agreement has deferred fixed rent and no
prepaid rent, the agreement has adequate interest only if the present
value test provided in paragraph (b)(1)(iii) of this section is met. The
present value of all fixed rent and interest payable under the rental
agreement is $384,971.22, determined as follows: $620,000/(1.10) \5\ =
$384,971.22. The present value of all fixed rent allocated under the
rental agreement (discounting the amount of fixed rent allocated to a
rental period from the last day of the rental period) is $379,078.68,
determined as follows:
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[GRAPHIC] [TIFF OMITTED] TR18MY99.000
(B) The rental agreement provides adequate interest on fixed rent
because the present value of the single amount payable under the section
467 rental agreement exceeds the sum of the present values of fixed rent
allocated.
(iv) For an example illustrating the computation of the yield on the
rental agreement and the allocation of the interest and rent provided
for under the rental agreement, see Sec. 1.467-4(f), Example 2.
Example 2. (i) E and F enter into a section 467 rental agreement for
the lease of equipment beginning on January 1, 2000, and ending on
December 31, 2004. The rental agreement provides that rent of $100,000
accrues for each calendar month during the lease term. All rent is
payable on December 31, 2004, together with interest on accrued rent at
a qualified floating rate set at a current value (as defined in Sec.
1.1275-5(a)(4)) that is compounded at the end of each calendar month and
adjusted at the beginning of each calendar month throughout the lease
term. Therefore, the rental agreement provides for variable interest
within the meaning of paragraph (b)(2) of this section.
(ii) On the agreement date the qualified floating rate is 7.5
percent, and 110 percent of the applicable Federal rate, as defined in
paragraph (e)(3) of this section, based on monthly compounding, is 7
percent. Under paragraph (b)(2) of this section, the fixed rate
substitute for the qualified floating rate is 7.5 percent and the
agreement is treated as providing for interest at this fixed rate for
purposes of determining whether adequate interest is provided under
paragraph (b) of this section. Accordingly, the requirements of
paragraph (b)(1)(ii) of this section are satisfied, and the rental
agreement has adequate interest.
Example 3. (i) X and Y enter into a section 467 rental agreement for
the lease of real property beginning on January 1, 2000, and ending on
December 31, 2002. The rental agreement provides that rent of $800,000
is allocable to 2000, $1,000,000 is allocable to 2001, and $1,200,000 is
allocable to 2002. Under the rental agreement, Y must make a $3,000,000
payment on December 31, 2002. Assume that both X and Y choose the
calendar year as the rental period, X and Y are calendar year taxpayers,
and 110 percent of the applicable Federal rate is 8.5 percent compounded
annually.
(ii) The rental agreement fails to provide adequate interest under
paragraph (b)(1) of this section. Therefore, under Sec. 1.467-
1(d)(2)(ii), the fixed rent for each rental period is the proportional
rental amount.
(iii)(A) The proportional rental amount is computed under paragraph
(c) of this section. Because the rental agreement does not call for any
fixed rent payments prior to the lease term, under paragraph (d) of this
section, the present value is determined as of the first day of the
first rental period in the lease term. The present value of the single
amount payable by the lessee under the rental agreement is computed as
follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.001
(B) The sum of the present values of the fixed rent allocated to
each rental period (discounting the fixed rent allocated to a rental
period from the last day of such rental period) is computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.002
(C) Thus, the fraction for determining the proportional rental
amount is .9297194 ($2,348,724.30/$2,526,272.20). The section 467
interest for each of the taxable years within the lease term is computed
and taken into account as provided in Sec. 1.467-4. The section 467
rent for each of the taxable years within the lease term is as follows:
------------------------------------------------------------------------
Taxable year Section 467 rent
------------------------------------------------------------------------
2000............................. $743,775.52
($ 800,000 x .9297194).
2001............................. 929,719.40
($1,000,000 x .9297194).
2002............................. 1,115,663.28
($1,200,000 x .9297194).
------------------------------------------------------------------------
[T.D. 8820, 64 FR 26859, May 18, 1999, as amended by T.D. 8917, 66 FR
1040, Jan. 5, 2001]
Sec. 1.467-3 Disqualified leasebacks and long-term agreements.
(a) General rule. Under Sec. 1.467-1(d)(2)(i), constant rental
accrual (as described under paragraph (d) of this section) must be used
to determine the fixed rent for each rental period in the lease term if
the section 467 rental agreement is a disqualified leaseback or long-
term agreement within the
[[Page 314]]
meaning of paragraph (b) of this section. Constant rental accrual may
not be used in the absence of a determination by the Commissioner,
pursuant to paragraph (b)(1)(ii) of this section, that the rental
agreement is disqualified. Such determination may be made either on a
case-by-case basis or in regulations or other guidance published by the
Commissioner (see Sec. 601.601(d)(2) of this chapter) providing that a
certain type or class of leaseback or long-term agreement will be
treated as disqualified and subject to constant rental accrual.
(b) Disqualified leaseback or long-term agreement--(1) In general. A
leaseback (as defined in paragraph (b)(2) of this section) or a long-
term agreement (as defined in paragraph (b)(3) of this section) is
disqualified only if--
(i) A principal purpose for providing increasing or decreasing rent
is the avoidance of Federal income tax (as described in paragraph (c) of
this section);
(ii) The Commissioner determines that, because of the tax avoidance
purpose, the agreement should be treated as a disqualified leaseback or
long-term agreement; and
(iii) For section 467 rental agreements entered into before July 19,
1999, the amount determined with respect to the rental agreement under
Sec. 1.467-1(c)(4) (relating to the exception for rental agreements
involving total payments of $250,000 or less) exceeds $2,000,000.
(2) Leaseback. A section 467 rental agreement is a leaseback if the
lessee (or a related person) had any interest (other than a de minimis
interest) in the property at any time during the two-year period ending
on the agreement date. For this purpose, interests in property include
options and agreements to purchase the property (whether or not the
lessee or related person was considered the owner of the property for
Federal income tax purposes) and, in the case of subleased property, any
interest as a sublessor.
(3) Long-term agreement--(i) In general. A section 467 rental
agreement is a long-term agreement if the lease term exceeds 75 percent
of the property's statutory recovery period.
(ii) Statutory recovery period--(A) In general. The term statutory
recovery period means--
(1) In the case of property depreciable under section 168, the
applicable period determined under section 467(e)(3)(A);
(2) In the case of land, 19 years; and
(3) In the case of any other tangible property, the period that
would apply under section 467(e)(3)(A) if the property were property to
which section 168 applied.
(B) Special rule for rental agreements relating to properties having
different statutory recovery periods. In the case of a rental agreement
relating to two or more related properties that have different statutory
recovery periods, the statutory recovery period for purposes of
paragraph (b)(3)(ii)(A) of this section is the weighted average, based
on the fair market values of the properties on the agreement date, of
the statutory recovery periods of each of the properties.
(c) Tax avoidance as principal purpose for increasing or decreasing
rent--(1) In general. In determining whether a principal purpose for
providing increasing or decreasing rent is the avoidance of Federal
income tax, all relevant facts and circumstances are taken into account.
However, an agreement will not be treated as a disqualified leaseback or
long-term agreement if either of the safe harbors set forth in paragraph
(c)(3) of this section is met. The mere failure of a leaseback or long-
term agreement to meet one of these safe harbors will not, by itself,
cause the agreement to be treated as one in which tax avoidance was a
principal purpose for providing increasing or decreasing rent.
(2) Tax avoidance--(i) In general. If, as of the agreement date, a
significant difference between the marginal tax rates of the lessor and
lessee can reasonably be expected at some time during the lease term,
the agreement will be closely scrutinized and clear and convincing
evidence will be required to establish that tax avoidance is not a
principal purpose for providing increasing or decreasing rent. The term
``marginal tax rate'' means the percentage determined by dividing one
dollar into the amount of the increase or decrease in the Federal income
tax
[[Page 315]]
liability of the taxpayer that would result from an additional dollar of
rental income or deduction.
(ii) Significant difference in tax rates. A significant difference
between the marginal tax rates of the lessor and lessee is reasonably
expected if--
(A) The rental agreement has increasing rents and the lessor's
marginal tax rate is reasonably expected to exceed the lessee's marginal
tax rate by more than 10 percentage points during any rental period to
which the rental agreement allocates annualized fixed rent that is less
than the average rent allocated to all calendar years (determined by
taking into account the rules set forth in paragraph (c)(4)(iii) of this
section); or
(B) The rental agreement has decreasing rents and the lessee's
marginal tax rate is reasonably expected to exceed the lessor's marginal
tax rate by more than 10 percentage points during any rental period to
which the rental agreement allocates annualized fixed rent that is
greater than the average rent allocated to all calendar years
(determined by taking into account the rules set forth in paragraph
(c)(4)(iii) of this section).
(iii) Special circumstances. In determining the expected marginal
tax rates of the lessor and lessee, net operating loss and credit
carryovers and any other attributes or special circumstances reasonably
expected to affect the Federal income tax liability of the taxpayer
(including the alternative minimum tax) are taken into account. For
example, in the case of a partnership or S corporation, the amount of
rental income or deduction that would be allocable to the partners or
shareholders, respectively, is taken into account.
(3) Safe harbors. Tax avoidance will not be considered a principal
purpose for providing increasing or decreasing rent if--
(i) The uneven rent test (as defined in paragraph (c)(4) of this
section) is met; or
(ii) The increase or decrease in rent is wholly attributable to one
or more of the following provisions--
(A) A contingent rent provision set forth in Sec. 1.467-
1(c)(2)(iii)(B); or
(B) A single rent holiday provision allowing reduced rent (or no
rent) for one consecutive period during the lease term, but only if--
(1) The rent holiday is for a period of three months or less at the
beginning of the lease term and for no other period; or
(2) The duration of the rent holiday is reasonable, determined by
reference to commercial practice (as of the agreement date) in the
locality where the use of the property occurs, and does not exceed the
lesser of 24 months or 10 percent of the lease term.
(4) Uneven rent test--(i) In general. The uneven rent test is met if
the rent allocated to each calendar year does not vary from the average
rent allocated to all calendar years (determined in accordance with the
rules set forth in paragraph (c)(4)(iii) of this section) by more than
10 percent.
(ii) Special rule for real estate. Paragraph (c)(4)(i) of this
section is applied by substituting ``15 percent'' for ``10 percent'' if
the rental agreement is a long-term agreement and at least 90 percent of
the property subject to the agreement (determined on the basis of fair
market value as of the agreement date) consists of real property (as
defined in Sec. 1.856-3(d)).
(iii) Operating rules. In determining whether the uneven rent test
has been met, the following rules apply:
(A) Any contingent rent attributable to a provision set forth in
Sec. 1.467-1(c)(2)(iii)(B)(3) through (9) is disregarded.
(B) If the lease term includes one or more partial calendar years (a
period less than a complete calendar year), the average rent allocated
to each calendar year is the total rent allocated under the rental
agreement, divided by the actual length (in years) of the lease term.
The rent allocated to a partial calendar year is annualized by
multiplying the allocated rent by the number of periods of the partial
calendar year's length in a full calendar year and the annualized rent
is treated as the amount of rent allocated to that year in determining
whether the uneven rent test is met.
(C) In the case of a rental agreement not described in paragraph
(c)(4)(ii) of
[[Page 316]]
this section, an initial rent holiday period and any rent allocated to
such period are disregarded for purposes of this paragraph (c)(4) if
taking such period and rent into account would cause the agreement to
fail to meet the uneven rent test. For purposes of this paragraph
(c)(4), an initial rent holiday period is any period of three months or
less at the beginning of the lease term during which annualized fixed
rent (determined by treating such period as a rental period for purposes
of Sec. 1.467-1(j)(3)) is less than the average rent allocated to all
calendar years (determined before the application of this paragraph
(c)(4)(iii)(C)).
(D) In the case of a rental agreement described in paragraph
(c)(4)(ii) of this section, one qualified rent holiday period and any
rent allocated to such period are disregarded for purposes of this
paragraph (c)(4) if taking such period and rent into account would cause
the agreement to fail the uneven rent test. For this purpose, a
qualified rent holiday period is a consecutive period that is an initial
rent holiday period or that meets the following conditions:
(1) The period does not exceed the lesser of 24 months or 10 percent
of the lease term (determined before the application of this paragraph
(c)(4)(iii)(D)).
(2) Annualized fixed rent during the period (determined by treating
the period as a rental period for purposes of Sec. 1.467-1(j)(3)) is
less than the average rent allocated to all calendar years (determined
before the application of this paragraph (c)(4)(iii)(D)).
(3) Providing less than average rent for the period is reasonable,
determined by reference to commercial practice (as of the agreement
date) in the locality where the use of the property occurs.
(E) If the rental agreement contains a variable interest rate
provision, the uneven rent test is applied by treating the rent as
having been fixed under the terms of the rental agreement for the entire
lease term using fixed rate substitutes (determined in the same manner
as Sec. 1.1275-5(e), treating the agreement date as the issue date) for
the variable rates of interest provided under the terms of the lessor's
indebtedness.
(d) Calculating constant rental amount--(1) In general. Except as
provided in paragraph (d)(2) of this section, the constant rental amount
is the amount that, if paid at the end of each rental period, would
result in a present value equal to the present value of all amounts
payable under the disqualified leaseback or long-term agreement as rent
and interest. In computing the constant rental amount, the rules for
determining present value are the same as those provided in Sec. 1.467-
2(d) for computing the proportional rental amount. If constant rental
accrual is required, all rental periods (other than an initial or final
short period of not more than one month) must be equal in length and
satisfy the requirements of Sec. 1.467-1(j)(5).
(2) Initial or final short periods. If a disqualified leaseback or
long-term agreement has an initial or final short rental period, the
constant rental amount for the initial or final short period may be
determined under any reasonable method. However, the sum of the present
values of all the constant rental amounts must equal the present values
of all amounts payable under the disqualified leaseback or long-term
agreement as rent and interest. Any adjustment necessary to eliminate
the section 467 loan balance because of the method used to determine the
constant rental amount for short periods must be taken into account as
section 467 rent for the final rental period.
(3) Method to determine constant rental amount; no short periods--
(i) Step 1. Determine the present value of amounts payable under the
disqualified leaseback or long-term agreement as rent or interest.
(ii) Step 2. Determine the present value of $1 to be received at the
end of each rental period during the lease term as of the first day of
the first rental period during the lease term (or, if earlier, the first
day a rent payment is required under the rental agreement).
(iii) Step 3. Divide the amount determined in paragraph (d)(3)(i) of
this section (Step 1) by the number of dollars determined in paragraph
(d)(3)(ii) of this section (Step 2).
[[Page 317]]
(e) Examples. The following examples illustrate the application of
this section:
Example 1. (i) K, lessor, and L, lessee, enter into a long-term
agreement for a 10-year lease of personal property beginning on January
1, 2000. K and L are C corporations that use the calendar year as their
taxable year. K does not have any unused losses or credits from taxable
years preceding 2000. In addition, as of the agreement date, K expects
that it will be subject to the maximum rate of tax imposed by section 11
in 2000 and that it will not be limited in its ability to use any losses
or credits. As of the agreement date, L expects that it will be subject
to the alternative minimum tax imposed by section 55 in 2000. The rental
agreement provides for rent allocations in each year of the lease term,
as follows:
------------------------------------------------------------------------
Year Amount
------------------------------------------------------------------------
2000.................................................... $427,500
2001.................................................... 442,500
2002.................................................... 457,500
2003.................................................... 472,500
2004.................................................... 487,500
2005.................................................... 502,500
2006.................................................... 517,500
2007.................................................... 532,500
2008.................................................... 547,500
2009.................................................... 562,500
------------------------------------------------------------------------
(ii) As described in paragraph (c)(2) of this section, as of the
agreement date, a significant difference between the marginal tax rates
of the lessor and lessee can reasonably be expected at some time during
the lease term. First, the rental agreement has increasing rents.
Second, the lessor's marginal tax rate exceeds the lessee's marginal tax
rate by more than 10 percentage points during a rental period to which
the rental agreement allocates less than a ratable portion of the
aggregate amount of rent payable under the agreement. For example, for
the year 2000, the lessor's expected marginal tax rate is 35 percent,
the percentage determined by dividing the increase in the Federal income
tax liability of K that would result from an additional dollar of rental
income ($.35) by $1. Because the lessee is subject to the alternative
minimum tax, the lessee's expected marginal tax rate for 2000 is 20
percent, the percentage determined by dividing the decrease in the
Federal income tax liability (taking into account both the decrease in
the lessee's regular tax and the increase in the lessee's alternative
minimum tax) that would result from an additional dollar of rental
deduction ($.20) by $1. Further, for the year 2000, the rent allocated
in accordance with the rental agreement is $427,500, which is less than
a ratable portion of the aggregate amount of rental payments, $495,000,
determined by dividing the total rents payable under the agreement
($4,950,000) by the number of years in the lease term (10). Thus,
because a significant difference between the marginal tax rates of the
lessor and lessee can reasonably be expected during the lease term, the
agreement will be closely scrutinized and clear and convincing evidence
will be required to establish that tax avoidance is not a principal
purpose for providing increasing rent.
Example 2. (i) A and B enter into a long-term agreement for a 5-year
lease of personal property beginning on July 1, 2000, and ending on June
30, 2005. The rental agreement provides that the rent is allocated to
the calendar years in the lease term in accordance with the following
schedule and is paid at successive six-month intervals (on December 31
and June 30) during the lease term:
------------------------------------------------------------------------
Year Amount
------------------------------------------------------------------------
2000.................................................... $450,000
2001.................................................... 900,000
2002.................................................... 900,000
2003.................................................... 1,100,000
2004.................................................... 1,100,000
2005.................................................... 550,000
------------------------------------------------------------------------
(ii) In determining whether the uneven rent test described in
paragraph (c)(4)(i) of this section is met, the total amount of rent
allocated under the rental agreement is $5,000,000, and the lease term
is five years. The average rent for each year is $1,000,000 (see
paragraph (c)(4)(iii)(B) of this section), and the uneven rent test is
met if the rent for each year is not less than $900,000 and not more
than $1,100,000. The test is met for 2000 because the annualized rent
for that year is $900,000. The test is met for 2005 because the
annualized rent for that year is $1,100,000. The test is met for each of
the years 2001 through 2004 because the rent for each of these years is
not less than $900,000 and not more than $1,100,000. Accordingly,
because the uneven rent test of paragraph (c)(4)(i) of this section is
met, the long-term agreement will not be treated as disqualified.
Example 3. (i) C and D enter into a long-term agreement for a lease
of personal property beginning on October 1, 1999, and ending on
December 31, 2005. The rental agreement provides that the rent is
allocated to the calendar years in the lease term in accordance with the
following schedule and is paid at successive six-month intervals (on
December 31 and June 30) during the lease term:
------------------------------------------------------------------------
Year Amount
------------------------------------------------------------------------
1999.................................................... $0
2000.................................................... 900,000
2001.................................................... 900,000
2002.................................................... 900,000
2003.................................................... 1,100,000
2004.................................................... 1,100,000
2005.................................................... 1,100,000
------------------------------------------------------------------------
[[Page 318]]
(ii) The three-month rent holiday period at the beginning of the
lease term is an initial rent holiday within the meaning of paragraph
(c)(4)(iii)(C) of this section. Moreover, the agreement would fail the
uneven rent test if the rent holiday period and the rent allocated to
the period were taken into account. Thus, under paragraph (c)(4)(iii)(C)
of this section, the period and the rent allocated to the period are
disregarded for purposes of applying the uneven rent test. In that case,
the lease term is six years, and the uneven rent test is met because the
average rent for each year in the lease term is $1,000,000 and the rent
for each calendar year in the lease term is not less than $900,000 nor
more than $1,100,000. Accordingly, the long-term agreement will not be
treated as disqualified.
Example 4. (i) E and F enter into a long-term agreement for a 6-year
lease of personal property beginning on January 1, 2000, and ending on
December 31, 2005. The rental agreement provides that the rent allocated
to the calendar years in the lease term and paid at successive six-month
intervals (on June 30 and December 31) during the lease term is the sum
of the interest on the lessor's indebtedness, in the amount of
$4,637,577, and an amount determined in accordance with the following
schedule:
------------------------------------------------------------------------
Year Amount
------------------------------------------------------------------------
2000.................................................... $539,574
2001.................................................... 583,603
2002.................................................... 631,225
2003.................................................... 886,733
2004.................................................... 959,090
2005.................................................... 1,037,352
------------------------------------------------------------------------
(ii) Assume further that the lessor's indebtedness bears interest at
the rate of 2 percent in excess of the 6-month London Interbank Offered
Rate (LIBOR) in effect on the first day of the 6-month period for each
rental period and that, on the agreement date, the interest rate under
this formula would be 8 percent. If the interest rate remained fixed
during the entire lease term, the formula for determining the rent
payable by the lessee would result in payments of rent in the amount of
$450,000 for each six-month period in 2000, 2001, and 2002, and $550,000
for each six-month period in 2003, 2004, and 2005.
(iii) Under paragraph (c)(4)(iii)(E) of this section, the fixed rate
substitute for the variable interest rate provision produces a schedule
of fixed rents that meets the uneven rent test of paragraph (c)(4)(i) of
this section. Thus, even if the actual rents payable under the rental
agreement do not meet the uneven rent test because of fluctuations in
the 6-month LIBOR, the uneven rent test will be treated as having been
met, and the long-term agreement will not be treated as disqualified.
Example 5. (i) G and H enter into a long-term agreement for a 5-year
lease of personal property beginning on January 1, 2000, and ending on
December 31, 2004. The rental agreement provides that the rent is
payable to G at the rate of $40,000 per month in arrears, subject to an
adjustment based on changes in prevailing interest rates during the
lease term. Under this adjustment, the lessor is entitled to receive an
amount equal to the sum of a specified dollar amount, which increases
each month as payments of rent are made, and interest on a notional
principal amount (as defined in Sec. 1.446-3(c)(3)) at a qualified
floating rate (as defined in Sec. 1.1275-5(b)). The notional principal
amount is initially established at 80 percent of the cost of the
property. As each payment of rent is made, the notional principal amount
is reduced (but not below zero) to an amount that would represent the
outstanding principal balance of a loan the payments on which are equal
to the monthly payments of rent. As of the agreement date, the value of
the qualified floating rate is 9 percent. Although G did not incur
indebtedness specifically for the purpose of acquiring the property, the
parties agreed to the adjustment provisions in order to compensate G for
its general costs of borrowing.
(ii) The adjustment provision produces a schedule of rent payments
that is virtually identical to the schedule that would have resulted if
G had actually borrowed money in an amount and on terms identical to the
terms used in determining interest on the notional principal amount and
the adjustment were based on that indebtedness. An adjustment based on
actual indebtedness of the lessor would have been a variable interest
rate provision eligible for a safe harbor under paragraph (c)(3)(ii)(A)
of this section. Accordingly, based on all the facts and circumstances,
the adjustment provision did not have as one of its principal purposes
the avoidance of Federal income tax, and thus the long-term agreement
will not be treated as disqualified.
Example 6. (i) X and Y enter into a leaseback for a 5-year lease of
personal property beginning on January 1, 1998, and ending on December
31, 2002. The rental agreement provides that $0 of rent is allocated to
years 1998, 1999, and 2000, and that rent of $17,500,000 is allocated to
years 2001 and 2002. The rental agreement provides that the rent
allocated to each year is payable on December 31 of that year. Assume
all rental periods are the calendar year. Assume also that 110 percent
of the applicable Federal rate based on annual compounding is 12
percent.
(ii)(A) If the Commissioner determines that the leaseback is
disqualified, the constant rental amount is computed as follows:
(B) Step 1 in calculating the constant rental amount is to determine
the present value
[[Page 319]]
of the two payments due under the rental agreement as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.003
(iii) Because no amounts of rent are payable before the lease term,
Step 2 in calculating the constant rental amount is to determine the
present value as of the first day of the lease term of $1 to be received
at the end of each rental period during the lease term. This results in
a present value of $3.6047762. In Step 3 the amount determined in Step 1
is divided by the number of dollars determined in Step 2. Thus, the
constant rental amount is $5,839,901 for each calendar year during the
lease term computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.004
[T.D. 8820, 64 FR 26860, May 18, 1999, as amended by T.D. 8917, 66 FR
1040, Jan. 5, 2001]
Sec. 1.467-4 Section 467 loan.
(a) In general--(1) Overview. Except as provided in paragraph (a)(2)
of this section, the section 467 loan rules of this section apply to a
section 467 rental agreement if, as of the first day of a rental period,
there is a difference between the amount of fixed rent payable under the
rental agreement on or before the first day and the amount of fixed rent
required to be accrued in accordance with Sec. 1.467-1(d)(2) before the
first day. Paragraph (b) of this section provides rules for computing
the principal balance of a section 467 loan at the beginning of any
rental period. The principal balance of a section 467 loan may be
positive or negative. For Federal tax purposes, if the principal balance
is positive, the amount represents a loan from the lessor to the lessee,
and if the principal balance is negative, the amount represents a loan
from the lessee to the lessor.
(2) No section 467 loan in the case of certain section 467 rental
agreements. Except as provided in paragraphs (a)(3) and (4) of this
section, this section does not apply to section 467 rental agreements
that provide adequate interest under Sec. 1.467-2(b)(1)(i) (agreements
with no deferred or prepaid rent) or Sec. 1.467-2(b)(1)(ii) (agreements
with deferred or prepaid rent that provide adequate stated interest at a
single fixed rate).
(3) Rental agreements subject to constant rental accrual.
Notwithstanding the provisions of paragraph (a)(2) of this section, this
section applies to rental agreements subject to constant rental accrual
under Sec. 1.467-3 (relating to disqualified leasebacks or long-term
agreements).
(4) Special rule in applying the provisions of Sec. 1.467-7(e),
(f), or (g). Notwithstanding the provisions of paragraph (a)(2) of this
section, section 467 loan balances must be computed for section 467
rental agreements that are not subject to constant rental accrual under
Sec. 1.467-3 and that provide adequate interest under Sec. 1.467-
2(b)(1)(i) or (ii), but only for purposes of applying the provisions of
Sec. 1.467-7(e) (relating to dispositions of property subject to a
section 467 rental agreement), Sec. 1.467-7(f) (relating to assignments
by lessees and lessee-financed renewals), and Sec. 1.467-7(g) (relating
to modifications of rental agreements).
(b) Principal balance--(1) In general. Except as provided in
paragraph (b)(2) of this section or in Sec. 1.467-7(e), (f), or (g),
the principal balance of the section 467 loan at the beginning of a
rental period equals--
(i) The fixed rent accrued in preceding rental periods;
(ii) Increased by the sum of--
(A) The interest on fixed rent includible in the gross income of the
lessor for preceding rental periods; and
(B) Any amount payable by the lessor on or before the first day of
the rental period as interest on prepaid fixed rent; and
(iii) Decreased by the sum of--
(A) The interest on prepaid fixed rent includible in the gross
income of the lessee for preceding rental periods; and
(B) Any amount payable by the lessee on or before the first day of
the rental period as fixed rent or interest thereon.
(2) Section 467 rental agreements that provide for prepaid fixed
rent and adequate interest. If a section 467 rental agreement calls for
prepaid fixed rent and provides adequate interest under Sec. 1.467-
2(b)(1)(iv), the principal balance of the section 467 loan at the
beginning of a rental period equals the principal balance determined
under paragraph (b)(1) of this section, plus the fixed rent accrued for
that rental period.
[[Page 320]]
(3) Timing of payments. For purposes of this paragraph (b), the day
on which an amount is payable is determined under the rules of Sec.
1.467-1(j)(2)(i)(B) through (E) and Sec. 1.467-1(j)(2)(ii).
(c) Yield--(1) In general--(i) Method of determining yield. Except
as provided in paragraphs (c)(2) and (3) of this section, the yield of a
section 467 loan is the discount rate at which the sum of the present
values of all amounts payable by the lessee as fixed rent and interest
on fixed rent, plus the sum of the present values of all amounts payable
by the lessor as interest on prepaid fixed rent, equals the sum of the
present values of the fixed rent that accrues in accordance with Sec.
1.467-1(d)(2). The yield must be constant over the term of the section
467 rental agreement and, when expressed as a percentage, must be
calculated to at least two decimal places.
(ii) Method of stating yield. In determining the section 467
interest for a rental period, the yield of the section 467 loan must be
stated appropriately by taking into account the length of the rental
period. Section 1.1272-1(j), Example 1, provides a formula for
converting a yield based on a period of one length to an equivalent
yield based on a period of a different length.
(iii) Rounding adjustments. Any adjustment necessary to eliminate
the section 467 loan because of rounding the yield to two or more
decimal places must be taken into account as an adjustment to the
section 467 interest for the final rental period determined as provided
in paragraph (e) of this section.
(2) Yield of section 467 rental agreements for which constant rental
amount or proportional rental amount is computed. In the case of a
section 467 rental agreement to which Sec. 1.467-1(d)(2)(i) or (ii)
applies, the yield of the section 467 loan equals 110 percent of the
applicable Federal rate (based on a compounding period equal to the
length of the rental period).
(3) Yield for purposes of applying paragraph (a)(4) of this section.
For purposes of applying paragraph (a)(4) of this section, the yield of
the section 467 loan balance of any party, or prior party, to a section
467 rental agreement for a period is the same for all parties and is the
yield that results in the net accrual of positive or negative interest
for that period equal to the amount of such interest that accrues under
the terms of the rental agreement for that period. For example, if
property subject to a section 467 rental agreement is sold (transferred)
and the beginning section 467 loan balance of the transferor (as
described in Sec. 1.467-7(e)(2)(i)) is positive and the beginning
section 467 loan balance of the transferee (as described in Sec. 1.467-
7(e)(2)(ii)) is negative, the yield on each of these loan balances for
any period is the same for all parties and is the yield that results in
the net accrual of positive or negative interest, taking into account
the aggregate positive or negative interest on the section 467 loan
balances of both the transferor and transferee, equal to the amount of
such interest that accrues under the terms of the rental agreement for
that period.
(4) Determination of present values. The rules for determining
present value in computing the yield of a section 467 loan are the same
as those provided in Sec. 1.467-2(d) for computing the proportional
rental amount.
(d) Contingent payments. Except as otherwise required, contingent
payments are not taken into account in calculating either the yield or
the principal balance of a section 467 loan.
(e) Section 467 rental agreements that call for payments before or
after the lease term. If a section 467 rental agreement calls for the
payment of fixed rent or interest thereon before the beginning of the
lease term, this section is applied by treating the period beginning on
the first day an amount is payable and ending on the day before the
beginning of the first rental period of the lease term as one or more
rental periods. If a rental agreement calls for the payment of fixed
rent or interest thereon after the end of the lease term, this section
is applied by treating the period beginning on the day after the end of
the last rental period of the lease term and ending on the last day an
amount of fixed rent or interest thereon is payable as one or more
rental periods. Rental period length for the period before the lease
term or after the lease term is determined in accordance with the rules
of Sec. 1.467-1(j)(5).
[[Page 321]]
(f) Examples. The following examples illustrate the application of
this section:
Example 1. (i)(A) A leases property to B for a three-year period
beginning on January 1, 2000, and ending on December 31, 2002. The
section 467 rental agreement has the following rent allocation schedule
and payment schedule:
------------------------------------------------------------------------
Rent
allocation Payment
------------------------------------------------------------------------
2000.......................................... $400,000 ...........
2001.......................................... 600,000 ...........
2002.......................................... 800,000 $1,800,000
------------------------------------------------------------------------
(B) The rental agreement requires a $1.8 million payment to be made
on December 31, 2002, but does not provide for interest on deferred
rent. Assume A and B choose the calendar year as the rental period
length and that 110 percent of the applicable Federal rate based on
annual compounding is 10 percent. Assume also that the agreement is not
a leaseback or long-term agreement and, therefore, is not subject to
constant rental accrual.
(ii) Because the section 467 rental agreement does not provide
adequate interest under Sec. 1.467-2(b) and is not subject to constant
rental accrual, the fixed rent that accrues during each rental period is
the proportional rental amount as described in Sec. 1.467-2(c). The
proportional rental amounts for each rental period are as follows:
2000...................................................... $370,370.37
2001...................................................... 555,555.56
2002...................................................... 740,740.73
(iii) A section 467 loan arises at the beginning of the second
rental period because the rent payable on or before that day (zero) is
less than the fixed rent accrued under Sec. 1.467-1(d)(2) in all
preceding rental periods ($370,370.37). Under paragraph (c)(2) of this
section, the yield of the loan is equal to 110 percent of the applicable
Federal rate (10 percent compounded annually). Because no payments are
treated as made on or before the first day of the second rental period,
the principal balance of the loan at the beginning of the second rental
period is $370,370.37. The interest for the second rental period on
fixed rent is $37,037.04 (.10 x $370,370.37) and, under Sec. 1.467-
1(e)(3), is treated as interest income of the lessor and as an interest
expense of the lessee.
(iv) Because no payments are made on or before the first day of the
third rental period, the principal balance of the loan at the beginning
of the third rental period is equal to the fixed rent accrued during the
first and second rental periods plus the lessor's interest income on
fixed rent for the second rental period ($962,962.97 = $370,370.37 +
$555,555.56 + $37,037.04). The interest for the third rental period on
fixed rent is $96,296.30 (.10 x $962,962.97). Thus, the sum of the fixed
rent and interest on fixed rent for the three rental periods is equal to
the total amount paid over the lease term (first year fixed rent
accrual, $370,370.37, plus second year fixed rent and interest accrual,
$555,555.56 + $37,037.04, plus third year fixed rent and interest
accrual, $740,740.73 + $96,296.30, equals $1,800,000). B takes the
amounts of interest and rent into account as interest and rent expense,
respectively, and A takes such amounts into account as interest and rent
income, respectively, for the calendar years identified above,
regardless of their respective overall methods of accounting.
Example 2. (i) The facts are the same as in Example 1, Sec. 1.467-
2(f). C agrees to lease property from D for five years beginning on
January 1, 2000, and ending on December 31, 2004. The section 467 rental
agreement provides that rent of $100,000 accrues in each calendar year
in the lease term and that rent of $500,000 plus $120,000 of interest is
payable on December 31, 2004. The parties select the calendar year as
the rental period, and 110 percent of the applicable Federal rate is 10
percent, compounded annually. The rental agreement has deferred rent but
provides adequate interest on fixed rent.
(ii)(A) Pursuant to paragraph (c)(1) of this section, the yield of
the section 467 loan is 10.775078%, compounded annually. The following
is a schedule of the rent allocable to each rental period during the
lease term, the balance of the section 467 loan as of the end of each
rental period (determined, in the case of the calendar year 2004,
without regard to the single payment of rent and interest in the amount
of $620,000 payable on the last day of the lease term), and the interest
on the section 467 loan allocable to each rental period:
----------------------------------------------------------------------------------------------------------------
Section 467 Section 467 Section 467
Calendar year interest rent loan balance
----------------------------------------------------------------------------------------------------------------
2000............................................................ $0 $100,000.00 $100,000.00
2001............................................................ 10,775.08 100,000.00 210,775.08
2002............................................................ 22,711.18 100,000.00 333,486.26
2003............................................................ 35,933.41 100,000.00 469,419.67
2004............................................................ 50,580.33 100,000.00 620,000.00
----------------------------------------------------------------------------------------------------------------
[[Page 322]]
(B) C takes the amounts of interest and rent into account as expense
and D takes such amounts into account as income for the calendar years
identified above, regardless of their respective overall methods of
accounting.
[T.D. 8820, 64 FR 26863, May 18, 1999]
Sec. 1.467-5 Section 467 rental agreements with variable interest.
(a) Variable interest on deferred or prepaid rent--(1) In general.
This section provides rules for computing section 467 rent and interest
in the case of section 467 rental agreements providing variable
interest. For purposes of this section, a rental agreement provides for
variable interest if the rental agreement provides for stated interest
that is paid or compounded at least annually at a rate or rates that
meet the requirements of Sec. 1.1275-5(a)(3)(i)(A) or (B) and (a)(4).
If a section 467 rental agreement provides for interest that is neither
variable interest nor fixed interest, the agreement provides for
contingent payments.
(2) Exceptions. This section is not applicable to section 467 rental
agreements that provide adequate interest under Sec. 1.467-2(b)(1)(i)
(agreements with no deferred or prepaid rent) or (b)(1)(ii) (rental
agreements with stated interest at a single fixed rate). The exceptions
in this paragraph (a)(2) do not apply to rental agreements subject to
constant rental accrual under Sec. 1.467-3.
(b) Variable rate treated as fixed--(1) In general. If a section 467
rental agreement provides variable interest--
(i) The fixed rate substitutes (determined in the same manner as
under Sec. 1.1275-5(e), treating the agreement date as the issue date)
for the variable rates of interest on deferred or prepaid fixed rent
provided by the rental agreement must be used in computing the
proportional rental amount under Sec. 1.467-2(c), the constant rental
amount under Sec. 1.467-3(d), the principal balance of a section 467
loan under Sec. 1.467-4(b), and the yield of a section 467 loan under
Sec. 1.467-4(c); and
(ii) The interest on fixed rent for any rental period is equal to
the amount that would be determined under Sec. 1.467-1(e)(2) if the
section 467 rental agreement did not provide variable interest, using
the fixed rate substitutes determined under paragraph (b)(1)(i) of this
section in place of the variable rates called for by the rental
agreement, plus the variable interest adjustment amount provided in
paragraph (b)(2) of this section.
(2) Variable interest adjustment amount--(i) In general. The
variable interest adjustment amount for a rental period equals the
difference between--
(A) The amount of interest that, without regard to section 467,
would have accrued during the rental period under the terms of the
section 467 rental agreement; and
(B) The amount of interest that, without regard to section 467,
would have accrued during the rental period under the terms of the
section 467 rental agreement using the fixed rate substitutes determined
under paragraph (b)(1)(i) of this section in place of the variable
interest rates called for by the rental agreement.
(ii) Positive or negative adjustment. If the amount determined under
paragraph (b)(2)(i)(A) of this section is greater than the amount
determined under paragraph (b)(2)(i)(B) of this section, the variable
interest adjustment amount is positive. If the amount determined under
paragraph (b)(2)(i)(A) of this section is less than the amount
determined under paragraph (b)(2)(i)(B) of this section, the variable
interest adjustment amount is negative.
(3) Section 467 loan balance. The variable interest adjustment
amount is not taken into account in determining the principal balance of
a section 467 loan under Sec. 1.467-4(b). Instead, the section 467 loan
balance is computed as if all amounts payable under the section 467
rental agreement were based on the fixed rate substitutes determined
under paragraph (b)(1)(i) of this section.
(c) Examples. The following examples illustrate the application of
this section:
Example 1. (i) X and Y enter into a section 467 rental agreement for
the lease of personal property beginning on January 1, 2000, and ending
on December 31, 2002. The rental agreement allocates $100,000 of rent to
2000, $200,000 to 2001, and $100,000 to 2002, and requires the lessee to
pay all $400,000 of rent on December 31, 2002. The rental agreement
requires the accrual of interest on unpaid accrued rent at two different
qualified floating rates (as defined in Sec. 1.1275-5(b)), one for 2001
and the other for 2002, such interest to be
[[Page 323]]
paid on December 31 of the year it accrues. The rental agreement
provides that the qualified floating rate is set at a current value
within the meaning of Sec. 1.1275-5(a)(4). Assume that on the agreement
date, 110 percent of the applicable Federal rate is 10 percent,
compounded annually. Assume also that the agreement is not a leaseback
or long-term agreement and, therefore, is not subject to constant rental
accrual.
(ii) To determine if the section 467 rental agreement provides for
adequate interest under Sec. 1.467-2(b), Sec. 1.467-2(b)(2) requires
the use of fixed rate substitutes (in this example determined in the
same manner as under Sec. 1.1275-5(e)(3)(i) treating the agreement date
as the issue date) in place of the variable rates called for by the
rental agreement. Assume that on the agreement date the qualified
floating rates, and therefore the fixed rate substitutes, relating to
2001 and 2002 are 10 and 15 percent compounded annually. Taking into
account the fixed rate substitutes, the sum of the present values of all
amounts payable by the lessee as fixed rent and interest thereon is
greater than the sum of the present values of the fixed rent allocated
to each rental period. Accordingly, the rental agreement provides
adequate interest under Sec. 1.467-2(b)(1)(iii) and the fixed rent
accruing in each calendar year during the rental agreement is the fixed
rent allocated under the rental agreement.
(iii) Because the section 467 rental agreement provides for variable
interest on unpaid accrued fixed rent at qualified floating rates and
the qualified floating rates are set at a current value, the
requirements of Sec. 1.1275-5(a)(3)(i)(A) and (4) are met and the
rental agreement provides for variable interest within the meaning of
paragraph (a)(1) of this section. Therefore, under paragraph (b)(1)(i)
of this section, the yield of the section 467 loan is computed based on
the fixed rate substitutes. Under Sec. 1.467-4(c), the constant yield
(rounded to two decimal places) equals 13.63 percent compounded
annually. Based on the fixed rate substitutes, the fixed rent, interest
on fixed rent, and the principal balance of the section 467 loan, for
each calendar year during the lease term, are as follows:
----------------------------------------------------------------------------------------------------------------
Accrued Projected Cumulative
Accrued rent interest payment loan
----------------------------------------------------------------------------------------------------------------
2000........................................... $100,000 $0 $0 $100,000
2001........................................... 200,000 13,630 (10,000) 303,630
2002........................................... 100,000 41,370 (445,000) 0
----------------------------------------------------------------------------------------------------------------
(iv) To compute the actual reported interest on fixed rent for each
calendar year, the variable interest adjustment amount, as described in
paragraph (b)(2) of this section, must be added to the accrued interest
determined in paragraph (iii) of this Example 1. Assume that the
variable rates for 2001 and 2002 are actually 11 and 14 percent,
respectively. Without regard to section 467, the interest that would
have accrued during each calendar year under the terms of the section
467 rental agreement, and the interest that would have accrued under the
terms of the rental agreement using the fixed rate substitutes
determined under paragraph (b)(1)(i) of this section are as follows:
------------------------------------------------------------------------
Accrued Accrued
interest under interest using
rental fixed rate
agreement substitutes
------------------------------------------------------------------------
2000.................................. $0 $0
2001.................................. 11,000 10,000
2002.................................. 42,000 45,000
------------------------------------------------------------------------
(v) Under paragraph (b)(2) of this section, the variable interest
adjustment amount is $1,000 ($11,000-$10,000) for 2001 and is -$3,000
($42,000-$45,000) for 2002. Thus, under paragraph (b)(1)(ii) of this
section, the actual interest on fixed rent for 2001 is $14,630 ($13,630
+ $1,000) and for 2002 is $38,370 ($41,370-$3,000).
Example 2. (i) The facts are the same as in Example 1 except that
110 percent of the applicable Federal rate is 15 percent compounded
annually and the section 467 rental agreement does not provide adequate
interest under Sec. 1.467-2(b). Consequently, the fixed rent for each
calendar year during the lease is the proportional rental amount.
(ii) The sum of the present values of the fixed rent provided for
each calendar year during the lease term, discounted at 15 percent
compounded annually, equals $303,936.87.
(iii)(A) Paragraph (b)(1)(i) of this section requires the
proportional rental amount to be computed based on the assumption that
interest will accrue and be paid based on the fixed rate substitutes.
Thus, the sum of the present values of the projected payments under the
section 467 rental agreement equals $300,156.16, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR18MY99.005
(B) The fraction for computing the proportional rental amount equals
.9875609 ($300,156.16/$303,936.87).
[[Page 324]]
(iv) Based on the fixed rate substitutes, the fixed rent, interest
on fixed rent, and the balance of the section 467 loan for each calendar
year during the lease term are as follows:
----------------------------------------------------------------------------------------------------------------
Proportional Accrued Projected Cumulative
rent interest payment loan
----------------------------------------------------------------------------------------------------------------
2000........................................... $98,756.09 $0.00 $0 $98,756.09
2001........................................... 197,512.18 14,813.41 (10,000) 301,081.68
2002........................................... 98,756.09 45,162.23 (445,000) 0.00
----------------------------------------------------------------------------------------------------------------
(v) The variable interest adjustment amount in this example is the
same as in Example 1. Under paragraph (b)(1)(ii) of this section, the
actual interest on fixed rent for 2001 is $15,813.41 ($14,813.41 +
$1,000) and for 2002 is $42,162.23 ($45,162.23-$3,000).
[T.D. 8820, 64 FR 26865, May 18, 1999]
Sec. 1.467-6 Section 467 rental agreements with contingent payments.
[Reserved]
Sec. 1.467-7 Section 467 recapture and other rules relating to dispositions
and modifications.
(a) Section 467 recapture. Notwithstanding any other provision of
the Internal Revenue Code, except as provided in paragraph (c) of this
section, a lessor disposing of property in a transaction to which this
paragraph (a) applies must recognize the recapture amount (determined
under paragraph (b) of this section) and treat that amount as ordinary
income. This paragraph (a) applies to any disposition of property
subject to a section 467 rental agreement that--
(1) Is a leaseback (as defined in Sec. 1.467-3(b)(2)) or a long-
term agreement (as defined in Sec. 1.467-3(b)(3));
(2) Is not disqualified under Sec. 1.467-3(b)(1); and
(3) Allocates to any rental period fixed rent that, when annualized,
exceeds the annualized fixed rent allocated to any preceding rental
period.
(b) Recapture amount--(1) In general. The recapture amount for a
disposition is the lesser of--
(i) The prior understated inclusion (determined under paragraph
(b)(2) of this section); or
(ii) The section 467 gain (determined under paragraph (b)(3) of this
section).
(2) Prior understated inclusion. The prior understated inclusion is
the excess (if any) of--
(i) The aggregate amount of section 467 rent and section 467
interest for the period during which the lessor held the property,
determined as if the section 467 rental agreement were a disqualified
leaseback or long-term agreement subject to constant rental accrual
under Sec. 1.467-3; over
(ii) The aggregate amount of section 467 rent and section 467
interest accrued by the lessor during that period.
(3) Section 467 gain--(i) In general. Except as otherwise provided
in paragraph (b)(3)(ii) of this section, the section 467 gain is the
excess (if any) of--
(A) The amount realized from the disposition; over
(B) The sum of the adjusted basis of the property and the amount of
any gain from the disposition that is treated as ordinary income under
any provision of subtitle A of the Internal Revenue Code other than
section 467(c) (for example, section 1245 or 1250).
(ii) Certain dispositions. In the case of a disposition that is not
a sale or exchange, the section 467 gain is the excess (if any) of the
fair market value of the property on the date of disposition over the
amount determined under paragraph (b)(3)(i)(B) of this section.
(c) Special rules--(1) Gifts. Paragraph (a) of this section does not
apply to a disposition by gift. However, see paragraph (c)(4) of this
section for dispositions by transferees. If a disposition is in part a
sale or exchange and in part a gift, paragraph (a) of this section
applies to the disposition but the prior understated inclusion is
determined by taking into account only section 467 rent and section 467
interest properly allocable to the portion of the property not disposed
of by gift.
(2) Dispositions at death. Paragraph (a) of this section does not
apply to a disposition if the basis of the property in the hands of the
transferee is determined under section 1014(a) or section 1022. However,
see paragraph (c)(4) of this section for dispositions of property
[[Page 325]]
subject to section 1022 by transferees. This paragraph (c)(2) does not
apply to property that constitutes a right to receive an item of income
in respect of a decedent. See sections 691, 1014(c), and 1022(f).
(3) Certain tax-free exchanges--(i) In general. The recapture amount
in the case of a disposition to which this paragraph (c)(3) applies is
limited to the amount of gain recognized to the transferor (determined
without regard to paragraph (a) of this section), reduced by the amount
of any gain from the disposition that is treated as ordinary income
under any provision of subtitle A of the Internal Revenue Code other
than section 467(c). However, see paragraph (c)(4) of this section for
dispositions by transferees.
(ii) Dispositions covered--(A) In general. Except as provided in
paragraph (c)(3)(ii)(B) of this section, this paragraph (c)(3) applies
to a disposition of property if the basis of the property in the hands
of the transferee is determined by reference to its basis in the hands
of the transferor by reason of the application of section 332, 351, 361,
721, or 731.
(B) Transfers to certain tax-exempt organizations. This paragraph
(c)(3) does not apply to a disposition to an organization (other than a
cooperative described in section 521) which is exempt from tax imposed
by chapter 1, subtitle A of the Internal Revenue Code (a tax-exempt
entity) except to the extent the property is used in an activity the
income from which is subject to tax under section 511(a) (a section
511(a) activity). However, if assets used to any extent in a section
511(a) activity are disposed of by the tax-exempt entity, then,
notwithstanding any other provision of law (except section 1031 or
section 1033) the recapture amount with respect to such disposition, to
the extent attributable under paragraph (c)(4) of this section to the
period of the transferor's ownership of the property prior to the first
disposition, shall be included in the tax-exempt entity's unrelated
business taxable income. To the extent that the tax-exempt entity ceases
to use the property in a section 511(a) activity, the entity will be
treated for purposes of this paragraph (c)(3) and paragraph (c)(4) of
this section as having disposed of the property to such extent on the
date of the cessation.
(4) Dispositions by transferee. If the recapture amount with respect
to a disposition of property (the first disposition) is limited under
paragraph (c)(1) or (c)(3) of this section, or under paragraph (c)(2) of
this section because the basis of the property in the hands of the
transferee is determined under section 1022, and the transferee
subsequently disposes of the property in a transaction to which
paragraph (a) of this section applies, the prior understated inclusion
determined under paragraph (b)(2) of this section is computed by taking
into account the amounts attributable to the period of the transferor's
ownership of the property prior to the first disposition. Thus, for
example, the section 467 rent and section 467 interest that would have
been taken into account by the transferee if the section 467 rental
agreement were a disqualified leaseback or long-term agreement subject
to constant rental accrual include the amounts that would have been
taken into account by the transferor, and the aggregate amount of
section 467 rent and section 467 interest accrued by the transferee
includes the aggregate amount of section 467 rent and section 467
interest that was taken into account by the transferor. The prior
understated inclusion determined under this paragraph (c)(4) must be
reduced by any recapture amount taken into account under paragraph (a)
of this section by the transferor.
(5) Like-kind exchanges and involuntary conversions. If property is
disposed of or converted and, before the application of paragraph (a) of
this section, gain is not recognized in whole or in part under section
1031 or 1033, then the amount of section 467 gain taken into account by
the lessor is limited to the sum of--
(i) The amount of gain recognized on the disposition or conversion
of the property (determined without regard to paragraph (a) of this
section); and
(ii) The fair market value of property acquired that is not subject
to the same section 467 rental agreement and that is not taken into
account under paragraph (c)(5)(i) of this section.
[[Page 326]]
(6) Installment sales. In the case of an installment sale of
property to which paragraph (a) of this section applies--
(i) The recapture amount is recognized and treated as ordinary
income in the year of the disposition; and
(ii) Any gain in excess of the recapture amount is reported under
the installment method of accounting if and to the extent that method is
otherwise available under section 453.
(7) Dispositions covered by section 170(e), 341(e)(12), or 751(c).
For purposes of sections 170(e), 341(e)(12), and 751(c), amounts treated
as ordinary income under paragraph (a) of this section must be treated
in the same manner as amounts treated as ordinary income under section
1245 or 1250.
(d) Examples. The following examples illustrate the application of
paragraphs (a), (b), and (c) of this section. In each of these examples
the transferor of property subject to a section 467 rental agreement is
entitled to the rent for the day of the disposition. The examples are as
follows:
Example 1. (i)(A) X and Y enter into a section 467 rental agreement
for a 5-year lease of personal property beginning on January 1, 2000,
and ending on December 31, 2004. The rental agreement provides that the
calendar year will be the rental period and that rents accrue and are
paid in the following pattern:
------------------------------------------------------------------------
Allocation Payment
------------------------------------------------------------------------
2000.................................... $0 $0
2001.................................... 87,500 0
2002.................................... 87,500 175,000
2003.................................... 87,500 175,000
2004.................................... 87,500 0
------------------------------------------------------------------------
(B) Assume that both X and Y are calendar year taxpayers and that
110 percent of the applicable Federal rate is 11 percent, compounded
annually. Assume also that the rental agreement is a long-term agreement
(as defined in Sec. 1.467-3(b)(3)), but it is not a disqualified
leaseback or long-term agreement. Further, because the agreement does
not provide prepaid or deferred rent, proportional rental accrual is not
applicable. (See Sec. 1.467-2(b)(1)(i)). Therefore, the rent taken into
account under Sec. 1.467-1(d)(2) is the fixed rent allocated to the
rental periods under Sec. 1.467-1(c)(2)(ii).
(ii) On December 31, 2000, X sells the property subject to the
section 467 rental agreement to an unrelated person for $575,000. At the
time of the sale, X's adjusted basis in the property is $175,000. Thus,
X's gain on the sale of the property is $400,000. Assume that $175,000
of this gain would be treated as ordinary income under provisions of the
Internal Revenue Code other than section 467(c). Under paragraph (a) of
this section, X is required to take the recapture amount into account as
ordinary income. Under paragraph (b) of this section, the recapture
amount is the lesser of the prior understated inclusion or the section
467 gain.
(iii)(A) In computing the prior understated inclusion under
paragraph (b)(2) of this section, assume that the section 467 rent and
section 467 interest (based on constant rental accrual) would be taken
into account as follows if the section 467 rental agreement were a
disqualified long-term agreement:
------------------------------------------------------------------------
Section 467 Section 467
rent interest
------------------------------------------------------------------------
2000................................... $65,812.55 $0
2001................................... 65,812.55 7,239.38
2002................................... 65,812.55 15,275.09
2003................................... 65,812.55 4,944.73
2004................................... 65,812.55 (6,521.95)
------------------------------------------------------------------------
(B) The total amount of section 467 rent and section 467 interest
for 2000, based on constant rental accrual, is $65,812.55. Since X did
not take any section 467 rent or section 467 interest into account in
2000, the prior understated inclusion is also $65,812.55. X's section
467 gain is $225,000, which is the excess of the gain realized
($400,000) over the amount of that gain treated as ordinary income under
non-section 467 provisions ($175,000). Accordingly, the recapture amount
(the lesser of the prior understated inclusion or the section 467 gain)
treated as ordinary income is $65,812.55.
Example 2. (i) The facts are the same as in Example 1, except that
the section 467 rental agreement specifies that rents accrue and are
paid in the following pattern:
------------------------------------------------------------------------
Allocation Payment
------------------------------------------------------------------------
2000.................................... $60,000 $0
2001.................................... 65,000 0
2002.................................... 70,000 175,000
2003.................................... 75,000 175,000
2004.................................... 80,000 0
------------------------------------------------------------------------
(ii)(A) Assume the section 467 rental agreement does not provide for
adequate interest under Sec. 1.467-2(b), and, therefore, the fixed rent
for a rental period is the proportional rental amount. See Sec. 1.467-
1(d)(2)(ii). Under Sec. 1.467-2(c), the following amounts would be
required to be taken into account:
------------------------------------------------------------------------
Section 467 Section 467
rent interest
------------------------------------------------------------------------
2000................................... $57,260.43 $ 0
2001................................... 62,032.13 6,298.65
2002................................... 66,803.83 13,815.03
2003................................... 71,575.53 3,433.11
2004................................... 76,347.23 (7,565.94)
------------------------------------------------------------------------
[[Page 327]]
(B) The amount of section 467 rent and section 467 interest taken
into account by X for 2000 is $57,260.43. Thus, the prior understated
inclusion is $8,552.12 (the excess of the amount of section 467 rent and
section 467 interest based on constant rental accrual for 2000,
$65,812.55, over the amount of section 467 rent and section 467 interest
actually taken into account, $57,260.43). Since the prior understated
inclusion is less than the section 467 gain ($225,000, as determined in
Example 1(iii)(B)), the recapture amount treated as ordinary income is
also $8,552.12.
Example 3. (i) The facts are the same as in Example 1, except that,
instead of selling the property, X transfers the property to S on
December 31, 2002, in exchange for stock of S in a transaction that
meets the requirements of section 351(a). Under paragraph (c)(3) of this
section, because of the application of section 351, X is not required to
take into account any section 467 recapture.
(ii) On December 31, 2003, S sells the property subject to the
section 467 rental agreement to an unrelated person for $450,000. At the
time of the sale, S's adjusted basis in the property is $105,000. Thus,
S's gain on the sale of the property is $345,000. Assume that $245,000
of this gain would be treated as ordinary income under provisions of the
Internal Revenue Code other than section 467(c). Under paragraph (a) of
this section, S is required to take the recapture amount into account as
ordinary income which, under paragraph (b) of this section, is the
lesser of the prior understated inclusion or the section 467 gain.
(iii) S owned the property in 2003 and, under paragraph (c)(4) of
this section, for purposes of determining S's prior understated
inclusion, S is treated as if it had owned the property during the years
2000 through 2002. In computing S's prior understated inclusion under
paragraph (b)(2) of this section, the section 467 rent and section 467
interest based on constant rental accrual are the same as the amounts
set forth in the schedule in Example 1(iii)(A). Thus, the constant
rental amount for 2000, 2001, 2002, and 2003 is $290,709.40 ((4 x
$65,812.55) + $7,239.38 + $15,275.09 + $4,944.73). The section 467 rent
and section 467 interest actually taken into account prior to the
disposition is $262,500. Thus, S's prior understated inclusion is
$28,209.40 ($290,709.40 minus $262,500 (3 x $87,500)). S's section 467
gain is $100,000, the difference between the gain realized on the
disposition ($345,000) and the amount of gain that is treated as
ordinary income under non-section 467 Code provisions ($245,000).
Accordingly, S's recapture amount, the lesser of the prior understated
inclusion or the section 467 gain, is $28,209.40.
(e) Other rules relating to dispositions--(1) In general. If there
is a sale, exchange, or other disposition of property subject to a
section 467 rental agreement (the transfer), the section 467 rent and,
if applicable, section 467 interest for a period are taken into account
by the owner of the property during the period. The following rules
apply in determining the section 467 rent and section 467 interest for
the portion of the rental period ending immediately prior to the
transfer:
(i) The section 467 rent and section 467 interest for the portion of
the rental period ending immediately prior to the transfer are a pro
rata portion of the section 467 rent and the section 467 interest,
respectively, for the rental period. Such amounts are also taken into
account in determining the transferor's section 467 loan balance, prior
to any adjustment thereof that may be required under paragraph (h) of
this section, immediately before the transfer.
(ii) If the transferor of the property is entitled to the rent for
the day of transfer, the transfer is treated as occurring at the end of
the day of the transfer.
(iii) If the transferee of the property is entitled to the rent for
the day of transfer, the transfer is treated as occurring at the
beginning of the day of the transfer.
(2) Treatment of section 467 loan. If there is a transfer described
in paragraph (e)(1) of this section, the following rules apply in
determining the transferor's and the transferee's section 467 loans for
the period after the transfer, the amount realized by the transferor,
and the transferee's basis in the property:
(i) The beginning balance of the transferor's section 467 loan is
equal to the net present value at the time of the transfer (but after
giving effect to the transfer) of all subsequent amounts payable as
fixed rent and interest on fixed rent to the transferor and all
subsequent amounts payable as interest on prepaid fixed rent by the
transferor. The transferor must continue to take into account interest
on the transferor's section 467 loan balance after the date of the
transfer.
(ii) The beginning balance of the transferee's section 467 loan is
equal to the principal balance of the transferor's section 467 loan
immediately before the transfer reduced (below zero, if
[[Page 328]]
appropriate) by the beginning balance of the transferor's section 467
loan. Amounts payable to the transferor are not taken into account in
adjusting the transferee's section 467 loan balance.
(iii) If the beginning balance of the transferee's section 467 loan
is negative, the transferor and transferee must treat the balance as a
liability that is either assumed in connection with the transfer of the
property or secured by the property acquired subject to the liability.
If the beginning balance of the transferee's section 467 loan is
positive, the transferor and transferee must treat the balance as an
additional asset acquired in connection with the transfer of the
property. In the case of a positive beginning balance of the
transferee's section 467 loan, the transferee will have an initial cost
basis in the section 467 loan equal to the lesser of the beginning
balance of the loan or the aggregate consideration for the transfer of
the property subject to the section 467 rental agreement and the
transfer of the transferor's interest in the section 467 loan.
(3) [Reserved]
(4) Examples. The following examples illustrate the application of
this paragraph (e). In each of these examples the transferor of property
subject to a section 467 rental agreement is entitled to the rent for
the day of the transfer. The examples are as follows:
Example 1. (i) Q and R enter into a section 467 rental agreement for
a 5-year lease of personal property beginning on January 1, 2000, and
ending on December 31, 2004. The rental agreement provides that $0 of
rent is allocated to 2000, 2001, and 2002, and $1,750,000 is allocated
to each of the years 2003 and 2004. The rental agreement provides that
the calendar year will be the rental period and that the rent allocated
to each calendar year is payable on the last day of that calendar year.
Assume that both Q and R are calendar year taxpayers and that 110
percent of the applicable Federal rate is 11 percent, compounded
annually. Assume further that the rental agreement is a disqualified
long-term agreement (as defined in Sec. 1.467-3(b)(3)) and that the
section 467 rent, the section 467 interest, and the section 467 loan
balance would be the following amounts:
----------------------------------------------------------------------------------------------------------------
Section 467 Section 467 loan
Calendar year Payment interest Section 467 rent balance
----------------------------------------------------------------------------------------------------------------
2000................................ $0 $0 $592,905.87 $592,905.87
2001................................ 0 65,219.65 592,905.87 1,251,031.39
2002................................ 0 137,613.45 592,905.87 1,981,550.71
2003................................ 1,750,000.00 217,970.58 592,905.87 1,042,427.16
2004................................ 1,750,000.00 114,666.97 592,905.87 0
----------------------------------------------------------------------------------------------------------------
(ii) On December 31, 2002, Q sells the property subject to the
section 467 rental agreement to P, an unrelated person, for $3,000,000.
Q does not retain the right to receive any amounts payable by R under
the rental agreement after the date of sale, but the agreement is not
otherwise modified. At the time of the sale, Q's adjusted basis in the
property is $975,000. Assume that, under Sec. 1.467-1(f)(7), the
disposition is not a substantial modification. Further, the Commissioner
does not determine that the treatment of the agreement as a disqualified
long-term agreement should be changed and, under Sec. 1.467-
1(f)(4)(iii), the agreement remains subject to constant rental accrual.
Thus, under paragraph (g)(2)(iii) of this section, section 467 rent and
section 467 interest for periods after the disposition will be taken
into account on the basis of constant rental accrual applied to the
terms of the entire agreement (as modified).
(iii) Under paragraph (e)(2)(ii) of this section, the beginning
balance of P's section 467 loan is $1,981,550.71. P's section 467 loan
balance is computed by reducing the balance of the section 467 loan
immediately before the transfer ($1,981,550.71) by the beginning balance
of the transferor's section 467 loan ($0 because Q does not retain the
right to receive any amounts payable under the rental agreement
subsequent to the transfer).
(iv) Q will be treated as if it had received $1,981,550.71 from the
disposition of the section 467 loan and $1,018,449.29 from the sale of
the property subject to the rental agreement. Thus, Q's gain on the sale
of the property is $43,449.29 ($1,018,449.29 amount realized less
$975,000 adjusted basis). Q's gain is not subject to the recapture
provisions of section 467(c) and paragraph (a) of this section because
the rental agreement was disqualified under Sec. 1.467-3(b)(1) and,
thus, the requirement of paragraph (a)(2) of this section is not met. Q
recognizes no gain on the disposition of the section 467 loan because
Q's basis in the loan equals the amount considered received for the
loan. Further, Q does not take into account any of the section 467
[[Page 329]]
rent or section 467 interest attributable to periods after the transfer
of the property.
(v) P is treated as if it had acquired the property and the positive
balance in the transferee's section 467 loan. P's cost basis in the
property is $1,018,449.29, and its cost basis in the section 467 loan
immediately following the transfer is $1,981,550.71. P takes section 467
rent and section 467 interest into account for the calendar years 2002
and 2003 under the constant rental accrual method and, accordingly,
treats payments received under the rental agreement as recoveries of the
principal balance of the section 467 loan (as adjusted from time to
time).
Example 2. (i) The facts are the same as Example 1, except that on
December 31, 2002, Q transfers the property to P in exchange for stock
of P having a fair market value of $3,000,000 and the transaction meets
the requirements of section 351(a).
(ii) Q is treated as having transferred two assets to P, the
property subject to the rental agreement and the positive balance of the
section 467 loan. Under section 351(a), because only stock of P is
received by Q, Q does not recognize any of the gain realized on the
transaction. Pursuant to section 358(a), the basis of Q in the P stock
received in the exchange is the same as the aggregate basis of the
property exchanged, or $2,956,550.71 (the sum of the balance of the
section 467 loan, $1,981,550.71, and the adjusted basis of the property,
$975,000). Q does not take into account any of the section 467 rent or
section 467 interest attributable to periods after the transfer of the
property.
(iii) P is treated as if it had acquired the property and the
positive balance in the transferee's section 467 loan in the
transaction. Pursuant to section 362(a), P's basis in each asset is the
same as the basis of Q immediately preceding the transfer. Thus, the
basis of P in the property subject to the rental agreement is $975,000,
and the basis of P in the section 467 loan immediately following the
transfer is $1,981,550.71. P takes section 467 rent and section 467
interest into account for the calendar years 2003 and 2004 under the
constant rental accrual method and, accordingly, treats payments
received under the rental agreement as recoveries of the principal
balance of the section 467 loan (as adjusted from time to time).
(f) Treatment of assignments by lessee and lessee-financed
renewals--(1) Substitute lessee use. If a lessee assigns its interest in
a section 467 rental agreement to a substitute lessee, or if a period
when a substitute lessee has the use of property subject to a section
467 rental agreement is otherwise included in the lease term under Sec.
1.467-1(h)(6), the section 467 rent for a period is taken into account
by the person having the use of the property during the period. The
following rules apply in determining the section 467 rent and section
467 interest for the portion of the rental period ending immediately
prior to the assignment:
(i) The section 467 rent and section 467 interest for the portion of
the rental period ending immediately prior to the assignment are a pro
rata portion of the section 467 rent and the section 467 interest,
respectively, for the rental period. Such amounts are also taken into
account in determining the lessee's section 467 loan balance, prior to
any adjustment thereof that may be required under paragraph (h) of this
section, immediately before the substitute lessee first has use of the
property.
(ii) If the lessee is liable for the rent for the day that the
substitute lessee first has use of the property, the substitute lessee's
use shall be treated as beginning at the end of that day.
(iii) If the substitute lessee is liable for the rent for the day
that the substitute lessee first has use of the property, the substitute
lessee's use shall be treated as beginning at the beginning of that day.
(2) Treatment of section 467 loan. If, as described in paragraph
(f)(1) of this section, a lessee assigns its interest in a section 467
rental agreement to a substitute lessee or a period when a substitute
lessee has the use of property subject to a section 467 rental agreement
is otherwise included in the lease term under Sec. 1.467-1(h)(6), the
following rules apply in determining the amount of the lessee's and the
substitute lessee's section 467 loans for the period when the substitute
lessee has use of the property and in computing the taxable income of
the lessee and substitute lessee:
(i) The beginning balance of the lessee's section 467 loan is equal
to the net present value, as of the time the substitute lessee first has
use of the property (but after giving effect to the transfer of the
right to use the property), of all amounts subsequently payable by the
lessee as fixed rent and interest on fixed rent and all amounts
subsequently payable as interest on prepaid fixed rent to the lessee.
For purposes of this paragraph (f), any
[[Page 330]]
amount otherwise payable by the lessee is not treated as an amount
subsequently payable by the lessee to the extent that such payment, if
made by the lessee, would give rise to a right of contribution or other
similar claim against the substitute lessee or any other person. The
lessee must continue to take into account interest on the lessee's
section 467 loan balance after the substitute lessee first has use of
the property.
(ii) The beginning balance of the substitute lessee's section 467
loan is equal to the principal balance of the lessee's section 467 loan
immediately before the substitute lessee first has use of the property
reduced (below zero, if appropriate) by the beginning balance of the
lessee's section 467 loan. Amounts payable by the lessee to any person
other than the substitute lessee (or a related person) or payable to the
lessee by any person other than the substitute lessee (or a related
person) are not taken into account in adjusting the substitute lessee's
section 467 loan balance.
(iii) If the beginning balance of the substitute lessee's section
467 loan is positive, the beginning balance is treated as--
(A) Gross receipts of the lessee for the taxable year in which the
substitute lessee first has use of the property; and
(B) A liability that is either assumed in connection with the
transfer of the leasehold interest to the substitute lessee or secured
by property acquired subject to the liability.
(iv) If the beginning balance of the substitute lessee's section 467
loan is negative, the following rules apply:
(A) If the principal balance of the lessee's section 467 loan
immediately before the substitute lessee first has use of the property
was negative, any consideration paid by the substitute lessee to the
lessee in conjunction with the transfer of the use of the property shall
be treated as a nontaxable return of capital to the lessee to the extent
that--
(1) The consideration does not exceed the amount owed to the lessee
under the lessee's section 467 loan balance immediately before the
substitute lessee first has use of the property; and
(2) The lessee has basis in the principal balance of the lessee's
section 467 loan immediately before the substitute lessee first has use
of the property.
(B) Except as provided in paragraph (f)(2)(iv)(D) of this section,
the excess, if any, of the beginning balance of the amount owed to the
substitute lessee under the section 467 loan, over any consideration
paid by the substitute lessee to the lessee in conjunction with the
transfer of the use of the property, is treated as an amount incurred by
the lessee for the taxable year in which the substitute lessee first has
use of the property.
(C) To the extent the beginning balance of the amount owed to the
substitute lessee under the section 467 loan exceeds any consideration
paid by the substitute lessee to the lessee in conjunction with the
transfer of the use of the property, repayments of the beginning balance
are items of gross income of the substitute lessee in the taxable year
in which repayment occurs (determined by applying any repayment first to
the beginning balance of the substitute lessee's section 467 loan).
(D) Any amount incurred by the lessee under paragraph (f)(2)(iv)(B)
of this section with respect to a transfer of the use of property (the
current transfer) shall be reduced (but not below zero) to the extent
that the lessee, in its capacity, if any, as a substitute lessee with
respect to an earlier transfer of the use of the property would have
recognized additional gross income under paragraph (f)(2)(iv)(C) of this
section if the current transfer had not occurred.
(v) For purposes of paragraph (f)(2)(iv)(C) of this section,
repayments occur as the negative balance is amortized through the net
accrual of rent and negative interest.
(3) Lessor use. If a period when the lessor has the use of property
subject to a section 467 rental agreement is included in the lease term
under Sec. 1.467-1(h)(6), the section 467 rent for the period is not
taken into account and the lessor is treated as a substitute lessee for
purposes of this paragraph (f).
(4) Examples. The following examples illustrate the application of
this paragraph (f). In each of these examples,
[[Page 331]]
the substitute lessee is liable for the rent for the day on which the
substitute lessee first has use of the property subject to the section
467 rental agreement. Further, assume that in each example the lessee
assignment is not a substantial modification under Sec. 1.467-1(f). The
examples are as follows:
Example 1. (i) The facts are the same as in Example 1 of paragraph
(e)(4) of this section, except that on December 31, 2001, R, the lessee,
contracts to assign its entire remaining interest in the leasehold to S,
a calendar year taxpayer. The assignment becomes effective at the
beginning of January 1, 2002. Pursuant to the terms of the assignment, R
agrees with S that R will make $1,400,000 of the $1,750,000 rental
payment required on December 31, 2003.
(ii) Under paragraph (f)(2)(i) of this section, R's section 467 loan
balance as of the beginning of January 1, 2002, the time S first has use
of the property, is $1,136,271.41 ($1,400,000/(1.11)2). Under paragraph
(f)(2)(ii) of this section, S's section 467 loan balance as of the
beginning of January 1, 2002, is $114,759.98 (the principal balance of
R's section 467 loan immediately before S has use of the property
($1,251,031.39), less R's section 467 loan balance at the beginning of
January 1, 2002 ($1,136,271.41)).
(iii) Because S's $114,759.98 section 467 loan balance is positive,
under paragraph (f)(2)(iii)(A) of this section, such amount is treated
as gross receipts of R for 2002, R's taxable year in which S first has
use of the property. R will treat the $114,759.98 as an amount received
in exchange for the transfer of the leasehold interest. Under paragraph
(f)(2)(iii)(B) of this section, S will treat that amount as a liability
assumed in acquiring the leasehold interest. Thus, S's cost basis in the
leasehold interest is $114,759.98.
(iv) Under paragraph (f)(1) of this section, S takes the section 467
rent attributable to the property into account for the period beginning
on January 1, 2002. For 2002, S takes section 467 interest into account
based on S's section 467 loan balance at the beginning of 2002. S's
amounts payable, section 467 rent, section 467 interest, and end-of-year
section 467 loan balances for calendar years 2002 through 2004 are as
follows:
----------------------------------------------------------------------------------------------------------------
Section 467 Section 467 loan
Calendar year Payment interest Section 467 rent balance
----------------------------------------------------------------------------------------------------------------
Beginning........................... ................. ................. ................. $114,759.98
2002................................ $0 $12,623.60 $592,905.87 720,289.45
2003................................ 350,000.00 79,231.83 592,905.87 1,042,427.15
2004................................ 1,750,000.00 114,666.98 592,905.87 0
----------------------------------------------------------------------------------------------------------------
(v) Under paragraph (f)(2)(i) of this section, R must continue to
take into account section 467 interest on R's section 467 loan balance
after S first has use of the property. R's section 467 loan balance
beginning when S first has use of the property is $1,136,271.41. R's
section 467 interest and end-of-year section 467 loan balances for
calendar years 2002 through 2003 are as follows:
----------------------------------------------------------------------------------------------------------------
Section 467 Section 467 loan
Calendar year Payment interest balance
----------------------------------------------------------------------------------------------------------------
Beginning.............................................. ................. ................. $1,136,271.41
2002................................................... $0 $124,989.85 1,261,261.26
2003................................................... 1,400,000.00 138,738.74 0
----------------------------------------------------------------------------------------------------------------
Example 2. (i) On January 1, 2000, B leases tangible personal
property from C for a period of five years. The rental agreement
provides that the rental period is the calendar year and that rent
payments are due at the end of the calendar year. The rental agreement
does not provide for interest on prepaid rent. Assume that B and C are
both calendar year taxpayers and that 110 percent of the applicable
Federal rate is 10 percent, compounded annually. The rental agreement
allocates rents and provides for payments of rent as follows:
------------------------------------------------------------------------
Calendar year Rent Payments
------------------------------------------------------------------------
2000.................................... $200,000 $400,000
2001.................................... 200,000 300,000
2002.................................... 200,000 200,000
2003.................................... 200,000 100,000
2004.................................... 200,000 0
------------------------------------------------------------------------
(ii) The rental agreement has prepaid rent within the meaning of
Sec. 1.467-1(c)(3)(ii) because the cumulative amount of rent payable
through the end of 2001 ($700,000) exceeds the cumulative amount of rent
allocated to calendar years 2000 through 2002 ($600,000). Because the
rental agreement does not provide for adequate interest on prepaid fixed
rent,
[[Page 332]]
the rent for each calendar year during the lease term is the
proportional rental amount, as described in Sec. 1.467-2(c). The
amounts payable, section 467 rent, section 467 interest, and end-of-year
section 467 loan balances for each calendar year are as follows:
----------------------------------------------------------------------------------------------------------------
Section 467 Section 467 loan
Calendar year Payment interest Section 467 rent balance
----------------------------------------------------------------------------------------------------------------
2000.............................. $400,000 $0 $218,987.40 ($181,012.60)
2001.............................. 300,000 (18,101.26) 218,987.40 (280,126.46)
2002.............................. 200,000 (28,012.64) 218,987.40 (289,151.70)
2003.............................. 100,000 (28,915.17) 218,987.40 (199,079.47)
2004.............................. 0 (19,907.93) 218,987.40 0
----------------------------------------------------------------------------------------------------------------
(iii) On December 31, 2001, B contracts to assign its entire
remaining interest in the leasehold to D, a calendar year taxpayer. The
assignment becomes effective at the beginning of January 1, 2002. D pays
B $278,000 on January 1, 2002, in conjunction with the assignment of the
leasehold interest. Under the terms of the assignment, B is not
obligated to make any rental payments due after the assignment.
(iv) Under paragraph (f)(2)(i) of this section, B's section 467 loan
balance as of the beginning of January 1, 2002, the time D first has use
of the property, is zero because D is obligated to make all rent
payments due after the assignment of the leasehold interest. Under
paragraph (f)(2)(ii) of this section, D's section 467 loan balance as of
the beginning of January 1, 2002, is negative $280,126.46 (the principal
balance of B's section 467 loan immediately before D has use of the
property (negative $280,126.46), less B's section 467 loan balance when
D first has use of the property (zero)). Because D's beginning section
467 loan balance is negative, paragraph (f)(2)(iv) of this section
applies.
(v) Because B's $280,126.46 section 467 loan balance at the end of
2001 (that is, immediately before D has use of the property) is
negative, paragraph (f)(2)(iv)(A) of this section applies. B's loan
balance is the amount owed to B under the section 467 loan and consists
of the excess of B's payments to C over the net amount of rent and
negative interest B has taken into account through the end of 2001.
Thus, B's basis in the negative section 467 loan balance at the end of
2001 is $280,126.46. Because the $278,000 paid by D to B in conjunction
with the transfer of the leasehold interest does not exceed the amount
owed to B under the section 467 loan at the end of 2001, and does not
exceed B's basis in that loan balance, under paragraph (f)(2)(iv)(A) of
this section B treats the $278,000 payment from D as a nontaxable return
of capital.
(vi) The beginning balance of the amount owed to D under the section
467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 paid by D to B
in conjunction with the transfer of the leasehold interest. Paragraph
(f)(2)(iv)(B) of this section treats the $2,126.46 as an amount incurred
by B in 2002, B's taxable year in which D first has use of the property.
Paragraph (f)(2)(iv)(D) of this section does not apply to reduce the
amount incurred by B because B is the original lessee under the section
467 rental agreement.
(vii) Under paragraph (f)(1) of this section, D takes the section
467 rent into account for the period beginning when D first has use of
the property. D takes section 467 interest into account based on a
beginning section 467 loan balance of negative $280,126.46.
(viii) The beginning balance of the amount owed to D under the
section 467 loan ($280,126.46) exceeds by $2,126.46 the $278,000 paid by
D to B in conjunction with the transfer of the leasehold interest. Under
paragraph (f)(2)(iv)(C) of this section, D must include this amount in
gross income in 2002, the year in which this amount of D's beginning
section 467 loan balance is paid through the net accrual of rent and
negative interest. This inclusion in gross income ensures that the
reductions in D's taxable income attributable to the section 467 rental
agreement will not exceed the actual amount of D's expenditures.
(g) Application of section 467 following a rental agreement
modification--(1) Substantial modifications. The following rules apply
to any substantial modification of a rental agreement occurring after
May 18, 1999 unless the entire agreement (as modified) is treated as a
single agreement under Sec. 1.467-1(f)(4)(vi):
(i) Treatment of pre-modification items. The lessor and lessee must
take pre-modification items (within the meaning of Sec. 1.467-
1(f)(5)(v)) into account under their method of accounting used before
the modification to report income and expense attributable to the rental
agreement.
(ii) Computations with respect to post-modification items. In
computing section 467 rent, section 467 interest, and the amount of the
section 467 loan with respect to post-modification items--
[[Page 333]]
(A) Post-modification items are treated as provided under a rental
agreement (the post-modification agreement) separate from the agreement
under which pre-modification items are provided;
(B) The lease term of the post-modification agreement begins at the
beginning of the first period for which rent other than pre-modification
rent is provided; and
(C) The applicable Federal rate for the post-modification agreement
is the applicable Federal rate in effect on the day on which the
modification occurs.
(iii) Adjustments--(A) Adjustment relating to certain prepayments.
If any payments before the beginning of the lease term of the post-
modification agreement are post-modification items, the lessor and
lessee must take into account, in the taxable year in which the
modification occurs, any adjustment necessary to prevent duplication
with respect to such payments or the omission of interest thereon for
periods before the beginning of the lease term.
(B) Adjustment relating to retroactive beginning of lease term. If
the lease term of a post-modification agreement begins before the date
on which the modification occurs, the lessor and lessee must take into
account in the taxable year in which the modification occurs any amount
necessary to prevent the duplication or omission of rent or interest for
the period after the beginning of the lease term of the post-
modification agreement and before the beginning of the taxable year in
which the modification occurs. For this purpose, the amount necessary to
prevent duplication or omission is determined after taking into account
any adjustments required by the Commissioner for taxable years ending
prior to the beginning of the taxable year in which the modification
occurs. In determining any adjustments required by the Commissioner for
taxable years ending prior to the beginning of the taxable year in which
the modification occurs, the Commissioner will disregard the
modification.
(iv) Coordination with rules relating to dispositions and
assignments--(A) Dispositions. If the modification involves a sale,
exchange, or other disposition of the property subject to the rental
agreement--
(1) Adjustments required under this paragraph (g) are taken into
account before applying paragraphs (a), (b), (c), and (e) of this
section;
(2) The prior understated inclusion for purposes of paragraph (b) of
this section is the sum of the prior understated inclusion with respect
to pre-modification items and the prior understated inclusion with
respect to post-modification items; and
(3) Paragraph (e) of this section applies separately with respect to
pre-modification items and post-modification items.
(B) Assignments. If the modification involves an assignment of the
lessee's interest in the rental agreement to a substitute lessee or a
substitute lessee having use of the property during a period otherwise
included in the lease term--
(1) Adjustments required under this paragraph (g) are taken into
account before applying paragraph (f) of this section; and
(2) Paragraph (f) of this section applies separately with respect to
pre-modification items and post-modification items.
(2) Other modifications. The following rules apply to a modification
(other than a substantial modification) of a rental agreement occurring
after May 18, 1999:
(i) Computation of section 467 loan for modified agreement. The
amount of the section 467 loan relating to the agreement is computed as
of the effective date of the modification. The section 467 rent and
section 467 interest for periods before the effective date of the
modification are determined, solely for purposes of computing the amount
of the section 467 loan, under the terms of the entire agreement (as
modified).
(ii) Change in balance of section 467 loan. (A) If the balance of
the section 467 loan determined under paragraph (g)(2)(i) of this
section is greater than the balance of the section 467 loan immediately
before the effective date of the modification, the difference is taken
into account, in the taxable year in which the modification occurs, as
additional rent.
[[Page 334]]
(B) If the balance of the section 467 loan determined under
paragraph (g)(2)(i) of this section is less than the balance of the
section 467 loan immediately before the effective date of the
modification, the difference is taken into account, in the taxable year
in which the modification occurs, as a reduction of the rent previously
taken into account by the lessor and lessee.
(C) For purposes of this paragraph (g)(2)(ii), a negative balance is
less than a positive balance, a zero balance, or any other negative
balance that is closer to a zero balance.
(iii) Section 467 rent and interest after the modification. The
section 467 rent and section 467 interest for periods after the
effective date of the modification are determined under the terms of the
entire agreement (as modified).
(iv) Applicable Federal rate. The applicable Federal rate for the
agreement does not change as a result of the modification.
(v) Modification effective within a rental period. If the effective
date of a modification does not coincide with the beginning or end of a
rental period under the agreement in effect before the modification, the
section 467 rent and section 467 interest for the portion of the rental
period ending immediately prior to the effective date of the
modification are a pro rata portion of the section 467 rent and the
section 467 interest, respectively, for the rental period. Such amounts
are also taken into account in determining the section 467 loan balance,
prior to any adjustment thereof that may be required under paragraph (h)
of this section, immediately before the effective date of the
modification. Similar rules apply with respect to the section 467 rent
and section 467 interest determined under the terms of the entire
agreement (as modified) for purposes of computing the amount of the
section 467 loan under paragraph (g)(2)(i) of this section and the
section 467 rent and section 467 interest for a partial rental period
beginning on the effective date of the modification.
(vi) Other adjustments. The lessor and lessee must take into
account, in the taxable year in which a retroactive modification occurs,
any amount necessary to prevent the duplication or omission of rent or
interest for the period before the beginning of the taxable year in
which the modification occurs.
(vii) Coordination with rules relating to dispositions and
assignments. If the modification involves a sale, exchange, or other
disposition of the property subject to the rental agreement, an
assignment of the lessee's interest in the rental agreement to a
substitute lessee or a substitute lessee having use of the property
during a period otherwise included in the lease term, adjustments
required under this paragraph (g) are taken into account before applying
paragraphs (a), (b), (c), (e), and (f) of this section.
(viii) Exception for agreements entered into prior to effective date
of section 467. This paragraph (g)(2) does not apply to a modification
of a rental agreement that is not subject to section 467 because of the
effective date provisions of section 92(c) of the Tax Reform Act of 1984
(Public Law 98-369 (98 Stat. 612)).
(3) Adjustment by Commissioner. If the entire agreement (as
modified) is treated as a single agreement under Sec. 1.467-
1(f)(4)(vi), the Commissioner may require adjustments to taxable income
to reflect the effect of the modification, including adjustments that
are similar to those required under paragraph (g)(2) of this section.
(4) Effective date of modification. The effective date of a
modification of a rental agreement occurs at the earliest of--
(i) The date on which the modification occurs;
(ii) The beginning of the first period for which the amount of rent
or interest provided under the entire agreement (as modified) differs
from the amount of rent or interest provided under the agreement in
effect before the modification;
(iii) The due date of the first payment, under either the entire
agreement (as modified) or the agreement in effect before the
modification, that is not identical, in due date and amount, under both
such agreements;
(iv) The date, in the case of a modification involving the
substitution of a new lessor, on which the property subject to the
rental agreement is transferred; or
[[Page 335]]
(v) The date, in the case of a modification involving the
substitution of a new lessee, on which the substitute lessee first has
use of the property subject to the rental agreement.
(5) Examples. The following examples illustrate the application of
this paragraph (g):
Example 1. (i) F, a cash method lessor, and G, an accrual method
lessee, agree to a 7-year lease of tangible personal property for the
period beginning on January 1, 1998, and ending on December 31, 2004.
The rental agreement allocates $100,000 of rent to each calendar year
during the lease term, such rent to be paid December 31 following the
close of the calendar year to which it is allocated. Because the rental
agreement does not provide for increasing rent, or deferred rent within
the meaning of section 467(d)(1)(A), section 467 does not apply to the
rental agreement.
(ii) Prior to January 1, 2001, G timely makes the $100,000 rental
payments required as of December 31, 1999, and December 31, 2000. On
January 1, 2001, F and G modify the rental agreement payment schedule to
provide for a single final payment of $500,000 on December 31, 2004.
Assume that the change is a substantial modification within the meaning
of Sec. 1.467-1(f)(5)(ii). Because the modification occurs after May
18, 1999, the post-modification agreement is treated, under Sec. 1.467-
1(f)(1), as a new agreement for purposes of determining whether it is a
section 467 rental agreement.
(iii) Under Sec. 1.467-1(f)(5)(v), the $200,000 of rent allocated
to calendar years 1998 and 1999 (periods prior to the modification)
constitutes pre-modification rent, and the $100,000 rent payments made
on December 31, 1999, and December 31, 2000, constitute pre-modification
payments. Although calendar year 2000 is also prior to the modification,
the rent allocated to calendar year 2000 is not pre-modification rent
and the related payment is not a pre-modification payment because the
modification changed the time at which that rent is payable. See Sec.
1.467-1(f)(5)(v)(A).
(iv) Under paragraph (g)(1)(i) of this section, F and G take pre-
modification rent and pre-modification payments into account under the
method of accounting they used to report income and deductions
attributable to the pre-modification agreement.
(v) Under Sec. 1.467-1(f)(1)(i), the post-modification agreement
providing rent for the period beginning on January 1, 2000, and ending
on December 31, 2004, is treated as a new rental agreement. This rental
agreement allocates $100,000 of rent to each of the calendar years 2000
through 2004 and provides for a single rental payment of $500,000 on
December 31, 2004. Because the post-modification agreement provides for
deferred rent under Sec. 1.467-1(c)(3)(i), section 467 applies.
Further, the post-modification agreement does not provide for adequate
interest on fixed rent, and therefore F and G must account for fixed
rent and interest on fixed rent using proportional rental accrual. Under
paragraph (g)(1)(iii) of this section, for their taxable years which
include January 1, 2001, F and G must adjust reported rent for the
difference between the rent taken into account for the calendar year
2000 under the unmodified agreement and the proportional rental amount
for that year under the post-modification agreement.
Example 2. (i) On January 1, 2000, X, lessee, and Y, lessor, enter
into a rental agreement for a 6-year lease of tangible personal property
beginning January 1, 2000, and endingDecember 31, 2005. The agreement
provides that the calendar year is the rental period and all rent
payments are due on July 15 of all years in which a payment is required.
Assume the agreement is not a disqualified leaseback or long-term
agreement within the meaning of Sec. 1.467-3(b), and has the following
allocation schedule and payment schedule:
------------------------------------------------------------------------
Year Allocation Payment
------------------------------------------------------------------------
2000.................................... $800,000 $0
2001.................................... 900,000 0
2002.................................... 1,000,000 1,500,000
2003.................................... 1,000,000 1,500,000
2004.................................... 1,100,000 1,500,000
2005.................................... 1,200,000 1,500,000
------------------------------------------------------------------------
(ii) The rental agreement has deferred rent within the meaning of
Sec. 1.467-1(c)(3)(i) because the rent allocated to 2000 is not payable
until 2002 and some of the rent allocable to 2001 is not payable until
2003. Further, the rental agreement does not provide adequate interest
on fixed rent within the meaning of Sec. 1.467-2(b). Therefore, the
rent amount to be accrued by X and Y for each rental period is the
proportional rental amount, as described in Sec. 1.467-2(c). Assuming
110 percent of the applicableFederal rate is 10 percent compounded
annually, the section 467 rent, interest, and loan balances are as
follows:
----------------------------------------------------------------------------------------------------------------
Year Rent Interest Loan balance
----------------------------------------------------------------------------------------------------------------
2000................................................... $736,949.55 $0 $736,949.55
2001................................................... 829,068.24 73,694.96 1,639,712.75
2002................................................... 921,186.94 163,971.28 1,224,870.97
2003................................................... 921,186.94 122,487.10 768,545.01
2004................................................... 1,013,305.63 76,854.50 358,705.14
[[Page 336]]
2005................................................... 1,105,424.33 35,870.53 0
----------------------------------------------------------------------------------------------------------------
(iii)(A) On January 1, 2004, X and Y agree that the $1,500,000
payment scheduled for July 15, 2005, will be made in three equal
installments on June 15, 2005, July 15, 2005, and August 15, 2005. Under
Sec. 1.467-1(j)(2)(i)(C) (relating to timing conventions), the payment
to be made on June 15, 2005, is treated as if it were payable on
December 31, 2004, for purposes of determining present values and yield
of the section 467 loan. Assume that this change, which results in the
following allocation schedule and payment schedule, is not a substantial
modification within the meaning of Sec. 1.467-1(f)(5)(ii):
------------------------------------------------------------------------
Year Allocation Payment
------------------------------------------------------------------------
2000.................................... $800,000 $0
2001.................................... 900,000 0
2002.................................... 1,000,000 1,500,000
2003.................................... 1,000,000 1,500,000
2004.................................... 1,100,000 2,000,000
2005.................................... 1,200,000 1,000,000
------------------------------------------------------------------------
(B) The agreement remains subject to proportional rental accrual
after the modification because it has deferred rent and does not provide
adequate interest on fixed rent within the meaning of Sec. 1.467-2(b).
(iv) Because the modification occurs after May 18, 1999, and is not
substantial within the meaning of Sec. 1.467-1(f)(5)(ii), paragraph
(g)(2) of this section applies. Under paragraph (g)(2)(i) of this
section, the amount of the section 467 loan relating to the modified
agreement is computed as of the effective date of the modification, and,
solely for purposes of recomputing the amount of the section 467 loan,
the section 467 rent and section 467 interest for periods before the
modification are determined under the terms of the entire agreement (as
modified). In addition, the applicable Federal rate does not change as a
result of the modification. Thus, the recomputed section 467 rent,
interest, and loan balances are as follows:
----------------------------------------------------------------------------------------------------------------
Year Rent Interest Loan balance
----------------------------------------------------------------------------------------------------------------
2000................................................. $ 742,242.59 $ 0 $ 742,242.59
2001................................................. 835,022.91 74,224.26 1,651,489.76
2002................................................. 927,803.24 165,148.98 1,244,441.98
2003................................................. 927,803.24 124,444.20 796,689.42
2004................................................. 1,020,583.56 79,668.94 (103,058.08)
2005................................................. 1,113,363.88 (10,305.80) 0
----------------------------------------------------------------------------------------------------------------
(v) Under paragraph (g)(2)(ii) of this section, the difference
between the section 467 loan balance immediately before the effective
date of the modification and the recomputed section 467 loan balance as
of the effective date of the modification is taken into account. In this
example, the loan balance immediately before the effective date of the
modification is $768,545.01 and the recomputed loan balance as of the
effective date of the modification is $796,689.42. Thus, because the
recomputed loan balance exceeds the original loan balance, the
difference ($28,144.41) is taken into account, in the taxable year in
which the modification occurs, as additional rent. Beginning on January
1, 2004, section 467 rent and interest are taken into account by X and Y
in accordance with the recomputed rent schedule set forth in paragraph
(iv) of this example.
(h) Omissions or duplications--(1) In general. In applying the rules
of this section in conjunction with the rules of Sec. Sec. 1.467-1
through 1.467-5, adjustments must be made to the extent necessary to
prevent the omission or duplication of items of income, deduction, gain,
or loss. For example, if a transferee lessor acquires property subject
to a section 467 rental agreement at other than the beginning or end of
a rental period, and the transferee lessor's beginning section 467 loan
balance differs from the transferor lessor's section 467 loan balance
immediately prior to the transfer, it will be necessary to treat the
rental period that includes the day of transfer as consisting of two
rental periods, one beginning at the beginning of the rental period that
includes the day of transfer and ending with or immediately prior to the
transfer and one beginning with or immediately after the transfer and
ending immediately prior to the beginning of the succeeding rental
period. Because the substitution of two rental periods for one rental
period may change the proportional rental amount or constant rental
amount, the change in rental periods should be treated as a modification
of
[[Page 337]]
the rental agreement that occurs immediately prior to the transfer. The
change in rental periods, by itself, is not treated as a substantial
modification of the rental agreement although the substitution of a new
lessor may constitute a substantial modification of the rental
agreement. Likewise, Sec. 1.467-1(j)(2), which provides rules regarding
when amounts are treated as payable, is designed to simplify
calculations of present values, section 467 loan balances, and
proportional and constant rental amounts. These simplifying conventions
assume that there will be no change in the lessor or lessee under a
section 467 rental agreement and that the terms of the section 467
rental agreement will not be modified. Therefore, as illustrated in the
example in paragraph (h)(2) of this section, when actual events do not
reflect these assumptions, it may be necessary to alter the application
of these rules to properly reflect taxable income.
(2) Example. The following example illustrates an application of
this paragraph (h):
Example. (i) J leases tangible personal property from K for five
years beginning on January 1, 2000, and ending on December 31, 2004.
Under the rental agreement, rent is payable on July 15 of the calendar
year to which it is allocated. Both J and K treat the calendar year as
the rental period. The allocation of rent and payments of rent required
under the rental agreement are as follows:
------------------------------------------------------------------------
Calendar year Rent Payments
------------------------------------------------------------------------
2000.................................... $200,000 $450,000
2001.................................... 200,000 250,000
2002.................................... 200,000 200,000
2003.................................... 200,000 100,000
2004.................................... 200,000 0
------------------------------------------------------------------------
(ii) The rental agreement does not provide for interest on prepaid
rent. The rental agreement has prepaid rent under Sec. 1.467-
1(c)(3)(ii) because the rent payable at the end of 2000 exceeds the
cumulative amount of rent allocated to 2000 and 2001. Therefore, J and K
must take section 467 rent into account under the proportional rental
method of Sec. 1.467-2(c). Assume that 110 percent of the applicable
Federal rate is 10 percent, compounded annually. The section 467 rent,
section 467 interest, amounts payable, and section 467 loan balances for
each of the calendar years under the terms of the rental agreement are
as follows:
----------------------------------------------------------------------------------------------------------------
Section 467 Section 467 loan
Calendar Year Section 467 rent interest Payments balance
----------------------------------------------------------------------------------------------------------------
2000.............................. $220,077.48 $0 $450,000 $(229,922.52)
2001.............................. 220,077.48 (22,992.25) 250,000 (282,837.29)
2002.............................. 220,077.48 (28,283.73) 200,000 (291,043.54)
2003.............................. 220,077.48 (29,104.35) 100,000 (200,070.41)
2004.............................. 220,077.48 (20,007.07) 0 0
----------------------------------------------------------------------------------------------------------------
(iii) On January 1, 2002, J and K amend the terms of the rental
agreement to advance the due date of the $200,000 payment originally due
on July 15, 2002, to June 15, 2002. This change in the payment schedule
constitutes a modification of the terms of the rental agreement within
the meaning of Sec. 1.467-1(f)(5)(i). Assume, however, that the change
is not a substantial modification within the meaning of Sec. 1.467-
1(f)(5)(ii). Because the modification occurs after May 18, 1999, and is
not substantial, paragraph (g)(2) of this section applies. Thus, the
section 467 loan balance at the beginning of 2002 must be recomputed as
if the June 15, 2002, payment date had been included in the terms of the
pre-modification rental agreement. If this had been the case, the
section 467 rent, section 467 interest, amounts payable, and section 467
loan balances for each of the calendar years under the terms of the
rental agreement would have been as follows:
----------------------------------------------------------------------------------------------------------------
Section 467 Section 467 loan
Calendar Section 467 rent interest Payments balance
----------------------------------------------------------------------------------------------------------------
2000.............................. $224,041.38 $0 $450,000 $(225,958.62)
2001.............................. 224,041.38 (22,595.86) 450,000 (474,513.10)
2002.............................. 224,041.38 (47,451.31) 0 (297,923.03)
2003.............................. 224,041.38 (29,792.30) 100,000 (203,673.95)
2004.............................. 224,041.38 (20,367.43) 0 0
----------------------------------------------------------------------------------------------------------------
(iv) Section 1.467-4(b)(3) incorporates the conventions of Sec.
1.467-1(j)(2) in determining when amounts are treated as payable for
purposes of determining the section 467 loan
[[Page 338]]
balance. Section 1.467-1(j)(2)(i)(C) treats amounts payable during the
first half of any rental period except the first rental period as
payable on the last day of the preceding rental period. Therefore,
because June 15, 2002, occurs in the first half of 2002, in determining
the section 467 loan balance at the beginning of 2002 under the amended
terms of the rental agreement, the $200,000 payment due on June 15,
2002, is treated as payable on December 31, 2001.
(v) Under paragraph (g)(2)(ii)(B) of this section, if the recomputed
section 467 loan balance is less than the section 467 loan balance
immediately before the modification, the difference is taken into
account as a reduction of the rent previously taken into account by the
lessor and the lessee. In this example, the recomputed section 467 loan
balance immediately after the modification is negative $474,513.10 and
the section 467 loan balance immediately before the modification is
negative $282,837.29. However, the section 467 loan balance immediately
before the modification does not take into account the $200,000 payment
originally payable on July 15, 2002, whereas, under the conventions of
Sec. 1.467-1(j)(2)(i)(C), the recomputed section 467 loan balance
immediately after the modification takes into account that $200,000
payment because it is now payable in the first half of the rental period
(June 15). Under these circumstances, if the recomputed section 467 loan
balance immediately after the modification is treated as negative
$474,513.10 for purposes of applying paragraph (g)(2)(ii)(B) of this
section, K's gross income and J's deductions attributable to the section
467 rental agreement will be understated by $200,000. Therefore, under
paragraph (h)(1) of this section, only for purposes of applying
paragraph (g)(2)(ii)(B) of this section, the $200,000 payment due on
June 15, 2002, should not be taken into account in determining the
recomputed section 467 loan balance immediately after the modification.
[T.D. 8820, 64 FR 26867, May 18, 1999, as amended by T.D. 9811, 82 FR
6238, Jan. 19, 2017]
Sec. 1.467-8 Automatic consent to change to constant rental accrual
for certain rental agreements.
(a) General rule. For the first taxable year ending after May 18,
1999, a taxpayer may change to the constant rental accrual method, as
described in Sec. 1.467-3, for all of its section 467 rental agreements
described in paragraph (b) of this section. A change to the constant
rental accrual method is a change in method of accounting to which the
provisions of sections 446 and 481 and the regulations thereunder apply.
A taxpayer changing its method of accounting in accordance with this
section must follow the automatic change in accounting method provisions
of Rev. Proc. 98-60 (see Sec. 601.601(d)(2) of this chapter) except,
for purposes of this paragraph (a), the scope limitations in section
4.02 of Rev. Proc. 98-60 are not applicable. Taxpayers changing their
method of accounting in accordance with this section must do so for all
of their section 467 rental agreements described in paragraph (b) of
this section.
(b) Agreements to which automatic consent applies. A section 467
rental agreement is described in this paragraph (b) if--
(1) The property subject to the section 467 rental agreement is
financed with an ``exempt facility bond'' within the meaning of section
142;
(2) The facility subject to the section 467 rental agreement is
described in section 142(a)(1), (2), (3), or (12);
(3) The section 467 rental agreement does not include a specific
allocation of fixed rent within the meaning of Sec. 1.467-
1(c)(2)(ii)(A)(2); and
(4) The section 467 rental agreement was entered into on or before
May 18, 1999.
[T.D. 8820, 64 FR 26875, May 18, 1999]
Sec. 1.467-9 Effective/applicability dates and automatic method changes
for certain agreements.
(a) In general. Sections 1.467-1 through 1.467-7 are applicable
for--
(1) Disqualified leasebacks and long-term agreements entered into
after June 3, 1996; and
(2) Rental agreements not described in paragraph (a)(1) of this
section that are entered into after May 18, 1999.
(b) Automatic consent for certain rental agreements. Section 1.467-8
applies only to rental agreements described in Sec. 1.467-8.
(c) Application of regulation project IA-292-84 to certain
leasebacks and long-term agreements. In the case of any leaseback or
long-term agreement (other than a disqualified leaseback or long-term
agreement) entered into after June 3, 1996, and on or before May 18,
1999, a taxpayer may choose to apply the provisions of regulation
project IA-292-84
[[Page 339]]
(1996-2 C.B. 462)(see Sec. 601.601(d)(2) of this chapter).
(d) Entered into. For purposes of this section and Sec. 1.467-8, a
rental agreement is entered into on its agreement date (within the
meaning of Sec. 1.467-1(h)(1) and, if applicable, Sec. 1.467-
1(f)(1)(i)).
(e) Change in method of accounting--(1) In general. For the first
taxable year ending after May 18, 1999, a taxpayer is granted consent of
the Commissioner to change its method of accounting for rental
agreements described in paragraph (a)(2) of this section to comply with
the provisions of Sec. Sec. 1.467-1 through 1.467-7.
(2) Application of regulation project IA-292-84. For the first
taxable year ending after May 18, 1999, a taxpayer is granted consent of
the Commissioner to change its method of accounting for any rental
agreement described in paragraph (c) of this section to comply with the
provisions of regulation project IA-292-84 (1996-2 C.B. 462) (see Sec.
601.601(d)(2) of this chapter).
(3) Automatic change procedures. A taxpayer changing its method of
accounting in accordance with this paragraph (e) must follow the
automatic change in accounting method provisions of Rev. Proc. 98-60
(see Sec. 601.601(d)(2) of this chapter) except, for purposes of this
paragraph (e), the scope limitations in section 4.02 of Rev. Proc. 98-60
are not applicable. A method change in accordance with paragraph (e)(1)
of this section is made on a cut-off basis so no adjustment under
section 481(a) is required.
(f) Application of section 1022. The provisions of Sec. 1.467-
7(c)(2) and (4) relating to section 1022 are effective on and after
January 19, 2017.
[T.D. 8820, 64 FR 26875, May 18, 1999, as amended by T.D. 9811, 82 FR
6238, Jan. 19, 2017]
Sec. 1.468A-0 Nuclear decommissioning costs; table of contents.
This section lists the paragraphs contained in Sec. Sec. 1.468A-1
through 1.468A-9.
Sec. 1.468A-1 Nuclear decommissioning costs; general rules.
(a) Introduction.
(b) Definitions.
(c) Special rules applicable to certain experimental nuclear
facilities.
Sec. 1.468A-2 Treatment of electing taxpayer.
(a) In general.
(b) Limitation on payments to a nuclear decommissioning fund.
(1) In general.
(2) Excess contributions not deductible.
(c) Deemed payment rules.
(1) In general.
(2) Cash payment by customer.
(d) Treatment of distributions.
(1) In general.
(2) Exceptions to inclusion in gross income.
(i) Payment of administrative costs and incidental expenses.
(ii) Withdrawals of excess contributions.
(iii) Actual distributions of amounts included in gross income as
deemed distributions.
(e) Deduction when economic performance occurs.
Sec. 1.468A-3 Ruling amount.
(a) In general.
(b) Level funding limitation.
(c) Funding period.
(d) Decommissioning costs allocable to a fund.
(1) General rule.
(2) Total estimated cost of decommissioning.
(3) Taxpayer's share.
(e) Manner of requesting schedule of ruling amounts.
(1) In general.
(2) Information required.
(3) Administrative procedures.
(f) Review and revision of schedule of ruling amounts.
(1) Mandatory review.
(2) Elective review.
(3) Determination of revised schedule of ruling amounts.
(g) Special rule permitting payments to a nuclear decommissioning
fund before receipt of an initial or revised ruling amount applicable to
a taxable year.
Sec. 1.468A-4 Treatment of nuclear decommissioning fund.
(a) In general.
(b) Modified gross income.
(c) Special rules.
(1) Period for computation of modified gross income.
(2) Gain or loss upon distribution of property by a fund.
(3) Denial of credits against tax.
(4) Other corporate taxes inapplicable.
(d) Treatment as corporation for purposes of subtitle F.
Sec. 1.468A-5 Nuclear decommissioning fund--miscellaneous provisions.
(a) Qualification requirements.
(1) In general.
(2) Limitation on contributions.
[[Page 340]]
(3) Limitation on use of fund.
(i) In general.
(ii) Definition of administrative costs and expenses.
(4) Trust provisions.
(b) Prohibitions against self-dealing.
(1) In general.
(2) Self-dealing defined.
(3) Disqualified person defined.
(c) Disqualification of nuclear decommissioning fund.
(1) In general.
(2) Exception to disqualification.
(i) In general.
(ii) Excess contribution defined.
(iii) Taxation of income attributable to an excess contribution.
(3) Effect of disqualification.
(4) Further effects of disqualification.
(d) Termination of nuclear decommissioning fund upon substantial
completion of decommissioning.
(1) In general.
(2) Additional rules.
(3) Substantial completion of decommissioning defined.
Sec. 1.468A-6 Disposition of an interest in a nuclear power plant.
(a) In general.
(b) Requirements.
(c) Tax consequences.
(1) The transferor and its Fund.
(2) The transferee and its Fund.
(3) Basis.
(d) Determination of proportionate amount.
(e) Calculation of schedule of ruling amounts and schedule of
deduction amounts for dispositions described in this section.
(1) Transferor.
(i) Taxable year of disposition.
(ii) Taxable years after the disposition.
(2) Transferee.
(i) Taxable year of disposition.
(ii) Taxable years after the disposition.
(3) Examples.
(f) Anti-abuse provision.
Sec. 1.468A-7 Manner of and time for making election.
(a) In general.
(b) Required information.
Sec. 1.468A-8 Special transfers to qualified funds pursuant to section
468A(f).
(a) General rule.
(1) In general.
(2) Pre-2005 nonqualifying amount.
(i) In general.
(ii) Pre-2005 nonqualifying amount of transferee.
(3) Transfers in multiple years.
(4) Deemed payment rules.
(i) In general.
(ii) Special rule for certain transfers.
(b) Deduction for amounts transferred.
(1) In general.
(2) Amount of deduction.
(i) General Rule.
(ii) Election.
(A) In general.
(B) Manner of making election.
(C) Election allowed for property transferred prior to December 23,
2010.
(3) Denial of deduction for previously deducted amounts.
(4) Transfers of qualified nuclear decommissioning funds.
(5) Special rules.
(i) Gain or loss not recognized on transfers to fund.
(ii) Taxpayer basis in fund.
(iii) Fund basis in transferred property.
(A) In general.
(B) Basis in case of election.
(c) Schedule of deductions required.
(1) In general.
(2) Transfers in multiple taxable years.
(3) Transfer of partial interest in fund.
(4) Special transfer permitted before receipt of schedule.
(d) Manner of requesting schedule of deduction amounts.
(1) In general.
(2) Information required.
(3) Statement required.
(4) Administrative procedures.
Sec. 1.468A-9 Effective/applicability date.
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
Sec. 1.468A-1 Nuclear decommissioning costs; general rules.
(a) Introduction. Section 468A provides an elective method for
taking into account nuclear decommissioning costs for Federal income tax
purposes. In general, an eligible taxpayer that elects the application
of section 468A pursuant to the rules contained in Sec. 1.468A-7 is
allowed a deduction (as determined under Sec. 1.468A-2) for the taxable
year in which the taxpayer makes a cash payment to a nuclear
decommissioning fund. Taxpayers using an accrual method of accounting
that do not elect the application of section 468A are not allowed a
deduction for nuclear decommissioning costs prior to the taxable year in
which economic performance occurs with respect to such costs (see
section 461(h)).
(b) Definitions. The following terms are defined for purposes of
section 468A and Sec. Sec. 1.468A-1 through 1.468A-9:
(1) The term eligible taxpayer means any taxpayer that possesses a
qualifying interest in a nuclear power plant
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(including a nuclear power plant that is under construction).
(2) The term qualifying interest means--
(i) A direct ownership interest; and
(ii) A leasehold interest in any portion of a nuclear power plant
if--
(A) The holder of the leasehold interest is primarily liable under
Federal or State law for decommissioning such portion of the nuclear
power plant; and
(B) No other person establishes a nuclear decommissioning fund with
respect to such portion of the nuclear power plant.
(3) The term direct ownership interest includes an interest held as
a tenant in common or joint tenant, but does not include stock in a
corporation that owns a nuclear power plant or an interest in a
partnership that owns a nuclear power plant. Thus, in the case of a
partnership that owns a nuclear power plant, the election under section
468A must be made by the partnership and not by the partners. In the
case of an unincorporated organization described in Sec. 1.761-2(a)(3)
that elects under section 761(a) to be excluded from the application of
subchapter K, each taxpayer that is a co-owner of the nuclear power
plant is eligible to make a separate election under section 468A.
(4) The terms nuclear decommissioning fund and qualified nuclear
decommissioning fund mean a fund that satisfies the requirements of
Sec. 1.468A-5. The term nonqualified fund means a fund that does not
satisfy those requirements.
(5) The term nuclear power plant means any nuclear power reactor
that is used predominantly in the trade or business of the furnishing or
sale of electric energy. Each unit (that is, nuclear reactor) located on
a multi-unit site is a separate nuclear power plant. The term nuclear
power plant also includes the portion of the common facilities of a
multi-unit site allocable to a unit on that site.
(6) The term nuclear decommissioning costs or decommissioning costs
includes all otherwise deductible expenses to be incurred in connection
with the entombment, decontamination, dismantlement, removal and
disposal of the structures, systems and components of a nuclear power
plant, whether that nuclear power plant will continue to produce
electric energy or has permanently ceased to produce electric energy.
Such term includes all otherwise deductible expenses to be incurred in
connection with the preparation for decommissioning, such as engineering
and other planning expenses, and all otherwise deductible expenses to be
incurred with respect to the plant after the actual decommissioning
occurs, such as physical security and radiation monitoring expenses.
Such term also includes costs incurred in connection with the
construction, operation, and ultimate decommissioning of a facility used
solely to store, pending acceptance by the government for permanent
storage or disposal, spent nuclear fuel generated by the nuclear power
plant or plants located on the same site as the storage facility. Such
term does not include otherwise deductible expenses to be incurred in
connection with the disposal of spent nuclear fuel under the Nuclear
Waste Policy Act of 1982 (Pub. L. 97-425). An expense is otherwise
deductible for purposes of this paragraph (b)(6) if it would be
deductible under chapter 1 of the Internal Revenue Code without regard
to section 280B.
(7) The term public utility commission means any State or political
subdivision thereof, any agency, instrumentality or judicial body of the
United States, or any judicial body, commission or other similar body of
the District of Columbia or of any State or any political subdivision
thereof that establishes or approves rates for the furnishing or sale of
electric energy.
(8) The term ratemaking proceeding means any proceeding before a
public utility commission in which rates for the furnishing or sale of
electric energy are established or approved. Such term includes a
generic proceeding that applies to two or more taxpayers that are
subject to the jurisdiction of a single public utility commission.
(9) The term special transfer means any transfer of funds to a
qualified nuclear decommissioning fund pursuant to Sec. 1.468A-8.
(c) Special rules applicable to certain experimental nuclear
facilities. (1) The owner of a qualifying interest in an experimental
nuclear facility possesses a
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qualifying interest in a nuclear power plant for purposes of paragraph
(b) of this section if such person is engaged in the trade or business
of the furnishing or sale of electric energy.
(2) An owner of stock in a corporation that owns an experimental
nuclear facility possesses a qualifying interest in a nuclear power
plant for purposes of paragraph (b)(1) of this section if--
(i) Such stockholder satisfies the conditions of paragraph (c)(1) of
this section; and
(ii) The corporation that directly owns the facility is not engaged
in the trade or business of the furnishing or sale of electric energy.
(3) For purposes of this paragraph (c), an experimental nuclear
facility is a nuclear power reactor that is used predominantly for the
purpose of conducting experimentation and research.
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
Sec. 1.468A-2 Treatment of electing taxpayer.
(a) In general. An eligible taxpayer that elects the application of
section 468A pursuant to the rules contained in Sec. 1.468A-7 (an
electing taxpayer) is allowed a deduction for the taxable year in which
the taxpayer makes a cash payment (or is deemed to make a cash payment
as provided in paragraph (c) of this section) to a nuclear
decommissioning fund and for any taxable year in which a deduction is
allowed for a special transfer described in Sec. 1.468A-8. The amount
of the deduction for any taxable year equals the total amount of cash
payments made (or deemed made) by the electing taxpayer to a nuclear
decommissioning fund (or nuclear decommissioning funds) during such
taxable year under this section, plus any amount allowable as a
deduction in that taxable year for a special transfer described in Sec.
1.468A-8. The amount of a special transfer permitted under Sec. 1.468A-
8 is not treated as a cash payment for purposes of this paragraph (a),
and a taxpayer making a special transfer is allowed a ratable deduction
in each taxable year during the remaining useful life of the nuclear
power plant for the special transfer. A payment may not be made (or
deemed made) to a nuclear decommissioning fund before the first taxable
year in which all of the following conditions are satisfied:
(1) The construction of the nuclear power plant to which the nuclear
decommissioning fund relates has commenced.
(2) A ruling amount is applicable to the nuclear decommissioning
fund (see Sec. 1.468A-3).
(b) Limitation on payments to a nuclear decommissioning fund--(1) In
general. For purposes of paragraph (a) of this section, the maximum
amount of cash payments made (or deemed made) to a nuclear
decommissioning fund under paragraph (a) of this section during any
taxable year shall not exceed the ruling amount applicable to the
nuclear decommissioning fund for such taxable year (as determined under
Sec. 1.468A-3).
(2) Excess contributions not deductible. If the amount of cash
payments made (or deemed made) to a nuclear decommissioning fund during
any taxable year exceeds the limitation of paragraph (b)(1) of this
section, the excess is not deductible by the electing taxpayer. In
addition, see paragraph (c) of Sec. 1.468A-5 for rules which provide
that the Internal Revenue Service may disqualify a nuclear
decommissioning fund if the amount of cash payments made (or deemed
made) to a nuclear decommissioning fund during any taxable year exceeds
the limitation of paragraph (b)(1) of this section.
(3) Special transfer disregarded. The amount of a special transfer
permitted under Sec. 1.468A-8 is not treated as a cash payment for
purposes of this paragraph (b).
(c) Deemed payment rules--(1) In general. The amount of any cash
payment made by an electing taxpayer to a nuclear decommissioning fund
on or before the 15th day of the third calendar month after the close of
any taxable year (the deemed payment deadline date) shall be deemed made
during such taxable year if the electing taxpayer irrevocably designates
the amount as relating to such taxable year on its timely filed Federal
income tax return for such taxable year (see Sec. 1.468A-7(b)(4)(iii)
and (iv) for rules relating to such designation).
(2) Cash payment by customer. The amount of any cash payment made by
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a customer of an electing taxpayer to a nuclear decommissioning fund of
such electing taxpayer shall be deemed made by the electing taxpayer if
the amount is included in the gross income of the electing taxpayer in
the manner prescribed by section 88 and Sec. 1.88-1.
(d) Treatment of distributions--(1) In general. Except as otherwise
provided in paragraph (d)(2) of this section, the amount of any actual
or deemed distribution from a nuclear decommissioning fund shall be
included in the gross income of the electing taxpayer for the taxable
year in which the distribution occurs. The amount of any distribution of
property equals the fair market value of the property on the date of the
distribution. See Sec. 1.468A-5(c) and (d) for rules relating to the
deemed distribution of the assets of a nuclear decommissioning fund in
the case of a disqualification or termination of the fund. A
distribution from a nuclear decommissioning fund shall include an
expenditure from the fund or the use of the fund's assets--
(i) To satisfy, in whole or in part, the liability of the electing
taxpayer for decommissioning costs of the nuclear power plant to which
the fund relates; and
(ii) To pay administrative costs and other incidental expenses of
the fund.
(2) Exceptions to inclusion in gross income--(i) Payment of
administrative costs and incidental expenses. The amount of any payment
by a nuclear decommissioning fund for administrative costs or other
incidental expenses of such fund (as defined in Sec. 1.468A-
5(a)(3)(ii)) shall not be included in the gross income of the electing
taxpayer unless such amount is paid to the electing taxpayer (in which
case the amount of the payment is included in the gross income of the
electing taxpayer under section 61).
(ii) Withdrawals of excess contributions. The amount of a withdrawal
of an excess contribution (as defined in Sec. 1.468A-5(c)(2)(ii)) by an
electing taxpayer pursuant to the rules of Sec. 1.468A-5(c)(2) shall
not be included in the gross income of the electing taxpayer. See
paragraph (b)(2) of this section, which provides that the payment of
such amount to the nuclear decommissioning fund is not deductible by the
electing taxpayer.
(iii) Actual distributions of amounts included in gross income as
deemed distributions. If the amount of a deemed distribution is included
in the gross income of the electing taxpayer for the taxable year in
which the deemed distribution occurs, no further amount is required to
be included in gross income when the amount of the deemed distribution
is actually distributed by the nuclear decommissioning fund. The amount
of a deemed distribution is actually distributed by a nuclear
decommissioning fund as the first actual distributions are made by the
nuclear decommissioning fund on or after the date of the deemed
distribution.
(e) Deduction when economic performance occurs. An electing taxpayer
using an accrual method of accounting is allowed a deduction for nuclear
decommissioning costs no earlier than the taxable year in which economic
performance occurs with respect to such costs (see section 461(h)(2)).
The amount of nuclear decommissioning costs that is deductible under
this paragraph (e) is determined without regard to section 280B (see
Sec. 1.468A-1(b)(6)). A deduction is allowed under this paragraph (e)
whether or not a deduction was allowed with respect to such costs under
section 468A(a) and paragraph (a) of this section for an earlier taxable
year.
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
Sec. 1.468A-3 Ruling amount.
(a) In general. (1) Except as otherwise provided in paragraph (g) of
this section or in Sec. 1.468A-8 (relating to deductions for special
transfers into a nuclear decommissioning fund), an electing taxpayer is
allowed a deduction under section 468A(a) for the taxable year in which
the taxpayer makes a cash payment (or is deemed to make a cash payment)
to a nuclear decommissioning fund only if the taxpayer has received a
schedule of ruling amounts for the nuclear decommissioning fund that
includes a ruling amount for such taxable year. Except as provided in
paragraph (a)(4) or (5) of this section, a schedule of ruling amounts
for a nuclear decommissioning fund (schedule of ruling amounts) is a
ruling (within
[[Page 344]]
the meaning of Sec. 601.201(a)(2) of this chapter) specifying the
annual payments (ruling amounts) that, over the taxable years remaining
in the funding period as of the date the schedule first applies, will
result in a projected balance of the nuclear decommissioning fund as of
the last day of the funding period equal to (and in no event greater
than) the amount of decommissioning costs allocable to the fund. The
projected balance of a nuclear decommissioning fund as of the last day
of the funding period shall be calculated by taking into account the
fair market value of the assets of the fund as of the first day of the
first taxable year to which the schedule of ruling amounts applies and
the estimated rate of return to be earned by the assets of the fund
after payment of the estimated administrative costs and incidental
expenses to be incurred by the fund (as defined in Sec. 1.468A-
5(a)(3)(ii)), including all Federal, State and local income taxes to be
incurred by the fund (the after-tax rate of return). See paragraph (c)
of this section for a definition of funding period and paragraph (d) of
this section for guidance with respect to the amount of decommissioning
costs allocable to a fund.
(2) Each schedule of ruling amounts must be consistent with the
principles and provisions of this section and must be based on
reasonable assumptions concerning--
(i) The after-tax rate of return to be earned by the assets of the
qualified nuclear decommissioning fund;
(ii) The total estimated cost of decommissioning the nuclear power
plant (see paragraph (d)(2) of this section); and
(iii) The frequency of contributions to a nuclear decommissioning
fund for a taxable year (for example, monthly, quarterly, semi-annual or
annual contributions).
(3) The Internal Revenue Service (IRS) shall provide a schedule of
ruling amounts that is identical to the schedule of ruling amounts
proposed by the taxpayer in connection with the taxpayer's request for a
schedule of ruling amounts (see paragraph (e)(2)(viii) of this section),
but no schedule of ruling amounts shall be provided unless the
taxpayer's proposed schedule of ruling amounts is consistent with the
principles and provisions of this section and is based on reasonable
assumptions. If a proposed schedule of ruling amounts is not consistent
with the principles and provisions of this section or is not based on
reasonable assumptions, the taxpayer may propose an amended schedule of
ruling amounts that is consistent with such principles and provisions
and is based on reasonable assumptions.
(4) The taxpayer bears the burden of demonstrating that the proposed
schedule of ruling amounts is consistent with the principles and
provisions of this section and is based on reasonable assumptions. If a
public utility commission established or approved the currently
applicable rates for the furnishing or sale by the taxpayer of
electricity from the plant, the taxpayer can generally satisfy this
burden of proof by demonstrating that the schedule of ruling amounts is
calculated using the assumptions used by the public utility commission
in its most recent order. In addition, a taxpayer that owns an interest
in a deregulated nuclear plant may submit assumptions used by a public
utility commission that formerly had regulatory jurisdiction over the
plant as support for the assumptions used in calculating the taxpayer's
proposed schedule of ruling amounts, with the understanding that the
assumptions used by the public utility commission may be given less
weight if they are out of date or were developed in a proceeding for a
different taxpayer. The use of other industry standards, such as the
assumptions underlying the taxpayer's most recent financial assurance
filing with the NRC, are an alternative means of demonstrating that the
taxpayer has calculated its proposed schedule of ruling amounts on a
reasonable basis. Consistency with financial accounting statements is
not sufficient, in the absence of other supporting evidence, to meet the
taxpayer's burden of proof under this paragraph (a)(4).
(5) The IRS will approve, at the request of the taxpayer, a formula
or method for determining a schedule of ruling amounts (rather than
providing a schedule specifying a dollar amount
[[Page 345]]
for each taxable year) if the formula or method is consistent with the
principles and provisions of this section and is based on reasonable
assumptions. See paragraph (f)(1)(ii) of this section for a special rule
relating to the mandatory review of ruling amounts that are determined
pursuant to a formula or method.
(6) The IRS may, in its discretion, provide a schedule of ruling
amounts that is determined on a basis other than the rules of paragraphs
(a) through (d) of this section if--
(i) In connection with its request for a schedule of ruling amounts,
the taxpayer explains the need for special treatment and sets forth an
alternative basis for determining the schedule of ruling amounts; and
(ii) The IRS determines that special treatment is consistent with
the purpose of section 468A.
(b) Level funding limitation. (1) Except as otherwise provided in
paragraph (b)(3) of this section, the ruling amount specified in a
schedule of ruling amounts for any taxable year in the funding period
(as defined in paragraph (c) of this section) shall not be less than the
ruling amount specified in such schedule for any earlier taxable year.
(2) The ruling amount specified in a schedule of ruling amounts for
a taxable year after the end of the funding period may be less than the
ruling amount specified in such schedule for an earlier taxable year.
(3) The ruling amount specified in a schedule of ruling amounts for
the last taxable year in the funding period may be less than the ruling
amount specified in such schedule for an earlier taxable year if, when
annualized, the amount specified for the last taxable year is not less
than the amount specified for such earlier taxable year. The amount
specified for the last taxable year is annualized by--
(i) Determining the number of days between the beginning of the
taxable year and the end of the plant's estimated useful life;
(ii) Dividing the amount specified for the last taxable year by such
number of days; and
(iii) Multiplying the result by the number of days in the last
taxable year (generally 365).
(c) Funding period--(1) In general. For purposes of this section,
the funding period for a nuclear decommissioning fund is the period
that--
(i) Begins on the first day of the first taxable year for which a
deductible payment is made (or deemed made) to such nuclear
decommissioning fund (see Sec. 1.468A-2(a) for rules relating to the
first taxable year for which a payment may be made (or deemed made) to a
nuclear decommissioning fund); and
(ii) Ends on the last day of the taxable year that includes the last
day of the estimated useful life of the nuclear power plant to which the
nuclear decommissioning fund relates.
(2) Estimated useful life. The last day of the estimated useful life
of a nuclear power plant is determined under the following rules:
(i) Except as provided in paragraph (c)(2)(ii) of this section--
(A) The last day of the estimated useful life of a nuclear power
plant that has been included in rate base for ratemaking purposes in any
ratemaking proceeding that established rates for a period before January
1, 2006, is the date used in the first such ratemaking proceeding as the
estimated date on which the nuclear power plant will no longer be
included in the taxpayer's rate base for ratemaking purposes;
(B) The last day of the estimated useful life of a nuclear power
plant that is not described in paragraph (c)(2)(i)(A) of this section is
the last day of the estimated useful life of the plant determined as of
the date it is placed in service;
(C) A taxpayer with an interest in a plant that is not described in
paragraph (c)(2)(i)(A) of this section may use any reasonable method for
determining the last day of such estimated useful life; and
(D) A reasonable method for purposes of paragraph (c)(2)(i)(C) of
this section may include use of the period for which a public utility
commission has included a comparable nuclear power plant in rate base
for ratemaking purposes.
(ii) If it can be established that the estimated useful life of the
nuclear
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power plant will end on a date other than the date determined under
paragraph (c)(2)(i) of this section, the taxpayer may use such other
date as the last day of the estimated useful life but is not required to
do so. If the last day of the estimated useful life was determined under
paragraph (c)(2)(i)(A) of this section and the most recent ratemaking
proceeding used an alternative date as the estimated date on which the
nuclear power plant will no longer be included rate base, the most
recent ratemaking proceeding will generally be treated as establishing
such alternative date as the last day of the estimated useful life.
(iii) The estimated useful life of a nuclear power plant determined
for purposes of paragraph (c)(1) of this section may end on a different
date from the estimated useful life of a nuclear power plant determined
for purposes of Sec. 1.468A-8(b)(1) and (c)(1).
(d) Decommissioning costs allocable to a fund. The amount of
decommissioning costs allocable to a nuclear decommissioning fund is
determined for purposes of this section by applying the following rules
and definitions:
(1) General rule. The amount of decommissioning costs allocable to a
nuclear decommissioning fund is the taxpayer's share of the total
estimated cost of decommissioning the nuclear power plant to which the
fund relates.
(2) Total estimated cost of decommissioning. Under paragraph (a)(2)
of this section, the taxpayer must demonstrate the reasonableness of the
assumptions concerning the total estimated cost of decommissioning the
nuclear power plant.
(3) Taxpayer's share. The taxpayer's share of the total estimated
cost of decommissioning a nuclear power plant equals the total estimated
cost of decommissioning such nuclear power plant multiplied by the
percentage of such nuclear power plant that the qualifying interest of
the taxpayer represents. (See Sec. 1.468A-1(b)(2) for circumstances in
which a taxpayer possesses a qualifying interest in a nuclear power
plant).
(e) Manner of requesting schedule of ruling amounts--(1) In general.
(i) In order to receive a ruling amount for any taxable year, a taxpayer
must file a request for a schedule of ruling amounts that complies with
the requirements of this paragraph (e), the applicable procedural rules
set forth in Sec. 601.201(e) of this chapter (Statement of Procedural
Rules), and the requirements of any applicable revenue procedure that is
in effect on the date the request is filed.
(ii) A separate request for a schedule of ruling amounts is required
for each nuclear decommissioning fund established by a taxpayer. (See
paragraph (a) of Sec. 1.468A-5 for rules relating to the number of
nuclear decommissioning funds that a taxpayer can establish.)
(iii) Except as provided by Sec. Sec. 1.468A-5(a)(1)(iv) (relating
to certain unincorporated organizations that may be taxable as
corporations) and 1.468A-8 (relating to a special transfer under section
468A(f)(1)), a request for a schedule of ruling amounts must not contain
a request for a ruling on any other issue, whether the issue involves
section 468A or another section of the Internal Revenue Code.
(iv) In the case of an affiliated group of corporations that join in
the filing of a consolidated return, the common parent of the group may
request a schedule of ruling amounts for each member of the group that
possesses a qualifying interest in the same nuclear power plant by
filing a single submission with the IRS.
(v) The IRS will not provide or revise a ruling amount applicable to
a taxable year in response to a request for a schedule of ruling amounts
that is filed after the deemed payment deadline date (as defined in
Sec. 1.468A-2(c)(1)) for such taxable year. In determining the date
when a request is filed, the principles of sections 7502 and 7503 shall
apply.
(vi) Except as provided in paragraph (e)(1)(vii) of this section, a
request for a schedule of ruling amounts shall be considered filed only
if such request complies substantially with the requirements of this
paragraph (e).
(vii) If a request does not comply substantially with the
requirements of this paragraph (e), the IRS will notify
[[Page 347]]
the taxpayer of that fact. If the information or materials necessary to
comply substantially with the requirements of this paragraph (e) are
provided to the IRS within 30 days after this notification, the request
will be considered filed on the date of the original submission. In
addition, the request will be considered filed on the date of the
original submission in a case in which the information and materials are
provided more than 30 days after the notification if the IRS determines
that the electing taxpayer made a good faith effort to provide the
applicable information or materials within 30 days after notification
and also determines that treating the request as filed on the date of
the original submission is consistent with the purposes of section 468A.
In any other case in which the information or materials necessary to
comply substantially with the requirements of this paragraph (e) are not
provided within 30 days after the notification, the request will be
considered filed on the date that all information or materials necessary
to comply with the requirements of this paragraph (e) are provided.
(2) Information required. A request for a schedule of ruling amounts
must contain the following information:
(i) The taxpayer's name, address, and taxpayer identification
number.
(ii) Whether the request is for an initial schedule of ruling
amounts, a mandatory review of the schedule of ruling amounts (see
paragraph (f)(1) of this section), or an elective review of the schedule
of ruling amounts (see paragraph (f)(2) of this section).
(iii) The name and location of the nuclear power plant with respect
to which a schedule of ruling amounts is requested.
(iv) A description of the taxpayer's qualifying interest in the
nuclear power plant and the percentage of such nuclear power plant that
the qualifying interest of the taxpayer represents.
(v) Where applicable, an identification of each public utility
commission that establishes or approves rates for the furnishing or sale
by the taxpayer of electric energy generated by the nuclear power plant,
and, for each public utility commission identified--
(A) Whether the public utility commission has determined the amount
of decommissioning costs to be included in the taxpayer's cost of
service for ratemaking purposes;
(B) The amount of decommissioning costs that are to be included in
the taxpayer's cost of service for each taxable year under the current
determination and amounts that otherwise are required to be included in
the taxpayer's income under section 88 and the regulations thereunder;
(C) A description of the assumptions, estimates and other factors
used by the public utility commission to determine the amount of
decommissioning costs;
(D) A copy of such portions of any order or opinion of the public
utility commission as pertain to the public utility commission's most
recent determination of the amount of decommissioning costs to be
included in cost of service; and
(E) A copy of each engineering or cost study that was relied on or
used by the public utility commission in determining the amount of
decommissioning costs to be included in the taxpayer's cost of service
under the current determination.
(vi) A description of the assumptions, estimates and other factors
that were used by the taxpayer to determine the amount of
decommissioning costs, including each of the following if applicable:
(A) A description of the proposed method of decommissioning the
nuclear power plant (for example, prompt removal/dismantlement, safe
storage entombment with delayed dismantlement, or safe storage
mothballing with delayed dismantlement).
(B) The estimated year in which substantial decommissioning costs
will first be incurred.
(C) The estimated year in which the decommissioning of the nuclear
power plant will be substantially complete (see Sec. 1.468A-5(d)(3) for
a definition of substantial completion of decommissioning).
(D) The total estimated cost of decommissioning expressed in current
dollars (that is, based on price levels in effect at the time of the
current determination).
[[Page 348]]
(E) The total estimated cost of decommissioning expressed in future
dollars (that is, based on anticipated price levels when expenses are
expected to be paid).
(F) For each taxable year in the period that begins with the year
specified in paragraph (e)(2)(vi)(B) of this section (the estimated year
in which substantial decommissioning costs will first be incurred) and
ends with the year specified in paragraph (e)(2)(vi)(C) of this section
(the estimated year in which the decommissioning of the nuclear power
plant will be substantially complete), the estimated cost of
decommissioning expressed in future dollars.
(G) A description of the methodology used in converting the
estimated cost of decommissioning expressed in current dollars to the
estimated cost of decommissioning expressed in future dollars.
(H) The assumed after-tax rate of return to be earned by the assets
of the qualified nuclear decommissioning fund.
(I) A copy of each engineering or cost study that was relied on or
used by the taxpayer in determining the amount of decommissioning costs.
(vii) A proposed schedule of ruling amounts for each taxable year
remaining in the funding period as of the date the schedule of ruling
amounts will first apply.
(viii) A description of the assumptions, estimates and other factors
that were used in determining the proposed schedule of ruling amounts,
including, if applicable--
(A) The funding period (as such term is defined in paragraph (c) of
this section);
(B) The assumed after-tax rate of return to be earned by the assets
of the nuclear decommissioning fund;
(C) The fair market value of the assets (if any) of the nuclear
decommissioning fund as of the first day of the first taxable year to
which the schedule of ruling amounts will apply;
(D) The amount expected to be earned by the assets of the nuclear
decommissioning fund (based on the after-tax rate of return applicable
to the fund) over the period that begins on the first day of the first
taxable year to which the schedule of ruling amounts will apply and ends
on the last day of the funding period;
(E) The amount of decommissioning costs allocable to the nuclear
decommissioning fund (as determined under paragraph (d) of this
section);
(F) The total estimated cost of decommissioning (as determined under
paragraph (d)(2) of this section); and
(G) The taxpayer's share of the total estimated cost of
decommissioning (as such term is defined in paragraph (d)(3) of this
section).
(ix) If the request is for a revised schedule of ruling amounts, the
after-tax rate of return earned by the assets of the nuclear
decommissioning fund for each taxable year in the period that begins
with the date of the initial contribution to the fund and ends with the
first day of the first taxable year to which the revised schedule of
ruling amounts applies.
(x) If applicable, an explanation of the need for a schedule of
ruling amounts determined on a basis other than the rules of paragraphs
(a) through (d) of this section and a description of an alternative
basis for determining a schedule of ruling amounts (see paragraph (a)(5)
of this section).
(xi) A chart or table, based upon the assumed after-tax rate of
return to be earned by the assets of the nuclear decommissioning fund,
setting forth the years the fund will be in existence, the annual
contribution to the fund, the estimated annual earnings of the fund and
the cumulative total balance in the fund.
(xii) If the request is for a revised schedule of ruling amounts, a
copy of the schedule of ruling amounts that the revised schedule would
replace.
(xiii) If the request for a schedule of ruling amounts contains a
request, pursuant to Sec. 1.468A-5(a)(1)(iv), that the IRS rule whether
an unincorporated organization through which the assets of the fund are
invested is an association taxable as a corporation for Federal tax
purposes, a copy of the legal documents establishing or otherwise
governing the organization.
(xiv) Any other information required by the IRS that may be
necessary or useful in determining the schedule of ruling amounts.
[[Page 349]]
(3) Administrative procedures. The IRS may prescribe administrative
procedures that supplement the provisions of paragraph (e)(1) and (2) of
this section. In addition, the IRS may, in its discretion, waive the
requirements of paragraph (e)(1) and (2) of this section under
appropriate circumstances.
(f) Review and revision of schedule of ruling amounts--(1) Mandatory
review. (i) Any taxpayer that has obtained a schedule of ruling amounts
pursuant to paragraph (e) of this section must file a request for a
revised schedule of ruling amounts on or before the deemed payment
deadline date for the 10th taxable year that begins after the taxable
year in which the most recent schedule of ruling amounts was received.
If the taxpayer calculated its most recent schedule of ruling amounts on
any basis other than an order issued by a public utility commission, the
taxpayer must file a request for a revised schedule of ruling amounts on
or before the deemed payment deadline date for the 5th taxable year that
begins after the taxable year in which the most recent schedule of
ruling amounts was received.
(ii)(A) Any taxpayer that has obtained a formula or method for
determining a schedule of ruling amounts for any taxable year under
paragraph (a)(5) of this section must file a request for a revised
schedule on or before the earlier of the deemed payment deadline for the
5th taxable year that begins after its taxable year in which the most
recent formula or method was approved or the deemed payment deadline for
the first taxable year that begins after a taxable year in which there
is a substantial variation in the ruling amount determined under the
most recent formula or method. There is a substantial variation in the
ruling amount determined under the formula or method in effect for a
taxable year if the ruling amount for the year and the ruling amount for
any earlier year since the most recent formula or method was approved
differ by more than 50 percent of the smaller amount.
(B) Any taxpayer that has determined its ruling amount for any
taxable year under a formula prescribed by Sec. 1.468A-6 (which
prescribes ruling amounts for the taxable year in which there is a
disposition of a qualifying interest in a nuclear power plant) must file
a request for a revised schedule of ruling amounts on or before the
deemed payment deadline for its first taxable year that begins after the
disposition.
(iii) A taxpayer requesting a schedule of deduction amounts for a
nuclear decommissioning fund under Sec. 1.468A-8 must also request a
revised schedule of ruling amounts for the fund. The revised schedule of
ruling amounts must apply beginning with the first taxable year
following the first year in which a deduction is allowed under the
schedule of deduction amounts.
(iv) If the operating license of the nuclear power plant to which a
nuclear decommissioning fund relates is renewed, the taxpayer
maintaining the fund must request a revised schedule of ruling amounts.
The request for the revised schedule must be submitted on or before the
deemed payment deadline for the taxable year that includes the date on
which the operating license is renewed.
(v) A request for a schedule of ruling amounts required by this
paragraph (f)(1) must be made in accordance with the rules of paragraph
(e) of this section. If a taxpayer does not properly file a request for
a revised schedule of ruling amounts by the date provided in paragraph
(f)(1)(i), (ii) or (iv) of this section (whichever is applicable), the
taxpayer's ruling amount for the first taxable year to which the revised
schedule of ruling amounts would have applied and for all succeeding
taxable years until a new schedule is obtained shall be zero dollars,
unless, in its discretion, the IRS provides otherwise in such new
schedule of ruling amounts. Thus, if a taxpayer is required to request a
revised schedule of ruling amounts under any provision of this section,
and each ruling amount in the revised schedule would equal zero dollars,
the taxpayer may, instead of requesting a new schedule of ruling
amounts, begin treating the ruling amounts under its most recent
schedule as equal to zero dollars.
(2) Elective review. Any taxpayer that has obtained a schedule of
ruling amounts pursuant to paragraph (e) of this section can request a
revised
[[Page 350]]
schedule of ruling amounts. Such a request must be made in accordance
with the rules of paragraph (e) of this section; thus, the IRS will not
provide a revised ruling amount applicable to a taxable year in response
to a request for a schedule of ruling amounts that is filed after the
deemed payment deadline date for such taxable year (see paragraph
(e)(1)(vi) of this section).
(3) Determination of revised schedule of ruling amounts. A revised
schedule of ruling amounts for a nuclear decommissioning fund shall be
determined under this section without regard to any schedule of ruling
amounts for such nuclear decommissioning fund that was issued prior to
such revised schedule. Thus, a ruling amount specified in a revised
schedule of ruling amounts for any taxable year in the funding period
can be less than one or more ruling amounts specified in a prior
schedule of ruling amounts for a prior taxable year.
(g) Special rule permitting payments to a nuclear decommissioning
fund before receipt of an initial or revised ruling amount applicable to
a taxable year. (1) If an electing taxpayer has filed a timely request
for an initial or revised ruling amount for a taxable year beginning on
or after January 1, 2006, and does not receive the ruling amount on or
before the deemed payment deadline date for such taxable year, the
taxpayer may make a payment to a nuclear decommissioning fund on the
basis of the ruling amount proposed in the taxpayer's request. Thus,
under the preceding sentence, an electing taxpayer may make a payment to
a nuclear decommissioning fund for such taxable year that does not
exceed the ruling amount proposed by the taxpayer for such taxable year
in a timely filed request for a schedule of ruling amounts.
(2) If an electing taxpayer makes a payment to a nuclear
decommissioning fund for any taxable year pursuant to paragraph (g)(1)
of this section and the ruling amount that is provided by the IRS is
greater than the ruling amount proposed by the taxpayer for such taxable
year, the taxpayer is not allowed to make an additional payment to the
fund for such taxable year after the deemed payment deadline date for
such taxable year.
(3) If the payment or transfer that an electing taxpayer makes to a
nuclear decommissioning fund for any taxable year pursuant to paragraph
(g)(1) of this section exceeds the ruling amount that is provided by the
IRS for such taxable year, the following rules apply:
(i) The amount of the excess is an excess contribution (as defined
in Sec. 1.468A-5(c)(2)(ii)) for such taxable year.
(ii) The amount of the excess contribution is not deductible (see
Sec. 1.468A-2(b)(2)) and must be withdrawn by the taxpayer pursuant to
the rules of Sec. 1.468A-5(c)(2)(i).
(iii) The taxpayer must withdraw the after-tax earnings on the
excess contribution.
(iv) If the taxpayer claimed a deduction for the excess
contribution, the taxpayer should file an amended return for the taxable
year.
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
Sec. 1.468A-4 Treatment of nuclear decommissioning fund.
(a) In general. A nuclear decommissioning fund is subject to tax on
all of its modified gross income (as defined in paragraph (b) of this
section). The rate of tax is 20 percent for taxable years beginning
after December 31, 1995. This tax is in lieu of any other tax that may
be imposed under subtitle A of the Internal Revenue Code (Code) on the
income earned by the assets of the nuclear decommissioning fund.
(b) Modified gross income. For purposes of this section, the term
modified gross income means gross income as defined under section 61
computed with the following modifications:
(1) The amount of any payment or special transfer to the nuclear
decommissioning fund with respect to which a deduction is allowed under
section 468A(a) or section 468A(f) is excluded from gross income.
(2) A deduction is allowed for the amount of administrative costs
and other incidental expenses of the nuclear decommissioning fund
(including taxes, legal expenses, accounting expenses, actuarial
expenses and trustee
[[Page 351]]
expenses, but not including decommissioning costs) that are otherwise
deductible and that are paid by the nuclear decommissioning fund to any
person other than the electing taxpayer. An expense is otherwise
deductible for purposes of this paragraph (b)(2) if it would be
deductible under chapter 1 of the Code in determining the taxable income
of a corporation. For example, because Federal income taxes are not
deductible under chapter 1 of the Code in determining the taxable income
of a corporation, the tax imposed by section 468A(e)(2) and paragraph
(a) of this section is not deductible in determining the modified gross
income of a nuclear decommissioning fund. Similarly, because certain
expenses allocable to tax-exempt interest income are not deductible
under section 265 in determining the taxable income of a corporation,
such expenses are not deductible in determining the modified gross
income of a nuclear decommissioning fund.
(3) A deduction is allowed for the amount of an otherwise deductible
loss that is sustained by the nuclear decommissioning fund in connection
with the sale, exchange or worthlessness of any investment. A loss is
otherwise deductible for purposes of this paragraph (b)(3) if such loss
would be deductible by a corporation under section 165(f) or (g) and
sections 1211(a) and 1212(a).
(4) A deduction is allowed for the amount of an otherwise deductible
net operating loss of the nuclear decommissioning fund. For purposes of
this paragraph (b), the net operating loss of a nuclear decommissioning
fund for a taxable year is the amount by which the deductions allowable
under paragraphs (b)(2) and (3) of this section exceed the gross income
of the nuclear decommissioning fund computed with the modification
described in paragraph (b)(1) of this section. A net operating loss is
otherwise deductible for purposes of this paragraph (b)(4) if such a net
operating loss would be deductible by a corporation under section
172(a).
(c) Special rules--(1) Period for computation of modified gross
income. The modified gross income of a nuclear decommissioning fund must
be computed on the basis of the taxable year of the electing taxpayer.
If an electing taxpayer changes its taxable year, each nuclear
decommissioning fund of the electing taxpayer must change to the new
taxable year. See section 442 and Sec. 1.442-1 for rules relating to
the change to a new taxable year.
(2) Gain or loss upon distribution of property by a fund. A
distribution of property by a nuclear decommissioning fund (whether an
actual distribution or a deemed distribution) shall be considered a
disposition of property by the nuclear decommissioning fund for purposes
of section 1001. In determining the amount of gain or loss from such
disposition, the amount realized by the nuclear decommissioning fund
shall be the fair market value of the property on the date of
disposition.
(3) Denial of credits against tax. The tax imposed on the modified
gross income of a nuclear decommissioning fund under paragraph (a) of
this section is not to be reduced or offset by any credits against tax
provided by part IV of subchapter A of chapter 1 of the Code other than
the credit provided by section 31(c) for amounts withheld under section
3406 (back-up withholding).
(4) Other corporate taxes inapplicable. Although the modified gross
income of a nuclear decommissioning fund is subject to tax at the rate
specified by section 468A(e)(2) and paragraph (a) of this section, a
nuclear decommissioning fund is not subject to the other taxes imposed
on corporations under subtitle A of the Code. For example, a nuclear
decommissioning fund is not subject to the alternative minimum tax
imposed by section 55, the accumulated earnings tax imposed by section
531, the personal holding company tax imposed by section 541, and the
alternative tax imposed on a corporation under section 1201(a).
(d) Treatment as corporation for purposes of subtitle F. For
purposes of subtitle F of the Code and Sec. Sec. 1.468A-1 through
1.468A-9, a nuclear decommissioning fund is to be treated as if it were
a corporation and the tax imposed by section 468A(e)(2) and paragraph
(a) of this section is to be treated as a tax imposed by section 11.
Thus, for example, the following rules apply:
[[Page 352]]
(1) A nuclear decommissioning fund must file a return with respect
to the tax imposed by section 468A(e)(2) and paragraph (a) of this
section for each taxable year (or portion thereof) that the fund is in
existence even though no amount is included in the gross income of the
fund for such taxable year. The return is to be made on Form 1120-ND in
accordance with the instructions relating to such form. For purposes of
this paragraph (d)(1), a nuclear decommissioning fund is in existence
for the period that--
(i) Begins on the date that the first deductible payment is actually
made to such nuclear decommissioning fund; and
(ii) Ends on the date of termination (see Sec. 1.468A-5(d)), the
date that the entire fund is disqualified (see Sec. 1.468A-5(c)), or
the date that the electing taxpayer disposes of its entire qualifying
interest in the nuclear power plant to which the nuclear decommissioning
fund relates (other than in connection with the transfer of the entire
fund to the person acquiring such interest), whichever is applicable.
(2) For each taxable year of the nuclear decommissioning fund, the
return described in paragraph (d)(1) of this section must be filed on or
before the 15th day of the third month following the close of such
taxable year unless the nuclear decommissioning fund is granted an
extension of time for filing under section 6081. If such an extension is
granted for any taxable year, the return for such taxable year must be
filed on or before the extended due date for such taxable year.
(3) A nuclear decommissioning fund must provide its employer
identification number on returns, statements and other documents as
required by the forms and instructions relating thereto. The employer
identification number is obtained by filing a Form SS-4, Application for
Employer Identification Number, in accordance with the instructions
relating thereto.
(4) A nuclear decommissioning fund must deposit all payments of tax
imposed by section 468A(e)(2) and paragraph (a) of this section
(including any payments of estimated tax) with an authorized government
depositary in accordance with Sec. 1.6302-1.
(5) A nuclear decommissioning fund is subject to the addition to tax
imposed by section 6655 in case of a failure to pay estimated income
tax. For purposes of section 6655 and this section--
(i) The tax with respect to which the amount of the underpayment is
computed in the case of a nuclear decommissioning fund is the tax
imposed by section 468A(e)(2) and paragraph (a) of this section; and
(ii) The taxable income with respect to which the nuclear
decommissioning fund's status as a large corporation is measured is
modified gross income (as defined by paragraph (b) of this section).
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
Sec. 1.468A-5 Nuclear decommissioning fund qualification requirements;
prohibitions against self-dealing; disqualification of nuclear
decommissioning fund; termination of fund upon substantial completion
of decommissioning.
(a) Qualification requirements--(1) In general. (i) A nuclear
decommissioning fund must be established and maintained at all times in
the United States pursuant to an arrangement that qualifies as a trust
under State law. Such trust must be established for the exclusive
purpose of providing funds for the decommissioning of one or more
nuclear power plants, but a single trust agreement may establish
multiple funds for such purpose. Thus, for example--
(A) Two or more nuclear decommissioning funds can be established and
maintained pursuant to a single trust agreement; and
(B) One or more funds that are to be used for the decommissioning of
a nuclear power plant and that do not qualify as nuclear decommissioning
funds under this paragraph (a) can be established and maintained
pursuant to a trust agreement that governs one or more nuclear
decommissioning funds.
(ii) A separate nuclear decommissioning fund is required for each
electing taxpayer and for each nuclear power plant with respect to which
an electing taxpayer possesses a qualifying interest. The Internal
Revenue Service (IRS) will issue a separate
[[Page 353]]
schedule of ruling amounts with respect to each nuclear decommissioning
fund, and each nuclear decommissioning fund must file a separate income
tax return even if other nuclear decommissioning funds or nonqualified
funds are established and maintained pursuant to the trust agreement
governing such fund or the assets of other nuclear decommissioning funds
or nonqualified funds are pooled with the assets of such fund.
(iii) An electing taxpayer can maintain only one nuclear
decommissioning fund for each nuclear power plant with respect to which
the taxpayer elects the application of section 468A. If a nuclear power
plant is subject to the ratemaking jurisdiction of two or more public
utility commissions and any such public utility commission requires a
separate fund to be maintained for the benefit of ratepayers whose rates
are established or approved by the public utility commission, the
separate funds maintained for such plant (whether or not established and
maintained pursuant to a single trust agreement) shall be considered a
single nuclear decommissioning fund for purposes of section 468A and
Sec. Sec. 1.468A-1 through 1.468A-4, this section and Sec. Sec.
1.468A-7 through 1.468A-9. Thus, for example, the IRS will issue one
schedule of ruling amounts with respect to such nuclear power plant, the
nuclear decommissioning fund must file a single income tax return (see
Sec. 1.468A-4(d)(1)), and, if the IRS disqualifies the nuclear
decommissioning fund, the assets of each separate fund are treated as
distributed on the date of disqualification (see paragraph (c)(3) of
this section).
(iv) If assets of a nuclear decommissioning fund are (or will be)
invested through an unincorporated organization, within the meaning of
Sec. 301.7701-2 of this chapter, the IRS will rule, if requested,
whether the organization is an association taxable as a corporation for
Federal tax purposes. A request for this ruling may be made by the
electing taxpayer as part of its request for a schedule of ruling
amounts or as part of a request under Sec. 1.468A-8 for a schedule of
deduction amounts.
(2) Limitation on contributions. Except as otherwise provided in
Sec. 1.468A-8 (relating to special transfers under section 468A(f)), a
nuclear decommissioning fund is not permitted to accept any
contributions in cash or property other than cash payments with respect
to which a deduction is allowed under section 468A(a) and Sec. 1.468A-
2(a). Thus, for example, except in the case of a special transfer
pursuant to Sec. 1.468A-8, securities may not be contributed to a
nuclear decommissioning fund even if the taxpayer or a fund established
by the taxpayer previously held such securities for the purpose of
providing funds for the decommissioning of a nuclear power plant.
(3) Limitation on use of fund--(i) In general. The assets of a
nuclear decommissioning fund are to be used exclusively--
(A) To satisfy, in whole or in part, the liability of the electing
taxpayer for decommissioning costs of the nuclear power plant to which
the nuclear decommissioning fund relates;
(B) To pay administrative costs and other incidental expenses of the
nuclear decommissioning fund; and
(C) To the extent that the assets of the nuclear decommissioning
fund are not currently required for the purposes described in paragraph
(a)(3)(i)(A) or (B) of this section, to make investments.
(ii) Definition of administrative costs and expenses. For purposes
of paragraph (a)(3)(i) of this section, the term administrative costs
and other incidental expenses of a nuclear decommissioning fund means
all ordinary and necessary expenses incurred in connection with the
operation of the nuclear decommissioning fund. Such term includes the
tax imposed by section 468A(e)(2) and Sec. 1.468A-4(a), any State or
local tax imposed on the income or the assets of the fund, legal
expenses, accounting expenses, actuarial expenses and trustee expenses.
Such term does not include decommissioning costs or the payment of
insurance premiums on a policy to pay for the nuclear decommissioning
costs of a nuclear power plant. Such term also does not include the
excise tax imposed on the trustee or other disqualified person under
section 4951 or the reimbursement of any expenses incurred in connection
with the assertion of such tax unless such expenses
[[Page 354]]
are considered reasonable and necessary under section 4951(d)(2)(C) and
it is determined that the trustee or other disqualified person is not
liable for the excise tax.
(4) Trust provisions. Each qualified nuclear decommissioning fund
trust agreement must provide that assets in the fund must be used as
authorized by section 468A and Sec. Sec. 1.468A-1 through 1.468A-9 and
that the agreement may not be amended so as to violate section 468A or
Sec. Sec. 1.468A-1 through 1.468A-9.
(b) Prohibitions against self-dealing--(1) In general. Except as
otherwise provided in this paragraph (b), the excise taxes imposed by
section 4951 shall apply to each act of self-dealing between a
disqualified person and a nuclear decommissioning fund.
(2) Self-dealing defined. For purposes of this paragraph (b), the
term self-dealing means any act described in section 4951(d), except--
(i) A payment by a nuclear decommissioning fund for the purpose of
satisfying, in whole or in part, the liability of the electing taxpayer
for decommissioning costs of the nuclear power plant to which the
nuclear decommissioning fund relates;
(ii) A withdrawal of an excess contribution by the electing taxpayer
pursuant to the rules of paragraph (c)(2) of this section;
(iii) A withdrawal by the electing taxpayer of amounts that have
been treated as distributed under paragraph (c)(3) of this section;
(iv) A payment of amounts remaining in a nuclear decommissioning
fund to the electing taxpayer after the termination of such fund (as
determined under paragraph (d) of this section);
(v) Any act described in section 4951(d)(2)(B) or (C);
(vi) Any act that is described in Sec. 53.4951-1(c) of this chapter
and is undertaken to facilitate the temporary investment of assets or
the payment of reasonable administrative expenses of the nuclear
decommissioning fund; or
(vii) A payment by a nuclear decommissioning fund for the
performance of trust functions and certain general banking services by a
bank or trust company that is a disqualified person if the banking
services are reasonable and necessary to carry out the purposes of the
fund and the compensation paid to the bank or trust company for such
services, taking into account the fair interest rate for the use of the
funds by the bank or trust company, is not excessive.
(3) Disqualified person defined. For purposes of this paragraph (b),
the term disqualified person includes each person described in section
4951(e)(4) and Sec. 53.4951-1(d).
(4) General banking services. The general banking services allowed
by paragraph (b)(2)(vii) of this section are--
(i) Checking accounts, as long as the bank does not charge interest
on any overwithdrawals;
(ii) Savings accounts, as long as the fund may withdraw its funds on
no more than 30 days' notice without subjecting itself to a loss of
interest on its money for the time during which the money was on
deposit; and
(iii) Safekeeping activities (see Sec. 53.4941(d)-3(c)(2), Example
3, of this chapter).
(c) Disqualification of nuclear decommissioning fund--(1) In
general--(i) Disqualification events. Except as otherwise provided in
paragraph (c)(2) of this section, the IRS may, in its discretion,
disqualify all or any portion of a nuclear decommissioning fund if at
any time during a taxable year of the fund--
(A) The fund does not satisfy the requirements of paragraph (a) of
this section; or
(B) The fund and a disqualified person engage in an act of self-
dealing (as defined in paragraph (b)(2) of this section).
(ii) Date of disqualification. (A) Except as otherwise provided in
this paragraph (c)(1)(ii), the date on which a disqualification under
this paragraph (c) will take effect (date of disqualification) is the
date that the fund does not satisfy the requirements of paragraph (a) of
this section or the date on which the act of self-dealing occurs,
whichever is applicable.
(B) If the IRS determines, in its discretion, that the
disqualification should take effect on a date subsequent to the date
specified in paragraph (c)(1)(ii)(A) of this section, the date of
disqualification is such subsequent date.
[[Page 355]]
(iii) Notice of disqualification. The IRS will notify the electing
taxpayer of the disqualification of a nuclear decommissioning fund and
the date of disqualification by registered or certified mail to the last
known address of the electing taxpayer (the notice of disqualification).
For further guidance regarding the definition of last known address, see
Sec. 301.6212-2 of this chapter.
(2) Exception to disqualification--(i) In general. A nuclear
decommissioning fund will not be disqualified under paragraph (c)(1) of
this section by reason of an excess contribution or the withdrawal of
such excess contribution by an electing taxpayer if the amount of the
excess contribution is withdrawn by the electing taxpayer on or before
the date prescribed by law (including extensions) for filing the return
of the nuclear decommissioning fund for the taxable year to which the
excess contribution relates. In the case of an excess contribution that
is the result of a payment made pursuant to Sec. 1.468A-3(g)(1), a
nuclear decommissioning fund will not be disqualified under paragraph
(c)(1) of this section if the amount of the excess contribution is
withdrawn by the electing taxpayer on or before the later of--
(A) The date prescribed by law (including extensions) for filing the
return of the nuclear decommissioning fund for the taxable year to which
the excess contribution relates; or
(B) The date that is 30 days after the date that the taxpayer
receives the ruling amount for such taxable year.
(ii) Excess contribution defined. For purposes of this section, an
excess contribution is the amount by which cash payments made (or deemed
made) to a nuclear decommissioning fund during any taxable year exceed
the payment limitation contained in section 468A(b) and Sec. 1.468A-
2(b). The amount of a special transfer permitted under Sec. 1.468A-8 is
not treated as a cash payment for this purpose.
(iii) Taxation of income attributable to an excess contribution. The
income of a nuclear decommissioning fund attributable to an excess
contribution is required to be included in the gross income of the
nuclear decommissioning fund under Sec. 1.468A-4(b).
(3) Disqualification treated as distribution. If all or any portion
of a nuclear decommissioning fund is disqualified under paragraph (c)(1)
of this section, the portion of the nuclear decommissioning fund that is
disqualified is treated as distributed to the electing taxpayer on the
date of disqualification. Such a distribution shall be treated for
purposes of section 1001 as a disposition of property held by the
nuclear decommissioning fund (see Sec. 1.468A-4(c)(2)). In addition,
the electing taxpayer must include in gross income for the taxable year
that includes the date of disqualification an amount equal to the fair
market value of the distributable assets of the nuclear decommissioning
fund multiplied by the fraction of the nuclear decommissioning fund that
was disqualified under paragraph (c)(1) of this section. For this
purpose, the fair market value of the distributable assets of the
nuclear decommissioning fund is equal to the fair market value of the
assets of the fund determined as of the date of disqualification,
reduced by--
(i) The amount of any excess contribution that was not withdrawn
before the date of disqualification if no deduction was allowed with
respect to such excess contribution;
(ii) The amount of any deemed distribution that was not actually
distributed before the date of disqualification (as determined under
Sec. 1.468A-2(d)(2)(iii)) if the amount of the deemed distribution was
included in the gross income of the electing taxpayer for the taxable
year in which the deemed distribution occurred; and
(iii) The amount of any tax that--
(A) Is imposed on the income of the fund;
(B) Is attributable to income taken into account before the date of
disqualification or as a result of the disqualification; and
(C) Has not been paid as of the date of disqualification.
(4) Further effects of disqualification. Contributions made to a
disqualified fund after the date of disqualification are not deductible
under section 468A(a) and Sec. 1.468A-2(a), or, if the fund is
disqualified only in part, are deductible only to the extent provided in
the notice of disqualification. In addition,
[[Page 356]]
if any assets of the fund that are deemed distributed under paragraph
(c)(3) of this section are held by the fund after the date of
disqualification (or if additional assets are acquired with
nondeductible contributions made to the fund after the date of
disqualification), the income earned by such assets after the date of
disqualification must be included in the gross income of the electing
taxpayer (see section 671) to the extent that such income is otherwise
includible under chapter 1 of the Internal Revenue Code (Code). An
electing taxpayer can establish a nuclear decommissioning fund to
replace a fund that has been disqualified in its entirety only if the
IRS specifically consents to the establishment of a replacement fund in
connection with the issuance of an initial schedule of ruling amounts
for such replacement fund.
(d) Termination of nuclear decommissioning fund upon substantial
completion of decommissioning--(1) In general. Upon substantial
completion of the decommissioning of a nuclear power plant to which a
nuclear decommissioning fund relates, such nuclear decommissioning fund
shall be considered terminated and treated as having distributed all of
its assets on the date the termination occurs (the termination date).
Such a distribution shall be treated for purposes of section 1001 as a
disposition of property held by the nuclear decommissioning fund (see
Sec. 1.468A-4(c)(2)). In addition, the electing taxpayer shall include
in gross income for the taxable year in which the termination occurs an
amount equal to the fair market value of the assets of the fund
determined as of the termination date, reduced by--
(i) The amount of any deemed distribution that was not actually
distributed before the termination date if the amount of the deemed
distribution was included in the gross income of the electing taxpayer
for the taxable year in which the deemed distribution occurred; and
(ii) The amount of any tax that--
(A) Is imposed on the income of the fund;
(B) Is attributable to income taken into account before the
termination date or as a result of the termination; and
(C) Has not been paid as of the termination date.
(2) Additional rules. Contributions made to a nuclear
decommissioning fund after the termination date are not deductible under
section 468A(a) and Sec. 1.468A-2(a). In addition, if any assets are
held by the fund after the termination date, the income earned by such
assets after the termination date must be included in the gross income
of the electing taxpayer (see section 671) to the extent that such
income is otherwise includible under chapter 1 of the Code. Finally,
under Sec. 1.468A-2(e), an electing taxpayer using an accrual method of
accounting is allowed a deduction for nuclear decommissioning costs that
are incurred during any taxable year even if such costs are incurred
after substantial completion of decommissioning (for example, expenses
incurred to monitor or safeguard the plant site).
(3) Substantial completion of decommissioning and termination date.
(i) The substantial completion of the decommissioning of a nuclear power
plant occurs on the date that the maximum acceptable radioactivity
levels mandated by the Nuclear Regulatory Commission with respect to a
decommissioned nuclear power plant are satisfied (the substantial
completion date). Except as otherwise provided in paragraph (d)(3)(ii)
of this section, the substantial completion date is also the termination
date.
(ii) If a significant portion of the total estimated decommissioning
costs with respect to a nuclear power plant are not incurred on or
before the substantial completion date, an electing taxpayer may
request, and the IRS will issue, a ruling that designates a date
subsequent to the substantial completion date as the termination date.
The termination date designated in the ruling will not be later than the
last day of the third taxable year after the taxable year that includes
the substantial completion date. The request for a ruling under this
paragraph (d)(3)(ii) must be filed during the taxable year that includes
the substantial completion date and must comply with the procedural
rules in effect at the time of the request.
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
[[Page 357]]
Sec. 1.468A-6 Disposition of an interest in a nuclear power plant.
(a) In general. This section describes the Federal income tax
consequences of a transfer of the assets of a nuclear decommissioning
fund (Fund) within the meaning of Sec. 1.468A-1(b)(4) in connection
with a sale, exchange, or other disposition by a taxpayer (transferor)
of all or a portion of its qualifying interest in a nuclear power plant
to another taxpayer (transferee). This section also explains how a
schedule of ruling amounts will be determined for the transferor and
transferee. For purposes of this section, a nuclear power plant includes
a plant that previously qualified as a nuclear power plant and that has
permanently ceased to produce electricity.
(b) Requirements. This section applies if--
(1) Immediately before the disposition, the transferor maintained a
Fund with respect to the interest disposed of;
(2) Immediately after the disposition--
(i) The transferee maintains a Fund with respect to the interest
acquired;
(ii) The interest acquired is a qualifying interest of the
transferee in the nuclear power plant;
(3) In connection with the disposition, either--
(i) The transferee acquires part or all of the transferor's
qualifying interest in the plant and a proportionate amount of the
assets of the transferor's Fund (all such assets if the transferee
acquires the transferor's entire qualifying interest in the plant) is
transferred to a Fund of the transferee; or
(ii) The transferee acquires the transferor's entire qualifying
interest in the plant and the transferor's entire Fund is transferred to
the transferee; and
(4) The transferee continues to satisfy the requirements of Sec.
1.468A-5(a)(1)(iii), which permits an electing taxpayer to maintain only
one Fund for each plant.
(c) Tax consequences. A disposition that satisfies the requirements
of paragraph (b) of this section will have the following tax
consequences at the time it occurs:
(1) The transferor and its Fund. (i) Except as provided in paragraph
(c)(1)(ii) of this section, neither the transferor nor the transferor's
Fund will recognize gain or loss or otherwise take any income or
deduction into account by reason of the transfer of a proportionate
amount of the assets of the transferor's Fund to the transferee's Fund
(or by reason of the transfer of the transferor's entire Fund to the
transferee). For purposes of Sec. Sec. 1.468A-1 through 1.468A-9, this
transfer (or the transfer of the transferor's Fund) will not be
considered a distribution of assets by the transferor's Fund.
(ii) Notwithstanding paragraph (c)(1)(i) of this section, if the
transferor has made a special transfer under Sec. 1.468A-8 prior to the
transfer of the Fund or Fund assets, any deduction with respect to that
special transfer allowable under section 468A(f)(2) for a taxable year
ending after the date of the transfer of the Fund or Fund assets (the
unamortized special transfer deduction) is allowed under section
468A(f)(2)(C) for the taxable year that includes the date of the
transfer of the Fund or Fund assets. If the taxpayer transfers only a
portion of its interest in a nuclear power plant, only the corresponding
portion of the unamortized special transfer deduction qualifies for the
acceleration under section 468A(f)(2)(C).
(2) The transferee and its Fund. Neither the transferee nor the
transferee's Fund will recognize gain or loss or otherwise take any
income or deduction into account by reason of the transfer of a
proportionate amount of the assets of the transferor's Fund to the
transferee's Fund (or by reason of the transfer of the transferor's Fund
to the transferee). For purposes of Sec. Sec. 1.468A-1 through 1.468A-
9, this transfer (or the transfer of the transferor's Fund) will not
constitute a payment or a contribution of assets by the transferee to
its Fund.
(3) Basis. Transfers of assets of a Fund to which this section
applies do not affect basis. Thus, the transferee's Fund will have a
basis in the assets received from the transferor's Fund that is the same
as the basis of those assets in the transferor's Fund immediately before
the disposition.
(d) Determination of proportionate amount. For purposes of this
section, a transferor of a qualifying interest in a
[[Page 358]]
nuclear power plant is considered to transfer a proportionate amount of
the assets of its Fund to a Fund of a transferee of the interest if, on
the date of the transfer of the interest, the percentage of the fair
market value of the Fund's assets attributable to the assets transferred
equals the percentage of the transferor's qualifying interest that is
transferred.
(e) Calculation of schedule of ruling amounts and schedule of
deduction amounts for dispositions described in this section--(1)
Transferor. If a transferor disposes of all or a portion of its
qualifying interest in a nuclear power plant in a transaction to which
this section applies, the transferor's schedule of ruling amounts with
respect to the interests disposed of and retained (if any) and, if
applicable, the amount allowable as a deduction for a special transfer
under Sec. 1.468A-8 will be determined under the following rules:
(i) Taxable year of disposition; ruling amount. If the transferor
does not file a request for a revised schedule of ruling amounts on or
before the deemed payment deadline for the taxable year of the
transferor in which the disposition of its interest in the nuclear power
plant occurs (that is, the date that is two and one-half months after
the close of that year), the transferor's ruling amount with respect to
that plant for that year will equal the sum of--
(A) The ruling amount contained in the transferor's current schedule
of ruling amounts with respect to that plant for that taxable year
multiplied by the portion of the qualifying interest that is retained
(if any); and
(B) The ruling amount contained in the transferor's current schedule
of ruling amounts with respect to that plant for that taxable year
multiplied by the product of--
(1) The portion of the transferor's qualifying interest that is
disposed of; and
(2) A fraction, the numerator of which is the number of days in that
taxable year that precede the date of disposition, and the denominator
of which is the number of days in that taxable year.
(ii) Taxable year of disposition; deduction under Sec. 1.468A-8. If
the transferor has elected to make a special transfer under section
468A(f), the amount allowable as a deduction under Sec. 1.468A-8 for
the taxable year in which it transfers a portion of its interest in the
nuclear plant is equal to the deduction amount for that taxable year
from its existing schedule of deduction amounts multiplied by the
percentage of its interest that it retains. This deduction is in
addition to the deduction described in paragraph (c)(1)(ii) of this
section.
(iii) Taxable years after the year of disposition. A transferor that
retains a qualifying interest in a nuclear power plant must file a
request for a revised schedule of ruling amounts (and, if applicable, a
revised schedule of deduction amounts) with respect to that interest on
or before the deemed payment deadline for the first taxable year of the
transferor beginning after the disposition. See Sec. Sec. 1.468A-
3(f)(1)(ii)(B) and 1.468A-8(c)(3). If the transferor does not timely
file such a request, the transferor's ruling amount and the transferor's
deduction amount under Sec. 1.468A-8 with respect to that interest for
the affected year or years will be zero, unless the Internal Revenue
Service (IRS) waives the application of this paragraph (e)(1)(iii) upon
a showing of good cause for the delay.
(2) Transferee. If a transferee acquires all or a portion of a
transferor's qualifying interest in a nuclear power plant in a
transaction to which this section applies, the transferee's schedule of
ruling amounts with respect to the interest acquired will be determined
under the following rules:
(i) Taxable year of disposition. If the transferee does not file a
request for a schedule of ruling amounts on or before the deemed payment
deadline for the taxable year of the transferee in which the disposition
occurs (that is, the date that is two and one-half months after the
close of that year), the transferee's ruling amount with respect to the
interest acquired in the nuclear power plant for that year is equal to
the amount contained in the transferor's current schedule of ruling
amounts for that plant for the taxable year of the transferor in which
the disposition occurred, multiplied by the product of--
(A) The portion of the transferor's qualifying interest that is
transferred; and
[[Page 359]]
(B) A fraction, the numerator of which is the number of days in the
taxable year of the transferor including and following the date of
disposition, and the denominator of which is the number of days in that
taxable year.
(ii) Taxable years after the year of disposition. A transferee of a
qualifying interest in a nuclear power plant must file a request for a
revised schedule of ruling amounts with respect to that interest on or
before the deemed payment deadline for the first taxable year of the
transferee beginning after the disposition. See Sec. 1.468A-
3(f)(1)(ii)(B). If the transferee does not timely file such a request,
the transferee's ruling amount with respect to that interest for the
affected year or years will be zero, unless the IRS waives the
application of this paragraph (e)(2)(ii) upon a showing of good cause
for the delay.
(3) Examples. The following examples illustrate the provisions of
this paragraph (e):
Example 1. (i) X Corporation is a calendar year taxpayer engaged in
the sale of electric energy generated by a nuclear power plant. The
plant is owned entirely by X. On May 27, 2010, X transfers a 60-percent
qualifying interest in the plant to Y Corporation, a calendar year
taxpayer. Before the transfer, X had received a schedule of ruling
amounts containing an annual ruling amount of $10 million for the
taxable years 2005 through 2025. For 2010, neither X nor Y files a
request for a revised schedule of ruling amounts.
(ii) Under paragraph (e)(1)(i) of this section, X's ruling amount
for 2010 is calculated as follows: ($10,000,000 x .40) + ($10,000,000 x
.60 x 146/365) = $6,400,000. Under paragraph (e)(2)(i) of this section,
Y's ruling amount for 2010 is calculated as follows: $10,000,000 x .60 x
219/365 = $3,600,000. Under paragraphs (e)(1)(iii) and (e)(2)(ii) of
this section, X and Y must file requests for revised schedules of ruling
amounts by March 15, 2012.
Example 2. Y Corporation, the sole owner of a nuclear power plant,
is a calendar year taxpayer. In year 1, Y elects to make a special
transfer under section 468A(f)(1) to the nuclear decommissioning fund Y
maintains with respect to the plant. The amount of the special transfer
is $100 x , and the remaining useful life of the plant is 20 years. Y
obtains a schedule of deduction amounts under Sec. 1.468A-8T(c)
permitting a $5 x deduction each year over the 20-year remaining useful
life, and deducts $5 x of the special transfer amount in year 1, year 2,
year 3, and year 4. On the first day of year 5, Y transfers a 25%
interest in the plant to an unrelated party. Under paragraph (c)(1)(ii)
of this section, Y may deduct in Year 5 the unamortized special transfer
deduction corresponding to the portion of the plant transferred (25
percent of $80 x or $20 x ). In addition, under paragraph (e)(1)(ii) of
this section, Y may deduct the portion of the deduction amount for year
5 from the schedule of deduction amounts corresponding to its retained
interest in the plant (75 percent of $5 x or $3.75 x ). Pursuant to
paragraph (e)(1)(iii) of this section, Y must file a request for a
revised schedule of ruling amounts by March 15 of year 7.
(f) Anti-abuse provision. The IRS may treat a disposition as
satisfying the requirements of this section if the IRS determines that
this treatment is necessary or appropriate to carry out the purposes of
section 468A and Sec. Sec. 1.468A-1 through 1.468A-9.
[T.D. 9512, 75 FR 80701, Dec. 23, 2010, as amended by 76 FR 3837, Jan.
21, 2011]
Sec. 1.468A-7 Manner of and time for making election.
(a) In general. An eligible taxpayer is allowed a deduction for the
taxable year in which the taxpayer makes a cash payment (or is deemed to
make a cash payment) to a nuclear decommissioning fund or for a special
transfer under Sec. 1.468A-8 only if the taxpayer elects the
application of section 468A. A separate election is required for each
nuclear decommissioning fund and for each taxable year with respect to
which payments are to be deducted under section 468A or a special
transfer is made under Sec. 1.468A-8. In the case of an affiliated
group of corporations that join in the filing of a consolidated return
for a taxable year, the common parent must make a separate election on
behalf of each member whose payments to a nuclear decommissioning fund
during such taxable year are to be deducted under section 468A and each
member that makes a special transfer under Sec. 1.468A-8 with respect
to such year. The election under section 468A for any taxable year is
irrevocable and must be made by attaching a statement (Election
Statement) and a copy of the schedule of ruling amounts provided
pursuant to the rules of Sec. 1.468A-3 to the taxpayer's Federal income
tax return (or, in the case of an affiliated group of corporations that
join in the filing of a consolidated return, the consolidated return)
for such taxable year. The return to which the Election
[[Page 360]]
Statement and a copy of the schedule of ruling amounts is attached must
be filed on or before the time prescribed by law (including extensions)
for filing the return for the taxable year with respect to which
payments are to be deducted under section 468A.
(b) Required information. The Election Statement must include the
following information:
(1) The legend ``Election Under Section 468A'' typed or legibly
printed at the top of the first page.
(2) The electing taxpayer's name, address and taxpayer
identification number (or, in the case of an affiliated group of
corporations that join in the filing of a consolidated return, the name,
address and taxpayer identification number of each electing taxpayer).
(3) The taxable year for which the election is made.
(4) For each nuclear decommissioning fund for which an election is
made--
(i) The name and location of the nuclear power plant to which the
fund relates;
(ii) The name and employer identification number of the nuclear
decommissioning fund;
(iii) The total amount of actual cash payments made to the nuclear
decommissioning fund during the taxable year that were not treated as
deemed cash payments under Sec. 1.468A-2(c)(1) for a prior taxable
year;
(iv) The total amount of cash payments deemed made to the nuclear
decommissioning fund under Sec. 1.468A-2(c)(1) for the taxable year;
(v) The total amount of any special transfers (whether in cash or
property) made to the nuclear decommissioning fund under Sec. 1.468A-8
during the taxable year that were not treated as deemed transfers under
Sec. 1.468A-8(a)(4) for a prior taxable year;
(vi) The total amount of any special transfers (whether in cash or
property) deemed made to the nuclear decommissioning fund under Sec.
1.468A-8(a)(4) for the taxable year; and
(vii) For each item of property included in the amounts described in
paragraph (b)(4)((v) or (vi) of this section, the amount of the item of
property and whether the basis of the item of property is determined
under Sec. 1.468A-8(b)(5)(iii)(A) or Sec. 1.468A-8(b)(5)(iii)(B).
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
Sec. 1.468A-8 Special transfers to qualified funds
pursuant to section 468A(f).
(a) General rule--(1) In general. Under section 468A(f), a taxpayer
maintaining a qualified nuclear decommissioning fund with respect to a
nuclear power plant may transfer cash or property into the fund (a
special transfer). The special transfer is not subject to the ruling
amount limitation in section 468A(b) and is not treated as a cash
payment for purposes of that limitation. Thus, a taxpayer may, in the
same taxable year, pay the ruling amount and make a special transfer
into the fund. A special transfer may be made in cash, property, or both
cash and property. The amount of a special transfer (that is, the amount
of cash and the fair market value of property transferred) may not
exceed the present value of the pre-2005 nonqualifying amount of nuclear
decommissioning costs with respect to the nuclear power plant. The
taxpayer is entitled to a deduction against income for a special
transfer, as described in paragraph (b) of this section. A special
transfer may not be made to a nuclear decommissioning fund before the
first taxable year in which a deduction amount is applicable to the
nuclear decommissioning fund (see paragraph (c) of this section).
(2) Pre-2005 nonqualifying amount--(i) In general. The present value
of the pre-2005 nonqualifying amount of nuclear decommissioning costs
with respect to a nuclear power plant is the amount equal to the pre-
2005 nonqualifying percentage of the present value of the estimated
future decommissioning costs (as defined in Sec. 1.468A-1(b)(6)) with
respect to the nuclear power plant as of the first day of the taxable
year of the taxpayer in which the special transfer is made or deemed
made (or a later date that is on or before the date on which the special
transfer is expected to be made if the taxpayer establishes to the
satisfaction of the IRS that the determination of present value as of
such date is reasonable and consistent with the principles and
provisions of
[[Page 361]]
this section). For this purpose, the pre-2005 nonqualifying percentage
for the plant is 100 percent reduced by the sum of--
(A) The qualifying percentage (within the meaning of Sec. 1.468A-
3(d)(4) as in effect on December 31, 2005) used in determining the
taxpayer's last schedule of ruling amounts for the nuclear
decommissioning fund under the law in effect before the enactment of the
Energy Policy Act of 2005 (that is, the percentage of the plant's total
nuclear decommissioning costs that were permitted to be funded through
the fund under the law in effect before the enactment of the Energy
Policy Act of 2005); and
(B) The percentage of decommissioning costs transferred in any
previous special transfer (that is, the amount transferred as a
percentage of the present value of the estimated future costs of
decommissioning as of the first day of the taxable year in which such
previous transfer was made).
(ii) Pre-2005 nonqualifying amount of transferee. If there is a
transfer of a nuclear decommissioning fund or part or all of its assets
and Sec. 1.468A-6 applies to the transfer, the pre-2005 nonqualifying
amount determined with respect to the transferee is equal to the pre-
2005 nonqualifying amount (or a proportionate part of the pre-2005
nonqualifying amount) that would have been determined with respect to
the transferor but for such transfer.
(3) Transfers in multiple years. A taxpayer making a special
transfer is not required to transfer the entire eligible amount in a
single year. The requirements of paragraph (c) of this section apply
separately to each year in which a special transfer is made. In
calculating the amount of any subsequent transfer, the taxpayer must
reduce the pre-2005 nonqualifying percentage under paragraph (a)(2) of
this section to take into account all previous transfers. For example,
if a taxpayer has a pre-2005 nonqualifying percentage of 40 percent, and
transfers half of the eligible amount in a special transfer, any
subsequent transfer must be calculated on the basis of a pre-2005
nonqualifying percentage of 20 percent.
(4) Deemed payment rules--(i) In general. The amount of any special
transfer (whether in cash or property) described in Sec. 1.468A-8 and
made by an electing taxpayer to a nuclear decommissioning fund on or
before the 15th day of the third calendar month after the close of any
taxable year (the deemed payment deadline date) shall be deemed made
during such taxable year if the electing taxpayer irrevocably designates
the amount as relating to such taxable year on its timely filed Federal
income tax return for such taxable year or, in the case of special
transfers described in paragraph (a)(4)(ii) of this section, on an
amended return for such taxable year (see Sec. 1.468A-7(b)(4)(v) and
(vi) for rules relating to such designation).
(ii) Special rule for certain special transfers. Special transfers
that the electing taxpayer designates as relating to a taxable year
beginning after December 31, 2005, and ending before January 1, 2010,
which are actually made within 90 days after the electing taxpayer
receives a ruling from the Secretary relating to the special transfer
are deemed made during the taxable year designated as the year to which
the special transfer relates.
(b) Deduction for amounts transferred--(1) In general. (i) Except as
provided in this paragraph (b), the deduction for any special transfer
is allowed ratably over the remaining useful life of the nuclear power
plant. The amount of the deduction for any taxable year is the deduction
amount for such year specified in the schedule of deduction amounts
required under paragraph (c) of this section.
(ii) For purposes of this paragraph (b), the remaining useful life
of the nuclear power plant is the period beginning on the first day of
the taxable year during which the transfer is made and ending on the
last day of the taxable year that includes the last day of the estimated
useful life of the nuclear power plant. The last day of the estimated
useful life of the nuclear power plant is determined for this purpose
under the rules of Sec. 1.468A-3(c)(2).
(2) Amount of deduction--(i) General rule. Except as provided in
this paragraph (b)(2), the deduction for property contributed in a
special transfer is limited to the lesser of the fair market
[[Page 362]]
value of the property contributed or the taxpayer's basis in that
property.
(ii) Election--(A) In general. If the fair market value of the
property contributed is less than the taxpayer's adjusted basis in such
property as of the date the property is contributed and the fund elects
to treat the fair market value of the property as its adjusted basis in
the property, the taxpayer may deduct an amount equal to the adjusted
basis of the contributed property.
(B) Manner of making election. The election described in paragraph
(b)(2)(ii)(A) of this section is made for property contributed in a
special transfer by attaching a description of the property and a
statement that the fund is making an election under Sec. 1.468A-
8(b)(2)(ii) with respect to the property to the return of the fund for
the taxable year in which the property is contributed to the fund.
(C) Election allowed for property transferred prior to December 23,
2010. The election described in paragraph (b)(2)(ii)(A) of this section
may be made and a deduction equal to adjusted basis will be allowed for
property contributed in a special transfer prior to December 23, 2010.
The election in such a case may be made on an amended return of the fund
for the taxable year in which the property is contributed to the fund
and the transferor may amend previously filed returns to claim a
deduction calculated by reference to the adjusted basis of the property.
(3) Denial of deduction for previously deducted amounts. If a
deduction (other than a deduction under section 468A) has been allowed
to the taxpayer (or a predecessor) on account of expected
decommissioning costs for a nuclear power plant (a nonconforming
deduction) or an amount otherwise includible in income has been excluded
from the gross income of the taxpayer (or a predecessor) on account of
such expected decommissioning costs (a nonconforming exclusion), the
deduction allowed for a special transfer to the nuclear decommissioning
fund maintained with respect to the plant is reduced. In the case of a
single special transfer of the full eligible amount, the reduction is
equal to the aggregate amount of all nonconforming deductions and
nonconforming exclusions. In the case of a transfer of less than the
full eligible amount, the reduction is a ratable portion of such
aggregate amount.
(4) Transfers of qualified nuclear decommissioning funds. (i) If a
special transfer is made to any qualified nuclear decommissioning fund,
there is a subsequent transfer of the fund or the assets of the fund (a
fund transfer), and Sec. 1.468-6 applies to the fund transfer, any
amount of the deduction under paragraph (b) of this section allocable to
taxable years ending after the date of the fund transfer will be allowed
as a current deduction to the transferor for the taxable year that
includes the date of the fund transfer. See Sec. 468A-6(c) for
additional rules concerning transfers of decommissioning funds,
including the transfer of a portion of the taxpayer's interest in a
nuclear power plant. If a taxpayer transfers only part of the fund or
the fund's assets, the rules in this paragraph (b)(4) apply only to the
corresponding portion of the deduction under paragraph (b) of this
section.
(ii) If a deduction is allowed to the transferor under paragraph
(b)(4)(i) of this section and the transferee is related to the
transferor, the Internal Revenue Service (IRS) will not approve the
transferee's schedule of ruling amounts for taxable years beginning
after the date of the transfer unless the ruling amounts are deferred in
a manner that results in recapture of the acceleration amount. For this
purpose--
(A) The acceleration amount is the difference between the deduction
allowed under this paragraph (b)(4) and the present value as of the
beginning of the acceleration period of the deductions that, but for the
transfer, would have been allowed under this paragraph (b) for taxable
years during the acceleration period;
(B) The acceleration amount is recaptured if the aggregate present
value of the ruling amounts at the beginning of the acceleration period
is equal to the amount by which the aggregate present value of the
ruling amounts that would have been approved but for this paragraph
(b)(4)(ii) exceeds the acceleration amount;
[[Page 363]]
(C) The acceleration period is the period from the first day of the
transferor's first taxable year beginning after the date of the transfer
until the end of the plant's remaining useful life;
(D) Present values will be determined using the assumptions that are
used in determining the transferee's first schedule of ruling amounts;
and
(E) A transferor and a transferee are related if their relationship
is specified in section 267(b) or section 707(b)(1) or they are treated
as a single taxpayer under section 41(f)(1)(A) or (B).
(5) Special rules--(i) Gain or loss not recognized on transfers to
fund. No gain or loss will be recognized on any special transfer.
(ii) Taxpayer basis in fund. Notwithstanding any other provision of
the Internal Revenue Code (Code) and regulations, the taxpayer's basis
in the fund is not increased by reason of the special transfer.
(iii) Fund basis in transferred property--(A) In general. Except as
provided in paragraph (b)(5)(iii)(B) of this section, the fund's basis
in any property transferred in a special transfer is the same as the
transferor's basis in the property immediately before the transfer.
(B) Basis in case of election. If a fund makes the election
described in paragraph (b)(2)(ii) of this section, the fund's basis in
the property transferred is the fair market value of the property on the
date of transfer.
(c) Schedule of deductions required--(1) In general. A taxpayer may
not make a special transfer to a qualified nuclear decommissioning fund
unless the taxpayer requests from the IRS a schedule of deduction
amounts in connection with such transfer. A schedule of deduction
amounts for a nuclear decommissioning fund (schedule of deduction
amounts) is a ruling (within the meaning of Sec. 601.201(a)(2) of this
chapter) specifying the annual deductions (deduction amounts) that, over
the taxable years in the remaining useful life of the nuclear power
plant, will result in the deduction of the entire amount of the special
transfer. Such a request may be combined with a request for a schedule
of ruling amounts under Sec. 1.468A-3(a). In the case of a combined
request, the schedule of deduction amounts requested under this
paragraph (c)(1) must be stated separately from the schedule of ruling
amounts requested under Sec. 1.468A-3(a) and approval of the schedule
of deduction amounts under this section will constitute a separate
ruling. A request for a schedule of deduction amounts must comply with
all provisions of paragraph (d) of this section.
(2) Transfers in multiple taxable years. A taxpayer making a special
transfer in more than one taxable year pursuant to paragraph (a)(3) of
this section must request a separate schedule of deduction amounts in
connection with each special transfer. More than one schedule of
deduction amounts can be requested in a single ruling request to the
Secretary and the Secretary will provide, in a single ruling, separate
schedules of deduction amounts for each of a series of special transfers
provided that each request for a separate schedule of deduction amounts
complies with all requirements of this paragraph.
(3) Transfer of partial interest in fund. If a taxpayer transfers
part of a fund or a fund's assets and is allowed a deduction under
paragraph (b)(3) of this section, the taxpayer must request a new
schedule of deduction amounts in connection with the transfer.
(4) Special transfer permitted before receipt of schedule. If an
electing taxpayer has filed a timely request for a schedule of deduction
amounts in connection with a special transfer for a taxable year and
does not receive the schedule of deduction amounts before the deemed
payment deadline for such taxable year, the taxpayer may make a special
transfer to the nuclear decommissioning fund on the basis of the special
transfer amount proposed in the taxpayer's request. If the schedule of
deduction amounts provided by the Secretary is based on a special
transfer amount that differs from the special transfer amount proposed
in the taxpayer's request, rules similar to the rules of Sec. 1.468A-
3(g)(2) and (3) shall apply.
(d) Manner of requesting schedule of deduction amounts--(1) In
general. (i) In order to receive a deduction amount for any taxable
year, a taxpayer must
[[Page 364]]
file a request for a schedule of deduction amounts that complies with
the requirements of this paragraph (d), the applicable procedural rules
set forth in Sec. 601.201(e) of this chapter (Statement of Procedural
Rules) and the requirements of any applicable revenue procedure that is
in effect on the date the request is filed.
(ii) A separate request for a schedule of deduction amounts is
required for each nuclear decommissioning fund established by a taxpayer
(see Sec. 1.468A-5(a) for rules relating to the number of nuclear
decommissioning funds that a taxpayer can establish).
(iii) Except as provided by Sec. 1.468A-5(a)(1)(iv) (relating to
certain unincorporated organizations that may be taxable as
corporations) and Sec. 1.468A-3 (relating to a request for a schedule
of ruling amounts), a request for a schedule of deduction amounts must
not contain a request for a ruling on any other issue, whether the issue
involves section 468A or another section of the Code.
(iv) In the case of an affiliated group of corporations that join in
the filing of a consolidated return, the common parent of the group may
request a schedule of deduction amounts for each member of the group
that possesses a qualifying interest in the same nuclear power plant by
filing a single submission with the IRS.
(v) Except as provided in paragraph (d)(1)(vi) of this section, the
IRS will not provide or revise a deduction amount applicable to a
taxable year in response to a request for a schedule of deduction
amounts that is filed after the deemed payment deadline date (as defined
in paragraph (a)(4) of this section) for such taxable year.
(vi) For special transfers relating to taxable years beginning after
December 31, 2005, and before January 1, 2010, the IRS will not provide
a deduction amount in response to a request for a schedule of deduction
amounts that is filed after February 22, 2011.
(vii) Except as provided in paragraph (d)(1)(viii) of this section,
a request for a schedule of deduction amounts shall be considered filed
only if such request complies substantially with the requirements of
this paragraph (d). In determining the date when a request is filed, the
principles of sections 7502 and 7503 shall apply.
(viii) If a request does not comply substantially with the
requirements of this paragraph (d), the IRS will notify the taxpayer of
that fact. If the information or materials necessary to comply
substantially with the requirements of this paragraph (d) are provided
to the IRS within 30 days after this notification, the request will be
considered filed on the date of the original submission. In addition,
the request will be considered filed on the date of the original
submission in a case in which the information and materials are provided
more than 30 days after the notification if the IRS determines that the
electing taxpayer made a good faith effort to provide the applicable
information or materials within 30 days after notification and also
determines that treating the request as filed on the date of the
original submission is consistent with the purposes of section 468A. In
any other case in which the information or materials necessary to comply
substantially with the requirements of this paragraph (d) are not
provided within 30 days after the notification, the request will be
considered filed on the date that all information or materials necessary
to comply with the requirements of this paragraph (d) are provided.
(2) Information required. A request for a schedule of deduction
amounts must contain the following information:
(i) The taxpayer's name, address and taxpayer identification number.
(ii) Whether the request is for an initial schedule of deduction
amounts or a schedule of deduction amounts for a subsequent special
transfer.
(iii) The name and location of the nuclear power plant with respect
to which a schedule of deduction amounts is requested.
(iv) A description of the taxpayer's qualifying interest in the
nuclear power plant and the percentage of such nuclear power plant that
the qualifying interest of the taxpayer represents.
(v) The present value of the estimated future decommissioning costs
(as defined in Sec. 1.468A-1(b)(6)) with respect to the taxpayer's
qualifying interest in the nuclear power plant as of the first day of
the taxable year of the
[[Page 365]]
taxpayer in which a transfer is made under this section.
(vi) A description of the assumptions, estimates and other factors
that were used by the taxpayer to determine the amount of
decommissioning costs, including each of the following if applicable:
(A) A description of the proposed method of decommissioning the
nuclear power plant (for example, prompt removal/dismantlement, safe
storage entombment with delayed dismantlement, or safe storage
mothballing with delayed dismantlement).
(B) The estimated year in which substantial decommissioning costs
will first be incurred.
(C) The estimated year in which the decommissioning of the nuclear
power plant will be substantially complete (see Sec. 1.468A-5(d)(3) for
a definition of substantial completion of decommissioning).
(D) The total estimated cost of decommissioning expressed in current
dollars (that is, based on price levels in effect at the time of the
current determination).
(E) The total estimated cost of decommissioning expressed in future
dollars (that is, based on anticipated price levels when expenses are
expected to be paid).
(F) For each taxable year in the period that begins with the year
specified in paragraph (d)(2)(vi)(B) of this section (the estimated year
in which substantial decommissioning costs will first be incurred) and
ends with the year specified in paragraph (d)(2)(vi)(C) of this section
(the estimated year in which the decommissioning of the nuclear power
plant will be substantially complete), the estimated cost of
decommissioning expressed in future dollars.
(G) A description of the methodology used in converting the
estimated cost of decommissioning expressed in current dollars to the
estimated cost of decommissioning expressed in future dollars.
(H) The assumed after-tax rate of return to be earned by the amounts
collected for decommissioning.
(I) A copy of each engineering or cost study that was relied on or
used by the taxpayer in determining the amount of decommissioning costs.
(vii) The taxpayer's pre-2005 nonqualifying percentage (as defined
in paragraph (a)(2) of this section).
(viii) The estimated useful life of the nuclear power plant (as such
term is defined in paragraph (b)(1)(ii) or (iii) of this section).
(ix) If the request is for a subsequent schedule of deduction
amounts, the amount of the previous special transfer and the present
value of the estimated future decommissioning costs (as defined in Sec.
1.468A-1(b)(6)) with respect to the taxpayer's qualifying interest in
the nuclear power plant as of the first day of the taxable year of the
taxpayer in which the previous special transfer was made.
(x) If the request is for a subsequent schedule of deduction
amounts, a copy of all schedules of deduction amounts that relate to the
nuclear power plant to which the request relates and that were
previously issued to the taxpayer making the request.
(xi) If the request for a schedule of deduction amounts contains a
request, pursuant to Sec. 1.468A-5(a)(1)(iv), that the IRS rule whether
an unincorporated organization through which the assets of the fund are
invested is an association taxable as a corporation for Federal tax
purposes, a copy of the legal documents establishing or otherwise
governing the organization.
(xii) Any other information required by the IRS that may be
necessary or useful in determining the schedule of deduction amounts.
(3) Statement required. A taxpayer requesting a schedule of
deduction amounts under this paragraph (d) must submit a statement that
any nonconforming deductions and nonconforming exclusions have reduced
the deduction allowed for the special transfer in accordance with
paragraph (b)(2) of this section.
(4) Administrative procedures. The IRS may prescribe administrative
procedures that supplement the provisions of paragraphs (d)(1) and (2)
of this section. In addition, the IRS may, in its discretion, waive the
requirements of paragraphs (d)(1) and (2) of this section under
appropriate circumstances.
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
[[Page 366]]
Sec. 1.468A-9 Effective/applicability date.
Sections 1.468A-1 through 1.468A-8 are effective on December 23,
2010 and apply with respect to taxable years ending after such date.
Special rules that are provided for taxable years ending on or before
such date, such as the special rule for certain special transfers
contained in Sec. 1.468A-8(a)(4)(ii), apply with respect to such
taxable years. In addition, a taxpayer may apply the provisions of
Sec. Sec. 1.468A-1 through 1.468A-8 with respect to a taxable year
ending on or before December 23, 2010 if all such provisions are
consistently applied.
[T.D. 9512, 75 FR 80701, Dec. 23, 2010]
Sec. 1.468B Designated settlement funds.
A designated settlement fund, as defined in section 468B(d)(2), is
taxed in the manner described in Sec. 1.468B-2. The rules for
transferors to a qualified settlement fund described in Sec. 1.468B-3
apply to transferors to a designated settlement fund. Similarly, the
rules for claimants of a qualified settlement fund described in Sec.
1.468B-4 apply to claimants of a designated settlement fund. A fund,
account, or trust that does not qualify as a designated settlement fund
is, however, a qualified settlement fund if it meets the requirements of
a qualified settlement fund described in Sec. 1.468B-1.
[T.D. 8459, 57 FR 60988, Dec. 23, 1992]
Sec. 1.468B-0 Table of contents.
This section lists the table of contents for Sec. Sec. 1.468B-1
through 1.468B-9.
Sec. 1.468B-1 Qualified settlement funds.
(a) In general.
(b) Coordination with other entity classifications.
(c) Requirements.
(d) Definitions.
(1) Transferor.
(2) Related person.
(e) Governmental order or approval requirement.
(1) In general.
(2) Arbitration panels.
(f) Resolve or satisfy requirement.
(1) Liabilities to provide property or services.
(2) CERCLA liabilities.
(g) Excluded liabilities.
(h) Segregation requirement.
(1) In general.
(2) Classification of fund established to resolve or satisfy
allowable and non-allowable claims.
(i) [Reserved]
(j) Classification of fund prior to satisfaction of requirements in
paragraph (c) of this section.
(1) In general.
(2) Relation-back rule.
(i) In general.
(ii) Relation-back election.
(k) Election to treat a qualified settlement fund as a subpart E
trust.
(1) In general.
(2) Manner of making grantor trust election.
(i) In general.
(ii) Requirements for election statement.
(3) Effect of making the election.
(l) Examples.
Sec. 1.468B-2 Taxation of qualified settlement funds and related
administrative requirements.
(a) In general.
(b) Modified gross income.
(c) Partnership interests held by a qualified settlement fund on
February 14, 1992.
(1) In general.
(2) Limitation on changes in partnership agreements and capital
contributions.
(d) Distributions to transferors and claimants.
(e) Basis of property transferred to a qualified settlement fund.
(f) Distribution of property.
(g) Other taxes.
(h) Denial of credits against tax.
(i) [Reserved]
(j) Taxable year and accounting method.
(k) Treatment as corporation for purposes of subtitle F.
(l) Information reporting withholding requirements.
(1) Payments to a qualified settlement fund.
(2) Payments and distributions by a qualified settlement fund.
(i) In general.
(ii) Special rules.
(m) Request for prompt assessment.
(n) Examples.
Sec. 1.468B-3 Rules applicable to the transferor.
(a) Transfer of property.
(1) In general.
(2) Anti-abuse rule.
(b) Qualified appraisal requirement for transfers of certain
property.
(1) In general.
(2) Provision of copies.
(3) Qualified appraisal.
(4) Information included in a qualified appraisal.
(5) Effect of signature of the qualified appraiser.
(c) Economic performance.
[[Page 367]]
(1) In general.
(2) Right to a refund or reversion.
(i) In general.
(ii) Right extinguished.
(3) Obligations of a transferor.
(d) Payment of insurance amounts.
(e) Statement to the qualified settlement fund and the Internal
Revenue Service.
(1) In general.
(2) Required statement.
(i) In general.
(ii) Combined statements.
(f) Distributions to transferors.
(1) In general.
(2) Deemed distributions.
(i) Other liabilities.
(ii) Constructive receipt.
(3) Tax benefit rule.
(g) Example.
Sec. 1.468B-4 Taxability of distributions to claimants.
Sec. 1.468B-5 Effective dates and transition rules applicable to
qualified settlement funds.
(a) In general.
(b) Taxation of certain pre-1996 fund income.
(1) Reasonable method.
(i) In general.
(ii) Qualified settlement funds established after February 14, 1992,
but before January 1, 1993.
(iii) Use of cash method of accounting.
(iv) Unreasonable position.
(v) Waiver of penalties.
(2) Election to apply qualified settlement fund rules.
(i) In general.
(ii) Election statement.
(iii) Due date of returns and amended returns.
(iv) Computation of interest and waiver of penalties.
(c) Grantor trust elections under Sec. 1.468B-1(k).
(1) In general.
(2) Transition rules.
(3) Qualified settlement funds established by the U.S. government on
or before February 3, 2006.
Sec. 1.468B-6 Escrow accounts, trusts, and other funds used during
deferred exchanges of like-kind property under section 1031(a)(3).
(a) Scope.
(b) Definitions.
(1) In general.
(2) Exchange funds.
(3) Exchange facilitator.
(4) Transactional expenses.
(i) In general.
(ii) Special rule for certain fees for exchange facilitator
services.
(c) Taxation of exchange funds.
(1) Exchange funds generally treated as loaned to an exchange
facilitator.
(2) Exchange funds not treated as loaned to an exchange facilitator.
(i) Scope.
(ii) Earnings attributable to the taxpayer's exchange funds.
(A) Separately identified account.
(B) Allocation of earnings in commingled accounts.
(C) Transactional expenses.
(iii) Treatment of the taxpayer.
(d) Information reporting requirements.
(e) Examples.
(f) Effective/applicability dates.
(1) In general.
(2) Transition rule.
Sec. 1.468B-7 Pre-closing escrows.
(a) Scope.
(b) Definitions.
(c) Taxation of pre-closing escrows.
(d) Reporting obligations of the administrator.
(e) Examples.
(f) Effective dates.
(1) In general.
(2) Transition rule.
Sec. 1.468B-8 Contingent-at-closing escrows. [Reserved]
Sec. 1.468B-9 Disputed ownership funds.
(a) Scope.
(b) Definitions.
(c) Taxation of a disputed ownership fund.
(1) In general.
(2) Exceptions.
(3) Property received by the disputed ownership fund.
(i) Generally excluded from income.
(ii) Basis and holding period.
(4) Property distributed by the disputed ownership fund.
(i) Computing gain or loss.
(ii) Denial of deduction.
(5) Taxable year and accounting method.
(6) Unused carryovers.
(d) Rules applicable to transferors that are not transferor-
claimants.
(1) Transfer of property.
(2) Economic performance.
(i) In general.
(ii) Obligations of the transferor.
(3) Distributions to transferors.
(i) In general.
(ii) Exception.
(iii) Deemed distributions.
(e) Rules applicable to transferor-claimants.
(1) Transfer of property.
(2) Economic performance.
(i) In general.
(ii) Obligations of the transferor-claimant.
(3) Distributions to transferor-claimants.
(i) In general.
(ii) Deemed distributions.
(f) Distributions to claimants other than transferor-claimants.
[[Page 368]]
(g) Statement to the disputed ownership fund and the Internal
Revenue Service with respect to transfers of property other than cash.
(1) In general.
(2) Combined statements.
(3) Information required on the statement.
(h) Examples.
(i) [Reserved]
(j) Effective dates.
(1) In general.
(2) Transition rule.
[T.D. 8459, 57 FR 60988, Dec. 23, 1992, as amended by T.D. 8495, 58 FR
58787, Nov. 4, 1993; T.D. 9249, 71 FR 6200, Feb. 7, 2006; T.D. 9413, 73
FR 39619, July 10, 2008]
Sec. 1.468B-1 Qualified settlement funds.
(a) In general. A qualified settlement fund is a fund, account, or
trust that satisfies the requirements of paragraph (c) of this section.
(b) Coordination with other entity classifications. If a fund,
account, or trust that is a qualified settlement fund could be
classified as a trust within the meaning of Sec. 301.7701-4 of this
chapter, it is classified as a qualified settlement fund for all
purposes of the Internal Revenue Code (Code). If a fund, account, or
trust, organized as a trust under applicable state law, is a qualified
settlement fund, and could be classified as either an association
(within the meaning of Sec. 301.7701-2 of this chapter) or a
partnership (within the meaning of Sec. 301.7701-3 of this chapter), it
is classified as a qualified settlement fund for all purposes of the
Code. If a fund, account, or trust, established for contested
liabilities pursuant to Sec. 1.461-2(c)(1) is a qualified settlement
fund, it is classified as a qualified settlement fund for all purposes
of the Code.
(c) Requirements. A fund, account, or trust satisfies the
requirements of this paragraph (c) if--
(1) It is established pursuant to an order of, or is approved by,
the United States, any state (including the District of Columbia),
territory, possession, or political subdivision thereof, or any agency
or instrumentality (including a court of law) of any of the foregoing
and is subject to the continuing jurisdiction of that governmental
authority;
(2) It is established to resolve or satisfy one or more contested or
uncontested claims that have resulted or may result from an event (or
related series of events) that has occurred and that has given rise to
at least one claim asserting liability--
(i) Under the Comprehensive Environmental Response, Compensation and
Liability Act of 1980 (hereinafter referred to as CERCLA), as amended,
42 U.S.C. 9601 et seq.; or
(ii) Arising out of a tort, breach of contract, or violation of law;
or
(iii) Designated by the Commissioner in a revenue ruling or revenue
procedure; and
(3) The fund, account, or trust is a trust under applicable state
law, or its assets are otherwise segregated from other assets of the
transferor (and related persons).
(d) Definitions. For purposes of this section--
(1) Transferor. A ``transferor'' is a person that transfers (or on
behalf of whom an insurer or other person transfers) money or property
to a qualified settlement fund to resolve or satisfy claims described in
paragraph (c)(2) of this section against that person.
(2) Related person. A ``related person'' is any person who is
related to the transferor within the meaning of sections 267(b) or
707(b)(1).
(e) Governmental order or approval requirement--(1) In general. A
fund, account, or trust is ``ordered by'' or ``approved by'' a
governmental authority described in paragraph (c)(1) of this section
when the authority issues its initial or preliminary order to establish,
or grants its initial or preliminary approval of, the fund, account, or
trust, even if that order or approval may be subject to review or
revision. Except as otherwise provided in paragraph (j)(2) of this
section, the governmental authority's order or approval has no
retroactive effect and does not permit a fund, account, or trust to be a
qualified settlement fund prior to the date the order is issued or the
approval is granted.
(2) Arbitration panels. An arbitration award that orders the
establishment of, or approves, a fund, account, or trust is an order or
approval of a governmental authority described in paragraph (c)(1) of
this section if--
(i) The arbitration award is judicially enforceable;
[[Page 369]]
(ii) The arbitration award is issued pursuant to a bona fide
arbitration proceeding in accordance with rules that are approved by a
governmental authority described in paragraph (c)(1) of this section
(such as self-regulatory organization-administered arbitration
proceedings in the securities industry); and
(iii) The fund, account, or trust is subject to the continuing
jurisdiction of the arbitration panel, the court of law that has
jurisdiction to enforce the arbitration award, or the governmental
authority that approved the rules of the arbitration proceeding.
(f) Resolve or satisfy requirement--(1) Liabilities to provide
services or property. Except as otherwise provided in paragraph (f)(2)
of this section, a liability is not described in paragraph (c)(2) of
this section if it is a liability for the provision of services or
property, unless the transferor's obligation to provide services or
property is extinguished by a transfer or transfers to the fund,
account, or trust.
(2) CERCLA liabilities. A transferor's liability under CERCLA to
provide services or property is described in paragraph (c)(2) of this
section if following its transfer to a fund, account, or trust the
transferor's only remaining liability to the Environmental Protection
Agency (if any) is a remote, future obligation to provide services or
property.
(g) Excluded liabilities. A liability is not described in paragraph
(c)(2) of this section if it--
(1) Arises under a workers compensation act or a self-insured health
plan;
(2) Is an obligation to refund the purchase price of, or to repair
or replace, products regularly sold in the ordinary course of the
transferor's trade or business;
(3) Is an obligation of the transferor to make payments to its
general trade creditors or debtholders that relates to a title 11 or
similar case (as defined in section 368(a)(3)(A)), or a workout; or
(4) Is designated by the Commissioner in a revenue ruling or a
revenue procedure (see Sec. 601.601(d)(2)(ii)(b) of this chapter).
(h) Segregation requirement--(1) In general. If it is not a trust
under applicable state law, a fund, account, or trust satisfies the
requirements of paragraph (c)(3) of this section if its assets are
physically segregated from other assets of the transferor (and related
persons). For example, cash held by a transferor in a separate bank
account satisfies the segregation requirement of paragraph (c)(3) of
this section.
(2) Classification of fund established to resolve or satisfy
allowable and non-allowable claims. If a fund, account, or trust is
established to resolve or satisfy claims described in paragraph (c)(2)
of this section as well as other types of claims (i.e., non-allowable
claims) arising from the same event or related series of events, the
fund is a qualified settlement fund. However, under Sec. 1.468B-3(c),
economic performance does not occur with respect to transfers to the
qualified settlement fund for non-allowable claims.
(i) [Reserved]
(j) Classification of fund prior to satisfaction of requirements in
paragraph (c) of this section--(1) In general. If a fund, account, or
trust is established to resolve or satisfy claims described in paragraph
(c)(2) of this section, the assets of the fund, account, or trust are
treated as owned by the transferor of those assets until the fund,
account, or trust also meets the requirements of paragraphs (c) (1) and
(3) of this section. On the date the fund, account, or trust satisfies
all the requirements of paragraph (c) of this section, the transferor is
treated as transferring the assets to a qualified settlement fund.
(2) Relation-back rule--(i) In general. If a fund, account, or trust
meets the requirements of paragraphs (c)(2) and (c)(3) of this section
prior to the time it meets the requirements of paragraph (c)(1) of this
section, the transferor and administrator (as defined in Sec. 1.468B-
2(k)(3)) may jointly elect (a relation-back election) to treat the fund,
account, or trust as coming into existence as a qualified settlement
fund on the later of the date the fund, account, or trust meets the
requirements of paragraphs (c)(2) and (c)(3) of this section or January
1 of the calendar year in which all the requirements of paragraph (c) of
this section are met. If a relation-back election is made, the assets
held by the fund, account, or trust on the date the qualified settlement
[[Page 370]]
fund is treated as coming into existence are treated as transferred to
the qualified settlement fund on that date.
(ii) Relation-back election. A relation-back election is made by
attaching a copy of the election statement, signed by each transferor
and the administrator, to (and as part of) the timely filed income tax
return (including extensions) of the qualified settlement fund for the
taxable year in which the fund is treated as coming into existence. A
copy of the election statement must also be attached to (and as part of)
the timely filed income tax return (including extensions), or an amended
return that is consistent with the requirements of Sec. Sec. 1.468B-1
through 1.468B-4, of each transferor for the taxable year of the
transferor that includes the date on which the qualified settlement fund
is treated as coming into existence. The election statement must
contain--
(A) A legend, ``Sec. 1.468B-1 Relation-Back Election'', at the top
of the first page;
(B) Each transferor's name, address, and taxpayer identification
number;
(C) The qualified settlement fund's name, address, and employer
identification number;
(D) The date as of which the qualified settlement fund is treated as
coming into existence; and
(E) A schedule describing each asset treated as transferred to the
qualified settlement fund on the date the fund is treated as coming into
existence. The schedule of assets does not have to identify the amount
of cash or the property treated as transferred by a particular
transferor. If the schedule does not identify the transferor of each
asset, however, each transferor must include with the copy of the
election statement that is attached to its income tax return (or amended
return) a schedule describing each asset the transferor is treated as
transferring to the qualified settlement fund.
(k) Election to treat a qualified settlement fund as a subpart E
trust--(1) In general. If a qualified settlement fund has only one
transferor (as defined in paragraph (d)(1) of this section), the
transferor may make an election (grantor trust election) to treat the
qualified settlement fund as a trust all of which is owned by the
transferor under section 671 and the regulations thereunder. A grantor
trust election may be made whether or not the qualified settlement fund
would be classified, in the absence of paragraph (b) of this section, as
a trust all of which is treated as owned by the transferor under section
671 and the regulations thereunder. A grantor trust election may be
revoked only for compelling circumstances upon consent of the
Commissioner by private letter ruling.
(2) Manner of making grantor trust election--(i) In general. To make
a grantor trust election, a transferor must attach an election statement
satisfying the requirements of paragraph (k)(2)(ii) of this section to a
timely filed (including extensions) Form 1041, ``U.S. Income Tax Return
for Estates and Trusts,'' that the administrator files on behalf of the
qualified settlement fund for the taxable year in which the qualified
settlement fund is established. However, if a Form 1041 is not otherwise
required to be filed (for example, because the provisions of Sec.
1.671-4(b) apply), then the transferor makes a grantor trust election by
attaching an election statement satisfying the requirements of paragraph
(k)(2)(ii) of this section to a timely filed (including extensions)
income tax return of the transferor for the taxable year in which the
qualified settlement fund is established. See Sec. 1.468B-5(c)(2) for
transition rules.
(ii) Requirements for election statement. The election statement
must include a statement by the transferor that the transferor will
treat the qualified settlement fund as a grantor trust. The election
statement must include the transferor's name, address, taxpayer
identification number, and the legend, ``Sec. 1.468B-1(k) Election.''
The election statement and the statement described in Sec. 1.671-4(a)
may be combined into a single statement.
(3) Effect of making the election. If a grantor trust election is
made--
(i) Paragraph (b) of this section, and Sec. Sec. 1.468B-2, 1.468B-
3, and 1.468B-5(a) and (b) do not apply to the qualified settlement
fund. However, this section (except for paragraph (b) of this section)
and Sec. 1.468B-4 apply to the qualified settlement fund;
[[Page 371]]
(ii) The qualified settlement fund is treated, for Federal income
tax purposes, as a trust all of which is treated as owned by the
transferor under section 671 and the regulations thereunder;
(iii) The transferor must take into account in computing the
transferor's income tax liability all items of income, deduction, and
credit (including capital gains and losses) of the qualified settlement
fund in accordance with Sec. 1.671-3(a)(1); and
(iv) The reporting obligations imposed by Sec. 1.671-4 on the
trustee of a trust apply to the administrator.
(l) Examples. The following examples illustrate the rules of this
section:
Example 1. In a class action brought in a United States federal
district court, the court holds that the defendant, Corporation X,
violated certain securities laws and must pay damages in the amount of
$150 million. Pursuant to an order of the court, Corporation X transfers
$50 million in cash and transfers property with a fair market value of
$75 million to a state law trust. The trust will liquidate the property
and distribute the cash proceeds to the plaintiffs in the class action.
The trust is a qualified settlement fund because it was established
pursuant to the order of a federal district court to resolve or satisfy
claims against Corporation X for securities law violations that have
occurred.
Example 2. (i) Assume the same facts as in Example 1, except that
Corporation X and the class of plaintiffs reach an out-of-court
settlement that requires Corporation X to establish and fund a state law
trust before the settlement agreement is submitted to the court for
approval.
(ii) The trust is not a qualified settlement fund because it neither
is established pursuant to an order of, nor has it been approved by, a
governmental authority described in paragraph (c)(1) of this section.
Example 3. On June 1, 1994, Corporation Y establishes a fund to
resolve or satisfy claims against it arising from the violation of
certain securities laws. On that date, Corporation Y transfers $10
million to a segregated account. On December 1, 1994, a federal district
court approves the fund. Assuming Corporation Y and the administrator of
the qualified settlement fund do not make a relation-back election,
Corporation Y is treated as the owner of the $10 million, and is taxable
on any income earned on that money, from June 1 through November 30,
1994. The fund is a qualified settlement fund beginning on December 1,
1994.
Example 4. (i) On September 1, 1993, Corporation X, which has a
taxable year ending on October 31, enters into a settlement agreement
with a plaintiff class for asserted tort liabilities. Under the
settlement agreement, Corporation X makes two $50 million payments into
a segregated fund, one on September 1, 1993, and one on October 1, 1993,
to resolve or satisfy the tort liabilities. A federal district court
approves the settlement agreement on November 1, 1993.
(ii) The administrator of the fund and Corporation X elect to treat
the fund as a qualified settlement fund prior to governmental approval
under the relation-back rule of paragraph (j)(2) of this section. The
administrator must attach the relation-back election statement to the
fund's income tax return for calendar year 1993, and Corporation X must
attach the election to its original or amended income tax return for its
taxable year ending October 31, 1993.
(iii) Pursuant to the relation-back election, the fund begins its
existence as a qualified settlement fund on September 1, 1993, and
Corporation X is treated as transferring $50 million to the qualified
settlement fund on September 1, 1993, and $50 million on October 1,
1993.
(iv) With respect to these transfers, Corporation X must provide the
statement described in Sec. 1.468B-3(e) to the administrator of the
qualified settlement fund by February 15, 1994, and must attach a copy
of this statement to its original or amended income tax return for its
taxable year ending October 31, 1993.
Example 5. Assume the same facts as in Example 4, except that the
court approves the settlement on May 1, 1994. The administrator must
attach the relation-back election statement to the fund's income tax
return for calendar year 1994, and Corporation X must attach the
election statement to its original or amended income tax return for its
taxable year ending October 31, 1994. Pursuant to this election, the
fund begins its existence as a qualified settlement fund on January 1,
1994. In addition, Corporation X is treated as transferring to the
qualified settlement fund all amounts held in the fund on January 1,
1994. With respect to the transfer, Corporation X must provide the
statement described in Sec. 1.468B-3(e) to the administrator of the
qualified settlement fund by February 15, 1995, and must attach a copy
of this statement to its income tax return for its taxable year ending
October 31, 1994.
Example 6. Corporation Z establishes a fund that meets all the
requirements of section 468B(d)(2) for a designated settlement fund,
except that Corporation Z does not make the election under section
468B(d)(2)(F). Although the fund does not qualify as a designated
settlement fund, it is a qualified settlement fund because the fund
meets the requirements of paragraph (c) of this section.
Example 7. Corporation X owns and operates a landfill in State A.
State A requires
[[Page 372]]
Corporation X to transfer money to a trust annually based on the total
tonnage of material placed in the landfill during the year. Under the
laws of State A, Corporation X will be required to perform (either
itself or through contractors) specified closure activities when the
landfill is full, and the trust assets will be used to reimburse
Corporation X for those closure costs. The trust is not a qualified
settlement fund because it is established to secure the liability of
Corporation X to perform the closure activities.
[T.D. 8459, 57 FR 60989, Dec. 23, 1992; 58 FR 7865, Feb. 10, 1993, as
amended by T.D. 9249, 71 FR 6201, Feb. 7, 2006]
Sec. 1.468B-2 Taxation of qualified settlement funds
and related administrative requirements.
(a) In general. A qualified settlement fund is a United States
person and is subject to tax on its modified gross income for any
taxable year at a rate equal to the maximum rate in effect for that
taxable year under section 1(e).
(b) Modified gross income. The ``modified gross income'' of a
qualified settlement fund is its gross income, as defined in section 61,
computed with the following modifications--
(1) In general, amounts transferred to the qualified settlement fund
by, or on behalf of, a transferor to resolve or satisfy a liability for
which the fund is established are excluded from gross income. However,
dividends on stock of a transferor (or a related person), interest on
debt of a transferor (or a related person), and payments in compensation
for late or delayed transfers, are not excluded from gross income.
(2) A deduction is allowed for administrative costs and other
incidental expenses incurred in connection with the operation of the
qualified settlement fund that would be deductible under chapter 1 of
the Internal Revenue Code in determining the taxable income of a
corporation. Administrative costs and other incidental expenses include
state and local taxes, legal, accounting, and actuarial fees relating to
the operation of the qualified settlement fund, and expenses arising
from the notification of claimants and the processing of their claims.
Administrative costs and other incidental expenses do not include legal
fees incurred by, or on behalf of, claimants.
(3) A deduction is allowed for losses sustained by the qualified
settlement fund in connection with the sale, exchange, or worthlessness
of property held by the fund to the extent the losses would be
deductible in determining the taxable income of a corporation under
section 165 (f) or (g), and sections 1211(a) and 1212(a).
(4) A deduction is allowed for the amount of a net operating loss of
the qualified settlement fund to the extent the loss would be deductible
in determining the taxable income of a corporation under section 172(a).
For purposes of this paragraph (b)(4), the net operating loss of a
qualified settlement fund for a taxable year is the amount by which the
deductions allowed under paragraphs (b)(2) and (b)(3) of this section
exceed the gross income of the fund computed with the modification
described in paragraph (b)(1) of this section.
(c) Partnership interests held by a qualified settlement fund on
February 14, 1992--(1) In general. For taxable years ending prior to
January 1, 2003, a qualified settlement fund that holds a partnership
interest it acquired prior to February 15, 1992, is allowed a deduction
for its distributive share of that partnership's items of loss,
deduction, or credit described in section 702(a) that would be
deductible in determining the taxable income (or in the case of a
credit, the income tax liability) of a corporation to the extent of the
fund's distributive share of that partnership's items of income and gain
described in section 702(a) for the same taxable year. For purposes of
this paragraph (c)(1), a distributive share of a partnership credit is
treated as a deduction in an amount equal to the amount of the credit
divided by the rate described in paragraph (a) of this section.
(2) Limitation on changes in partnership agreements and capital
contributions. For purposes of paragraph (c)(1) of this section, changes
in a qualified settlement fund's distributive share of items of income,
gain, loss, deduction, or credit are disregarded if--
(i) They result from a change in the terms of the partnership
agreement on or after December 18, 1992, or a capital contribution to
the partnership on or
[[Page 373]]
after December 18, 1992, unless the partnership agreement as in effect
prior to December 18, 1992, requires the contribution; and
(ii) A principal purpose of the change in the terms of the
partnership agreement or the capital contribution is to circumvent the
limitation described in paragraph (c)(1) of this section.
(d) Distributions to transferors and claimants. Amounts that are
distributed by a qualified settlement fund to, or on behalf of, a
transferor or a claimant are not deductible by the fund.
(e) Basis of property transferred to a qualified settlement fund. A
qualified settlement fund's initial basis in property it receives from a
transferor (or from an insurer or other person on behalf of a
transferor) is the fair market value of that property on the date of
transfer to the fund.
(f) Distribution of property. A qualified settlement fund must treat
a distribution of property as a sale or exchange of that property for
purposes of section 1001(a). In computing gain or loss, the amount
realized by the qualified settlement fund is the fair market value of
the property on the date of distribution.
(g) Other taxes. The tax imposed under paragraph (a) of this section
is in lieu of any other taxation of the income of a qualified settlement
fund under subtitle A of the Internal Revenue Code. Thus, a qualified
settlement fund is not subject to the alternative minimum tax of section
55, the accumulated earnings tax of section 531, the personal holding
company tax of section 541, or the maximum capital gains rate of section
1(h). A qualified settlement fund is, however, subject to taxes that are
not imposed on the income of a taxpayer, such as the tax on transfers of
property to foreign entities under section 1491.
(h) Denial of credits against tax. The tax imposed on the modified
gross income of a qualified settlement fund under paragraph (a) of this
section may not be reduced or offset by any credits against tax provided
by part IV of subchapter A of chapter 1 of the Internal Revenue Code.
(i) [Reserved]
(j) Taxable year and accounting method. The taxable year of a
qualified settlement fund is the calendar year. A qualified settlement
fund must use an accrual method of accounting within the meaning of
section 446(c).
(k) Treatment as corporation for purposes of subtitle F. Except as
otherwise provided in Sec. 1.468B-5(b), for purposes of subtitle F of
the Internal Revenue Code, a qualified settlement fund is treated as a
corporation and any tax imposed under paragraph (a) of this section is
treated as a tax imposed by section 11. Subtitle F rules that apply to
qualified settlement funds include, but are not limited to--
(1) A qualified settlement fund must file an income tax return with
respect to the tax imposed under paragraph (a) of this section for each
taxable year that the fund is in existence, whether or not the fund has
gross income for that taxable year.
(2) A qualified settlement fund is in existence for the period
that--
(i) Begins on the first date on which the fund is treated as a
qualified settlement fund under Sec. 1.468B-1; and
(ii) Ends on the earlier of the date the fund--
(A) No longer satisfies the requirements of Sec. 1.468B-1; or
(B) No longer has any assets and will not receive any more
transfers. (See paragraph (m) of this section for procedures for the
prompt assessment of tax.)
(3) The income tax return of the qualified settlement fund must be
filed on or before March 15 of the year following the close of the
taxable year of the qualified settlement fund unless the fund is granted
an extension of time for filing under section 6081. The return must be
made by the administrator of the qualified settlement fund. The
``administrator'' (which may include a trustee if the qualified
settlement fund is a trust) of a qualified settlement fund is, in order
of priority--
(i) The person designated, or approved, by the governmental
authority that ordered or approved the fund for purposes of Sec.
1.468B-1(c)(1);
(ii) The person designated in the escrow agreement, settlement
agreement, or other similar agreement governing the fund;
[[Page 374]]
(iii) The escrow agent, custodian, or other person in possession or
control of the fund's assets; or
(iv) The transferor or, if there are multiple transferors, all the
transferors, unless an agreement signed by all the transferors
designates a single transferor as the administrator.
(4) The administrator of a qualified settlement fund must obtain an
employer identification number for the fund.
(5) A qualified settlement fund must deposit all payments of tax
imposed under paragraph (a) of this section (including any payments of
estimated tax) with an authorized government depositary in accordance
with Sec. 1.6302-1.
(6) A qualified settlement fund is subject to the addition to tax
imposed by section 6655 in the case of an underpayment of estimated tax
computed with respect to the tax imposed under paragraph (a) of this
section. For purposes of section 6655(g)(2), a qualified settlement
fund's taxable income is its modified gross income and a transferor is
not considered a predecessor of a qualified settlement fund.
(l) Information reporting and withholding requirements--(1) Payments
to a qualified settlement fund. Payments to a qualified settlement fund
are treated as payments to a corporation for purposes of the information
reporting requirements of part III of subchapter A of chapter 61 of the
Internal Revenue Code.
(2) Payments and distributions by a qualified settlement fund--(i)
In general. Payments and distributions by a qualified settlement fund
are subject to the information reporting requirements of part III of
subchapter A of chapter 61 of the Internal Revenue Code (Code), and the
withholding requirements of subchapter A of chapter 3 of subtitle A and
subtitle C of the Code.
(ii) Special rules. The following rules apply with respect to
payments and distributions by a qualified settlement fund--
(A) A qualified settlement fund must make a return for, or must
withhold tax on, a distribution to a claimant if one or more transferors
would have been required to make a return or withhold tax had that
transferor made the distribution directly to the claimant;
(B) For purposes of sections 6041(a) and 6041A, if a qualified
settlement fund makes a payment or distribution to a transferor, the
fund is deemed to make the payment or distribution to the transferor in
the course of a trade or business;
(C) For purposes of sections 6041(a) and 6041A, if a qualified
settlement fund makes a payment or distribution on behalf of a
transferor or a claimant, the fund is deemed to make the payment or
distribution to the recipient of that payment or distribution in the
course of a trade or business;
(D) With respect to a distribution or payment described in paragraph
(1)(2)(ii)(C) of this section and the information reporting requirements
of part III of subchapter A of chapter 61 of the Internal Revenue Code,
the qualified settlement fund is also deemed to have made the
distribution or payment to the transferor or claimant.
(m) Request for prompt assessment. A qualified settlement fund is
eligible to request the prompt assessment of tax under section 6501(d).
For purposes of section 6501(d), a qualified settlement fund is treated
as dissolving on the date the fund no longer has any assets (other than
a reasonable reserve for potential tax liabilities and related
professional fees) and will not receive any more transfers.
(n) Examples. The following examples illustrate the rules of this
section:
Example 1. On June 30, 1993, a United States federal district court
approves the settlement of a lawsuit under which Corporation X must
transfer $10,833,000 to a qualified settlement fund on August 1, 1993.
The $10,833,000 includes $10 million of damages incurred by plaintiffs
on October 1, 1992, and $833,000 of interest calculated at 10 percent
annually from October 1, 1992, to August 1, 1993. The $833,000 of
interest is not a payment to the qualified settlement fund in
compensation for a late or delayed transfer to the fund within the
meaning of paragraph (b)(1) of this section because the payment of
$10,833,000 to the fund is not due until August 1, 1993.
Example 2. Assume the same facts as in Example 1 except that the
settlement agreement also provides for interest to accrue at a rate of
12 percent annually on any amount not transferred to the qualified
settlement fund on August 1, 1993, and the only transfer
[[Page 375]]
Corporation X makes to the fund is $11,374,650 on January 1, 1994. The
additional payment of $541,650 ($11,374,650 paid on January 1, 1994,
less $10,833,000 due on August 1, 1993) is a payment to the qualified
settlement fund in compensation for a late or delayed transfer to the
fund within the meaning of paragraph (b)(1) of this section.
[T.D. 8459, 57 FR 60991, Dec. 23, 1992; 58 FR 7865, Feb. 10, 1993]
Sec. 1.468B-3 Rules applicable to the transferor.
(a) Transfer of property--(1) In general. A transferor must treat a
transfer of property to a qualified settlement fund as a sale or
exchange of that property for purposes of section 1001(a). In computing
the gain or loss, the amount realized by the transferor is the fair
market value of the property on the date the transfer is made (or is
treated as made under Sec. 1.468B-1(g)) to the qualified settlement
fund. Because the issuance of a transferor's debt, obligation to provide
services or property in the future, or obligation to make a payment
described in Sec. 1.461-4(g), is generally not a transfer of property
by the transferor, it generally does not result in gain or loss to the
transferor under this paragraph (a)(1). If a person other than the
transferor transfers property to a qualified settlement fund, there may
be other tax consequences as determined under general federal income tax
principles.
(2) Anti-abuse rule. The Commissioner may disallow a loss resulting
from the transfer of property to a qualified settlement fund if the
Commissioner determines that a principal purpose for the transfer was to
claim the loss and--
(i) The transferor places significant restrictions on the fund's
ability to use or dispose of the property; or
(ii) The property (or substantially similar property) is distributed
to the transferor (or a related person).
(b) Qualified appraisal requirement for transfers of certain
property--(1) In general. A transferor must obtain a qualified appraisal
to support a loss or deduction it claims with respect to a transfer to a
qualified settlement fund of the following types of property--
(i) Nonpublicly traded securities (as defined in Sec. 1.170A-
13(c)(7)(ix)) issued by the transferor (or a related person); and
(ii) Interests in the transferor (if the transferor is a
partnership) and in a partnership in which the transferor (or a related
person) is a direct or indirect partner.
(2) Provision of copies. The transferor must provide a copy of the
qualified appraisal to the administrator of the qualified settlement
fund no later than February 15 of the year following the calendar year
in which the property is transferred. The transferor also must attach a
copy of the qualified appraisal to (and as part of) its timely filed
income tax return (including extensions) for the taxable year of the
transferor in which the transfer is made.
(3) Qualified appraisal. A ``qualified appraisal'' is a written
appraisal that--
(i) Is made within 60 days before or after the date the property is
transferred to the qualified settlement fund;
(ii) Is prepared, signed, and dated by an individual who is a
qualified appraiser within the meaning of Sec. 1.170A-13(c)(5);
(iii) Includes the information required by paragraph (b)(4) of this
section; and
(iv) Does not involve an appraisal fee of the type prohibited by
Sec. 1.170A-13(c)(6).
(4) Information included in a qualified appraisal. A qualified
appraisal must include the following information--
(i) A description of the appraised property;
(ii) The date (or expected date) of the property's transfer to the
qualified settlement fund;
(iii) The appraised fair market value of the property on the date
(or expected date) of transfer;
(iv) The method of valuing the property, such as the comparable
sales approach;
(v) The specific basis for the valuation, such as specific
comparable sales or statistical sampling, including a justification for
using comparable sales or statistical sampling and an explanation of the
procedure employed;
(vi) The terms of any agreement or understanding entered into (or
expected to be entered into) by or on behalf of the transferor (or a
related person) or the qualified settlement fund that relates to the
use, sale, or other disposition of the transferred property,
[[Page 376]]
including, for example, the terms of any agreement or understanding that
temporarily or permanently--
(A) Restricts the qualified settlement fund's right to use or
dispose of the property; or
(B) Reserves to, or confers upon, any person other than the
qualified settlement fund any right (including designating another
person as having the right) to income from the property, to possess the
property (including the right to purchase or otherwise acquire the
property), or to exercise any voting rights with respect to the
property;
(vii) The name, address, and taxpayer identification number of the
qualified appraiser; and if the qualified appraiser is acting in his or
her capacity as a partner in a partnership, an employee of any person,
or an independent contractor engaged by a person other than the
transferor, the name, address, and taxpayer identification number of the
partnership or the person who employs or engages the qualified
appraiser;
(viii) The qualifications of the qualified appraiser, including the
appraiser's background, experience, education, and membership, if any,
in professional appraisal associations; and
(ix) A statement that the appraisal was prepared for income tax
purposes.
(5) Effect of signature of the qualified appraiser. Any appraiser
who falsely or fraudulently overstates the value of the transferred
property referred to in a qualified appraisal may be subject to a civil
penalty under section 6701 for aiding and abetting an understatement of
tax liability and may have appraisals disregarded pursuant to 31 U.S.C.
330(c).
(c) Economic performance--(1) In general. Except as otherwise
provided in this paragraph (c), for purposes of section 461(h), economic
performance occurs with respect to a liability described in Sec.
1.468B-1(c)(2) (determined with regard to Sec. 1.468B-1(f) and (g)) to
the extent the transferor makes a transfer to a qualified settlement
fund to resolve or satisfy the liability.
(2) Right to a refund or reversion--(i) In general. Economic
performance does not occur to the extent--
(A) The transferor (or a related person) has a right to a refund or
reversion of a transfer if that right is exercisable currently and
without the agreement of an unrelated person that is independent or has
an adverse interest (e.g., the court or agency that approved the fund,
or the fund claimants); or
(B) Money or property is transferred under conditions that allow its
refund or reversion by reason of the occurrence of an event that is
certain to occur, such as the passage of time, or if restrictions on its
refund or reversion are illusory.
(ii) Right extinguished. With respect to a transfer described in
paragraph (c)(2)(i) of this section, economic performance is deemed to
occur on the date, and to the extent, the transferor's right to a refund
or reversion is extinguished.
(3) Obligations of a transferor. Economic performance does not occur
when a transferor transfers to a qualified settlement fund its debt (or
the debt of a related person). Instead, economic performance occurs as
the transferor (or related person) makes principal payments on the debt.
Similarly, economic performance does not occur when a transferor
transfers to a qualified settlement fund its obligation (or the
obligation of a related person) to provide services or property in the
future, or to make a payment described in Sec. 1.461-4(g). Instead,
economic performance with respect to such an obligation occurs as
services, property or payments are provided or made to the qualified
settlement fund or a claimant.
(d) Payment of insurance amounts. No deduction is allowed to a
transferor for a transfer to a qualified settlement fund to the extent
the transferred amounts represent amounts received from the settlement
of an insurance claim and are excludable from gross income. If the
settlement of an insurance claim occurs after a transferor makes a
transfer to a qualified settlement fund for which a deduction has been
taken, the transferor must include in income the amounts received from
the settlement of the insurance claim to the extent of the deduction.
(e) Statement to the qualified settlement fund and the Internal
Revenue Service--
[[Page 377]]
(1) In general. A transferor must provide the statement described in
paragraph (e)(2) of this section to the administrator of a qualified
settlement fund no later than February 15 of the year following each
calendar year in which the transferor (or an insurer or other person on
behalf of the transferor) makes a transfer to the fund. The transferor
must attach a copy of the statement to (and as part of) its timely filed
income tax return (including extensions) for the taxable year of the
transferor in which the transfer is made.
(2) Required statement--(i) In general. The statement required by
this paragraph (e) must provide the following information--
(A) A legend, ``Sec. 1.468B-3 Statement'', at the top of the first
page;
(B) The transferor's name, address, and taxpayer identification
number;
(C) The qualified settlement fund's name, address, and employer
identification number;
(D) The date of each transfer;
(E) The amount of cash transferred; and
(F) A description of property transferred and its fair market value
on the date of transfer.
(ii) Combined statements. If a qualified settlement fund has more
than one transferor, any two or more of the transferors may provide a
combined statement to the administrator that does not identify the
amount of cash or the property transferred by a particular transferor.
If a combined statement is used, however, each transferor must include
with its copy of the statement that is attached to its income tax return
a schedule describing each asset that the transferor transferred to the
qualified settlement fund.
(f) Distributions to transferors--(1) In general. A transferor must
include in gross income any distribution (including a deemed
distribution described in paragraph (f)(2) of this section) it receives
from a qualified settlement fund. If property is distributed, the amount
includible in gross income and the basis in that property, is the fair
market value of the property on the date of the distribution.
(2) Deemed distributions--(i) Other liabilities. If a qualified
settlement fund makes a distribution on behalf of a transferor to a
person that is not a claimant, or to a claimant to resolve or satisfy a
liability of the transferor (or a related person) other than a liability
described in Sec. 1.468B-1(c)(2) for which the fund was established,
the distribution is deemed made by the fund to the transferor. The
transferor, in turn, is deemed to have made a payment to the actual
recipient.
(ii) Constructive receipt. To the extent a transferor acquires a
right to a refund or reversion described in paragraph (c)(2) of this
section of all or a portion of the assets of a qualified settlement fund
subsequent to the transfer of those assets to the fund, the fund is
deemed to distribute those assets to the transferor on the date the
right is acquired.
(3) Tax benefit rule. A distribution described in paragraph (f)(1)
or (f)(2) of this section is excluded from the gross income of a
transferor to the extent provided by section 111(a).
(g) Example. The following example illustrates the rules of this
section:
Example. On March 1, 1993, Individual A transfers $1 million to a
qualified settlement fund to resolve or satisfy claims against him
resulting from certain violations of securities laws. Individual A uses
the cash receipts and disbursements method of accounting. Since
Individual A does not use the accrual method of accounting, the economic
performance rules of paragraph (c) of this section are not applicable.
Therefore, whether, when, and to what extent Individual A can deduct the
transfer is determined under applicable provisions of the Internal
Revenue Code, such as sections 162 and 461.
[T.D. 8459, 57 FR 60992, Dec. 23, 1992]
Sec. 1.468B-4 Taxability of distributions to claimants.
Whether a distribution to a claimant is includible in the claimant's
gross income is generally determined by reference to the claim in
respect of which the distribution is made and as if the distribution
were made directly by the transferor. For example, to the extent a
distribution is in satisfaction of damages on account of personal injury
or sickness, the distribution may be excludable from gross income under
section 104(a)(2). Similarly, to the extent a distribution is in
satisfaction of a claim for foregone taxable interest, the
[[Page 378]]
distribution is includible in the claimant's gross income under section
61(a)(4).
[T.D. 8459, 57 FR 60994, Dec. 23, 1992]
Sec. 1.468B-5 Effective dates and transition rules applicable
to qualified settlement funds.
(a) In general. Section 468B, including section 468B(g), is
effective as provided in the Tax Reform Act of 1986 and the Technical
and Miscellaneous Revenue Act of 1988. Except as otherwise provided in
this section, Sec. Sec. 1.468B-1 through 1.468-4 are effective on
January 1, 1993. Thus, the regulations apply to income of a qualified
settlement fund earned after December 31, 1992, transfers to a fund
after December 31, 1992, and distributions from a fund after December
31, 1992. For purposes of Sec. 1.468B-3(c) (relating to economic
performance), previously transferred assets held by a qualified
settlement fund on the date these regulations first apply to the fund
(i.e., January 1, 1993, or the earlier date provided under paragraph
(b)(2) of this section) are treated as transferred to the fund on that
date, to the extent no taxpayer has previously claimed a deduction for
the transfer.
(b) Taxation of certain pre-1996 fund income--(1) Reasonable
method--(i) In general. With respect to a fund, account, or trust
established after August 16, 1986, but prior to February 15, 1992, that
satisfies (or, if it no longer exists, would have satisfied) the
requirements of Sec. 1.468B-1(c), the Internal Revenue Service will not
challenge a reasonable, consistently applied method of taxation for
transfers to the fund, income earned by the fund, and distributions made
by the fund after August 16, 1986, but prior to January 1, 1996. A
method is generally considered reasonable if, depending on the facts and
circumstances, all transferors and the administrator of the fund have
consistently treated transfers to the fund, income earned by the fund,
and distributions made by the fund after August 16, 1986, as if the fund
were--
(A) A grantor trust and the transferors are the grantors;
(B) A complex trust and the transferors are the grantors; or
(C) A designated settlement fund.
(ii) Qualified settlement funds established after February 14, 1992,
but before January 1, 1993. With respect to a fund, account, or trust
established after February 14, 1992, but prior to January 1, 1993, that
satisfies the requirements of Sec. 1.468B-1(c), the Internal Revenue
Service will not challenge a reasonable, consistently applied method of
taxation as described in paragraph (b)(1)(i) of this section for
transfers to, income earned by, and distributions made by the fund prior
to January 1, 1993. However, pursuant to paragraph (a) of this section,
sections 1.468B-1 through 1.468B-4 apply to transfers to, income earned
by, and distributions made by the qualified settlement fund after 1992.
(iii) Use of cash method of accounting. For purposes of paragraphs
(b)(i) and (b)(ii) of this section, for taxable years beginning prior to
January 1, 1996, the Internal Revenue Service will not challenge the use
of the cash receipts and disbursement method of accounting by a fund,
account, or trust.
(iv) Unreasonable position. In no event is it a reasonable position
to assert, pursuant to Rev. Rul. 71-119 (see Sec. 601.601(d)(2)(ii)(b)
of this chapter), that there is no current taxation of the income of a
fund established after August 16, 1986.
(v) Waiver of penalties. For taxable years beginning prior to
January 1, 1993, if a fund, account or trust is subject to section
468B(g) and the Internal Revenue Service does not challenge the method
of taxation for transfers to, income earned by, and distributions made
by, the fund pursuant to paragraph (b)(1)(i) or (b)(1)(ii) of this
section, penalties will not be imposed in connection with the use of
such method. For example, the penalties under section 6655 for failure
to pay estimated tax, section 6651(a)(1) for failure to file a return,
section 6651(a)(2) for failure to pay tax, section 6656 for failure to
make deposit of taxes, and section 6662 for accuracy-related
underpayments will generally not be imposed.
(2) Election to apply qualified settlement fund rules--(i) In
general. The person that will be the administrator of a qualified
settlement fund may elect to apply Sec. Sec. 1.468B-1 through 1.468B-4
to
[[Page 379]]
transfers to, income earned by, and distributions made by, the fund in
taxable years ending after August 16, 1986. The election is effective
beginning on the first day of the earliest open taxable year of the
qualified settlement fund. For purposes of this paragraph (b)(2), a
taxable year is considered open if the period for assessment and
collection of tax has not expired pursuant to the rules of section 6501.
The election statement must provide the information described in
paragraph (b)(2)(ii) of this section and must be signed by the person
that will be the administrator. Such person must also provide each
transferor of the qualified settlement fund with a copy of the election
statement on or before March 15, 1993.
(ii) Election statement. The election statement must provide the
following information--
(A) A legend, ``Sec. 1.468B-5(b)(2) Election'', at the top of the
first page;
(B) Each transferor's name, address, and taxpayer identification
number;
(C) The qualified settlement fund's name, address, and employer
identification number; and
(D) The date the qualified settlement fund was established within
the meaning of Sec. 1.468B-1(j).
(iii) Due date of returns and amended returns. The election
statement described in paragraph (b)(2)(ii) of this section must be
filed with, and as part of, the qualified settlement fund's timely filed
tax return for the taxable year ended December 31, 1992. In addition,
the qualified settlement fund must file an amended return that is
consistent with the requirements of Sec. Sec. 1.468B-1 through 1.468B-4
for any taxable year to which the election applies in which the fund
took a position inconsistent with those requirements. Any such amended
return must be filed no later than March 15, 1993, and must include a
copy of the election statement described in paragraph (b)(2)(ii) of this
section.
(iv) Computation of interest and waiver of penalties. For purposes
of section 6601 and section 6611, the income tax return for each taxable
year of the qualified settlement fund to which the election applies is
due on March 15 of the year following the taxable year of the fund. For
taxable years of a qualified settlement fund ending prior to January 1,
1993, the income earned by the fund is deemed to have been earned on
December 31 of each taxable year for purposes of section 6655. Thus, the
addition to tax for failure to pay estimated tax under section 6655 will
not be imposed. The penalty for failure to file a return under section
6651(a)(1), the penalty for failure to pay tax under section 6651(a)(2),
the penalty for failure to make deposit of taxes under section 6656, and
the accuracy-related penalty under section 6662 will not be imposed on a
qualified settlement fund if the fund files its tax returns for taxable
years ending prior to January 1, 1993, and pays any tax due for those
taxable years, on or before March 15, 1993.
(c) Grantor trust elections under Sec. 1.468B-1(k)--(1) In general.
A transferor may make a grantor trust election under Sec. 1.468B-1(k)
if the qualified settlement fund is established after February 3, 2006.
(2) Transition rules. A transferor may make a grantor trust election
under Sec. 1.468B-1(k) for a qualified settlement fund that was
established on or before February 3, 2006, if the applicable period of
limitation on filing an amended return has not expired for both the
qualified settlement fund's first taxable year and all subsequent
taxable years and the transferor's corresponding taxable year or years.
A grantor trust election under this paragraph (c)(2) requires that the
returns of the qualified settlement fund and the transferor for all
affected taxable years are consistent with the grantor trust election.
This requirement may be satisfied by timely filed original returns or
amended returns filed before the applicable period of limitation
expires.
(3) Qualified settlement funds established by the U.S. government on
or before February 3, 2006. If the U.S. government, or any agency or
instrumentality thereof, established a qualified settlement fund on or
before February 3, 2006, and the fund would have been classified as a
trust all of which is treated as owned by the U.S. government under
section 671 and the regulations thereunder without regard to the
regulations under section 468B, then the U.S. government is deemed to
have made a grantor trust election under
[[Page 380]]
Sec. 1.468B-1(k), and the election is applicable for all taxable years
of the fund.
[T.D. 8459, 57 FR 60994, Dec. 23, 1992, as amended by T.D. 9249, 71 FR
6201, Feb. 7, 2006]
Sec. 1.468B-6 Escrow accounts, trusts, and other funds used
during deferred exchanges of like-kind property under section 1031(a)(3).
(a) Scope. This section provides rules under section 468B(g)
relating to the current taxation of escrow accounts, trusts, and other
funds used during deferred exchanges.
(b) Definitions. The definitions in this paragraph (b) apply for
purposes of this section.
(1) In general. Deferred exchange, escrow agreement, escrow holder,
exchange agreement, qualified escrow account, qualified intermediary,
qualified trust, relinquished property, replacement property, taxpayer,
trust agreement, and trustee have the same meanings as in Sec.
1.1031(k)-1; deferred exchange also includes any exchange intended to
qualify as a deferred exchange, and qualified intermediary also includes
any person or entity intended by a taxpayer to be a qualified
intermediary within the meaning of Sec. 1.1031(k)-1(g)(4).
(2) Exchange funds. Exchange funds means relinquished property,
cash, or cash equivalent that secures an obligation of a transferee to
transfer replacement property, or proceeds from a transfer of
relinquished property, held in a qualified escrow account, qualified
trust, or other escrow account, trust, or fund in a deferred exchange.
(3) Exchange facilitator. Exchange facilitator means a qualified
intermediary, transferee, escrow holder, trustee, or other party that
holds exchange funds for a taxpayer in a deferred exchange pursuant to
an escrow agreement, trust agreement, or exchange agreement.
(4) Transactional expenses--(i) In general. Except as provided in
paragraph (b)(4)(ii) of this section, transactional expenses means
transactional items within the meaning of Sec. 1.1031(k)-1(g)(7)(ii).
(ii) Special rule for certain fees for exchange facilitator
services. The fee for the services of an exchange facilitator is not a
transactional expense unless the escrow agreement, trust agreement, or
exchange agreement, as applicable, provides that--
(A) The amount of the fee payable to the exchange facilitator is
fixed on or before the date of the transfer of the relinquished property
by the taxpayer (either by stating the fee as a fixed dollar amount in
the agreement or determining the fee by a formula, the result of which
is known on or before the transfer of the relinquished property by the
taxpayer); and
(B) The amount of the fee is payable by the taxpayer regardless of
whether the earnings attributable to the exchange funds are sufficient
to pay the fee.
(c) Taxation of exchange funds--(1) Exchange funds generally treated
as loaned to an exchange facilitator. Except as provided in paragraph
(c)(2) of this section, exchange funds are treated as loaned from a
taxpayer to an exchange facilitator (exchange facilitator loan). If a
transaction is treated as an exchange facilitator loan under this
paragraph (c)(1), the exchange facilitator must take into account all
items of income, deduction, and credit (including capital gains and
losses) attributable to the exchange funds. See Sec. 1.7872-16 to
determine if an exchange facilitator loan is a below-market loan for
purposes of section 7872 and Sec. 1.7872-5(b)(16) to determine if an
exchange facilitator loan is exempt from section 7872.
(2) Exchange funds not treated as loaned to an exchange
facilitator--(i) Scope. This paragraph (c)(2) applies if, in accordance
with an escrow agreement, trust agreement, or exchange agreement, as
applicable, all the earnings attributable to a taxpayer's exchange funds
are paid to the taxpayer.
(ii) Earnings attributable to the taxpayer's exchange funds--(A)
Separately identified account. If an exchange facilitator holds all of
the taxpayer's exchange funds in a separately identified account, the
earnings credited to that account are deemed to be all the earnings
attributable to the taxpayer's exchange funds for purposes of paragraph
(c)(2)(i) of this section. In general, a separately identified account
is
[[Page 381]]
an account established under the taxpayer's name and taxpayer
identification number with a depository institution. For purposes of
paragraph (c)(2)(i) of this section, a sub-account will be treated as a
separately identified account if the master account under which the sub-
account is created is established with a depository institution, the
depository institution identifies the sub-account by the taxpayer's name
and taxpayer identification number, and the depository institution
specifically credits earnings to the sub-account.
(B) Allocation of earnings in commingled accounts. If an exchange
facilitator commingles (for investment or otherwise) the taxpayer's
exchange funds with other funds or assets, all the earnings attributable
to the taxpayer's exchange funds are paid to the taxpayer if all of the
earnings attributable to the commingled funds or assets that are
allocable on a pro-rata basis (using a reasonable method that takes into
account the time that the exchange funds are in the commingled account,
actual rate or rates of return, and the respective account balances) to
the taxpayer's exchange funds either are paid to the taxpayer or are
treated as paid to the taxpayer under paragraph (c)(2)(ii)(C) of this
section.
(C) Transactional expenses. Any payment from the taxpayer's exchange
funds, or from the earnings attributable to the taxpayer's exchange
funds, for a transactional expense of the taxpayer (as defined in
paragraph (b)(4) of this section) is treated as first paid to the
taxpayer and then paid by the taxpayer to the recipient.
(iii) Treatment of the taxpayer. If this paragraph (c)(2) applies,
exchange funds are not treated as loaned from a taxpayer to an exchange
facilitator. The taxpayer must take into account all items of income,
deduction, and credit (including capital gains and losses) attributable
to the exchange funds.
(d) Information reporting requirements. A payor (as defined in Sec.
1.6041-1) must report the income attributable to exchange funds to the
extent required by the information reporting provisions of subpart B,
Part III, subchapter A, chapter 61, Subtitle F of the Internal Revenue
Code, and the regulations under those provisions. See Sec. 1.6041-1(f)
for rules relating to the amount to be reported when fees, expenses or
commissions owed by a payee to a third party are deducted from a
payment.
(e) Examples. The provisions of this section are illustrated by the
following examples in which T is a taxpayer that uses a calendar taxable
year and the cash receipts and disbursements method of accounting. The
examples are as follows:
Example 1. All earnings attributable to exchange funds paid to
taxpayer. (i) T enters into a deferred exchange with R. The sales
agreement provides that T will transfer property (the relinquished
property) to R and R will transfer replacement property to T. R's
obligation to transfer replacement property to T is secured by cash
equal to the fair market value of the relinquished property, which R
will deposit into a qualified escrow account that T establishes with B,
a depository institution. T enters into an escrow agreement with B that
provides that all the earnings attributable to the exchange funds will
be paid to T.
(ii) On November 1, 2008, T transfers property to R and R deposits
$2,100,000 in T's qualified escrow account with B. Between November 1
and December 31, 2008, B credits T's account with $14,000 of interest.
During January 2009, B credits T's account with $7000 of interest. On
February 1, 2009, R transfers replacement property worth $2,100,000 to T
and B pays $2,100,000 from the qualified escrow account to R.
Additionally, on February 1, 2009, B pays the $21,000 of interest to T.
(iii) Under paragraph (b) of this section, the $2,100,000 deposited
with B constitutes exchange funds and B is an exchange facilitator.
Because all the earnings attributable to the exchange funds are paid to
T in accordance with the escrow agreement, paragraph (c)(2) of this
section applies. The exchange funds are not treated as loaned from T to
B. T must take into account in computing T's income tax liability for
2008 the $14,000 of earnings credited to the qualified escrow account in
2008 and for 2009 the $7,000 of earnings credited to the qualified
escrow account in 2009.
Example 2. Payment of transactional expenses from earnings. (i) The
facts are the same as in Example 1, except that the escrow agreement
provides that, prior to paying the earnings to T, B may deduct any
amounts B has paid to third parties for T's transactional expenses. B
pays a third party $350 on behalf of T for a survey of the replacement
property. After deducting $350 from the earnings attributable to T's
qualified escrow account, B
[[Page 382]]
pays T the remainder ($20,650) of the earnings.
(ii) Under paragraph (b)(4) of this section, the cost of the survey
is a transactional expense. Under paragraph (c)(2)(ii)(C) of this
section, the $350 that B pays for the survey is treated as first paid to
T and then from T to the third party. Therefore, all the earnings
attributable to T's exchange funds are paid or treated as paid to T in
accordance with the escrow agreement, and paragraph (c)(2) of this
section applies. The exchange funds are not treated as loaned from T to
B, and T must take into account in computing T's income tax liability
the $21,000 of earnings credited to the qualified escrow account.
Example 3. Earnings retained by exchange facilitator as compensation
for services. (i) The facts are the same as in Example 1, except that
the escrow agreement provides that B also may deduct any outstanding
fees owed by T for B's services in facilitating the deferred exchange.
In accordance with paragraph (b)(4)(ii) of this section, the escrow
agreement provides for a fixed fee of $1,200 for B's services, which is
payable by T regardless of the amount of earnings attributable to the
exchange funds. Because the earnings on the exchange funds in this case
exceed $1,200, B retains $1,200 as the unpaid portion of its fee and
pays T the remainder ($19,800) of the earnings.
(ii) Under paragraph (b)(4) of this section, B's fee is treated as a
transactional expense. Under paragraph (c)(2)(ii)(C) of this section,
the $1200 that B retains for its fee is treated as first paid to T and
then from T to B. Therefore, all the earnings attributable to T's
exchange funds are paid or treated as paid to T in accordance with the
escrow agreement, and paragraph (c)(2) of this section applies. The
exchange funds are not treated as loaned from T to B, and T must take
into account in computing T's income tax liability the $21,000 of
earnings credited to the qualified escrow account.
Example 4. Exchange funds deposited by exchange facilitator with
related depository institution in account in taxpayer's name. (i) The
facts are the same as in Example 1 except that, instead of entering into
an escrow agreement, T enters into an exchange agreement with QI, a
qualified intermediary. The exchange agreement provides that R will pay
$2,100,000 to QI, QI will deposit $2,100,000 into an account with a
depository institution under T's name and taxpayer identification number
(TIN), and all the earnings attributable to the account will be paid to
T.
(ii) On May 1, 2008, T transfers property to QI, QI transfers the
property to R, R delivers $2,100,000 to QI, and QI deposits $2,100,000
into a money market account with depository institution B under T's name
and TIN. B and QI are members of the same consolidated group of
corporations within the meaning of section 1501. Between May 1 and
September 1, 2008, the account earns $28,000 of interest at the stated
rate established by B. During the period May 1 to September 1, 2008, B
invests T's exchange funds and earns $40,000. On September 1, 2008, QI
uses $2,100,000 of the funds in the account to purchase replacement
property identified by T and transfers the replacement property to T. B
pays to T the $28,000 of interest earned on the money market account at
the stated rate.
(iii) Under paragraph (b) of this section, the $2,100,000 QI
receives from R for the relinquished property is exchange funds and QI
is an exchange facilitator. B is not an exchange facilitator. T has not
entered into an escrow agreement, trust agreement, or exchange agreement
with B, and QI, not B, holds the exchange funds on behalf of T. Under
paragraph (c)(2)(ii)(A) of this section, the $40,000 B earns from
investing T's exchange funds are not treated as earnings attributable to
T's exchange funds. Because all the earnings attributable to T's
exchange funds are paid to T in accordance with the exchange agreement,
paragraph (c)(2) of this section applies. The exchange funds are not
treated as loaned from T to QI, and T must take into account in
computing T's income tax liability for 2008 the $28,000 of interest
earned on the money market account.
Example 5. Earnings of related depository institution credited to
exchange facilitator. (i) The facts are the same as in Example 4, except
that at the end of each taxable year, B credits a portion of its
earnings on deposits to QI. The amount credited is based on the total
amount of exchange funds QI has deposited with B during the year. At the
end of the 2008 taxable year, B credits $152,500 of B's earnings to QI.
(ii) Under paragraph (c)(2)(ii)(A) of this section, no part of the
$152,500 credited by B to QI is earnings attributable to T's exchange
funds. Therefore, all of the earnings attributable to the exchange funds
are paid to T in accordance with the exchange agreement, and paragraph
(c)(2) of this section applies. The exchange funds are not treated as
loaned from T to QI, and T must take into account in computing T's
income tax liability for 2008 the $28,000 of interest earned on T's
account.
Example 6. Exchange funds deposited by exchange facilitator with
unrelated depository institution in sub-account in taxpayer's name. (i)
The facts are the same as in Example 4, except that QI and B are
unrelated and the money market account in which QI deposits the
$2,100,000 received from T is a sub-account within a master account QI
maintains with B in QI's name and TIN. The master account includes other
sub-accounts, each in the name and TIN of a taxpayer that has entered
into an exchange agreement with QI, into which QI deposits each
taxpayer's exchange funds. Each month, B transfers to
[[Page 383]]
QI's master account an additional amount of interest based upon the
average daily balance of all exchange funds within the master account
during the month. At the end of the 2008 taxable year, B has credited
$152,500 of additional interest to QI.
(ii) Under paragraph (c)(2)(ii)(A) of this section, no part of the
$152,500 credited by B to QI is earnings attributable to T's exchange
funds. Therefore, all of the earnings attributable to the exchange funds
are paid to T in accordance with the exchange agreement, and paragraph
(c)(2) of this section applies. The exchange funds are not treated as
loaned from T to QI, and T must take into account in computing T's
income tax liability for 2008 the $28,000 of interest earned on T's
account.
Example 7. Marketing fee paid to exchange facilitator. (i) The facts
are the same as in Example 4, except that at the end of each taxable
year, B pays a marketing fee to QI for using B as its depository
institution for exchange funds. The amount of the fee is based on the
total amount of exchange funds QI has deposited with B during the year.
(ii) Under paragraph (c)(2)(ii)(A) of this section, no part of the
marketing fee that B pays to QI is earnings attributable to T's exchange
funds. Therefore, all of the earnings attributable to the exchange funds
are paid to T in accordance with the exchange agreement, and paragraph
(c)(2) of this section applies. The exchange funds are not treated as
loaned from T to QI, and T must take into account in computing T's
income tax liability for 2008 the $28,000 of interest earned on T's
account.
Example 8. Stated rate of interest on account less than earnings
attributable to exchange funds. (i) The facts are the same as in Example
4, except that the exchange agreement provides only that QI will pay T a
stated rate of interest. QI invests the exchange funds and earns
$40,000. The exchange funds earn $28,000 at the stated rate of interest,
and QI pays the $28,000 to T.
(ii) Paragraph (c)(1) of this section applies and the exchange funds
are treated as loaned from T to QI. QI must take into account in
computing QI's income tax liability all items of income, deduction, and
credit (including capital gains and losses) attributable to the exchange
funds. Paragraph (c)(2) of this section does not apply because QI does
not pay all the earnings attributable to the exchange funds to T. See
Sec. Sec. 1.7872-5 and 1.7872-16 for rules relating to exchange
facilitator loans.
Example 9. All earnings attributable to commingled exchange funds
paid to taxpayer. (i) The facts are the same as in Example 4, except
that the exchange agreement does not specify how the $2,100,000 QI
receives from R must be invested.
(ii) On May 1, 2008, QI deposits the $2,100,000 with B in a pre-
existing interest-bearing account under QI's name and TIN. The account
has a total balance of $5,275,000 immediately thereafter. On the last
day of each month between May and September, 2008, the account earns
interest as follows: $17,583 in May, $17,642 in June, $18,756 in July,
and $17,472 in August. On July 11, 2008, QI deposits $500,000 in the
account. On August 15, 2008, QI withdraws $1,175,000 from the account.
(iii) QI calculates T's pro-rata share of the earnings allocable to
the $2,100,000 based on the actual return, the average daily principal
balances, and a 30-day month convention, as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Account's avg. T's avg. daily T's share*
Month daily bal. bal. (percent) Monthly interest T's end. bal.**
--------------------------------------------------------------------------------------------------------------------------------------------------------
May...................................................... $5,275,000 $2,100,000 39.8 $17,583 $2,106,998
June..................................................... 5,292,583 2,106,998 39.8 17,642 2,114,020
July..................................................... 5,643,558 2,114,020 37.5 18,756 2,121,054
August................................................... 5,035,647 2,121,054 42.1 17,472 2,128,410
--------------------------------------------------------------------------------------------------------------------------------------------------------
* T's Average Daily Balance / Account's Average Daily Balance.
** T's beginning balance + [(T's share) (Monthly Interest)].
(iv) On September 1, 2008, QI uses $2,100,000 of the funds to
purchase replacement property identified by T and transfers the property
to T. QI pays $28,410, the earnings of the account allocated to T's
exchange funds, to T.
(v) Because QI uses a reasonable method to calculate the pro-rata
share of account earnings allocable to T's exchange funds in accordance
with paragraph (c)(2)(ii)(B) of this section, and pays all those
earnings to T, paragraph (c)(2) of this section applies. The exchange
funds are not treated as loaned from T to QI. T must take into account
in computing T's income tax liability for 2008 the $28,410 of earnings
attributable to T's exchange funds.
(f) Effective/applicability dates--(1) In general. This section
applies to transfers of relinquished property made by taxpayers on or
after October 8, 2008.
(2) Transition rule. With respect to transfers of relinquished
property made by taxpayers after August 16, 1986, but before October 8,
2008, the Internal Revenue Service will not challenge a
[[Page 384]]
reasonable, consistently applied method of taxation for income
attributable to exchange funds.
[T.D. 9413, 73 FR 39620, July 10, 2008]
Sec. 1.468B-7 Pre-closing escrows.
(a) Scope. This section provides rules under section 468B(g) for the
current taxation of income of a pre-closing escrow.
(b) Definitions. For purposes of this section--
(1) A pre-closing escrow is an escrow account, trust, or fund--
(i) Established in connection with the sale or exchange of real or
personal property;
(ii) Funded with a down payment, earnest money, or similar payment
that is deposited into the escrow prior to the sale or exchange of the
property;
(iii) Used to secure the obligation of the purchaser to pay the
purchase price for the property;
(iv) The assets of which, including any income earned thereon, will
be paid to the purchaser or otherwise distributed for the purchaser's
benefit when the property is sold or exchanged (for example, by being
distributed to the seller as a credit against the purchase price); and
(v) Which is not an escrow account or trust established in
connection with a deferred exchange under section 1031(a)(3).
(2) Purchaser means, in the case of an exchange, the intended
transferee of the property whose obligation to pay the purchase price is
secured by the pre-closing escrow;
(3) Purchase price means, in the case of an exchange, the required
consideration for the property; and
(4) Administrator means the escrow agent, escrow holder, trustee, or
other person responsible for administering the pre-closing escrow.
(c) Taxation of pre-closing escrows. The purchaser must take into
account in computing the purchaser's income tax liability all items of
income, deduction, and credit (including capital gains and losses) of
the pre-closing escrow. In the case of an exchange with a single pre-
closing escrow funded by two or more purchasers, each purchaser must
take into account in computing the purchaser's income tax liability all
items of income, deduction, and credit (including capital gains and
losses) earned by the pre-closing escrow with respect to the money or
property deposited in the pre-closing escrow by or on behalf of that
purchaser.
(d) Reporting obligations of the administrator. For each calendar
year (or portion thereof) that a pre-closing escrow is in existence, the
administrator must report the income of the pre-closing escrow on Form
1099 to the extent required by the information reporting provisions of
subpart B, Part III, subchapter A, chapter 61, Subtitle F of the
Internal Revenue Code and the regulations thereunder. See Sec. 1.6041-
1(f) for rules relating to the amount to be reported when fees,
expenses, or commissions owed by a payee to a third party are deducted
from a payment.
(e) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. P enters into a contract with S for the purchase of
residential property owned by S for the price of $200,000. P is required
to deposit $10,000 of earnest money into an escrow. At closing, the
$10,000 and the interest earned thereon will be credited against the
purchase price of the property. The escrow is a pre-closing escrow. P is
taxable on the interest earned on the pre-closing escrow prior to
closing.
Example 2. X and Y enter into a contract in which X agrees to
exchange certain construction equipment for residential property owned
by Y. The contract requires X and Y to each deposit $10,000 of earnest
money into an escrow. At closing, $10,000 and the interest earned
thereon will be paid to X and $10,000 and the interest earned thereon
will be paid to Y. The escrow is a pre-closing escrow. X is taxable on
the interest earned prior to closing on the $10,000 of funds X deposited
in the pre-closing escrow. Similarly, Y is taxable on the interest
earned prior to closing on the $10,000 of funds Y deposited in the pre-
closing escrow.
(f) Effective dates--(1) In general. This section applies to pre-
closing escrows established after February 3, 2006.
(2) Transition rule. With respect to a pre-closing escrow
established after August 16, 1986, but on or before February 3, 2006,
the Internal Revenue Service will not challenge a reasonable,
consistently applied method of
[[Page 385]]
taxation for income earned by the escrow or a reasonable, consistently
applied method for reporting the income.
[T.D. 9249, 71 FR 6202, Feb. 7, 2006]
Sec. 1.468B-8 Contingent-at-closing escrows. [Reserved]
Sec. 1.468B-9 Disputed ownership funds.
(a) Scope. This section provides rules under section 468B(g)
relating to the current taxation of income of a disputed ownership fund.
(b) Definitions. For purposes of this section--
(1) Disputed ownership fund means an escrow account, trust, or fund
that--
(i) Is established to hold money or property subject to conflicting
claims of ownership;
(ii) Is subject to the continuing jurisdiction of a court;
(iii) Requires the approval of the court to pay or distribute money
or property to, or on behalf of, a claimant, transferor, or transferor-
claimant; and
(iv) Is not a qualified settlement fund under Sec. 1.468B-1, a
bankruptcy estate (or part thereof) resulting from the commencement of a
case under title 11 of the United States Code, or a liquidating trust
under Sec. 301.7701-4(d) of this chapter (except as provided in
paragraph (c)(2)(ii) of this section);
(2) Administrator means a person designated as such by a court
having jurisdiction over a disputed ownership fund, however, if no
person is designated, the administrator is the escrow agent, escrow
holder, trustee, receiver, or other person responsible for administering
the fund;
(3) Claimant means a person who claims ownership of, in whole or in
part, or a legal or equitable interest in, money or property immediately
before and immediately after that property is transferred to a disputed
ownership fund;
(4) Court means a court of law or equity of the United States or of
any state (including the District of Columbia), territory, possession,
or political subdivision thereof;
(5) Disputed property means money or property held in a disputed
ownership fund subject to the claimants' conflicting claims of
ownership;
(6) Related person means any person that is related to a transferor
within the meaning of section 267(b) or 707(b)(1);
(7) Transferor means, in general, a person that transfers disputed
property to a disputed ownership fund, except that--
(i) If disputed property is transferred by an agent, fiduciary, or
other person acting in a similar capacity, the transferor is the person
on whose behalf the agent, fiduciary, or other person acts; and
(ii) A payor of interest or other income earned by a disputed
ownership fund is not a transferor within the meaning of this section
(unless the payor is also a claimant);
(8) Transferor-claimant means a transferor that claims ownership of,
in whole or in part, or a legal or equitable interest in, the disputed
property immediately before and immediately after that property is
transferred to the disputed ownership fund. Because a transferor-
claimant is both a transferor and a claimant, generally the terms
transferor and claimant also include a transferor-claimant. See
paragraph (d) of this section for rules applicable only to transferors
that are not transferor-claimants and paragraph (e) of this section for
rules applicable only to transferors that are also transferor-claimants.
(c) Taxation of a disputed ownership fund--(1) In general. For
Federal income tax purposes, a disputed ownership fund is treated as the
owner of all assets that it holds. A disputed ownership fund is treated
as a C corporation for purposes of subtitle F of the Internal Revenue
Code, and the administrator of the fund must obtain an employer
identification number for the fund, make all required income tax and
information returns, and deposit all tax payments. Except as otherwise
provided in this section, a disputed ownership fund is taxable as--
(i) A C corporation, unless all the assets transferred to the fund
by or on behalf of transferors are passive investment assets. For
purposes of this section, passive investment assets are assets of the
type that generate portfolio income within the meaning of Sec. 1.469-
2T(c)(3)(i); or
[[Page 386]]
(ii) A qualified settlement fund, if all the assets transferred to
the fund by or on behalf of transferors are passive investment assets. A
disputed ownership fund taxable as a qualified settlement fund under
this section is subject to all the provisions contained in Sec. 1.468B-
2, except that the rules contained in paragraphs (c)(3), (4), and
(c)(5)(i) of this section apply in lieu of the rules in Sec. 1.468B-
2(b)(1), (d), (e), (f) and (j).
(2) Exceptions. (i) The claimants to a disputed ownership fund may
submit a private letter ruling request proposing a method of taxation
different than the method provided in paragraph (c)(1) of this section.
(ii) The trustee of a liquidating trust established pursuant to a
plan confirmed by the court in a case under title 11 of the United
States Code may, in the liquidating trust's first taxable year, elect to
treat an escrow account, trust, or fund that holds assets of the
liquidating trust that are subject to disputed claims as a disputed
ownership fund. Pursuant to this election, creditors holding disputed
claims are not treated as transferors of the money or property
transferred to the disputed ownership fund. A trustee makes the election
by attaching a statement to the timely filed Federal income tax return
of the disputed ownership fund for the taxable year for which the
election becomes effective. The election statement must include a
statement that the trustee will treat the escrow account, trust, or fund
as a disputed ownership fund and must include a legend, ``Sec. 1.468B-
9(c) Election,'' at the top of the page. The election may be revoked
only upon consent of the Commissioner by private letter ruling.
(3) Property received by the disputed ownership fund--(i) Generally
excluded from income. In general, a disputed ownership fund does not
include an amount in income on account of a transfer of disputed
property to the disputed ownership fund. However, the accrual or receipt
of income from the disputed property in a disputed ownership fund is not
a transfer of disputed property to the fund. Therefore, a disputed
ownership fund must include in income all income received or accrued
from the disputed property, including items such as--
(A) Payments to a disputed ownership fund made in compensation for
late or delayed transfers of money or property;
(B) Dividends on stock of a transferor (or a related person) held by
the fund; and
(C) Interest on debt of a transferor (or a related person) held by
the fund.
(ii) Basis and holding period. In general, the initial basis of
property transferred by, or on behalf of, a transferor to a disputed
ownership fund is the fair market value of the property on the date of
transfer to the fund, and the fund's holding period begins on the date
of the transfer. However, if the transferor is a transferor-claimant,
the fund's initial basis in the property is the same as the basis of the
transferor-claimant immediately before the transfer to the fund, and the
fund = s holding period for the property is determined under section
1223(2).
(4) Property distributed by the disputed ownership fund--(i)
Computing gain or loss. Except in the case of a distribution or deemed
distribution described in paragraph (e)(3) of this section, a disputed
ownership fund must treat a distribution of disputed property as a sale
or exchange of that property for purposes of section 1001(a). In
computing gain or loss, the amount realized by the disputed ownership
fund is the fair market value of that property on the date of
distribution.
(ii) Denial of deduction. A disputed ownership fund is not allowed a
deduction for a distribution of disputed property or of the net after-
tax income earned by the disputed ownership fund made to or on behalf of
a transferor or claimant.
(5) Taxable year and accounting method. (i) A disputed ownership
fund taxable as a C corporation under paragraph (c)(1)(i) of this
section may compute taxable income under any accounting method allowable
under section 446 and is not subject to the limitations contained in
section 448. A disputed ownership fund taxable as a C corporation may
use any taxable year allowable under section 441.
(ii) A disputed ownership fund taxable as a qualified settlement
fund under paragraph (c)(1)(ii) of this section may compute taxable
income
[[Page 387]]
under any accounting method allowable under section 446 and may use any
taxable year allowable under section 441.
(iii) Appropriate adjustments must be made by a disputed ownership
fund or transferors to the fund to prevent the fund and the transferors
from taking into account the same item of income, deduction, gain, loss,
or credit (including capital gains and losses) more than once or from
omitting such items. For example, if a transferor that is not a
transferor-claimant uses the cash receipts and disbursements method of
accounting and transfers an account receivable to a disputed ownership
fund that uses an accrual method of accounting, at the time of the
transfer of the account receivable to the disputed ownership fund, the
transferor must include in its gross income the value of the account
receivable because, under paragraph (c)(3)(ii) of this section, the
disputed ownership fund will take a fair market value basis in the
receivable and will not include the fair market value in its income when
received from the transferor or when paid by the customer. If the
account receivable were transferred to the disputed ownership fund by a
transferor-claimant using the cash receipts and disbursements method,
however, the disputed ownership fund would take a basis in the
receivable equal to the transferor's basis, or $0, and would be required
to report the income upon collection of the account.
(6) Unused carryovers. Upon the termination of a disputed ownership
fund, if the fund has an unused net operating loss carryover under
section 172, an unused capital loss carryover under section 1212, or an
unused tax credit carryover, or if the fund has, for its last taxable
year, deductions in excess of gross income, the claimant to which the
fund's net assets are distributable will succeed to and take into
account the fund's unused net operating loss carryover, unused capital
loss carryover, unused tax credit carryover, or excess of deductions
over gross income for the last taxable year of the fund. If the fund's
net assets are distributable to more than one claimant, the unused net
operating loss carryover, unused capital loss carryover, unused tax
credit carryover, or excess of deductions over gross income for the last
taxable year must be allocated among the claimants in proportion to the
value of the assets distributable to each claimant from the fund. Unused
carryovers described in this paragraph (c)(6) are not money or other
property for purposes of paragraph (e)(3)(ii) of this section and thus
are not deemed transferred to a transferor-claimant before being
transferred to the claimants described in this paragraph (c)(6).
(d) Rules applicable to transferors that are not transferor-
claimants. The rules in this paragraph (d) apply to transferors (as
defined in paragraph (b)(7) of this section) that are not transferor-
claimants (as defined in paragraph (b)(8) of this section).
(1) Transfer of property. A transferor must treat a transfer of
property to a disputed ownership fund as a sale or other disposition of
that property for purposes of section 1001(a). In computing the gain or
loss on the disposition, the amount realized by the transferor is the
fair market value of the property on the date the transfer is made to
the disputed ownership fund.
(2) Economic performance--(i) In general. For purposes of section
461(h), if a transferor using an accrual method of accounting has a
liability for which economic performance would otherwise occur under
Sec. 1.461-4(g) when the transferor makes payment to the claimant or
claimants, economic performance occurs with respect to the liability
when and to the extent that the transferor makes a transfer to a
disputed ownership fund to resolve or satisfy that liability.
(ii) Obligations of the transferor. Economic performance does not
occur when a transferor using an accrual method of accounting issues to
a disputed ownership fund its debt (or provides the debt of a related
person). Instead, economic performance occurs as the transferor (or
related person) makes principal payments on the debt. Economic
performance does not occur when the transferor provides to a disputed
ownership fund its obligation (or the obligation of a related person) to
provide property or services in the future or to make a payment
described in Sec. 1.461-4(g)(1)(ii)(A). Instead, economic
[[Page 388]]
performance occurs with respect to such an obligation as property or
services are provided or payments are made to the disputed ownership
fund or a claimant. With regard to interest on a debt issued or provided
to a disputed ownership fund, economic performance occurs as determined
under Sec. 1.461-4(e).
(3) Distributions to transferors--(i) In general. Except as provided
in section 111(a) and paragraph (d)(3)(ii) of this section, the
transferor must include in gross income any distribution to the
transferor (including a deemed distribution described in paragraph
(d)(3)(iii) of this section) from the disputed ownership fund. If
property is distributed, the amount includible in gross income and the
basis in that property are generally the fair market value of the
property on the date of distribution.
(ii) Exception. A transferor is not required to include in gross
income a distribution of money or property that it previously
transferred to the disputed ownership fund if the transferor did not
take into account, for example, by deduction or capitalization, an
amount with respect to the transfer either at the time of the transfer
to, or while the money or property was held by, the disputed ownership
fund. The transferor's gross income does not include a distribution of
money from the disputed ownership fund equal to the net after-tax income
earned on money or property transferred to the disputed ownership fund
by the transferor while that money or property was held by the fund.
Money distributed to a transferor by a disputed ownership fund will be
deemed to be distributed first from the money or property transferred to
the disputed ownership fund by that transferor, then from the net after-
tax income of any money or property transferred to the disputed
ownership fund by that transferor, and then from other sources.
(iii) Deemed distributions. If a disputed ownership fund makes a
distribution of money or property on behalf of a transferor to a person
that is not a claimant, the distribution is deemed made by the fund to
the transferor. The transferor, in turn, is deemed to make a payment to
the actual recipient.
(e) Rules applicable to transferor-claimants. The rules in this
paragraph (e) apply to transferor-claimants (as defined in paragraph
(b)(8) of this section).
(1) Transfer of property. A transfer of property by a transferor-
claimant to a disputed ownership fund is not a sale or other disposition
of the property for purposes of section 1001(a).
(2) Economic performance--(i) In general. For purposes of section
461(h), if a transferor-claimant using an accrual method of accounting
has a liability for which economic performance would otherwise occur
under Sec. 1.461-4(g) when the transferor-claimant makes payment to
another claimant, economic performance occurs with respect to the
liability when and to the extent that the disputed ownership fund
transfers money or property to the other claimant to resolve or satisfy
that liability.
(ii) Obligations of the transferor-claimant. Economic performance
does not occur when a disputed ownership fund transfers the debt of a
transferor-claimant (or of a person related to the transferor-claimant)
to another claimant. Instead, economic performance occurs as principal
payments on the debt are made to the other claimant. Economic
performance does not occur when a disputed ownership fund transfers to
another claimant the obligation of a transferor-claimant (or of a person
related to the transferor-claimant) to provide property or services in
the future or to make a payment described in Sec. 1.461-4(g)(1)(ii)(A).
Instead, economic performance occurs with respect to such an obligation
as property or services are provided or payments are made to the other
claimant. With regard to interest on a debt issued or provided to a
disputed ownership fund, economic performance occurs as determined under
Sec. 1.461-4(e).
(3) Distributions to transferor-claimants--(i) In general. The gross
income of a transferor-claimant does not include a distribution to the
transferor-claimant (including a deemed distribution described in
paragraph (e)(3)(ii) of this section) of money or property from a
disputed ownership fund that the transferor-claimant previously
transferred to the fund, or the net after-tax
[[Page 389]]
income earned on that money or property while it was held by the fund.
If such property is distributed to the transferor-claimant by the
disputed ownership fund, then the transferor-claimant's basis in the
property is the same as the disputed ownership fund's basis in the
property immediately before the distribution.
(ii) Deemed distributions. If a disputed ownership fund makes a
distribution of money or property to a claimant or makes a distribution
of money or property on behalf of a transferor-claimant to a person that
is not a claimant, the distribution is deemed made by the fund to the
transferor-claimant. The transferor-claimant, in turn, is deemed to make
a payment to the actual recipient.
(f) Distributions to claimants other than transferor-claimants.
Whether a claimant other than a transferor-claimant must include in
gross income a distribution of money or property from a disputed
ownership fund generally is determined by reference to the claim in
respect of which the distribution is made.
(g) Statement to the disputed ownership fund and the Internal
Revenue Service with respect to transfers of property other than cash--
(1) In general. By February 15 of the year following each calendar year
in which a transferor (or other person acting on behalf of a transferor)
makes a transfer of property other than cash to a disputed ownership
fund, the transferor must provide a statement to the administrator of
the fund setting forth the information described in paragraph (g)(3) of
this section. The transferor must attach a copy of this statement to its
return for the taxable year of transfer.
(2) Combined statements. If a disputed ownership fund has more than
one transferor, any two or more transferors may provide a combined
statement to the administrator. If a combined statement is used, each
transferor must attach a copy of the combined statement to its return
and maintain with its books and records a schedule describing each asset
that the transferor transferred to the disputed ownership fund.
(3) Information required on the statement. The statement required by
paragraph (g)(1) of this section must include the following
information--
(i) A legend, ``Sec. 1.468B-9 Statement,'' at the top of the first
page;
(ii) The transferor's name, address, and taxpayer identification
number;
(iii) The disputed ownership fund's name, address, and employer
identification number;
(iv) A statement declaring whether the transferor is a transferor-
claimant;
(v) The date of each transfer;
(vi) A description of the property (other than cash) transferred;
and
(vii) The disputed ownership fund's basis in the property and
holding period on the date of transfer as determined under paragraph
(c)(3)(ii) of this section.
(h) Examples. The following examples illustrate the rules of this
section:
Example 1. (i) X Corporation petitions the United States Tax Court
in 2006 for a redetermination of its tax liability for the 2003 taxable
year. In 2006, the Tax Court determines that X Corporation is liable for
an income tax deficiency for the 2003 taxable year. X Corporation files
an appellate bond in accordance with section 7485(a) and files a notice
of appeal with the appropriate United States Court of Appeals. In 2006,
the Court of Appeals affirms the decision of the Tax Court and the
United States Supreme Court denies X Corporation's petition for a writ
of certiorari.
(ii) The appellate bond that X Corporation files with the court for
the purpose of staying assessment and collection of deficiencies pending
appeal is not an escrow account, trust or fund established to hold
property subject to conflicting claims of ownership. Although X
Corporation was found liable for an income tax deficiency, ownership of
the appellate bond is not disputed. Rather, the bond serves as security
for a disputed liability. Therefore, the bond is not a disputed
ownership fund.
Example 2. (i) The facts are the same as Example 1, except that X
Corporation deposits United States Treasury bonds with the Tax Court in
accordance with section 7845(c)(2) and 31 U.S.C. 9303.
(ii) The deposit of United States Treasury bonds with the court for
the purpose of staying assessment and collection of deficiencies while X
Corporation prosecutes an appeal does not create a disputed ownership
fund because ownership of the bonds is not disputed.
Example 3. (i) Prior to A's death, A was the insured under a life
insurance policy issued by X, an insurance company. X uses an accrual
method of accounting. Both A's current spouse and A's former spouse
claim to
[[Page 390]]
be the beneficiary under the policy and entitled to the policy proceeds
($1 million). In 2005, X files an interpleader action and deposits $1
million into the registry of the court. On June 1, 2006, a final
determination is made that A's current spouse is the beneficiary under
the policy and entitled to the money held in the registry of the court.
The interest earned on the registry account is $12,000. The money in the
registry account is distributed to A's current spouse.
(ii) The money held in the registry of the court consisting of the
policy proceeds and the earnings thereon are a disputed ownership fund
taxable as if it were a qualified settlement fund. See paragraphs (b)(1)
and (c)(1)(ii) of this section. The fund's gross income does not include
the $1 million transferred to the fund by X, however, the $12,000
interest is included in the fund's gross income in accordance with its
method of accounting. See paragraph (c)(3)(i) of this section. Under
paragraph (c)(4)(ii) of this section, the fund is not allowed a
deduction for a distribution to A's current spouse of the $1 million or
the interest income earned by the fund.
(iii) X is a transferor that is not a transferor-claimant. See
paragraphs (b)(7) and (b)(8) of this section.
(iv) Whether A's current spouse must include in income the $1
million insurance proceeds and the interest received from the fund is
determined under other provisions of the Internal Revenue Code. See
paragraph (f) of this section.
Example 4. (i) Corporation B and unrelated individual C claim
ownership of certain rental property. B uses an accrual method of
accounting. The rental property is property used in a trade or business.
B claims to have purchased the property from C's father. However, C
asserts that the purported sale to B was ineffective and that C acquired
ownership of the property through intestate succession upon the death of
C's father. For several years, B has maintained and received the rent
from the property.
(ii) Pending the resolution of the title dispute between B and C,
the title to the rental property is transferred to a court-supervised
registry account on February 1, 2005. On that date the court appoints R
as receiver for the property. R collects the rent earned on the property
and hires employees necessary for the maintenance of the property. The
rents paid to R cannot be distributed to B or C without the court's
approval.
(iii) On June 1, 2006, the court makes a final determination that
the rental property is owned by C. The court orders C to refund to B the
purchase price paid by B to C's father plus interest on that amount from
February 1, 2005. The court also orders that a distribution be made to C
of all funds held in the court registry consisting of the rent collected
by R and the income earned thereon. C takes title to the rental
property.
(iv) The rental property and the funds held by the court registry
are a disputed ownership fund under paragraph (b)(1) of this section.
The fund is taxable as if it were a C corporation because the rental
property is not a passive investment asset within the meaning of
paragraph (c)(1)(i) of this section.
(v) The fund's gross income does not include the value of the rental
property transferred to the fund by B. See paragraph (c)(3)(i) of this
section. Under paragraph (c)(3)(ii) of this section, the fund's initial
basis in the property is the same as B's adjusted basis immediately
before the transfer to the fund and the fund's holding period is
determined under section 1223(2). The fund's gross income includes the
rents collected by R and any income earned thereon. For the period
between February 1, 2005, and June 1, 2006, the fund may be allowed
deductions for depreciation and for the costs of maintenance of the
property because the fund is treated as owning the property during this
period. See sections 162, 167, and 168. Under paragraph (c)(4)(ii) of
this section, the fund may not deduct the distribution to C of the
property, or the rents (or any income earned thereon) collected from the
property while the fund holds the property. No gain or loss is
recognized by the fund from this distribution or from the fund's
transfer of the rental property to C pursuant to the court's
determination that C owns the property. See paragraphs (c)(4)(i) and
(e)(3) of this section.
(vi) B is the transferor to the fund. Under paragraphs (b)(8) and
(e)(1) of this section, B is a transferor-claimant and does not
recognize gain or loss under section 1001(a) on transfer of the property
to the disputed ownership fund. The money and property distributed from
the fund to C is deemed to be distributed first to B and then
transferred from B to C. See paragraph (e)(3)(ii) of this section. Under
paragraph (e)(2)(i) of this section, economic performance occurs when
the disputed ownership fund transfers the property and any earnings
thereon to C. The income tax consequences of the deemed transfer from B
to C as well as the income tax consequences of C's refund to B of the
purchase price paid to C's father and interest thereon are determined
under other provisions of the Internal Revenue Code.
(i) [Reserved]
(j) Effective dates--(1) In general. This section applies to
disputed ownership funds established after February 3, 2006.
(2) Transition rule. With respect to a disputed ownership fund
established after August 16, 1986, but on or before February 3, 2006,
the Internal Revenue
[[Page 391]]
Service will not challenge a reasonable, consistently applied method of
taxation for income earned by the fund, transfers to the fund, and
distributions made by the fund.
[T.D. 9249, 71 FR 6202, Feb. 7, 2006]
Sec. 1.469-0 Table of contents.
This section lists the captions that appear in the regulations under
section 469.
Sec. 1.469-1 General rules.
(a)-(c)(7) [Reserved]
(c)(8) Consolidated groups.
(c)(9)-(d)(1) [Reserved]
(2) Coordination with sections 613A(d) and 1211.
(d)(3)-(e)(1) [Reserved]
(2) Trade or business activity.
(e)(3)(i)-(e)(3)(ii) [Reserved]
(iii) Average period of customer use.
(A) In general.
(B) Average use factor.
(C) Average period of customer use for class of property.
(D) Period of customer use.
(E) Class of property.
(F) Gross rental income and daily rent.
(e)(3)(iv)-(e)(3)(vi)(C) [Reserved]
(D) Lodging rented for convenience of employer.
(E) Unadjusted basis.
(e)(3)(vii)-(e)(4)(iii) [Reserved]
(iv) Definition of ``working interest.''
(e)(4)(v)-(vi) [Reserved]
(5) Rental of dwelling unit.
(e)(6)-(f)(3)(iii) [Reserved]
(4) Carryover of disallowed deductions and credits.
(i) In general.
(ii) Operations continued through C corporations or similar
entities.
(iii) Examples.
(g)(1)-(g)(4)(ii)(B) [Reserved]
(4)(ii)(C) (no paragraph heading)
(5) [Reserved]
(h)(1) In general.
(2) Definitions.
(3) [Reserved]
(4) Status and participation of members.
(i) Determination by reference to status and participation of group.
(ii) Determination of status and participation of consolidated
group.
(5) [Reserved]
(6) Intercompany transactions.
(i) In general.
(ii) Example.
(iii) Effective dates.
(h)(7)-(k) [Reserved]
Sec. 1.469-1T General rules (temporary).
(a) Passive activity loss and credit disallowed.
(1) In general.
(2) Exceptions.
(b) Taxpayers to whom these rules apply.
(c) Cross references.
(1) Definition of passive activity.
(2) Passive activity loss.
(3) Passive activity credit.
(4) Effect of rules for other purposes.
(5) Special rule for oil and gas working interests.
(6) Treatment of disallowed losses and credits.
(7) Corporations subject to section 469.
(8) [Reserved]
(9) Joint returns.
(10) Material participation.
(11) Effective date and transition rules.
(12) Future regulations.
(d) Effect of section 469 and the regulations thereunder for other
purposes.
(1) Treatment of items of passive activity income and gain.
(2) Coordination with sections 613A(d) and 1211. [Reserved]
(3) Treatment of passive activity losses.
(e) Definition of ``passive activity.''
(1) In general.
(2) Trade or business activity. [Reserved]
(3) Rental Activity.
(i) In general.
(ii) Exceptions.
(iii) Average period of customer use. [Reserved]
(A) In general. [Reserved]
(B) Average use factor. [Reserved]
(C) Average period of customer use for class of property. [Reserved]
(D) Period of Customer use. [Reserved]
(E) Class of property. [Reserved]
(F) Gross rental income and daily rent. [Reserved]
(iv) Significant personal services.
(A) In general.
(B) Excluded services.
(v) Extraordinary personal services.
(vi) Rental of property incidental to a nonrental activity of the
taxpayer.
(A) In general.
(B) Property held for investment.
(C) Property used in a trade or business.
(D) Lodging rented for convenience of employer. [Reserved]
(E) Unadjusted basis. [Reserved]
(vii) Property made available for use in a nonrental activity
conducted by a partnership, S corporation or joint venture in which the
taxpayer owns an interest.
(viii) Examples.
(4) Special rules for oil and gas working interests.
(i) In general.
(ii) Exception for deductions attributable to a period during which
liability is limited.
(A) In general.
(B) Coordination with rules governing the identification of
disallowed passive activity deductions.
[[Page 392]]
(C) Meaning of certain terms.
(1) Allocable deductions.
(2) Disqualified deductions.
(3) Net loss.
(4) Ratable portion.
(iii) Examples.
(iv) Definition of ``working interest.'' [Reserved]
(v) Entities that limit liability.
(A) General rule.
(B) Other limitations disregarded.
(C) Examples.
(vi) Cross reference to special rule for income from certain oil or
gas properties.
(5) Rental of dwelling unit. [Reserved]
(6) Activity of trading personal property.
(i) In general.
(ii) Personal property.
(iii) Example.
(f) Treatment of disallowed passive activity losses and credits.
(1) Scope of this paragraph.
(2) Identification of disallowed passive activity deductions.
(i) Allocation of disallowed passive activity deductions.
(A) General rule.
(B) Loss from an activity.
(C) Significant participation passive activities.
(D) Examples.
(ii) Allocation with loss activities.
(A) In general.
(B) Excluded deductions.
(iii) Separately identified deductions.
(3) Identification of disallowed credits from passive activities.
(i) General rule.
(ii) Coordination rule.
(iii) Separately identified credits.
(4) Carryover of disallowed deductions and credits. [Reserved]
(i) In general.
(ii) Operations continued through C corporations or similar
entities.
(iii) Examples.
(g) Application of these rules to C corporations.
(1) In general.
(2) Definitions.
(3) Participation of corporations.
(i) Material participation.
(ii) Significant participation.
(iii) Participation of individual.
(4) Modified computation of passive activity loss in the case of
closely held corporations.
(i) In general.
(ii) Net active income.
(iii) Examples.
(5) Allowance of passive activity credit of closely held
corporations to extent of net active income tax liability.
(i) In general.
(ii) Net active income tax liability.
(h) Special rules for affiliated group filing consolidated return.
(1)-(2) [Reserved]
(3) Disallowance of consolidated group's passive activity loss or
credit.
(4) Status and participation of members. [Reserved]
(i) Determination by reference to status and participation of group.
[Reserved]
(ii) Determination of status and participation of consolidated
group. [Reserved]
(5) Modification of rules for identifying disallowed passive
activity deductions and credits.
(i) Identification of disallowed deductions.
(ii) Ratable portion of disallowed passive activity losses.
(iii) Identification of disallowed credits.
(6) [Reserved]
(7) Disposition of stock of a member of an affiliated group.
(8) Dispositions of property used in multiple activities.
(i) [Reserved]
(j) Spouses filing joint returns.
(1) In general.
(2) Exceptions of treatment as one taxpayer.
(i) Identification of disallowed deductions and credits.
(ii) Treatment of deductions disallowed under sections 704(d),
1366(d) and 465.
(iii) Treatment of losses from working interests.
(3) Joint return no longer filed.
(4) Participation of spouses.
(k) Former passive activities and changes in status of corporations.
[Reserved]
Sec. 1.469-2 Passive activity loss.
(a)-(c)(2)(ii) [Reserved]
(iii) Disposition of substantially appreciated property formerly
used in a nonpassive activity.
(A) In general.
(B) Date of disposition.
(C) Substantially appreciated property.
(D) Investment property.
(E) Coordination with Sec. l.469-2T(c)(2)(ii).
(F) Coordination with section 163(d).
(G) Examples.
(iv) Taxable acquisitions.
(v) Property held for sale to customers.
(A) Sale incidental to another activity.
(1) Applicability.
(i) In general.
(ii) Principal purpose.
(2) Dealing activity not taken into account.
(B) Use in a nondealing activity incidental to sale.
(C) Examples.
(c)(3)-(c)(5) [Reserved]
(6) Gross income from certain oil or gas properties.
(i) In general.
(ii) Gross and net passive income from the property.
(iii) Property.
[[Page 393]]
(iv) Examples 1 and 2.
(c)(6)(iv) Example 3-(c)(7)(iii) [Reserved]
(c)(7)(iv) through (vi) (no paragraph headings)
(d)(1)-(d)(2)(viii) [Reserved]
(d)(2)(ix) through (d)(2)(xii) (no paragraph headings)
(d)(3)-(d)(5)(ii) [Reserved]
(d)(5)(iii)(A) Applicability of rules in Sec. 1.469-2T(c)(2).
(d)(5)(iii)(B)-(d)(6)(v)(D) [Reserved]
(d)(6)(v)(E) (no paragraph heading)
(d)(6)(v)(F)-(d)(7) [Reserved]
(8) Taxable year in which item arises.
(e)(1)-(e)(2)(i) [Reserved]
(ii) Section 707(c).
(iii) Payments in liquidation of a partner's interest in partnership
property.
(A) In general.
(B) Payments in liquidation of a partner's interest in unrealized
receivables and goodwill under section 736(a).
(e)(3)(i)-(iii)(A) [Reserved]
(e)(3)(iii)(B) (no paragraph heading)
(e)(3)(iii)(C)-(f)(4) [Reserved]
(5) Net income from certain property rented incidental to
development activity.
(i) In general.
(ii) Commencement of use.
(iii) Services performed for the purpose of enhancing the value of
property.
(iv) Examples.
(6) Property rented to a nonpassive activity.
(f)(7)-(f)(9)(ii) [Reserved]
(f)(9)(iii) through (f)(9)(iv) (no paragraph heading).
(10) Coordination with section 163(d).
(f)(11) [Reserved]
Sec. 1.469-2T Passive activity loss (temporary).
(a) Scope of this section.
(b) Definition of passive activity loss.
(1) In general.
(2) Cross reference.
(c) Passive activity group income.
(1) In general.
(2) Treatment of gain from disposition of an interest in an activity
or an interest in property used in an activity.
(i) In general.
(A) Treatment of gain.
(B) Dispositions of partnership interest and S corporation stock.
(C) Interest in property.
(D) Examples.
(ii) Disposition of property used in more than one activity in 12-
month period preceding disposition.
(iii) Disposition of substantially appreciated property used in
nonpassive activity. [Reserved]
(A) In general. [Reserved]
(B) Date of disposition. [Reserved]
(C) Substantially appreciated property. [Reserved]
(D) Investment property. [Reserved]
(E) Coordination with paragraph (c)(2)(ii) of this section.
[Reserved]
(F) Coordination with section 163(d). [Reserved]
(G) Examples. [Reserved]
(iv) Taxable acquisitions. [Reserved]
(v) Property held for sale to customers. [Reserved]
(A) Sale incidental to another activity. [Reserved]
(1) Applicability. [Reserved]
(i) In general. [Reserved]
(ii) Principal purpose. [Reserved]
(2) Dealing activity not taken into account. [Reserved]
(B) Use in a nondealing activity incidental to sale. [Reserved]
(C) Examples. [Reserved]
(3) Items of portfolio income specifically excluded.
(i) In general.
(ii) Gross income derived in the ordinary course of a trade or
business.
(iii) Special rules.
(A) Income from property held for investment by dealer.
(B) Royalties derived in the ordinary course of the trade or
business of licensing intangible property.
(1) In general.
(2) Substantial services or costs.
(i) In general.
(ii) Exception.
(iii) Expenditures taken into account.
(3) Passthrough entities.
(4) Cross reference.
(C) Mineral production payments.
(iv) Examples.
(4) Items of personal service income specifically excluded.
(i) In general.
(ii) Example.
(5) Income from section 481 adjustments.
(i) In general.
(ii) Positive section 481 adjustments.
(iii) Ratable portion.
(6) Gross income from certain oil or gas properties. [Reserved]
(i) In general. [Reserved]
(ii) Gross and net passive income from the properties. [Reserved]
(iii) Property. [Reserved]
(iv) Examples.
(7) Other items specifically excluded.
(d) Passive activity deductions.
(1) In general.
(2) Exceptions.
(3) Interest expense.
(4) Clearly and directly allocable expenses.
(5) Treatment of loss from disposition.
(i) In general.
(ii) Disposition of property used in more than one activity in 12-
month period preceding disposition.
(iii) Other applicable rules.
(A) Applicability or rules in paragraph (c)(2).
[[Page 394]]
(B) Dispositions of partnership interest and S corporation stock.
(6) Coordination with other limitations on deductions that apply
before section 469.
(i) In general.
(ii) Proration of deductions disallowed under basis limitations.
(A) Deductions disallowed under section 704(d).
(B) Deductions disallowed under section 1366(d).
(iii) Proration of deductions disallowed under at-risk limitations.
(iv) Coordination of basis and at-risk limitations.
(v) Separately identified items of deduction and loss.
(7) Deductions from section 481 adjustment.
(i) In general.
(ii) Negative section 481 adjustment.
(iii) Ratable portion.
(8) Taxable year in which item arises.
(e) Special rules for partners and S corporation shareholders.
(1) In general.
(2) Payments under sections 707(a), 707(c), and 736(b).
(i) Section 707(a).
(ii) Section 707(c).
(iii) Payments in liquidation of a partner's interest in partnership
property.
(A) In general.
(B) Payments in liquidation of a partner's interest of a partnership
property.
(3) Sale or exchange of interest in passthrough entity.
(i) Application of this paragraph (e)(3).
(ii) General rule.
(A) Allocation among activities.
(B) Ratable portions.
(1) Disposition on which gain is recognized.
(2) Disposition on which loss is recognized.
(C) Default rule.
(D) Special rules.
(1) Applicable valuation date.
(i) In general.
(ii) Exception.
(2) Basis adjustment.
(3) Tiered passthrough entities.
(E) Meaning of certain terms.
(iii) Treatment of gain allocated to certain passive activities as
not from a passive activity.
(iv) Dispositions occurring in taxable years beginning before
February 19, 1988.
(A) In general.
(B) Exceptions.
(v) Treatment of portfolio assets.
(vi) Definitions.
(vii) Examples.
(f) Recharacterization of passive income in certain situations.
(1) In general.
(2) Special rule for significant participation.
(i) In general.
(ii) Significant participation passive activity.
(iii) Example.
(3) Rental of nondepreciable property.
(4) Net interest income from passive equity-financed lending
activity.
(i) In general.
(ii) Equity-financed lending activity.
(A) In general.
(B) Certain liabilities not taken into account.
(iii) Equity-financed interest income.
(iv) Net interest income.
(v) Interest-bearing assets.
(vi) Liabilities incurred in the activity.
(vii) Average outstanding balance.
(viii) Example.
(5) Net income from certain property rented incidental to
development activity.
(i) In general. [Reserved]
(ii) Commencement of use. [Reserved]
(iii) Services performed for the purpose of enhancing the value of
property. [Reserved]
(iv) Examples. [Reserved]
(6) Property rented to a nonpassive activity.
(7) Special rules applicable to the acquisition of an interest of a
passthrough entity engaged in the trade or business of licensing
intangible property.
(i) In general.
(ii) Royalty income from property.
(iii) Exceptions.
(iv) Capital expenditures.
(v) Example.
(8) Limitation on recharacterized income.
(9) Meaning of certain terms.
(10) Coordination with section 163(d).
(11) Effective date.
Sec. 1.469-3 Passive activity credit.
(a)-(d) [Reserved]
(e) Coordination with section 38(b).
(f) Coordination with section 50.
(g) [Reserved]
Sec. 1.469-3T Passive activity credit (temporary).
(a) Computation of passive activity credit.
(b) Credits subject to section 469.
(1) In general.
(2) Treatment of credits attributed to qualified progress
expenditures.
(3) Special rule for partners and S corporations shareholders.
(4) Exception for pre-1987 credits.
(c) Taxable year to which credit is attributable.
(d) Regular tax liability allocable to passive activities.
(1) In general.
(2) Regular tax liability.
(e) Coordination with section 38(b). [Reserved]
(f) Coordination with section 47. [Reserved]
(g) Examples.
[[Page 395]]
Sec. 1.469-4 Definition of activity.
(a) Scope and purpose.
(b) Definitions.
(1) Trade or business activities.
(2) Rental activities.
(c) General rules for grouping activities.
(1) Appropriate economic unit.
(2) Facts and circumstances test.
(3) Examples.
(d) Limitation on grouping certain activities.
(1) Grouping rental activities with other trade or business
activities.
(i) Rule.
(ii) Examples.
(2) Grouping real property rentals and personal property rentals
prohibited.
(3) Certain activities of limited partners and limited
entrepreneurs.
(i) In general.
(ii) Example.
(4) Other activities identified by the Commissioner.
(5) Activities conducted through section 469 entities.
(i) In general.
(ii) Cross reference.
(e) Disclosure and consistency requirements.
(1) Original groupings.
(2) Regroupings.
(f) Grouping by Commissioner to prevent tax avoidance.
(1) Rule.
(2) Example.
(g) Treatment of partial dispositions.
(h) Rules for grouping rental real estate activities for taxpayers
qualifying under section 469(c)(7).
Sec. 1.469-5 Material participation.
(a)-(e) [Reserved]
(f) Participation.
(1) In general.
(f)(2)-(h)(2) [Reserved]
(3) Coordination with rules governing the treatment of passthroughs
entities.
(i) [Reserved]
(j) Material participation for preceding taxable years.
(1) In general.
(2) Material participation test for taxable years beginning before
January 1, 1987
(k) Examples (1)-(4). [Reserved]
(k) Example 5.
(k) Examples (6)-(8). [Reserved]
Sec. 1.469-5T Material participation (temporary).
(a) In general.
(b) Facts and circumstances.
(1) In general. [Reserved]
(2) Certain participation insufficient to constitute material
participation under this paragraph (b).
(i) Participation satisfying standards not contained in section 469.
(ii) Certain management activities.
(iii) Participation less than 100 hours.
(c) Significant participation activity.
(1) In general.
(2) Significant participation.
(d) Personal service activity.
(e) Treatment of limited partners.
(1) General rule.
(2) Exceptions.
(3) Limited partnership interest.
(i) In general.
(ii) Limited partner holding general partner interest.
(f) Participation. [Reserved]
(1) In general. [Reserved]
(2) Exceptions.
(i) Certain work not customarily done by owners.
(ii) participation as an investor.
(A) In general.
(B) Work done in individual's capacity as an investor.
(3) Participation of spouses.
(4) Methods of proof.
(g) Material participation of trust and estates. [Reserved]
(h) Miscellaneous rules.
(1) Participation of corporations.
(2) Treatment of certain retired farmers and surviving spouses of
retired or disabled farmers.
(3) Coordination with rules governing the treatment of passthroughs
entities. [Reserved]
(i) [Reserved]
(j) Material participation for preceding taxable years. [Reserved]
(1) In general. [Reserved]
(2) Material participation for taxable years beginning before
January 1, 1987. [Reserved]
(k) Examples.
Sec. 1.469-6 Treatment of losses upon certain dispositions. [Reserved]
Sec. 1.469-7 Treatment of self-charged items of interest income and
deduction.
(a) In general.
(1) Applicability and effect of rules.
(2) Priority of rules in this section.
(b) Definitions.
(1) Passthrough entity.
(2) Taxpayer's share.
(3) Taxpayer's indirect interest.
(4) Entity taxable year.
(5) Deductions for a taxable year.
(c) Taxpayer loans to passthrough entity.
(1) Applicability.
(2) General rule.
(3) Applicable percentage.
(d) Passthrough entity loans to taxpayer.
(1) Applicability.
(2) General rule.
(3) Applicable percentage.
(e) Identically-owned passthrough entities.
(1) Applicability.
(2) General rule.
[[Page 396]]
(1) Example.
(f) Identification of properly allocable deductions.
(g) Election to avoid application of the rules of this section.
(1) In general.
(2) Form of election.
(3) Period for which election applies.
(4) Revocation.
(h) Examples.
Sec. 1.469-8 Application of section 469 to trust, estates, and their
beneficiaries. [Reserved]
Sec. 1.469-9 Rules for certain rental real estate activities.
(a) Scope and purpose.
(b) Definitions.
(1) Trade or business.
(2) Real property trade or business.
(3) Rental real estate.
(4) Personal services.
(5) Material participation.
(6) Qualifying taxpayer.
(c) Requirements for qualifying taxpayers.
(1) In general.
(2) Closely held C corporations.
(3) Requirement of material participation in the real property
trades or businesses.
(4) Treatment of spouses.
(5) Employees in real property trades or businesses.
(d) General rule for determining real property trades or businesses.
(1) Facts and circumstances.
(2) Consistency requirement.
(e) Treatment of rental real estate activities of a qualifying
taxpayer.
(1) In general.
(2) Treatment as a former passive activity.
(3) Grouping rental real estate activities with other activities.
(i) In general.
(ii) Special rule for certain management activities.
(4) Example.
(f) Limited partnership interests in rental real estate activities.
(1) In general.
(2) De minimis exception.
(g) Election to treat all interests in rental real estate as a
single rental real estate activity.
(1) In general.
(2) Certain changes not material.
(3) Filing a statement to make or revoke the election.
(h) Interests in rental real estate held by certain passthrough
entities.
(1) General rule.
(2) Special rule if a qualifying taxpayer holds a fifty-percent or
greater interest in a passthrough entity.
(3) Special rule for interests held in tiered passthrough entities.
(i) [Reserved]
(j) $25,000 offset for rental real estate activities of qualifying
taxpayers.
(1) In general.
(2) Example.
Sec. 1.469-10 Application of section 469 to publicly traded
partnerships. [Reserved]
Sec. 1.469-11 Effective date and transition rules.
(a) Generally applicable effective dates.
(b) Additional effective dates.
(1) Application of 1992 amendments for taxable years beginning
before October 4, 1994.
(2) Additional transition rule for 1992 amendments.
(3) Fresh starts under consistency rules.
(i) Regrouping when tax liability is first determined under Project
PS-1-89.
(ii) Regrouping when tax liability is first determined under Sec.
1.469-4.
(iii) Regrouping when taxpayer is first subject to section
469(c)(7).
(iv) Regrouping for taxpayers subject to section 1411.
(A) In general.
(B) Eligibility criteria.
(C) Consequences of amended returns and examination adjustments.
(1) Taxpayers first subject to section 1411.
(2) Taxpayers ceasing to be subject to section 1411.
(3) Examples.
(D) Effective/applicability date.
(4) Certain investment credit property.
(c) Special rules.
(1) Application of certain income recharacterization rules and self-
charged rules.
(i) Certain recharacterization rules inapplicable in 1987.
(ii) Property rented to a nonpassive activity.
(iii) Self-charged rules.
(2) Qualified low-income housing projects.
(3) Effect of events occurring in years prior to 1987.
(d) Examples.
[T.D. 8417, 57 FR 20748, May 15, 1992, as amended by T.D. 8477, 58 FR
11538, Feb. 26, 1993; T.D. 8495, 58 FR 58787, Nov. 4, 1993; T.D. 8565,
59 FR 50487, Oct. 4, 1994; T.D. 8597, 60 FR 36684, July 18, 1995; T.D.
8645, 60 FR 66498, Dec. 22, 1995; T.D. 9013, 67 FR 54089, Aug. 21, 2002;
T.D. 9644, 78 FR 72421, Dec. 2, 2013]
Sec. 1.469-1 General rules.
(a)-(c)(7) [Reserved]
(c)(8) Consolidated groups. Rules relating to the application of
section 469 to consolidated groups are contained in paragraph (h) of
this section.
(c)(9)-(d)(1) [Reserved]
[[Page 397]]
(d)(2) Coordination with sections 613A (d) and 1211. A passive
activity deduction that is not disallowed for the taxable year under
section 469 and the regulations thereunder may nonetheless be disallowed
for the taxable year under section 613A(d) or 1211. The following
example illustrates the application of this paragraph (d)(2):
Example. In 1993, an individual derives $10,000 of ordinary income
from passive activity X, no gains from the sale or exchange of capital
assets or assets used in a trade or business, $12,000 of capital loss
from passive activity Y, and no income, gain, deductions, or losses from
any other passive activity. The capital loss from activity Y is a
passive activity deduction (within the meaning of Sec. 1.469-2T(d)).
Under section 469 and the regulations thereunder, the taxpayer is
allowed $10,000 of the $12,000 passive activity deduction and has a
$2,000 passive activity loss for the taxable year. Since the $10,000
passive activity deduction allowed under section 469 is a capital loss,
such deduction is allowable for the taxable year only to the extent
provided under section 1211. Therefore, the taxpayer is allowed $3,000
of the $10,000 capital loss under section 1211 and has a $7,000 capital
loss carryover (within the meaning of section 1212(b)) to the succeeding
taxable year.
(d)(3)-(e)(1) [Reserved]
(e)(2) Trade or business activities. Trade or business activities
are activities that constitute trade or business activities within the
meaning of Sec. 1.469-4(b)(1).
(e)(3)(i)-(e)(3)(ii) [Reserved]
(e)(3)(iii) Average period of customer use--(A) In general. For
purposes of this paragraph (e)(3), the average period of customer use
for property held in connection with an activity (the activity's average
period of customer use) is the sum of the average use factors for each
class of property held in connection with the activity.
(B) Average use factor. The average use factor for a class of
property held in connection with an activity is the average period of
customer use for that class of property multiplied by the fraction
obtained by dividing--
(1) The activity's gross rental income attributable to that class of
property; by
(2) The activity's gross rental income.
(C) Average period of customer use for class of property. In
determining an activity's average period of customer use for a taxable
year, the average period of customer use for a class of property held in
connection with an activity is determined by dividing--
(1) The aggregate number of days in all periods of customer use for
property in the class (taking into account only periods that end during
the taxable year or that include the last day of the taxable year); by
(2) The number of those periods of customer use.
(D) Period of customer use. Each period during which a customer has
a continuous or recurring right to use an item of property held in
connection with the activity (without regard to whether the customer
uses the property for the entire period or whether the right to use the
property is pursuant to a single agreement or to renewals thereof) is
treated for purposes of this paragraph (e)(3)(iii) as a separate period
of customer use. The duration of a period of customer use that includes
the last day of a taxable year may be determined on the basis of
reasonable estimates.
(E) Class of property. Taxpayers may organize property into classes
for purposes of this paragraph (e)(3)(iii) using any method under which
items of property for which the amount of the daily rent differs
significantly are not included in the same class.
(F) Gross rental income and daily rent. In determining an activity's
average period of customer use for a taxable year--
(1) The activity's gross rental income is the gross income from the
activity for the taxable year taking into account only income that is
attributable to amounts paid for the use of property;
(2) The activity's gross rental income attributable to a class of
property is the gross income from the activity for the taxable year
taking into account only income that is attributable to amounts paid for
the use of property in that class; and
(3) The daily rent for items of property may be determined on any
basis that reasonably reflects differences during the taxable year in
the amounts ordinarily paid for one day's use of those items of
property.
(e)(3)(iv)-(e)(3)(vi)(C) [Reserved]
[[Page 398]]
(e)(3)(vi)(D) Lodging rented for convenience of employer. The
provision of lodging to an employee or to an employee's spouse or
dependents is treated as incidental to the activity (or activities) of
the taxpayer in which the employee performs services if the lodging is
furnished for the taxpayer's convenience (within the meaning of section
119).
(E) Unadjusted basis. For purposes of this paragraph (e)(3)(vi), the
term unadjusted basis means adjusted basis determined without regard to
any adjustment described in section 1016 that decreases basis.
(e)(3)(vii)-(e)(4)(iii) [Reserved]
(e)(4)(iv) Definition of ``working interest.'' For purposes of
section 469 and the regulations thereunder, the term working interest
means a working or operating mineral interest in any tract or parcel of
land (within the meaning of Sec. 1.612-4(a)).
(e)(4)(v)-(f)(3) [Reserved]
(f)(4) Carryover of disallowed deductions and credits--(i) In
general. In the case of an activity of a taxpayer with respect to which
any deductions or credits are disallowed for a taxable year under Sec.
1.469-1T (f)(2) or (f)(3) (the loss activity)--
(A) The disallowed deductions or credits is allocated among the
taxpayer's activities for the succeeding taxable year in a manner that
reasonably reflects the extent to which each activity continues the loss
activity; and
(B) The disallowed deductions or credits allocated to an activity
under paragraph (f)(4)(i)(A) of this section shall be treated as
deductions or credits from the activity for the succeeding taxable year.
(ii) Business continued through C corporations or similar entities.
If a taxpayer continues part or all of a loss activity through a C
corporation or similar entity (C corporation entity), the taxpayer's
interest in the C corporation entity shall be treated for purposes of
this paragraph (f)(4) as an interest in a passive activity that
continues that loss activity in whole or part. An entity is similar to a
C corporation for this purpose if the owners of interests in the entity
derive only portfolio income (within the meaning of Sec. 1.469-
2T(c)(3)(i)) from the interests.
(iii) Examples. The following examples illustrate the application of
this paragraph (f)(4). In each example, the taxpayer is an individual
whose taxable year is the calendar year.
Example 1. (i) The taxpayer owns interests in a convenience store
and an apartment building. In each taxable year, the taxpayer's
interests in the convenience store and the apartment building are
treated under Sec. 1.469-4 as interests in two separate passive
activities of the taxpayer. A $5,000 loss from the convenience-store
activity and a $3,000 loss from the apartment-building activity are
disallowed under Sec. 1.469-1T(f)(2) for 1993. Under Sec. 1.469-
1T(f)(2), the $5,000 loss from the convenience-store activity is
allocated among the passive activity deductions from that activity for
1993, and the $3,000 loss from the apartment-building activity is
treated similarly.
(ii) In 1994, the convenience store is continued in a single
activity, and the section 469 activities that constituted the apartment
building is similarly continued in a separate activity. Thus, the
disallowed deductions from the convenience-store activity for 1993 must
be allocated under paragraph (f)(4)(i)(A) of this section to the
taxpayer's convenience-store activity in 1994. Similarly, the disallowed
deductions from the apartment-building activity for 1993 must be
allocated to the taxpayer's apartment-building activity in 1994. Under
paragraph (f)(4)(i)(B) of this section, the disallowed deductions
allocated to the convenience-store activity in 1994 are treated as
deductions from that activity for 1994, and the disallowed deductions
allocated to the apartment-building activity for 1994 are treated as
deductions from the apartment-building activity for 1994.
Example 2. (i) In 1993, the taxpayer acquires a restaurant and a
catering business. Assume that in 1993 and 1994 the restaurant and the
catering business are treated under Sec. 1.469-4 as an interest in a
single passive activity of the taxpayer (the restaurant and catering
activity). A $10,000 loss from the activity is disallowed under Sec.
1.469-1T(f)(2) for 1994. Assume that in 1995, the taxpayer's interests
in the restaurant and the catering business are treated under Sec.
1.469-4 as interests in two separate passive activities of the taxpayer.
(ii) Under Sec. 1.469-1T(f)(2), the $10,000 loss from the
restaurant and catering activity is allocated among the passive activity
deductions from that activity for 1994. In 1995, the businesses that
constituted the restaurant and catering activity are continued, but are
treated as two separate activities under Sec. 1.469-4. Thus, the
disallowed deductions from the restaurant and catering activity for 1994
must be allocated under paragraph (f)(4)(i)(A) of this section between
the restaurant activity and the catering activity in
[[Page 399]]
1995 in a manner that reasonably reflects the extent to which each of
the activities continues the single restaurant and catering activity.
Under paragraph (f)(4)(i)(B) of this section, the disallowed deductions
allocated to the restaurant activity in 1995 are treated as deductions
from the restaurant activity for 1995, and the disallowed deductions
allocated to the catering activity in 1995 are treated as deductions
from the catering activity for 1995.
Example 3. (i) In 1993, the taxpayer acquires a restaurant and a
catering business. Assume that in 1993 and 1994 the restaurant and the
catering business are treated underSec. 1.469-4 as an interest in a
single passive activity of the taxpayer (the restaurant and catering
activity). A $10,000 loss from the activity is disallowed under Sec.
1.469-1T(f)(2) for 1994. Assume that in 1995, the taxpayer's interests
in the restaurant and the catering business are treated under Sec.
1.469-4 as interestes in two separate passive activities of the
taxpayer. In addition, a $20,000 loss from the activity was disallowed
under Sec. 1.469-1T(f)(2) for 1993, and the gross income and deductions
(including deductions that were disallowed for 1993 under Sec. 1.469-
1T(f)(2)) from the restaurant and catering business for 1993 and 1994
are as follows:
------------------------------------------------------------------------
Catering
Restaurant business
------------------------------------------------------------------------
1993:
Gross income................................ $20,000 $60,000
Deductions.................................. 40,000 60,000
--------------
Net income (loss)....................... (20,000) ...........
1994:
Gross income................................ 40,000 50,000
Deductions.................................. \1\ 30,000 \2\ 70,000
--------------
Net income (loss)....................... 10,000 (20,000)
------------------------------------------------------------------------
\1\ Includes $8,000 of deductions that were disallowed for 1993 ($20,000
x $40,000/$100,000).
\2\ Includes $12,000 of deductions that were disallowed for 1993
($20,000 x $60,000/$100,000).
(ii) Under paragraph (f)(4)(i)(A) of this section, the disallowed
deductions from the restaurant and catering activity must be allocated
among the taxpayer's activities for the succeeding year in a manner that
reasonably reflects the extent to which those activities continue the
restaurant and catering activity. The remainder of this example
describes a number of allocation methods that will ordinarily satisfy
the requirement of paragraph (f)(4)(i)(A) of this section. The
description of specific allocation methods in this example does not
preclude the use of other reasonable allocation methods for purposes of
paragraph (f)(4)(i)(A) of this section.
(iii) Ordinarily, an allocation of disallowed deductions from the
restaurant to the restaurant activity and disallowed deductions from the
catering business to the catering activity would satisfy the requirement
of paragraph (f)(4)(i)(A) of this section. Under Sec. 1.469-1T
(f)(2)(ii), a ratable portion of each deduction from the restaurant and
catering activity is disallowed for 1994. Thus, $3,000 of the 1994
deductions from the restaurant are disallowed ($10,000 x $30,000/
$100,000), and $7,000 of the 1994 deductions from the catering business
are disallowed ($10,000 x $70,000/$100,000). Thus, the taxpayer can
ordinarily treat $3,000 of the disallowed deductions as deductions from
the restaurant activity for 1995, and $7,000 of the disallowed
deductions as deductions from the catering activity for 1995.
(iv) Ordinarily, an allocation of disallowed deductions between the
restaurant activity and catering activity in proportion to the losses
from the restaurant and from the catering business for 1994 would also
satisfy the requirement of paragraph (f)(4)(i)(A) of this section. If
the restaurant and the catering business had been treated as separate
activities in 1994, the restaurant activity would have had net income of
$10,000 and the catering activity would have had a $20,000 loss. Thus,
the taxpayer can ordinarily treat all $10,000 of disallowed deductions
as deductions from the catering activity for 1995.
(v) Ordinarily, an allocation of disallowed deductions between the
restaurant activity and catering activity in proportion to the losses
from the restaurant and from the catering business for 1994 (determined
as if the restaurant and the catering business had been separate
activities for all taxable years) would also satisfy the requirement of
paragraph (f)(4)(i)(A) of this section. If the restaurant and the
catering business had been treated as separate activities for all
taxable years, the entire $20,000 loss from the restaurant in 1993 would
have been allocated to the restaurant activity in 1994, and the gross
income and deductions from the separate activities for 1994 would be as
follows:
------------------------------------------------------------------------
Catering
Restaurant business
------------------------------------------------------------------------
Gross income.................................. $40,000 $50,000
Deductions.................................... 42,000 58,000
-------------------------
Net income (loss)....................... (2,000) (8,000)
------------------------------------------------------------------------
Thus, the taxpayer can ordinarily treat $2,000 of the disallowed
deductions as deductions from the restaurant activity for 1995, and
$8,000 of the disallowed deductions as deductions from the catering
activity for 1995.
Example 4. (i) The taxpayer is a partner in a law partnership that
acquires a building in December 1993 for use in the partnership's law
practice. In taxable year 1993, four floors that are not needed in the
law practice are leased to tenants; in taxable year 1994, two floors are
leased to tenants; in taxable years after 1994, only one floor is leased
to tenants and the rental operations are insubstantial. Assume that
under Sec. 1.469-4, the law practice and the rental property are
treated as a
[[Page 400]]
trade or business activity and a separate rental activity for taxable
years 1993 and 1994. Assume further that the law practice and the rental
operations are a single trade or business activity for taxable years
after 1994 under Sec. 1.469-4. The trade or business activity is not a
passive activity of the taxpayer. The rental activity, however, is a
passive activity. Under Sec. 1.469-T(f)(2), a $12,000 loss from the
rental activity is disallowed for 1993 and a $9,000 loss from the rental
activity is disallowed for 1994.
(ii) Under Sec. 1.469-1T(f)(2), the $12,000 loss from the rental
activity for 1993 is allocated among the passive activity deductions
from that activity for 1993. In 1994, the business of the rental
activity is continued in two separate activities. Only two floors of the
building remain in the rental activity, and the other two floors (i.e.,
the floors that were leased to tenants in 1993, but not in 1994) are
used in the taxpayer's law-practice activity. Thus, the disallowed
deductions from the rental activity for 1993 must be allocated under
paragraph (f)(4)(i)(A) of this section between the rental activity and
the law-practice activity in a manner that reasonably reflects the
extent to which each of the activities continues business on the four
floors that were leased to tenants in 1993. In these circumstances, the
requirement of paragraph (f)(4)(i)(A) of this section would ordinarily
be satisfied by any of the allocation methods illustrated in Example 3
or by an allocation of 50 percent of the disallowed deductions to each
activity. Under paragraph (f)(4)(i)(B) of this section, the disallowed
deductions allocated to the rental activity in 1994 are treated as
deductions from the rental activity for 1994, and the disallowed
deductions ($6,000) allocated to the law-practice activity in 1994 are
treated as deductions from the law-practice activity for 1994.
(iii) Under Sec. 1.469-1T(f)(2), the $9,000 loss from the rental
activity for 1994 is allocated among the passive activity deductions
from that activity for 1994. In 1995, the rental activity is continued
in the taxpayer's law-practice activity. Thus, the disallowed deductions
from the rental activity for 1994 must be allocated under paragraph
(f)(4)(ii) of this section to the taxpayer's law-practice activity in
1995. Under paragraph (f)(4)(i)(B) of this section, the disallowed
deductions allocated to the law-practice activity are treated as
deductions from the law-practice activity for 1995.
(iv) Rules relating to former passive activities will be contained
in paragraph (k) of this section. Under those rules, any disallowed
deductions from the rental activity that are treated as deductions from
the law-practice activity will be treated as unused deductions that are
allocable to a former passive activity.
Example 5. (i) The taxpayer owns stock in a corporation that is an S
corporation for the taxpayer's 1993 taxable year and a C coporation
thereafter. The only activity of the corporation is a rental activity.
For 1993, the taxpayer's pro rata share of the corporation's loss from
the rental activity is $5,000, and the entire loss is disallowed under
Sec. 1.469-1T(f)(2) of this section.
(ii) Under Sec. 1.469-1T(f)(2), the taxpayer's $5,000 loss from the
rental activity is allocated among the taxpayer's deductions from that
activity for 1993. In 1994, the rental activity is continued through a C
corporation, and the taxpayer's interest in the C corporation is treated
under paragraph (f)(4)(ii) of this section as a passive activity that
continues the rental activity (the C corporation activity) for purposes
of allocating the previously disallowed loss. Thus, the disallowed
deductions from the rental activity for 1993 must be allocated under
paragraph (f)(4)(i)(A) of this section to the taxpayer's C corporation
activity in 1994, and are treated under paragraph (f)(4)(i)(B) of this
section as deductions from the C corporation activity for 1994.
(iii) Treating the taxpayer's interest in the C corporation as an
interest in a passive activity that continues the business of the rental
activity does not change the character of the taxpayer's dividend income
from the C corporation. Thus, the taxpayer's dividend income is
portfolio income (within the meaning of Sec. 1.469-2T(c)(3)(i)) and is
not included in passive activity gross income. Accordingly, the
taxpayer's loss from the C corporation activity for 1994 is $5,000.
Example 6. (i) The taxpayer owns stock in a corporation that is an S
corporation for the taxpayer's 1993 taxable year and a C corporation
thereafter. The only activity of the corporation is a rental activity.
For 1993, the taxpayer's pro rata share of the corporation's loss from
the rental activity is $5,000, and the entire loss is disallowed under
Sec. 1.469-1T(f)(2). The taxpayer has $2,000 in income from other
passive activities for 1994, and as a result, only 60% of the taxpayer's
loss from the C corporation activity ($3,000) is disallowed for 1994
under Sec. 1.469-1T(f)(2).
(ii) Under Sec. 1.469-1T(f)(2), the $3,000 disallowed loss from the
C corporation activity is allocated among the passive activity
deductions from that activity for 1994. In effect, therefore, 60 percent
of each disallowed deduction from the rental activity for 1993 is again
disallowed for 1994.
(iii) Under paragraph (f)(4) of this section, the taxpayer's
interest in the C corporation is treated as a loss activity and as an
interest in a passive activity that continues the business of that loss
activity for 1995. Thus, the disallowed deductions from the C
corporation activity for 1994 must be allocated under paragraph
(f)(4)(i)(A) of this section to the taxpayer's C corporation activity in
1995, and are treated under paragraph (f)(4)(i)(B)
[[Page 401]]
of this section as deductions from that activity for 1995.
(g)(1)-(g)(4)(ii)(B) [Reserved]
(g)(4)(ii)(C) Portfolio income (within the meaning of Sec. 1.469-
2T(c)(3)(i)), including any gross income that is treated as portfolio
income under any other provision of the regulations (See, e.g., Sec.
1.469-2(c)(2)(iii)(F) (relating to gain from the disposition of
substantially appreciated property formerly held for investment) and
Sec. 1.469-2(f)(10) (relating to certain recharacterized passive
activity gross income))
(5) [Reserved]
(h)(1) In general. This paragraph (h) provides rules for applying
section 469 in computing a consolidated group's consolidated taxable
income and consolidated tax liability (and the separate taxable income
and tax liability of each member).
(2) Definitions. The definitions and nomenclature in the regulations
under section 1502 apply for purposes of this paragraph (h). See, e.g.,
Sec. Sec. 1.1502-1 (definitions of group, consolidated group, member,
subsidiary, and consolidated return year), 1.1502-2 (consolidated tax
liability), 1.1502-11 (consolidated taxable income), 1.1502-12 (separate
taxable income), 1.1502-13 (intercompany transactions), 1.1502-21 (net
operating losses, and 1.1502-22 (consolidated net capital gain and
loss).
(3) [Reserved]
(4) Status and participation of members--(i) Determination by
reference to status and participation of group. For purposes of section
469 and the regulations thereunder--
(A) Each member of a consolidated group shall be treated as a
closely held corporation or personal service corporation, respectively,
for the taxable year, if and only if the consolidated group is treated
(under the rules of paragraph (h)(4)(ii) of this section) as a closely
held corporation or personal service corporation for that year; and
(B) The determination of whether a trade or business activity
(within the meaning of paragraph (e)(2) of this section) conducted by
one or more members of a consolidated group is a passive activity of the
members is made by reference to the consolidated group's participation
in the activity.
(ii) Determination of status and participation of consolidated
group. For purposes of determining under Sec. 1.469-1T(g)(2) whether a
consolidated group is treated as a closely held corporation or a
personal service corporation, and determining under Sec. 1.469-1T(g)(3)
whether the consolidated group materially or significantly participates
in any activity conducted by one or more members of the group--
(A) The members of the consolidated group shall be treated as one
corporation;
(B) Only the outstanding stock of the common parent shall be treated
as outstanding stock of the corporation;
(C) An employee of any member of the group shall be treated as an
employee of the corporation; and
(D) An activity is treated as the principal activity of the
corporation if and only if it is the principal activity (within the
meaning of Sec. 1.441-3(e)) of the consolidated group.
(5) [Reserved]
(6) Intercompany transactions--(i) In general. Section 1.1502-13
applies to determine the treatment under section 469 of intercompany
items and corresponding items from intercompany transactions between
members of a consolidated group. For example, the matching rule of Sec.
1.1502-13(c) treats the selling member (S) and the buying member (B) as
divisions of a single corporation for purposes of determining whether
S's intercompany items and B's corresponding items are from a passive
activity. Thus, for purposes of applying Sec. 1.469-2(c)(2)(iii) and
Sec. 1.469-2T(d)(5)(ii) to property sold by S to B in an intercompany
transaction--
(A) S and B are treated as divisions of a single corporation for
determining the uses of the property during the 12-month period
preceding its disposition to a nonmember, and generally have an
aggregate holding period for the property; and
(B) Sec. 1.469-2(c)(2)(iv) does not apply.
(ii) Example. The following example illustrates the application of
this paragraph (h)(6).
Example. (i) P, a closely held corporation, is the common parent of
the P consolidated group. P owns all of the stock of S and B. X is a
person unrelated to any member of the P group. S owns and operates
equipment
[[Page 402]]
that is not used in a passive activity. On January 1 of Year 1, S sells
the equipment to B at a gain. B uses the equipment in a passive activity
and does not dispose of the equipment before it has been fully
depreciated.
(ii) Under the matching rule of Sec. 1.1502-13(c), S's gain taken
into account as a result of B's depreciation is treated as gain from a
passive activity even though S used the equipment in a nonpassive
activity.
(iii) The facts are the same as in paragraph (a) of this Example,
except that B sells the equipment to X on December 1 of Year 3 at a
further gain. Assume that if S and B were divisions of a single
corporation, gain from the sale to X would be passive income
attributable to a passive activity. To the extent of B's depreciation
before the sale, the results are the same as in paragraph (ii) of this
Example. B's gain and S's remaining gain taken into account as a result
of B's sale are treated as attributable to a passive activity.
(iv) The facts are the same as in paragraph (iii) of this Example,
except that B recognizes a loss on the sale to X. B's loss and S's gain
taken into account as a result of B's sale are treated as attributable
to a passive activity.
(iii) Effective dates. This paragraph (h)(6) applies with respect to
transactions occurring in years beginning on or after July 12, 1995. For
transactions occurring in years beginning before July 12, 1995, see
Sec. 1.469-1T(h)(6) (as contained in the 26 CFR part 1 edition revised
as of April 1, 1995).
(h)(7)-(k) [Reserved]
[T.D. 8417, 57 FR 20750, May 15, 1992; 57 FR 28612, June 26, 1992, as
amended by T.D. 8417, 59 FR 45623, Sept. 2, 1994; T.D. 8597, 60 FR
36684, July 18, 1995; T.D. 8677, 61 FR 33322, June 27, 1996; T.D. 8823,
64 FR 36099, July 2, 1999; T.D. 8996, 67 FR 35012, May 17, 2002]
Sec. 1.469-1T General rules (temporary).
(a) Passive activity loss and credit disallowed--(1) In general.
Except as otherwise provided in paragraph (a)(2) of this section--
(i) The passive activity loss for the taxable year shall not be
allowed as a deduction; and
(ii) The passive activity credit for the taxable year shall not be
allowed.
(2) Exceptions. Paragraph (a)(1) of this section shall not apply to
the passive activity loss or the passive activity credit for the taxable
year to the extent provided in--
(i) Section 469(i) and the rules to be contained in Sec. 1.469-9T
(relating to losses and credits attributable to certain rental real
estate activities); and
(ii) Section 1.469-11T (relating to losses and credits attributable
to certain pre-enactment interests in activities).
(b) Taxpayers to whom these rules apply. The rules of section 469
and the regulations thereunder generally apply to--
(1) Individuals;
(2) Trusts (other than trusts (or portions of trusts) described in
section 671);
(3) Estates;
(4) Personal service corporations (within the meaning of paragraph
(g)(2)(i) of this section); and
(5) Closely held corporations (within the meaning of paragraph
(g)(2)(ii) of this section).
(c) Cross references--(1) Definition of ``passive activity.'' Rules
relating to the definition of the term ``passive activity'' are
contained in paragraph (e) of this section.
(2) Passive activity loss. Rules relating to the computation of the
passive activity loss for the taxable year are contained in Sec. 1.469-
2T.
(3) Passive activity credit. Rules relating to the computation of
the passive activity credit for the taxable year are contained in Sec.
1.469-3T.
(4) Effect of rules for other purposes. Rules relating to the effect
of section 469 and the regulations thereunder for other purposes under
the Code are contained in paragraph (d) of this section.
(5) Special rule for oil and gas working interests. Rules relating
to the treatment of losses and credits from certain interests in oil and
gas wells are contained in paragraph (e)(4) of this section
(6) Treatment of disallowed losses and credits. Paragraph (f) of
this section contains rules relating to--
(i) The treatment of deductions from passive activities in taxable
years in which the passive activity loss is disallowed in whole or in
part under paragraph (a)(1)(i) of this section; and
(ii) The treatment of credits from passive activities in taxable
years in which the passive activity credit is disallowed in whole or in
part under paragraph (a)(1)(ii) of this section.
[[Page 403]]
(7) Corporation subject to section 469. Rules relating to the
application of section 469 and regulations thereunder to C corporations
are contained in paragraph (g) of this section.
(8) [Reserved]
(9) Joint returns. Rules relating to the application of section 469
and the regulations thereunder to spouses filing a joint return for the
taxable year are contained in paragraph (j) of this section.
(10) Material participation. Rules defining the term ``material
participation'' are contained in Sec. 1.469-5T.
(11) Effective date and transition rules. Rules relating to the
effective date of section 469 and the regulations thereunder and
transition rules applicable to pre-enactment interests in activities are
contained in Sec. 1.469-11T.
(12) Future regulations. (i) Rules relating to former passive
activities and changes in corporate status will be contained in
paragraph (k) of this section.
(ii) Rules relating to the definition of ``activity'' will be
contained in Sec. 1.469-4T.
(iii) Rules relating to the treatment of deductions from activities
that are disposed of in certain transactions will be contained in Sec.
1.469-6T.
(iv) Rules relating to the treatment of self-charged items of income
and expense will be contained in Sec. 1.469-7T.
(v) Rules relating to the application of section 469 and the
regulations thereunder to trusts, estates, and their beneficiaries will
be contained in Sec. 1.469-8T.
(vi) Rules relating to the treatment of income, deductions, and
credits from certain rental real estate activities of individuals and
certain estates will be contained in Sec. 1.469-9T.
(vii) Rules relating to the application of section 469 to publicly
traded partnerships will be contained in Sec. 1.469-10T.
(d) Effect of section 469 and the regulations thereunder for other
purposes--(1) Treatment of items of passive activity income and gain.
Neither the provisions of section 469 (a)(1) and paragraph (a)(1) of
this section nor the characterization of items of income or deduction as
passive activity gross income (within the meaning of Sec. 1.469-2T (c))
or passive activity deductions (within the meaning of Sec. 1.469-2T
(d)) affects the treatment of any item of income or gain under any
provision of the Internal Revenue Code other than section 469. The
following example illustrates the application of this paragraph (d)(1):
Example. (i) In 1991, an individual's only income and loss from
passive activities are a $10,000 capital gain from passive activity X
and a $12,000 ordinary loss from passive activity Y. The taxpayer also
has a $10,000 capital loss that is not derived from a passive activity.
(ii) Under Sec. 1.469-2T (b), the taxpayer has a $2,000 passive
activity loss for the taxable year. The only effect of section 469 and
the regulations thereunder is to disallow a deduction for the taxpayer's
$2,000 passive activity loss for the taxable year. Thus, the taxpayer's
capital loss for the taxable year is allowed because the $10,000 capital
gain from passive activity X is taken into account under section 1211
(b) in computing the taxpayer's allowable capital loss for the year.
(2) Coordination with sections 613A(d) and 1211. [Reserved]. See
Sec. 1.469-1(d)(2) for rules relating to this paragraph.
(3) Treatment of passive activity losses. Except as otherwise
provided by regulations, a deduction that is disallowed for a taxable
year under section 469 and the regulations thereunder is not taken into
account as a deduction that is allowed for the taxable year in computing
the amount subject to any tax imposed by subtitle A of the Internal
Revenue Code. The following example illustrates the application of this
paragraph (d)(3):
Example. An individual has a $5,000 passive activity loss for a
taxable year, all of which is disallowed under paragraph (a)(1) of this
section. All of the disallowed loss is allocated under paragraph (f) of
this section to activities that are trades or businesses (within the
meaning of section 1402(c)). Such loss is not taken into account for the
taxable year in computing the taxpayer's taxable income subject to tax
under section 1. In addition, under this paragraph (d)(3), such loss is
not taken into account for the taxable year in computing the taxpayer's
net earnings from self-employment subject to tax under section 1401.
(e) Definition of ``passive activity''--(1) In general. Except as
otherwise provided in this paragraph (e), an activity is a passive
activity of the taxpayer for a taxable year if and only if the
activity--
[[Page 404]]
(i) Is a trade or business activity (within the meaning of paragraph
(e)(2) of this section) in which the taxpayer does not materially
participate for such taxable year; or
(ii) Is a rental activity (within the meaning of paragraph (e)(3) of
this section), without regard to whether or to what extent the taxpayer
participates in such activity.
(2) Trade or business activity. [Reserved]. See Sec. 1.469-1(e)(2)
for rules relating to this paragraph.
(3) Rental activity--(i) In general. Except as otherwise provided in
this paragraph (e)(3), an activity is a rental activity for a taxable
year if--
(A) During such taxable year, tangible property held in connection
with the activity is used by customers or held for use by customers; and
(B) The gross income attributable to the conduct of the activity
during such taxable year represents (or, in the case of an activity in
which property is held for use by customers, the expected gross income
from the conduct of the activity will represent) amounts paid or to be
paid principally for the use of such tangible property (without regard
to whether the use of the property by customers is pursuant to a lease
or pursuant to a service contract or other arrangement that is not
denominated a lease).
(ii) Exceptions. For purposes of this paragraph (e)(3), an activity
involving the use of tangible property is not a rental activity for a
taxable year if for such taxable year--
(A) The average period of customer use for such property is seven
days or less;
(B) The average period of customer use for such property is 30 days
or less, and significant personal services (within the meaning of
paragraph (e)(3)(iv) of this section) are provided by or on behalf of
the owner of the property in connection with making the property
available for use by customers;
(C) Extraordinary personal services (within the meaning of paragraph
(e)(3)(v) of this section) are provided by or on behalf of the owner of
the property in connection with making such property available for use
by customers (without regard to the average period of customer use);
(D) The rental of such property is treated as incidental to a
nonrental activity of the taxpayer under paragraph (e)(3)(vi) of this
section;
(E) The taxpayer customarily makes the property available during
defined business hours for nonexclusive use by various customers; or
(F) The provision of the property for use in an activity conducted
by a partnership, S corporation, or joint venture in which the taxpayer
owns an interest is not a rental activity under paragraph (e)(3)(vii) of
this section.
(iii) Average period of customer use. [Reserved]. See Sec. 1.469-
1(e)(3)(iii) for rules relating to this paragraph.
(iv) Significant personal services--(A) In general. For purposes of
paragraph (e)(3)(ii)(B) of this section, personal services include only
services performed by individuals, and do not include excluded services
(within the meaning of paragraph (e)(3)(iv)(B) of this section). In
determining whether personal services provided in connection with making
property available for use by customers are significant, all of the
relevant facts and circumstances shall be taken into account. Relevant
facts and circumstances include the frequency with which such services
are provided, the type and amount of labor required to perform such
services, and the value of such services relative to the amount charged
for the use of the property.
(B) Excluded services. For purposes of paragraph (e)(3)(iv)(A) of
this section, the term ``excluded services'' means, with respect to any
property made available for use by customers--
(1) Services necessary to permit the lawful use of the property;
(2) Services performed in connection with the construction of
improvements to the property, or in connection with the performance of
repairs that extend the property's useful life for a period
substantially longer than the average period for which such property is
used by customers; and
(3) Services, provided in connection with the use of any improved
real property, that are similar to those commonly provided in connection
with long-term rentals of high-grade commercial or residential real
property (e.g., cleaning and maintenance of
[[Page 405]]
common areas, routine repairs, trash collection, elevator service, and
security at entrances or perimeters).
(v) Extraordinary personal services. For purposes of paragraph
(e)(3)(ii)(C) of this section, extraordinary personal services are
provided in connection with making property available for use by
customers only if the services provided in connection with the use of
the property are performed by individuals, and the use by customers of
the property is incidental to their receipt of such services. For
example, the use by patients of a hospital's boarding facilities
generally is incidental to their receipt of the personal services
provided by the hospital's medical and nursing staff. Similarly, the use
by students of a boarding school's dormitories generally is incidental
to their receipt of the personal services provided by the school's
teaching staff.
(vi) Rental of property incidental to a nonrental activity of the
taxpayer--(A) In general. For purposes of paragraph (e)(3)(ii)(D) of
this section, the rental of property shall be treated as incidental to a
nonrental activity of the taxpayer only to the extent provided in this
paragraph (e)(3)(vi).
(B) Property held for investment. The rental of property during a
taxable year shall be treated as incidental to an activity of holding
such property for investment if and only if--
(1) The principal purpose for holding the property during such
taxable year is to realize gain from the appreciation of the property
(without regard to whether it is expected that such gain will be
realized from the sale or exchange of the property in its current state
of development); and
(2) The gross rental income from the property for such taxable year
is less than two percent of the lesser of--
(i) The unadjusted basis of such property; and
(ii) The fair market value of such property.
(C) Property used in a trade or business. The rental of property
during a taxable year shall be treated as incidental to a trade or
business activity (within the meaning of paragraph (e)(2) of this
section) if and only if--
(1) The taxpayer owns an interest in such trade or business activity
during the taxable year;
(2) The property was predominantly used in such trade or business
activity during the taxable year or during at least two of the five
taxable years that immediately precede the taxable year; and
(3) The gross rental income from such property for the taxable year
is less than two percent of the lesser of--
(i) The unadjusted basis of such property; and
(ii) The fair market value of such property.
(D) Lodging for convenience of employer. [Reserved]. See Sec.
1.469-1(e)(3)(vi)(D) for rules relating to this paragraph.
(E) Unadjusted basis. [Reserved]. See Sec. 1.469-1(e)(3)(vi)(E) for
rules relating to this paragraph.
(vii) Property made available for use in a nonrental activity
conducted by a partnership, S corporation, or joint venture in which the
taxpayer owns an interest. If the taxpayer owns an interest in a
partnership, S corporation, or joint venture conducting an activity
other than a rental activity, and the taxpayer provides property for use
in the activity in the taxpayer's capacity as an owner of an interest in
such partnership, S corporation, or joint venture, the provision of such
property is not a rental activity. Thus, if a partner contributes the
use of property to a partnership, none of the partner's distributive
share of partnership income is income from a rental activity unless the
partnership is engaged in a rental activity. In addition, a partner's
gross income attributable to a payment described in section 707(c) is
not income from a rental activity under any circumstances (see Sec.
1.469-2T (e)(2)). The determination of whether property used in an
activity is provided by the taxpayer in the taxpayer's capacity as an
owner of an interest in a partnership, S corporation, or joint venture
shall be made on the basis of all of the facts and circumstances.
(viii) Examples. The following examples illustrate the application
of this paragraph (e)(3):
Example 1. The taxpayer is engaged in an activity of leasing
photocopying equipment.
[[Page 406]]
The average period of customer use for the equipment exceeds 30 days.
Pursuant to the lease agreements, skilled technicians employed by the
taxpayer maintain the equipment and service malfunctioning equipment for
no additional charge. Service calls occur frequently (three times per
week on average) and require substantial labor. The value of the
maintenance and repair services (measured by the cost to the taxpayer of
employees performing these services) exceeds 50 percent of the amount
charged for the use of the equipment. Under these facts, services
performed by individuals are provided in connection with the use of the
photocopying equipment, but the customers' use of the photocopying
equipment is not incidental to their receipt of the services. Therefore,
extraordinary personal services (within the meaning of paragraph
(e)(3)(v) of this section) are not provided in connection with making
the photocopying equipment available for use by customers, and the
activity is a rental activity.
Example 2. The facts are the same as in Example 1, except that the
average period of customer use for the photocopying equipment exceeds
seven days but does not exceed 30 days. Under these facts, significant
personal services (within the meaning of paragraph (e)(3)(iv) of this
section) are provided in connection with making the photocopying
equipment available for use by customers and, under paragraph
(e)(3)(ii)(B) of this section, the activity is not a rental activity.
Example 3. The taxpayer is engaged in an activity of transporting
goods for customers. In conducting the activity, the taxpayer provides
tractor-trailers to transport goods for customers pursuant to
arrangements under which the tractor-trailers are selected by the
taxpayer, may be replaced at the sole option of the taxpayer, and are
operated and maintained by drivers and mechanics employed by the
taxpayer. The average period of customer use for the tractor-trailers
exceeds 30 days. Under these facts, the use of tractor-trailers by the
taxpayer's customers is incidental to their receipt of personal services
provided by the taxpayer. Accordingly, the services performed in the
activity are extraordinary personal services (within the meaning of
paragraph (e)(3)(v) of this section) and, under paragraph (e)(3)(ii)(C)
of this section, the activity is not a rental activity.
Example 4. The taxpayer is engaged in an activity of owning and
operating a residential apartment hotel. For the taxable year, the
average period of customer use for apartments exceeds seven days but
does not exceed 30 days. In addition to cleaning public entrances,
exists, stairways, and lobbies, and collecting and removing trash, the
taxpayer provides a daily maid and linen service at no additional
charge. All of the services other than maid and linen service are
excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this
section), because such services are similar to those commonly provided
in connection with long-term rentals of high-grade residential real
property. The value of the maid and linen services (measured by the cost
to the taxpayer of employees performing such services) is less than 10
percent of the amount charged to tenants for occupancy of apartments.
Under these facts, neither significant personal services (within the
meaning of paragraph (e)(3)(iv) of this section) nor extraordinary
personal services (within the meaning of paragraph (e)(3)(v) of this
section) are provided in connection with making apartments available for
use by customers. Accordingly, the activity is a rental activity.
Example 5. The taxpayer owns 1,000 acres of unimproved land with a
fair market value of $350,000 and an unadjusted basis of $210,000. The
taxpayer holds the land for the principal purpose of realizing gain from
appreciation. In order to defray the cost of carrying the land, the
taxpayer leases the land to a rancher, who uses the land to graze cattle
and pays rent of $4,000 per year. Thus, the gross rental income from the
land is less than two percent of the lesser of the fair market value and
the unadjusted basis of the land (.02 x $210,000 = $4,200). Accordingly,
under paragraph (e)(3)(ii)(D) of this section, the rental of the land is
not a rental activity because the rental is treated under paragraph
(e)(3)(vi)(B) of this section as incidental to an activity of holding
the property for investment.
Example 6. (i) A calendar year taxpayer owns an interest in a
farming activity which is a trade or business activity (within the
meaning of paragraph (e)(2) of this section) and owns farmland which was
used in the farming activity in 1985 and 1986. The fair market value of
the farmland is $350,000 and its unadjusted basis is $210,000. In 1987,
1988, and 1989, the taxpayer continues to own an interest in the farming
activity but does not use the land in the activity. In 1987, the
taxpayer leases the land for $4,000 to a rancher, who uses the land to
graze cattle. In 1988, the taxpayer leases the land for $10,000 to a
film production company, which uses the land to film scenes for a movie.
In 1989, the taxpayer again leases the land for $4,000 to the rancher.
(ii) For 1987 and 1989, the taxpayer owns an interest in a trade or
business activity, and the farmland which the taxpayer leases to the
rancher was used in such activity for two out of the five immediately
preceding taxable years. In addition, the gross rental income from the
land ($4,000) is less than two percent of the lesser of the fair market
value and the unadjusted basis of the land (.02 x $210,000 = $4,200).
Accordingly, the taxpayer's rental of the land is treated under
paragraph (e)(3)(vi)(C) of this section as incidental to
[[Page 407]]
the taxpayer's farming activity, and is not a rental activity.
(iii) Because the taxpayer's gross rental income from the land for
1988 ($10,000) is not less than two percent of the lesser of the fair
market value and the unadjusted basis of the land, the requirement of
paragraph (e)(3)(vi)(C)(3) of this section is not met. Therefore, the
taxpayer's rental of the land in 1988 is not treated as incidental to
the taxpayer's farming activity and is a rental activity.
Example 7. (i) In 1988, the taxpayer acquires vacant land for the
purpose of constructing a shopping mall. Before commencing construction,
the taxpayer leases the land under a one-year lease to an automobile
dealer, who uses the land to park cars held in its inventory. The
taxpayer commences construction of the shopping mall in 1989.
(ii) The taxpayer acquired the land for the principal purpose of
constructing the shopping mall, not for the principal purpose of
realizing gain from the appreciation of the property. Therefore, the
rental of the property in 1988 is not treated under paragraph
(e)(3)(vi)(B) of this section as incidental to an activity of holding
the property for investment.
(iii) The land has not been used in any taxable year in any trade or
business of the taxpayer. Therefore, the rental of the property in 1988
is not treated under paragraph (e)(3)(vi)(C) of this section as
incidental to a trade or business activity.
(iv) Since the rental of the land in 1988 is not treated under
paragraph (e)(3)(vi) of this section as incidental to a nonrental
activity of the taxpayer, the rental of the land in 1988 is a rental
activity. See Sec. 1.469-2T(f)(3) for a special rule relating to the
treatment of gross income from the rental of nondepreciable property.
Example 8. The taxpayer makes farmland available to a tenant farmer
pursuant to an arrangement designated a ``crop-share lease.'' Under the
arrangement, the tenant is required to use the tenant's best efforts to
farm the land and produce marketable crops. The taxpayer is obligated to
pay 50 percent of the costs incurred in the activity (without regard to
whether any crops are successfully produced or marketed), and is
entitled to 50 percent of the crops produced (or 50 percent of the
proceeds from marketing the crops). For purposes of paragraph
(e)(3)(vii) of this section, the taxpayer is treated as providing the
farmland for use in a farming activity conducted by a joint venture in
the taxpayer's capacity as an owner of an interest in the joint venture.
Accordingly, under paragraph (e)(3)(ii)(F) of this section, the taxpayer
is not engaged in a rental activity, without regard to whether the
taxpayer performs any services in the farming activity.
Example 9. The taxpayer owns a taxicab which the taxpayer operates
during the day and leases to another driver for use at night under a
one-year lease. Under the terms of the lease, the other driver is
charged a fixed rental for use of the taxicab. Assume that, under the
rules to be contained in Sec. 1.469-4T, the taxpayer is engaged in two
separate activities, an activity of operating the taxicab and an
activity of making the taxicab available for use by the other driver.
Under these facts, the period for which the other driver uses the
taxicab exceeds 30 days, and the taxpayer does not provide extraordinary
personal services in connection with making the taxicab available to the
other driver. Accordingly, the lease of the taxicab is a rental
activity.
Example 10. The taxpayer operates a golf course. Some customers of
the golf course pay green fees upon each use of the golf course, while
other customers purchase weekly, monthly, or annual passes. The golf
course is open to all customers from sunrise to sunset every day of the
year except certain holidays and days on which the taxpayer determines
that the course is too wet for play. The taxpayer thus makes the golf
course available during prescribed hours for nonexclusive use by various
customers. Accordingly, under paragraph (e)(3)(ii)(E) of this section,
the taxpayer is not engaged in a rental activity, without regard to the
average period of customer use for the golf course.
(4) Special rule for oil and gas working interests--(i) In general.
Except as otherwise provided in paragraph (e)(4)(ii) of this section, an
interest in an oil or gas well drilled or operated pursuant to a working
interest (within the meaning of paragraph (e)(4)(iv) of this section) of
a taxpayer is not an interest in a passive activity for the taxpayer's
taxable year (without regard to whether the taxpayer materially
participates in such activity) if at any time during such taxable year
the taxpayer holds such working interest either--
(A) Directly; or
(B) Through an entity that does not limit the liability of the
taxpayer with respect to the drilling or operation of such well pursuant
to such working interest.
(ii) Exception for deductions attributable to a period during which
liability is limited--(A) In general. If paragraph (e)(4)(i) of this
section applies for a taxable year to the taxpayer's interest in an oil
or gas well that would, but for the application of paragraph (e)(4)(i)
of this section, by an interest in a passive activity for the taxable
year, and the
[[Page 408]]
taxpayer has a net loss (within the meaning of paragraph
(e)(4)(ii)(C)(3) of this section) from the well for the taxable year--
(1) The taxpayer's disqualified deductions (within the meaning of
paragraph (e)(4)(ii)(C)(2) of this section) from such oil or gas well
for such year shall be treated as passive activity deductions for such
year (within the meaning of Sec. 1.469-2T(d)); and
(2) A ratable portion (within the meaning of paragraph
(e)(4)(ii)(C)(4) of this section) of the taxpayer's gross income from
such oil or gas well for such year shall be treated as passive activity
gross income for such year (within the meaning of Sec. 1.469-2T(c)).
(B) Coordination with rules governing the identification of
disallowed passive activity deductions. If gross income and deductions
from an activity for a taxable year are treated as passive activity
gross income and passive activity deductions under paragraph
(e)(4)(ii)(A) of this section, such activity shall be treated as a
passive activity for such year for purposes of applying paragraph (f)
(2) and (4) of this section.
(C) Meaning of certain terms. For purposes of this paragraph
(e)(4)(ii), the following terms shall have the meanings set forth below:
(1) Allocable deductions. The deductions allocable to a taxable year
are any deductions that arise in such year (within the meaning of Sec.
1.469-2T (d)(8)) and any deductions that are treated as deductions for
such year under paragraph (f)(4) of this section.
(2) Disqualified deductions. The taxpayer's ``disqualified
deductions'' from an oil or gas well for a taxable year are the
taxpayer's deductions--
(i) That are attributable to such well and allocable to the taxable
year; and
(ii) With respect to which economic performance (within the meaning
of section 461(h), without regard to section 461 (h)(3) or (i)(2))
occurs at a time during which the taxpayer's only interest in the
working interest is held through an entity that limits the taxpayer's
liability with respect to the drilling or operation of such well.
(3) Net loss. The ``net loss'' of a taxpayer from an oil or gas well
for a taxable year equals the amount by which the taxpayer's deductions
that are attributable to such oil or gas well and allocable to such year
exceeds the gross income of the taxpayer from such well for such year.
(4) Ratable portion. The ``ratable portion'' of the taxpayer's gross
income from an oil or gas well for a taxable year equals the total
amount of such gross income multiplied by the fraction obtained by
dividing--
(i) The disqualified deductions from such oil or gas well for the
taxable year; by
(ii) The total amount of the deductions that are attributable to
such oil or gas well and allocable to the taxable year.
(iii) Examples. The following examples illustrate the application of
paragraphs (e)(4) (i) and (ii) of this section:
Example 1. (i) A, a calendar year individual, acquires on January 1,
1987, a general partnership interest in P, a calendar year partnership
that holds a working interest in an oil or gas property. Pursuant to the
partnership agreement, A is entitled to convert the general partnership
interest into a limited partnership interest at any time. On December 1,
1987, pursuant to a contract with D, an independent drilling contractor,
P commences drilling a single well pursuant to the working interest.
Under the drilling contract, P pays D for the drilling only as the work
is performed. All drilling costs are deducted by P in the year in which
they are paid. At the end of 1987, A converts the general partnership
interest into a limited partnership interest, effective immediately. The
drilling of the well is completed on February 28, 1988. A's interest in
the well would but for this paragraph (e)(4) be an interest in a passive
activity.
(ii) Throughout 1987, A holds the working interest through an entity
that does not limit A's liability with respect to the drilling of the
well pursuant to the working interest. In 1988, however, A holds the
working interest through an entity that limits A's liability with
respect to the drilling and operation of the well throughout such year.
Accordingly, under paragraph (e)(4)(i) of this section, A's interest in
P's well is not an interest in a passive activity for 1987 but is an
interest in a passive activity for 1988. Moreover, since economic
performance occurs in 1987 with respect to all items of deduction for
drilling costs that are allocable to 1987, A has no disqualified
deductions for 1987.
Example 2. The facts are the same as in Example 1, except that all
costs of drilling under the contract with D (including costs of drilling
performed after 1987) are paid before the end of 1987 and A has a net
loss for 1987. In addition, A has $15,000 of total deductions
[[Page 409]]
that are attributable to the well and allocable to 1987, but economic
performance (as that term is used in paragraph (e)(4)(ii)(C)(2)(ii) of
this section) does not occur with respect to $5,000 of those deductions
until 1988. Under paragraph (e)(4)(ii) of this section, the $5,000 of
deductions with respect to which economic performance occurs in 1988 are
disqualified deductions and are treated as passive activity deductions
for 1987. In addition, one-third ($5,000/$15,000) of A's gross income
from the well for 1987 is treated as passive activity gross income.
(iv) Definition of ``working interest.'' [Reserved]. See Sec.
1.469-1(e)(4)(iv) for rules relating to this paragraph.
(v) Entities that limit liability--(A) General rule. For purposes of
paragraph (e)(4)(i)(B) of this section, an entity limits the liability
of the taxpayer with respect to the drilling or operation of a well
pursuant to a working interest held through such entity if the
taxpayer's interest in the entity is in the form of--
(1) A limited partnership interest in a partnership in which the
taxpayer is not a general partner;
(2) Stock in a corporation; or
(3) An interest in any entity (other than a limited partnership or
corporation) that, under applicable State law, limits the potential
liability of a holder of such an interest for all obligations of the
entity to a determinable fixed amount (for example, the sum of the
taxpayer's capital contributions).
(B) Other limitations disregarded. For purposes of this paragraph
(e)(4), protection against loss through any of the following is not
taken into account in determining whether a taxpayer holds a working
interest through an entity that limits the taxpayer's liability:
(1) An indemnification agreement;
(2) A stop loss arrangement;
(3) Insurance;
(4) Any similar arrangement; or
(5) Any combination of the foregoing.
(C) Examples. The following examples illustrate the application of
this paragraph (e)(4)(v):
Example 1. A owns a 20 percent interest as a general partner in the
capital and profits of P, a partnership which owns oil or gas working
interests. The other partners of P agree to indemnify A against
liability in excess of A's capital contribution for any of P's costs and
expenses with respect to P's working interests. As a general partner,
however, A is jointly and severally liable for all of P's liabilities
and, under paragraph (e)(4)(v)(B)(1) of this section, the
indemnification agreement is not taken into account in determining
whether A holds the working interests through an entity that limits A's
liability. Accordingly, the partnership does not limit A's liability
with respect to the drilling or operation of wells pursuant to the
working interests.
Example 2. B owns a 10 percent interest in X, an entity (other than
a limited partnership or corporation) created under applicable State law
to hold working interests in oil or gas properties. Under applicable
State law, B is liable without limitation for 10 percent of X's costs
and expenses with respect to X's working interests but is not liable for
the remaining 90 percent of such costs and expenses. Since B's liability
for the obligations of X is not limited to a determinable fixed amount
(within the meaning of paragraph (e)(4)(v)(A)(3) of this section), the
entity does not limit B's liability with respect to the drilling or
operation of wells pursuant to the working interests.
Example 3. C is both a general partner and a limited partner in a
partnership that owns a working interest in oil or gas property. Because
C owns an interest as a general partner in each well drilled pursuant to
the working interest, C's entire interest in each well drilled pursuant
to the working interest is treated under paragraph (e)(4)(i) of this
section as an interest in an activity that is not a passive activity
(without regard to whether C materially participates in such activity).
(vi) Cross reference to special rule for income from certain oil or
gas properties. A special rule relating to the treatment of income from
certain interests in oil or gas properties is contained in Sec. 1.469-
2T(c)(6).
(5) Rental of dwelling unit. [Reserved]. See Sec. 1.469-
2(d)(2)(xii) for rules relating to this paragraph.
(6) Activity of trading personal property--(i) In general. An
activity of trading personal property for the account of owners of
interests in the activity is not a passive activity (without regard to
whether such activity is a trade or business activity (within the
meaning of paragraph (e)(2) of this section)).
(ii) Personal property. For purposes of this paragraph (e)(6), the
term ``personal property'' means personal property (within the meaning
of section 1092(d), without regard to paragraph (3) thereof).
(iii) Example. The following example illustrates the application of
this paragraph (e)(6):
[[Page 410]]
Example. A partnership is a trader of stocks, bonds, and other
securities (within the meaning of section 1236(c)). The capital employed
by the partnership in the trading activity consists of amounts
contributed by the partners in exchange for their partnership interests,
and funds borrowed by the partnership. The partnership derives gross
income from the activity in the form of interest, dividends, and capital
gains. Under these facts, the partnership is treated as conducting an
activity of trading personal property for the account of its partners.
Accordingly, under this paragraph (e)(6), the activity is not a passive
activity.
(f) Treatment of disallowed passive activity losses and credits--(1)
Scope of this paragraph. The rules in this paragraph (f)--
(i) Identify the passive activity deductions that are disallowed for
any taxable year in which all or a portion of the taxpayer's passive
activity loss is disallowed under paragraph (a)(1)(i) of this section;
(ii) Identify the credits from passive activities that are
disallowed for any taxable year in which all or a portion of the
taxpayer's passive activity credit is disallowed under paragraph
(a)(1)(i) of this section; and
(iii) Provide for the carryover of disallowed deductions and
credits.
(2) Identification of disallowed passive activity deductions--(i)
Allocation of disallowed passive activity loss among activities--(A)
General rule. If all or any portion of the taxpayer's passive activity
loss is disallowed for the taxable year under paragraph (a)(1)(i) of
this section, a ratable portion of the loss (if any) from each passive
activity of the taxpayer is disallowed. For purposes of the preceding
sentence, the ratable portion of a loss from an activity is computed by
multiplying the passive activity loss that is disallowed for the taxable
year by the fraction obtained by dividing--
(1) The loss from the activity for the taxable year; by
(2) The sum of the losses for the taxable year from all activities
having losses for such year.
(B) Loss from an activity. For purposes of this paragraph (f)(2)(i),
the term ``loss from an activity'' means--
(1) The amount by which the passive activity deductions from the
activity for the taxable year (within the meaning of Sec. 1.469-2T(d))
exceed the passive activity gross income from the activity for the
taxable year (within the meaning of Sec. 1.469-2T(c)); reduced by
(2) Any part of such amount that is allowed under section 469(i) and
the rules to be contained in Sec. 1.469-9T (relating to the $25,000
allowance for certain rental real estate activities).
(C) Significant participation passive activities. If the taxpayer's
passive activity gross income from significant participation passive
activities (within the meaning of Sec. 1.469-2T(f)(2)(ii)) for the
taxable year (determined without regard to Sec. 1.469-2T(f)(2) through
(4)) exceeds the taxpayer's passive activity deductions from such
activities for the taxable year, such activities shall be treated,
solely for purposes of applying this paragraph (f)(2)(i) for the taxable
year, as a single activity that does not have a loss for such taxable
year.
(D) Examples. The following examples illustrate the application of
this paragraph (f)(2)(i):
Example 1. An individual holds interests in three passive
activities, A, B, and C. The gross income and deductions from these
activities for the taxable year are as follows:
----------------------------------------------------------------------------------------------------------------
A B C Total
----------------------------------------------------------------------------------------------------------------
Gross income................................................ $7,000 $4,000 $12,000 $23,000
Deductions.................................................. (16,000) (20,000) (8,000) (44,000)
---------------------------------------------------
Net income (loss)....................................... ($9,000) ($16,000) $4,000 ($21,000)
----------------------------------------------------------------------------------------------------------------
The taxpayer's $21,000 passive activity loss for the taxable year is
disallowed under paragraph (a)(1)(i) of this section. Therefore, a
ratable portion of the losses from activities A and B is disallowed. The
disallowed portion of each loss is determined as follows:
A: $21,000 x $9,000/$25,000................................... $7,560
B: $21,000 x $16,000/$25,000.................................. $13,440
---------
Total..................................................... $21,000
Example 2. An individual holds interests in four passive activities,
A, B, C, and D. The results of operations of these activities for the
taxable year are as follows:
[[Page 411]]
----------------------------------------------------------------------------------------------------------------
A B C D Total
----------------------------------------------------------------------------------------------------------------
Gross income................................... 15,000 5,000 10,000 10,000 40,000
Deductions..................................... (5,000) (10,000) (20,000) (8,000) (43,000)
Net income (loss).......................... 10,000 (5,000) (10,000) 2,000 (3,000)
----------------------------------------------------------------------------------------------------------------
Activities A and B are significant participation passive activities
(within the meaning of Sec. 1.469-2T(f)(2)(ii)). The gross income from
these activities for the taxable year ($20,000) exceeds the passive
activity deductions from those activities for the taxable year ($15,000)
by $5,000 and, under Sec. 1.469-2T(f)(2), $5,000 of gross income from
those activities is treated as not from a passive activity. Therefore,
solely for purposes of applying this paragraph (f)(2)(i) for the taxable
year, activities A and B are treated as a single activity that does not
have a loss for the taxable year. Under Sec. 1.469-2T(b), the
taxpayer's passive activity loss for the taxable year is $8,000 ($43,000
of passive activity deductions minus $35,000 of passive activity gross
income). The results of treating activities A and B as a single activity
that does not have a loss for the taxable year is that none of the
$8,000 passive activity loss is allocated under this paragraph (f)(2)(i)
to activity B for the taxable year, even though the taxpayer incurred a
loss in that activity for the taxable year.
(ii) Allocation within loss activities--(A) In general. If all or
any portion of a taxpayer's loss from an activity is disallowed under
paragraph (f)(2)(i) of this section for the taxable year, a ratable
portion of each passive activity deduction (other than an excluded
deduction (within the meaning of paragraph (f)(2)(ii)(B) of this
section)) of the taxpayer from such activity is disallowed. For purposes
of the preceding sentence, the ratable portion of a passive activity
deduction of a taxpayer is the amount of the disallowed portion of the
taxpayer's loss from the activity (within the meaning of paragraph
(f)(2)(i)(B) of this section) for the taxable year multiplied by the
fraction obtained by dividing--
(1) The amount of such deduction; by
(2) The sum of all passive activity deductions (other than excluded
deductions (within the meaning of paragraph (f)(2)(ii)(B) of this
section)) of the taxpayer from such activity from the taxable year.
(B) Excluded deductions. The term ``excluded deduction'' means any
passive activity deduction of a taxpayer that is taken into account in
computing the taxpayer's net income from an item of property for a
taxable year in which an amount of the taxpayer's gross income from such
item of property is treated as not from a passive activity under Sec.
1.469-2T(c)(6) or Sec. 1.469-2T(f) (5), (6), or (7).
(iii) Separately identified deductions. In identifying the
deductions from an activity that are disallowed under this paragraph
(f)(2), the taxpayer need not account separately for a deduction unless
such deduction may, if separately taken into account, result in an
income tax liability for any taxable year different from that which
would result were such deduction not taken into account separately. For
related rules applicable to partnerships and S corporations, see Sec.
1.702-1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Deductions
that must be accounted for separately include (but are not limited to)
deductions that--
(A) Arise in a rental real estate activity (within the meaning of
section 469(i) and the rules to be contained in Sec. 1.469-9T) in
taxable years in which the taxpayer actively participates (within the
meaning of section 469(i) and the rules to be contained in Sec. 1.469-
9T) in such activity;
(B) Arise in a rental real estate activity (within the meaning of
section 469(i) and the rules to be contained in Sec. 1.469-9T) in
taxable years in which the taxpayer does not actively participate
(within the meaning of section 469(i) and the rules to be contained in
Sec. 1.469-9T) in such activity; or
(C) Are taken into account under section 1211 (relating to the
limitation on capital losses) or section 1231 (relating to property used
in a trade or business and involuntary conversions).
(3) Identification of disallowed credits from passive activities--
(i) General rule. If all or any portion of the taxpayer's passive
activity credit is disallowed for the taxable year under paragraph
(a)(1)(ii) of this section, a ratable portion of each credit from each
passive activity of the taxpayer is disallowed.
[[Page 412]]
For purposes of the preceding sentence, the ratable portion of a credit
of a taxpayer is computed by multiplying the portion of the taxpayer's
passive activity credit that is disallowed for the taxable year by the
fraction obtained by dividing--
(A) The amount of the credit; by
(B) The sum of all of the taxpayer's credits from passive activities
for the taxable year.
(ii) Coordination rule. For purposes of paragraph (f)(3)(i) of this
section, the credits from a passive activity do not include any credit
or portion of a credit that--
(A) Is allowed for the taxable year under section 469(i) and the
rules to be contained in Sec. 1.469-9T (relating to the $25,000
allowance for certain rental real estate activities); or
(B) Increases the basis of property during the taxable year under
section 469(j)(9) and the rules to be contained in Sec. 1.469-6T
(relating to the election to increase the basis of certain property by
disallowed credits).
(iii) Separately identified credits. In identifying the credits from
an activity that are disallowed under this paragraph (f)(3), the
taxpayer need not account separately for any credit unless such credit
may, if separately taken into account, result in an income tax liability
for any taxable year different from that which would result were such
credit not taken into account separately. For related rules applicable
to partnerships and S corporations, see Sec. 1.702-1(a)(8)(ii) and
section 1366(a)(1)(A), respectively. Credits that must be accounted for
separately include (but are not limited to)--
(A) Credits (other than the low-income housing and rehabilitation
investment credits) from a rental real estate activity (within the
meaning of section 469(i) and the rules to be contained in Sec. 1.469-
9T) that arise in a taxable year in which the taxpayer actively
participates (within the meaning of section 469(i) and the rules to be
contained in Sec. 1.469-9T) in such activity;
(B) Credits (other than the low-income housing and rehabilitation
investment credits) from a rental real estate activity (within the
meaning of section 469(i) and the rules to be contained in Sec. 1.469-
9T) that arise in a taxable year in which the taxpayer does not actively
participate (within the meaning of section 469(i) and the rules to be
contained in Sec. 1.469-9T) in such activity;
(C) Low-income housing and rehabilitation investment credits from a
rental real estate activity (within the meaning of section 469(i) and
the rules to be contained in Sec. 1.469-9T); and
(D) Any credit that is subject to the limitations of sections 26(a),
28(d)(2), 29(b)(5), or 38(c) in a manner that differs from the manner in
which any other credit is subject to such limitations.
(4) Carryover of disallowed deductions and credits. [Reserved]. See
Sec. 1.469-1(f)(4) for rules relating to this paragraph.
(g) Application of these rules to C corporations--(1) In general.
Except as otherwise provided in the rules to be contained in paragraph
(k) of this section, section 469 and the regulations thereunder do not
apply to any corporation that is not a personal service corporation or a
closely held corporation for the taxable year. See paragraphs (g) (4)
and (5) of this section for special rules for computing the passive
activity loss and passive activity credit, respectively, of a closely
held corporation.
(2) Definitions. For purposes of section 469 and the regulations
thereunder--
(i) The term personal service corporation means a C corporation that
is a personal service corporation for the taxable year (within the
meaning of Sec. 1.441-3(c)); and
(ii) The term closely held corporation means a C corporation that
meets the stock ownership requirements of section 542(a)(2) (taking into
account the modifications in section 465(a)(3)) for the taxable year and
is not a personal service corporation for such year.
(3) Participation of corporations--(i) Material participation. For
purposes of section 469 and the regulations thereunder, a corporation
described in paragraph (g)(2) of this section shall be treated as
materially participating in an activity for a taxable year if and only
if--
(A) One or more individuals, each of whom is treated under paragraph
(g)(3)(iii) of this section as materially participating in such activity
for the
[[Page 413]]
taxable year, directly or indirectly hold (in the aggregate) more than
50 percent (by value) of the outstanding stock of such corporation; or
(B) In the case of a closely held corporation (within the meaning of
paragraph (g)(2)(ii) of this section), the requirements of section
465(c)(7)(C) (without regard to clause (iv) thereof and taking into
account section 465(c)(7)(D)) are met with respect to such activity.
(ii) Significant participation. For purposes of Sec. 1.469-
2T(f)(2), an activity of a corporation described in paragraph (g)(2) of
this section shall be treated as a significant participation passive
activity for a taxable year if and only if--
(A) The corporation is not treated as materially participating in
such activity for the taxable year; and
(B) One or more individuals, each of whom is treated under paragraph
(g)(3)(iii) of this section as significantly participating in such
activity, directly or indirectly hold (in the aggregate) more than 50
percent (by value) of the outstanding stock of such corporation.
(iii) Participation of individual. Whether an individual is treated
for purposes of this paragraph (g)(3) as materially participating or
significantly participating in an activity of a corporation shall be
determined under the rules of Sec. 1.469-5T, except that in applying
such rules--
(A) All activities of the corporation shall be treated as activities
in which the individual holds an interest in determining whether the
individual participates (within the meaning of Sec. 1.469-5T(f)) in an
activity of the corporation; and
(B) The individual's participation in all activities other than
activities of the corporation shall be disregarded in determining
whether the individual's participation in an activity of the corporation
is treated as material participation under Sec. 1.469-5T(a)(4)
(relating to material participation in significant participation
activities).
(4) Modified computation of passive activity loss in the case of
closely held corporations--(i) In general. A closely held corporation's
passive activity loss for the taxable year is the amount, if any, by
which the corporation's passive activity deductions for the taxable year
(within the meaning of Sec. 1.469-2T(d)) exceed the sum of--
(A) The corporation's passive activity gross income for the taxable
year (within the meaning of Sec. 1.469-2T(c)); and
(B) The corporation's net active income for the taxable year.
(ii) Net active income. For purposes of this paragraph (g)(4), a
corporation's net active income for the taxable year is such
corporation's taxable income for the taxable year, determined without
regard to the following items for the year:
(A) Passive activity gross income;
(B) Passive activity deductions;
(C) [Reserved]. See Sec. 1.469-1(g)(4)(ii)(C) for rules relating to
this paragraph.
(D) Gross income that is treated under Sec. 1.469-2T(c)(6)
(relating to gross income from certain oil or gas properties) as not
from a passive activity;
(E) Gross income and deductions from any trade or business activity
(within the meaning of paragraph (e)(2) of this section) that is
described in paragraph (e)(6) of this section (relating to certain
activities of trading personal property) but only if the corporation did
not materially participate in such activity for the taxable year;
(F) Deductions described in Sec. 1.469-2T(d)(2)(i), (ii), and (iv)
(relating to certain deductions attributable to portfolio income); and
(G) Interest expense allocated under Sec. 1.163-8T to a portfolio
expenditure (within the meaning of Sec. 1.163-8T(b)(6)).
(iii) Examples. The following examples illustrate the application of
this paragraph (g)(4):
Example 1. (i) For 1987, X, a closely held corporation, is engaged
in two activities, a trade or business activity in which X materially
participates for 1987 and a rental activity. X also holds portfolio
investments. For 1987, X has the following gross income and deductions:
Gross income:
Rents.................................................... $60,000
Gross income from business............................... 100,000
Portfolio income......................................... 35,000
------------
Total.................................................. $195,000
============
Deductions:
Rental deductions........................................ ($100,000)
Business deductions (80,000).............................
Interest expense allocable to portfolio expenditures (10,000)
under Sec. 1.163-8T...................................
[[Page 414]]
Deductions (other than interest expense) clearly and (5,000)
directly allocable to portfolio income..................
------------
Total.................................................. ($195,000)
============
(ii) The corporation's net active income for 1987 is $20,000,
computed as follows:
Gross income..................... ........... $195,000
Amounts not taken into account in
computing net active income:
Rents (see paragraph $60,000
(g)(4)(ii)(A) of this section)
Portfolio income (see paragraph $35,000
(g)(4)(ii)(C) of this section)
--------------
$95,000 ($95,000)
--------------------------
Gross income taken into account ........... $100,000 $100,000
in computing net active income..
=============
Deductions....................... ........... ($195,000)
Amounts not taken into account in
computing net active income:
Rental deductions (see ($100,000)
paragraph (g)(4)(ii)(B) of
this section).................
Interest expense allocated to ($10,000)
portfolio expenditures (see
paragraph (g)(4)(ii)(G) of
this section).................
Other deductions clearly and ($5,000)
directly allocable to portfolio
income (see paragraph
(g)(4)(ii)(F) of this section)..
-------------
($115,000) $115,000
-------------
Deductions taken into account in ........... ($80,000) ($80,000)
computing net active income.....
=============
Net active income................ ........... ........... $20,000
============
(iii) Under paragraph (g)(4)(i) of this section, X's passive
activity loss for 1987 is $20,000, the amount by which the passive
activity deductions for the taxable year ($100,000) exceed the sum of
(a) the passive activity gross income for the taxable year ($60,000) and
(b) the net active income for the taxable year ($20,000). Under
paragraph (f)(4) of this section, the $20,000 of deductions from X's
rental activity that are disallowed for 1987 are treated as deductions
from the rental activity for 1988. If computed without regard to the net
active income for the taxable year, X's passive activity loss would be
$40,000 ($100,000 of rental deductions minus $60,000 of rental income).
Thus, the effect of the rule in paragraph (g)(4)(i) of this section is
to reduce the corporation's passive activity loss for the taxable year
by the amount of the corporation's net active income for such year.
(iv) Under these facts, X's taxable income for 1987 is $20,000,
computed as follows:
Gross income.................................. ........... $195,000
Deductions:
Total deductions............................ ($195,000)
Passive activity loss....................... $20,000
--------------
Allowable deductions........................ ($175,000) ($175,000)
------------
Taxable income................................ ........... $20,000
============
Example 2. (i) The facts are the same as in Example 1, except that,
in 1988, X has a loss from the trade or business activity, and a net
operating loss (``NOL'') of $15,000 that is carried back under section
172(b) to 1987. Since NOL carrybacks are taken into account in computing
net active income, X's net active income for 1987 must be recomputed as
follows:
Net active income before NOL carryback..................... $20,000
NOL carryback.............................................. ($15,000)
------------
Net active income.......................................... $5,000
============
(ii) Under these facts, X's disallowed passive activity loss for
1987 is $35,000, the amount by which the passive activity deductions for
the taxable year ($100,000) exceed the sum of (a) the passive activity
gross income for the taxable year ($60,000) and (b) the net active
income for the taxable year ($5,000).
(iii) Under paragraph (f)(4) of this section, the $35,000 of
deductions from X's rental activity that are disallowed for 1987 are
treated as deductions from the rental activity for 1988. X's taxable
income for 1987 is $20,000, computed as follows:
Gross income.................................. ........... $195,000
Deductions:
Total deductions............................ ($210,000)
Passive activity loss....................... $35,000
Allowable deductions........................ ($175,000) ($175,000)
------------
Taxable income................................ ........... $20,000
============
Thus, taking the NOL carryback into account in computing net active
income for 1987 does not affect X's taxable income for 1987, but
increases the deductions treated under paragraph (f)(4) as deductions
from X's rental activity for 1988 and decreases X's NOL carryover to
years other than 1987.
(5) Allowance of passive activity credit of closely held
corporations to extent of
[[Page 415]]
net active income tax liability--(i) In general. Solely for purposes of
determining the amount disallowed under paragraph (a)(1)(ii) of this
section, a closely held corporation's passive activity credit for the
taxable year shall be reduced by such corporation's net active income
tax liability for such year.
(ii) Net active income tax liability. For purposes of paragraph
(g)(5)(i) of this section, a corporation's net active income tax
liability for a taxable year is the amount (if any) by which--
(A) The corporation's regular tax liability (within the meaning of
section 26(b)) for the taxable year, determined by reducing the
corporation's taxable income for such year by an amount equal to the
excess (if any) of the corporation's passive activity gross income for
such year over the corporation's passive activity deductions for such
year; exceeds
(B) The sum of--
(1) The corporation's regular tax liability for the taxable year,
determined by reducing the corporation's taxable income for such year by
an amount equal to the excess (if any) of the sum of the corporation's
net active income (within the meaning of paragraph (g)(4)(ii) of this
section) and passive activity gross income for such year over the
corporation's passive activity deductions for such year; and
(2) The corporation's credits (other than credits from passive
activities) that are allowable for the taxable year (without regard to
the limitations contained in sections 26(a), 28(d)(2), 29(b)(5), 38(c),
and 469).
(h) Special rules for affiliated group filing consolidated return.
(1)-(2) [Reserved]
(3) Disallowance of consolidated group's passive activity loss or
credit. A consolidated group's passive activity loss or passive activity
credit for the taxable year shall be disallowed to the extent provided
in paragraph (a) of this section. For purposes of the preceding
sentence, a consolidated group's passive activity loss and passive
activity credit shall be determined by taking into account the following
items of each member of such group:
(i) Passive activity gross income;
(ii) Passive activity deductions;
(iii) Net active income (in the case of a consolidated group treated
as a closely held corporation under paragraph (h)(4)(ii) of this
section); and
(iv) Credits from passive activities.
(4) [Reserved]. See Sec. 1.469-1(h)(4) for rules relating to this
paragraph.
(5) Modification of rules for identifying disallowed passive
activity deductions and credits--(i) Identification of disallowed
deductions. In applying paragraphs (f) (2) and (4) of this section to a
consolidated group for purposes of identifying the passive activity
deductions of such consolidated group and of each member of such
consolidated group that are disallowed for the taxable year and treated
as deductions from activities for the succeeding taxable year, the
following rules shall apply:
(A) A ratable portion (within the meaning of paragraph (h)(5)(ii) of
this section) of the passive activity loss of the consolidated group
that is disallowed for the taxable year shall be allocated to each
member of the group;
(B) Pararaph (f)(2) of this section shall then be applied to each
member of the group as if--
(1) Such member were a separate taxpayer; and
(2) The amount allocated to such member under paragraph (h)(5)(i)(A)
of this section were the amount of such member's passive activity loss
that is disallowed for the taxable year; and
(C) Paragraph (f)(4) of this section shall be applied to each member
of the group as if it were a separate taxpayer.
(ii) Ratable portion of disallowed passive activity loss. For
purposes of paragraph (h)(5)(i)(A) of this section, a member's ratable
portion of the disallowed passive activity loss of the consolidated
group is the amount of such disallowed loss multiplied by the fraction
obtained by dividing--
(A) The amount of the passive activity loss of such member of the
consolidated group that would be disallowed for the taxable year if the
items of gross income and deduction of such member were the only items
of the group for such year; by
(B) The sum of the amounts described in paragraph (h)(5)(ii)(A) of
this section for all members of the group.
[[Page 416]]
(iii) Identification of disallowed credits. In applying paragraph
(f)(3) of this section to a consolidated group for purposes of
identifying the credits from passive activities of members of such
consolidated group that are disallowed for the taxable year, the
consolidated group shall be treated as one taxpayer. Thus, a ratable
portion of each of the group's credits from passive activities is
disallowed.
(6) [Reserved]
(7) Disposition of stock of a member of an affiliated group. Any
gain recognized by a member on the disposition of stock of a subsidiary
(including income resulting from the recognition of an excess loss
account under Sec. 1.1502-19) shall be treated as portfolio income
(within the meaning of Sec. 1.469-2T (c)(3)(i)).
(8) Dispositions of property used in multiple activities. The
determination of whether Sec. 1.469-2T(c)(2)(ii) or (iii) or (d)(5)(ii)
applies to a disposition (including a deemed disposition described in
paragraph (h)(6)(iii)(C)(1) of this section) of property by a member of
a consolidated group shall be made by treating such member as having
held the property for the entire period that the group has owned such
property and as having used the property in all of the activities in
which the group has used such property
(i) [Reserved]
(j) Spouses filing joint return--(1) In general. Except as otherwise
provided in the regulations under section 469, spouses filing a joint
return for a taxable year shall be treated for such year as one taxpayer
for purposes of section 469 and the regulations thereunder Thus, for
example, spouses filing a joint return are treated as one taxpayer for
purposes of--
(i) Section 1.469-2T (relating generally to the computation of such
taxpayer's passive activity loss); and
(ii) Paragraph (f) of this section (relating to the allocation of
such taxpayer's disallowed passive activity loss and passive activity
credit among activities and the identification of disallowed passive
activity deductions and credits from passive activities).
(2) Exceptions to treatment as one taxpayer--(i) Identification of
disallowed deductions and credits. For purposes of paragraphs
(f)(2)(iii) and (3)(iii) of this section, spouses filing a joint return
for the taxable year must account separately for the deductions and
credits attributable to the interests of each spouse in any activity.
(ii) Treatment of deductions disallowed under sections 704(d),
1366(d), and 465. Notwithstanding any other provision of this section or
Sec. 1.469-2T, this paragraph (j) shall not affect the application of
section 704(d), section 1366(d), or section 465 to taxpayers filing a
joint return for the taxable year.
(iii) Treatment of losses from working interests. Paragraph (e)(4)
of this section (relating to losses and credits from certain interests
in oil and gas wells) shall be applied by treating a husband and wife
(whether or not filing a joint return) as separate taxpayers.
(3) Joint return no longer filed. If an individual--
(A) Does not file a joint return for the taxable years; and
(B) Filed a joint return for the immediately preceding taxable year;
then the passive activity deductions and credits allocable to such
individual's activities for the taxable year under paragraph (f)(4) of
this section shall be determined by taking into account the items of
deduction and credit attributable to such individual's interests in
passive activities for the immediately preceding taxable year. See
paragraph (j)(2)(i) of this section.
(4) Participation of spouses. Rules treating an individual's
participation in an activity as participation of such individual's
spouse in such activity (without regard to whether the spouses file a
joint return) are contained in Sec. 1.469-5T(f)(3).
(k) Former passive activities and changes in status of corporations.
[Reserved]
[T.D. 8175, 53 FR 5700, Feb. 25, 1988, as amended by T.D. 8253, 54 FR
20535, May 12, 1989; T.D. 8319, 55 FR 49038, Nov. 26, 1990; T.D. 8417,
57 FR 20753, May 15, 1992; 58 FR 29536, May 21, 1993; 58 FR 45059, Aug.
26, 1993; 59 FR 17478, Apr. 13, 1994; T.D. 8560, 59 FR 41674, Aug. 15,
1994; T.D. 8597, 60 FR 36685, July 18, 1995; T.D. 8996, 67 FR 35012, May
17, 2002]
Sec. 1.469-2 Passive activity loss.
(a)-(c)(2)(ii) [Reserved]
(c)(2)(iii) Disposition of substantially appreciated property
formerly used in
[[Page 417]]
nonpassive activity--(A) In general. If an interest in property used in
an activity is substantially appreciated at the time of its disposition,
any gain from the disposition shall be treated as not from a passive
activity unless the interest in property was used in a passive activity
for either--
(1) 20 percent of the period during which the taxpayer held the
interest in property; or
(2) The entire 24-month period ending on the date of the
disposition.
(B) Date of disposition. For purposes of this paragraph (c)(2)(iii),
a disposition of an interest in property is deemed to occur on the date
that the interest in property becomes subject to an oral or written
agreement that either requires the owner or gives the owner an option to
transfer the interest in property for consideration that is fixed or
otherwise determinable on that date.
(C) Substantially appreciated property. For purposes of this
paragraph (c)(2)(iii), an interest in property is substantially
appreciated if the fair market value of the interest in property exceeds
120 percent of the adjusted basis of the interest.
(D) Investment property. For purposes of this paragraph (c)(2)(iii),
an interest in property is treated as an interest in property used in an
activity other than a passive activity and as an interest in property
held for investment for any period during which the interest is held
through a C corporation or similar entity. An entity is similar to a C
corporation for this purpose if the owners of interests in the entity
derive only portfolio income (within the meaning of Sec. 1.469-2T) from
the interests.
(E) Coordination with Sec. 1.469-2T(c)(2)(ii). If Sec. 1.469-
2T(c)(2)(ii) applies to the disposition of an interest in property, this
paragraph (c)(2)(iii) applies only to that portion of the gain from the
disposition of the interest in property that is characterized as gain
from a passive activity after the application of Sec. 1.469-
2T(c)(2)(ii).
(F) Coordination with section 163(d). Gain that is treated as not
from a passive activity under this paragraph (c)(2)(iii) is treated as
income described in section 469(e)(1)(A) and Sec. 1.469-2T(c)(3)(i) if
and only if the gain is from the disposition of an interest in property
that was held for investment for more than 50 percent of the period
during which the taxpayer held that interest in property in activities
other than passive activities.
(G) Examples. The following examples illustrate the application of
this paragraph (c)(2)(iii):
Example 1. A acquires a building on January 1, 1993, and uses the
building in a trade or business activity in which A materially
participates until March 31, 2004. On April 1, 2004, A leases the
building to B. On December 31, 2005, A sells the building. At the time
of the sale, A's interest in the building is substantially appreciated
(within the meaning of paragraph (c)(2)(iii)(C) of this section).
Assuming A's lease of the building to B constitutes a rental activity
(within the meaning of Sec. 1.469-1T(e)(3)), the building is used in a
passive activity for 21 months (April 1, 2004, through December 31,
2005). Thus, the building was not used in a passive activity for the
entire 24-month period ending on the date of the sale. In addition, the
21-month period during which the building was used in a passive activity
is less than 20 percent of A's holding period for the building (13
years). Therefore, the gain from the sale is treated under this
paragraph (c)(2)(iii) as not from a passive activity.
Example 2. (i) A, an individual, is a stockholder of corporation X.
X is a C corporation until December 31, 1993, and is an S corporation
thereafter. X acquires a building on January 1, 1993, and sells the
building on March 1, 1994. At the time of the sale, A's interest in the
building held through X is substantially appreciated (within the meaning
of paragraph (c)(2)(iii)(C) of this section). The building is leased to
various tenants at all times during the period in which it is held by X.
Assume that the lease of the building would constitute a rental activity
(within the meaning of Sec. 1.469-1T(e)(3)) with respect to a person
that holds the building directly or through an S corporation.
(ii) Paragraph (c)(2)(iii)(D) of this section provides that an
interest in property is treated for purposes of this paragraph
(c)(2)(iii) as used in an activity other than a passive activity and as
held for investment for any period during which the interest is held
through a C corporation. Thus, for purposes of determining the character
of A's gain from the sale of the building, A's interest in the building
is treated as an interest in property held for investment for the period
from January 1, 1993, to December 31, 1993, and as an interest in
property used in a passive activity for the period from January 1, 1994,
to February 28, 1994.
(iii) A's interest in the building was not used in a passive
activity for the entire 24-month period ending on the date of the sale.
[[Page 418]]
In addition, the 2-month period during which A's interest in the
building was used in a passive activity is less than 20 percent of the
period during which A held an interest in the building (14 months).
Therefore, the gain from the sale is treated under this paragraph
(c)(2)(iii) as not from a passive activity.
(iv) Under paragraph (c)(2)(iii)(F) of this section, gain that is
treated as nonpassive under this paragraph (c)(2)(iii) is treated as
portfolio income (within the meaning of Sec. 1.469-2T(c)(3)(i)) if the
gain is from the disposition of an interest in property that was held
for investment for more than 50 percent of the period during which the
taxpayer held the interest in activities other than passive activities.
In this case, A's interest in the building was treated as held for
investment for the entire period during which it was used in activities
other than passive activities (i.e., the 12-month period from January 1,
1993, to December 31, 1993). Accordingly, A's gain from the sale is
treated under this paragraph (c)(2)(iii) as portfolio income.
(iv) Taxable acquisitions. If a taxpayer acquires an interest in
property in a transaction other than a nonrecognition transaction
(within the meaning of section 7701(a)(45)), the ownership and use of
the interest in property before the transaction is not taken into
account for purposes of applying this paragraph (c)(2) to any subsequent
disposition of the interest in property by the taxpayer.
(v) Property held for sale to customers--(A) Sale incidental to
another activity--(1) Applicability--(i) In general. This paragraph
(c)(2)(v)(A) applies to the disposition of a taxpayer's interest in
property if and only if--
(A) At the time of the disposition, the taxpayer holds the interest
in property in an activity that, for purposes of section 1221(1),
involves holding the property or similar property primarily for sale to
customers in the ordinary course of a trade or business (a dealing
activity);
(B) One or more other activities of the taxpayer do not involve
holding similar property for sale to customers in the ordinary course of
a trade or business (nondealing activities) and the interest in property
was used in the nondealing activity or activities for more than 80
percent of the period during which the taxpayer held the interest in
property; and
(C) The interest in property was not acquired and held by the
taxpayer for the principal purpose of selling the interest to customers
in the ordinary course of a trade or business.
(ii) Principal purpose. For purposes of this paragraph (c)(2)(v)(A),
a taxpayer is rebuttably presumed to have acquired and held an interest
in property for the principal purpose of selling the interest to
customers in the ordinary course of a trade or business if--
(A) The period during which the interest in property was used in
nondealing activities of the taxpayer does not exceed the lesser of 24
months or 20 percent of the recovery period (within the meaning of
section 168) applicable to the property; or
(B) The interest in property was simultaneously offered for sale to
customers and used in a nondealing activity of the taxpayer for more
than 25 percent of the period during which the interest in property was
used in nondealing activities of the taxpayer.
For purposes of the preceding sentence, an interest in property is
not considered to be offered for sale to customers solely because a
lessee of the property has been granted an option to purchase the
property.
(2) Dealing activity not taken into account. If paragraph
(c)(2)(v)(A) applies to the disposition of a taxpayer's interest in
property, holding the interest in the dealing activity is treated, for
purposes of Sec. 1.469-2T(c)(2), as the use of the interest in the last
nondealing activity of the taxpayer in which the interest in property
was used prior to its disposition.
(B) Use in a nondealing activity incidental to sale. If paragraph
(c)(2)(v)(A) of this section does not apply to the disposition of a
taxpayer's interest in property that is held in a dealing activity of
the taxpayer at the time of disposition, the use of the interest in
property in a nondealing activity of the taxpayer for any period during
which the interest in property is also offered for sale to customers is
treated, for purposes of Sec. 1.469-2T(c)(2), as the use of the
interest in property in the dealing activity of the taxpayer.
(C) Examples. The following examples illustrate the application of
this paragraph (c)(2)(v):
Example 1. (i) The taxpayer acquires a residential apartment
building on January 1,
[[Page 419]]
1993, and uses the building in a rental activity. In January 1996, the
taxpayer converts the apartments into condominium units. After the
conversion, the taxpayer holds the condominium units for sale to
customers in the ordinary course of a trade or business of dealing in
condominium units. (Assume that these are dealing operations treated as
separate activities under Sec. 1.469-4, and that the taxpayer
materially participates in the activity.) In addition, the taxpayer
continues to use the units in the rental activity until they are sold.
The units are first held for sale on January 1, 1996, and the last unit
is sold on December 31, 1996.
(ii) This paragraph (c)(2)(v) provides that holding an interest in
property in a dealing activity (the marketing of the property) is
treated for purposes of Sec. 1.469-2T(c)(2) as the use of the interest
in a nondealing activity if the marketing of the property is incidental
to the nondealing use. Under paragraph (c)(2)(v)(A)(2) of this section,
the interests in property are treated as used in the last nondealing
activity in which they were used prior to their disposition. In
addition, paragraph (c)(2)(v)(A)(1) of this section provides rules for
determining whether the marketing of the property is incidental to the
use of an interest in property in a nondealing activity. Under these
rules, the marketing of the property is treated as incidental to the use
in a nondealing activity if the interest in property was used in
nondealing activities for more than 80 percent of the taxpayer's holding
period in the property (the holding period requirement) and the taxpayer
did not acquire and hold the interest in property for the principal
purpose of selling it to customers in the ordinary course of a trade or
business (a dealing purpose).
(iii) In this case, the apartments were used in a rental activity
for the entire period during which they were held by the taxpayer. Thus,
the apartments were used in a nondealing activity for more than 80
percent of the taxpayer's holding period in the property, and the
marketing of the property satisfies the holding period requirement.
(iv) Paragraph (c)(2)(v)(A)(1)(ii) of this section provides that a
taxpayer is rebuttably presumed to have a dealing purpose unless the
interest in property was used in nondealing activities for more than 24
months or 20 percent of the property's recovery period (whichever is
less). The same presumption applies if the interest in property was
offered for sale to customers during more than 25 percent of the period
in which the interest was held in nondealing activities. In this case,
the taxpayer used each apartment in a nondealing activity (the rental
activity) for a period of 36 to 48 months (i.e., from January 1, 1993,
to the date of sale in the period from January through December 1996).
Thus, the apartments were used in nondealing activities for more than 24
months, and the first of the rebuttable presumptions described above
does not apply. In addition, the apartments were offered for sale to
customers for up to 12 months (depending on the month in which the
apartment was sold) during the period in which the apartments were used
in a nondealing activity. The percentage obtained by dividing the period
during which an apartment was held for sale to customers by the period
during which the apartment was used in nondealing activities ranges from
zero in the case of apartments sold on January 1, 1996, to 25 percent
(i.e., 12 months/48 months) in the case of apartments sold on December
31, 1996. Thus, no apartment was offered for sale to customers during
more than 25 percent of the period in which it was used in nondealing
activities, and the second rebuttable presumption does not apply.
(v) Because neither of the rebuttable presumptions in paragraph
(c)(2)(v)(A)(1)((ii) of this section applies in this case, the taxpayer
will not be treated as having a dealing purpose unless other facts and
circumstances establish that the taxpayer acquired and held the
apartments for the principal purpose of selling the apartments to
customers in the ordinary course of a trade or business. Assume that
none of the facts and circumstances suggest that the taxpayer had such a
purpose. If that is the case, the taxpayer does not have a dealing
purpose.
(vi) The marketing of the property satisfies the holding period
requirement, and the taxpayer does not have a dealing purpose. Thus,
holding the apartments in the taxpayer's dealing activity is treated for
purposes of this paragraph (c)(2) as the use of the apartments in a
nondealing activity. In this case, the rental activity is the only
nondealing activity in which the apartments were used prior to their
disposition. Thus, the apartments are treated under paragraph
(c)(2)(v)(A)(2) of this section as interests in property that were used
only in the rental activity for the entire period during which the
taxpayer held the interests. Accordingly, the rules in Sec. 1.469-
2T(c)(2)(ii) and paragraph (c)(2)(iii) of this section do not apply, and
all gain from the sale of the apartments is treated as passive activity
gross income.
Example 2. (i) The taxpayer acquires a residential apartment
building on January 1, 1993, and uses the building in a rental activity.
The taxpayer converts the apartments into condominium units on July 1,
1993. After the conversion, the taxpayer holds the condominium units for
sale to customers in the ordinary course of a trade or business of
dealing in condominium units. (Assume that these are dealing operations
treated as separate activities under Sec. 1.469-4, and that the
taxpayer materially participates in the activities.) In addition, the
taxpayer continues to use the units in the rental activity until
[[Page 420]]
they are sold. The first unit is sold on January 1, 1994, and the last
unit is sold on December 31, 1996.
(ii) In this case, all of the apartments were simultaneously offered
for sale to customers and used in a nondealing activity of the taxpayer
for more than 25 percent of the period during which the apartments were
used in nondealing activities. Thus, the taxpayer is rebuttably presumed
to have acquired the apartments (including apartments that are used in
the rental activity for at least 24 months) for the principal purpose of
selling them to customers in the ordinary course of a trade or business.
Assume that the facts and circumstances do not rebut this presumption.
If that is the case, the taxpayer has a dealing purpose, and paragraph
(c)(2)(v)(A) of this section does not apply to the disposition of the
apartments.
(iii) Paragraph (c)(2)(v)(B) of this section provides that if
paragraph (c)(2)(v)(A) of this section does not apply to the disposition
of a taxpayer's interest in property that is held in a dealing activity
of the taxpayer at the time of the disposition, the use of the interest
in property in any nondealing activity of the taxpayer for any period
during which the interest is also offered for sale to customers is
treated as incidental to the use of the interest in the dealing
activity. Accordingly, for purposes of applying the rules of Sec.
1.469-2T(c)(2) to the disposition of the apartments, the rental of the
apartments after July 1, 1993, is treated as the use of the apartments
in the taxpayer's dealing activity.
Example 3. (i) The taxpayer acquires a residential apartment
building on January 1, 1993, and uses the building in a rental activity.
In January 1996, the taxpayer converts the apartments into condominium
units. After the conversion, the taxpayer holds the condominium units
for sale to customers in the ordinary course of a trade or business of
dealing in condominium units. (Assume that these are dealing operations
treated as separate activities under Sec. 1.469-4, and that the
taxpayer materially participates in the activities.) In addition, the
taxpayer continues to use the units in the rental activity until they
are sold. The units are first held for sale on January 1, 1996, and the
last unit is sold in 1997.
(ii) The treatment of apartments sold in 1996 is the same as in
Example 1. The apartments sold in 1997, however, were simultaneously
offered for sale to customers and used in a nondealing activity for more
than 25 percent of the period during which the apartments were used in
nondealing activities. (For example, an apartment that is sold on
January 31, 1997, has been offered for sale for 13 months or 26.1
percent of the 49-month period during which it was used in nondealing
activities.) Thus, the taxpayer is rebuttably presumed to have acquired
the apartments sold in 1997 for the principal purpose of selling them to
customers in the ordinary course of a trade of business. Assume that the
facts and circumstances do not rebut this presumption. In that case, the
marketing of the apartments sold in 1997 does not satisfy the principal
purpose requirement, and paragraph (c)(2)(v)(A) of this section does not
apply to the disposition of those apartments. Accordingly, for purposes
of applying the rules of Sec. 1.469-2T(c)(2) to the disposition of the
apartments sold in 1997, the rental of the apartments after January 1,
1996, is treated, under paragraph (c)(2)(v)(B) of this section, as the
use of the apartments in the taxpayer's dealing activity.
(c)(3)-(c)(5) [Reserved]
(c)(6) Gross income from certain oil or gas properties--(i) In
general. Notwithstanding any other provision of the regulations under
section 469, passive activity gross income for any taxable year does not
include an amount of the taxpayer's gross passive income for the year
from a property described in this paragraph (c)(6)(i) equal to the
taxpayer's net passive income from the property for the year. Property
is described in this paragraph (c)(6)(i) if the property is--
(A) An oil or gas property that includes an oil or gas well if, for
any prior taxable year beginning after December 31, 1986, any of the
taxpayer's loss from the well was treated, solely by reason of Sec.
1.469-1T(e)(4) (relating to a special rule for losses from oil and gas
working interests), and not by reason of the taxpayer's material
participation in the activity, as a loss that is not from a passive
activity; or
(B) Any property the basis of which is determined in whole or in
part by reference to the basis of property described in paragraph
(c)(6)(i)(A) of this section.
(ii) Gross and net passive income from the property. For purposes of
this paragraph (c)(6)--
(A) The taxpayer's gross passive income for any taxable year from
any property described in paragraph (c)(6)(i) of this section is any
passive activity gross income for the year (determined without regard to
this paragraph (c)(6) and Sec. 1.469-2T(f)) from the property;
(B) The taxpayer's net passive income for any taxable year from any
property described in paragraph
[[Page 421]]
(c)(6)(i) of this section is the excess, if any, of--
(1) The taxpayer's gross passive income for the taxable year from
the property; over
(2) Any passive activity deductions for the taxable year (including
any deduction treated as a deduction for the year under Sec. 1.469-
1T(f)(4)) that are reasonably allocable to the income; and
(C) if any oil or gas well or other item of property (the item) is
included in two or more properties described in paragraph (c)(6)(i) of
this section (the properties), the taxpayer must allocate the passive
activity gross income (determined without regard to this paragraph
(c)(6) and Sec. 1.469-2T(f) from the item and the passive activity
deductions reasonably allocable to the item among the properties.
(iii) Property. For purposes of paragraph (c)(6)(i)(A) of this
section, the term ``property'' does not have the meaning given the term
by section 614(a) or the regulations thereunder, and an oil or gas
property that includes an oil or gas well is--
(A) The well; and
(B) Any other item of property (including any oil or gas well) the
value of which is directly enhanced by any drilling, logging, seismic
testing, or other activities the costs of which were taken into account
in determining the amount of the taxpayer's income or loss from the
well.
(iv) Examples. The following examples illustrate the application of
this paragraph (c)(6):
Example 1. A is a general partner in partnership P and a limited
partner in partnership R. P and R own oil and gas working interests in
two separate tracts of land acquired from two separate landowners. In
1993, P drills a well on its tract, and A's distributive share of P's
losses from drilling the well are treated under Sec. 1.469-1T(e)(4) as
not from a passive activity. In the course of selecting the drilling
site and drilling the well, P develops information indicating that the
reservior in which the well was drilled underlies R's tract as well as
P's. Under these facts, P's and R's tracts are treated as one property
for purposes of this paragraph (c)(6), even if A's interests in the
mineral deposits in the tracts are treated as separate properties under
section 614(a). Accordingly, in 1994 and subsequent years, A's
distributive share of both P's and R's income and expenses from their
respective tracts is taken into account in computing A's net passive
income from the property for purposes of this paragraph (c)(6).
Example 2. B is a general partner in partnership S. S owns an oil
and gas working interest in a single tract of land. In 1993, S drills a
well, and B's distributive share of S's losses from drilling the well is
treated under Sec. 1.469-1T(e)(4) as not from a passive activity. In
the course of drilling the well, S discovers two oil-bearing formations,
one underlying the other. On December 1, 1993, S completes the well in
the underlying formation. On January 1, 1994, B converts B's entire
general partnership interest in S into a limited partnership interest.
In 1994, S completes in, and commences production from, the shallow
formation. Under these facts, the two mineral deposits in S's tract are
treated as one property for purposes of this paragraph (c)(6), even if
they are treated as separate properties under section 614(a).
Accordingly, B's distributive share of S's income and expenses from both
the underlying formation and from recompletion in and production from
the shallow formation is taken into account in computing B's net passive
income from the property for purposes of this paragraph (c)(6).
(c)(6)(iv) Example 3--(c)(7)(iii) [Reserved]
(c)(7)(iv) Gross income of an individual from a covenant by such
individual not to compete;
(v) Gross income that is treated as not from a passive activity
under any provision of the regulations under section 469, including but
not limited to Sec. 1.469-1T(h)(6) (relating to income from
intercompany transactions of members of an affiliated group of
corporations filing a consolidated return) and Sec. 1.469-2T(f) and
paragraph (f) of this section (relating to recharacterized passive
income);
(vi) Gross income attributable to the reimbursement of a loss from
fire, storm, shipwreck, or other casualty, or from theft (as such terms
are used in section 165(c)(3)) if--
(A) The reimbursement is included in gross income under Sec. 1.165-
1(d)(2)(iii) (relating to reimbursements of losses that the taxpayer
deducted in a prior taxable year); and
(B) The deduction for the loss was not a passive activity deduction;
and
(c)(7)(vii) Gross income or gain allocable to business or rental use
of a dwelling unit for any taxable year in which section 280A(c)(5)
applies to such business or rental use.
[[Page 422]]
(d)(1)-(d)(2)(viii) [Reserved]
(ix) An item of loss or deduction that is carried to the taxable
year under section 172(a), section 613A(d), section 1212(a)(1) (in the
case of corporations), or section 1212(b) (in the case of taxpayers
other than corporations);
(x) An item of loss or deduction that would have been allowed for a
taxable year beginning before January 1, 1987, but for section 704(d),
1366, or 465;
(xi) A deduction for a loss from fire, storm, shipwreck, or other
casualty, or from theft (as such terms are used in section 165(c)(3)) if
losses that are similar in cause and severity do not recur regularly in
the conduct of the activity; and
(xii) A deduction or loss allocable to business or rental use of a
dwelling unit for any taxable year in which section 280A(c)(5) applies
to such business or rental use.
(d)(3)-(d)(5)(ii) [Reserved]
(d)(5)(iii) Other applicable rules--(A) Applicability of rules in
Sec. 1.469-2T(c)(2). For purposes of this paragraph (d)(5), a
taxpayer's interests in property used in an activity and the amounts
allocated to the interests shall be determined under Sec. 1.469-
2T(c)(2)(i)(C). In addition, the rules contained in paragraph (c)(2)(iv)
and (v) of this section apply in determining for purposes of this
paragraph (d)(5) the activity (or activities) in which an interest in
property is used at the time of its disposition and during the 12-month
period ending on the date of its disposition.
(d)(5)(iii)(B)-(d)(6)(v)(D) [Reserved]
(d)(6)(v)(E) Are taken into account under section 613A(d) (relating
to limitations on certain depletion deductions), section 1211 (relating
to the limitation on capital losses), or section 1231 (relating to
property used in a trade or business and involuntary conversions); or
(d)(6)(v)(F)-(d)(7) [Reserved]
(d)(8) Taxable year in which item arises. For purposes of Sec.
1.469-2T(d), an item of deduction arises in the taxable year in which
the item would be allowable as a deduction under the taxpayer's method
of accounting if taxable income for all taxable years were determined
without regard to sections 469, 613A(d) and 1211.
(e)(1)-(e)(2)(i) [Reserved]
(e)(2)(ii) Section 707(c). Except as provided in paragraph
(e)(2)(iii)(B) of this section, any payment to a partner for services or
the use of capital that is described in section 707(c), including any
payment described in section 736(a)(2) (relating to guaranteed payments
made in liquidation of the interest of a retiring or deceased partner),
is characterized as a payment for services or as the payment of
interest, respectively, and not as a distributive share of partnership
income.
(iii) Payments in liquidation of a partner's interest in partnership
property--(A) In general. If any gain or loss is taken into account by a
retiring partner (or any other person that owns (directly or indirectly)
an interest in the partner if the partner is a passthrough entity) or a
deceased partner's successor in interest as a result of a payment to
which section 736(b) (relating to payments made in exchange for a
retired or deceased partner's interest in partnership property) applies,
the gain or loss is treated as passive activity gross income or a
passive activity deduction only to the extent that the gain or loss
would have been passive activity gross income or a passive activity
deduction of the retiring or deceased partner (or the other person) if
it had been recognized at the time the liquidation of the partner's
interest commenced.
(B) Payments in liquidation of a partner's interest in unrealized
receivables and goodwill under section 736(a). (1) If a payment is made
in liquidation of a retiring or deceased partner's interest, the payment
is described in section 736(a), and any income--
(i) Is taken into account by the retiring partner (or any other
person that owns (directly or indirectly) an interest in the partner if
the partner is a passthrough entity) or the deceased partner's successor
in interest as a result of the payment; and
(ii) Is attributable to the portion (if any) of the payment that is
allocable to the unrealized receivables (within the meaning of section
751(c)) and goodwill of the partnership;
the percentage of the income that is treated as passive activity gross
income shall not exceed the percentage of passive activity gross income
that would be included in the gross income
[[Page 423]]
that the retiring or deceased partner (or the other person) would have
recognized if the unrealized receivables and goodwill had been sold at
the time that the liquidation of the partner's interest commenced.
(2) For purposes of this paragarph (e)(2)(iii)(B), the portion (if
any) of a payment under section 736(a) that is allocable to unrealized
receivables and goodwill of a partnership shall be determined in
accordance with the principles employed under Sec. 1.736-1(b) for
determining the portion of a payment made under section 736 that is
treated as a distribution under section 736(b).
(e)(3)(i)-(iii)(A) [Reserved]
(B) An amount of gain that would have been treated as gain that is
not from a passive activity under paragraph (c)(2)(iii) of this section
(relating to substantially appreciated property formerly used in a
nonpassive activity), paragraph (c)(6) of this section (relating to
certain oil or gas properties), Sec. 1.469-2T(f)(5) (relating to
certain property rented incidental to development), paragraph (f)(6) of
this section (relating to property rented to a nonpassive activity), or
Sec. 1.469-2T(f)(7) (relating to certain interests in a passthrough
entity engaged in the trade or business of licensing intangible
property) would have been allocated to the holder (or such other person)
with respect to the interest if all of the property used in the passive
activity had been sold immediately prior to the disposition for its fair
market value on the applicable valuation date (within the meaning of
Sec. 1.469-2T(e)(3)(ii)(D)(1)); and
(e)(3)(iii)(C)-(f)(4) [Reserved]
(f)(5) Net income from certain property rented incidental to
development activity--(i) In general. An amount of the taxpayer's gross
rental activity income for the taxable year from an item of property
equal to the net rental activity income for the year from the item of
property shall be treated as not from a passive activity if--
(A) Any gain from the sale, exchange, or other disposition of the
item of property is included in the taxpayer's income for the taxable
year;
(B) The taxpayer's use of the item of property in an activity
involving the rental of the property commenced less than 12 months
before the date of the disposition (within the meaning of paragraph
(c)(2)(iii)(B) of this section) of such property; and
(C) The taxpayer materially participated (within the meaning of
Sec. 1.469-5T) or significantly participated (within the meaning of
Sec. 1.469-5T(c)(2)) for any taxable year in an activity that involved
for such year the performance of services for the purpose of enhancing
the value of such item of property (or any other item of property if the
basis of the item of property that is sold, exchanged, or otherwise
disposed of is determined in whole or in part by reference to the basis
of such other item of property).
(ii) Commencement of use--(A) In general. For purposes of paragraph
(f)(5)(i)(B) of this section, a taxpayer's use of an item of property in
an activity involving the rental of the property commences on the first
date on which--
(1) The taxpayer owns an interest in the property;
(2) Substantially all of the property is rented (or is held out for
rent and is in a state of readiness for rental); and
(3) No significant value-enhancing services (within the meaning of
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
(B) Value-enhancing services. For purposes of this paragraph
(f)(5)(ii), the term value-enhancing services means the services
described in paragraphs (f)(5) (i)(C) and (iii) of this section, except
that the term does not include lease-up. Thus, in cases in which this
paragraph (f)(5) applies solely because substantial lease-up remains to
be performed (see paragraph (f)(5)(iii)(C) of this section), the twelve
month period described in paragraph (f)(5)(i)(B) of this section will
begin when the taxpayer acquires an interest in the property if
substantially all of the property is held out for rent and is in a state
of readiness for rental on that date.
(iii) Services performed for the purpose of enhancing the value of
property. For purposes of paragraph (f)(5)(i)(C) of this section,
services that are treated as performed for the purpose of enhancing the
value of an item of property include but are not limited to--
(A) Construction;
(B) Renovation; and
[[Page 424]]
(C) Lease-up (unless more than 50 percent of the property is leased
on the date that the taxpayer acquires an interest in the property).
(iv) Examples. The following examples illustrate the application of
this paragraph (f)(5):
Example 1. (i) A, a calendar year individual, is a partner in P, a
calendar year partnership, which develops real estate. In 1993, P
acquires an interest in undeveloped land and arranges for the financing
and construction of an office building on the land. Construction is
completed in February 1995, and substantially all of the building is
either rented or held out for rent and in a state of readiness for
rental beginning on March 1, 1995. Twenty percent of the building is
leased as of March 1, 1995.
(ii) P rents the building (or holds it out for rent) for the
remainder of 1995 and all of 1996, and sells the building on February 1,
1997, pursuant to a contract entered into on January 15, 1996. P did not
hold the building (or any other buildings) for sale to customers in the
ordinary course of P's trade or business (see paragraph (c)(2)(v) of
this section). A's distributive share of P's taxable losses from the
rental of the building is $50,000 for 1995 and $30,000 for 1996. All of
A's losses from the rental of the building are disallowed under 1.469-
1(a)(1)(i) (relating to the disallowance of the passive activity loss
for the taxable year). A's distributive share of P's gain from the sale
of the building is $150,000. A has no other gross income or deductions
from the activity of renting the building.
(iii) The real estate development activity that A holds through P in
1993, 1994, and 1995 involves the performance of services (e.g.,
construction) for the purpose of enhancing the value of the building.
Accordingly, an amount equal to A's net rental activity income from the
building may be treated as gross income that is not from a passive
activity if A's use of the building in an activity involving the rental
of the building commenced less that 12 months before the date of the
disposition of the building. In this case, the date of the disposition
of the building is January 15, 1996, the date of the binding contract
for its sale.
(iv)(A) A taxpayer's use of an item of property in an activity
involving the rental of the property commences on the first date on
which--
(1) The taxpayer owns an interest in the item of property;
(2) Substantially all of the property is rented (or is held out for
rent and is in a state of readiness for rental); and
(3) No significant value-enhancing services (within the meaning of
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
(B) In this case, A's use of the building in an activity involving
the rental of the building commenced on March 1, 1995, less than 12
months before January 15, 1996, the date of disposition. Accordingly, if
A materially (or significantly) participated in the real estate
development activity in 1993, 1994, or 1995 (without regard to whether A
materially participated in the activity in more than one of those
years), an amount of A's gross rental activity income from the building
for 1997 equal to A's net rental activity income from the building for
1997 is treated under this paragraph (f)(5) as gross income that is not
from a passive activity. Under paragraph (f)(9)(iv) of this section, A's
net rental activity income from the building for 1997 is $70,000
($150,000 distributive share of gain from the disposition of the
building minus $80,000 of reasonably allocable passive activity
deductions).
Example 2. (i) X, a calendar year taxpayer subject to section 469,
acquires a building on February 1, 1994, when the building is 25 percent
leased. During 1994, X rents the building (or holds it out for rent) and
materially participates in an activity that involves the lease-up of the
building. X's activities do not otherwise involve the performance of
construction or other services for the purpose of enhancing the value of
the building, and X does not hold the building (or any other building)
for sale to customers in the ordinary course of X's trade or business. X
sells the building on December 1, 1994.
(ii)(A) Under paragraph (f)(5)(iii)(C) of this section, lease-up is
considered a service performed for the purpose of enhancing the value of
property unless more than 50 percent of the property is leased on the
date the taxpayer acquires an interest in the property. Under paragraph
(f)(5)(ii)(B) of this section, however, lease-up is not considered a
value-enhancing service for purposes of determining when the taxpayer
commences using an item of property in an activity involving the rental
of the property. Accordingly, X's acquisition of the building
constitutes a commencement of X's use of the building in a rental
activity, because February 1, 1994, is the first date on which--
(1) The taxpayer owns an interest in the item of property;
(2) Substantially all of the property is held out for rent; and
(3) No significant value-enhancing services (within the meaning of
paragraph (f)(5)(ii)(B) of this section) remain to be performed.
(B) In this case, X disposes of the property within 12 months of the
date X commenced using the building in a rental activity. Accordingly,
an amount of X's gross rental activity income for 1994 equal to X's net
rental activity income from the building for 1994 is treated under this
paragraph (f)(5) as gain that is not from a passive activity.
[[Page 425]]
Example 3. The facts are the same as in Example 2, except that at
the time X acquires the building it is 60 percent leased. Under
paragraph (f)(5)(iii)(C) of this section, lease-up is not considered a
service performed for the purpose of enhancing the value of property if
more than 50 percent of the property is leased on the date the taxpayer
acquires an interest in the property. Therefore, additional lease-up
performed by X is not taken into account under this paragraph (f)(5).
Since X's activities do not otherwise involve the performance of
services for the purpose of enhancing the value of the building, none of
X's gross rental activity income from the building will be treated as
income that is not from a passive activity under this paragraph (f)(5).
(f)(6) Property rented to a nonpassive activity. An amount of the
taxpayer's gross rental activity income for the taxable year from an
item of property equal to the net rental activity income for the year
from that item of property is treated as not from a passive activity if
the property--
(i) Is rented for use in a trade or business activity (within the
meaning of paragraph (e)(2) of this section) in which the taxpayer
materially participates (within the meaning of Sec. 1.469-5T) for the
taxable year; and
(ii) Is not described in Sec. 1.469-2T(f)(5).
(f)(7)-(f)(9)(ii) [Reserved]
(f)(9)(iii) The gross rental activity income for a taxable year from
an item of property is any passive activity gross income (determined
without regard to Sec. 1.469-2T(f)(2) through (f)(6)) that--
(A) Is income for the year from the rental or disposition of such
item of property; and
(B) In the case of income from the disposition of such item of
property, is income from an activity that involved the rental of such
item of property during the 12-month period ending on the date of the
disposition (see Sec. 1.469-2T(c)(2)(ii)); and
(iv) The net rental activity income from an item of property for the
taxable year is the excess, if any, of--
(A) The gross rental activity income from the item of property for
the taxable year; over
(B) Any passive activity deductions for the taxable year (including
any deduction treated as a deduction for the year under Sec. 1.469-
1(f)(4)) that are reasonably allocable to the income.
(10) Coordination with section 163(d). Gross income that is treated
as not from a passive activity under Sec. 1.469-2T(f)(3), (4), or (7)
is treated as income described in section 469(e)(1)(A) and Sec. 1.469-
2T(c)(3)(i) except in determining whether--
(i) Any property is treated for purposes of section
469(e)(1)(A)(ii)(I) and Sec. 1.469-2T(c)(3)(i)(C) as property that
produces income of a type described in Sec. 1.469-2T(c)(3)(i)(A);
(ii) Any property is treated for purposes of section
469(e)(1)(A)(ii)(II) and Sec. 1.469-2T(c)(3)(i)(D) as property held for
investment;
(iii) An expense (other than interest expense) is treated for
purposes of section 469(e)(1)(A)(i)(II) and Sec. 1.469-2T(d)(4) as
clearly and directly allocable to portfolio income (within the meaning
of Sec. 1.469-2T(c)(3)(i); and
(iv) Interest expense is allocated under Sec. 1.163-8T to an
investment expenditure (within the meaning of Sec. 1.163-8T(b)(3)) or
to a passive activity expenditure (within the meaning of Sec. 1.163-
8T(b)(4)).
(11) [Reserved]
[T.D. 8417, 57 FR 20754, May 15, 1992, as amended by T.D. 8477, 58 FR
11538, Feb. 26, 1993; 58 FR 13706, Mar. 15, 1993; 58 FR 29536, May 21,
1993; T.D. 8495, 58 FR 58787, Nov. 4, 1993; T.D. 8417, 59 FR 45623,
Sept. 2, 1994]
Sec. 1.469-2T Passive activity loss (temporary).
(a) Scope of this section. This section contains rules for
determining the amount of the taxpayer's passive activity loss for the
taxable year for purposes of section 469 and the regulations thereunder.
The rules contained in this section--
(1) Provide general guidance for identifying items of income and
deduction that are taken into account in determining the amount of the
passive activity loss for the taxable year;
(2) Specify particular items of income and deduction that are not
taken into account in determining the amount of the passive activity
loss for the taxable year; and
(3) Specify the manner in which provisions of the Internal Revenue
Code and the regulations, other than section 469 and the regulations
thereunder, are applied for purposes of determining the
[[Page 426]]
extent to which items of deduction are taken into account for a taxable
year in computing the amount of the passive activity loss for such year.
(b) Definition of passive activity loss--(1) In general. In the case
of a taxpayer other than a closely held corporation (within the meaning
of Sec. 1.469-1T(g)(2)(ii)), the passive activity loss for the taxable
year is the amount, if any, by which the passive activity deductions for
the taxable year exceed the passive activity gross income for the
taxable year.
(2) Cross references. See paragraph (c) of this section for the
definition of ``passive activity gross income,'' paragraph (d) of this
section for the definition of ``passive activity deduction,'' and Sec.
1.469-1T(g)(4) for the computation of the passive activity loss of a
closely held corporation.
(c) Passive activity gross income--(1) In general. Except as
otherwise provided in the regulations under section 469, passive
activity gross income for a taxable year includes an item of gross
income if and only if such income is from a passive activity.
(2) Treatment of gain from disposition of an interest in an activity
or an interest in property used in an activity--(i) In general--(A)
Treatment of gain. Except as otherwise provided in the regulations under
section 469, any gain recognized upon the sale, exchange or other
disposition (a ``disposition'') of an interest in property used in an
activity at the time of the disposition or of an interest in an activity
held through a partnership or S corporation is treated in the following
manner:
(1) The gain is treated as gross income from such activity for the
taxable year or years in which it is recognized;
(2) If the activity is a passive activity of the taxpayer for the
taxable year of the disposition, the gain is treated as passive activity
gross income for the taxable year or years in which it is recognized;
and
(3) If the activity is not a passive activity of the taxpayer for
the taxable year of the disposition, the gain is treated as not from a
passive activity.
(B) Dispositions of partnership interests and S corporation stock. A
partnership interest or S corporation stock is not property used in an
activity for purposes of this paragraph (c)(2). See paragraph (e)(3) of
this section for rules treating the gain recognized upon the disposition
of a partnership interest or S corporation stock as gain from the
disposition of interests in the activities in which the partnership or S
corporation has an interest.
(C) Interest in property. For purposes of applying this paragraph
(c)(2) to a disposition of property--
(1) Any material portion of the property that was used, at any time
before the disposition, in any activity at a time when the remainder of
the property was not used in such activity shall be treated as a
separate interest in property; and
(2) The amount realized from the disposition and the adjusted basis
of the property must be allocated among the separate interests in a
reasonable manner.
(D) Examples. The following examples illustrate the application of
this paragraph (c)(2)(i):
Example 1. A owns an interest in a trade or business activity in
which A has never materially participated. In 1987, A sells equipment
that was used exclusively in the activity and realizes a gain on the
sale. Under paragraph (c)(2)(i)(A)(2) of this section, the gain is
passive activity gross income.
Example 2. B owns an interest in a trade or business activity in
which B materially participates for 1987. In 1987, B sells a building
used in the activity in an installment sale and realizes a gain on the
sale. B does not materially participate in the activity for 1988 or any
subsequent year. Under paragraph (c)(2)(i)(A)(3) of this section, none
of B's gain from the sale (including gain taken into account after 1987)
is passive activity gross income.
Example 3. C enters into a contract to acquire property used by the
seller in a rental activity. Before acquiring the property pursuant to
the contract, C sells all rights under the contract and realizes a gain
on the sale. Since C's rights under the contract are not property used
in a rental activity, the gain is not income from a rental activity. The
result would be the same if C owned an option to acquire the property
and sold the option.
Example 4. D sells a ten-floor office building. D owned the building
for three years preceding the sale and at all times during that period
used seven floors of the building in a trade or business activity and
three floors in a rental activity. The fair market value per square foot
is substantially the same throughout the building, and D did not
[[Page 427]]
maintain a separate adjusted basis for any part of the building. Under
paragraph (c)(2)(i)(C)(1) of this section, the seven floors used in the
trade or business activity and the three floors used in the rental
activity are treated as separate interests in property. Under paragraph
(c)(2)(i)(C)(2) of this section, the amount realized and the adjusted
basis of the building must be allocated between the separate interests
in a reasonable manner. Under these facts, an allocation based on the
square footage of the parts of the building used in each activity would
be reasonable.
Example 5. The facts are the same as in Example 4, except that two
of the seven floors used in the trade or business activity were used in
the rental activity until five months before the sale. Under paragraph
(c)(2)(i)(C)(1) of this section, the five floors used exclusively in the
trade or business activity and the two floors used first in the rental
activity and then in the trade or business activity are treated as
separate interests in property. See paragraph (c)(2)(ii) of this section
for rules for allocating amount realized and adjusted basis upon a
disposition of an interest in property used in more than one activity
during the 12-month period ending on the date of the disposition.
(ii) Disposition of property used in more than one activity in 12-
month period preceding disposition. In the case of a disposition of an
interest in property that is used in more than one activity during the
12-month period ending on the date of the disposition, the amount
realized from the disposition and the adjusted basis of such interest
must be allocated among such activities on a basis that reasonably
reflects the use of such interest in property during such 12-month
period. For purposes of this paragraph (c)(2)(ii), an allocation of the
amount realized and adjusted basis solely to the activity in which an
iterest in property is predominantly used during the 12-month period
ending on the date of the disposition reasonably reflects the use of
such interest in property if the fair market value of such interest does
not exceed the lesser of--
(A) $10,000; and
(B) 10 percent of the sum of the fair market value of such interest
and the fair market value of all other property used in such activity
immediately before the disposition.
The following examples illustrate the application of this paragraph
(c)(2)(ii):
Example 1. The facts are the same as in Example 5 of paragraph
(c)(2)(i)(D) of this section. Under paragraph (c)(2)(i)(C)(2) of this
section, D allocates the amount realized and adjusted basis of the
building 30 percent to the three floors used exclusively in the rental
activity, 50 percent to the five floors used exclusively in the trade or
business activity, and 20 percent to the two floors used first in the
rental activity and then in the trade or business activity. Under this
paragraph (c)(2)(ii), the amount realized and adjusted basis allocated
to the two floors that were used in both activities during the 12-month
period ending on the date of the disposition must also be allocated
between such activities. Under these facts, an allocation of \7/12\ of
such amounts to the rental activity and \5/12\ of such amounts to the
trade or business activity would reasonably reflect the use of the two
floors during the 12-month period ending on the date of the disposition.
Example 2. B is a limited partner in a partnership that sells a
tractor-trailer. During the 12-month period ending on the date of the
sale, the tractor-trailer was used in several activities, and the
partnership allocates the amount realized from the disposition and the
adjusted basis of the tractor-trailer among the activities based on the
number of days during the 12-month period that the partnership used the
tractor-trailer in each activity. Under these facts, the partnership's
allocation reasonably reflects the use of the tractor-trailer during the
12-month period ending on the date of the sale.
Example 3. C sells a personal computer for $8,000. During the 12-
month period ending on the date of the sale, 70 percent of C's use of
the computer was in a passive activity. Immediately before the sale, the
fair market value of all property used in the passive activity
(including the personal computer) was $200,000. Under these facts, the
computer was predominatly used in the passive activity during the 12-
month period ending on the date of the sale, and the value of the
computer, as measured by its sale price ($8,000), does not exceed the
lesser of (a) $10,000, and (b) 10 percent of the value of all property
used in the activity immediately before the sale ($20,000). C allocates
the amount realized and the adjusted basis solely to the passive
activity. Under this paragraph (c)(2)(ii), C's allocation reasonably
reflects the use of the computer during the 12-month period ending on
the date of the sale.
(iii) Disposition of substantially appreciated property formerly
used in nonpassive activity. [Reserved]. See Sec. 1.469-4(c)(2)(iii)
for rules relating to this paragraph.
(iv) Taxable acquisitions. [Reserved]. See Sec. 1.469-2(c)(iv) for
rules relating to this paragraph.
[[Page 428]]
(v) Property held for sale to customers. [Reserved]. See Sec.
1.469-2(c)(v) for rules relating to this paragraph.
(3) Items of portfolio income specifically excluded--(i) In general.
Passive activity gross income does not include portfolio income. For
purposes of the preceding sentence, portfolio income includes all gross
income, other than income derived in the ordinary course of a trade or
business (within the meaning of paragraph (c)(3)(ii) of this section),
that is attributable to--
(A) Interest (including amounts treated as interest under paragraph
(e)(2)(ii) of this section, relating to certain payments to partners for
the use of capital); annuities; royalties (including fees and other
payments for the use of intangible property); dividends on C corporation
stock; and income (including dividends) from a real estate investment
trust (within the meaning of section 856), regulated investment company
(within the meaning of section 851), real estate mortgage investment
conduit (within the meaning of section 860D), common trust fund (within
the meaning of section 584), controlled foreign corporation (within the
meaning of section 957), qualified electing fund (within the meaning of
section 1295(a)), or cooperative (within the meaning of section
1381(a));
(B) Dividends on S corporation stock (within the meaning of section
1368(c)(2);
(C) The disposition of property that produces income of a type
described in paragraph (c)(3)(i)(A) of this section; and
(D) The disposition of property held for investment (within the
meaning of section 163 (d)).
(ii) Gross income derived in the ordinary course of a trade or
business. Solely for purposes of paragraph (c)(3)(i) of this section,
gross income derived in the ordinary course of a trade or business
includes only--
(A) Interest income on loans and investments made in the ordinary
course of a trade or business of lending money;
(B) Interest on accounts receivable arising from the performance of
services or the sale of property in the ordinary course of a trade or
business of performing such services or selling such property, but only
if credit is customarily offered to customers of the business;
(C) Income from investments made in the ordinary course of a trade
or business of furnishing insurance or annuity contracts or reinsuring
risks underwritten by insurance companies;
(D) Income or gain derived in the ordinary course of an activity of
trading or dealing in any property if such activity constitutes a trade
or business (but see paragraph (c)(3)(iii)(A) of this section);
(E) Royalties derived by the taxpayer in the ordinary course of a
trade or business of licensing intangible property (within the meaning
of paragraph (c)(3)(iii)(B) of this section);
(F) Amount included in the gross income of a patron of a cooperative
(within the meaning of section 1381(a), without regard to paragraph
(2)(A) or (C) thereof) by reason of any payment or allocation to the
patron based on patronage occurring with respect to a trade or business
of the patron; and
(G) Other income identified by the Commissioner as income derived by
the taxpayer in the ordinary course of a trade or business.
(iii) Special rules--(A) Income from property held for investment by
dealer. For purposes of paragraph (c)(3)(i) of this section, a dealer's
income or gain from an item of property is not dervied by the dealer in
the ordinary course of a trade or business of dealing in such property
if the dealer held the property for investment at any time before such
income or gain is recognized.
(B) Royalties derived in the ordinary course of the trade or
business of licensing intangible property--(1) In general. Royalties
received by any person with respect to a license or other transfer of
any rights in intangible property shall be considered to be derived in
the ordinary course of the trade or business of licensing such property
only if such person--
(i) Created such property; or
(ii) Performed substantial services or incurred substantial costs
with respect to the development or marketing of such property.
(2) Substantial services or costs--(i) In general. Except as
provided in paragraph (c)(3)(iii)(B)(2)(ii) of this section,
[[Page 429]]
the determination of whether a person has performed substantial services
or incurred substantial costs with respect to the development or
marketing of an item of intangible property shall be made on the basis
of all the facts and circumstances.
(ii) Exception. A person has performed substantial services or
incurred substantial costs for a taxable year with respect to the
development or marketing of an item of intangible property if--
(a) The expenditures reasonably incurred by such person in such
taxable year with respect to the development or marketing of the
property exceed 50 percent of the gross royalties from licensing such
property that are includible in such person's gross income for the
taxable year; or
(b) The expenditures reasonably incurred by such person in such
taxable year and all prior taxable years with respect to the development
or marketing of the property exceed 25 percent of the aggregate capital
expenditures (without any adjustment of amortization) made by such
person with respect to the property in all such taxable years.
(iii) Expenditures taken into account. For purposes of paragraph
(c)(3)(iii)(B)(2)(ii) of this section, expenditures in a taxable year
include amounts chargeable to capital account for such year without
regard to the year or years (if any) in which any deduction for such
expenditure is allowed.
(3) Passthrough entities. For purposes of this paragraph
(c)(3)(iii)(B), in the case of any intangible property held by a
partnership, S corporation, estate, or trust, the determination of
whether royalties from such property are derived in the ordinary course
of a trade or business shall be made by applying the rules of this
paragraph (c)(3)(iii)(B) to such entity and not to any holder of an
interest in such entity.
(4) Cross reference. For special rules applicable to certain gross
income from a trade or business of licensing intangible property, see
paragraph (f)(7) of this section.
(C) Mineral production payments. For purposes of section 469 and the
regulations thereunder--
(1) If a mineral production payment is treated as a loan under
section 636, the portion of any payment in discharge of the production
payment that is the equivalent of interest shall be treated as interest;
and
(2) If a mineral production payment is not treated as a loan under
section 636, payments in discharge of the production payment shall be
treated as royalties.
(iv) Examples. The following examples illustrate the application of
this paragraph (c)(3):
Example 1. A, an individual engaged in the trade or business of
farming, disposes of farmland in an installment sale. A is not engaged
in a trade or business of selling farmland. Therefore, A's interest
income from the installment note is not gross income derived in the
ordinary course of a trade or business.
Example 2. P, a partnership, operates a rental apartment building
for low-income tenants in City Y. Under Y's laws relating to the
operation of low-income housing, P is required to maintain a reserve
fund to pay for the maintenance and repair of the building. P invests
the reserve fund in short-term interest-bearing deposits. Because P's
interest income from the investment of the reserve fund is not interest
income described in paragraph (c)(3)(ii) of this section, such income is
not treated as derived in the ordinary course of a trade or business.
Accordingly, P's interest income from the deposits is portfolio income
(within the meaning of paragraph (c)(3)(i) of this section).
Example 3. (i) B is a partner in a partnership that is engaged in an
activity involving the conduct of a trade or business of dealing in
securities. On February 1, the partnership acquires certain securities
for investment (within the meaning of section 163(d)). On February 2,
before recognizing any income with respect to the securities, the
partnership determines that it would be advisable to hold the securities
primarily for sale to customers and subsequently sells them to customers
in the ordinary course of its business.
(ii) Under paragraph (c)(3)(iii)(A) of this section, income or gain
from any security (including any security acquired pursuant to an
investment of working capital) held by a dealer for investment at any
time before such income or gain is recognized is not treated for
purposes of paragraph (c)(3)(i) of this section as derived by the dealer
in the ordinary course of its trade or business of dealing in
securities. Accordingly, B's distributive share of the partnership's
interest, dividends, or gains from the securities acquired by the
partnership for investment on February 1 is portfolio income of B,
notwithstanding that such securities were held by
[[Page 430]]
the partnership, subsequent to February 1, primarily for sale to
customers in the ordinary course of the partnership's trade or business
of dealing in securities.
Example 4. C is a partner in a partnership that is engaged in an
activity of trading or dealing in royalty interests in mineral
properties. The partnership derives royalty income from royalty
interests held in the activity. If the activity is a trade or business
activity, C's distributive share of the partnership's royalty income
from such royalty interests is treated under paragraph (c)(3)(ii)(D) of
this section as derived in the ordinary course of the partnership's
trade or business.
Example 5. (i) D, a calendar year individual, is a partner in a
calendar year partnership that is engaged in an activity of developing
and marketing a design for a system that reduces air pollution in office
buildings. D has a 10 percent distributive share of all items of
partnership income, gain, loss, deduction, and credit. In 1987, the
partnership acquired the rights to the design for $100,000. In 1987,
1988, and 1989, the partnership incurs expenditures with respect to the
development and marketing of the design, and derives gross royalties
from licensing the design, in the amounts set forth in the table below.
The expenditures incurred in 1987 and 1988 are currently deductible
expenses. The expenditures incurred in 1989 are capitalized and may be
deducted only in subsequent taxable years.
------------------------------------------------------------------------
Cumulative
Year Gross Expenditures capital
royalties expenditures
------------------------------------------------------------------------
1987........................... $20,000 $8,000 $100,000
1988........................... 20,000 12,000 100,000
1989........................... 60,000 15,000 115,000
1990........................... 120,000 0 115,000
------------------------------------------------------------------------
(ii) Under paragraph (c)(3)(iii)(B)(3) of this section, the
determination of whether royalties from intangible property are derived
in the ordinary course of a trade or business of a partnership is made
by applying the rules of paragraph (c)(3)(iii)(B) of this section to the
partnership rather than the partners. The expenditures reasonably
incurred by the partnership in 1987 with respect to the development or
marketing of the design ($8,000) do not exceed 50 percent of the
partnership's gross royalties for such year from licensing the design
($20,000). In addition, the sum of such expenditures incurred in 1987
and all prior taxable years ($8,000) does not exceed 25 percent of the
aggregate capital expenditures made by the partnership in all such
taxable years with respect to the design ($100,000). Accordingly, for
1987, the partnership is not treated under paragraph
(c)(3)(iii)(B)(2)(ii) of this section as performing substantial services
or incurring substantial costs with respect to the development or
marketing of the design. Therefore, unless all of the facts and
circumstances indicate that the partnership performed substantial
services or incurred substantial costs with respect to the development
or marketing of the design, D's distributive share of the partnership's
royalty income for 1987 is portfolio income.
(iii) As of the end of 1988, the sum of the expenditures reasonably
incurred by the partnership during such taxable year and all prior
taxable years with respect to the development or marketing of the design
($20,000) does not exceed 25 percent of the aggregate capital
expenditures made by the partnership in all such years with respect to
the design ($100,000). However, the amount of such expenditures incurred
by the partnership in 1988 ($12,000) exceeds 50 percent of the
partnership's gross royalties for such year from licensing the design
($20,000). Accordingly, for 1988, under paragraph
(c)(3)(iii)(B)(2)(ii)(a) of this section, the partnership is treated as
performing substantial services or incurring substantial costs with
respect to the development or marketing of the design, and D's
distributive share of the partnership's royalty income for 1988 is
considered for purposes of paragraph (c)(3)(i) of this section to be
derived in the ordinary course of a trade or business and therefore is
not portfolio income.
(iv) The expenditures reasonably incurred by the partnership in 1989
with respect to the development or marketing of the design ($15,000) do
not exceed 50 percent of the partnership's gross royalties for such year
from licensing the design ($60,000). However, the sum of such
expenditures incurred by the partnership in 1989 and all prior taxable
years ($35,000) exceeds 25 percent of the partnership's aggregate
capital expenditures made in all such years with respect to the design
($115,000). Accordingly, for 1989, under paragraph
(c)(3)(iii)(B)(2)(ii)(b) of this section, the partnership is treated as
performing substantial services or incurring substantial costs with
respect to the development or marketing of the design, and D's
distributive share of the partnership's royalty income in 1989 is
considered for purposes of paragraph (c)(3)(i) of this section to be
derived in the ordinary course of a trade or business and therefore is
not portfolio income.
(v) The result for 1990 is the same as for 1989, notwithstanding
that the partnership incurs no expenditures in 1990 with respect to the
development or marketing of the design.
Example 6. The facts are the same as in Example 5, except that, for
1987, D's distributive share of the partnership's development and
marketing costs is 15 percent, while D's distributive share of the
partnership's gross royalties is 10 percent. Although D's distributive
share of the expenditures reasonably incurred by the partnership during
1987
[[Page 431]]
with respect to the development and marketing of the design ($1,200) is
more than 50 percent of D's distributive share of the partnership's
gross royalties from licensing the design ($2,000), D is not treated as
performing substantial services or incurring substantial costs with
respect to the development or marketing of the design for 1987 under
paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. This is because,
under paragraph (c)(3)(iii)(B)(3) of this section, the determination of
whether the royalties are derived in the ordinary course of a trade or
business is made by applying paragraph (c)(3)(iii)(B) of this section to
the partnership, and not to D.
(4) Items of personal service income specifically excluded--(i) In
general. Passive activity gross income does not include compensation
paid to or on behalf of an individual for personal services performed or
to be performed by such individual at any time. For purposes of this
paragraph (c)(4), compensation for personal services includes only--
(A) Earned income (within the meaning of section 911(d)(2)(A)),
including gross income from a payment described in paragraph (e)(2) of
this section that represents compensation for the performance of
services by a partner;
(B) Amounts includible in gross income under section 83;
(C) Amounts includible in gross income under sections 402 and 403;
(D) Amounts (other than amounts described in paragraph (c)(4)(i)(C)
of this section) paid pursuant to retirement, pension, and other
arrangements for deferred compensation for services;
(E) Social security benefits (within the meaning of section 86(d))
includible in gross income under section 86; and
(F) Other income identified by the Commissioner as income derived by
the taxpayer from personal services;
provided, however, that no portion of a partner's distributive share of
partnership income (within the meaning of section 704(b)) or a
shareholder's pro rata share of income from an S corporation (within the
meaning of section 1377(a)) shall be treated as compensation for
personal services.
(ii) Example. The following example illustrates the application of
this paragraph (c)(4):
Example. C owns 50 percent of the stock of X, an S corporation. X
owns rental real estate, which it manages. X pays C a salary for
services performed by C on behalf of X in connection with the management
of X's rental properties. Under this paragraph (c)(4), although C's pro
rata share of X's gross rental income is passive activity gross income
(even if the salary paid to C is less than the fair market value of C's
services), the salary paid to C does not constitute passive activity
gross income.
(5) Income from section 481 adjustment--(i) In general. If a change
in accounting method results in a positive section 481 adjustment with
respect to an activity, a ratable portion (within the meaning of
paragraph (c)(5)(iii) of this section) of the amount taken into account
for a taxable year as a net positive section 481 adjustment by reason of
such change shall be treated as gross income from the activity for such
taxable year, and such gross income shall be treated as passive activity
gross income if and only if such activity is a passive activity for the
year of the change (within the meaning of section 481(a)).
(ii) Positive section 481 adjustments. For purposes of applying this
paragraph (c)(5)--
(A) The term ``net positive section 481 adjustment'' means the
increase (if any) in taxable income taken into account under section
481(a) to prevent amounts from being duplicated or omitted by reason of
a change in accounting method; and
(B) The term ``positive section 481 adjustment with respect to an
activity'' means the increase (if any) in taxable income that would be
taken into account under section 481(a) to prevent only the duplication
or omission of amounts from such activity by reason of the change in
accounting method.
(iii) Ratable portion. The ratable portion of the amount taken into
account as a net positive section 481 adjustment for a taxable year by
reason of a change in accounting method is determined with respect to an
activity by multiplying such amount by the fraction obtained by
dividing--
(A) The positive section 481 adjustment with respect to the
activity; by
(B) The sum of the positive section 481 adjustments with respect to
all of the activities of the taxpayer.
(6) Gross income from certain oil or gas properties--(i) In general.
[Reserved]. See Sec. 1.469-2(c)(6)(i) for rules relating to this
paragraph.
[[Page 432]]
(ii) Gross and net passive income from the property. [Reserved]. See
Sec. 1.469-2(c)(6)(ii) for rules relating to this paragraph.
(iii) Property. [Reserved]. See 1.469-2(c)(6)(iii) for rules
relating to this paragraph.
(iv) Examples. The following examples illustrate the application of
this (c)(6):
Example 1. [Reserved]. See Sec. 1.469-2(c)(6)(iv) Example 1.
Example 2. [Reserved]. See Sec. 1.469-2(c)(6)(iv) Example 2.
Example 3. C is a general partner in partnership T and a limited
partner in partnership U. T and U both own oil and gas working interests
in tracts of land in County X. In 1987, T drills a well, and C's
distributive share of T's losses from drilling the well is treated under
Sec. 1.469-1T(e)(4) as not from a passive activity. In the course of
selecting the drilling site and drilling the well, T develops
information indicating a significant probability that substantial oil
and gas reserves underlie most portions of County X. As a result, the
value of all oil and gas properties in County X is enhanced. The
information developed by T does not, however, indicate that the
reservoir in which T's well is drilled underlies U's tract. Under these
facts, T's and U's tracts are not treated as one property for purposes
of this paragraph (c)(6), because the value of U's tract is not directly
enhanced by T's activities.
(7) Other items specifically excluded. Notwithstanding any other
provision of the regulations under section 469, passive activity gross
income does not include the following:
(i) Gross income of an individual from intangible property, such as
a patent, copyright, or literary, musical, or artistic composition, if
the taxpayer's personal efforts significantly contributed to the
creation of such property;
(ii) Gross income from a qualified low-income housing project
(within the meaning of section 502 of the Tax Reform Act of 1986) for
any taxable year in the relief period (within the meaning of section
502(b) of such Act;
(iii) Gross income attributable to a refund of any state, local, or
foreign income, war profits, or excess profits tax;
(iv) [Reserved]. See Sec. 1.469-2(c)(7)(iv) for rules relating to
this paragraph (c)(7)(iv).
(v) [Reserved]. See Sec. 1.469-2(c)(7)(v) for rules relating to
this paragraph (c)(7)(v).
(vi) [Reserved]. See Sec. 1.469-2(c)(7)(vi) for rules relating to
this paragraph (c)(7)(vi).
(d) Passive activity deductions--(1) In general. Except as otherwise
provided in section 469 and the regulations thereunder, a deduction is a
passive activity deduction for a taxable year if and only if such
deduction--
(i) Arises (within the meaning of paragraph (d)(8) of this section)
in connection with the conduct of an activity that is a passive activity
for the taxable year; or
(ii) Is treated as a deduction from an activity under Sec. 1.469-
1T(f)(4) for the taxable year.
The following example illustrates the application of this paragraph
(d)(1):
Example. (i) In 1987, A, a calendar year individual, acquires a
partnership interest in R, a calendar year partnership. R's only
activity is a trade or business activity in which A materially
participates for 1987. R incurs a loss in 1987. A's distributive share
of R's 1987 loss is $1,000. However, A's basis in the partnership
interest at the end of 1987 (without regard to A's distributive share of
partnership loss) is $600; accordingly, section 704(d) disallows any
deduction in 1987 for $400 of A's distributive share of R's loss. The
remainder of A's distributive share of R's loss would be allowed as a
deduction for 1987 if taxable income for all taxable years were
determined without regard to sections 469, 613A(d), and 1211. See
paragraph (d)(8) of this section.
(ii) A does not materially participate in R's activity for 1988. In
1988, R again incurs a loss, and A's distributive share of the loss is
again $1,000. At the end of 1988, A's basis in the partnership interest
(without regard to A's distributive share of partnership loss) is
$2,000; accordingly, in 1988 section 704(d) does not limit A's deduction
for either A's $1,000 distributive share of R's 1988 loss or the $400
loss carried over from 1987 under the second sentence of section 704(d).
These losses would be allowed as a deduction for 1988 if taxable income
for all taxable years were determined without regard to sections 469,
613A(d) and 1211. See paragraph (d)(8) of this section.
(iii) Under these facts, only $400 of A's distributive share of R's
deductions from the activity are disallowed under section 704(d) in
1987. A's remaining deductions from the activity are treated as
deductions that arise in connection with the activity for 1987 under
paragraph (d)(8) of this section. Because A materially participates in
the activity for 1987, the activity is not a passive activity (within
the meaning of Sec. 1.469-1T(e)(1)) of A for such year. Accordingly,
the deductions that are not disallowed in 1987 are not passive activity
deductions.
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(iv) A does not materially participate in R's activity for 1988.
Accordingly, the activity is a passive activity of A for such year. No
portion of A's distributive share of R's deductions from the activity is
disallowed under section 704(d) in 1988. Accordingly, A's distributive
share of R's deductions for 1988 and the $400 of deductions carried over
from 1987 are both treated under paragraph (d)(8) of this section as
deductions that arise in 1988. Since the activity is a passive activity
for 1988, such deductions are passive activity deductions.
(2) Exceptions. Passive activity deductions do not include--
(i) A deduction for an item of expense (other than interest) that is
clearly and directly allocable (within the meaning of paragraph (d)(4)
of this section) to portfolio income (within the meaning of paragraph
(c)(3)(i) of this section);
(ii) A deduction allowed under section 243, 244, or 245 with respect
to any dividend that is not included in passive activity gross income;
(iii) Interest expense (other than interest expense described in
paragraph (d)(3) of this section);
(iv) A deduction for a loss from the disposition of property of a
type that produces portfolio income (within the meaning of paragraph
(c)(3)(i) of this section);
(v) A deduction that, under section 469(g) and Sec. 1.469-6T
(relating to the allowance of passive activity losses upon certain
dispositions of interests in passive activities), is treated as a
deduction that is not a passive activity deduction;
(vi) A deduction for any state, local, or foreign income, war
profits, or excess profits tax;
(vii) A miscellaneous itemized deduction (within the meaning of
section 67(b)) that is subject to disallowance in whole or in part under
section 67(a) (without regard to whether any amount of such deduction is
disallowed under section 67);
(viii) A deduction allowed under section 170 for a charitable
contribution;
(ix) [Reserved]. See Sec. 1.469-2(d)(2)(ix) for rules relating to
this paragraph.
(x) [Reserved]. See Sec. 1.469-2(d)(2)(x) for rules relating to
this paragraph (d)(2)(x).
(xi) [Reserved]. See Sec. 1.469-2(d)(2)(xi) for rules relating to
this paragraph (d)(2)(xi).
(xii) [Reserved]. See Sec. 1.469-2(d)(2)(xii) for rules relating to
this paragraph (d)(2)(xii).
(3) Interest expense. Except as otherwise provided in the
regulations under section 469, interest expense is taken into account as
a passive activity deduction if and only if such interest expense--
(i) Is allocated under Sec. 1.163-8T to a passive activity
expenditure (within the meaning of Sec. 1.163-8T(b)(4)); and
(ii) Is not--
(A) Qualified residence interest (within the meaning of Sec. 1.163-
10T); or
(B) Capitalized pursuant to a capitalization provision (within the
meaning of Sec. 1.163-8T(m)(7)(i)).
(4) Clearly and directly allocable expenses. For purposes of section
469 and the regulations thereunder, an expense (other than interest
expense) is clearly and directly allocable to portfolio income (within
the meaning of paragraph (c)(3)(i) of this section) if and only if such
expense is incurred as a result of, or incident to, an activity in which
such gross income is derived or in connection with property from which
such gross income is derived. For example, general and administrative
expenses and compensation paid to officers attributable to the
performance of services that do not directly benefit or are not incurred
by reason of a particular activity or particular property are not
clearly and directly allocable to portfolio income (within the meaning
of paragraph (c)(3)(i) of this section).
(5) Treatment of loss from disposition--(i) In general. Except as
otherwise provided in the regulations under section 469--
(A) Any loss recognized in any year upon the sale, exchange, or
other disposition (a ``disposition'') of an interest in property used in
an activity at the time of the disposition or of an interest in an
activity held through a partnership or S corporation and any deduction
allowed on account of the abandonment or worthlessness of such an
interest is treated as a deduction from such activity; and
[[Page 434]]
(B) Any such deduction is a passive activity deduction if and only
if the activity is a passive activity of the taxpayer for the taxable
year of the disposition (or other event giving rise to the deduction).
(ii) Disposition of property used in more than one activity in 12-
month period preceding disposition. In the case of a disposition of an
interest in property that is used in more than one activity during the
12-month period ending on the date of the disposition, the amount
realized from the disposition and the adjusted basis of such interest
must be allocated among such activities in the manner described in
paragraph (c)(2)(ii) of this section.
(iii) Other applicable rules--(A) Applicability of rules in
paragraph (c)(2). [Reserved]. See Sec. 1.469-2(d)(5)(iii)(A) for rules
relating to this paragraph.
(B) Dispositions of partnership interests and S corporation stock. A
partnership interest or S corporation stock is not property used in an
activity for purposes of this paragraph (d)(5). See paragraph (e)(3) of
this section for rules treating the loss recognized upon the disposition
of a partnership interest or S corporation stock as loss from the
disposition of interests in the activities in which the partnership or S
corporation has an interest.
(6) Coordination with other limitations on deductions that apply
before section 469--(i) In general. An item of deduction from a passive
activity that is disallowed for a taxable year under section 704(d),
1366(d), or 465 is not a passive activity deduction for the taxable
year. Paragraphs (d)(6) (ii) and (iii) of this section provide rules for
determining the extent to which items of deduction from a passive
activity are disallowed for a taxable year under sections 704(d),
1366(d), and 465.
(ii) Proration of deductions disallowed under basis limitations--(A)
Deductions disallowed under section 704(d). If any amount of a partner's
distributive share of a partnership's loss for the taxable year is
disallowed under section 704(d), a ratable portion of the partner's
distributive share of each item of deduction or loss of the partnership
is disallowed for the taxable year. For purposes of the preceding
sentence, the ratable portion of an item of deduction or loss is the
amount of such item multiplied by the fraction obtained by dividing--
(1) The amount of the partner's distributive share of partnership
loss that is disallowed for the taxable year; by
(2) The sum of the partner's distributive shares of all items of
deduction and loss of the partnership for the taxable year.
(B) Deductions disallowed under section 1366(d). If any amount of an
S corporation shareholder's pro rata share of an S corporation's loss
for the taxable year is disallowed under section 1366(d), a ratable
portion of the taxpayer's pro rata share of each item of deduction or
loss of the S corporation is disallowed for the taxable year. For
purposes of the preceding sentence, the ratable portion of an item of
deduction or loss is the amount of such item multiplied by the fraction
obtained by dividing--
(1) The amount of the shareholder's pro rata share of S corporation
loss that is disallowed for the taxable year; by
(2) The sum of the shareholder's pro rata shares of all items of
deduction and loss of the corporation for the taxable year.
(iii) Proration of deductions disallowed under at-risk limitation.
If any amount of the taxpayer's loss from an activity (within the
meaning of section 465(c)) is disallowed under section 465 for the
taxable year, a ratable portion of each item of deduction or loss from
the activity is disallowed for the taxable year. For purposes of the
preceding sentence, the ratable portion of an item of deduction or loss
is the amount of such item multiplied by the fraction obtained by
dividing--
(1) The amount of the loss from the activity that is disallowed for
the taxable year; by
(2) The sum of all deductions from the activity for the taxable
year.
(iv) Coordination of basis and at-risk limitations. The portion of
any item of deduction or loss that is disallowed for the taxable year
under section 704(d) or 1366(d) is not taken into account for the
taxable year in determining the loss from an activity (within the
meaning of section 465(c)) for purposes of applying section 465.
[[Page 435]]
(v) Separately identified items of deduction and loss. In
identifying the items of deduction and loss from an activity that are
not disallowed under sections 704(d), 1366(d), and 465 (and that
therefore may be treated as passive activity deductions), the taxpayer
need not account separately for any item of deduction or loss unless
such item may, if separately taken into account, result in an income tax
liability different from that which would result were such item of
deduction or loss taken into account separately. For related rules
applicable to partnerships and S corporations, see Sec. 1.702-
1(a)(8)(ii) and section 1366(a)(1)(A), respectively. Items of deduction
or loss that must be accounted for separately include (but are not
limited to) items of deduction or loss that--
(A) Are attributable to separate activities (within the meaning of
the rules to be contained in Sec. 1.469-4T);
(B) Arise in a rental real estate activity (within the meaning of
section 469(i) and the rules to be contained in Sec. 1.469-9T) in
taxable years in which the taxpayer activity participates (within the
meaning of section 469(i) and the rules to be contained in Sec. 1.469-
9T) in such activity;
(C) Arise in a rental real estate activity (within the meaning of
section 469(i) and the rules to be contained in Sec. 1.469-9T) in
taxable years in which the taxpayer does not actively participate
(within the meaning of section 469(i) and the rules to be contained in
Sec. 1.469-9T) in such activity;
(D) Arose in a taxable year beginning before 1987 and were not
allowed for such taxable year under section 704(d), 1366(d), or
465(a)(2);
(E) [Reserved]. See Sec. 1.469-2(d)(6)(v)(E) for rules relating to
this paragraph.
(F) Are attributable to pre-enactment interests in activities
(within the meaning of Sec. 1.469-11T(c)).
(7) Deductions from section 481 adjustment--(i) In general. If a
change in accounting method results in a negative section 481 adjustment
with respect to an activity, a ratable portion (within the meaning of
paragraph (d)(7)(iii) of this section) of the amount taken into account
for a taxable year as a net negative section 481 adjustment by reason of
such change shall be treated as a deduction from the activity for such
taxable year, and such deduction shall be treated as a passive activity
deduction if and only if such activity is a passive activity for the
year of the change (within the meaning of section 481(a)). See the rules
to be contained in Sec. 1.469-1T(k) for the treatment of passive
activity deductions from an activity in taxable years in which the
activity is a former passive activity.
(ii) Negative section 481 adjustments. For purposes of applying this
paragraph (d)(7)--
(A) The term ``net negative section 481 adjustment'' means the
decrease (if any) in taxable income taken into account under section
481(a) to prevent amounts from being duplicated or omitted by reason of
a change in accounting method; and
(B) The term ``negative section 481 adjustment with respect to an
activity'' means the decrease (if any) in taxable income that would be
taken into account under section 481(a) to prevent only the duplication
or omission of amounts from such activity by reason of the change in
accounting method.
(iii) Ratable portion. The ratable portion of the amount taken into
account as a net negative section 481 adjustments for a taxable year by
reason of a change in accounting method is determined with respect to an
activity by multiplying such amount by the fraction obtained by
dividing--
(A) The negative section 481 adjustment with respect to the
activity; by
(B) The sum of the negative section 481 adjustments with respect to
all of the activities of the taxpayer.
(8) Taxable year in which item arises. [Reserved]. See Sec. 1.469-
2(d)(8) for rules relating to this paragraph.
(e) Special rules for partners and S corporation shareholders--(1)
In general. For purposes of section 469 and the regulations thereunder,
the character (as an item of passive activity gross income or passive
activity deduction) of each item of gross income and deduction allocated
to a taxpayer from a partnership or S corporation (a ``passthrough
entity'') shall be determined, in any case in which participation is
relevant, by reference to the participation of the taxpayer in the
activity (or activities) that generated such item.
[[Page 436]]
Such participation is determined for the taxable year of the passthrough
entity (and not the taxable year of the taxpayer). The following example
illustrates the application of this paragraph (e)(1):
Example. A, a calendar year individual, is a partner in a
partnership that has a taxable year ending January 31. During its
taxable year ending on January 31, 1988, the partnership engages in a
single trade or business activity. For the period from February 1, 1987,
through January 31, 1988, A does not materially participate in this
activity. In A's calendar year 1988 return, A's distributive share of
the partnership's gross income and deductions from the activity must be
treated as passive activity gross income and passive activity
deductions, without regard to A's participation in the activity from
February 1, 1988, through December 31, 1988. See also Sec. 1.469-
11T(a)(4) (relating to the effective date of, and transition rules
under, section 469 and the regulations thereunder).
(2) Payments under sections 707(a), 707(c), and 736(b). Items of
gross income and deduction attributable to a transaction described in
section 707(a), 707(c), or 736(b) shall be characterized for purposes of
section 469 and the regulations thereunder in accordance with the
following rules:
(i) Section 707(a). Any item of gross income or deduction
attributable to a transaction that is treated under section 707(a) as a
transaction between a partnership and a partner acting in a capacity
other than as a member of such partnership shall be characterized for
purposes of section 469 and the regulations thereunder in a manner that
is consistent with the treatment of such transaction under section
707(a).
(ii) Section 707(c). [Reserved]. See Sec. 1.469-2(e)(ii) for rules
relating to this paragraph.
(iii) Payments in liquidation of a partner's interest in partnership
property. [Reserved]. See Sec. 1.469-2(e)(iii) for rules relating to
this paragraph.
(3) Sale or exchange of interest in passthrough entity--(i)
Application of this paragraph (e)(3). In the case of the sale, exchange,
or other disposition (a ``disposition'') of an interest in a passthrough
entity, the amount of the seller's gain or loss from each activity in
which such entity has an interest is determined, for purposes of section
469 and the regulations thereunder, under this paragraph (e)(3). In the
case of any such disposition, except as otherwise provided in paragraph
(e)(3)(iii) or (iv) of this section, paragraph (e)(3)(ii) of this
section shall apply. See paragraphs (c)(2) and (d)(5) of this section
for rules for determining the character of gain or loss, respectively,
recognized upon a disposition of an interest in an activity held through
a passthrough entity.
(ii) General rule--(A) Allocation among activities. Except as
otherwise provided in this paragraph (e)(3)(ii) or in paragraph (e)(3)
(iii) or (iv) of this section, if a holder of an interest in a
passthrough entity disposes of such interest, a ratable portion (within
the meaning of paragraph (e)(3)(ii)(B) of this section) of any gain or
loss from such disposition shall be treated as gain or loss from the
disposition of an interest in each trade or business, rental, or
investment activity in which such passthrough entity owns an interest on
the applicable valuation date.
(B) Ratable portion--(1) Dispositions on which gain is recognized.
The ratable portion of any gain from the disposition of an interest in a
passthrough entity that is allocable to an activity described in
paragraph (e)(3)(ii)(A) of this section is determined by multiplying the
amount of such gain by the fraction obtained by dividing--
(i) The amount of net gain (within the meaning of paragraph
(e)(3)(ii)(E)(3) of this section) that would have been allocated to the
holder of such interest with respect thereto if the passthrough entity
had sold its entire interest in such activity for its fair market value
on the applicable valuation date; by
(ii) The sum of the amounts of net gain that would have been
allocated to the holder of such interest with respect thereto if the
passthrough entity had sold its entire interest in each appreciated
activity (within the meaning of paragraph (e)(3)(ii)(E)(1) of this
section) described in paragraph (e)(3)(ii)(A) of this section for the
fair market value of each such activity on the applicable valuation
date.
(2) Dispositions on which loss is recognized. The ratable portion of
any loss from the disposition of an interest in a passthrough entity
that is allocable to
[[Page 437]]
an activity described in paragraph (e)(3)(ii)(A) of this section is
determined by multiplying the amount of such loss by the fraction
obtained by dividing--
(i) The amount of net loss (within the meaning of paragraph
(e)(3)(ii)(E)(4) of this section) that would have been allocated to the
holder of such interest with respect thereto if the passthrough entity
had sold its entire interest in such activity for its fair market value
on the applicable valuation date; by
(ii) The sum of the amounts of net loss that would have been
allocated to the holder of such interest with respect thereto if the
passthrough entity had sold its entire interest in each depreciated
activity (within the meaning of paragraph (e)(3)(ii)(E)(2) of this
section) described in paragraph (e)(3)(ii)(A) of this section for the
fair market value of each such activity on the applicable valuation
date.
(C) Default rule. If the gain or loss recognized upon the
disposition of an interest in a passthrough entity cannot be allocated
under paragraph (e)(3)(ii)(A) of this section, such gain or loss shall
be allocated among the activities described in paragraph (e)(3)(ii)(A)
of this section in proportion to the respective fair market values of
the passthrough entity's interests in such activities at the applicable
valuation date, and the gain or loss allocated to each activity of the
passthrough entity shall be treated as gain or loss from the disposition
of an interest in such activity.
(D) Special rules. For purposes of this paragraph (e)(3)(ii), the
following rules shall apply:
(1) Applicable valuation date--(i) In general. Except as otherwise
provided in paragraph (e)(3)(ii)(D)(1)(ii) of this section, the
applicable valuation date with respect to any disposition of an interest
in a passthrough entity is whichever one of the following dates is
selected by the passthrough entity:
(a) The beginning of the taxable year of the passthrough entity in
which such disposition occurs; or
(b) The date on which such disposition occurs.
(ii) Exception. If, after the beginning of a passthrough entity's
taxable year in which a holder's disposition of an interest in such
passthrough entity occurs and before the time of such disposition--
(a) The passthrough entity disposes of more than 10 percent of its
interest (by value as of the beginning of such taxable year) in any
activity;
(b) More than 10 percent of the property (by value as of the
beginning of such taxable year) used in any activity of the passthrough
entity is disposed of; or
(c) The holder of such interest contributes to the passthrough
entity substantially appreciated property or substantially depreciated
property with a total fair market value or adjusted basis, respectively,
which exceeds 10 percent of the total fair market value of the holder's
interest in the passthrough entity as of the beginning of such taxable
year;
then the applicable valuation date shall be the date immediately
preceding the date on which such disposition occurs.
(2) Basis adjustments. Any adjustment to the basis of partnership
property under section 743(b) made with respect to the holder of an
interest in a partnership shall be taken into account in computing the
net gain or net loss that would have been allocated to the holder with
respect to such interest if the partnership had sold its entire interest
in an activity.
(3) Tiered passthrough entities. In the case of a disposition of an
interest in a passthrough entity (the ``subsidiary passthrough entity'')
by a holder that is also a passthrough entity, any gain or loss from
such disposition that is taken into account by any person that owns
(directly or indirectly) an interest in such holder shall be allocated
among the activities of the subsidiary passthrough entity by applying
the rules of this paragraph (e)(3)(ii) to the person taking such gain or
loss into account as if such person has been the holder of an interest
in such subsidiary passthrough entity and had recognized such gain or
loss as a result of a disposition of such interest.
(E) Meaning of certain terms. For purposes of this paragraph
(e)(3)(ii)--
(1) An activity is an appreciated activity with respect to a holder
that has
[[Page 438]]
disposed of an interest in a passthrough entity if a net gain would have
been allocated to the holder with respect to such interest if the
passthrough entity has sold its entire interest in such activity for its
fair market value on the applicable valuation date;
(2) An activity is a depreciated activity with respect to a holder
that has disposed of an interest in a passthrough entity if a net loss
would have been allocated to the holder with respect to such interest if
the passthrough entity had sold its entire interest in such activity for
its fair market value on the applicable valuation date;
(3) The term ``net gain'' means, with respect to the sale of a
passthrough entity's entire interest in an activity, the amount by which
the gains from the sale of all of the property used by (or representing
the interest of) the passthrough entity in such activity exceed the
losses (if any) from such sale;
(4) The term ``net loss'' means, with respect to the sale of a
passthrough entity's entire interest in an activity, the amount by which
the losses from the sale of all of the property used by (or representing
the interest of) the passthrough entity in such activity exceed the
gains (if any) from such sale.
(iii) Treatment of gain allocated to certain passive activities as
not from a passive activity. If, in the case of a disposition of an
interest in a passthrough entity--
(A) An amount of gain recognized on account of such disposition by
the holder of such interest (or any other person that owns (directly or
indirectly) an interest in such holder if such holder is a passthrough
entity) is allocated to a passive activity of such holder (or such other
person) under paragraph (e)(3)(ii) of this section;
(B) [Reserved]. See Sec. 1.469-2(e)(3)(iii)(B) for rules relating
to this paragraph.
(C) The amount of the gain of the holder (or such other person)
described in paragraph (e)(3)(iii)(B) of this section exceeds 10 percent
of the amount of the gain of the holder (or such other person) described
in paragraph (e)(3)(iii)(A) of this section;
then the gain of the holder (or such other person) that is described in
paragraph (e)(3)(iii)(A) of this section shall be treated as gain that
is not from a passive activity to the extent that such gain does not
exceed the amount of the gain of the holder (or such other person)
described in paragraph (e)(3)(iii)(B) of this section. For purposes of
applying the preceding sentence to the disposition of an interest in a
partnership, the amount of gain that would have been allocated to the
holder (or such other person) if all of the property used in an activity
had been sold shall be determined by taking into account any adjustment
to the basis of partnership property made with respect to such holder
(or such other person) under section 743(b).
(iv) Dispositions occurring in taxable years beginning before
February 19, 1988--(A) In general. Except as otherwise provided in this
paragraph (e)(3)(iv), if the holder of an interest in a passthrough
entity sells, exchanges, or otherwise disposes of all or part of such
interest during a taxable year of such entity beginning prior to
February 19, 1988, any gain or loss recognized from such disposition
shall be allocated among the activities of the passthrough entity under
any reasonable method selected by the passthrough entity, and the gain
or loss allocated to each activity of the passthrough entity shall be
treated as gain or loss from the disposition of an interest in such
activity. For purposes of the preceding sentence, a reasonable method
shall include the method prescribed by paragraph (e)(3)(ii) of this
section. In addition, a method that allocates gain or loss among the
passthrough entity's activities on the basis of the fair market value,
cost, or adjusted basis of the property used in such activities shall
generally be considered a reasonable method for purposes of this
paragraph (e)(3)(iv).
(B) Exceptions. This paragraph (e)(3)(iv) shall not apply to any
disposition of an interest in a passthrough entity occurring after
February 19, 1988, if after such date, but before the holder's
disposition of such interest, the holder (or any other person that owns
(directly or indirectly) an interest in
[[Page 439]]
such holder if such holder is a passthrough entity) contributes to the
passthrough entity substantially appreciated portfolio assets or any
other substantially appreciated property that was used in any trade or
business activity (within the meaning of Sec. 1.469-1T(e)) of the
holder (or such other person) during--
(1) The taxable year of such person in which such contribution
occurs; or
(2) The immediately preceding taxable year of such person;
but only if such person materially participated (within the meaning of
Sec. 1.469-5T) in the activity for such year.
(v) Treatment of portfolio assets. For purposes of the paragraph
(e)(3), all portfolio assets owned by a passthrough entity shall be
treated as held in a single investment activity.
(vi) Definitions. For purposes of this paragraph (e)(3)--
(A) The term ``portfolio asset'' means any property of a type that
produces portfolio income (within the meaning of paragraph (c)(3)(i) of
this section);
(B) The term ``substantially appreciated property'' means property
with a fair market value that exceeds 120 percent of its adjusted basis;
and
(C) The term ``substantially depreciated property'' means property
with an adjusted basis that exceeds 120 percent of its fair market
value.
(vii) Examples. The following examples illustrate the application of
this paragraph (e)(3):
Example 1. (i) A owns a one-half interest in P, a calendar year
partnership. In 1993, A sells 50 percent of such interest for $50,000.
A's adjusted basis for the interest sold is $30,000. Thus, A recognizes
$20,000 of gain from the sale. P is engaged in three trade or business
activities, X, Y, and Z, and owns marketable securities that are
portfolio assets. For 1993, A materially participates in activity Z, but
does not participate in activities X and Y. Paragraph (c)(2)(iii) of
this section would not have applied to any of the gain that A would have
been allocated if, immediately before A's sale, P had disposed of all of
the property used in its trade or business activities. During the
portion of 1993 preceding A's sale, P did not sell any of the property
used in its activities, and A did not contribute any property to P.
(ii) Under paragraph (e)(3)(ii) of this section, a ratable portion
of A's $20,000 gain is allocated to each appreciated activity in which P
owned an interest on the applicable valuation date (within the meaning
of paragraph (e)(3)(ii)(D)(1) of this section). For this purpose,
paragraph (e)(3)(v) of this section treats the marketable securities
owned by P as a single investment activity.
(iii) P selects the beginning of 1993 as the applicable valuation
date pursuant to paragraph (e)(3)(ii)(D)(1)(i) of this section. P is not
required to use the date of A's sale as the applicable valuation date
under paragraph (e)(3)(ii)(D)(1)(ii) of this section because during the
portion of 1993 preceding A's sale, P did not sell any of its property
and A did not contribute any property to P. At the beginning of 1993,
the fair market value and adjusted basis of the property used in P's
activities are as follows:
------------------------------------------------------------------------
Fair
Adjusted market
basis value
------------------------------------------------------------------------
X................................................. $68,000 $48,000
Y................................................. 30,000 62,000
Z................................................. 20,000 80,000
Marketable securities............................. 2,000 10,000
---------------------
Total....................................... 120,000 200,000
------------------------------------------------------------------------
(iv) Under paragraph (e)(3)(ii)(B) of this section, the portion of
A's $20,000 gain that is allocated to an appreciated activity of P
(i.e., activities Y and Z and the marketable securities) is the amount
of such gain multiplied by the fraction obtained by dividing (a) the net
gain that would have been allocated to A with respect to the interest
sold by A if P had sold its entire interest in such activity at the
beginning of 1993 by (b) the sum of the amounts of net gain that would
have been allocated to A with respect to the interest sold by A if P had
sold its entire interest in each appreciated activity at the beginning
of 1993.
(v) If P had sold its entire interest in activities Y and Z and the
marketable securities at the beginning of 1993, A would have been
allocated the following amounts of net gain with respect to the interest
in P that A sold in 1993:
------------------------------------------------------------------------
Activity Net gain
------------------------------------------------------------------------
Y............................................................ $8,000
Z............................................................ 15,000
Marketable securities........................................ 2,000
----------
Total.................................................. 25,000
------------------------------------------------------------------------
(vi) Accordingly, under paragraph (e)(3)(ii) of this section, $6,400
of A's $20,000 gain ($20,000 x $8,000/$25,000) is allocated to activity
Y, $12,000 of A's $20,000 gain ($20,000 x $15,000/$25,000) is allocated
to activity Z, and $1,600 of A's $20,000 gain ($20,000 x $2,000/$25,000)
is allocated to the marketable securities. The gain allocated to
activity Y is passive activity gross income. None of that gain is
treated as gain that is not from a passive activity under paragraph
(e)(3)(iii) of this section because paragraph (c)(2)(iii) of
[[Page 440]]
this section would not have applied to any of the gain that A would have
been allocated if P had sold all of the property used in activity Y
immediately prior to A's sale.
Example 2. (i) B and C, calendar year individuals, are equal
partners in calendar year partnership R, which they formed on January 1,
2005, with contributions of property and money. The only item of
property (other than money) contributed by B was a building that B had
used for 12 years preceding the contribution in an activity that was not
a passive activity during such period. At the time of its contribution,
the building had an adjusted basis of $40,000 and a fair market value of
$66,000. R is engaged in a single activity: the sale of equipment to
customers in the ordinary course of the business of dealing in such
property. R uses the building contributed by B in the dealership
activity. B did not materially participate in the dealership activity
during 2005. On July 1, 2005, D purchases one-half of B's interest in R
for $37,500 in cash. At the time of the sale, the balance sheet of R,
which uses the accrual method of accounting, is as follows:
------------------------------------------------------------------------
Adjusted Fair
basis per market
books value
------------------------------------------------------------------------
Assets
------------------------------------------------------------------------
Cash.............................................. $30,000 $30,000
Accounts receivable:
Dealership...................................... 20,000 18,000
Inventory:
Dealership...................................... 52,000 66,000
Building.......................................... 40,000 66,000
---------------------
Total....................................... 142,000 180,000
------------------------------------------------------------------------
Liabilities and Capital
------------------------------------------------------------------------
Liabilities....................................... $30,000 $30,000
Capital:
B............................................... 47,000 75,000
C............................................... 65,000 75,000
---------------------
Total....................................... 142,000 180,000
------------------------------------------------------------------------
Thus, B's gain from the sale is $14,000 ($45,000 amount realized from
the sale (consisting of $37,500 of cash and $7,500 of liabilities
assumed by the purchaser) minus B's $31,000 adjusted basis for the
interest sold (one-half of B's total adjusted basis of $62,000)).
(ii) Under paragraph (e)(3)(ii) of this section, all $14,000 of B's
gain from the sale is allocated to R's dealership activity, which is a
passive activity of B for 2005. If, however, R had sold its interest in
the building immediately prior to B's sale for its fair market value on
the applicable valuation date (the valuation date selected by R is
irrelevant since the building had a fair market value of $66,000 at the
beginning of 2005 and at the time of the sale), B would have been
allocated $13,000 of gain under section 704(c) with respect to the
interest in R that B sold to D. This gain would have been treated as
gain that is not from a passive activity under paragraph (c)(2)(iii) of
this section and would have exceeded 10 percent of the total amount of
B's gain that is allocated to the dealership activity under paragraph
(e)(3)(ii) of this section. Accordingly, under paragraph (e)(3)(iii) of
this section, B's gain from the sale ($14,000) is treated as gain that
is not from a passive activity to the extent that such gain does not
exceed the amount of gain subject to paragraph (c)(2)(iii) of this
section that B would have been allocated with respect to the interest
sold to D if R had sold all of the property used in the dealership
activity immediately prior to B's sale ($13,000). Thus, $13,000 of B's
gain from the sale is treated as gain that is not from a passive
activity.
(f) Recharacterization of passive income in certain situations--(1)
In general. This paragraph (f) sets forth rules that require income from
certain passive activities to be treated as income that is not from a
passive activity (regardless of whether such income is treated as
passive activity gross income under section 469 or any other provision
of the regulations thereunder). For definitions of certain terms used in
this paragraph (f), see paragraph (f)(9) of this section.
(2) Special rule for significant participation--(i) In general. An
amount of the taxpayer's gross income from each significant
participation passive activity for the taxable year equal to a ratable
portion of the taxpayer's net passive income from such activity for the
taxable year shall be treated as not from a passive activity if the
taxpayer's passive activity gross income from all significant
participation passive activities for the taxable year (determined
without regard to paragraphs (f) (2) through (4) of this section)
exceeds the taxpayer's passive activity deductions from all such
activities for such year. For purposes of this paragraph (f)(2), the
ratable portion of the net passive income from an activity is determined
by multiplying the amount of such income by the fraction obtained by
dividing--
(A) The amount of the excess described in the preceding sentence; by
(B) The amount of the excess described in the preceding sentence
taking into account only significant participation passive activities
from which the taxpayer has net passive income for the taxable year.
[[Page 441]]
(ii) Significant participation passive activity. For purposes of
this paragraph (f)(2), the term ``significant participation passive
activity'' means any trade or business activity (within the meaning of
Sec. 1.469-1T(e)(2)) in which the taxpayer significantly participates
(within the meaning of Sec. 1.469-5T(c)(2)) for the taxable year but in
which the taxpayer does not materially participate (within the meaning
of Sec. 1.469-5T) for such year.
(iii) Example. The following example illustrates the application of
this paragraph (f)(2):
Example. (i) A owns interests in three trade or business activities,
X, Y, and Z. A does not materially participate in any of these
activities for the taxable year, but participates in activity X for 110
hours, in activity Y for 160 hours, and in activity Z for 125 hours. A
owns no interest in any other trade or business activity in which A does
not materially participate for the taxable year but in which A
participates for more than 100 hours during the taxable year. A's net
passive income (or loss) for the taxable year from activities X, Y, and
Z is as follows:
------------------------------------------------------------------------
X Y Z
------------------------------------------------------------------------
Passive activity gross income................. $600 $700 $900
Passive activity deductions................... (200) (1,000) (300)
-------------------------
Net passive income............................ 400 (300) 600
------------------------------------------------------------------------
(ii) Under paragraph (f)(2)(ii) of this section, activities X, Y,
and Z are A's only significant participation passive activities for the
taxable year. A's passive activity gross income from significant
participation passive activities ($2,200) exceeds A's passive activity
deductions from significant participation passive activities ($1,500) by
$700 for such year. Therefore, under paragraph (f)(2)(i) of this
section, a ratable portion of A's gross income from activities X and Z
(A's significant participation passive activities with net passive
income for the taxable year) is treated as gross income that is not from
a passive activity. The ratable portion is determined by dividing (a)
the amount by which A's passive activity gross income from significant
participation passive activities exceeds A's passive activity deductions
from significant participation passive activities for the taxable year
($700) by (b) such excess taking into account only A's significant
participation passive activities having net passive income for the
taxable year ($1,000). Accordingly, $280 of gross income from activity X
($400 x 700/1000) and $420 of gross income from activity Z ($600 x 700/
1000) is treated as gross income that is not from a passive activity.
(3) Rental of nondepreciable property. If less than 30 percent of
the unadjusted basis of the property used or held for use by customers
in a rental activity (within the meaning of Sec. 1.469-1T(e)(3)) during
the taxable year is subject to the allowance for depreciation under
section 167, an amount of the taxpayer's gross income from the activity
equal to the taxpayer's net passive income from the activity shall be
treated as not from a passive activity. For purposes of this paragraph
(f)(3), the term ``unadjusted basis'' means adjusted basis determined
without regard to any adjustment described in section 1016 that
decreases basis. The following example illustrates the application of
this paragraph (f)(3):
Example. C is a limited partner in a partnership. The partnership
acquires vacant land for $300,000, constructs improvements on the land
at a cost of $100,000, and leases the land and improvements to a tenant.
The partnership then sells the land and improvements for $600,000,
thereby realizing a gain on the disposition. The unadjusted basis of the
improvements ($100,000) equals 25 percent of the unadjusted basis of all
property ($400,000) used in the rental activity. Therefore, under this
paragraph (f)(3), an amount of C's gross income from the activity equal
to the net passive income from the activity (which is computed by taking
into account the gain from the disposition, including gain allocable to
the improvements) is treated as not from a passive activity.
(4) Net interest income from passive equity-financed lending
activity--(i) In general. An amount of the taxpayer's gross income for
the taxable year from any equity-financed lending activity equal to the
lesser of--
(A) The taxpayer's equity-financed interest income from the activity
for such year; and
(B) The taxpayer's net passive income from the activity for such
year
shall be treated as not from a passive activity.
(ii) Equity-financed lending activity--(A) In general. For purposes
of this paragraph (f)(4), an activity is an equity-financed lending
activity for a taxable year if--
(1) The activity involves a trade or business of lending money; and
(2) The average outstanding balance of the liabilities incurred in
the activity for the taxable year does not exceed
[[Page 442]]
80 percent of the average outstanding balance of the interest-bearing
assets held in the activity for such year.
(B) Certain liabilities not taken into account. For purposes of
paragraph (f)(4)(ii)(A)(2) of this section, liabilities incurred
principally for the purpose of increasing the percentage described in
paragraph (f)(4)(ii)(A)(2) of this section shall not be taken into
account in computing such percentage.
(iii) Equity-financed interest income. For purposes of this
paragraph (f)(4), the taxpayer's equity-financed interest income from an
activity for a taxable year is the amount of the taxpayer's net interest
income from the activity for such year multiplied by the fraction
obtained by dividing--
(A) The excess of the average outstanding balance for such year of
the interest-bearing assets held in the activity over the average
outstanding balance for such year of the liabilities incurred in the
activity; by
(B) The average outstanding balance for such year of the interest-
bearing assets held in the activity.
(iv) Net interest income. For purposes of this paragraph (f)(4), the
net interest income from an activity for a taxable year is--
(A) The gross interest income from the activity for such year;
reduced by
(B) Expenses from the activity (other than interest on liabilities
described in paragraph (f)(4)(vi) of this section) for such year that
are reasonably allocable to such gross interest income.
(v) Interest-bearing assets. For purposes of this paragraph (f)(4),
the interest-bearing assets held in an activity include all assets that
produce interest income, including loans to customers.
(vi) Liabilities incurred in the activity. For purposes of this
paragraph (f)(4), liabilities incurred in an activity include all fixed
and determinable liabilities incurred in the activity that bear interest
or are issued with original issue discount other than debts secured by
tangible property used in the activity. In the case of an activity
conducted by an entity in which the taxpayer owns an interest,
liabilities incurred in an activity include only liabilities with
respect to which the entity is the borrower.
(vii) Average outstanding balance. For purposes of this paragraph
(f)(4), the average outstanding balance of liabilities incurred in an
activity or of the interest-bearing assets held in an activity may be
computed on a daily, monthly, or quarterly basis at the option of the
taxpayer.
(viii) Example. The following example illustrates the application of
this paragraph (f)(4):
Example: (i) A, a calendar year individual, acquires on January 1,
1988, a limited partnership interest in P, a calendar year partnership.
Under the partnership agreement, A has a one percent share of each item
of income, gain, loss, deduction, and credit of P. A acquires the
partnership interest for $90,000, using $50,000 of unborrowed funds and
$40,000 of proceeds of a loan bearing interest at an annual rate of 10
percent. A pays $4,000 of interest on the loan in 1988.
(ii) P's sole activity is a trade or business of lending money. A
does not materially participate in the activity for 1988. During 1988,
the average outstanding balance of P's interest-bearing assets
(including loans to customers, temporary deposits with other lending
institutions, and government and corporate securities) is $20 million. P
incurs numerous interest-bearing liabilities in connection with its
lending activity, including liabilities for deposits taken from
customers, unsecured short-term and long-term loans from other lending
institutions, and a mortgage loan secured by the building, owned by P,
in which P conducts its business. For 1988, the average outstanding
balance of all of these liabilities (other than the mortgage loan) is
$11 million. None of these liabilities was incurred by P principally for
the purpose of increasing the percentage described in paragraph
(f)(4)(ii)(A)(2) of this section.
(iii) The interest income derived by P for 1988 from its interest-
bearing assets is $2.2 million. The interest expense paid by P for 1988
with respect to the liabilities incurred in connection with its lending
activity (other than the mortgage loan) is $990,000. P's other expenses
for 1988 that are reasonably allocable to P's gross interest income
(including expenses for advertising, loan processing and servicing, and
insurance, and depreciation on P's building) total $250,000. P's
interest expense for 1988 on the mortgage loan secured by the building
used in P's lending activity is $50,000. All of the interest expense
paid or incurred by P for 1988 is allocated under Sec. 1.63-8T to
expeditures in connection with P's lending activity.
(iv) Under paragraph (f)(4)(ii) of this section, P's activity is an
equity-financed lending activity for 1988, since, for 1988, the activity
involves a trade or business of lending money and the average
outstanding balance
[[Page 443]]
of the liabilities incurred in the activity ($11 million) does not
exceed 80 percent of the average outstanding balance of the interest-
bearing assets held in the activity ($20 million). Accordingly, under
paragraph (f)(4)(i) of this section, an amount of A's gross income from
the activity equal to the lesser of (a) A's equity-financed interest
income from the activity for 1988, or (b) A's net passive income from
the activity for 1988, is treated as income that is not from a passive
activity.
(v) Under paragraph (f)(4)(iii) of this section, A's equity-financed
interest income from the activity for 1988 is determined by multiplying
A's net interest income from the activity for 1988 by the fraction
obtained by dividing $9 million (the excess of the average interest-
bearing assets for 1988 over the average interest-bearing liabilities
for 1988) by $20 million (the average interest-bearing assets for 1988).
Under paragraph (f)(4)(iv) of this section, A's net interest income from
the activity for 1988 is $19,000 (A's distributive share of $2.2 million
of gross interest income less A's distributive share of $300,000 of
expenses described in paragraph (f)(4)(iv)(B) of this section, including
interest expense on the mortgage loan). A's distributive share of P's
other interest expense ($990,000) is not taken into account in computing
A's net interest income for 1988. Accordingly, A's equity-financed
interest income from the activity for 1988 is $8,550 ($19,000 x $9
million/$20 million).
(vi) Under paragraph (f)(9)(i) of this section, A's net passive
income from the activity for 1988 is determined by taking into account
A's distributive share of P's gross income and deductions from the
activity for 1988, as well as any interest expense incurred by A
individually that is taken into account under Sec. 1.163-8T in
determining A's income or loss from the activity for 1988. Assuming that
for 1988 all $4,000 of interest expense on the loan that A used to
finance the acquisition of A's interest in P is allocated under Sec.
1.163-8T to expenditures of A in connection with the lending activity
for 1988, A's net passive income from the activity for 1988 is $5,100,
computed as set forth in the following table:
Gross income:
Interest income.......................................... $22,000
Deductions:
Distributive share of P's expenses from the activity..... (12,900)
Interest expense on A's acquisition debt................. (4,000)
------------
Net passive income....................................... 5,100
(vii) A's net passive income from the activity for 1988 ($5,100) is
less than A's equity-financed income from the activity for 1988
($8,550). Accordingly, under this paragraph (f)(4), $5,100 of A's gross
income from the activity for 1988 is treated as not from a passive
activity.
(5) Net income from certain property rented incidental to
development activity--
(i) In general. [Reserved]. See Sec. 1.469-2(f)(5)(i) for rules
relating to this paragraph.
(ii) Commencement. [Reserved]. See Sec. 1.469-2(f)(5)(ii) for rules
relating to this paragraph (f)(5)(ii).
(iii) Services performed for the purpose of enhancing the value of
property. [Reserved]. See Sec. 1.469-2(f)(5)(iii) for rules relating to
this paragraph (f)(5)(iii).
(iv) Examples. [Reserved]. See Sec. 1.469-2(f)(5)(iv) for examples
relating to this paragraph (f)(5)(iv).
(6) Property rented to a nonpassive activity. [Reserved]. See Sec.
1.469-2(f)(6) for rules relating to this paragraph.
(7) Special rules applicable to the acquisition of an interest in a
passthrough entity engaged in the trade or business of licensing
intangible property--(i) In general. If a taxpayer acquires an interest
in an entity described in paragraph (c)(3)(iii)(B)(3) of this section
(the ``development entity'') after the development entity has created an
item of intangible property or performed substantial services or
incurred substantial costs with respect to the development or marketing
of an item of intangible property, an amount of the taxpayer's gross
royalty income for the taxable year from such item of property equal to
the taxpayer's net royalty income for the year from such item of
property shall be treated as not from a passive activity.
(ii) Royalty income from property. For purposes of this paragraph
(f)(7)--
(A) A taxpayer's gross royalty income for a taxable year from an
item of property is the taxpayer's share of passive activity gross
income for such year (determined without regard to paragraphs (f)(2)
through (7) of this section) from the licensing or transfer of any right
in such property; and
(B) A taxpayer's net royalty income for a taxable year from an item
of property is the excess, if any, of--
(1) The taxpayer's gross royalty income for the taxable year from
such item of property; over
(2) Any passive activity deductions for such taxable year (including
any deduction treated as a deduction for such year under Sec. 1.469-1T
(f)(4)) that
[[Page 444]]
are reasonably allocable to such item of property.
(iii) Exceptions. Paragraph (f)(7)(i) of this section shall not
apply to a taxpayer's gross royalty income for a taxable year from the
licensing of an item of intangible property if--
(A) The expenditures reasonably incurred by the development entity
for the taxable year of the entity ending with or within the taxpayer's
taxable year with respect to the development or marketing of such
property satisfy paragraph (c)(3)(iii)(B)(2)(ii) (a) of this section; or
(B) The taxpayer's share of the expenditures reasonably incurred by
the development entity with respect to the development or marketing of
such property for all taxable years of the entity beginning with the
taxable year of the entity in which the taxpayer acquired the interest
in the entity and ending with the taxable year of the entity ending with
or within the taxpayer's current taxable year exceeds 25 percent of the
fair market value of the taxpayer's interest in such property at the
time the taxpayer acquired the interest in the entity.
(iv) Capital expenditures. For purposes of paragraph (f)(7)(iii)(B)
of this section, a capital expenditure shall be taken into account for
the taxable year of the entity in which such expenditure is chargeable
to capital account, and the taxpayer's share of such expenditure shall
be determined as though such expenditure were allowed as a deduction for
such year.
(v) Example. The following example illustrates the application of
this paragraph (f)(7):
Example. (i) The facts are the same as in Example 5 in paragraph
(c)(3)(iv) of this section, except that, in 1988, D's 10 percent
partnership interest is sold to F for $13,000, all of which is
attributable to the design licensed by the partnership.
(ii) For 1988, the expenditures reasonably incurred by the
partnership with respect to the development or marketing of the design
satisfy paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section. Accordingly,
under paragraph (f)(7)(iii)(A) of this section, paragraph (f)(7)(i) of
this section does not apply to F's distributive share of the
partnership's gross income from licensing the design.
(iii) For 1989, the expenditures reasonably incurred by the
partnership with respect to the development or marketing of the design
do not satisfy paragraph (c)(3)(iii)(B)(2)(ii)(a) of this section.
Moreover, F's distributive share of such expenditures reasonably
incurred by the partnership for 1988 and 1989 ($27,000 x .10 = $2,700)
does not exceed 25 percent of the fair market value of F's interest in
the design at the time F acquired the partnership interest ($13,000).
Accordingly, neither of the exceptions provided in paragraph (f)(7)(iii)
of this section applies for 1989 and, under paragraph (f)(7)(i) of this
section, an amount of F's gross royalty income from the design equal to
F's net royalty income from the design is treated as not from a passive
activity.
(8) Limitation on recharacterized income. The amount of gross income
from an activity that is treated as not from a passive activity for the
taxable year under subparagraphs (f) (2) through (4) of this paragraph
(f) shall not exceed the greatest amount of gross income treated as not
from a passive activity under any one of such subparagraphs.
(9) Meaning of certain terms. For purposes of this paragraph (f),
the terms set forth below shall have the following meanings:
(i) The net passive income from an activity for a taxable year is
the amount by which the taxpayer's passive activity gross income from
the activity for the taxable year (determined without regard to
paragraphs (f) (2) through (4) of this section) exceeds the taxpayer's
passive activity deductions from the activity for such year;
(ii) The net passive loss from an activity for a taxable year is the
amount by which the taxpayer's passive activity deductions from the
activity for the taxable year exceeds the taxpayer's passive activity
gross income from the activity for such year (determined without regard
to paragraphs (f) (2) through (4) of this section).
(iii) [Reserved]. See Sec. 1.469-2(f)(9)(iii) for rules relating to
this paragraph.
(iv) [Reserved]. See Sec. 1.469-2(f)(9)(iv) for rules relating to
this paragraph.
(10) Coordination with section 163(d). [Reserved]. See paragraph
1.469-2(f)(10) for rules relating to this paragraph.
(11) Effective date. For the effective date of the rules in this
paragraph (f),
[[Page 445]]
see Sec. 1.469-11T (relating to effective date and transition rules).
[T.D. 8175, 53 FR 5711, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988, as
amended by T.D. 8253, 54 FR 20538, May 12, 1989; T.D. 8290, 55 FR 6981,
Feb. 28, 1990; T.D. 8318, 55 FR 48108, Nov. 19, 1990; 55 FR 51688, Dec.
17, 1990; T.D. 8417, 57 FR 20758, May 15, 1992; T.D. 8477, 58 FR 11538,
Feb. 26, 1993; T.D. 8495, 58 FR 58788, Nov. 4, 1993]
Sec. 1.469-3 Passive activity credit.
(a)-(d) [Reserved]
(e) Coordination with section 38(b). Any credit described in section
38(b) (1) through (5) is taken into account in computing the current
year business credit for the first taxable year in which the credit is
subject to section 469 and is not disallowed by section 469 and the
regulations thereunder.
(f) Coordination with section 50. In the case of any cessation
described in section 50(a) (1) or (2), the credits allocable to the
taxpayer's activities under Sec. 1.469-1(f)(4) shall be adjusted by
reason of the cessation.
(g) [Reserved]
[T.D. 8417, 57 FR 20758, May 15, 1992]
Sec. 1.469-3T Passive activity credit (temporary).
(a) Computation of passive activity credit. The taxpayer's passive
activity credit for the taxable year is the amount (if any) by which--
(1) The sum of all of the taxpayer's credits that are subject to
section 469 for such year; exceeds
(2) The taxpayer's regular tax liability allocable to all passive
activities for such year.
(b) Credits subject to section 469--(1) In general. Except as
otherwise provided in this paragraph (b), a credit is subject to section
469 for a taxable year if and only if--
(i) Such credit--
(A) Is attributable to such taxable year and arises in connection
with the conduct of an activity that is a passive activity for such
taxable year; and
(B) Is described in--
(1) Section 38(b) (1) through (5) (relating to general business
credits);
(2) Section 27(b) (relating to corporations described in section
936);
(3) Section 28 (relating to clinical testing of certain drugs); or
(4) Section 29 (relating to fuel from nonconventional sources); or
(ii) Such credit is allocable to an activity for such taxable year
under Sec. 1.469-1T(f)(4).
(2) Treatment of credits attributable to qualified progress
expenditures. Any credit attributable to an increase in qualified
investment under section 46(d)(1)(A) (relating to qualified progress
expenditures) with respect to progress expenditure property (as defined
in section 46(d)(2)) is subject to section 469 for a taxable year if--
(i) Such credit is attributable to such taxable year;
(ii) Such credit is described in paragraph (b)(1)(i)(B) of this
section; and
(iii) It is reasonable to believe that such progress expenditure
property will be used in a passive activity of the taxpayer when it is
placed in service.
(3) Special rule for partners and S corporation shareholders. The
character of a credit of a taxpayer arising in connection with an
activity conducted by a partnership or S corporation (as a credit
subject to section 469) shall be determined, in any case in which
participation is relevant, by reference to the participation of the
taxpayer in such activity. Such participation is determined for the
taxable year of the partnership or S corporation (and not the taxable
year of the taxpayer). See Sec. 1.469-2T(e)(1).
(4) Exception for pre-1987 credits. A credit is not subject to
section 469 if it is attributable to a taxable year of the taxpayer
beginning prior to January 1, 1987.
(c) Taxable year to which credit is attributable. A credit is
attributable to the taxable year in which such credit would be (or would
have been) allowed if the credits regard to the limitations contained in
sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469.
(d) Regular tax liability allocable to passive activities--(1) In
general. For purposes of paragraph (a)(2) of this section, the
taxpayer's regular tax liability allocable to all passive activities for
the taxable year is the excess (if any) of--
(i) The taxpayer's regular tax liability for such taxable year; over
(ii) The amount of such regular tax liability determined by reducing
the
[[Page 446]]
taxpayer's taxable income for such year by the excess (if any) of the
taxpayer's passive activity gross income for such year over the
taxpayer's passive activity deductions for such year.
(2) Regular tax liability. For purposes of this section, the term
``regularly tax liability'' has the meaning given such term in section
26(b).
(e) Coordination with section 38(b). [Reserved]. See Sec. 1.469-
3(e) for rules relating to this paragraph.
(f) Coordination with section 50. [Reserved]. See Sec. 1.469-3(f)
for rules relating to this paragraph.
(g) Examples. The following examples illustrate the application of
this section:
Example 1. (i) A, a calendar year individual, is a general partner
in calendar year partnership P. P purchases a building in 1987 and, in
1987, 1988, and 1989, incurs rehabilitation costs with respect to the
building. The building is placed in service in the rental activity in
1989. P's rehabilitation costs are qualified rehabilitation expenditures
(within the meaning of section 48(g)(2)) and are taken into account in
determining the amount of the investment credit for rehabilitation
expenditures. P's qualified rehabilitation expenditures are not
qualified progress expenditures (within the meaning of section 46(d)).
(ii) Because, under section 46(c)(1), the credit is allowable for
the taxable year in which the rehabilitated property is placed in
service, the credit allowable for P's qualified rehabilitation
expenditures arises in connection with the activity in which the
property is placed in service. In addition, the credit is attributable
to 1989, the year in which the property is placed in service, because it
would be allowed for such year if A's credits allowed for all taxable
years were determined without regard to the limitations contained in
sections 26(a), 28(d)(2), 29(b)(5), 38(c), and 469. Accordingly, under
paragraph (b)(1) of this section, A's distributive share of the credit
is subject to section 469 for 1989 because the credit arises in
connection with a rental activity for such year.
Example 2. The facts are the same as in Example 1, except that the
rehabilitation costs are incurred in anticipation of placing the
building in service in a rental activity, the qualified rehabilitation
expenditures in 1987 and 1988 are qualified progress expenditures
(``QPEs'') (within the meaning of section 46(d)(3)), the improvements
resulting from the expenditures are progress expenditure property
(within the meaning of paragraph (d)(2) of this section), and it is
reasonable to expect that such property will be transition property
(within the meaning of section 49(e)) when the property is placed in
service. Therefore, under section 46(d)(1)(A), the qualified investment
for 1987 and 1988 is increased by an amount equal to the aggregate of
the applicable percentage of the qualified rehabilitation expenditures
incurred in such years. The credits that are based on these expenditures
are attributable (under paragraph (c) of this section) to 1987 and 1988,
respectively. It is reasonable to believe in 1987 and 1988 that the
progress expenditure property will be used in a rental activity when it
is placed in service. Accordingly, under paragraph (b)(2) of this
section, A's distributive share of the credit for 1987 and 1988 is
subject to section 469. Under paragraph (b)(1) of this section (as in
Example 1), A's distributive share of the credit for 1989 is also
subject to section 469.
Example 3. (i) B, a single individual, acquires an interest in a
partnership that, in 1988, rehabilitates a building and places it in
service in a trade or business activity in which B does not materially
participate. For 1988, B has the following items of gross income,
deduction, and credit:
Gross income:
Income other than passive activity gross income. $110,000
Passive activity gross income................... 20,000 $130,000
-----------
Deductions:
Deductions other than passive activity 23,950
deductions.....................................
Passive activity deductions..................... 18,000 (41,950)
-----------==========
Taxable income.................................. ......... 88,050
==========
Credits:
Rehabilitation credit from the passive activity. ......... 8,000
(ii) For 1988, the amount by which B's passive activity gross income
exceeds B's passive activity deductions (B's net passive income) is
$2,000. Under paragraph (d) of this section, B's regular tax liability
allocable to passive activities for 1988 is determined as follows:
(A) Taxable income............................. $88,050
(B) Regular tax liability...................... ........ $24,578.50
(C) Taxable income minus net passive income.... 86,050
(D) Regular tax liability for taxable income of ........ 23,918.50
$86,050.00....................................
------------
(E) Regular tax liability allocable to passive ........ $660.00
activities ((B) minus (D))....................
(iii) Under paragraph (a) of this section, B's passive activity
credit for 1988 is the amount by which B's credits that are subject to
section 469 for 1988 ($8,000) exceed B's regular tax liability allocable
to passive activities for 1988 ($660.00). Accordingly, B's passive
activity credit for 1988 is $7,340.
Example 4. (i) The facts are the same as in Example 3 except that,
in 1988, B also has additional deductions of $100,000 from a trade or
business activity in which B materially
[[Page 447]]
participates for 1988. Thus, B has a taxable loss for 1988 of $11,950,
determined as follows:
Gross income:
Income other than passive activity gross income $110,000
Passive activity gross income.................. 20,000 $130,000
-----------
Deductions:
Deductions other than passive activity 123,950
deductions....................................
Passive activity deductions.................... 18,000 (141,950)
----------------------
Taxable income................................. ......... (11,950)
(ii) Under section 26(b) and paragraph (d)(2) of this section, the
regular tax liability for a taxable year cannot exceed the tax imposed
by chapter 1 of subtitle A of the Internal Revenue Code for the taxable
year. Therefore, under paragraph (d)(1) of this section, B's regular tax
liability allocable to passive activities for 1988 is zero. Although B's
net operating loss for the taxable year is reduced by B's net passive
income, and B's regular tax liability for other taxable years may
increase as a result of the reduction, such an increase does not change
B's regular tax liability allocable to passive activities for 1988.
Accordingly, B's passive activity credit for 1988 is $8,000.
[T.D. 8175, 53 FR 5724, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988; T.D.
8253, 54 FR 20542, May 12, 1989; T.D. 8417, 57 FR 20758, May 15, 1992]
Sec. 1.469-4 Definition of activity.
(a) Scope and purpose. This section sets forth the rules for
grouping a taxpayer's trade or business activities and rental activities
for purposes of applying the passive activity loss and credit limitation
rules of section 469. A taxpayer's activities include those conducted
through C corporations that are subject to section 469, S corporations,
and partnerships.
(b) Definitions. The following definitions apply for purposes of
this section--
(1) Trade or business activities. Trade or business activities are
activities, other than rental activities or activities that are treated
under Sec. 1.469-1T(e)(3)(vi)(B) as incidental to an activity of
holding property for investment, that--
(i) Involve the conduct of a trade or business (within the meaning
of section 162);
(ii) Are conducted in anticipation of the commencement of a trade or
business; or
(iii) Involve research or experimental expenditures that are
deductible under section 174 (or would be deductible if the taxpayer
adopted the method described in section 174(a)).
(2) Rental activities. Rental activities are activities that
constitute rental activities within the meaning of Sec. 1.469-1T(e)(3).
(c) General rules for grouping activities--(1) Appropriate economic
unit. One or more trade or business activities or rental activities may
be treated as a single activity if the activities constitute an
appropriate economic unit for the measurement of gain or loss for
purposes of section 469.
(2) Facts and circumstances test. Except as otherwise provided in
this section, whether activities constitute an appropriate economic unit
and, therefore, may be treated as a single activity depends upon all the
relevant facts and circumstances. A taxpayer may use any reasonable
method of applying the relevant facts and circumstances in grouping
activities. The factors listed below, not all of which are necessary for
a taxpayer to treat more than one activity as a single activity, are
given the greatest weight in determining whether activities constitute
an appropriate economic unit for the measurement of gain or loss for
purposes of section 469--
(i) Similarities and differences in types of trades or businesses;
(ii) The extent of common control;
(iii) The extent of common ownership;
(iv) Geographical location; and
(v) Interdependencies between or among the activities (for example,
the extent to which the activities purchase or sell goods between or
among themselves, involve products or services that are normally
provided together, have the same customers, have the same employees, or
are accounted for with a single set of books and records).
(3) Examples. The following examples illustrate the application of
this paragraph (c).
Example 1. Taxpayer C has a significant ownership interest in a
bakery and a movie theater at a shopping mall in Baltimore and in a
bakery and a movie theater in Philadelphia. In this case, after taking
into account all the relevant facts and circumstances, there may be more
than one reasonable method for grouping C's activities. For instance,
depending on the relevant facts and circumstances, the following
groupings may
[[Page 448]]
or may not be permissible: a single activity; a movie theater activity
and a bakery activity; a Baltimore activity and a Philadelphia activity;
or four separate activities. Moreover, once C groups these activities
into appropriate economic units, paragraph (e) of this section requires
C to continue using that grouping in subsequent taxable years unless a
material change in the facts and circumstances makes it clearly
inappropriate.
Example 2. Taxpayer B, an individual, is a partner in a business
that sells non-food items to grocery stores (partnership L). B also is a
partner in a partnership that owns and operates a trucking business
(partnership Q). The two partnerships are under common control. The
predominant portion of Q's business is transporting goods for L, and Q
is the only trucking business in which B is involved. Under this
section, B appropriately treats L's wholesale activity and Q's trucking
activity as a single activity.
(d) Limitation on grouping certain activities. The grouping of
activities under this section is subject to the following limitations:
(1) Grouping rental activities with other trade or business
activities--(i) Rule. A rental activity may not be grouped with a trade
or business activity unless the activities being grouped together
constitute an appropriate economic unit under paragraph (c) of this
section and--
(A) The rental activity is insubstantial in relation to the trade or
business activity;
(B) The trade or business activity is insubstantial in relation to
the rental activity; or
(C) Each owner of the trade or business activity has the same
proportionate ownership interest in the rental activity, in which case
the portion of the rental activity that involves the rental of items of
property for use in the trade or business activity may be grouped with
the trade or business activity.
(ii) Examples. The following examples illustrate the application of
paragraph (d)(1)(i) of this section:
Example 1. (i) H and W are married and file a joint return. H is the
sole shareholder of an S corporation that conducts a grocery store trade
or business activity. W is the sole shareholder of an S corporation that
owns and rents out a building. Part of the building is rented to H's
grocery store trade or business activity (the grocery store rental). The
grocery store rental and the grocery store trade or business are not
insubstantial in relation to each other.
(ii) Because they file a joint return, H and W are treated as one
taxpayer for purposes of section 469. See Sec. 1.469-1T(j). Therefore,
the sole owner of the trade or business activity (taxpayer H-W) is also
the sole owner of the rental activity. Consequently, each owner of the
trade or business activity has the same proportionate ownership interest
in the rental activity. Accordingly, the grocery store rental and the
grocery store trade or business activity may be grouped together (under
paragraph (d)(1)(i) of this section) into a single trade or business
activity, if the grouping is appropriate under paragraph (c) of this
section.
Example 2. Attorney D is a sole practitioner in town X. D also
wholly owns residential real estate in town X that D rents to third
parties. D's law practice is a trade or business activity within the
meaning of paragraph (b)(1) of this section. The residential real estate
is a rental activity within the meaning of Sec. 1.469-1T(e)(3) and is
insubstantial in relation to D's law practice. Under the facts and
circumstances, the law practice and the residential real estate do not
constitute an appropriate economic unit under paragraph (c) of this
section. Therefore, D may not treat the law practice and the residential
real estate as a single activity.
(2) Grouping real property rentals and personal property rentals
prohibited. An activity involving the rental of real property and an
activity involving the rental of personal property (other than personal
property provided in connection with the real property or real property
provided in connection with the personal property) may not be treated as
a single activity.
(3) Certain activities of limited partners and limited
entrepreneurs--(i) In general. Except as provided in this paragraph, a
taxpayer that owns an interest, as a limited partner or a limited
entrepreneur (as defined in section 464(e)(2)), in an activity described
in section 465(c)(1), may not group that activity with any other
activity. A taxpayer that owns an interest as a limited partner or a
limited entrepreneur in an activity described in the preceding sentence
may group that activity with another activity in the same type of
business if the grouping is appropriate under the provisions of
paragraph (c) of this section.
(ii) Example. The following example illustrates the application of
this paragraph (d)(3):
[[Page 449]]
Example. (i) Taxpayer A, an individual, owns and operates a farm. A
is also a member of M, a limited liability company that conducts a
cattle-feeding business. A does not actively participate in the
management of M (within the meaning of section 464(e)(2)(B)). In
addition, A is a limited partner in N, a limited partnership engaged in
oil and gas production.
(ii) Because A does not actively participate in the management of M,
A is a limited entrepreneur in M's activity. M's cattle-feeding business
is described in section 465(c)(1)(B) (relating to farming) and may not
be grouped with any other activity that does not involve farming.
Moreover, A's farm may not be grouped with the cattle-feeding activity
unless the grouping constitutes an appropriate economic unit for the
measurement of gain or loss for purposes of section 469.
(iii) Because A is a limited partner in N and N's activity is
described in section 465(c)(1)(D) (relating to exploring for, or
exploiting, oil and gas resources), A may not group N's oil and gas
activity with any other activity that does not involve exploring for, or
exploiting, oil and gas resources. Thus, N's activity may not be grouped
with A's farm or with M's cattle-feeding business.
(4) Other activities identified by the Commissioner. A taxpayer that
owns an interest in an activity identified in guidance issued by the
Commissioner as an activity covered by this paragraph (d)(4) may not
group that activity with any other activity, except as provided in the
guidance issued by the Commissioner.
(5) Activities conducted through section 469 entities--(i) In
general. A C corporation subject to section 469, an S corporation, or a
partnership (a section 469 entity) must group its activities under the
rules of this section. Once the section 469 entity groups its
activities, a shareholder or partner may group those activities with
each other, with activities conducted directly by the shareholder or
partner, and with activities conducted through other section 469
entities, in accordance with the rules of this section. A shareholder or
partner may not treat activities grouped together by a section 469
entity as separate activities.
(ii) Cross reference. An activity that a taxpayer conducts through a
C corporation subject to section 469 may be grouped with another
activity of the taxpayer, but only for purposes of determining whether
the taxpayer materially or significantly participates in the other
activity. See Sec. 1.469-2T(c)(3)(i)(A) and (c)(4)(i) for the rules
regarding dividends on C corporation stock and compensation paid for
personal services.
(e) Disclosure and consistency requirements--(1) Original groupings.
Except as provided in paragraph (e)(2) of this section and Sec. 1.469-
11, once a taxpayer has grouped activities under this section, the
taxpayer may not regroup those activities in subsequent taxable years.
Taxpayers must comply with disclosure requirements that the Commissioner
may prescribe with respect to both their original groupings and the
addition and disposition of specific activities within those chosen
groupings in subsequent taxable years.
(2) Regroupings. If it is determined that a taxpayer's original
grouping was clearly inappropriate or a material change in the facts and
circumstances has occurred that makes the original grouping clearly
inappropriate, the taxpayer must regroup the activities and must comply
with disclosure requirements that the Commissioner may prescribe.
(f) Grouping by Commissioner to prevent tax avoidance--(1) Rule. The
Commissioner may regroup a taxpayer's activities if any of the
activities resulting from the taxpayer's grouping is not an appropriate
economic unit and a principal purpose of the taxpayer's grouping (or
failure to regroup under paragraph (e) of this section) is to circumvent
the underlying purposes of section 469.
(2) Example. The following example illustrates the application of
this paragraph (f):
Example. (i) Taxpayers D, E, F, G, and H are doctors who operate
separate medical practices. D invested in a tax shelter several years
ago that generates passive losses and the other doctors intend to invest
in real estate that will generate passive losses. The taxpayers form a
partnership to engage in the trade or business of acquiring and
operating X-ray equipment. In exchange for equipment contributed to the
partnership, the taxpayers receive limited partnership interests. The
partnership is managed by a general partner selected by the taxpayers;
the taxpayers do not materially participate in its operations.
Substantially all of the partnership's services are provided to the
[[Page 450]]
taxpayers or their patients, roughly in proportion to the doctors'
interests in the partnership. Fees for the partnership's services are
set at a level equal to the amounts that would be charged if the
partnership were dealing with the taxpayers at arm's length and are
expected to assure the partnership a profit. The taxpayers treat the
partnership's services as a separate activity from their medical
practices and offset the income generated by the partnership against
their passive losses.
(ii) For each of the taxpayers, the taxpayer's own medical practice
and the services provided by the partnership constitute an appropriate
economic unit, but the services provided by the partnership do not
separately constitute an appropriate economic unit. Moreover, a
principal purpose of treating the medical practices and the
partnership's services as separate activities is to circumvent the
underlying purposes of section 469. Accordingly, the Commissioner may
require the taxpayers to treat their medical practices and their
interests in the partnership as a single activity, regardless of whether
the separate medical practices are conducted through C corporations
subject to section 469, S corporations, partnerships, or sole
proprietorships. The Commissioner may assert penalties under section
6662 against the taxpayers in appropriate circumstances.
(g) Treatment of partial dispositions. A taxpayer may, for the
taxable year in which there is a disposition of substantially all of an
activity, treat the part disposed of as a separate activity, but only if
the taxpayer can establish with reasonable certainty--
(1) The amount of deductions and credits allocable to that part of
the activity for the taxable year under Sec. 1.469-1(f)(4) (relating to
carryover of disallowed deductions and credits); and
(2) The amount of gross income and of any other deductions and
credits allocable to that part of the activity for the taxable year.
(h) Rules for grouping rental real estate activities for taxpayers
qualifying under section 469(c)(7). See Sec. 1.469-9 for rules for
certain rental real estate activities.
[T.D. 8565, 59 FR 50487, Oct. 4, 1994, as amended by T.D. 8645, 60 FR
66499, Dec. 22, 1995]
Sec. 1.469-4T Definition of activity (temporary).
(a) Overview--(1) Purpose and effect of overview. This paragraph (a)
contains a general description of the rules contained in this section
and is intended solely as an aid to readers. The provisions of this
paragraph (a) are not a substitute for the more detailed rules contained
in the remainder of this section and cannot be relied upon in cases in
which those rules qualify the general description contained in this
paragraph (a).
(2) Scope and structure of Sec. 1.469-4T. This section provides
rules under which a taxpayer's business and rental operations are
treated as one or more activities for purposes of section 469 and the
regulations thereunder. (See paragraph (b)(2)(ii) of this section for
the definition of business and rental operations.) In general, these
rules are divided into three groups:
(i) Rules that identify the business and rental operations that
constitute an undertaking (the undertaking rules).
(ii) Rules that identify the undertaking or undertakings that
constitute an activity (the activity rules).
(iii) Rules that apply only under certain special circumstances (the
special rules).
(3) Undertaking rules--(i) In general. The undertaking is generally
the smallest unit that can constitute an activity. (See paragraph (b)(1)
of this section for the general rule and paragraph (k)(2)(iii) of this
section for a special rule that permits taxpayers to treat a single
rental real estate undertaking as multiple activities.) An undertaking
may include diverse business and rental operations.
(ii) Basic undertaking rule. The basic undertaking rule identifies
the business and rental operations that constitute an undertaking by
reference to their location and ownership. Under this rule, business and
rental operations that are conducted at the same location and are owned
by the same person are generally treated as part of the same
undertaking. Conversely, business and rental operations generally
constitute separate undertakings to the extent that they are conducted
at different locations or are not owned by the same person. (See
paragraph (c)(2)(i) of this section.)
(iii) Circumstances in which location is disregarded. In some
circumstances, the undertaking in which business and rental operations
are included does not
[[Page 451]]
depend on the location at which the operations are conducted. Operations
that are not conducted at any fixed place of business or that are
conducted at the customer's place of business are treated as part of the
undertaking with which the operations are most closely associated (see
paragraph (c)(2)(iii)(C) of this section). In addition, operations that
are conducted at a location but do not relate to the production of
property at that location or to the transaction of business with
customers at that location are treated, in effect, as part of the
undertaking or undertakings that the operations support (see paragraph
(c)(2)(ii) of this section).
(iv) Rental undertakings. The basic undertaking rule is also
modified if the undertaking determined under that rule includes both
rental and nonrental operations. In such cases, the rental operations
and the nonrental operations generally must be treated as separate
undertakings (see paragraph (d)(1) of this section). This rule does not
apply if more than 80 percent of the income of the undertaking
determined under the basic rule is attributable to one class of
operations (i.e., rental or nonrental) or if the rental operations would
not be treated as part of a rental activity because of the exceptions
contained in Sec. 1.469-1T(e)(3)(ii) (see paragraph (d)(2) of this
section). In applying the rental undertaking rules, short-term rentals
of real property (e.g., hotel-room rentals) are generally treated as
nonrental operations (see paragraph (d)(3)(ii) of this section).
(v) Oil and gas wells. Another exception to the basic undertaking
rule treats oil and gas wells that are subject to the working-interest
exception in Sec. 1.469-1T(e)(4) as separate undertakings (see
paragraph (e) of this section).
(4) Activity rules--(i) In general. The basic activity rule treats
each undertaking in which a taxpayer owns an interest as a separate
activity of the taxpayer (see paragraph (b)(1) of this section). In the
case of trade or business undertakings, professional service
undertakings, and rental real estate undertakings, additional rules may
either require or permit the aggregation of two or more undertakings
into a single activity.
(ii) Aggregation of trade or business undertakings--(A) Trade or
business undertakings. Trade or business undertakings include all
nonrental undertakings other than oil and gas undertakings described in
paragraph (a)(3)(v) of this section and professional service
undertakings described in paragraph (a)(4)(iii) of this section (see
paragraph (f)(1)(ii) of this section).
(B) Similar, commonly-controlled undertakings treated as a single
activity. An aggregation rule treats trade or business undertakings that
are both similar and controlled by the same interests as part of the
same activity. This rule is, however, generally inapplicable to small
interests held by passive investors in such undertakings, except to the
extent such interests are held through the same passthrough entity. (See
paragraph (f)(2) of this section.) Undertakings are similar for purposes
of this rule if more than half (by value) of their operations are in the
same line of business (as defined in a revenue procedure issued pursuant
to paragraph (f)(4)(iv) of this section) or if the undertakings are
vertically integrated (see paragraph (f)(4)(iii) of this section). All
the facts and circumstances are taken into account in determining
whether undertakings are controlled by the same interests for purposes
of the aggregation rule (see paragraph (j)(1) of this section). If,
however, each member of a group of five or fewer persons owns a
substantial interest in each of the undertakings, the undertakings may
be rebuttably presumed to be controlled by the same interests (see
paragraph (j) (2) and (3) of this section).
(C) Integrated businesses treated as a single activity. Trade or
business undertakings (including undertakings that have been aggregated
because of their similarity and common control) are subject to a second
aggregation rule. Under this rule undertakings that constitute an
integrated business and are controlled by the same interests must be
treated as part of the same activity. (See paragraph (g) of this
section.)
(iii) Aggregation of professional service undertakings. Professional
service undertakings are nonrental undertakings that predominantly
involve the provision of services in the fields of health,
[[Page 452]]
law, engineering, architecture, accounting, actuarial science,
performing arts, or consulting (see paragraph (h)(1)(ii) of this
section). In general, professional service undertakings that are either
similar, related, or controlled by the same interests must be treated as
part of the same activity (see paragraph (h)(2) of this section). The
rules for determining whether trade or business undertakings are
controlled by the same interests also apply with respect to professional
service undertakings. Professional service undertakings are similar,
however, if more than 20 percent (by value) of their operations are in
the same field, and two professional service undertakings are related if
one of the undertakings derives more than 20 percent of its gross income
from persons who are customers of the other undertaking (see paragraph
(h)(3) of this section).
(iv) Rules for rental real estate--(A) Taxpayers permitted to
determine rental real estate activities. The rules for aggregating
rental real estate undertakings are generally elective. They permit
taxpayers to treat any combination of rental real estate undertakings as
a single activity. Taxpayers may also divide their rental real estate
undertakings and then treat portions of the undertakings as separate
activities or recombine the portions into activities that include parts
of different undertakings. (See paragraph (k)(2) (i) and (iii) of this
section.)
(B) Limitations on fragmentation and aggregation of rental real
estate. Taxpayers may not fragment their rental real estate in a manner
that is inconsistent with their treatment of such property in prior
taxable years or with the treatment of such property by the passthrough
entity through which it is held (see paragraph (k) (2)(ii) and (3) of
this section). There are no comparable limitations on the aggregation of
rental real estate into a single activity. If however, the income or
gain from a rental real estate undertaking is subject to
recharacterization under Sec. 1.469-2T(f)(3) (relating to the rental of
nondepreciable property), a coordination rule provides that the
undertaking must be treated as a separate activity (see paragraph (k)(6)
of this section.)
(v) Election to treat nonrental undertakings as separate activities.
Another elective rule permits taxpayers to treat a nonrental undertaking
as a separate activity even if the undertaking would be treated as part
of a larger activity under the aggregation rules applicable to the
undertaking (see paragraph (o)(2) of this section). This elective rule
is limited by consistency requirements similar to those that apply to
rental real estate operations (see paragraph (o) (3) and (4) of this
section). Moreover, in cases in which a taxpayer elects to treat a
nonrental undertaking as a separate activity, the taxpayer's level of
participation (i.e., material, significant, or otherwise) in the
separate activity is the same as the taxpayer's level of participation
in the larger activity in which the undertaking would be included but
for the election (see paragraph (o)(6) of this section).
(5) Special rules--(i) Consolidated groups and publicly traded
partnerships. Special rules apply to the business and rental operations
of consolidated groups of corporations and publicly traded partnerships.
Under these rules, a consolidated group is treated as one taxpayer in
determining its activities and those of its members (see paragraph (m)
of this section), and business and rental operations owned through a
publicly traded partnership cannot be aggregated with operations that
are not owned through the partnership (see paragraph (n) of this
section).
(ii) Transitional rule. A special rule applies for taxable years
ending before August 10, 1989. In those years, taxpayers may organize
business and rental operations into activities under any reasonable
method (see paragraph (p)(1) of this section). A taxpayer will also be
permitted to use any reasonable method to allocate disallowed deductions
and credits among activities for the first taxable year in which the
taxpayer's activities are determined under the general rules of Sec.
1.469-4T (see paragraph (p)(3) of this section).
(b) General rule and definitions of general application--(1) General
rule. Except as otherwise provided in this section, each undertaking in
which a taxpayer owns an interest shall be treated as a separate
activity of the taxpayer. See
[[Page 453]]
paragraphs (f), (g), and (h) of this section for rules requiring certain
nonrental undertakings to be treated as part of the same activity and
paragraph (k) of this section for rules identifying the rental real
estate undertakings (or portions thereof) that are included in an
activity.
(2) Definitions of general application. The following definitions
set forth the meaning of certain terms for purposes of this section:
(i) Passthrough entity. The term ``passthrough entity'' means a
partnership, S corporation, estate, or trust.
(ii) Business and rental operations--(A) In general. Except as
provided in paragraph (b)(2)(ii)(B) of this section, the term ``business
and rental operations'' means all endeavors that are engaged in for
profit or the production of income and satisfy one or more of the
following conditions for the taxable year:
(1) Such endeavors involve the conduct of a trade or business
(within the meaning of section 162) or are conducted in anticipation of
such endeavors becoming a trade or business;
(2) Such endeavors involve making tangible property available for
use by customers; or
(3) Research or experimental expenditures paid or incurred with
respect to such endeavors are deductible under section 174 (or would be
deductible if the taxpayer adopted the method described in section
174(a)).
(B) Operations conducted through nonpassthrough entities. For
purposes of applying section 469 and the regulations thereunder, a
taxpayer's activities do not include operations that a taxpayer conducts
through one or more entities (other than passthrough entities). The
following example illustrates the operation of this paragraph
(b)(2)(ii)(B):
Example. (i) A, an individual, owns stock of X, a closely held
corporation (within the meaning of Sec. 1.469-1T(g)(2)(ii) that is
directly engaged in the conduct of a real estate development business. A
participates in X's real estate development business, but does not own
any interest in the business other than through ownership of the stock
of X.
(ii) X is subject to section 469 (see Sec. 1.469-1T(b)(5)) and does
not hold the real estate development business through another entity.
Accordingly, for purposes of section 469 and the regulations thereunder,
the operations of X's real estate development business are treated as
part of X's activities.
(iii) A is also subject to section 469 (see Sec. 1.469-1T(b)(1)),
but A's only interest in the real estate development business is held
through X. X is a C corporation and therefore is not a passthrough
entity. Thus, for purposes of section 469 and the regulations
thereunder, A's activities do not include the operations of X's real
estate development business. Accordingly, A's participation in X's
busines is not participation in an activity of A, and is not taken into
account in determining whether A materially participates (within the
meaning of Sec. 1.469-5T) or significantly participates (within the
meaning of Sec. 1.469-1T(c)(2)) in any activity. (See, however, Sec.
1.469-1T(g)(3) for rules under which a shareholder's participation is
taken into account for purposes of determining whether a corporation
materially or significantly participates in an activity.
(c) Undertaking--(1) In general. Except as otherwise provided in
paragraphs (d), (e), and (k)(2)(iii) of this section, business and
rental operations that constitute a separate source of income production
shall be treated as a single undertaking that is separate from other
undertakings.
(2) Operations treated as a separate source of income production--
(i) In general. Except as otherwise provided in this paragraph (c)(2),
business and rental operations shall be treated for purposes of this
paragraph (c) as a separate source of income production if and only if--
(A) Such operations are conducted at the same location (within the
meaning of paragraph (c)(2)(iii) of this section) and are owned by the
same person (within the meaning of paragraph (c)(2)(v) of this section);
and
(B) Income-producing operations (within the meaning of paragraph
(c)(2)(iv) of this section) owned by such person are conducted at such
location.
(ii) Treatment of support operations--(A) In general. For purposes
of section 469 and the regulations thereunder--
(1) The support operations conducted at a location shall not be
treated as part of an undertaking under paragraph (c)(2)(i) of this
section; and
(2) The income and expenses that are attributable to such operations
and are reasonably allocable to an undertaking conducted at a different
location shall be taken into account in determining the income or loss
from the activity or
[[Page 454]]
activities that include such undertaking.
(B) Support operations. For purposes of this paragraph (c)(2), the
business and rental operations conducted at a location are treated as
support operations to the extent that--
(1) Such operations and an undertaking that is conducted at a
different location are owned by the same person (within the meaning of
paragraph (c)(2)(v) of this section);
(2) Such operations involve the provision of property or services to
such undertaking; and
(3) Such operations are not income-producing operations (within the
meaning of paragraph (c)(2)(iv) of this section).
(iii) Location. For purposes of this paragraph (c)(2)--
(A) The term ``location'' means, with respect to any business and
rental operations, a fixed place of business at which such operations
are regularly conducted;
(B) Business and rental operations are conducted at the same
location if they are conducted in the same physical structure or within
close proximity of one another;
(C) Business and rental operations that are not conducted at a fixed
place of business or that are conducted on the customer's premises shall
be treated as operations that are conducted at the location (other than
the customer's premises) with which they are most closely associated;
(D) All the facts and circumstances (including, in particular, the
factors listed in paragraph (c)(3) of this section) are taken into
account in determining the location with which business and rental
operations are most closely associated; and
(E) Oil and gas operations that are conducted for the development of
a common reservoir are conducted within close proximity of one another.
(iv) Income-producing operations. For purposes of this paragraph
(c)(2), the term ``income-producing operations'' means business and
rental operations that are conducted at a location and relate to (or are
conducted in reasonable anticipation of)--
(A) The production of property at such location;
(B) The sale of property to customers at such location;
(C) The performance of services for customers at such location;
(D) Transactions in which customers take physical possession at such
location of property that is made available for their use; or
(E) Any other transactions that involve the presence of customers at
such location.
(v) Ownership by the same person. For purposes of this paragraph
(c)(2), business and rental operations are owned by the same person if
and only if one person (within the meaning of section 7701(a)(1)) is the
direct owner of such operations.
(3) Facts and circumstances determinations. In determining whether a
location is the location with which business and rental operations are
most closely associated for purposes of paragraph (c)(2)(iii)(D) of this
section, the following relationships between operations that are
conducted at such location and other operations are generally the most
significant:
(i) The extent to which other persons conduct similar operations at
one location;
(ii) Whether such operations are treated as a unit in the primary
accounting records reflecting the results of such operations;
(iii) The extent to which other persons treat similar operations as
a unit in the primary accounting records reflecting the results of such
similar operations;
(iv) The extent to which such operations involve products or
services that are commonly provided together;
(v) The extent to which such operations serve the same customers;
(vi) The extent to which the same personnel, facilities, or
equipment are used to conduct such operations;
(vii) The extent to which such operations are conducted in
coordination with or reliance upon each other;
(viii) The extent to which the conduct of any such operations is
incidental to the conduct of the remainder of such operations;
(ix) The extent to which such operations depend on each other for
their economic success; and
[[Page 455]]
(x) Whether such operations are conducted under the same trade name.
(4) Examples. The following examples illustrate the application of
this paragraph (c). In each example that does not state otherwise, the
taxpayer is an individual and the facts, analysis, and conclusion relate
to a single taxable year.
Example 1. The taxpayer is the sole owner of a department store and
a restaurant and conducts both businesses in the same building. Thus,
the department store and restaurant operations are conducted at the same
location (within the meaning of paragraph (c)(2)(iii) of this section)
and are owned by the same person (i.e., the taxpayer is the direct owner
of the operations). In addition, the taxpayer conducts income-producing
operations (within the meaning of paragraph (c)(2)(iv) of this section)
at the location (i.e., property is sold to customers and services are
performed for customers on the premises of the department store).
Accordingly, the department store and restaurant operations are treated
as a separate source of income production (see paragraph (c)(2) of this
section) and as a single undertaking that is separate from other
undertakings (see paragraph (c)(1) of this section).
Example 2. (i) The facts are the same as in Example 1, except that
the taxpayer is also the sole owner of an automotive center that
services automobiles and sells tires, batteries, motor oil, and
accessories. The taxpayer operates the automotive center in a separate
structure in the shopping mall in which the department store is located.
Although the automotive center operations and the department store and
restaurant operations are not conducted in the same physical structure,
they are conducted within close proximity (within the meaning of
paragraph (c)(2)(iii)(B) of this section) of one another. Thus, the
department store, restaurant, and automotive center operations are
conducted at the same location (within the meaning of paragraph
(c)(2)(iii) of this section).
(ii) As in Example 1, the operations conducted at the same location
are owned by the same person, and the taxpayer conducts income-producing
operations (within the meaning of paragraph (c)(2)(iv) of this section)
at the location. Accordingly, the department store, restaurant, and
automotive center operations are treated as a separate source of income
production (see paragraph (c)(2) of this section) and as a single
undertaking that is separate from other undertakings (see paragraph
(c)(1) of this section).
Example 3. (i) The facts are the same as in Example 2, except that
the automotive center is located several blocks from the shopping mall.
As in Example 1, the department store and restaurant operations are
treating as a single undertaking that is separate from other
undertakings. Because, however, the automotive center operations are not
conducted within close proximity (within the meaning of paragraph
(c)(2)(iii)(B) of this section) of the department store and restaurant
operations, all of the taxpayer's operations are not conducted at the
same location (within the meaning of paragraph (c)(2)(iii) of this
section).
(ii) All of the automotive center operations are conducted at the
same location (within the meaning of paragraph (c)(2)(iii) of this
section) and are owned by the same person (i.e., the taxpayer is the
direct owner of the operations). In addition, the taxpayer conducts
income producing operations (within the meaning of paragraph (c)(2)(iv)
of this section) at the location (i.e., property is sold to customers
and services are performed for customers on the premises of the
automotive center). Accordingly, the automotive center operations are
also treated as a separate source of income production (see paragraph
(c)(2) of this section) and as a single undertaking that is separate
from other undertakings (see paragraph (c)(1) of this section). See,
however, paragraph (g) of this section for rules under which certain
trade or business activities are treated as a single activity.
Example 4. The taxpayer is the sole owner of a building and rents
residential, office, and retail space in the building to various
tenants. The taxpayer manages these rental operations from an office
located in the building. The rental operations are conducted at the same
location (within the meaning of paragraph (c)(2)(iii) of this section)
and are owned by the same person (i.e., the taxpayer is the direct owner
of the operations). In addition, the taxpayer conducts income-producing
operations (within the meaning of paragraph (c)(2)(iv) of this section)
at the location (i.e., customers take physical possession in the
building of property made available for their use). Accordingly, the
rental operations are treated as a separate source of income production
(see paragraph (c)(2) of this section) and as a single undertaking that
is separate from other undertakings (see paragraph (c)(1) of this
section). See paragraph (d) of this section for rules for determining
whether this undertaking is a rental undertaking and paragraph (k) of
this section for rules for identifying rental real estate activities.
Example 5. (i) The facts are the same as in Example 4, except that
the taxpayer also uses the rental office in the building (``Building
1'') to manage rental operations in another building (``Building 2'')
that the
[[Page 456]]
taxpayer owns. The rental operations conducted in Building 2 are
treated as a separate source of income production under paragraph (c)(2)
of this section and as a single undertaking that is separate from other
undertakings (the ``Building 2 undertaking'') under paragraph (c)(1) of
this section.
(ii) The operations conducted at the rental office in Building 1
and the Building 2 undertaking are owned by the same person (i.e., the
taxpayer is the direct owner of the operations). In addition, the
operations conducted at the rental office with respect to the Building
2 undertaking relate to transactions in which customers take physical
possession at another location of property that is made available for
their use (i.e., the operations are not income-producing operations
(within the meaning of paragraph (c)(2)(iv) of this section)). Thus, to
the extent the operations conducted at the rental office involve the
management of the Building 2 undertaking, they are support operations
(within the meaning of paragraph (c)(2)(ii)(B) of this section) with
respect to the Building 2 undertaking.
(iii) Paragraph (c)(2)(ii)(A)(1) of this section provides that
support operations are not treated as part of an undertaking under
paragraph (c)(2)(i) of this section. Therefore, the support operations
conducted at the rental office are not treated as part of the
undertaking that consists of the rental operations conducted in Building
1 (the ``Building 1 undertaking''). Paragraph (c)(2)(ii)(A)(2) of this
section provides that the income and expenses that are attributable to
support operations and are reasonably allocable to an undertaking
conducted at a different location shall be taken into account in
determining the income or loss from the activity that includes such
undertaking. Accordingly, the income and expenses of the rental office
that are reasonably allocable to the Building 2 undertaking are taken
into account in determining the income or loss from the activity or
activities that include the Building 2 undertaking. See paragraph (k)
of this section for rules for identifying rental real estate activities.
(iv) Rental office operations that involve the management of rental
operations conducted in Building 1 are not support operations (within
the meaning of paragraph (c)(2)(ii)(B) of this section) because they
relate to an undertaking that is conducted at the same location (the
``Building 1 undertaking''). Thus, the rules for support operations in
paragraph (c)(2)(ii)(A) of this section do not apply to such operations,
and they are treated as part of the Building 1 undertaking.
Example 6. (i) The taxpayer conducts business and rental operations
at eleven different locations (within the meaning of paragraph
(c)(2)(iii) of this section). At ten of the locations the taxpayer owns
grocery stores, and at the eleventh location the taxpayer owns a
warehouse that receives goods and supplies them to the taxpayer's
stores. The operations of each store are conducted at the same location
(within the meaning of paragraph (c)(2)(iii) of this section) and are
owned by the same person (i.e., the taxpayer is the direct owner of the
operations). In addition, the taxpayer conducts income-producing
operations (within the meaning of paragraph (c)(2)(iv) of this section)
at each location (i.e., property is sold to customers on the store
premises, and customers take physical possession on the store premises
of property made available for their use). Accordingly, the operations
of each of the ten grocery stores are treated as a separate source of
income production (see paragraph (c)(2) of this section), and each store
is treated as a single undertaking (a ``grocery store undertaking'')
that is separate from other undertakings (see paragraph (c)(1) of this
section). The operations conducted at the warehouse, however, do not
include any income-producing operations (within the meaning of paragraph
(c)(2)(iv) of this section). Accordingly, the warehouse operations do
not satisfy the requirements of paragraph (c)(2)(i) of this section and
are not treated as a separate undertaking under paragraph (c)(1) of this
section.
(ii) The warehouse operations and the grocery store undertakings are
owned by the same person (i.e., the taxpayer is the direct owner of the
operations), the operations conducted at the warehouse involve the
provision of property to the grocery store undertakings, and the
warehouse operations are not income-producing operations (within the
meaning of paragraph (c)(2)(iv) of this section). Thus, the warehouse
operations are support operations (within the meaning of paragraph
(c)(2)(ii)(B) of this section) with respect to the grocery store
undertakings. Paragraph (c)(2)(ii)(A)(2) of this section provides that
the income and expenses that are attributable to support operations and
are reasonably allocable to an undertaking conducted at a different
location shall be taken into account in determining the income or loss
from the activity or activities that include such undertaking.
Accordingly, the income and expenses of the warehouse operations that
are reasonably allocable to a grocery store undertaking are taken into
account in determining the income or loss from the activity or
activities that include such undertaking. See paragraph (f) of this
section for rules under which certain similar, commonly-controlled
undertakings are treated as a single activity.
Example 7. (i) The facts are the same as in Example 6, except that
the warehouse operations also include the sale of goods to grocery
stores that the taxpayer does not own (``other grocery stores'').
Because of these
[[Page 457]]
sales, the taxpayer conducts income-producing operations (within the
meaning of paragraph (c)(2)(iv) of this section) at the warehouse. The
warehouse operations are conducted at the same location (within the
meaning of paragraph (c)(2)(iii) of this section) and are owned by the
same person (i.e., the taxpayer is the direct owner of the operations).
Accordingly, prior to the application of the rules for support
operations in paragraph (c)(2)(ii) of this section, the warehouse
operations are treated as a separate source of income production (see
paragraph (c)(2) of this section) and as a single undertaking (the
``separate warehouse undertaking'') that is separate from other
undertakings (see paragraph (c)(1) of this section).
(ii) As in Example 6, the warehouse operations that involve
supplying goods to the taxpayer's grocery store undertakings are support
operations with respect to those undertakings. Therefore, those
operations are not treated as part of the separate warehouse undertaking
(see paragraph (c)(2)(ii)(A)(1) of this section), and the income and
expenses of such operations are taken into account, as in Example 6, in
determining the income or loss from the activity or activities that
include the taxpayer's grocery store undertakings.
Example 8. (i) A partnership is formed to acquire real property and
construct a building on the property. The partnership hires brokers to
locate a suitable parcel of land, lawyers to negotiate zoning variances,
easements, and building permits, and architects and engineers to design
the improvements. After the architects and engineers have designed the
improvements and other preliminaries have been completed, the
partnership hires a general contractor who hires subcontractors and
oversees construction. During the construction process and after
construction has been completed, the partnership leases out space in the
building. The partnership then operates the building as a rental
property. The operations of acquiring the real property, negotiating
contracts, overseeing the designing and construction of the
improvements, leasing up the building, and operating the building are
conducted at an office (the ``management office'') that is not at the
same location (within the meaning of paragraph (c)(2)(iii) of this
section) as the building.
(ii) The operations conducted at the building site (e.g., excavating
the land, pouring the concrete for the foundation, erecting the frame of
the building, completing the exterior of the building, and building out
the interior of the building) are conducted at the same location (within
the meaning of paragraph (c)(2)(iii) of this section) and are owned by
the same person (i.e., the partnership is the direct owner of the
operations). In addition, the partnership conducts income-producing
operations (within the meaning of paragraph (c)(2)(iv) of this section)
at the location (i.e., during the construction period property (the
building) is produced at the building site, and during the rental period
customers take physical possession in the building of property made
available for their use). Accordingly, the operations conducted at the
building site are treated as a separate source of income production (see
paragraph (c)(2) of this section) and as a single undertaking that is
separate from other undertakings (see paragraph (c)(1) of this section).
(iii) The operations conducted at the management office and the
undertaking conducted at the building site are owned by the same person
(i.e., the partnership is the direct owner of the operations). In
addition, the operations conducted at the management office relate to
transactions in which customers take physical possession at another
location of property that is made available for their use (i.e., the
operations are not income-producing operations (within the meaning of
paragraph (c)(2)(iv) of this section)). Thus, to the extent the
operations conducted at the management office involve the provision of
services to the undertaking conducted at the building site, they are
support operations (within the meaning of paragraph (c)(2)(ii)(B) of
this section) with respect to such undertaking.
(iv) Paragraph (c)(2)(ii)(A)(2) of this section provides that the
income and expenses of support operations that are reasonably allocable
to an undertaking conducted at a different location shall be taken into
account in determining the income or loss from the activity that
includes such undertaking. Accordingly, the income and expenses of the
management office that are reasonably allocable to the undertaking
conducted at the building site are taken into account in determining the
income or loss from the activity or activities that include such
undertaking.
(v) Until the building is first held out for rent and is in a state
of readiness for rental, the undertaking conducted at the building site
is a trade or business undertaking (within the meaning of paragraph
(f)(1)(ii) of this section). See paragraph (d) of this section for rules
for determining whether the undertaking is a rental undertaking for
periods after the building is first held out for rent and is in a state
of readiness for rental and paragraph (k) of this section for rules for
identifying rental real estate activities.
Example 9. The taxpayer owns 15 oil wells pursuant to a single
working interest (within the meaning of Sec. 1.469-1T (e)(4)(iv). All
of the wells are drilled and operated for the development of a common
reservoir. Thus, all of the wells are at the same location (see
paragraph (c)(2)(iii)(E) of this section). All of the wells are owned by
the same person (i.e., the taxpayer is the direct owner of the
operations), and the taxpayer conducts income-producing operations
(within the meaning of
[[Page 458]]
paragraph (c)(2)(iv) of this section) at the location (i.e., oil wells
are drilled in reasonable anticipation of producing oil at the
location). Accordingly, the operations of the wells are treated as a
separate source of income production (see paragraph (c)(2) of this
section) and as a single undertaking that is separate from other
undertakings (see paragraph (c)(1) of this section). See paragraph (e)
of this section for rules under which certain oil and gas operations are
treated as multiple undertakings even if they would be part of the same
undertaking under the rules of this paragraph (c).
Example 10. (i) Partnership X owns an automobile dealership and
partnership Y owns an automobile repair shop. The dealership and repair
shop operations are conducted in the same physical structure.
Individuals A, B, and C are the only partners in partnerships X and Y,
and each of the partners owns a one-third interest in both partnerships.
(ii) The dealership operations and the repair-shop operations are
conducted at the same location (within the meaning of paragraph
(c)(2)(iii) of this section), but are owned by different persons (i.e.,
X is the direct owner of the dealership operations, and Y is the direct
owner of the repair-shop operations). Moreover, indirect ownership of
the operations is not taken into account under paragraph (c)(2)(v) of
this section. Thus, it is irrelevant that the two partnerships are owned
by the same persons in identical proportions. Accordingly, the
dealership and repair-shop operations are not treated as part of the
same source of income production (see paragraph (c)(2) of this section)
or as a single undertaking that is separate from other undertakings (see
paragraph (c)(1) of this section). See, however, paragraph (g) of this
section for rules under which certain trade or business activities are
treated as a single activity.
Example 11. (i) The taxpayer owns and operates a delivery service.
The business consists of a central office, retail establishments, and
messengers who transport packages from one place to another. Customers
may bring their packages to a retail establishment for delivery
elsewhere or, by calling the central office, may have packages picked up
at their homes or offices. The central office dispatches messengers and
coordinates all pickups and deliveries. Customers may pay for deliveries
when they drop off or pick up packages at a retail establishment, or the
central office will bill the customer for services rendered. In
addition, many packages are routed through the central office.
(ii) The operations conducted at the central office are conducted at
the same location (within the meaning of paragraph (c)(2)(iii) of this
section) and are owned by the same person (i.e., the taxpayer is the
direct owner of the operations). The operations actually conducted at
the central office, however, do not include any income-producting
operations (within the meaning of paragraph (c)(2)(iv) of this section).
(iii) Under paragraph (c)(2)(iii) (C) and (D) of this section,
business and rental operations that are not conducted at a fixed place
of business or that are conducted on the customer's premises are treated
as operations that are conducted at the location (other than the
customer's premises) with which they are most closely associated, and
all the facts and circumstances are taken into account in determining
the location with which business and rental operations are most closely
associated. The facts and circumstances in this case (including the
facts that the central office dispatches messengers, coordinates all
pickups and deliveries, and is the transshipment point for many
packages) establish that the operations of delivering packages from one
location to another are most closely associated with the central office.
Thus, the delivery operations are treated as operations that are
conducted at the central office, and the deliveries are treated as
income-producing operations (i.e., the performance of services for
customers) that the taxpayer conducts at the central office.
Accordingly, the operations conducted at the central office are treated
as a separate source of income production (see paragraph (c)(2) of this
section) and as a single undertaking that is separate from other
undertakings (see paragraph (c)(1) of this section).
(iv) The operations conducted at each retail establishment are
conducted at the same location (within the meaning of paragraph
(c)(2)(iii) of this section) and are owned by the same person (i.e., the
taxpayer is the direct owner of the operations). At each retail
establishment, the taxpayer's operations include transactions that
involve the presence of customers at the establishment. Thus, the
taxpayer conducts income-producing operations (within the meaning of
paragraph (c)(2)(iv)(E) of this section) at the retail establishments.
Accordingly, the operations of each retail establishment are treated as
a separate source of income production (see paragraph (c)(2) of this
section) and as a single undertaking that is separate from other
undertakings (see paragraph (c)(1) of this section). See, however,
paragraph (f) of this section for rules under which certain similar,
commonly-controlled undertakings are treated as a single activity.
Example 12. (i) The taxpayer is the sole owner of a saw mill and a
lumber yard. The taxpayer's business operations consist of converting
timber into lumber and other wood products and selling the resulting
products. The timber is processed at the saw mill, and the resulting
products are transported to the lumber yard where they are sold. The saw
mill and the lumber yard are at different locations (within the meaning
of
[[Page 459]]
paragraph (c)(2)(iii) of this section). The transportation operations
are managed at the saw mill.
(ii) The operations conducted at the saw mill are conducted at the
same location (within the meaning of paragraph (c)(2)(iii) of this
section) and are owned by the same person (i.e., the taxpayer is the
direct owner of the operations). In addition, the taxpayer conducts
income-producing operations (within the meaning of paragraph (c)(2)(iv)
of this section) at the location (i.e., lumber is produced at the mill).
Similarly, the selling operations at the lumber yard are conducted at
the same location (within the meaning of paragraph (c)(2)(iii) of this
section) and are owned by the same person (i.e., the taxpayer is the
direct owner of the operations). In addition, the taxpayer conducts
income-producing operations (within the meaning of paragraph (c)(2)(iv)
of this section) at the location (i.e., lumber is sold to customers at
the lumber yard). Thus, the milling operations and the selling
operations are treated as separate sources of income production (see
paragraph (c)(2) of this section) and as separate undertakings (see
paragraph (c)(1) of this section).
(iii) The operations conducted at the mill involve the provision of
property to the lumber-yard undertaking. Nonetheless, the milling
operations are income-producing operations because they relate to the
production of property at the mill, and an undertaking's income-
producing operations are not treated as support operations (see
paragraph (c)(2)(ii)(B)(3) of this section). Accordingly, the milling
operations are not support operations with respect to the lumber-yard
undertaking. See, however, paragraph (f) of this section for rules under
which certain vertically-integrated undertakings are treated as part of
the same activity.
(iv) The operations of transporting finished products from the saw
mill to the lumber yard are not conducted at a fixed location. Under
paragraphs (c)(2)(iii) (C) and (D) of this section, business and rental
operations that are not conducted at a fixed place of business or that
are conducted on the customer's premises are treated as operations that
are conducted at the location (other than the customer's premises) with
which they are most closely associated, and all the facts and
circumstances are taken into account in determining the location with
which business and rental operations are most closely associated. The
facts and circumstances in this case (including the fact that the
transportation operations are managed at the saw mill) establish that
the transportation operations are most closely associated with the saw
mill. Thus, the transportation operations are treated as operations that
are conducted at the mill and as part of the undertaking that consists
of the milling operations.
(d) Rental undertaking--(1) In general. This paragraph (d) applies
to operations that are treated, under paragraph (c) of this section and
before the application of paragraph (d)(1)(i) of this section, as a
single undertaking that is separate from other undertakings (a
``paragraph (c) undertaking''). For purposes of this section--
(i) A paragraph (c) undertaking's rental operations and its
operations other than rental operations shall be treated, except as
otherwise provided in paragraph (d)(2) of this section, as two separate
undertakings;
(ii) The income and expenses that are reasonably allocable to an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) shall be taken into account in determining the income or
loss from the activity or activities that include such undertaking; and
(iii) An undertaking (determined after the application of paragraph
(d)(1)(i) of this section) shall be treated as a rental undertaking if
and only if such undertaking, considered as a separate activity, would
constitute a rental activity (within the meaning of Sec. 1.469-
1T(e)(3)).
(2) Exceptions. Paragraph (d)(1)(i) of this section shall not apply
to a paragraph (c) undertaking for any taxable year in which--
(i) The rental operations of the paragraph (c) undertaking,
considered as a separate activity, would not constitute a rental
activity (within the meaning of Sec. 1.469-1T(e)(3));
(ii) Less than 20 percent of the gross income of the paragraph (c)
undertaking is attributable to rental operations; or
(iii) Less than 20 percent of the gross income of the paragraph (c)
undertaking is attributable to operations other than rental operations.
(3) Rental operations. For purposes of this paragraph (d), a
paragraph (c) undertaking's rental operations are determined under the
following rules:
(i) General rule. Except as otherwise provided in paragraph (d)(3)
(ii) or (iii) of this section, a paragraph (c) undertaking's rental
operations are all of the undertaking's business and rental operations
that involve making tangible property available for use by customers
[[Page 460]]
and the provision of property and services in connection therewith.
(ii) Real property provided for short-term use. A paragraph (c)
undertaking's operations that involve making short-term real property
available for use by customers and the provision of property and
services in connection therewith shall not be treated as rental
operations if such operations, considered as a separate activity, would
not constitute a rental activity. An item of property is treated as
short-term real property for this purpose if and only if such item is
real property that the paragraph (c) undertaking makes available for use
by customers and the average period of customer use (within the meaning
of Sec. 1.469-1T(e)(3)(iii)) for all of the paragraph (c) undertaking's
real property of the same type as such item is 30 days or less.
(iii) Property made available to licensees. A paragraph (c)
undertaking's operations that involve making tangible property available
during defined business hours for nonexclusive use by various customers
shall not be treated as rental operations. (See Sec. 1.469-
1T(e)(3)(ii)(E).)
(4) Examples. The following examples illustrate the application of
this paragraph (d). In each example that does not state otherwise, the
taxpayer is an individual and the facts, analysis, and conclusions
relate to a single taxable year.
Example 1. (i) The taxpayer owns a building in which the taxpayer
rents office space to tenants and operates a parking garage that is used
by tenants and other persons. (Assume that, under paragraph (c)(1) of
this section, the operations conducted in the building are treated as a
single paragraph (c) undertaking.) The taxpayer's tenants typically
occupy an office for at least one year, and the services provided to
tenants are those customarily provided in office buildings. Some persons
(including tenants) rent spaces in the parking garage on a monthly or
annual basis. In general, however, spaces are rented on an hourly or
daily basis, and the average period for which all customers (including
tenants) use the parking garage is less than 24 hours. The paragraph (c)
undertaking derives 75 percent of its gross income from office-space
rentals and 25 percent of its gross income from the parking garage. The
operations conducted in the building are not incidental to any other
activity of the taxpayer (within the meaning of Sec. 1.469-
1T(e)(3)(vi)).
(ii) The parking spaces are real property and the average period of
customer use (within the meaning of Sec. 1.469-1T(e)(3)(iii)) for the
parking spaces is 30 days or less. Thus, the parking spaces are short-
term real properties (within the meaning of paragraph (d)(3)(ii) of this
section). (For this purpose, individual parking spaces that are rented
on a monthly or annual basis are, nevertheless, short-term real
properties because all the parking spaces are property of the same type,
and the average rental period taking all parking spaces into account is
30 days or less.) In addition, the parking-garage operations involve
making short-term real properties available for use by customers and the
provision of property and services in connection therewith.
(iii) Paragraph (d)(3) (i) and (ii) of this section provides, in
effect, that a paragraph (c) undertaking's operations that involve
making short-term real properties available for use by customers and the
provision of property and services in connection therewith are treated
as rental operations if and only if the operations, considered as a
separate activity, would constitute a rental activity (within the
meaning of Sec. 1.469-1T(e)(3)). In this case, the parking-garage
operations, if considered as a separate activity, would not constitute a
rental activity because the average period of customer use for the
parking spaces is seven days or less (see Sec. 1.469-1T(e)(3)(ii)(A)).
Accordingly, the parking-garage operations are not treated as rental
operations.
(iv) The paragraph (c) undertaking's remaining operations involve
the provision of tangible property (the office spaces) for use by
customers and the provision of property and services in connection
therewith. The average period of customer use for the office spaces
exceeds 30 days. Thus, the office spaces are not short-term real
properties, and the undertaking's operations involving the rental of
office spaces are rental operations.
(v) Paragraph (d)(1)(i) of this section provides, with certain
exceptions, that a paragraph (c) undertaking's rental operations and its
operations other than rental operations are treated as two separate
undertakings. In this case, at least 20 percent of the paragraph (c)
undertaking's gross income is attributable to rental operations (the
office-space operations) and at least 20 percent is attributable to
operations other than rental operations (the parking-garage operations).
Thus, the exceptions in paragraph (d)(2) (ii) and (iii) of this section
do not apply. In addition, the average period of customer use for the
office spaces exceeds 30 days, extraordinary personal services (within
the meaning of Sec. 1.469-1T(e)(3)(v)) are not provided, and the rental
of the office spaces is
[[Page 461]]
not treated as incidental to a nonrental activity under Sec. 1.469-
1T(e)(3)(vi) (relating to incidental rentals that are not treated as a
rental activity). Thus, the rental operations, if considered as a
separate activity, would constitute a rental activity, and the exception
in paragraph (d)(2)(i) of this section does not apply. Accordingly, the
rental operations and the parking-garage operations are treated as two
separate undertakings (the ``office-space undertaking'' and the
``parking-garage undertaking'').
(vi) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking if and only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the office-space undertaking, if
considered as a separate activity, would constitute a rental activity
(see (v) above), and the parking-garage undertaking, if considered as a
separate activity, would not constitute a rental activity (see (iii)
above). Accordingly, the office-space undertaking is treated as a rental
undertaking, and the parking-garage undertaking is not.
Example 2. (i) The taxpayer owns a building in which the taxpayer
rents apartments to tenants and operates a restaurant. (Assume that,
under paragraph (c)(1) of this section, the operations conducted in the
building are treated as a single paragraph (c) undertaking.) The
taxpayer's tenants typically occupy an apartment for at least one year,
and the services provided to tenants are those customarily provided in
residential apartment buildings. The paragraph (c) undertaking derives
85 percent of its gross income from apartment rentals and 15 percent of
its gross income from the restaurant. The operations conducted in the
building are not incidental to any other activity of the taxpayer
(within the meaning of Sec. 1.469-1T(e)(3)(vi)).
(ii) The operations with respect to apartments (the ``apartment
operations'') involve the provision of tangible property (the
apartments) for use by customers and the provision of property and
services in connection therewith. In addition, the apartments are not
short-term real properties (within the meaning of paragraph (d)(3)(ii)
of this section) because the average period of customer use (within the
meaning of Sec. 1.469-1T(e)(3)(iii)) for the apartments exceeds 30
days. Accordingly, the apartment operations are rental operations
(within the meaning of paragraph (d)(3) of this section). The restaurant
operations do not involve the provision of tangible property for use by
customers or the provision of property or services in connection
therewith. Thus, the restaurant operations are not rental operations.
(iii) Paragraph (d)(1)(i) of this section provides, with certain
exceptions, that a paragraph (c) undertaking's rental operations and its
operations other than rental operations are treated as two separate
undertakings. In this case, however, the exception in paragraph
(d)(2)(iii) of this section applies because less than 20 percent of the
paragraph (c) undertaking's gross income is attributable to operations
other than rental operations (the restaurant operations). Accordingly,
the rental operations and the restaurant operations are not treated as
two separate undertakings under paragraph (d)(1)(i) of this section.
(iv) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking if and only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the undertaking (determined after the
application of paragraph (d)(1)(i) of this section) includes both the
apartment operations and the restaurant operations, and the gross income
of this undertaking represents amounts paid principally for the use of
tangible property (the apartments). Moreover, the average period of
customer use for the apartments exceeds 30 days, extraordinary personal
services (within the meaning of Sec. 1.469-1T(e)(3)(v)) are not
provided, and the rental of the apartments is not treated as incidental
to a nonrental activity under Sec. 1.469-1T(e)(3)(vi) (relating to
incidental rentals that are not treated as a rental activity). Thus, the
undertaking, if considered as a separate activity, would constitute a
rental activity. Accordingly, the undertaking is treated as a rental
undertaking.
Example 3. (i) The taxpayer owns a building in which the taxpayer
rents hotel rooms, meeting rooms, and parking spaces to customers, rents
space to various retailers, and operates a restaurant and health club.
(Assume that, under paragraph (c)(1) of this section, the operations
conducted in the building are treated as a single paragraph (c)
undertaking.) Although some customers occupy hotel rooms for extended
periods (including some customers who reside in the hotel), customers
use hotel rooms for an average period of two days and meeting rooms for
an average period of one day. The services provided to persons using the
hotel rooms and meeting rooms are those customarily provided in hotels
(including wake-up calls, valet services, and delivery of food and
beverages to rooms). Some customers rent spaces in the parking garage on
a monthly or annual basis. In general, however, parking spaces are
rented on an hourly or daily basis, and the average period for which
customers use the parking garage is less than 24 hours. Retail tenants
typically occupy their space for at least one year, and the services
provided to retail tenants are those customarily provided in commercial
buildings. The paragraph (c) undertaking derives 45 percent of its gross
income from renting hotel rooms,
[[Page 462]]
meeting rooms, and parking spaces, 35 percent of its gross income from
renting retail space, and 20 percent of its gross income from the
restaurant and health club. The operations conducted in the building are
not incidental to any other activity of the taxpayer (within the meaning
of Sec. 1.469-1T(e)(3)(vi)).
(ii) The parking spaces, hotel rooms, and meeting rooms are real
property of three different types, but the average period of customer
use (within the meaning of Sec. 1.469-1T (e)(3)(iii)) for property of
each type is 30 days or less. Thus, the parking spaces, hotel rooms, and
meeting rooms are short-term real properties. (For this purpose,
individual parking spaces or hotel rooms that are rented for extended
periods are, nevertheless, short-term real properties if the average
rental period for all parking spaces is 30 days or less and the average
rental period for all hotel rooms is 30 days or less.) In addition, the
parking garage operations, the operations with respect to hotel rooms
(the ``hotel-room operations''), and the operations with respect to
meeting rooms (the ``meeting-room operations'') involve making short-
term real properties available for use by customers and the provision of
property and services in connection therewith.
(iii) Paragraph (d)(3) (i) and (ii) of this section provides, in
effect, that a paragraph (c) undertaking's operations that involve
making short-term real properties available for use by customers and the
provision of property and services in connection therewith are treated
as rental operations if and only if the operations, considered as a
separate activity, would constitute a rental activity (within the
meaning of Sec. 1.469-1T (e)(3)). In this case the parking-garage,
hotel-room and meeting-room operations, if considered as separate
activities, would not constitute rental activities because the average
period of customer use for parking spaces, hotel rooms, and meeting
rooms does not exceed seven days (see Sec. 1.469-1T (e)(3)(ii)(A)).
Accordingly, the parking-garage, hotel-room, and meeting-room operations
are not treated as rental operations.
(iv) The operations with respect to retail space in the building
(the ``retail-space operations'') involve the provision of tangible
property (the retail spaces) for use by customers and the provision of
property and services in connection therewith. In addition, the retail
spaces are not short-term real properties (within the meaning of
paragraph (d)(3)(ii) of this section) because the average period of
customer use (within the meaning of Sec. 1.469-1T (e)(3)(iii)) for the
retail spaces exceeds 30 days. Accordingly, the retail-space operations
are rental operations.
(v) The health-club operations involve making tangible property
available for use by customers, but the property is customarily made
available during defined business hours for nonexclusive use by various
customers. Accordingly, the health-club operations are not rental
operations (see paragraph (d)(3)(iii) of this seciton). The restaurant
operations do not involve the provision of tangible property for use by
customers or the provision of property or services in connection
therewith. Accordingly, the restaurant operations also are not rental
operations.
(vi) Paragraph (d)(1)(i) of this section provides, with certain
exceptions, that a paragraph (c) undertaking's rental operations and its
operations other than rental operations are treated as two separate
undertakings. In this case, at least 20 percent of the paragraph (c)
undertaking's gross income is attributable to rental operations (35
percent of the paragraph (c) undertaking's gross income is from the
retail-space operations) and at least 20 percent is attributable to
operations other than rental operations (45 percent from the hotel-room,
meeting-room and parking-garage operations and 20 percent from the
restaurant and health-club operations). Thus, the exceptions in
paragraph (d)(2) (ii) and (iii) of this section do not apply. In
addition, the average period of customer use for the retail space
exceeds 30 days, extraordinary personal services (within the meaning of
Sec. 1.469-1T (e)(3)(v)) are not provided, and the rental of the retail
space is not treated as incidental to a nonrental activity under Sec.
1.469-1T (e)(3)(vi) (relating to incidental rentals that are not treated
as a rental activity). Thus, the retail-space operations, if considered
as a separate activity, would constitute a rental activity, and the
exception in paragraph (d)(2)(i) of this section does not apply.
Accordingly, the retail-space operations are treated as an undertaking
(the ``retail-space undertaking'') and all the other operations
conducted in the building (i.e., renting hotel and meeting rooms and
parking spaces and operating the restaurant and health club) are treated
as a separate undertaking (the ``hotel undertaking'').
(vii) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking if and only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the retail-space undertaking, if
considered as a separate activity, would constitute a rental activity
(see (iv) above). Accordingly, the retail-space undertaking is treated
as a rental undertaking. The hotel undertaking, if considered as a
separate activity, would not constitute a rental activity because all
tangible property provided for the use of customers in the hotel
undertaking is either property for which the average period of customer
use is seven days or less (see Sec. 1.469-1T (e)(3)(ii)(A))
[[Page 463]]
or property customarily made available during defined business hours for
nonexclusive use by various customers (see Sec. 1.469-1T
(e)(3)(ii)(E)). Accordingly, the hotel undertaking is not treated as a
rental undertaking.
Example 4. (i) A law partnership owns a ten-story building. The
partnership uses eight floors of the building in its law practice and
leases two floors to one or more tenants. (Assume that, under paragraph
(c)(1) of this section, the operations conducted in the building are
treated as a single paragraph (c) undertaking.) Tenants typically occupy
space on the two rented floors for at least one year, and the services
provided to tenants are those customarily provided in office buildings.
The paragraph (c) undertaking derives 90 percent of its gross income
from rendering legal services and 10 percent of its gross income from
renting space. The operations conducted in the building are not
incidental to any other activity of the taxpayer (within the meaning of
Sec. 1.469-1T (e)(3)(vi)).
(ii) The operations with respect to the office space leased to
tenants (the ``office-space operations'') involve the provision of
tangible property (the office space) for use by customers and the
provision of property and services in connection therewith. In addition,
the office spaces are not short-term real properties (within the meaning
of paragraph (d)(3)(ii) of this section) because the average period of
customer use (within the meaning of Sec. 1.469-1T(e)(3)(iii)) for the
office space exceeds 30 days. Accordingly, the office-space operations
are rental operations (within the meaning of paragraph (d)(3) of this
section).
(iii) The operations that involve the performance of legal services
(the ``law-practice operations'') do not involve the provision of
tangible property for use by customers or the provision of property or
services in connection therewith. Accordingly, the law-practice
operations are not rental operations.
(iv) Paragraph (d)(1)(i) of this section provides, with certain
exceptions, that a paragraph (c) undertaking's rental operations and its
operations other than rental operations are treated as two separate
undertakings. In this case, however, the exception in paragraph
(d)(2)(ii) of this section applies because less than 20 percent of the
paragraph (c) undertaking's gross income is attributable to rental
operations (the office-space operations). Accordingly, the law-practice
operations and the office-space operations are not treated as two
separate undertakings under paragraph (d)(1)(i) of this section.
(v) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the undertaking (determined after the
application of paragraph (d)(1)(i) of this section) includes both the
law-practice operations and the office-space operations, and the gross
income of this undertaking does not represent amounts paid principally
for the use of tangible property. Thus, the undertaking, if considered
as a separate activity, would not constitute a rental activity.
Accordingly, the undertaking is not treated as a rental undertaking.
Example 5. (i) The facts are the same as in Example 4, except that
the building is owned by a separate partnership (the ``real estate
partnership''), which leases eight floors of the building to the law
partnership for use in its law practice and two floors to one or more
other tenants. The law partnership and real estate partnership are owned
by the same individuals in identical proportions.
(ii) The operations conducted in the building are owned by two
different persons (i.e., the law partnership and the real estate
partnership). (See paragraph (c)(2)(v) of this section.) Thus, the
operations conducted in the building are not treated as a single
undertaking under paragraph (c)(1) of this section. Instead, each
partnership's share of such operations is treated as a separate
paragraph (c) undertaking (the ``law-practice undertaking'' and the
``office-space undertaking'').
(iii) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking if and only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the office-space undertaking, if
considered as a separate activity, would constitute a rental activity
because all of the undertaking's gross income (including rents paid by
the law partnership) represents amounts paid principally for the use of
tangible property (the office space), the average period of customer use
for the office space exceeds 30 days, extraordinary personal services
(within the meaning of Sec. 1.469-1T(e)(3)(v)) are not provided, and
the rental of the office space is not treated as incidental to a
nonrental activity under Sec. 1.469-1T(e)(3)(vi) (relating to
incidental rentals that are not treated as a rental activity).
Accordingly, the office-space undertaking is treated as a rental
undertaking. See, however, Sec. 1.469-2T(f)(6) (relating to certain
rentals of property to a trade or business activity in which the
taxpayer materially participates).
(iv) The law-practice undertaking, if considered as a separate
activity, would not constitute a rental activity because none of the
undertaking's gross income represents amounts paid principally for the
use of tangible property. Accordingly, the law-practice undertaking is
not treated as a rental undertaking.
[[Page 464]]
Example 6. (i) The taxpayer owns a building in which the taxpayer
operates a nursing home and a medical clinic. (Assume that, under
paragraph (c)(1) of this section, the operations conducted in the
building are treated as a single paragraph (c) undertaking.) The
nursing-home operations consist of renting apartments in the nursing
home to elderly and handicapped persons and providing medical care,
meals, and social activities. (Assume that these services are
extraordinary personal services (within the meaning of Sec. 1.469-
1T(e)(3)(v)). The medical clinic provides medical care to nursing-home
residents and other individuals. Nursing-home residents typically occupy
an apartment for at least one year. The paragraph (c) undertaking
derives 55 percent of its gross income from nursing-home operations
(including the provision of medical services to nursing-home residents)
and 45 percent of its gross income from medical-clinic operations. The
operations conducted in the building are not incidental to any other
activity of the taxpayer (within the meaning of Sec. 1.469-
1T(e)(3)(vi)).
(ii) The paragraph (c) undertaking's nursing-home operations involve
the provision of tangible property (the apartments) for use by customers
and the provision of property and services in connection therewith. In
addition, the apartments are not short-term real properties (within the
meaning of paragraph (d)(3)(ii) of this section) because the average
period of customer use (within the meaning of Sec. 1.469-1T(e)(3)(iii))
for the apartments exceeds 30 days. Accordingly, the nursing-home
operations are rental operations (within the meaning of paragraph (d)(3)
of this section). The medical-clinic operations do not involve the
provision of tangible property for use by customers or the provision of
property or services in connection therewith. Thus, the medical-clinic
operations are not rental operations.
(iii) Paragraph (d)(1)(i) of this section provides, with certain
exceptions, that a paragraph (c) undertaking's rental operations and its
operations other than rental operations are treated as two separate
undertakings. In this case, however, the nursing-home operations, if
considered as a separate activity, would not constitute a rental
activity because extraordinary personal services are provided in
connection with making nursing-home apartments available for use by
customers (see Sec. 1.469-T(e)(3)(ii)(C)). Thus, the exception in
paragraph (d)(2)(i) of this section applies, and the nursing-home
operations and the medical-clinic operations are not treated as two
separate undertakings under paragraph (d)(1)(i) of this section.
(iv) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the nursing-home operations, if
considered as a separate activity, would not constitute a rental
activity (see (iii) above). Thus, an undertaking that includes no rental
operations other than the nursing-home operations would not, if
considered as a separate activity, constitute a rental activity.
Accordingly, the undertaking is not treated as a rental undertaking.
Example 7. (i) The taxpayer rents and sells videocassettes. (Assumes
that, under paragraph (c)(1) of this section, the videocassette
operations are treated as a single paragraph (c) undertaking.) Renters
of videocassettes typically keep the videocassettes for one or two days,
and do not receive any other property or services in connection with
videocassette rentals. The paragraph (c) undertaking derives 70 percent
of its gross income from renting videocassettes and 30 percent of its
gross income from selling videocassettes. The videocassette operations
are not incidental to any other activity of the taxpayer (within the
meaning of Sec. 1.469-1T(e)(3)(vi)).
(ii) The rental of videocassettes involves the provision of tangible
property (the videocassettes) for use by customers. In addition, the
special rules for short-term real properties contained in paragraph
(d)(3)(ii) of this section do not apply in this case because the
videocassettes are not real property. Thus, the operations that involve
videocassette rentals are rental operations (within the meaning of
paragraph (d)(3) of this section). The sale of videocassettes does not
involve the provision of tangible property for use by customers or the
provision of property or services in connection therewith. Thus, the
operations that involve videocassette sales are not rental operations.
(iii) Paragraph (d)(1)(i) of this section provides, with certain
exceptions, that a paragraph (c) undertaking's rental operations and its
operations other than rental operations are treated as two separate
undertakings. In this case, however, the rental operations, if
considered as a separate activity, would not constitute a rental
activity because the average period of customer use for rented
videocassettes does not exceed seven days (see Sec. 1.469-
1T(e)(3)(ii)(A)). Accordingly, the exception in paragraph (d)(2)(i) of
this section applies, and the videocassette-rental operations and
videocassette-sales operations are not treated as two separate
undertakings under paragraph (d)(1)(i) of this section.
(iv) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the videocassette-rental
[[Page 465]]
operations, if considered as a separate activity, would not constitute a
rental activity (see (iii) above). Thus, an undertaking that includes no
rental operations other than the videocassette-rental operations would
not, if considered as a separate activity, constitute a rental activity.
Accordingly, the undertaking is not treated as a rental undertaking.
Example 8. (i) The taxpayer owns a building in which the taxpayer
sells, leases, and services automobiles. (Assume that, under paragraph
(c)(1) of this section, the operations conducted in the building are
treated as a single paragraph (c) undertaking.) The minimum lease term
for any leased automobile is 31 days, and the services provided to
lessees (including periodic oil changes, lubrication, and routine
services and repairs) are those customarily provided in long-term
automobile leases. The paragraph (c) undertaking derives 75 percent of
its gross income from selling automobiles, 15 percent of its gross
income from servicing automobiles other than leased automobiles, and 10
percent of its gross income from leasing automobiles. The taxpayer's
automobile operations are not incidental to any other activity of the
taxpayer (within the meaning of Sec. 1.469-1T(e)(3)(vi)).
(ii) The paragraph (c) undertaking's automobile-leasing operations
involve the provision of tangible property (the automobiles) for use by
customers and the provision of services in connection therewith. In
addition, the special rules for short-term real properties contained in
paragraph (d)(3)(ii) of this section do not apply in this case because
the automobiles are not real property. Accordingly, the automobile-
leasing operations are rental operations (within the meaning of
paragraph (d)(3) of this section). The paragraph (c) undertaking's
automobile-sales operations and servicing operations for automobiles
other than leased automobiles (the ``selling-and-servicing operations'')
do not involve the provision of tangible property for use by customers
or the provision of property or services in connection therewith. Thus,
the selling-and-servicing operations are not rental operations.
(iii) Paragraph (d)(1)(i) of this section provides, with certain
exceptions, that a paragraph (c) undertaking's rental operations and its
operations other than rental operations are treated as two separate
undertakings. In this case, however, the exception in paragraph
(d)(2)(ii) of this section applies because less than 20 percent of the
paragraph (c) undertaking's gross income is attributable to rental
operations (the ``automobile-leasing operations''). Accordingly, the
rental operations and the selling-and-servicing operations are not
treated as two separate undertakings under paragraph (d)(1)(i) of this
section.
(iv) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the undertaking (determined after the
application of paragraph (d)(1)(i) of this section) includes both the
selling-and-servicing operations and the automobile-leasing operations,
and the gross income of the undertaking does not represent amounts paid
principally for the use of tangible property. Thus, the undertaking, if
considered as a separate activity, would not constitute a rental
activity. Accordingly, the undertaking is not treated as a rental
undertaking.
Example 9. (i) The facts are the same as in Example 8, except that
the paragraph (c) undertaking derives 60 percent of its gross income
from selling automobiles, 15 percent of its gross income from servicing
automobiles other than leased automobiles, and 25 percent of its gross
income from leasing automobiles.
(ii) Paragraph (d)(1)(i) of this section provides, with certain
exceptions, that a paragraph (c) undertaking's rental operations and its
operations other than rental operations are treated as two separate
undertakings. In this case, more than 20 percent of the paragraph (c)
undertaking's gross income is attributable to rental operations (the
automobile-leasing operations), and more than 20 percent is attributable
to operations other than rental operations (the selling-and-servicing
operations). Thus, the exceptions in paragraph (d)(2) (ii) and (iii) of
this section do not apply. In addition, the average period of customer
use for leased automobiles exceeds 30 days, extraordinary personal
services (within the meaning of Sec. 1.469-1T(e)(3)(v)) are not
provided, and the leasing of the automobiles is not treated as
incidental to a nonrental activity under Sec. 1.469-1T(e)(3)(vi)
(relating to incidental rentals that are not treated as a rental
activity). Thus, the leasing operations, if considered as a separate
activity, would constitute a rental activity, and the exception in
paragraph (d)(2)(i) of this section does not apply. Accordingly, the
rental operations and the selling-and-servicing operations are treated
as two separate undertakings (the ``automobile-leasing undertaking'' and
the ``automobile selling-and-servicing undertaking'').
(iii) Paragraph (d)(1)(iii) of this section provides that an
undertaking (determined after the application of paragraph (d)(1)(i) of
this section) is treated as a rental undertaking if and only if the
undertaking, considered as a separate activity, would constitute a
rental activity. In this case, the automobile-leasing undertaking would,
if considered as a separate activity, constitute a rental activity, and
the automobile selling-
[[Page 466]]
and-servicing undertaking would not, if considered as a separate
activity, constitute a rental activity (see Example 8 and (ii) above).
Accordingly, the automobile-leasing undertaking is treated as a rental
undertaking, and the automobile selling-and-servicing undertaking is
not.
(e) Special rules for certain oil and gas operations--(1) Wells
treated as nonpassive under Sec. 1.469-1T(e)(4)(i). An oil or gas well
shall be treated as an undertaking that is separate from other
undertakings in determining the activities of a taxpayer for a taxable
year if the following conditions are satisfied:
(i) The well is drilled or operated pursuant to a working interest
(within the meaning of Sec. 1.469-1T(e)(4)(iv)) and at any time during
such taxable year the taxpayer holds such working interest either--
(A) Directly; or
(B) Through an entity that does not limit the liability of the
taxpayer with respect to the drilling or operation of such well pursuant
to such working interest; and
(ii) The taxpayer would not be treated as materially participating
(within the meaning of Sec. 1.469-5T) for the taxable year in the
activity in which such well would be included if the taxpayer's
activities were determined without regard to this paragraph (e).
(2) Business and rental operations that constitute an undertaking.
In any case in which an oil or gas well is treated under this paragraph
(e) as an undertaking that is separate from other undertakings, the
business and rental operations that constitute such undertaking are the
business and rental operations that are attributable to such well.
(3) Examples. The following examples illustrate the application of
this paragraph (e). In each example, the taxpayer is an individual whose
taxable year is the calendar year.
Example 1. During 1989, A directly owns an undivided interest in a
working interest (within the meaning of Sec. 1.469-1T(e)(4)(iv)) in two
oil wells. A does not participate in the activity in which the wells
would be included if A's activities were determined without regard to
this paragraph (e). Under paragraph (e)(1) of this section, each well is
treated as a separate undertaking in determining A's activities for 1989
because A holds the working interest directly and would not be treated
as materially participating for 1989 in the activity in which the wells
would be included if A's activities were determined without regard to
this paragraph (e). The aggregation rules in paragraph (f) of this
section do not apply to these undertakings (see paragraph (f)(1)(ii)(B)
of this section). Thus, each of the undertakings is treated as a
separate activity under paragraph (b)(1) of this section. The result is
the same even if A has net income from one or both wells for 1989 and
even if the wells would otherwise be treated as part of the same
undertaking under paragraph (c) of this section. The result would also
be the same if A held the working interest through an entity, such as a
general partnership, that does not limit A's liability with respect to
the drilling or operation of the wells pursuant to the working interest.
Example 2. (i) During 1989, B is a general partner in a partnership
that owns a working interest (within the meaning of Sec. 1.469-
1T(e)(4)(iv)) in an oil well. B does not own any interest in the well
other than through the partnership. At the end of 1989, however, B's
partnership interest is converted into a limited partnership interest,
and during 1990 B holds the working interest only as a limited partner.
B does not participate in the activity in which the well would be
included if B's activities were determined without regard to this
paragraph (e).
(ii) Under paragraph (e)(1) of this section, the well is treated as
a separate undertaking in determining B's activities for 1989 because B
holds the working interest during 1989 through an entity that does not
limit B's liability with respect to the drilling or operation of the
well pursuant to the working interest, and B would not be treated as
materially participating for 1989 in the activity in which the well
would be included if B's activities were determined without regard to
this paragraph (e). Throughout 1990, however, B's liability with respect
to the drilling and operation of the well is limited by the entity
through which B holds the working interest (i.e., the limited
partnership). Accordingly, paragraph (e)(1) of this section does not
apply to the well in 1990, and the well may be included under paragraph
(c) of this section in an undertaking that includes other operations.
Example 3. The facts are the same as in Example 2, except that B's
partnership interest is converted into a limited partnership interest at
the end of November 1989. An oil or gas well may be treated as a
separate undertaking under paragraph (e)(1) of this section if at any
time during the taxable year the taxpayer holds a working interest in
the well directly or through an entity that does not limit the
taxpayer's liability with respect to the drilling or operation of the
well pursuant to the working interest (see Sec. 1.469-1T(e)(4)(i)).
Thus, although B's liability with respect to the drilling and operation
of the
[[Page 467]]
well is limited during December 1989, the result in both 1989 and 1990
is the same as in Example 2. In 1989, however, disqualified deductions
and a ratable portion of the gross income from the well may be treated
under Sec. 1.469-1T(e)(4)(ii) as passive activity deductions and
passive activity gross income, respectively.
(f) Certain trade or business undertakings treated as part of the
same activity--(1) Applicability--(i) In general. This paragraph (f)
applies to a taxpayer's interests in trade or business undertakings
(within the meaning of paragraph (f)(1)(ii) of this section).
(ii) Trade or business undertaking. For purposes of this paragraph
(f), the term ``trade or business undertaking'' means any undertaking in
which a taxpayer has an interest, other than--
(A) A rental undertaking (within the meaning of paragraph (d) of
this section);
(B) An oil or gas well treated as an undertaking that is separate
from other undertakings under paragraph (e) of this section; or
(C) A professional service undertaking (within the meaning of
paragraph (h) of this section).
(2) Treatment as part of the same activity. A taxpayer's interests
in two or more trade or business undertakings that are similar (within
the meaning of paragraph (f)(4) of this section) and controlled by the
same interests (within the meaning of paragraph (j) of this section)
shall be treated as part of the same activity of the taxpayer for any
taxable year in which the taxpayer--
(i) Owns interests in each such undertaking through the same
passthrough entity;
(ii) Owns a direct or substantial indirect interest (within the
meaning of paragraph (f)(3) of this section) in each such undertaking;
or
(iii) Materially or significantly participates (within the meaning
of Sec. 1.469-5T) in the activity that would result if such
undertakings were treated as part of the same activity.
(3) Substantial indirect interest--(i) In general. For purposes of
this paragraph (f), a taxpayer owns a substantial indirect interest in
an undertaking for a taxable year if at any time during such taxable
year the taxpayer's ownership percentage (determined in accordance with
paragraph (j)(3) of this section) in a passthrough entity that directly
owns such undertaking exceeds ten percent.
(ii) Coordination rule. A taxpayer shall be treated for purposes of
this paragraph (f) as owning a substantial indirect interest in each of
two or more undertakings for any taxable year in which--
(A) Such undertakings are treated as part of the same activity of
the taxpayer under paragraph (f)(2)(i) of this section; and
(B) The taxpayer owns a substantial indirect interest (within the
meaning of paragraph (f)(3)(i) of this section) in any such undertaking.
(4) Similar undertakings--(i) In general. Except as provided in
paragraph (f)(4)(iii) of this section, two undertakings are similar for
purposes of this paragraph (f) if and only if--
(A) There are predominant operations in each such undertaking; and
(B) The predominant operations of both undertakings are in the same
line of business.
(ii) Predominant operations. For purposes of paragraph (f)(4)(i)(A)
of this section, there are predominant operations in an undertaking if
more than 50 percent of the undertaking's gross income is attributable
to operations in a single line of business.
(iii) Vertically-integrated undertakings. If an undertaking (the
``supplier undertaking'') provides property or services to other
undertakings (the ``recipient undertakings''), the following rules apply
for purposes of this paragraph (f):
(A) Supplier undertaking similar to recipient undertaking. If the
supplier undertaking predominantly involves the provision of property
and services to a recipient undertaking that is controlled by the same
interests (within the meaning of paragraph (j) of this section), the
supplier undertaking shall be treated as similar to the recipient
undertaking. For purposes of applying the preceding sentence--
(1) If a supplier undertaking and two or more recipient undertakings
that are similar (within the meaning of paragraph (f)(4)(i) of this
section) are controlled by the same interests, such recipient
undertakings shall be treated as a single undertaking; and
[[Page 468]]
(2) A supplier undertaking predominantly involves the provision of
property and services to a recipient undertaking for any taxable year in
which such recipient undertaking obtains more than 50 percent (by value)
of all property and services provided by the supplier undertaking.
(B) Recipient undertaking similar to supplier undertaking. If the
supplier undertaking is the predominant provider of property and
services to a recipient undertaking that is controlled by the same
interests (within the meaning of paragraph (j) of this section), the
recipient undertaking shall be treated, except as otherwise provided in
paragraph (f)(4)(iii)(C) of this section, as similar to the supplier
undertaking. For purposes of the preceding sentence, a supplier
undertaking is the predominant provider of property and services to a
recipient undertaking for any taxable year in which the supplier
undertaking provides more than 50 percent (by value) of all property and
services obtained by the recipient undertaking.
(C) Coordination rules. (1) Paragraph (f)(4)(iii)(B) of this section
does not apply if, under paragraph (f)(4)(iii)(A) of this section--
(i) The supplier undertaking is treated as an undertaking that is
similar to any recipient undertaking;
(ii) The recipient undertaking is treated as a supplier undertaking
that is similar to another recipient undertaking; or
(iii) Another supplier undertaking is treated as an undertaking that
is similar to the recipient undertaking.
(2) If paragraph (f)(4)(iii)(A) of this section applies to a
supplier undertaking, the supplier undertaking shall be treated as
similar to undertakings that are similar to the recipient undertaking
and shall not otherwise be treated as similar to undertakings to which
the supplier undertaking would be similar without regard to paragraph
(f)(4)(iii) of this section.
(3) If paragraph (f)(4)(iii)(B) of this section applies to a
recipient undertaking, the recipient undertaking shall be treated as
similar to undertakings that are similar to the supplier undertaking and
shall not otherwise be treated as similar to undertakings to which the
recipient undertaking would be similar without regard to paragraph
(f)(4)(iii) of this section.
(iv) Lines of business. The Commissioner shall establish, by revenue
procedure, lines of business for purposes of this paragraph (f)(4).
Business and rental operations that are not included in the lines of
business established by the Commissioner shall nonetheless be included
in a line of business for purposes of this paragraph (f)(4). Such
operations shall be included in a single line of business or in multiple
lines of business on a basis that reasonably reflects--
(A) Similarities and differences in the property or services
provided pursuant to such operations and in the markets to which such
property or services are offered; and
(B) The treatment within the lines of business established by the
Commissioner of operations that are comparable in their similarities and
differences.
(5) Examples. The following examples illustrate the application of
this paragraph (f). In each example that does not state otherwise, the
taxpayer is an individual and the facts, analysis, and conclusions
relate to a single taxable year.
Example 1. (i) The taxpayer is a partner in partnerships A, B, C,
and D and owns a five-percent interest in each partnership. Each
partnership owns a single undertaking (undertakings A, B, C, and D), and
the undertakings are trade or business undertakings (within the meaning
of paragraph (f)(1)(ii) of this section) that are controlled by the same
interests (within the meaning of paragraph (j) of this section). In
addition, undertakings A, B, and D are similar (within the meaning of
paragraph (f)(4) of this section). The taxpayer is not related to any of
the other partners, and does not participate in any of the undertakings.
(ii) In general, each undertaking in which a taxpayer owns an
interest is treated as a single activity that is separate from other
activities of the taxpayer (see paragraph (b)(1) of this section). This
paragraph (f) provides aggregation rules for trade or business
undertakings that are similar and controlled by the same interests.
These aggregation rules do not apply, however, unless the taxpayer owns
interests in the undertakings through the same passthrough entity, owns
direct or substantial indirect interests in the undertakings, or
materially or significantly participates in the undertakings. In this
case, the taxpayer does not satisfy any of
[[Page 469]]
these conditions, and the aggregation rules in this paragraph (f) do not
apply. Accordingly, except as otherwise provided in paragraph (g) of
this section (relating to an aggregation rule for integrated
businesses), undertakings A, B, C, and D are treated as separate
activities of the taxpayer under paragraph (b)(1) of this section.
Example 2. (i) The facts are the same as in Example 1, except that
the taxpayer owns a 25-percent interest in partnership A, a 15-percent
interest in partnership B, and a 40-percent interest in partnership C.
(ii) Paragraph (f)(2)(ii) of this section provides that trade or
business undertakings that are similar and controlled by the same
interests are treated as part of the same activity of the taxpayer if
the taxpayer owns a direct or substantial indirect interest in each such
undertaking. In this case, the taxpayer owns more than ten percent of
partnerships A, B, and C, and these partnerships directly own
undertakings A, B, and C. Thus, the taxpayer owns a substantial indirect
interest in undertakings A, B, and C (see paragraph (f)(3)(i) of this
section). Of these undertakings, only undertakings A and B are both
similar and controlled by the same interests. Accordingly, the
taxpayer's interests in undertakings A and B are treated as part of the
same activity. As in Example 1, the aggregation rules in this paragraph
(f) do not apply to undertakings C and D, and except as otherwise
provided in paragraph (g) of this section, undertakings C and D are
treated as separate activities.
Example 3. (i) The facts are the same as in Example 1, except that
the taxpayer participates (within the meaning of Sec. 1.469-5T(f)) for
60 hours in undertaking A and for 60 hours in undertaking B.
(ii) Paragraph (f)(2)(iii) of this section provides that trade or
business undertakings that are similar and controlled by the same
interests are treated as part of the same activity of the taxpayer if
the taxpayer materially or significantly participates (within the
meaning of Sec. 1.469-5T) in the activity that would result from the
treatment of similar, commonly-controlled undertakings as part of the
same activity. In this case, the activity that would result from
treating the similar, commonly-controlled undertakings as part of the
same activity consists of undertakings A, B, and D, and the taxpayer
participates for 120 hours in the activity that results from this
treatment. Accordingly, undertakings A, B, and D are treated as part of
the same activity because the taxpayer significantly participates
(within the meaning of Sec. 1.469-5T(c)(2)) in the activity that
results from this treatment. The result is the same whether the taxpayer
participates in one, two, or all three of the similar, commonly-
controlled undertakings, so long as the taxpayer's aggregate
participation in undertakings A, B, and D exceeds 100 hours. As in
Example 1, the aggregation rules in this paragraph (f) do not apply to
undertaking C, and except as otherwise provided in paragraph (g) of this
section, undertaking C is treated as a separate activity.
Example 4. (i) The taxpayer owns a 5-percent interest in partnership
A. Partnership A owns interests in partnerships B and C, each of which
owns a single undertaking (undertakings B and C). In addition, the
taxpayer is a partner in partnerships C and D and directly owns a 15-
percent interest in each partnership. Partnership D also owns a single
undertaking (undertaking D). Undertakings B, C, and D are trade or
business undertakings (within the meaning of paragraph (f)(1)(ii) of
this section) that are similar (within the meaning of paragraph (f)(4)
of this section) and controlled by the same interests (within the
meaning of paragraph (j) of this section). The taxpayer does not
participate in undertaking B, C, or D.
(ii) Paragraph (f)(2)(i) of this section provides that trade or
business undertakings that are similar and controlled by the same
interests are treated as part of the same activity of the taxpayer if
the taxpayer owns interests in the undertakings through the same
passthrough entity. In this case, the taxpayer owns interests in
undertakings B and C through partnership A. Thus, the taxpayer's
interests in undertakings B and C are treated as part of the same
activity.
(iii) Paragraph (f)(2)(ii) of this section provides that trade or
business undertakings that are similar and controlled by the same
interests are treated as part of the same activity of the taxpayer if
the taxpayer owns a direct or substantial indirect interest in each such
undertaking. In this case, the taxpayer owns more than ten percent of
partnerships C and D, and these partnerships directly own undertakings C
and D. Thus, the taxpayer owns a substantial indirect interest in
undertakings C and D (see paragraph (f)(3)(i) of this section).
(iv) The coordination rule in paragraph (f)(3)(ii) of this section
applies to undertakings B and C because they are treated as part of the
same activity under paragraph (f)(2)(i) of this section, and the
taxpayer owns a substantial indirect interest in undertaking C. Under
the coordination rule, the taxpayer is treated as owning a substantial
indirect interest in undertaking B as well as undertaking C.
Accordingly, the taxpayer's interests in undertakings B, C, and D are
treated as part of the same activity.
Example 5. (i) Undertakings A, B, C, and D are trade or business
undertakings (within the meaning of paragraph (f)(1)(ii) of this
section), each of which involves the operation of a department store,
restaurants, and movie theaters. The following table shows, for each
undertaking, the percentages of gross income attributable to the various
operations of the undertaking.
[[Page 470]]
------------------------------------------------------------------------
Department Movie
store Restaurants Theaters
------------------------------------------------------------------------
Undertaking A........................ 70% 20% 10%
Undertaking B........................ 60% 20% 20%
Undertaking C........................ 35% 35% 30%
Undertaking D........................ 35% 10% 55%
------------------------------------------------------------------------
(ii) Paragraph (f)(4)(i) of this section provides that two
undertakings are similar for purposes of this paragraph (f) if and only
if there are predominant operations in each undertaking and the
predominant operations of the two undertakings are in the same line of
business. (Assume that the applicable revenue procedure provides that
``general merchandise stores,'' ``eating and drinking places,'' and
``motion picture services'' are three separate lines of business.)
(iii) Undertaking A and undertaking B each derives more than 50
percent of its gross income from department-store operations, which are
in the general-merchandise-store line of business. Thus, there are
predominant operations in undertaking A and undertaking B, and the
predominant operations of the two undertakings are in the same line of
business. Accordingly, undertakings A and B are similar.
(iv) Undertaking C does not derive more than 50 percent of its gross
income from operations in any single line of business. Thus, there are
no predominant operations in undertaking C, and undertaking C is not
similar to any of the other undertakings.
(v) Undertaking D derives more than 50 percent of its gross income
from movie-theater operations, which are in the motion-picture-services
line of business. Thus, there are predominant operations in undertaking
D. The predominant operations of undertaking D, however, are not in the
same line of business as those of undertakings A and B. Accordingly,
undertaking D is not similar to undertakings A and B.
Example 6. (i) Undertakings A and B are trade or business
undertakings (within the meaning of paragraph (f)(1)(ii) of this
section) that derive all of their gross income from the sale of
automobiles. Undertakings C and D derive all of their gross income from
the rental of automobiles. Undertaking C is not a rental undertaking
(within the meaning of paragraph (d)(1)(iii) of this section) because
the average period of customer use (within the meaning of Sec. 1.469-
1T(e)(3)(iii)) for its automobiles does not exceed seven days (see Sec.
1.469-1T(e)(3)(ii)(A)). Undertaking D, on the other hand, leases
automobiles for periods of one year or more and is a rental undertaking.
(ii) Paragraph (f)(4)(i) of this section provides that two
undertakings are similar for purposes of this paragraph (f) if and only
if there are predominant operations in each undertaking and the
predominant operations of the two undertakings are in the same line of
business. (Assume that the applicable revenue procedure provides that
(a) ``automotive dealers and service stations'' (automotive retail) and
(b) ``auto repair, services (including rentals), and parking''
(automotive services) are two separate lines of business.)
(iii) Undertakings A and B both derive more than 50 percent of their
gross income from operations in the automotive-retail line of business
(the automobile-sales operations). Similarly, undertakings C and D both
derive more than 50 percent of their gross income from operations in the
automotive-services line of business (the automobile-rental operations).
Thus, there are predominant operations in each undertaking, the
predominant operations of undertakings A and B are in the same line of
business, and the predominant operations of undertakings C and D are in
the same line of business. Accordingly, undertakings A and B are
similar, undertakings C and D are similar, and undertakings A and B are
not similar to undertakings C and D.
(iv) Paragraph (f)(1) of this section provides that this paragraph
(f) applies only to trade or business undertakings and that a rental
undertaking is not a trade or business undertaking. Accordingly, this
paragraph (f) does not apply to undertaking D, and undertakings C and D,
although similar, are not treated, under this paragraph (f), as part of
the same activity.
Example 7. (i) Undertakings A, B, and C are trade or business
undertakings (within the meaning of paragraph (f)(1)(ii) of this
section) that involve real estate operations. Undertaking A derives all
of its gross income from the development of real property, undertaking B
derives all of its gross income from the management of real property and
the performance of services as a leasing agent with respect to real
property, and undertaking C derives all of its gross income from buying,
selling, or arranging purchases and sales of real property. Undertaking
D derives all of its gross income from the rental of residential
apartments and is a rental undertaking (within the meaning of paragraph
(d)(1)(iii) of this section).
(ii) Paragraph (f)(4)(i) of this section provides that two
undertakings are similar for purposes of this paragraph (f) if there are
predominant operations in each undertaking and the predominant
operations of the two undertakings are in the same line of business.
(Assume that the applicable revenue procedure provides that real estate
development and services (including the development and management of
real property, dealing in real property, and the performance of services
as a leasing agent with respect to real property) is a single line of
business (the ``real-estate'' line of business).)
(iii) Undertakings A, B, and C all derive more than 50 percent of
their gross income
[[Page 471]]
from operations in the real-estate line of business. Thus, there are
predominant operations in undertakings A, B, and C, and the predominant
operations of the three undertakings are in the same line of business.
Accordingly, undertakings A, B, and C are similar.
(iv) Undertaking D also derives more than 50 percent of its gross
income from operations in the real-estate line of business. Thus, there
are predominant operations in undertaking D, and the predominant
operations of undertaking D are in the same line of business as those of
undertakings A, B, and C. Paragraph (f)(1) of this section provides,
however, that this paragraph (f) applies only to trade or business
undertakings and that a rental undertaking is not a trade or business
undertaking. Accordingly, this paragraph (f) does not apply to
undertaking D, and undertaking D, although similar to undertakings A, B,
and C, is not treated, under this paragraph (f), as part an activity
that includes undertaking A, B, or C.
Example 8. (i) Undertakings A and B are trade or business
undertakings (within the meaning of paragraph (f)(1)(ii) of this
section), both of which involve the provision of moving services.
Undertaking A derives its gross income principally from local moves, and
undertaking B derives its gross income principally from long-distance
moves.
(ii) Paragraph (f)(4)(i) of this section provides that two
undertakings are similar for purposes of this paragraph (f) if there are
predominant operations in each undertaking and the predominant
operations of the two undertakings are in the same line of business.
Under paragraph (f)(4)(iv) of this section, operations that are not in
the lines of business established by the applicable revenue procedure
are nonetheless included in a line of business. In addition, such
operations are included in a single line of business or in multiple
lines of business on a basis that reasonably reflects (a) similarities
and differences in the property or services provided pursuant to such
operations and in the markets to which such property or services are
offered, and (b) the treatment within the lines of business established
by the Commissioner of operations that are comparable in their
similarities and differences. (Assume that the provision of moving
services is not in any line of business established by the Commissioner
and that within the lines of business established by the Commissioner
services that differ only in the distance over which they are performed
(e.g., local and long-distance telephone services) are generally treated
as part of the same line of business.)
(iii) Undertakings A and B provide the same types of services to
similar customers, and the only significant difference in the services
provided is the distance over which they are performed. Thus, treating
local and long-distance moving services as a single line of business
(the ``moving-services'' line of business) reasonably reflects the
treatment within the lines of business established by the Commissioner
of operations that are comparable in their similarities and differences.
(iv) Each undertaking derives more than 50 percent of its gross
income from operations in the moving-services line of business. Thus,
there are predominant operations in each undertaking, and the
predominant operations of the two undertakings are in the same line of
business. Accordingly, undertakings A and B are similar.
Example 9. (i) Undertakings A, B, C, D, and E are trade or business
undertakings (within the meaning of paragraph (f)(1)(ii) of this
section) and are controlled by the same interests (within the meaning of
paragraph (j) of this section). Undertakings A, B, and C derive all of
their gross income from retail sales of dairy products, and undertakings
D and E derive all of their gross income from the processing of dairy
products. Undertakings D and E sell less than ten percent of their dairy
products to undertakings A, B, and C, and sell the remainder to
unrelated undertakings. Undertakings A, B, and C purchase less than ten
percent of their inventory from undertakings D and E and purchase the
remainder from unrelated undertakings.
(ii) Paragraph (f)(4)(i) of this section provides that, except as
provided in paragraph (f)(4)(iii) of this section, undertakings are
similar for purposes of this paragraph (f) if and only if there are
predominant operations in each undertaking and the predominant
operations of the undertakings are in the same line of business. (Assume
that the applicable revenue procedure provides that (a) ``food stores''
and (b) ``manufacturing--food and kindred products'' are two separate
lines of business.)
(iii) Undertakings A, B, and C all derive more than 50 percent of
their gross income from operations in the food-store line of business
(the dairy-sales operations). Thus, there are predominant operations in
undertakings A, B, and C, and the predominant operations of the three
undertakings are in the same line of business. Accordingly, undertakings
A, B, and C are similar.
(iv) Undertakings D and E both derive more than 50 percent of their
gross income from operations in the food-manufacturing line of business
(the dairy-processing operations). Thus, there are predominant
operations in undertakings D and E, and the predominant operations of
the two undertakings are in the same line of business. Accordingly,
undertakings D and E are similar. The predominant operations of
undertakings D and E are not in the same line of business
[[Page 472]]
as those of undertakings A, B, and C. Accordingly, undertakings D and E
are not similar to undertakings A, B, and C.
(v) Paragraph (f)(4)(iii) of this section provides rules under which
certain undertakings whose operations are not in the same line of
business nevertheless are similar to one another if one of the
undertakings (the ``supplier undertaking'') provides property or
services to the other undertaking (the ``recipient undertaking''), and
the undertakings are controlled by the same interests. These rules
apply, however, only if the supplier undertaking predominantly involves
the provision of property and services to the recipient undertaking (see
paragraph (f)(4)(iii)(A) of this section), or the supplier undertaking
is the predominant provider of property and services to the recipient
undertaking (see paragraph (f)(4)(iii)(B) of this section). In this
case, undertakings D and E are supplier undertakings, and undertakings
A, B, and C are recipient undertakings. Undertakings D and E, however,
sell less than ten percent of their dairy products to undertakings A, B,
and C and thus do not predominantly involve the provision of property
and services to recipient undertakings. Similarly, undertakings D and E
are not the predominant providers of property and services to
undertakings A, B, and C. Thus, the rules for vertically-integrated
undertakings in paragraph (f)(4)(iii) of this section do not apply in
this case.
Example 10. (i) The facts are the same as in Example 9, except that
undertaking D sells 75 percent of its dairy products to undertakings A,
B, and C.
(ii) Paragraph (f)(4)(iii)(A) of this section applies if a supplier
undertaking predominantly involves the provision of property to a
recipient undertaking that is controlled by the same interests.
Paragraph (f)(4)(iii)(A)(2) of this section provides that a supplier
undertaking predominantly involves the provision of property to a
recipient undertaking if the supplier undertaking provides more than 50
percent of its property to such recipient undertaking. In addition,
paragraph (f)(4)(iii)(A)(1) of this section provides that if a supplier
undertaking and two or more similar recipient undertakings are
controlled by the same interests, the recipient undertakings are treated
as a single undertaking for purposes of applying paragraph
(f)(4)(iii)(A) of this section. Undertakings D and E both provide dairy
products to undertakings A, B, and C. Thus, for purposes of paragraph
(f)(4)(iii) of this section, undertakings D and E are supplier
undertakings and undertakings A, B, and C are recipient undertakings.
Undertaking D predominantly involves the provision of property to
undertakings A, B, and C. Moreover, undertakings A, B, and C are treated
as a single undertaking under paragraph (f)(4)(iii)(A)(1) of this
section because undertakings A, B, and C are similar to one another
under paragraph (f)(4)(i) of this section, and undertakings A, B, C, and
D are controlled by the same interests. Accordingly, paragraph
(f)(4)(iii)(A) of this section applies to undertakings A, B, C, and D.
(iii) If paragraph (f)(4)(iii)(A) of this section applies to
supplier and recipient undertakings, the supplier undertaking is treated
under paragraph (f)(4)(iii) (A) and (C)(2) of this section as an
undertaking that is similar to the recipient undertakings and to
undertakings to which the recipient undertakings are similar.
Accordingly, undertaking D is similar, for purposes of this paragraph
(f), to undertakings A, B, and C.
(iv) Undertaking E does not predominantly involve the provision of
property to undertakings A, B, and C, or to any other related
undertakings. Thus, paragraph (f)(4)(iii)(A) of this section does not
apply to undertaking E, and undertaking E is not similar to undertakings
A, B, and C. Moreover, undertakings D and E are not similar because,
under paragraph (f)(4)(iii)(C)(2) of this section, undertaking D is not
similar to any undertaking that is not similar to undertakings A, B, and
C.
Example 11. (i) The facts are the same as in Example 10, except that
75 percent of undertaking D's dairy products are sold to undertakings A
and B, and none are sold to undertaking C.
(ii) In this case, undertaking D is a supplier undertaking only with
respect to undertakings A and B. Accordingly, paragraph (f)(4)(iii)(A)
applies only to undertakings A, B, and D. As in Example 10, undertaking
D is similar to undertakings A and B, and is not similar to undertaking
E. In addition, if paragraph (f)(4)(iii)(A) of this section applies to
supplier and recipient undertakings, the supplier undertaking is treated
under paragraph (f)(4)(iii)(C)(2) of this section as an undertaking that
is similar to the recipient undertakings and undertakings to which the
recipient undertakings are similar. Accordingly, even though undertaking
D does not provide any property or services to undertaking C,
undertaking D is similar to undertaking C because undertaking C is
similar to undertakings A and B.
Example 12. (i) The facts are the same as in Example 9, except that
undertakings A and B purchase 80 percent of their inventory from
undertaking D.
(ii) Paragraph (f)(4)(iii)(B) of this section applies, except as
provided in paragraph (f)(4)(iii)(C) of this section, if a supplier
undertaking is the predominant provider of property to a recipient
undertaking that is controlled by the same interests. Undertakings D and
E both provide dairy products to undertakings A, B, and C. Thus, for
purposes of paragraph (f)(4)(iii) of this section,
[[Page 473]]
undertakings D and E are supplier undertakings, and undertakings A, B,
and C are recipient undertakings. In addition, undertaking D is the
predominant provider of property and services to undertakings A and B,
and undertakings A, B and D are controlled by the same interests. Thus,
except as provided in paragraph (f)(4)(iii)(C) of this section,
paragraph (f)(4)(iii)(B) of this section applies to undertakings A, B,
and D.
(iii) The coordination rules in paragraph (f)(4)(iii)(C)(1) of this
section provide that paragraph (f)(4)(iii)(B) of this section does not
apply in certain cases to which paragraph (f)(4)(iii)(A) of this section
applies. These coordination rules would apply if undertaking D or E (or
any other undertaking that is controlled by the interests that control
undertakings A, B, and C) predominantly involved the provision of
property and services to undertakings A, B, and C. The coordination
rules in paragraph (f)(4)(iii)(C)(1) of this section would also apply if
undertaking A, B, or D predominantly involved the provision of property
or services to a recipient undertaking that is controlled by the same
interests. Assume that these coordination rules do not apply in this
case.
(iv) If paragraph (f)(4)(iii)(B) of this section applies to supplier
and recipient undertakings, the recipient undertakings are treated under
paragraph (f)(4)(iii) (B) and (C)(3) of this section as undertakings
that are similar to the supplier undertaking and to undertakings to
which the supplier undertaking is similar. Accordingly, undertakings A
and B are similar, for purposes of this paragraph (f), to undertaking D
and, because undertakings D and E are similar, to undertaking E.
(v) The principal providers of property and services to undertaking
C are unrelated undertakings. Thus, paragraph (f)(4)(iii)(B) of this
section does not apply to undertaking C, and undertaking C is not
similar to undertakings D and E. Moreover, undertaking C is not similar
to undertakings A and B because, under paragraph (f)(4)(iii)(C)(3) of
this section, undertakings A and B are not similar to any undertaking
that is not similar to undertaking D.
Example 13. (i) Undertakings A through Z are trade or business
undertakings (within the meaning of paragraph (f)(1)(ii) of this
section) and are controlled by the same interests (within the meaning of
paragraph (j) of this section). Undertaking A derives all of its gross
income from the manufacture and sale of men's and women's clothing,
undertaking B derives all of its gross income from sales of men's and
women's clothing to retail stores, and undertakings C through Z derive
all of their gross income from retail sales of men's and women's
clothing. Undertaking A sells clothing exclusively to undertaking B.
Undertaking B sells 75 percent of its clothing to undertakings C through
Z, and sells the remainder to unrelated retail stores. Undertaking B
purchases 80 percent of its inventory from undertaking A, and
undertakings C through Z purchase 60 to 90 percent of their inventory
from undertaking B.
(ii) Paragraph (f)(4)(iii)(A) of this section applies if a supplier
undertaking predominantly involves the provision of property to a
recipient undertaking that is controlled by the same interests. In
addition, paragraph (f)(4)(iii)(A)(1) of this section provides that if a
supplier undertaking and two or more similar recipient undertakings are
controlled by the same interests, the recipient undertaking are treated
as a single undertaking for this purpose. Undertaking B provides men's
and women's clothing to undertaking C through Z. Thus, for purposes of
paragraph (f)(4)(iii) of this section, undertaking B is a supplier
undertaking and undertakings C through Z are recipient undertakings. In
addition, undertaking B predominantly involves the provision of property
to undertakings C through Z, and undertakings C through Z are treated as
a single undertaking for purposes of paragraph (f)(4)(iii)(A) of this
section. Accordingly, paragraph (f)(4)(iii)(A) of this section applies
to undertakings B and C through Z.
(iii) If paragraph (f)(4)(iii)(A) of this section applies to
supplier and recipient undertakings, the supplier undertaking is treated
under paragraph (f)(4)(iii)(A) of this section as an undertaking that is
similar to the recipient undertakings. Accordingly, undertaking B is
similar, for purposes of this paragraph (f), to undertakings C through
Z.
(iv) Undertaking A provides men's and women's clothing to
undertaking B. Thus, for purposes of paragraph (f)(4)(iii) of this
section, undertaking A is a supplier undertaking and undertaking B is a
recipient undertaking. In addition, undertaking A predominantly involves
the provision of property to undertaking B, and undertakings A and B are
controlled by the same interests. Accordingly, paragraph (f)(4)(iii)(A)
of this section applies to undertakings A and B, and undertaking A is
similar to undertaking B.
(v) If paragraph (f)(4)(iii)(A) of this section applies to supplier
and recipient undertakings, the supplier undertaking is treated under
paragraph (f)(4)(iii)(C)(2) of this section as an undertaking that is
similar to undertakings to which the recipient undertakings are similar.
Accordingly, undertaking A is also similar, for purposes of this
paragraph (f), to undertakings C through Z.
(vi) The coordination rule in paragraph (f)(4)(iii)(C)(1)(i) of this
section provides that paragraph (f)(4)(iii)(B) of this section does not
apply if, as described above, the supplier undertaking predominantly
involves the provision of property to recipient undertakings and is
treated under paragraph (f)(4)(iii)(A) of this section as an undertaking
that is
[[Page 474]]
similar to such recipient undertakings. Accordingly, paragraph
(f)(4)(iii)(B) of this section does not apply to undertakings B through
Z, even though undertaking B is the predominant provider of property and
services to undertakings C through Z, and undertakings B through Z are
controlled by the same interests. For the same reason, paragraph
(f)(4)(iii)(B) of this section does not apply to undertaking A and B.
(Paragraph (f)(4)(iii)(B) of this section is also inapplicable to
undertakings A and B because the coordination rule in paragraph
(f)(4)(iii)(C)(1)(ii) of this section applies if the recipient
undertaking (undertaking B) is itself a supplier undertaking that is
treated under paragraph (f)(4)(iii)(A) of this section as an undertaking
that is similar to its recipient undertakings (undertakings C through
Z).)
(g) Integrated businesses--(1) Applicability--(i) In general. This
paragraph (g) applies to a taxpayer's interests in trade or business
activities (within the meaning of paragraph (g)(1)(ii) of this section).
(ii) Trade or business activity. For purposes of this paragraph (g),
the term ``trade or business activity'' means any activity (determined
without regard to this paragraph (g)) that consists of interests in one
or more trade or business undertakings (within the meaning of paragraph
(f)(1)(ii) of this section).
(2) Treatment as a single activity. A taxpayer's interests in two or
more trade or business activities shall be treated as a single activity
if and only if--
(i) The operations of such trade or business activities constitute a
single integrated business, activities constitute a single integrated
business; and
(ii) Such activities are controlled by the same interests (within
the meaning of paragraph (j) of this section).
(3) Facts and circumstances test. In determining whether the
operations of two or more trade or business activities constitute a
single integrated business for purposes of this paragraph (g), all the
facts and circumstances are taken into account, and the following
factors are generally the most significant:
(i) Whether such operations are conducted at the same location;
(ii) The extent to which other persons conduct similar operations at
one location;
(iii) Whether such operations are treated as a unit in the primary
accounting records reflecting the results of such operations;
(iv) The extent to which other persons treat similar operations as a
unit in the primary accounting records reflecting the results of such
similar operations;
(v) Whether such operations are owned by the same person (within the
meaning of paragraph (c)(2)(v) of this section);
(vi) The extent to which such operations involve products or
services that are commonly provided together;
(vii) The extent to which such operations serve the same customers;
(viii) The extent to which the same personnel, facilities, or
equipment are used to conduct such operations;
(ix) The extent to which such operations are conducted in
coordination with or reliance upon each other;
(x) The extent to which the conduct of any such operations is
incidental to the conduct of the remainder of such operations;
(xi) The extent to which such operations depend on each other for
their economic success; and
(xii) Whether such operations are conducted under the same trade
name.
(4) Examples. The following examples illustrate the application of
this paragraph (g). The facts, analysis, and conclusion in each example
relate to a single taxable year, and the trade or business activities
described in each example are controlled by the same interests (within
the meaning of paragraph (j) of this section).
Example 1. (i) The taxpayer owns a number of department stores and
auto-supply stores. Some of the taxpayer's department stores include
auto-supply departments. In other cases, the taxpayer operates a
department store and an auto-supply store at the same location (within
the meaning of paragraph (c)(2)(iii) of this section), or at different
locations from which the same group of customers can be served. In cases
in which a department store and an auto-supply store are operated at the
same location, the department-store operations are the predominant
operations (within the meaning of paragraph (f)(4)(ii) of this section),
and the undertaking that includes the stores is treated as a department-
store undertaking for purposes of paragraph (f) of this section. Under
paragraph (f) of this section, the department-
[[Page 475]]
store undertakings are all treated as part of the same activity of the
taxpayer (the ``department-store activity''). Similarly, the auto-supply
undertakings (i.e., the auto-supply stores that are not operated at a
department-store location) are all treated as part of the same activity
(the ``auto-supply activity''). (Assume that department-store
undertakings and auto-supply undertakings are not similar and are not
treated as part of the same activity under paragraph (f) of this
section.)
(ii) The department stores and auto-supply stores use a common trade
name and coordinate their marketing activities (e.g., the stores
advertise in the same catalog and the same newspaper supplements, honor
the same credit cards (including credit cards issued by the department
stores), and jointly conduct sales and other promotional activities).
Although sales personnel generally work only in a particular store or in
a particular department within a store, other employees (e.g., cashiers,
janitorial and maintenance workers, and clerical staff) may work in or
perform services for various stores, including both department and auto-
supply stores. In addition, the management of store operations is
organized on a geographical basis, and managers above the level of the
individual store generally supervise operations in both types of store.
A central office provides payroll, financial, and other support services
to all stores and establishes pricing and other business policies. Most
inventory for both types of stores is acquired through a central
purchasing department and inventory for all stores in an area is stored
in a common warehouse.
(iii) Based on the foregoing facts and circumstances, the operations
of the department-store activity and the auto-supply activity constitute
an integrated business. Paragraph (g)(3) of this section provides that
the factors relevant to this determination include the conduct of
department-store and auto-supply operations at the same location, the
location of department and auto-supply stores at sites where the same
group of customers can be served, the treatment of all such operations
as a unit in the taxpayer's financial statements, the taxpayer's
ownership and the common management of all such operations, the use of
the same personnel, facilities, and equipment to conduct and support the
operations, the use of a common trade name, and the coordination (as
evidenced by the coordinated marketing activities) of department-store
and auto-supply operations.
(iv) Paragraph (g)(2) of this section provides that a taxpayer's
interests in two or more trade or business activities (within the
meaning of paragraph (g)(1)(ii) of this section) are treated as a single
activity of the taxpayer if the operations of such activities constitute
an integrated business and the activities are controlled by the same
interests. The department-store activity and the auto-supply activity
consist of trade or business undertakings and, thus, are trade or
business activities. In addition, the activities are controlled by the
same interests (the taxpayer), and the operations of the activities
constitute an integrated business. Accordingly, the department-store
activity and the auto-supply activity are treated as a single activity
of the taxpayer.
Example 2. (i) The taxpayer owns a number of stores that sell stereo
equipment and a repair shop that services stereo equipment. Under
paragraph (f) of this section, the stores are all treated as part of the
same activity of the taxpayer (the ``store activity''). The repair shop
does not sell stereo equipment, does not predominantly involve the
provision of services to the taxpayer's stores, and is treated as a
separate activity (the ``repair-shop activity''). (Assume that stereo-
sales undertakings and stereo-repair undertakings are not similar and
are not treated as part of the same activity under paragraph (f) of this
section.)
(ii) The stores sell stereo equipment produced by manufacturers for
which the stores are an authorized distributor. The repair shop's
operations principally involve the servicing of stereo equipment
produced by the same manufacturers. These operations include repairs on
equipment under warranty for which reimbursement is received from the
manufacturer and reconditioning of equipment taken as trade-ins by the
taxpayer's stores. The majority of the operations, however, involve
repairs that are performed for customers and are not covered by a
warranty. The taxpayer's distribution agreements with manufacturers
generally require the taxpayer to repair and service equipment produced
by the manufacturer both during and after the warranty period. In some
cases, the distribution agreements require that the taxpayer's repair
facility meet the manufacturer's standards and provide for periodic
inspections to ensure that these standards are met.
(iii) The stores and the repair shop use a common trade name. Sales
personnel generally work only in a particular store and stereo
technicians work only in the repair shop. The stores and the repair shop
are, however, managed from a central office, which supervises both store
and repair-shop operations, provides payroll, financial, and other
support services to the stores and the repair shop, and establishes
pricing and other business policies. In addition, inventory for the
stores and supplies for the repair shop are acquired through a central
purchasing department and are stored in a single warehouse.
[[Page 476]]
(iv) Based on the foregoing facts and circumstances, the operations
of the store activity and the repair-shop activity constitute an
integrated business. Paragraph (g)(3) of this section provides that the
factors relevant to this determination include the treatment of all such
operations as a unit in the taxpayer's financial statements, the
taxpayer's ownership and the common management of all such operations,
the use of the same personnel and facilities to support the operations,
the use of a common trade name, the extent to which the same customers
patronize both the stores and the repair shop, the similarity of the
products (i.e., stereo equipment) involved in both store and repair-shop
operations, and the extent to which the provision of repair services
contributes to the taxpayer's ability to obtain the stereo equipment
sold in store operations.
(v) Paragraph (g)(2) of this section provides that a taxpayer's
interests in two or more trade or business activities (within the
meaning of paragraph (g)(1)(ii) of this section) are treated as a single
activity of the taxpayer if the operations of such activities constitute
an integrated business and the activities are controlled by the same
interests. The store activity and repair-shop activity consist of trade
or business undertakings and thus are trade or business activities. In
addition, the activities are controlled by the same interests (the
taxpayer), and the operations of the activities constitute an integrated
business. Accordingly, the store activity and the repair-shop activity
are treated as a single activity of the taxpayer.
Example 3. (i) The taxpayer owns interests in three partnerships.
One partnership owns a television station, the second owns a
professional sports franchise, and the third owns a motion-picture
production company. The operations of the partnerships are treated as
three separate undertakings. Although other persons own interests in the
partnerships, all three undertakings are controlled (within the meaning
of paragraph (j) of this section) by the taxpayer. The operations of the
partnerships are treated as three separate activities (the ``television
activity,'' the ``sports activity,'' and the ``motion-picture
activity''). (Assume that the undertakings are not similar and are not
treated as part of the same activity under paragraph (f) of this
section.)
(ii) Each partnership prepares financial statements that reflect
only the results of that partnership's operations, and each of the
activities is conducted under its own trade name. The taxpayer
participates extensively in the management of each partnership and makes
the major business decisions for all three partnerships. Each
partnership, however, employs separate management and other personnel
who conduct its operations on a day-to-day basis. The taxpayer generally
arranges the partnerships' financing and often obtains loans for two, or
all three, partnerships from the same source. Although the assets of one
partnership are not used as security for loans to another partnership,
the taxpayer's interest in a partnership may secure loans to the other
partnerships. The television station broadcasts the sports franchise's
games, and the motion-picture production company occasionally prepares
programming for the television station. In addition, support staff of
one partnership may, during periods of peak activity or in the case of
emergency, be made available to another partnership on a temporary
basis. There are no other significant transactions between the
partnerships. Moreover, all transactions between the partnerships
involve essentially the same terms as would be provided in transactions
between unrelated persons.
(iii) Based on the foregoing facts and circumstances, the television
activity, the sports activity, and the motion-picture activity
constitute three separate businesses. Paragraph (g)(3) of this section
provides that the factors relevant to this determination include the
treatment of the activities as separate units in the partnerships'
financial statements, the use of a different trade name for each
activity, the separate day-to-day management of the activities, and the
limited extent to which the activities contribute to or depend on each
other (as evidenced by the small number of significant transactions
between the partnerships and the arm's length nature of those
transactions). The taxpayer's participation in management and financing
are taken into account in this determination, as are the transactions
between the partnerships, but these factors do not of themselves support
a determination that the activities constitute an integrated business.
(iv) Paragraph (g)(2) of this section provides that a taxpayer's
interests in two or more trade or business activities (within the
meaning of paragraph (g)(1)(ii) of this section) are treated as a single
activity of the taxpayer only if the operations of such activities
constitute an integrated business and the activities are controlled by
the same interests. In this case, the taxpayer's activities do not
constitute an integrated business, and the aggregation rule in paragraph
(g)(2) of this section does not apply. Accordingly, the television
activity, the sports activity, and the motion-picture activity are
treated as three separate activities of the taxpayer.
(h) Certain professional service undertakings treated as a single
activity--(1) Applicability--(i) In general. This paragraph (h) applies
to a taxpayer's interests in professional service undertakings (within
the meaning of paragraph (h)(1)(ii) of this section).
[[Page 477]]
(ii) Professional service undertaking. For purposes of this
paragraph (h), an undertaking is treated as a professional service
undertaking for any taxable year in which the undertaking derives more
than 50 percent of its gross income from the provision of services that
are treated, for purposes of section 448 (d)(2)(A) and the regulations
thereunder, as services performed in the fields of health, law,
engineering, architecture, accounting, actuarial science, performing
arts, or consulting.
(2) Treatment as a single activity--(i) Undertakings controlled by
the same interest. A taxpayer's interests in two or more professional
service undertakings that are controlled by the same interests (within
the meaning of paragraph (j) of this section) shall be treated as part
of the same activity of the taxpayer.
(ii) Undertakings involving significant similar or significant
related services. A taxpayer's interests in two or more professional
service undertakings that involve the provision of significant similar
services or significant related services shall be treated as part of the
same activity of the taxpayer.
(iii) Coordination rule. (A) Except as provided in paragraph
(h)(2)(iii)(B) of this section, a taxpayer's interests in two or more
undertakings (the ``original undertakings'') that are treated as part of
the same activity of the taxpayer under the provisions of paragraph
(h)(2) (i) or (ii) of this section shall be treated as interests in a
single professional service undertaking (the ``aggregated undertaking'')
for purposes of reapplying such provisions.
(B) If any original undertaking included in an aggregated
undertaking and any other undertaking that is not included in such
aggregated undertaking involve the provision of significant similar or
related services, the aggregated undertaking and such other undertaking
shall be treated as undertakings that involve the provision of
significant similar or related services for purposes of reapplying the
provisions of paragraph (h)(2)(ii) of this section.
(3) Significant similar or significant related services. For
purposes of this paragraph (h)--
(i) Services (other than consulting services) in any field described
in paragraph (h)(1)(ii) of this section are similar to all other
services in the same field;
(ii) All the facts and circumstances are taken into account in
determining whether consulting services are similar;
(iii) Two professional service undertakings involve the provision of
significant similar services if and only if--
(A) Each such undertaking provides significant professional
services; and
(B) Significant professional services provided by one such
undertaking are similar to significant professional services provided by
the other such undertaking;
(iv) Services are significant professional services if and only if
such services are in a field described in paragraph (h)(1)(ii) of this
section and more than 20 percent of the undertaking's gross income is
attributable to services in such field (or, in the case of consulting
services, to similar services in such field); and
(v) Two professional service undertakings involve the provision of
significant related services if and only if more than 20 percent of the
gross income of one such undertaking is derived from customers that are
also customers of the other such undertaking.
(4) Examples. The following examples illustrate the application of
this paragraph (h). In each example that does not state otherwise, the
taxpayer is an individual, and the facts, analysis, and conclusions
relate to a single taxable year.
Example 1. (i) The taxpayer is a partner in a law partnership that
has offices in various cities. Some of the partnership's offices provide
a full range of legal services. Other offices, however, specialize in a
particular area or areas of the law (e.g., litigation, tax law,
corporate law, etc.). In either case, substantially all of the office's
gross income is derived from the provision of legal services. Under
paragraph (c)(1) of this section, each of the law partnership's offices
is treated as a single undertaking that is separate from other
undertakings (a ``law-office undertaking'').
(ii) Each law-office undertaking derives more than 50 percent of its
gross income from the provision of services in the field law. Thus, each
such undertaking is treated as a professional service undertaking
(within
[[Page 478]]
the meaning of paragraph (h)(1)(ii) of this section).
(iii) Each law-office undertaking derives more than 20 percent of
its gross income from services in the field of law. Thus, each such
undertaking involves significant professional services (within the
meaning of paragraph (h)(3)(iv) of this section) in the field of law. In
addition, all services in the field of law are treated as similar
services under paragraph (h)(3)(i) of this section. Thus, the law-office
undertakings involve the provision of significant similar services
(within the meaning of paragraph (h)(3)(iii) of this section).
(iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's
interest in professional service undertakings that involve the provision
of significant similar services are treated as part of the same activity
of the taxpayer. Accordingly, the taxpayer's interests in the law-office
undertakings are treated as part of the same activity of the taxpayer
under paragraph (h)(2)(ii) of this section even if the undertakings are
not controlled by the same interests (within the meaning of paragraph
(j) of this section).
Example 2. (i) The taxpayer is a partner in medical partnerships A
and B. Both partnerships derive all of their gross income from the
provision of medical services, but partnership A specializes in internal
medicine and partnership B operates a radiology laboratory. Under
paragraph (c)(1) of this section, the medical-service business of each
partnership is treated as a single undertaking that is separate from
other undertakings (a ``medical-service undertaking''). Partnerships A
and B are not controlled by the same interests (within the meaning of
paragraph (j) of this section).
(ii) Each partnership's medical-service undertaking derives more
than 50 percent of its gross income from the provision of services in
the field of health. Thus, each partnership's medical-service
undertaking is treated as a professional service undertaking (within the
meaning of paragraph (h)(1)(ii) of this section).
(iii) Each partnership's medical-service undertaking derives more
than 20 percent of its gross income from services in the field of
health. Thus, each such undertaking involves significant professional
services (within the meaning of paragraph (h)(3)(iv) of this section) in
the field of health. In addition, all services in the field of health
are treated as similar services under paragraph (h)(3)(i) of this
section. Thus, the medical-services undertakings of partnerships A and B
involve the provision of significant similar services (within the
meaning of paragraph (h)(3)(iii) of this section).
(iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's
interests in professional service undertakings that involve the
provision of significant similar services are treated as part of the
same activity of the taxpayer. Accordingly, the taxpayer's interests in
the medical-service undertakings of partnerships A and B are treated as
part of the same activity of the taxpayer under paragraph (h)(2)(ii) of
this section even though the undertakings are not controlled by the same
interests.
Example 3. (i) The facts are the same as in Example 2, except that
the taxpayer withdraws from partnership A in 1989 and becomes a partner
in partnership B in 1990. In addition, the taxpayer was a full-time
participant in the operations of partnership A from 1970 through 1989,
but does not participate in the operations of partnership B.
(ii) Paragraph (h)(2)(ii) of this section provides that a taxpayer's
interests in professional service undertakings that involve the
provision of significant similar services are treated as part of the
same activity of the taxpayer. This rule is not limited to cases in
which the taxpayer holds such interests simultaneously. Thus, as in
Example 2, the taxpayer's interests in the medical-service undertakings
of partnerships A and B are treated as part of the same activity of the
taxpayer.
(iii) The activity that includes the taxpayer's interests in the
medical-service undertakings of partnerships A and B is a personal
service activity (within the meaning of Sec. 1.469-5T(d)) because it
involves the performance of personal services in the field of health. In
addition, the taxpayer materially participated in the activity for three
or more taxable years preceding 1990 (see Sec. 1.469-5T(j)(1)). Thus,
even if the taxpayer does not work in the activity after 1989, the
taxpayer is treated, under Sec. 1.469-5T(a)(6), as materially
participating in the activity for 1990 and subsequent taxable years.
Example 4. (i) The taxpayer is a partner in an accounting
partnership that has offices in various cities (partnership A) and in a
management-consulting partnership that has a single office (partnership
B). Each of partnership A's offices derives substantially all of its
gross income from services in the field of accounting, and partnership B
derives substantially all of its gross income from services in the field
of consulting. Under paragraph (c)(1) of this section, partnership B's
consulting business is treated as a single undertaking that is separate
from other undertakings (the ``consulting undertaking'') and each of
partnership A's offices is similarly treated (the ``accounting
undertakings''). The accounting undertakings are controlled by the same
interests, but partnerships A and B are not controlled by the same
interests (within the meaning of paragraph (j) of this section).
Partnership B's consulting business derives 50 percent of its gross
income from customers of partnership A's accounting undertakings, but
does not derive more than 20 percent of its gross income
[[Page 479]]
from the customers of any single accounting undertaking.
(ii) Each accounting undertaking derives more than 50 percent of its
gross income from the provision of services in the field of accounting,
and the consulting undertaking derives more than 50 percent of its gross
income from the provision of services in the field of consulting. Thus,
each accounting undertaking is treated as a professional service
undertaking (within the meaning of paragraph (h)(1)(ii) of this
section), and the consulting undertaking is also treated as a
professional service undertaking.
(iii) Each accounting undertaking derives more than 20 percent of
its gross income from services in the field of accounting. Thus, each
such undertaking involves significant professional services (within the
meaning of paragraph (h)(3)(iv) of this section) in the field of
accounting. In addition, all services in the field of accounting are
treated as similar services under paragraph (h)(3)(i) of this section.
Thus, the accounting undertakings involve the provision of significant
similar services (within the meaning of paragraph (h)(3)(iii) of this
section).
(iv) Paragraph (h)(2) (i) and (ii) of this section provides that a
taxpayer's interests in professional service undertakings that are
controlled by the same interests or that involve the provision of
significant similar services are treated as part of the same activity of
the taxpayer. The accounting undertakings are controlled by the same
interests (see (i) above) and involve the provision of significant
similar services (see (iii) above). Accordingly, the taxpayer's
interests in the accounting undertakings are treated as part of the same
activity under paragraph (h)(2) (i) and (ii) of this section.
(v) The consulting undertaking derives more than 20 percent of its
gross income from services in the field of consulting. If, based on all
the facts and circumstances, these services are determined to be similar
consulting services under paragraph (h)(3)(ii) of this section, the
consulting undertaking involves significant professional services
(within the meaning of paragraph (h)(3)(iv) of this section). In this
case, however, the consulting undertaking and the accounting
undertakings do not involve the provision of significant similar
services (within the meaning of paragraph (h)(3)(iii) of this section)
because consulting services and accounting services are not treated as
similar services under paragraph (h)(3)(i) of this section.
(vi) The consulting undertaking does not derive more than 20 percent
of its gross income from the customers of any single accounting
undertaking of partnership A. If, however, partnership A's accounting
undertakings are aggregated, the consulting undertaking derives more
than 20 percent of its gross income from customers of the aggregated
undertakings. Paragraph (h)(3)(v) of this section provides that two
professional service undertakings involve the provision of significant
related services if more than 20 percent of the gross income of one
undertaking is derived from customers of the other undertaking. For
purposes of applying this rule, partnership A's accounting undertakings
are treated as a single undertaking under paragraph (h)(2)(iii) of this
section because the accounting undertakings are treated as part of the
same activity under paragraph (h)(2)(i) and (ii) of this section. Thus,
the consulting undertaking and the accounting undertakings involve the
provision of significant related services.
(vii) Paragraph (h)(2)(ii) of this section provides that a
taxpayer's interests in professional service undertakings that involve
the provision of significant related services are treated as part of the
same activity of the taxpayer. Accordingly, the taxpayer's interests in
the consulting undertaking and the accounting undertakings are treated
as part of the same activity of the taxpayer under paragraph (h)(2)(ii)
of this section.
Example 5. (i) The facts are the same as in Example 4, except that
partnership B's consulting business derives only 15 percent of its gross
income from customers of partnership A's accounting undertakings.
(ii) As in Example 4, the taxpayer's interests in the accounting
undertakings are treated as part of the same activity under paragraph
(h)(2)(i) and (ii) of this section and are treated under paragraph
(h)(2)(iii) of this section as a single undertaking for purposes of
reapplying those provisions. In this case, however, the consulting
undertaking does not derive more than 20 percent of its gross income
from the customers of partnership A's accounting undertakings. Thus, the
consulting undertaking and the accounting undertakings do not involve
the provision of significant related services. Accordingly, the
accounting undertakings and the consulting undertaking are not treated
as part of the same activity under paragraph (h)(2)(i) or (ii) of this
section because they are not controlled by the same interests and do not
involve the provision of significant similar or related services.
Example 6. (i) The taxpayer is a partner in partnerships A, B, and
C. Partnership A derives substantially all of its gross income from the
provision of engineering services, partnership B derives substantially
all of its gross income from the provision of architectural services,
and partnership C derives 40 percent of its gross income from the
provision of engineering services and the remainder from the provision
of architectural services. Under paragraph (c)(1) of this section, each
partnership's service business is treated as a single undertaking that
is separate from other undertakings. Partnerships A, B, and C are not
controlled by the same interests
[[Page 480]]
(within the meaning of paragraph (j) of this section).
(ii) Each partnership's undertaking derives more than 50 percent of
its gross income from the provision of services in the fields of
architecture and engineering. Thus, each such undertaking is treated as
a professional service undertaking (within the meaning of paragraph
(h)(1)(ii) of this section).
(iii) Partnership A's undertaking (``undertaking A'') derives more
than 20 percent of its gross income from services in the field of
engineering, partnership B's undertaking (``undertaking B'') derives
more than 20 percent of its gross income from services in the field of
architecture, and partnership C's undertaking (``undertaking C'')
derives more than 20 percent of its gross income from services in the
field of engineering and more than 20 percent of its gross income from
services in the field of architecture. Thus, undertaking A involves
significant services in the field of engineering, undertaking B involves
significant services in the field of architecture, and undertaking C
involves significant services in both fields. Under paragraph (h)(3)(i)
of this section, all services within each field are treated as similar
services, but engineering services and architectural services are not
treated as similar services. Thus, undertakings A and C, and
undertakings B and C, involve the provision of significant similar
services (within the meaning of paragraph (h)(3)(iii) of this section).
(iv) Paragraph (h)(2)(ii) of this section provides that a taxpayer's
interests in professional service undertakings that involve the
provision of significant similar services are treated as part of the
same activity of the taxpayer. Accordingly, the taxpayer's interests in
undertakings A and C are treated as part of the same activity of the
taxpayer.
(v) Under paragraph (h)(2)(iii)(A) of this section, undertakings A
and C are also treated as a single undertaking for purposes of
determining whether undertaking B involves the provision of significant
similar services. Paragraph (h)(2)(iii)(B) of this section in effect
provides that treating undertakings A and C as a single undertaking does
not affect the conclusion that the architectural services provided by
undertakings B and C are significant similar services. Thus, undertaking
B and the single undertaking in which undertakings A and C are included
under paragraph (h)(3)(iii) of this section involve the provision of
significant similar services, and the taxpayer's interests in
undertakings A, B, and C are treated as part of the same activity of the
taxpayer under paragraph (h)(2)(ii) of this section.
(i) [Reserved]
(j) Control by the same interests and ownership percentage--(1) In
general. Except as otherwise provided in paragraph (j)(2) of this
section, all the facts and circumstances are taken into account in
determining, for purposes of this section, whether undertakings are
controlled by the same interests. For this purpose, control includes any
kind of control, direct or indirect, whether legally enforceable, and
however exercisable or exercised. It is the reality of control that is
determinative, and not its form or mode of exercise.
(2) Presumption--(i) In general. Undertakings are rebuttably
presumed to be controlled by the same interests if such undertakings are
part of the same common-ownership group.
(ii) Common-ownership group. Except as provided in paragraph
(j)(2)(iii) of this section, two or more undertakings of a taxpayer are
part of the same common-ownership group for purposes of this paragraph
(j)(2) if and only if the sum of the common-ownership percentages of any
five or fewer persons (within the meaning of section 7701(a)(1), but not
including passthrough entities) with respect to such undertakings
exceeds 50 percent. For this purpose, the common-ownership percentage of
a person with respect to such undertakings is the person's smallest
ownership percentage (determined in accordance with paragraph (j)(3) of
this section) in any such undertaking.
(iii) Special aggregation rule. If, without regard to this paragraph
(j)(2)(iii), an undertaking of a taxpayer is part of two or more common-
ownership groups, any undertakings of the taxpayer that are part of any
such common-ownership group shall be treated for purposes of this
paragraph (j)(2) as part of a single common-ownership group in
determining the activities of such taxpayer.
(3) Ownership percentage--(i) In general. For purposes of this
section, a person's ownership percentage in an undertaking or in a
passthrough entity shall include any interest in such undertaking or
passthrough entity that the person holds directly and the person's share
of any interest in such undertaking or passthrough entity that is held
through one or more passthrough entities.
(ii) Passthrough entities. The following rules apply for purposes of
applying paragraph (j)(3)(i) of this section:
[[Page 481]]
(A) A partner's interest in a partnership and share of any interest
in a passthrough entity or undertaking held through a partnership shall
be determined on the basis of the greater of such partner's percentage
interest in the capital (by value) of such partnership or such partner's
largest distributive share of any item of income or gain (disregarding
guaranteed payments under section 707(c)) of such partnership.
(B) A shareholder's interest in an S corporation and share of any
interest in a passthrough entity or undertaking held through an S
corporation shall be determined on the basis of such shareholder's stock
ownership.
(C) A beneficiary's interest in a trust or estate and share of any
interest in a passthrough entity or undertaking held through a trust or
estate shall not be taken into account.
(iii) Attribution rules--(A) In general. Except as otherwise
provided in paragraph (j)(3)(iii)(B) of this section, a person's
ownership percentage in a passthrough entity or in an undertaking shall
be determined by treating such person as the owner of any interest that
a person related to such person owns (determined without regard to this
paragraph (j)(3)(iii)) in such passthrough entity or in such
undertaking.
(B) Determination of common-ownership percentage. The common-
ownership percentage of five or fewer persons with respect to two or
more undertakings shall be determined, in any case in which, after the
application of paragraph (j)(3)(iii)(A) of this section, two or more
such persons own the same interest in any such undertaking (the
``related-party owners'') by treating as the only owner of such interest
(or portion thereof) the related-party owner whose ownership of such
interest (or a portion thereof) would result in the highest common-
ownership percentage.
(C) Related person. A person is related to another person for
purposes of this paragraph (j)(3)(iii) if the relationship of such
persons is described in section 267(b) or 707(b)(1).
(4) Special rule for trade or business activities. In determining
whether two or more trade or business activities are controlled by the
same interests for purposes of paragraph (g) of this section, each such
activity shall be treated as a separate undertaking in applying this
paragraph (j).
(5) Examples. The following examples illustrate the application of
this paragraph (j):
Example 1. (i) Partnership X is the sole owner of an undertaking
(undertaking X), and partnership Y is the sole owner of another
undertaking (undertaking Y). Individuals A, B, C, D, and E are the only
partners in partnerships X and Y, and the partnership agreements of both
X and Y provide that no action may be taken or decision made on behalf
of the partnership without the unanimous consent of the partners.
Moreover, each partner actually participates in, and agrees to, all
major decisions that affect the operations of either partnership. The
ownership percentages (within the meaning of paragraph (j)(3) of this
section) of A, B, C, D, and E in each partnership (and in the
undertaking owned by the partnership) are as follows:
------------------------------------------------------------------------
Partnership/Undertaking
Partner -------------------------
X (percent) Y (percent)
------------------------------------------------------------------------
A............................................. 15 5
B............................................. 10 60
C............................................. 10 20
D............................................. 77 12
E............................................. 8 20
-------------------------
120 117
------------------------------------------------------------------------
The sum of the ownership percentages exceeds 100 percent for both X
and Y because, under paragraph (j)(3)(ii)(A) of this section, each
partner's ownership percentage is determined on the basis of the greater
of the partner's percentage interest in the capital of the partnership
or the partner's largest distributive share of any item of income or
gain of the partnership.
(ii) Paragraph (j)(2)(ii) of this section provides that a person's
common-ownership percentage with respect to any two or more undertakings
is the person's smallest ownership percentage in any such undertaking.
Thus, the common-ownership percentages of A, B, C, D, and E with respect
to undertakings X and Y are as follows:
------------------------------------------------------------------------
Common-ownership
Partner percentage
------------------------------------------------------------------------
A.................................................. 5
B.................................................. 10
C.................................................. 10
D.................................................. 12
E.................................................. 8
--------------------
45
------------------------------------------------------------------------
[[Page 482]]
(iii) Paragraph (j)(2)(i) of this section provides that undertakings
are rebuttably presumed to be controlled by the same interests if the
undertakings are part of the same common-ownership group. In general,
undertakings are part of a common-ownership group only if the sum of the
common-ownership percentages of any five or fewer persons with respect
to such undertakings exceeds 50 percent. In this case, the sum of the
partners' common-ownership percentages with respect to undertakings X
and Y is only 45 percent. Thus, undertakings X and Y are not part of the
same common-ownership group.
(iv) If the presumption in paragraph (j)(2)(i) of this section does
not apply, all the facts and circumstances are taken into account in
determining whether undertakings are controlled by the same interests
(see paragraph (j)(1) of this section). In this case, all actions and
decisions in both undertakings require the unanimous consent of the same
persons and each of those persons actually participates in, and agrees
to, all major decisions. Accordingly, undertakings X and Y are
controlled by the same interests (i.e., A, B, C, D, and E).
Example 2. (i) Partnerships W, X, Y, and Z are each the sole owner
of an undertaking (undertakings W, X, Y, and Z). Individuals A, B, and C
are partners in each of the four partnerships, and the remaining
interests in each partnership are owned by a number of unrelated
individuals, none of whom owns more than a one-percent interest in any
of the partnerships. The ownership percentages (within the meaning of
paragraph (j)(3) of this section) of A, B, and C in each partnership
(and in the undertaking owned by the partnership) are as follows:
------------------------------------------------------------------------
Partner
Partnership/Undertaking --------------------------
A B C
------------------------------------------------------------------------
W............................................ 23% 21% 40%
X............................................ 19% 30% 22%
Y............................................ 25% 25% 20%
Z............................................ 8% 4% 2%
------------------------------------------------------------------------
(ii) Paragraph (j)(2)(ii) of this section provides that a person's
common-ownership percentage with respect to any two or more undertakings
is the person's smallest ownership percentage in any such undertaking.
Thus, the common-ownership percentages of A, B, and C in undertakings W,
X, Y, and Z are as follows:
------------------------------------------------------------------------
Common-ownership
Partner percentage
------------------------------------------------------------------------
A.................................................. 8
B.................................................. 4
C.................................................. 2
--------------------
14
------------------------------------------------------------------------
(iii) The sum of the common-ownership percentages of A, B, and C
with respect to undertakings W, X, Y, and Z is 14 percent, and no other
person owns more than a one-percent interest in any of the undertakings.
Thus, the sum of the common-ownership percentages of any five or fewer
persons with respect to all four undertakings cannot exceed 50 percent.
Accordingly, undertakings W, X, Y, and Z are not part of the same
common-ownership group (see paragraph (j)(2)(ii) of this section) and
are not rebuttably presumed to be controlled by the same interests (see
paragraph (j)(2)(i) of this section).
(iv) The common-ownership percentages of A, B, and C in undertakings
W, X, and Y are as follows:
------------------------------------------------------------------------
Common ownership
Partner percentage
------------------------------------------------------------------------
A.................................................. 19
B.................................................. 21
C.................................................. 20
--------------------
60
------------------------------------------------------------------------
(v) The sum of the common-ownership percentages of A, B, and C,
taking into account only undertakings W, X, and Y, is 60 percent.
Because the sum of the common-ownership percentages exceeds 50 percent,
undertakings W, X, and Y are part of the same common-ownership group
(see paragraph (j)(2)(ii) of this section and are rebuttably presumed to
be controlled by the same interests (see paragraph (j)(2)(i) of this
section).
Example 3. (i) Corporation X, an S corporation, is the sole owner of
an undertaking (undertaking X), and corporation Y, another S
corporation, is the sole owner of another undertaking (undertaking Y).
Individuals A, B, and C are shareholders in corporations X and Y. Both A
and B are related (within the meaning of paragraph (j)(3)(iii)(C) of
this section) to C, but not to each other. A, B, and C are not related
to any other person that owns an interest in either corporation X or
corporation Y. The ownership percentages (determined without regard to
the attribution rules of paragraph (j)(3)(iii) of this section) of A, B,
and C in each corporation (and in the undertaking owned by the
corporation) are as follows:
Corporation/Undertaking
------------------------------------------------------------------------
Shareholder X (percent) Y (percent)
------------------------------------------------------------------------
A............................................. 20 ...........
B............................................. ........... 20
C............................................. 5 5
------------------------------------------------------------------------
(ii) In general, a person's ownership percentage is determined by
treating the person as the owner of interests that are actually owned by
related persons (see paragraph (j)(3)(iii)(A) of this section). If A, B,
and C
[[Page 483]]
are treated as owning interests that are actually owned by related
persons, their ownership percentages are as follows:
Corporation/Undertaking
------------------------------------------------------------------------
Shareholder X (percent) Y (percent)
------------------------------------------------------------------------
A............................................. 25 5
B............................................. 5 25
C............................................. 25 25
------------------------------------------------------------------------
(iii) Paragraph (j)(3)(iii)(B) of this section provides that, in
determining the sum of the common-ownership percentages of any five or
fewer persons with respect to any undertakings, each interest in such
undertakings is counted only once. If two or more persons are treated as
owners of the same interest under paragraph (j)(3)(iii)(A) of this
section, the person whose ownership would result in the highest sum is
treated as the only owner of the interest. In this case, C's common-
ownership percentage with respect to undertakings X and Y, determined by
treating C as the owner of the interests actually owned by A and B, is
25 percent. If, however, A and B are treated as the owners of the
interests actually owned by C, each has a common-ownership percentage of
only five percent. Thus, in determining the sum of common-ownership
percentages with respect to undertakings X and Y, C is treated as the
owner of the interests actually owned by A and B because this treatment
results in the highest sum of common-ownership percentages with respect
to such undertakings.
Example 4. (i) The ownership percentages of individuals A, B, and C
in undertakings X, Y, and Z are as follows:
Undertaking
------------------------------------------------------------------------
Individual X Y Z
------------------------------------------------------------------------
A................................ 30% 30% 30%
B................................ 30% 30% 30%
C................................ ........... 30% 30%
------------------------------------------------------------------------
No other person owns an interest in more than one of the undertakings.
(ii) Paragraph (j)(2)(ii) of this section provides that a person's
common ownership percentage with respect to any two or more undertakings
is the person's smallest ownership percentage in any such undertaking.
Thus, A's common-ownership percentage with respect to undertakings X, Y,
and Z is 30 percent, and the common-ownership percentages of B and C
(and all other persons owning interests in such undertakings) with
respect to such undertakings is zero. Accordingly, the sum of the common
ownership percentages with respect to undertakings X, Y, and Z is only
30 percent, and undertakings X, Y, and Z are not treated as part of the
same common-ownership group under paragraph (j)(2)(ii) of this section.
(iii) B's common-ownership percentage with respect to undertakings X
and Y is 30 percent, and the sum of A's and B's common-ownership
percentages with respect to such undertakings is 60 percent. Thus,
undertakings X and Y are treated as part of the same common-ownership
group under paragraph (j)(2)(ii) of this section. Similarly, C's common-
ownership percentage with respect to undertakings Y and Z is 30 percent,
and the sum of A's and C's common-ownership percentages with respect to
such undertakings is 60 percent. Thus, undertakings Y and Z are also
treated as part of the same common-ownership group under paragraph
(j)(2)(ii) of this section.
(iv) Paragraph (j)(2)(iii) of this section requires the aggregation
of common-ownership groups that include the same undertaking. In this
case, undertaking Y is treated as part of the common-ownership group XY
and as part of the common-ownership group YZ. Accordingly, undertakings
X, Y, and Z are treated as part of a single common-ownership group and
are rebuttably presumed to be controlled by the same interests (see
paragraph (j)(2)(i) of this section) even though B does not own an
interest in undertaking Z and C does not own an interest in undertaking
X. The fact that B and C are not common owners with respect to
undertakings X and Z is taken into account, however, in determining
whether this presumption is rebutted.
(k) Identification of rental real estate activities--(1)
Applicability--(i) In general. Except as otherwise provided in paragraph
(k)(6) of this section, this paragraph (k) applies to a taxpayer's
interests in rental real estate undertakings (within the meaning of
paragraph (k)(1)(ii) of this section).
(ii) Rental real estate undertaking. For purposes of this paragraph
(k), a rental real estate undertaking is a rental undertaking (within
the meaning of paragraph (d) of this section) in which at least 85
percent of the unadjusted basis (within the meaning of Sec. 1.469-
2T(f)(3)) of the property made available for use by customers is real
property. For this purpose the term ``real property'' means any tangible
property other than tangible personal property (within the meaning of
Sec. 1.48-1(c)).
(2) Identification of activities--(i) Multiple undertakings treated
as a single activity or multiple activities by taxpayer. Except as
otherwise provided in this paragraph (k), a taxpayer may treat two or
more rental real estate undertakings (determined after the application
of paragraph (k)(2) (ii) and (iii) of
[[Page 484]]
this section) as a single activity or may treat such undertakings as
separate activities.
(ii) Multiple undertakings treated as a single activity by
passthrough entity. A taxpayer must treat two or more rental real estate
undertakings as a single rental real estate undertaking for a taxable
year if any passthrough entity through which the taxpayer holds such
undertakings treats such undertakings as a single activity on the
applicable return of the passthrough entity for the taxable year of the
taxpayer.
(iii) Single undertaking treated as multiple undertakings.
Notwithstanding that a taxpayer's interest in leased property would, but
for the application of this paragraph (k)(2)(iii), be treated as used in
a single rental real estate undertaking, the taxpayer may, except as
otherwise provided in paragraph (k)(3) of this section, treat a portion
of the leased property (including a ratable portion of any common areas
or facilities) as a rental real estate undertaking that is separate from
the undertaking or undertakings in which the remaining portion of the
property is treated as used. This paragraph (k)(2)(iii) shall apply for
a taxable year if and only if--
(A) Such portion of the leased property can be separately conveyed
under applicable State and local law (taking into account the
limitations, if any, imposed by any special rules or procedures, such as
condominium conversion laws, restricting the separate conveyance of
parts of the same structure); and
(B) The taxpayer holds such leased property directly or through one
or more passthrough entities, each of which treats such portion of the
leased property as a separate activity on the applicable return of the
passthrough entity for the taxable year of the taxpayer.
(3) Treatment in succeeding taxable years. All rental real estate
undertakings or portions of such undertakings that are treated, under
this paragraph (k), as part of the same activity for a taxable year
ending after August 9, 1989 must be treated as part of the same activity
in each succeeding taxable year.
(4) Applicable return of passthrough entity. For purposes of this
paragraph (k), the applicable return of a passthrough entity for a
taxable year of a taxpayer is the return reporting the passthrough
entity's income, gain, loss, deductions, and credits taken into account
by the taxpayer for such taxable year.
(5) Evidence of treatment required. For purposes of this paragraph
(k), a person (including a passthrough entity) does not treat a rental
real estate undertaking as multiple undertakings for a taxable year or,
except as otherwise provided in paragraph (k) (2)(ii) or (3) of this
section, treat multiple rental real estate undertakings as a single
undertaking for a taxable year unless such treatment is reflected on a
schedule attached to the person's return for the taxable year.
(6) Coordination rule for rental of nondepreciable property. This
paragraph (k) shall not apply to a rental real estate undertaking if
less than 30 percent of the unadjusted basis (within the meaning of
Sec. 1.469-2T(f)(3)) of property used or held for use by customers in
such undertaking during the taxable year is subject to the allowance for
depreciation under section 167.
(7) Coordination rule for rental of dwelling unit. For any taxable
year in which section 280A(c)(5) applies to a taxpayer's use of a
dwelling unit--
(i) Paragraph (k) (2) and (3) of this section shall not apply to the
taxpayer's interest in such dwelling unit; and
(ii) The taxpayer's interest in such dwelling unit shall be treated
as a separate activity of the taxpayer.
(8) Examples. The following examples illustrate the application of
this paragraph (k). In each example, the taxpayer is an individual whose
taxable year is the calendar year.
Example 1. (i) In 1989, the taxpayer directly owns five condominium
units (units A, B, C, D, and E) in three different buildings. Units A,
B, and C are in one of the buildings and constitute a single rental real
estate undertaking (within the meaning of paragraph (k)(1)(ii) of this
section). Units D and E are in the other two buildings, and each of
these units constitutes a separate rental real estate undertaking. Each
of the units can be separately conveyed under applicable State and local
law.
[[Page 485]]
(ii) Paragraph (k)(2)(iii) of this section permits a taxpayer to
treat a portion of the property included in a rental real estate
undertaking as a separate rental real estate undertaking if the property
can be separately conveyed under applicable State and local law and the
taxpayer owns the property directly. Thus, the taxpayer can treat units
A, B, and C as three separate undertakings. Alternatively, the taxpayer
could treat two of those units (e.g., units A and C) as an undertaking
and the remaining unit as a separate undertaking, or could treat units
A, B, and C as a single undertaking.
(iii) Paragraph (k)(2)(i) of this section permits a taxpayer to
treat two or more rental real estate undertakings as a single activity,
or to treat such undertakings as separate activities. Thus, the
taxpayer, by combining undertakings, can treat all five units as a
single activity. Alternatively, the taxpayer could treat each
undertaking as a separate activity, or could combine some, but not all,
undertakings. Thus, for example, the taxpayer could treat units A, B, C,
and D as an activity and unit E as a separate activity.
(iv) For purposes of paragraph (k)(2)(i) of this section, a
taxpayer's rental real estate undertakings are determined after the
application of paragraph (k)(2)(iii) of this section. Thus, the
taxpayer, by treating units as separate undertakings under paragraph
(k)(2)(iii) of this section and combining them with other units under
paragraph (k)(2)(i) of this section, can treat any combination of units
as a single activity. For example, the taxpayer could treat units A and
B as a separate rental real estate undertaking, and then treat units A,
B, and D as a single activity. In that case, the taxpayer could treat
units C and E either as a single activity or as two separate activities.
Example 2. (i) The facts are the same as in Example 1. In addition,
the taxpayer treats all five units as a single activity for 1989 and
sells unit E in 1990. (See paragraph (k)(5) of this section for a rule
providing that the units are treated as a single activity only if such
treatment is reflected on a schedule attached to the taxpayer's return.)
(ii) Under paragraph (k)(3) of this section, rental real estate
undertakings that are treated as part of the same activity for a taxable
year must be treated as part of the same activity in each succeeding
year. In this case, all five units were treated as part of the same
activity for 1989 and must therefore be treated as part of the same
activity for 1990. Accordingly, the taxpayer's sale of unit E in 1990
cannot be treated as a disposition of the taxpayer's entire interest in
an activity for purposes of section 469(g) and the rules to be contained
in Sec. 1.469-6T (relating to the treatment of losses upon certain
dispositions of passive and former passive activities).
Example 3. (i) The facts are the same as in Example 1, except that
the taxpayer is a partner in a partnership that is the direct owner of
the five condominium units. In its return for its taxable year ending on
November 30, 1989, the partnership treats the five units as a single
activity. (See paragraph (k)(5) of this section for a rule providing
that the units are treated as a single activity only if such treatment
is reflected on a schedule attached to the partnership's return.) The
partnership sells unit E on November 1, 1990.
(ii) Paragraph (k)(2)(ii) of this section provides that a taxpayer
who holds rental real estate undertakings through a passthrough entity
must treat those undertakings as a single rental real estate undertaking
if they are treated as a single activity on the applicable return of the
passthrough entity. Under paragraph (k)(4) of this section, the
applicable return of the partnership for the taxpayer's 1989 taxable
year is the partnership's return for its taxable year ending on November
30, 1989. Accordingly, the taxpayer must treat the five condominium
units as a single rental real estate undertaking (and thus as part of
the same activity) for 1989 because they are treated as a single
activity on the partnership's return for its taxable year ending in
1989.
(iii) Under paragraph (k)(3) of this section, the taxpayer must
continue treating the condominium units as part of the same activity for
taxable years after 1989. Accordingly, as in Example 2, the five
condominium units are treated as part of the same activity for 1990, and
the sale of unit E in 1990 cannot be treated as a disposition of the
taxpayer's interest in an activity for purposes of section 469(g) and
the rules to be contained in Sec. 1.469-6T.
Example 4. (i) The taxpayer owns a shopping center and a vacant lot
that are separate rental real estate undertakings (within the meaning of
paragraph (k)(1)(ii) of this section). The taxpayer rents space in the
shopping center to various tenants and rents the vacant lot to a parking
lot operator. Most of the unadjusted basis of the property used in the
shopping-center undertaking (taking into account the land on which the
shopping center is built) is subject to the allowance for depreciation,
but no depreciable property is used in the parking-lot undertaking.
(ii) This paragraph (k) provides rules for identifying rental real
estate activities (including the rule in paragraph (k)(2)(i) of this
section that permits a taxpayer to treat two or more rental real estate
undertakings as a single activity). Paragraph (k)(6) of this section
provides, however, that these rules do not apply to a rental real estate
undertaking if less than 30 percent of the unadjusted basis of the
property used in the undertaking is subject to the allowance for
depreciation.
[[Page 486]]
Thus, the taxpayer may not combine the parking-lot undertaking, which
includes no depreciable property, with the shopping-center undertaking
or any other rental real estate undertaking under paragraph (k)(2)(i) of
this section. Accordingly, the parking lot undertaking is treated as a
separate activity under paragraph (b)(1) of this section.
Example 5. (i) The facts are the same as in Example 4, except that
the shopping center and the vacant lot are at the same location (within
the meaning of paragraph (c)(2)(iii) of this section) and are part of
the same rental real estate undertaking (within the meaning of paragraph
(k)(1)(ii) of this section). Taking into account the property used in
the shopping center operations (including the land on which the shopping
center is built) and the vacant lot, 50 percent of the unadjusted basis
of the property used in the undertaking is subject to the allowance for
depreciation.
(ii) In this case, the vacant lot is used in a rental real estate
undertaking in which depreciable property is also used. Moreover, the
exception in paragraph (k)(6) of this section does not apply to the
undertaking consisting of the shopping center and the parking lot
because at least 30 percent of unadjusted basis of the property used in
the undertaking is subject to the allowance for depreciation.
Accordingly, the taxpayer may combine the undertaking with other rental
real estate undertakings and treat the combined undertakings as a single
activity under paragraph (k)(2)(i) of this section.
(l) [Reserved]
(m) Consolidated groups--(1) In general. The activities of a
consolidated group (within the meaning of Sec. 1.469-1T(h)(2)(ii)) and
of each member of such group shall be determined under this section as
if the consolidated group were one taxpayer.
(2) Examples. The following examples illustrate the application of
this paragraph (m). In each example, the facts, analysis, and
conclusions relate to a single taxable year.
Example 1. (i) Corporations M, N, and O are the members of a
consolidated group (within the meaning of Sec. 1.469-1T(h)(2)(ii)).
Under Sec. 1.469-1T(h)(4)(i)(A) and (ii), the consolidated group and
its members are treated as closely held corporations (within the meaning
of Sec. 1.469-1T(g)(2)(ii)). Each member of the consolidated group owns
a two-percent interest in partnership X and a two-percent interest in
partnership Y, and owns interests in a number of trade or business
undertakings (within the meaning of paragraph (f)(1)(ii) of this
section) through the partnerships. Each of these undertakings is
directly owned by partnership X or Y, and all the undertakings of
partnerships X and Y are controlled by the same interests (within the
meaning of paragraph (j) of this section) and are similar (within the
meaning of paragraph (f)(4) of this section). The employees of the
consolidated group and the shareholders of its common parent do not
participate in the undertakings that the member corporations own through
the partnerships.
(ii) Paragraph (f)(2)(i) of this section provides that trade or
business undertakings that are similar and controlled by the same
interests are treated as part of the same activity of the taxpayer if
the taxpayer owns interests in the undertakings through the same
passthrough entity. In this case, the member corporations own interests
in similar, commonly-controlled undertakings through both partnerships,
and such interests are treated under this paragraph (m) as interests
owned by one taxpayer (the consolidated group). Accordingly, the member
corporations' interests in the undertakings owned through partnership X
are treated as part of the same activity of the consolidated group, and
their interests in the undertakings owned through partnership Y are
treated similarly.
Example 2. (i) The facts are the same as in Example 1, except that
each member of the consolidated group owns a five-percent interest in
partnership X and a five-percent interest in partnership Y.
(ii) Paragraph (f)(2)(ii) of this section provides that trade or
business undertakings that are similar and controlled by the same
interests are treated as part of the same activity of the taxpayer if
the taxpayer owns a direct or substantial indirect interest in each such
undertaking. In this case, the member corporations own, in the
aggregate, a 15-percent interest in partnership X and a 15-percent
interest in partnership Y, and such interests are treated under this
paragraph (m) as interests owned by one taxpayer (the consolidated
group). Thus, the consolidated group owns a substantial indirect
interest in the similar, commonly-controlled undertakings owned by
partnerships X and Y (see paragraph (f)(3)(i) of this section).
Accordingly, the member corporations' interests in the undertakings
owned through partnerships X and Y are treated as part of the same
activity of the consolidated group.
(n) Publicly traded partnerships. The rules of this section shall
apply to a taxpayer's interest in business and rental operations held
through a publicly traded partnership (within the meaning of section
469(k)(2)) as if the taxpayer had no interest in any other business and
rental operations. The following example illustrates the application of
this paragraph (n):
[[Page 487]]
Example. (i) The taxpayer, an individual, owns a 20-percent interest
in partnership X and a 15-percent interest in partnership Y. Partnership
X directly owns a hotel (``hotel 1'') and a commercial office building
(``building 1''). Partnership Y directly owns two hotels (``hotels 2 and
3'') and two commercial office buildings (``buildings 2 and 3''). Each
of the three hotels is a separate trade or business undertaking (within
the meaning of paragraph (f)(1)(ii) of this section), and each of the
three office buildings is a separate rental real estate undertaking
(within the meaning of paragraph (k)(1)(ii) of this section). The three
hotel undertakings are similar (within the meaning of paragraph (f)(4)
of this section) and are controlled by the same interests (within the
meaning of paragraph (j) of this section). Partnership X is not a
publicly traded partnership (within the meaning of section 469(k)(2)).
Partnership Y, however, is a publicly traded partnership and is not
treated as a corporation under section 7704.
(ii) This paragraph (n) provides that the rules of this section
apply to a taxpayer's interest in business and rental operations held
through a publicly traded partnership as if the taxpayer had no interest
in any other business and rental operations. Thus, undertakings owned
through partnership Y may be treated as part of the same activity under
the rules of this section, but an undertaking owned through partnership
Y and an undertaking that is not owned through partnership Y may not be
treated as part of the same activity.
(iii) Paragraph (f)(2)(i) of this section provides that a taxpayer's
interests in two or more trade or business undertakings that are similar
and controlled by the same interests are treated as part of the same
activity if the taxpayer owns interests in each undertaking through the
same passthrough entity. Partnership Y's hotel undertakings (i.e.,
hotels 2 and 3) are similar and are controlled by the same interests. In
addition, the taxpayer owns interests in both undertakings through the
same partnership. Accordingly, the taxpayer's interests in partnership
Y's hotel undertakings are treated as part of the same activity.
(iv) The hotel undertaking owned through partnership X (i.e., hotel
1) and the hotel undertakings owned through partnership Y are similar
and controlled by the same interests, and the taxpayer owns a
substantial indirect interest in each of the undertakings (see paragraph
(f)(3)(i) of this section). Thus, the three undertakings would
ordinarily be treated as part of the same activity under paragraph
(f)(2)(ii) of this section. Under this paragraph (n), however,
undertakings that are owned through a publicly traded partnership cannot
be treated as part of the same activity as any undertaking not owned
through that partnership. Accordingly, the hotel undertaking that the
taxpayer owns through partnership X and the hotel undertakings that the
taxpayer owns through partnership Y are treated as two separate
activities.
(v) Paragraph (k)(2)(i) of this section provides that, with certain
exceptions, a taxpayer may treat two or more rental real estate
undertakings as a single activity or as separate activities. Thus, the
taxpayer's interests in the rental real estate undertakings owned
through partnership Y (i.e., buildings 2 and 3) may be treated as a
single activity or as separate activities. Under this paragraph (n),
however, undertakings that are owned through a publicly traded
partnership cannot be treated as part of the same activity as any
undertaking not owned through that partnership. Accordingly, the
taxpayer's interest in the rental real estate undertaking owned through
partnership X (building 1) cannot be treated as part of an activity that
includes any rental real estate undertaking owned through partnership Y.
(o) Elective treatment of undertakings as separate activities--(1)
Applicability. This paragraph applies to a taxpayer's interest in any
undertaking (other than a rental real estate undertaking (within the
meaning of paragraph (k)(1)(ii) of this section)) that would otherwise
be treated under this section as part of an activity that includes the
taxpayer's interest in any other undertaking.
(2) Undertakings treated as separate activities. Except as otherwise
provided in this paragraph (o), a person (including a passthrough
entity) shall treat an undertaking to which this paragraph (o) applies
as an activity separate from the remainder of the activity in which such
undertaking would otherwise be included for a taxable year if and only
if, for such taxable year or any preceding taxable year, such person
made an election with respect to such undertaking under this paragraph
(o).
(3) Multiple undertakings treated as a single activity by
passthrough entity. A person (including a passthrough entity) must treat
interests in two or more undertakings as part of the same activity for a
taxable year if any passthrough entity through which the person holds
such undertakings treats such undertakings as part of the same activity
on the applicable return of the passthrough entity for the taxable year
of such person.
[[Page 488]]
(4) Multiple undertakings treated as a single activity for a
preceding taxable year. If a person (including a passthrough entity)
treats undertakings as part of the same activity on such person's return
for a taxable year ending after August 9, 1989, such person may not
treat such undertakings as part of different activities under this
paragraph (o) for any subsequent taxable year.
(5) Applicable return of passthrough entity. For purposes of this
paragraph (o), the applicable return of a passthrough entity for a
taxable year of a taxpayer is the return reporting the passthrough
entity's income, gain, loss, deductions, and credits taken into account
by the taxpayer for such taxable year.
(6) Participation. The following rules apply to multiple activities
(the ``separate activities'') that would be treated as a single activity
(the ``original activity'') if the taxpayer's activities were determined
without regard to this paragraph (o):
(i) The taxpayer shall be treated as materially participating
(within the meaning of Sec. 1.469-5T) for the taxable year in the
separate activities if and only if the taxpayer would, but for the
application of this paragraph (o), be treated as materially
participating for the taxable year in the original activity.
(ii) The taxpayer shall be treated as significantly participating
(within the meaning of Sec. 1.469-5T(c)(2)) for the taxable year in the
separate activities if and only if the taxpayer would, but for the
application of this paragraph (o), be treated as significantly
participating for the taxable year in the original activity.
(7) Election--(i) In general. A person makes an election with
respect to an undertaking under this paragraph (o) by attaching the
written statement described in paragraph (o)(7)(ii) of this section to
such person's return for the taxable year for which the election is made
(see paragraph (o)(2) of this section).
(ii) Written statement. The written statement required by paragraph
(o)(7)(i) of this section must--
(A) State the name, address, and taxpayer identification number of
the person making the election;
(B) Contain a declaration that an election is being made under Sec.
1.469-4T(o);
(C) Identify the undertaking with respect to which such election is
being made; and
(D) Identify the remainder of the activity in which such undertaking
would otherwise be included.
(8) Examples. The following examples illustrate the application of
this paragraph (o):
Example 1. (i) During 1989, the taxpayer, an individual whose
taxable year is the calendar year, acquires and is the direct owner of
ten grocery stores. The operations of each grocery store are treated
under paragraph (c)(1) of this section as a single undertaking that is
separate from other undertakings (a ``grocery-store undertaking''), and
the taxpayer's interests in the grocery-store undertakings would be
treated as part of the same activity of the taxpayer under paragraph
(f)(2) of this section.
(ii) Paragraph (o)(2) of this section provides that, with certain
exceptions, undertakings that would be treated as part of the same
activity under other rules in this section may, at the election of the
taxpayer, be treated as separate activities. Thus, the taxpayer may
elect to treat each grocery-store undertaking as a separate activity for
1989. Alternatively, the taxpayer may combine grocery-store undertakings
in any manner and treat each combination of undertakings (and each
uncombined undertaking) as a separate activity for 1989. In either case,
the election must be made by attaching the written statement described
in paragraph (o)(7)(ii) of this section to the taxpayer's 1989 return.
Example 2. (i) The facts are the same as in Example 1. In addition,
the taxpayer, in 1989, elects to treat each grocery-store undertaking as
a separate activity and participates for 15 hours in each of the
grocery-store undertakings.
(ii) The taxpayer's interest in each grocery-store undertaking is
treated, under paragraph (o)(2) of this section, as a separate activity
of the taxpayer for 1989 (a ``grocery-store activity''). In 1989,
however, the taxpayer participates for more than 100 hours in the
activity in which the undertakings would be included (but for the
election to treat the grocery-store undertakings as separate activities)
and would be treated under Sec. 1.469-5T(c)(2) as significantly
participating in such activity. Accordingly, the taxpayer is treated
under paragraph (o)(6)(ii) of this section as significantly
participating in each of the grocery-store activities for 1989.
Example 3. (i) The facts are the same as in Example 1. In addition,
the taxpayer, in 1989,
[[Page 489]]
elects to treat each grocery-store undertaking as a separate activity.
The taxpayer does not participate in any of the grocery-store
undertakings in 1989 or 1990, and sells one of the grocery stores in
1990.
(ii) As in Example 2, the taxpayer's interests in each grocery-store
undertaking is treated, under paragraph (o)(2) of this section, as a
separate activity of the taxpayer for 1989. Because the taxpayer elected
to treat the undertakings as separate activities for a preceding taxable
year (1989), each grocery-store undertaking is also treated, under
paragraph (o)(2) of this section, as a separate activity of the taxpayer
for 1990. In addition, each of the taxpayer's grocery-store activities
is a passive activity for 1989 and 1990 because the taxpayer does not
participate in any of the grocery store undertakings for 1989 and 1990.
Accordingly, the taxpayer's sale of the grocery store will generally be
treated as a disposition of the taxpayer's entire interest in a passive
activity for purposes of section 469(g) and the rules to be contained in
Sec. 1.469-6T (relating to the treatment of losses upon certain
dispositions of passive and former passive activities).
Example 4. (i) The facts are the same as in Example 3, except that
the taxpayer elects to treat the grocery-store undertakings as two
separate activities. One of the activities includes three grocery-store
undertakings, and the store sold in 1990 is part of this activity. The
other activity includes the seven remaining grocery-store undertakings.
(ii) Paragraph (o)(4) of this section provides that a person who
treats undertakings as part of the same activity for a taxable year
ending after August 9, 1989, may not elect to treat those undertakings
as separate activities for a subsequent taxable year. The grocery store
sold in 1990 was treated for 1989 as part of an activity that includes
two other grocery stores. Thus, those three stores must be treated as
part of the same activity for 1990. Accordingly, the taxpayer's sale of
the grocery store cannot be treated as a disposition of the taxpayer's
entire interest in a passive activity for purposes of section 469(g) and
the rules to be contained in Sec. 1.469-6T.
Example 5. (i) The facts are the same as in Example 1, except that
the taxpayer is a partner in a partnership that acquires and is the
direct owner of the ten grocery stores. The taxable year of the
partnership ends on November 30, and the partnership acquires the
grocery stores in its taxable year ending on November 30, 1989. In its
return for that taxable year, the partnership treats the grocery-store
undertakings as a single activity.
(ii) Paragraph (o)(3) of this section provides that a person who
holds undertakings through a passthrough entity may not elect to treat
those undertakings as separate activities if they are treated as part of
the same activity on the applicable return of the passthrough entity.
Under paragraph (o)(5) of this section, the applicable return of the
partnership for the taxpayer's 1989 taxable year is the partnership's
return for its taxable year ending on November 30, 1989. Accordingly,
the taxpayer must treat the grocery-store undertakings as a single
activity for 1989 because those undertakings are treated as a single
activity on the partnership's return for its taxable year ending in
1989.
(iii) Under paragraph (o)(4) of this section, the taxpayer must
continue treating the grocery-store undertakings as part of the same
activity for taxable years after 1989. This rule applies even if the
partnership subsequently distributes its interest in the grocery stores
to the taxpayer, and the taxpayer becomes the direct owner of the
grocery-store undertakings.
(p) Special rule for taxable years ending before August 10, 1989--
(1) In general. For purposes of applying section 469 and the regulations
thereunder for a taxable year ending before August 10, 1989, a
taxpayer's business and rental operations may be organized into
activities under the rules or paragraphs (b) through (n) of this section
or under any other reasonable method. For example, for such taxable
years a taxpayer may treat each of the taxpayer's undertakings as a
separate activity, or a taxpayer may treat undertakings that involve the
provision of similar goods or services as a single activity.
(2) Unreasonable methods. A method of organizing business and rental
operations into activities is not reasonable if such method--
(i) Treats rental operations (within the meaning of paragraph (d)(3)
of this section) that are not ancillary to a trade or business activity
(within the meaning of Sec. 1.469-1T(e)(2)) as part of a trade or
business activity;
(ii) Treats operations that are not rental operations and are not
ancillary to a rental activity (within the meaning of Sec. 1.469-
1T(e)(3)) as part of a rental activity;
(iii) Includes in a passive activity of a taxpayer any oil or gas
well that would be treated, under paragraph (e)(1) of this section, as a
separate undertaking in determining the taxpayer's activities;
(iv) Includes in a passive activity of a taxpayer any interest in a
dwelling unit that would be treated, under paragraph (K)(7) of this
section, as a separate activity of the taxpayer; or
[[Page 490]]
(v) Is inconsistent with the taxpayer's method of organizing
business and rental operations into activities for the taxpayer's first
taxable year beginning after December 31, 1986.
(3) Allocation of dissallowed deductions in succeeding taxable year.
If any of the taxpayer's passive activity deductions or the taxpayer's
credits from passive activities are disallowed under Sec. 1.469-1T for
the last taxable year of the taxpayer ending before August 10, 1989,
such disallowed deductions or credits shall be allocated among the
taxpayer's activities for the first taxable year of the taxpayer ending
after August 9, 1989, using any reasonable method. See Sec. 1.469-
1T(f)(4).
[T.D. 8253, 54 FR 20542, May 12, 1989]
Sec. 1.469-5 Material participation.
(a)-(e) [Reserved]
(f) Participation--(1) In general. Except as otherwise provided in
this paragraph (f), any work done by an individual (without regard to
the capacity in which the individual does the work) in connection with
an activity in which the individual owns an interest at the time the
work is done shall be treated for purposes of this section as
participation of the individual in the activity.
(f)(2)-(h)(2) [Reserved]
(h)(3) Coordination with rules governing the treatment of
passthrough entities. If a taxpayer takes into account for a taxable
year of the taxpayer any item of gross income or deduction from a
partnership or S corporation that is characterized as an item of gross
income or deduction from an activity in which the taxpayer materially
participated under Sec. 1.469-2T(e)(1), the taxpayer is treated as
materially participating in the activity for the taxable year for
purposes of applying Sec. 1.469-5T(a)(5) and (6) to any succeeding
taxable year of the taxpayer.
(i) [Reserved]
(j) Material participation for preceding taxable years--(1) In
general. For purposes of Sec. 1.469-5T(a)(5) and (6), a taxpayer has
materially participated in an activity for a preceding taxable year if
the activity includes significant section 469 activities that are
substantially the same as significant section 469 activities that were
included in an activity in which the taxpayer materially participated
(determined without regard to Sec. 1.469-5T(a)(5)) for the preceding
taxable year.
(2) Material participation for taxable years beginning before
January 1, 1987. In any case in which it is necessary to determine
whether an individual materially participated in any activity for a
taxable year beginning before January 1, 1987 (other than a taxable year
of a partnership, S corporation, estate, or trust ending after December
31, 1986), the determination shall be made without regard to paragraphs
(a)(2) through (7) of this section.
(k) Examples. Example 1--Example 4 [Reserved]
Example 5. In 1993, D, an individual, acquires stock in an S
corporation engaged in a trade or business activity (within the meaning
of Sec. 1.469-1(e)(2)). For every taxable year from 1993 through 1997,
D is treated as materially participating (without regard to Sec. 1.469-
5T(a)(5)) in the activity. D retires from the activity at the beginning
of 1998, and would not be treated as materially participating in the
activity for 1998 and subsequent taxable years if material participation
of those years were determined without regard to Sec. 1.469-5T(a)(5).
Under Sec. 1.469-5T(a)(5) of this section, however, D is treated as
materially participating in the activity for taxable years 1998 through
2003 because D materially participated in the activity (determined
without regard to Sec. 1.469-5T(a)(5) for five taxable years during the
ten taxable years that immediately precede each of those years. D is not
treated under Sec. 1.469-5T(a)(5) as materially participating in the
activity for taxable years beginning after 2003 because for those years
D has not materially participated in the activity (determined without
regard to Sec. 1.469-5T(a)(5) for five of the last ten immediately
preceding taxable years.
[T.D. 8417, 57 FR 20758, May 15, 1992]
Sec. 1.469-5T Material participation (temporary).
(a) In general. Except as provided in paragraphs (e) and (h)(2) of
this section, an individual shall be treated, for purposes of section
469 and the regulations thereunder, as materially participating in an
activity for the taxable year if and only if--
(1) The individual participates in the activity for more than 500
hours during such year;
[[Page 491]]
(2) The individual's participation in the activity for the taxable
year constitutes substantially all of the participation in such activity
of all individuals (including individuals who are not owners of
interests in the activity) for such year;
(3) The individual participates in the activity for more than 100
hours during the taxable year, and such individual's participation in
the activity for the taxable year is not less than the participation in
the activity of any other individual (including individuals who are not
owners of interests in the activity) for such year;
(4) The activity is a significant participation activity (within the
meaning of paragraph (c) of this section) for the taxable year, and the
individual's aggregate participation in all significant participation
activities during such year exceeds 500 hours;
(5) The individual materially participated in the activity
(determined without regard to this paragraph (a)(5)) for any five
taxable years (whether or not consecutive) during the ten taxable years
that immediately precede the taxable year;
(6) The activity is a personal service activity (within the meaning
of paragraph (d) of this section), and the individual materially
participated in the activity for any three taxable years (whether or not
consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances (taking into account
the rules in paragraph (b) of this section), the individual participates
in the activity on a regular, continuous, and substantial basis during
such year.
(b) Facts and circumstances--(1) In general. [Reserved]
(2) Certain participation insufficient to constitute material
participation under this paragraph (b)--(i) Participation satisfying
standards not contained in section 469. Except as provided in section
469(h)(3) and paragraph (h)(2) of this section (relating to certain
retired individuals and surviving spouses in the case of farming
activities), the fact that an individual satisfies the requirements of
any participation standard (whether or not referred to as ``material
participation'') under any provision (including sections 1402 and 2032A
and the regulations thereunder) other than section 469 and the
regulations thereunder shall not be taken into account in determining
whether such individual materially participates in any activity for any
taxable year for purposes of section 469 and the regulations thereunder.
(ii) Certain management activities. An individual's services
performed in the management of an activity shall not be taken into
account in determining whether such individual is treated as materially
participating in such activity for the taxable year under paragraph
(a)(7) of this section unless, for such taxable year--
(A) No person (other than such individual) who performs services in
connection with the management of the activity receives compensation
described in section 911(d)(2)(A) in consideration for such services;
and
(B) No individual performs services in connection with the
management of the activity that exceed (by hours) the amount of such
services performed by such individual.
(iii) Participation less than 100 hours. If an individual
participates in an activity for 100 hours or less during the taxable
year, such individual shall not be treated as materially participating
in such activity for the taxable year under paragraph (a)(7) of this
section.
(c) Significant participation activity--(1) In general. For purposes
of paragraph (a)(4) of this section, an activity is a significant
participation activity of an individual if and only if such activity--
(i) Is a trade or business activity (within the meaning of Sec.
1.469-1T(e)(2)) in which the individual significantly participates for
the taxable year; and
(ii) Would be an activity in which the individual does not
materially participate for the taxable year if material participation
for such year were determined without regard to paragraph (a)(4) of this
section.
(2) Significant participation. An individual is treated as
significantly participating in an activity for a taxable year if and
only if the individual participates in the activity for more than 100
hours during such year.
[[Page 492]]
(d) Personal service activity. An activity constitutes a personal
service activity for purposes of paragraph (a)(6) of this section if
such activity involves the performance of personal services in--
(1) The fields of health, law, engineering, architecture,
accounting, actuarial science, performing arts, or consulting; or
(2) Any other trade or business in which capital is not a material
income-producing factor.
(e) Treatment of limited partners--(1) General rule. Except as
otherwise provided in this paragraph (e), an individual shall not be
treated as materially participating in any activity of a limited
partnership for purposes of applying section 469 and the regulations
thereunder to--
(i) The individual's share of any income, gain, loss, deduction, or
credit from such activity that is attributable to a limited partnership
interest in the partnership; and
(ii) Any gain or loss from such activity recognized upon a sale or
exchange of such an interest.
(2) Exceptions. Paragraph (e)(1) of this section shall not apply to
an individual's share of income, gain, loss, deduction, and credit for a
taxable year from any activity in which the individual would be treated
as materially participating for the taxable year under paragraph (a)(1),
(5), or (6) of this section if the individual were not a limited partner
for such taxable year.
(3) Limited partnership interest--(i) In general. Except as provided
in paragraph (e)(3)(ii) of this section, for purposes of section
469(h)(2) and this paragraph (e), a partnership interest shall be
treated as a limited partnership interest if--
(A) Such interest is designated a limited partnership interest in
the limited partnership agreement or the certificate of limited
partnership, without regard to whether the liability of the holder of
such interest for obligations of the partnership is limited under the
applicable State law; or
(B) The liability of the holder of such interest for obligations of
the partnership is limited, under the law of the State in which the
partnership is organized, to a determinable fixed amount (for example,
the sum of the holder's capital contributions to the partnership and
contractural obligations to make additional capital contributions to the
partnership).
(ii) Limited partner holding general partner interest. A partnership
interest of an individual shall not be treated as a limited partnership
interest for the individual's taxable year if the individual is a
general partner in the partnership at all times during the partnership's
taxable year ending with or within the individual's taxable year (or the
portion of the partnership's taxable year during which the individual
(directly or indirectly) owns such limited partnership interest).
(f) Participation--(1) [Reserved]. See Sec. 1.469-5(f)(1) for rules
relating to this paragraph.
(2) Exceptions--(i) Certain work not customarily done by owners.
Work done in connection with an activity shall not be treated as
participation in the activity for purposes of this section if--
(A) Such work is not of a type that is customarily done by an owner
of such an activity; and
(B) One of the principal purposes for the performance of such work
is to avoid the disallowance, under section 469 and the regulations
thereunder, of any loss or credit from such activity.
(ii) Participation as an investor--(A) In general. Work done by an
individual in the individual's capacity as an investor in an activity
shall not be treated as participation in the activity for purposes of
this section unless the individual is directly involved in the day-to-
day management or operations of the activity.
(B) Work done in individual's capacity as an investor. For purposes
of this paragraph (f)(2)(ii), work done by an individual in the
individual's capacity as an investor in an activity includes--
(1) Studying and reviewing financial statements or reports on
operations of the activity;
(2) Preparing or compiling summaries or analyses of the finances or
operations of the activity for the individual's own use; and
(3) Monitoring the finances or operations of the activity in a non-
managerial capacity.
[[Page 493]]
(3) Participation of spouse. In the case of any person who is a
married individual (within the meaning of section 7703) for the taxable
year, any participation by such person's spouse in the activity during
the taxable year (without regard to whether the spouse owns an interest
in the activity and without regard to whether the spouses file a joint
return for the taxable year) shall be treated, for purposes of applying
section 469 and the regulations thereunder to such person, as
participation by such person in the activity during the taxable year.
(4) Methods of proof. The extent of an individual's participation in
an activity may be established by any reasonable means. Contemporaneous
daily time reports, logs, or similar documents are not required if the
extent of such participation may be established by other reasonable
means. Reasonable means for purposes of this paragraph may include but
are not limited to the identification of services performed over a
period of time and the approximate number of hours spent performing such
services during such period, based on appointment books, calendars, or
narrative summaries.
(g) Material participation of trusts and estates. [Reserved]
(h) Miscellaneous rules--(1) Participation of corporations. For
rules relating to the participation in an activity of a personal service
corporation (within the meaning of Sec. 1.468-1T(g)(2)(i)) or a closely
held corporation (within the meaning of Sec. 1.469-1T(g)(2)(ii)), see
Sec. 1.469-1T(g)(3).
(2) Treatment of certain retired farmers and surviving spouses of
retired or disabled farmers. An individual shall be treated as
materially participating for a taxable year in any trade or business
activity of farming if paragraph (4) or (5) of section 2032A(b) would
cause the requirements of section 2032A(b)(1)(C)(ii) to be met with
respect to real property used in such activity had the individual died
during such taxable year.
(3) Coordination with rules governing the treatment of passthrough
entities. [Reserved]. See Sec. 1.469-5(h)(3) for rules relating to this
paragraph.
(i) [Reserved]
(j) Material participation for preceding taxable years. [Reserved].
See Sec. 1.469-5(j) for rules relating to this paragraph.
(k) Examples. The following examples illustrate the application of
this section:
Example 1. A, a calendar year individual, owns all of the stock of
X, a C corporation. X is the general partner, and A is the limited
partner, in P, a calendar year partnership. P has a single activity, a
restaurant, which is a trade or business activity (within the meaning of
Sec. 1.469-1T(e)(2)). During the taxable year, A works for an average
of 30 hours per week in connection with P's restaurant activity. Under
paragraphs (a)(1) and (e)(2) of this section, A is treated as materially
participating in the activity for the taxable year because A
participates in the restaurant activity during such year for more than
500 hours. In addition, under Sec. 1.469-1T(g)(3)(i), A's participation
will cause X to be treated as materially participating in the restaurant
activity.
Example 2. The facts are the same as in Example 1, except that the
partnership agreement provides that P's restaurant activity is to be
managed by X, and A's work in the activity is performed pursuant to an
employment contract between A and X. Under paragraph (f)(1) of this
section, work done by A in connection with the activity in any capacity
is treated as participation in the activity by A. Accordingly, the
conclusion is the same as in Example 1. The conclusion would be the same
if A owned no stock in X at any time, although in that case A's
participation would not be taken into account in determining whether X
materially participates in the restaurant activity.
Example 3. B, an individual, is employed fulltime as a carpenter. B
also owns an interest in a partnership which is engaged in a van
conversion activity, which is a trade or business activity (within the
meaning of Sec. 1.469-1T(e)(2)). B and C, the other partner, are the
only participants in the activity for the taxable year. The activity is
conducted entirely on Saturdays. Each Saturday throughout the taxable
year, B and C work for eight hours in the activity. Although B does not
participate in the activity for more than 500 hours during the taxable
year, under paragraph (a)(3) of this section, B is treated for such year
as materially participating in the activity because B participates in
the activity for more than 100 hours during the taxable year, and B's
participation in the activity for such year is not less than the
participation of any other person in the activity for such year.
Example 4. C, an individual, is employed full-time as an accountant.
C also owns interests in a restaurant and a shoe store. The restaurant
and shoe store are trade or business activities (within the meaning of
Sec. 1.469-
[[Page 494]]
1T(e)(2)) that are treated as separate activities under the rules to be
contained in Sec. 1.469-4T. Each activity has several full-time
employees. During the taxable year, C works in the restaurant activity
for 400 hours and in the shoe store activity for 150 hours. Under
paragraph (c) of this section, both the restaurant and shoe store
activities are significant participation activities of C for the taxable
year. Accordingly, since C's aggregate participation in the restaurant
and shoe store activities during the taxable year exceeds 500 hours, C
is treated under paragraph (a)(4) of this section as materially
participating in both activities.
Example 5. [Reserved]. See Sec. 1.469-5(k) Example 5 for this
example.
Example 6. The facts are the same as in Example 5, except that D
does not acquire any stock in the S corporation until 1994. Under
paragraph (f)(1) of this section, D is not treated as participating in
the activity for any taxable year prior to 1994 because D does not own
as interest in the activity for any such taxable year. Accordingly, D
materially participates in the activity for only one taxable year prior
to 1995, and D is not treated under paragraph (a)(5) of this section as
materially participating in the activity for 1995 or subsequent taxable
years.
Example 7. (i) E, a married individual filing a separate return for
the taxable year, is employed full-time as an attorney. E also owns an
interest in a professional football team that is a trade or business
activity (within the meaning of Sec. 1.469-1T(e)(2)). E does no work in
connection with this activity. E anticipates that, for the taxable year,
E's deductions from the activity will exceed E's gross income from the
activity and that, if E does not materially participate in the activity
for the taxable year, part or all of F's passive activity loss for the
taxable year will be disallowed under Sec. 1.469-1T(a)(1)(i).
Accordingly, E pays E's spouse to work as an office receptionist in
connection with the activity for an average of 15 hours per week during
the taxable year.
(ii) Under paragraph (f)(3) of this section any participation in the
activity by E's spouse is treated as participation in the activity by E.
However, under paragraph (f)(2)(i) of this section, the work done by E's
spouse is not treated as participation in the activity because work as
an office receptionist is not work of a type customarily done by an
owner of a football team, and one of E's principal purposes for paying
E's spouse to do this work is to avoid the disallowance under Sec.
1.469-1T(a)(1)(i) of E's passive activity loss. Accordingly, E is not
treated as participating in the activity for the taxable year.
Example 8. (i) F, an individual, owns an interest in a partnership
that feeds and sells cattle. The general partner of the partnership
periodically mails F a letter setting forth certain proposed actions and
decisions with respect to the cattle-feeding operation. Such actions and
decisions include, for example, what kind of feed to purchase, how much
to purchase, and when to purchase it, how often to feed cattle, and when
to sell cattle. The letters explain the proposed actions and decisions,
emphasize that taking or not taking a particular action or decision is
solely within the discretion of F and other partners, and ask F to
indicate a decision with respect to each proposed action by answering
certain questions. The general partner receives a fee that constitutes
earned income (within the meaning of section 911 (d)(2)(A)) for managing
the cattle-feeding operation. F is not treated as materially
participating in the cattle-feeding operation under paragraph (a) (1)
through (6) of this section.
(ii) F's only participation in the cattle-feeding operation is to
make certain managerial decisions. Under paragraph (b)(2)(ii) of this
section, such management services are not taken into account in
determining whether the taxpayer is treated as materially participating
in the activity for a taxable year under paragraph (a)(7) of this
section, if any other person performs services in connection with the
management of the activity and receives compensation described in
section 911(d)(2)(A) for such services. Therefore, F is not treated as
materially participating for the taxable year in the cattle-feeding
operation.
[T.D. 8175, 53 FR 5725, Feb. 25, 1988; 53 FR 15494, Apr. 29, 1988, as
amended by T.D. 8253, 54 FR 20565, May 12, 1989; T.D. 8417, 57 FR 20759,
May 15, 1992; 61 FR 14247, Apr. 1, 1996]
Sec. 1.469-6 Treatment of losses upon certain dispositions. [Reserved]
Sec. 1.469-7 Treatment of self-charged items of interest income
and deduction.
(a) In general--(1) Applicability and effect of rules. This section
sets forth rules that apply, for purposes of section 469 and the
regulations thereunder, in the case of a lending transaction (including
guaranteed payments for the use of capital under section 707(c)) between
a taxpayer and a passthrough entity in which the taxpayer owns a direct
or indirect interest, or between certain passthrough entities. The rules
apply only to items of interest income and interest expense that are
recognized in the same taxable year. The rules--
(i) Treat certain interest income resulting from these lending
transactions as passive activity gross income;
[[Page 495]]
(ii) Treat certain deductions for interest expense that is properly
allocable to the interest income as passive activity deductions; and
(iii) Allocate the passive activity gross income and passive
activity deductions resulting from this treatment among the taxpayer's
activities.
(2) Priority of rules in this section. The character of amounts
treated under the rules of this section as passive activity gross income
and passive activity deductions and the activities to which these
amounts are allocated are determined under the rules of this section and
not under the rules of Sec. Sec. 1.163-8T, 1.469-2(c) and (d), and
1.469-2T(c) and (d).
(b) Definitions. The following definitions set forth the meaning of
certain terms for purposes of this section:
(1) Passthrough entity. The term passthrough entity means a
partnership or an S corporation.
(2) Taxpayer's share. A taxpayer's share of an item of income or
deduction of a passthrough entity is the amount treated as an item of
income or deduction of the taxpayer for the taxable year under section
702 (relating to the treatment of distributive shares of partnership
items as items of partners) or section 1366 (relating to the treatment
of pro rata shares of S corporation items as items of shareholders).
(3) Taxpayer's indirect interest. The taxpayer has an indirect
interest in an entity if the interest is held through one or more
passthrough entities.
(4) Entity taxable year. In applying this section for a taxable year
of a taxpayer, the term entity taxable year means the taxable year of
the passthrough entity for which the entity reports items that are taken
into account under section 702 or section 1366 for the taxpayer's
taxable year.
(5) Deductions for a taxable year. The term deductions for a taxable
year means deductions that would be allowable for the taxable year if
the taxpayer's taxable income for all taxable years were determined
without regard to sections 163(d), 170(b), 469, 613A(d), and 1211.
(c) Taxpayer loans to passthrough entity--(1) Applicability. Except
as provided in paragraph (g) of this section, this paragraph (c) applies
with respect to a taxpayer's interest in a passthrough entity (borrowing
entity) for a taxable year if--
(i) The borrowing entity has deductions for the entity taxable year
for interest charged to the borrowing entity by persons that own direct
or indirect interests in the borrowing entity at any time during the
entity taxable year (the borrowing entity's self-charged interest
deductions);
(ii) The taxpayer owns a direct or an indirect interest in the
borrowing entity at any time during the entity taxable year and has
gross income for the taxable year from interest charged to the borrowing
entity by the taxpayer or a passthrough entity through which the
taxpayer holds an interest in the borrowing entity (the taxpayer's
income from interest charged to the borrowing entity); and
(iii) The taxpayer's share of the borrowing entity's self-charged
interest deductions includes passive activity deductions.
(2) General rule. If any of the borrowing entity's self-charged
interest deductions are allocable to an activity for a taxable year in
which this paragraph (c) applies, the passive activity gross income and
passive activity deductions from that activity are determined under the
following rules--
(i) The applicable percentage of each item of the taxpayer's income
for the taxable year from interest charged to the borrowing entity is
treated as passive activity gross income from the activity; and
(ii) The applicable percentage of each deduction for the taxable
year for interest expense that is properly allocable (within the meaning
of paragraph (f) of this section) to the taxpayer's income from the
interest charged to the borrowing entity is treated as a passive
activity deduction from the activity.
(3) Applicable percentage. In applying this paragraph (c) with
respect to a taxpayer's interest in a borrowing entity, the applicable
percentage is separately determined for each of the taxpayer's
activities. The percentage applicable to an activity for a taxable year
is obtained by dividing--
(i) The taxpayer's share for the taxable year of the borrowing
entity's self-charged interest deductions that are
[[Page 496]]
treated as passive activity deductions from the activity by
(ii) The greater of--
(A) The taxpayer's share for the taxable year of the borrowing
entity's aggregate self-charged interest deductions for all activities
(regardless of whether these deductions are treated as passive activity
deductions); or
(B) The taxpayer's aggregate income for the taxable year from
interest charged to the borrowing entity for all activities of the
borrowing entity.
(d) Passthrough entity loans to taxpayer--(1) Applicability. Except
as provided in paragraph (g) of this section, this paragraph (d) applies
with respect to a taxpayer's interest in a passthrough entity (lending
entity) for a taxable year if--
(i) The lending entity has gross income for the entity taxable year
from interest charged by the lending entity to persons that own direct
or indirect interests in the lending entity at any time during the
entity taxable year (the lending entity's self-charged interest income);
(ii) The taxpayer owns a direct or an indirect interest in the
lending entity at any time during the entity taxable year and has
deductions for the taxable year for interest charged by the lending
entity to the taxpayer or a passthrough entity through which the
taxpayer holds an interest in the lending entity (the taxpayer's
deductions for interest charged by the lending entity); and
(iii) The taxpayer's deductions for interest charged by the lending
entity include passive activity deductions.
(2) General rule. If any of the taxpayer's deductions for interest
charged by the lending entity are allocable to an activity for a taxable
year in which this paragraph (d) applies, the passive activity gross
income and passive activity deductions from that activity are determined
under the following rules--
(i) The applicable percentage of the taxpayer's share for the
taxable year of each item of the lending entity's self-charged interest
income is treated as passive activity gross income from the activity.
(ii) The applicable percentage of the taxpayer's share for the
taxable year of each deduction for interest expense that is properly
allocable (within the meaning of paragraph (f) of this section) to the
lending entity's self-charged interest income is treated as a passive
activity deduction from the activity.
(3) Applicable percentage. In applying this paragraph (d) with
respect to a taxpayer's interest in a lending entity, the applicable
percentage is separately determined for each of the taxpayer's
activities. The percentage applicable to an activity for a taxable year
is obtained by dividing--
(i) The taxpayer's deductions for the taxable year for interest
charged by the lending entity, to the extent treated as passive activity
deductions from the activity; by
(ii) The greater of--
(A) The taxpayer's aggregate deductions for all activities for the
taxable year for interest charged by the lending entity (regardless of
whether these deductions are treated as passive activity deductions); or
(B) The taxpayer's aggregate share for the taxable year of the
lending entity's self-charged interest income for all activities of the
lending entity.
(e) Identically-owned passthrough entities--(1) Applicability.
Except as provided in paragraph (g) of this section, this paragraph (e)
applies with respect to lending transactions between passthrough
entities if each owner of the borrowing entity has the same
proportionate ownership interest in the lending entity.
(2) General rule. To the extent an owner shares in interest income
from a loan between passthrough entities described in paragraph (e)(1)
of this section, the owner is treated as having made the loan to the
borrowing passthrough entity and paragraph (c) of this section applies
to determine the applicable percentage of portfolio income of properly
allocable interest expense that is recharacterized as passive.
(3) Example. The following example illustrates the application of
this paragraph (e):
Example. (i) A and B, both calendar year taxpayers, each own a 50-
percent interest in the capital and profits of partnerships RS and XY,
both calendar year partnerships.
[[Page 497]]
Under the partnership agreements of RS and XY, A and B are each entitled
to a 50-percent distributive share of each partnership's income, gain,
loss, deduction, or credit. RS makes a $20,000 loan to XY and XY pays RS
$2,000 of interest for the taxable year. A's distributive share of
interest income attributable to this loan is $1,000 (50 percent x
$2,000). XY uses all of the proceeds received from RS is a passive
activity. A's distributive share of interest expense attributable to the
loan is $1,000 (50 percent x $2,000).
(ii) This paragraph (e) applies in determining A's passive activity
gross income because RS and XY are identically-owned passthrough
entities as described in paragraph (e)(1) of this section. Under
paragraph (e)(2) of this section, the RS-to-XY loan is treated as if A
made the loan to XY. Therefore, A must apply paragraph (c) of this
section to determine the applicable percentage of portfolio income that
is recharacterized as passive income.
(iii) Paragraph (c) of this section applies in determining A's
passive activity gross income because: XY has deductions for interest
charged to XY by RS for the taxable year (XY's self-charged interest
deductions); A owns an interest in XY during XY's taxable year and has
gross income for the taxable year from interest charged to XY by RS; and
A's share of XY's self-charged interest deductions includes passive
activity deductions. See paragraph (c)(1) of this section.
(iv) Under paragraph (c)(2)(i) of this section, the applicable
percentage of A's interest income is recharacterized as passive activity
gross income from the activity. Paragraph (c)(3) of this section
provides that the applicable percentage is obtained by dividing A's
share for the taxable year of XY's self-charged interest deductions that
are treated as passive activity deductions from the activity ($1,000) by
the greater of A's share for the taxable year of XY's self-charged
interest deductions ($1,000), or A's income for the year from interest
charged to XY ($1,000). Thus, A's applicable percentage is 100 percent
($1,000/$1,000), and $1,000 (100 percent x $1,000) of A's income from
interest charged to XY is treated as passive activity gross income from
the passive activity.
(f) Identification of properly allocable deductions. For purposes of
this section, interest expense is properly allocable to an item of
interest income if the interest expense is allocated under Sec. 1.163-
8T to an expenditure that--
(1) Is properly chargeable to capital account with respect to the
investment producing the item of interest income; or
(2) May reasonably be taken into account as a cost of producing the
item of interest income.
(g) Election to avoid application of the rules of this section--(1)
In general. Paragraphs (c), (d) and (e) of this section shall not apply
with respect to any taxpayer's interest in a passthrough entity for a
taxable year if the passthrough entity has made, under this paragraph
(g), an election that applies to the entity's taxable year.
(2) Form of election. A passthrough entity makes an election under
this paragraph (g) by attaching to its return (or amended return) a
written statement that includes the name, address, and taxpayer
identification number of the passthrough entity and a declaration that
an election is being made under this paragraph (g).
(3) Period for which election applies. An election under this
paragraph (g) made with a return (or amended return) for a taxable year
applies to that taxable year and all subsequent taxable years that end
before the date on which the election is revoked.
(4) Revocation. An election under this paragraph (g) may be revoked
only with the consent of the Commissioner.
(h) Examples. The following examples illustrate the principles of
this section. The examples assume for purposes of simplifying the
presentation, that the lending transactions described do not result in
foregone interest (within the meaning of section 7872(e)(2)), original
issue discount (within the meaning of section 1273), or total unstated
interest (within the meaning of section 483(b)).
Example 1. (i) A and B, two calendar year individuals, each own 50-
percent interests in the capital, profits and losses of AB, a calendar
year partnership. AB is engaged in a single rental activity within the
meaning of Sec. 1.469-1T(e)(3). AB borrows $50,000 from A and uses the
loan proceeds in the rental activity. AB pays $5,000 of interest to A
for the taxable year. A and B each incur $2,500 of interest expense as
their distributive share of AB's interest expense.
(ii) AB has self-charged interest deductions for the taxable year
(i.e., the deductions for interest charged to AB by A); A owns a direct
interest in AB during AB's taxable year and has income for A's taxable
year from interest charged to AB; and A's share of AB's self-charged
interest deductions includes passive activity deductions. Accordingly,
paragraph (c) of this section applies in determining A's passive
activity gross income. See paragraph (c)(1) of this section.
[[Page 498]]
(iii) Under paragraph (c)(2)(i) of this section, the applicable
percentage of A's interest income is recharacterized as passive activity
gross income from AB's rental activity. Paragraph (c)(3) of this section
provides that the applicable percentage is obtained by dividing A's
share for the taxable year of AB's self-charged interest deductions that
are treated as passive activity deductions from the activity ($2,500) by
the greater of A's share for the taxable year of AB's self-charged
interest deductions ($2,500), or A's income for the taxable year from
interest charged to AB ($5,000). Thus, A's applicable percentage is 50
percent ($2,500/$5,000), and $2,500 (50 percent x $5,000) of A's income
from interest charged to AB is treated as passive activity gross income
from the passive activity A conducts through AB.
(iv) Because B does not have any gross income for the year from
interest charged to AB, this section does not apply to B. See paragraph
(c)(1)(ii) of this section.
Example 2. (i) C and D, two calendar year taxpayers, each own 50-
percent interests in the capital and profits of CD, a calendar year
partnership. CD is engaged in a single rental activity, within the
meaning of Sec. 1.469-1T(e)(3). C obtains a $10,000 loan from a third-
party lender, and pays the lender $900 in interest for the taxable year.
C lends the $10,000 to CD, and receives $1,000 of interest income from
CD for the taxable year. D lends $20,000 to CD and receives $2,000 of
interest income from CD for the taxable year. CD uses all of the
proceeds in the rental activity. C and D are each allocated $1,500 (50
percent x $3,000) of interest expense as their distributive share of
CD's interest expense for the taxable year.
(ii) CD has self-charged interest deductions for the taxable year
(i.e., deductions for interest charged to CD by C and D); C and D each
own direct interests in CD during CD's taxable year and have gross
income for the taxable year from interest charged to CD; and both C's
and D's shares of CD's self-charged interest deductions include passive
activity deductions. Accordingly, paragraph (c) of this section applies
in determining C's and D's passive activity gross income. See paragraph
(c)(1) of this section.
(iii) Under paragraph (c)(2)(i) of this section, the applicable
percentage of each partner's interest income is recharacterized as
passive activity gross income from CD's rental activity. Paragraph
(c)(3) of this section provides that C's applicable percentage is
obtained by dividing C's share for the taxable year of CD's self-charged
interest deductions that are treated as passive activity deductions from
the activity ($1,500) by the greater of C's share for the taxable year
of CD's self-charged interest deductions ($1,500), or C's income for the
taxable year from interest charged to CD ($1,000). Thus, C's applicable
percentage is 100 percent ($1,500/$1,500), and all of C's income from
interest charged to CD ($1,000) is treated as passive activity gross
income from the passive activity C conducts through CD. Similarly, D's
applicable percentage is obtained by dividing D's share for the taxable
year of CD's self-charged interest deductions that are treated as
passive activity deductions from the activity ($1,500) by the greater of
D's share for the taxable year of CD's self-charged interest deductions
($1,500), or D's income for the taxable year from interest charged to CD
($2,000). Thus, D's applicable percentage is 75 percent ($1,500/$2,000),
and $1,500 (75 percent x $2,000) of D's income from interest charged to
CD is treated as passive activity gross income from the rental activity.
(iv) The $900 of interest expense that C pays to the third-party
lender is allocated under Sec. 1.163-8T(c)(1) to an expenditure that is
properly chargeable to capital account with respect to the loan to CD.
Thus, the expense is properly allocable to the interest income C
receives from CD (see paragraph (f) of this section). Under paragraph
(c)(2)(ii) of this section, the applicable percentage of C's deductions
for the taxable year for interest expense that is properly allocable to
C's income from interest charged to CD is recharacterized as a passive
activity deduction from CD's rental activity. Accordingly, all of C's
$900 interest deduction is treated as a passive activity deduction from
the rental activity.
Example 3. (i) E and F, calendar year taxpayers, each own 50 percent
of the stock of X, a calendar year S corporation. E borrows $30,000 from
X, and pays X $3,000 of interest for the taxable year. E uses $15,000 of
the loan proceeds to make a personal expenditure (as defined in Sec.
1.163-8T(b)(5)), and uses $15,000 of loan proceeds to purchase a trade
or business activity in which E does not materially participate (within
the meaning of Sec. 1.469-5T) for the taxable year. E and F each
receive $1,500 as their pro rata share of X's interest income from the
loan for the taxable year.
(ii) X has gross income for X's taxable year from interest charged
to E (X's self-charged interest income); E owns a direct interest in X
during X's taxable year and has deductions for the taxable year for
interest charged by X; and E's deductions for interest charged by X
include passive activity deductions. Accordingly, paragraph (d) of this
section applies in determining E's passive activity gross income. See
paragraph (d)(1) of this section.
(iii) Under the rules in paragraph (d)(2)(i) of this section, the
applicable percentage of E's share of X's self-charged interest income
is recharacterized as passive activity gross income from the activity.
Paragraph (d)(3) of this section provides that the applicable percentage
is obtained by dividing E's deductions for the taxable year for interest
[[Page 499]]
charged by X, to the extent treated as passive activity deductions from
the activity ($1,500), by the greater of E's deductions for the taxable
year for interest charged by X, regardless of whether those deductions
are treated as passive activity deductions ($3,000), or E's share for
the taxable year of X's self-charged interest income ($1,500). Thus, E's
applicable percentage is 50 percent ($1,500/$3,000), and $750 (50
percent x $1,500) of E's share of X's self-charged interest income is
treated as passive activity gross income.
(iv) Because F does not have any deductions for the taxable year for
interest charged by X, this section does not apply to F. See paragraph
(d)(1)(ii) of this section.
Example 4. (i) This Example 4 illustrates the application of this
section to a partner that has a different taxable year from the
partnership. The facts are the same as in Example 1 except as follows:
Partnership AB has properly adopted a fiscal year ending June 30 for
federal tax purposes; AB borrows the $50,000 from A on October 1, 1990;
and under the terms of the loan, AB must pay A $5,000 in interest
annually, in quarterly installments, for a term of 2 years.
(ii) For A's taxable years from 1990 through 1993 and AB's
corresponding entity taxable years (as defined in paragraph (b)(4) of
this section) A's interest income and AB's interest deductions from the
loan are as follows:
------------------------------------------------------------------------
A's AB's
interest interest
income deductions
------------------------------------------------------------------------
1990.......................................... $1,250 0
1991.......................................... 5,000 $3,750
1992.......................................... 3,750 5,000
1993.......................................... 0 1,250
------------------------------------------------------------------------
(iii) For A's taxable year ending December 31, 1990, the
corresponding entity taxable year is AB's taxable year ending June 30,
1990. Because AB does not have any deductions for the entity taxable
year for interest charged to AB by A, paragraph (c) of this section does
not apply in determining A's passive activity gross income for 1990 (see
paragraph (c)(1)(i) of this section). Accordingly, A reports $1,250 of
portfolio income on A's 1990 income tax return.
(iv) For A's taxable year ending December 31, 1991, the
corresponding entity taxable year ends on June 30, 1991. AB has $3,750
of deductions for the entity taxable year for interest charged to AB by
A (AB's self-charged interest deductions); A owns a direct interest in
AB during the entity taxable year and has $5,000 of interest income for
A's taxable year from interest charged to AB; and A's share of AB's
self-charged interest deductions includes passive activity deductions.
Accordingly, paragraph (c) of this section applies in determining A's
passive activity gross income.
(v) Under paragraph (c)(2)(i) of this section, the applicable
percentage of A's 1991 interest income is recharacterized as passive
activity gross income from the activity. Paragraph (c)(3) of this
section provides that the applicable percentage is obtained by dividing
A's share for A's 1991 taxable year of AB's self-charged interest
deductions that are treated as passive activity deductions from the
activity (50 percent x $3,750 = $1,875) by the greater of A's share for
A's taxable year of AB's self-charged interest deductions ($1,875), or
A's income for A's taxable year from interest charged to AB ($5,000).
Thus, A's applicable percentage is 37.5 percent ($1,875/$5,000), and
$1,875 (37.5 percent x $5,000) of A's income from interest charged to AB
is treated as passive activity gross income from the passive activity A
conducts through AB.
(vi) For A's taxable year ending December 31, 1992, the
corresponding entity taxable year ends on June 30, 1992. AB has $5,000
of deductions for the entity taxable year for interest charged to AB by
A (AB's self-charged interest deductions); A owns a direct interest in
AB during the entity taxable year and has $3,750 of gross income for A's
taxable year from interest charged to AB; and A's share of AB's self-
charged interest deductions includes passive activity deductions.
Accordingly, paragraph (c) of this section applies in determining A's
passive activity gross income.
(vii) The applicable percentage for 1992 is obtained by dividing A's
share for A's 1992 taxable year of AB's self-charged interest deductions
that are treated as passive activity deductions from the activity
($2,500) by the greater of A's share for A's taxable year of AB's self-
charged interest deductions ($2,500), or A's income for A's taxable year
from interest charged to AB ($3,750). Thus, A's applicable percentage is
66\2/3\ percent ($2,500/$3,750), and $2,500 (66\2/3\ percent x $3,750)
of A's income from interest charged to AB is treated as passive activity
gross income from the passive activity A conducts through AB.
(viii) Paragraph (c) of this section does not apply in determining
A's passive activity gross income for the taxable year ending December
31, 1993, because A has no gross income for the taxable year from
interest charged to AB (see paragraph (c)(1)(ii) of this section). A's
share of AB's self-charged interest deductions for the entity taxable
year ending June 30, 1993 ($625) is taken into account as a passive
activity deduction on A's 1993 income tax return.
(ix) Because B does not have any gross income from interest charged
to AB for any of the taxable years, this section does not apply to B.
See paragraph (c)(1)(ii) of this section.
Example 5. (i) This Example 5 illustrates the application of the
rules of this section in the case of a taxpayer who has an indirect
interest in a partnership. G, a calendar year taxpayer, is an 80-percent
partner in partnership
[[Page 500]]
UTP. UTP owns a 25-percent interest in the capital and profits of
partnership LTP. UTP and LTP are both calendar year partnerships. The
partners of LTP conduct a single passive activity through LTP. UTP
obtains a $10,000 loan from a bank, and pays the bank $1,000 of interest
per year. G's distributive share of the interest paid to the bank is
$800 (80 percent x $1,000). UTP uses the $10,000 debt proceeds and
another $10,000 of cash to make a loan to LTP, and LTP pays UTP $2,000
of interest for the taxable year. G's distributive share of interest
income attributable to the UTP-to-LTP loan is $1,600 (80 percent x
$2,000). LTP uses all of the proceeds received from UTP in the passive
activity. UTP's distributive share of interest expense attributable to
the UTP-to-LTP loan is $500 (25 percent x $2,000). G's distributive
share of interest expense attributable to the UTP-to-LTP loan is $400
(80 percent x $500).
(ii) LTP has deductions for interest charged to LTP by UTP for the
taxable year (LTP's self-charged interest deductions); G owns an
indirect interest in LTP during LTP's taxable year and has gross income
for the taxable year from interest charged to LTP by a passthrough
entity (UTP) through which G owns an interest in LTP; and G's share of
LTP's self-charged interest deductions includes passive activity
deductions. Accordingly, paragraph (c) of this section applies in
determining G's passive activity gross income. See paragraph (c)(1) of
this section.
(iii) Under paragraph (c)(2)(i) of this section, the applicable
percentage of G's interest income is recharacterized as passive activity
gross income from the activity. Paragraph (c)(3) of this section
provides that the applicable percentage is obtained by dividing G's
share for the taxable year of LTP's self-charged interest deductions
that are treated as passive activity deductions from the activity ($400)
by the greater of G's share for the taxable year of LTP's self-charged
interest deductions ($400), or G's income for the year from interest
charged to LTP ($1,600). Thus, G's applicable percentage is 25 percent
($400/$1,600), and $400 (25 percent x $1,600) of G's income from
interest charged to LTP is treated as passive activity gross income from
the passive activity that G conducts through UTP and LTP.
(iv) G's $800 distributive share of the interest expense that UTP
pays to the third-party lender is allocated under Sec. 1.163-8T(c)(1)
to an expenditure that is properly chargeable to capital account with
respect to the loan to LTP. Thus, the expense is a deduction properly
allocable to the interest income that G receives as a result of the UTP-
to-LTP loan (see paragraph (f) of this section). Under paragraph
(c)(2)(ii) of this section, the applicable percentage of G's deductions
for the taxable year for interest expense that is properly allocable to
G's income from interest charged by UTP to LTP is recharacterized as a
passive activity deduction from LTP's passive activity. Accordingly,
$200 (25 percent x $800) of G's interest deduction is treated as a
passive activity deduction from LTP's activity.
Example 6. (i) This Example 6 illustrates the application of the
rules of this section in the case of a taxpayer who conducts two passive
activities through a passthrough entity. J, a calendar year taxpayer, is
the 100-percent shareholder of Y, a calendar year S corporation. J
conducts two passive activities through Y: a rental activity and a trade
or business activity in which J does not materially participate. Y
borrows $80,000 from J, and uses $60,000 of the loan proceeds in the
rental activity and $20,000 of the loan proceeds in the passive trade or
business activity. Y pays $8,000 of interest to J for the taxable year,
and J incurs $8,000 of interest expense as J's distributive share of Y's
interest expense.
(ii) Y has self-charged interest deductions for the taxable year
(i.e., the deductions for interest charged to Y by J); J owns a direct
interest in Y during Y's taxable year and has gross income for J's
taxable year from interest charged to Y; and J's share of Y's self-
charged interest deductions includes passive activity deductions.
Accordingly, paragraph (c) of this section applies in determining J's
passive activity gross income. See paragraph (c)(1) of this section.
(iii) Under paragraph (c)(2)(i) of this section, the applicable
percentage of J's interest income is recharacterized as passive activity
gross income attributable to the rental activity. Paragraph (c)(3) of
this section provides that the applicable percentage is obtained by
dividing J's share for the taxable year of Y's self-charged interest
deductions that are treated as passive activity deductions from the
rental activity ($6,000) by the greater of J's share for the taxable
year of Y's self-charged interest deductions ($8,000), or J's income for
the taxable year from interest charged to Y ($8,000). Thus, J's
applicable percentage is 75 percent ($6,000/$8,000), and $6,000 (75
percent x $8,000) of J's income from interest charged to Y is treated as
passive activity gross income from the rental activity J conducts
through Y.
(iv) Under paragraph (c)(2)(i) of this section, the applicable
percentage of J's interest income is recharacterized as passive activity
gross income attributable to the passive trade or business activity.
Paragraph (c)(3) of this section provides that the applicable percentage
is obtained by dividing J's share for the taxable year of Y's self-
charged interest deductions that are treated as passive activity
deductions from the passive trade or business activity ($2,000) by the
greater of J's share for the taxable year of Y's self-charged interest
deductions ($8,000),
[[Page 501]]
or J's income for the taxable year from interest charged to Y ($8,000).
Thus, J's applicable percentage is 25 percent ($2,000/$8,000), and
$2,000 of J's income from interest charged to Y is treated as passive
activity gross income from the passive trade or business activity J
conducts through Y.
[T.D. 9013, 67 FR 54089, Aug. 21, 2002]
Sec. 1.469-8 Application of section 469 to trust, estates,
and their beneficiaries. [Reserved]
Sec. 1.469-9 Rules for certain rental real estate activities.
(a) Scope and purpose. This section provides guidance to taxpayers
engaged in certain real property trades or businesses on applying
section 469(c)(7) to their rental real estate activities.
(b) Definitions. The following definitions apply for purposes of
this section:
(1) Trade or business. A trade or business is any trade or business
determined by treating the types of activities in Sec. 1.469-4(b)(1) as
if they involved the conduct of a trade or business, and any interest in
rental real estate, including any interest in rental real estate that
gives rise to deductions under section 212.
(2) Real property trade or business. Real property trade or business
is defined in section 469(c)(7)(C).
(3) Rental real estate. Rental real estate is any real property used
by customers or held for use by customers in a rental activity within
the meaning of Sec. 1.469-1T(e)(3). However, any rental real estate
that the taxpayer grouped with a trade or business activity under Sec.
1.469-4(d)(1)(i)(A) or (C) is not an interest in rental real estate for
purposes of this section.
(4) Personal services. Personal services means any work performed by
an individual in connection with a trade or business. However, personal
services do not include any work performed by an individual in the
individual's capacity as an investor as described in Sec. 1.469-
5T(f)(2)(ii).
(5) Material participation. Material participation has the same
meaning as under Sec. 1.469-5T. Paragraph (f) of this section contains
rules applicable to limited partnership interests in rental real estate
that a qualifying taxpayer elects to aggregate with other interests in
rental real estate of that taxpayer.
(6) Qualifying taxpayer. A qualifying taxpayer is a taxpayer that
owns at least one interest in rental real estate and meets the
requirements of paragraph (c) of this section.
(c) Requirements for qualifying taxpayers--(1) In general. A
qualifying taxpayer must meet the requirements of section 469(c)(7)(B).
(2) Closely held C corporations. A closely held C corporation meets
the requirements of paragraph (c)(1) of this section by satisfying the
requirements of section 469(c)(7)(D)(i). For purposes of section
469(c)(7)(D)(i), gross receipts do not include items of portfolio income
within the meaning of Sec. 1.469-2T(c)(3).
(3) Requirement of material participation in the real property
trades or businesses. A taxpayer must materially participate in a real
property trade or business in order for the personal services provided
by the taxpayer in that real property trade or business to count towards
meeting the requirements of paragraph (c)(1) of this section.
(4) Treatment of spouses. Spouses filing a joint return are
qualifying taxpayers only if one spouse separately satisfies both
requirements of section 469(c)(7)(B). In determining the real property
trades or businesses in which a married taxpayer materially participates
(but not for any other purpose under this paragraph (c)), work performed
by the taxpayer's spouse in a trade or business is treated as work
performed by the taxpayer under Sec. 1.469-5T(f)(3), regardless of
whether the spouses file a joint return for the year.
(5) Employees in real property trades or businesses. For purposes of
paragraph (c)(1) of this section, personal services performed during a
taxable year as an employee generally will be treated as performed in a
trade or business but will not be treated as performed in a real
property trade or business, unless the taxpayer is a five-percent owner
(within the meaning of section 416(i)(1)(B)) in the employer. If an
employee is not a five-percent owner in the employer at all times during
the taxable year, only the personal services performed by the employee
during the period the employee is a five-percent
[[Page 502]]
owner in the employer will be treated as performed in a real property
trade or business.
(d) General rule for determining real property trades or
businesses--(1) Facts and circumstances. The determination of a
taxpayer's real property trades or businesses for purposes of paragraph
(c) of this section is based on all of the relevant facts and
circumstances. A taxpayer may use any reasonable method of applying the
facts and circumstances in determining the real property trades or
businesses in which the taxpayer provides personal services. Depending
on the facts and circumstances, a real property trade or business
consists either of one or more than one trade or business specifically
described in section 469(c)(7)(C). A taxpayer's grouping of activities
under Sec. 1.469-4 does not control the determination of the taxpayer's
real property trades or businesses under this paragraph (d).
(2) Consistency requirement. Once a taxpayer determines the real
property trades or businesses in which personal services are provided
for purposes of paragraph (c) of this section, the taxpayer may not
redetermine those real property trades or businesses in subsequent
taxable years unless the original determination was clearly
inappropriate or there has been a material change in the facts and
circumstances that makes the original determination clearly
inappropriate.
(e) Treatment of rental real estate activities of a qualifying
taxpayer--(1) In general. Section 469(c)(2) does not apply to any rental
real estate activity of a taxpayer for a taxable year in which the
taxpayer is a qualifying taxpayer under paragraph (c) of this section.
Instead, a rental real estate activity of a qualifying taxpayer is a
passive activity under section 469 for the taxable year unless the
taxpayer materially participates in the activity. Each interest in
rental real estate of a qualifying taxpayer will be treated as a
separate rental real estate activity, unless the taxpayer makes an
election under paragraph (g) of this section to treat all interests in
rental real estate as a single rental real estate activity. Each
separate rental real estate activity, or the single combined rental real
estate activity if the taxpayer makes an election under paragraph (g),
will be an activity of the taxpayer for all purposes of section 469,
including the former passive activity rules under section 469(f) and the
disposition rules under section 469(g). However, section 469 will
continue to be applied separately with respect to each publicly traded
partnership, as required under section 469(k), notwithstanding the rules
of this section.
(2) Treatment as a former passive activity. For any taxable year in
which a qualifying taxpayer materially participates in a rental real
estate activity, that rental real estate activity will be treated as a
former passive activity under section 469(f) if disallowed deductions or
credits are allocated to the activity under Sec. 1.469-1(f)(4).
(3) Grouping rental real estate activities with other activities--
(i) In general. For purposes of this section, a qualifying taxpayer may
not group a rental real estate activity with any other activity of the
taxpayer. For example, if a qualifying taxpayer develops real property,
constructs buildings, and owns an interest in rental real estate, the
taxpayer's interest in rental real estate may not be grouped with the
taxpayer's development activity or construction activity. Thus, only the
participation of the taxpayer with respect to the rental real estate may
be used to determine if the taxpayer materially participates in the
rental real estate activity under Sec. 1.469-5T.
(ii) Special rule for certain management activities. A qualifying
taxpayer may participate in a rental real estate activity through
participation, within the meaning of Sec. Sec. 1.469-5(f) and 5T(f), in
an activity involving the management of rental real estate (even if this
management activity is conducted through a separate entity). In
determining whether the taxpayer materially participates in the rental
real estate activity, however, work the taxpayer performs in the
management activity is taken into account only to the extent it is
performed in managing the taxpayer's own rental real estate interests.
(4) Example. The following example illustrates the application of
this paragraph (e).
[[Page 503]]
Example. (i) Taxpayer B owns interests in three rental buildings, U,
V and W. In 1995, B has $30,000 of disallowed passive losses allocable
to Building U and $10,000 of disallowed passive losses allocable to
Building V under Sec. 1.469-1(f)(4). In 1996, B has $5,000 of net
income from Building U, $5,000 of net losses from Building V, and
$10,000 of net income from Building W. Also in 1996, B is a qualifying
taxpayer within the meaning of paragraph (c) of this section. Each
building is treated as a separate activity of B under paragraph (e)(1)
of this section, unless B makes the election under paragraph (g) to
treat the three buildings as a single rental real estate activity. If
the buildings are treated as separate activities, material participation
is determined separately with respect to each building. If B makes the
election under paragraph (g) to treat the buildings as a single
activity, all participation relating to the buildings is aggregated in
determining whether B materially participates in the combined activity.
(ii) Effective beginning in 1996, B makes the election under
paragraph (g) to treat the three buildings as a single rental real
estate activity. B works full-time managing the three buildings and thus
materially participates in the combined activity in 1996 (even if B
conducts this management function through a separate entity, including a
closely held C corporation). Accordingly, the combined activity is not a
passive activity of B in 1996. Moreover, as a result of the election
under paragraph (g), disallowed passive losses of $40,000 ($30,000 +
$10,000) are allocated to the combined activity. B's net income from the
activity for 1996 is $10,000 ($5,000-$5,000 + $10,000). This net income
is nonpassive income for purposes of section 469. However, under section
469(f), the net income from a former passive activity may be offset with
the disallowed passive losses from the same activity. Because Buildings
U, V and W are treated as one activity for all purposes of section 469
due to the election under paragraph (g), and this activity is a former
passive activity under section 469(f), B may offset the $10,000 of net
income from the buildings with an equal amount of disallowed passive
losses allocable to the buildings, regardless of which buildings
produced the income or losses. As a result, B has $30,000 ($40,000-
$10,000) of disallowed passive losses remaining from the buildings after
1996.
(f) Limited partnership interests in rental real estate activities--
(1) In general. If a taxpayer elects under paragraph (g) of this section
to treat all interests in rental real estate as a single rental real
estate activity, and at least one interest in rental real estate is held
by the taxpayer as a limited partnership interest (within the meaning of
Sec. 1.469-5T(e)(3)), the combined rental real estate activity will be
treated as a limited partnership interest of the taxpayer for purposes
of determining material participation. Accordingly, the taxpayer will
not be treated under this section as materially participating in the
combined rental real estate activity unless the taxpayer materially
participates in the activity under the tests listed in Sec. 1.469-
5T(e)(2) (dealing with the tests for determining the material
participation of a limited partner).
(2) De minimis exception. If a qualifying taxpayer elects under
paragraph (g) of this section to treat all interests in rental real
estate as a single rental real estate activity, and the taxpayer's share
of gross rental income from all of the taxpayer's limited partnership
interests in rental real estate is less than ten percent of the
taxpayer's share of gross rental income from all of the taxpayer's
interests in rental real estate for the taxable year, paragraph (f)(1)
of this section does not apply. Thus the taxpayer may determine material
participation under any of the tests listed in Sec. 1.469-5T(a) that
apply to rental real estate activities.
(g) Election to treat all interests in rental real estate as a
single rental real estate activity--(1) In general. A qualifying
taxpayer may make an election to treat all of the taxpayer's interests
in rental real estate as a single rental real estate activity. This
election is binding for the taxable year in which it is made and for all
future years in which the taxpayer is a qualifying taxpayer under
paragraph (c) of this section, even if there are intervening years in
which the taxpayer is not a qualifying taxpayer. The election may be
made in any year in which the taxpayer is a qualifying taxpayer, and the
failure to make the election in one year does not preclude the taxpayer
from making the election in a subsequent year. In years in which the
taxpayer is not a qualifying taxpayer, the election will not have effect
and the taxpayer's activities will be those determined under Sec.
1.469-4. If there is a material change in the taxpayer's facts and
circumstances, the taxpayer may revoke the election using the procedure
described in paragraph (g)(3) of this section.
[[Page 504]]
(2) Certain changes not material. The fact that an election is less
advantageous to the taxpayer in a particular taxable year is not, of
itself, a material change in the taxpayer's facts and circumstances.
Similarly, a break in the taxpayer's status as a qualifying taxpayer is
not, of itself, a material change in the taxpayer's facts and
circumstances.
(3) Filing a statement to make or revoke the election. A qualifying
taxpayer makes the election to treat all interests in rental real estate
as a single rental real estate activity by filing a statement with the
taxpayer's original income tax return for the taxable year. This
statement must contain a declaration that the taxpayer is a qualifying
taxpayer for the taxable year and is making the election pursuant to
section 469(c)(7)(A). The taxpayer may make this election for any
taxable year in which section 469(c)(7) is applicable. A taxpayer may
revoke the election only in the taxable year in which a material change
in the taxpayer's facts and circumstances occurs or in a subsequent year
in which the facts and circumstances remain materially changed from
those in the taxable year for which the election was made. To revoke the
election, the taxpayer must file a statement with the taxpayer's
original income tax return for the year of revocation. This statement
must contain a declaration that the taxpayer is revoking the election
under section 469(c)(7)(A) and an explanation of the nature of the
material change.
(h) Interests in rental real estate held by certain passthrough
entities--(1) General rule. Except as provided in paragraph (h)(2) of
this section, a qualifying taxpayer's interest in rental real estate
held by a partnership or an S corporation (passthrough entity) is
treated as a single interest in rental real estate if the passthrough
entity grouped its rental real estate as one rental activity under Sec.
1.469-4(d)(5). If the passthrough entity grouped its rental real estate
into separate rental activities under Sec. 1.469-4(d)(5), each rental
real estate activity of the passthrough entity will be treated as a
separate interest in rental real estate of the qualifying taxpayer.
However, the qualifying taxpayer may elect under paragraph (g) of this
section to treat all interests in rental real estate, including the
rental real estate interests held through passthrough entities, as a
single rental real estate activity.
(2) Special rule if a qualifying taxpayer holds a fifty-percent or
greater interest in a passthrough entity. If a qualifying taxpayer owns,
directly or indirectly, a fifty-percent or greater interest in the
capital, profits, or losses of a passthrough entity for a taxable year,
each interest in rental real estate held by the passthrough entity will
be treated as a separate interest in rental real estate of the
qualifying taxpayer, regardless of the passthrough entity's grouping of
activities under Sec. 1.469-4(d)(5). However, the qualifying taxpayer
may elect under paragraph (g) of this section to treat all interests in
rental real estate, including the rental real estate interests held
through passthrough entities, as a single rental real estate activity.
(3) Special rule for interests held in tiered passthrough entities.
If a passthrough entity owns a fifty-percent or greater interest in the
capital, profits, or losses of another passthrough entity for a taxable
year, each interest in rental real estate held by the lower-tier entity
will be treated as a separate interest in rental real estate of the
upper-tier entity, regardless of the lower-tier entity's grouping of
activities under Sec. 1.469-4(d)(5).
(i) [Reserved]
(j) $25,000 offset for rental real estate activities of qualifying
taxpayers--(1) In general. A qualifying taxpayer's passive losses and
credits from rental real estate activities (including prior-year
disallowed passive activity losses and credits from rental real estate
activities in which the taxpayer materially participates) are allowed to
the extent permitted under section 469(i). The amount of losses or
credits allowable under section 469(i) is determined after the rules of
this section are applied. However, losses allowable by reason of this
section are not taken into account in determining adjusted gross income
for purposes of section 469(i)(3).
(2) Example. The following example illustrates the application of
this paragraph (j).
[[Page 505]]
Example. (i) Taxpayer A owns building X and building Y, both
interests in rental real estate. In 1995, A is a qualifying taxpayer
within the meaning of paragraph (c) of this section. A does not elect to
treat X and Y as one activity under section 469(c)(7)(A) and paragraph
(g) of this section. As a result, X and Y are treated as separate
activities pursuant to section 469(c)(7)(A)(ii). A materially
participates in X which has $100,000 of passive losses disallowed from
prior years and produces $20,000 of losses in 1995. A does not
materially participate in Y which produces $40,000 of income in 1995. A
also has $50,000 of income from other nonpassive sources in 1995. A
otherwise meets the requirements of section 469(i).
(ii) Because X is not a passive activity in 1995, the $20,000 of
losses produced by X in 1995 are nonpassive losses that may be used by A
to offset part of the $50,000 of nonpassive income. Accordingly, A is
left with $30,000 ($50,000-$20,000) of nonpassive income. In addition, A
may use the prior year disallowed passive losses of X to offset any
income from X and passive income from other sources. Therefore, A may
offset the $40,000 of passive income from Y with $40,000 of passive
losses from X.
(iii) Because A has $60,000 ($100,000-$40,000) of passive losses
remaining from X and meets all of the requirements of section 469(i), A
may offset up to $25,000 of nonpassive income with passive losses from X
pursuant to section 469(i). As a result, A has $5,000 ($30,000-$25,000)
of nonpassive income remaining and disallowed passive losses from X of
$35,000 ($60,000-$25,000) in 1995.
[T.D. 8645, 60 FR 66499, Dec. 22, 1995]
Sec. 1.469-10 Application of section 469 to publicly traded partnerships.
(a) [Reserved]
(b) Publicly traded partnership--(1) In general. For purposes of
section 469(k), a partnership is a publicly traded partnership only if
the partnership is a publicly traded partnership as defined in Sec.
1.7704-1.
(2) Effective date. This section applies for taxable years of a
partnership beginning on or after December 17, 1998.
[T.D. 8799, 63 FR 69553, Dec. 17, 1998]
Sec. 1.469-11 Effective date and transition rules.
(a) Generally applicable effective dates. Except as otherwise
provided in this section--
(1) The rules contained in Sec. Sec. 1.469-1, 1.469-1T, 1.469-2,
1.469-2T, 1.469-3, 1.469-3T, 1.469-4, 1.469-5, and 1.469-5T apply for
taxable years ending after May 10, 1992.
(2) The rules contained in 26 CFR 1.469-1T, 1.469-2T, 1.469-3T,
1.469-4T, 1.469-5T, 1.469-11T (b) and (c) (as contained in the CFR
edition revised as of April 1, 1992) apply for taxable years beginning
after December 31, 1986, and ending on or before May 10, 1992;
(3) The rules contained in Sec. 1.469-9 apply for taxable years
beginning on or after January 1, 1995, and to elections made under Sec.
1.469-9(g) with returns filed on or after January 1, 1995;
(4) The rules contained in Sec. 1.469-7 apply for taxable years
ending after December 31, 1986; and
(5) This section applies for taxable years beginning after December
31, 1986.
(b) Additional effective dates--(1) Application of 1992 amendments
for taxable years beginning before October 4, 1994. Except as provided
in paragraph (b)(2) of this section, for taxable years that end after
May 10, 1992, and begin before October 4, 1994, a taxpayer may determine
tax liability in accordance with Project PS-1-89 published at 1992-1
C.B. 1219 (see Sec. 601.601(d)(2)(ii)(b) of this chapter).
(2) Additional transition rule for 1992 amendments. If a taxpayer's
first taxable year ending after May 10, 1992, begins on or before that
date, the taxpayer may treat the taxable year, for purposes of paragraph
(a) of this section, as a taxable year ending on or before May 10, 1992.
(3) Fresh starts under consistency rules--(i) Regrouping when tax
liability is first determined under Project PS-1-89. For the first
taxable year in which a taxpayer determines its tax liability under
Project PS-1-89, the taxpayer may regroup its activities without regard
to the manner in which the activities were grouped in the preceding
taxable year and must regroup its activities if the grouping in the
preceding taxable year is inconsistent with the rules of Project PS-1-
89.
(ii) Regrouping when tax liability is first determined under Sec.
1.469-4. For the first taxable year in which a taxpayer determines its
tax liability under Sec. 1.469-4, rather than under the rules of
Project PS-1-89, the taxpayer may regroup its activities without regard
to
[[Page 506]]
the manner in which the activities were grouped in the preceding taxable
year and must regroup its activities if the grouping in the preceding
taxable year is inconsistent with the rules of Sec. 1.469-4.
(iii) Regrouping when taxpayer is first subject to section
469(c)(7). For the first taxable year beginning after December 31, 1993,
a taxpayer may regroup its activities to the extent necessary or
appropriate to avail itself of the provisions of section 469(c)(7) and
without regard to the manner in which the activities were grouped in the
preceding taxable year.
(iv) Regrouping for taxpayers subject to section 1411--(A) In
general. If an individual, estate, or trust meets the Eligibility
Criteria, as defined in paragraph (b)(3)(iv)(B) of this section, such
individual, estate, or trust, in the first taxable year beginning after
December 31, 2013, in which section 1411 would apply to such taxpayer,
may regroup its activities without regard to the manner in which the
activities were grouped in the preceding taxable year. For this purpose,
the determination of whether a taxpayer meets the Eligibility Criteria
is made without regard to the effect of regrouping. The regrouping must
be made in the manner prescribed by forms, instructions, or in other
guidance on an original return for the taxable year for which the
regrouping is done. A taxpayer that is an individual, estate, or trust
may regroup its activities for any taxable year that begins during 2013,
if the individual, estate, or trust meets the Eligibility Criteria for
such year. A taxpayer may regroup activities only once pursuant to this
paragraph (b)(3)(iv), and a regrouping made pursuant to this paragraph
(b)(3)(iv) will apply to the taxable year for which the regrouping is
done and all subsequent years.
(B) Eligibility criteria. The term Eligibility Criteria means that
an individual, estate, or trust has net investment income (as defined in
Sec. 1.1411-4) and such individual's (as defined in Sec. 1.1411-2(a))
modified adjusted gross income (as defined in Sec. 1.1411-2(c)) exceeds
the applicable threshold in Sec. 1.1411-2(d) or such estate's or
trust's (as defined in Sec. 1.1411-3(a)(1)(i)) adjusted gross income
exceeds the amount described in Sec. 1.1411-3(a)(1)(ii)(B)(2).
(C) Consequences of amended returns and examination adjustments--(1)
Taxpayers first subject to section 1411. An individual, estate, or trust
also may regroup activities, in the manner described in paragraph
(b)(3)(iv)(A) of this section, on an amended return only if the changes
reported on such amended return cause the taxpayer to meet the
Eligibility Criteria for the first time beginning in the taxable year
for which the amended return is applicable and that the taxable year is
not closed by the period of limitations on assessments under section
6501. If the amended return is for a tax year that precedes a tax year
for which a taxpayer had regrouped its activities pursuant to paragraph
(b)(3)(iv)(A) of this section, the regrouping on such amended return
must be consistent with the taxpayer's subsequent year's regrouping. If
a regrouping on an amended return is inconsistent with a subsequent
year's grouping, the subsequent year's grouping is invalid under Sec.
1.469-4(e)(1) unless a material change in facts and circumstances
occurred in the subsequent year such that the subsequent year's grouping
constitutes a permissible regrouping under Sec. 1.469-4(e)(2). Similar
rules also apply for any taxable year that begins during 2013.
(2) Taxpayers ceasing to be subject to section 1411. In the event a
taxpayer regroups activities pursuant to paragraphs (b)(3)(iv)(A) or (C)
of this section and it is subsequently determined that such taxpayer
does not meet the Eligibility Criteria for the year of such regrouping,
such regrouping will have no effect for that year and all future years.
Appropriate adjustments should be made to reflect the voiding of the
ineffective regrouping. However, notwithstanding the previous sentence,
if an individual, estate, or trust meets the Eligibility Criteria in a
subsequent year, such taxpayer is deemed to treat such regrouping as
being made in such subsequent year unless the taxpayer either regroups
in a different manner (so long as such alternative regrouping is
permissible under Sec. 1.469-4) or properly reflects the ineffective
regrouping in the previous year. The subsequent year's regrouping may be
made on an
[[Page 507]]
original or on an amended return for that year. This paragraph
(b)(3)(iv)(C)(2) shall not apply if a taxpayer does not meet the
Eligibility Criteria for the year of such regrouping as a result of the
carryback of a net operating loss pursuant to section 172. Similar rules
also apply for any taxable year that begins during 2013.
(3) Examples. The following examples illustrate the principles of
paragraph (b)(3)(iv)(C) of this section. In each example, unless
otherwise indicated, the taxpayer uses a calendar taxable year, the
taxpayer is a United States citizen, and Year 1 is a taxable year in
which section 1411 is in effect:
Example 1. In Year 1, X, a single individual, reports modified
adjusted gross income (as defined in Sec. 1.1411-2(c)) of $198,000
(including $12,000 of net investment income (as defined in Sec. 1.1411-
4)); thus is not subject to 1411. After X filed his original return, X
receives a corrected Form 1099-DIV, which increases his modified
adjusted gross income (as defined in Sec. 1.1411-2(c)) and his net
investment income by $2,500. X files an amended return for Year 1 in
Year 2 reporting modified adjusted gross income of $200,500 and net
investment income of $14,500. Pursuant to paragraph (b)(3)(iv)(C)(1) of
this section, X may regroup his passive activities on an amended return,
because X now has MAGI above the applicable threshold amount and net
investment income.
Example 2. Same facts as Example 1, except that the $2,500 increase
to modified adjusted gross income and net investment income was a result
of an examination of X's Year 1 return. Pursuant to paragraph
(b)(3)(iv)(C)(1) of this section, X may regroup his passive activities
on an amended return.
Example 3. In Year 1, Y, a single individual reported modified
adjusted gross income (as defined in Sec. 1.1411-2(c)) of $205,000 and
net investment income (as defined in Sec. 1.1411-4) of $500. Pursuant
to paragraph (b)(3)(iv)(A) of this section, Y regrouped his four passive
activities, A, B, C, and D, into a single activity group. Prior to the
Year 1 regrouping, Y had grouped A and B into one group, and treated
each of C and D as separate activities. Y did not meet the Eligibly
Criteria in any year prior to Year 1 or Year 2. In Year 3, Y's employer
issued Y a corrected Year 1 Form W-2, which reduced Y's taxable wages by
$6,000. As a result, Y no longer meets the Eligibility Criteria in Year
1 because Y's modified adjusted gross income is now $199,000. Therefore,
Y's Year 1 regrouping is no longer effective and the prior groupings are
in effect (that is, Activity A and B are one group and Activity C and
Activity D separately). Appropriate adjustments should be made to
reflect the ineffective regrouping. However, if Y had a material change
in facts and circumstances such that Y could regroup in Year 1 or a
subsequent year, as applicable, by reason of Sec. 1.469-4(e)(2), then
the regrouping will be deemed to occur. Y could designate a different
regrouping for the year of the material change in facts and
circumstances.
Example 4. Same facts as Example 3, except that Y met the Eligibly
Criteria in Year 2. In this case, Y's Year 1 regrouping is no longer
effective and Y must report his income consistent with the pre-Year 1
groupings. In Year 2, Y has three options. First, without any action by
Y, Y's activities are regrouped as originally reported in Year 1. In
this case, the regrouping from the Year 1 return is deemed to occur on
the Year 2 return. This option is the default option. Second, pursuant
to paragraph (b)(3)(iv)(C)(2) of this section, Y may file an amended
return to report his income consistent with groupings in effect prior to
Year 1. Third, Y may file an original or an amended return to regroup in
a manner different from groupings in effect prior to Year 1 and
different from the Year 1 groupings (for example, Y could choose to
group Activity C and D into a single activity, thus causing Y to have
two groups; Group A-B and Group C-D).
(D) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013. However, taxpayers may apply
this section to taxable years beginning after December 31, 2012.
(4) Certain investment credit property. (i) The rules contained in
Sec. 1.469-3(f) apply with respect to property placed in service after
December 31, 1990 (other than property described in section 11813 (c)(2)
of the Omnibus Reconciliation Act of 1990 (P.L. 101-508)).
(ii) The rules contained in 26 CFR 1.469-3T(f) (as contained in the
CFR edition revised as of April 1, 1992) apply with respect to property
placed in service on or before December 31, 1990, and property described
in section 11813(c)(2) of the Omnibus Reconcilation Act of 1990.
(c) Special rules--(1) Application of certain income
recharacterization rules and self-charged rules--(i) Certain
recharacterization rules inapplicable in 1987. No amount of gross income
shall be treated under Sec. 1.469-2T(f)(3) through (7) as income that
is not from a passive activity for any taxable year of the taxpayer
beginning before January 1, 1988.
[[Page 508]]
(ii) Property rented to a nonpassive activity. In applying Sec.
1.469-2(f)(6) or Sec. 1.469-2T(f)(6) to a taxpayer's rental of an item
of property, the taxpayer's net rental activity income (within the
meaning of Sec. 1.469-2(f)(9)(iv) or Sec. 1.469-2T(f)(9)(iv)) from the
property for any taxable year beginning after December 31, 1987, does
not include the portion of the income (if any) that is attributable to
the rental of that item of property pursuant to a written binding
contract entered into before February 19, 1988.
(iii) Self-charged rules. For taxable years beginning before June 4,
1991--
(1) A taxpayer is not required to apply the rules in Sec. 1.469-7
in computing the taxpayer's passive activity loss and passive activity
credit; and
(2) A taxpayer that owns an interest in a passthrough entity may use
any reasonable method of offsetting items of interest income and
interest expense from lending transactions between the passthrough
entity and its owners or between identically-owned passthrough entities
(as defined in Sec. 1.469-7(e)) to compute the taxpayer's passive
activity loss and passive activity credit. Items from nonlending
transactions cannot be offset under the self-charged rules.
(2) Qualified low-income housing projects. For a transitional rule
concerning the application of section 469 to losses from qualified low-
income housing projects, see section 502 of the Tax Reform Act of 1986.
(3) Effect of events occurring in years prior to 1987. The treatment
for a taxable year beginning after December 31, 1986, of any item of
income, gain, loss, deduction, or credit as an item of passive activity
gross income, passive activity deduction, or credit from a passive
activity, is determined as if section 469 and the regulations thereunder
had been in effect for taxable years beginning before January 1, 1987,
but without regard to any passive activity loss or passive activity
credit that would have been disallowed for any taxable year beginning
before January 1, 1987, if section 469 and the regulations thereunder
had been in effect for that year. For example, in determining whether a
taxpayer materially participates in an activity under Sec. 1.469-
5T(a)(5) (relating to taxpayers who have materially participated in an
activity for five of the ten immediately preceding taxable years) for
any taxable year beginning after December 31, 1986, the taxpayer's
participation in the activity for all prior taxable years (including
taxable years beginning before 1987) is taken into account. See Sec.
1.469-5(j) (relating to the determination of material participation for
taxable years beginning before January 1, 1987).
(d) Examples. The following examples illustrate the application of
paragraph (c) of this section:
Example 1. A, a calendar year individual, is a partner in a
partnership with a taxable year ending on January 31. During its taxable
year ending January 31, 1987, the partnership was engaged in a single
activity involving the conduct of a trade or business. In applying
section 469 and the regulations thereunder to A for calendar year 1987,
A's distributive share of partnership items for the partnership's
taxable year ending January 31, 1987, is taken into account. Therefore,
under Sec. 1.469-2T(e)(1) and paragraph (c)(3) of this section, A's
participation in the activity throughout the partnership's taxable year
beginning February 1, 1986, and ending January 31, 1987, is taken into
account for purposes of determining the character under section 469 of
the items of gross income, deduction, and credit allocated to A for the
partnership's taxable year ending January 31, 1987.
Example 2. B, a calendar year individual, is a beneficiary of a
trust described in section 651 that has a taxable year ending January
31. The trust conducts a rental activity (within the meaning of Sec.
1.469-1T(e)(3)). Because the trust's taxable year ending January 31,
1987, began before January 1, 1987, section 469 and the regulations
thereunder do not applying to the trust for that year. Section 469 and
the regulations thereunder do apply, however, to B for B's calendar year
1987. Therefore, income of the trust from the rental activity for the
trust's taxable year ending January 31, 1987, that is included in B's
gross income for 1987 is taken into account in apply section 469 to B
for 1987.
[T.D. 8417, 57 FR 20759, May 15, 1992, as amended by T.D. 8417, 59 FR
45623, Sept. 2, 1994; T.D. 8565, 59 FR 50489, Oct. 4, 1994; T.D. 8645,
60 FR 66501, Dec. 22, 1995; T.D. 9013, 67 FR 54093, Aug. 21, 2002; T.D.
9644, 78 FR 72421, Dec. 2, 2013; 79 FR 18159, Apr. 1, 2014]
[[Page 509]]
inventories
Sec. 1.471-1 Need for inventories.
In order to reflect taxable income correctly, inventories at the
beginning and end of each taxable year are necessary in every case in
which the production, purchase, or sale of merchandise is an income-
producing factor. The inventory should include all finished or partly
finished goods and, in the case of raw materials and supplies, only
those which have been acquired for sale or which will physically become
a part of merchandise intended for sale, in which class fall containers,
such as kegs, bottles, and cases, whether returnable or not, if title
thereto will pass to the purchaser of the product to be sold therein.
Merchandise should be included in the inventory only if title thereto is
vested in the taxpayer. Accordingly, the seller should include in his
inventory goods under contract for sale but not yet segregated and
applied to the contract and goods out upon consignment, but should
exclude from inventory goods sold (including containers), title to which
has passed to the purchaser. A purchaser should include in inventory
merchandise purchased (including containers), title to which has passed
to him, although such merchandise is in transit or for other reasons has
not been reduced to physical possession, but should not include goods
ordered for future delivery, transfer of title to which has not yet been
effected. (But see Sec. 1.472-1.)
[T.D. 6500, 25 FR 11724, Nov. 26, 1960]
Sec. 1.471-2 Valuation of inventories.
(a) Section 471 provides two tests to which each inventory must
conform:
(1) It must conform as nearly as may be to the best accounting
practice in the trade or business, and
(2) It must clearly reflect the income.
(b) It follows, therefore, that inventory rules cannot be uniform
but must give effect to trade customs which come within the scope of the
best accounting practice in the particular trade or business. In order
to clearly reflect income, the inventory practice of a taxpayer should
be consistent from year to year, and greater weight is to be given to
consistency than to any particular method of inventorying or basis of
valuation so long as the method or basis used is in accord with
Sec. Sec. 1.471-1 through 1.471-11.
(c) The bases of valuation most commonly used by business concerns
and which meet the requirements of section 471 are (1) cost and (2) cost
or market, whichever is lower. (For inventories by dealers in
securities, see Sec. 1.471-5.) Any goods in an inventory which are
unsalable at normal prices or unusable in the normal way because of
damage, imperfections, shop wear, changes of style, odd or broken lots,
or other similar causes, including second-hand goods taken in exchange,
should be valued at bona fide selling prices less direct cost of
disposition, whether subparagraph (1) or (2) of this paragraph is used,
or if such goods consist of raw materials or partly finished goods held
for use or consumption, they shall be valued upon a reasonable basis,
taking into consideration the usability and the condition of the goods,
but in no case shall such value be less than the scrap value. Bona fide
selling price means actual offering of goods during a period ending not
later than 30 days after inventory date. The burden of proof will rest
upon the taxpayer to show that such exceptional goods as are valued upon
such selling basis come within the classifications indicated above, and
he shall maintain such records of the disposition of the goods as will
enable a verification of the inventory to be made.
(d) In respect of normal goods, whichever method is adopted must be
applied with reasonable consistency to the entire inventory of the
taxpayer's trade or business except as to those goods inventoried under
the last-in, first-out method authorized by section 472 or to animals
inventoried under the elective unit, livestock-price-method authorized
by Sec. 1.471-6. See paragraph (d) of Sec. 1.446-1 for rules
permitting the use of different methods of accounting if the taxpayer
has more than one trade or business. Where the taxpayer is engaged in
more than one trade or business the Commissioner may require that the
method of valuing inventories with respect to goods in one trade or
business also be used with respect to
[[Page 510]]
similar goods in other trades or businesses if, in the opinion of the
Commissioner, the use of such method with respect to such other goods is
essential to a clear reflection of income. Taxpayers were given an
option to adopt the basis of either (1) cost or (2) cost or market,
whichever is lower, for their 1920 inventories. The basis properly
adopted for that year or any subsequent year is controlling, and a
change can now be made only after permission is secured from the
Commissioner. Application for permission to change the basis of valuing
inventories shall be made in writing and filed with the Commissioner as
provided in paragraph (e) of Sec. 1.446-1. Goods taken in the inventory
which have been so intermingled that they cannot be identified with
specific invoices will be deemed to be the goods most recently purchased
or produced, and the cost thereof will be the actual cost of the goods
purchased or produced during the period in which the quantity of goods
in the inventory has been acquired. But see section 472 as to last-in,
first-out inventories. Where the taxpayer maintains book inventories in
accordance with a sound accounting system in which the respective
inventory accounts are charged with the actual cost of the goods
purchased or produced and credited with the value of goods used,
transferred, or sold, calculated upon the basis of the actual cost of
the goods acquired during the taxable year (including the inventory at
the beginning of the year), the net value as shown by such inventory
accounts will be deemed to be the cost of the goods on hand. The
balances shown by such book inventories should be verified by physical
inventories at reasonable intervals and adjusted to conform therewith.
(e) Inventories should be recorded in a legible manner, properly
computed and summarized, and should be preserved as a part of the
accounting records of the taxpayer. The inventories of taxpayers on
whatever basis taken will be subject to investigation by the district
director, and the taxpayer must satisfy the district director of the
correctness of the prices adopted.
(f) The following methods, among others, are sometimes used in
taking or valuing inventories, but are not in accord with the
regulations in this part:
(1) Deducting from the inventory a reserve for price changes, or an
estimated depreciation in the value thereof.
(2) Taking work in process, or other parts of the inventory, at a
nominal price or at less than its proper value.
(3) Omitting portions of the stock on hand.
(4) Using a constant price or nominal value for so-called normal
quantity of materials or goods in stock.
(5) Including stock in transit, shipped either to or from the
taxpayer, the title to which is not vested in the taxpayer.
(6) Segregating indirect production costs into fixed and variable
production cost classifications (as defined in Sec. 1.471-11(b)(3)(ii))
and allocating only the variable costs to the cost of goods produced
while treating fixed costs as period costs which are currently
deductible. This method is commonly referred to as the ``direct cost''
method.
(7) Treating all or substantially all indirect production costs
(whether classified as fixed or variable) as period costs which are
currently deductible. This method is generally referred to as the
``prime cost'' method.
[T.D. 6500, 25 FR 11724, Nov. 26, 1960, as amended by T.D. 7285, 38 FR
26185, Sept. 19, 1973]
Sec. 1.471-3 Inventories at cost.
Cost means:
(a) In the case of merchandise on hand at the beginning of the
taxable year, the inventory price of such goods.
(b) In the case of merchandise purchased since the beginning of the
taxable year, the invoice price less trade or other discounts, except
strictly cash discounts approximating a fair interest rate, which may be
deducted or not at the option of the taxpayer, provided a consistent
course is followed. To this net invoice price should be added
transportation or other necessary charges incurred in acquiring
possession of the goods. But see Sec. 1.263A-1(d)(2)(iv)(C) for special
rules for certain direct material costs that in certain cases are
permitted to be capitalized as additional section 263A costs by
taxpayers using a
[[Page 511]]
simplified method under Sec. 1.263A-2(b) or (c) or Sec. 1.263A-3(d).
For taxpayers acquiring merchandise for resale that are subject to the
provisions of section 263A, see Sec. Sec. 1.263A-1 and 1.263A-3 for
additional amounts that must be included in inventory costs.
(c) In the case of merchandise produced by the taxpayer since the
beginning of the taxable year, (1) the cost of raw materials and
supplies entering into or consumed in connection with the product, (2)
expenditures for direct labor, and (3) indirect production costs
incident to and necessary for the production of the particular article,
including in such indirect production costs an appropriate portion of
management expenses, but not including any cost of selling or return on
capital, whether by way of interest or profit. See Sec. Sec. 1.263A-1
and 1.263A-2 for more specific rules regarding the treatment of
production costs.
(d) In any industry in which the usual rules for computation of cost
of production are inapplicable, costs may be approximated upon such
basis as may be reasonable and in conformity with established trade
practice in the particular industry. Among such cases are:
(1) Farmers and raisers of livestock (see Sec. 1.471-6);
(2) Miners and manufacturers who by a single process or uniform
series of processes derive a product of two or more kinds, sizes, or
grades, the unit cost of which is substantially alike (see Sec. 1.471-
7); and
(3) Retail merchants who use what is known as the ``retail method''
in ascertaining approximate cost (see Sec. 1.471-8).
(e) Sales-based vendor allowances--(1) Treatment of sales-based
vendor chargebacks--(i) In general. A sales-based vendor chargeback is
an allowance, discount, or price rebate that a taxpayer becomes
unconditionally entitled to by selling a vendor's merchandise to
specific customers identified by the vendor at a price determined by the
vendor. A sales-based vendor chargeback decreases cost of goods sold and
does not reduce the cost of goods on hand at the end of the taxable
year.
(ii) Example. The following example illustrates the provisions of
this paragraph (e)(1).
Example. (i) W is a wholesaler of pharmaceuticals. W purchases Drug
X from the manufacturer, M, for $10x per unit. M has agreements with
specific customers that allow those customers to acquire Drug X from M's
wholesalers for $6x per unit. Under an agreement between W and M, W is
required to sell Drug X to specific customers at the prices M has
negotiated with such customers ($6x per unit) and, in exchange, M agrees
to provide a price rebate to W equal to the difference between W's cost
for Drug X and the price W is required to charge specific customers
under the agreement (a difference of $4x per unit). W sells Drug X to
specific customer Y for $6x. Under the agreement between W and M, the
price rebate can be paid to W, credited against M's invoice to W for W's
purchase of Drug X, or it can be credited to W's future purchases of
drugs from M.
(ii) Under the terms of the agreement, W is unconditionally entitled
to the price rebate of Drug X when it sells Drug X to specific customer
Y, a specifically identified customer of M. The price rebate received by
W for the sale of Drug X to Y is a sales-based vendor chargeback.
Therefore, the amount of the sales-based vendor charge back, $4x per
unit for Drug X, whether paid to W, credited against M's invoice to W
for W's purchase of Drug X or credited against a future purchase,
decreases cost of goods sold and does not reduce the cost of Drug X on
hand at the end of the taxable year.
(2) Treatment of other sales-based vendor allowances. [Reserved]
(f) Notwithstanding the other rules of this section, cost shall not
include an amount which is of a type for which a deduction would be
disallowed under section 162 (c), (f), or (g) and the regulations
thereunder in the case of a business expense.
(g) Effective/applicability date. Paragraph (f) of this section
applies to taxable years ending on or after January 13, 2014.
[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 7285, 38 FR
26185, Sept. 19, 1973; T.D. 7345, 40 FR 7439, Feb. 20, 1975; T.D. 8131,
52 FR 10084, Mar. 30, 1987; T.D. 8482, 58 FR 42233, Aug. 9, 1993; T.D.
9652, 79 FR 2098, Jan. 13, 2014; T.D. 9843, 83 FR 58498, Nov. 20, 2018]
Sec. 1.471-4 Inventories at cost or market, whichever is lower.
(a) In general--(1) Market definition. Under ordinary circumstances
and for
[[Page 512]]
normal goods in an inventory, market means the aggregate of the current
bid prices prevailing at the date of the inventory of the basic elements
of cost reflected in inventories of goods purchased and on hand, goods
in process of manufacture, and finished manufactured goods on hand. The
basic elements of cost include direct materials, direct labor, and
indirect costs required to be included in inventories by the taxpayer
(e.g., under section 263A and its underlying regulations for taxpayers
subject to that section). For taxpayers to which section 263A applies,
for example, the basic elements of cost must reflect all direct costs
and all indirect costs properly allocable to goods on hand at the
inventory date at the current bid price of those costs, including but
not limited to the cost of purchasing, handling, and storage activities
conducted by the taxpayer, both prior to and subsequent to acquisition
or production of the goods. The determination of the current bid price
of the basic elements of costs reflected in goods on hand at the
inventory date must be based on the usual volume of particular cost
elements purchased (or incurred) by the taxpayer.
(2) Fixed price contracts. Paragraph (a)(1) of this section does not
apply to any goods on hand or in process of manufacture for delivery
upon firm sales contracts (i.e., those not legally subject to
cancellation by either party) at fixed prices entered into before the
date of the inventory, under which the taxpayer is protected against
actual loss. Any such goods must be inventoried at cost.
(3) Examples. The valuation principles in paragraph (a)(1) of this
section are illustrated by the following examples:
Example 1. (i) Taxpayer A manufactures tractors. A values its
inventory using cost or market, whichever is lower, under paragraph
(a)(1) of this section. At the end of 1994, the cost of one of A's
tractors on hand is determined as follows:
Direct materials.............................................. $3,000
Direct labor.................................................. 4,000
Indirect costs under section 263A............................. 3,000
---------
Total section 263A costs (cost)......................... $10,000
(ii) A determines that the aggregate of the current bid prices of
the materials, labor, and overhead required to reproduce the tractor at
the end of 1994 are as follows:
Direct materials.............................................. $3,100
Direct labor.................................................. 4,100
Indirect costs under section 263A............................. 3,100
---------
Total section 263A costs (market)....................... $10,300
(iii) In determining the lower of cost or market value of the
tractor, A compares the cost of the tractor, $10,000, with the market
value of the tractor, $10,300, in accordance with paragraph (c) of this
section. Thus, under this section, A values the tractor at $10,000.
Example 2. (i) Taxpayer B purchases and resells several lines of
shoes and is subject to section 263A. B values its inventory using cost
or market, whichever is lower, under paragraph (a)(1) of this section.
At the end of 1994, the cost of one pair of shoes on hand is determined
as follows:
Acquisition cost.............................................. $200
Indirect costs under section 263A............................. 10
---------
Total section 263A costs (cost)......................... $210
(ii) B determines the aggregate current bid prices prevailing at the
end of 1994 for the elements of cost (both direct costs and indirect
costs incurred prior and subsequent to acquisition of the shoes) based
on the volume of the elements usually purchased (or incurred) by B as
follows:
Acquisition cost.............................................. $178
Indirect costs under section 263A............................. 12
---------
Total Sec. 263A costs (market)........................ $190
(iii) In determining the lower of cost or market value of the shoes,
B compares the cost of the pair of shoes, $210, with the market value of
the shoes, $190, in accordance with paragraph (c) of this section. Thus,
under this section, B values the shoes at $190.
(b) Inactive markets. Where no open market exists or where
quotations are nominal, due to inactive market conditions, the taxpayer
must use such evidence of a fair market price at the date or dates
nearest the inventory as may be available, such as specific purchases or
sales by the taxpayer or others in reasonable volume and made in good
faith, or compensation paid for cancellation of contracts for purchase
commitments. Where the taxpayer in the regular course of business has
offered for sale such merchandise at prices lower than the current price
as above defined, the inventory may be valued at such prices less direct
cost of disposition, and the correctness of such prices will be
determined by reference to the actual sales of the taxpayer for a
reasonable period before and after the date of the inventory. Prices
which vary materially from the actual prices
[[Page 513]]
so ascertained will not be accepted as reflecting the market.
(c) Comparison of cost and market. Where the inventory is valued
upon the basis of cost or market, whichever is lower, the market value
of each article on hand at the inventory date shall be compared with the
cost of the article, and the lower of such values shall be taken as the
inventory value of the article.
(d) Effective date. This section applies to inventory valuations for
taxable years beginning after December 31, 1993. For taxable years
beginning before January 1, 1994, taxpayers must take reasonable
positions on their federal income tax returns with respect to the
application of section 263A, and must have otherwise complied with Sec.
1.471-4 (as contained in the 26 CFR part 1 edition revised April 1,
1993). For purposes of this paragraph (d), a reasonable position as to
the application of section 263A is a position consistent with the
temporary regulations, revenue rulings, revenue procedures, notices, and
announcements concerning section 263A applicable in taxable years
beginning before January 1, 1994. (See Sec. 601.601(d)(2)(ii)(b) of
this chapter.)
[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 8482, 58 FR
42233, Aug. 9, 1993]
Sec. 1.471-5 Inventories by dealers in securities.
A dealer in securities who in his books of account regularly
inventories unsold securities on hand either--
(a) At cost,
(b) At cost or market, whichever is lower, or
(c) At market value,
may make his return upon the basis upon which his accounts are kept,
provided that a description of the method employed is included in or
attached to the return, that all the securities are inventoried by the
same method, and that such method is adhered to in subsequent years,
unless another method is authorized by the Commissioner pursuant to a
written application therefor filed as provided in paragraph (e) of Sec.
1.446-1. A dealer in securities in whose books of account separate
computations of the gain or loss from the sale of the various lots of
securities sold are made on the basis of the cost of each lot shall be
regarded, for the purposes of this section, as regularly inventorying
his securities at cost. For the purposes of this section, a dealer in
securities is a merchant of securities, whether an individual,
partnership, or corporation, with an established place of business,
regularly engaged in the purchase of securities and their resale to
customers; that is, one who as a merchant buys securities and sells them
to customers with a view to the gains and profits that may be derived
therefrom. If such business is simply a branch of the activities carried
on by such person, the securities inventoried as provided in this
section may include only those held for purposes of resale and not for
investment. Taxpayers who buy and sell or hold securities for investment
or speculation, irrespective of whether such buying or selling
constitutes the carrying on of a trade or business, and officers of
corporations and members of partnerships who in their individual
capacities buy and sell securities, are not dealers in securities within
the meaning of this section. See Sec. Sec. 1.263A-1 and 1.263A-3 for
rules regarding the treatment of costs with respect to property acquired
for resale.
[T.D. 6500, 25 FR 11725, Nov. 26, 1960, as amended by T.D. 8131, 52 FR
10084, Mar. 30, 1987; T.D. 8482, 58 FR 42234, Aug. 9, 1993]
Sec. 1.471-6 Inventories of livestock raisers and other farmers.
(a) A farmer may make his return upon an inventory method instead of
the cash receipts and disbursements method. It is optional with the
taxpayer which of these methods of accounting is used but, having
elected one method, the option so exercised will be binding upon the
taxpayer for the year for which the option is exercised and for
subsequent years unless another method is authorized by the Commissioner
as provided in paragraph (e) of Sec. 1.446-1.
(b) In any change of accounting method from the cash receipts and
disbursements method to an inventory method, adjustments shall be made
as provided in section 481 (relating to adjustments required by change
in method of accounting) and the regulations thereunder.
[[Page 514]]
(c) Because of the difficulty of ascertaining actual cost of
livestock and other farm products, farmers who render their returns upon
an inventory method may value their inventories according to the ``farm-
price method'', and farmers raising livestock may value their
inventories of animals according to either the ``farm-price method'' or
the ``unit-livestock-price method''. In addition, these inventory
methods may be used to account for the costs of property produced in a
farming business that are required to be capitalized under section 263A
regardless of whether the property being produced is otherwise treated
as inventory by the taxpayer, and regardless of whether the taxpayer is
otherwise using the cash or an accrual method of accounting.
(d) The ``farm-price method'' provides for the valuation of
inventories at market price less direct cost of disposition. If this
method of valuation is used, it generally must be applied to all
property produced by the taxpayer in the trade or business of farming,
except as to livestock accounted for, at the taxpayer's election, under
the unit livestock method of accounting. However, see Sec. 1.263A-
4(c)(3) for an exception to this rule. If the use of the ``farm-price
method'' of valuing inventories for any taxable year involves a change
in method of valuing inventories from that employed in prior years,
permission for such change shall first be secured from the Commissioner
as provided in paragraph (e) of Sec. 1.446-1.
(e) The ``unit-livestock-price method'' provides for the valuation
of the different classes of animals in the inventory at a standard unit
price for each animal within a class. A livestock raiser electing this
method of valuing his animals must adopt a reasonable classification of
the animals in his inventory with respect to the age and kind included
so that the unit prices assigned to the several classes will reasonably
account for the normal costs incurred in producing the animals within
such classes. Thus, if a cattle raiser determines that it costs
approximately $15 to produce a calf, and $7.50 each year to raise the
calf to maturity, his classifications and unit prices would be as
follows: Calves, $15; yearlings, $22.50; 2-year olds, $30; mature
animals, $37.50. The classification selected by the livestock raiser,
and the unit prices assigned to the several classes, are subject to
approval by the district director upon examination of the taxpayer's
return.
(f) A taxpayer that elects to use the ``unit-livestock-price
method'' must apply it to all livestock raised, whether for sale or for
draft, breeding, or dairy purposes. The inventoriable costs of animals
raised for draft, breeding, or dairy purposes can, at the election of
the livestock raiser, be included in inventory or treated as property
used in a trade or business subject to depreciation after maturity. See
Sec. 1.263A-4 for rules regarding the computation of inventoriable
costs for purposes of the unit-livestock-price method. Once established,
the methods of accounting used by the taxpayer to determine unit prices
and to classify animals must be consistently applied in all subsequent
taxable years. A taxpayer that uses the unit-livestock-price method must
annually reevaluate its unit prices and adjust the prices either upward
to reflect increases, or downward to reflect decreases, in the costs of
raising livestock. The consent of the Commissioner is not required to
make such upward or downward adjustments. No other changes in the
classification of animals or unit prices may be made without the consent
of the Commissioner. See Sec. 1.446-1(e) for procedures for obtaining
the consent of the Commissioner. The provisions of this paragraph (f)
apply to taxable years ending after October 28, 2002.
(g) A livestock raiser who uses the ``unit-livestock-price method''
must include in his inventory at cost any livestock purchased, except
that animals purchased for draft, breeding, or dairy purposes can, at
the election of the livestock raiser, be included in inventory or be
treated as property used in a trade or business subject to depreciation
after maturity. If the animals purchased are not mature at the time of
purchase, the cost should be increased at the end of each taxable year
in accordance with the established unit prices, except that no increase
is to be made in the taxable year of purchase if the animal is acquired
during the last
[[Page 515]]
six months of that year. If the records maintained permit identification
of a purchased animal, the cost of such animal will be eliminated from
the closing inventory in the event of its sale or loss. Otherwise, the
first-in, first-out method of valuing inventories must be applied.
(h) If a taxpayer using the ``farm-price method'' desires to adopt
the ``unit-livestock-price method'' in valuing his inventories of
livestock, permission for the change shall first be secured from the
Commissioner as provided in paragraph (e) of Sec. 1.446-1. However, a
taxpayer who has filed returns on the basis of inventories at cost, or
cost or market whichever is lower, may adopt the ``unit-livestock-price
method'' for valuing his inventories of livestock without formal
application for permission, but the classifications and unit prices
selected are subject to approval by the district director upon
examination of the taxpayer's return. A livestock raiser who has adopted
a constant unit-price method of valuing livestock inventories and filed
returns on that basis will be considered as having elected the ``unit-
livestock-price method''.
(i) If returns have been made in which the taxable income has been
computed upon incomplete inventories, the abnormality should be
corrected by submitting with the return for the current taxable year a
statement for the preceding taxable year. In this statement such
adjustments shall be made as are necessary to bring the closing
inventory for the preceding taxable year into agreement with the opening
complete inventory for the current taxable year. If necessary clearly to
reflect income, similar adjustments may be made as at the beginning of
the preceding year or years, and the tax, if any be due, shall be
assessed and paid at the rate of tax in effect for such year or years.
[T.D. 6500, 25 FR 11726, Nov. 26, 1960, as amended by T.D. 8131, 52 FR
10084, Mar. 30, 1987; T.D. 8729, 62 FR 44551, Aug. 22, 1997; T.D. 8897,
65 FR 50650, Aug. 21, 2000; T.D. 9019, 67 FR 65698, Oct. 28, 2002]
Sec. 1.471-7 Inventories of miners and manufacturers.
A taxpayer engaged in mining or manufacturing who by a single
process or uniform series of processes derives a product of two or more
kinds, sizes, or grades, the unit cost of which is substantially alike,
and who in conformity to a recognized trade practice allocates an amount
of cost to each kind, size, or grade of product, which in the aggregate
will absorb the total cost of production, may, with the consent of the
Commissioner, use such allocated cost as a basis for pricing
inventories, provided such allocation bears a reasonable relation to the
respective selling values of the different kinds, sizes, or grades of
product. See section 472 as to last-in, first-out inventories.
[T.D. 6500, 25 FR 11726, Nov. 26, 1960]
Sec. 1.471-8 Inventories of retail merchants.
(a) In general. A taxpayer that is a retail merchant may use the
retail inventory method of accounting described in this section. The
retail inventory method uses a formula to convert the retail selling
price of ending inventory to an approximation of cost (retail cost
method) or an approximation of lower of cost or market (retail LCM
method). A taxpayer may use the retail inventory method instead of
valuing inventory at cost under Sec. 1.471-3 or lower of cost or market
under Sec. 1.471-4.
(b) Computation--(1) In general. A taxpayer computes the value of
ending inventory under the retail inventory method by multiplying a cost
complement by the retail selling prices of the goods on hand at the end
of the taxable year.
(2) Cost complement--(i) In general. The cost complement is a ratio
computed as follows:
(A) The numerator is the value of beginning inventory plus the cost
(as determined under Sec. 1.471-3, except as otherwise provided in this
section) of goods purchased during the taxable year.
(B) The denominator is the retail selling prices of beginning
inventory plus the retail selling prices of goods purchased during the
year (that is, the bona fide retail selling prices of the
[[Page 516]]
items at the time acquired), adjusted for all permanent markups and
markdowns, including markup and markdown cancellations and corrections.
The denominator is not adjusted for temporary markups or markdowns.
(ii) Vendor allowances required to reduce only cost of goods sold. A
taxpayer may not reduce the numerator of the cost complement by the
amount of an allowance, discount, or price rebate that is required under
Sec. 1.471-3(e) to reduce only cost of goods sold.
(3) Additional rules for cost complement for retail LCM method--(i)
In general--(A) Margin protection payments. A taxpayer using the retail
LCM method may not reduce the numerator of the cost complement by the
amount of an allowance, discount, or price rebate that is related to or
intended to compensate for a permanent reduction in the taxpayer's
retail selling price of inventory (a margin protection payment).
(B) Markdowns. A taxpayer using the retail LCM method does not
adjust the denominator of the cost complement for markdowns (and
markdown cancellations or corrections). Markups must be reduced by the
markdowns made to cancel or correct them.
(ii) Alternative methods for computing cost complement--(A) In
general. In lieu of the method described in paragraph (b)(3)(i) of this
section, a taxpayer using the retail LCM method may compute the cost
complement using one of the alternative methods described in this
paragraph (b)(3)(ii). A taxpayer using an alternative method under this
paragraph (b)(3)(ii) must use that method for all cost complements.
(B) Adjust numerator and denominator. A taxpayer using the retail
LCM method may reduce the numerator of the cost complement by the amount
of all margin protection payments if the taxpayer also reduces the
denominator of the cost complement by the amount of the permanent
reduction in retail selling price to which the margin protection
payments relate (related markdowns).
(C) Deemed adjustment to denominator. A taxpayer using the retail
LCM method that is able to determine the amount of all margin protection
payments but cannot determine the amount of the related markdowns may
reduce the numerator of the cost complement by the amount of all margin
protection payments if the taxpayer also reduces the denominator by the
amount that, in conjunction with the reduction of the numerator for the
margin protection payments, maintains what would have been the cost
complement percentage before taking into account the margin protection
payment and the related markdown. A taxpayer that can determine the
amount of a related markdown but not the associated margin protection
payments may not use this method to compute an adjustment to the
numerator.
(iii) Statistical sampling. A taxpayer using the retail LCM method
may use statistical sampling in accordance with Rev. Proc. 2011-42 or
any successor (see Sec. 601.601(d) of this chapter), in conjunction
with any method of computing the cost complement described in this
paragraph (b)(3), to determine the amount of margin protection payments
and related markdowns. A taxpayer using statistical sampling must use it
for all margin protection payments and related markdowns associated with
the inventory items valued by a particular cost complement, but is not
required to use it for every cost complement.
(4) Ending inventory retail selling prices. A taxpayer must include
all permanent markups and markdowns but may not include temporary
markups or markdowns in determining the retail selling prices of goods
on hand at the end of the taxable year. A taxpayer may not include a
markdown that is not an actual reduction of retail selling price.
(c) Special rules for LIFO taxpayers. A taxpayer using the last-in,
first-out (LIFO) inventory method with the retail inventory method uses
the retail cost method. See Sec. 1.472-1(k) for additional adjustments
for a taxpayer using the LIFO inventory method with the retail cost
method.
(d) Scope of retail inventory method. A taxpayer may use the retail
inventory method to value ending inventory for a department, a class of
goods, or a stock-keeping unit. A taxpayer maintaining more than one
department or
[[Page 517]]
dealing in classes of goods with different percentages of gross profit
must compute cost complements separately for each department or class of
goods.
(e) Examples. The following examples illustrate the rules of this
section:
Example 1. (i) R, a retail merchant who uses the retail LCM method
and uses a calendar taxable year, has no beginning inventory in 2012. R
purchases 40 tables during 2012 for $60 each for a total of $2,400. R
offers the tables for sale at $100 each for an aggregate retail selling
price of $4,000. R does not sell any tables at a price of $100, so R
permanently marks down the retail selling price of its tables to $90
each. As a result of the $10 markdown, R's supplier provides R a $6 per
table margin protection payment. R sells 25 tables during 2012 and has
15 tables in ending inventory at the end of 2012.
(ii) Under paragraph (b)(2)(i)(A) of this section, the numerator of
the cost complement is the aggregate cost of the tables, $2,400. Under
paragraph (b)(3)(i)(A) of this section, R may not reduce the numerator
of the cost complement by the amount of the margin protection payment.
Under paragraph (b)(2)(i)(B) of this section, the denominator of the
cost complement is the aggregate of the bona fide retail selling prices
of all the tables at the time acquired, $4,000. Under paragraph
(b)(3)(i)(B) of this section, R does not adjust the denominator of the
cost complement for the markdown. Therefore, R's cost complement is
$2,400/$4,000, or 60%.
(iii) Under paragraph (b)(4) of this section, R includes the
permanent markdown in determining year-end retail selling prices.
Therefore, the aggregate retail selling price of R's ending table
inventory is $1,350 (15 * $90). Approximating LCM under the retail
method, the value of R's ending table inventory is $810 (60% * $1,350).
Example 2. (i) The facts are the same as in Example 1, except that R
permanently reduces the retail selling price of all 40 tables to $50 per
unit and the 15 tables on hand at the end of the year are marked for
sale at that price. The additional $40 markdown is unrelated to a margin
protection payment or other allowance.
(ii) Under paragraph (b)(3)(i)(B) of this section, R does not adjust
the denominator of the cost complement for the markdown. Therefore, R's
cost complement is $2,400/$4,000, or 60%.
(iii) Under paragraph (b)(4) of this section, R includes the
permanent markdowns in determining year-end retail selling prices.
Therefore, the aggregate retail selling price of R's ending inventory is
$750 (15 * $50). Approximating LCM under the retail method, the value of
R's ending inventory is $450 (60% * $750).
Example 3. (i) The facts are the same as in Example 1, except that R
computes the cost complement using the alternative method under
paragraph (b)(3)(ii)(B) of this section.
(ii) R reduces the numerator of the cost complement by the margin
protection payments of $240 ($6 * 40) and reduces the denominator of the
cost complement by the related markdowns of $400 ($10 * 40). Therefore,
R's cost complement is $2,160/$3,600, or 60%.
(iii) Under paragraph (b)(4) of this section, R includes the
permanent markdown in determining year-end retail selling prices.
Therefore, the aggregate retail selling price of R's ending table
inventory is $1,350 (15 * $90). Approximating LCM under the retail
method, the value of R's ending table inventory is $810 (60% * $1,350).
Example 4. (i) The facts are the same as in Example 1, except that R
cannot determine the amount of its related markdowns and computes the
cost complement using the alternative method under paragraph
(b)(3)(ii)(C) of this section.
(ii) R reduces the numerator of the cost complement by the margin
protection payments of $240 ($6 * 40). R reduces the denominator of the
cost complement by the amount that, in conjunction with the reduction in
the numerator, maintains the cost complement percentage before taking
into account the margin protection payments and the related markdowns.
R's original cost complement was 60% ($2,400/$4,000). The numerator of
R's new cost complement is $2,160 ($2,400-$240). Therefore, R reduces
the denominator by $400, which maintains the cost complement of 60%
($2,160/$3,600).
(iii) Under paragraph (b)(4) of this section, R includes the
permanent markdowns in determining year-end retail selling prices.
Therefore, the aggregate retail selling price of R's ending table
inventory is $1,350 (15 * $90). Approximating LCM under the retail
method, the value of R's ending table inventory is $810 (60% * $1,350).
Example 5. (i) The facts are the same as in Example 1, except that R
uses the LIFO inventory method. R must value inventories at cost and,
under paragraph (c) of this section, uses the retail cost method.
(ii) Under paragraph (b)(2)(i)(A) of this section, R reduces the
numerator of the cost complement by the amount of the margin protection
payment. Under paragraph (b)(2)(i)(B) of this section, R includes the
permanent markdown in the denominator of the cost complement. Therefore,
R's cost complement is $2,160/$3,600, or 60%.
(iii) Under paragraph (b)(4) of this section, R includes the
permanent markdown in determining year-end retail selling prices.
Therefore, the aggregate retail selling price of R's ending inventory is
$1,350 (15 * $90). Approximating cost under the retail method, the value
of R's ending inventory is $810 (60% * $1,350).
[[Page 518]]
(f) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2014. For taxable years beginning
before January 1, 2015, see Sec. 1.471-8 as contained in 26 CFR part 1,
revised April 1, 2014.
[T.D. 9688, 79 FR 48036, Aug. 15, 2014]
Sec. 1.471-9 Inventories of acquiring corporations.
For additional rules in the case of certain corporate acquisitions
specified in section 381(a), see section 381(c)(5) and the regulations
thereunder.
[T.D. 6500, 25 FR 11727, Nov. 26, 1960]
Sec. 1.471-10 Applicability of long-term contract methods.
See Sec. 1.460-2 for rules providing for the application of the
long-term contract methods to certain manufacturing contracts.
[T.D. 8067, 51 FR 393, Jan. 6, 1986, as amended by T.D. 8929, 66 FR
2240, Jan. 11, 2001]
Sec. 1.471-11 Inventories of manufacturers.
(a) Use of full absorption method of inventory costing. In order to
conform as nearly as may be possible to the best accounting practices
and to clearly reflect income (as required by section 471 of the Code),
both direct and indirect production costs must be taken into account in
the computation of inventoriable costs in accordance with the ``full
absorption'' method of inventory costing. Under the full absorption
method of inventory costing production costs must be allocated to goods
produced during the taxable year, whether sold during the taxable year
or in inventory at the close of the taxable year determined in
accordance with the taxpayer's method of identifying goods in inventory.
Thus, the taxpayer must include as inventoriable costs all direct
production costs and, to the extent provided by paragraphs (c) and (d)
of this section, all indirect production costs. For purposes of this
section, the term ``financial reports'' means financial reports
(including consolidated financial statements) to shareholders, partners,
beneficiaries or other proprietors and for credit purposes. See also
Sec. 1.263A-1T with respect to the treatment of production costs
incurred in taxable years beginning after December 31, 1986, and before
January 1, 1994. See also Sec. Sec. 1.263A-1 and 1.263A-2 with respect
to the treatment of production costs incurred in taxable years beginning
after December 31, 1993.
(b) Production costs--(1) In general. Costs are considered to be
production costs to the extent that they are incident to and necessary
for production or manufacturing operations or processes. Production
costs include direct production costs and fixed and variable indirect
production costs.
(2) Direct production costs. (i) Costs classified as ``direct
production costs'' are generally those costs which are incident to and
necessary for production or manufacturing operations or processes and
are components of the cost of either direct material or direct labor.
Direct material costs include the cost of those materials which become
an integral part of the specific product and those materials which are
consumed in the ordinary course of manufacturing and can be identified
or associated with particular units or groups of units of that product.
See Sec. 1.471-3 for the elements of direct material costs. Direct
labor costs include the cost of labor which can be identified or
associated with particular units or groups of units of a specific
product. The elements of direct labor costs include such items as basic
compensation, overtime pay, vacation and holiday pay, sick leave pay
(other than payments pursuant to a wage continuation plan under section
105(d)), shift differential, payroll taxes and payments to a
supplemental unemployment benefit plan paid or incurred on behalf of
employees engaged in direct labor. For the treatment of rework labor,
scrap, spoilage costs, and any other costs not specifically described as
direct production costs see Sec. 1.471-11(c)(2).
(ii) Under the full absorption method, a taxpayer must take into
account all items of direct production cost in his inventoriable costs.
Nevertheless, a taxpayer will not be treated as using an incorrect
method of inventory costing if he treats any direct production costs as
indirect production costs, provided such costs are allocated to the
taxpayer's ending inventory to the extent provided by paragraph (d) of
this
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section. Thus, for example, a taxpayer may treat direct labor costs as
part of indirect production costs (for example, by use of the conversion
cost method), provided all such costs are allocated to ending inventory
to the extent provided by paragraph (d) of this section.
(3) Indirect production costs--(i) In general. The term ``indirect
production costs'' includes all costs which are incident to and
necessary for production or manufacturing operations or processes other
than direct production costs (as defined in subparagraph (2) of this
paragraph). Indirect production costs may be classified as to kind or
type in accordance with acceptable accounting principles so as to enable
convenient identification with various production or manufacturing
activities or functions and to facilitate reasonable groupings of such
costs for purposes of determining unit product costs.
(ii) Fixed and variable classifications. For purposes of this
section, fixed indirect production costs are generally those costs which
do not vary significantly with changes in the amount of goods produced
at any given level of production capacity. These fixed costs may
include, among other costs, rent and property taxes on buildings and
machinery incident to and necessary for manufacturing operations or
processes. On the other hand, variable indirect production costs are
generally those costs which do vary significantly with changes in the
amount of goods produced at any given level of production capacity.
These variable costs may include, among other costs, indirect materials,
factory janitorial supplies, and utilities. Where a particular cost
contains both fixed and variable elements, these elements should be
segregated into fixed and variable classifications to the extent
necessary under the taxpayer's method of allocation, such as for the
application of the practical capacity concept (as described in paragraph
(d) (4) of this section).
(c) Certain indirect and production costs--(1) General rule. Except
as provided in paragraph (c)(3) of this section and in paragraph
(d)(6)(v) of Sec. 1.451-3, in order to determine whether indirect
production costs referred to in paragraph (b) of this section must be
included in a taxpayer's computation of the amount of inventoriable
costs, three categories of costs have been provided in subparagraph (2)
of this paragraph. Costs described in subparagraph (2)(i) of this
paragraph must be included in the taxpayer's computation of the amount
of inventoriable costs, regardless of their treatment by the taxpayer in
his financial reports. Costs described in subparagraph (2)(ii) of this
paragraph need not enter into the taxpayer's computation of the amount
of inventoriable costs, regardless of their treatment by the taxpayer in
his financial reports. Costs described in subparagraph (2)(iii) of this
paragraph must be included in or excluded from the taxpayer's
computation of the amount inventoriable costs in accordance with the
treatment of such costs by the taxpayer in his financial reports and
generally accepted accounting principles. For the treatment of indirect
production costs described in subparagraph (2) of this paragraph in the
case of a taxpayer who is not using comparable methods of accounting for
such costs for tax and financial reporting see paragraph (c)(3) of this
section. For contracts entered into after December 31, 1982,
notwithstanding this section, taxpayers who use an inventory method of
accounting for extended period long-term contracts (as defined in
paragraph (b)(3) of Sec. 1.451-3) for tax purposes may be required to
use the cost allocation rules provided in paragraph (d)(6) of Sec.
1.451-3 rather than the cost allocation rules provided in this section.
See paragraph (d)(6)(v) of Sec. 1.451-3. After a taxpayer has
determined which costs must be treated as indirect production costs
includible in the computation of the amount of inventoriable costs, such
costs must be allocated to a taxpayer's ending inventory in a manner
prescribed by paragraph (d) of this section.
(2) Includibility of certain indirect production costs--(i) Indirect
production costs included in inventoriable costs. Indirect production
costs which must enter into the computation of the amount of
inventoriable costs (regardless of their treatment by a taxpayer in his
financial reports) include:
(a) Repair expenses,
(b) Maintenance,
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(c) Utilities, such as heat, power and light,
(d) Rent,
(e) Indirect labor and production supervisory wages, including basic
compensation, overtime pay, vacation and holiday pay, sick leave pay
(other than payments pursuant to a wage continuation plan under section
105(d), shift differential, payroll taxes and contributions to a
supplemental unemployment benefit plan,
(f) Indirect materials and supplies,
(g) Tools and equipment not capitalized, and
(h) Costs of quality control and inspection,
to the extent, and only to the extent, such costs are incident to and
necessary for production or manufacturing operations or processes.
(ii) Costs not included in inventoriable costs. Costs which are not
required to be included for tax purposes in the computation of the
amount of inventoriable costs (regardless of their treatment by a
taxpayer in his financial reports) include:
(a) Marketing expenses,
(b) Advertising expenses,
(c) Selling expenses,
(d) Other distribution expenses,
(e) Interest,
(f) Research and experimental expenses including engineering and
product development expenses,
(g) Losses under section 165 and the regulations thereunder,
(h) Percentage depletion in excess of cost depletion,
(i) Depreciation and amortization reported for Federal income tax
purposes in excess of depreciation reported by the taxpayer in his
financial reports,
(j) Income taxes attributable to income received on the sale of
inventory,
(k) Pension contributions to the extent that they represent past
services cost,
(l) General and administrative expenses incident to and necessary
for the taxpayer's activities as a whole rather than to production or
manufacturing operations or processes, and
(m) Salaries paid to officers attributable to the performance of
services which are incident to and necessary for the taxpayer's
activities taken as a whole rather than to production or manufacturing
operations or processes.
Notwithstanding the preceding sentence, if a taxpayer consistently
includes in his computation of the amount of inventoriable costs any of
the costs described in the preceding sentence, a change in such method
of inclusion shall be considered a change in method of accounting within
the meaning of sections 446, 481, and paragraph (e)(4) of this section.
(iii) Indirect production costs includible in inventoriable costs
depending upon treatment in taxpayer's financial reports. In the case of
costs listed in this subdivision, the inclusion or exclusion of such
costs from the amount of inventoriable costs for purposes of a
taxpayer's financial reports shall determine whether such costs must be
included in or excluded from the computation of inventoriable costs for
tax purposes, but only if such treatment is not inconsistent with
generally accepted accounting principles. In the case of costs which are
not included in subdivision (i) or (ii) of this subparagraph, nor listed
in this subdivision, whether such costs must be included in or excluded
from the computation of inventoriable costs for tax purposes depends
upon the extent to which such costs are similar to costs included in
subdivision (i) or (ii), and if such costs are dissimilar to costs in
subdivision (i) or (ii), such costs shall be treated as included in or
excludable from the amount of inventoriable costs in accordance with
this subdivision. The costs listed in this subdivision are:
(a) Taxes. Taxes otherwise allowable as a deduction under section
164 (other than State and local and foreign income taxes) attributable
to assets incident to and necessary for production or manufacturing
operations or processes. Thus, for example, the cost of State and local
property taxes imposed on a factory or other production facility and any
State and local taxes imposed on inventory must be included in or
excluded from the computation of the amount of inventoriable costs for
tax purposes depending upon their treatment by a taxpayer in his
financial reports.
(b) Depreciation and depletion. Depreciation reported in financial
reports
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and cost depletion on assets incident to and necessary for production or
manufacturing operations or processes. In computing cost depletion under
this section, the adjusted basis of such assets shall be reduced by cost
depletion and not by percentage depletion taken thereon.
(c) Employee benefits. Pension and profit-sharing contributions
representing current service costs otherwise allowable as a deduction
under section 404, and other employee benefits incurred on behalf of
labor incident to and necessary for production or manufacturing
operations or processes. These other benefits include workmen's
compensation expenses, payments under a wage continuation plan described
in section 105(d), amounts of a type which would be includible in the
gross income of employees under non-qualified pension, profit-sharing
and stock bonus plans, premiums on life and health insurance and
miscellaneous benefits provided for employees such as safety, medical
treatment, cafeteria, recreational facilities, membership dues, etc.,
which are otherwise allowable as deductions under chapter 1 of the Code.
(d) Costs attributable to strikes, rework labor, scrap and spoilage.
Costs attributable to rework labor, scrap and spoilage which are
incident to and necessary for production or manufacturing operations or
processes and costs attributable to strikes incident to production or
manufacturing operation or processes.
(e) Factory administrative expenses. Administrative costs of
production (but not including any cost of selling or any return on
capital) incident to and necessary for production or manufacturing
operations or processes.
(f) Officers' salaries. Salaries paid to officers attributable to
services performed incident to and necessary for production or
manufacturing operations or processes.
(g) Insurance costs. Insurance costs incident to and necessary for
production or manufacturing operations or processes such as insurance on
production machinery and equipment. A change in the taxpayer's treatment
in his financial reports of costs described in this subdivision which
results in a change in treatment of such costs for tax purposes shall
constitute a change in method of accounting within the meaning of
sections 446 and 481 to which paragraph (e) applies.
(3) Exception. Except as provided in paragraph (d)(6) of Sec.
1.451-3, in the case of a taxpayer whose method of accounting for
production costs in his financial reports is not comparable to his
method of accounting for such costs for tax purposes (such as a taxpayer
using the prime cost method for purposes of financial reports), the
following rules apply:
(i) Indirect production costs included in inventoriable costs.
Indirect production costs which must enter into the computation of the
amount of inventoriable costs (to the extent, and only to the extent,
such costs are incident to and necessary for production or manufacturing
operations or processes) include:
(a) Repair expenses,
(b) Maintenance,
(c) Utilities, such as heat, power and light,
(d) Rent,
(e) Indirect labor and production supervisory wages, including basic
compensation, overtime pay, vacation and holiday pay, sick leave pay
(other than payments pursuant to a wage continuation plan under section
105(d)), shift differential, payroll taxes and contributions to a
supplemental unemployment benefit plan,
(f) Indirect materials and supplies,
(g) Tools and equipment not capitalized,
(h) Costs of quality control and inspection,
(i) Taxes otherwise allowable as a deduction under section 164
(other than State and local and foreign income taxes),
(j) Depreciation and amortization reported for financial purposes
and cost depletion,
(k) Administrative costs of production (but not including any cost
of selling or any return on capital) incident to and necessary for
production or manufacturing operations or processes,
(l) Salaries paid to officers attributable to services performed
incident to and necessary for production or
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manufacturing operations or processes, and
(m) Insurance costs incident to and necessary for production or
manufacturing operations or processes such as insurance on production
machinery and equipment.
(ii) Costs not included in inventoriable costs. Costs which are not
required to be included in the computation of the amount of
inventoriable costs include:
(a) Marketing expenses,
(b) Advertising expenses,
(c) Selling expenses,
(d) Other distribution expenses,
(e) Interest,
(f) Research and experimental expenses including engineering and
product development expenses,
(g) Losses under section 165 and the regulations thereunder,
(h) Percentage depletion in excess of cost depletion,
(i) Depreciation reported for Federal income tax purposes in excess
of depreciation reported by the taxpayer in his financial reports,
(j) Income taxes attributable to income received on the sale of
inventory,
(k) Pension and profit-sharing contributions representing either
past service costs or representing current service costs otherwise
allowable as a deduction under section 404, and other employee benefits
incurred on behalf of labor. These other benefits include workmen's
compensation expenses, payments under a wage continuation plan described
in section 105(d), amounts of a type which would be includible in the
gross income of employees under nonqualified pension, profit-sharing and
stock bonus plans, premiums on life and health insurance and
miscellaneous benefits provided for employees such as safety, medical
treatment, cafeteria, recreational facilities, membership dues, etc.,
which are otherwise allowable as deductions under chapter 1 of the Code,
(l) Cost attributable to strikes, rework labor, scrap and spoilage,
(m) General and administrative expenses incident to and necessary
for the taxpayer's activities as a whole rather than to production or
manufacturing operations or processes, and
(n) Salaries paid to officers attributable to the performance of
services which are incident to and necessary for the taxpayer's
activities as a whole rather than to production or manufacturing
operations or processes.
(d) Allocation methods--(1) In general. Indirect production costs
required to be included in the computation of the amount of
inventoriable costs pursuant to paragraphs (b) and (c) of this paragraph
must be allocated to goods in a taxpayer's ending inventory (determined
in accordance with the taxpayer's method of identification) by the use
of a method of allocation which fairly apportions such costs among the
various items produced. Acceptable methods for allocating indirect
production costs to the cost of goods in the ending inventory include
the manufacturing burden rate method and the standard cost method. In
addition, the practical capacity concept can be used in conjunction with
either the manufacturing burden rate or standard cost method.
(2) Manufacturing burden rate method--(i) In general. Manufacturing
burden rates may be developed in accordance with acceptable accounting
principles and applied in a reasonable manner. In developing a
manufacturing burden rate, the factors described in paragraph (d)(2)(ii)
of this section may be taken into account. Furthermore, if the taxpayer
chooses, he may allocate different indirect production costs on the
basis of different manufacturing burden rates. Thus, for example, the
taxpayer may use one burden rate for allocating rent and another burden
rate for allocating utilities. The method used by the taxpayer in
allocating such costs in his financial reports shall be given great
weight in determining whether the taxpayer's method employed for tax
purposes fairly allocates indirect production costs to the ending
inventory. Any change in a manufacturing burden rate which is merely a
periodic adjustment to reflect current operating conditions, such as
increases in automation or changes in operation, does not constitute a
change in method of accounting under section 446. However, a change in
the concept upon which such rates are developed does constitute a change
in method of accounting requiring the consent of the Commissioner. The
taxpayer shall
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maintain adequate records and working papers to support all
manufacturing burden rate calculations.
(ii) Development of manufacturing burden rate. The following
factors, among others, may be taken into account in developing
manufacturing burden rates:
(a) The selection of an appropriate level of activity and period of
time upon which to base the calculation of rates which will reflect
operating conditions for purposes of the unit costs being determined;
(b) The selection of an appropriate statistical base such as direct
labor hours, direct labor dollars, or machine hours, or a combination
thereof, upon which to apply the overhead rate to determine production
costs; and
(c) The appropriate budgeting, classification and analysis of
expenses (for example, the analysis of fixed and variable costs).
(iii) Operation of the manufacturing burden rate method. (a) The
purpose of the manufacturing burden rate method used in conjunction with
the full absorption method of inventory costing is to allocate an
appropriate amount of indirect production costs to a taxpayer's goods in
ending inventory by the use of predetermined rates intended to
approximate the actual amount of indirect production costs incurred.
Accordingly, the proper use of the manufacturing burden rate method
under this section requires that any net negative or net positive
difference between the total predetermined amount of indirect production
costs allocated to the goods in ending inventory and the total amount of
indirect production costs actually incurred and required to be allocated
to such goods (i.e., the under or over-applied burden) must be treated
as an adjustment to the taxpayer's ending inventory in the taxable year
in which such difference arises. However, if such adjustment is not
significant in amount in relation to the taxpayer's total actual
indirect production costs for the year then such adjustment need not be
allocated to the taxpayer's goods in ending inventory unless such
allocation is made in the taxpayer's financial reports. The taxpayer
must treat both positive and negative adjustments consistently.
(b) Notwithstanding subdivision (a), the practical capacity concept
may be used to determine the total amount of fixed indirect production
costs which must be allocated to goods in ending inventory. See
subparagraph (4) of this paragraph.
(3) Standard cost method--(i) In general. A taxpayer may use the so-
called ``standard cost'' method of allocating inventoriable costs to the
goods in ending inventory, provided he treats variances in accordance
with the procedures prescribed in paragraph (d)(3)(ii) of this section.
The method used by the taxpayer in allocating such costs in his
financial reports shall be given great weight in determining whether the
taxpayer's method employed for tax purposes fairly allocates indirect
production costs to the ending inventory. For purposes of this
subparagraph, a ``net positive overhead variance'' shall mean the excess
of total standard (or estimated) indirect production costs over total
actual indirect production costs and a ``net negative overhead
variance'' shall mean the excess of total actual indirect production
costs over total standard (or estimated) indirect production costs.
(ii) Treatment of variances. (a) The proper use of the standard cost
method pursuant to this subparagraph requires that a taxpayer must
reallocate to the goods in ending inventory a pro rata portion of any
net negative or net positive overhead variances and any net negative or
net positive direct production cost variances. The taxpayer must
apportion such variances among his various items in ending inventory.
However, if such variances are not significant in amount in relation to
the taxpayer's total actual indirect production costs for the year then
such variances need not be allocated to the taxpayer's goods in ending
inventory unless such allocation is made in the taxpayer's financial
reports. The taxpayer must treat both positive and negative variances
consistently.
(b) Notwithstanding subdivision (a), the practical capacity concept
may be used to determine the total amount of fixed indirect production
costs which must be allocated to goods in ending inventory. See
subparagraph (4) of this paragraph.
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(4) Practical capacity concept--(i) In general. Under the practical
capacity concept, the percentage of practical capacity represented by
actual production (not greater than 100 percent), as calculated under
subdivision (ii) of this subparagraph, is used to determine the total
amount of fixed indirect production costs which must be included in the
taxpayer's computation of the amount of inventoriable costs. The portion
of such costs to be included in the taxpayer's computation of the amount
of inventoriable costs is then combined with variable indirect
production costs and both are allocated to the goods in ending inventory
in accordance with this paragraph. See the example in subdivision
(ii)(d) of this subparagraph. The difference (if any) between the amount
of all fixed indirect production costs and the fixed indirect production
costs which are included in the computation of the amount of
inventoriable costs under the practical capacity concept is allowable as
a deduction for the taxable year in which such difference occurs.
(ii) Calculation of practical capacity--(a) In general. Practical
capacity and theoretical capacity (as described in (c) of this
subdivision) may be computed in terms of tons, pounds, yards, labor
hours, machine hours, or any other unit of production appropriate to the
cost accounting system used by a particular taxpayer. The determination
of practical capacity and theoretical capacity should be modified from
time to time to reflect a change in underlying facts and conditions such
as increased output due to automation or other changes in plant
operation. Such a change does not constitute a change in method of
accounting under sections 446 and 481.
(b) Based upon taxpayer's experience. In selecting an appropriate
level of production activity upon which to base the calculation of
practical capacity, the taxpayer shall establish the production
operating conditions expected during the period for which the costs are
being determined, assuming that the utilization of production facilities
during operations will be approximately at capacity. This level of
production activity is frequently described as practical capacity for
the period and is ordinarily based upon the historical experience of the
taxpayer. For example, a taxpayer operating on a 5-day, 8-hour basis may
have a ``normal'' production of 100,000 units a year based upon three
years of experience.
(c) Based upon theoretical capacity. Practical capacity may also be
established by the use of ``theoretical'' capacity, adjusted for
allowances for estimated inability to achieve maximum production, such
as machine breakdown, idle time, and other normal work stoppages.
Theoretical capacity is the level of production the manufacturer could
reach if all machines and departments were operated continously at peak
efficiency.
(d) Example. The provisions of (c) of this subdivision may be
illustrated by the following example:
Corporation X operates a stamping plant with a theoretical capacity
of 50 u nits per hour. The plant actually operates 1960 hours per year
based on an 8-hour day, 5 day week basis and 15 shutdown days for
vacations and holidays. A reasonable allowance for down time (the time
allowed for ordinary and necessary repairs and maintenance) is 5 percent
of practical capacity before reduction for down time. Assuming no loss
of production during starting up, closing down, or employee work breaks,
under these facts and circumstances X may properly make a practical
capacity computation as follows:
Practical capacity without allowance for down time based on 98,000
theoretical capacity per hour is (1960 x 50)..................
Reduction for down time (98,000 x 5 percent)................... 4,900
Practical capacity............................................. 93,100
The 93,100 unit level of activity (i.e., practical capacity) would,
therefore, constitute an appropriate base for calculating the amount of
fixed indirect production costs to be included in the computation of the
amount of inventoriable costs for the period under review. On this basis
if only 76,000 units were produced for the period, the effect would be
that approximately 81.6 percent (76,000, the actual number of units
produced, divided by 93,100, the maximum number of units producible at
practical capacity) of the fixed indirect production costs would be
included in the computation of the amount of inventoriable costs during
the year. The portion of the fixed indirect production costs not so
included in the computation of the amount of inventoriable costs would
be deductible in the year in which paid or incurred. Assume further that
7,600 units were on hand at the end of the taxable year and the 7,600
units were in the same proportion to the total units produced. Thus, 10
percent
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(7,600 units in inventory at the end of the taxable year, divided by
76,000, the actual number of units produced) of the fixed indirect
production costs included in the computation of the amount of
inventoriable costs (the above-mentioned 81.6 percent) and 10 percent of
the variable indirect production costs would be included in the cost of
the goods in the ending inventory, in accordance with a method of
allocation provided by this paragraph.
(e) Transition to full absorption method of inventory costing--(1)
In general--(i) Mandatory requirement. A taxpayer not using the full
absorption method of inventory costing, as prescribed by paragraph (a)
of this section, must change to that method. Any change to the full
absorption method must be made by the taxpayer with respect to all
trades or businesses of the taxpayer to which this section applies. A
taxpayer not using the full absorption method of inventory costing, as
prescribed by paragraph (a) of this section, who makes the special
election provided in subdivision (ii) of this subparagraph during the
transition period described in subdivision (ii) of this subparagraph
need not change to the full absorption method of inventory costing for
taxable years prior to the year for which such election is made. In
determining whether the taxpayer is changing to a more or less inclusive
method of inventory costing, all positive and negative adjustments for
all items and all trades or businesses of the taxpayer shall be
aggregated. If the net adjustment is positive, paragraph (e)(3) shall
apply, and if the net adjustment is negative, paragraph (e)(4) shall
apply to the change. The rules otherwise prescribed in sections 446 and
481 and the regulations thereunder shall apply to any taxpayer who fails
to make the special election in subdivision (ii) of this subparagraph.
The transition rules of this paragraph are available only to those
taxpayers who change their method of inventory costing.
(ii) Special election during two-year-transition period. If a
taxpayer elects to change to the full absorption method of inventory
costing during the transition period provided herein, he may elect on
Form 3115 to change to such full absorption method of inventory costing
and, in so doing, employ the transition procedures and adopt any of the
transition methods prescribed in subparagraph (3) of this paragraph.
Such election shall be made during the first 180 days of any taxable
year beginning on or after September 19, 1973 and before September 19,
1975 (i.e., the ``transition period'') and the change in inventory
costing method shall be made for the taxable year in which the election
is made. Notwithstanding the preceding sentence if the taxpayer's prior
returns have been examined by the Service prior to Sept. 19, 1973, and
there is a pending issue involving the taxpayer's method of inventory
costing, the taxpayer may request the application of this regulation by
agreeing and filing a letter to that effect with the district director,
within 90 days after September 19, 1973 to change to the full absorption
method for the first taxable year of the taxpayer beginning after Sept.
19, 1973 and subsequently filing Form 3115 within the first 180 days of
such taxable year of change.
(iii) Change initiated by the Commissioner. A taxpayer who properly
makes an election under subdivision (ii) of this subparagraph shall be
considered to have made a change in method of accounting not initiated
by the taxpayer, notwithstanding the provisions of Sec. 1.481-1(c)(5).
Thus, any of the taxpayer's ``pre-1954 inventory balances'' with respect
to such inventory shall not be taken into account as an adjustment under
section 481. For purposes of this paragraph, a ``pre-1954 inventory
balance'' is the net amount of the adjustments which would have been
required if the taxpayer had made such change in his method of
accounting with respect to his inventory in his first taxable year which
began after December 31, 1953, and ended after August 16, 1954. See
section 481(a)(2) and Sec. 1.481-3.
(2) Procedural rules for change. If a taxpayer makes an election
pursuant to subparagraph (1)(ii) of this paragraph, the Commissioner's
consent will be evidenced by a letter of consent to the taxpayer,
setting forth the values of inventory, as provided by the taxpayer,
determined under the full absorption method of inventory costing, except
to the extent that no determination of such values is necessary under
subparagraph (3)(ii)(B) of this
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paragraph (the cut off method), the amount of the adjustments (if any)
required to be taken into account by section 481, and the treatment to
be accorded to any such adjustments. Such full absorption values shall
be subject to verification on examination by the district director. The
taxpayer shall preserve at his principal place of business all records,
data, and other evidence relating to the full absorption values of
inventory.
(3) Transition methods. In the case of a taxpayer who properly makes
an election under subparagraph (1)(ii) of this paragraph during the
transition period--
(i) 10-year adjustment period. Such taxpayer may elect to take any
adjustment required by section 481 with respect to any inventory being
revalued under the full absorption method into account ratably over a
period designated by the taxpayer at the time of such election, not to
exceed the lesser of 10 taxable years commencing with the year of
transition or the number of years the taxpayer has been on the inventory
method from which he is changing. If the taxpayer dies or ceases to
exist in a transaction other than one to which section 381(a) of the
Code applies or if the taxpayer's inventory (determined under the full
absorption method) on the last day of any taxable year is reduced (by
other than a strike or involuntary conversion) by more than an amount
equal to 33\1/3\ percent of the taxpayer's inventory (determined under
the full absorption method) as of the beginning of the year of change,
the entire amount of the section 481 adjustment not previously taken
into account in computing income shall be taken into account in
computing income for the taxable year in which such taxpayer so ceases
to exist or such taxpayer's inventory is so reduced.
(ii) Additional rules for LIFO taxpayers. A taxpayer who uses the
LIFO method of inventory identification may either--
(a) Employ the special transition rules described in subdivision (i)
of this subparagraph. Accordingly, all LIFO layers must be revalued
under the full absorption method and the section 481 adjustment must be
computed for all items in all layers in inventory, but no pre-1954
inventory balances shall be taken into account as adjustments under
section 481; or
(b)(1) Employ a cut-off method whereby the full absorption method is
only applied in costing layers of inventory acquired during all taxable
years beginning with the year for which an election is made under
subparagraph (e)(1)(ii).
(2) In the case of a taxpayer using dollar value LIFO, employ a cut-
off method whereby the taxpayer must use, for the year of change, the
full absorption method in computing the base year cost and current cost
of a dollar value inventory pool for the beginning of such year. The
taxpayer shall not be required to recompute his LIFO inventories based
on the full absorption method for a taxable year beginning prior to the
year of change to the full absorption method. The base cost and layers
of increment previously computed shall be retained and treated as if
such base cost and layers of increment had been computed under the
method authorized by this section. The taxpayer shall use the year of
change as the base year in applying the double extension method or other
method approved by the Commissioner, instead of the earliest year for
which he adopted the LIFO method for any items in the pool.
(4) Transition to full absorption method of inventory costing from a
method more inclusive of indirect production costs--(i) Taxpayer has not
previously changed to his present method pursuant to subparagraphs (1),
(2), and (3) of this paragraph. If a taxpayer wishes to change to the
full absorption method of inventory costing (as prescribed by paragraph
(a) of this section) from a method of inventory costing which is more
inclusive of indirect production costs and he has not previously changed
to his present method by use of the special transition rules provided by
subparagraphs (1), (2) and (3) of this paragraph, he may elect on Form
3115 to change to the full absorption method of inventory costing and,
in so doing, take into account any resulting section 481 adjustment
generally over 10 taxable years commencing with the year
[[Page 527]]
of transition. The Commissioner's consent to such election will be
evidenced by a letter of consent to the taxpayer setting forth the
values of inventory, as provided by the taxpayer determined under the
full absorption method of inventory costing, except to the extent that
no determination of such values is necessary under subparagraph
(3)(ii)(b) of this paragraph, the amount of the adjustments (if any)
required to be taken into account by section 481, and the treatment to
be accorded such adjustments, subject to terms and conditions specified
by the Commissioner to prevent distortions of income. Such election must
be made within the transition period described in subparagraph (1)(ii)
of this paragraph. A change pursuant to this subparagraph shall be a
change initiated by the taxpayer as provided by Sec. 1.481-1(c)(5).
Thus, any of the taxpayers ``pre-1954 inventory balances'' will be taken
into account as an adjustment under section 481.
(ii) Taxpayer has previously changed to his present method pursuant
to subparagraph (1), (2), and (3) of this paragraph or would satisfy all
the requirements of subdivision (i) of this subparagraph but fails to
elect within the transition period. If a taxpayer wishes to change to
the full absorption method of inventory costing (as prescribed by
paragraph (a) of this section) from a method of inventory costing which
is more inclusive of indirect production costs and he has previously
changed to his present method pursuant to subparagraphs (1), (2), and
(3) of this paragraph or he would satisfy the requirements of
subdivision (i) of this subparagraph but he fails to elect within the
transition period, he must secure the consent of the Commissioner prior
to making such change.
[T.D. 7285, 38 FR 26185, Sept. 19, 1973, as amended by T.D. 8067, 51 FR
393, Jan. 6, 1986; T.D. 8131, 52 FR 10084, Mar. 30, 1987; T.D. 8482, 58
FR 42234, Aug. 9, 1993]
Sec. 1.472-1 Last-in, first-out inventories.
(a) Any taxpayer permitted or required to take inventories pursuant
to the provisions of section 471, and pursuant to the provisions of
Sec. Sec. 1.471-1 to 1.471-9, inclusive, may elect with respect to
those goods specified in his application and properly subject to
inventory to compute his opening and closing inventories in accordance
with the method provided by section 472, this section, and Sec. 1.472-
2. Under this last-in, first-out (LIFO) inventory method, the taxpayer
is permitted to treat those goods remaining on hand at the close of the
taxable year as being:
(1) Those included in the opening inventory of the taxable year, in
the order of acquisition and to the extent thereof, and
(2) Those acquired during the taxable year.
The LIFO inventory method is not dependent upon the character of the
business in which the taxpayer is engaged, or upon the identity or want
of identity through commingling of any of the goods on hand, and may be
adopted by the taxpayer as of the close of any taxable year.
(b) If the LIFO inventory method is used by a taxpayer who regularly
and consistently, in a manner similar to hedging on a futures market,
matches purchases with sales, then firm purchases and sales contracts
(i.e., those not legally subject to cancellation by either party)
entered into at fixed prices on or before the date of the inventory may
be included in purchases or sales, as the case may be, for the purpose
of determining the cost of goods sold and the resulting profit or loss,
provided that this practice is regularly and consistently adhered to by
the taxpayer and provided that, in the opinion of the Commissioner,
income is clearly reflected thereby.
(c) A manufacturer or processor who has adopted the LIFO inventory
method as to a class of goods may elect to have such method apply to the
raw materials only (including those included in goods in process and in
finished goods) expressed in terms of appropriate units. If such method
is adopted, the adjustments are confined to costs of the raw material in
the inventory and the cost of the raw material in goods in process and
in finished goods produced by such manufacturer or processor and
reflected in the inventory. The provisions of this paragraph may be
illustrated by the following examples:
Example 1. Assume that the opening inventory had 10 units of raw
material, 10 units of goods in process, and 10 units of finished
[[Page 528]]
goods, and that the raw material cost was 6 cents a unit, the processing
cost 2 cents a unit, and overhead cost 1 cent a unit. For the purposes
of this example, it is assumed that the entire amount of goods in
process was 50 percent processed.
Opening Inventory
------------------------------------------------------------------------
Goods
Raw in Finished
material process goods
------------------------------------------------------------------------
Raw material $0.60 $0.60 $0.60
Processing cost ........ .10 .20
Overhead ........ .05 .10
------------------------------------------------------------------------
In the closing inventory there are 20 units of raw material, 6 units of
goods in process, and 8 units of finished goods and the costs were: Raw
material 10 cents, processing cost 4 cents, and overhead 1 cent.
Closing Inventory
[Based on cost and prior to adjustment]
------------------------------------------------------------------------
Goods
Raw in Finished
material process goods
------------------------------------------------------------------------
Raw material $2.00 $0.60 $0.80
Processing costs ........ .12 .32
Overhead ........ .03 .08
----------------------------
Total 2.00 .75 1.20
------------------------------------------------------------------------
There were 30 units of raw material in the opening inventory and 34
units in the closing inventory. The adjustment to the closing inventory
would be as follows:
Closing Inventory as Adjusted
------------------------------------------------------------------------
Goods
Raw in Finished
material process goods
------------------------------------------------------------------------
Raw material:
20 at 6 cents $1.20 ....... ........
6 at 6 cents ........ $0.36 ........
4 at 6 cents ........ ....... $0.24
4 at 10 cents \1\ ........ ....... .40
Processing costs ........ .12 .32
Overhead ........ .03 .08
----------------------------
Total 1.20 .51 1.04
------------------------------------------------------------------------
\1\ This excess is subject to determination of price under section
472(b)(1) and Sec. 1.472-2. If the excess falls in goods in process,
the same adjustment is applicable.
The only adjustment to the closing inventory is the cost of the raw
material; the processing costs and overhead cost are not changed.
Example 2. Assume that the opening inventory had 5 units of raw
material, 10 units of goods in process, and 20 units of finished goods,
with the same prices as in Example 1, and that the closing inventory had
20 units of raw material, 20 units of goods in process, and 10 units of
finished goods, with raw material costs as in the closing inventory in
Example 1. The adjusted closing inventory would be as follows in so far
as the raw material is concerned:
Raw material, 20 at 6 cents.................................... $1.20
Goods in process:
15 at 6 cents................................................ .90
5 at 10 cents \1\............................................ .50
Finished goods:
None at 6 cents.............................................. 0.00
10 at 10 cents \1\........................................... 1.00
\1\ This excess is subject to determination of price under section
472(b)(1) and Sec. 1.472-2.
The 20 units of raw material in the raw state plus 15 units of raw
material in goods in process make up the 35 units of raw material that
were contained in the opening inventory.
(d) For the purposes of this section, raw material in the opening
inventory must be compared with similar raw material in the closing
inventory. There may be several types of raw materials, depending upon
the character, quality, or price, and each type of raw material in the
opening inventory must be compared with a similar type in the closing
inventory.
(e) In the cotton textile industry there may be different raw
materials depending upon marked differences in length of staple, in
color or grade of the cotton. But where different staple lengths or
grades of cotton are being used at different times in the same mill to
produce the same class of goods, such differences would not necessarily
require the classification into different raw materials.
(f) As to the pork packing industry a live hog is considered as
being composed of various raw materials, different cuts of a hog varying
markedly in price and use. Generally a hog is processed into
approximately 10 primal cuts and several miscellaneous articles.
However, due to similarity in price and use, these may be grouped into
fewer classifications, each group being classed as one raw material.
(g) When the finished product contains two or more different raw
materials as in the case of cotton and rayon mixtures, each raw material
is treated separately and adjustments made accordingly.
(h) Upon written notice addressed to the Commissioner of Internal
Revenue, Attention T:R, Washington, D.C. 20224 by the taxpayer, a
taxpayer who has heretofore adopted the LIFO inventory method in respect
of any goods may adopt the method authorized in this
[[Page 529]]
section and limit the election to the raw material including raw
materials entering into goods in process and in finished goods. If this
method is adopted as to any specific goods, it must be used exclusively
for such goods for any prior taxable year (not closed by agreement) to
which the prior election applies and for all subsequent taxable years,
unless permission to change is granted by the Commissioner.
(i) The election may also be limited to that phase in the
manufacturing process where a product is produced that is recognized
generally as a salable product as, for example, in the textile industry
where one phase of the process is the production of yarn. Since yarn is
generally recognized as a salable product, the election may be limited
to that portion of the process when yarn is produced. In the case of
copper and brass processors, the election may be limited to the
production of bars, plates, sheets, etc., although these may be further
processed into other products.
(j) The election may also apply to any one raw material, when two or
more raw materials enter into the composition of the finished product;
for example, in the case of cotton and rayon yarn, the taxpayer may
elect to inventory the cotton only. However, a taxpayer who has
previously made an election to use the LIFO inventory method may not
later elect to exclude any raw materials that were covered by such
previous election.
(k) If a taxpayer using the retail method of pricing inventories,
authorized by Sec. 1.471-8, elects to use in connection therewith the
LIFO inventory method authorized by section 472 and this section, the
apparent cost of the goods on hand at the end of the year, determined
pursuant to Sec. 1.471-8, shall be adjusted to the extent of price
changes therein taking place after the close of the preceding taxable
year. The amount of any apparent inventory increase or decrease to be
eliminated in this adjustment shall be determined by reference to
acceptable price indexes established to the satisfaction of the
Commissioner. Price indexes prepared by the United States Bureau of
Labor Statistics which are applicable to the goods in question will be
considered acceptable to the Commissioner. Price indexes which are based
upon inadequate records, or which are not subject to complete and
detailed audit within the Internal Revenue Service, will not be
approved.
(l) If a taxpayer uses consistently the so-called ``dollar-value''
method of pricing inventories, or any other method of computation
established to the satisfaction of the Commissioner as reasonably
adaptable to the purpose and intent of section 472 and this section, and
if such taxpayer elects under section 472 to use the LIFO inventory
method authorized by such section, the taxpayer's opening and closing
inventories shall be determined under section 472 by the use of the
appropriate adaptation. See Sec. 1.472-8 for rules relating to the use
of the dollar-value method.
[T.D. 6500, 25 FR 11727, Nov. 26, 1960, as amended by T.D. 6539, 26 FR
518, Jan. 20, 1961]
Sec. 1.472-2 Requirements incident to adoption and use
of LIFO inventory method.
Except as otherwise provided in Sec. 1.472-1 with respect to raw
material computations, with respect to retail inventory computations,
and with respect to other methods of computation established to the
satisfaction of the Commissioner as reasonably adapted to the purpose
and intent of section 472, and in Sec. 1.472-8 with respect to the
``dollar-value'' method, the adoption and use of the LIFO inventory
method is subject to the following requirements:
(a) The taxpayer shall file an application to use such method
specifying with particularity the goods to which it is to be applied.
(b) The inventory shall be taken at cost regardless of market value.
(c) Goods of the specified type included in the opening inventory of
the taxable year for which the method is first used shall be considered
as having been acquired at the same time and at a unit cost equal to the
actual cost of the aggregate divided by the number of units on hand. The
actual cost of the aggregate shall be determined pursuant to the
inventory method employed by the taxpayer under the regulations
applicable to the prior taxable year with
[[Page 530]]
the exception that restoration shall be made with respect to any
writedown to market values resulting from the pricing of former
inventories.
(d) Goods of the specified type on hand as of the close of the
taxable year in excess of what were on hand as of the beginning of the
taxable year shall be included in the closing inventory, regardless of
identification with specific invoices and regardless of specific cost
accounting records, at costs determined pursuant to the provisions of
subparagraph (1) or (2) of this paragraph, dependent upon the character
of the transactions in which the taxpayer is engaged:
(1)(i) In the case of a taxpayer engaged in the purchase and sale of
merchandise, such as a retail grocer or druggist, or engaged in the
initial production of merchandise and its sale without processing, such
as a miner selling his ore output without smelting or refining, such
costs shall be determined--
(a) By reference to the actual cost of the goods most recently
purchased or produced;
(b) By reference to the actual cost of the goods purchased or
produced during the taxable year in the order of acquisition;
(c) By application of an average unit cost equal to the aggregate
cost of all of the goods purchased or produced throughout the taxable
year divided by the total number of units so purchased or produced, the
goods reflected in such inventory increase being considered for the
purposes of section 472 as having been acquired all at the same time; or
(d) Pursuant to any other proper method which, in the opinion of the
Commissioner, clearly reflects income.
(ii) Whichever of the several methods of valuing the inventory
increase is adopted by the taxpayer and approved by the Commissioner
shall be consistently adhered to in all subsequent taxable years so long
as the LIFO inventory method is used by the taxpayer.
(iii) The application of subdivisions (i) and (ii) of this
subparagraph may be illustrated by the following examples:
Example 1. Suppose that the taxpayer adopts the LIFO inventory
method for the taxable year 1957 with an opening inventory of 10 units
at 10 cents per unit, that it makes 1957 purchases of 10 units as
follows:
January................................... 1 at $0.11= $0.11
April..................................... 2 at .12= .24
July...................................... 3 at .13= .39
October................................... 4 at .14= .56
---------- ---------
Totals................................. 10 ........ 1.30
and that it has a 1957 closing inventory of 15 units. This closing
inventory, depending upon the taxpayer's method of valuing inventory
increases, will be computed as follows:
(a) Most recent purchases--
10 at $0.10 $1.00
October...................................... 4 at .14 .56
July......................................... 1 at .13 .13
--------- --------
Totals..................................... 15 ....... 1.69
(b) In order of acquisitions--
10 at $0.10 $1.00
January...................................... 1 at .11 .11
April........................................ 2 at .12 .24
July......................................... 2 at .13 .26
--------- --------
Totals.................................... 15 ....... 1.61
or
(c) At an annual average--
10 at $0.10 $1.00
(130/10)..................................... 5 at .13 .65
--------- --------
Totals.................................... 15 ....... 1.65
Example 2. Suppose that the taxpayer's closing inventory for 1958,
the year following that involved in Example 1 of this subdivision,
reflects an inventory decrease for the year, and not an increase;
suppose that there is, accordingly, a 1958 closing inventory of 13
units. Inasmuch as the decreased closing inventory will be determined
wholly by reference to the 15 units reflected in the opening inventory
for the year, and will be taken ``in the order of acquisition'' pursuant
to section 472 (b) (1), and inasmuch as the character of the taxpayer's
opening inventory for 1958 will be dependent upon its method of valuing
its 5-unit inventory increase for 1957, the closing inventory for 1958
will be computed as follows:
(a) In case the increase for 1957 was taken by reference to the most
recent purchases--
From 1956.................................... 10 at $0.10 $1.00
July 1957.................................... 1 at .13 .13
October 1957................................. 2 at .14 .28
--------- --------
Totals................................... 13 ....... 1.41
or
(b) In case the increase for 1957 was taken in the order of
acquisition--
From 1956.................................... 10 at $0.10 $1.00
January 1957................................. 51 at .11 .11
April 1957................................... 2 at .12 .24
--------- --------
Totals................................... 13 ....... 1.35
or
[[Page 531]]
(c) In case the increase for 1957 was taken on the basis of an
average--
From 1956.................................... 10 at $0.10 $1.00
From 1957.................................... 3 at .13 .39
--------- --------
Totals................................... 13 ....... 1.39
(2) In the case of a taxpayer engaged in manufacturing, fabricating,
processing, or otherwise producing merchandise, such costs shall be
determined:
(i) In the case of raw materials purchased or initially produced by
the taxpayer, in the manner elected by the taxpayer under subparagraph
(1) of this paragraph to the same extent as if the taxpayer were engaged
in purchase and sale transactions; and
(ii) In the case of goods in process, regardless of the stage to
which the manufacture, fabricating, or processing may have advanced, and
in the case of finished goods, pursuant to any proper method which, in
the opinion of the Commissioner, clearly reflects income.
(e) LIFO conformity requirement--(1) In general. The taxpayer must
establish to the satisfaction of the Commissioner that the taxpayer, in
ascertaining the income, profit, or loss for the taxable year for which
the LIFO inventory method is first used, or for any subsequent taxable
year, for credit purposes or for purposes of reports to shareholders,
partners, or other proprietors, or to beneficiaries, has not used any
inventory method other than that referred to in Sec. 1.472-1 or at
variance with the requirement referred to in Sec. 1.472-2(c). See
paragraph (e)(2) of this section for rules relating to the meaning of
the term ``taxable year'' as used in this paragraph. The following are
not considered at variance with the requirement of this paragraph:
(i) The taxpayer's use of an inventory method other than LIFO for
purposes of ascertaining information reported as a supplement to or
explanation of the taxpayer's primary presentation of the taxpayer's
income, profit, or loss for a taxable year in credit statements or
financial reports (including preliminary and unaudited financial
reports). See paragraph (e)(3) of this section for rules relating to the
reporting of supplemental and explanatory information ascertained by the
use of an inventory method other than LIFO.
(ii) The taxpayer's use of an inventory method other than LIFO to
ascertain the value of the taxpayer's inventory of goods on hand for
purposes of reporting the value of such inventories as assets. See
paragraph (e)(4) of this section for rules relating to such disclosures.
(iii) The taxpayer's use of an inventory method other than LIFO for
purposes of ascertaining information reported in internal management
reports. See paragraph (e)(5) of this section for rules relating to such
reports.
(iv) The taxpayer's use of an inventory method other than LIFO for
purposes of issuing reports or credit statements covering a period of
operations that is less than the whole of a taxable year for which the
LIFO method is used for Federal income tax purposes. See paragraph
(e)(6) of this section for rules relating to series of interim reports.
(v) The taxpayer's use of the lower of LIFO cost or market method to
value LIFO inventories for purposes of financial reports and credit
statements. However, except as provided in paragraph (e)(7) of this
section, a taxpayer may not use market value in lieu of cost to value
inventories for purposes of financial reports or credit statements.
(vi) The taxpayer's use of a costing method or accounting method to
ascertain income, profit, or loss for credit purposes or for purposes of
financial reports if such costing method or accounting method is neither
inconsistent with the inventory method referred to in Sec. 1.472-1 nor
at variance with the requirement referred to in Sec. 1.472-2(c),
regardless of whether such costing method or accounting method is used
by the taxpayer for Federal income tax purposes. See paragraph (e)(8) of
this section for examples of such costing methods and accounting
methods.
(vii) For credit purposes or for purposes of financial reports, the
taxpayer's treatment of inventories, after such inventories have been
acquired in a transaction to which section 351 applies from a transferor
that used the LIFO method with respect to such inventories, as if such
inventories had
[[Page 532]]
the same acquisition dates and costs as in the hands of the transferor.
(viii) For credit purposes or for purposes of financial reports
relating to a taxable year, the taxpayer's determination of income,
profit, or loss for the taxable year by valuing inventories in
accordance with the procedures described in section 472(b) (1) and (3),
notwithstanding that such valuation differs from the valuation of
inventories for Federal income tax purposes because the taxpayer
either--
(A) Adopted such procedures for credit or financial reporting
purposes beginning with an accounting period other than the taxable year
for which the LIFO method was first used by the taxpayer for Federal
income tax purposes, or
(B) With respect to such inventories treated a business combination
for credit or financial reporting purposes in a manner different from
the treatment of the business combination for Federal income tax
purposes.
(2) One-year periods other than a taxable year. The rules of this
paragraph relating to the determination of income, profit, or loss for a
taxable year and credit statements or financial reports that cover a
taxable year also apply to the determination of income, profit, or loss
for a one-year period other than a taxable year and credit statements or
financial reports that cover a one-year period other than a taxable
year, but only if the one-year period both begins and ends in a taxable
year or years for which the taxpayer uses the LIFO method for Federal
income tax purposes. For example, the requirements of paragraph (e)(1)
of this section apply to a taxpayer's determination of income for
purposes of a credit statement that covers a 52-week fiscal year
beginning and ending in a taxable year for which the taxpayer uses the
LIFO method for Federal income tax purposes. Similarly, in the case of a
calendar year taxpayer, the requirements of paragraph (e)(1) of this
section apply to the taxpayer's determination of income for purposes of
a credit statement that covers the period October 1, 1981, through
September 30, 1982, if the taxpayer uses the LIFO method for Federal
income tax purposes in taxable years 1981 and 1982. However, the
Commissioner will waive any violation of the requirements of this
paragraph in the case of a credit statement or financial report that
covers a one-year period other than a taxable year if the report was
issued before January 22, 1981.
(3) Supplemental and explanatory information--(i) Face of the income
statement. Information reported on the face of a taxpayer's financial
income statement for a taxable year is not considered a supplement to or
explanation of the taxpayer's primary presentation of the taxpayer's
income, profit, or loss for the taxable year in credit statements or
financial reports. For purposes of paragraph (e)(3) of this section, the
face of an income statement does not include notes to the income
statement presented on the same page as the income statement, but only
if all notes to the financial income statement are presented together.
(ii) Notes to the income statement. Information reported in notes to
a taxpayer's financial income statement is considered a supplement to or
explanation of the taxpayer's primary presentation of income, profit, or
loss for the period covered by the income statement if all notes to the
financial income statement are presented together and if they accompany
the income statement in a single report. If notes to an income statement
are issued in a report that does not include the income statement, the
question of whether the information reported therein is supplemental or
explanatory is determined under the rules in paragraph (e)(3)(iv) of
this section.
(iii) Appendices and supplements to the income statement.
Information reported in an appendix or supplement to a taxpayer's
financial income statement is considered a supplement to or explanation
of the taxpayer's primary presentation of income, profit, or loss for
the period covered by the income statement if the appendix or supplement
accompanies the income statement in a single report and the information
reported in the appendix or supplement is clearly identified as a
supplement to or explanation of the taxpayer's primary presentation of
income, profit, or loss
[[Page 533]]
as reported on the face of the taxpayer's income statement. If an
appendix or supplement to an income statement is issued in a report that
does not include the income statement, the question of whether the
information reported therein is supplemental or explanatory is
determined under the rules in paragraph (e)(3)(iv) of this section. For
purposes of paragraph (e)(3)(iii) of this section, an appendix or
supplement to an income statement includes written statements,
schedules, and reports that are labelled supplements or appendices to
the income statement. However, sections of an annual report such as
those labelled ``President's Letter'', ``Management's Analysis'',
``Statement of Changes in Financial Position'', ``Summary of Key
Figures'', and similar sections are reports described in paragraph
(e)(3)(iv) of this section and are not considered ``supplements or
appendices to an income statement'' within the meaning of paragraph
(e)(3)(iii) of this section, regardless of whether such sections are
also labelled as supplements or appendices. For purposes of paragraph
(e)(3)(iii) of this section, information is considered to be clearly
identified as a supplement to or explanation of the taxpayer's primary
presentation of income, profit, or loss as reported on the face of the
taxpayer's income statement if the information either--
(A) Is reported in an appendix or supplement that contains a general
statement identifying all such supplemental or explanatory information;
(B) Is identified specifically as supplemental or explanatory by a
statement immediately preceding or following the disclosure of the
information;
(C) Is disclosed in the context of making a comparison to
corresponding information disclosed both on the face of the taxpayer's
income statement and in the supplement or appendix; or
(D) Is a disclosure of the effect on an item reported on the face of
the taxpayer's income statement of having used the LIFO method.
For example, a restatement of cost of goods sold based on an inventory
method other than LIFO is considered to be clearly identified as
supplemental or explanatory information if the supplement or appendix
containing the restatement contains a general statement that all
information based on such inventory method is reported in the appendix
or supplement as a supplement to or explanation of the taxpayer's
primary presentation of income, profit, or loss as reported on the face
of the taxpayer's income statement.
(iv) Other reports; in general. The rules of paragraph (e)(3) (iv),
(v), and (vi) of this section apply to the following types of reports:
news releases; letters to shareholders, partners, or other proprietors
or beneficiaries; oral statements at press conferences, shareholders'
meetings or securities analysts' meetings; sections of an annual report
such as those labelled ``President's Letter'', ``Management's
Analysis'', ``Statement of Changes in Financial Position'', ``Summary of
Key Figures'', and similar sections; and reports other than a taxpayer's
income statement or accompanying notes, appendices, or supplements.
Information disclosed in such a report is considered a supplement to or
explanation of the taxpayer's primary presentation of income, profit, or
loss for the period covered by an income statement if the supplemental
or explanatory information is clearly identified as a supplement to or
explanation of the taxpayer's primary presentation of income, profit, or
loss as reported on the face of the taxpayer's income statement and the
specific item of information being explained or supplemented, such as
the cost of goods sold, net income, or earnings per share ascertained
using the LIFO method, is also reported in the other report.
(v) Other reports; disclosure of non-LIFO income. For purposes of
paragraph (e)(3)(iv) of this section, supplemental or explanatory
information is considered to have been clearly identified as such if it
would be considered to have been clearly identified as such under the
rules of paragraph (e)(3)(iii) of this section, relating to information
reported in supplements or appendices to an income statement. For
example, if at a securities analysts' meeting the following question is
asked, ``What would the reported earnings per share for the year have
been if the FIFO
[[Page 534]]
method had been used to value inventories?'', it would be permissible to
respond ``Reported earnings per share for the year were $6.00. If the
company had used the FIFO method to value inventories this year and had
computed earnings based upon the following assumptions, earnings per
share would have been $8.20. FIFO earnings are based on the following
assumptions:
``(A) The use of the same effective tax rate as used in computing
LIFO earnings, and
``(B) All other conditions and assumptions remain the same,
including--
``(1) The use of the LIFO method for Federal income tax purposes and
``(2) The investment of the tax savings resulting from such use of
the LIFO method, the income from which is included in both LIFO and FIFO
``earnings.'' ''
(vi) Other reports; disclosure of effect on income. For purposes of
paragraph (e)(3)(iv) of this section, if the only supplement to or
explanation of a specific item is the effect on the item of having used
LIFO instead of a method other than LIFO to value inventories, it is not
necessary to also report the specific item. For example, if at a
shareholders' meeting the question is asked, ``What was the effect on
reported earnings per share of not having used FIFO to value
inventories?'', it would be permissible to respond ``If earnings would
have been computed on the basis of the following assumptions, the use of
LIFO instead of FIFO to value inventories would have decreased reported
earnings per share by $2.20. FIFO earnings are based on the following
assumptions:
``(A) The use of the same effective tax rate as used in computing
LIFO earnings, and
``(B) All other conditions and assumptions remain the same,
including--
``(1) The use of the LIFO method for Federal income tax purposes and
``(2) The investment of the tax savings resulting from such use of
the LIFO method, the income from which is included in both LIFO and FIFO
earnings.''
(4) Inventory asset value disclosures. Under paragraph (e)(1)(ii) of
this section, the use of an inventory method other than LIFO to
ascertain the value of the taxpayer's inventories for purposes of
reporting the value of the inventories as assets is not considered the
ascertainment of income, profit, or loss and therefore is not considered
at variance with the requirement of paragraph (e)(1) of this section.
Therefore, a taxpayer may disclose the value of inventories on a balance
sheet using a method other than LIFO to identify the inventories, and
such a disclosure will not be considered at variance with the
requirement of paragraph (e)(1) of this section. However, the disclosure
of income, profit, or loss for a taxable year on a balance sheet issued
to creditors, shareholders, partners, other proprietors, or
beneficiaries is considered at variance with the requirement of
paragraph (e)(1) of this section if such income information is
ascertained using an inventory method other than LIFO and such income
information is for a taxable year for which the LIFO method is used for
Federal income tax purposes. Therefore, a balance sheet that discloses
the net worth of a taxpayer, determined as if income had been
ascertained using an inventory method other than LIFO, may be at
variance with the requirement of paragraph (e)(1) of this section if the
disclosure of net worth is made in a manner that also discloses income,
profit, or loss for a taxable year.
However, a disclosure of income, profit, or loss using an inventory
method other than LIFO is not considered at variance with the
requirement of paragraph (e)(1) of this section if the disclosure is
made in the form of either a footnote to the balance sheet or a
parenthetical disclosure on the face of the balance sheet. In addition,
an income disclosure is not considered at variance with the requirement
of paragraph (e)(1) of this section if the disclosure is made on the
face of a supplemental balance sheet labelled as a supplement to the
taxpayer's primary presentation of financial position, but only if,
consistent with the rules of paragraph (e)(3) of this section, such a
disclosure is clearly identified as a supplement to or explanation of
the taxpayer's primary presentation of financial income
[[Page 535]]
as reported on the face of the taxpayer's income statement.
(5) Internal management reports. [Reserved]
(6) Series of interim reports. For purposes of paragraph (e)(1)(iv)
of this section, a series of credit statements or financial reports is
considered a single statement or report covering a period of operations
if the statements or reports in the series are prepared using a single
inventory method and can be combined to disclose the income, profit, or
loss for the period. However, the Commissioner will waive any violation
of the requirement of this paragraph in the case of a series of interim
reports issued before February 6, 1978, that cover a taxable year, or a
series of interim reports issued before January 22, 1981 that cover a
one-year period other than a taxable year.
(7) Market value. The Commissioner will waive any violation of the
requirement of this paragraph in the case of a taxpayer's use of market
value in lieu of cost for a credit statement or financial report issued
before January 22, 1981. However, the special rule of this (7) applies
only to a taxpayer's use of market value in lieu of cost and does not
apply to the use of a method of valuation such as market value in lieu
of cost but not more than FIFO cost.
(8) Use of different methods. The following are examples of costing
methods and accounting methods that are neither inconsistent with the
inventory method referred to in Sec. 1.472-1 nor at variance with the
requirement of Sec. 1.472-2(c) and which, under paragraph (e)(1)(vi) of
this section, may be used to ascertain income, profit, or loss for
credit purposes or for purposes of financial reports regardless of
whether such method is also used by the taxpayer for Federal income tax
purposes:
(i) Any method relating to the determination of which costs are
includible in the computation of the cost of inventory under the full
absorption inventory method.
(ii) Any method of establishing pools for inventory under the
dollar-value LIFO inventory method.
(iii) Any method of determining the LIFO value of a dollar-value
inventory pool, such as the double-extension method, the index method,
and the link chain method.
(iv) Any method of determining or selecting a price index to be used
with the index or link chain method of valuing inventory pools under the
dollar-value LIFO inventory method.
(v) Any method permitted under Sec. 1.472-8 for determining the
current-year cost of closing inventory for purposes of using the dollar-
value LIFO inventory method.
(vi) Any method permitted under Sec. 1.472-2(d) for determining the
cost of goods in excess of goods on hand at the beginning of the year
for purposes of using a LIFO method other than the dollar-value LIFO
method.
(vii) Any method relating to the classification of an item as
inventory or a capital asset.
(viii) The use of an accounting period other than the period used
for Federal income tax purposes.
(ix) The use of cost estimates.
(x) The use of actual cost of cut timber or the cost determined
under section 631(a).
(xi) The use of inventory costs unreduced by any adjustment required
by the application of section 108 and section 1017, relating to
discharge of indebtedness.
(xii) The determination of the time when sales or purchases are
accrued.
(xiii) The use of a method to allocate basis in the case of a
business combination other than the method used for Federal income tax
purposes.
(xiv) The treatment of transfers of inventory between affiliated
corporations in a manner different from that required by Sec. 1.1502-
13.
(9) Reconciliation of LIFO inventory values. A taxpayer may be
required to reconcile differences between the value of inventories
maintained for credit or financial reporting purposes and for Federal
income tax purposes in order to show that the taxpayer has satisfied the
requirements of this paragraph.
(f) Goods of the specified type on hand as of the close of the
taxable year preceding the taxable year for which this inventory method
is first used shall be included in the taxpayer's closing inventory for
such preceding taxable year at cost determined in the
[[Page 536]]
manner prescribed in paragraph (c) of this section.
(g) The LIFO inventory method, once adopted by the taxpayer with the
approval of the Commissioner, shall be adhered to in all subsequent
taxable years unless--
(1) A change to a different method is approved by the Commissioner;
or
(2) The Commissioner determines that the taxpayer, in ascertaining
income, profit, or loss for the whole of any taxable year subsequent to
his adoption of the LIFO inventory method, for credit purposes or for
the purpose of reports to shareholders, partners, or other proprietors,
or to beneficiaries, has used any inventory method at variance with that
referred to in Sec. 1.472-1 and requires of the taxpayer a change to a
different method for such subsequent taxable year or any taxable year
thereafter.
(h) The records and accounts employed by the taxpayer in keeping his
books shall be maintained in conformity with the inventory method
referred to in Sec. 1.472-1; and such supplemental and detailed
inventory records shall be maintained as will enable the district
director readily to verify the taxpayer's inventory computations as well
as his compliance with the requirements of section 472 and Sec. Sec.
1.472-1 through 1.472-7.
(i) Where the taxpayer is engaged in more than one trade or
business, the Commissioner may require that if the LIFO method of
valuing inventories is used with respect to goods in one trade or
business the same method shall also be used with respect to similar
goods in the other trades or businesses if, in the opinion of the
Commissioner, the use of such method with respect to such other goods is
essential to a clear reflection of income.
[T.D. 6500, 25 FR 11728, Nov. 26, 1960, as amended by T.D. 6539, 26 FR
518, Jan. 20, 1961; T.D. 7756, 46 FR 6920, Jan. 22, 1981; T.D. 7756, 46
FR 15685, Mar. 9, 1981]
Sec. 1.472-3 Time and manner of making election.
(a) The LIFO inventory method may be adopted and used only if the
taxpayer files with his income tax return for the taxable year as of the
close of which the method is first to be used a statement of his
election to use such inventory method. The statement shall be made on
Form 970 pursuant to the instructions printed with respect thereto and
to the requirements of this section, or in such other manner as may be
acceptable to the Commissioner. Such statement shall be accompanied by
an analysis of all inventories of the taxpayer as of the beginning and
as of the end of the taxable year for which the LIFO inventory method is
proposed first to be used, and also as of the beginning of the prior
taxable year. In the case of a manufacturer, this analysis shall show in
detail the manner in which costs are computed with respect to raw
materials, goods in process, and finished goods, segregating the
products (whether in process or finished goods) into natural groups on
the basis of either (1) similarity in factory processes through which
they pass, or (2) similarity of raw materials used, or (3) similarity in
style, shape, or use of finished products. Each group of products shall
be clearly described.
(b) The taxpayer shall submit for the consideration of the
Commissioner in connection with the taxpayer's adoption or use of the
LIFO inventory method such other detailed information with respect to
his business or accounting system as may be at any time requested by the
Commissioner.
(c) As a condition to the taxpayer's use of the LIFO inventory
method, the Commissioner may require that the method be used with
respect to goods other than those specified in the taxpayer's statement
of election if, in the opinion of the Commissioner, the use of such
method with respect to such other goods is essential to a clear
reflection of income.
(d) Whether or not the taxpayer's application for the adoption and
use of the LIFO inventory method should be approved, and whether or not
such method, once adopted, may be continued, and the propriety of all
computations incidental to the use of such method, will be determined by
the Commissioner in connection with the examination of the taxpayer's
income tax returns.
[T.D. 6500, 25 FR 11729, Nov. 26, 1960, as amended by T.D. 7295, 38 FR
34203, Dec. 12, 1973]
[[Page 537]]
Sec. 1.472-4 Adjustments to be made by taxpayer.
A taxpayer may not change to the LIFO method of taking inventories
unless, at the time he files his application for the adoption of such
method, he agrees to such adjustments incident to the change to or from
such method, or incident to the use of such method, in the inventories
of prior taxable years or otherwise, as the district director upon the
examination of the taxpayer's returns may deem necessary in order that
the true income of the taxpayer will be clearly reflected for the years
involved.
[T.D. 6500, 25 FR 11730, Nov. 26, 1960]
Sec. 1.472-5 Revocation of election.
An election made to adopt and use the LIFO inventory method is
irrevocable, and the method once adopted shall be used in all subsequent
taxable years, unless the use of another method is required by the
Commissioner, or authorized by him pursuant to a written application
therefor filed as provided in paragraph (e) of Sec. 1.446-1.
[T.D. 6500, 25 FR 11730, Nov. 26, 1960]
Sec. 1.472-6 Change from LIFO inventory method.
If the taxpayer is granted permission by the Commissioner to
discontinue the use of LIFO method of taking inventories, and thereafter
to use some other method, or if the taxpayer is required by the
Commissioner to discontinue the use of the LIFO method by reason of the
taxpayer's failure to conform to the requirements detailed in Sec.
1.472-2, the inventory of the specified goods for the first taxable year
affected by the change and for each taxable year thereafter shall be
taken--
(a) In conformity with the method used by the taxpayer under section
471 in inventorying goods not included in his LIFO inventory
computations; or
(b) If the LIFO inventory method was used by the taxpayer with
respect to all of his goods subject to inventory, then in conformity
with the inventory method used by the taxpayer prior to his adoption of
the LIFO inventory method; or
(c) If the taxpayer had not used inventories prior to his adoption
of the LIFO inventory method and had no goods currently subject to
inventory by a method other than the LIFO inventory method, then in
conformity with such inventory method as may be selected by the taxpayer
and approved by the Commissioner as resulting in a clear reflection of
income; or
(d) In any event, in conformity with any inventory method to which
the taxpayer may change pursuant to application approved by the
Commissioner.
[T.D. 6500, 25 FR 11730, Nov. 26, 1960]
Sec. 1.472-7 Inventories of acquiring corporations.
For additional rules in the case of certain corporate acquisitions
specified in section 381(a), see section 381(c)(5) and the regulations
thereunder.
[T.D. 6500, 25 FR 11730, Nov. 26, 1960]
Sec. 1.472-8 Dollar-value method of pricing LIFO inventories.
(a) Election to use dollar-value method. Any taxpayer may elect to
determine the cost of his LIFO inventories under the so-called ``dollar-
value'' LIFO method, provided such method is used consistently and
clearly reflects the income of the taxpayer in accordance with the rules
of this section. The dollar-value method of valuing LIFO inventories is
a method of determining cost by using ``base-year'' cost expressed in
terms of total dollars rather than the quantity and price of specific
goods as the unit of measurement. Under such method the goods contained
in the inventory are grouped into a pool or pools as described in
paragraphs (b) and (c) of this section. The term ``base-year cost'' is
the aggregate of the cost (determined as of the beginning of the taxable
year for which the LIFO method is first adopted, i.e., the base date) of
all items in a pool. The taxable year for which the LIFO method is first
adopted with respect to any item in the pool is the ``base year'' for
that pool, except as provided in paragraph (g)(3) of this section.
Liquidations and increments of items contained in the pool shall be
reflected only in terms of a net liquidation or increment for the pool
as a whole. Fluctuations may occur in
[[Page 538]]
quantities of various items within the pool, new items which properly
fall within the pool may be added, and old items may disappear from the
pool, all without necessarily effecting a change in the dollar value of
the pool as a whole. An increment in the LIFO inventory occurs when the
end of the year inventory for any pool expressed in terms of base-year
cost is in excess of the beginning of the year inventory for that pool
expressed in terms of base-year cost. In determining the inventory value
for a pool, the increment, if any, is adjusted for changing unit costs
or values by reference to a percentage, relative to base-year-cost,
determined for the pool as a whole. See paragraph (e) of this section.
See also paragraph (f) of this section for rules relating to the change
to the dollar-value LIFO method from another LIFO method.
(b) Principles for establishing pools of manufacturers and
processors--(1) Natural business unit pools. A pool shall consist of all
items entering into the entire inventory investment for a natural
business unit of a business enterprise, unless the taxpayer elects to
use the multiple pooling method provided in subparagraph (3) of this
paragraph. Thus, if a business enterprise is composed of only one
natural business unit, one pool shall be used for all of its
inventories, including raw materials, goods in process, and finished
goods. If, however, a business enterprise is actually composed of more
than one natural business unit, more than one pool is required. Where
similar types of goods are inventoried in two or more natural business
units of the taxpayer, the Commissioner may apportion or allocate such
goods among the various natural business units, if he determines that
such apportionment or allocation is necessary in order to clearly
reflect the income of such taxpayer. Where a manufacturer or processor
is also engaged in the wholesaling or retailing of goods purchased from
others, any pooling of the LIFO inventory of such purchased goods for
the wholesaling or retailing operations shall be determined in
accordance with the rules of paragraph (c) of this section.
(2) Definition of natural business unit. (i) Whether an enterprise
is composed of more than one natural business unit is a matter of fact
to be determined from all the circumstances. The natural business
divisions adopted by the taxpayer for internal management purposes, the
existence of separate and distinct production facilities and processes,
and the maintenance of separate profit and loss records with respect to
separate operations are important considerations in determining what is
a business unit, unless such divisions, facilities, or accounting
records are set up merely because of differences in geographical
location. In the case of a manufacturer or processor, a natural business
unit ordinarily consists of the entire productive activity of the
enterprise within one product line or within two or more related product
lines including (to the extent engaged in by the enterprise) the
obtaining of materials, the processing of materials, and the selling of
manufactured or processed goods. Thus, in the case of a manufacturer or
processor, the maintenance and operation of a raw material warehouse
does not generally constitute, of itself, a natural business unit. If
the taxpayer maintains and operates a supplier unit the production of
which is both sold to others and transferred to a different unit of the
taxpayer to be used as a component part of another product, the supplier
unit will ordinarily constitute a separate and distinct natural business
unit. Ordinarily, a processing plant would not in itself be considered a
natural business unit if the production of the plant, although saleable
at this stage, is not sold to others, but is transferred to another
plant of the enterprise, not operated as a separate division, for
further processing or incorporation into another product. On the other
hand, if the production of a manufacturing or processing plant is
transferred to a separate and distinct division of the taxpayer, which
constitutes a natural business unit, the supplier unit itself will
ordinarily be considered a natural business unit. However, the mere fact
that a portion of the production of a manufacturing or processing plant
may be sold to others at a certain stage of processing with the
remainder of the
[[Page 539]]
production being further processed or incorporated into another product
will not of itself be determinative that the activities devoted to the
production of the portion sold constitute a separate business unit.
Where a manufacturer or processor is also engaged in the wholesaling or
retailing of goods purchased from others, the wholesaling or retailing
operations with respect to such purchased goods shall not be considered
a part of any manufacturing or processing unit.
(ii) The rules of this subparagraph may be illustrated by the
following examples:
Example 1. A corporation manufactures, in one division, automatic
clothes washers and driers of both commercial and domestic grade as well
as electric ranges, mangles, and dishwashers. The corporation
manufactures, in another division, radios and television sets. The
manufacturing facilities and processes used in manufacturing the radios
and television sets are distinct from those used in manufacturing the
automatic clothes washers, etc. Under these circumstances, the
enterprise would consist of two business units and two pools would be
appropriate, one consisting of all of the LIFO inventories entering into
the manufacture of clothes washers and driers, electric ranges, mangles,
and dishwashers and the other consisting of all of the LIFO inventories
entering into the production of radio and television sets.
Example 2. A taxpayer produces plastics in one of its plants.
Substantial amounts of the production are sold as plastics. The
remainder of the production is shipped to a second plant of the taxpayer
for the production of plastic toys which are sold to customers. The
taxpayer operates his plastics plant and toy plant as separate
divisions. Because of the different product lines and the separate
divisions the taxpayer has two natural business units.
Example 3. A taxpayer is engaged in the manufacture of paper. At one
stage of processing, uncoated paper is produced. Substantial amounts of
uncoated paper are sold at this stage of processing. The remainder of
the uncoated paper is transferred to the taxpayer's finishing mill where
coated paper is produced and sold. This taxpayer has only one natural
business unit since coated and uncoated paper are within the same
product line.
(3) Multiple pools--(i) Principles for establishing multiple pools.
(a) A taxpayer may elect to establish multiple pools for inventory items
which are not within a natural business unit as to which the taxpayer
has adopted the natural business unit method of pooling as provided in
subparagraph (1) of this paragraph. Each such pool shall ordinarily
consist of a group of inventory items which are substantially similar.
In determining whether such similarity exists, consideration shall be
given to all the facts and circumstances. The formulation of detailed
rules for selection of pools applicable to all taxpayers is not
feasible. Important considerations to be taken into account include, for
example, whether there is substantial similarity in the types of raw
materials used or in the processing operations applied; whether the raw
materials used are readily interchangeable; whether there is similarity
in the use of the products; whether the groupings are consistently
followed for purposes of internal accounting and management; and whether
the groupings follow customary business practice in the taxpayer's
industry. The selection of pools in each case must also take into
consideration such factors as the nature of the inventory items subject
to the dollar-value LIFO method and the significance of such items to
the taxpayer's business operations. Where similar types of goods are
inventoried in natural business units and multiple pools of the
taxpayer, the Commissioner may apportion or allocate such goods among
the natural business units and the multiple pools, if he determines that
such apportionment or allocation is necessary in order to clearly
reflect the income of the taxpayer.
(b) Raw materials which are substantially similar shall be pooled
together in accordance with the principles of this subparagraph.
However, inventories of raw or unprocessed materials of an unlike nature
may not be placed into one pool, even though such materials become part
of otherwise identical finished products.
(c) Finished goods and goods-in-process in the inventory shall be
placed into pools classified by major classes or types of goods. The
same class or type of finished goods and goods-in-process shall
ordinarily be included in the same pool. Where the material content of a
class of finished goods and goods-in-process included in a pool has been
changed, for example, to conform
[[Page 540]]
with current trends in an industry, a separate pool of finished goods
and goods-in-process will not ordinarily be required unless the change
in material content results in a substantial change in the finished
goods.
(d) The requirement that pools be established by major types of
materials or major classes of goods is not to be construed so as to
preclude the establishment of a miscellaneous pool. Since a taxpayer may
elect the dollar-value LIFO method with respect to all or any designated
goods in his inventory, there may be a number of such inventory items
covered in the election. A miscellaneous pool shall consist only of
items which are relatively insignificant in dollar value by comparison
with other inventory items in the particular trade or business and which
are not properly includible as part of another pool.
(ii) Raw materials content pools. The dollar-value method of pricing
LIFO inventories may be used in conjunction with the raw materials
content method authorized in Sec. 1.472-1. Raw materials (including the
raw material content of finished goods and goods-in-process) which are
substantially similar shall be pooled together in accordance with the
principles of subdivision (i) of this subparagraph. However, inventories
of materials of an unlike nature may not be placed into one pool, even
though such materials become part of otherwise identical finished
products.
(4) IPIC method pools. A manufacturer or processor that elects to
use the inventory price index computation method described in paragraph
(e)(3) of this section (IPIC method) for a trade or business may elect
to establish dollar-value pools for those items accounted for using the
IPIC method based on the 2-digit commodity codes (i.e., major commodity
groups) in Table 6 (Producer price indexes and percent changes for
commodity groupings and individual items, not seasonally adjusted) of
the ``PPI Detailed Report'' published monthly by the United States
Bureau of Labor Statistics (available from New Orders, Superintendent of
Documents, PO Box 371954, Pittsburgh, PA 15250-7954). A taxpayer
electing to establish dollar-value pools under this paragraph (b)(4) may
combine IPIC pools that comprise less than 5 percent of the total
current-year cost of all dollar-value pools to form a single
miscellaneous IPIC pool. A taxpayer electing to establish dollar-value
pools under this paragraph (b)(4) may combine a miscellaneous IPIC pool
that comprises less than 5 percent of the total current-year cost of all
dollar-value pools with the largest IPIC pool. Each of these 5 percent
rules is a method of accounting. A taxpayer may not change to, or cease
using, either 5 percent rule without obtaining the Commissioner's prior
consent. Whether a specific IPIC pool or the miscellaneous IPIC pool
satisfies the applicable 5 percent rule must be determined in the year
of adoption or year of change (whichever is applicable) and redetermined
every third taxable year. Any change in pooling required or permitted as
a result of a 5 percent rule is a change in method of accounting. A
taxpayer must secure the consent of the Commissioner pursuant to Sec.
1.446-1(e) before combining or separating pools and must combine or
separate its IPIC pools in accordance with paragraph (g)(2) of this
section.
(c) Principles for establishing pools for wholesalers, retailers,
etc--(1) In general. Items of inventory in the hands of wholesalers,
retailers, jobbers, and distributors shall be placed into pools by major
lines, types, or classes of goods. In determining such groupings,
customary business classifications of the particular trade in which the
taxpayer is engaged is an important consideration. An example of such
customary business classification is the department in the department
store. In such case, practices are relatively uniform throughout the
trade, and departmental grouping is peculiarly adapted to the customs
and needs of the business. However, in appropriate cases, the principles
set forth in paragraphs (b) (1) and (2) of this section, relating to
pooling by natural business units, may be used, with permission of the
Commissioner, by wholesalers, retailers, jobbers, or distributors. Where
a wholesaler or retailer is also engaged in the manufacturing or
processing of goods, the pooling of the LIFO inventory for the
manufacturing or processing operations shall be determined
[[Page 541]]
in accordance with the rules of paragraph (b) of this section.
(2) IPIC method pools. A retailer that elects to use the inventory
price index computation method described in paragraph (e)(3) of this
section (IPIC method) for a trade or business may elect to establish
dollar-value pools for those items accounted for using the IPIC method
based on either the general expenditure categories (i.e., major groups)
in Table 3 (Consumer Price Index for all Urban Consumers (CPI-U): U.S.
city average, detailed expenditure categories) of the ``CPI Detailed
Report'' or the 2-digit commodity codes (i.e., major commodity groups)
in Table 6 (Producer price indexes and percent changes for commodity
groupings and individual items, not seasonally adjusted) of the ``PPI
Detailed Report.'' A wholesaler, jobber, or distributor that elects to
use the IPIC method for a trade or business may elect to establish
dollar-value pools for any group of goods accounted for using the IPIC
method and included within one of the 2-digit commodity codes (i.e.,
major commodity groups) in Table 6 (Producer price indexes and percent
changes for commodity groupings and individual items, not seasonally
adjusted) of the ``PPI Detailed Report.'' The ``CPI Detailed Report''
and the ``PPI Detailed Report'' are published monthly by the United
States Bureau of Labor Statistics (BLS) (available from New Orders,
Superintendent of Documents, P.O. Box 371954, Pittsburgh, PA 15250-
7954). A taxpayer electing to establish dollar-value pools under this
paragraph (c)(2) may combine IPIC pools that comprise less than 5
percent of the total current-year cost of all dollar-value pools to form
a single miscellaneous IPIC pool. A taxpayer electing to establish pools
under this paragraph (c)(2) may combine a miscellaneous IPIC pool that
comprises less than 5 percent of the total current-year cost of all
dollar-value pools with the largest IPIC pool. Each of these 5 percent
rules is a method of accounting. Thus, a taxpayer may not change to, or
cease using, either 5 percent rule without obtaining the Commissioner's
prior consent. Whether a specific IPIC pool or the miscellaneous IPIC
pool satisfies the applicable 5 percent rule must be determined in the
year of adoption or year of change (whichever is applicable) and
redetermined every third taxable year. Any change in pooling required or
permitted under a 5 percent rule is a change in method of accounting. A
taxpayer must secure the consent of the Commissioner pursuant to section
1.446-1(e) before combining or separating pools and must combine or
separate its IPIC pools in accordance with paragraph (g)(2) of this
section.
(d) Determination of appropriateness of pools. Whether the number
and the composition of the pools used by the taxpayer is appropriate, as
well as the propriety of all computations incidental to the use of such
pools, will be determined in connection with the examination of the
taxpayer's income tax returns. Adequate records must be maintained to
support the base-year unit cost as well as the current-year unit cost
for all items priced on the dollar-value LIFO inventory method,
regardless of the method authorized by paragraph (e) of this section
which is used in computing the LIFO value of the dollar-value pool. The
pool or pools selected must be used for the year of adoption and for all
subsequent taxable years unless a change is required by the Commissioner
in order to clearly reflect income, or unless permission to change is
granted by the Commissioner as provided in paragraph (e) of Sec. 1.446-
1. However, see paragraph (h) of this section for authorization to
change the method of pooling in certain specified cases.
(e) Methods of computation of the LIFO value of a dollar-value
pool--(1) Methods authorized. A taxpayer may ordinarily use only the so-
called ``double-extension'' method for computing the base-year and
current-year cost of a dollar-value inventory pool. Where the use of the
double-extension method is impractical, because of technological
changes, the extensive variety of items, or extreme fluctuations in the
variety of the items, in a dollar-value pool, the taxpayer may use an
index method for computing all or part of the LIFO value of the pool. An
index may be computed by double-extending a representative portion of
the inventory in a pool or by the use of other sound and
[[Page 542]]
consistent statistical methods. The index used must be appropriate to
the inventory pool to which it is to be applied. The appropriateness of
the method of computing the index and the accuracy, reliability, and
suitability of the use of such index must be demonstrated to the
satisfaction of the district director in connection with the examination
of the taxpayer's income tax returns. The use of any so-called ``link-
chain'' method will be approved for taxable years beginning after
December 31, 1960, only in those cases where the taxpayer can
demonstrate to the satisfaction of the district director that the use of
either an index method or the double-extension method would be
impractical or unsuitable in view of the nature of the pool. A taxpayer
using either an index or link-chain method shall attach to his income
tax return for the first taxable year beginning after December 31, 1960,
for which the index or link-chain method is used, a statement describing
the particular link-chain method or the method used in computing the
index. The statement shall be in sufficient detail to facilitate the
determination as to whether the method used meets the standards set
forth in this subparagraph. In addition, a copy of the statement shall
be filed with the Commissioner of Internal Revenue, Attention: T:R,
Washington, D.C. 20224. The taxpayer shall submit such other information
as may be requested with respect to such index or link-chain method.
Adequate records must be maintained by the taxpayer to support the
appropriateness, accuracy, and reliability of an index or link-chain
method. A taxpayer may request the Commissioner to approve the
appropriateness of an index or link-chain method for the first taxable
year beginning after December 31, 1960, for which it is used. Such
request must be submitted within 90 days after the beginning of the
first taxable year beginning after December 31, 1960, in which the
taxpayer desires to use the index or link-chain method, or on or before
May 1, 1961, whichever is later. A taxpayer entitled to use the retail
method of pricing LIFO inventories authorized by paragraph (k) of Sec.
1.472-1 may use retail price indexes prepared by the United States
Bureau of Labor Statistics. Any method of computing the LIFO value of a
dollar-value pool must be used for the year of adoption and all
subsequent taxable years, unless the taxpayer obtains the consent of the
Commissioner in accordance with paragraph (e) of Sec. 1.446-1 to use a
different method.
(2) Double-extension method. (i) Under the double-extension method
the quantity of each item in the inventory pool at the close of the
taxable year is extended at both base-year unit cost and current-year
unit cost. The respective extensions at the two costs are then each
totaled. The first total gives the amount of the current inventory in
terms of base-year cost and the second total gives the amount of such
inventory in terms of current-year cost.
(ii) The total current-year cost of items making up a pool may be
determined--
(a) By reference to the actual cost of the goods most recently
purchased or produced;
(b) By reference to the actual cost of the goods purchased or
produced during the taxable year in the order of acquisition;
(c) By application of an average unit cost equal to the aggregate
cost of all of the goods purchased or produced throughout the taxable
year divided by the total number of units so purchased or produced; or
(d) Pursuant to any other proper method which, in the opinion of the
Commissioner, clearly reflects income.
(iii) Under the double-extension method a base-year unit cost must
be ascertained for each item entering a pool for the first time
subsequent to the beginning of the base year. In such a case, the base-
year unit cost of the entering item shall be the current-year cost of
that item unless the taxpayer is able to reconstruct or otherwise
establish a different cost. If the entering item is a product or raw
material not in existence on the base date, its cost may be
reconstructed, that is, the taxpayer using reasonable means may
determine what the cost of the item would have been had it been in
existence in the base year. If the item was in existence on the base
date but not stocked by the taxpayer, he may establish, by using
available data or records, what the cost of the item would have
[[Page 543]]
been to the taxpayer had he stocked the item. If the base-year unit cost
of the entering item is either reconstructed or otherwise established to
the satisfaction of the Commissioner, such cost may be used as the base-
year unit cost in applying the double-extension method. If the taxpayer
does not reconstruct or establish to the satisfaction of the
Commissioner a base-year unit cost, but does reconstruct or establish to
the satisfaction of the Commissioner the cost of the item at some year
subsequent to the base year, he may use the earliest cost which he does
reconstruct or establish as the base-year unit cost.
(iv) To determine whether there is an increment or liquidation in a
pool for a particular taxable year, the end of the year inventory of the
pool expressed in terms of base-year cost is compared with the beginning
of the year inventory of the pool expressed in terms of base-year cost.
When the end of the year inventory of the pool is in excess of the
beginning of the year inventory of the pool an increment occurs in the
pool for that year. If there is an increment for the taxable year, the
ratio of the total current-year cost of the pool to the total base-year
cost of the pool must be computed. This ratio when multiplied by the
amount of the increment measured in terms of base-year cost gives the
LIFO value of such increment. The LIFO value of each such increment is
hereinafter referred to in this section as the ``layer of increment''
and must be separately accounted for and a record thereof maintained as
a separate layer of the pool, and may not be combined with a layer of
increment occurring in a different year. On the other hand, when the end
of the year inventory of the pool is less than the beginning of the year
inventory of the pool, a liquidation occurs in the pool for that year.
Such liquidation is to be reflected by reducing the most recent layer of
increment by the excess of the beginning of the year inventory over the
end of the year inventory of the pool. However, if the amount of the
liquidation exceeds the amount of the most recent layer of increment,
the preceding layers of increment in reverse chronological order are to
be successively reduced by the amount of such excess until all the
excess is absorbed. The base-year inventory is to be reduced by
liquidation only to the extent that the aggregate of all liquidation
exceeds the aggregate of all layers of increment.
(v) The following examples illustrate inventories under the double-
extension the computation of the LIFO value of method.
Example 1. (a) A taxpayer elects, beginning with the calendar year
1961, to compute his inventories by use of the LIFO inventory method
under section 472 and further elects to use the dollar-value method in
pricing such inventories as provided in paragraph (a) of this section.
He creates Pool No. 1 for items A, B, and C. The composition of the
inventory for Pool No. 1 at the base date, January 1, 1961, is as
follows:
------------------------------------------------------------------------
Unit Total
Items Units cost cost
------------------------------------------------------------------------
A.............................................. 1,000 $5 $5,000
B.............................................. 2,000 4 8,000
C.............................................. 500 2 1,000
--------
Total base-year cost at Jan. 1, 1961......... ...... ...... 14,000
------------------------------------------------------------------------
(b) The closing inventory of Pool No. 1 at December 31, 1961,
contains 3,000 units of A, 1,000 units of B, and 500 units of C. The
taxpayer computes the current-year cost of the items making up the pool
by reference to the actual cost of goods most recently purchased. The
most recent purchases of items A, B, and C are as follows:
------------------------------------------------------------------------
Quantity Unit
Item Purchase date purchased cost
------------------------------------------------------------------------
A............................... Dec. 15, 1961..... 3,500 $6.00
B............................... Dec. 10, 1961..... 2,000 5.00
C............................... Nov. 1, 1961...... 500 2.50
------------------------------------------------------------------------
(c) The inventory of Pool No. 1 at December 31, 1961, shown at base-
year and current-year cost is as follows:
----------------------------------------------------------------------------------------------------------------
Dec. 31, 1961, Dec. 31, 1961,
inventory at inventory at
Jan. 1, 1961, current-year
Item Quantity base-year cost cost
-----------------------------------
Unit Unit
cost Amount cost Amount
----------------------------------------------------------------------------------------------------------------
A................................................................. 3,000 $5.00 $15,000 $6.00 $18,000
B................................................................. 1,000 4.00 4,000 5.00 5,000
C................................................................. 500 2.00 1,000 2.50 1,250
---------- ---------
Total........................................................... ........ ...... 20,000 ...... 24,250
----------------------------------------------------------------------------------------------------------------
(d) If the amount of the December 31, 1961, inventory at base-year
cost were equal to, or less than, the base-year cost of $14,000 at
January 1, 1961, such amount would be the
[[Page 544]]
closing LIFO inventory at December 31, 1961. However, since the base-
year cost of the closing LIFO inventory at December 31, 1961, amounts to
$20,000, and is in excess of the $14,000 base-year cost of the opening
inventory for that year, there is a $6,000 increment in Pool No. 1
during the year. This increment must be valued at current-year cost,
i.e., the ratio of 24,250/20,000, or 121.25 percent. The LIFO value of
the inventory at December 31, 1961, is $21,275, computed as follows:
Pool No. 1
------------------------------------------------------------------------
Ratio of
Dec. 31, total
1961, current- Dec. 31,
inventory year cost 1961,
at Jan. to total inventory
1, 1961, base-year at LIFO
base-year cost value
cost (percent)
------------------------------------------------------------------------
Jan. 1, 1961, base cost................ 14,000 100.00 $14,000
Dec. 31, 1961, increment............... 6,000 121.25 7,275
----------- ----------
Total.............................. 20,000 ......... 21,275
------------------------------------------------------------------------
Example 2. (a) Assume the taxpayer in Example 1 during the year 1962
completely disposes of item C and purchases item D. Assume further that
item D is properly includible in Pool No. 1 under the provisions of this
section. The closing inventory on December 31, 1962, consists of
quantities at current-year unit cost, as follows:
------------------------------------------------------------------------
Current-
year unit
Items Units cost Dec.
31, 1962
------------------------------------------------------------------------
A.................................................. 2,000 $6.50
B.................................................. 1,500 6.00
D.................................................. 1,000 5.00
------------------------------------------------------------------------
(b) The taxpayer establishes that the cost of item D, had he
acquired it on January 1, 1961, would have been $2.00 per unit. Such
cost shall be used as the base-year unit cost for item D, and the LIFO
computations at December 31, 1962, are made as follows:
----------------------------------------------------------------------------------------------------------------
Dec. 31, 1962, Dec. 31, 1962,
inventory at inventory at
Jan. 1, 1961, current-year
Item Quantity base-year cost cost
-----------------------------------
Unit Unit
cost Amount cost Amount
----------------------------------------------------------------------------------------------------------------
A................................................................. 2,000 $5.00 $10,000 $6.50 $13,000
B................................................................. 1,500 4.00 6,000 6.00 9,000
D................................................................. 1,000 2.00 2,000 5.00 5,000
---------- ---------
Total.......................................................... ........ ...... 18,000 ...... 27,000
----------------------------------------------------------------------------------------------------------------
(c) Since the closing inventory at base-year cost, $18,000, is less
than the 1962 opening inventory at base-year cost, $20,000, a
liquidation of $2,000 has occurred during 1962. This liquidation is to
be reflected by reducing the most recent layer of increment. The LIFO
value of the inventory at December 31, 1962, is $18,850, and is
summarized as follows:
Pool No. 1
------------------------------------------------------------------------
Ratio of
Dec. 31, total
1962, current- Dec. 31,
inventory year cost 1962,
at Jan. to total inventory
1, 1961, base-year at LIFO
base-year cost value
cost (percent)
------------------------------------------------------------------------
Jan. 1, 1961, base cost................ 14,000 100.00 $14,000
Dec. 31, 1961, increment............... 4,000 121.25 4,850
----------- ----------
Total............................... 18,000 ......... 18,850
------------------------------------------------------------------------
(3) Inventory price index computation (IPIC) method--(i) In general.
The inventory price index computation method provided by this paragraph
(e)(3) (IPIC method) is an elective method of determining the LIFO value
of a dollar-value pool using consumer or producer price indexes
published by the United States Bureau of Labor Statistics (BLS). A
taxpayer using the IPIC method must compute a separate inventory price
index (IPI) for each dollar-value pool. This IPI is used to convert the
total current-year cost of the items in a dollar-value pool to base-year
cost in order to determine whether there is an increment or liquidation
in terms of base-year cost and, if there is an increment, to determine
the LIFO inventory value of the current year's layer of increment
(layer). Using one IPI to compute the base-year cost of a dollar-value
pool for the current taxable year and using a different IPI to compute
the LIFO inventory value of the current taxable year's layer is not
permitted under the IPIC method. The IPIC method will be accepted by the
Commissioner as an appropriate method of computing an index, and the use
of that index to compute the LIFO value of a dollar-value pool will be
accepted as accurate, reliable, and suitable. The appropriateness of a
taxpayer's computation of an IPI, which includes all the steps described
in paragraph (e)(3)(iii) of this section, will be determined in
connection with an examination of the taxpayer's federal income tax
return. A taxpayer using the IPIC method may elect to establish
[[Page 545]]
dollar-value pools according to the special rules in paragraphs (b)(4)
and (c)(2) of this section or the general rules in paragraphs (b) and
(c) of this section. Taxpayers eligible to use the IPIC method are
described in paragraph (e)(3)(ii) of this section. The manner in which
an IPI is computed is described in paragraph (e)(3)(iii) of this
section. Rules relating to the adoption of, or change to, the IPIC
method are in paragraph (e)(3)(iv) of this section.
(ii) Eligibility. Any taxpayer electing to use the dollar-value LIFO
method may elect to use the IPIC method. Except as provided in this
paragraph (e)(3)(ii) or in other published guidance, a taxpayer that
elects to use the IPIC method for a specific trade or business must use
that method to account for all items of dollar-value LIFO inventory. A
taxpayer that uses the retail price indexes computed by the BLS and
published in ``Department Store Inventory Price Indexes'' (available
from the BLS by calling (202) 606-6325 and entering document code 2415)
may elect to use the IPIC method for items that do not fall within any
of the major groups listed in ``Department Store Inventory Price
Indexes.''
(iii) Computation of an inventory price index--(A) In general. The
computation of an IPI for a dollar-value pool requires the following
four steps, which are described in more detail in this paragraph
(e)(3)(iii): First, selection of a BLS table and an appropriate month;
second, assignment of items in a dollar-value pool to BLS categories
(selected BLS categories); third, computation of category inflation
indexes for selected BLS categories; and fourth, computation of the IPI.
A taxpayer may compute the IPI for each dollar-value pool using either
the double-extension method (double-extension IPIC method) or the link-
chain method (link-chain IPIC method), without regard to whether the use
of a double-extension method is impractical or unsuitable. The use of
either the double-extension IPIC method or the link-chain IPIC method is
a method of accounting, and the adopted method must be applied
consistently to all dollar-value pools within a trade or business
accounted for under the IPIC method. A taxpayer that wants to change
from the double-extension IPIC method to the link-chain IPIC method, or
vice versa, must secure the consent of the Commissioner under Sec.
1.446-1(e). This change must be made with a new base year as described
in paragraph (e)(3)(iv)(B)(1).
(B) Selection of BLS table and appropriate month--(1) In general.
Under the IPIC method, an IPI is computed using the consumer or producer
price indexes for certain categories (BLS price indexes and BLS
categories, respectively) listed in the selected BLS table of the ``CPI
Detailed Report'' or the ``PPI Detailed Report'' for the appropriate
month.
(2) BLS table selection. Manufacturers, processors, wholesalers,
jobbers, and distributors must select BLS price indexes from Table 6
(Producer price indexes and percent changes for commodity groupings and
individual items, not seasonally adjusted) of the ``PPI Detailed
Report'', unless the taxpayer can demonstrate that selecting BLS price
indexes from another table of the ``PPI Detailed Report'' is more
appropriate. Retailers may select BLS price indexes from either Table 3
(Consumer Price Index for all Urban Consumers (CPI-U): U.S. city
average, detailed expenditure categories) of the ``CPI Detailed Report''
or from Table 6 (or another more appropriate table) of the ``PPI
Detailed Report.'' The selection of a BLS table is a method of
accounting and must be used for the taxable year of adoption and all
subsequent years, unless the taxpayer obtains the Commissioner's consent
under Sec. 1.446-1(e) to change its table selection. A taxpayer that
changes its BLS table must establish a new base year in the year of
change as described in paragraph (e)(3)(iv)(B) of this section.
(3) Appropriate month. In the case of a retailer using the retail
method, the appropriate month is the last month of the retailer's
taxable year. In the case of all other taxpayers, the appropriate month
is the month most consistent with the method used to determine the
current-year cost of the dollar-value pool under paragraph (e)(2)(ii) of
this section and the taxpayer's history of inventory production or
purchases during the taxable year. A taxpayer not using the retail
method may annually
[[Page 546]]
select an appropriate month for each dollar-value pool or make an
election on Form 970, ``Application to Use LIFO Inventory Method,'' to
use a representative appropriate month (representative month). An
election to use a representative month is a method of accounting and the
month elected must be used for the taxable year of the election and all
subsequent taxable years, unless the taxpayer obtains the Commissioner's
consent under Sec. 1.446-1(e) to change or revoke its election.
(4) Examples. The following examples illustrate the rules of this
paragraph (e)(3)(iii)(B)(3):
Example 1. Determining an appropriate month. A wholesaler of
seasonal goods timely files a Form 970, ``Application to Use LIFO
Inventory Method,'' for the taxable year ending December 31, 2001. The
taxpayer indicates elections to use the dollar-value LIFO method, to
determine the current-year cost using the earliest acquisitions method
in accordance with paragraph (e)(2)(ii)(b) of this section, and to use
the IPIC method under paragraph (e)(3) of this section. Although the
taxpayer purchases inventory items regularly throughout the year, the
items purchased vary according to the seasons. The seasonal items on
hand at December 31, 2001, are purchased between October and December.
Thus, based on the taxpayer's use of the earliest acquisitions method of
determining current-year cost and its experience with inventory
purchases, the appropriate month for the items represented in the ending
inventory at December 31, 2001, is October.
Example 2. Electing a representative month. A retailer not using the
retail method timely files a Form 970, ``Application to Use LIFO
Inventory Method,'' for the taxable year ending December 31, 2001. The
taxpayer indicates elections to use the dollar-value LIFO method, the
most recent purchases method of determining current-year cost under
paragraph (e)(2)(ii)(a) of this section, the IPIC method under paragraph
(e)(3) of this section, and December as its representative month under
paragraph (e)(3)(iii)(B)(3) of this section. The items in the taxpayer's
ending inventory are purchased fairly uniformly throughout the year,
with the first purchases normally occurring in January and the last
purchases normally occurring in December. The taxpayer's election to use
December as its representative month is permissible because the taxpayer
elected to use the most recent purchases method and the taxpayer's last
purchases of the taxable year normally occur during December, the last
month of the taxpayer's taxable year.
Example 3. Changing representative month. The facts are the same as
in Example 2, except the taxpayer files a Form 3115, ``Application for
Change in Accounting Method,'' requesting permission to change to the
earliest acquisitions method of determining current-year cost in
accordance with paragraph (e)(2)(ii)(b) of this section and to change
its representative month from December to January beginning with the
taxable year ending December 31, 2003. If the Commissioner consents to
the taxpayer's request to change to the earliest acquisitions method,
December will no longer be a permissible representative month for this
taxpayer because of the absence of a nexus between the earliest
acquisitions method, the month of December (the last month of the
taxpayer's taxable year), and the taxpayer's experience with inventory
purchases during the year. Thus, the Commissioner will permit the
taxpayer to change its representative month to January, the first month
of the taxpayer's taxable year.
Example 4. Changing representative month. The facts are the same as
in Example 2. In 2002, the taxpayer changes its annual accounting period
to a taxable year ending June 30, which requires the taxpayer to file a
return for the short taxable year beginning January 1, 2002, and ending
June 30, 2002. As a result, December is no longer a permissible
representative month because of the absence of a nexus between the most
recent purchases method, the month of December, and the taxpayer's
experience with inventory purchases during the year. The taxpayer should
file a Form 3115 requesting permission to change its representative
month from December to June beginning with the short taxable year ending
June 30, 2002. Because the taxpayer's last purchases of the taxable year
now will occur in June, the Commissioner will consent to the taxpayer's
request to change its representative month to June.
Example 5. Changing representative month. The facts are the same as
in Example 2, except that the taxpayer elects to use January as its
representative month. The taxpayer timely files a Form 3115 requesting
permission to change its representative month from January to December
beginning with the taxable year ending December 31, 2003. January is not
a permissible representative month because of the absence of a nexus
between the most recent purchases method, the taxpayer's history of
inventory purchases, and the month of January, the first month in the
taxpayer's taxable year. Because December is a permissible
representative month, the Commissioner will permit the taxpayer to
change its representative month to December.
(C) Assignment of inventory items to BLS categories--(1) In general.
Except as provided in paragraph (e)(3)(iii)(C)(2) of this section, a
taxpayer must assign each item in a dollar-value pool to the
[[Page 547]]
most-detailed BLS category of the selected BLS table that contains that
item. For example, in Table 6 of the ``PPI Detailed Report'' for a given
month, the commodity codes for the various BLS categories run from 2 to
8 digits, with the least-detailed BLS categories having a 2-digit code
and the most-detailed BLS categories usually (but not always) having an
8-digit code. For purposes of assigning items to the most-detailed BLS
category, manufacturers and processors must assign each raw material
item to the most-detailed PPI category that includes that raw material
and must assign each finished good item to the most-detailed PPI
category that includes that finished good. In addition, manufacturers
and processors must assign each work-in-process (WIP) item to the most-
detailed PPI category that includes the finished good into which the
item will be manufactured or processed. For this purpose, finished good
means a salable item that the taxpayer regularly sells. For example, a
gasoline-engine manufacturer that also manufactures the pistons used in
those engines and regularly sells some of the pistons (e.g., to
retailers of replacement parts) must assign both finished pistons that
have not been affixed to an engine block and piston WIP items to the
most-detailed PPI category that includes pistons. Finished pistons that
have been affixed to an engine block must be assigned to the most-
detailed PPI category that includes gasoline engines. In contrast, if
sales of these pistons occur infrequently, the taxpayer must assign both
finished pistons and piston WIP items to the most-detailed PPI category
that includes gasoline engines.
(2) 10 percent method. Instead of assigning each item in a dollar-
value pool to the most-detailed BLS categories, as described in
paragraph (e)(3)(iii)(C)(1) of this section, a taxpayer may elect to use
the 10 percent method described in this paragraph (e)(3)(iii)(C)(2).
Under the 10 percent method, items are assigned to BLS categories using
a three-step procedure. First, when the current-year cost of a specific
item is 10 percent or more of the total current-year cost of the dollar-
value pool, the taxpayer must assign that item to the most-detailed BLS
category that includes that item (10 percent BLS category). Any other
item that is includible in that 10 percent BLS category (other than an
item that qualifies for its own 10 percent BLS category under the
preceding sentence) must be assigned to that 10 percent BLS category.
Second, if one or more items have not been assigned to BLS categories in
the first step, the taxpayer must investigate successively less-detailed
BLS categories and assign the unassigned item(s) to the first BLS
category that contains unassigned items whose current-year cost, in the
aggregate, is 10 percent or more of the total current-year cost of the
dollar-value pool (also, 10 percent BLS categories). This step must be
repeated until all the items in the dollar-value pool have been included
in an appropriate 10 percent BLS category, the current-year cost of the
unassigned items, in the aggregate, is less than 10 percent of the total
current-year cost of the dollar-value pool, or the taxpayer determines
that a single BLS category is not appropriate for the aggregate of the
unassigned items. Third, if items in a dollar-value pool have not been
assigned to a 10 percent BLS category because the current-year cost of
those items, in the aggregate, is less than 10 percent of the total
current-year cost of the dollar-value pool, the taxpayer must assign
those items to the most-detailed BLS category that includes all those
items (also, a 10 percent category). On the other hand, if items in a
dollar-value pool have not been assigned to a 10 percent BLS category
because the taxpayer determines that a single BLS category is not
appropriate for the aggregate of those items, the taxpayer must assign
each of those items to a single miscellaneous BLS category created by
the taxpayer (also, a 10 percent category). In no event may a taxpayer
assign items in a dollar-value pool to a BLS category that is less
detailed than either the major groups of consumer goods described in
Table 3 of the monthly ``CPI Detailed Report'' or the major commodity
groups of producer goods described in Table 6 of the monthly ``PPI
Detailed Report.'' Principles similar to those described in paragraph
[[Page 548]]
(e)(3)(iii)(C)(1) apply for purposes of assigning raw material, work-in-
process, and finished good items to the most-detailed BLS category under
the 10 percent method.
(3) Change in method of accounting. The 10 percent method of
assigning items in a dollar-value pool to BLS categories is a method of
accounting. In addition, a taxpayer's selection of a BLS category for a
specific item is a method of accounting. However, the assignment of
items to different BLS categories solely as a result of the application
of the 10 percent method is a change in underlying facts and not a
change in method of accounting. Likewise, the selection of a new BLS
category for a specific item as a result of a revision to a BLS table is
a change in underlying facts and not a change in method of accounting. A
taxpayer that wants to change its method of selecting BLS categories
(i.e., to or from the 10-percent method) or of selecting a BLS category
for a specific item must secure the Commissioner's consent in accordance
with Sec. 1.446-1(e). A taxpayer that voluntarily changes its method of
selecting BLS categories or of selecting a BLS category for a specific
item must establish a new base year in the year of change as described
in paragraph (e)(3)(iv)(B) of this section.
(D) Computation of a category inflation index--(1) In general. As
described in more detail in this paragraph (e)(3)(iii)(D), a category
inflation index reflects the inflation that occurs in the BLS price
indexes for a selected BLS category (or, if applicable, 10 percent BLS
category) during the relevant measurement period.
(2) BLS price indexes. The BLS price indexes are the cumulative
indexes published in the selected BLS table for the appropriate month. A
taxpayer may elect to use either preliminary or final BLS price indexes
for the appropriate month, provided that the selected BLS price indexes
are used consistently. However, a taxpayer that elects to use final BLS
price indexes for the appropriate month must use preliminary BLS price
indexes for any taxable year for which the taxpayer files its original
federal income tax return before the BLS publishes final BLS price
indexes for the appropriate month. If a BLS price index for a most-
detailed or 10 percent BLS category is not otherwise available for the
appropriate or representative month (but not because the BLS categories
in the BLS table have been revised), the taxpayer must use the BLS price
index for the next most-detailed BLS category that includes the specific
item(s) in the most-detailed or 10 percent BLS category. If a BLS price
index is not otherwise available for the appropriate or representative
month because the BLS categories in the BLS table have been revised, the
rules of paragraph (e)(3)(iii)(D)(4) of this section apply.
(3) Category inflation index--(i) In general. Except as provided in
paragraph (e)(3)(iii)(D)(4) of this section (concerning compound
category inflation indexes) or (e)(3)(iii)(D)(5) of this section
(concerning category inflation indexes for certain 10 percent BLS
categories), a category inflation index for a selected BLS category (or,
if applicable, 10 percent BLS category) is computed under the rules of
this paragraph (e)(3)(iii)(D)(3).
(ii) Double-extension IPIC method. In the case of a taxpayer using
the double-extension IPIC method, the category inflation index for a BLS
category is the quotient of the BLS price index for the appropriate or
representative month of the current year divided by the BLS price index
for the appropriate month of the taxable year preceding the base year
(base month). However, if the taxpayer did not have an opening inventory
in the year that its election to use the dollar-value LIFO method and
double-extension IPIC method became effective, the category inflation
index for a BLS category is the quotient of the BLS price index for the
appropriate or representative month of the current year divided by the
BLS price index for the month immediately preceding the month of the
taxpayer's first inventory production or purchase.
(iii) Link-chain IPIC method. In the case of a taxpayer using the
link-chain IPIC method, the category inflation index for a BLS category
is the quotient of the BLS price index for the appropriate or
representative month of the current year divided by the BLS price index
for the appropriate month
[[Page 549]]
used for the immediately preceding taxable year. However, if the
taxpayer did not have an opening inventory in the year that its election
to use the dollar-value LIFO method and link-chain IPIC method became
effective, the category inflation index for a BLS category for the year
of election is the quotient of the BLS price index for the appropriate
or representative month of the current year divided by the BLS price
index for the month immediately preceding the month of the taxpayer's
first inventory production or purchase.
(iv) Special rules concerning representative months. A taxpayer
electing to use a representative month under paragraph (e)(3)(iii)(B)(3)
of this section must use an appropriate month, rather than the
representative month, to determine category inflation indexes in the
circumstances described in this paragraph (e)(3)(iii)(D)(3)(iv) and in
other similar circumstances. For example, in the case of a short taxable
year, the category inflation index should reflect the inflation that
occurs from the base month (in the case of the double-extension IPIC
method), or the appropriate or representative month used for the
preceding taxable year (in the case of the link-chain IPIC method), and
the appropriate month for the short taxable year. Similarly, if a
taxpayer using the link-chain IPIC method is granted consent to change
both its method of determining the current-year cost of a dollar-value
pool and its representative month, the category inflation index for the
year of change should reflect the inflation that occurs between the old
representative month used for the preceding taxable year and the new
representative month used for the year of change.
(4) Compound category inflation index for revised BLS categories or
price indexes--(i) In general. Periodically, the BLS revises a BLS table
to add one or more new BLS categories, eliminate one or more previously
reported BLS categories, or reset the base-year BLS price index of one
or more BLS categories. If the BLS has revised the applicable BLS table
for a taxable year, a taxpayer must compute the category inflation index
for each BLS category for which the taxpayer cannot compute a category
inflation index in accordance with paragraph (e)(3)(iii)(D)(3) of this
section (affected BLS category) using a reasonable method, provided the
method is used consistently for all affected BLS categories within a
particular taxable year. For example, if the BLS revised the CPI by
adding new BLS categories as of January 2001 and eliminating some
previously reported BLS categories as of December 2000, January 2002
would be the first month for which it would be possible to compute a
category inflation index for a 12-month period using the BLS price
indexes for any affected category. The compound category inflation index
described in paragraph (e)(3)(iii)(D)(4)(ii) of this section is a
reasonable method of computing the category inflation index for an
affected BLS category.
(ii) Computation of compound category inflation index. When the
applicable BLS table is revised as described in paragraph
(e)(3)(iii)(D)(4)(i) of this section, a taxpayer may use the procedure
described in this paragraph (e)(3)(iii)(D)(4)(ii) to compute a compound
category inflation index for each affected BLS category represented in
the taxpayer's ending inventory. For this purpose, a compound category
inflation index is the product of the category inflation index for the
``first portion'' multiplied by the corresponding category inflation
index for the ``second portion.'' The category inflation index for the
first portion must reflect the inflation that occurs between the end of
the base month (in the case of the double-extension IPIC method), or the
preceding year's appropriate or representative month (in the case of the
link-chain IPIC method), and the end of the last month covered by the
unrevised BLS table based on the old BLS category. The corresponding
category inflation index for the second portion must reflect the
inflation that occurs between the beginning of the first month covered
by the revised BLS table based on the new BLS category and the end of
the current year's appropriate or representative month. First, using the
revised BLS table for the current-year's appropriate or representative
month, the taxpayer assigns items in the dollar-value pool using its
method of assigning items to
[[Page 550]]
BLS categories as described in paragraph (e)(3)(iii)(C) of this section.
Second, for each affected BLS category represented in the ending
inventory, the taxpayer computes the category inflation index for the
second portion using this formula: [A/B], where A equals the BLS price
index for the current year's appropriate or representative month and B
equals the BLS price index for the last month covered by the unrevised
BLS table (as published for the first month of the revised BLS table).
Third, using the unrevised BLS table for the base month (in the case of
the double extension IPIC method) or the preceding year's appropriate or
representative month (in the case of the link-chain IPIC method), the
taxpayer assigns each of the items in the dollar-value pool using its
method of assigning items to BLS categories. Fourth, for each affected
BLS category represented in the ending inventory, the taxpayer computes
the category inflation index for the first portion using this formula:
[C/D], where C equals the BLS price index for the last month covered by
the unrevised BLS table (as published for the last month of the
unrevised BLS table) and D equals the BLS price index for the base month
(in the case of the double-extension IPIC method) or the preceding
year's appropriate or representative month (in the case of the link-
chain IPIC method). Fifth, for each affected BLS category represented in
the ending inventory, the taxpayer computes the compound category
inflation index using this formula: [X*Y], where X equals the category
inflation index for the second portion, and Y equals the corresponding
category inflation index for the first portion. For the purpose of
computing the compound category inflation index for each affected BLS
category, the corresponding category inflation index for the first
portion is the category inflation index for the unrevised BLS category
that includes the specific inventory item(s) included in the revised BLS
category. If items included in a single revised BLS category had been
included in separate BLS categories before the revision of the BLS
table, the corresponding category inflation index for the first portion
is the weighted harmonic mean of the category inflation indexes for
these unrevised BLS categories. See paragraph (e)(3)(iii)(E)(1) of this
section for a formula of the weighted harmonic mean. When computing this
weighted-average category inflation index, a taxpayer must use the
current-year costs (or in the case of a retailer using the retail
method, the retail selling prices) in ending inventory as the weights.
(iii) New base year. A taxpayer may establish a new base year in the
year following the taxable year for which the taxpayer computed a
compound category inflation index under this paragraph (e)(3)(iii)(D)(4)
for one or more affected BLS categories in a dollar-value pool. See
paragraph (e)(3)(iv)(B) of this section for the procedures and
computations incident to establishing a new base year.
(iv) Examples. The following examples illustrate the rules of this
paragraph (e)(3)(iii)(D)(4):
Example 1. BLS categories eliminated. (i) A retailer, whose taxable
year ends January 31, elected to account for its inventories using the
dollar-value LIFO method and double-extension IPIC method (based on the
CPI), beginning with the taxable year ending January 31, 1997. The
taxpayer does not use the retail method, but elected to use January as
its representative month. On January 31, 1999, the taxpayer's only
dollar-value pool contains only two items--lemons and peaches. The total
current-year cost of these items is as follows: lemons, $40, and
peaches, $30.
(ii) The CPI was revised in October of 1998 to eliminate the
``Citrus fruits'' subcategory of ``Other fresh fruits.'' In addition,
the base-year BLS price index for ``Other fresh fruits'' was reset to
100.00 as of October 1, 1998. In relevant part, the January 1999 CPI
permits the assignment of both lemons and peaches to ``Other fresh
fruits.'' The January 1999 BLS price indexes for ``Citrus fruits'' and
``Other fresh fruits'' are 96.6 and 105.6, respectively. In relevant
part, the September 1998 CPI permits the assignment of lemons to
``Citrus fruits'' and peaches to ``Other fresh fruits.'' The September
1998 BLS price indexes for ``Citrus fruits'' and ``Other fresh fruits''
are 194.9 and 294.9, respectively, and the January 1997 BLS price
indexes for ``Citrus fruits'' and ``Other fresh fruits'' are 190.2 and
290.2, respectively.
(iii) Because the BLS eliminated the category, ``Citrus fruits,'' as
of October 1998, it did not publish a BLS price index for that category
in the January 1999 CPI. Thus, the
[[Page 551]]
taxpayer cannot compute a category inflation index for ``Citrus fruits''
under the normal procedures, but may compute a compound category
inflation index for that affected BLS category using the procedures
described in paragraph (e)(3)(iii)(D)(4)(ii) of this section.
(iv) The taxpayer computes a compound category inflation index for
the two BLS categories that formerly included lemons and peaches. The
taxpayer first assigns lemons and peaches to ``Other fresh fruits,'' the
most-detailed index in the January 1999 CPI, and then computes the
category inflation index for the second portion as follows:
----------------------------------------------------------------------------------------------------------------
Jan. 1999 index/Sept.
Item 1999 category 1998 index (as Category
published in Oct. 1998) inflation index
----------------------------------------------------------------------------------------------------------------
Lemons and Peaches............. Other fresh fruits................. 105.6/100.0 1.0560
----------------------------------------------------------------------------------------------------------------
(v) The taxpayer assigns the lemons and peaches to the most-detailed
BLS categories in the January 1998 CPI as follows: lemons to ``Citrus
fruits'' and peaches to ``Other fresh fruits.'' Then, the taxpayer
computes the category inflation index for the first portion as follows:
----------------------------------------------------------------------------------------------------------------
Sept. 1998 index (as
Item 1998 category published in Sept. Category inflation
1998)/Jan. 1997 index
----------------------------------------------------------------------------------------------------------------
Lemons........................ Citrus fruits...................... 194.9/190.2 1.0247
Peaches....................... Other fresh Fruits................. 294.9/290.2 1.0162
----------------------------------------------------------------------------------------------------------------
(vi) Because lemons and peaches, which are included together in the
revised ``Other fresh fruits'' category, had been included in separate
BLS categories before the BLS table was revised, the taxpayer must
compute a single corresponding category inflation index for the affected
BLS categories for the first portion. This corresponding category
inflation index is the weighted harmonic mean of the separate
corresponding category inflation indexes for the first portion using the
cost of the items in ending inventory as the weights. The taxpayer
computes the corresponding category inflation index for ``Other fresh
fruits'' for the first portion as follows:
----------------------------------------------------------------------------------------------------------------
(I) Weight (cost (II) Category (III) Quotient:
Item of item) inflation index (I)/(II)
----------------------------------------------------------------------------------------------------------------
Lemons.................................................... $40.00 1.0247 $39.04
Peaches................................................... 30.00 1.0162 29.52
-----------------------------------------------------
Total................................................. 70.00 ................ 68.56
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
(V) Sum of (weight/ (VI) Weighted harmonic
(IV) Sum of weights category inflation mean of other fresh
index) fruits: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$70.00...................................................... $68.56 1.0210
----------------------------------------------------------------------------------------------------------------
(vii) Finally, the taxpayer computes the compound category inflation
index for Other fresh fruits as follows:
----------------------------------------------------------------------------------------------------------------
(III) Compound
(I) Category (II) Category category
Item inflation index inflation index inflation index:
(second portion) (first portion) (I)*(II)
----------------------------------------------------------------------------------------------------------------
Other fresh fruits..................................... 1.0560 1.0210 1.0782
----------------------------------------------------------------------------------------------------------------
[[Page 552]]
(viii) The taxpayer may establish a new base year for the taxable
year ending January 31, 2000.
Example 2. BLS categories separated. (i) The facts are the same as
in Example 1, except prior to October 1998, both lemons and peaches were
assigned to ``Other fresh fruits'' and in the October 1998 CPI, the BLS
created a new category, ``Citrus fruits,'' for citrus fruits, such as
lemons. Moreover, the BLS reset the base-year BLS price index for
``Other fresh fruits'' to 100.0 as of October 1, 1998. As a result of
these changes, the taxpayer may no longer assign lemons to ``Other fresh
fruits.''
(ii) Because ``Citrus fruits'' is new as of October 1998, the BLS
did not publish a BLS price index for this BLS category in the January
1999 CPI. Thus, because the taxpayer cannot compute a category inflation
index for ``Citrus fruits'' under the normal procedures, the taxpayer
may compute a compound category inflation index for the affected BLS
category using the procedures described in paragraph
(e)(3)(iii)(D)(4)(ii) of this section.
(iii) Based on the January 1999 CPI, the taxpayer assigns lemons to
``Citrus fruits'' and peaches to ``Other fresh fruits.'' Then, the
taxpayer computes a compound category inflation index for each of the
two BLS categories. The computation of the category inflation index for
the second portion is as follows:
----------------------------------------------------------------------------------------------------------------
Jan. 1999 index/Sept.
Item 1999 category 1998 index (as Category
published in Oct. 1998) inflation index
----------------------------------------------------------------------------------------------------------------
Lemons......................... Citrus fruits...................... 96.6/100 0.9660
Peaches........................ Other fresh fruits................. 105.6/100 1.0560
----------------------------------------------------------------------------------------------------------------
(iv) Then, the taxpayer computes the category inflation index for
the first portion as follows:
----------------------------------------------------------------------------------------------------------------
Sept. 1998 index (as
Item 1998 category published in Sept. 1998)/ Category inflation
Jan. 1997 index
----------------------------------------------------------------------------------------------------------------
Lemons & Peaches.............. Other fresh fruits................ 294.9/290.2 1.0162
----------------------------------------------------------------------------------------------------------------
(v) Finally, the taxpayer computes the compound category inflation
index for ``Citrus fruits'' and ``Other fresh fruits'':
----------------------------------------------------------------------------------------------------------------
(III) Compound
(I) Category (II) Category category
Item inflation index inflation index inflation index:
(second portion) (first portion) (I)*(II)
----------------------------------------------------------------------------------------------------------------
Citrus fruits............................................. 0.9660 1.0162 0.9816
Other fresh fruits........................................ 1.0560 1.0162 1.0731
----------------------------------------------------------------------------------------------------------------
(vi) The taxpayer may establish a new base year for the taxable year
ending January 31, 2000.
(5) 10 percent method. (i) Applicability. A taxpayer that elects to
use the 10 percent method described in paragraph (e)(3)(iii)(C)(2) of
this section must compute a category inflation index for a less-detailed
10 percent BLS category as provided in this paragraph (e)(3)(iii)(D)(5).
A less-detailed 10 percent category is a BLS category that--
(A) subsumes two or more BLS categories;
(B) Does not have a single assigned item whose current-year cost is
10 percent or more of the current-year cost of all the items in the
dollar-value pool;
(C) Has at least one item in at least one of the subsumed BLS
categories; and
(D) Has at least one subsumed BLS category that either does not have
any assigned items or is a separate 10 percent BLS category.
(ii) Determination of category inflation index. If the rules of this
paragraph (e)(3)(iii)(D)(5) apply, the category inflation index for the
less-detailed 10 percent BLS category is equal to the
[[Page 553]]
weighted arithmetic mean of the category inflation index (or, compound
category inflation index, if applicable) for each of the subsumed BLS
categories that have been assigned at least one item from the taxpayer's
dollar-value pool (excluding any item that is properly assigned to a
separate 10 percent BLS category). [Weighted Arithmetic Mean = Sum of
(Weight x Category Inflation Index)]/Sum of Weights]. The appropriate
weight for each of the most-detailed BLS categories referenced in the
preceding sentence is the corresponding BLS weight. Currently, in
January of each year, the BLS publishes the BLS weights determined for
December of the preceding year. In the case of a taxpayer using the
double-extension IPIC method, the BLS weights for December of the
taxable year preceding the base year are to be used for all taxable
years. In the case of a taxpayer using the link-chain IPIC method, the
BLS weights for December of a given calendar year are to be used for
taxable years that end during the 12-month period that begins on July 1
of the following calendar year. However, if the BLS weights are not
published for all of the most-detailed BLS categories referenced above,
the taxpayer may use the current-year cost (or in the case of a retailer
using the retail method, the retail selling prices) of all items
assigned to a specific most-detailed BLS category as the appropriate
weight for that category, but must compute a weighted harmonic mean. See
paragraph (e)(3)(iii)(E)(1) of this section for a formula of the
weighted harmonic mean.
(E) Computation of Inventory Price Index (IPI)--(1) Double-extension
IPIC method. Under the double-extension IPIC method, the IPI for a
dollar-value pool is the weighted harmonic mean of the category
inflation indexes (or, if applicable, compound category inflation
indexes) determined under paragraph (e)(3)(iii)(D) of this section for
each selected BLS category (or, if applicable 10 percent BLS category)
represented in the taxpayer's dollar-value pool at the end of the
taxable year. The formula for computing the weighted harmonic mean of
the category inflation indexes is: [Sum of Weights/Sum of (Weight/
Category Inflation Index)]. The weights to be used when computing this
weighted harmonic mean are the current-year costs (or, in the case of a
retailer using the retail method, the retail selling prices) in each
selected BLS category represented in the dollar-value pool at the end of
the taxable year.
(2) Link-chain IPIC method. Under the link-chain IPIC method, the
IPI for a dollar-value pool is the product of the weighted harmonic mean
of the category inflation indexes (or, if applicable, the compound
category inflation indexes) determined under paragraph (e)(3)(iii)(D) of
this section for each selected BLS category (or, if applicable, 10
percent BLS category) represented in the taxpayer's dollar-value pool at
the end of the taxable year multiplied by the IPI for the immediately
preceding taxable year. The formula for computing the weighted harmonic
mean of the category inflation indexes is: [Sum of Weights/Sum of
(Weight/Category Inflation Index)]. The weights to be used when
computing this weighted harmonic mean are the current-year costs (or, in
the case of a retailer using the retail method, the retail selling
prices) in each selected BLS category represented in the dollar-value
pool at the end of the taxable year.
(3) Examples. The following examples illustrate the rules of this
paragraph (e)(3)(iii)(E):
Example 1. Double-extension method. (i) Introduction. R is a retail
furniture merchant that does not use the retail method. For the taxable
year ending December 31, 2000, R used the first-in, first-out method of
identifying inventory and valued its inventory at cost. The total cost
of R's inventory on December 31, 2000, was $850,000. R elected to use
the dollar-value LIFO and double-extension IPIC methods for its taxable
year ending December 31, 2001. R does not elect to use the 10 percent
method described in paragraph (e)(3)(iii)(C)(2) of this section. R
determines the current-year cost of the items using the actual cost of
the most recently purchased goods. R elected to pool its inventory based
on the major groups in Table 6 of the monthly ``PPI Detailed Report'' in
accordance with the special IPIC pooling rules of paragraph (b)(4) of
this section. All items in R's inventory fall within the 2-digit
commodity code
[[Page 554]]
in Table 6 of the monthly ``PPI Detailed Report'' for ``furniture and
household durables.'' Therefore, R will maintain a single dollar-value
pool.
(ii) Select a BLS table and appropriate month for 2001. R determines
that the appropriate month for 2001 is October. R also determines that
the appropriate month for 2000 would have been December if R had used
the IPIC method for that year.
(iii) Assign inventory items to BLS categories for 2001. For 2001, R
assigns all items in the dollar-value pool to the most-detailed BLS
categories listed in Table 6 of the October 2001 ``PPI Detailed Report''
that contain those items. The BLS categories and the current-year cost
of the items assigned to them are summarized as follows:
----------------------------------------------------------------------------------------------------------------
Current-year
Commodity code Category cost
----------------------------------------------------------------------------------------------------------------
12120101........................................ Living Room Table........................... $111,924.00
12120211........................................ Dining Room Table........................... 159,578.00
12120216........................................ Dining Room Chairs.......................... 98,639.00
12130101........................................ Upholstered Sofas........................... 332,488.00
12130111........................................ Upholstered Chairs.......................... 218,751.00
-----------------
Total....................................... ............................................ 921,380.00
----------------------------------------------------------------------------------------------------------------
(iv) Compute category inflation indexes for 2001. Because R elected
to use the double-extension IPIC method and did not elect the 10 percent
method, the category inflation indexes are computed in accordance with
paragraph (e)(3)(iii)(D)(3)(ii) of this section (BLS price indexes for
October 2001 divided by BLS price indexes for December 2000). R computes
the category inflation indexes for 2001 as follows:
----------------------------------------------------------------------------------------------------------------
(III) Category
Category (I) Oct. 2001 (II) Dec. 2000 inflation index:
index index (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Table......................................... 172.4 169.2 1.018913
Dining Room Table......................................... 171.9 168.1 1.022606
Dining Room Chairs........................................ 172.8 169.7 1.018268
Upholstered Sofas......................................... 142.2 140.9 1.009226
Upholstered Chairs........................................ 134.1 132.5 1.012075
----------------------------------------------------------------------------------------------------------------
(v) Compute IPI for 2001. R must compute the IPI for 2001, which is
the weighted harmonic mean of the category inflation indexes for 2001.
The formula for the weighted harmonic mean provided in paragraph
(e)(3)(iii)(E)(1) of this section is [Sum of Weights/Sum of (Weight/
Category Inflation Index)]. The IPI for 2001 is computed as follows:
----------------------------------------------------------------------------------------------------------------
(II) Category (III) Quotient:
Category (I) Weight inflation index (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Table......................................... $111,924.00 1.018913 $109,846.47
Dining Room Table......................................... 159,578.00 1.022606 156,050.33
Dining Room Chairs........................................ 98,639.00 1.018268 96,869.39
Upholstered Sofas......................................... 332,488.00 1.009226 329,448.51
Upholstered Chairs........................................ 218,751.00 1.012075 216,141.10
-----------------------------------------------------
Total................................................. $921,380.00 ................ $908,355.80
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
(V) Sum of (weight/
(IV) Sum of weights category inflation (VI) Inventory price
index) index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$921,380.00....................................................... $908,355.80 1.01433821
----------------------------------------------------------------------------------------------------------------
(vi) Determine the LIFO value of the dollar-value pool for 2001. For
2001, R determines the total base-year cost of its ending inventory by
dividing the total current-year cost of the items in the dollar-value
pool by the IPI for 2001. The total base-year cost of R's ending
inventory is $908,355.80 ($921,380/1.01433821). Comparing the base-year
cost of the ending inventory to the base-year cost of the beginning
inventory, R determines that the base-
[[Page 555]]
year cost of the 2001 increment is $58,355.80 ($908,355.80 -
$850,000.00). R multiplies the base-year cost of the 2001 increment by
the IPI for 2001 and determines that the LIFO value of the 2001 layer is
$59,192.52 ($58,355.80 * 1.01433821). Thus, the LIFO value of R's total
inventory at the end of 2001 is $909,192.52 ($850,000.00 (opening
inventory) + $59,192.52 (2001 layer)).
(vii) Select a BLS table and appropriate month for 2002. For 2002, R
must compute a new IPI under the double-extension IPIC method to
determine the LIFO value of its dollar-value pool. R determines that the
appropriate month for 2002 is November.
(viii) Assign inventory items to BLS categories for 2002. For 2002,
R assigns all items in the dollar-value pool to the most-detailed BLS
categories listed in Table 6 of the November 2002 ``PPI Detailed
Report'' that contain those items. The BLS categories and the current-
year cost of the items assigned to them are summarized as follows:
----------------------------------------------------------------------------------------------------------------
Current-year
Commodity code Category cost
----------------------------------------------------------------------------------------------------------------
12120103........................................ Living Room Desks........................... $125,008.00
12120211........................................ Dining Room Table........................... 136,216.00
12120216........................................ Dining Room Chairs.......................... 113,569.00
12130101........................................ Upholstered Sofas........................... 343,900.00
12130111........................................ Upholstered Chairs.......................... 233,050.00
-----------------
Total....................................... ............................................ $951,743.00
----------------------------------------------------------------------------------------------------------------
(ix) Compute category inflation indexes for 2002. Because R uses the
double-extension IPIC method and did not elect the 10 percent method,
the category inflation indexes are computed in accordance with paragraph
(e)(3)(iii)(D)(3)(ii) of this section (BLS price indexes for November
2002 divided by BLS price indexes for December 2000). R computes the
category inflation indexes for 2002 as follows:
----------------------------------------------------------------------------------------------------------------
(III) Category
Category (I) Nov. 2002 (II) Dec. 2000 inflation index
index index (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks......................................... 172.6 160.3 1.076731
Dining Room Table......................................... 174.8 168.1 1.039857
Dining Room Chairs........................................ 177.0 169.7 1.043017
Upholstered Sofas......................................... 144.9 140.9 1.028389
Upholstered Chairs........................................ 136.6 132.5 1.030943
----------------------------------------------------------------------------------------------------------------
(x) Compute IPI for 2002. R must compute the IPI for 2002, which is
the weighted harmonic mean [Sum of Weights/Sum of (Weight/Category
Inflation Index)] of the category inflation indexes for 2002. The IPI
for 2002 is computed as follows:
----------------------------------------------------------------------------------------------------------------
(II) Category (III) Quotient:
Category (I) Weight inflation index (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks......................................... $125,008.00 1.076731 $116,099.56
Dining Room Table......................................... 136,216.00 1.039857 130,994.93
Dining Room Chairs........................................ 113,569.00 1.043017 108,885.09
Upholstered Sofas......................................... 343,900.00 1.028389 334,406.53
Upholstered Chairs........................................ 233,050.00 1.030943 226,055.17
-----------------------------------------------------
Total................................................. 951,743.00 ................ 916,441.28
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
(V) Category (VI) Inventory price
(IV) Sum of weights inflation index index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$951,743.00....................................................... $916,441.28 1.03852044
----------------------------------------------------------------------------------------------------------------
(xi) Determine the LIFO value of the pool for 2002. For 2002, R
determines the total base-year cost of its ending inventory by dividing
the total current-year cost of the items in the dollar-value pool by the
IPI for 2002. The total base-year cost of the ending inventory is
$916,441.28 ($951,743.00/1.03852044). Comparing the base-year cost of
the ending inventory to the base-year cost of the beginning inventory, R
determines that the base-
[[Page 556]]
year cost of the 2002 increment is $8,085.48 ($916,441.28-$908,355.80).
R multiplies the base-year cost of the 2002 increment by the IPI for
2002 and determines that the LIFO value of the 2002 layer is $8,396.94
($8,085.48 * 1.03852044). Thus, the LIFO value of R's total inventory at
the end of 2002 is $917,589.46 ($850,000.00 (opening inventory) +
$59,192.52 (2001 layer) + $8,396.94 (2002 layer)).
Example 2. Link-chain method. (i) Introduction. The facts are the
same as Example 1, except that R uses the link-chain IPIC method. The
double-extension IPIC method and the link-chain IPIC method yield the
same results for the first taxable year in which the dollar-value LIFO
and IPIC methods are used. Therefore, this example illustrates only how
R will compute the IPI for, and determine the LIFO value of, its dollar-
value pool for 2002.
(ii) Select a BLS table and appropriate month for 2002. R determines
that the appropriate month for 2002 is November.
(iii) Assign inventory items to BLS categories for 2002. For 2002, R
assigns all items in the dollar-value pool to the most-detailed BLS
categories listed in Table 6 of the November 2002 ``PPI Detailed
Report'' that contain those items. The BLS categories and the current-
year cost of the items assigned to them are summarized as follows:
----------------------------------------------------------------------------------------------------------------
Current-year
Commodity code Category cost
----------------------------------------------------------------------------------------------------------------
12120103........................................ Living Room Desks........................... $125,008.00
12120211........................................ Dining Room Table........................... 136,216.00
12120216........................................ Dining Room Chairs.......................... 113,569.00
12130101........................................ Upholstered Sofas........................... 343,900.00
12130111........................................ Upholstered Chairs.......................... 233,050.00
-----------------
Total....................................... ............................................ 951,743.00
----------------------------------------------------------------------------------------------------------------
(iv) Compute category inflation indexes for 2002. Because R uses the
link-chain IPIC method and did not elect the 10 percent method, the
category inflation indexes are computed in accordance with paragraph
(e)(3)(iii)(D)(3)(iii) of this section (BLS price indexes for November
2002 divided by BLS price indexes for October 2001). R computes the
category inflation indexes for 2002 as follows:
----------------------------------------------------------------------------------------------------------------
(III) Category
Category (I) Nov. 2002 (II) Oct. 2001 inflation index:
index index (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks......................................... 172.6 162.0 1.065432
Dining Room Table......................................... 174.8 171.9 1.016870
Dining Room Chairs........................................ 177.0 172.8 1.024306
Upholstered Sofas......................................... 144.9 142.2 1.018987
Upholstered Chairs........................................ 136.6 134.1 1.018643
----------------------------------------------------------------------------------------------------------------
(v) Compute IPI for 2002. As provided in paragraph (e)(3)(iii)(E)(2)
of this section, R must compute the IPI for 2002 by multiplying the
weighted harmonic mean of the category inflation indexes for 2002 by the
IPI for 2001. The IPI for 2002 is computed as follows:
----------------------------------------------------------------------------------------------------------------
(II) Category (III) Quotient:
Category (I) Weight inflation index (I)/(II)
----------------------------------------------------------------------------------------------------------------
Living Room Desks......................................... $125,008.00 1.065432 $117,330.81
Dining Room Table......................................... 136,216.00 1.016870 133,956.16
Dining Room Chairs........................................ 113,569.00 1.024306 110,874.09
Upholstered Sofas......................................... 343,900.00 1.018987 337,492.04
------------------ -----------------
Upholstered Chairs........................................ 233,050.00 1.018643 228,784.77
Total................................................. 951,743.00 ................ 928,437.87
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
(VI) Weighted
(V) Sum of (weight/ harmonic mean of (VII) Inventory (VIII) Inventory
(IV) Sum of weights category inflation category inflation price index for price index for
index) indexes for 2002: 2001 2002: (VI)*(VII)
(IV)/(V)
----------------------------------------------------------------------------------------------------------------
$951,743.00................. $928,437.87 1.02510144 1.01433821 1.03979956
----------------------------------------------------------------------------------------------------------------
[[Page 557]]
(vi) Determine the LIFO value of the pool for 2002. R determines the
total base-year cost of its ending inventory by dividing the total
current-year cost of the items in the dollar-value pool by the IPI for
2002. The total base-year cost of the ending inventory is $915,313.91
($951,743.00 / 1.03979956). Comparing the base-year cost of the ending
inventory to the base-year cost of the beginning inventory, R determines
that the base-year cost of the 2002 layer is $6,958.11 ($915,313.91-
$908,355.80). R multiplies the base-year cost of the 2002 layer by the
IPI for 2002 and determines that the LIFO value of the 2002 layer is
$7,235.04 ($6,958.11 * 1.03979956). Thus, the LIFO value of R's total
inventory at the end of 2002 is $916,427.56 ($850,000.00 (opening
inventory) + $59,192.52 (2001 layer) + $7,235.04 (2002 layer)).
(iv) Adoption or change of method--(A) Adoption or change to IPIC
method. The use of an inventory price index computed under the IPIC
method is a method of accounting. A taxpayer permitted to adopt the
dollar-value LIFO method without first securing the Commissioner's
consent also may adopt the IPIC method without first securing the
Commissioner's consent. The IPIC method may be adopted and used,
however, only if the taxpayer provides the following information on a
Form 970, ``Application to Use LIFO Inventory Method,'' or in another
manner as may be acceptable to the Commissioner: A complete list of
dollar-value pools (including a description of the items in each dollar-
value pool); the BLS table (i.e., CPI or PPI) selected for each dollar-
value pool; the representative month, if applicable, elected for each
dollar-value pool; the BLS categories to which the items in each dollar-
value pool will be assigned; the method of assigning items to BLS
categories (e.g., the 10 percent method) for each dollar-value pool; and
the method of computing the IPI (i.e., double-extension IPIC method or
link-chain IPIC method) for each dollar-value pool. In the case of a
taxpayer permitted to adopt the IPIC method without requesting the
Commissioner's consent, the Form 970 must be attached to the taxpayer's
income tax return for the taxable year of adoption. In all other cases,
a taxpayer may change to the IPIC method only after securing the
Commissioner's consent as provided in Sec. 1.446-1(e). In these latter
cases, the Form 970 containing the information described in this
paragraph (e)(3)(iv)(A) must be attached to a Form 3115, ``Application
for Change in Accounting Method,'' filed as required by Sec. 1.446-
1(e). A taxpayer that simultaneously changes to the dollar-value LIFO
and IPIC methods from another LIFO method must apply the rules of
paragraph (f)(2) of this section before applying the rules of paragraph
(e)(3)(iv)(B)(1) of this section. To satisfy the requirements of Sec.
1.472-2(h), taxpayers must maintain adequate books and records,
including those concerning the use of the IPIC method and necessary
computations. Notwithstanding the rules in paragraph (e)(1) of this
section, a taxpayer that adopts, or changes to, the link-chain IPIC
method is not required to demonstrate that the use of any other method
of determining the LIFO value of a dollar-value pool is impractical.
(B) New base year--(1) Voluntary change--(i) In general. In the case
of a taxpayer using a non-IPIC method to determine the LIFO value of
inventory, the layers previously determined under that method, if any,
and the LIFO values of those layers are retained if the taxpayer
voluntarily changes to the IPIC method. Instead of using the earliest
taxable year for which the taxpayer adopted the LIFO method for any
items in the dollar-value pool, the year of change is used as the new
base year for the purpose of determining the amount of increments and
liquidations, if any, for the year of change and subsequent taxable
years. The base-year cost of the layers in a dollar-value pool at the
beginning of the year of change must be restated in terms of new base-
year cost using the year of change as the new base year and, if
applicable, the indexes for the previously determined layers must be
recomputed accordingly. The recomputed indexes will be used to determine
the LIFO value of subsequent liquidations. For purposes of computing an
IPI under paragraph (e)(3)(iii)(E) of this section, the IPI for the
immediately preceding year is 1.00. The new total base-year cost of the
items in a dollar-value pool for the purpose of determining future
increments and liquidations is equal to the total current-year cost of
the items in the dollar-value pool (determined using the
[[Page 558]]
taxpayer's method of determining the total current-year cost of the
items in the dollar-value pool under paragraph (e)(2)(ii) of this
section). A taxpayer must allocate this new total base-year cost to each
layer based on the ratio of the old base-year cost of the layer to the
old total base-year cost of the dollar-value pool.
(ii) Example. The following example illustrates the rules of this
paragraph (e)(3)(iv)(B)(1):
Example. (i) In 1990, X elected to use a dollar-value LIFO method
(other than the IPIC method) for its single dollar-value pool. X is
granted permission to change to the link-chain IPIC method, beginning
with the taxable year ending December 31, 2001. X will continue using a
single dollar-value pool. X's beginning inventory as of January 1, 2001,
computed using its former inventory method, is as follows:
----------------------------------------------------------------------------------------------------------------
(III) LIFO
Layer (I) Base-year (II) Inflation value: (I) *
cost index (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................ $135,000 1.00 $135,000
1991 layer................................................ 20,000 1.43 28,600
1994 layer................................................ 60,000 1.55 93,000
1995 layer................................................ 13,000 1.59 20,670
1997 layer................................................ 2,000 1.61 3,220
------------------ -----------------
Total................................................. 230,000 ................ 280,490
----------------------------------------------------------------------------------------------------------------
(ii) Under X's method of determining the current-year cost of items
in a dollar-value pool, the current-year cost of the beginning inventory
is $391,000. Thus, X's new base-year cost as of January 1, 2001, is
$391,000. X allocates this new base-year cost to each layer based on the
ratio of old base-year cost of the layer to the total old base-year cost
of the dollar-value pool. To recompute the inflation indexes for each of
its layers, X divides the LIFO value of each layer by the new base-year
cost attributable to the layer. The new base-year cost, recomputed
inflation indexes, and LIFO value of X's layers as of January 1, 2001,
are as follows:
----------------------------------------------------------------------------------------------------------------
(III) LIFO
Layer (I) Base-year (II) Inflation value: (I) *
cost index (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................ $229,500 0.588235 $135,000
1991 layer................................................ 34,000 0.841176 28,600
1994 layer................................................ 102,000 0.911765 93,000
1995 layer................................................ 22,100 0.935294 20,670
1997 layer................................................ 3,400 0.947059 3,220
------------------ -----------------
Total................................................. 391,000 ................ 280,490
----------------------------------------------------------------------------------------------------------------
(iii) In 2001, the current-year cost of X's ending inventory is
$430,139. The weighted harmonic mean of the category inflation indexes
applicable to X's ending inventory is 1.075347, and in accordance with
paragraph (e)(3)(iv)(B)(1)(i) of this section, the inflation index for
the immediately preceding taxable year is 1.00. Thus, X's IPI for 2001
is 1.075347 (1.00 * 1.075347). The total base-year cost of X's ending
inventory is $400,000 ($430,139/1.075347). The base-year cost, IPI, and
LIFO value of X's layers as of December 31, 2001, are as follows:
----------------------------------------------------------------------------------------------------------------
(III) LIFO
Layer (I) Base-year (II) Inventory value: (I) *
cost price index (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................ $229,500 0.588235 $135,000
1991 layer................................................ 34,000 0.841176 28,600
1994 layer................................................ 102,000 0.911765 93,000
1995 layer................................................ 22,100 0.935294 20,670
1997 layer................................................ 3,400 0.947059 3,220
2001 layer................................................ 9,000 1.075347 9,678
------------------ -----------------
Total................................................. 400,000 ................ 290,168
----------------------------------------------------------------------------------------------------------------
[[Page 559]]
(iv) In 2002, the current-year cost of X's ending inventory is
$418,000. The weighted harmonic mean of the category inflation indexes
applicable to X's ending inventory is 1.02292562, and the IPI for the
immediately preceding year is 1.075347. Thus, X's IPI for 2001 is 1.10
(1.075347 * 1.02292562). The total base-year cost of X's ending
inventory is $380,000 ($418,000/1.10), which results in a liquidation of
$20,000 ($400,000-$380,000) in terms of base-year cost. This liquidation
eliminates the 2001 layer ($9,000 base-year cost), the 1997 layer
($3,400 base-year cost), and part of the 1995 layer ($7,600 base-year
cost). The base-year cost, indexes, and LIFO value of X's layers as of
December 31, 2002, are as follows:
----------------------------------------------------------------------------------------------------------------
(III) LIFO
Layer (I) Base-year (II) Inventory value: (I) *
cost price index (II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................ $229,500 0.588235 $135,000
1991 layer................................................ 34,000 0.841176 28,600
1994 layer................................................ 102,000 0.911765 93,000
1995 layer................................................ 14,500 0.935294 13,562
------------------ -----------------
Total................................................. 380,000 ................ 270,162
----------------------------------------------------------------------------------------------------------------
(2) Involuntary change--(i) In general. If a taxpayer uses a non-
IPIC method to compute the LIFO value of a dollar-value pool, and if the
Commissioner determines that the taxpayer's method does not clearly
reflect income, the Commissioner may require the taxpayer to change to
the IPIC method. If the Commissioner requires a taxpayer to change to
the IPIC method, and the taxpayer does not provide sufficient
information from its books and records to compute an adjustment under
section 481, the Commissioner may implement the change using the
simplified transition method described in paragraph (e)(3)(iv)(B)(2)(ii)
of this section.
(ii) Simplified Transition Method. Under the simplified transition
method, the Commissioner will recompute the LIFO value of each dollar-
value pool as of the beginning of the year of change using the double-
extension IPIC method or the link-chain IPIC method. The adjustment
under section 481 is equal to the difference between the recomputed LIFO
value and the LIFO value of the pool determined under the taxpayer's
former method. The Commissioner will compute an IPI using the double-
extension IPIC method or link-chain IPIC method for each taxable year in
which the LIFO method was used by the taxpayer based on the assumptions
that the ending inventory of the pool in each taxable year was comprised
of items that fall into the same BLS categories as the items in the
ending inventory of the year of change and that the relative weights of
those BLS categories in all prior years were the same as the relative
weights of those BLS categories in the ending inventory of the year of
change. The base-year cost of the items in a dollar-value pool at the
end of a taxable year will be determined by dividing the IPI computed
for the taxable year into the current-year cost of the items in that
pool determined in accordance with paragraph (e)(2)(ii) of this section.
If the comparison of the base-year cost of the beginning and ending
inventory produces a current-year increment, the base-year cost of that
increment will be multiplied by the IPI computed for that taxable year
to determine the LIFO value of that layer.
(iii) Example. The following example illustrates the rules of this
paragraph (e)(3)(iv)(B)(2)(ii).
Example. (i) Z began using a dollar-value LIFO method other than the
IPIC method in the taxable year ending December 31, 1998, and maintains
a single dollar-value pool. Z's beginning inventory as of January 1,
2000, computed using its method of accounting, was as follows:
----------------------------------------------------------------------------------------------------------------
(I) Base-year (II) Inflation (III) LIFO
Layer cost index value: (I)*(II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................ $105,000 1.00 $105,000
1998 layer................................................ 3,000 1.40 4,200
------------------ -----------------
[[Page 560]]
Total................................................. 108,000 ................ 109,200
----------------------------------------------------------------------------------------------------------------
(ii) Upon examining Z's federal income tax return for the taxable
year ending December 31, 2000, the examining agent determines that Z's
dollar-value LIFO method does not clearly reflect income. The examining
agent chooses to change Z to the double-extension IPIC method for 2000
and implements the change using the simplified transition method as
follows. First, the inventory in Z's dollar-value pool at the end of
2000 is assigned to the most-detailed categories in the CPI or PPI,
whichever is appropriate. Assume that 80 percent of the current-year
cost of Z's inventory as of December 31, 2000, is assigned to Category
1, 10 percent is assigned to Category 2, and 10 percent is assigned to
Category 3. Assume further that the current-year cost of the inventory
in Z's dollar-value pool at the end of 1998 and 1999 was $133,000 and
$145,000, respectively.
(iii) The category inflation indexes for 1998 computed under the
double-extension IPIC method are 1.17 for Category 1, 1.26 for Category
2, and 1.19 for Category 3. The weights to be used in computing the IPI
for 1998 are $106,400 ($133,000 * 80 percent) for Category 1, $13,300
($133,000 * 10 percent) for Category 2, and $13,300 ($133,000 * 10
percent) for Category 3. The IPI for 1998 is computed as follows:
----------------------------------------------------------------------------------------------------------------
(II) Category (III) Quotient:
Category (I) Weight inflation index (I)/(II)
----------------------------------------------------------------------------------------------------------------
1......................................................... $106,400 1.17 90,940
2......................................................... 13,300 1.26 10,556
3......................................................... 13,300 1.19 11,176
------------------ -----------------
Total................................................. 133,000 ................ 112,672
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
(V) Sum of (weight/
(IV) Sum of weights category inflation (VI) Inventory price
index) index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$133,000.......................................................... $112,672 1.180417
----------------------------------------------------------------------------------------------------------------
(iv) The base-year cost of the inventory in Z's pool at the end of
1998 is $112,672 ($133,000/1.180417), and the base-year cost of the 1998
increment is $7,672 ($112,672-$105,000). The LIFO value of the 1998
layer is $9,056 ($7,672 x 1.180417).
(v) The category inflation indexes for 1999 computed under the
double-extension IPIC method were 1.21 for Category 1, 1.29 for Category
2 and 1.23 for Category 3. The weights to be used in computing the IPI
for 1999 are $116,000 ($145,000 x 80 percent) for Category 1, $14,500
($145,000 x 10 percent) for Category 2, and $14,500 ($145,000 x 10
percent) for Category 3. The IPI for 1999 is computed as follows:
----------------------------------------------------------------------------------------------------------------
(II) Category (III) Quotient:
Category (I) Weight inflation index (I)/(II)
----------------------------------------------------------------------------------------------------------------
1......................................................... $116,000 1.21 $95,868
2......................................................... 14,500 1.29 11,240
3......................................................... 14,500 1.23 11,789
------------------ -----------------
Total................................................. 145,000 ................ 118,897
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
(V) Sum of (weight/
(IV) Sum of weights category inflation (VI) Inventory price
index) index: (IV)/(V)
----------------------------------------------------------------------------------------------------------------
$145,000.......................................................... $118,897 1.219543
----------------------------------------------------------------------------------------------------------------
(vi) The base-year cost of the inventory in Z's pool at the end of
1999 is $118,897 ($145,000/1.219543), and the base-year cost of the 1999
layer is $6,225 ($118,897-$112,672). The LIFO value of the 1999 layer is
$7,592 ($6,225 x 1.219543).
[[Page 561]]
(vii) The LIFO value of Z's dollar-value pool at the end of 1999
computed under the double-extension IPIC method is as follows:
----------------------------------------------------------------------------------------------------------------
(I) Base-year (II) Inventory (III) LIFO
Layer cost price index value: (I)*(II)
----------------------------------------------------------------------------------------------------------------
Base layer................................................ $105,000 1.000000 $105,000
1998 layer................................................ 7,672 1.180417 9,056
1999 layer................................................ 6,225 1.219542 7,592
�����������������������������������������������������������
Total................................................. 118,897 ................ 121,648
----------------------------------------------------------------------------------------------------------------
(viii) The section 481(a) adjustment is equal to the difference
between the LIFO value of the inventory at the beginning of 2000
computed under Z's former method of accounting and recomputed by the
examining agent under the double-extension IPIC method, or $12,448
($121,648--$109,200).
(ix) Finally, the examining agent will recompute Z's taxable income
for 2000 and succeeding taxable years using the double-extension IPIC
method.
(v) Effective date--(A) In general. The rules of this paragraph
(e)(3) and paragraphs (b)(4) and (c)(2) of this section are applicable
for taxable years ending on or after December 31, 2001.
(B) Change in method of accounting. Any change in a taxpayer's
method of accounting necessary to comply with this paragraph (e)(3) or
with paragraphs (b)(4) or (c)(2) of this section is a change in method
of accounting to which the provisions of section 446 and the regulations
thereunder apply. For the first or second taxable year ending on or
after December 31, 2001, a taxpayer is granted the consent of the
Commissioner to change its method of accounting to a method required or
permitted by this paragraph (e)(3) and paragraphs (b)(4) and (c)(2) of
this section. A taxpayer that wants to change its method of accounting
under this paragraph (e)(3)(v) must follow the automatic consent
procedures in Rev. Proc. 2002-9 (2002-3 I.R.B. xxx) (see Sec.
601.601(d)(2) of this chapter). However, the scope limitations in
section 4.02 of Rev. Proc. 2002-9 do not apply, and the five-year
limitation on the readoption of the LIFO method under section 10.01(2)
of the appendix is waived. In addition, if the taxpayer's method of
accounting for its LIFO inventories is an issue under consideration at
the time the application is filed with the national office, the audit
protection of section 7 of Rev. Proc. 2002-9 does not apply. If a
taxpayer changing its method of accounting under this paragraph
(e)(3)(v)(B) is under examination, before an appeals office, or before a
federal court with respect to any income tax issue, the taxpayer must
provide a copy of the application to the examining agent(s), appeals
officer or counsel for the government, as appropriate, at the same time
it files the application with the national office. Any change under this
paragraph (e)(3)(v)(B) must be made using a cut-off method and new base
year. See paragraph (e)(3)(iv)(B)(1) of this section for an example of
this computation. Because a change under this paragraph (e)(3)(v)(B) is
made using a cut-off method, a section 481(a) adjustment is not
permitted. However, a taxpayer changing its method of accounting under
this paragraph (e)(3)(v)(B) must comply with the requirements of section
10.06(3) of the APPENDIX of Rev. Proc. 2002-9 (concerning bargain
purchases).
(f) Change to dollar-value method from another method of pricing
LIFO inventories--(1) Consent required. Except as provided in Sec.
1.472-3 in the case of a taxpayer electing to use a LIFO inventory
method for the first time, or in the case of a taxpayer changing to the
dollar-value method and continuing to use the same pools as were used
under another LIFO method, a taxpayer using another LIFO method of
pricing inventories may not change to the dollar-value method of pricing
such inventories unless he first secures the consent of the Commissioner
in accordance with paragraph (e) of Sec. 1.446-1.
(2) Method of converting inventory. Where the taxpayer changes from
one method of pricing LIFO inventories to the dollar-value method, the
ending
[[Page 562]]
LIFO inventory for the taxable year immediately preceding the year of
change shall be converted to the dollar-value LIFO method. This is done
to establish the base-year cost for subsequent calculations. Thus, if
the taxpayer was previously valuing LIFO inventories on the specific
goods method, these separate values shall be combined into appropriate
pools. For this purpose, the base year for the pool shall be the
earliest taxable year for which the LIFO inventory method had been
adopted for any item in that pool. No change will be made in the overall
LIFO value of the opening inventory for the year of change as a result
of the conversion, and that inventory will merely be restated in the
manner used under the dollar-value method. All layers of increment for
such inventory must be retained, except that all layers of increment
which occurred in the same taxable year must be combined. The following
examples illustrate the provisions of this subparagraph:
Example 1. (i) Assume that the taxpayer has used another LIFO method
for finished goods since 1954 and has complied with all the requirements
prerequisite for a change to the dollar-value method. Items A, B, and C,
which have previously been inventoried under the specific goods LIFO
method, may properly be included in a single dollar-value LIFO pool. The
LIFO inventory value of items A, B, and C at December 31, 1960, is
$12,200, computed as follows:
------------------------------------------------------------------------
Dec. 31,
Base 1960,
Year quantity Unit inventory
and yearly cost at LIFO
increments value
------------------------------------------------------------------------
Item A
1954 (base year)........................ 100 $1 $100
1955.................................... 200 2 400
1956.................................... 100 4 400
1960.................................... 100 6 600
------------ ----------
Total................................ 500 ....... 1,500
Item B
1954 (base year)........................ 300 6 1,800
1955.................................... 100 8 800
1960.................................... 50 10 500
------------ ----------
Total................................ 450 ....... 3,100
Item C
1954 (base year)........................ 1,000 4 4,000
1955.................................... 200 6 1,200
1956.................................... 300 8 2,400
------------ ----------
Total................................. 1,500 ....... 7,600
============
LIFO value of items A, B, and C at .......... ....... 12,200
Dec. 31, 1960........................
------------------------------------------------------------------------
There were no increments in the years 1957, 1958, or 1959.
(ii) The computation of the ratio of the total current-year cost to
the total base-year cost for the base year and each layer of increment
in Pool No. 1 is shown as follows:
----------------------------------------------------------------------------------------------------------------
1954 Increments
base- --------------------------------------
Item year Year 1954
unit 1955 1956 1960
cost
----------------------------------------------------------------------------------------------------------------
A
Base-year cost..................................... $1.00 $100 $200 $100 $100
LIFO value......................................... ....... 100 400 400 600
B
Base-year cost..................................... 6.00 1,800 600 ........... 300
LIFO value......................................... ....... 1,800 800 ........... 500
C
Base-year cost..................................... 4.00 4,000 800 1,200 ...........
LIFO value......................................... ....... 4,000 1,200 2,400 ...........
---------------------------------------------------
Total--Base-year cost.............................. 5,900 1,600 1,300 400
Total--LIFO value.................................. 5,900 2,400 2,800 1,100
===================================================
Ratio of total current-year cost to total base-year ....... 100.00 150.00 215.38 275.00
cost (percent)....................................
----------------------------------------------------------------------------------------------------------------
[[Page 563]]
(iii) On the basis of the foregoing computations, the LIFO inventory
of Pool No. 1, at December 31, 1960, is restated as follows:
------------------------------------------------------------------------
Ratio of
total
Dec. 31, current- Dec. 31,
1960, year cost 1960,
inventory to total inventory
at base- base-year at LIFO
year cost cost value
(percent)
------------------------------------------------------------------------
1954 base cost....................... $5,900 100.00 $5,900
1955 increment....................... 1,600 150.00 2,400
1956 increment....................... 1,300 215.38 2,800
1960 increment....................... 400 275.00 1,100
------------ ----------
Total............................ 9,200 .......... 12,200
------------------------------------------------------------------------
Example 2. Assume the same facts as in Example 1 and assume further
that the base-year cost of Pool No. 1 at December 31, 1961, is $8,350.
Since the closing inventory for the taxable year 1961 at base-year cost
is less than the opening inventory for that year at base-year cost, a
liquidation has occurred during 1961. This liquidation absorbs all of
the 1960 layer of increment and part of the 1956 layer of increment. The
December 31, 1961, inventory is $10,131, computed as follows:
------------------------------------------------------------------------
Ratio of
total
Dec. 31, current- Dec. 31,
1961, year cost 1961,
inventory to total inventory
at base- base-year at LIFO
year cost cost value
(percent)
------------------------------------------------------------------------
1954 base cost....................... $5,900 100.00 $5,900
1955 increment....................... 1,600 150.00 2,400
1956 increment....................... 850 215.38 1,831
------------ ----------
Total............................ 8,350 .......... 10,131
------------------------------------------------------------------------
(g) Transitional rules--(1) Change in method of pooling. Any method
of pooling authorized by this section and used by the taxpayer in
computing his LIFO inventories under the dollar-value method shall be
treated as a method of accounting. Any method of pooling which is
authorized by this section shall be used for the year of adoption and
for all subsequent taxable years unless a change is required by the
Commissioner in order to clearly reflect income, or unless permission to
change is granted by the Commissioner as provided in paragraph (e) of
Sec. 1.446-1. Where the taxpayer changes from one method of pooling to
another method of pooling permitted by this section, the ending LIFO
inventory for the taxable year preceding the year of change shall be
restated under the new method of pooling.
(2) Manner of combining or separating dollar-value pools. (i) A
taxpayer who has been using the dollar-value LIFO method and who is
permitted or required to change his method of pooling, shall combine or
separate the LIFO value of his inventory for the base year and each
yearly layer of increment in order to conform to the new pool or pools.
Each yearly layer of increment in the new pool or pools must be
separately accounted for and a record thereof maintained, and any
liquidation occurring in the new pool or pools subsequent to the
formation thereof shall be treated in the same manner as if the new pool
or pools had existed from the date the taxpayer first adopted the LIFO
inventory method. The combination or separation of the LIFO value of his
inventory for the base year and each yearly layer of increment shall be
made in accordance with the appropriate method set forth in this
subparagraph, unless the use of a different method is approved by the
Commissioner.
(ii) Where the taxpayer is permitted or required to separate a pool
into more than one pool, the separation shall be made in the following
manner: First, each item in the former pool shall be placed in an
appropriate new pool. Every item in each new pool is then extended at
its base-year unit cost and the extensions are totaled. Each total is
the amount of inventory for each new pool expressed in terms of base-
year cost. Then a ratio of the total base-year cost of each new pool to
the base-year cost of the former pool is computed. The resulting ratio
is applied to the amount of inventory for the base year and each yearly
layer of increment of the former pool to obtain an allocation to each
new pool of the base-year inventory of the former pool and subsequent
layers of increment thereof. The foregoing may be illustrated by the
following example of a change for the taxable year 1961:
Example. (a) Assume that items A, B, C, and D are all grouped
together in one pool prior to December 31, 1960. The LIFO inventory
value at December 31, 1960, is computed as follows:
[[Page 564]]
------------------------------------------------------------------------
Pool ABCD
----------------------------------
Ratio of
Dec. 31, total
1960, current- Dec. 31,
inventory year cost 1960,
at Jan. 1, to total inventory
1956, base- base-year at LIFO
year cost cost value
(percent)
------------------------------------------------------------------------
Jan. 1, 1956, base cost.............. $10,000 100 $10,000
Dec. 31, 1956, increment............. 1,000 110 1,100
Dec. 31, 1958, increment............. 5,000 120 6,000
Dec. 31, 1960, increment............. 4,000 125 5,000
------------ ----------
Total.............................. 20,000 .......... 22,100
------------------------------------------------------------------------
(b) The extension of the quantity of items A, B, C, and D at
respective base-year unit costs is as follows:
------------------------------------------------------------------------
Base-
year
Item Quantity unit Amount
cost
------------------------------------------------------------------------
A.......................................... 2,000 $2 $4,000
B.......................................... 1,000 3 3,000
C.......................................... 1,000 5 5,000
D.......................................... 4,000 2 8,000
--------
Total.................................. ........ ........ 20,000
------------------------------------------------------------------------
(c) Under the provisions of this section the taxpayer separates
former Pool ABCD into two pools, Pool AB and Pool CD. The computation of
the ratio of total base-year cost for each of the new pools to the base-
year cost of the former pool is as follows:
------------------------------------------------------------------------
Total
Item base-year Ratio
cost
------------------------------------------------------------------------
Pool AB:
A.......................................... $4,000 ..............
B.......................................... 3,000 ..............
-----------
7,000 7,000/20,000
===========
Pool CD:
C.......................................... 5,000 ..............
D.......................................... 8,000 ..............
13,000 13,000/20,000
-----------
Total for pool ABCD........................ 20,000 ..............
------------------------------------------------------------------------
(d) The ratio of the base-year cost of new Pools AB and CD to the
base-year cost of former Pool ABCD is 7,000/20,000 and 13,000/20,000,
respectively. The allocation of the January 1, 1956 base cost and
subsequent yearly layers of increment of former Pool ABCD to new Pools
AB and CD is as follows:
------------------------------------------------------------------------
Base-year Pool
cost to -----------------
be
allocated AB CD
------------------------------------------------------------------------
Jan. 1, 1956, base cost.................... $10,000 $3,500 $6,500
Dec. 31, 1956, increment................... 1,000 350 650
Dec. 31, 1958, increment................... 5,000 1,750 3,250
Dec. 31, 1960, increment................. 4,000 1,400 2,600
----------------------------
Total................................ 20,000 7,000 13,000
------------------------------------------------------------------------
(e) The LIFO value of new Pools AB and CD at December 31, 1960, as
allocated, is as follows:
------------------------------------------------------------------------
Ratio of
Dec. 31, total
1960, current- Dec. 31,
inventory year cost 1960,
at Jan. 1, to total inventory
1956, base- base-year at LIFO
year cost cost value
(percent)
------------------------------------------------------------------------
Pool AB
Jan. 1, 1956, base cost.............. $3,500 100 $3,500
Dec. 31, 1956, increment............. 350 110 385
Dec. 31, 1958, increment............. 1,750 20 2,100
Dec. 31, 1960, increment............. 1,400 125 1,750
------------ ----------
Total.......................... 7,000 .......... 7,735
=============
Pool CD
Jan. 1, 1956, base cost.............. 6,500 100 6,500
Dec. 31, 1956, increment............. 650 110 715
Dec. 31, 1958, increment............. 3,250 120 3,900
Dec. 31, 1960, increment............. 2,600 125 3,250
------------ ----------
Total.......................... 13,000 .......... 14,365
------------------------------------------------------------------------
(iii) Where the taxpayer is permitted or required to combine two or
more pools having the same base year, they shall be combined into one
pool in the following manner: The LIFO value of the base-year inventory
of each of the former pools is combined to obtain a LIFO value of the
base-year inventory for the new pool. Then, any layers of increment in
the various pools which occurred in the same taxable year are combined
into one total layer of increment for that taxable year. However, layers
of increment which occurred in different taxable years may not be
combined. In combining the layers of increment a new ratio of current-
year cost to base-year cost is computed for each of the combined layers
of increment. The foregoing may be illustrated by the following example:
Example. (a) Assume the taxpayer has two pools at December 31, 1960.
Under the provisions of this section the taxpayer combines
[[Page 565]]
these pools into a single pool as of January 1, 1961. The LIFO inventory
value of each pool at December 31, 1960, is shown as follows:
------------------------------------------------------------------------
Ratio of
Dec. 31, total
1960, current- Dec. 31,
inventory year cost 1960,
at Jan. 1, to total inventory
1957, base- base-year at LIFO
year cost cost value
(percent)
------------------------------------------------------------------------
Pool No. 1
Jan. 1, 1956, base cost.............. $10,000 100 $10,000
Dec. 31, 1957, increment............. 2,000 110 2,200
Dec. 31, 1960, increment............. 1,000 120 1,200
------------ ----------
Total.......................... 13,000 .......... 13,400
==================================
Pool No. 2
Jan. 1, 1957, base cost.............. 5,000 100 5,000
Dec. 31, 1960, increment............. 3,000 140 4,200
------------ ----------
Total.......................... 8,000 .......... 9,200
------------------------------------------------------------------------
(b) The computation of the ratio of the total current-year cost to
the total base-year cost for the base year and each yearly layer of
increment in the new pool is as follows:
------------------------------------------------------------------------
Increments
Base -------------------
Pool year Dec. 31, Dec. 31,
1957 1957 1960
------------------------------------------------------------------------
No. 1:
Base-year cost.......................... $10,000 $2,000 $1,000
LIFO value.............................. 10,000 2,200 1,200
No. 2:
Base-year cost.......................... 5,000 ........ 3,000
LIFO value.............................. 5,000 ........ 4,200
-----------------------------
Total, base-year cost................... 15,000 2,000 4,000
Total, LIFO value....................... 15,000 2,200 5,400
=============================
Ratio of total current-year cost to total 100 110 135
base-year cost (percent).................
------------------------------------------------------------------------
(c) On the basis of the foregoing computations, the LIFO inventory
of the new pool at December 31, 1960, is restated as follows:
------------------------------------------------------------------------
Ratio of
Dec. 31, total
1960, current- Dec. 31,
inventory year cost 1960,
at Jan. 1, to total inventory
1957, base- base-year at LIFO
year cost cost value
(percent)
------------------------------------------------------------------------
Jan. 1, 1957, base cost.............. $15,000 100 $15,000
Dec. 31, 1957, increment............. 2,000 110 2,200
Dec. 31, 1960, increment............. 4,000 135 5,400
------------ ----------
Total.......................... 21,000 .......... 22,600
------------------------------------------------------------------------
(iv) In combining pools having different base years, the principles
set forth in subdivision (iii) of this subparagraph are to be applied,
except that all base years subsequent to the earliest base year shall be
treated as increments, and the base-year costs for all pools having a
base year subsequent to the earliest base year of any pool shall be
redetermined in terms of the base cost for the earliest base year. The
foregoing may be illustrated by the following example:
Example. (a) Assume that the taxpayer has two pools at December 31,
1960. Under the provisions of this section the taxpayer combines these
pools into a single pool as of January 1, 1961. The LIFO inventory value
of each pool at December 31, 1960, is shown as follows:
------------------------------------------------------------------------
Ratio of
Dec. 31, total
1960, current Dec. 31,
inventory rent-year 1960,
at Jan. 1, cost to inventory
1956, base- total base- at LIFO
year cost year cost value
(percent)
------------------------------------------------------------------------
Pool No. 1
Jan. 1, 1956, base cost.............. $7,000 100 $7,000
Dec. 31, 1956, increment............. 1,000 105 1,050
Dec. 31, 1957, increment............. 500 110 550
Dec. 31, 1958, increment............. 500 110 550
Dec. 31, 1960, increment............. 1,000 120 1,200
------------ ----------
Total.......................... 10,000 .......... 10,350
==================================
Pool No. 2
Jan. 1, 1958, base cost.............. 3,500 100 3,500
Dec. 31, 1958, increment............. 1,000 110 1,100
Dec. 31, 1959, increment............. 500 115 575
Total.......................... 5,000 .......... 5,175
------------------------------------------------------------------------
(b) The next step is to redetermine the 1958 base-year cost for Pool
No. 2 in terms of 1956 base-year cost. January 1, 1956 base-year unit
cost must be reconstructed or established in accordance with paragraph
(e)(2) of this section for each item in Pool No. 2. Such costs are
assumed to be $9.00 for item A, $20.00 for item B, and $1.80 for item C.
A ratio of the 1958 total base-year cost to the 1956 total base-year
cost for Pool No. 2 is computed as follows:
[[Page 566]]
------------------------------------------------------------------------
Jan. 1,
1956, Jan. 1,
base- 1956,
Item Quantity year base-
unit year
cost cost
------------------------------------------------------------------------
A......................................... 250 $9.00 $2,250
B......................................... 75 20.00 1,500
C......................................... 500 1.80 900
---------
Total............................... ........ ........ 4,650
-----------------------------
A......................................... 250 10.00 2,500
B......................................... 75 20.00 1,500
C......................................... 500 2.00 1,000
---------
Total............................... ........ ........ 5,000
------------------------------------------------------------------------
(c) The ratio of the 1956 total base-year cost to the 1958 total
base-year cost for Pool No. 2 is 4,650/5,000 or 93 percent. The January
1, 1958 base cost and each yearly layer of increment at 1958 base-year
cost is multiplied by this ratio. Such computation is as follows:
------------------------------------------------------------------------
Dec. 31,
Dec. 31, 1960,
1960, inventory
inventory Ratio restated
at Jan. 1, (percent) at Jan. 1,
1958, base- 1956, base-
year cost year cost
------------------------------------------------------------------------
Jan. 1, 1958, base cost.............. $3,500 93 $3,255
Dec. 31, 1958, increment............. 1,000 93 930
Dec. 31, 1959, increment............. 500 93 465
-----------
Total.......................... .......... ......... 4,650
------------------------------------------------------------------------
(d) The computation of the ratio of the total current-year cost to
the total base-year cost for the base year (1956) and each yearly layer
of increment in the new pool is as follows:
----------------------------------------------------------------------------------------------------------------
Increments
Base year ------------------------------------------------------
Pool 1956 Dec. 31, Dec. 31, Dec. 31, Dec. 31, Dec. 31,
1956 1957 1958 1959 1960
----------------------------------------------------------------------------------------------------------------
No. 1:
Base-year cost............................. $7,000 $1,000 $500 $500 ......... $1,000
LIFO value................................. 7,000 1,050 550 550 ......... 1,200
No. 2:
Base-year cost as restated................. .......... ......... 3,255 930 $465 .........
LIFO value................................. .......... ......... 3,500 1,100 575 .........
------------------------------------------------------------------
Total, base-year cost.................. 7,000 1,000 3,755 1,430 465 1,000
Total, LIFO value...................... 7,000 1,050 4,050 1,650 575 1,200
==================================================================
Ratio of total current-year cost to total 100.00 105.00 107.86 115.38 133.66 120.00
base-year cost (percent)..................
----------------------------------------------------------------------------------------------------------------
(e) On the basis of the foregoing computation, the LIFO inventory of
the new pool at December 31, 1960, is restated as follows:
------------------------------------------------------------------------
Ratio of
Dec. 31, total
1960, current- Dec. 31,
inventory year cost 1960,
at Jan. 1, to total inventory
1956, base- base-year at LIFO
year cost cost value
(percent)
------------------------------------------------------------------------
Jan. 1, 1956, base cost.............. $7,000 100.00 $7,000
Dec. 31, 1956, increment............. 1,000 105.00 1,050
Dec. 31, 1957, increment............. 3,755 107.86 4,050
Dec. 31, 1958, increment............. 1,430 115.38 1,650
Dec. 31, 1959, increment............. 465 123.66 575
Dec. 31, 1960, increment............. 1,000 120.00 1,200
------------ ----------
Total.......................... 14,650 .......... 15,525
------------------------------------------------------------------------
(3) Change in methods of computation at the LIFO value of a dollar-
value pool. For the first taxable year beginning after December 31,
1960, the taxpayer must use a method authorized by paragraph (e)(1) of
this section in computing the base-year cost and current-year cost of a
dollar-value inventory pool for the end of such year. If the taxpayer
had previously used any methods other than one authorized by paragraph
(e)(1) of this section, he shall not be required to recompute his LIFO
inventories for taxable years beginning on or before December 31, 1960,
under a method authorized by such paragraph. The base cost and layers of
increment previously computed by such other method shall be retained and
treated as if such base cost and layers of increment had been computed
under a method authorized by paragraph (e)(1) of this section. The
taxpayer shall use the year of change as the base year in applying the
double-extension method or
[[Page 567]]
other method approved by the Commissioner, instead of the earliest year
for which he adopted the LIFO method for any items in the pool.
(h) LIFO inventories received in certain nonrecognition
transactions--(1) In general. Except as provided in paragraph (h)(3) of
this section, if inventory items accounted for under the LIFO method are
received in a transaction described in paragraph (h)(2) of this section,
then, for the purpose of determining future increments and liquidations,
the transferee must use the year of transfer as the base year and must
use its current-year cost (computed under the transferee's method of
accounting) of those items as their new base-year cost. If the
transferee had opening inventories in the year of transfer, then, for
the purpose of determining future increments and liquidations, the
transferee must use its current-year cost (computed under the
transferee's method of accounting) of those inventories as their new
base-year cost. For this purpose, ``opening inventory'' refers to all
items owned by the transferee before the transfer for which the
transferee uses, or elects to use, the LIFO method. The total new base-
year cost of the transferee's inventory as of the beginning of the year
of transfer is equal to the new base-year cost of the inventory received
from the transferor and the new base-year cost of the transferee's
opening inventory. The index (or, the cumulative index in the case of
the link-chain method) for the year immediately preceding the year of
transfer is 1.00. The base-year cost of any layers in the dollar-value
pool, as determined after the transfer, must be recomputed accordingly.
See paragraph (e)(3)(iv)(B)(1) of this section for an example of this
computation.
(2) Transactions to which this paragraph (h) applies. The rules in
this paragraph (h) apply to a transaction in which--
(i) The transferee determines its basis in the inventories, in whole
or in part, by reference to the basis of the inventories in the hands of
the transferor;
(ii) The transferor used the dollar-value LIFO method to account for
the transferred inventories;
(iii) The transferee uses the dollar-value LIFO method to account
for the inventories in the year of the transfer; and
(iv) The transaction is not described in section 381(a).
(3) Anti-avoidance rule. The rules in this paragraph (h) do not
apply to a transaction entered into with the principal purpose to avail
the transferee of a method of accounting that would be unavailable to
the transferor (or would be unavailable to the transferor without
securing consent from the Commissioner). In determining the principal
purpose of a transfer, consideration will be given to all of the facts
and circumstances. However, a transfer is deemed made with the principal
purpose to avail the transferee of a method of accounting that would be
unavailable to the transferor without securing consent from the
Commissioner if the transferor acquired inventory in a bargain purchase
within the five taxable years preceding the year of the transfer and
used a dollar-value LIFO method to account for that inventory that did
not treat the bargain purchase inventory and physically identical
inventory acquired at market prices as separate items. Inventory is
deemed acquired in a bargain purchase if the actual cost of the
inventory (or, if appropriate, the allocated cost of the inventory) was
less than or equal to 50 percent of the replacement cost of physically
identical inventory. Inventory is not considered acquired in a bargain
purchase if the actual cost of the inventory (or, if appropriate, the
allocated cost of the inventory) was greater than or equal to 75 percent
of the replacement cost of physically identical inventory.
(4) Effective date. The rules of this paragraph (h) are applicable
for transfers that occur during a taxable year ending on or after
December 31, 2001.
[T.D. 6539, 26 FR 518, Jan. 20, 1961, as amended by T.D. 7814, 47 FR
11272, Mar. 16, 1982; T.D. 8976, 67 FR 1082, Jan. 9, 2002; 67 FR 5062,
5148, Feb. 4, 2002]
Sec. 1.475-0 Table of contents.
This section lists the major captions in Sec. Sec. 1.475(a)-3,
1.475(a)-4, 1.475(b)-1, 1.475(b)-2, 1.475(c)-1, 1.475(c)-2, 1.475(d)-1
and 1.475(g)-1.
[[Page 568]]
Sec. Sec. 1.475(a)-1--1.475(a)-2 [Reserved]
Sec. 1.475(a)-3 Acquisition by a dealer of a security with a
substituted basis.
(a) Scope.
(b) Rules.
Sec. 1.475(a)-4 Safe Harbor for Valuation Under Section 475.
(a) Overview.
(1) Purpose.
(2) Dealer business model.
(3) Summary of paragraphs.
(b) Safe harbor.
(1) General rule.
(2) Example. Use of eligible and non-eligible methods.
(3) Scope of the safe harbor.
(c) Eligible taxpayer.
(d) Eligible method.
(1) Sufficient consistency.
(2) General requirements.
(i) Frequency.
(ii) Recognition at the mark.
(iii) Recognition on disposition.
(iv) Fair value standard.
(3) Limitations.
(i) Bid-ask method.
(A) General Rule.
(B) Safe harbor.
(ii) Valuations based on present values of projected cash flows.
(iii) Accounting for costs and risks.
(4) Examples.
(e) Compliance with other rules.
(f) Election.
(1) Making the election.
(2) Duration of the election.
(3) Revocation.
(i) By the taxpayer.
(ii) By the Commissioner.
(4) Re-election.
(g) Eligible positions.
(h) Applicable financial statement.
(1) Definition.
(2) Primary financial statement.
(i) Statement required to be filed with Securities and Exchange
Commission (SEC).
(ii) Statement filed with a Federal agency other than the IRS.
(iii) Certified audited financial statement.
(3) Example. Primary financial statement.
(4) Financial statements of equal priority.
(5) Consolidated groups.
(6) Supplement or amendment to a financial statement.
(7) Certified audited financial statement.
(i) [Reserved]
(j) Significant business use.
(1) In general.
(2) Financial statement value.
(3) Management of a business as a dealer.
(4) Significant use.
(k) Retention and production of records.
(1) In general.
(2) Specific requirements.
(i) Reconciliation.
(A) In general.
(B) Values on books and records with supporting schedules.
(C) Consolidation schedules.
(ii) Instructions provided by the Commissioner.
(3) Time for producing records.
(4) Retention period for records.
(5) Agreements with the Commissioner.
(l) [Reserved]
(m) Use of different values.
Sec. 1.475(b)-1 Scope of exemptions from mark-to-market requirement.
(a) Securities held for investment or not held for sale.
(b) Securities deemed identified as held for investment.
(1) In general.
(2) Relationships.
(i) General rule.
(ii) Attribution.
(iii) Trusts treated as partnerships.
(3) Securities traded on certain established financial markets.
(4) Changes in status.
(i) Onset of prohibition against marking.
(ii) Termination of prohibition against marking.
(iii) Examples.
(c) Securities deemed not held for investment; dealers in notional
principal contracts and derivatives.
(d) Special rule for hedges of another member's risk.
(e) Transitional rules.
(1) Stock, partnership, and beneficial ownership interests in
certain controlled corporations, partnerships, and trusts before January
23, 1997.
(i) In general.
(ii) Control defined.
(iii) Applicability.
(2) Dealers in notional principal contracts and derivatives acquired
before January 23, 1997.
(i) General rule.
(ii) Exception for securities not acquired in dealer capacity.
(iii) Applicability.
Sec. 1.475(b)-2 Exemptions--identification requirements.
(a) Identification of the basis for exemption.
(b) Time for identifying a security with a substituted basis.
(c) Integrated transactions under Sec. 1.1275-6.
(1) Definitions.
(2) Synthetic debt held by a taxpayer as a result of legging in.
(3) Securities held after legging out.
[[Page 569]]
Sec. 1.475(b)-3 [Reserved]
Sec. 1.475(c)-1 Definitions--dealer in securities.
(a) Dealer-customer relationship.
(1) [Reserved]
(2) Transactions described in section 475(c)(1)(B).
(i) In general.
(ii) Examples.
(3) Related parties.
(i) General rule.
(ii) Special rule for members of a consolidated group.
(iii) The intragroup-customer election.
(A) Effect of election.
(B) Making and revoking the election.
(iv) Examples.
(b) Sellers of nonfinancial goods and services.
(1) Purchases and sales of customer paper.
(2) Definition of customer paper.
(3) Exceptions.
(4) Election not to be governed by the exception for sellers of
nonfinancial goods or services.
(i) Method of making the election.
(A) Taxable years ending after December 24, 1996.
(B) Taxable years ending on or before December 24, 1996.
(ii) Continued applicability of an election.
(c) Taxpayers that purchase securities from customers but engage in
no more than negligible sales of the securities.
(1) Exemption from dealer status.
(i) General rule.
(ii) Election to be treated as a dealer.
(2) Negligible sales.
(3) Special rules for members of a consolidated group.
(i) Intragroup-customer election in effect.
(ii) Intragroup-customer election not in effect.
(4) Special rules.
(5) Example.
(d) Issuance of life insurance products.
Sec. 1.475(c)-2 Definitions--security.
(a) Items that are not securities.
(b) Synthetic debt that Sec. 1.1275-6(b) treats the taxpayer as
holding.
(c) Negative value REMIC residuals acquired before January 4, 1995.
(1) Description.
(2) Special rules applicable to negative value REMIC residuals
acquired before January 4, 1995.
Sec. 1.475(d)-1 Character of gain or loss.
(a) Securities never held in connection with the taxpayer's
activities as a dealer in securities.
(b) Ordinary treatment for notional principal contracts and
derivatives held by dealers in notional principal contracts and
derivatives.
Sec. 1.475(g)-1 Effective dates.
[T.D. 8700, 61 FR 67719, Dec. 24, 1996, as amended by T.D. 9328, 72 FR
32177, June 12, 2007; T.D. 9849, 84 FR 9235, Mar. 14, 2019]
Sec. Sec. 1.475(a)-1--1.475(a)-2 [Reserved]
Sec. 1.475(a)-3 Acquisition by a dealer of a security
with a substituted basis.
(a) Scope. This section applies if--
(1) A dealer in securities acquires a security that is subject to
section 475(a) and the dealer's basis in the security is determined, in
whole or in part, by reference to the basis of that security in the
hands of the person from whom the security was acquired; or
(2) A dealer in securities acquires a security that is subject to
section 475(a) and the dealer's basis in the security is determined, in
whole or in part, by reference to other property held at any time by the
dealer.
(b) Rules. If this section applies to a security--
(1) Section 475(a) applies only to changes in value of the security
occurring after the acquisition; and
(2) Any built-in gain or loss with respect to the security (based on
the difference between the fair market value of the security on the date
the dealer acquired it and its basis to the dealer on that date) is
taken into account at the time, and has the character, provided by the
sections of the Internal Revenue Code that would apply to the built-in
gain or loss if section 475(a) did not apply to the security.
[T.D. 8700, 61 FR 67720, Dec. 24, 1996]
Sec. 1.475(a)-4 Valuation safe harbor.
(a) Overview--(1) Purpose. This section sets forth a safe harbor
that, under certain circumstances, permits taxpayers to elect to use the
values of positions reported on certain financial statements as the fair
market values of those positions for purposes of section 475. This safe
harbor is based on the principle that, if a mark-to-market method used
for financial reporting is sufficiently consistent with the requirements
of section 475 and if the financial statement employing that
[[Page 570]]
method has certain indicia of reliability, then the values used on that
financial statement may be used for purposes of section 475. If other
provisions of the Internal Revenue Code or regulations require
adjustments to fair market value, use of the safe harbor does not
eliminate the need for those adjustments. See paragraph (e) of this
section.
(2) Dealer business model. The safe harbor is based on the business
model for a derivatives dealer. Under this model, the dealer seeks to
capture and profit from bid-ask spreads in the marketplace by entering
into substantially offsetting positions with customers that will remain
on the derivatives dealer's books over their terms. Because the
positions in the aggregate tend to offset each other, the dealer has
achieved a predictable net cash flow (for example, a synthetic annuity)
that reflects the captured bid-ask spread. This net cash flow is
generally impervious to market fluctuations in the values on which the
component derivatives are based. Section 475 requires current
recognition of the present value of the net cash flow attributable to
the capture of these spreads.
(3) Summary of paragraphs. Paragraph (b) of this section sets forth
the safe harbor. To determine who may use the safe harbor, paragraph (c)
of this section defines the term ``eligible taxpayer.'' Paragraph (d) of
this section sets forth the basic requirements for determining whether
the method used for financial reporting is sufficiently consistent with
the requirements of section 475. Paragraph (e) of this section describes
adjustments to the financial statement values that may be required for
purposes of applying this safe harbor. Paragraph (f) of this section
describes the procedure for making the safe harbor election and the
conditions under which the election may be revoked. Paragraph (g) of
this section provides that the Commissioner will issue a revenue
procedure that lists the types of securities and commodities that are
eligible positions for purposes of the safe harbor. Using rules for
determining priorities among financial statements, paragraph (h) of this
section defines the term ``applicable financial statement'' and so
describes the financial statement, if any, whose values may be used in
the safe harbor. In some cases, as required by paragraph (j) of this
section, the safe harbor is available only if the taxpayer's operations
make significant business use of financial statement values. Paragraph
(k) of this section sets forth requirements for record retention and
record production. Paragraph (m) of this section provides that the
Commissioner may use fair market values that clearly reflect income, but
which differ from values used on the applicable financial statement, if
an electing taxpayer fails to comply with the recordkeeping and record
production requirements of paragraph (k) of this section.
(b) Safe harbor--(1) General rule. Subject to any adjustment
required by paragraph (e) of this section, if an eligible taxpayer uses
an eligible method for the valuation of an eligible position on its
applicable financial statement and the eligible taxpayer is subject to
the election described in paragraph (f) of this section, the value that
the eligible taxpayer assigns to that eligible position on its
applicable financial statement is the fair market value of the eligible
position for purposes of section 475 and must be used for purposes of
section 475, even if that value is not the fair market value of the
position for any other purpose of the internal revenue laws.
Notwithstanding the rule set forth in this paragraph, the Commissioner
may, in certain circumstances, use fair market values that clearly
reflect income but differ from the values used on the applicable
financial statement. See paragraph (m) of this section.
(2) Example. Use of eligible and non-eligible methods. X uses
eligible methods on its applicable financial statement for some, but not
all, securities and commodities that are eligible positions. When X
elects into the safe harbor, the election applies to all eligible
positions for which X has an eligible method. Therefore, once the
election is in effect, the financial statement values for eligible
positions for which X has an eligible method are the fair market values
of those eligible positions for purposes of section 475. Since
[[Page 571]]
X, however, does not have an eligible method for all eligible positions,
those eligible positions for which X does not have an eligible method
remain subject to the fair market value requirements of section 475 as
set out in case law and otherwise.
(3) Scope of the safe harbor. The safe harbor may be used only to
determine values for eligible positions that are properly marked to
market under section 475. It does not determine whether any positions
may or may not be subject to mark-to-market accounting under section
475.
(c) Eligible taxpayer. An eligible taxpayer is--
(1) A dealer in securities, as defined in section 475(c)(1); or
(2) A dealer in commodities, as defined in section 475(e), that is
subject to an election under section 475(e).
(d) Eligible method--(1) Sufficient consistency. An eligible method
is a mark-to-market method that is sufficiently consistent with the
requirements of a mark-to-market method under section 475. To be
sufficiently consistent with the requirements of a mark-to-market method
under section 475, the eligible method must satisfy all of the
requirements of paragraph (d)(2) and paragraph (d)(3) of this section.
(2) General requirements. The method--
(i) Frequency. Must require a valuation of the eligible position no
less frequently than annually, including a valuation as of the last
business day of the taxable year;
(ii) Recognition at the mark. Must recognize into income on the
income statement for each taxable year mark-to-market gain or loss based
upon the valuation or valuations described in paragraph (d)(2)(i) of
this section;
(iii) Recognition on disposition. Must require, on disposition of
the eligible position, recognition into income (on the income statement
for the taxable year of disposition) as if a year-end mark occurred
immediately before such disposition; and
(iv) Fair value standard. Must require use of a valuation standard
that arrives at fair value in accordance with U.S. Generally Accepted
Accounting Principles (U.S. GAAP).
(3) Limitations--(i) Bid-ask method--(A) General rule. Except for
eligible positions that are traded on a qualified board or exchange, as
defined in section 1256(g)(7), or eligible positions that the
Commissioner designates in a revenue procedure or other published
guidance, the valuation standard used must not, other than on a de
minimis portion of a taxpayer's positions, permit values at or near the
bid or ask value. Consequently, the valuation method described in Sec.
1.471-4(a)(1) fails to satisfy this paragraph (d)(3)(i)(A).
(B) Safe harbor. The restriction in paragraph (d)(3)(i)(A) of this
section is satisfied if the method consistently produces values that are
closer to the mid-market values than they are to the bid or ask values.
(ii) Valuations based on present values of projected cash flows. If
the method of valuation consists of projecting cash flows from an
eligible position or positions and determining the present value of
those cash flows, the method must not take into account any cash flows
attributable to a period or time on or before the valuation date. In
addition, adjustment of the gain or loss recognized on the mark may be
required with respect to payments that will be made after the valuation
date to the extent that portions of the payments have been recognized
for tax purposes before the valuation and appropriate adjustment has not
been made for purposes of determining financial statement value.
(iii) Accounting for costs and risks. Valuations may account for
appropriate costs and risks, but no cost or risk may be accounted for
more than once, either directly or indirectly. Further, no valuation
adjustment for any cost or risk may be made for purposes of this safe
harbor if that valuation adjustment is not also permitted by, and taken
for, U.S. GAAP purposes on the taxpayer's applicable financial
statement. If appropriate, the costs and risks that may be accounted for
include, but are not limited to, credit risk (appropriately adjusted for
any credit enhancement), future administrative costs, and model risk. An
adjustment for credit risk is implicit in computing the present value of
cash flows using a discount rate greater
[[Page 572]]
than a risk-free rate. Accordingly, a determination of whether any
further downward adjustment to value for credit risk is warranted, or
whether an upward adjustment is required, must take that implicit
adjustment into consideration.
(4) Examples. The following examples illustrate this paragraph (d):
Example 1. (i) X, a calendar year taxpayer, is a dealer in
securities within the meaning of section 475(c)(1). X generally
maintains a balanced portfolio of interest rate swaps and other interest
rate derivatives, capturing bid-ask spreads and keeping its market
exposure within desired limits (using, if necessary, additional
derivatives for this purpose). X uses a mark-to-market method on a
statement that it is required to file with the United States Securities
and Exchange Commission and that satisfies paragraph (d)(2) of this
section with respect to both the contracts with customers and the
additional derivatives. When determining the amount of any gain or loss
realized on a sale, exchange, or termination of a position, X makes a
proper adjustment for amounts taken into account respecting payments or
receipts. X and all of its counterparties on the derivatives have the
same general credit quality as each other.
(ii) Under X's valuation method, as of each valuation date, X
determines a mid-market probability distribution of future cash flows
under the derivatives and computes the present values of these cash
flows. In computing these present values, X uses an industry standard
yield curve that is appropriate for obligations by persons with this
same general credit quality. In addition, based on information that
includes its own knowledge about the counterparties, X adjusts some of
these present values either upward or downward to reflect X's reasonable
judgment about the extent to which the true credit status of each
counterparty's obligation, taking credit enhancements into account,
differs from the general credit quality used in the yield curve to
present value the derivatives.
(iii) X's methodology does not violate the requirement in paragraph
(d)(3)(iii) of this section that the same cost or risk not be taken into
account, directly or indirectly, more than once.
(iv) Applicability date. This Example 1 applies to valuations of
securities on or after July 6, 2011.
Example 2. (i) The facts are the same as in Example 1, except that X
uses a better credit quality in determining the yield curve to discount
the payments to be received under the derivatives. Based on information
that includes its own knowledge about the counterparties, X adjusts
these present values to reflect X's reasonable judgment about the extent
to which the true credit status of each counterparty's obligation,
taking credit enhancements into account, differs from this better credit
quality obligation.
(ii) X's methodology does not violate the requirement in paragraph
(d)(3)(iii) of this section that the same cost or risk not be taken into
account, directly or indirectly, more than once.
(iii) Applicability date. This Example 2 applies to valuations of
securities on or after July 6, 2011.
Example 3. (i) The facts are the same as in Example 1, except that,
after computing present values using the discount rates that are
appropriate for obligors with the same general credit quality, and based
on information that includes X's own knowledge about the counterparties,
X adjusts some of these present values either upward or downward to
reflect X's reasonable judgment about the extent to which the true
credit status of each counterparty's obligation, taking credit
enhancements into account, differs from a better credit quality.
(ii) X's methodology violates the requirement in paragraph
(d)(3)(iii) of this section that the same cost or risk not be taken into
account, directly or indirectly, more than once. By using the same
general credit quality discount rate, X's method takes into account the
difference between risk-free obligations and obligations with that lower
credit quality. By adjusting values for the difference between a higher
credit quality and that lower credit quality, X takes into account risks
that it had already accounted for through the discount rates that it
used. The same result would occur if X judged some of its
counterparties' obligations to be of a higher credit quality but X
failed to adjust the values of those obligations to reflect the
difference between a higher credit quality and the lower credit quality.
(iii) Applicability date. This Example 3 applies to valuations of
securities on or after July 6, 2011.
Example 4. (i) The facts are the same as in Example 1, except that X
determines the mid-market value for each derivative and then subtracts
the corresponding part of the bid-ask spread.
(ii) X's methodology violates the rule in paragraph (d)(3)(i) of
this section that forbids valuing positions at or near the bid or ask
value.
Example 5. (i) The facts are the same as in Example 1, and, in
addition, X's adjustments for all risks and costs, including credit
risk, future administrative costs and model risk, may occasionally cause
the adjusted value of an eligible position to be at or near the bid
value or ask value.
(ii) X's methodology does not violate the rule in paragraph
(d)(3)(i)(A) of this section
[[Page 573]]
that forbids valuing eligible positions at or near the bid or ask value.
(e) Compliance with other rules. Notwithstanding any other
provisions of this section, the fair market values for purposes of the
safe harbor must be consistent with section 482, or rules that adopt
section 482 principles, when applicable. For example, if a notional
principal contract is subject to section 482 or section 482 principles,
the values of future cash flows taken into account in determining the
value of the contract for purposes of section 475 must be consistent
with section 482.
(f) Election--(1) Making the election. Unless the Commissioner
prescribes otherwise, an eligible taxpayer elects under this section by
filing with the Commissioner a statement declaring that the taxpayer
makes the safe harbor election in this section for all eligible
positions for which it has an eligible method. In addition to any other
information that the Commissioner may require, the statement must
describe the taxpayer's applicable financial statement for the first
taxable year for which the election is effective and must state that the
taxpayer agrees to provide upon the request of the Commissioner all
information, records, and schedules in the manner required by paragraph
(k) of this section. The statement must be attached to a timely filed
Federal income tax return (including extensions) for the taxable year
for which the election is first effective.
(2) Duration of the election. Once made, the election continues in
effect for all subsequent taxable years unless revoked.
(3) Revocation--(i) By the taxpayer. An eligible taxpayer that is
subject to an election under this section may revoke the election only
with the consent of the Commissioner.
(ii) By the Commissioner. The Commissioner, after consideration of
the relevant facts and circumstances, may revoke an election under this
section, effective beginning with the first open year for which the
election is effective or with any subsequent year, if--
(A) The taxpayer fails to comply with paragraph (k) of this section
(concerning record retention and production) and the taxpayer does not
show reasonable cause for this failure;
(B) The taxpayer ceases to have an applicable financial statement or
ceases to use an eligible method; or
(C) For any other reason, no more than a de minimis number of
eligible positions, or no more than a de minimis fraction of the
taxpayer's eligible positions, are covered by the safe harbor in
paragraph (b) of this section.
(4) Re-election. If an election is revoked, either by the
Commissioner or by the taxpayer, the taxpayer (or any successor in
interest of the taxpayer) may not make the election without the consent
of the Commissioner for any taxable year that begins before the date
that is six years after the first day of the earliest taxable year
affected by the revocation.
(g) Eligible positions. For any taxpayer, an eligible position is
any security or commodity that the Commissioner in a revenue procedure
or other published guidance designates as an eligible position with
respect to that taxpayer for purposes of this safe harbor.
(h) Applicable financial statement--(1) Definition. An eligible
taxpayer's applicable financial statement for a taxable year is the
taxpayer's primary financial statement for that year if that primary
financial statement is described in paragraph (h)(2)(i) of this section
(concerning statements required to be filed with the SEC) or if that
primary financial statement both meets the requirements of paragraph (j)
of this section (concerning significant business use) and is described
in either paragraph (h)(2)(ii) or (iii) of this section. Otherwise, or
if the taxpayer does not have a primary financial statement for the
taxable year, the taxpayer does not have an applicable financial
statement for the taxable year.
(2) Primary financial statement. For any taxable year, an eligible
taxpayer's primary financial statement is the financial statement, if
any, described in one or more of paragraphs (h)(2)(i), (ii), and (iii)
of this section. If more than one financial statement of the taxpayer
for the year is so described, the primary financial statement is the one
first described in paragraphs (h)(2)(i), (ii), and (iii) of this
section. A taxpayer
[[Page 574]]
has only one primary financial statement for any taxable year.
(i) Statement required to be filed with the Securities and Exchange
Commission (SEC). A financial statement that is prepared in accordance
with U.S. GAAP and that is required to be filed with the SEC, such as
the 10--K or the Annual Statement to Shareholders.
(ii) Statement filed with a Federal agency other than the Internal
Revenue Service. A financial statement that is prepared in accordance
with U.S. GAAP and that is required to be provided to the Federal
government or any of its agencies other than the Internal Revenue
Service (IRS).
(iii) Certified audited financial statement. A certified audited
financial statement that is prepared in accordance with U.S. GAAP; that
is given to creditors for purposes of making lending decisions, given to
equity holders for purposes of evaluating their investment in the
eligible taxpayer, or provided for other substantial non-tax purposes;
and that the taxpayer reasonably anticipates will be directly relied on
for the purposes for which it was given or provided.
(3) Example. Primary financial statement. X prepares financial
statement FS1, which is required to be filed with a Federal government
agency other than the SEC or the IRS. FS1 is thus described in paragraph
(h)(2)(ii) of this section. X also prepares financial statement FS2,
which is a certified audited financial statement that is given to
creditors and that X reasonably anticipates will be relied on for
purposes of making lending decisions. FS2 is thus described in paragraph
(h)(2)(iii) of this section. Because FS1, which is described in
paragraph (h)(2)(ii) of this section, is described before FS2, which is
described in paragraph (h)(2)(iii) of this section, FS1 is X's primary
financial statement.
(4) Financial statements of equal priority. If the rules of
paragraph (h)(2) of this section cause two or more financial statements
to be of equal priority, then the statement that results in the highest
aggregate valuation of eligible positions being marked to market under
section 475 is the primary financial statement.
(5) Consolidated groups. If the taxpayer is a member of an
affiliated group that files a consolidated return, the primary financial
statement of the taxpayer is the primary financial statement, if any, of
the common parent (within the meaning of section 1504(a)(1)) of the
consolidated group.
(6) Supplement or amendment to a financial statement. A financial
statement includes any supplement or amendment to the financial
statement.
(7) Certified audited financial statement. For purposes of this
paragraph (h), a financial statement is a certified audited financial
statement if it is certified by an independent certified public
accountant from a Registered Public Accounting firm, as defined in
section 2(a)(12) of the Sarbanes-Oxley Act of 2002, Public Law 107-204,
116 Stat. 746 (July 30, 2002), 15 U.S.C. Sec. 7201(a)(12), and rules
promulgated under that Act, and is--
(i) Certified to be fairly presented (a ``clean'' opinion);
(ii) Certified to be fairly presented subject to a concern about a
contingency, other than a contingency relating to the value of eligible
positions (a qualified ``subject to'' opinion); or
(iii) Certified to be fairly presented except for a method of
accounting with which the Certified Public Accountant disagrees and
which is not a method used to determine the value of an eligible
position held by the eligible taxpayer (a qualified ``except for''
opinion).
(i) [Reserved]
(j) Significant business use--(1) In general. A financial statement
is described in this paragraph (j) if--
(i) The financial statement contains values for eligible positions;
(ii) The eligible taxpayer makes significant use of financial
statement values in most of the significant management functions of its
business; and
(iii) That use is related to the management of all or substantially
all of the eligible taxpayer's business.
(2) Financial statement value. For purposes of this paragraph (j),
the term financial statement value means--
(i) A value that is taken from the financial statement; or
(ii) A value that is produced by a process that is in all respects
identical
[[Page 575]]
to the process that produces the values that appear on the financial
statement but that is not taken from the statement because either--
(A) The value was determined as of a date for which the financial
statement does not value eligible positions; or
(B) The value is used in the management of the business before the
financial statement has been prepared.
(3) Management functions of a business. For purposes of this
paragraph (j), the term management functions of a business refers to the
financial and commercial oversight of the business. Oversight includes,
but is not limited to, senior management review of business-unit
profitability, market risk measurement or management, credit risk
measurement or management, internal allocation of capital, and
compensation of personnel. Management functions of a business do not
include either tax accounting or reporting the results of operations to
persons other than directors or employees.
(4) Significant use. If an eligible taxpayer uses financial
statement values for some significant management functions and uses
values that are not financial statement values for other significant
management functions, then the determination of whether the taxpayer has
made significant use of the financial statement values is made on the
basis of all the facts and circumstances. This determination must
particularly take into account whether the taxpayer's reliance on the
financial statement values exposes the taxpayer to material adverse
economic consequences if the values are incorrect.
(k) Retention and production of records--(1) In general. In addition
to all records that section 6001 otherwise requires to be retained, an
eligible taxpayer subject to the election provided by this section must
keep, and timely provide to the Commissioner upon request, records and
books of account that are sufficient to establish that the financial
statement to which the income tax return conforms is the taxpayer's
applicable financial statement, that the method used on that statement
is an eligible method, and that the values used for eligible positions
for purposes of section 475 are the values used in the applicable
financial statement. This obligation extends to all records and books
that are required to be maintained for any period for financial or
regulatory reporting purposes, even if these records or books may not
otherwise be specifically covered by section 6001. All records and books
described in this paragraph (k) must be maintained for the period
described in paragraph (k)(4) of this section, even if a lesser period
of retention applies for financial statement or regulatory purposes.
(2) Specific requirements--(i) Verification and reconciliation.
Unless the Commissioner otherwise provides--
(A) In general. An eligible taxpayer must provide books and records
to verify the appropriate use of the safe harbor and reconciliation
schedules between the applicable financial statement for the taxable
year and the Federal income tax return for that year. The required
verification materials and reconciliation schedules include all
supporting schedules, exhibits, computer programs, and any other
information used in producing the values and schedules, including the
documentation of rules and procedures governing determination of the
values. The required reconciliation schedules must also include a
detailed explanation of any adjustments necessitated by the imperfect
overlap between the eligible positions that the taxpayer marks to market
under section 475 and the eligible positions for which the applicable
financial statement uses an eligible method. In the time and manner
provided by the Commissioner, a corporate taxpayer subject to this
paragraph (k) must reconcile the net income amount reported on its
applicable financial statement to the amount reported on the applicable
forms and schedules on its Federal income tax return (such as the
Schedule M-1, ``Net Income(Loss) Reconciliation for Corporations With
Total Assets of $10 Million or More''; Schedule M-3, ``Net Income(Loss)
Reconciliation for Corporations With Total Assets of $10 Million or
More''; and Form 1120F, ``U.S. Income Tax Return of a Foreign
Corporation''). Eligible taxpayers that are not otherwise required to
file a Schedule M-1 or Schedule M-3 must reconcile net income using
substitute schedules
[[Page 576]]
similar to Schedule M-1 and Schedule M-3, and these substitute schedules
must be attached to the return.
(B) Values on books and records with supporting schedules. The books
and records must state the value used for each eligible position
separately from the value used for any other eligible position. However,
an eligible taxpayer may make adjustments to values on a pooled basis,
if the taxpayer demonstrates that it can compute gain or loss
attributable to the sale or other disposition of an individual eligible
position.
(C) Consolidation schedules. An eligible taxpayer must provide a
schedule showing the consolidation and de-consolidation that is used in
preparing the applicable financial statement, along with exhibits and
subordinate schedules. This schedule must provide information that
addresses the differences for consolidation and de-consolidation between
the applicable financial statement and the Federal income tax return.
(ii) Instructions provided by the Commissioner. The Commissioner may
provide an alternative time or manner in which an eligible taxpayer
subject to this paragraph (k) must establish that the same values used
for eligible positions on the applicable financial statement are also
the values used for purposes of section 475 on the Federal income tax
return.
(3) Time for producing records. All documents described in this
paragraph (k) must be produced within 30 days of a request by the
Commissioner, unless the Commissioner grants a written extension.
Generally, the Commissioner will exercise his discretion to excuse a
minor or inadvertent failure to provide requested documents if the
taxpayer shows reasonable cause for the failure, has made a good faith
effort to comply with the requirement to produce records, and promptly
remedies the failure. For failures to maintain, or timely produce,
records, see paragraph (f)(3)(ii) of this section (allowing the
Commissioner to revoke the election), and see paragraph (m) of this
section (allowing the Commissioner, but not the taxpayer, to use for
eligible positions that otherwise might be subject to the safe harbor
fair market values that clearly reflect income but that are different
from the values used on the applicable financial statement).
(4) Retention period for records. All materials required by this
paragraph (k) and section 6001 must be retained as long as their
contents may become material in the administration of any internal
revenue law.
(5) Agreements with the Commissioner. The Commissioner and an
eligible taxpayer may enter into a written agreement that establishes,
for purposes of this paragraph (k), which records must be maintained,
how they must be maintained, and for how long they must be maintained.
(l) [Reserved]
(m) Use of different values. If, with respect to the records that
relate to certain eligible positions for a taxable year, the taxpayer
fails to satisfy paragraph (k) of this section (concerning record
retention and record production), then, for those eligible positions for
that year, the Commissioner may use values that the Commissioner
determines to be fair market values that are appropriate to clearly
reflect income, even if the values so determined are different from the
values reported for those positions on the applicable financial
statement. See also paragraph (f)(3)(ii) of this section (concerning
revocation of the election by the Commissioner when a taxpayer does not
produce required records and fails to demonstrate reasonable cause for
the failure).
[T.D. 9328, 72 FR 32177, June 12, 2007, as amended by T.D. 9533, 76 FR
39281, July 6, 2011; T.D. 9637, 78 FR 54760, Sept. 6, 2013]
Sec. 1.475(b)-1 Scope of exemptions from mark-to-market requirement.
(a) Securities held for investment or not held for sale. Except as
otherwise provided by this section and subject to the identification
requirements of section 475(b)(2), a security is held for investment
(within the meaning of section 475(b)(1)(A)) or not held for sale
(within the meaning of section 475(b)(1)(B)) if it is not held by the
taxpayer primarily for sale to customers in the ordinary course of the
taxpayer's trade or business.
[[Page 577]]
(b) Securities deemed identified as held for investment--(1) In
general. The following items held by a dealer in securities are per se
held for investment within the meaning of section 475(b)(1)(A) and are
deemed to be properly identified as such for purposes of section
475(b)(2)--
(i) Except as provided in paragraph (b)(3) of this section, stock in
a corporation, or a partnership or beneficial ownership interest in a
widely held or publicly traded partnership or trust, to which the
taxpayer has a relationship specified in paragraph (b)(2) of this
section; or
(ii) A contract that is treated for federal income tax purposes as
an annuity, endowment, or life insurance contract (see sections 72, 817,
and 7702).
(2) Relationships--(i) General rule. The relationships specified in
this paragraph (b)(2) are--
(A) Those described in section 267(b) (2), (3), (10), (11), or (12);
or
(B) Those described in section 707(b)(1)(A) or (B).
(ii) Attribution. The relationships described in paragraph (b)(2)(i)
of this section are determined taking into account sections 267(c) and
707(b)(3), as appropriate.
(iii) Trusts treated as partnerships. For purposes of this paragraph
(b)(2), the phrase partnership or trust is substituted for the word
partnership in sections 707(b) (1) and (3), and a reference to
beneficial ownership interest is added to each reference to capital
interest or profits interest in those sections.
(3) Securities traded on certain established financial markets.
Paragraph (b)(1)(i) of this section does not apply to a security if--
(i) The security is actively traded within the meaning of Sec.
1.1092(d)-1(a) taking into account only established financial markets
identified in Sec. 1.1092(d)-1(b)(1) (i) or (ii) (describing national
securities exchanges and interdealer quotation systems);
(ii) Less than 15 percent of all of the outstanding shares or
interests in the same class are held by the taxpayer and all persons
having a relationship to the taxpayer that is specified in paragraph
(b)(2) of this section; and
(iii) If the security was acquired (e.g., on original issue) from a
person having a relationship to the taxpayer that is specified in
paragraph (b)(2) of this section, then, after the time the security was
acquired--
(A) At least one full business day has passed; and
(B) There has been significant trading involving persons not having
a relationship to the taxpayer that is specified in paragraph (b)(2) of
this section.
(4) Changes in status--(i) Onset of prohibition against marking. (A)
Once paragraph (b)(1) of this section begins to apply to the security
and for so long as it continues to apply, section 475(a) does not apply
to the security in the hands of the taxpayer.
(B) If a security has not been timely identified under section
475(b)(2) and, after the last day on which such an identification would
have been timely, paragraph (b)(1) of this section begins to apply to
the security, then the dealer must recognize gain or loss on the
security as if it were sold for its fair market value as of the close of
business of the last day before paragraph (b)(1) of this section begins
to apply to the security, and gain or loss is taken into account at that
time.
(ii) Termination of prohibition against marking. If a taxpayer did
not timely identify a security under section 475(b)(2), and paragraph
(b)(1) of this section applies to the security on the last day on which
such an identification would have been timely but thereafter ceases to
apply--
(A) An identification of the security under section 475(b)(2) is
timely if made on or before the close of the day paragraph (b)(1) of
this section ceases to apply; and
(B) Unless the taxpayer timely identifies the security under section
475(b)(2) (taking into account the additional time for identification
that is provided by paragraph (b)(4)(ii)(A) of this section), section
475(a) applies to changes in value of the security after the cessation
in the same manner as under section 475(b)(3).
(iii) Examples. These examples illustrate this paragraph (b)(4):
Example 1. Onset of prohibition against marking. (A) Facts.
Corporation H owns 75 percent
[[Page 578]]
of the stock of corporation D, a dealer in securities within the meaning
of section 475(c)(1). On December 1, 1995, D acquired less than half of
the stock in corporation X. D did not identify the stock for purposes of
section 475(b)(2). On July 17, 1996, H acquired from other persons 70
percent of the stock of X. As a result, D and X became related within
the meaning of paragraph (b)(2)(i) of this section. The stock of X is
not described in paragraph (b)(3) of this section (concerning some
securities traded on certain established financial markets).
(B) Holding. Under paragraph (b)(4)(i) of this section, D recognizes
gain or loss on its X stock as if the stock were sold for its fair
market value at the close of business on July 16, 1996, and the gain or
loss is taken into account at that time. As with any application of
section 475(a), proper adjustment is made in the amount of any gain or
loss subsequently realized. After July 16, 1996, section 475(a) does not
apply to D's X stock while paragraph (b)(1)(i) of this section
(concerning the relationship between X and D) continues to apply.
Example 2. Termination of prohibition against marking; retained
securities identified as held for investment. (A) Facts. On July 1,
1996, corporation H owned 60 percent of the stock of corporation Y and
all of the stock of corporation D, a dealer in securities within the
meaning of section 475(c)(1). Thus, D and Y are related within the
meaning of paragraph (b)(2)(i) of this section. Also on July 1, 1996, D
acquired, as an investment, 10 percent of the stock of Y. The stock of Y
is not described in paragraph (b)(3) of this section (concerning some
securities traded on certain established financial markets). When D
acquired its shares of Y stock, it did not identify them for purposes of
section 475(b)(2). On December 24, 1996, D identified its shares of Y
stock as held for investment under section 475(b)(2). On December 30,
1996, H sold all of its shares of stock in Y to an unrelated party. As a
result, D and Y ceased to be related within the meaning of paragraph
(b)(2)(i) of this section.
(B) Holding. Under paragraph (b)(4)(ii)(A) of this section,
identification of the Y shares is timely if done on or before the close
of December 30, 1996. Because D timely identified its Y shares under
section 475(b)(2), it continues after December 30, 1996, to refrain from
marking to market its Y stock.
Example 3. Termination of prohibition against marking; retained
securities not identified as held for investment. (A) Facts. The facts
are the same as in Example 2 above, except that D did not identify its
stock in Y for purposes of section 475(b)(2) on or before December 30,
1996. Thus, D did not timely identify these securities under section
475(b)(2) (taking into account the additional time for identification
provided in paragraph (b)(4)(ii)(A) of this section).
(B) Holding. Under paragraph (b)(4)(ii)(B) of this section, section
475(a) applies to changes in value of D's Y stock after December 30,
1996, in the same manner as under section 475(b)(3).
Thus, any appreciation or depreciation that occurred while the
securities were prohibited from being marked to market is suspended.
Further, section 475(a) applies only to those changes occurring after
December 30, 1996.
Example 4. Acquisition of actively traded stock from related party.
(A) Facts. Corporation P is the parent of a consolidated group whose
taxable year is the calendar year, and corporation M, a member of that
group, is a dealer in securities within the meaning of section
475(c)(1). Corporation M regularly acts as a market maker with respect
to common and preferred stock of corporation P. Corporation P has
outstanding 2,000,000 shares of series X preferred stock, which are
traded on a national securities exchange. During the business day on
December 29, 1997, corporation P sold 100,000 shares of series X
preferred stock to corporation M for $100 per share. Subsequently, also
on December 29, 1997, persons not related to corporation M engaged in
significant trading of the series X preferred stock. At the close of
business on December 30, 1997, the fair market value of series X stock
was $99 per share. At the close of business on December 31, 1997, the
fair market value of series X stock was $98.50 per share. Corporation M
sold the series X stock on the exchange on January 2, 1998. At all
relevant times, corporation M and all persons related to M owned less
than 15% of the outstanding series X preferred stock.
(B) Holding. The 100,000 shares of series X preferred stock held by
corporation M are not subject to mark-to-market treatment under section
475(a) on December 29, 1997, because at that time the stock was held for
less than one full business day and is therefore treated as properly
identified as held for investment. At the close of business on December
30, 1997, that prohibition on marking ceases to apply, and section
475(b)(3) begins to apply. The built-in loss is suspended, and
subsequent appreciation and depreciation are subject to section 475(a).
Accordingly, when corporation M marks the series X stock to market at
the close of business on December 31, 1997, under section 475(a) it
recognizes and takes into account a loss of $.50 per share. Under
section 475(b)(3), when corporation M sells the series X stock on
January 2, 1998, it takes into account the suspended loss, that is, the
difference between the $100 per share it paid corporation P for that
stock and the $99-per-share fair market value when section 475(b)(1)
ceased to be applied to the stock. No deduction, however, is allowed for
that loss. (See Sec. 1.1502-13(f)(6), under which no deduction is
allowed to a
[[Page 579]]
member of a consolidated group for a loss with respect to a share of
stock of the parent of that consolidated group, if the member does not
take the gain or loss into account pursuant to section 475(a).)
(c) Securities deemed not held for investment; dealers in notional
principal contracts and derivatives. (1) Except as otherwise determined
by the Commissioner in a revenue ruling, revenue procedure, or letter
ruling, section 475(b)(1)(A) (exempting from mark-to-market accounting
certain securities that are held for investment) does not apply to a
security if--
(i) The security is described in section 475(c)(2) (D) or (E)
(describing certain notional principal contracts and derivative
securities); and
(ii) The taxpayer is a dealer in such securities.
(2) See Sec. 1.475(d)-1(b) for a rule concerning the character of
gain or loss on securities described in this paragraph (c).
(d) Special rule for hedges of another member's risk. A taxpayer may
identify under section 475(b)(1)(C) (exempting certain hedges from mark-
to-market accounting) a security that hedges a position of another
member of the taxpayer's consolidated group if the security meets the
following requirements--
(1) The security is a hedging transaction within the meaning of
Sec. 1.1221-2(b);
(2) The security is timely identified as a hedging transaction under
Sec. 1.1221-2(f) (including identification of the hedged item); and
(3) The security hedges a position that is not marked to market
under section 475(a).
(e) Transitional rules--(1) Stock, partnership, and beneficial
ownership interests in certain controlled corporations, partnerships,
and trusts before January 23, 1997--(i) In general. The following items
held by a dealer in securities are per se held for investment within the
meaning of section 475(b)(1)(A) and are deemed to be properly identified
as such for purposes of section 475(b)(2)--
(A) Stock in a corporation that the taxpayer controls (within the
meaning of paragraph (e)(1)(ii) of this section); or
(B) A partnership or beneficial ownership interest in a widely held
or publicly traded partnership or trust that the taxpayer controls
(within the meaning of paragraph (e)(1)(ii) of this section).
(ii) Control defined. Control means the ownership, directly or
indirectly through persons described in section 267(b) (taking into
account section 267(c)), of--
(A) 50 percent or more of the total combined voting power of all
classes of stock entitled to vote; or
(B) 50 percent or more of the capital interest, the profits
interest, or the beneficial ownership interest in the widely held or
publicly traded partnership or trust.
(iii) Applicability. The rules of this paragraph (e)(1) apply only
before January 23, 1997.
(2) Dealers in notional principal contracts and derivatives acquired
before January 23, 1997--(i) General rule. Section 475(b)(1)(A)
(exempting certain securities from mark-to-market accounting) does not
apply to a security if--
(A) The security is described in section 475(c)(2) (D) or (E)
(describing certain notional principal contracts and derivative
securities); and
(B) The taxpayer is a dealer in such securities.
(ii) Exception for securities not acquired in dealer capacity. This
paragraph (e)(2) does not apply if the taxpayer establishes
unambiguously that the security was not acquired in the taxpayer's
capacity as a dealer in such securities.
(iii) Applicability. The rules of paragraph (e)(2) apply only to
securities acquired before January 23, 1997.
[T.D. 8700, 61 FR 67720, Dec. 24, 1996, as amended by T.D. 8985, 67 FR
12865, Mar. 20, 2002]
Sec. 1.475(b)-2 Exemptions--identification requirements.
(a) Identification of the basis for exemption. An identification of
a security as exempt from mark to market does not satisfy section
475(b)(2) if it fails to state whether the security is described in--
(1) Either of the first two subparagraphs of section 475(b)(1)
(identifying a security as held for investment or not held for sale); or
[[Page 580]]
(2) The third subparagraph thereof (identifying a security as a
hedge).
(b) Time for identifying a security with a substituted basis. For
purposes of determining the timeliness of an identification under
section 475(b)(2), the date that a dealer acquires a security is not
affected by whether the dealer's basis in the security is determined, in
whole or in part, either by reference to the basis of the security in
the hands of the person from whom the security was acquired or by
reference to other property held at any time by the dealer. See Sec.
1.475(a)-3 for rules governing how the dealer accounts for such a
security if this identification is not made.
(c) Integrated transactions under Sec. 1.1275-6--(1) Definitions.
The following terms are used in this paragraph (c) with the meanings
that are given to them by Sec. 1.1275-6: integrated transaction,
legging into, legging out, qualifying debt instrument, Sec. 1.1275-6
hedge, and synthetic debt instrument.
(2) Synthetic debt held by a taxpayer as a result of legging in. If
a taxpayer is treated as the holder of a synthetic debt instrument as
the result of legging into an integrated transaction, then, for purposes
of the timeliness of an identification under section 475(b)(2), the
synthetic debt instrument is treated as having the same acquisition date
as the qualifying debt instrument. A pre-leg-in identification of the
qualifying debt instrument under section 475(b)(2) applies to the
integrated transaction as well.
(3) Securities held after legging out. If a taxpayer legs out of an
integrated transaction, then, for purposes of the timeliness of an
identification under section 475(b)(2), the qualifying debt instrument,
or the Sec. 1.1275-6 hedge, that remains in the taxpayer's hands is
generally treated as having been acquired, originated, or entered into,
as the case may be, immediately after the leg-out. If any loss or
deduction determined under Sec. 1.1275-6(d)(2)(ii)(B) is disallowed by
Sec. 1.1275-6(d)(2)(ii)(D) (which disallows deductions when a taxpayer
legs out of an integrated transaction within 30 days of legging in),
then, for purposes of this section and section 475(b)(2), the qualifying
debt instrument that remains in the taxpayer's hands is treated as
having been acquired on the same date that the synthetic debt instrument
was treated as having been acquired.
[T.D. 8700, 61 FR 67722, Dec. 24, 1996]
Sec. 1.475(b)-3 [Reserved]
Sec. 1.475(c)-1 Definitions--dealer in securities.
(a) Dealer-customer relationship. Whether a taxpayer is transacting
business with customers is determined on the basis of all of the facts
and circumstances.
(1) [Reserved]
(2) Transactions described in section 475(c)(1)(B)--(i) In general.
For purposes of section 475(c)(1)(B), the term dealer in securities
includes, but is not limited to, a taxpayer that, in the ordinary course
of the taxpayer's trade or business, regularly holds itself out as being
willing and able to enter into either side of a transaction enumerated
in section 475(c)(1)(B).
(ii) Examples. The following examples illustrate the rules of this
paragraph (a)(2). In the following examples, B is a bank and is not a
member of a consolidated group:
Example 1. B regularly offers to enter into interest rate swaps with
other persons in the ordinary course of its trade or business. B is
willing to enter into interest rate swaps under which it either pays a
fixed interest rate and receives a floating rate or pays a floating rate
and receives a fixed rate. B is a dealer in securities under section
475(c)(1)(B), and the counterparties are its customers.
Example 2. B, in the ordinary course of its trade or business,
regularly holds itself out as being willing and able to enter into
either side of positions in a foreign currency with other banks in the
interbank market. B's activities in the foreign currency make it a
dealer in securities under section 475(c)(1)(B), and the other banks in
the interbank market are its customers.
Example 3. B engages in frequent transactions in a foreign currency
in the interbank market. Unlike the facts in Example 2, however, B does
not regularly hold itself out as being willing and able to enter into
either side of positions in the foreign currency, and all of B's
transactions are driven by its internal need to adjust its position in
the currency. No other circumstances are present to suggest that B is a
dealer in securities for purposes of section 475(c)(1)(B). B's activity
in the foreign currency does not qualify it as a dealer in securities
for purposes of section
[[Page 581]]
475(c)(1)(B), and its transactions in the interbank market are not
transactions with customers.
(3) Related parties--(i) General rule. Except as provided in
paragraph (a)(3)(ii) of this section (concerning transactions between
members of a consolidated group, as defined in Sec. 1.1502-1(h)), a
taxpayer's transactions with related persons may be transactions with
customers for purposes of section 475. For example, if a taxpayer, in
the ordinary course of the taxpayer's trade or business, regularly holds
itself out to its foreign subsidiaries or other related persons as being
willing and able to enter into either side of transactions enumerated in
section 475(c)(1)(B), the taxpayer is a dealer in securities within the
meaning of section 475(c)(1), even if it engages in no other
transactions with customers.
(ii) Special rule for members of a consolidated group. Solely for
purposes of paragraph (c)(1) of section 475 (concerning the definition
of dealer in securities) and except as provided in paragraph (a)(3)(iii)
of this section, a taxpayer's transactions with other members of its
consolidated group are not with customers. Accordingly, notwithstanding
paragraph (a)(2) of this section, the fact that a taxpayer regularly
holds itself out to other members of its consolidated group as being
willing and able to enter into either side of a transaction enumerated
in section 475(c)(1)(B) does not cause the taxpayer to be a dealer in
securities within the meaning of section 475(c)(1)(B).
(iii) The intragroup-customer election--(A) Effect of election. If a
consolidated group makes the intragroup-customer election, paragraph
(a)(3)(ii) of this section (special rule for members of a consolidated
group) does not apply to the members of the group. Thus, a member of a
group that has made this election may be a dealer in securities within
the meaning of section 475(c)(1) even if its only customer transactions
are with other members of its consolidated group.
(B) Making and revoking the election. Unless the Commissioner
otherwise prescribes, the intragroup-customer election is made by filing
a statement that says, ``[Insert name and employer identification number
of common parent] hereby makes the Intragroup-Customer Election (as
described in Sec. 1.475(c)-1(a)(3)(iii) of the income tax regulations)
for the taxable year ending [describe the last day of the year] and for
subsequent taxable years.'' The statement must be signed by the common
parent and attached to the timely filed federal income tax return for
the consolidated group for that taxable year. The election applies for
that year and continues in effect for subsequent years until revoked.
The election may be revoked only with the consent of the Commissioner.
(iv) Examples. The following examples illustrate this paragraph
(a)(3):
General Facts. HC, a hedging center, provides interest rate hedges
to all of the members of its affiliated group (as defined in section
1504(a)(1)). Because of the efficiencies created by having a centralized
risk manager, group policy prohibits members other than HC from entering
into derivative interest rate positions with outside parties. HC
regularly holds itself out as being willing and able to, and in fact
does, enter into either side of interest rate swaps with its fellow
members. HC periodically computes its aggregate position and hedges the
net risk with an unrelated party. HC does not otherwise enter into
interest rate positions with persons that are not members of the
affiliated group. HC attempts to operate at cost, and the terms of its
swaps do not factor in any risk of default by the affiliate. Thus, HC's
affiliates receive somewhat more favorable terms then they would receive
from an unrelated swaps dealer (a fact that may subject HC and its
fellow members to reallocation of income under section 482). No other
circumstances are present to suggest that HC is a dealer in securities
for purposes of section 475(c)(1)(B).
Example 1. General rule for related persons. In addition to the
General Facts stated above, assume that HC's affiliated group has not
elected under section 1501 to file a consolidated return. Under
paragraph (a)(3)(i) of this section, HC's transactions with its
affiliates can be transactions with customers for purposes of section
475(c)(1). Thus, under paragraph (a)(2)(i) of this section, HC is a
dealer in securities within the meaning of section 475(c)(1)(B), and the
members of the group with which it does business are its customers.
Example 2. Special rule for members of a consolidated group. In
addition to the General Facts stated above, assume that HC's affiliated
group has elected to file consolidated returns and has not made the
intragroup-customer election. Under paragraph (a)(3)(ii)
[[Page 582]]
of this section, HC's interest rate swap transactions with the members
of its consolidated group are not transactions with customers for
purposes of determining whether HC is a dealer in securities within the
meaning of section 475(c)(1). Further, the fact that HC regularly holds
itself out to members of its consolidated group as being willing and
able to enter into either side of a transaction enumerated in section
475(c)(1)(B) does not cause HC to be a dealer in securities within the
meaning of section 475(c)(1)(B). Because no other circumstances are
present to suggest that HC is a dealer in securities for purposes of
section 475(c)(1)(B), HC is not a dealer in securities.
Example 3. Intragroup-customer election. In addition to the General
Facts stated above, assume that HC's affiliated group has elected to
file a consolidated return but has also made the intragroup-customer
election under paragraph (a)(3)(iii) of this section. Thus, the analysis
and result are the same as in Example 1.
(b) Sellers of nonfinancial goods and services--(1) Purchases and
sales of customer paper. Except as provided in paragraph (b)(3) of this
section, if a taxpayer would not be a dealer in securities within the
meaning of section 475(c)(1) but for its purchases and sales of debt
instruments that, at the time of purchase or sale, are customer paper
with respect to either the taxpayer or a corporation that is a member of
the same consolidated group (as defined in Sec. 1.1502-1(h)) as the
taxpayer, then for purposes of section 475 the taxpayer is not a dealer
in securities.
(2) Definition of customer paper. A debt instrument is customer
paper with respect to a person at a point in time if--
(i) The person's principal activity is selling nonfinancial goods or
providing nonfinancial services;
(ii) The debt instrument was issued by a purchaser of the goods or
services at the time of the purchase of those goods or services in order
to finance the purchase; and
(iii) At all times since the debt instrument was issued, it has been
held either by the person selling those goods or services or by a
corporation that is a member of the same consolidated group as that
person.
(3) Exceptions. Paragraph (b)(1) of this section does not apply if--
(i) For purposes of section 471, the taxpayer accounts for any
security (as defined in section 475(c)(2)) as inventory;
(ii) The taxpayer is subject to an election under paragraph (b)(4)
of this section; or
(iii) The taxpayer is not described in paragraph (b)(2)(i) of this
section and one or more debt instruments that are customer paper with
respect to a corporation that is a member of the same consolidated group
as the taxpayer are accounted for by the taxpayer, or by a corporation
that is a member of the same consolidated group as the taxpayer, in a
manner that allows recognition of unrealized gains or losses or
deductions for additions to a reserve for bad debts.
(4) Election not to be governed by the exception for sellers of
nonfinancial goods or services--(i) Method of making the election.
Unless the Commissioner otherwise prescribes, an election under this
paragraph (b)(4) must be made in the manner, and at the time, prescribed
in this paragraph (b)(4)(i). The taxpayer must file with the Internal
Revenue Service a statement that says, ``[Insert name and taxpayer
identification number of the taxpayer] hereby elects not to be governed
by Sec. 1.475(c)-1(b)(1) of the income tax regulations for the taxable
year ending [describe the last day of the year] and for subsequent
taxable years.''
(A) Taxable years ending after December 24, 1996. If the first
taxable year subject to an election under this paragraph (b)(4) ends
after December 24, 1996, the statement must be attached to a timely
filed federal income tax return for that taxable year.
(B) Taxable years ending on or before December 24, 1996. If the
first taxable year subject to an election under this paragraph (b)(4)
ends on or before December 24, 1996 and the election changes the
taxpayer's taxable income for any taxable year the federal income tax
return for which was filed before February 24, 1997, the statement must
be attached to an amended return for the earliest such year that is so
affected, and that amended return (and an amended return for any other
such year that is so affected) must be filed not later than June 23,
1997. If the first taxable year subject to an election under this
paragraph (b)(4) ends on or
[[Page 583]]
before December 24, 1996 but the taxpayer is not described in the
preceding sentence, the statement must be attached to the first federal
income tax return that is for a taxable year subject to the election and
that is filed on or after February 24, 1997.
(ii) Continued applicability of an election. An election under this
paragraph (b)(4) continues in effect for subsequent taxable years until
revoked. The election may be revoked only with the consent of the
Commissioner.
(c) Taxpayers that purchase securities from customers but engage in
no more than negligible sales of the securities--(1) Exemption from
dealer status--(i) General rule. A taxpayer that regularly purchases
securities from customers in the ordinary course of a trade or business
(including regularly making loans to customers in the ordinary course of
a trade or business of making loans) but engages in no more than
negligible sales of the securities so acquired is not a dealer in
securities within the meaning of section 475(c)(1) unless the taxpayer
elects to be so treated or, for purposes of section 471, the taxpayer
accounts for any security (as defined in section 475(c)(2)) as
inventory.
(ii) Election to be treated as a dealer. A taxpayer described in
paragraph (c)(1)(i) of this section elects to be treated as a dealer in
securities by filing a federal income tax return reflecting the
application of section 475(a) in computing its taxable income.
(2) Negligible sales. Solely for purposes of paragraph (c)(1) of
this section, a taxpayer engages in negligible sales of debt instruments
that it regularly purchases from customers in the ordinary course of its
business if, and only if, during the taxable year, either--
(i) The taxpayer sells all or part of fewer than 60 debt
instruments, regardless how acquired; or
(ii) The total adjusted basis of the debt instruments (or parts of
debt instruments), regardless how acquired, that the taxpayer sells is
less than 5 percent of the total basis, immediately after acquisition,
of the debt instruments that it acquires in that year.
(3) Special rules for members of a consolidated group--(i)
Intragroup-customer election in effect. If a taxpayer is a member of a
consolidated group that has made the intragroup-customer election
(described in paragraph (a)(3)(iii) of this section), the negligible
sales test in paragraph (c)(2) of this section takes into account all of
the taxpayer's sales of debt instruments to other group members.
(ii) Intragroup-customer election not in effect. If a taxpayer is a
member of a consolidated group that has not made the intragroup-customer
election (described in paragraph (a)(3)(iii) of this section), the
taxpayer satisfies the negligible sales test in paragraph (c)(2) of this
section if either--
(A) The test is satisfied by the taxpayer, taking into account sales
of debt instruments to other group members (as in paragraph (c)(3)(i) of
this section); or
(B) The test is satisfied by the group, treating the members of the
group as if they were divisions of a single corporation.
(4) Special rules. Whether sales of securities are negligible is
determined without regard to--
(i) Sales of securities that are necessitated by exceptional
circumstances and that are not undertaken as recurring business
activities;
(ii) Sales of debt instruments that decline in quality while in the
taxpayer's hands and that are sold pursuant to an established policy of
the taxpayer to dispose of debt instruments below a certain quality; or
(iii) Acquisitions and sales of debt instruments that are
qualitatively different from all debt instruments that the taxpayer
purchases from customers in the ordinary course of its business.
(5) Example. The following example illustrates paragraph (c)(4)(iii)
of this section:
Example. I, an insurance company, regularly makes policy loans to
its customers but does not sell them. I, however, actively trades
Treasury securities. No other circumstances are present to suggest that
I is a dealer in securities for purposes of section 475(c)(1). Since the
Treasuries are qualitatively different from the policy loans that I
originates, under paragraph (c)(4)(iii) of this section, I disregards
the purchases and sales of Treasuries in applying the negligible sales
test in paragraph (c)(2) of this section.
(d) Issuance of life insurance products. A life insurance company
that is not otherwise a dealer in securities within
[[Page 584]]
the meaning of section 475(c)(1) does not become a dealer in securities
solely because it regularly issues life insurance products to its
customers in the ordinary course of a trade or business. For purposes of
the preceding sentence, the term life insurance product means a contract
that is treated for federal income tax purposes as an annuity,
endowment, or life insurance contract. See sections 72, 817, and 7702.
[T.D. 8700, 61 FR 67723, Dec. 24, 1996]
Sec. 1.475(c)-2 Definitions--security.
(a) Items that are not securities. The following items are not
securities within the meaning of section 475(c)(2) with respect to a
taxpayer and, therefore, are not subject to section 475--
(1) A security (determined without regard to this paragraph (a)) if
section 1032 prevents the taxpayer from recognizing gain or loss with
respect to that security;
(2) A debt instrument issued by the taxpayer (including a synthetic
debt instrument, within the meaning of Sec. 1.1275-6(b)(4), that Sec.
1.1275-6(b) treats the taxpayer as having issued); or
(3) A REMIC residual interest, or an interest or arrangement that is
determined by the Commissioner to have substantially the same economic
effect, if the residual interest or the interest or arrangement is
acquired on or after January 4, 1995.
(b) Synthetic debt that Sec. 1.1275-6(b) treats the taxpayer as
holding. If Sec. 1.1275-6 treats a taxpayer as the holder of a
synthetic debt instrument (within the meaning of Sec. 1.1275-6(b)(4)),
the synthetic debt instrument is a security held by the taxpayer within
the meaning of section 475(c)(2)(C).
(c) Negative value REMIC residuals acquired before January 4, 1995.
A REMIC residual interest that is described in paragraph (c)(1) of this
section or an interest or arrangement that is determined by the
Commissioner to have substantially the same economic effect is not a
security within the meaning of section 475(c)(2).
(1) Description. A residual interest in a REMIC is described in this
paragraph (c)(1) if, on the date the taxpayer acquires the residual
interest, the present value of the anticipated tax liabilities
associated with holding the interest exceeds the sum of--
(i) The present value of the expected future distributions on the
interest; and
(ii) The present value of the anticipated tax savings associated
with holding the interest as the REMIC generates losses.
(2) Special rules applicable to negative value REMIC residuals
acquired before January 4, 1995. Solely for purposes of this paragraph
(c)--
(i) If a transferee taxpayer acquires a residual interest with a
basis determined by reference to the transferor's basis, then the
transferee is deemed to acquire the interest on the date the transferor
acquired it (or is deemed to acquire it under this paragraph (c)(2)(i)).
(ii) Anticipated tax liabilities, expected future distributions, and
anticipated tax savings are determined under the rules in Sec. 1.860E-
2(a)(3) and without regard to the operation of section 475.
(iii) Present values are determined under the rules in Sec. 1.860E-
2(a)(4).
[T.D. 8700, 61 FR 67725, Dec. 24, 1996]
Sec. 1.475(d)-1 Character of gain or loss.
(a) Securities never held in connection with the taxpayer's
activities as a dealer in securities. If a security is never held in
connection with the taxpayer's activities as a dealer in securities,
section 475(d)(3)(A) does not affect the character of gain or loss from
the security, even if the taxpayer fails to identify the security under
section 475(b)(2).
(b) Ordinary treatment for notional principal contracts and
derivatives held by dealers in notional principal contracts and
derivatives. Section 475(d)(3)(B)(ii) (concerning the character of gain
or loss with respect to a security held by a person other than in
connection with its activities as a dealer in securities) does not apply
to a security if Sec. 1.475(b)-1(c) and the absence of a determination
by the Commissioner prevent section 475(b)(1)(A) from applying to the
security.
[T.D. 8700, 61 FR 67725, Dec. 24, 1996]
Sec. 1.475(g)-1 Effective dates.
(a)-(b) [Reserved]
[[Page 585]]
(c) Section 1.475(a)-3 (concerning acquisition by a dealer of a
security with a substituted basis) applies to securities acquired,
originated, or entered into on or after January 4, 1995.
(d) Section 1.475(a)-4 (concerning a safe harbor to use applicable
financial statement values for purposes of section 475) applies to
taxable years ending on or after June 12, 2007.
(e) Except as provided elsewhere in this paragraph (d), Sec.
1.475(b)-1 (concerning the scope of exemptions from the mark-to-market
requirement) applies to taxable years ending on or after December 31,
1993.
(1) Section 1.475(b)-1(b) applies as follows:
(i) Section 1.475(b)-1(b)(1)(i) (concerning equity interests issued
by a related person) applies beginning June 19, 1996. If, on June 18,
1996, a security is subject to mark-to-market accounting and, on June
19, 1996, Sec. 1.475(b)-1(b)(1) begins to apply to the security solely
because of the effective dates in this paragraph (d) (rather than
because of a change in facts), then the rules of Sec. 1.475(b)-
1(b)(4)(i)(A) (concerning the prohibition against marking) apply, but
Sec. 1.475(b)-1(b)(4)(i)(B) (imposing a mark-to-market on the day
before the onset of the prohibition) does not apply.
(ii) Section 1.475(b)-1(b)(2) (concerning relevant relationships for
purposes of determining whether equity interests in related persons are
prohibited from being marked to market) applies beginning June 19, 1996.
(iii) Section 1.475(b)-1(b)(3) (concerning certain actively traded
securities) applies beginning June 19, 1996, to securities held on or
after that date, except for securities described in Sec. 1.475(b)-
1(e)(1)(i) (concerning equity interests issued by controlled entities).
If a security is described in Sec. 1.475(b)-1(e)(1)(i), Sec. 1.475(b)-
1(b)(3) applies only on or after January 23, 1997 if the security is
held on or after that date. If Sec. 1.475(b)-1(b)(1) ceases to apply to
a security by virtue of the operation of this paragraph (d)(1)(iii), the
rules of Sec. 1.475(b)-1(b)(4)(ii) apply to the cessation.
(iv) Except to the extent provided in paragraph (d)(1) of this
section, Sec. 1.475(b)-1(b)(4) (concerning changes in status) applies
beginning June 19, 1996.
(2) Section 1.475(b)-1(c) (concerning securities deemed not held for
investment by dealers in notional principal contracts and derivatives)
applies to securities acquired on or after January 23, 1997.
(3) Section 1.475(b)-1(d) (concerning the special rule for hedges of
another member's risk) is effective for securities acquired, originated,
or entered into on or after January 23, 1997.
(f) Section 1.475(b)-2 (concerning identification of securities that
are exempt from mark-to-market treatment) applies as follows:
(1) Section 1.475(b)-2(a) (concerning the general rules for
identification of basis for exemption from mark to market treatment)
applies to identifications made on or after July 1, 1997.
(2) Section 1.475(b)-2(b) (concerning time for identifying a
security with a substituted basis) applies to securities acquired,
originated, or entered into on or after January 4, 1995.
(3) Section 1.475(b)-2(c) (concerning identification in the context
of integrated transactions under Sec. 1.1275-6) applies on and after
August 13, 1996 (the effective date of Sec. 1.1275-6).
(g)-(h) [Reserved]
(i) Section 1.475(c)-1 applies as follows:
(1) Except as otherwise provided in this paragraph (h)(1), Sec.
1.475(c)-1(a) (concerning the dealer-customer relationship) applies to
taxable years beginning on or after January 1, 1995.
(i) [Reserved]
(ii) Section 1.475(c)-1(a)(2)(ii) (illustrating rules concerning the
dealer-customer relationship) applies to taxable years beginning on or
after June 20, 1996.
(iii)(A) Section 1.475(c)-1(a)(3) applies to taxable years beginning
on or after June 20, 1996, except for transactions between members of
the same consolidated group.
(B) For transactions between members of the same consolidated group,
paragraph Sec. 1.475(c)-1(a)(3) applies to taxable years beginning on
or after December 24, 1996.
[[Page 586]]
(2) Section 1.475(c)-1(b) (concerning sellers of nonfinancial goods
and services) applies to taxable years ending on or after December 31,
1993.
(3) Except as otherwise provided in this paragraph (h)(3), section
1.475(c)-1(c) (concerning taxpayers that purchase securities but engage
in no more than negligible sales of the securities) applies to taxable
years ending on or after December 31, 1993.
(i) Section 1.475(c)-1(c)(3) (special rules for members of a
consolidated group) is effective for taxable years beginning on or after
December 24, 1996.
(ii) A taxpayer may rely on the rules set out in Sec. 1.475(c)-
1T(b) (as contained in 26 CFR part 1 revised April 1, 1996) for taxable
years beginning before January 23, 1997, provided the taxpayer applies
that paragraph reasonably and consistently.
(4) Section 1.475(c)-1(d) (concerning the issuance of life insurance
products) applies to taxable years beginning on or after January 1,
1995.
(j) Section 1.475(c)-2 (concerning the definition of security)
applies to taxable years ending on or after December 31, 1993. By its
terms, however, Sec. 1.475(c)-2(a)(3) applies only to residual
interests or to interests or arrangements that are acquired on or after
January 4, 1995; and the integrated transactions that are referred to in
Sec. Sec. 1.475(c)-2(a)(2) and 1.475(c)-2(b) exist only after August
13, 1996 (the effective date of Sec. 1.1275-6).
(k) Section 1.475(d)-1 (concerning the character of gain or loss)
applies to taxable years ending on or after December 31, 1993.
[T.D. 8700, 61 FR 67725, Dec. 24, 1996. Redesignated and amended by T.D.
9328, 72 FR 32181, June 12, 2007; T.D. 9849, 84 FR 9235, Mar. 14, 2019]
Adjustments
Sec. 1.481-1 Adjustments in general.
(a)(1) Section 481 prescribes the rules to be followed in computing
taxable income in cases where the taxable income of the taxpayer is
computed under a method of accounting different from that under which
the taxable income was previously computed. A change in method of
accounting to which section 481 applies includes a change in the over-
all method of accounting for gross income or deductions, or a change in
the treatment of a material item. For rules relating to changes in
methods of accounting, see section 446(e) and paragraph (e) of Sec.
1.446-1. In computing taxable income for the taxable year of the change,
there shall be taken into account those adjustments which are determined
to be necessary solely by reason of such change in order to prevent
amounts from being duplicated or omitted. The ``year of the change'' is
the taxable year for which the taxable income of the taxpayer is
computed under a method of accounting different from that used for the
preceding taxable year.
(2) Unless the adjustments are attributable to a change in method of
accounting initiated by the taxpayer, no part of the adjustments
required by subparagraph (1) of this paragraph shall be based on amounts
which were taken into account in computing income (or which should have
been taken into account had the new method of accounting been used) for
taxable years beginning before January 1, 1954, or ending before August
17, 1954 (hereinafter referred to as pre-1954 years).
(b) The adjustments specified in section 481(a) and this section
shall take into account inventories, accounts receivable, accounts
payable, and any other item determined to be necessary in order to
prevent amounts from being duplicated or omitted.
(c)(1) The term ``adjustments'', as used in section 481, has
reference to the net amount of the adjustments required by section
481(a) and paragraph (b) of this section. In the case of a change in the
over-all method of accounting, such as from the cash receipts and
disbursements method to an accrual method, the term ``net amount of the
adjustments'' means the consolidation of adjustments (whether the
amounts thereof represent increases or decreases in items of income or
deductions) arising with respect to balances in various accounts, such
as inventory, accounts receivable, and accounts payable, at the
beginning of the taxable year of the change in method of accounting.
With respect to the portion of the adjustments attributable to pre-
[[Page 587]]
1954 years, it is immaterial that the same items or class of items with
respect to which adjustments would have to be made (for the first
taxable year to which section 481 applies) do not exist at the time the
actual change in method of accounting occurs. For purposes of section
481, only the net dollar balance is to be taken into account. In the
case of a change in the treatment of a single material item, the amount
of the adjustment shall be determined with reference only to the net
dollar balances in that particular account.
(2) If a change in method of accounting is voluntary (i.e.,
initiated by the taxpayer), the entire amount of the adjustments
required by section 481(a) is generally taken into account in computing
taxable income in the taxable year of the change, regardless of whether
the adjustments increase or decrease taxable income. See, however,
Sec. Sec. 1.446-1(e)(3) and 1.481-4 which provide that the Commissioner
may prescribe the taxable year or years in which the adjustments are
taken into account.
(3) If the change in method of accounting is involuntary (i.e., not
initiated by the taxpayer), then only the amount of the adjustments
required by section 481(a) that is attributable to taxable years
beginning after December 31, 1953, and ending after August 16, 1954,
(hereinafter referred to as post-1953 years) is taken into account. This
amount is generally taken into account in computing taxable income in
the taxable year of the change, regardless of whether the adjustments
increase or decrease taxable income. See, however, Sec. Sec. 1.446-
1(e)(3) and 1.481-4 which provide that the Commissioner may prescribe
the taxable year or years in which the adjustments are taken into
account. See also Sec. 1.481-3 for rules relating to adjustments
attributable to pre-1954 years.
(4) For any adjustments attributable to post-1953 years that are
taken into account entirely in the year of change and that increase
taxable income by more than $3,000, the limitations on tax provided in
section 481(b) (1) or (2) apply. See Sec. 1.481-2 for rules relating to
the limitations on tax provided by sections 481(b) (1) and (2).
(5) A change in the method of accounting initiated by the taxpayer
includes not only a change which he originates by securing the consent
of the Commissioner, but also a change from one method of accounting to
another made without the advance approval of the Commissioner. A change
in the taxpayer's method of accounting required as a result of an
examination of the taxpayer's income tax return will not be considered
as initiated by the taxpayer. On the other hand, a taxpayer who, on his
own initiative, changes his method of accounting in order to conform to
the requirements of any Federal income tax regulation or ruling shall
not, merely because of such fact, be considered to have made an
involuntary change.
(d) Any adjustments required under section 481(a) that are taken
into account during a taxable year must be properly taken into account
for purposes of computing gross income, adjusted gross income, or
taxable income in determining the amount of any item of gain, loss,
deduction, or credit that depends on gross income, adjusted gross
income, or taxable income.
[T.D. 6500, 25 FR 11731, Nov. 26, 1960, as amended by T.D. 8608, 60 FR
40078, Aug. 7, 1995]
Sec. 1.481-2 Limitation on tax.
(a) Three-year allocation. Section 481(b)(1) provides a limitation
on the tax under chapter 1 of the Internal Revenue Code for the taxable
year of change that is attributable to the adjustments required under
section 481(a) and Sec. 1.481-1 if the entire amount of the adjustments
is taken into account in the year of change. If such adjustments
increase the taxpayer's taxable income for the taxable year of the
change by more than $3,000, then the tax for such taxable year that is
attributable to the adjustments shall not exceed the lesser of the tax
attributable to taking such adjustments into account in computing
taxable income for the taxable year of the change under section 481(a)
and Sec. 1.481-1, or the aggregate of the increases in tax that would
result if the adjustments were included ratably in the taxable year of
the change and the two preceding taxable years. For the purpose of
computing the limitation on tax under section 481(b)(1), the adjustments
shall be allocated ratably to the
[[Page 588]]
taxable year of the change and the two preceding taxable years, whether
or not the adjustments are in fact attributable in whole or in part to
such years. The limitation on the tax provided in this paragraph shall
be applicable only if the taxpayer used the method of accounting from
which the change was made in computing taxable income for the two
taxable years preceding the taxable year of the change.
(b) Allocation under new method of accounting. Section 481(b)(2)
provides a second alternative limitation on the tax for the taxable year
of change under chapter 1 of the Internal Revenue Code that is
attributable to the adjustments required under section 481(a) and Sec.
1.481-1 where such adjustments increase taxable income for the taxable
year of change by more than $3,000. If the taxpayer establishes from his
books of account and other records what his taxable income would have
been under the new method of accounting for one or more consecutive
taxable years immediately preceding the taxable year of the change, and
if the taxpayer in computing taxable income for such years used the
method of accounting from which the change was made, then the tax
attributable to the adjustments shall not exceed the smallest of the
following amounts:
(1) The tax attributable to taking the adjustments into account in
computing taxable income for the taxable year of the change under
section 481(a) and Sec. 1.481-1;
(2) The tax attributable to such adjustments computed under the 3-
year allocation provided in section 481(b)(1), if applicable; or
(3) The net increase in the taxes under chapter 1 (or under
corresponding provisions of prior revenue laws) which would result from
allocating that portion of the adjustments to the one or more
consecutive preceding taxable years to which properly allocable under
the new method of accounting and from allocating the balance thereof to
the taxable year of the change.
(c) Rules for computation of tax. (1) The first step in determining
whether either of the limitations described in section 481(b) (1) or (2)
applies is to compute the increase in tax for the taxable year of the
change that is attributable to the increase in taxable income for such
year resulting solely from the adjustments required under section 481(a)
and Sec. 1.481-1. This increase in tax is the excess of the tax for the
taxable year computed by taking into account such adjustments under
section 481(a) over the tax computed for such year without taking the
adjustments into account.
(2) The next step is to compute under section 481(b)(1) the tax
attributable to the adjustments referred to in paragraph (c)(1) of this
section for the taxable year of the change and the two preceding taxable
years as if an amount equal to one-third of the net amount of such
adjustments had been received or accrued in each of such taxable years.
The increase in tax attributable to the adjustments for each such
taxable year is the excess of the tax for such year computed with the
allocation of one-third of the net adjustments to such taxable year over
the tax computed without the allocation of any part of the adjustments
to such year. For the purpose of computing the aggregate increase in
taxes for such taxable years, there shall be taken into account the
increase or decrease in tax for any taxable year preceding the taxable
year of the change to which no adjustment is allocated under section
481(b)(1) but which is affected by a net operating loss under section
172 or by a capital loss carryback or carryover under section 1212,
determined with reference to taxable years with respect to which
adjustments under section 481(b)(1) are allocated.
(3) In the event that the taxpayer satisfies the conditions set
forth in section 481(b)(2), the next step is to determine the amount of
the net increase in tax attributable to the adjustments referred to in
paragraph (c)(1) of this section for:
(i) The taxable year of the change,
(ii) The consecutive taxable year or years immediately preceding the
taxable year of the change for which the taxpayer can establish his
taxable income under the new method of accounting, and
(iii) Any taxable year preceding the taxable year of the change to
which no adjustment is allocated under section
[[Page 589]]
481(b)(2), but which is affected by a net operating loss or by a capital
loss carryback or carryover determined with reference to taxable years
with respect to which such adjustments are allocated.
The net increase in tax for the taxable years specified in subdivisions
(i), (ii), and (iii) of this subparagraph shall be computed as if the
amount of the adjustments for the prior taxable years to which properly
allocable in accordance with section 481(b)(2) had been received or
accrued, or paid or incurred, as the case may be, in such prior years
and the balance of the adjustments in the taxable year of the change.
The amount of tax attributable to such adjustments for the taxable years
specified in subdivisions (i), (ii), and (iii) of this subparagraph is
the aggregate of the differences (increases and decreases) between the
tax for each such year computed by taking into account the allocable
portion of the adjustments in computing taxable income and the tax
computed without taking into account any portion of the adjustments in
computing taxable income. Generally, where there is an increase in
taxable income for a preceding consecutive taxable year established
under the new method of accounting, computed without regard to
adjustments attributable to any preceding taxable year, the amount of
the adjustments to be allocated to each such year shall be an amount
equal to such increase. However, where the amount of the adjustments to
be allocated to a prior taxable year is less than the increase in
taxable income for such year established under the new method of
accounting, the amount of the increase in such taxable income for
purposes of determining the increase in tax under section 481(b)(2) for
such year shall be considered to be the amount so allocated. For
example, if the amount of the adjustments required by section 481(a) for
1958 (the taxable year of the change) is $60,000, and the increase in
taxable income is determined by the taxpayer to be $40,000, $5,000, and
$35,000, computed under the new method of accounting, for the taxable
years 1957, 1956, and 1955, respectively, then the amount of the
adjustments to be allocated to 1955 will be the balance of the
adjustments, or $15,000.
(4) The tax for the taxable year of the change shall be the tax for
such year, computed without taking any of the adjustments referred to in
paragraph (c)(1) of this section into account, increased by the smallest
of the following amounts--
(i) The amount of tax for the taxable year of the change
attributable solely to taking into account the entire amount of the
adjustments required by section 481(a) and Sec. 1.481-1;
(ii) The sum of the increases in tax liability for the taxable year
of the change and the two immediately preceding taxable years that would
have resulted solely from taking into account one-third of the amount of
such adjustments required for each of such years as though such amounts
had been properly attributable to such years (computed in accordance
with paragraph (c)(2) of this section); or
(iii) The net increase in tax attributable to allocating such
adjustments under the new method of accounting (computed in accordance
with paragraph (c)(3) of this section).
(5)(i) In the case of a change in method of accounting by a
partnership, the adjustments required by section 481 shall be made with
respect to the taxable income of the partnership but the limitations on
tax under section 481(b) shall apply to the individual partners. Each
partner shall take into account his distributive share of the
partnership items, as so adjusted, for the taxable year of the change.
Section 481(b) applies to a partner whose taxable income is so increased
by more than $3,000 as a result of such adjustments to the partnership
taxable income. It is not necessary for the partner to have been a
member of the partnership for the two taxable years immediately
preceding the taxable year of the change of the partnership's accounting
method in order to have the limitation provided by section 481(b)(1)
apply. Further, a partner may apply section 481(b)(2) even though he was
not a member of the partnership for all the taxable years affected by
the computation thereunder.
(ii) In the case of a change in method of accounting by an electing
small
[[Page 590]]
business corporation under subchapter S, chapter 1 of the Code, the
adjustments required by section 481 shall be made with respect to the
taxable income of such electing corporation in the year of the change,
but the limitations on tax under section 481(b) shall apply to the
individual shareholders. Section 481(b) applies to a shareholder of an
electing small business corporation whose taxable income is so increased
by more than $3,000 as a result of such adjustments to such
corporation's taxable income. It is not necessary for the shareholder to
have been a member of the electing small business corporation, or for
such corporation to have been an electing small business corporation,
for the two taxable years immediately preceding the taxable year of the
change of the corporation's accounting method in order to have the
limitation provided by section 481(b)(1) apply. Further, a shareholder
may apply section 481(b)(2), even though he was not a shareholder, or
the corporation was not an electing small business corporation, for all
the taxable years affected by the computation thereunder.
(6) For the purpose of the successive computations of the
limitations on tax under section 481(b) (1) or (2), if the treatment of
any item under the provisions of the Internal Revenue Code of 1986 (or
corresponding provisions of prior internal revenue laws) depends upon
the amount of gross income, adjusted gross income, or taxable income
(for example, medical expenses, charitable contributions, or credits
against the tax), such item shall be determined for the purpose of each
such computation by taking into account the proper portion of the amount
of any adjustments required to be taken into account under section 481
in each such computation.
(7) The increase or decrease in the tax for any taxable year for
which an assessment of any deficiency, or a credit or refund of any
overpayment, is prevented by any law or rule of law, shall be determined
by reference to the tax previously determined (within the meaning
section 1314(a) for such year.
(8) In applying section 7807(b)(1), the provisions of chapter 1
(other than subchapter E, relating to tax on self-employment income) and
chapter 2 of the Internal Revenue Code of 1939 shall be treated as the
corresponding provisions of the Internal Revenue Code of 1939.
(d) Examples. The application of section 481(b) (1) and (2) may be
illustrated by the following examples. Although the examples in this
paragraph are based upon adjustments required in the case of a change in
the over-all method of accounting, the principles illustrated would be
equally applicable to adjustments required in the case of a change in
method of accounting for a particular material item, provided the
treatment of such adjustments is not specifically subject to some other
provision of the Internal Revenue Code of 1986.
Example 1. An unmarried individual taxpayer using the cash receipts
and disbursements method of accounting for the calendar year is required
by the Commissioner to change to an accrual method effective with the
year 1958. As of January 1, 1958, he had an opening inventory of
$11,000. On December 31, 1958, he had a closing inventory of $12,500.
Merchandise purchases during the year amounted to $22,500, and net sales
were $32,000. Total deductible business expenses were $5,000. There were
no receivables or payables at January 1, 1958. The computation of
taxable income for 1958, assuming no other adjustments, using the new
method of accounting follows:
Net sales........................................... ........ $32,000
Opening inventory................................... $11,000
Purchases........................................... 22,500
-----------
Total............................................ 33,500
Less closing inventory.............................. 12,500
-----------
Cost of goods sold.................................. ........ 21,000
---------
Gross profit..................................... ........ 11,000
Business expenses................................... ........ 5,000
---------
Business income................................... ........ 6,000
Personal exemption and itemized deductions.......... ........ 1,600
---------
Taxable income................................... ........ 4,400
Under the cash receipts and disbursements method of accounting, only
$9,000 of the $11,000 opening inventory had been included in the cost of
goods sold and claimed as a deduction for the taxable years 1954 through
1957; the remaining $2,000 had been so accounted for in pre-1954 years.
In order to prevent the same item from reducing taxable income twice, an
adjustment of $9,000 must be made to the taxable income of 1958 under
the provisions of section 481(a) and Sec. 1.481-1. Since the change in
method of accounting was not initiated by the taxpayer, the $2,000
[[Page 591]]
of opening inventory which had been included in cost of goods sold in
pre-1954 years is not taken into account. Taxable income for 1958 is
accordingly increased by $9,000 under section 481(a) to $13,400.
Assuming that the tax on $13,400 is $4,002 and that the tax on $4,400
(income without the adjustment) is $944, the increase in tax
attributable to the adjustment, if taken into account for the taxable
year of the change, would be the difference between the two, or $3,058.
Since the adjustment required by section 481(a) and Sec. 1.481-1
($9,000) increases taxable income by more than $3,000, the increase in
tax for the taxable year 1958 attributable to the adjustment of $9,000
(i.e., $3,058) may be limited under the provisions of section 481(b) (1)
or (2). See examples (2) and (3).
Example 2. Assume that the taxpayer in Example 1 used the cash
receipts and disbursements method of accounting in computing taxable
income for the years 1956 and 1957 and that the taxable income for these
years determined under such method was $4,000 and $6,000, respectively.
The section 481(b)(1) limitation on tax with a pro rata three-year
allocation of the $9,000 adjustment is computed as follows:
----------------------------------------------------------------------------------------------------------------
Increase in
Taxable Taxable Assumed tax tax
Taxable year income income with Assume before attributable
before adjustment total tax adjustment to
adjustment adjustment
----------------------------------------------------------------------------------------------------------------
1956........................................... $4,000 $7,000 $1,660 $840 $820
1957........................................... 6,000 9,000 2,300 1,360 940
1958........................................... 4,400 7,400 1,780 944 836
----------------------------------------------------------------
Total....................................... ........... ........... .......... ........... 2,596
----------------------------------------------------------------------------------------------------------------
Since this increase in tax of $2,596 is less than the increase in tax
attributable to the inclusion of the entire adjustment in the income for
the taxable year of the change ($3,058), the limitation provided by
section 481(b)(1) applies, and the total tax for 1958, the taxable year
of the change, if section 481(b)(2) does not apply, is determined as
follows:
Tax without any portion of adjustment.......................... $944
Increase in tax attributable to adjustment computed under 2,596
section 481(b)(1).............................................
--------
Total tax for taxable year of the change.................... 3,540
Example 3. (i) Assume the same facts as in Example 1 and, in
addition, assume that the taxpayer used the cash receipts and
disbursements method of accounting in computing taxable income for the
years 1953 through 1957; that he established his taxable income under
the new method for the taxable years 1953, 1954, and 1957, but did not
have sufficient records to establish his taxable income under such
method for the taxable years 1955 and 1956. The original taxable income
and taxable income as redetermined are as follows:
------------------------------------------------------------------------
Taxable income
---------------------------- Increase
Determined or
Taxable year under cash Established (decrease)
receipts and under new in taxable
disbursements method income
method
------------------------------------------------------------------------
1953............................ $5,000 $7,000 $2,000
1954............................ 6,000 7,000 1,000
1955............................ 5,500 (\1\) ..........
1956............................ 4,000 (\1\) ..........
1957............................ 6,000 10,000 4,000
------------------------------------------------------------------------
\1\ Undetermined.
As in examples (1) and (2), the total adjustment under section 481(a) is
$9,000. Of the $9,000 adjustment, $4,000 may be allocated to 1957, which
is the only year consecutively preceding the taxable year of the change
for which the taxpayer was able to establish his income under the new
method. Since the income cannot be established under the new method for
1956 and 1955, no allocation may be made to 1954 or 1953, even though
the taxpayer has established his income for those years under the new
method of accounting. The balance of $5,000 ($9,000 minus $4,000) must
be allocated to 1958.
(ii) The limitation provided by section 481(b)(2) is computed as
follows: The tax for 1957, based on taxable income of $6,000, is assumed
to be $1,360. Under the new method, based on taxable income of $10,000,
the tax for 1957 is assumed to be $2,640, the increase attributable to
$4,000 of the $9,000 section 481(a) adjustment being $1,280, ($2,640
minus $1,360). The tax for 1958, computed on the basis of taxable income
of $4,400 (determined under the new method), is assumed to be $944. The
tax computed for 1958 on taxable income of $9,400 ($4,400 plus the
$5,000 adjustment allocated to 1958) is assumed to be $2,436, leaving a
difference of $1,492 ($2,436
[[Page 592]]
minus $944) attributable to the inclusion in 1958 of the portion of the
total adjustment to be taken into account which could not be properly
allocated to the taxable year or years consecutively preceding 1958.
(iii) The tax attributable to the adjustment is determined by
selecting the smallest of the three following amounts:
Increase in tax attributable to adjustment computed under $2,772
section 481(b)(2) ($1,280 + $1,492)...........................
Increase in tax attributable to adjustment computed under 2,596
section 481(b)(1) (Example 2).................................
Increase in tax if the entire adjustment is taken into account 3,058
in the taxable year of the change (Example 1).................
The final tax for 1958 is then $3,540 computed as follows:
Tax before inclusion of any adjustment......................... $944
Increase in tax attributable to adjustments (smallest of 2,596
$2,772, $2,596 or $3,058).....................................
--------
Total tax for 1958 (limited in accordance with section 3,540
481(b)(1))..................................................
Example 4. Assume that X Corporation has maintained its books of
account and filed its income tax returns using the cash receipts and
disbursements method of accounting for the years 1953 through 1957. The
corporation secures permission to change to an accrual method of
accounting for the calendar year 1958. The following tabulation presents
the data with respect to the taxpayer's income for the years involved:
----------------------------------------------------------------------------------------------------------------
Taxable income under the
cash receipts and
disbursements method Taxable Changes in
-------------------------- income Increase or taxable
Before After established (decrease) income due
Year application application under attributable to changes
of net of net accrual to change in net
operating operating method loss
loss loss carryback
carryback carryback
----------------------------------------------------------------------------------------------------------------
1953........................................... $2,000 0 (\1\) ............ $2,000
1954........................................... 4,000 $1,000 (\1\) ............ 3,000
1955........................................... (5,000) ........... $1,000 $6,000 ..........
1956........................................... 80,000 80,000 77,000 (3,000) ..........
1957........................................... 90,000 90,000 96,000 6,000 ..........
1958........................................... ........... ........... 100,000 ............ ..........
----------------------------------------------------------------------------------------------------------------
\1\ Not established.
As indicated above, taxable income for 1953 and 1954, as determined
under the cash receipts and disbursements method of accounting, was
$2,000 and $4,000, respectively, and after application of the net
operating loss carryback from 1955, the taxable income was reduced to
zero in 1953 and to $1,000 in 1954. The taxpayer was unable to establish
taxable income for these years under an accrual method of accounting;
however, under section 481(b)(3)(A), increases or decreases in the tax
for taxable years to which no adjustment is allocated must,
nevertheless, be taken into account to the extent the tax for such years
would be affected by a net operating loss determined with reference to
taxable years to which adjustments are allocated. The total amount of
the adjustments required under section 481(a) and attributable to the
taxable years 1953 through 1957 in this example is assumed to be
$10,000. The redetermination of taxable income established by the
taxpayer for the taxable years 1955, 1956, and 1957 appears under the
heading ``Taxable income established under accrual method'' in the above
tabulation. The tabulation assumes that the taxpayer has been able to
recompute the income for those years so as to establish a net adjustment
of $9,000, which leaves a balance of $1,000 unaccounted for. In
accordance with the requirements of section 481(b)(2), the $1,000 amount
is allocated to 1958, the taxable year of the change. The following
computations are necessary in order to determine the tax attributable to
the adjustments under section 481(a):
Increase in tax attributable to inclusion in 1958 of the entire $10,000
adjustment
Tax on income of 1958 increased by entire amount of adjustment $51,700
($100,000 + $10,000).........................................
Tax on income of 1958 without adjustment ($100,000)........... 46,500
---------
Increase in tax attributable to inclusion of entire adjustment 5,200
in year of the change........................................
Increase in tax attributed to adjustment computed under section 481(b)(1)
----------------------------------------------------------------------------------------------------------------
Increase in
tax
Amount of Tax before Tax after liability
Year adjustment adjustment adjustment attributable
to
adjustment
----------------------------------------------------------------------------------------------------------------
1958.......................................................... $3,334 $46,500 $48,234 $1,734
1957.......................................................... 3,333 41,300 43,033 1,733
[[Page 593]]
1956.......................................................... 3,333 36,100 37,833 1,733
-------------
Increase in tax attributable to adjustment computed under .......... .......... .......... 5,200
section 481(b)(1)..........................................
----------------------------------------------------------------------------------------------------------------
Increase in tax attributed to adjustment computed under section 481(b)(2)
----------------------------------------------------------------------------------------------------------------
1953.......................................................... \1\ $2,000 0 \1\ $600 $600
1954.......................................................... \1\ 3,000 $300 \1\1,200 900
1955.......................................................... 6,000 0 300 300
1956.......................................................... (3,000) 36,100 34,540 (1,560)
1957.......................................................... 96,000 41,300 44,420 3,120
1958.......................................................... \2\ 1,000 46,500 \2\ 47,020 520
-------------
Increase in tax attributable to the adjustment computed .......... .......... .......... 3,880
under section 481(b)(2)....................................
----------------------------------------------------------------------------------------------------------------
\1\ Attributable to recomputations of net operating loss carrybacks determined with reference to net operating
loss in 1955.
\2\ Attributable to the inclusion of $1,000 in the year of the change which represents the portion of the
$10,000 adjustment not allocated to taxable years prior to the year of the change for which taxable income is
established under the new method.
Since the limitation under section 481(b)(2) ($3,880) on the amount of
tax attributable to the adjustments is applicable, the final tax for the
taxable year of the change is computed by adding such amount to the tax
for that year computed without the inclusion of any amount attributable
to the adjustments, that is, $46,500 plus $3,880, or $50,380.
[T.D. 6500, 25 FR 11732, Nov. 26, 1960, as amended by T.D. 6490, 25 FR
8374, Sept. 1, 1960; T.D. 7301, 39 FR 963, Jan. 4, 1974; T.D. 8608, 60
FR 40078, Aug. 7, 1995]
Sec. 1.481-3 Adjustments attributable to pre-1954 years where change
was not initiated by taxpayer.
If the adjustments required by section 481(a) and Sec. 1.481-1 are
attributable to a change in method of accounting which was not initiated
by the taxpayer, no portion of any adjustments which is attributable to
pre-1954 years shall be taken into account in computing taxable income.
For example, if the total adjustments in the case of a change in method
of accounting which is not initiated by the taxpayer amount to $10,000,
of which $4,000 is attributable to pre-1954 years, only $6,000 of the
$10,000 total adjustments is required to be taken into account under
section 481 in computing taxable income. The portion of the adjustments
which is attributable to pre-1954 years is the net amount of the
adjustments which would have been required if the taxpayer had changed
his method of accounting in his first taxable year which began after
December 31, 1953, and ended after August 16, 1954.
[T.D. 6500, 25 FR 11735, Nov. 26, 1960, as amended by T.D. 8608, 60 FR
40079, Aug. 7, 1995]
Sec. 1.481-4 Adjustments taken into account with consent.
(a) In addition to the terms and conditions prescribed by the
Commissioner under Sec. 1.446-1(e)(3) for effecting a change in method
of accounting, including the taxable year or years in which the amount
of the adjustments required by section 481(a) is to be taken into
account, or the methods of allocation described in section 481(b), a
taxpayer may request approval of an alternative method of allocating the
amount of the adjustments under section 481. See section 481(c).
Requests for approval of an alternative method of allocation shall set
forth in detail the facts and circumstances upon which the taxpayer
bases its request. Permission will be granted only if the taxpayer and
the Commissioner agree to the terms and conditions under which the
allocation is to be effected. See Sec. 1.446-1(e) for the rules
regarding how to secure the Commissioner's consent to a change in method
of accounting.
[[Page 594]]
(b) An agreement to the terms and conditions of a change in method
of accounting under Sec. 1.446-1(e)(3), including the taxable year or
years prescribed by the Commissioner under that section (or an
alternative method described in paragraph (a) of this section) for
taking the amount of the adjustments under section 481(a) into account,
shall be in writing and shall be signed by the Commissioner and the
taxpayer. It shall set forth the items to be adjusted, the amount of the
adjustments, the taxable year or years for which the adjustments are to
be taken into account, and the amount of the adjustments allocable to
each year. The agreement shall be binding on the parties except upon a
showing of fraud, malfeasance, or misrepresentation of material fact.
[T.D. 8608, 60 FR 40079, Aug. 7, 1995]
Sec. 1.481-5 Effective dates.
Sections 1.481-1, 1.481-2, 1.481-3, and 1.481-4 are effective for
Consent Agreements signed on or after December 27, 1994. For Consent
Agreements signed before December 27, 1994, see Sec. Sec. 1.481-1,
1.481-2, 1.481-3, 1.481-4, and 1.481-5 (as contained in the 26 CFR part
1 edition revised as of April 1, 1995).
[T.D. 8608, 60 FR 40079, Aug. 7, 1995]
Sec. 1.482-0 Outline of regulations under section 482.
This section contains major captions for Sec. Sec. 1.482-1 through
1.482-9.
Sec. 1.482-1 Allocation of income and deductions among taxpayers.
(a) In general.
(1) Purpose and scope.
(2) Authority to make allocations.
(3) Taxpayer's use of section 482.
(b) Arm's length standard.
(1) In general.
(2) Arm's length methods.
(i) Methods.
(ii) Selection of category of method applicable to transaction.
(iii) Coordination of methods applicable to certain intangible
development arrangements.
(c) Best method rule.
(1) In general.
(2) Determining the best method.
(i) Comparability.
(ii) Data and assumptions.
(A) Completeness and accuracy of data.
(B) Reliability of assumptions.
(C) Sensitivity of results to deficiencies in data and assumptions.
(iii) Confirmation of results by another method.
(d) Comparability.
(1) In general.
(2) Standard of comparability.
(3) Factors for determining comparability.
(i) Functional analysis.
(ii) Contractual terms.
(A) In general.
(B) Identifying contractual terms.
(1) Written agreement.
(2) No written agreement.
(C) Examples.
(iii) Risk.
(A) In general.
(B) Identification of party that bears risk.
(C) Examples.
(iv) Economic conditions.
(v) Property or services.
(4) Special circumstances.
(i) Market share strategy.
(ii) Different geographic markets.
(A) In general.
(B) Example.
(C) Location savings.
(D) Example.
(iii) Transactions ordinarily not accepted as comparables.
(A) In general.
(B) Examples.
(e) Arm's length range.
(1) In general.
(2) Determination of arm's length range.
(i) Single method.
(ii) Selection of comparables.
(iii) Comparables included in arm's length range.
(A) In general.
(B) Adjustment of range to increase reliability.
(C) Interquartile range.
(3) Adjustment if taxpayer's results are outside arm's length range.
(4) Arm's length range not prerequisite to allocation.
(5) Examples.
(f) Scope of review.
(1) In general.
(i) Intent to evade or avoid tax not a prerequisite.
(ii) Realization of income not a prerequisite.
(A) In general.
(B) Example.
(iii) Nonrecognition provisions may not bar allocation.
(A) In general.
(B) Example.
(iv) Consolidated returns.
(2) Rules relating to determination of true taxable income.
(i) [Reserved]
(ii) Allocation based on taxpayer's actual transactions.
(A) In general.
[[Page 595]]
(B) [Reserved]
(iii) Multiple year data.
(A) In general.
(B) Circumstances warranting consideration of multiple year data.
(C) Comparable effect over comparable period.
(D) Applications of methods using multiple year averages.
(E) Examples.
(iv) Product lines and statistical techniques.
(v) Allocations apply to results, not methods.
(A) In general.
(B) Example.
(g) Collateral adjustments with respect to allocations under section
482.
(1) In general.
(2) Correlative allocations.
(i) In general.
(ii) Manner of carrying out correlative allocation.
(iii) Events triggering correlative allocation.
(iv) Examples.
(3) Adjustments to conform accounts to reflect section 482
allocations.
(i) In general.
(ii) Example.
(4) Setoffs.
(i) In general.
(ii) Requirements.
(iii) Examples.
(h) Special rules.
(1) Small taxpayer safe harbor. [Reserved]
(2) Effect of foreign legal restrictions.
(i) In general.
(ii) Applicable legal restrictions.
(iii) Requirement for electing the deferred income method of
accounting.
(iv) Deferred income method of accounting.
(v) Examples.
(3) Coordination with section 936.
(i) Cost sharing under section 936.
(ii) Use of terms.
(i) Definitions.
(j) Effective/applicability date.
Sec. 1.482-2 Determination of taxable income in specific situations.
(a) Loans or advances.
(1) Interest on bona fide indebtedness.
(i) In general.
(ii) Application of paragraph (a) of this section.
(A) Interest on bona fide indebtedness.
(B) Alleged indebtedness.
(iii) Period for which interest shall be charged.
(A) General rule.
(B) Exception for certain intercompany transactions in the ordinary
course of business.
(C) Exception for trade or business of debtor member located outside
the United States.
(D) Exception for regular trade practice of creditor member or
others in creditor's industry.
(E) Exception for property purchased for resale in a foreign
country.
(1) General rule.
(2) Interest-free period.
(3) Average collection period.
(4) Illustration.
(iv) Payment; book entries.
(2) Arm's length interest rate.
(i) In general.
(ii) Funds obtained at situs of borrower.
(iii) Safe haven interest rates for certain loans and advances made
after May 8, 1986.
(A) Applicability.
(1) General rule.
(2) Grandfather rule for existing loans.
(B) Safe haven interest rate based on applicable Federal rate.
(C) Applicable Federal rate.
(D) Lender in business of making loans.
(E) Foreign currency loans.
(3) Coordination with interest adjustments required under certain
other Internal Revenue Code sections.
(4) Examples.
(b) Rendering of services.
(c) Use of tangible property.
(1) General rule.
(2) Arm's length charge.
(i) In general.
(ii) Safe haven rental charge.
(iii) Subleases.
(d) Transfer of property.
(e) Cost sharing arrangement.
(f) Effective/applicability Date.
(1) In general.
(2) Election to apply paragraph (b) to earlier taxable years.
Sec. 1.482-3 Methods to determine taxable income in connection with a
transfer of tangible property.
(a) In general.
(b) Comparable uncontrolled price method.
(1) In general.
(2) Comparability and reliability considerations.
(i) In general.
(ii) Comparability.
(A) In general.
(B) Adjustments for differences between controlled and uncontrolled
transactions.
(iii) Data and assumptions.
(3) Arm's length range.
(4) Examples.
(5) Indirect evidence of comparable uncontrolled transactions.
(i) In general.
(ii) Limitations.
(iii) Examples.
(c) Resale price method.
(1) In general.
(2) Determination of arm's length price.
(i) In general.
(ii) Applicable resale price.
[[Page 596]]
(iii) Appropriate gross profit.
(iv) Arm's length range.
(3) Comparability and reliability considerations.
(i) In general.
(ii) Comparability.
(A) Functional comparability.
(B) Other comparability factors.
(C) Adjustments for differences between controlled and uncontrolled
transactions.
(D) Sales agent.
(iii) Data and assumptions.
(A) In general.
(B) Consistency in accounting.
(4) Examples.
(d) Cost plus method.
(1) In general.
(2) Determination of arm's length price.
(i) In general.
(ii) Appropriate gross profit.
(iii) Arm's length range.
(3) Comparability and reliability considerations.
(i) In general.
(ii) Comparability.
(A) Functional comparability.
(B) Other comparability factors.
(C) Adjustments for differences between controlled and uncontrolled
transactions.
(D) Purchasing agent.
(iii) Data and assumptions.
(A) In general.
(B) Consistency in accounting.
(4) Examples.
(e) Unspecified methods.
(1) In general.
(2) Example.
(f) Coordination with intangible property rules.
Sec. 1.482-4 Methods to determine taxable income in connection with a
transfer of intangible property.
(a) In general.
(b) Definition of intangible.
(c) Comparable uncontrolled transaction method.
(1) In general.
(2) Comparability and reliability considerations.
(i) In general.
(ii) Reliability.
(iii) Comparability.
(A) In general.
(B) Factors to be considered in determining comparability.
(1) Comparable intangible property.
(2) Comparable circumstances.
(iv) Data and assumptions.
(3) Arm's length range.
(4) Examples.
(d) Unspecified methods.
(1) In general.
(2) Example.
(e) Coordination with tangible property rules.
(f) Special rules for transfers of intangible property.
(1) Form of consideration.
(2) Periodic adjustments.
(i) General rule.
(ii) Exceptions.
(A) Transactions involving the same intangible.
(B) Transactions involving comparable intangible.
(C) Methods other than comparable uncontrolled transaction.
(D) Extraordinary events.
(E) Five-year period.
(iii) Examples.
(3) Ownership of intangible property.
(i) Identification of owner.
(A) In general.
(B) Cost sharing arrangements.
(ii) Examples.
(4) Contribution to the value of intangible property owned by
another.
(i) In general.
(ii) Examples.
(5) Consideration not artificially limited.
(6) Lump sum payments
(i) In general.
(ii) Exceptions.
(iii) Example.
(g) Coordination with rules governing cost sharing arrangements.
(h) Effective/applicability date.
(1) In general.
(2) Election to apply regulation to earlier taxable years.
Sec. 1.482-5 Comparable profits method.
(a) In general.
(b) Determination of arm's length result.
(1) In general.
(2) Tested party.
(i) In general.
(ii) Adjustments for tested party.
(3) Arm's length range.
(4) Profit level indicators.
(i) Rate of return on capital employed.
(ii) Financial ratios.
(iii) Other profit level indicators.
(c) Comparability and reliability considerations.
(1) In general.
(2) Comparability.
(i) In general.
(ii) Functional, risk and resource comparability.
(iii) Other comparability factors.
(iv) Adjustments for differences between tested party and the
uncontrolled taxpayers.
(3) Data and assumptions.
(i) In general.
(ii) Consistency in accounting.
(iii) Allocations between the relevant business activity and other
activities.
(d) Definitions.
(e) Examples.
[[Page 597]]
Sec. 1.482-6 Profit split method.
(a) In general.
(b) Appropriate share of profits and losses.
(c) Application.
(1) In general.
(2) Comparable profit split.
(i) In general.
(ii) Comparability and reliability considerations.
(A) In general.
(B) Comparability.
(1) In general.
(2) Adjustments for differences between the controlled and
uncontrolled taxpayers.
(C) Data and assumptions.
(D) Other factors affecting reliability.
(3) Residual profit split.
(i) In general.
(A) Allocate income to routine contributions.
(B) Allocate residual profit.
(1) Nonroutine contributions generally.
(2) Nonroutine contributions of intangible property.
(ii) Comparability and reliability considerations.
(A) In general.
(B) Comparability.
(C) Data and assumptions.
(D) Other factors affecting reliability
(d) Effective/applicability date.
(iii) Example.
Sec. 1.482-7 Methods to determine taxable income in connection with a
cost sharing arrangement.
(a) In general.
(1) RAB share method for cost sharing transactions (CSTs).
(2) Methods for platform contribution transactions (PCTs).
(3) Methods for other controlled transactions.
(i) Contribution to a CSA by a controlled taxpayer that is not a
controlled participant.
(ii) Transfer of interest in a cost shared intangible.
(iii) Other controlled transactions in connection with a CSA.
(iv) Controlled transactions in the absence of a CSA.
(4) Coordination with the arm's length standard.
(b) Cost sharing arrangement.
(1) Substantive requirements.
(i) CSTs.
(ii) PCTs.
(iii) Divisional interests.
(iv) Examples.
(2) Administrative requirements.
(3) Date of a PCT.
(4) Divisional interests.
(i) In general.
(ii) Territorial based divisional interests.
(iii) Field of use based divisional interests.
(iv) Other divisional bases.
(v) Examples.
(5) Treatment of certain arrangements as CSAs.
(i) Situation in which Commissioner must treat arrangement as a CSA.
(ii) Situation in which Commissioner may treat arrangement as a CSA.
(iii) Examples.
(6) Entity classification of CSAs.
(c) Platform contributions.
(1) In general.
(2) Terms of platform contributions.
(i) Presumed to be exclusive.
(ii) Rebuttal of Exclusivity.
(iii) Proration of PCT Payments to the extent allocable to other
business activities.
(A) In general.
(B) Determining the proration of PCT Payments.
(3) Categorization of the PCT.
(4) Certain make-or-sell rights excluded.
(i) In general.
(ii) Examples.
(5) Examples.
(d) Intangible development costs.
(1) Determining whether costs are IDCs.
(i) Definition and scope of the IDA.
(ii) Reasonably anticipated cost shared intangible.
(iii) Costs included in IDCs.
(iv) Examples.
(2) Allocation of costs.
(3) Stock-based compensation.
(i) In general.
(ii) Identification of stock-based compensation with the IDA.
(iii) Measurement and timing of stock-based compensation IDC.
(A) In general.
(1) Transfers to which section 421 applies.
(2) Deductions of foreign controlled participants.
(3) Modification of stock option.
(4) Expiration or termination of CSA.
(B) Election with respect to options on publicly traded stock.
(1) In general.
(2) Publicly traded stock.
(3) Generally accepted accounting principles.
(4) Time and manner of making the election.
(C) Consistency.
(4) IDC share.
(5) Examples.
(e) Reasonably anticipated benefits share.
(1) Definition.
(i) In general.
(ii) Reliability.
(iii) Examples.
(2) Measure of benefits.
(i) In general.
(ii) Indirect bases for measuring anticipated benefits.
(A) Units used, produced, or sold.
(B) Sales.
(C) Operating profit.
[[Page 598]]
(D) Other bases for measuring anticipated benefits.
(E) Examples.
(iii) Projections used to estimate benefits.
(A) In general.
(B) Examples.
(f) Changes in participation under a CSA.
(1) In general.
(2) Controlled transfer of interests.
(3) Capability variation.
(4) Arm's length consideration for a change in participation.
(5) Examples.
(g) Supplemental guidance on methods applicable to PCTs.
(1) In general.
(2) Best method analysis applicable for evaluation of a PCT pursuant
to a CSA.
(i) In general.
(ii) Consistency with upfront contractual terms and risk
allocation--the investor model.
(A) In general.
(B) Example.
(iii) Consistency of evaluation with realistic alternatives.
(A) In general.
(B) Examples.
(iv) Aggregation of transactions.
(v) Discount rate.
(A) In general.
(B) Considerations in best method analysis of discount rate.
(1) Discount rate variation between realistic alternatives.
(2) [Reserved]
(3) Discount rate variation between forms of payment.
(4) Post-tax rate.
(C) Example.
(vi) Financial projections.
(vii) Accounting principles.
(A) In general.
(B) Examples.
(viii) Valuations of subsequent PCTs.
(A) Date of subsequent PCT.
(B) Best method analysis for subsequent PCT.
(ix) Arm's length range.
(A) In general.
(B) Methods based on two or more input parameters.
(C) Variable input parameters.
(D) Determination of arm's length PCT Payment.
(1) No variable input parameters.
(2) One variable input parameter.
(3) More than one variable input parameter.
(E) Adjustments.
(x) Valuation undertaken on a pre-tax basis.
(3) Comparable uncontrolled transaction method.
(4) Income method.
(i) In general.
(A) Equating cost sharing and licensing alternatives.
(B) Cost sharing alternative.
(C) Licensing alternative.
(D) Only one controlled participant with nonroutine platform
contributions.
(E) Income method payment forms.
(F) Discount rates appropriate to cost sharing and licensing
alternatives.
(G) The effect of taxation on determining the arm's length amount.
(ii) Evaluation of PCT Payor's cost sharing alternative.
(iii) Evaluation of PCT Payor's licensing alternative.
(A) Evaluation based on CUT.
(B) Evaluation based on CPM.
(iv) Lump sum payment form.
(v) [Reserved]
(vi) Best method analysis considerations.
(A) Coordination with Sec. 1.482-1(c).
(B) Assumptions Concerning Tax Rates.
(C) Coordination with Sec. 1.482-4(c)(2).
(D) Coordination with Sec. 1.482-5(c).
(E) Certain Circumstances Concerning PCT Payor.
(F) Discount rates.
(1) Reflection of similar risk profiles of cost sharing alternative
and licensing alternative.
(2) [Reserved]
(vii) Routine platform and operating contributions.
(viii) Examples.
(5) Acquisition Price Method.
(i) In general.
(ii) Determination of arm's length charge.
(iii) Adjusted acquisition price.
(iv) Best method analysis considerations.
(v) Example.
(6) Market capitalization method.
(i) In general.
(ii) Determination of arm's length charge.
(iii) Average market capitalization.
(iv) Adjusted average market capitalization.
(v) Best method analysis considerations.
(vi) Examples.
(7) Residual profit split method.
(i) In general.
(ii) Appropriate share of profits and losses.
(iii) Profit split.
(A) In general.
(B) Determine nonroutine residual divisional profit or loss.
(C) Allocate nonroutine residual divisional profit or loss.
(1) In general.
(2) Relative value determination.
(3) Determination of PCT Payments.
(4) Routine platform and operating contributions.
(iv) Best method analysis considerations.
(A) In general.
(B) Comparability.
(C) Data and assumptions.
(D) Other factors affecting reliability.
[[Page 599]]
(v) Examples.
(8) Unspecified methods.
(h) Form of payment rules.
(1) CST Payments.
(2) PCT Payments.
(i) In general.
(ii) No PCT Payor stock.
(iii) Specified form of payment.
(A) In general.
(B) Contingent payments.
(C) Examples.
(iv) Conversion from fixed to contingent form of payment.
(3) Coordination of best method rule and form of payment.
(i) Allocations by the Commissioner in connection with a CSA.
(1) In general.
(2) CST allocations.
(i) In general.
(ii) Adjustments to improve the reliability of projections used to
estimate RAB shares.
(A) Unreliable projections.
(B) Foreign-to-foreign adjustments.
(C) Correlative adjustments to PCTs.
(D) Examples.
(iii) Timing of CST allocations.
(3) PCT allocations.
(4) Allocations regarding changes in participation under a CSA.
(5) Allocations when CSTs are consistently and materially
disproportionate to RAB shares.
(6) Periodic adjustments.
(i) In general.
(ii) PRRR.
(iii) AERR.
(A) In general.
(B) PVTP.
(C) PVI.
(iv) ADR.
(A) In general.
(B) Publicly traded companies.
(C) Publicly traded.
(D) PCT Payor WACC.
(E) Generally accepted accounting principles.
(v) Determination of periodic adjustments.
(A) In general.
(B) Adjusted RPSM as of Determination Date.
(vi) Exceptions to periodic adjustments.
(A) Controlled participants establish periodic adjustment not
warranted.
(1) Transactions involving the same platform contribution as in the
Trigger PCT.
(2) Results not reasonably anticipated.
(3) Reduced AERR does not cause Periodic Trigger.
(4) Increased AERR does not cause Periodic Trigger.
(B) Circumstances in which Periodic Trigger deemed not to occur.
(1) 10-year period.
(2) 5-year period.
(vii) Examples.
(j) Definitions and special rules.
(1) Definitions.
(i) In general.
(ii) Examples.
(2) Special rules.
(i) Consolidated group.
(ii) Trade or business.
(iii) Partnership.
(3) Character.
(i) CST Payments.
(ii) PCT Payments.
(iii) Examples.
(k) CSA administrative requirements.
(1) CSA contractual requirements.
(i) In general.
(ii) Contractual provisions.
(iii) Meaning of contemporaneous.
(A) In general.
(B) Example.
(iv) Interpretation of contractual provisions.
(A) In general.
(B) Examples.
(2) CSA documentation requirements.
(i) In general.
(ii) Additional CSA documentation requirements.
(iii) Coordination rules and production of documents.
(A) Coordination with penalty regulations.
(B) Production of documentation.
(3) CSA accounting requirements.
(i) In general.
(ii) Reliance on financial accounting.
(4) CSA reporting requirements.
(i) CSA Statement.
(ii) Content of CSA Statement.
(iii) Time for filing CSA Statement.
(A) 90-day rule.
(B) Annual return requirement.
(1) In general.
(2) Special filing rule for annual return requirement.
(iv) Examples.
(l) Effective/applicability date.
(m) Transition rule.
(1) In general.
(2) Transitional modification of applicable provisions.
(3) Special rule for certain periodic adjustments.
Sec. 1.482-8 Examples of the best method rule.
(a) Introduction.
(b) Examples.
(c) Effective/applicability date.
Sec. 1.482-9 Methods to determine taxable income in connection with a
controlled services transaction.
(a) In general.
(b) Services cost method.
(1) In general.
(2) Eligibility for the services cost method.
(3) Covered services.
(i) Specified covered services.
(ii) Low margin covered services.
[[Page 600]]
(4) Excluded activities.
(5) Not services that contribute significantly to fundamental risks
of business success or failure.
(6) Adequate books and records.
(7) Shared services arrangement.
(i) In general.
(ii) Requirements for shared services arrangement.
(A) Eligibility.
(B) Allocation.
(C) Documentation.
(iii) Definitions and special rules.
(A) Participant.
(B) Aggregation.
(C) Coordination with cost sharing arrangements.
(8) Examples.
(c) Comparable uncontrolled services price method.
(1) In general.
(2) Comparability and reliability considerations.
(i) In general.
(ii) Comparability.
(A) In general.
(B) Adjustments for differences between controlled and uncontrolled
transactions.
(iii) Data and assumptions.
(3) Arm's length range.
(4) Examples.
(5) Indirect evidence of the price of a comparable uncontrolled
services transaction.
(i) In general.
(ii) Example.
(d) Gross services margin method.
(1) In general.
(2) Determination of arm's length price.
(i) In general.
(ii) Relevant uncontrolled transaction.
(iii) Applicable uncontrolled price.
(iv) Appropriate gross services profit.
(v) Arm's length range.
(3) Comparability and reliability considerations.
(i) In general.
(ii) Comparability.
(A) Functional comparability.
(B) Other comparability factors.
(C) Adjustments for differences between controlled and uncontrolled
transactions.
(D) Buy-sell distributor.
(iii) Data and assumptions.
(A) In general.
(B) Consistency in accounting.
(4) Examples.
(e) Cost of services plus method.
(1) In general.
(2) Determination of arm's length price.
(i) In general.
(ii) Appropriate gross services profit.
(iii) Comparable transactional costs.
(iv) Arm's length range.
(3) Comparability and reliability considerations.
(i) In general.
(ii) Comparability.
(A) Functional comparability.
(B) Other comparability factors.
(C) Adjustments for differences between the controlled and
uncontrolled transactions.
(iii) Data and assumptions.
(A) In general.
(B) Consistency in accounting.
(4) Examples.
(f) Comparable profits method.
(1) In general.
(2) Determination of arm's length result.
(i) Tested party.
(ii) Profit level indicators.
(iii) Comparability and reliability considerations--Data and
assumptions--Consistency in accounting.
(3) Examples.
(g) Profit split method.
(1) In general.
(2) Examples.
(h) Unspecified methods.
(i) Contingent-payment contractual terms for services.
(1) Contingent-payment contractual terms recognized in general.
(2) Contingent-payment arrangement.
(i) General requirements.
(A) Written contract.
(B) Specified contingency.
(C) Basis for payment.
(ii) Economic substance and conduct.
(3) Commissioner's authority to impute contingent-payment terms.
(4) Evaluation of arm's length charge.
(5) Examples.
(j) Total services costs.
(k) Allocation of costs.
(1) In general.
(2) Appropriate method of allocation and apportionment.
(i) Reasonable method standard.
(ii) Use of general practices.
(3) Examples.
(l) Controlled services transaction.
(1) In general.
(2) Activity.
(3) Benefit.
(i) In general.
(ii) Indirect or remote benefit.
(iii) Duplicative activities.
(iv) Shareholder activities.
(v) Passive association.
(4) Disaggregation of transactions.
(5) Examples.
(m) Coordination with transfer pricing rules for other transactions.
(1) Services transactions that include other types of transactions.
(2) Services transactions that effect a transfer of intangible
property.
(3) Coordination with rules governing cost sharing arrangements.
(4) Other types of transactions that include controlled services
transactions.
(5) Examples.
(n) Effective/applicability dates.
[[Page 601]]
(1) In general.
(2) Election to apply regulations to earlier taxable years.
[T.D. 8552, 59 FR 34988, July 8, 1994, as amended by T.D. 8632, 60 FR
65557, Dec. 20, 1995; 61 FR 7157, Feb. 26, 1996; T.D. 8670, 61 FR 21956,
May 13, 1996; T.D. 9088, 68 FR 51177, Aug. 26, 2003; T.D. 9278, 71 FR
44479, Aug. 4, 2006; T.D. 9441, 74 FR 348, Jan. 5, 2009, 74 FR 9571,
Mar. 5, 2009; T.D. 9456, 74 FR 38837, Aug. 4, 2009; T.D. 9568, 76 FR
80087, Dec. 22, 2011; T.D. 9738, 80 FR 55540, Sept. 16, 2015]
Sec. 1.482-1 Allocation of income and deductions among taxpayers.
(a) In general--(1) Purpose and scope. The purpose of section 482 is
to ensure that taxpayers clearly reflect income attributable to
controlled transactions and to prevent the avoidance of taxes with
respect to such transactions. Section 482 places a controlled taxpayer
on a tax parity with an uncontrolled taxpayer by determining the true
taxable income of the controlled taxpayer. This section sets forth
general principles and guidelines to be followed under section 482.
Section 1.482-2 provides rules for the determination of the true taxable
income of controlled taxpayers in specific situations, including
controlled transactions involving loans or advances or the use of
tangible property. Sections 1.482-3 through 1.482-6 provide rules for
the determination of the true taxable income of controlled taxpayers in
cases involving the transfer of property. Section 1.482-7T sets forth
the cost sharing provisions applicable to taxable years beginning on or
after January 5, 2009. Section 1.482-8 provides examples illustrating
the application of the best method rule. Finally, Sec. 1.482-9 provides
rules for the determination of the true taxable income of controlled
taxpayers in cases involving the performance of services.
(2) Authority to make allocations. The district director may make
allocations between or among the members of a controlled group if a
controlled taxpayer has not reported its true taxable income. In such
case, the district director may allocate income, deductions, credits,
allowances, basis, or any other item or element affecting taxable income
(referred to as allocations). The appropriate allocation may take the
form of an increase or decrease in any relevant amount.
(3) Taxpayer's use of section 482. If necessary to reflect an arm's
length result, a controlled taxpayer may report on a timely filed U.S.
income tax return (including extensions) the results of its controlled
transactions based upon prices different from those actually charged.
Except as provided in this paragraph, section 482 grants no other right
to a controlled taxpayer to apply the provisions of section 482 at will
or to compel the district director to apply such provisions. Therefore,
no untimely or amended returns will be permitted to decrease taxable
income based on allocations or other adjustments with respect to
controlled transactions. See Sec. 1.6662-6T(a)(2) or successor
regulations.
(b) Arm's length standard--(1) In general. In determining the true
taxable income of a controlled taxpayer, the standard to be applied in
every case is that of a taxpayer dealing at arm's length with an
uncontrolled taxpayer. A controlled transaction meets the arm's length
standard if the results of the transaction are consistent with the
results that would have been realized if uncontrolled taxpayers had
engaged in the same transaction under the same circumstances (arm's
length result). However, because identical transactions can rarely be
located, whether a transaction produces an arm's length result generally
will be determined by reference to the results of comparable
transactions under comparable circumstances. See Sec. 1.482-1(d)(2)
(Standard of comparability). Evaluation of whether a controlled
transaction produces an arm's length result is made pursuant to a method
selected under the best method rule described in Sec. 1.482-1(c).
(2) Arm's length methods--(i) Methods. Sections 1.482-2 through
1.482-7 and 1.482-9 provide specific methods to be used to evaluate
whether transactions between or among members of the controlled group
satisfy the arm's length standard, and if they do not, to determine the
arm's length result. This section provides general principles applicable
in determining arm's length results of such controlled transactions, but
do not provide methods, for which reference must be made to those other
sections in accordance with paragraphs
[[Page 602]]
(b)(2)(ii) and (iii) of this section. Section 1.482-7 provides the
specific methods to be used to evaluate whether a cost sharing
arrangement as defined in Sec. 1.482-7 produces results consistent with
an arm's length result.
(ii) Selection of category of method applicable to transaction. The
methods listed in Sec. 1.482-2 apply to different types of
transactions, such as transfers of property, services, loans or
advances, and rentals. Accordingly, the method or methods most
appropriate to the calculation of arm's length results for controlled
transactions must be selected, and different methods may be applied to
interrelated transactions if such transactions are most reliably
evaluated on a separate basis. For example, if services are provided in
connection with the transfer of property, it may be appropriate to
separately apply the methods applicable to services and property in
order to determine an arm's length result. But see Sec. 1.482-
1(f)(2)(i) (Aggregation of transactions). In addition, other applicable
provisions of the Code may affect the characterization of a transaction,
and therefore affect the methods applicable under section 482. See for
example section 467.
(iii) Coordination of methods applicable to certain intangible
development arrangements. Section 1.482-7 provides the specific methods
to be used to determine arm's length results of controlled transactions
in connection with a cost sharing arrangement as defined in Sec. 1.482-
7. Sections 1.482-4 and 1.482-9, as appropriate, provide the specific
methods to be used to determine arm's length results of arrangements,
including partnerships, for sharing the costs and risks of developing
intangibles, other than a cost sharing arrangement covered by Sec.
1.482-7. See also Sec. Sec. 1.482-4(g) (Coordination with rules
governing cost sharing arrangements) and 1.482-9(m)(3) (Coordination
with rules governing cost sharing arrangements).
(c) Best method rule--(1) In general. The arm's length result of a
controlled transaction must be determined under the method that, under
the facts and circumstances, provides the most reliable measure of an
arm's length result. Thus, there is no strict priority of methods, and
no method will invariably be considered to be more reliable than others.
An arm's length result may be determined under any method without
establishing the inapplicability of another method, but if another
method subsequently is shown to produce a more reliable measure of an
arm's length result, such other method must be used. Similarly, if two
or more applications of a single method provide inconsistent results,
the arm's length result must be determined under the application that,
under the facts and circumstances, provides the most reliable measure of
an arm's length result. See Sec. 1.482-8 for examples of the
application of the best method rule. See Sec. 1.482-7 for the
applicable methods in the case of a cost sharing arrangement.
(2) Determining the best method. Data based on the results of
transactions between unrelated parties provides the most objective basis
for determining whether the results of a controlled transaction are
arm's length. Thus, in determining which of two or more available
methods (or applications of a single method) provides the most reliable
measure of an arm's length result, the two primary factors to take into
account are the degree of comparability between the controlled
transaction (or taxpayer) and any uncontrolled comparables, and the
quality of the data and assumptions used in the analysis. In addition,
in certain circumstances, it also may be relevant to consider whether
the results of an analysis are consistent with the results of an
analysis under another method. These factors are explained in paragraphs
(c)(2)(i), (ii), and (iii) of this section.
(i) Comparability. The relative reliability of a method based on the
results of transactions between unrelated parties depends on the degree
of comparability between the controlled transaction or taxpayers and the
uncontrolled comparables, taking into account the factors described in
Sec. 1.482-1(d)(3) (Factors for determining comparability), and after
making adjustments for differences, as described in Sec. 1.482-1(d)(2)
(Standard of comparability). As the degree of comparability increases,
the number and extent of potential differences that could render the
analysis inaccurate is reduced. In addition, if adjustments are
[[Page 603]]
made to increase the degree of comparability, the number, magnitude, and
reliability of those adjustments will affect the reliability of the
results of the analysis. Thus, an analysis under the comparable
uncontrolled price method will generally be more reliable than analyses
obtained under other methods if the analysis is based on closely
comparable uncontrolled transactions, because such an analysis can be
expected to achieve a higher degree of comparability and be susceptible
to fewer differences than analyses under other methods. See Sec. 1.482-
3(b)(2)(ii)(A). An analysis will be relatively less reliable, however,
as the uncontrolled transactions become less comparable to the
controlled transaction.
(ii) Data and assumptions. Whether a method provides the most
reliable measure of an arm's length result also depends upon the
completeness and accuracy of the underlying data, the reliability of the
assumptions, and the sensitivity of the results to possible deficiencies
in the data and assumptions. Such factors are particularly relevant in
evaluating the degree of comparability between the controlled and
uncontrolled transactions. These factors are discussed in paragraphs
(c)(2)(ii) (A), (B), and (C) of this section.
(A) Completeness and accuracy of data. The completeness and accuracy
of the data affects the ability to identify and quantify those factors
that would affect the result under any particular method. For example,
the completeness and accuracy of data will determine the extent to which
it is possible to identify differences between the controlled and
uncontrolled transactions, and the reliability of adjustments that are
made to account for such differences. An analysis will be relatively
more reliable as the completeness and accuracy of the data increases.
(B) Reliability of assumptions. All methods rely on certain
assumptions. The reliability of the results derived from a method
depends on the soundness of such assumptions. Some assumptions are
relatively reliable. For example, adjustments for differences in payment
terms between controlled and uncontrolled transactions may be based on
the assumption that at arm's length such differences would lead to price
differences that reflect the time value of money. Although selection of
the appropriate interest rate to use in making such adjustments involves
some judgement, the economic analysis on which the assumption is based
is relatively sound. Other assumptions may be less reliable. For
example, the residual profit split method may be based on the assumption
that capitalized intangible development expenses reflect the relative
value of the intangible property contributed by each party. Because the
costs of developing an intangible may not be related to its market
value, the soundness of this assumption will affect the reliability of
the results derived from this method.
(C) Sensitivity of results to deficiencies in data and assumptions.
Deficiencies in the data used or assumptions made may have a greater
effect on some methods than others. In particular, the reliability of
some methods is heavily dependent on the similarity of property or
services involved in the controlled and uncontrolled transaction. For
certain other methods, such as the resale price method, the analysis of
the extent to which controlled and uncontrolled taxpayers undertake the
same or similar functions, employ similar resources, and bear similar
risks is particularly important. Finally, under other methods, such as
the profit split method, defining the relevant business activity and
appropriate allocation of costs, income, and assets may be of particular
importance. Therefore, a difference between the controlled and
uncontrolled transactions for which an accurate adjustment cannot be
made may have a greater effect on the reliability of the results derived
under one method than the results derived under another method. For
example, differences in management efficiency may have a greater effect
on a comparable profits method analysis than on a comparable
uncontrolled price method analysis, while differences in product
characteristics will ordinarily have a greater effect on a comparable
uncontrolled price method analysis than on a comparable profits method
analysis.
(iii) Confirmation of results by another method. If two or more
methods produce inconsistent results, the best
[[Page 604]]
method rule will be applied to select the method that provides the most
reliable measure of an arm's length result. If the best method rule does
not clearly indicate which method should be selected, an additional
factor that may be taken into account in selecting a method is whether
any of the competing methods produce results that are consistent with
the results obtained from the appropriate application of another method.
Further, in evaluating different applications of the same method, the
fact that a second method (or another application of the first method)
produces results that are consistent with one of the competing
applications may be taken into account.
(d) Comparability--(1) In general. Whether a controlled transaction
produces an arm's length result is generally evaluated by comparing the
results of that transaction to results realized by uncontrolled
taxpayers engaged in comparable transactions under comparable
circumstances. For this purpose, the comparability of transactions and
circumstances must be evaluated considering all factors that could
affect prices or profits in arm's length dealings (comparability
factors). While a specific comparability factor may be of particular
importance in applying a method, each method requires analysis of all of
the factors that affect comparability under that method. Such factors
include the following--
(i) Functions;
(ii) Contractual terms;
(iii) Risks;
(iv) Economic conditions; and
(v) Property or services.
(2) Standard of comparability. In order to be considered comparable
to a controlled transaction, an uncontrolled transaction need not be
identical to the controlled transaction, but must be sufficiently
similar that it provides a reliable measure of an arm's length result.
If there are material differences between the controlled and
uncontrolled transactions, adjustments must be made if the effect of
such differences on prices or profits can be ascertained with sufficient
accuracy to improve the reliability of the results. For purposes of this
section, a material difference is one that would materially affect the
measure of an arm's length result under the method being applied. If
adjustments for material differences cannot be made, the uncontrolled
transaction may be used as a measure of an arm's length result, but the
reliability of the analysis will be reduced. Generally, such adjustments
must be made to the results of the uncontrolled comparable and must be
based on commercial practices, economic principles, or statistical
analyses. The extent and reliability of any adjustments will affect the
relative reliability of the analysis. See Sec. 1.482-1(c)(1) (Best
method rule). In any event, unadjusted industry average returns
themselves cannot establish arm's length results.
(3) Factors for determining comparability. The comparability factors
listed in Sec. 1.482-1(d)(1) are discussed in this section. Each of
these factors must be considered in determining the degree of
comparability between transactions or taxpayers and the extent to which
comparability adjustments may be necessary. In addition, in certain
cases involving special circumstances, the rules under paragraph (d)(4)
of this section must be considered.
(i) Functional analysis. Determining the degree of comparability
between controlled and uncontrolled transactions requires a comparison
of the functions performed, and associated resources employed, by the
taxpayers in each transaction. This comparison is based on a functional
analysis that identifies and compares the economically significant
activities undertaken, or to be undertaken, by the taxpayers in both
controlled and uncontrolled transactions. A functional analysis should
also include consideration of the resources that are employed, or to be
employed, in conjunction with the activities undertaken, including
consideration of the type of assets used, such as plant and equipment,
or the use of valuable intangibles. A functional analysis is not a
pricing method and does not itself determine the arm's length result for
the controlled transaction under review. Functions that may need to be
accounted for in determining the comparability of two transactions
include--
(A) Research and development;
[[Page 605]]
(B) Product design and engineering;
(C) Manufacturing, production and process engineering;
(D) Product fabrication, extraction, and assembly;
(E) Purchasing and materials management;
(F) Marketing and distribution functions, including inventory
management, warranty administration, and advertising activities;
(G) Transportation and warehousing; and
(H) Managerial, legal, accounting and finance, credit and
collection, training, and personnel management services.
(ii) Contractual terms--(A) In general. Determining the degree of
comparability between the controlled and uncontrolled transactions
requires a comparison of the significant contractual terms that could
affect the results of the two transactions. These terms include--
(1) The form of consideration charged or paid;
(2) Sales or purchase volume;
(3) The scope and terms of warranties provided;
(4) Rights to updates, revisions or modifications;
(5) The duration of relevant license, contract or other agreements,
and termination or renegotiation rights;
(6) Collateral transactions or ongoing business relationships
between the buyer and the seller, including arrangements for the
provision of ancillary or subsidiary services; and
(7) Extension of credit and payment terms. Thus, for example, if the
time for payment of the amount charged in a controlled transaction
differs from the time for payment of the amount charged in an
uncontrolled transaction, an adjustment to reflect the difference in
payment terms should be made if such difference would have a material
effect on price. Such comparability adjustment is required even if no
interest would be allocated or imputed under Sec. 1.482-2(a) or other
applicable provisions of the Internal Revenue Code or regulations.
(B) Identifying contractual terms--(1) Written agreement. The
contractual terms, including the consequent allocation of risks, that
are agreed to in writing before the transactions are entered into will
be respected if such terms are consistent with the economic substance of
the underlying transactions. In evaluating economic substance, greatest
weight will be given to the actual conduct of the parties, and the
respective legal rights of the parties (see, for example, Sec. 1.482-
4(f)(3) (Ownership of intangible property)). If the contractual terms
are inconsistent with the economic substance of the underlying
transaction, the district director may disregard such terms and impute
terms that are consistent with the economic substance of the
transaction.
(2) No written agreement. In the absence of a written agreement, the
district director may impute a contractual agreement between the
controlled taxpayers consistent with the economic substance of the
transaction. In determining the economic substance of the transaction,
greatest weight will be given to the actual conduct of the parties and
their respective legal rights (see, for example, Sec. 1.482-4(f)(3)
(Ownership of intangible property)). For example, if, without a written
agreement, a controlled taxpayer operates at full capacity and regularly
sells all of its output to another member of its controlled group, the
district director may impute a purchasing contract from the course of
conduct of the controlled taxpayers, and determine that the producer
bears little risk that the buyer will fail to purchase its full output.
Further, if an established industry convention or usage of trade assigns
a risk or resolves an issue, that convention or usage will be followed
if the conduct of the taxpayers is consistent with it. See UCC 1-205.
For example, unless otherwise agreed, payment generally is due at the
time and place at which the buyer is to receive goods. See UCC 2-310.
(C) Examples. The following examples illustrate this paragraph
(d)(3)(ii).
Example 1. Differences in volume. USP, a United States agricultural
exporter, regularly buys transportation services from FSub, its foreign
subsidiary, to ship its products from the United States to overseas
markets. Although FSub occasionally provides transportation services to
URA, an unrelated domestic corporation, URA accounts for only 10% of the
gross revenues of FSub, and the remaining 90% of FSub's gross revenues
are attributable to FSub's transactions with
[[Page 606]]
USP. In determining the degree of comparability between FSub's
uncontrolled transaction with URA and its controlled transaction with
USP, the difference in volumes involved in the two transactions and the
regularity with which these services are provided must be taken into
account if such difference would have a material effect on the price
charged. Inability to make reliable adjustments for these differences
would affect the reliability of the results derived from the
uncontrolled transaction as a measure of the arm's length result.
Example 2. Reliability of adjustment for differences in volume. (i)
FS manufactures product XX and sells that product to its parent
corporation, P. FS also sells product XX to uncontrolled taxpayers at a
price of $100 per unit. Except for the volume of each transaction, the
sales to P and to uncontrolled taxpayers take place under substantially
the same economic conditions and contractual terms. In uncontrolled
transactions, FS offers a 2% discount for quantities of 20 per order,
and a 5% discount for quantities of 100 per order. If P purchases
product XX in quantities of 60 per order, in the absence of other
reliable information, it may reasonably be concluded that the arm's
length price to P would be $100, less a discount of 3.5%.
(ii) If P purchases product XX in quantities of 1,000 per order, a
reliable estimate of the appropriate volume discount must be based on
proper economic or statistical analysis, not necessarily a linear
extrapolation from the 2% and 5% catalog discounts applicable to sales
of 20 and 100 units, respectively.
Example 3. Contractual terms imputed from economic substance. (i)
FP, a foreign producer of wristwatches, is the registered holder of the
YY trademark in the United States and in other countries worldwide. In
year 1, FP enters the United States market by selling YY wristwatches to
its newly organized United States subsidiary, USSub, for distribution in
the United States market. USSub pays FP a fixed price per wristwatch.
USSub and FP undertake, without separate compensation, marketing
activities to establish the YY trademark in the United States market.
Unrelated foreign producers of trademarked wristwatches and their
authorized United States distributors respectively undertake similar
marketing activities in independent arrangements involving distribution
of trademarked wristwatches in the United States market. In years 1
through 6, USSub markets and sells YY wristwatches in the United States.
Further, in years 1 through 6, USSub undertakes incremental marketing
activities in addition to the activities similar to those observed in
the independent distribution transactions in the United States market.
FP does not directly or indirectly compensate USSub for performing these
incremental activities during years 1 through 6. Assume that, aside from
these incremental activities, and after any adjustments are made to
improve the reliability of the comparison, the price paid per wristwatch
by the independent, authorized distributors of wristwatches would
provide the most reliable measure of the arm's length price paid per YY
wristwatch by USSub.
(ii) By year 7, the wristwatches with the YY trademark generate a
premium return in the United States market, as compared to wristwatches
marketed by the independent distributors. In year 7, substantially all
the premium return from the YY trademark in the United States market is
attributed to FP, for example through an increase in the price paid per
watch by USSub, or by some other means.
(iii) In determining whether an allocation of income is appropriate
in year 7, the Commissioner may consider the economic substance of the
arrangements between USSub and FP, and the parties' course of conduct
throughout their relationship. Based on this analysis, the Commissioner
determines that it is unlikely that, ex ante, an uncontrolled taxpayer
operating at arm's length would engage in the incremental marketing
activities to develop or enhance intangible property owned by another
party unless it received contemporaneous compensation or otherwise had a
reasonable anticipation of receiving a future benefit from those
activities. In this case, USSub's undertaking the incremental marketing
activities in years 1 through 6 is a course of conduct that is
inconsistent with the parties' attribution to FP in year 7 of
substantially all the premium return from the enhanced YY trademark in
the United States market. Therefore, the Commissioner may impute one or
more agreements between USSub and FP, consistent with the economic
substance of their course of conduct, which would afford USSub an
appropriate portion of the premium return from the YY trademark
wristwatches. For example, the Commissioner may impute a separate
services agreement that affords USSub contingent-payment compensation
for its incremental marketing activities in years 1 through 6, which
benefited FP by contributing to the value of the trademark owned by FP.
In the alternative, the Commissioner may impute a long-term, exclusive
agreement to exploit the YY trademark in the United States that allows
USSub to benefit from the incremental marketing activities it performed.
As another alternative, the Commissioner may require FP to compensate
USSub for terminating USSub's imputed long-term, exclusive agreement to
exploit the YY trademark in the United States, an agreement that USSub
made more valuable at its own expense and risk. The taxpayer may present
additional facts that could indicate which of these or other alternative
[[Page 607]]
agreements best reflects the economic substance of the underlying
transactions, consistent with the parties' course of conduct in the
particular case.
Example 4. Contractual terms imputed from economic substance. (i)
FP, a foreign producer of athletic gear, is the registered holder of the
AA trademark in the United States and in other countries worldwide. In
year 1, FP enters into a licensing agreement that affords its newly
organized United States subsidiary, USSub, exclusive rights to certain
manufacturing and marketing intangible property (including the AA
trademark) for purposes of manufacturing and marketing athletic gear in
the United States under the AA trademark. The contractual terms of this
agreement obligate USSub to pay FP a royalty based on sales, and also
obligate both FP and USSub to undertake without separate compensation
specified types and levels of marketing activities. Unrelated foreign
businesses license independent United States businesses to manufacture
and market athletic gear in the United States, using trademarks owned by
the unrelated foreign businesses. The contractual terms of these
uncontrolled transactions require the licensees to pay royalties based
on sales of the merchandise, and obligate the licensors and licensees to
undertake without separate compensation specified types and levels of
marketing activities. In years 1 through 6, USSub manufactures and sells
athletic gear under the AA trademark in the United States. Assume that,
after adjustments are made to improve the reliability of the comparison
for any material differences relating to marketing activities,
manufacturing or marketing intangible property, and other comparability
factors, the royalties paid by independent licensees would provide the
most reliable measure of the arm's length royalty owed by USSub to FP,
apart from the additional facts in paragraph (ii) of this Example 4.
(ii) In years 1 through 6, USSub performs incremental marketing
activities with respect to the AA trademark athletic gear, in addition
to the activities required under the terms of the license agreement with
FP, that are also incremental as compared to those observed in the
comparables. FP does not directly or indirectly compensate USSub for
performing these incremental activities during years 1 through 6. By
year 7, AA trademark athletic gear generates a premium return in the
United States, as compared to similar athletic gear marketed by
independent licensees. In year 7, USSub and FP enter into a separate
services agreement under which FP agrees to compensate USSub on a cost
basis for the incremental marketing activities that USSub performed
during years 1 through 6, and to compensate USSub on a cost basis for
any incremental marketing activities it may perform in year 7 and
subsequent years. In addition, the parties revise the license agreement
executed in year 1, and increase the royalty to a level that attributes
to FP substantially all the premium return from sales of the AA
trademark athletic gear in the United States.
(iii) In determining whether an allocation of income is appropriate
in year 7, the Commissioner may consider the economic substance of the
arrangements between USSub and FP and the parties' course of conduct
throughout their relationship. Based on this analysis, the Commissioner
determines that it is unlikely that, ex ante, an uncontrolled taxpayer
operating at arm's length would engage in the incremental marketing
activities to develop or enhance intangible property owned by another
party unless it received contemporaneous compensation or otherwise had a
reasonable anticipation of a future benefit. In this case, USSub's
undertaking the incremental marketing activities in years 1 through 6 is
a course of conduct that is inconsistent with the parties' adoption in
year 7 of contractual terms by which FP compensates USSub on a cost
basis for the incremental marketing activities that it performed.
Therefore, the Commissioner may impute one or more agreements between
USSub and FP, consistent with the economic substance of their course of
conduct, which would afford USSub an appropriate portion of the premium
return from the AA trademark athletic gear. For example, the
Commissioner may impute a separate services agreement that affords USSub
contingent-payment compensation for the incremental activities it
performed during years 1 through 6, which benefited FP by contributing
to the value of the trademark owned by FP. In the alternative, the
Commissioner may impute a long-term, exclusive United States license
agreement that allows USSub to benefit from the incremental activities.
As another alternative, the Commissioner may require FP to compensate
USSub for terminating USSub's imputed long-term United States license
agreement, a license that USSub made more valuable at its own expense
and risk. The taxpayer may present additional facts that could indicate
which of these or other alternative agreements best reflects the
economic substance of the underlying transactions, consistent with the
parties' course of conduct in this particular case.
Example 5. Non-arm's length compensation. (i) The facts are the same
as in paragraph (i) of Example 4. As in Example 4, assume that, after
adjustments are made to improve the reliability of the comparison for
any material differences relating to marketing activities, manufacturing
or marketing intangible property, and other comparability factors, the
royalties paid by independent licensees would provide the most reliable
measure of the arm's length royalty owed by USSub to
[[Page 608]]
FP, apart from the additional facts described in paragraph (ii) of this
Example 5.
(ii) In years 1 through 4, USSub performs certain incremental
marketing activities with respect to the AA trademark athletic gear, in
addition to the activities required under the terms of the basic license
agreement, that are also incremental as compared with those activities
observed in the comparables. At the start of year 1, FP enters into a
separate services agreement with USSub, which states that FP will
compensate USSub quarterly, in an amount equal to specified costs plus
X%, for these incremental marketing functions. Further, these written
agreements reflect the intent of the parties that USSub receive such
compensation from FP throughout the term of the agreement, without
regard to the success or failure of the promotional activities. During
years 1 through 4, USSub performs marketing activities pursuant to the
separate services agreement and in each year USSub receives the
specified compensation from FP on a cost of services plus basis.
(iii) In evaluating year 4, the Commissioner performs an analysis of
independent parties that perform promotional activities comparable to
those performed by USSub and that receive separately-stated compensation
on a current basis without contingency. The Commissioner determines that
the magnitude of the specified cost plus X% is outside the arm's length
range in each of years 1 through 4. Based on an evaluation of all the
facts and circumstances, the Commissioner makes an allocation to require
payment of compensation to USSub for the promotional activities
performed in year 4, based on the median of the interquartile range of
the arm's length markups charged by the uncontrolled comparables
described in paragraph (e)(3) of this section.
(iv) Given that based on facts and circumstances, the terms agreed
by the controlled parties were that FP would bear all risks associated
with the promotional activities performed by USSub to promote the AA
trademark product in the United States market, and given that the
parties' conduct during the years examined was consistent with this
allocation of risk, the fact that the cost of services plus markup on
USSub's services was outside the arm's length range does not, without
more, support imputation of additional contractual terms based on
alternative views of the economic substance of the transaction, such as
terms indicating that USSub, rather than FP, bore the risk associated
with these activities.
Example 6. Contractual terms imputed from economic substance. (i)
Company X is a member of a controlled group that has been in operation
in the pharmaceutical sector for many years. In years 1 through 4,
Company X undertakes research and development activities. As a result of
those activities, Company X developed a compound that may be more
effective than existing medications in the treatment of certain
conditions.
(ii) Company Y is acquired in year 4 by the controlled group that
includes Company X. Once Company Y is acquired, Company X makes
available to Company Y a large amount of technical data concerning the
new compound, which Company Y uses to register patent rights with
respect to the compound in several jurisdictions, making Company Y the
legal owner of such patents. Company Y then enters into licensing
agreements with group members that afford Company Y 100% of the premium
return attributable to use of the intangible property by its
subsidiaries.
(iii) In determining whether an allocation is appropriate in year 4,
the Commissioner may consider the economic substance of the arrangements
between Company X and Company Y, and the parties' course of conduct
throughout their relationship. Based on this analysis, the Commissioner
determines that it is unlikely that an uncontrolled taxpayer operating
at arm's length would make available the results of its research and
development or perform services that resulted in transfer of valuable
know how to another party unless it received contemporaneous
compensation or otherwise had a reasonable anticipation of receiving a
future benefit from those activities. In this case, Company X's
undertaking the research and development activities and then providing
technical data and know-how to Company Y in year 4 is inconsistent with
the registration and subsequent exploitation of the patent by Company Y.
Therefore, the Commissioner may impute one or more agreements between
Company X and Company Y consistent with the economic substance of their
course of conduct, which would afford Company X an appropriate portion
of the premium return from the patent rights. For example, the
Commissioner may impute a separate services agreement that affords
Company X contingent-payment compensation for its services in year 4 for
the benefit of Company Y, consisting of making available to Company Y
technical data, know-how, and other fruits of research and development
conducted in previous years. These services benefited Company Y by
giving rise to and contributing to the value of the patent rights that
were ultimately registered by Company Y. In the alternative, the
Commissioner may impute a transfer of patentable intangible property
rights from Company X to Company Y immediately preceding the
registration of patent rights by Company Y. The taxpayer may present
additional facts that could indicate which of these or other alternative
agreements best reflects the economic substance of the underlying
transactions, consistent with the parties' course of conduct in the
particular case.
[[Page 609]]
(iii) Risk--(A) Comparability. Determining the degree of
comparability between controlled and uncontrolled transactions requires
a comparison of the significant risks that could affect the prices that
would be charged or paid, or the profit that would be earned, in the two
transactions. Relevant risks to consider include--
(1) Market risks, including fluctuations in cost, demand, pricing,
and inventory levels;
(2) Risks associated with the success or failure of research and
development activities;
(3) Financial risks, including fluctuations in foreign currency
rates of exchange and interest rates;
(4) Credit and collection risks;
(5) Product liability risks; and
(6) General business risks related to the ownership of property,
plant, and equipment.
(B) Identification of taxpayer that bears risk. In general, the
determination of which controlled taxpayer bears a particular risk will
be made in accordance with the provisions of Sec. 1.482-1(d)(3)(ii)(B)
(Identifying contractual terms). Thus, the allocation of risks specified
or implied by the taxpayer's contractual terms will generally be
respected if it is consistent with the economic substance of the
transaction. An allocation of risk between controlled taxpayers after
the outcome of such risk is known or reasonably knowable lacks economic
substance. In considering the economic substance of the transaction, the
following facts are relevant--
(1) Whether the pattern of the controlled taxpayer's conduct over
time is consistent with the purported allocation of risk between the
controlled taxpayers; or where the pattern is changed, whether the
relevant contractual arrangements have been modified accordingly;
(2) Whether a controlled taxpayer has the financial capacity to fund
losses that might be expected to occur as the result of the assumption
of a risk, or whether, at arm's length, another party to the controlled
transaction would ultimately suffer the consequences of such losses; and
(3) The extent to which each controlled taxpayer exercises
managerial or operational control over the business activities that
directly influence the amount of income or loss realized. In arm's
length dealings, parties ordinarily bear a greater share of those risks
over which they have relatively more control.
(C) Examples. The following examples illustrate this paragraph
(d)(3)(iii).
Example 1. FD, the wholly-owned foreign distributor of USM, a U.S.
manufacturer, buys widgets from USM under a written contract. Widgets
are a generic electronic appliance. Under the terms of the contract, FD
must buy and take title to 20,000 widgets for each of the five years of
the contract at a price of $10 per widget. The widgets will be sold
under FD's label, and FD must finance any marketing strategies to
promote sales in the foreign market. There are no rebate or buy back
provisions. FD has adequate financial capacity to fund its obligations
under the contract under any circumstances that could reasonably be
expected to arise. In Years 1, 2 and 3, FD sold only 10,000 widgets at a
price of $11 per unit. In Year 4, FD sold its entire inventory of
widgets at a price of $25 per unit. Since the contractual terms
allocating market risk were agreed to before the outcome of such risk
was known or reasonably knowable, FD had the financial capacity to bear
the market risk that it would be unable to sell all of the widgets it
purchased currently, and its conduct was consistent over time, FD will
be deemed to bear the risk.
Example 2. The facts are the same as in Example 1, except that in
Year 1 FD had only $100,000 in total capital, including loans. In
subsequent years USM makes no additional contributions to the capital of
FD, and FD is unable to obtain any capital through loans from an
unrelated party. Nonetheless, USM continues to sell 20,000 widgets
annually to FD under the terms of the contract, and USM extends credit
to FD to enable it to finance the purchase. FD does not have the
financial capacity in Years 1, 2 and 3 to finance the purchase of the
widgets given that it could not sell most of the widgets it purchased
during those years. Thus, notwithstanding the terms of the contract, USM
and not FD assumed the market risk that a substantial portion of the
widgets could not be sold, since in that event FD would not be able to
pay USM for all of the widgets it purchased.
Example 3. S, a Country X corporation, manufactures small motors
that it sells to P, its U.S. parent. P incorporates the motors into
various products and sells those products to uncontrolled customers in
the United States. The contract price for the motors is
[[Page 610]]
expressed in U.S. dollars, effectively allocating the currency risk for
these transactions to S for any currency fluctuations between the time
the contract is signed and payment is made. As long as S has adequate
financial capacity to bear this currency risk (including by hedging all
or part of the risk) and the conduct of S and P is consistent with the
terms of the contract (i.e., the contract price is not adjusted to
reflect exchange rate movements), the agreement of the parties to
allocate the exchange risk to S will be respected.
Example 4. USSub is the wholly-owned U.S. subsidiary of FP, a
foreign manufacturer. USSub acts as a distributor of goods manufactured
by FP. FP and USSub execute an agreement providing that FP will bear any
ordinary product liability costs arising from defects in the goods
manufactured by FP. In practice, however, when ordinary product
liability claims are sustained against USSub and FP, USSub pays the
resulting damages. Therefore, the district director disregards the
contractual arrangement regarding product liability costs between FP and
USSub, and treats the risk as having been assumed by USSub.
(iv) Economic conditions. Determining the degree of comparability
between controlled and uncontrolled transactions requires a comparison
of the significant economic conditions that could affect the prices that
would be charged or paid, or the profit that would be earned in each of
the transactions. These factors include--
(A) The similarity of geographic markets;
(B) The relative size of each market, and the extent of the overall
economic development in each market;
(C) The level of the market (e.g., wholesale, retail, etc.);
(D) The relevant market shares for the products, properties, or
services transferred or provided;
(E) The location-specific costs of the factors of production and
distribution;
(F) The extent of competition in each market with regard to the
property or services under review;
(G) The economic condition of the particular industry, including
whether the market is in contraction or expansion; and
(H) The alternatives realistically available to the buyer and
seller.
(v) Property or services. Evaluating the degree of comparability
between controlled and uncontrolled transactions requires a comparison
of the property or services transferred in the transactions. This
comparison may include any intangible property that is embedded in
tangible property or services being transferred (embedded intangibles).
The comparability of the embedded intangibles will be analyzed using the
factors listed in Sec. 1.482-4(c)(2)(iii)(B)(1) (comparable intangible
property). The relevance of product comparability in evaluating the
relative reliability of the results will depend on the method applied.
For guidance concerning the specific comparability considerations
applicable to transfers of tangible and intangible property and
performance of services, see Sec. Sec. 1.482-3 through 1.482-6 and
Sec. 1.482-9; see also Sec. Sec. 1.482-3(f), 1.482-4(f)(4), and 1.482-
9(m), dealing with the coordination of intangible and tangible property
and performance of services rules.
(4) Special circumstances--(i) Market share strategy. In certain
circumstances, taxpayers may adopt strategies to enter new markets or to
increase a product's share of an existing market (market share
strategy). Such a strategy would be reflected by temporarily increased
market development expenses or resale prices that are temporarily lower
than the prices charged for comparable products in the same market.
Whether or not the strategy is reflected in the transfer price depends
on which party to the controlled transaction bears the costs of the
pricing strategy. In any case, the effect of a market share strategy on
a controlled transaction will be taken into account only if it can be
shown that an uncontrolled taxpayer engaged in a comparable strategy
under comparable circumstances for a comparable period of time, and the
taxpayer provides documentation that substantiates the following--
(A) The costs incurred to implement the market share strategy are
borne by the controlled taxpayer that would obtain the future profits
that result from the strategy, and there is a reasonable likelihood that
the strategy will result in future profits that reflect an appropriate
return in relation to the costs incurred to implement it;
(B) The market share strategy is pursued only for a period of time
that is reasonable, taking into consideration
[[Page 611]]
the industry and product in question; and
(C) The market share strategy, the related costs and expected
returns, and any agreement between the controlled taxpayers to share the
related costs, were established before the strategy was implemented.
(ii) Different geographic markets--(A) In general. Uncontrolled
comparables ordinarily should be derived from the geographic market in
which the controlled taxpayer operates, because there may be significant
differences in economic conditions in different markets. If information
from the same market is not available, an uncontrolled comparable
derived from a different geographic market may be considered if
adjustments are made to account for differences between the two markets.
If information permitting adjustments for such differences is not
available, then information derived from uncontrolled comparables in the
most similar market for which reliable data is available may be used,
but the extent of such differences may affect the reliability of the
method for purposes of the best method rule. For this purpose, a
geographic market is any geographic area in which the economic
conditions for the relevant product or service are substantially the
same, and may include multiple countries, depending on the economic
conditions.
(B) Example. The following example illustrates this paragraph
(d)(4)(ii).
Example. Manuco, a wholly-owned foreign subsidiary of P, a U.S.
corporation, manufactures products in Country Z for sale to P. No
uncontrolled transactions are located that would provide a reliable
measure of the arm's length result under the comparable uncontrolled
price method. The district director considers applying the cost plus
method or the comparable profits method. Information on uncontrolled
taxpayers performing comparable functions under comparable circumstances
in the same geographic market is not available. Therefore, adjusted data
from uncontrolled manufacturers in other markets may be considered in
order to apply the cost plus method. In this case, comparable
uncontrolled manufacturers are found in the United States. Accordingly,
data from the comparable U.S. uncontrolled manufacturers, as adjusted to
account for differences between the United States and Country Z's
geographic market, is used to test the arm's length price paid by P to
Manuco. However, the use of such data may affect the reliability of the
results for purposes of the best method rule. See Sec. 1.482-1(c).
(C) Location savings. If an uncontrolled taxpayer operates in a
different geographic market than the controlled taxpayer, adjustments
may be necessary to account for significant differences in costs
attributable to the geographic markets. These adjustments must be based
on the effect such differences would have on the consideration charged
or paid in the controlled transaction given the relative competitive
positions of buyers and sellers in each market. Thus, for example, the
fact that the total costs of operating in a controlled manufacturer's
geographic market are less than the total costs of operating in other
markets ordinarily justifies higher profits to the manufacturer only if
the cost differences would increase the profits of comparable
uncontrolled manufacturers operating at arm's length, given the
competitive positions of buyers and sellers in that market.
(D) Example. The following example illustrates the principles of
this paragraph (d)(4)(ii)(C).
Example. Couture, a U.S. apparel design corporation, contracts with
Sewco, its wholly owned Country Y subsidiary, to manufacture its
clothes. Costs of operating in Country Y are significantly lower than
the operating costs in the United States. Although clothes with the
Couture label sell for a premium price, the actual production of the
clothes does not require significant specialized knowledge that could
not be acquired by actual or potential competitors to Sewco at
reasonable cost. Thus, Sewco's functions could be performed by several
actual or potential competitors to Sewco in geographic markets that are
similar to Country Y. Thus, the fact that production is less costly in
Country Y will not, in and of itself, justify additional profits derived
from lower operating costs in Country Y inuring to Sewco, because the
competitive positions of the other actual or potential producers in
similar geographic markets capable of performing the same functions at
the same low costs indicate that at arm's length such profits would not
be retained by Sewco.
(iii) Transactions ordinarily not accepted as comparables--(A) In
general. Transactions ordinarily will not constitute reliable measures
of an arm's
[[Page 612]]
length result for purposes of this section if--
(1) They are not made in the ordinary course of business; or
(2) One of the principal purposes of the uncontrolled transaction
was to establish an arm's length result with respect to the controlled
transaction.
(B) Examples. The following examples illustrate the principle of
this paragraph (d)(4)(iii).
Example 1. Not in the ordinary course of business. USP, a United
States manufacturer of computer software, sells its products to FSub,
its foreign distributor in country X. Compco, a United States competitor
of USP, also sells its products in X through unrelated distributors.
However, in the year under review, Compco is forced into bankruptcy, and
Compco liquidates its inventory by selling all of its products to
unrelated distributors in X for a liquidation price. Because the sale of
its entire inventory was not a sale in the ordinary course of business,
Compco's sale cannot be used as an uncontrolled comparable to determine
USP's arm's length result from its controlled transaction.
Example 2. Principal purpose of establishing an arm's length result.
USP, a United States manufacturer of farm machinery, sells its products
to FSub, its wholly-owned distributor in Country Y. USP, operating at
nearly full capacity, sells 95% of its inventory to FSub. To make use of
its excess capacity, and also to establish a comparable uncontrolled
price for its transfer price to FSub, USP increases its production to
full capacity. USP sells its excess inventory to Compco, an unrelated
foreign distributor in Country X. Country X has approximately the same
economic conditions as that of Country Y. Because one of the principal
purposes of selling to Compco was to establish an arm's length price for
its controlled transactions with FSub, USP's sale to Compco cannot be
used as an uncontrolled comparable to determine USP's arm's length
result from its controlled transaction.
(e) Arm's length range--(1) In general. In some cases, application
of a pricing method will produce a single result that is the most
reliable measure of an arm's length result. In other cases, application
of a method may produce a number of results from which a range of
reliable results may be derived. A taxpayer will not be subject to
adjustment if its results fall within such range (arm's length range).
(2) Determination of arm's length range--(i) Single method. The
arm's length range is ordinarily determined by applying a single pricing
method selected under the best method rule to two or more uncontrolled
transactions of similar comparability and reliability. Use of more than
one method may be appropriate for the purposes described in paragraph
(c)(2)(iii) of this section (Best method rule).
(ii) Selection of comparables. Uncontrolled comparables must be
selected based upon the comparability criteria relevant to the method
applied and must be sufficiently similar to the controlled transaction
that they provide a reliable measure of an arm's length result. If
material differences exist between the controlled and uncontrolled
transactions, adjustments must be made to the results of the
uncontrolled transaction if the effect of such differences on price or
profits can be ascertained with sufficient accuracy to improve the
reliability of the results. See Sec. 1.482-1(d)(2) (Standard of
comparability). The arm's length range will be derived only from those
uncontrolled comparables that have, or through adjustments can be
brought to, a similar level of comparability and reliability, and
uncontrolled comparables that have a significantly lower level of
comparability and reliability will not be used in establishing the arm's
length range.
(iii) Comparables included in arm's length range--(A) In general.
The arm's length range will consist of the results of all of the
uncontrolled comparables that meet the following conditions: the
information on the controlled transaction and the uncontrolled
comparables is sufficiently complete that it is likely that all material
differences have been identified, each such difference has a definite
and reasonably ascertainable effect on price or profit, and an
adjustment is made to eliminate the effect of each such difference.
(B) Adjustment of range to increase reliability. If there are no
uncontrolled comparables described in paragraph (e)(2)(iii)(A) of this
section, the arm's length range is derived from the results of all the
uncontrolled comparables, selected pursuant to paragraph (e)(2)(ii) of
this section, that achieve a similar level of comparability and
reliability. In such cases the reliability of the
[[Page 613]]
analysis must be increased, where it is possible to do so, by adjusting
the range through application of a valid statistical method to the
results of all of the uncontrolled comparables so selected. The
reliability of the analysis is increased when statistical methods are
used to establish a range of results in which the limits of the range
will be determined such that there is a 75 percent probability of a
result falling above the lower end of the range and a 75 percent
probability of a result falling below the upper end of the range. The
interquartile range ordinarily provides an acceptable measure of this
range; however a different statistical method may be applied if it
provides a more reliable measure.
(C) Interquartile range. For purposes of this section, the
interquartile range is the range from the 25th to the 75th percentile of
the results derived from the uncontrolled comparables. For this purpose,
the 25th percentile is the lowest result derived from an uncontrolled
comparable such that at least 25 percent of the results are at or below
the value of that result. However, if exactly 25 percent of the results
are at or below a result, then the 25th percentile is equal to the
average of that result and the next higher result derived from the
uncontrolled comparables. The 75th percentile is determined analogously.
(3) Adjustment if taxpayer's results are outside arm's length range.
If the results of a controlled transaction fall outside the arm's length
range, the district director may make allocations that adjust the
controlled taxpayer's result to any point within the arm's length range.
If the interquartile range is used to determine the arm's length range,
such adjustment will ordinarily be to the median of all the results. The
median is the 50th percentile of the results, which is determined in a
manner analogous to that described in paragraph (e)(2)(iii)(C) of this
section (Interquartile range). In other cases, an adjustment normally
will be made to the arithmetic mean of all the results. See Sec. 1.482-
1(f)(2)(iii)(D) for determination of an adjustment when a controlled
taxpayer's result for a multiple year period falls outside an arm's
length range consisting of the average results of uncontrolled
comparables over the same period.
(4) Arm's length range not prerequisite to allocation. The rules of
this paragraph (e) do not require that the district director establish
an arm's length range prior to making an allocation under section 482.
Thus, for example, the district director may properly propose an
allocation on the basis of a single comparable uncontrolled price if the
comparable uncontrolled price method, as described in Sec. 1.482-3(b),
has been properly applied. However, if the taxpayer subsequently
demonstrates that the results claimed on its income tax return are
within the range established by additional equally reliable comparable
uncontrolled prices in a manner consistent with the requirements set
forth in Sec. 1.482-1(e)(2)(iii), then no allocation will be made.
(5) Examples. The following examples illustrate the principles of
this paragraph (e).
Example 1. Selection of comparables. (i) To evaluate the arm's
length result of a controlled transaction between USSub, the United
States taxpayer under review, and FP, its foreign parent, the district
director considers applying the resale price method. The district
director identifies ten potential uncontrolled transactions. The
distributors in all ten uncontrolled transactions purchase and resell
similar products and perform similar functions to those of USSub.
(ii) Data with respect to three of the uncontrolled transactions is
very limited, and although some material differences can be identified
and adjusted for, the level of comparability of these three uncontrolled
comparables is significantly lower than that of the other seven.
Further, of those seven, adjustments for the identified material
differences can be reliably made for only four of the uncontrolled
transactions. Therefore, pursuant to Sec. 1.482-1(e)(2)(ii) only these
four uncontrolled comparables may be used to establish an arm's length
range.
Example 2. Arm's length range consists of all the results. (i) The
facts are the same as in Example 1. Applying the resale price method to
the four uncontrolled comparables, and making adjustments to the
uncontrolled comparables pursuant to Sec. 1.482-1(d)(2), the district
director derives the following results:
------------------------------------------------------------------------
Result
Comparable (price)
------------------------------------------------------------------------
1............................................................ $44.00
2............................................................ 45.00
3............................................................ 45.00
[[Page 614]]
4............................................................ 45.50
------------------------------------------------------------------------
(ii) The district director determines that data regarding the four
uncontrolled transactions is sufficiently complete and accurate so that
it is likely that all material differences between the controlled and
uncontrolled transactions have been identified, such differences have a
definite and reasonably ascertainable effect, and appropriate
adjustments were made for such differences. Accordingly, if the resale
price method is determined to be the best method pursuant to Sec.
1.482-1(c), the arm's length range for the controlled transaction will
consist of the results of all of the uncontrolled comparables, pursuant
to paragraph (e)(2)(iii)(A) of this section. Thus, the arm's length
range in this case would be the range from $44 to $45.50.
Example 3. Arm's length range limited to interquartile range. (i)
The facts are the same as in Example 2, except in this case there are
some product and functional differences between the four uncontrolled
comparables and USSub. However, the data is insufficiently complete to
determine the effect of the differences. Applying the resale price
method to the four uncontrolled comparables, and making adjustments to
the uncontrolled comparables pursuant to Sec. 1.482-1(d)(2), the
district director derives the following results:
------------------------------------------------------------------------
Result
Uncontrolled comparable (price)
------------------------------------------------------------------------
1............................................................ $42.00
2............................................................ 44.00
3............................................................ 45.00
4............................................................ 47.50
------------------------------------------------------------------------
(ii) It cannot be established in this case that all material
differences are likely to have been identified and reliable adjustments
made for those differences. Accordingly, if the resale price method is
determined to be the best method pursuant to Sec. 1.482-1(c), the arm's
length range for the controlled transaction must be established pursuant
to paragraph (e)(2)(iii)(B) of this section. In this case, the district
director uses the interquartile range to determine the arm's length
range, which is the range from $43 to $46.25. If USSub's price falls
outside this range, the district director may make an allocation. In
this case that allocation would be to the median of the results, or
$44.50.
Example 4. Arm's length range limited to interquartile range. (i) To
evaluate the arm's length result of controlled transactions between USP,
a United States manufacturing company, and FSub, its foreign subsidiary,
the district director considers applying the comparable profits method.
The district director identifies 50 uncontrolled taxpayers within the
same industry that potentially could be used to apply the method.
(ii) Further review indicates that only 20 of the uncontrolled
manufacturers engage in activities requiring similar capital investments
and technical know-how. Data with respect to five of the uncontrolled
manufacturers is very limited, and although some material differences
can be identified and adjusted for, the level of comparability of these
five uncontrolled comparables is significantly lower than that of the
other 15. In addition, for those five uncontrolled comparables it is not
possible to accurately allocate costs between the business activity
associated with the relevant transactions and other business activities.
Therefore, pursuant to Sec. 1.482-1(e)(2)(ii) only the other fifteen
uncontrolled comparables may be used to establish an arm's length range.
(iii) Although the data for the fifteen remaining uncontrolled
comparables is relatively complete and accurate, there is a significant
possibility that some material differences may remain. The district
director has determined, for example, that it is likely that there are
material differences in the level of technical expertise or in
management efficiency. Accordingly, if the comparable profits method is
determined to be the best method pursuant to Sec. 1.482-1(c), the arm's
length range for the controlled transaction may be established only
pursuant to paragraph (e)(2)(iii)(B) of this section.
(f) Scope of review--(1) In general. The authority to determine true
taxable income extends to any case in which either by inadvertence or
design the taxable income, in whole or in part, of a controlled taxpayer
is other than it would have been had the taxpayer, in the conduct of its
affairs, been dealing at arm's length with an uncontrolled taxpayer.
(i) Intent to evade or avoid tax not a prerequisite. In making
allocations under section 482, the district director is not restricted
to the case of improper accounting, to the case of a fraudulent,
colorable, or sham transaction, or to the case of a device designed to
reduce or avoid tax by shifting or distorting income, deductions,
credits, or allowances.
(ii) Realization of income not a prerequisite--(A) In general. The
district director may make an allocation under section 482 even if the
income ultimately anticipated from a series of transactions has not been
or is never realized. For example, if a controlled taxpayer sells a
product at less than an
[[Page 615]]
arm's length price to a related taxpayer in one taxable year and the
second controlled taxpayer resells the product to an unrelated party in
the next taxable year, the district director may make an appropriate
allocation to reflect an arm's length price for the sale of the product
in the first taxable year, even though the second controlled taxpayer
had not realized any gross income from the resale of the product in the
first year. Similarly, if a controlled taxpayer lends money to a related
taxpayer in a taxable year, the district director may make an
appropriate allocation to reflect an arm's length charge for interest
during such taxable year even if the second controlled taxpayer does not
realize income during such year. Finally, even if two controlled
taxpayers realize an overall loss that is attributable to a particular
controlled transaction, an allocation under section 482 is not
precluded.
(B) Example. The following example illustrates this paragraph
(f)(1)(ii).
Example. USSub is a U.S. subsidiary of FP, a foreign corporation.
Parent manufactures product X and sells it to USSub. USSub functions as
a distributor of product X to unrelated customers in the United States.
The fact that FP may incur a loss on the manufacture and sale of product
X does not by itself establish that USSub, dealing with FP at arm's
length, also would incur a loss. An independent distributor acting at
arm's length with its supplier would in many circumstances be expected
to earn a profit without regard to the level of profit earned by the
supplier.
(iii) Nonrecognition provisions may not bar allocation--(A) In
general. If necessary to prevent the avoidance of taxes or to clearly
reflect income, the district director may make an allocation under
section 482 with respect to transactions that otherwise qualify for
nonrecognition of gain or loss under applicable provisions of the
Internal Revenue Code (such as section 351 or 1031).
(B) Example. The following example illustrates this paragraph
(f)(1)(iii).
Example. (i) In Year 1 USP, a United States corporation, bought 100
shares of UR, an unrelated corporation, for $100,000. In Year 2, when
the value of the UR stock had decreased to $40,000, USP contributed all
100 shares of UR stock to its wholly-owned subsidiary in exchange for
subsidiary's capital stock. In Year 3, the subsidiary sold all of the UR
stock for $40,000 to an unrelated buyer, and on its U.S. income tax
return, claimed a loss of $60,000 attributable to the sale of the UR
stock. USP and its subsidiary do not file a consolidated return.
(ii) In determining the true taxable income of the subsidiary, the
district director may disallow the loss of $60,000 on the ground that
the loss was incurred by USP. National Securities Corp. v Commissioner,
137 F.2d 600 (3rd Cir. 1943), cert. denied, 320 U.S. 794 (1943).
(iv) Consolidated returns. Section 482 and the regulations
thereunder apply to all controlled taxpayers, whether the controlled
taxpayer files a separate or consolidated U.S. income tax return. If a
controlled taxpayer files a separate return, its true separate taxable
income will be determined. If a controlled taxpayer is a party to a
consolidated return, the true consolidated taxable income of the
affiliated group and the true separate taxable income of the controlled
taxpayer must be determined consistently with the principles of a
consolidated return.
(2) Rules relating to determination of true taxable income. The
following rules must be taken into account in determining the true
taxable income of a controlled taxpayer.
(i)(A) through (E) [Reserved]. For further guidance see Sec. 1.482-
1T(f)(2)(i)(A) through (E).
(ii) Allocation based on taxpayer's actual transactions--(A) In
general. The Commissioner will evaluate the results of a transaction as
actually structured by the taxpayer unless its structure lacks economic
substance. However, the Commissioner may consider the alternatives
available to the taxpayer in determining whether the terms of the
controlled transaction would be acceptable to an uncontrolled taxpayer
faced with the same alternatives and operating under comparable
circumstances. In such cases the Commissioner may adjust the
consideration charged in the controlled transaction based on the cost or
profit of an alternative as adjusted to account for material differences
between the alternative and the controlled transaction, but will not
restructure the transaction as if the alternative had been adopted by
the taxpayer. See paragraph (d)(3) of this section (factors for
determining
[[Page 616]]
comparability; contractual terms and risk); Sec. Sec. 1.482-3(e),
1.482-4(d), and 1.482-9(h) (unspecified methods).
(B) [Reserved]. For further guidance see Sec. 1.482-
1T(f)(2)(ii)(B).
(iii) Multiple year data--(A) In general. The results of a
controlled transaction ordinarily will be compared with the results of
uncontrolled comparables occurring in the taxable year under review. It
may be appropriate, however, to consider data relating to the
uncontrolled comparables or the controlled taxpayer for one or more
years before or after the year under review. If data relating to
uncontrolled comparables from multiple years is used, data relating to
the controlled taxpayer for the same years ordinarily must be
considered. However, if such data is not available, reliable data from
other years, as adjusted under paragraph (d)(2) (Standard of
comparability) of this section may be used.
(B) Circumstances warranting consideration of multiple year data.
The extent to which it is appropriate to consider multiple year data
depends on the method being applied and the issue being addressed.
Circumstances that may warrant consideration of data from multiple years
include the extent to which complete and accurate data are available for
the taxable year under review, the effect of business cycles in the
controlled taxpayer's industry, or the effects of life cycles of the
product or intangible property being examined. Data from one or more
years before or after the taxable year under review must ordinarily be
considered for purposes of applying the provisions of paragraph
(d)(3)(iii) of this section (risk), paragraph (d)(4)(i) of this section
(market share strategy), Sec. 1.482-4(f)(2) (periodic adjustments),
Sec. 1.482-5 (comparable profits method), Sec. 1.482-9(f) (comparable
profits method for services), and Sec. 1.482-9(i) (contingent-payment
contractual terms for services). On the other hand, multiple year data
ordinarily will not be considered for purposes of applying the
comparable uncontrolled price method of Sec. 1.482-3(b) or the
comparable uncontrolled services price method of Sec. 1.482-9(c)
(except to the extent that risk or market share strategy issues are
present).
(C) Comparable effect over comparable period. Data from multiple
years may be considered to determine whether the same economic
conditions that caused the controlled taxpayer's results had a
comparable effect over a comparable period of time on the uncontrolled
comparables that establish the arm's length range. For example, given
that uncontrolled taxpayers enter into transactions with the ultimate
expectation of earning a profit, persistent losses among controlled
taxpayers may be an indication of non-arm's length dealings. Thus, if a
controlled taxpayer that realizes a loss with respect to a controlled
transaction seeks to demonstrate that the loss is within the arm's
length range, the district director may take into account data from
taxable years other than the taxable year of the transaction to
determine whether the loss was attributable to arm's length dealings.
The rule of this paragraph (f)(2)(iii)(C) is illustrated by Example 3 of
paragraph (f)(2)(iii)(E) of this section.
(D) Applications of methods using multiple year averages. If a
comparison of a controlled taxpayer's average result over a multiple
year period with the average results of uncontrolled comparables over
the same period would reduce the effect of short-term variations that
may be unrelated to transfer pricing, it may be appropriate to establish
a range derived from the average results of uncontrolled comparables
over a multiple year period to determine if an adjustment should be
made. In such a case the district director may make an adjustment if the
controlled taxpayer's average result for the multiple year period is not
within such range. Such a range must be determined in accordance with
Sec. 1.482-1(e) (Arm's length range). An adjustment in such a case
ordinarily will be equal to the difference, if any, between the
controlled taxpayer's result for the taxable year and the mid-point of
the uncontrolled comparables' results for that year. If the
interquartile range is used to determine the range of average results
for the multiple year period, such adjustment will ordinarily be made to
the median of all the results of the uncontrolled comparables for the
taxable year. See Example 2 of
[[Page 617]]
Sec. 1.482-5(e). In other cases, the adjustment normally will be made
to the arithmetic mean of all the results of the uncontrolled
comparables for the taxable year. However, an adjustment will be made
only to the extent that it would move the controlled taxpayer's multiple
year average closer to the arm's length range for the multiple year
period or to any point within such range. In determining a controlled
taxpayer's average result for a multiple year period, adjustments made
under this section for prior years will be taken into account only if
such adjustments have been finally determined, as described in Sec.
1.482-1(g)(2)(iii). See Example 3 of Sec. 1.482-5(e).
(E) Examples. The following examples, in which S and P are
controlled taxpayers, illustrate this paragraph (f)(2)(iii). Examples 1
and 4 also illustrate the principle of the arm's length range of
paragraph (e) of this section.
Example 1. P sold product Z to S for $60 per unit in 1995. Applying
the resale price method to data from uncontrolled comparables for the
same year establishes an arm's length range of prices for the controlled
transaction from $52 to $59 per unit. Since the price charged in the
controlled transaction falls outside the range, the district director
would ordinarily make an allocation under section 482. However, in this
case there are cyclical factors that affect the results of the
uncontrolled comparables (and that of the controlled transaction) that
cannot be adequately accounted for by specific adjustments to the data
for 1995. Therefore, the district director considers results over
multiple years to account for these factors. Under these circumstances,
it is appropriate to average the results of the uncontrolled comparables
over the years 1993, 1994, and 1995 to determine an arm's length range.
The averaged results establish an arm's length range of $56 to $58 per
unit. For consistency, the results of the controlled taxpayers must also
be averaged over the same years. The average price in the controlled
transaction over the three years is $57. Because the controlled transfer
price of product Z falls within the arm's length range, the district
director makes no allocation.
Example 2. (i) FP, a Country X corporation, designs and manufactures
machinery in Country X. FP's costs are incurred in Country X currency.
USSub is the exclusive distributor of FP's machinery in the United
States. The price of the machinery sold by FP to USSub is expressed in
Country X currency. Thus, USSub bears all of the currency risk
associated with fluctuations in the exchange rate between the time the
contract is signed and the payment is made. The prices charged by FP to
USSub for 1995 are under examination. In that year, the value of the
dollar depreciated against the currency of Country X, and as a result,
USSub's gross margin was only 8%.
(ii) UD is an uncontrolled distributor of similar machinery that
performs distribution functions substantially the same as those
performed by USSub, except that UD purchases and resells machinery in
transactions where both the purchase and resale prices are denominated
in U.S. dollars. Thus, UD had no currency exchange risk. UD's gross
margin in 1995 was 10%. UD's average gross margin for the period 1990 to
1998 has been 12%.
(iii) In determining whether the price charged by FP to USSub in
1995 was arm's length, the district director may consider USSub's
average gross margin for an appropriate period before and after 1995 to
determine whether USSub's average gross margin during the period was
sufficiently greater than UD's average gross margin during the same
period such that USSub was sufficiently compensated for the currency
risk it bore throughout the period. See Sec. 1.482- 1(d)(3)(iii)
(Risk).
Example 3. FP manufactures product X in Country M and sells it to
USSub, which distributes X in the United States. USSub realizes losses
with respect to the controlled transactions in each of five consecutive
taxable years. In each of the five consecutive years a different
uncontrolled comparable realized a loss with respect to comparable
transactions equal to or greater than USSub's loss. Pursuant to
paragraph (f)(3)(iii)(C) of this section, the district director examines
whether the uncontrolled comparables realized similar losses over a
comparable period of time, and finds that each of the five comparables
realized losses in only one of the five years, and their average result
over the five-year period was a profit. Based on this data, the district
director may conclude that the controlled taxpayer's results are not
within the arm's length range over the five year period, since the
economic conditions that resulted in the controlled taxpayer's loss did
not have a comparable effect over a comparable period of time on the
uncontrolled comparables.
Example 4. (i) USP, a U.S. corporation, manufactures product Y in
the United States and sells it to FSub, which acts as USP's exclusive
distributor of product Y in Country N. The resale price method described
in Sec. 1.482-3(c) is used to evaluate whether the transfer price
charged by USP to FSub for the 1994 taxable year for product Y was arm's
length. For the period 1992 through 1994, FSub had a gross profit margin
for each year of 13%. A, B, C and D are uncontrolled distributors of
products that compete directly
[[Page 618]]
with product Y in country N. After making appropriate adjustments in
accordance with Sec. Sec. 1.482-1(d)(2) and 1.482-3(c), the gross
profit margins for A, B, C, and D are as follows:
------------------------------------------------------------------------
1992 1993 1994 Average
------------------------------------------------------------------------
A................................... 13 3 8 8.00
B................................... 11 13 2 8.67
7C.................................. 4 7 13 8.00
7D.................................. 7 9 6 7.33
------------------------------------------------------------------------
(ii) Applying the provisions of Sec. 1.482-1(e), the district
director determines that the arm's length range of the average gross
profit margins is between 7.33 and 8.67. The district director concludes
that FSub's average gross margin of 13% is not within the arm's length
range, despite the fact that C's gross profit margin for 1994 was also
13%, since the economic conditions that caused S's result did not have a
comparable effect over a comparable period of time on the results of C
or the other uncontrolled comparables. In this case, the district
director makes an allocation equivalent to adjusting FSub's gross profit
margin for 1994 from 13% to the mean of the uncontrolled comparables'
results for 1994 (7.25%).
(iv) Product lines and statistical techniques. The methods described
in Sec. Sec. 1.482-2 through 1.482-6 are generally stated in terms of
individual transactions. However, because a taxpayer may have controlled
transactions involving many different products, or many separate
transactions involving the same product, it may be impractical to
analyze every individual transaction to determine its arm's length
price. In such cases, it is permissible to evaluate the arm's length
results by applying the appropriate methods to the overall results for
product lines or other groupings. In addition, the arm's length results
of all related party transactions entered into by a controlled taxpayer
may be evaluated by employing sampling and other valid statistical
techniques.
(v) Allocations apply to results, not methods--(A) In general. In
evaluating whether the result of a controlled transaction is arm's
length, it is not necessary for the district director to determine
whether the method or procedure that a controlled taxpayer employs to
set the terms for its controlled transactions corresponds to the method
or procedure that might have been used by a taxpayer dealing at arm's
length with an uncontrolled taxpayer. Rather, the district director will
evaluate the result achieved rather than the method the taxpayer used to
determine its prices.
(B) Example. The following example illustrates this paragraph
(f)(2)(v).
Example. (i) FS is a foreign subsidiary of P, a U.S. corporation. P
manufactures and sells household appliances. FS operates as P's
exclusive distributor in Europe. P annually establishes the price for
each of its appliances sold to FS as part of its annual budgeting,
production allocation and scheduling, and performance evaluation
processes. FS's aggregate gross margin earned in its distribution
business is 18%.
(ii) ED is an uncontrolled European distributor of competing
household appliances. After adjusting for minor differences in the level
of inventory, volume of sales, and warranty programs conducted by FS and
ED, ED's aggregate gross margin is also 18%. Thus, the district director
may conclude that the aggregate prices charged by P for its appliances
sold to FS are arm's length, without determining whether the budgeting,
production, and performance evaluation processes of P are similar to
such processes used by ED.
(g) Collateral adjustments with respect to allocations under section
482--(1) In general. The district director will take into account
appropriate collateral adjustments with respect to allocations under
section 482. Appropriate collateral adjustments may include correlative
allocations, conforming adjustments, and setoffs, as described in this
paragraph (g).
(2) Correlative allocations--(i) In general. When the district
director makes an allocation under section 482 (referred to in this
paragraph (g)(2) as the primary allocation), appropriate correlative
allocations will also be made with respect to any other member of the
group affected by the allocation. Thus, if the district director makes
an allocation of income, the district director will not only increase
the income of one member of the group, but correspondingly decrease the
income of the other member. In addition, where appropriate, the district
director may make such further correlative allocations as may be
required by the initial correlative allocation.
(ii) Manner of carrying out correlative allocation. The district
director will furnish to the taxpayer with respect to which the primary
allocation is made a
[[Page 619]]
written statement of the amount and nature of the correlative
allocation. The correlative allocation must be reflected in the
documentation of the other member of the group that is maintained for
U.S. tax purposes, without regard to whether it affects the U.S. income
tax liability of the other member for any open year. In some
circumstances the allocation will have an immediate U.S. tax effect, by
changing the taxable income computation of the other member (or the
taxable income computation of a shareholder of the other member, for
example, under the provisions of subpart F of the Internal Revenue
Code). Alternatively, the correlative allocation may not be reflected on
any U.S. tax return until a later year, for example when a dividend is
paid.
(iii) Events triggering correlative allocation. For purposes of this
paragraph (g)(2), a primary allocation will not be considered to have
been made (and therefore, correlative allocations are not required to be
made) until the date of a final determination with respect to the
allocation under section 482. For this purpose, a final determination
includes--
(A) Assessment of tax following execution by the taxpayer of a Form
870 (Waiver of Restrictions on Assessment and Collection of Deficiency
in Tax and Acceptance of Overassessment) with respect to such
allocation;
(B) Acceptance of a Form 870-AD (Offer of Waiver of Restriction on
Assessment and Collection of Deficiency in Tax and Acceptance of
Overassessment);
(C) Payment of the deficiency;
(D) Stipulation in the Tax Court of the United States; or
(E) Final determination of tax liability by offer-in-compromise,
closing agreement, or final resolution (determined under the principles
of section 7481) of a judicial proceeding.
(iv) Examples. The following examples illustrate this paragraph
(g)(2). In each example, X and Y are members of the same group of
controlled taxpayers and each regularly computes its income on a
calendar year basis.
Example 1. (i) In 1996, Y, a U.S. corporation, rents a building
owned by X, also a U.S. corporation. In 1998 the district director
determines that Y did not pay an arm's length rental charge. The
district director proposes to increase X's income to reflect an arm's
length rental charge. X consents to the assessment reflecting such
adjustment by executing Form 870, a Waiver of Restrictions on Assessment
and Collection of Deficiency in Tax and Acceptance of Overassessment.
The assessment of the tax with respect to the adjustment is made in
1998. Thus, the primary allocation, as defined in paragraph (g)(2)(i) of
this section, is considered to have been made in 1998.
(ii) The adjustment made to X's income under section 482 requires a
correlative allocation with respect to Y's income. The district director
notifies X in writing of the amount and nature of the adjustment made
with respect to Y. Y had net operating losses in 1993, 1994, 1995, 1996,
and 1997. Although a correlative adjustment will not have an effect on
Y's U.S. income tax liability for 1996, an adjustment increasing Y's net
operating loss for 1996 will be made for purposes of determining Y's
U.S. income tax liability for 1998 or a later taxable year to which the
increased net operating loss may be carried.
Example 2. (i) In 1995, X, a U.S. construction company, provided
engineering services to Y, a U.S. corporation, in the construction of
Y's factory. In 1997, the district director determines that the fees
paid by Y to X for its services were not arm's length and proposes to
make an adjustment to the income of X. X consents to an assessment
reflecting such adjustment by executing Form 870. An assessment of the
tax with respect to such adjustment is made in 1997. The district
director notifies X in writing of the amount and nature of the
adjustment to be made with respect to Y.
(ii) The fees paid by Y for X's engineering services properly
constitute a capital expenditure. Y does not place the factory into
service until 1998. Therefore, a correlative adjustment increasing Y's
basis in the factory does not affect Y's U.S. income tax liability for
1997. However, the correlative adjustment must be made in the books and
records maintained by Y for its U.S. income tax purposes and such
adjustment will be taken into account in computing Y's allowable
depreciation or gain or loss on a subsequent disposition of the factory.
Example 3. In 1995, X, a U.S. corporation, makes a loan to Y, its
foreign subsidiary not engaged in a U.S. trade or business. In 1997, the
district director, upon determining that the interest charged on the
loan was not arm's length, proposes to adjust X's income to reflect an
arm's length interest rate. X consents to an assessment reflecting such
allocation by executing Form 870, and an assessment of the tax with
respect to the section 482 allocation is made in 1997. The district
director notifies X in writing of the
[[Page 620]]
amount and nature of the correlative allocation to be made with respect
to Y. Although the correlative adjustment does not have an effect on Y's
U.S. income tax liability, the adjustment must be reflected in the
documentation of Y that is maintained for U.S. tax purposes. Thus, the
adjustment must be reflected in the determination of the amount of Y's
earnings and profits for 1995 and subsequent years, and the adjustment
must be made to the extent it has an effect on any person's U.S. income
tax liability for any taxable year.
(3) Adjustments to conform accounts to reflect section 482
allocations--(i) In general. Appropriate adjustments must be made to
conform a taxpayer's accounts to reflect allocations made under section
482. Such adjustments may include the treatment of an allocated amount
as a dividend or a capital contribution (as appropriate), or, in
appropriate cases, pursuant to such applicable revenue procedures as may
be provided by the Commissioner (see Sec. 601.601(d)(2) of this
chapter), repayment of the allocated amount without further income tax
consequences.
(ii) Example. The following example illustrates the principles of
this paragraph (g)(3).
Example. Conforming cash accounts. (i) USD, a United States
corporation, buys Product from its foreign parent, FP. In reviewing
USD's income tax return, the district director determines that the arm's
length price would have increased USD's taxable income by $5 million.
The district director accordingly adjusts USD's income to reflect its
true taxable income.
(ii) To conform its cash accounts to reflect the section 482
allocation made by the district director, USD applies for relief under
Rev. Proc. 65-17, 1965-1 C.B. 833 (see Sec. 601.601(d)(2)(ii)(b) of
this chapter), to treat the $5 million adjustment as an account
receivable from FP, due as of the last day of the year of the
transaction, with interest accruing therefrom.
(4) Setoffs--(i) In general. If an allocation is made under section
482 with respect to a transaction between controlled taxpayers, the
Commissioner will take into account the effect of any other non-arm's
length transaction between the same controlled taxpayers in the same
taxable year which will result in a setoff against the original section
482 allocation. Such setoff, however, will be taken into account only if
the requirements of paragraph (g)(4)(ii) of this section are satisfied.
If the effect of the setoff is to change the characterization or source
of the income or deductions, or otherwise distort taxable income, in
such a manner as to affect the U.S. tax liability of any member,
adjustments will be made to reflect the correct amount of each category
of income or deductions. For purposes of this setoff provision, the term
arm's length refers to the amount defined in paragraph (b) of this
section (arm's length standard), without regard to the rules in Sec.
1.482-2(a) that treat certain interest rates as arm's length rates of
interest.
(ii) Requirements. The district director will take a setoff into
account only if the taxpayer--
(A) Establishes that the transaction that is the basis of the setoff
was not at arm's length and the amount of the appropriate arm's length
charge;
(B) Documents, pursuant to paragraph (g)(2) of this section, all
correlative adjustments resulting from the proposed setoff; and
(C) Notifies the district director of the basis of any claimed
setoff within 30 days after the earlier of the date of a letter by which
the district director transmits an examination report notifying the
taxpayer of proposed adjustments or the date of the issuance of the
notice of deficiency.
(iii) Examples. The following examples illustrate this paragraph
(g)(4).
Example 1. P, a U.S. corporation, renders construction services to
S, its foreign subsidiary in Country Y, in connection with the
construction of S's factory. An arm's length charge for such services
determined under Sec. 1.482-9 would be $100,000. During the same
taxable year P makes available to S the use of a machine to be used in
the construction of the factory, and the arm's length rental value of
the machine is $25,000. P bills S $125,000 for the services, but does
not charge S for the use of the machine. No allocation will be made with
respect to the undercharge for the machine if P notifies the district
director of the basis of the claimed setoff within 30 days after the
date of the letter from the district director transmitting the
examination report notifying P of the proposed adjustment, establishes
that the excess amount charged for services was equal to an arm's length
charge for the use of the machine and that the taxable income and income
tax liabilities of P are not distorted,
[[Page 621]]
and documents the correlative allocations resulting from the proposed
setoff.
Example 2. The facts are the same as in Example 1, except that, if P
had reported $25,000 as rental income and $25,000 less as service
income, it would have been subject to the tax on personal holding
companies. Allocations will be made to reflect the correct amounts of
rental income and service income.
(h) Special rules--(1) Small taxpayer safe harbor. [Reserved]
(2) Effect of foreign legal restrictions--(i) In general. The
district director will take into account the effect of a foreign legal
restriction to the extent that such restriction affects the results of
transactions at arm's length. Thus, a foreign legal restriction will be
taken into account only to the extent that it is shown that the
restriction affected an uncontrolled taxpayer under comparable
circumstances for a comparable period of time. In the absence of
evidence indicating the effect of the foreign legal restriction on
uncontrolled taxpayers, the restriction will be taken into account only
to the extent provided in paragraphs (h)(2) (iii) and (iv) of this
section (Deferred income method of accounting).
(ii) Applicable legal restrictions. Foreign legal restrictions
(whether temporary or permanent) will be taken into account for purposes
of this paragraph (h)(2) only if, and so long as, the conditions set
forth in paragraphs (h)(2)(ii) (A) through (D) of this section are met.
(A) The restrictions are publicly promulgated, generally applicable
to all similarly situated persons (both controlled and uncontrolled),
and not imposed as part of a commercial transaction between the taxpayer
and the foreign sovereign;
(B) The taxpayer (or other member of the controlled group with
respect to which the restrictions apply) has exhausted all remedies
prescribed by foreign law or practice for obtaining a waiver of such
restrictions (other than remedies that would have a negligible prospect
of success if pursued);
(C) The restrictions expressly prevented the payment or receipt, in
any form, of part or all of the arm's length amount that would otherwise
be required under section 482 (for example, a restriction that applies
only to the deductibility of an expense for tax purposes is not a
restriction on payment or receipt for this purpose); and
(D) The related parties subject to the restriction did not engage in
any arrangement with controlled or uncontrolled parties that had the
effect of circumventing the restriction, and have not otherwise violated
the restriction in any material respect.
(iii) Requirement for electing the deferred income method of
accounting. If a foreign legal restriction prevents the payment or
receipt of part or all of the arm's length amount that is due with
respect to a controlled transaction, the restricted amount may be
treated as deferrable if the following requirements are met--
(A) The controlled taxpayer establishes to the satisfaction of the
district director that the payment or receipt of the arm's length amount
was prevented because of a foreign legal restriction and circumstances
described in paragraph (h)(2)(ii) of this section; and
(B) The controlled taxpayer whose U.S. tax liability may be affected
by the foreign legal restriction elects the deferred income method of
accounting, as described in paragraph (h)(2)(iv) of this section, on a
written statement attached to a timely U.S. income tax return (or an
amended return) filed before the IRS first contacts any member of the
controlled group concerning an examination of the return for the taxable
year to which the foreign legal restriction applies. A written statement
furnished by a taxpayer subject to the Coordinated Examination Program
will be considered an amended return for purposes of this paragraph
(h)(2)(iii)(B) if it satisfies the requirements of a qualified amended
return for purposes of Sec. 1.6664-2(c)(3) as set forth in those
regulations or as the Commissioner may prescribe by applicable revenue
procedures. The election statement must identify the affected
transactions, the parties to the transactions, and the applicable
foreign legal restrictions.
(iv) Deferred income method of accounting. If the requirements of
paragraph (h)(2)(ii) of this section are satisfied, any portion of the
arm's length amount, the payment or receipt of
[[Page 622]]
which is prevented because of applicable foreign legal restrictions,
will be treated as deferrable until payment or receipt of the relevant
item ceases to be prevented by the foreign legal restriction. For
purposes of the deferred income method of accounting under this
paragraph (h)(2)(iv), deductions (including the cost or other basis of
inventory and other assets sold or exchanged) and credits properly
chargeable against any amount so deferred, are subject to deferral under
the provisions of Sec. 1.461- 1(a)(4). In addition, income is
deferrable under this deferred income method of accounting only to the
extent that it exceeds the related deductions already claimed in open
taxable years to which the foreign legal restriction applied.
(v) Examples. The following examples, in which Sub is a Country FC
subsidiary of U.S. corporation, Parent, illustrate this paragraph
(h)(2).
Example 1. Parent licenses an intangible to Sub. FC law generally
prohibits payments by any person within FC to recipients outside the
country. The FC law meets the requirements of paragraph (h)(2)(ii) of
this section. There is no evidence of unrelated parties entering into
transactions under comparable circumstances for a comparable period of
time, and the foreign legal restrictions will not be taken into account
in determining the arm's length amount. The arm's length royalty rate
for the use of the intangible property in the absence of the foreign
restriction is 10% of Sub's sales in country FC. However, because the
requirements of paragraph (h)(2)(ii) of this section are satisfied,
Parent can elect the deferred income method of accounting by attaching
to its timely filed U.S. income tax return a written statement that
satisfies the requirements of paragraph (h)(2)(iii)(B) of this section.
Example 2. (i) The facts are the same as in Example 1, except that
Sub, although it makes no royalty payment to Parent, arranges with an
unrelated intermediary to make payments equal to an arm's length amount
on its behalf to Parent.
(ii) The district director makes an allocation of royalty income to
Parent, based on the arm's length royalty rate of 10%. Further, the
district director determines that because the arrangement with the third
party had the effect of circumventing the FC law, the requirements of
paragraph (h)(2)(ii)(D) of this section are not satisfied. Thus, Parent
could not validly elect the deferred income method of accounting, and
the allocation of royalty income cannot be treated as deferrable. In
appropriate circumstances, the district director may permit the amount
of the distribution to be treated as payment by Sub of the royalty
allocated to Parent, under the provisions of Sec. 1.482-1(g)
(Collateral adjustments).
Example 3. The facts are the same as in Example 1, except that the
laws of FC do not prevent distributions from corporations to their
shareholders. Sub distributes an amount equal to 8% of its sales in
country FC. Because the laws of FC did not expressly prevent all forms
of payment from Sub to Parent, Parent cannot validly elect the deferred
income method of accounting with respect to any of the arm's length
royalty amount. In appropriate circumstances, the district director may
permit the 8% that was distributed to be treated as payment by Sub of
the royalty allocated to Parent, under the provisions of Sec. 1.482-
1(g) (Collateral adjustments).
Example 4. The facts are the same as in Example 1, except that
Country FC law permits the payment of a royalty, but limits the amount
to 5% of sales, and Sub pays the 5% royalty to Parent. Parent
demonstrates the existence of a comparable uncontrolled transaction for
purposes of the comparable uncontrolled transaction method in which an
uncontrolled party accepted a royalty rate of 5%. Given the evidence of
the comparable uncontrolled transaction, the 5% royalty rate is
determined to be the arm's length royalty rate.
(3) Coordination with section 936--(i) Cost sharing under section
936. If a possessions corporation makes an election under section
936(h)(5)(C)(i)(I), the corporation must make a section 936 cost sharing
payment that is at least equal to the payment that would be required
under section 482 if the electing corporation were a foreign
corporation. In determining the payment that would be required under
section 482 for this purpose, the provisions of Sec. Sec. 1.482-1 and
1.482-4 will be applied, and to the extent relevant to the valuation of
intangibles, Sec. Sec. 1.482-5 and 1.482-6 will be applied. The
provisions of section 936(h)(5)(C)(i)(II) (Effect of Election--electing
corporation treated as owner of intangible property) do not apply until
the payment that would be required under section 482 has been
determined.
(ii) Use of terms. A cost sharing payment, for the purposes of
section 936(h)(5)(C)(i)(I), is calculated using the provisions of
section 936 and the regulations thereunder and the provisions of this
paragraph (h)(3). The provisions relating to cost sharing under section
[[Page 623]]
482 do not apply to payments made pursuant to an election under section
936(h)(5)(C)(i)(I). Similarly, a profit split payment, for the purposes
of section 936(h)(5)(C)(ii)(I), is calculated using the provisions of
section 936 and the regulations thereunder, not section 482 and the
regulations thereunder.
(i) Definitions. The definitions set forth in paragraphs (i)(1)
through (i)(10) of this section apply to this section and Sec. Sec.
1.482-2 through 1.482-9.
(1) Organization includes an organization of any kind, whether a
sole proprietorship, a partnership, a trust, an estate, an association,
or a corporation (as each is defined or understood in the Internal
Revenue Code or the regulations thereunder), irrespective of the place
of organization, operation, or conduct of the trade or business, and
regardless of whether it is a domestic or foreign organization, whether
it is an exempt organization, or whether it is a member of an affiliated
group that files a consolidated U.S. income tax return, or a member of
an affiliated group that does not file a consolidated U.S. income tax
return.
(2) Trade or business includes a trade or business activity of any
kind, regardless of whether or where organized, whether owned
individually or otherwise, and regardless of the place of operation.
Employment for compensation will constitute a separate trade or business
from the employing trade or business.
(3) Taxpayer means any person, organization, trade or business,
whether or not subject to any internal revenue tax.
(4) Controlled includes any kind of control, direct or indirect,
whether legally enforceable or not, and however exercisable or
exercised, including control resulting from the actions of two or more
taxpayers acting in concert or with a common goal or purpose. It is the
reality of the control that is decisive, not its form or the mode of its
exercise. A presumption of control arises if income or deductions have
been arbitrarily shifted.
(5) Controlled taxpayer means any one of two or more taxpayers owned
or controlled directly or indirectly by the same interests, and includes
the taxpayer that owns or controls the other taxpayers. Uncontrolled
taxpayer means any one of two or more taxpayers not owned or controlled
directly or indirectly by the same interests.
(6) Group, controlled group, and group of controlled taxpayers mean
the taxpayers owned or controlled directly or indirectly by the same
interests.
(7) Transaction means any sale, assignment, lease, license, loan,
advance, contribution, or any other transfer of any interest in or a
right to use any property (whether tangible or intangible, real or
personal) or money, however such transaction is effected, and whether or
not the terms of such transaction are formally documented. A transaction
also includes the performance of any services for the benefit of, or on
behalf of, another taxpayer.
(8) Controlled transaction or controlled transfer means any
transaction or transfer between two or more members of the same group of
controlled taxpayers. The term uncontrolled transaction means any
transaction between two or more taxpayers that are not members of the
same group of controlled taxpayers.
(9) True taxable income means, in the case of a controlled taxpayer,
the taxable income that would have resulted had it dealt with the other
member or members of the group at arm's length. It does not mean the
taxable income resulting to the controlled taxpayer by reason of the
particular contract, transaction, or arrangement the controlled taxpayer
chose to make (even though such contract, transaction, or arrangement is
legally binding upon the parties thereto).
(10) Uncontrolled comparable means the uncontrolled transaction or
uncontrolled taxpayer that is compared with a controlled transaction or
taxpayer under any applicable pricing methodology. Thus, for example,
under the comparable profits method, an uncontrolled comparable is any
uncontrolled taxpayer from which data is used to establish a comparable
operating profit.
(j) Effective dates--(1) The regulations in this are generally
effective for taxable years beginning after October 6, 1994.
(2) Taxpayers may elect to apply retroactively all of the provisions
of these regulations for any open taxable
[[Page 624]]
year. Such election will be effective for the year of the election and
all subsequent taxable years.
(3) Although these regulations are generally effective for taxable
years as stated, the final sentence of section 482 (requiring that the
income with respect to transfers or licenses of intangible property be
commensurate with the income attributable to the intangible) is
generally effective for taxable years beginning after December 31, 1986.
For the period prior to the effective date of these regulations, the
final sentence of section 482 must be applied using any reasonable
method not inconsistent with the statute. The IRS considers a method
that applies these regulations or their general principles to be a
reasonable method.
(4) These regulations will not apply with respect to transfers made
or licenses granted to foreign persons before November 17, 1985, or
before August 17, 1986, for transfers or licenses to others.
Nevertheless, they will apply with respect to transfers or licenses
before such dates if, with respect to property transferred pursuant to
an earlier and continuing transfer agreement, such property was not in
existence or owned by the taxpayer on such date.
(5) The last sentences of paragraphs (b)(2)(i) and (c)(1) of this
section and of paragraph (c)(2)(iv) of Sec. 1.482-5 apply for taxable
years beginning on or after August 26, 2003.
(6)(i) The provisions of paragraphs (a)(1), (d)(3)(ii)(C) Example 3,
Example 4, Example 5, and Example 6, (d)(3)(v), (f)(2)(ii)(A),
(f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii), and (i) of this section are
generally applicable for taxable years beginning after July 31, 2009.
The provision of paragraph (b)(2)(iii) of this section is generally
applicable on January 5, 2009.
(ii) A person may elect to apply the provisions of paragraphs
(a)(1), (b)(2)(i), (d)(3)(ii)(C) Example 3, Example 4, Example 5, and
Example 6, (d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i),
(g)(4)(iii), and (i) of this section to earlier taxable years in
accordance with the rules set forth in Sec. 1.482-9(n)(2).
(7) [Reserved]. For further guidance see Sec. 1.482-1T(j)(7).
[T.D. 8552, 59 FR 34990, July 8, 1994, as amended by T.D. 9088, 68 FR
51177, Aug. 26, 2003; T.D. 9278, 71 FR 44481, Aug. 4, 2006; 71 FR 76903,
Dec. 22, 2006; T.D. 9441, 74 FR 351, Jan. 5, 2009; T.D. 9456, 74 FR
38839, Aug. 4, 2009; 74 FR 46345, Sept. 9, 2009; T.D. 9568, 76 FR 80089,
Dec. 22, 2011; 77 FR 3606, Jan. 25, 2012; T.D. 9738, 80 FR 55541, Sept.
16, 2015]
Sec. 1.482-1T Allocation of income and deductions among taxpayers
(temporary).
(a) through (f)(2) [Reserved]. For further guidance see Sec. 1.482-
1(a) through (f)(2).
(i) Compensation independent of the form or character of controlled
transaction--(A) In general. All value provided between controlled
taxpayers in a controlled transaction requires an arm's length amount of
compensation determined under the best method rule of Sec. 1.482-1(c).
Such amount must be consistent with, and must account for all of, the
value provided between the parties in the transaction, without regard to
the form or character of the transaction. For this purpose, it is
necessary to consider the entire arrangement between the parties, as
determined by the contractual terms, whether written or imputed in
accordance with the economic substance of the arrangement, in light of
the actual conduct of the parties. See, e.g., Sec. 1.482-1(d)(3)(ii)(B)
(identifying contractual terms) and (f)(2)(ii)(A) (regarding reference
to realistic alternatives).
(B) Aggregation. The combined effect of two or more separate
transactions (whether before, during, or after the year under review),
including for purposes of an analysis under multiple provisions of the
Code or regulations, may be considered if the transactions, taken as a
whole, are so interrelated that an aggregate analysis of the
transactions provides the most reliable measure of an arm's length
result determined under the best method rule of Sec. 1.482-1(c).
Whether two or more transactions are evaluated separately or in the
aggregate depends on the extent to which the transactions are
economically interrelated and on the relative reliability of the measure
of an arm's length result provided by an aggregate
[[Page 625]]
analysis of the transactions as compared to a separate analysis of each
transaction. For example, consideration of the combined effect of two or
more transactions may be appropriate to determine whether the overall
compensation in the transactions is consistent with the value provided,
including any synergies among items and services provided.
(C) Coordinated best method analysis and evaluation. Consistent with
the principles of paragraphs (f)(2)(i)(A) and (B) of this section, a
coordinated best method analysis and evaluation of two or more
controlled transactions to which one or more provisions of the Code or
regulations apply may be necessary to ensure that the overall value
provided, including any synergies, is properly taken into account. A
coordinated best method analysis would include a consistent
consideration of the facts and circumstances of the functions performed,
resources employed, and risks assumed in the relevant transactions, and
a consistent measure of the arm's length results, for purposes of all
relevant statutory and regulatory provisions.
(D) Allocations of value. In some cases, it may be necessary to
allocate one or more portions of the arm's length result that was
properly determined under a coordinated best method analysis described
in paragraph (f)(2)(i)(C) of this section. Any such allocation of the
arm's length result determined under the coordinated best method
analysis must be made using the method that, under the facts and
circumstances, provides the most reliable measure of an arm's length
result for each allocated amount. For example, if the full value of
compensation due in controlled transactions whose tax treatment is
governed by multiple provisions of the Code or regulations has been most
reliably determined on an aggregate basis, then that full value must be
allocated in a manner that provides the most reliable measure of each
allocated amount.
(E) Examples. The following examples illustrate the provisions of
this paragraph (f)(2)(i). For purposes of the examples in this paragraph
(E), P is a domestic corporation, and S1, S2, and S3 are foreign
corporations that are wholly owned by P.
Example 1. Aggregation of interrelated licensing, manufacturing, and
selling activities. P enters into a license agreement with S1 that
permits S1 to use a proprietary manufacturing process and to sell the
output from this process throughout a specified region. S1 uses the
manufacturing process and sells its output to S2, which in turn resells
the output to uncontrolled parties in the specified region. In
evaluating whether the royalty paid by S1 to P is an arm's length
amount, it may be appropriate to evaluate the royalty in combination
with the transfer prices charged by S1 to S2 and the aggregate profits
earned by S1 and S2 from the use of the manufacturing process and the
sale to uncontrolled parties of the products produced by S1.
Example 2. Aggregation of interrelated manufacturing, marketing, and
services activities. S1 is the exclusive Country Z distributor of
computers manufactured by P. S2 provides marketing services in
connection with sales of P computers in Country Z and in this regard
uses significant marketing intangibles provided by P. S3 administers the
warranty program with respect to P computers in Country Z, including
maintenance and repair services. In evaluating whether the transfer
prices paid by S1 to P, the fees paid by S2 to P for the use of P
marketing intangibles, and the service fees earned by S2 and S3 are
arm's length amounts, it would be appropriate to perform an aggregate
analysis that considers the combined effects of these interrelated
transactions if they are most reliably analyzed on an aggregated basis.
Example 3. Aggregation and reliability of comparable uncontrolled
transactions. The facts are the same as in Example 2. In addition, U1,
U2, and U3 are uncontrolled taxpayers that carry out functions
comparable to those of S1, S2, and S3, respectively, with respect to
computers produced by unrelated manufacturers. R1, R2, and R3 constitute
a controlled group of taxpayers (unrelated to the P controlled group)
that carry out functions comparable to those of S1, S2, and S3 with
respect to computers produced by their common parent. Prices charged to
uncontrolled customers of the R group differ from the prices charged to
customers of U1, U2, and U3. In determining whether the transactions of
U1, U2, and U3, or the transactions of R1, R2, and R3, would provide a
more reliable measure of the arm's length result, it is determined that
the interrelated R group transactions are more reliable than the wholly
independent transactions of U1, U2, and U3, given the interrelationship
of the P group transactions.
Example 4. Non-aggregation of transactions that are not
interrelated. P enters into a license agreement with S1 that permits S1
to
[[Page 626]]
use a proprietary process for manufacturing product X and to sell
product X to uncontrolled parties throughout a specified region. P also
sells to S1 product Y, which is manufactured by P in the United States
and unrelated to product X. Product Y is resold by S1 to uncontrolled
parties in the specified region. There is no connection between product
X and product Y other than the fact that they are both sold in the same
specified region. In evaluating whether the royalty paid by S1 to P for
the use of the manufacturing process for product X and the transfer
prices charged for unrelated product Y are arm's length amounts, it
would not be appropriate to consider the combined effects of these
separate and unrelated transactions.
Example 5. Aggregation of interrelated patents. P owns 10 individual
patents that, in combination, can be used to manufacture and sell a
successful product. P anticipates that it could earn profits of $25x
from the patents based on a discounted cash flow analysis that provides
a more reliable measure of the value of the patents exploited as a
bundle rather than separately. P licenses all 10 patents to S1 to be
exploited as a bundle. Evidence of uncontrolled licenses of similar
individual patents indicates that, exploited separately, each license of
each patent would warrant a price of $1x, implying a total price for the
patents of $10x. Under paragraph (f)(2)(i)(B) of this section, in
determining the arm's length royalty for the license of the bundle of
patents, it would not be appropriate to use the uncontrolled licenses as
comparables for the license of the bundle of patents, because, unlike
the discounted cash flow analysis, the uncontrolled licenses considered
separately do not reliably reflect the enhancement to value resulting
from the interrelatedness of the 10 patents exploited as a bundle.
Example 6. Consideration of entire arrangement, including imputed
contractual terms--(i) P conducts a business (``Business'') from the
United States, with a worldwide clientele, but until Date X has no
foreign operations. The success of Business significantly depends on
intangibles (including marketing, manufacturing, technological, and
goodwill or going concern value intangibles, collectively the ``IP''),
as well as ongoing support activities performed by P (including related
research and development, central marketing, manufacturing process
enhancement, and oversight activities, collectively ``Support''), to
maintain and improve the IP and otherwise maximize the profitability of
Business.
(ii) On Date X, Year 1, P contributes the foreign rights to conduct
Business, including the foreign rights to the IP, to newly incorporated
S1. S1, utilizing the IP of which it is now the owner, commences foreign
operations consisting of local marketing, manufacturing, and back office
activities in order to conduct and expand Business in the foreign
market.
(iii) Later, on Date Y, Year 1, P and S1 enter into a cost sharing
arrangement (``CSA'') to develop and exploit the rights to conduct the
Business. Under the CSA, P is entitled to the U.S. rights to conduct the
Business, and S1 is entitled to the rest-of-the-world (``ROW'') rights
to conduct the Business. P continues after Date Y to perform the
Support, employing resources, capabilities, and rights that as a factual
matter were not contributed to S1 in the Date X transaction, for the
benefit of the Business worldwide. Pursuant to the CSA, P and S1 share
the costs of P's Support in proportion to their reasonably anticipated
benefit shares from their respective rights to the Business.
(iv) P treats the Date X transaction as a transfer described in
section 351 that is subject to 367 and treats the Date Y transaction as
the commencement of a CSA subject to section 482 and Sec. 1.482-7. P
takes the position that the only platform contribution transactions
(``PCTs'') in connection with the Date Y CSA consist of P's contribution
of the U.S. Business IP rights and S1's contribution of the ROW Business
IP rights of which S1 had become the owner on account of the prior Date
X transaction.
(v) Pursuant to paragraph (f)(2)(i)(A) of this section, in
determining whether an allocation of income is appropriate in Year 1 or
subsequent years, the Commissioner may consider the economic substance
of the entire arrangement between P and S1, including the parties'
actual conduct throughout their relationship, regardless of the form or
character of the contractual arrangement the parties have expressly
adopted. The Commissioner determines that the parties' formal
arrangement fails to reflect the full scope of the value provided
between the parties in accordance with the economic substance of their
arrangement. Therefore, the Commissioner may impute one or more
agreements between P and S1, consistent with the economic substance of
their arrangement, that fully reflect their respective reasonably
anticipated commitments in terms of functions performed, resources
employed, and risks assumed over time. For example, because P continues
after Date Y to perform the Support, employing resources, capabilities,
and rights not contributed to S1, for the benefit of the Business
worldwide, the Commissioner may impute another PCT on Date Y pursuant to
which P commits to so continuing the Support. See Sec. 1.482-
7(b)(1)(ii). The taxpayer may present additional facts that could
indicate whether this or another alternative agreement best reflects the
economic substance of the underlying transactions and course of conduct,
provided that the taxpayer's position fully reflects the value of the
entire arrangement
[[Page 627]]
consistent with the realistic alternatives principle.
Example 7. Distinguishing provision of value from characterization--
(i) P developed a collection of resources, capabilities, and rights
(``Collection'') that it uses on an interrelated basis in ongoing
research and development of computer code that is used to create a
successful line of software products. P can continue to use the
Collection on such interrelated basis in the future to further develop
computer code and, thus, further build on its successful line of
software products. Under Sec. 1.482-7(g)(2)(ix), P determines that the
interquartile range of the net present value of its own use of the
Collection in future research and development and software product
marketing is between $1000x and $1100x, and this range provides the most
reliable measure of the value to P of continuing to use the Collection
on an interrelated basis in future research, development, and
exploitation. Instead, P enters into an exchange described in section
351 in which it transfers certain intangible property related to the
Collection to S1 for use in future research, development, and
exploitation but continues to perform the same development functions
that it did prior to the exchange, now on behalf of S1, under express or
implied commitments in connection with S1's use of the intangible
property. P takes the position that a portion of the Collection,
consisting of computer code and related instruction manuals and similar
intangible property (Portion 1), was transferrable intangible property
and was the subject of the section 351 exchange and compensable under
section 367(d). P claims that another portion of the Collection consists
of items that either do not constitute property for purposes of section
367 or are not transferrable (Portion 2). P then takes the position that
the value of Portion 2 does not give rise to income under section 367(d)
or gain under section 367(a).
(ii) Under paragraphs (f)(2)(i)(A) and (C) of this section, any part
of the value in Portion 2 that is not taken into account in an exchange
under section 367 must nonetheless be evaluated under section 482 and
the regulations thereunder to determine arm's length compensation for
any value provided to S1. Accordingly, even if P's assertion that
certain items were either not property or not capable of being
transferred were correct, arm's length compensation is nonetheless
required for all of the value associated with P's contributions under
the section 482 regulations. Alternatively, the Commissioner may
determine under all the facts and circumstances that P's assertion is
incorrect and that the transaction in fact constitutes an exchange of
property subject to, and therefore to be taken into account under,
section 367. Thus, whether any item that P identifies as being within
Portion 2 is properly characterized as property under section 367
(transferable or otherwise) is irrelevant because any value in Portion 2
that is provided to S1 must be compensated by S1 in a manner consistent
with the $1000x to $1100x interquartile range of the overall value.
Example 8. Arm's length compensation for equivalent provisions of
intangibles under sections 351 and 482. P owns the worldwide rights to
manufacturing and marketing intangibles that it uses to manufacture and
market a product in the United States (``US intangibles'') and the rest
of the world (``ROW intangibles''). P transfers all the ROW intangibles
to S1 in an exchange described in section 351 and retains the US
intangibles. Immediately after the exchange, P and S1 entered into a CSA
described in Sec. 1.482-7(b) that covers all research and development
of intangibles conducted by the parties. A realistic alternative that
was available to P and that would have involved the controlled parties
performing similar functions, employing similar resources, and assuming
similar risks as in the controlled transaction, was to transfer all ROW
intangibles to S1 upon entering into the CSA in a platform contribution
transaction described in Sec. 1.482-7(c), rather than in an exchange
described in section 351 immediately before entering into the CSA. Under
paragraph (f)(2)(i)(A) of this section, the arm's length compensation
for the ROW intangibles must correspond to the value provided between
the parties, regardless of the form of the transaction. Accordingly, the
arm's length compensation for the ROW intangibles is the same in both
scenarios, and the analysis of the amount to be taken into account under
section 367(d) pursuant to Sec. Sec. 1.367(d)-1T(c) and 1.482-4 should
include consideration of the amount that P would have charged for the
realistic alternative determined under Sec. 1.482-7(g) (and Sec.
1.482-4, to the extent of any make-or-sell rights transferred). See
Sec. Sec. 1.482-1(b)(2)(iii) and 1.482-4(g).
Example 9. Aggregation of interrelated manufacturing and marketing
intangibles governed by different statutes and regulations. The facts
are the same as in Example 8 except that P transfers only the ROW
intangibles related to manufacturing to S1 in an exchange described in
section 351 and, upon entering into the CSA, then transfers the ROW
intangibles related to marketing to S1 in a platform contribution
transaction described in Sec. 1.482-7(c) (rather than transferring all
ROW intangibles only upon entering into the CSA or only in a prior
exchange described in section 351). The value of the ROW intangibles
that P transferred in the two transactions is greater in the aggregate,
due to synergies among the different types of ROW intangibles, than if
valued as two separate transactions. Under paragraph (f)(2)(i)(B) of
this section, the arm's length standard requires these
[[Page 628]]
synergies to be taken into account in determining the arm's length
results for the transactions.
Example 10. Services provided using intangibles.--(i) P's worldwide
group produces and markets Product X and subsequent generations of
products, which result from research and development performed by P's
R&D Team. Through this collaboration with respect to P's proprietary
products, the members of the R&D Team have individually and as a group
acquired specialized knowledge and expertise subject to non-disclosure
agreements (collectively, ``knowhow'').
(ii) P arranges for the R&D Team to provide research and development
services to create a new line of products, building on the Product X
platform, to be owned and exploited by S1 in the overseas market. P
asserts that the arm's length charge for the services is only
reimbursement to P of its associated R&D Team compensation costs.
(iii) Even though P did not transfer the platform or the R&D Team to
S1, P is providing value associated with the use of the platform, along
with the value associated with the use of the knowhow, to S1 by way of
the services performed by the R&D Team for S1 using the platform and the
knowhow. The R&D Team's use of intangible property, and any other
valuable resources, in P's provision of services (regardless of whether
the service effects a transfer of intangible property or valuable
resources and regardless of whether the property is relatively high or
low value) must be evaluated under the section 482 regulations,
including the regulations specifically applicable to controlled services
transactions in Sec. 1.482-9, to ensure that P receives arm's length
compensation for any value (attributable to such property or services)
provided to S1 in a controlled transaction. See Sec. Sec. 1.482-4 and
1.482-9(m). Under paragraph (f)(2)(i)(A) of this section, the arm's
length compensation for the services performed by the R&D Team for S1
must be consistent with the value provided to S1, including the value of
the knowhow and any synergies with the platform. Under paragraphs
(f)(2)(i)(B) and (C) of this section, the best method analysis may
determine that the compensation is most reliably determined on an
aggregate basis reflecting the interrelated value of the services and
embedded value of the platform and knowhow.
(iv) In the alternative, the facts are the same as above, except
that P assigns to S1 all or a pertinent portion of the R&D Team and the
relevant rights in the platform. P takes the position that, although the
transferred platform rights must be compensated, the knowhow does not
have substantial value independent of the services of any individual on
the R&D Team and therefore is not an intangible within the meaning of
Sec. 1.482-4(b). In P's view, S1 owes no compensation to P on account
of the R&D Team, as S1 will directly bear the cost of the relevant R&D
Team compensation. However, in assembling and arranging to assign the
relevant R&D Team, and thereby making available the value of the knowhow
to S1, rather than other employees without the knowhow, P is performing
services for S1 under imputed contractual terms based on the parties'
course of conduct. Therefore, even if P's position were correct that the
knowhow is not an intangible under Sec. 1.482-4(b), a position that the
Commissioner may challenge, arm's length compensation is required for
all of the value that P provides to S1 through the interrelated
provision of platform rights, knowhow, and services under paragraphs
(f)(2)(i)(A), (B), and (C) of this section.
Example 11. Allocating arm's length compensation determined under an
aggregate analysis--(i) P provides services to S1, which is incorporated
in Country A. In connection with those services, P licenses intellectual
property to S2, which is incorporated in Country B. S2 sublicenses the
intellectual property to S1.
(ii) Under paragraph (f)(2)(i)(B) of this section, if an aggregate
analysis of the service and license transactions provides the most
reliable measure of an arm's length result, then an aggregate analysis
must be performed. Under paragraph (f)(2)(i)(D) of this section, if an
allocation of the value that results from such an aggregate analysis is
necessary, for example, for purposes of sourcing the services income
that P receives from S1 or determining deductible expenses incurred by
S1, then the value determined under the aggregate analysis must be
allocated using the method that provides the most reliable measure of
the services income and deductible expenses.
(ii)(A) [Reserved]. For further guidance see Sec. 1.482-
1(f)(2)(ii)(A).
(B) Example. The following example illustrates this paragraph
(f)(2)(ii):
Example. P and S are controlled taxpayers. P licenses a proprietary
process to S for S's use in manufacturing product X. Using its sales and
marketing employees, S sells product X to related and unrelated
customers outside the United States. If the license between P and S has
economic substance, the Commissioner ordinarily will not restructure the
taxpayer's transaction to treat P as if it had elected to exploit
directly the manufacturing process. However, because P could have
directly exploited the manufacturing process and manufactured product X
itself, this realistic alternative may be taken into account under Sec.
1.482-4(d) in determining the arm's length consideration for the
controlled transaction. For examples of such an analysis, see Examples 7
and 8 in paragraph (f)(2)(i)(E) of this section and the Example in Sec.
1.482-4(d)(2).
[[Page 629]]
(iii) through (j)(6) [Reserved]. For further guidance see Sec.
1.482-1(f)(2)(iii) through (j)(6).
(7) Certain effective/applicability dates--(i) Paragraphs
(f)(2)(i)(A) through (E) and (f)(2)(ii)(B) of this section apply to
taxable years ending on or after September 14, 2015.
(ii) Expiration date. The applicability of paragraphs (f)(2)(i)(A)
through (E) and (f)(2)(ii)(B) of this section expires on or before
September 14, 2018.
[T.D. 9738, 80 FR 55541, Sept. 16, 2015]
Sec. 1.482-2 Determination of taxable income in specific situations.
(a) Loans or advances--(1) Interest on bona fide indebtedness--(i)
In general. Where one member of a group of controlled entities makes a
loan or advance directly or indirectly to, or otherwise becomes a
creditor of, another member of such group and either charges no
interest, or charges interest at a rate which is not equal to an arm's
length rate of interest (as defined in paragraph (a)(2) of this section)
with respect to such loan or advance, the district director may make
appropriate allocations to reflect an arm's length rate of interest for
the use of such loan or advance.
(ii) Application of paragraph (a) of this section--(A) Interest on
bona fide indebtedness. Paragraph (a) of this section applies only to
determine the appropriateness of the rate of interest charged on the
principal amount of a bona fide indebtedness between members of a group
of controlled entities, including--
(1) Loans or advances of money or other consideration (whether or
not evidenced by a written instrument); and
(2) Indebtedness arising in the ordinary course of business from
sales, leases, or the rendition of services by or between members of the
group, or any other similar extension of credit.
(B) Alleged indebtedness. This paragraph (a) does not apply to so
much of an alleged indebtedness which is not in fact a bona fide
indebtedness, even if the stated rate of interest thereon would be
within the safe haven rates prescribed in paragraph (a)(2)(iii) of this
section. For example, paragraph (a) of this section does not apply to
payments with respect to all or a portion of such alleged indebtedness
where in fact all or a portion of an alleged indebtedness is a
contribution to the capital of a corporation or a distribution by a
corporation with respect to its shares. Similarly, this paragraph (a)
does not apply to payments with respect to an alleged purchase-money
debt instrument given in consideration for an alleged sale of property
between two controlled entities where in fact the transaction
constitutes a lease of the property. Payments made with respect to
alleged indebtedness (including alleged stated interest thereon) shall
be treated according to their substance. See Sec. 1.482-2(a)(3)(i).
(iii) Period for which interest shall be charged--(A) General rule.
This paragraph (a)(1)(iii) is effective for indebtedness arising after
June 30, 1988. See Sec. 1.482-2(a)(3) (26 CFR Part 1 edition revised as
of April 1, 1988) for indebtedness arising before July 1, 1988. Except
as otherwise provided in paragraphs (a)(1)(iii)(B) through (E) of this
section, the period for which interest shall be charged with respect to
a bona fide indebtedness between controlled entities begins on the day
after the day the indebtedness arises and ends on the day the
indebtedness is satisfied (whether by payment, offset, cancellation, or
otherwise). Paragraphs (a)(1)(iii)(B) through (E) of this section
provide certain alternative periods during which interest is not
required to be charged on certain indebtedness. These exceptions apply
only to indebtedness described in paragraph (a)(1)(ii)(A)(2) of this
section (relating to indebtedness incurred in the ordinary course of
business from sales, services, etc., between members of the group) and
not evidenced by a written instrument requiring the payment of interest.
Such amounts are hereinafter referred to as intercompany trade
receivables. The period for which interest is not required to be charged
on intercompany trade receivables under this paragraph (a)(1)(iii) is
called the interest-free period. In general, an intercompany trade
receivable arises at the time economic performance occurs (within the
meaning of section 461(h) and the regulations thereunder) with respect
to the
[[Page 630]]
underlying transaction between controlled entities. For purposes of this
paragraph (a)(1)(iii), the term United States includes any possession of
the United States, and the term foreign country excludes any possession
of the United States.
(B) Exception for certain intercompany transactions in the ordinary
course of business. Interest is not required to be charged on an
intercompany trade receivable until the first day of the third calendar
month following the month in which the intercompany trade receivable
arises.
(C) Exception for trade or business of debtor member located outside
the United States. In the case of an intercompany trade receivable
arising from a transaction in the ordinary course of a trade or business
which is actively conducted outside the United States by the debtor
member, interest is not required to be charged until the first day of
the fourth calendar month following the month in which such intercompany
trade receivable arises.
(D) Exception for regular trade practice of creditor member or
others in creditor's industry. If the creditor member or unrelated
persons in the creditor member's industry, as a regular trade practice,
allow unrelated parties a longer period without charging interest than
that described in paragraph (a)(1)(iii)(B) or (C) of this section
(whichever is applicable) with respect to transactions which are similar
to transactions that give rise to intercompany trade receivables, such
longer interest-free period shall be allowed with respect to a
comparable amount of intercompany trade receivables.
(E) Exception for property purchased for resale in a foreign
country--(1) General rule. If in the ordinary course of business one
member of the group (related purchaser) purchases property from another
member of the group (related seller) for resale to unrelated persons
located in a particular foreign country, the related purchaser and the
related seller may use as the interest-free period for the intercompany
trade receivables arising during the related seller's taxable year from
the purchase of such property within the same product group an interest-
free period equal the sum of--
(i) The number of days in the related purchaser's average collection
period (as determined under paragraph (a)(1)(iii)(E)(2) of this section)
for sales of property within the same product group sold in the ordinary
course of business to unrelated persons located in the same foreign
country; plus
(ii) Ten (10) calendar days.
(2) Interest-free period. The interest-free period under this
paragraph (a)(1)(iii)(E), however, shall in no event exceed 183 days.
The related purchaser does not have to conduct business outside the
United States in order to be eligible to use the interest-free period of
this paragraph (a)(1)(iii)(E). The interest-free period under this
paragraph (a)(1)(iii)(E) shall not apply to intercompany trade
receivables attributable to property which is manufactured, produced, or
constructed (within the meaning of Sec. 1.954-3(a)(4)) by the related
purchaser. For purposes of this paragraph (a)(1)(iii)(E) a product group
includes all products within the same three-digit Standard Industrial
Classification (SIC) Code (as prepared by the Statistical Policy
Division of the Office of Management and Budget, Executive Office of the
President.)
(3) Average collection period. An average collection period for
purposes of this paragraph (a)(1)(iii)(E) is determined as follows--
(i) Step 1. Determine total sales (less returns and allowances) by
the related purchaser in the product group to unrelated persons located
in the same foreign country during the related purchaser's last taxable
year ending on or before the first day of the related seller's taxable
year in which the intercompany trade receivable arises.
(ii) Step 2. Determine the related purchaser's average month-end
accounts receivable balance with respect to sales described in paragraph
(a)(1)(iii)(E)(2)(i) of this section for the related purchaser's last
taxable year ending on or before the first day of the related seller's
taxable year in which the intercompany trade receivable arises.
(iii) Step 3. Compute a receivables turnover rate by dividing the
total sales amount described in paragraph (a)(1)(iii)(E)(2)(i) of this
section by the average receivables balance described
[[Page 631]]
in paragraph (a)(1)(iii)(E)(2)(ii) of this section.
(iv) Step 4. Divide the receivables turnover rate determined under
paragraph (a)(1)(iii)(E)(2)(iii) of this section into 365, and round the
result to the nearest whole number to determine the number of days in
the average collection period.
(v) Other considerations. If the related purchaser makes sales in
more than one foreign country, or sells property in more than one
product group in any foreign country, separate computations of an
average collection period, by product group within each country, are
required. If the related purchaser resells fungible property in more
than one foreign country and the intercompany trade receivables arising
from the related party purchase of such fungible property cannot
reasonably be identified with resales in particular foreign countries,
then solely for the purpose of assigning an interest-free period to such
intercompany trade receivables under this paragraph (a)(1)(iii)(E), an
amount of each such intercompany trade receivable shall be treated as
allocable to a particular foreign country in the same proportion that
the related purchaser's sales of such fungible property in such foreign
country during the period described in paragraph (a)(1)(iii)(E)(2)(i) of
this section bears to the related purchaser's sales of all such fungible
property in all such foreign countries during such period. An interest-
free period under this paragraph (a)(1)(iii)(E) shall not apply to any
intercompany trade receivables arising in a taxable year of the related
seller if the related purchaser made no sales described in paragraph
(a)(1)(iii)(E)(2)(i) of this section from which the appropriate
interest-free period may be determined.
(4) Illustration. The interest-free period provided under paragraph
(a)(1)(iii)(E) of this section may be illustrated by the following
example:
Example. (i)Facts. X and Y use the calendar year as the taxable year
and are members of the same group of controlled entities within the
meaning of section 482. For Y's 1988 calendar taxable year X and Y
intend to use the interest-free period determined under this paragraph
(a)(1)(iii)(E) for intercompany trade receivables attributable to X's
purchases of certain products from Y for resale by X in the ordinary
course of business to unrelated persons in country Z. For its 1987
calendar taxable year all of X's sales in country Z were of products
within a single product group based upon a three-digit SIC code, were
not manufactured, produced, or constructed (within the meaning of Sec.
1.954-3(a)(4)) by X, and were sold in the ordinary course of X's trade
or business to unrelated persons located only in country Z. These sales
and the month-end accounts receivable balances (for such sales and for
such sales uncollected from prior months) are as follows:
------------------------------------------------------------------------
Accounts
Month Sales receivable
------------------------------------------------------------------------
Jan. 1987.................................. $500,000 $2,835,850
Feb........................................ 600,000 2,840,300
Mar........................................ 450,000 2,850,670
Apr........................................ 550,000 2,825,700
May........................................ 650,000 2,809,360
June....................................... 525,000 2,803,200
July....................................... 400,000 2,825,850
Aug........................................ 425,000 2,796,240
Sept....................................... 475,000 2,839,390
Oct........................................ 525,000 2,650,550
Nov........................................ 450,000 2,775,450
Dec. 1987.................................. 650,000 2,812,600
----------------------------
Totals............................... 6,200,000 33,665,160
------------------------------------------------------------------------
(ii) Average collection period. X's total sales within the same
product group to unrelated persons within country Z for the period are
$6,200,000. The average receivables balance for the period is $2,805,430
($33,665,160/12). The average collection period in whole days is
determined as follows:
[GRAPHIC] [TIFF OMITTED] TR08JY94.000
[GRAPHIC] [TIFF OMITTED] TR08JY94.001
[[Page 632]]
(iii) Interest-free period. Accordingly, for intercompany trade
receivables incurred by X during Y's 1988 calendar taxable year
attributable to the purchase of property from Y for resale to unrelated
persons located in country Z and included in the product group, X may
use an interest-free period of 175 days (165 days in the average
collection period plus 10 days, but not in excess of a maximum of 183
days). All other intercompany trade receivables incurred by X are
subject to the interest-free periods described in paragraphs (a)(1)(iii)
(B), (C), or (D), whichever are applicable. If X makes sales in other
foreign countries in addition to country Z or makes sales of property in
more than one product group in any foreign country, separate
computations of X's average collection period, by product group within
each country, are required in order for X and Y to determine an
interest-free period for such product groups in such foreign countries
under this paragraph (a)(1)(iii)(E).
(iv) Payment; book entries--(A) Except as otherwise provided in this
paragraph (a)(1)(iv), in determining the period of time for which an
amount owed by one member of the group to another member is outstanding,
payments or other credits to an account are considered to be applied
against the earliest amount outstanding, that is, payments or credits
are applied against amounts in a first-in, first-out (FIFO) order. Thus,
tracing payments to individual intercompany trade receivables is
generally not required in order to determine whether a particular
intercompany trade receivable has been paid within the applicable
interest-free period determined under paragraph (a)(1)(iii) of this
section. The application of this paragraph (a)(1)(iv)(A) may be
illustrated by the following example:
Example. (i) Facts. X and Y are members of a group of controlled
entities within the meaning of section 482. Assume that the balance of
intercompany trade receivables owed by X to Y on June 1 is $100, and
that all of the $100 balance represents amounts incurred by X to Y
during the month of May. During the month of June X incurs an additional
$200 of intercompany trade receivables to Y. Assume that on July 15, $60
is properly credited against X's intercompany account to Y, and that
$240 is properly credited against the intercompany account on August 31.
Assume that under paragraph (a)(1)(iii)(B) of this section interest must
be charged on X's intercompany trade receivables to Y beginning with the
first day of the third calendar month following the month the
intercompany trade receivables arise, and that no alternative interest-
free period applies. Thus, the interest-free period for intercompany
trade receivables incurred during the month of May ends on July 31, and
the interest-free period for intercompany trade receivables incurred
during the month of June ends on August 31.
(ii) Application of payments. Using a FIFO payment order, the
aggregate payments of $300 are applied first to the opening June
balance, and then to the additional amounts incurred during the month of
June. With respect to X's June opening balance of $100, no interest is
required to be accrued on $60 of such balance paid by X on July 15,
because such portion was paid within its interest-free period. Interest
for 31 days, from August 1 to August 31 inclusive, is required to be
accrued on the $40 portion of the opening balance not paid until August
31. No interest is required to be accrued on the $200 of intercompany
trade receivables X incurred to Y during June because the $240 credited
on August 31, after eliminating the $40 of indebtedness remaining from
periods before June, also eliminated the $200 incurred by X during June
prior to the end of the interest-free period for that amount. The amount
of interest incurred by X to Y on the $40 amount during August creates
bona fide indebtedness between controlled entities and is subject to the
provisions of paragraph (a)(1)(iii)(A) of this section without regard to
any of the exceptions contained in paragraphs (a)(1)(iii)(B) through
(E).
(B) Notwithstanding the first-in, first-out payment application rule
described in paragraph (a)(1)(iv)(A) of this section, the taxpayer may
apply payments or credits against amounts owed in some other order on
its books in accordance with an agreement or understanding of the
related parties if the taxpayer can demonstrate that either it or others
in its industry, as a regular trade practice, enter into such agreements
or understandings in the case of similar balances with unrelated
parties.
(2) Arm's length interest rate--(i) In general. For purposes of
section 482 and paragraph (a) of this section, an arm's length rate of
interest shall be a rate of interest which was charged, or would
[[Page 633]]
have been charged, at the time the indebtedness arose, in independent
transactions with or between unrelated parties under similar
circumstances. All relevant factors shall be considered, including the
principal amount and duration of the loan, the security involved, the
credit standing of the borrower, and the interest rate prevailing at the
situs of the lender or creditor for comparable loans between unrelated
parties.
(ii) Funds obtained at situs of borrower. Notwithstanding the other
provisions of paragraph (a)(2) of this section, if the loan or advance
represents the proceeds of a loan obtained by the lender at the situs of
the borrower, the arm's length rate for any taxable year shall be equal
to the rate actually paid by the lender increased by an amount which
reflects the costs or deductions incurred by the lender in borrowing
such amounts and making such loans, unless the taxpayer establishes a
more appropriate rate under the standards set forth in paragraph
(a)(2)(i) of this section.
(iii) Safe haven interest rates for certain loans and advances made
after May 8, 1986--(A) Applicability--(1) General rule. Except as
otherwise provided in paragraph (a)(2) of this section, paragraph
(a)(2)(iii)(B) applies with respect to the rate of interest charged and
to the amount of interest paid or accrued in any taxable year--
(i) Under a term loan or advance between members of a group of
controlled entities where (except as provided in paragraph
(a)(2)(iii)(A)(2)(ii) of this section) the loan or advance is entered
into after May 8, 1986; and
(ii) After May 8, 1986 under a demand loan or advance between such
controlled entities.
(2) Grandfather rule for existing loans. The safe haven rates
prescribed in paragraph (a)(2)(iii)(B) of this section shall not apply,
and the safe haven rates prescribed in Sec. 1.482-2(a)(2)(iii) (26 CFR
part 1 edition revised as of April 1, 1985), shall apply to--
(i) Term loans or advances made before May 9, 1986; and
(ii) Term loans or advances made before August 7, 1986, pursuant to
a binding written contract entered into before May 9, 1986.
(B) Safe haven interest rate based on applicable Federal rate.
Except as otherwise provided in this paragraph (a)(2), in the case of a
loan or advance between members of a group of controlled entities, an
arm's length rate of interest referred to in paragraph (a)(2)(i) of this
section shall be for purposes of chapter 1 of the Internal Revenue
Code--
(1) The rate of interest actually charged if that rate is--
(i) Not less than 100 percent of the applicable Federal rate (lower
limit); and
(ii) Not greater than 130 percent of the applicable Federal rate
(upper limit); or
(2) If either no interest is charged or if the rate of interest
charged is less than the lower limit, then an arm's length rate of
interest shall be equal to the lower limit, compounded semiannually; or
(3) If the rate of interest charged is greater than the upper limit,
then an arm's length rate of interest shall be equal to the upper limit,
compounded semiannually, unless the taxpayer establishes a more
appropriate compound rate of interest under paragraph (a)(2)(i) of this
section. However, if the compound rate of interest actually charged is
greater than the upper limit and less than the rate determined under
paragraph (a)(2)(i) of this section, or if the compound rate actually
charged is less than the lower limit and greater than the rate
determined under paragraph (a)(2)(i) of this section, then the compound
rate actually charged shall be deemed to be an arm's length rate under
paragraph (a)(2)(i). In the case of any sale-leaseback described in
section 1274(e), the lower limit shall be 110 percent of the applicable
Federal rate, compounded semiannually.
(C) Applicable Federal rate. For purposes of paragraph
(a)(2)(iii)(B) of this section, the term applicable Federal rate means,
in the case of a loan or advance to which this section applies and
having a term of--
(1) Not over 3 years, the Federal short-term rate;
(2) Over 3 years but not over 9 years, the Federal mid-term rate; or
(3) Over 9 years, the Federal long-term rate, as determined under
section 1274(d) in effect on the date such loan
[[Page 634]]
or advance is made. In the case of any sale or exchange between
controlled entities, the lower limit shall be the lowest of the
applicable Federal rates in effect for any month in the 3-calendar-
month period ending with the first calendar month in which there is a
binding written contract in effect for such sale or exchange (lowest 3-
month rate, as defined in section 1274(d)(2)). In the case of a demand
loan or advance to which this section applies, the applicable Federal
rate means the Federal short-term rate determined under section 1274(d)
(determined without regard to the lowest 3-month short term rate
determined under section 1274(d)(2)) in effect for each day on which any
amount of such loan or advance (including unpaid accrued interest
determined under paragraph (a)(2) of this section) is outstanding.
(D) Lender in business of making loans. If the lender in a loan or
advance transaction to which paragraph (a)(2) of this section applies is
regularly engaged in the trade or business of making loans or advances
to unrelated parties, the safe haven rates prescribed in paragraph
(a)(2)(iii)(B) of this section shall not apply, and the arm's length
interest rate to be used shall be determined under the standards
described in paragraph (a)(2)(i) of this section, including reference to
the interest rates charged in such trade or business by the lender on
loans or advances of a similar type made to unrelated parties at and
about the time the loan or advance to which paragraph (a)(2) of this
section applies was made.
(E) Foreign currency loans. The safe haven interest rates prescribed
in paragraph (a)(2)(iii)(B) of this section do not apply to any loan or
advance the principal or interest of which is expressed in a currency
other than U.S. dollars.
(3) Coordination with interest adjustments required under certain
other Code sections. If the stated rate of interest on the stated
principal amount of a loan or advance between controlled entities is
subject to adjustment under section 482 and is also subject to
adjustment under any other section of the Internal Revenue Code (for
example, section 467, 483, 1274 or 7872), section 482 and paragraph (a)
of this section may be applied to such loan or advance in addition to
such other Internal Revenue Code section. After the enactment of the Tax
Reform Act of 1964, Pub. L. 98-369, and the enactment of Pub. L. 99-121,
such other Internal Revenue Code sections include sections 467, 483,
1274 and 7872. The order in which the different provisions shall be
applied is as follows--
(i) First, the substance of the transaction shall be determined; for
this purpose, all the relevant facts and circumstances shall be
considered and any law or rule of law (assignment of income, step
transaction, etc.) may apply. Only the rate of interest with respect to
the stated principal amount of the bona fide indebtedness (within the
meaning of paragraph (a)(1) of this section), if any, shall be subject
to adjustment under section 482, paragraph (a) of this section, and any
other Internal Revenue Code section.
(ii) Second, the other Internal Revenue Code section shall be
applied to the loan or advance to determine whether any amount other
than stated interest is to be treated as interest, and if so, to
determine such amount according to the provisions of such other Internal
Revenue Code section.
(iii) Third, whether or not the other Internal Revenue Code section
applies to adjust the amounts treated as interest under such loan or
advance, section 482 and paragraph (a) of this section may then be
applied by the district director to determine whether the rate of
interest charged on the loan or advance, as adjusted by any other Code
section, is greater or less than an arm's length rate of interest, and
if so, to make appropriate allocations to reflect an arm's length rate
of interest.
(iv) Fourth, section 482 and paragraphs (b) through (d) of this
section and Sec. Sec. 1.482-3 through 1.482-7, if applicable, may be
applied by the district director to make any appropriate allocations,
other than an interest rate adjustment, to reflect an arm's length
transaction based upon the principal amount of the loan or advance and
the interest rate as adjusted under paragraph (a)(3) (i), (ii) or (iii)
of this section. For example, assume that two commonly controlled
taxpayers enter
[[Page 635]]
into a deferred payment sale of tangible property and no interest is
provided, and assume also that section 483 is applied to treat a portion
of the stated sales price as interest, thereby reducing the stated sales
price. If after this recharacterization of a portion of the stated sales
price as interest, the recomputed sales price does not reflect an arm's
length sales price under the principles of Sec. 1.482-3, the district
director may make other appropriate allocations (other than an interest
rate adjustment) to reflect an arm's length sales price.
(4) Examples. The principles of paragraph (a)(3) of this section may
be illustrated by the following examples:
Example 1. An individual, A, transfers $20,000 to a corporation
controlled by A in exchange for the corporation's note which bears
adequate stated interest. The district director recharacterizes the
transaction as a contribution to the capital of the corporation in
exchange for preferred stock. Under paragraph (a)(3)(i) of this section,
section 1.482-2(a) does not apply to the transaction because there is no
bona fide indebtedness.
Example 2. B, an individual, is an employee of Z corporation, and is
also the controlling shareholder of Z. Z makes a term loan of $15,000 to
B at a rate of interest that is less than the applicable Federal rate.
In this instance the other operative Code section is section 7872. Under
section 7872(b), the difference between the amount loaned and the
present value of all payments due under the loan using a discount rate
equal to 100 percent of the applicable Federal rate is treated as an
amount of cash transferred from the corporation to B and the loan is
treated as having original issue discount equal to such amount. Under
paragraph (a)(3)(iii) of this section, section 482 and paragraph (a) of
this section may also be applied by the district director to determine
if the rate of interest charged on this $15,000 loan (100 percent of the
AFR, compounded semiannually, as adjusted by section 7872) is an arm's
length rate of interest. Because the rate of interest on the loan, as
adjusted by section 7872, is within the safe haven range of 100-130
percent of the AFR, compounded semiannually, no further interest rate
adjustments under section 482 and paragraph (a) of this section will be
made to this loan.
Example 3. The facts are the same as in Example 2 except that the
amount lent by Z to B is $9,000, and that amount is the aggregate
outstanding amount of loans between Z and B. Under the $10,000 de
minimis exception of section 7872(c)(3), no adjustment for interest will
be made to this $9,000 loan under section 7872. Under paragraph
(a)(3)(iii) of this section, the district director may apply section 482
and paragraph (a) of this section to this $9,000 loan to determine
whether the rate of interest charged is less than an arm's length rate
of interest, and if so, to make appropriate allocations to reflect an
arm's length rate of interest.
Example 4. X and Y are commonly controlled taxpayers. At a time when
the applicable Federal rate is 12 percent, compounded semiannually, X
sells property to Y in exchange for a note with a stated rate of
interest of 18 percent, compounded semiannually. Assume that the other
applicable Code section to the transaction is section 483. Section 483
does not apply to this transaction because, under section 483(d), there
is no total unstated interest under the contract using the test rate of
interest equal to 100 percent of the applicable Federal rate. Under
paragraph (a)(3)(iii) of this section, section 482 and paragraph (a) of
this section may be applied by the district director to determine
whether the rate of interest under the note is excessive, that is, to
determine whether the 18 percent stated interest rate under the note
exceeds an arm's length rate of interest.
Example 5. Assume that A and B are commonly controlled taxpayers and
that the applicable Federal rate is 10 percent, compounded semiannually.
On June 30, 1986, A sells property to B and receives in exchange B's
purchase-money note in the amount of $2,000,000. The stated interest
rate on the note is 9%, compounded semiannually, and the stated
redemption price at maturity on the note is $2,000,000. Assume that the
other applicable Code section to this transaction is section 1274. As
provided in section 1274A(a) and (b), the discount rate for purposes of
section 1274 will be nine percent, compounded semiannually, because the
stated principal amount of B's note does not exceed $2,800,000. Section
1274 does not apply to this transaction because there is adequate stated
interest on the debt instrument using a discount rate equal to 9%,
compounded semiannually, and the stated redemption price at maturity
does not exceed the stated principal amount. Under paragraph (a)(3)(iii)
of this section, the district director may apply section 482 and
paragraph (a) of this section to this $2,000,000 note to determine
whether the 9% rate of interest charged is less than an arm's length
rate of interest, and if so, to make appropriate allocations to reflect
an arm's length rate of interest.
(b) Rendering of services. For rules governing allocations under
section 482 to reflect an arm's length charge for controlled
transactions involving the rendering of services, see Sec. 1.482-9.
(c) Use of tangible property--(1) General rule. Where possession,
use, or occupancy of tangible property owned or
[[Page 636]]
leased by one member of a group of controlled entities (referred to in
this paragraph as the owner) is transferred by lease or other
arrangement to another member of such group (referred to in this
paragraph as the user) without charge or at a charge which is not equal
to an arm's length rental charge (as defined in paragraph (c)(2)(i) of
this section) the district director may make appropriate allocations to
properly reflect such arm's length charge. Where possession, use, or
occupancy of only a portion of such property is transferred, the
determination of the arm's length charge and the allocation shall be
made with reference to the portion transferred.
(2) Arm's length charge--(i) In general. For purposes of paragraph
(c) of this section, an arm's length rental charge shall be the amount
of rent which was charged, or would have been charged for the use of the
same or similar property, during the time it was in use, in independent
transactions with or between unrelated parties under similar
circumstances considering the period and location of the use, the
owner's investment in the property or rent paid for the property,
expenses of maintaining the property, the type of property involved, its
condition, and all other relevant facts.
(ii) Safe haven rental charge. See Sec. 1.482-2(c)(2)(ii) (26 CFR
Part 1 revised as of April 1, 1985), for the determination of safe haven
rental charges in the case of certain leases entered into before May 9,
1986, and for leases entered into before August 7, 1986, pursuant to a
binding written contract entered into before May 9, 1986.
(iii) Subleases--(A) Except as provided in paragraph (c)(2)(iii)(B)
of this section, where possession, use, or occupancy of tangible
property, which is leased by the owner (lessee) from an unrelated party
is transferred by sublease or other arrangement to the user, an arm's
length rental charge shall be considered to be equal to all the
deductions claimed by the owner (lessee) which are attributable to the
property for the period such property is used by the user. Where only a
portion of such property was transferred, any allocations shall be made
with reference to the portion transferred. The deductions to be
considered include the rent paid or accrued by the owner (lessee) during
the period of use and all other deductions directly and indirectly
connected with the property paid or accrued by the owner (lessee) during
such period. Such deductions include deductions for maintenance and
repair, utilities, management and other similar deductions.
(B) The provisions of paragraph (c)(2)(iii)(A) of this section shall
not apply if either--
(1) The taxpayer establishes a more appropriate rental charge under
the general rule set forth in paragraph (c)(2)(i) of this section; or
(2) During the taxable year, the owner (lessee) or the user was
regularly engaged in the trade or business of renting property of the
same general type as the property in question to unrelated persons.
(d) Transfer of property. For rules governing allocations under
section 482 to reflect an arm's length consideration for controlled
transactions involving the transfer of property, see Sec. Sec. 1.482-3
through 1.482-6.
(e) Cost sharing arrangement. For rules governing allocations under
section 482 to reflect an arm's length consideration for controlled
transactions involving a cost sharing arrangement, see Sec. 1.482-7.
(f) Effective/applicability date--(1) In general. The provision of
paragraph (b) of this section is generally applicable for taxable years
beginning after December 31, 2006. The provision of paragraph (e) of
this section is generally applicable on January 5, 2009.
(2) Election to apply paragraph (b) to earlier taxable years. A
person may elect to apply the provisions of paragraph (b) of this
section to earlier taxable years in accordance with the rules set forth
in Sec. 1.482-9(n)(2).
[T.D. 8552, 59 FR 35002, July 8, 1994; 60 FR 16381, 16382, Mar. 30,
1995; T.D. 9278, 71 FR 44484, Aug. 4, 2006; T.D. 9456, 74 FR 38842, Aug.
4, 2009; T.D. 9568, 76 FR 80090, Dec. 22, 2011]
Sec. 1.482-3 Methods to determine taxable income in connection with
a transfer of tangible property.
(a) In general. The arm's length amount charged in a controlled
transfer of tangible property must be determined under one of the six
methods
[[Page 637]]
listed in this paragraph (a). Each of the methods must be applied in
accordance with all of the provisions of Sec. 1.482-1, including the
best method rule of Sec. 1.482-1(c), the comparability analysis of
Sec. 1.482-1(d), and the arm's length range of Sec. 1.482-1(e). The
methods are--
(1) The comparable uncontrolled price method, described in paragraph
(b) of this section;
(2) The resale price method, described in paragraph (c) of this
section;
(3) The cost plus method, described in paragraph (d) of this
section;
(4) The comparable profits method, described in Sec. 1.482-5;
(5) The profit split method, described in Sec. 1.482-6; and
(6) Unspecified methods, described in paragraph (e) of this section.
(b) Comparable uncontrolled price method--(1) In general. The
comparable uncontrolled price method evaluates whether the amount
charged in a controlled transaction is arm's length by reference to the
amount charged in a comparable uncontrolled transaction.
(2) Comparability and reliability considerations--(i) In general.
Whether results derived from applications of this method are the most
reliable measure of the arm's length result must be determined using the
factors described under the best method rule in Sec. 1.482-1(c). The
application of these factors under the comparable uncontrolled price
method is discussed in paragraph (b)(2)(ii) and (iii) of this section.
(ii) Comparability--(A) In general. The degree of comparability
between controlled and uncontrolled transactions is determined by
applying the provisions of Sec. 1.482-1(d). Although all of the factors
described in Sec. 1.482-1(d)(3) must be considered, similarity of
products generally will have the greatest effect on comparability under
this method. In addition, because even minor differences in contractual
terms or economic conditions could materially affect the amount charged
in an uncontrolled transaction, comparability under this method depends
on close similarity with respect to these factors, or adjustments to
account for any differences. The results derived from applying the
comparable uncontrolled price method generally will be the most direct
and reliable measure of an arm's length price for the controlled
transaction if an uncontrolled transaction has no differences with the
controlled transaction that would affect the price, or if there are only
minor differences that have a definite and reasonably ascertainable
effect on price and for which appropriate adjustments are made. If such
adjustments cannot be made, or if there are more than minor differences
between the controlled and uncontrolled transactions, the comparable
uncontrolled price method may be used, but the reliability of the
results as a measure of the arm's length price will be reduced. Further,
if there are material product differences for which reliable adjustments
cannot be made, this method ordinarily will not provide a reliable
measure of an arm's length result.
(B) Adjustments for differences between controlled and uncontrolled
transactions. If there are differences between the controlled and
uncontrolled transactions that would affect price, adjustments should be
made to the price of the uncontrolled transaction according to the
comparability provisions of Sec. 1.482-1(d)(2). Specific examples of
the factors that may be particularly relevant to this method include--
(1) Quality of the product;
(2) Contractual terms (e.g., scope and terms of warranties provided,
sales or purchase volume, credit terms, transport terms);
(3) Level of the market (i.e., wholesale, retail, etc.);
(4) Geographic market in which the transaction takes place;
(5) Date of the transaction;
(6) Intangible property associated with the sale;
(7) Foreign currency risks; and
(8) Alternatives realistically available to the buyer and seller.
(iii) Data and assumptions. The reliability of the results derived
from the comparable uncontrolled price method is affected by the
completeness and accuracy of the data used and the reliability of the
assumptions made to apply the method. See Sec. 1.482-1(c) (Best method
rule).
(3) Arm's length range. See Sec. 1.482-1(e)(2) for the
determination of an arm's length range.
[[Page 638]]
(4) Examples. The principles of this paragraph (b) are illustrated
by the following examples.
Example 1. Comparable Sales of Same Product. USM, a U.S.
manufacturer, sells the same product to both controlled and uncontrolled
distributors. The circumstances surrounding the controlled and
uncontrolled transactions are substantially the same, except that the
controlled sales price is a delivered price and the uncontrolled sales
are made f.o.b. USM's factory. Differences in the contractual terms of
transportation and insurance generally have a definite and reasonably
ascertainable effect on price, and adjustments are made to the results
of the uncontrolled transaction to account for such differences. No
other material difference has been identified between the controlled and
uncontrolled transactions. Because USM sells in both the controlled and
uncontrolled transactions, it is likely that all material differences
between the two transactions have been identified. In addition, because
the comparable uncontrolled price method is applied to an uncontrolled
comparable with no product differences, and there are only minor
contractual differences that have a definite and reasonably
ascertainable effect on price, the results of this application of the
comparable uncontrolled price method will provide the most direct and
reliable measure of an arm's length result. See Sec. 1.482-
3(b)(2)(ii)(A).
Example 2. Effect of Trademark. The facts are the same as in Example
1, except that USM affixes its valuable trademark to the property sold
in the controlled transactions, but does not affix its trademark to the
property sold in the uncontrolled transactions. Under the facts of this
case, the effect on price of the trademark is material and cannot be
reliably estimated. Because there are material product differences for
which reliable adjustments cannot be made, the comparable uncontrolled
price method is unlikely to provide a reliable measure of the arm's
length result. See Sec. 1.482-3(b)(2)(ii)(A).
Example 3. Minor Product Differences. The facts are the same as in
Example 1, except that USM, which manufactures business machines, makes
minor modifications to the physical properties of the machines to
satisfy specific requirements of a customer in controlled sales, but
does not make these modifications in uncontrolled sales. If the minor
physical differences in the product have a material effect on prices,
adjustments to account for these differences must be made to the results
of the uncontrolled transactions according to the provisions of Sec.
1.482- 1(d)(2), and such adjusted results may be used as a measure of
the arm's length result.
Example 4. Effect of Geographic Differences. FM, a foreign specialty
radio manufacturer, sells its radios to a controlled U.S. distributor,
AM, that serves the West Coast of the United States. FM sells its radios
to uncontrolled distributors to serve other regions in the United
States. The product in the controlled and uncontrolled transactions is
the same, and all other circumstances surrounding the controlled and
uncontrolled transactions are substantially the same, other than the
geographic differences. If the geographic differences are unlikely to
have a material effect on price, or they have definite and reasonably
ascertainable effects for which adjustments are made, then the adjusted
results of the uncontrolled sales may be used under the comparable
uncontrolled price method to establish an arm's length range pursuant to
Sec. 1.482-1(e)(2)(iii)(A). If the effects of the geographic
differences would be material but cannot be reliably ascertained, then
the reliability of the results will be diminished. However, the
comparable uncontrolled price method may still provide the most reliable
measure of an arm's length result, pursuant to the best method rule of
Sec. 1.482-1(c), and, if so, an arm's length range may be established
pursuant to Sec. 1.482-1(e)(2)(iii)(B).
(5) Indirect evidence of comparable uncontrolled transactions--(i)
In general. A comparable uncontrolled price may be derived from data
from public exchanges or quotation media, but only if the following
requirements are met--
(A) The data is widely and routinely used in the ordinary course of
business in the industry to negotiate prices for uncontrolled sales;
(B) The data derived from public exchanges or quotation media is
used to set prices in the controlled transaction in the same way it is
used by uncontrolled taxpayers in the industry; and
(C) The amount charged in the controlled transaction is adjusted to
reflect differences in product quality and quantity, contractual terms,
transportation costs, market conditions, risks borne, and other factors
that affect the price that would be agreed to by uncontrolled taxpayers.
(ii) Limitation. Use of data from public exchanges or quotation
media may not be appropriate under extraordinary market conditions.
(iii) Examples. The following examples illustrate this paragraph
(b)(5).
Example 1. Use of Quotation Medium. (i) On June 1, USOil, a United
States corporation, enters into a contract to purchase crude oil from
its foreign subsidiary, FS, in Country Z. USOil and FS agree to base
their sales
[[Page 639]]
price on the average of the prices published for that crude in a
quotation medium in the five days before August 1, the date set for
delivery. USOil and FS agree to adjust the price for the particular
circumstances of their transactions, including the quantity of the crude
sold, contractual terms, transportation costs, risks borne, and other
factors that affect the price.
(ii) The quotation medium used by USOil and FS is widely and
routinely used in the ordinary course of business in the industry to
establish prices for uncontrolled sales. Because USOil and FS use the
data to set their sales price in the same way that unrelated parties use
the data from the quotation medium to set their sales prices, and
appropriate adjustments were made to account for differences, the price
derived from the quotation medium used by USOil and FS to set their
transfer prices will be considered evidence of a comparable uncontrolled
price.
Example 2. Extraordinary Market Conditions. The facts are the same
as in Example 1, except that before USOil and FS enter into their
contract, war breaks out in Countries X and Y, major oil producing
countries, causing significant instability in world petroleum markets.
As a result, given the significant instability in the price of oil, the
prices listed on the quotation medium may not reflect a reliable measure
of an arm's length result. See Sec. 1.482-3(b)(5)(ii).
(c) Resale price method--(1) In general. The resale price method
evaluates whether the amount charged in a controlled transaction is
arm's length by reference to the gross profit margin realized in
comparable uncontrolled transactions. The resale price method measures
the value of functions performed, and is ordinarily used in cases
involving the purchase and resale of tangible property in which the
reseller has not added substantial value to the tangible goods by
physically altering the goods before resale. For this purpose,
packaging, repackaging, labelling, or minor assembly do not ordinarily
constitute physical alteration. Further the resale price method is not
ordinarily used in cases where the controlled taxpayer uses its
intangible property to add substantial value to the tangible goods.
(2) Determination of arm's length price--(i) In general. The resale
price method measures an arm's length price by subtracting the
appropriate gross profit from the applicable resale price for the
property involved in the controlled transaction under review.
(ii) Applicable resale price. The applicable resale price is equal
to either the resale price of the particular item of property involved
or the price at which contemporaneous resales of the same property are
made. If the property purchased in the controlled sale is resold to one
or more related parties in a series of controlled sales before being
resold in an uncontrolled sale, the applicable resale price is the price
at which the property is resold to an uncontrolled party, or the price
at which contemporaneous resales of the same property are made. In such
case, the determination of the appropriate gross profit will take into
account the functions of all members of the group participating in the
series of controlled sales and final uncontrolled resales, as well as
any other relevant factors described in Sec. 1.482-1(d)(3).
(iii) Appropriate gross profit. The appropriate gross profit is
computed by multiplying the applicable resale price by the gross profit
margin (expressed as a percentage of total revenue derived from sales)
earned in comparable uncontrolled transactions.
(iv) Arm's length range. See Sec. 1.482-1(e)(2) for determination
of the arm's length range.
(3) Comparability and reliability considerations--(i) In general.
Whether results derived from applications of this method are the most
reliable measure of the arm's length result must be determined using the
factors described under the best method rule in Sec. 1.482-1(c). The
application of these factors under the resale price method is discussed
in paragraphs (c)(3) (ii) and (iii) of this section.
(ii) Comparability--(A) Functional comparability. The degree of
comparability between an uncontrolled transaction and a controlled
transaction is determined by applying the comparability provisions of
Sec. 1.482-1(d). A reseller's gross profit provides compensation for
the performance of resale functions related to the product or products
under review, including an operating profit in return for the reseller's
investment of capital and the assumption of risks. Therefore, although
all of the factors described in Sec. 1.482-1(d)(3) must be considered,
comparability under this method is particularly dependent on
[[Page 640]]
similarity of functions performed, risks borne, and contractual terms,
or adjustments to account for the effects of any such differences. If
possible, appropriate gross profit margins should be derived from
comparable uncontrolled purchases and resales of the reseller involved
in the controlled sale, because similar characteristics are more likely
to be found among different resales of property made by the same
reseller than among sales made by other resellers. In the absence of
comparable uncontrolled transactions involving the same reseller, an
appropriate gross profit margin may be derived from comparable
uncontrolled transactions of other resellers.
(B) Other comparability factors. Comparability under this method is
less dependent on close physical similarity between the products
transferred than under the comparable uncontrolled price method. For
example, distributors of a wide variety of consumer durables might
perform comparable distribution functions without regard to the specific
durable goods distributed. Substantial differences in the products may,
however, indicate significant functional differences between the
controlled and uncontrolled taxpayers. Thus, it ordinarily would be
expected that the controlled and uncontrolled transactions would involve
the distribution of products of the same general type (e.g., consumer
electronics). Furthermore, significant differences in the value of the
distributed goods due, for example, to the value of a trademark, may
also affect the reliability of the comparison. Finally, the reliability
of profit measures based on gross profit may be adversely affected by
factors that have less effect on prices. For example, gross profit may
be affected by a variety of other factors, including cost structures (as
reflected, for example, in the age of plant and equipment), business
experience (such as whether the business is in a start-up phase or is
mature), or management efficiency (as indicated, for example, by
expanding or contracting sales or executive compensation over time).
Accordingly, if material differences in these factors are identified
based on objective evidence, the reliability of the analysis may be
affected.
(C) Adjustments for differences between controlled and uncontrolled
transactions. If there are material differences between the controlled
and uncontrolled transactions that would affect the gross profit margin,
adjustments should be made to the gross profit margin earned with
respect to the uncontrolled transaction according to the comparability
provisions of Sec. 1.482-1(d)(2). For this purpose, consideration of
operating expenses associated with functions performed and risks assumed
may be necessary, because differences in functions performed are often
reflected in operating expenses. If there are differences in functions
performed, however, the effect on gross profit of such differences is
not necessarily equal to the differences in the amount of related
operating expenses. Specific examples of the factors that may be
particularly relevant to this method include--
(1) Inventory levels and turnover rates, and corresponding risks,
including any price protection programs offered by the manufacturer;
(2) Contractual terms (e.g., scope and terms of warranties provided,
sales or purchase volume, credit terms, transport terms);
(3) Sales, marketing, advertising programs and services, (including
promotional programs, rebates, and co-op advertising);
(4) The level of the market (e.g., wholesale, retail, etc.); and
(5) Foreign currency risks.
(D) Sales agent. If the controlled taxpayer is comparable to a sales
agent that does not take title to goods or otherwise assume risks with
respect to ownership of such goods, the commission earned by such sales
agent, expressed as a percentage of the uncontrolled sales price of the
goods involved, may be used as the comparable gross profit margin.
(iii) Data and assumptions--(A) In general. The reliability of the
results derived from the resale price method is affected by the
completeness and accuracy of the data used and the reliability of the
assumptions made to apply this method. See Sec. 1.482-1(c) (Best method
rule).
[[Page 641]]
(B) Consistency in accounting. The degree of consistency in
accounting practices between the controlled transaction and the
uncontrolled comparables that materially affect the gross profit margin
affects the reliability of the result. Thus, for example, if differences
in inventory and other cost accounting practices would materially affect
the gross profit margin, the ability to make reliable adjustments for
such differences would affect the reliability of the results. Further,
the controlled transaction and the uncontrolled comparable should be
consistent in the reporting of items (such as discounts, returns and
allowances, rebates, transportation costs, insurance, and packaging)
between cost of goods sold and operating expenses.
(4) Examples. The following examples illustrate the principles of
this paragraph (c).
Example 1. A controlled taxpayer sells property to another member of
its controlled group that resells the property in uncontrolled sales.
There are no changes in the beginning and ending inventory for the year
under review. Information regarding an uncontrolled comparable is
sufficiently complete to conclude that it is likely that all material
differences between the controlled and uncontrolled transactions have
been identified and adjusted for. If the applicable resale price of the
property involved in the controlled sale is $100 and the appropriate
gross profit margin is 20%, then an arm's length result of the
controlled sale is a price of $80 ($100 minus (20% x $100)).
Example 2. (i) S, a U.S. corporation, is the exclusive distributor
for FP, its foreign parent. There are no changes in the beginning and
ending inventory for the year under review. S's total reported cost of
goods sold is $800, consisting of $600 for property purchased from FP
and $200 of other costs of goods sold incurred to unrelated parties. S's
applicable resale price and reported gross profit are as follows:
Applicable resale price......................................... $1000
Cost of goods sold:
Cost of purchases from FP................................... 600
Costs incurred to unrelated parties......................... 200
Reported gross profit........................................... 200
(ii) The district director determines that the appropriate gross
profit margin is 25%. Therefore, S's appropriate gross profit is $250
(i.e., 25% of the applicable resale price of $1000). Because S is
incurring costs of sales to unrelated parties, an arm's length price for
property purchased from FP must be determined under a two-step process.
First, the appropriate gross profit ($250) is subtracted from the
applicable resale price ($1000). The resulting amount ($750) is then
reduced by the costs of sales incurred to unrelated parties ($200).
Therefore, an arm's length price for S's cost of sales of FP's product
in this case equals $550 (i.e., $750 minus $200).
Example 3. FP, a foreign manufacturer, sells Product to USSub, its
U.S. subsidiary, which in turn sells Product to its domestic affiliate
Sister. Sister sells Product to unrelated buyers. In this case, the
applicable resale price is the price at which Sister sells Product in
uncontrolled transactions. The determination of the appropriate gross
profit margin for the sale from FP to USSub will take into account the
functions performed by USSub and Sister, as well as other relevant
factors described in Sec. 1.482-1(d)(3).
Example 4. USSub, a U.S. corporation, is the exclusive distributor
of widgets for its foreign parent. To determine whether the gross profit
margin of 25% earned by USSub is an arm's length result, the district
director considers applying the resale price method. There are several
uncontrolled distributors that perform similar functions under similar
circumstances in uncontrolled transactions. However, the uncontrolled
distributors treat certain costs such as discounts and insurance as cost
of goods sold, while USSub treats such costs as operating expenses. In
such cases, accounting reclassifications, pursuant to Sec. 1.482-
3(c)(3)(iii)(B), must be made to ensure consistent treatment of such
material items. Inability to make such accounting reclassifications will
decrease the reliability of the results of the uncontrolled
transactions.
Example 5. (i) USP, a U.S. corporation, manufactures Product X, an
unbranded widget, and sells it to FSub, its wholly owned foreign
subsidiary. FSub acts as a distributor of Product X in country M, and
sells it to uncontrolled parties in that country. Uncontrolled
distributors A, B, C, D, and E distribute competing products of
approximately similar value in country M. All such products are
unbranded.
(ii) Relatively complete data is available regarding the functions
performed and risks borne by the uncontrolled distributors and the
contractual terms under which they operate in the uncontrolled
transactions. In addition, data is available to ensure accounting
consistency between all of the uncontrolled distributors and FSub.
Because the available data is sufficiently complete and accurate to
conclude that it is likely that all material differences between the
controlled and uncontrolled transactions have been identified, such
differences have a definite and reasonably ascertainable effect, and
reliable adjustments are made to account for such differences, the
results of each of the uncontrolled distributors may be used to
establish an arm's length range pursuant to Sec. 1.482-1(e)(2)(iii)(A).
[[Page 642]]
Example 6. The facts are the same as Example 5, except that
sufficient data is not available to determine whether any of the
uncontrolled distributors provide warranties or to determine the payment
terms of the contracts. Because differences in these contractual terms
could materially affect price or profits, the inability to determine
whether these differences exist between the controlled and uncontrolled
transactions diminishes the reliability of the results of the
uncontrolled comparables. However, the reliability of the results may be
enhanced by the application of a statistical method when establishing an
arm's length range pursuant to Sec. 1.482-1(e)(2)(iii)(B).
Example 7. The facts are the same as in Example 5, except that
Product X is branded with a valuable trademark that is owned by P. A, B,
and C distribute unbranded competing products, while D and E distribute
products branded with other trademarks. D and E do not own any rights in
the trademarks under which their products are sold. The value of the
products that A, B, and C sold are not similar to the value of the
products sold by S. The value of products sold by D and E, however, is
similar to that of Product X. Although close product similarity is not
as important for a reliable application of the resale price method as
for the comparable uncontrolled price method, significant differences in
the value of the products involved in the controlled and uncontrolled
transactions may affect the reliability of the results. In addition,
because in this case it is difficult to determine the effect the
trademark will have on price or profits, reliable adjustments for the
differences cannot be made. Because D and E have a higher level of
comparability than A, B, and C with respect to S, pursuant to Sec.
1.482-1(e)(2)(ii), only D and E may be included in an arm's length
range.
(d) Cost plus method--(1) In general. The cost plus method evaluates
whether the amount charged in a controlled transaction is arm's length
by reference to the gross profit markup realized in comparable
uncontrolled transactions. The cost plus method is ordinarily used in
cases involving the manufacture, assembly, or other production of goods
that are sold to related parties.
(2) Determination of arm's length price--(i) In general. The cost
plus method measures an arm's length price by adding the appropriate
gross profit to the controlled taxpayer's costs of producing the
property involved in the controlled transaction.
(ii) Appropriate gross profit. The appropriate gross profit is
computed by multiplying the controlled taxpayer's cost of producing the
transferred property by the gross profit markup, expressed as a
percentage of cost, earned in comparable uncontrolled transactions.
(iii) Arm's length range. See Sec. 1.482-1(e)(2) for determination
of an arm's length range.
(3) Comparability and reliability considerations--(i) In general.
Whether results derived from the application of this method are the most
reliable measure of the arm's length result must be determined using the
factors described under the best method rule in Sec. 1.482-1(c).
(ii) Comparability--(A) Functional comparability. The degree of
comparability between controlled and uncontrolled transactions is
determined by applying the comparability provisions of Sec. 1.482-1(d).
A producer's gross profit provides compensation for the performance of
the production functions related to the product or products under
review, including an operating profit for the producer's investment of
capital and assumption of risks. Therefore, although all of the factors
described in Sec. 1.482-1(d)(3) must be considered, comparability under
this method is particularly dependent on similarity of functions
performed, risks borne, and contractual terms, or adjustments to account
for the effects of any such differences. If possible, the appropriate
gross profit markup should be derived from comparable uncontrolled
transactions of the taxpayer involved in the controlled sale, because
similar characteristics are more likely to be found among sales of
property by the same producer than among sales by other producers. In
the absence of such sales, an appropriate gross profit markup may be
derived from comparable uncontrolled sales of other producers whether or
not such producers are members of the same controlled group.
(B) Other comparability factors. Comparability under this method is
less dependent on close physical similarity between the products
transferred than under the comparable uncontrolled price method.
Substantial differences in the products may, however, indicate
significant functional differences between the controlled and
uncontrolled taxpayers. Thus, it ordinarily would be
[[Page 643]]
expected that the controlled and uncontrolled transactions involve the
production of goods within the same product categories. Furthermore,
significant differences in the value of the products due, for example,
to the value of a trademark, may also affect the reliability of the
comparison. Finally, the reliability of profit measures based on gross
profit may be adversely affected by factors that have less effect on
prices. For example, gross profit may be affected by a variety of other
factors, including cost structures (as reflected, for example, in the
age of plant and equipment), business experience (such as whether the
business is in a start-up phase or is mature), or management efficiency
(as indicated, for example, by expanding or contracting sales or
executive compensation over time). Accordingly, if material differences
in these factors are identified based on objective evidence, the
reliability of the analysis may be affected.
(C) Adjustments for differences between controlled and uncontrolled
transactions. If there are material differences between the controlled
and uncontrolled transactions that would affect the gross profit markup,
adjustments should be made to the gross profit markup earned in the
comparable uncontrolled transaction according to the provisions of Sec.
1.482-1(d)(2). For this purpose, consideration of the operating expenses
associated with the functions performed and risks assumed may be
necessary, because differences in functions performed are often
reflected in operating expenses. If there are differences in functions
performed, however, the effect on gross profit of such differences is
not necessarily equal to the differences in the amount of related
operating expenses. Specific examples of the factors that may be
particularly relevant to this method include--
(1) The complexity of manufacturing or assembly;
(2) Manufacturing, production, and process engineering;
(3) Procurement, purchasing, and inventory control activities;
(4) Testing functions;
(5) Selling, general, and administrative expenses;
(6) Foreign currency risks; and
(7) Contractual terms (e.g., scope and terms of warranties provided,
sales or purchase volume, credit terms, transport terms).
(D) Purchasing agent. If a controlled taxpayer is comparable to a
purchasing agent that does not take title to property or otherwise
assume risks with respect to ownership of such goods, the commission
earned by such purchasing agent, expressed as a percentage of the
purchase price of the goods, may be used as the appropriate gross profit
markup.
(iii) Data and assumptions--(A) In general. The reliability of the
results derived from the cost plus method is affected by the
completeness and accuracy of the data used and the reliability of the
assumptions made to apply this method. See Sec. 1.482-1(c) (Best method
rule).
(B) Consistency in accounting. The degree of consistency in
accounting practices between the controlled transaction and the
uncontrolled comparables that materially affect the gross profit markup
affects the reliability of the result. Thus, for example, if differences
in inventory and other cost accounting practices would materially affect
the gross profit markup, the ability to make reliable adjustments for
such differences would affect the reliability of the results. Further,
the controlled transaction and the comparable uncontrolled transaction
should be consistent in the reporting of costs between cost of goods
sold and operating expenses. The term cost of producing includes the
cost of acquiring property that is held for resale.
(4) Examples. The following examples illustrate the principles of
this paragraph (d).
Example 1. (i) USP, a domestic manufacturer of computer components,
sells its products to FS, its foreign distributor. UT1, UT2, and UT3 are
domestic computer component manufacturers that sell to uncontrolled
foreign purchasers.
(ii) Relatively complete data is available regarding the functions
performed and risks borne by UT1, UT2, and UT3, and the contractual
terms in the uncontrolled transactions. In addition, data is available
to ensure accounting consistency between all of the uncontrolled
manufacturers and USP. Because the available data is sufficiently
complete to conclude that it is likely that
[[Page 644]]
all material differences between the controlled and uncontrolled
transactions have been identified, the effect of the differences are
definite and reasonably ascertainable, and reliable adjustments are made
to account for the differences, an arm's length range can be established
pursuant to Sec. 1.482-1(e)(2)(iii)(A).
Example 2. The facts are the same as in Example 1, except that USP
accounts for supervisory, general, and administrative costs as operating
expenses, which are not allocated to its sales to FS. The gross profit
markups of UT1, UT2, and UT3, however, reflect supervisory, general, and
administrative expenses because they are accounted for as costs of goods
sold. Accordingly, the gross profit markups of UT1, UT2, and UT3 must be
adjusted as provided in paragraph (d)(3)(iii)(B) of this section to
provide accounting consistency. If data is not sufficient to determine
whether such accounting differences exist between the controlled and
uncontrolled transactions, the reliability of the results will be
decreased.
Example 3. The facts are the same as in Example 1, except that under
its contract with FS, USP uses materials consigned by FS. UT1, UT2, and
UT3, on the other hand, purchase their own materials, and their gross
profit markups are determined by including the costs of materials. The
fact that USP does not carry an inventory risk by purchasing its own
materials while the uncontrolled producers carry inventory is a
significant difference that may require an adjustment if the difference
has a material effect on the gross profit markups of the uncontrolled
producers. Inability to reasonably ascertain the effect of the
difference on the gross profit markups will affect the reliability of
the results of UT1, UT2, and UT3.
Example 4. (i) FS, a foreign corporation, produces apparel for USP,
its U.S. parent corporation. FS purchases its materials from unrelated
suppliers and produces the apparel according to designs provided by USP.
The district director identifies 10 uncontrolled foreign apparel
producers that operate in the same geographic market and are similar in
many respect to FS.
(ii) Relatively complete data is available regarding the functions
performed and risks borne by the uncontrolled producers. In addition,
data is sufficiently detailed to permit adjustments for differences in
accounting practices. However, sufficient data is not available to
determine whether it is likely that all material differences in
contractual terms have been identified. For example, it is not possible
to determine which parties in the uncontrolled transactions bear
currency risks. Because differences in these contractual terms could
materially affect price or profits, the inability to determine whether
differences exist between the controlled and uncontrolled transactions
will diminish the reliability of these results. Therefore, the
reliability of the results of the uncontrolled transactions must be
enhanced by the application of a statistical method in establishing an
arm's length range pursuant to Sec. 1.482-1(e)(2)(iii)(B).
(e) Unspecified methods--(1) In general. Methods not specified in
paragraphs (a)(1), (2), (3), (4), and (5) of this section may be used to
evaluate whether the amount charged in a controlled transaction is arm's
length. Any method used under this paragraph (e) must be applied in
accordance with the provisions of Sec. 1.482-1. Consistent with the
specified methods, an unspecified method should take into account the
general principle that uncontrolled taxpayers evaluate the terms of a
transaction by considering the realistic alternatives to that
transaction, and only enter into a particular transaction if none of the
alternatives is preferable to it. For example, the comparable
uncontrolled price method compares a controlled transaction to similar
uncontrolled transactions to provide a direct estimate of the price to
which the parties would have agreed had they resorted directly to a
market alternative to the controlled transaction. Therefore, in
establishing whether a controlled transaction achieved an arm's length
result, an unspecified method should provide information on the prices
or profits that the controlled taxpayer could have realized by choosing
a realistic alternative to the controlled transaction. As with any
method, an unspecified method will not be applied unless it provides the
most reliable measure of an arm's length result under the principles of
the best method rule. See Sec. 1.482-1(c). Therefore, in accordance
with Sec. 1.482-1(d) (Comparability), to the extent that a method
relies on internal data rather than uncontrolled comparables, its
reliability will be reduced. Similarly, the reliability of a method will
be affected by the reliability of the data and assumptions used to apply
the method, including any projections used.
(2) Example. The following example illustrates an application of the
principle of this paragraph (e).
Example. Amcan, a U.S. company, produces unique vessels for storing
and transporting toxic waste, toxicans, at its U.S. production
[[Page 645]]
facility. Amcan agrees by contract to supply its Canadian subsidiary,
Cancan, with 4000 toxicans per year to serve the Canadian market for
toxicans. Prior to entering into the contract with Cancan, Amcan had
received a bona fide offer from an independent Canadian waste disposal
company, Cando, to serve as the Canadian distributor for toxicans and to
purchase a similar number of toxicans at a price of $5,000 each. If the
circumstances and terms of the Cancan supply contract are sufficiently
similar to those of the Cando offer, or sufficiently reliable
adjustments can be made for differences between them, then the Cando
offer price of $5,000 may provide reliable information indicating that
an arm's length consideration under the Cancan contract will not be less
than $5,000 per toxican.
(f) Coordination with intangible property rules. The value of an
item of tangible property may be affected by the value of intangible
property, such as a trademark affixed to the tangible property (embedded
intangible). Ordinarily, the transfer of tangible property with an
embedded intangible will not be considered a transfer of such intangible
if the controlled purchaser does not acquire any rights to exploit the
intangible property other than rights relating to the resale of the
tangible property under normal commercial practices. Pursuant to Sec.
1.482-1(d)(3)(v), however, the embedded intangible must be accounted for
in evaluating the comparability of the controlled transaction and
uncontrolled comparables. For example, because product comparability has
the greatest effect on an application of the comparable uncontrolled
price method, trademarked tangible property may be insufficiently
comparable to unbranded tangible property to permit a reliable
application of the comparable uncontrolled price method. The effect of
embedded intangibles on comparability will be determined under the
principles of Sec. 1.482-4. If the transfer of tangible property
conveys to the recipient a right to exploit an embedded intangible
(other than in connection with the resale of that item of tangible
property), it may be necessary to determine the arm's length
consideration for such intangible separately from the tangible property,
applying methods appropriate to determining the arm's length result for
a transfer of intangible property under Sec. 1.482-4. For example, if
the transfer of a machine conveys the right to exploit a manufacturing
process incorporated in the machine, then the arm's length consideration
for the transfer of that right must be determined separately under Sec.
1.482-4.
[T.D. 8552, 59 FR 35011, July 8, 1994; 60 FR 16382, Mar. 30, 1995]
Sec. 1.482-4 Methods to determine taxable income in connection with
a transfer of intangible property.
(a) In general. The arm's length amount charged in a controlled
transfer of intangible property must be determined under one of the four
methods listed in this paragraph (a). Each of the methods must be
applied in accordance with all of the provisions of Sec. 1.482-1,
including the best method rule of Sec. 1.482-1(c), the comparability
analysis of Sec. 1.482-1(d), and the arm's length range of Sec. 1.482-
1(e). The arm's length consideration for the transfer of an intangible
determined under this section must be commensurate with the income
attributable to the intangible. See Sec. 1.482-4(f)(2) (Periodic
adjustments). The available methods are--
(1) The comparable uncontrolled transaction method, described in
paragraph (c) of this section;
(2) The comparable profits method, described in Sec. 1.482-5;
(3) The profit split method, described in Sec. 1.482-6; and
(4) Unspecified methods described in paragraph (d) of this section.
(b) Definition of intangible. For purposes of section 482, an
intangible is an asset that comprises any of the following items and has
substantial value independent of the services of any individual--
(1) Patents, inventions, formulae, processes, designs, patterns, or
know-how;
(2) Copyrights and literary, musical, or artistic compositions;
(3) Trademarks, trade names, or brand names;
(4) Franchises, licenses, or contracts;
(5) Methods, programs, systems, procedures, campaigns, surveys,
studies, forecasts, estimates, customer lists, or technical data; and
(6) Other similar items. For purposes of section 482, an item is
considered
[[Page 646]]
similar to those listed in paragraph (b)(1) through (5) of this section
if it derives its value not from its physical attributes but from its
intellectual content or other intangible properties.
(c) Comparable uncontrolled transaction method--(1) In general. The
comparable uncontrolled transaction method evaluates whether the amount
charged for a controlled transfer of intangible property was arm's
length by reference to the amount charged in a comparable uncontrolled
transaction. The amount determined under this method may be adjusted as
required by paragraph (f)(2) of this section (Periodic adjustments).
(2) Comparability and reliability considerations--(i) In general.
Whether results derived from applications of this method are the most
reliable measure of an arm's length result is determined using the
factors described under the best method rule in Sec. 1.482-1(c). The
application of these factors under the comparable uncontrolled
transaction method is discussed in paragraphs (c)(2)(ii), (iii), and
(iv) of this section.
(ii) Reliability. If an uncontrolled transaction involves the
transfer of the same intangible under the same, or substantially the
same, circumstances as the controlled transaction, the results derived
from applying the comparable uncontrolled transaction method will
generally be the most direct and reliable measure of the arm's length
result for the controlled transfer of an intangible. Circumstances
between the controlled and uncontrolled transactions will be considered
substantially the same if there are at most only minor differences that
have a definite and reasonably ascertainable effect on the amount
charged and for which appropriate adjustments are made. If such
uncontrolled transactions cannot be identified, uncontrolled
transactions that involve the transfer of comparable intangibles under
comparable circumstances may be used to apply this method, but the
reliability of the analysis will be reduced.
(iii) Comparability--(A) In general. The degree of comparability
between controlled and uncontrolled transactions is determined by
applying the comparability provisions of Sec. 1.482-1(d). Although all
of the factors described in Sec. 1.482-1(d)(3) must be considered,
specific factors may be particularly relevant to this method. In
particular, the application of this method requires that the controlled
and uncontrolled transactions involve either the same intangible
property or comparable intangible property, as defined in paragraph
(c)(2)(iii)(B)(1) of this section. In addition, because differences in
contractual terms, or the economic conditions in which transactions take
place, could materially affect the amount charged, comparability under
this method also depends on similarity with respect to these factors, or
adjustments to account for material differences in such circumstances.
(B) Factors to be considered in determining comparability--(1)
Comparable intangible property. In order for the intangible property
involved in an uncontrolled transaction to be considered comparable to
the intangible property involved in the controlled transaction, both
intangibles must--
(i) Be used in connection with similar products or processes within
the same general industry or market; and
(ii) Have similar profit potential. The profit potential of an
intangible is most reliably measured by directly calculating the net
present value of the benefits to be realized (based on prospective
profits to be realized or costs to be saved) through the use or
subsequent transfer of the intangible, considering the capital
investment and start-up expenses required, the risks to be assumed, and
other relevant considerations. The need to reliably measure profit
potential increases in relation to both the total amount of potential
profits and the potential rate of return on investment necessary to
exploit the intangible. If the information necessary to directly
calculate net present value of the benefits to be realized is
unavailable, and the need to reliably measure profit potential is
reduced because the potential profits are relatively small in terms of
total amount and rate of return, comparison of profit potential may be
based upon the factors referred to in paragraph
[[Page 647]]
(c)(2)(iii)(B)(2) of this section. See Example 3 of Sec. 1.482-4(c)(4).
Finally, the reliability of a measure of profit potential is affected by
the extent to which the profit attributable to the intangible can be
isolated from the profit attributable to other factors, such as
functions performed and other resources employed.
(2) Comparable circumstances. In evaluating the comparability of the
circumstances of the controlled and uncontrolled transactions, although
all of the factors described in Sec. 1.482-1(d)(3) must be considered,
specific factors that may be particularly relevant to this method
include the following--
(i) The terms of the transfer, including the exploitation rights
granted in the intangible, the exclusive or nonexclusive character of
any rights granted, any restrictions on use, or any limitations on the
geographic area in which the rights may be exploited;
(ii) The stage of development of the intangible (including, where
appropriate, necessary governmental approvals, authorizations, or
licenses) in the market in which the intangible is to be used;
(iii) Rights to receive updates, revisions, or modifications of the
intangible;
(iv) The uniqueness of the property and the period for which it
remains unique, including the degree and duration of protection afforded
to the property under the laws of the relevant countries;
(v) The duration of the license, contract, or other agreement, and
any termination or renegotiation rights;
(vi) Any economic and product liability risks to be assumed by the
transferee;
(vii) The existence and extent of any collateral transactions or
ongoing business relationships between the transferee and transferor;
and
(viii) The functions to be performed by the transferor and
transferee, including any ancillary or subsidiary services.
(iv) Data and assumptions. The reliability of the results derived
from the comparable uncontrolled transaction method is affected by the
completeness and accuracy of the data used and the reliability of the
assumptions made to apply this method. See Sec. 1.482-1(c) (Best method
rule).
(3) Arm's length range. See Sec. 1.482-1(e)(2) for the
determination of an arm's length range.
(4) Examples. The following examples illustrate the principles of
this paragraph (c).
Example 1. (i) USpharm, a U.S. pharmaceutical company, develops a
new drug Z that is a safe and effective treatment for the disease
zeezee. USpharm has obtained patents covering drug Z in the United
States and in various foreign countries. USpharm has also obtained the
regulatory authorizations necessary to market drug Z in the United
States and in foreign countries.
(ii) USpharm licenses its subsidiary in country X, Xpharm, to
produce and sell drug Z in country X. At the same time, it licenses an
unrelated company, Ydrug, to produce and sell drug Z in country Y, a
neighboring country. Prior to licensing the drug, USpharm had obtained
patent protection and regulatory approvals in both countries and both
countries provide similar protection for intellectual property rights.
Country X and country Y are similar countries in terms of population,
per capita income and the incidence of disease zeezee. Consequently,
drug Z is expected to sell in similar quantities and at similar prices
in both countries. In addition, costs of producing and marketing drug Z
in each country are expected to be approximately the same.
(iii) USpharm and Xpharm establish terms for the license of drug Z
that are identical in every material respect, including royalty rate, to
the terms established between USpharm and Ydrug. In this case the
district director determines that the royalty rate established in the
Ydrug license agreement is a reliable measure of the arm's length
royalty rate for the Xpharm license agreement.
Example 2. The facts are the same as in Example 1, except that the
incidence of the disease zeezee in Country Y is much higher than in
Country X. In this case, the profit potential from exploitation of the
right to make and sell drug Z is likely to be much higher in country Y
than it is in Country X. Consequently, the Ydrug license agreement is
unlikely to provide a reliable measure of the arm's length royalty rate
for the Xpharm license.
Example 3. (i) FP, is a foreign company that designs, manufactures
and sells industrial equipment. FP has developed proprietary components
that are incorporated in its products. These components are important in
the operation of FP's equipment and some of them have distinctive
features, but other companies produce similar components
[[Page 648]]
and none of these components by itself accounts for a substantial part
of the value of FP's products.
(ii) FP licenses its U.S. subsidiary, USSub, exclusive North
American rights to use the patented technology for producing component
X, a heat exchanger used for cooling operating mechanisms in industrial
equipment. Component X incorporates proven technology that makes it
somewhat more efficient than the heat exchangers commonly used in
industrial equipment. FP also agrees to provide technical support to
help adapt component X to USSub's products and to assist with initial
production. Under the terms of the license agreement USSub pays FP a
royalty equal to 3 percent of sales of USSub equipment incorporating
component X.
(iii) FP does not license unrelated parties to use component X, but
many similar components are transferred between uncontrolled taxpayers.
Consequently, the district director decides to apply the comparable
uncontrolled transaction method to evaluate whether the 3 percent
royalty for component X is an arm's length royalty.
(iv) The district director uses a database of company documents
filed with the Securities and Exchange Commission (SEC) to identify
potentially comparable license agreements between uncontrolled taxpayers
that are on file with the SEC. The district director identifies 40
license agreements that were entered into in the same year as the
controlled transfer or in the prior or following year, and that relate
to transfers of technology associated with industrial equipment that has
similar applications to USSub's products. Further review of these
uncontrolled agreements indicates that 25 of them involved components
that have a similar level of technical sophistication as component X and
could be expected to play a similar role in contributing to the total
value of the final product.
(v) The district director makes a detailed review of the terms of
each of the 25 uncontrolled agreements and finds that 15 of them are
similar to the controlled agreement in that they all involve--
(A) The transfer of exclusive rights for the North American market;
(B) Products for which the market could be expected to be of a
similar size to the market for the products into which USSub
incorporates component X;
(C) The transfer of patented technology;
(D) Continuing technical support;
(E) Access to technical improvements;
(F) Technology of a similar age; and
(G) A similar duration of the agreement.
(vi) Based on these factors and the fact that none of the components
to which these license agreements relate accounts for a substantial part
of the value of the final products, the district director concludes that
these fifteen intangibles have similar profit potential to the component
X technology.
(vii) The 15 uncontrolled comparables produce the following royalty
rates:
------------------------------------------------------------------------
Royalty
License rate
(percent)
------------------------------------------------------------------------
1........................................................... 1.0
2........................................................... 1.0
3........................................................... 1.25
4........................................................... 1.25
5........................................................... 1.5
6........................................................... 1.5
7........................................................... 1.75
8........................................................... 2.0
9........................................................... 2.0
10.......................................................... 2.0
11.......................................................... 2.25
12.......................................................... 2.5
13.......................................................... 2.5
14.......................................................... 2.75
15.......................................................... 3.0
------------------------------------------------------------------------
(viii) Although the uncontrolled comparables are clearly similar to
the controlled transaction, it is likely that unidentified material
differences exist between the uncontrolled comparables and the
controlled transaction. Therefore, an appropriate statistical technique
must be used to establish the arm's length range. In this case the
district director uses the interquartile range to determine the arm's
length range. Therefore, the arm's length range covers royalty rates
from 1.25 to 2.5 percent, and an adjustment is warranted to the 3
percent royalty charged in the controlled transfer. The district
director determines that the appropriate adjustment corresponds to a
reduction in the royalty rate to 2.0 percent, which is the median of the
uncontrolled comparables.
Example 4. (i) USdrug, a U.S. pharmaceutical company, has developed
a new drug, Nosplit, that is useful in treating migraine headaches and
produces no significant side effects. Nosplit replaces another drug,
Lessplit, that USdrug had previously produced and marketed as a
treatment for migraine headaches. A number of other drugs for treating
migraine headaches are already on the market, but Nosplit can be
expected rapidly to dominate the worldwide market for such treatments
and to command a premium price since all other treatments produce side
effects. Thus, USdrug projects that extraordinary profits will be
derived from Nosplit in the U.S. market and other markets.
(ii) USdrug licenses its newly established European subsidiary,
Eurodrug, the rights to produce and market Nosplit in the European
market. In setting the royalty rate for this license, USdrug considers
the royalty that it established previously when it licensed the right to
produce and market Lessplit in the European market to an unrelated
European pharmaceutical company. In many respects
[[Page 649]]
the two license agreements are closely comparable. The drugs were
licensed at the same stage in their development and the agreements
conveyed identical rights to the licensees. Moreover, there appear to
have been no significant changes in the European market for migraine
headache treatments since Lessplit was licensed. However, at the time
that Lessplit was licensed there were several other similar drugs
already on the market to which Lessplit was not in all cases superior.
Consequently, the projected and actual Lessplit profits were
substantially less than the projected Nosplit profits. Thus, USdrug
concludes that the profit potential of Lessplit is not similar to the
profit potential of Nosplit, and the Lessplit license agreement
consequently is not a comparable uncontrolled transaction for purposes
of this paragraph (c) in spite of the other indicia of comparability
between the two intangibles.
(d) Unspecified methods--(1) In general. Methods not specified in
paragraphs (a)(1), (2), and (3) of this section may be used to evaluate
whether the amount charged in a controlled transaction is arm's length.
Any method used under this paragraph (d) must be applied in accordance
with the provisions of Sec. 1.482-1. Consistent with the specified
methods, an unspecified method should take into account the general
principle that uncontrolled taxpayers evaluate the terms of a
transaction by considering the realistic alternatives to that
transaction, and only enter into a particular transaction if none of the
alternatives is preferable to it. For example, the comparable
uncontrolled transaction method compares a controlled transaction to
similar uncontrolled transactions to provide a direct estimate of the
price the parties would have agreed to had they resorted directly to a
market alternative to the controlled transaction. Therefore, in
establishing whether a controlled transaction achieved an arm's length
result, an unspecified method should provide information on the prices
or profits that the controlled taxpayer could have realized by choosing
a realistic alternative to the controlled transaction. As with any
method, an unspecified method will not be applied unless it provides the
most reliable measure of an arm's length result under the principles of
the best method rule. See Sec. 1.482-1(c). Therefore, in accordance
with Sec. 1.482-1(d) (Comparability), to the extent that a method
relies on internal data rather than uncontrolled comparables, its
reliability will be reduced. Similarly, the reliability of a method will
be affected by the reliability of the data and assumptions used to apply
the method, including any projections used.
(2) Example. The following example illustrates an application of the
principle of this paragraph (d).
Example. (i) USbond is a U.S. company that licenses to its foreign
subsidiary, Eurobond, a proprietary process that permits the manufacture
of Longbond, a long-lasting industrial adhesive, at a substantially
lower cost than otherwise would be possible. Using the proprietary
process, Eurobond manufactures Longbond and sells it to related and
unrelated parties for the market price of $550 per ton. Under the terms
of the license agreement, Eurobond pays USbond a royalty of $100 per ton
of Longbond sold. USbond also manufactures and markets Longbond in the
United States.
(ii) In evaluating whether the consideration paid for the transfer
of the proprietary process to Eurobond was arm's length, the district
director may consider, subject to the best method rule of Sec. 1.482-
1(c), USbond's alternative of producing and selling Longbond itself.
Reasonably reliable estimates indicate that if USbond directly supplied
Longbond to the European market, a selling price of $300 per ton would
cover its costs and provide a reasonable profit for its functions, risks
and investment of capital associated with the production of Longbond for
the European market. Given that the market price of Longbond was $550
per ton, by licensing the proprietary process to Eurobond, USbond
forgoes $250 per ton of profit over the profit that would be necessary
to compensate it for the functions, risks and investment involved in
supplying Longbond to the European market itself. Based on these facts,
the district director concludes that a royalty of $100 for the
proprietary process is not arm's length.
(e) Coordination with tangible property rules. See Sec. 1.482-3(f)
for the provisions regarding the coordination between the tangible
property and intangible property rules.
(f) Special rules for transfers of intangible property--(1) Form of
consideration. If a transferee of an intangible pays nominal or no
consideration and the transferor has retained a substantial interest in
the property, the arm's length consideration shall be in the form of a
royalty, unless a different form is demonstrably more appropriate.
[[Page 650]]
(2) Periodic adjustments--(i) General rule. If an intangible is
transferred under an arrangement that covers more than one year, the
consideration charged in each taxable year may be adjusted to ensure
that it is commensurate with the income attributable to the intangible.
Adjustments made pursuant to this paragraph (f)(2) shall be consistent
with the arm's length standard and the provisions of Sec. 1.482-1. In
determining whether to make such adjustments in the taxable year under
examination, the district director may consider all relevant facts and
circumstances throughout the period the intangible is used. The
determination in an earlier year that the amount charged for an
intangible was an arm's length amount will not preclude the district
director in a subsequent taxable year from making an adjustment to the
amount charged for the intangible in the subsequent year. A periodic
adjustment under the commensurate with income requirement of section 482
may be made in a subsequent taxable year without regard to whether the
taxable year of the original transfer remains open for statute of
limitation purposes. For exceptions to this rule see paragraph
(f)(2)(ii) of this section.
(ii) Exceptions--(A) Transactions involving the same intangible. If
the same intangible was transferred to an uncontrolled taxpayer under
substantially the same circumstances as those of the controlled
transaction; this transaction serves as the basis for the application of
the comparable uncontrolled transaction method in the first taxable year
in which substantial periodic consideration was required to be paid; and
the amount paid in that year was an arm's length amount, then no
allocation in a subsequent year will be made under paragraph (f)(2)(i)
of this paragraph for a controlled transfer of intangible property.
(B) Transactions involving comparable intangible. If the arm's
length result is derived from the application of the comparable
uncontrolled transaction method based on the transfer of a comparable
intangible under comparable circumstances to those of the controlled
transaction, no allocation will be made under paragraph (f)(2)(i) of
this section if each of the following facts is established--
(1) The controlled taxpayers entered into a written agreement
(controlled agreement) that provided for an amount of consideration with
respect to each taxable year subject to such agreement, such
consideration was an arm's length amount for the first taxable year in
which substantial periodic consideration was required to be paid under
the agreement, and such agreement remained in effect for the taxable
year under review;
(2) There is a written agreement setting forth the terms of the
comparable uncontrolled transaction relied upon to establish the arm's
length consideration (uncontrolled agreement), which contains no
provisions that would permit any change to the amount of consideration,
a renegotiation, or a termination of the agreement, in circumstances
comparable to those of the controlled transaction in the taxable year
under review (or that contains provisions permitting only specified,
non-contingent, periodic changes to the amount of consideration);
(3) The controlled agreement is substantially similar to the
uncontrolled agreement, with respect to the time period for which it is
effective and the provisions described in paragraph (f)(2)(ii)(B)(2) of
this section;
(4) The controlled agreement limits use of the intangible to a
specified field or purpose in a manner that is consistent with industry
practice and any such limitation in the uncontrolled agreement;
(5) There were no substantial changes in the functions performed by
the controlled transferee after the controlled agreement was executed,
except changes required by events that were not foreseeable; and
(6) The aggregate profits actually earned or the aggregate cost
savings actually realized by the controlled taxpayer from the
exploitation of the intangible in the year under examination, and all
past years, are not less than 80% nor more than 120% of the prospective
profits or cost savings that were foreseeable when the comparability of
the uncontrolled agreement was established under paragraph (c)(2) of
this section.
[[Page 651]]
(C) Methods other than comparable uncontrolled transaction. If the
arm's length amount was determined under any method other than the
comparable uncontrolled transaction method, no allocation will be made
under paragraph (f)(2)(i) of this section if each of the following facts
is established--
(1) The controlled taxpayers entered into a written agreement
(controlled agreement) that provided for an amount of consideration with
respect to each taxable year subject to such agreement, and such
agreement remained in effect for the taxable year under review;
(2) The consideration called for in the controlled agreement was an
arm's length amount for the first taxable year in which substantial
periodic consideration was required to be paid, and relevant supporting
documentation was prepared contemporaneously with the execution of the
controlled agreement;
(3) There have been no substantial changes in the functions
performed by the transferee since the controlled agreement was executed,
except changes required by events that were not foreseeable; and
(4) The total profits actually earned or the total cost savings
realized by the controlled transferee from the exploitation of the
intangible in the year under examination, and all past years, are not
less than 80% nor more than 120% of the prospective profits or cost
savings that were foreseeable when the controlled agreement was entered
into.
(D) Extraordinary events. No allocation will be made under paragraph
(f)(2)(i) of this section if the following requirements are met--
(1) Due to extraordinary events that were beyond the control of the
controlled taxpayers and that could not reasonably have been anticipated
at the time the controlled agreement was entered into, the aggregate
actual profits or aggregate cost savings realized by the taxpayer are
less than 80% or more than 120% of the prospective profits or cost
savings; and
(2) All of the requirements of paragraph (f)(2)(ii) (B) or (C) of
this section are otherwise satisfied.
(E) Five-year period. If the requirements of Sec. 1.482-4
(f)(2)(ii)(B) or (f)(2)(ii)(C) are met for each year of the five-year
period beginning with the first year in which substantial periodic
consideration was required to be paid, then no periodic adjustment will
be made under paragraph (f)(2)(i) of this section in any subsequent
year.
(iii) Examples. The following examples illustrate this paragraph
(f)(2).
Example 1. (i) USdrug, a U.S. pharmaceutical company, has developed
a new drug, Nosplit, that is useful in treating migraine headaches and
produces no significant side effects. A number of other drugs for
treating migraine headaches are already on the market, but Nosplit can
be expected rapidly to dominate the worldwide market for such treatments
and to command a premium price since all other treatments produce side
effects. Thus, USdrug projects that extraordinary profits will be
derived from Nosplit in the U.S. and European markets.
(ii) USdrug licenses its newly established European subsidiary,
Eurodrug, the rights to produce and market Nosplit for the European
market for 5 years. In setting the royalty rate for this license, USdrug
makes projections of the annual sales revenue and the annual profits to
be derived from the exploitation of Nosplit by Eurodrug. Based on the
projections, a royalty rate of 3.9% is established for the term of the
license.
(iii) In Year 1, USdrug evaluates the royalty rate it received from
Eurodrug. Given the high profit potential of Nosplit, USdrug is unable
to locate any uncontrolled transactions dealing with licenses of
comparable intangible property. USdrug therefore determines that the
comparable uncontrolled transaction method will not provide a reliable
measure of an arm's length royalty. However, applying the comparable
profits method to Eurodrug, USdrug determines that a royalty rate of
3.9% will result in Eurodrug earning an arm's length return for its
manufacturing and marketing functions.
(iv) In Year 5, the U.S. income tax return for USdrug is examined,
and the district director must determine whether the royalty rate
between USdrug and Eurodrug is commensurate with the income attributable
to Nosplit. In making this determination, the district director
considers whether any of the exceptions in Sec. 1.482-4(f)(2)(ii) are
applicable. In particular, the district director compares the profit
projections attributable to Nosplit made by USdrug against the actual
profits realized by Eurodrug. The projected and actual profits are as
follows:
------------------------------------------------------------------------
Profit
projections Actual profits
------------------------------------------------------------------------
Year 1.................................. 200 250
Year 2.................................. 250 300
Year 3.................................. 500 600
[[Page 652]]
Year 4.................................. 350 200
Year 5.................................. 100 100
-------------------------------
Total............................... 1400 1450
------------------------------------------------------------------------
(v) The total profits earned through Year 5 were not less than 80%
nor more than 120% of the profits that were projected when the license
was entered into. If the district director determines that the other
requirements of Sec. 1.482-4(f)(2)(ii)(C) were met, no adjustment will
be made to the royalty rate between USdrug and Eurodrug for the license
of Nosplit.
Example 2. (i) The facts are the same as in Example 1, except that
Eurodrug's actual profits earned were much higher than the projected
profits, as follows:
------------------------------------------------------------------------
Profit
projections Actual profits
------------------------------------------------------------------------
Year 1.................................. 200 250
Year 2.................................. 250 500
Year 3.................................. 500 800
Year 4.................................. 350 700
Year 5.................................. 100 600
-------------------------------
Total............................... 1400 2850
------------------------------------------------------------------------
(ii) In examining USdrug's tax return for Year 5, the district
director considers the actual profits realized by Eurodrug in Year 5,
and all past years. Accordingly, although Years 1 through 4 may be
closed under the statute of limitations, for purposes of determining
whether an adjustment should be made with respect to the royalty rate in
Year 5 with respect to Nosplit, the district director aggregates the
actual profits from those years with the profits of Year 5. However, the
district director will make an adjustment, if any, only with respect to
Year 5.
Example 3. (i) FP, a foreign corporation, licenses to USS, its U.S.
subsidiary, a new air-filtering process that permits manufacturing
plants to meet new environmental standards. The license runs for a 10-
year period, and the profit derived from the new process is projected to
be $15 million per year, for an aggregate profit of $150 million.
(ii) The royalty rate for the license is based on a comparable
uncontrolled transaction involving a comparable intangible under
comparable circumstances. The requirements of paragraphs
(f)(2)(ii)(B)(1) through (5) of this section have been met.
Specifically, FP and USS have entered into a written agreement that
provides for a royalty in each year of the license, the royalty rate is
considered arm's length for the first taxable year in which a
substantial royalty was required to be paid, the license limited the use
of the process to a specified field, consistent with industry practice,
and there are no substantial changes in the functions performed by USS
after the license was entered into.
(iii) In examining Year 4 of the license, the district director
determines that the aggregate actual profits earned by USS through Year
4 are $30 million, less than 80% of the projected profits of $60
million. However, USS establishes to the satisfaction of the district
director that the aggregate actual profits from the process are less
than 80% of the projected profits in Year 3 because an earthquake
severely damaged USS's manufacturing plant. Because the difference
between the projected profits and actual profits was due to an
extraordinary event that was beyond the control of USS, and could not
reasonably have been anticipated at the time the license was entered
into, the requirement under Sec. 1.482-4(f)(2)(ii)(D) has been met, and
no adjustment under this section is made.
(3) Ownership of intangible property--(i) Identification of owner--
(A) In general. The legal owner of intangible property pursuant to the
intellectual property law of the relevant jurisdiction, or the holder of
rights constituting an intangible property pursuant to contractual terms
(such as the terms of a license) or other legal provision, will be
considered the sole owner of the respective intangible property for
purposes of this section unless such ownership is inconsistent with the
economic substance of the underlying transactions. See Sec. 1.482-
1(d)(3)(ii)(B) (identifying contractual terms). If no owner of the
respective intangible property is identified under the intellectual
property law of the relevant jurisdiction, or pursuant to contractual
terms (including terms imputed pursuant to Sec. 1.482-1(d)(3)(ii)(B))
or other legal provision, then the controlled taxpayer who has control
of the intangible property, based on all the facts and circumstances,
will be considered the sole owner of the intangible property for
purposes of this section.
(B) Cost sharing arrangements. The rules in this paragraph (f)(3)
regarding ownership with respect to cost shared intangibles and cost
sharing arrangements will apply only as provided in Sec. 1.482-7.
(ii) Examples. The principles of this paragraph (f)(3) are
illustrated by the following examples:
Example 1. FP, a foreign corporation, is the registered holder of
the AA trademark in the
[[Page 653]]
United States. FP licenses to its U.S. subsidiary, USSub, the exclusive
rights to manufacture and market products in the United States under the
AA trademark. FP is the owner of the trademark pursuant to intellectual
property law. USSub is the owner of the license pursuant to the terms of
the license, but is not the owner of the trademark. See paragraphs
(b)(3) and (4) of this section (defining an intangible as, among other
things, a trademark or a license).
Example 2. The facts are the same as in Example 1. As a result of
its sales and marketing activities, USSub develops a list of several
hundred creditworthy customers that regularly purchase AA trademarked
products. Neither the terms of the contract between FP and USSub nor the
relevant intellectual property law specify which party owns the customer
list. Because USSub has knowledge of the contents of the list, and has
practical control over its use and dissemination, USSub is considered
the sole owner of the customer list for purposes of this paragraph
(f)(3).
(4) Contribution to the value of intangible property owned by
another--(i) In general. The arm's length consideration for a
contribution by one controlled taxpayer that develops or enhances the
value, or may be reasonably anticipated to develop or enhance the value,
of intangible property owned by another controlled taxpayer will be
determined in accordance with the applicable rules under section 482. If
the consideration for such a contribution is embedded within the
contractual terms for a controlled transaction that involves such
intangible property, then ordinarily no separate allocation will be made
with respect to such contribution. In such cases, pursuant to Sec.
1.482-1(d)(3), the contribution must be accounted for in evaluating the
comparability of the controlled transaction to uncontrolled comparables,
and accordingly in determining the arm's length consideration in the
controlled transaction.
(ii) Examples. The principles of this paragraph (f)(4) are
illustrated by the following examples:
Example 1. A, a member of a controlled group, allows B, another
member of the controlled group, to use tangible property, such as
laboratory equipment, in connection with B's development of an
intangible that B owns. By furnishing tangible property, A makes a
contribution to the development of intangible property owned by another
controlled taxpayer, B. Pursuant to paragraph (f)(4)(i) of this section,
the arm's length charge for A's furnishing of tangible property will be
determined under the rules for use of tangible property in Sec. 1.482-
2(c).
Example 2. (i) Facts. FP, a foreign producer of wristwatches, is the
registered holder of the YY trademark in the United States and in other
countries worldwide. FP enters into an exclusive, five-year, renewable
agreement with its newly organized U.S. subsidiary, USSub. The
contractual terms of the agreement grant USSub the exclusive right to
re-sell YY trademark wristwatches in the United States, obligate USSub
to pay a fixed price per wristwatch throughout the entire term of the
contract, and obligate both FP and USSub to undertake without separate
compensation specified types and levels of marketing activities.
(ii) The consideration for FP's and USSub's marketing activities, as
well as the consideration for the exclusive right to re-sell YY
trademarked merchandise in the United States, are embedded in the
transfer price paid for the wristwatches. Accordingly, pursuant to
paragraph (f)(4)(i) of this section, ordinarily no separate allocation
would be appropriate with respect to these embedded contributions.
(iii) Whether an allocation is warranted with respect to the
transfer price for the wristwatches is determined under Sec. Sec.
1.482-1, 1.482-3, and this section through Sec. 1.482-6. The
comparability analysis would include consideration of all relevant
factors, including the nature of the intangible property embedded in the
wristwatches and the nature of the marketing activities required under
the agreement. This analysis would also take into account that the
compensation for the activities performed by USSub and FP, as well as
the consideration for USSub's use of the YY trademark, is embedded in
the transfer price for the wristwatches, rather than provided for in
separate agreements. See Sec. Sec. 1.482-3(f) and 1.482-9(m)(4).
Example 3. (i) Facts. FP, a foreign producer of athletic gear, is
the registered holder of the AA trademark in the United States and in
other countries. In year 1, FP licenses to a newly organized U.S.
subsidiary, USSub, the exclusive rights to use certain manufacturing and
marketing intangible property to manufacture and market athletic gear in
the United States under the AA trademark. The license agreement
obligates USSub to pay a royalty based on sales of trademarked
merchandise. The license agreement also obligates FP and USSub to
perform without separate compensation specified types and levels of
marketing activities. In year 1, USSub manufactures and sells athletic
gear under the AA trademark in the United States.
(ii) The consideration for FP's and USSub's respective marketing
activities is embedded in the contractual terms of the license for the
AA trademark. Accordingly, pursuant to
[[Page 654]]
paragraph (f)(4)(i) of this section, ordinarily no separate allocation
would be appropriate with respect to the embedded contributions in year
1. See Sec. 1.482-9(m)(4).
(iii) Whether an allocation is warranted with respect to the royalty
under the license agreement would be analyzed under Sec. 1.482-1, and
this section through Sec. 1.482-6. The comparability analysis would
include consideration of all relevant factors, such as the term and
geographical exclusivity of the license, the nature of the intangible
property subject to the license, and the nature of the marketing
activities required to be undertaken pursuant to the license. Pursuant
to paragraph (f)(4)(i) of this section, the analysis would also take
into account the fact that the compensation for the marketing services
is embedded in the royalty paid for use of the AA trademark, rather than
provided for in a separate services agreement. For illustrations of
application of the best method rule, see Sec. 1.482-8 Examples 10, 11,
and 12.
Example 4. (i) Facts. The year 1 facts are the same as in Example 3,
with the following exceptions. In year 2, USSub undertakes certain
incremental marketing activities in addition to those required by the
contractual terms of the license for the AA trademark executed in year
1. The parties do not execute a separate agreement with respect to these
incremental marketing activities performed by USSub. The license
agreement executed in year 1 is of sufficient duration that it is
reasonable to anticipate that USSub will obtain the benefit of its
incremental activities, in the form of increased sales or revenues of
trademarked products in the U.S. market.
(ii) To the extent that it was reasonable to anticipate that USSub's
incremental marketing activities would increase the value only of
USSub's intangible property (that is, USSub's license to use the AA
trademark for a specified term), and not the value of the AA trademark
owned by FP, USSub's incremental activities do not constitute a
contribution for which an allocation is warranted under paragraph
(f)(4)(i) of this section.
Example 5. (i) Facts. The year 1 facts are the same as in Example 3.
In year 2, FP and USSub enter into a separate services agreement that
obligates USSub to perform certain incremental marketing activities to
promote AA trademark athletic gear in the United States, above and
beyond the activities specified in the license agreement executed in
year 1. In year 2, USSub begins to perform these incremental activities,
pursuant to the separate services agreement with FP.
(ii) Whether an allocation is warranted with respect to USSub's
incremental marketing activities covered by the separate services
agreement would be evaluated under Sec. Sec. 1.482-1 and 1.482-9,
including a comparison of the compensation provided for the services
with the results obtained under a method pursuant to Sec. 1.482-9,
selected and applied in accordance with the best method rule of Sec.
1.482-1(c).
(iii) Whether an allocation is warranted with respect to the royalty
under the license agreement is determined under Sec. 1.482-1, and this
section through Sec. 1.482-6. The comparability analysis would include
consideration of all relevant factors, such as the term and geographical
exclusivity of the license, the nature of the intangible property
subject to the license, and the nature of the marketing activities
required to be undertaken pursuant to the license. The comparability
analysis would take into account that the compensation for the
incremental activities by USSub is provided for in the separate services
agreement, rather than embedded in the royalty paid for use of the AA
trademark. For illustrations of application of the best method rule, see
Sec. 1.482-8 Examples 10, 11, and 12.
Example 6. (i) Facts. The year 1 facts are the same as in Example 3.
In year 2, FP and USSub enter into a separate services agreement that
obligates FP to perform incremental marketing activities, not specified
in the year 1 license, by advertising AA trademarked athletic gear in
selected international sporting events, such as the Olympics and the
soccer World Cup. FP's corporate advertising department develops and
coordinates these special promotions. The separate services agreement
obligates USSub to pay an amount to FP for the benefit to USSub that may
reasonably be anticipated as the result of FP's incremental activities.
The separate services agreement is not a qualified cost sharing
arrangement under Sec. 1.482-7T. FP begins to perform the incremental
activities in year 2 pursuant to the separate services agreement.
(ii) Whether an allocation is warranted with respect to the
incremental marketing activities performed by FP under the separate
services agreement would be evaluated under Sec. 1.482-9. Under the
circumstances, it is reasonable to anticipate that FP's activities would
increase the value of USSub's license as well as the value of FP's
trademark. Accordingly, the incremental activities by FP may constitute
in part a controlled services transaction for which USSub must
compensate FP. The analysis of whether an allocation is warranted would
include a comparison of the compensation provided for the services with
the results obtained under a method pursuant to Sec. 1.482-9, selected
and applied in accordance with the best method rule of Sec. 1.482-1(c).
(iii) Whether an allocation is appropriate with respect to the
royalty under the license agreement would be evaluated under Sec. Sec.
1.482-1 through 1.482-3, this section, and Sec. Sec. 1.482-5
[[Page 655]]
and 1.482-6. The comparability analysis would include consideration of
all relevant factors, such as the term and geographical exclusivity of
USSub's license, the nature of the intangible property subject to the
license, and the marketing activities required to be undertaken by both
FP and USSub pursuant to the license. This comparability analysis would
take into account that the compensation for the incremental activities
performed by FP was provided for in the separate services agreement,
rather than embedded in the royalty paid for use of the AA trademark.
For illustrations of application of the best method rule, see Sec.
1.482-8, Example 10, Example 11, and Example 12.
(5) Consideration not artificially limited. The arm's length
consideration for the controlled transfer of an intangible is not
limited by the consideration paid in any uncontrolled transactions that
do not meet the requirements of the comparable uncontrolled transaction
method described in paragraph (c) of this section. Similarly, the arm's
length consideration for an intangible is not limited by the prevailing
rates of consideration paid for the use or transfer of intangibles
within the same or similar industry.
(6) Lump sum payments--(i) In general. If an intangible is
transferred in a controlled transaction for a lump sum, that amount must
be commensurate with the income attributable to the intangible. A lump
sum is commensurate with income in a taxable year if the equivalent
royalty amount for that taxable year is equal to an arm's length
royalty. The equivalent royalty amount for a taxable year is the amount
determined by treating the lump sum as an advance payment of a stream of
royalties over the useful life of the intangible (or the period covered
by an agreement, if shorter), taking into account the projected sales of
the licensee as of the date of the transfer. Thus, determining the
equivalent royalty amount requires a present value calculation based on
the lump sum, an appropriate discount rate, and the projected sales over
the relevant period. The equivalent royalty amount is subject to
periodic adjustments under Sec. 1.482-4(f)(2)(i) to the same extent as
an actual royalty payment pursuant to a license agreement.
(ii) Exceptions. No periodic adjustment will be made under paragraph
(f)(2)(i) of this section if any of the exceptions to periodic
adjustments provided in paragraph (f)(2)(ii) of this section apply.
(iii) Example. The following example illustrates the principle of
this paragraph (f)(5).
Example. Calculation of the equivalent royalty amount. (i) FSub is
the foreign subsidiary of USP, a U.S. company. USP licenses FSub the
right to produce and sell the whopperchopper, a patented new kitchen
appliance, for the foreign market. The license is for a period of five
years, and payment takes the form of a single lump-sum charge of
$500,000 that is paid at the beginning of the period.
(ii) The equivalent royalty amount for this license is determined by
deriving an equivalent royalty rate equal to the lump-sum payment
divided by the present discounted value of FSub's projected sales of
whopperchoppers over the life of the license. Based on the riskiness of
the whopperchopper business, an appropriate discount rate is determined
to be 10 percent. Projected sales of whopperchoppers for each year of
the license are as follows:
------------------------------------------------------------------------
Projected
Year sales
------------------------------------------------------------------------
1....................................................... $2,500,000
2....................................................... 2,600,000
3....................................................... 2,700,000
4....................................................... 2,700,000
5....................................................... 2,750,000
------------------------------------------------------------------------
(iii) Based on this information, the present discounted value of the
projected whopperchopper sales is approximately $10 million, yielding an
equivalent royalty rate of approximately 5%. Thus, the equivalent
royalty amounts for each year are as follows:
------------------------------------------------------------------------
Projected Equivalent
Year sales royalty amount
------------------------------------------------------------------------
1....................................... $2,500,000 $125,000
2....................................... 2,600,000 130,000
3....................................... 2,700,000 135,000
4....................................... 2,700,000 135,000
5....................................... 2,750,000 137,500
------------------------------------------------------------------------
(iv) If in any of the five taxable years the equivalent royalty
amount is determined not to be an arm's length amount, a periodic
adjustment may be made pursuant to Sec. 1.482-4(f)(2)(i). The
adjustment in such case would be equal to the difference between the
equivalent royalty amount and the arm's length royalty in that taxable
year.
(g) Coordination with rules governing cost sharing arrangements.
Section 1.482-7 provides the specific methods to be used to determine
arm's length results of controlled transactions in connection with a
cost sharing arrangement.
[[Page 656]]
This section provides the specific methods to be used to determine arm's
length results of a transfer of intangible property, including in an
arrangement for sharing the costs and risks of developing intangibles
other than a cost sharing arrangement covered by Sec. 1.482-7. In the
case of such an arrangement, consideration of the principles, methods,
comparability, and reliability considerations set forth in Sec. 1.482-7
is relevant in determining the best method, including an unspecified
method, under this section, as appropriately adjusted in light of the
differences in the facts and circumstances between such arrangement and
a cost sharing arrangement.
(h) Effective/applicability date--(1) In general. Except as provided
in the succeeding sentence, the provisions of paragraphs (f)(3) and (4)
of this section are generally applicable for taxable years beginning
after December 31, 2006. The provisions of paragraphs (f)(3)(i)(B) and
(g) of this section are generally applicable on January 5, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraphs (f)(3) and (4) of this
section to earlier taxable years in accordance with the rules set forth
in Sec. 1.482-9(n)(2).
[T.D. 8552, 59 FR 35016, July 8, 1994; T.D. 9278, 71 FR 44484, Aug. 4,
2006; T.D. 9456, 74 FR 38842, Aug. 4, 2009; T.D. 9568, 76 FR 80090, Dec.
22, 2011]
Sec. 1.482-5 Comparable profits method.
(a) In general. The comparable profits method evaluates whether the
amount charged in a controlled transaction is arm's length based on
objective measures of profitability (profit level indicators) derived
from uncontrolled taxpayers that engage in similar business activities
under similar circumstances.
(b) Determination of arm's length result--(1) In general. Under the
comparable profits method, the determination of an arm's length result
is based on the amount of operating profit that the tested party would
have earned on related party transactions if its profit level indicator
were equal to that of an uncontrolled comparable (comparable operating
profit). Comparable operating profit is calculated by determining a
profit level indicator for an uncontrolled comparable, and applying the
profit level indicator to the financial data related to the tested
party's most narrowly identifiable business activity for which data
incorporating the controlled transaction is available (relevant business
activity). To the extent possible, profit level indicators should be
applied solely to the tested party's financial data that is related to
controlled transactions. The tested party's reported operating profit is
compared to the comparable operating profits derived from the profit
level indicators of uncontrolled comparables to determine whether the
reported operating profit represents an arm's length result.
(2) Tested party--(i) In general. For purposes of this section, the
tested party will be the participant in the controlled transaction whose
operating profit attributable to the controlled transactions can be
verified using the most reliable data and requiring the fewest and most
reliable adjustments, and for which reliable data regarding uncontrolled
comparables can be located. Consequently, in most cases the tested party
will be the least complex of the controlled taxpayers and will not own
valuable intangible property or unique assets that distinguish it from
potential uncontrolled comparables.
(ii) Adjustments for tested party. The tested party's operating
profit must first be adjusted to reflect all other allocations under
section 482, other than adjustments pursuant to this section.
(3) Arm's length range. See Sec. 1.482-1(e)(2) for the
determination of the arm's length range. For purposes of the comparable
profits method, the arm's length range will be established using
comparable operating profits derived from a single profit level
indicator.
(4) Profit level indicators. Profit level indicators are ratios that
measure relationships between profits and costs incurred or resources
employed. A variety of profit level indicators can be calculated in any
given case. Whether use of a particular profit level indicator is
appropriate depends upon a number of factors, including the nature of
the activities of the tested party, the reliability of the available
data with respect to uncontrolled comparables, and
[[Page 657]]
the extent to which the profit level indicator is likely to produce a
reliable measure of the income that the tested party would have earned
had it dealt with controlled taxpayers at arm's length, taking into
account all of the facts and circumstances. The profit level indicators
should be derived from a sufficient number of years of data to
reasonably measure returns that accrue to uncontrolled comparables.
Generally, such a period should encompass at least the taxable year
under review and the preceding two taxable years. This analysis must be
applied in accordance with Sec. 1.482-1(f)(2)(iii)(D). Profit level
indicators that may provide a reliable basis for comparing operating
profits of the tested party and uncontrolled comparables include the
following--
(i) Rate of return on capital employed. The rate of return on
capital employed is the ratio of operating profit to operating assets.
The reliability of this profit level indicator increases as operating
assets play a greater role in generating operating profits for both the
tested party and the uncontrolled comparable. In addition, reliability
under this profit level indicator depends on the extent to which the
composition of the tested party's assets is similar to that of the
uncontrolled comparable. Finally, difficulties in properly valuing
operating assets will diminish the reliability of this profit level
indicator.
(ii) Financial ratios. Financial ratios measure relationships
between profit and costs or sales revenue. Since functional differences
generally have a greater effect on the relationship between profit and
costs or sales revenue than the relationship between profit and
operating assets, financial ratios are more sensitive to functional
differences than the rate of return on capital employed. Therefore,
closer functional comparability normally is required under a financial
ratio than under the rate of return on capital employed to achieve a
similarly reliable measure of an arm's length result. Financial ratios
that may be appropriate include the following--
(A) Ratio of operating profit to sales; and
(B) Ratio of gross profit to operating expenses. Reliability under
this profit level indicator also depends on the extent to which the
composition of the tested party's operating expenses is similar to that
of the uncontrolled comparables.
(iii) Other profit level indicators. Other profit level indicators
not described in this paragraph (b)(4) may be used if they provide
reliable measures of the income that the tested party would have earned
had it dealt with controlled taxpayers at arm's length. However, profit
level indicators based solely on internal data may not be used under
this paragraph (b)(4) because they are not objective measures of
profitability derived from operations of uncontrolled taxpayers engaged
in similar business activities under similar circumstances.
(c) Comparability and reliability considerations--(1) In general.
Whether results derived from application of this method are the most
reliable measure of the arm's length result must be determined using the
factors described under the best method rule in Sec. 1.482-1(c).
(2) Comparability--(i) In general. The degree of comparability
between an uncontrolled taxpayer and the tested party is determined by
applying the provisions of Sec. 1.482-1(d)(2). The comparable profits
method compares the profitability of the tested party, measured by a
profit level indicator (generally based on operating profit), to the
profitability of uncontrolled taxpayers in similar circumstances. As
with all methods that rely on external market benchmarks, the greater
the degree of comparability between the tested party and the
uncontrolled taxpayer, the more reliable will be the results derived
from the application of this method. The determination of the degree of
comparability between the tested party and the uncontrolled taxpayer
depends upon all the relevant facts and circumstances, including the
relevant lines of business, the product or service markets involved, the
asset composition employed (including the nature and quantity of
tangible assets, intangible assets and working capital), the size and
scope of operations, and the stage in a business or product cycle.
(ii) Functional, risk and resource comparability. An operating
profit represents a return for the investment of
[[Page 658]]
resources and assumption of risks. Therefore, although all of the
factors described in Sec. 1.482-1(d)(3) must be considered,
comparability under this method is particularly dependent on resources
employed and risks assumed. Moreover, because resources and risks
usually are directly related to functions performed, it is also
important to consider functions performed in determining the degree of
comparability between the tested party and an uncontrolled taxpayer. The
degree of functional comparability required to obtain a reliable result
under the comparable profits method, however, is generally less than
that required under the resale price or cost plus methods. For example,
because differences in functions performed often are reflected in
operating expenses, taxpayers performing different functions may have
very different gross profit margins but earn similar levels of operating
profit.
(iii) Other comparability factors. Other factors listed in Sec.
1.482-1(d)(3) also may be particularly relevant under the comparable
profits method. Because operating profit usually is less sensitive than
gross profit to product differences, reliability under the comparable
profits method is not as dependent on product similarity as the resale
price or cost plus method. However, the reliability of profitability
measures based on operating profit may be adversely affected by factors
that have less effect on results under the comparable uncontrolled
price, resale price, and cost plus methods. For example, operating
profit may be affected by varying cost structures (as reflected, for
example, in the age of plant and equipment), differences in business
experience (such as whether the business is in a start-up phase or is
mature), or differences in management efficiency (as indicated, for
example, by objective evidence such as expanding or contracting sales or
executive compensation over time). Accordingly, if material differences
in these factors are identified based on objective evidence, the
reliability of the analysis may be affected.
(iv) Adjustments for the differences between the tested party and
the uncontrolled taxpayers. If there are differences between the tested
party and an uncontrolled comparable that would materially affect the
profits determined under the relevant profit level indicator,
adjustments should be made according to the comparability provisions of
Sec. 1.482-1(d)(2). In some cases, the assets of an uncontrolled
comparable may need to be adjusted to achieve greater comparability
between the tested party and the uncontrolled comparable. In such cases,
the uncontrolled comparable's operating income attributable to those
assets must also be adjusted before computing a profit level indicator
in order to reflect the income and expense attributable to the adjusted
assets. In certain cases it may also be appropriate to adjust the
operating profit of the tested party and comparable parties. For
example, where there are material differences in accounts payable among
the comparable parties and the tested party, it will generally be
appropriate to adjust the operating profit of each party by increasing
it to reflect an imputed interest charge on each party's accounts
payable. As another example, it may be appropriate to adjust the
operating profit of a party to account for material differences in the
utilization of or accounting for stock-based compensation (as defined by
Sec. 1.482-7(d)(3)(i)) among the tested party and comparable parties.
(3) Data and assumptions--(i) In general. The reliability of the
results derived from the comparable profits method is affected by the
quality of the data and assumptions used to apply this method.
(ii) Consistency in accounting. The degree of consistency in
accounting practices between the controlled transaction and the
uncontrolled comparables that materially affect operating profit affects
the reliability of the result. Thus, for example, if differences in
inventory and other cost accounting practices would materially affect
operating profit, the ability to make reliable adjustments for such
differences would affect the reliability of the results.
(iii) Allocations between the relevant business activity and other
activities. The reliability of the allocation of costs,
[[Page 659]]
income, and assets between the relevant business activity and other
activities of the tested party or an uncontrolled comparable will affect
the reliability of the determination of operating profit and profit
level indicators. If it is not possible to allocate costs, income, and
assets directly based on factual relationships, a reasonable allocation
formula may be used. To the extent direct allocations are not made, the
reliability of the results derived from the application of this method
is reduced relative to the results of a method that requires fewer
allocations of costs, income, and assets. Similarly, the reliability of
the results derived from the application of this method is affected by
the extent to which it is possible to apply the profit level indicator
to the tested party's financial data that is related solely to the
controlled transactions. For example, if the relevant business activity
is the assembly of components purchased from both controlled and
uncontrolled suppliers, it may not be possible to apply the profit level
indicator solely to financial data related to the controlled
transactions. In such a case, the reliability of the results derived
from the application of this method will be reduced.
(d) Definitions. The definitions set forth in paragraphs (d)(1)
through (6) of this section apply for purposes of this section.
(1) Sales revenue means the amount of the total receipts from sale
of goods and provision of services, less returns and allowances.
Accounting principles and conventions that are generally accepted in the
trade or industry of the controlled taxpayer under review must be used.
(2) Gross profit means sales revenue less cost of goods sold.
(3) Operating expenses includes all expenses not included in cost of
goods sold except for interest expense, foreign income taxes (as defined
in Sec. 1.901-2(a)), domestic income taxes, and any other expenses not
related to the operation of the relevant business activity. Operating
expenses ordinarily include expenses associated with advertising,
promotion, sales, marketing, warehousing and distribution,
administration, and a reasonable allowance for depreciation and
amortization.
(4) Operating profit means gross profit less operating expenses.
Operating profit includes all income derived from the business activity
being evaluated by the comparable profits method, but does not include
interest and dividends, income derived from activities not being tested
by this method, or extraordinary gains and losses that do not relate to
the continuing operations of the tested party.
(5) Reported operating profit means the operating profit of the
tested party reflected on a timely filed U.S. income tax return. If the
tested party files a U.S. income tax return, its operating profit is
considered reflected on a U.S. income tax return if the calculation of
taxable income on its return for the taxable year takes into account the
income attributable to the controlled transaction under review. If the
tested party does not file a U.S. income tax return, its operating
profit is considered reflected on a U.S. income tax return in any
taxable year for which income attributable to the controlled transaction
under review affects the calculation of the U.S. taxable income of any
other member of the same controlled group. If the comparable operating
profit of the tested party is determined from profit level indicators
derived from financial statements or other accounting records and
reports of comparable parties, adjustments may be made to the reported
operating profit of the tested party in order to account for material
differences between the tested party's operating profit reported for U.S
income tax purposes and the tested party's operating profit for
financial statement purposes. In addition, in accordance with Sec.
1.482-1(f)(2)(iii)(D), adjustments under section 482 that are finally
determined may be taken into account in determining reported operating
profit.
(6) Operating assets. The term operating assets means the value of
all assets used in the relevant business activity of the tested party,
including fixed assets and current assets (such as cash, cash
equivalents, accounts receivable, and inventories).
The term does not include investments in subsidiaries, excess cash,
and
[[Page 660]]
portfolio investments. Operating assets may be measured by their net
book value or by their fair market value, provided that the same method
is consistently applied to the tested party and the comparable parties,
and consistently applied from year to year. In addition, it may be
necessary to take into account recent acquisitions, leased assets,
intangibles, currency fluctuations, and other items that may not be
explicitly recorded in the financial statements of the tested party or
uncontrolled comparable. Finally, operating assets must be measured by
the average of the values for the beginning of the year and the end of
the year, unless substantial fluctuations in the value of operating
assets during the year make this an inaccurate measure of the average
value over the year. In such a case, a more accurate measure of the
average value of operating assets must be applied.
(e) Examples. The following examples illustrate the application of
this section.
Example 1. Transfer of tangible property resulting in no adjustment.
(i) FP is a publicly traded foreign corporation with a U.S. subsidiary,
USSub, that is under audit for its 1996 taxable year. FP manufactures a
consumer product for worldwide distribution. USSub imports the assembled
product and distributes it within the United States at the wholesale
level under the FP name.
(ii) FP does not allow uncontrolled taxpayers to distribute the
product. Similar products are produced by other companies but none of
them is sold to uncontrolled taxpayers or to uncontrolled distributors.
(iii) Based on all the facts and circumstances, the district
director determines that the comparable profits method will provide the
most reliable measure of an arm's length result. USSub is selected as
the tested party because it engages in activities that are less complex
than those undertaken by FP.
There is data from a number of independent operators of wholesale
distribution businesses. These potential comparables are further
narrowed to select companies in the same industry segment that perform
similar functions and bear similar risks to USSub. An analysis of the
information available on these taxpayers shows that the ratio of
operating profit to sales is the most appropriate profit level
indicator, and this ratio is relatively stable where at least three
years are included in the average. For the taxable years 1994 through
1996, USSub shows the following results:
----------------------------------------------------------------------------------------------------------------
1994 1995 1996 Average
----------------------------------------------------------------------------------------------------------------
Sales...................................................... $500,000 $560,000 $500,000 $520,000
Cost of Goods Sold......................................... 393,000 412,400 400,000 401,800
Operating Expenses......................................... 80,000 110,000 104,600 98,200
Operating Profit........................................... 27,000 37,600 (4,600) 20,000
----------------------------------------------------------------------------------------------------------------
(iv) After adjustments have been made to account for identified
material differences between USSub and the uncontrolled distributors,
the average ratio of operating profit to sales is calculated for each of
the uncontrolled distributors. Applying each ratio to USSub would lead
to the following comparable operating profit (COP) for USSub:
------------------------------------------------------------------------
OP/S
Uncontrolled distributor (percent) USSub COP
------------------------------------------------------------------------
A................................................. 1.7 $8,840
B................................................. 3.1 16,120
C................................................. 3.8 19,760
D................................................. 4.5 23,400
E................................................. 4.7 24,440
F................................................. 4.8 24,960
G................................................. 4.9 25,480
H................................................. 6.7 34,840
I................................................. 9.9 51,480
J................................................. 10.5 54,600
------------------------------------------------------------------------
(v) The data is not sufficiently complete to conclude that it is
likely that all material differences between USSub and the uncontrolled
distributors have been identified. Therefore, an arm's length range can
be established only pursuant to Sec. 1.482- 1(e)(2)(iii)(B). The
district director measures the arm's length range by the interquartile
range of results, which consists of the results ranging from $19,760 to
$34,840. Although USSub's operating income for 1996 shows a loss of
$4,600, the district director determines that no allocation should be
made, because USSub's average reported operating profit of $20,000 is
within this range.
Example 2. Transfer of tangible property resulting in adjustment.
(i) The facts are the same as in Example 1 except that USSub reported
the following income and expenses:
[[Page 661]]
----------------------------------------------------------------------------------------------------------------
1994 1995 1996 Average
----------------------------------------------------------------------------------------------------------------
Sales..................................................... $500,000 $560,000 $500,000 $520,000
Cost of Good Sold......................................... 370,000 460,000 400,000 410,000
Operating Expenses........................................ 110,000 110,000 110,000 110,000
Operating Profit.......................................... 20,000 (10,000) (10,000) 0
----------------------------------------------------------------------------------------------------------------
(ii) The interquartile range of comparable operating profits remains
the same as derived in Example 1: $19,760 to $34,840. USSub's average
operating profit for the years 1994 through 1996 ($0) falls outside this
range. Therefore, the district director determines that an allocation
may be appropriate.
(iii) To determine the amount, if any, of the allocation, the
district director compares USSub's reported operating profit for 1996 to
comparable operating profits derived from the uncontrolled distributors'
results for 1996. The ratio of operating profit to sales in 1996 is
calculated for each of the uncontrolled comparables and applied to
USSub's 1996 sales to derive the following results:
------------------------------------------------------------------------
OP/S USSub
Uncontrolled distributor (percent) COP
------------------------------------------------------------------------
C................................................... 0.5 $2,500
D................................................... 1.5 7,500
E................................................... 2.0 10,000
A................................................... 1.6 13,000
F................................................... 2.8 14,000
B................................................... 2.9 14,500
J................................................... 3.0 15,000
I................................................... 4.4 22,000
H................................................... 6.9 34,500
G................................................... 7.4 37,000
------------------------------------------------------------------------
(iv) Based on these results, the median of the comparable operating
profits for 1996 is $14,250. Therefore, USSub's income for 1996 is
increased by $24,250, the difference between USSub's reported operating
profit for 1996 and the median of the comparable operating profits for
1996.
Example 3. Multiple year analysis. (i) The facts are the same as in
Example 2. In addition, the district director examines the taxpayer's
results for the 1997 taxable year. As in Example 2, the district
director increases USSub's income for the 1996 taxable year by $24,250.
The results for the 1997 taxable year, together with the 1995 and 1996
taxable years, are as follows:
----------------------------------------------------------------------------------------------------------------
1995 1996 1997 Average
----------------------------------------------------------------------------------------------------------------
Sales................................................... $560,000 $500,000 $530,000 $530,000
Cost of Good Sold....................................... 460,000 400,000 430,000 430,000
Operating Expenses...................................... 110,000 110,000 110,000 110,000
Operating Profit........................................ (10,000) (10,000) (10,000) (10,000)
----------------------------------------------------------------------------------------------------------------
(ii) The interquartile range of comparable operating profits, based
on average results from the uncontrolled comparables and average sales
for USSub for the years 1995 through 1997, ranges from $15,500 to
$30,000. In determining whether an allocation for the 1997 taxable year
may be made, the district director compares USSub's average reported
operating profit for the years 1995 through 1997 to the interquartile
range of average comparable operating profits over this period. USSub's
average reported operating profit is determined without regard to the
adjustment made with respect to the 1996 taxable year. See Sec. 1.482-
1(f)(2)(iii)(D). Therefore, USSub's average reported operating profit
for the years 1995 through 1997 is ($10,000). Because this amount of
income falls outside the interquartile range, the district director
determines that an allocation may be appropriate.
(iii) To determine the amount, if any, of the allocation for the
1997 taxable year, the district director compares USSub's reported
operating profit for 1997 to the median of the comparable operating
profits derived from the uncontrolled distributors' results for 1997.
The median of the comparable operating profits derived from the
uncontrolled comparables results for the 1997 taxable year is $12,000.
Based on this comparison, the district director increases USSub's 1997
taxable income by $22,000, the difference between the median of the
comparable operating profits for the 1997 taxable year and USSub's
reported operating profit of ($10,000) for the 1997 taxable year.
Example 4. Transfer of intangible to offshore manufacturer. (i)
DevCo is a U.S. developer, producer and marketer of widgets. DevCo
develops a new ``high tech widget'' (htw) that is manufactured by its
foreign subsidiary ManuCo located in Country H. ManuCo sells the htw to
MarkCo (a U.S. subsidiary of DevCo) for distribution and marketing in
the United States. The taxable year 1996 is under audit, and the
district director examines whether the royalty rate of 5 percent paid by
[[Page 662]]
ManuCo to DevCo is an arm's length consideration for the htw technology.
(ii) Based on all the facts and circumstances, the district director
determines that the comparable profits method will provide the most
reliable measure of an arm's length result. ManuCo is selected as the
tested party because it engages in relatively routine manufacturing
activities, while DevCo engages in a variety of complex activities using
unique and valuable intangibles. Finally, because ManuCo engages in
manufacturing activities, it is determined that the ratio of operating
profit to operating assets is an appropriate profit level indicator.
(iii) Uncontrolled taxpayers performing similar functions cannot be
found in country H. It is determined that data available in countries M
and N provides the best match of companies in a similar market
performing similar functions and bearing similar risks. Such data is
sufficiently complete to identify many of the material differences
between ManuCo and the uncontrolled comparables, and to make adjustments
to account for such differences. However, data is not sufficiently
complete so that it is likely that no material differences remain. In
particular, the differences in geographic markets might have materially
affected the results of the various companies.
(iv) In a separate analysis, it is determined that the price that
ManuCo charged to MarkCo for the htw's is an arm's length price under
Sec. 1.482-3(b). Therefore, ManuCo's financial data derived from its
sales to MarkCo are reliable. ManuCo's financial data from 1994-1996 is
as follows:
----------------------------------------------------------------------------------------------------------------
1994 1995 1996 Average
----------------------------------------------------------------------------------------------------------------
Assets..................................................... $24,000 $25,000 $26,000 $25,000
Sales to MarkCo............................................ 25,000 30,000 35,000 30,000
Cost of Goods Sold......................................... 6,250 7,500 8,750 7,500
Royalty to DevCo (5%).................................... 1,250 1,500 1,750 1,500
Other.................................................... 5,000 6,000 7,000 6,000
Operating Expenses......................................... 1,000 1,000 1,000 1,000
Operating Profit........................................... 17,750 21,500 25,250 21,500
----------------------------------------------------------------------------------------------------------------
(v) Applying the ratios of average operating profit to operating
assets for the 1994 through 1996 taxable years derived from a group of
similar uncontrolled comparables located in country M and N to ManuCo's
average operating assets for the same period provides a set of
comparable operating profits. The interquartile range for these average
comparable operating profits is $3,000 to $4,500. ManuCo's average
reported operating profit for the years 1994 through 1996 ($21,500)
falls outside this range. Therefore, the district director determines
that an allocation may be appropriate for the 1996 taxable year.
(vi) To determine the amount, if any, of the allocation for the 1996
taxable year, the district director compares ManuCo's reported operating
profit for 1996 to the median of the comparable operating profits
derived from the uncontrolled distributors' results for 1996. The median
result for the uncontrolled comparables for 1996 is $3,750. Based on
this comparison, the district director increases royalties that ManuCo
paid by $21,500 (the difference between $25,250 and the median of the
comparable operating profits, $3,750).
Example 5. Adjusting operating assets and operating profit for
differences in accounts receivable. (i) USM is a U.S. company that
manufactures parts for industrial equipment and sells them to its
foreign parent corporation. For purposes of applying the comparable
profits method, 15 uncontrolled manufacturers that are similar to USM
have been identified.
(ii) USM has a significantly lower level of accounts receivable than
the uncontrolled manufacturers. Since the rate of return on capital
employed is to be used as the profit level indicator, both operating
assets and operating profits must be adjusted to account for this
difference. Each uncontrolled comparable's operating assets is reduced
by the amount (relative to sales) by which they exceed USM's accounts
receivable. Each uncontrolled comparable's operating profit is adjusted
by deducting imputed interest income on the excess accounts receivable.
This imputed interest income is calculated by multiplying the
uncontrolled comparable's excess accounts receivable by an interest rate
appropriate for short-term debt.
Example 6. Adjusting operating profit for differences in accounts
payable. (i) USD is the U.S. subsidiary of a foreign corporation. USD
purchases goods from its foreign parent and sells them in the U.S.
market. For purposes of applying the comparable profits method, 10
uncontrolled distributors that are similar to USD have been identified.
(ii) There are significant differences in the level of accounts
payable among the uncontrolled distributors and USD. To adjust for these
differences, the district director increases the operating profit of the
uncontrolled distributors and USD to reflect interest expense imputed to
the accounts payable.
[[Page 663]]
The imputed interest expense for each company is calculated by
multiplying the company's accounts payable by an interest rate
appropriate for its short-term debt.
[T.D. 8552, 59 FR 35021, July 8, 1994; 60 FR 16703, Mar. 31, 1995; T.D.
9088, 68 FR 51177, Aug. 26, 2003; T.D. 9441, 74 FR 352, Jan. 5,
2009;T.D. 9568, 76 FR 80090, Dec. 22, 2011]
Sec. 1.482-6 Profit split method.
(a) In general. The profit split method evaluates whether the
allocation of the combined operating profit or loss attributable to one
or more controlled transactions is arm's length by reference to the
relative value of each controlled taxpayer's contribution to that
combined operating profit or loss. The combined operating profit or loss
must be derived from the most narrowly identifiable business activity of
the controlled taxpayers for which data is available that includes the
controlled transactions (relevant business activity).
(b) Appropriate share of profits and losses. The relative value of
each controlled taxpayer's contribution to the success of the relevant
business activity must be determined in a manner that reflects the
functions performed, risks assumed, and resources employed by each
participant in the relevant business activity, consistent with the
comparability provisions of Sec. 1.482-1(d)(3). Such an allocation is
intended to correspond to the division of profit or loss that would
result from an arrangement between uncontrolled taxpayers, each
performing functions similar to those of the various controlled
taxpayers engaged in the relevant business activity. The profit
allocated to any particular member of a controlled group is not
necessarily limited to the total operating profit of the group from the
relevant business activity. For example, in a given year, one member of
the group may earn a profit while another member incurs a loss. In
addition, it may not be assumed that the combined operating profit or
loss from the relevant business activity should be shared equally, or in
any other arbitrary proportion. The specific method of allocation must
be determined under paragraph (c) of this section.
(c) Application--(1) In general. The allocation of profit or loss
under the profit split method must be made in accordance with one of the
following allocation methods--(i) The comparable profit split, described
in paragraph (c)(2) of this section; or
(ii) The residual profit split, described in paragraph (c)(3) of
this section.
(2) Comparable profit split--(i) In general. A comparable profit
split is derived from the combined operating profit of uncontrolled
taxpayers whose transactions and activities are similar to those of the
controlled taxpayers in the relevant business activity. Under this
method, each uncontrolled taxpayer's percentage of the combined
operating profit or loss is used to allocate the combined operating
profit or loss of the relevant business activity.
(ii) Comparability and reliability considerations--(A) In general.
Whether results derived from application of this method are the most
reliable measure of the arm's length result is determined using the
factors described under the best method rule in Sec. 1.482-1(c).
(B) Comparability--(1) In general. The degree of comparability
between the controlled and uncontrolled taxpayers is determined by
applying the comparability provisions of Sec. 1.482-1(d). The
comparable profit split compares the division of operating profits among
the controlled taxpayers to the division of operating profits among
uncontrolled taxpayers engaged in similar activities under similar
circumstances. Although all of the factors described in Sec. 1.482-
1(d)(3) must be considered, comparability under this method is
particularly dependent on the considerations described under the
comparable profits method in Sec. 1.482-5(c)(2) or Sec. 1.482-
9(f)(2)(iii) because this method is based on a comparison of the
operating profit of the controlled and uncontrolled taxpayers. In
addition, because the contractual terms of the relationship among the
participants in the relevant business activity will be a principal
determinant of the allocation of functions and risks among them,
comparability under this method also depends particularly on the degree
of similarity of the contractual terms of the controlled and
uncontrolled taxpayers. Finally, the comparable profit
[[Page 664]]
split may not be used if the combined operating profit (as a percentage
of the combined assets) of the uncontrolled comparables varies
significantly from that earned by the controlled taxpayers.
(2) Adjustments for differences between the controlled and
uncontrolled taxpayers. If there are differences between the controlled
and uncontrolled taxpayers that would materially affect the division of
operating profit, adjustments must be made according to the provisions
of Sec. 1.482-1(d)(2).
(C) Data and assumptions. The reliability of the results derived
from the comparable profit split is affected by the quality of the data
and assumptions used to apply this method. In particular, the following
factors must be considered--
(1) The reliability of the allocation of costs, income, and assets
between the relevant business activity and the participants' other
activities will affect the accuracy of the determination of combined
operating profit and its allocation among the participants. If it is not
possible to allocate costs, income, and assets directly based on factual
relationships, a reasonable allocation formula may be used. To the
extent direct allocations are not made, the reliability of the results
derived from the application of this method is reduced relative to the
results of a method that requires fewer allocations of costs, income,
and assets. Similarly, the reliability of the results derived from the
application of this method is affected by the extent to which it is
possible to apply the method to the parties' financial data that is
related solely to the controlled transactions. For example, if the
relevant business activity is the assembly of components purchased from
both controlled and uncontrolled suppliers, it may not be possible to
apply the method solely to financial data related to the controlled
transactions. In such a case, the reliability of the results derived
from the application of this method will be reduced.
(2) The degree of consistency between the controlled and
uncontrolled taxpayers in accounting practices that materially affect
the items that determine the amount and allocation of operating profit
affects the reliability of the result. Thus, for example, if differences
in inventory and other cost accounting practices would materially affect
operating profit, the ability to make reliable adjustments for such
differences would affect the reliability of the results. Further,
accounting consistency among the participants in the controlled
transaction is required to ensure that the items determining the amount
and allocation of operating profit are measured on a consistent basis.
(D) Other factors affecting reliability. Like the methods described
in Sec. Sec. 1.482-3, 1.482-4, 1.482-5, and 1.482-9, the comparable
profit split relies exclusively on external market benchmarks. As
indicated in Sec. 1.482-1(c)(2)(i), as the degree of comparability
between the controlled and uncontrolled transactions increases, the
relative weight accorded the analysis under this method will increase.
In addition, the reliability of the analysis under this method may be
enhanced by the fact that all parties to the controlled transaction are
evaluated under the comparable profit split. However, the reliability of
the results of an analysis based on information from all parties to a
transaction is affected by the reliability of the data and the
assumptions pertaining to each party to the controlled transaction.
Thus, if the data and assumptions are significantly more reliable with
respect to one of the parties than with respect to the others, a
different method, focusing solely on the results of that party, may
yield more reliable results.
(3) Residual profit split--(i) In general. Under this method, the
combined operating profit or loss from the relevant business activity is
allocated between the controlled taxpayers following the two-step
process set forth in paragraphs (c)(3)(i)(A) and (B) of this section.
(A) Allocate income to routine contributions. The first step
allocates operating income to each party to the controlled transactions
to provide a market return for its routine contributions to the relevant
business activity. Routine contributions are contributions of the same
or a similar kind to those made by uncontrolled taxpayers involved in
similar business activities for which it
[[Page 665]]
is possible to identify market returns. Routine contributions ordinarily
include contributions of tangible property, services and intangible
property that are generally owned by uncontrolled taxpayers engaged in
similar activities. A functional analysis is required to identify these
contributions according to the functions performed, risks assumed, and
resources employed by each of the controlled taxpayers. Market returns
for the routine contributions should be determined by reference to the
returns achieved by uncontrolled taxpayers engaged in similar
activities, consistent with the methods described in Sec. Sec. 1.482-3,
1.482-4, 1.482-5 and 1.482-9.
(B) Allocate residual profit--(1) Nonroutine contributions
generally. The allocation of income to the controlled taxpayer's routine
contributions will not reflect profits attributable to each controlled
taxpayer's contributions to the relevant business activity that are not
routine (nonroutine contributions). A nonroutine contribution is a
contribution that is not accounted for as a routine contribution. Thus,
in cases where such nonroutine contributions are present, there normally
will be an unallocated residual profit after the allocation of income
described in paragraph (c)(3)(i)(A) of this section. Under this second
step, the residual profit generally should be divided among the
controlled taxpayers based upon the relative value of their nonroutine
contributions to the relevant business activity. The relative value of
the nonroutine contributions of each taxpayer should be measured in a
manner that most reliably reflects each nonroutine contribution made to
the controlled transaction and each controlled taxpayer's role in the
nonroutine contributions. If the nonroutine contribution by one of the
controlled taxpayers is also used in other business activities (such as
transactions with other controlled taxpayers), an appropriate allocation
of the value of the nonroutine contribution must be made among all the
business activities in which it is used.
(2) Nonroutine contributions of intangible property. In many cases,
nonroutine contributions of a taxpayer to the relevant business activity
may be contributions of intangible property. For purposes of paragraph
(c)(3)(i)(B)(1) of this section, the relative value of nonroutine
intangible property contributed by taxpayers may be measured by external
market benchmarks that reflect the fair market value of such intangible
property. Alternatively, the relative value of nonroutine intangible
property contributions may be estimated by the capitalized cost of
developing the intangible property and all related improvements and
updates, less an appropriate amount of amortization based on the useful
life of each intangible property. Finally, if the intangible property
development expenditures of the parties are relatively constant over
time and the useful life of the intangible property contributed by all
parties is approximately the same, the amount of actual expenditures in
recent years may be used to estimate the relative value of nonroutine
intangible property contributions.
(ii) Comparability and reliability considerations--(A) In general.
Whether results derived from this method are the most reliable measure
of the arm's length result is determined using the factors described
under the best method rule in Sec. 1.482-1(c). Thus, comparability and
the quality of data and assumptions must be considered in determining
whether this method provides the most reliable measure of an arm's
length result. The application of these factors to the residual profit
split is discussed in paragraph (c)(3)(ii)(B), (C), and (D) of this
section.
(B) Comparability. The first step of the residual profit split
relies on market benchmarks of profitability. Thus, the comparability
considerations that are relevant for the first step of the residual
profit split are those that are relevant for the methods that are used
to determine market returns for the routine contributions. The second
step of the residual profit split, however, may not rely so directly on
market benchmarks. Thus, the reliability of the results under this
method is reduced to the extent that the allocation of profits in the
second step does not rely on market benchmarks.
(C) Data and assumptions. The reliability of the results derived
from the residual profit split is affected by the
[[Page 666]]
quality of the data and assumptions used to apply this method. In
particular, the following factors must be considered--
(1) The reliability of the allocation of costs, income, and assets
as described in paragraph (c)(2)(ii)(C)(1) of this section;
(2) Accounting consistency as described in paragraph
(c)(2)(ii)(C)(2) of this section;
(3) The reliability of the data used and the assumptions made in
valuing the intangible property contributed by the participants. In
particular, if capitalized costs of development are used to estimate the
value of intangible property, the reliability of the results is reduced
relative to the reliability of other methods that do not require such an
estimate, for the following reasons. First, in any given case, the costs
of developing the intangible may not be related to its market value.
Second, the calculation of the capitalized costs of development may
require the allocation of indirect costs between the relevant business
activity and the controlled taxpayer's other activities, which may
affect the reliability of the analysis. Finally, the calculation of
costs may require assumptions regarding the useful life of the
intangible property.
(D) Other factors affecting reliability. Like the methods described
in Sec. Sec. 1.482-3, 1.482-4, 1.482-5, and 1.482-9, the first step of
the residual profit split relies exclusively on external market
benchmarks. As indicated in Sec. 1.482-1(c)(2)(i), as the degree of
comparability between the controlled and uncontrolled transactions
increases, the relative weight accorded the analysis under this method
will increase. In addition, to the extent the allocation of profits in
the second step is not based on external market benchmarks, the
reliability of the analysis will be decreased in relation to an analysis
under a method that relies on market benchmarks. Finally, the
reliability of the analysis under this method may be enhanced by the
fact that all parties to the controlled transaction are evaluated under
the residual profit split. However, the reliability of the results of an
analysis based on information from all parties to a transaction is
affected by the reliability of the data and the assumptions pertaining
to each party to the controlled transaction. Thus, if the data and
assumptions are significantly more reliable with respect to one of the
parties than with respect to the others, a different method, focusing
solely on the results of that party, may yield more reliable results.
(iii) Example. The provisions of this paragraph (c)(3) are
illustrated by the following example.
Example--Application of Residual Profit Split. (i) XYZ is a U.S.
corporation that develops, manufactures and markets a line of products
for police use in the United States. XYZ's research unit developed a
bulletproof material for use in protective clothing and headgear
(Nulon). XYZ obtains patent protection for the chemical formula for
Nulon. Since its introduction in the U.S., Nulon has captured a
substantial share of the U.S. market for bulletproof material.
(ii) XYZ licensed its European subsidiary, XYZ-Europe, to
manufacture and market Nulon in Europe. XYZ-Europe is a well-
established company that manufactures and markets XYZ products in
Europe. XYZ-Europe has a research unit that adapts XYZ products for the
defense market, as well as a well-developed marketing network that
employs brand names that it developed.
(iii) XYZ-Europe's research unit alters Nulon to adapt it to
military specifications and develops a high-intensity marketing campaign
directed at the defense industry in several European countries.
Beginning with the 1995 taxable year, XYZ-Europe manufactures and sells
Nulon in Europe through its marketing network under one of its brand
names.
(iv) For the 1995 taxable year, XYZ has no direct expenses
associated with the license of Nulon to XYZ-Europe and incurs no
expenses related to the marketing of Nulon in Europe. For the 1995
taxable year, XYZ-Europe's Nulon sales and pre-royalty expenses are $500
million and $300 million, respectively, resulting in net pre-royalty
profit of $200 million related to the Nulon business. The operating
assets employed in XYZ-Europe's Nulon business are $200 million. Given
the facts and circumstances, the district director determines under the
best method rule that a residual profit split will provide the most
reliable measure of an arm's length result. Based on an examination of a
sample of European companies performing functions similar to those of
XYZ-Europe, the district director determines that an average market
return on XYZ-Europe's operating assets in the Nulon business is 10
percent, resulting in a market return of $20 million (10% x $200
million) for XYZ- Europe's Nulon business, and a residual profit of $180
million.
[[Page 667]]
(v) Since the first stage of the residual profit split allocated
profits to XYZ-Europe's contributions other than those attributable to
highly valuable intangible property, it is assumed that the residual
profit of $180 million is attributable to the valuable intangibles
related to Nulon, i.e., the European brand name for Nulon and the Nulon
formula (including XYZ-Europe's modifications). To estimate the relative
values of these intangibles, the district director compares the ratios
of the capitalized value of expenditures as of 1995 on Nulon-related
research and development and marketing over the 1995 sales related to
such expenditures.
(vi) Because XYZ's protective product research and development
expenses support the worldwide protective product sales of the XYZ
group, it is necessary to allocate such expenses among the worldwide
business activities to which they relate. The district director
determines that it is reasonable to allocate the value of these expenses
based on worldwide protective product sales. Using information on the
average useful life of its investments in protective product research
and development, the district director capitalizes and amortizes XYZ's
protective product research and development expenses. This analysis
indicates that the capitalized research and development expenditures
have a value of $0.20 per dollar of global protective product sales in
1995.
(vii) XYZ-Europe's expenditures on Nulon research and development
and marketing support only its sales in Europe. Using information on the
average useful life of XYZ-Europe's investments in marketing and
research and development, the district director capitalizes and
amortizes XYZ-Europe's expenditures and determines that they have a
value in 1995 of $0.40 per dollar of XYZ-Europe's Nulon sales.
(viii) Thus, XYZ and XYZ-Europe together contributed $0.60 in
capitalized intangible development expenses for each dollar of XYZ-
Europe's protective product sales for 1995, of which XYZ contributed
one-third (or $0.20 per dollar of sales). Accordingly, the district
director determines that an arm's length royalty for the Nulon license
for the 1995 taxable year is $60 million, i.e., one-third of XYZ-
Europe's $180 million in residual Nulon profit.
(d) Effective/applicability date--(1) In general. The provisions of
paragraphs (c)(2)(ii)(B)(1) and (D), (c)(3)(i)(A) and (B), and
(c)(3)(ii)(D) of this section are generally applicable for taxable years
beginning after July 31, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraphs (c)(2)(ii)(B)(1) and
(D), (c)(3)(i)(A) and (B), and (c)(3)(ii)(D) of this section to earlier
taxable years in accordance with the rules set forth in Sec. 1.482-
9(n)(2).
[T.D. 8552, 59 FR 35025, July 8, 1994; 60 FR 16382, Mar. 30, 1995, as
amended by T.D. 9278, 71 FR 44486, Aug. 4, 2006; T.D. 9456, 74 FR 38844,
Aug. 4, 2009; 74 FR 46345, Sept. 9, 2009]
Sec. 1.482-7 Methods to determine taxable income in connection
with a cost sharing arrangement.
(a) In general. The arm's length amount charged in a controlled
transaction reasonably anticipated to contribute to developing
intangibles pursuant to a cost sharing arrangement (CSA), as described
in paragraph (b) of this section, must be determined under a method
described in this section. Each method must be applied in accordance
with the provisions of Sec. 1.482-1, except as those provisions are
modified in this section.
(1) RAB share method for cost sharing transactions (CSTs). See
paragraph (b)(1)(i) of this section regarding the requirement that
controlled participants, as defined in section (j)(1)(i) of this
section, share intangible development costs (IDCs) in proportion to
their shares of reasonably anticipated benefits (RAB shares) by entering
into cost sharing transactions (CSTs).
(2) Methods for platform contribution transactions (PCTs). The arm's
length amount charged in a platform contribution transaction (PCT)
described in paragraph (b)(1)(ii) of this section must be determined
under the method or methods applicable under the other section or
sections of the section 482 regulations, as supplemented by paragraph
(g) of this section. See Sec. 1.482-1(b)(2)(ii) (Selection of category
of method applicable to transaction), Sec. 1.482-1(b)(2)(iii)
(Coordination of methods applicable to certain intangible development
arrangements), and paragraph (g) of this section (Supplemental guidance
on methods applicable to PCTs).
(3) Methods for other controlled transactions--(i) Contribution to a
CSA by a controlled taxpayer that is not a controlled participant. If a
controlled taxpayer that is not a controlled participant contributes to
developing a cost shared intangible, as defined in section (j)(1)(i) of
this section, it must receive
[[Page 668]]
consideration from the controlled participants under the rules of Sec.
1.482-4(f)(4) (Contribution to the value of an intangible owned by
another). Such consideration will be treated as an intangible
development cost for purposes of paragraph (d) of this section.
(ii) Transfer of interest in a cost shared intangible. If at any
time (during the term, or upon or after the termination, of a CSA) a
controlled participant transfers an interest in a cost shared intangible
to another controlled taxpayer, the controlled participant must receive
an arm's length amount of consideration from the transferee under the
rules of Sec. Sec. 1.482-4 through 1.482-6 as supplemented by paragraph
(f)(4) of this section regarding arm's length consideration for a change
in participation. For this purpose, a capability variation described in
paragraph (f)(3) of this section is considered to be a controlled
transfer of interests in cost shared intangibles.
(iii) Other controlled transactions in connection with a CSA.
Controlled transactions between controlled participants that are not
PCTs or CSTs and are not described in paragraph (a)(3)(ii) of this
section (for example, provision of a cross operating contribution, as
defined in paragraph (j)(1)(i) of this section, or make-or-sell rights,
as defined in paragraph (c)(4) of this section) require arm's length
consideration under the rules of Sec. Sec. 1.482-1 through 1.482-6, and
1.482-9 as supplemented by paragraph (g)(2)(iv) of this section.
(iv) Controlled transactions in the absence of a CSA. If a
controlled transaction is reasonably anticipated to contribute to
developing intangibles pursuant to an arrangement that is not a CSA
described in paragraph (b)(1) or (5) of this section, whether the
results of any such controlled transaction are consistent with an arm's
length result must be determined under the applicable rules of the other
sections of the regulations under section 482. For example, an
arrangement for developing intangibles in which one controlled
taxpayer's costs of developing the intangibles significantly exceeds its
share of reasonably anticipated benefits from exploiting the developed
intangibles would not in substance be a CSA, as described in paragraphs
(b)(1)(i) through (iii) of this section or paragraph (b)(5)(i) of this
section. In such a case, unless the rules of this section are applicable
by reason of paragraph (b)(5) of this section, the arrangement must be
analyzed under other applicable sections of regulations under section
482 to determine whether it achieves arm's length results, and if not,
to determine any allocations by the Commissioner that are consistent
with such other regulations under section 482. See Sec. 1.482-
1(b)(2)(ii) (Selection of category of method applicable to transaction)
and (iii) (Coordination of methods applicable to certain intangible
development arrangements).
(4) Coordination with the arm's length standard. A CSA produces
results that are consistent with an arm's length result within the
meaning of Sec. 1.482-1(b)(1) if, and only if, each controlled
participant's IDC share (as determined under paragraph (d)(4) of this
section) equals its RAB share, each controlled participant compensates
its RAB share of the value of all platform contributions by other
controlled participants, and all other requirements of this section are
satisfied.
(b) Cost sharing arrangement. A cost sharing arrangement is an
arrangement by which controlled participants share the costs and risks
of developing cost shared intangibles in proportion to their RAB shares.
An arrangement is a CSA if and only if the requirements of paragraphs
(b)(1) through (4) of this section are met.
(1) Substantive requirements--(i) CSTs. All controlled participants
must commit to, and in fact, engage in cost sharing transactions. In
CSTs, the controlled participants make payments to each other (CST
Payments) as appropriate, so that in each taxable year each controlled
participant's IDC share is in proportion to its respective RAB share.
(ii) PCTs. All controlled participants must commit to, and in fact,
engage in platform contributions transactions to the extent that there
are platform contributions pursuant to paragraph (c) of this section. In
a PCT, each other controlled participant (PCT Payor) is obligated to,
and must in fact, make arm's length payments (PCT Payments) to
[[Page 669]]
each controlled participant (PCT Payee) that provides a platform
contribution. For guidance on determining such arm's length obligation,
see paragraph (g) of this section.
(iii) Divisional interests. Each controlled participant must receive
a non-overlapping interest in the cost shared intangibles without
further obligation to compensate another controlled participant for such
interest.
(iv) Examples. The following examples illustrate the principles of
this paragraph (b)(1):
Example 1. Company A and Company B, who are members of the same
controlled group, execute an agreement to jointly develop vaccine X and
own the exclusive rights to commercially exploit vaccine X in their
respective territories, which together comprise the whole world. The
agreement provides that they will share some, but not all, of the costs
for developing Vaccine X in proportion to RAB share. Such agreement is
not a CSA because Company A and Company B have not agreed to share all
of the IDCs in proportion to their respective RAB shares.
Example 2. Company A and Company B agree to share all the costs of
developing Vaccine X. The agreement also provides for employing certain
resources and capabilities of Company A in this program including a
skilled research team and certain research facilities, and provides for
Company B to make payments to Company A in this respect. However, the
agreement expressly provides that the program will not employ, and so
Company B is expressly relieved of the payments in regard to, certain
software developed by Company A as a medical research tool to model
certain cellular processes expected to be implicated in the operation of
Vaccine X even though such software would reasonably be anticipated to
be relevant to developing Vaccine X and, thus, would be a platform
contribution. See paragraph (c) of this section. Such agreement is not a
CSA because Company A and Company B have not engaged in a necessary PCT
for purposes of developing Vaccine X.
Example 3. Companies C and D, who are members of the same controlled
group, enter into a CSA. In the first year of the CSA, C and D conduct
the intangible development activity, as described in paragraph (d)(1) of
this section. The total IDCs in regard to such activity are $3,000,000
of which C and D pay $2,000,000 and $1,000,000, respectively, directly
to third parties. As between C and D, however, their CSA specifies that
they will share all IDCs in accordance with their RAB shares (as
described in paragraph (e)(1) of this section), which are 60% for C and
40% for D. It follows that C should bear $1,800,000 of the total IDCs
(60% of total IDCs of $3,000,000) and D should bear $1,200,000 of the
total IDCs (40% of total IDCs of $3,000,000). D makes a CST payment to C
of $200,000, that is, the amount by which D's share of IDCs in
accordance with its RAB share exceeds the amount of IDCs initially borne
by D ($1,200,000-$1,000,000), and which also equals the amount by which
the total IDCs initially borne by C exceeds its share of IDCS in
accordance with its RAB share ($2,000,000--$1,800,000). As a result of
D's CST payment to C, the IDC shares of C and D are in proportion to
their respective RAB shares.
(2) Administrative requirements. The CSA must meet the requirements
of paragraph (k) of this section.
(3) Date of a PCT. The controlled participants must enter into a PCT
as of the earliest date on or after the CSA is entered into on which a
platform contribution is reasonably anticipated to contribute to
developing cost shared intangibles.
(4) Divisional interests--(i) In general. Pursuant to paragraph
(b)(1)(iii) of this section, each controlled participant must receive a
non-overlapping interest in the cost shared intangibles without further
obligation to compensate another controlled participant for such
interest. Each controlled participant must be entitled to the perpetual
and exclusive right to the profits from transactions of any member of
the controlled group that includes the controlled participant with
uncontrolled taxpayers to the extent that such profits are attributable
to such interest in the cost shared intangibles.
(ii) Territorial based divisional interests. The CSA may divide all
interests in cost shared intangibles on a territorial basis as follows.
The entire world must be divided into two or more non-overlapping
geographic territories. Each controlled participant must receive at
least one such territory, and in the aggregate all the participants must
receive all such territories. Each controlled participant will be
assigned the perpetual and exclusive right to exploit the cost shared
intangibles through the use, consumption, or disposition of property or
services in its territories. Thus, compensation will be required if
other members of the controlled group exploit the cost shared
intangibles in such territory.
[[Page 670]]
(iii) Field of use based divisional interests. The CSA may divide
all interests in cost shared intangibles on the basis of all uses
(whether or not known at the time of the division) to which cost shared
intangibles are to be put as follows. All anticipated uses of cost
shared intangibles must be identified. Each controlled participant must
be assigned at least one such anticipated use, and in the aggregate all
the participants must be assigned all such anticipated uses. Each
controlled participant will be assigned the perpetual and exclusive
right to exploit the cost shared intangibles through the use or uses
assigned to it and one controlled participant must be assigned the
exclusive and perpetual right to exploit cost shared intangibles through
any unanticipated uses.
(iv) Other divisional bases. (A) In the event that the CSA does not
divide interests in the cost shared intangibles on the basis of
exclusive territories or fields of use as described in paragraphs
(b)(4)(ii) and (iii) of this section, the CSA may adopt some other basis
on which to divide all interests in the cost shared intangibles among
the controlled participants, provided that each of the following
criteria is met:
(1) The basis clearly and unambiguously divides all interests in
cost shared intangibles among the controlled participants.
(2) The consistent use of such basis for the division of all
interests in the cost shared intangibles can be dependably verified from
the records maintained by the controlled participants.
(3) The rights of the controlled participants to exploit cost shared
intangibles are non-overlapping, exclusive, and perpetual.
(4) The resulting benefits associated with each controlled
participant's interest in cost shared intangibles are predictable with
reasonable reliability.
(B) See paragraph (f)(3) of this section for rules regarding the
requirement of arm's length consideration for changes in participation
in CSAs involving divisions of interest described in this paragraph
(b)(4)(iv).
(v) Examples. The following examples illustrate the principles of
this paragraph (b)(4):
Example 1. Companies P and S, both members of the same controlled
group, enter into a CSA to develop product Z. Under the CSA, P receives
the interest in product Z in the United States and S receives the
interest in product Z in the rest of the world, as described in
paragraph (b)(4)(ii) of this section. Both P and S have plants for
manufacturing product Z located in their respective geographic
territories. However, for commercial reasons, product Z is nevertheless
manufactured by P in the United States for sale to customers in certain
locations just outside the United States in close proximity to P's U.S.
manufacturing plant. Because S owns the territorial rights outside the
United States, P must compensate S to ensure that S realizes all the
cost shared intangible profits from P's sales of product Z in S's
territory. The pricing of such compensation must also ensure that P
realizes an appropriate return for its manufacturing efforts. Benefits
projected with respect to such sales will be included for purposes of
estimating S's, but not P's, RAB share.
Example 2. The facts are the same as in Example 1 except that P and
S agree to divide their interest in product Z based on site of
manufacturing. P will have exclusive and perpetual rights in product Z
manufactured in facilities owned by P. S will have exclusive and
perpetual rights to product Z manufactured in facilities owned by S. P
and S agree that neither will license manufacturing rights in product Z
to any related or unrelated party. Both P and S maintain books and
records that allow production at all sites to be verified. Both own
facilities that will manufacture product Z and the relative capacities
of these sites are known. All facilities are currently operating at near
capacity and are expected to continue to operate at near capacity when
product Z enters production so that it will not be feasible to shift
production between P's and S's facilities. P and S have no plans to
build new facilities and the lead time required to plan and build a
manufacturing facility precludes the possibility that P or S will build
a new facility during the period for which sales of Product Z are
expected. Based on these facts, this basis for the division of interests
in Product Z is a division described in paragraph (b)(4)(iv) of this
section. The basis for the division of interest is unambiguous and
clearly defined and its use can be dependably verified. P and S both
have non-overlapping, exclusive and perpetual rights in Product Z. The
division of interest results in the participant's relative benefits
being predictable with reasonable reliability.
Example 3. The facts are the same as in Example 2 except that P's
and S's manufacturing facilities are not expected to operate at full
capacity when product Z enters production. Production of Product Z can
be shifted at any time between sites owned by P
[[Page 671]]
and sites owned by S, although neither P nor S intends to shift
production as a result of the agreement. The division of interests in
Product Z between P and S based on manufacturing site is not a division
described in paragraph (b)(4)(iv) of this section because their relative
shares of benefits are not predictable with reasonable reliability. The
fact that neither P nor S intends to shift production is irrelevant.
(5) Treatment of certain arrangements as CSAs--(i) Situation in
which Commissioner must treat arrangement as a CSA. The Commissioner
must apply the rules of this section to an arrangement among controlled
taxpayers if the administrative requirements of paragraph (b)(2) of this
section are met with respect to such arrangement and the controlled
taxpayers reasonably concluded that such arrangement was a CSA meeting
the requirements of paragraphs (b)(1), (3), and (4) of this section.
(ii) Situation in which Commissioner may treat arrangement as a CSA.
For arrangements among controlled taxpayers not described in paragraph
(b)(5)(i) of this section, the Commissioner may apply the provisions of
this section if the Commissioner concludes that the administrative
requirements of paragraph (b)(2) of this section are met, and,
notwithstanding technical failure to meet the substantive requirements
of paragraph (b)(1), (3), or (4) of this section, the rules of this
section will provide the most reliable measure of an arm's length
result. See Sec. 1.482-1(c)(1) (the best method rule). For purposes of
applying this paragraph (b)(5)(ii), any such arrangement shall be
interpreted by reference to paragraph (k)(1)(iv) of this section.
(iii) Examples. The following examples illustrate the principles of
this paragraph (b)(5). In the examples, assume that Companies P and S
are both members of the same controlled group.
Example 1. (i) P owns the patent on a formula for a capsulated pain
reliever, P-Cap. P reasonably anticipates, pending further research and
experimentation, that the P-Cap formula could form the platform for a
formula for P-Ves, an effervescent version of P-Cap. P also owns
proprietary software that it reasonably anticipates to be critical to
the research efforts. P and S execute a contract that purports to be a
CSA by which they agree to proportionally share the costs and risks of
developing a formula for P-Ves. The agreement reflects the various
contractual requirements described in paragraph (k)(1) of this section
and P and S comply with the documentation, accounting, and reporting
requirements of paragraphs (k)(2) through (4) of this section. Both the
patent rights for P-Cap and the software are reasonably anticipated to
contribute to the development of P-Ves and therefore are platform
contributions for which compensation is due from S as part of PCTs.
Though P and S enter into and implement a PCT for the P-Cap patent
rights that satisfies the arm's length standard, they fail to enter into
a PCT for the software.
(ii) In this case, P and S have substantially complied with the
contractual requirements of paragraph (k)(1) of this section and the
documentation, accounting, and reporting requirements of paragraphs
(k)(2) through (4) of this section and therefore have met the
administrative requirements of paragraph (b)(2) of this section.
However, because they did not enter into a PCT, as required under
paragraphs (b)(1)(ii) and (b)(3) of this section, for the software that
was reasonably anticipated to contribute to the development of P-Ves
(see paragraph (c) of this section), they cannot reasonably conclude
that their arrangement was a CSA. Accordingly, the Commissioner is not
required under paragraph (b)(5)(i) of this section to apply the rules of
this section to their arrangement.
(iii) Nevertheless, the arrangement between P and S closely
resembles a CSA. If the Commissioner concludes that the rules of this
section provide the most reliable measure of an arm's length result for
such arrangement, then pursuant to paragraph (b)(5)(ii) of this section,
the Commissioner may apply the rules of this section and treat P and S
as entering into a PCT for the software in accordance with the
requirements of paragraph (b)(1)(ii) of this section, and make any
appropriate allocations under paragraph (i) of this section.
Alternatively, the Commissioner may conclude that the rules of this
section do not provide the most reliable measure of an arm's length
result. In such case, the arrangement would be analyzed under the
methods under other sections of the 482 regulations to determine whether
the arrangement reaches an arm's length result.
Example 2. The facts are the same as in Example 1 except that P and
S do enter into and implement a PCT for the software as required under
this paragraph (b). The Commissioner determines that the PCT Payments
for the software were not arm's length; nevertheless, under the facts
and circumstances at the time they entered into the CSA and PCTs, P and
S reasonably concluded their arrangement to be a CSA. Because P and S
have met the requirements of paragraph (b)(2) of this section and
reasonably concluded their arrangement is a CSA, pursuant to paragraph
(b)(5)(i) of this section, the Commissioner must apply the rules
[[Page 672]]
of this section to their arrangement. Accordingly, the Commissioner
treats the arrangement as a CSA and makes adjustments to the PCT
Payments as appropriate under this section to achieve an arm's length
result for the PCT for the software.
Example 3. (i) The facts are the same as in Example 1 except that P
and S do enter into a PCT for the software as required under this
paragraph (b). The agreement entered into by P and S provides for a
fixed consideration of $50 million per year for four years, payable at
the end of each year. This agreement satisfies the arm's length
standard. However, S actually pays P consideration at the end of each
year in the form of four annual royalties equal to two percent of sales.
While such royalties at the time of the PCT were expected to be $50
million per year, actual sales during the first year were less than
anticipated and the first royalty payment was only $25 million.
(ii) In this case, P and S failed to implement the terms of their
agreement. Under these circumstances, P and S could not reasonably
conclude that their arrangement was a CSA, as described in paragraph
(b)(1) of this section. Accordingly, the Commissioner is not required
under paragraph (b)(5)(i) of this section to apply the rules of this
section to their arrangement.
(iii) Nevertheless, the arrangement between P and S closely
resembles a CSA. If the Commissioner concludes that the rules of this
section provide the most reliable measure of an arm's length result for
such arrangement, then pursuant to paragraph (b)(5)(ii) of this section,
the Commissioner may apply the rules of this section and make any
appropriate allocations under paragraph (i) of this section.
Alternatively, the Commissioner may conclude that the rules of this
section do not provide the most reliable measure of an arm's length
result. In such case, the arrangement would be analyzed under the
methods under other sections of the 482 regulations to determine whether
the arrangement reaches an arm's length result.
Example 4. (i) The facts are the same as in Example 1 except that P
does not own proprietary software and P and S use a method for
determining the arm's length amount of the PCT Payment for the P-Cap
patent rights different from the method used in Example 1.
(ii) P and S determine that the arm's length amount of the PCT
Payments for the P-Cap patent is $10 million. However, the Commissioner
determines the best method for determining the arm's length amount of
the PCT Payments for the P-Cap patent rights and under such method the
arm's length amount is $100 million. To determine this $10 million
present value, P and S assumed a useful life of eight years for the
platform contribution, because the P-Cap patent rights will expire after
eight years. However, the P-Cap patent rights are expected to lead to
benefits attributable to exploitation of the cost shared intangibles
extending many years beyond the expiration of the P-Cap patent, because
use of the P-Cap patent rights will let P and S bring P-Ves to market
before the competition, and because P and S expect to apply for
additional patents covering P-Ves, which would bar competitors from
selling that product for many future years. The assumption by P and S of
a useful life for the platform contribution that is less than the
anticipated period of exploitation of the cost shared intangibles is
contrary to paragraph (g)(2)(ii) of this section, and reduces the
reliability of the method used by P and S.
(iii) The method used by P and S employs a declining royalty. The
royalty starts at 8% of sales, based on an application of the CUT method
in which the purported CUTs all involve licenses to manufacture and sell
the current generation of P-Cap, and declines to 0% over eight years,
declining by 1% each year. Such make-or-sell rights are fundamentally
different from use of the P-Cap patent rights to generate a new product.
This difference raises the issue of whether the make-or-sell rights are
sufficiently comparable to the rights that are the subject of the PCT
Payment. See Sec. 1.482-4(c). While a royalty rate for make-or-sell
rights can form the basis for a reliable determination of an arm's
length PCT Payment in the CUT-based implementation of the income method
described in paragraph (g)(4) of this section, under that method such
royalty rate does not decline to zero. Therefore, the use of a declining
royalty rate based on an initial rate for make-or-sell rights further
reduces the reliability of the method used by P and S.
(iv) Sales of the next-generation product are not anticipated until
after seven years, at which point the royalty rate will have declined to
1%. The temporal mismatch between the period of the royalty rate decline
and the period of exploitation raises further concerns about the
method's reliability.
(v) For the reasons given in paragraphs (ii) through (iv) of this
Example 4, the method used by P and S is so unreliable and so contrary
to provisions of this section that P and S could not reasonably conclude
that they had contracted to make arm's length PCT Payments as required
by paragraphs (b)(1)(ii) and (b)(3) of this section, and thus could not
reasonably conclude that their arrangement was a CSA. Accordingly, the
Commissioner is not required under paragraph (b)(5)(i) of this section
to apply the rules of this section to their arrangement.
(vi) Nevertheless, the arrangement between P and S closely resembles
a CSA. If the Commissioner concludes that the rules of this section
provide the most reliable measure of an arm's length result for such
arrangement, then pursuant to paragraph
[[Page 673]]
(b)(5)(ii) of this section, the Commissioner may apply the rules of this
section and make any appropriate allocations under paragraph (i) of this
section. Alternatively, the Commissioner may conclude that the rules of
this section do not provide the most reliable measure of an arm's length
result. In such case, the arrangement would be analyzed under the
methods under other section 482 regulations to determine whether the
arrangement reaches an arm's length result.
(6) Entity classification of CSAs. See Sec. 301.7701-1(c) of this
chapter for the classification of CSAs for purposes of the Internal
Revenue Code.
(c) Platform contributions--(1) In general. A platform contribution
is any resource, capability, or right that a controlled participant has
developed, maintained, or acquired externally to the intangible
development activity (whether prior to or during the course of the CSA)
that is reasonably anticipated to contribute to developing cost shared
intangibles. The determination whether a resource, capability, or right
is reasonably anticipated to contribute to developing cost shared
intangibles is ongoing and based on the best available information.
Therefore, a resource, capability, or right reasonably determined not to
be a platform contribution as of an earlier point in time, may be
reasonably determined to be a platform contribution at a later point in
time. The PCT obligation regarding a resource or capability or right
once determined to be a platform contribution does not terminate merely
because it may later be determined that such resource or capability or
right has not contributed, and no longer is reasonably anticipated to
contribute, to developing cost shared intangibles. Notwithstanding the
other provisions of this paragraph (c), platform contributions do not
include rights in land or depreciable tangible property, and do not
include rights in other resources acquired by IDCs. See paragraph (d)(1)
of this section.
(2) Terms of platform contributions--(i) Presumed to be exclusive.
For purposes of a PCT, the PCT Payee's provision of a platform
contribution is presumed to be exclusive. Thus, it is presumed that the
platform resource, capability, or right is not reasonably anticipated to
be committed to any business activities other than the CSA Activity, as
defined in paragraph (j)(1)(i) of this section, whether carried out by
the controlled participants, other controlled taxpayers, or uncontrolled
taxpayers.
(ii) Rebuttal of exclusivity. The controlled participants may rebut
the presumption set forth in paragraph (c)(2)(i) of this section to the
satisfaction of the Commissioner. For example, if the platform resource
is a research tool, then the controlled participants could rebut the
presumption by establishing to the satisfaction of the Commissioner
that, as of the date of the PCT, the tool is reasonably anticipated not
only to contribute to the CSA Activity but also to be licensed to an
uncontrolled taxpayer. In such case, the PCT Payments may need to be
prorated as described in paragraph (c)(2)(iii) of this section.
(iii) Proration of PCT Payments to the extent allocable to other
business activities--(A) In general. Some transfer pricing methods
employed to determine the arm's length amount of the PCT Payments do so
by considering the overall value of the platform contributions as
opposed to, for example, the value of the anticipated use of the
platform contributions in the CSA Activity. Such a transfer pricing
method is consistent with the presumption that the platform contribution
is exclusive (that is, that the resources, capabilities or rights that
are the subject of a platform contribution are reasonably anticipated to
contribute only to the CSA Activity). See paragraph (c)(2)(i) (Terms of
platform contributions--Presumed to be exclusive) of this section. The
PCT Payments determined under such transfer pricing method may have to
be prorated if the controlled participants can rebut the presumption
that the platform contribution is exclusive to the satisfaction of the
Commissioner as provided in paragraph (c)(2)(ii) of this section. In the
case of a platform contribution that also contributes to lines of
business of a PCT Payor that are not reasonably anticipated to involve
exploitation of the cost shared intangibles, the need for explicit
proration may in some cases be avoided through aggregation of
transactions. See paragraph (g)(2)(iv) of this section (Aggregation of
transactions).
[[Page 674]]
(B) Determining the proration of PCT Payments. Proration will be
done on a reasonable basis in proportion to the relative economic value,
as of the date of the PCT, reasonably anticipated to be derived from the
platform contribution by the CSA Activity as compared to the value
reasonably anticipated to be derived from the platform contribution by
other business activities. In the case of an aggregate valuation done
under the principles of paragraph (g)(2)(iv) of this section that
addresses payment for resources, capabilities, or rights used for
business activities other than the CSA Activity (for example, the right
to exploit an existing intangible without further development), the
proration of the aggregate payments may have to reflect the economic
value attributable to such resources, capabilities, or rights as well.
For purposes of the best method rule under Sec. 1.482-1(c), the
reliability of the analysis under a method that requires proration
pursuant to this paragraph is reduced relative to the reliability of an
analysis under a method that does not require proration.
(3) Categorization of the PCT. For purposes of Sec. 1.482-
1(b)(2)(ii) and paragraph (a)(2) of this section, a PCT must be
identified by the controlled participants as a particular type of
transaction (for example, a license for royalty payments). See paragraph
(k)(2)(ii)(H) of this section. Such designation must be consistent with
the actual conduct of the controlled participants. If the conduct is
consistent with different, economically equivalent types of transactions
then the controlled participants may designate the PCT as being any of
such types of transactions. If the controlled participants fail to make
such designation in their documentation, the Commissioner may make a
designation consistent with the principles of paragraph (k)(1)(iv) of
this section.
(4) Certain make-or-sell rights excluded--(i) In general. Any right
to exploit an existing resource, capability, or right without further
development of such item, such as the right to make, replicate, license,
or sell existing products, does not constitute a platform contribution
to a CSA (and the arm's length compensation for such rights (make-or-
sell rights) does not satisfy the compensation obligation under a PCT)
unless exploitation without further development of such item is
reasonably anticipated to contribute to developing or further developing
a cost shared intangible.
(ii) Examples. The following examples illustrate the principles of
this paragraph (c)(4):
Example 1. P and S, which are members of the same controlled group,
execute a CSA. Under the CSA, P and S will bear their RAB shares of IDCs
for developing the second generation of ABC, a computer software
program. Prior to that arrangement, P had incurred substantial costs and
risks to develop ABC. Concurrent with entering into the arrangement, P
(as the licensor) executes a license with S (as the licensee) by which S
may make and sell copies of the existing ABC. Such make-or-sell rights
do not constitute a platform contribution to the CSA. The rules of
Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6 must be applied to
determine the arm's length consideration in connection with the make-or-
sell licensing arrangement. In certain circumstances, this determination
of the arm's length consideration may be done on an aggregate basis with
the evaluation of compensation obligations pursuant to the PCTs entered
into by P and S in connection with the CSA. See paragraph (g)(2)(iv) of
this section.
Example 2. (i) P, a software company, has developed and currently
exploits software program ABC. P and S enter into a CSA to develop
future generations of ABC. The ABC source code is the platform on which
future generations of ABC will be built and is therefore a platform
contribution of P for which compensation is due from S pursuant to a
PCT. Concurrent with entering into the CSA, P licenses to S the make-or-
sell rights for the current version of ABC. P has entered into similar
licenses with uncontrolled parties calling for sales-based royalty
payments at a rate of 20%. The current version of ABC has an expected
product life of three years. P and S enter into a contingent payment
agreement to cover both the PCT Payments due from S for P's platform
contribution and payments due from S for the make-or-sell license. Based
on the uncontrolled make-or-sell licenses, P and S agree on a sales-
based royalty rate of 20% in Year 1 that declines on a straight line
basis to 0% over the 3 year product life of ABC.
(ii) The make-or-sell rights for the current version of ABC are not
platform contributions, though paragraph (g)(2)(iv) of this section
provides for the possibility that the most reliable determination of an
arm's length charge for the platform contribution and the make-or-sell
license may be one that
[[Page 675]]
values the two transactions in the aggregate. A contingent payment
schedule based on the uncontrolled make-or-sell licenses may provide an
arm's length charge for the separate make-or-sell license between P and
S, provided the royalty rates in the uncontrolled licenses similarly
decline, but as a measure of the aggregate PCT and licensing payments it
does not account for the arm's length value of P's platform
contributions which include the rights in the source code and future
development rights in ABC.
Example 3. S is a controlled participant that owns Patent Q, which
protects S's use of a research tool that is helpful in developing and
testing new pharmaceutical compounds. The research tool, which is not
itself such a compound, is used in the CSA Activity to develop such
compounds. However, the CSA Activity is not anticipated to result in the
further development of the research tool or in patents based on Patent
Q. Although the right to use Patent Q is not anticipated to result in
the further development of Patent Q or the technology that it protects,
that right constitutes a platform contribution (as opposed to make-or-
sell rights) because it is anticipated to contribute to the research
activity to develop cost shared intangibles relating to pharmaceutical
compounds covered by the CSA.
(5) Examples. The following examples illustrate the principles of
this paragraph (c). In each example, Companies P and S are members of
the same controlled group, and execute a CSA providing that each will
have the exclusive right to exploit cost shared intangibles in its own
territory. See paragraph (b)(4)(ii) of this section (Territorial based
divisional interests).
Example 1. Company P has developed and currently markets version 1.0
of a new software application XYZ. Company P and Company S execute a CSA
under which they will share the IDCs for developing future versions of
XYZ. Version 1.0 is reasonably anticipated to contribute to the
development of future versions of XYZ and therefore Company P's rights
in version 1.0 constitute a platform contribution from Company P that
must be compensated by Company S pursuant to a PCT. Pursuant to
paragraph (c)(3) of this section, the controlled participants designate
the platform contribution as a transfer of intangibles that would
otherwise be governed by Sec. 1.482-4, if entered into by controlled
parties. Accordingly, pursuant to paragraph (a)(2) of this section, the
applicable method for determining the arm's length value of the
compensation obligation under the PCT between Company P and Company S
will be governed by Sec. 1.482-4 as supplemented by paragraph (g) of
this section. Absent a showing to the contrary by P and S, the platform
contribution in this case is presumed to be the exclusive provision of
the benefit of all rights in version 1.0, other than the rights
described in paragraph (c)(4) of this section (Certain make-or-sell
rights excluded). This includes the right to use version 1.0 for
purposes of research and the exclusive right in S's territory to exploit
any future products that incorporated the technology of version 1.0, and
would cover a term extending as long as the controlled participants were
to exploit future versions of XYZ or any other product based on the
version 1.0 platform. The compensation obligation of Company S pursuant
to the PCT will reflect the full value of the platform contribution, as
limited by Company S's RAB share.
Example 2. Company P and Company S execute a CSA under which they
will share the IDCs for developing Vaccine Z. Company P will commit to
the project its research team that has successfully developed a number
of other vaccines. The expertise and existing integration of the
research team is a unique resource or capability of Company P which is
reasonably anticipated to contribute to the development of Vaccine Z.
Therefore, P's provision of the capabilities of the research team
constitute a platform contribution for which compensation is due from
Company S as part of a PCT. Pursuant to paragraph (c)(3) of this
section, the controlled parties designate the platform contribution as a
provision of services that would otherwise be governed by Sec. 1.482-
9(a) if entered into by controlled parties. Accordingly, pursuant to
paragraph (a)(2) of this section, the applicable method for determining
the arm's length value of the compensation obligation under the PCT
between Company P and Company S will be governed by Sec. 1.482-9(a) as
supplemented by paragraph (g) of this section. Absent a showing to the
contrary by P and S, the platform contribution in this case is presumed
to be the exclusive provision of the benefits by Company P of its
research team to the development of Vaccine Z. Because the IDCs include
the ongoing compensation of the researchers, the compensation obligation
under the PCT is only for the value of the commitment of the research
team by Company P to the CSA's development efforts net of such
researcher compensation. The value of the compensation obligation of
Company S for the PCT will reflect the full value of the provision of
services, as limited by Company S's RAB share.
(d) Intangible development costs--(1) Determining whether costs are
IDCs. Costs included in IDCs are determined by reference to the scope of
the intangible development activity (IDA).
(i) Definition and scope of the IDA. For purposes of this section,
the IDA means
[[Page 676]]
the activity under the CSA of developing or attempting to develop
reasonably anticipated cost shared intangibles. The scope of the IDA
includes all of the controlled participants' activities that could
reasonably be anticipated to contribute to developing the reasonably
anticipated cost shared intangibles. The IDA cannot be described merely
by a list of particular resources, capabilities, or rights that will be
used in the CSA, because such a list would not identify reasonably
anticipated cost shared intangibles. Also, the scope of the IDA may
change as the nature or identity of the reasonably anticipated cost
shared intangibles changes or the nature of the activities necessary for
their development become clearer. For example, the relevance of certain
ongoing work to developing reasonably anticipated cost shared
intangibles or the need for additional work may only become clear over
time.
(ii) Reasonably anticipated cost shared intangible. For purposes of
this section, reasonably anticipated cost shared intangible means any
intangible, within the meaning of Sec. 1.482-4(b), that, at the
applicable point in time, the controlled participants intend to develop
under the CSA. Reasonably anticipated cost shared intangibles may change
over the course of the CSA. The controlled participants may at any time
change the reasonably anticipated cost shared intangibles but must
document any such change pursuant to paragraph (k)(2)(ii)(A)(1) of this
section. Removal of reasonably anticipated cost shared intangibles does
not affect the controlled participants' interests in cost shared
intangibles already developed under the CSA. In addition, the reasonably
anticipated cost shared intangibles automatically expand to include the
intended result of any further development of a cost shared intangible
already developed under the CSA, or applications of such an intangible.
However, the controlled participants may override this automatic
expansion in a particular case if they separately remove specified
further development of such intangible (or specified applications of
such intangible) from the IDA, and document such separate removal
pursuant to paragraph (k)(2)(ii)(A)(3) of this section.
(iii) Costs included in IDCs. For purposes of this section, IDCs
mean all costs, in cash or in kind (including stock-based compensation,
as described in paragraph (d)(3) of this section), but excluding
acquisition costs for land or depreciable property, in the ordinary
course of business after the formation of a CSA that, based on analysis
of the facts and circumstances, are directly identified with, or are
reasonably allocable to, the IDA. Thus, IDCs include costs incurred in
attempting to develop reasonably anticipated cost shared intangibles
regardless of whether such costs ultimately lead to development of those
intangibles, other intangibles developed unexpectedly, or no
intangibles. IDCs shall also include the arm's length rental charge for
the use of any land or depreciable tangible property (as determined
under Sec. 1.482-2(c) (Use of tangible property)) directly identified
with, or reasonably allocable to, the IDA. Reference to generally
accepted accounting principles or Federal income tax accounting rules
may provide a useful starting point but will not be conclusive regarding
inclusion of costs in IDCs. IDCs do not include interest expense,
foreign income taxes (as defined in Sec. 1.901-2(a)), or domestic
income taxes.
(iv) Examples. The following examples illustrate the principles of
this paragraph (d)(1):
Example 1. A contract that purports to be a CSA provides that the
IDA to which the agreement applies consists of all research and
development activity conducted at laboratories A, B, and C but not at
other facilities maintained by the controlled participants. The contract
does not describe the reasonably anticipated cost shared intangibles
with respect to which research and development is to be undertaken. The
contract fails to meet the requirements set forth in paragraph
(k)(1)(ii)(B) of this section because it fails to adequately describe
the scope of the IDA to be undertaken.
Example 2. A contract that purports to be a CSA provides that the
IDA to which the agreement applies consists of all research and
development activity conducted by any of the controlled participants
with the goal of developing a cure for a particular disease. Such a cure
is thus a reasonably anticipated cost shared intangible. The contract
also
[[Page 677]]
contains a provision that the IDA will exclude any activity that builds
on the results of the controlled participants' prior research concerning
Enzyme X even though such activity could reasonably be anticipated to
contribute to developing such cure. The contract fails to meet the
requirement set forth in paragraph (d)(1)(i) of this section that the
scope of the IDA include all of the controlled participants' activities
that could reasonably be anticipated to contribute to developing
reasonably anticipated cost shared intangibles.
(2) Allocation of costs. If a particular cost is directly identified
with, or reasonably allocable to, a function the results of which will
benefit both the IDA and other business activities, the cost must be
allocated on a reasonable basis between the IDA and such other business
activities in proportion to the relative economic value that the IDA and
such other business activities are anticipated to derive from such
results.
(3) Stock-based compensation--(i) In general. As used in this
section, the term stock-based compensation means any compensation
provided by a controlled participant to an employee or independent
contractor in the form of equity instruments, options to acquire stock
(stock options), or rights with respect to (or determined by reference
to) equity instruments or stock options, including but not limited to
property to which section 83 applies and stock options to which section
421 applies, regardless of whether ultimately settled in the form of
cash, stock, or other property.
(ii) Identification of stock-based compensation with the IDA. The
determination of whether stock-based compensation is directly identified
with, or reasonably allocable to, the IDA is made as of the date that
the stock-based compensation is granted. Accordingly, all stock-based
compensation that is granted during the term of the CSA and, at date of
grant, is directly identified with, or reasonably allocable to, the IDA
is included as an IDC under paragraph (d)(1) of this section. In the
case of a repricing or other modification of a stock option, the
determination of whether the repricing or other modification constitutes
the grant of a new stock option for purposes of this paragraph
(d)(3)(ii) will be made in accordance with the rules of section 424(h)
and related regulations.
(iii) Measurement and timing of stock-based compensation IDC--(A) In
general. Except as otherwise provided in this paragraph (d)(3)(iii), the
cost attributable to stock-based compensation is equal to the amount
allowable to the controlled participant as a deduction for federal
income tax purposes with respect to that stock-based compensation (for
example, under section 83(h)) and is taken into account as an IDC under
this section for the taxable year for which the deduction is allowable.
(1) Transfers to which section 421 applies. Solely for purposes of
this paragraph (d)(3)(iii)(A), section 421 does not apply to the
transfer of stock pursuant to the exercise of an option that meets the
requirements of section 422(a) or 423(a).
(2) Deductions of foreign controlled participants. Solely for
purposes of this paragraph (d)(3)(iii)(A), an amount is treated as an
allowable deduction of a foreign controlled participant to the extent
that a deduction would be allowable to a United States taxpayer.
(3) Modification of stock option. Solely for purposes of this
paragraph (d)(3)(iii)(A), if the repricing or other modification of a
stock option is determined, under paragraph (d)(3)(ii) of this section,
to constitute the grant of a new stock option not identified with, or
reasonably allocable to, the IDA, the stock option that is repriced or
otherwise modified will be treated as being exercised immediately before
the modification, provided that the stock option is then exercisable and
the fair market value of the underlying stock then exceeds the price at
which the stock option is exercisable. Accordingly, the amount of the
deduction that would be allowable (or treated as allowable under this
paragraph (d)(3)(iii)(A)) to the controlled participant upon exercise of
the stock option immediately before the modification must be taken into
account as an IDC as of the date of the modification.
(4) Expiration or termination of CSA. Solely for purposes of this
paragraph (d)(3)(iii)(A), if an item of stock-based compensation
identified with, or reasonably allocable to, the IDA is not exercised
during the term of a CSA, that
[[Page 678]]
item of stock-based compensation will be treated as being exercised
immediately before the expiration or termination of the CSA, provided
that the stock-based compensation is then exercisable and the fair
market value of the underlying stock then exceeds the price at which the
stock-based compensation is exercisable. Accordingly, the amount of the
deduction that would be allowable (or treated as allowable under this
paragraph (d)(3)(iii)(A)) to the controlled participant upon exercise of
the stock-based compensation must be taken into account as an IDC as of
the date of the expiration or termination of the CSA.
(B) Election with respect to options on publicly traded stock--(1)
In general. With respect to stock-based compensation in the form of
options on publicly traded stock, the controlled participants in a CSA
may elect to take into account all IDCs attributable to those stock
options in the same amount, and as of the same time, as the fair value
of the stock options reflected as a charge against income in audited
financial statements or disclosed in footnotes to such financial
statements, provided that such statements are prepared in accordance
with United States generally accepted accounting principles by or on
behalf of the company issuing the publicly traded stock.
(2) Publicly traded stock. As used in this paragraph (d)(3)(iii)(B),
the term publicly traded stock means stock that is regularly traded on
an established United States securities market and is issued by a
company whose financial statements are prepared in accordance with
United States generally accepted accounting principles for the taxable
year.
(3) Generally accepted accounting principles. For purposes of this
paragraph (d)(3)(iii)(B), a financial statement prepared in accordance
with a comprehensive body of generally accepted accounting principles
other than United States generally accepted accounting principles is
considered to be prepared in accordance with United States generally
accepted accounting principles provided that either--
(i) The fair value of the stock options under consideration is
reflected in the reconciliation between such other accounting principles
and United States generally accepted accounting principles required to
be incorporated into the financial statement by the securities laws
governing companies whose stock is regularly traded on United States
securities markets; or
(ii) In the absence of a reconciliation between such other
accounting principles and United States generally accepted accounting
principles that reflects the fair value of the stock options under
consideration, such other accounting principles require that the fair
value of the stock options under consideration be reflected as a charge
against income in audited financial statements or disclosed in footnotes
to such statements.
(4) Time and manner of making the election. The election described
in this paragraph (d)(3)(iii)(B) is made by an explicit reference to the
election in the written contract required by paragraph (k)(1) of this
section or in a written amendment to the CSA entered into with the
consent of the Commissioner pursuant to paragraph (d)(3)(iii)(C) of this
section. In the case of a CSA in existence on August 26, 2003, the
election by written amendment to the CSA may be made without the consent
of the Commissioner if such amendment is entered into not later than the
latest due date (with regard to extensions) of a federal income tax
return of any controlled participant for the first taxable year
beginning after August 26, 2003.
(C) Consistency. Generally, all controlled participants in a CSA
taking options on publicly traded stock into account under paragraph
(d)(3)(ii), (d)(3)(iii)(A), or (d)(3)(iii)(B) of this section must use
that same method of identification, measurement and timing for all
options on publicly traded stock with respect to that CSA. Controlled
participants may change their method only with the consent of the
Commissioner and only with respect to stock options granted during
taxable years subsequent to the taxable year in which the Commissioner's
consent is obtained. All controlled participants in the CSA must join in
requests for the Commissioner's consent under this paragraph
(d)(3)(iii)(C). Thus, for example, if the controlled participants make
the election described in paragraph
[[Page 679]]
(d)(3)(iii)(B) of this section upon the formation of the CSA, the
election may be revoked only with the consent of the Commissioner, and
the consent will apply only to stock options granted in taxable years
subsequent to the taxable year in which consent is obtained. Similarly,
if controlled participants already have granted stock options that have
been or will be taken into account under the general rule of paragraph
(d)(3)(iii)(A) of this section, then except in cases specified in the
last sentence of paragraph (d)(3)(iii)(B)(4) of this section, the
controlled participants may make the election described in paragraph
(d)(3)(iii)(B) of this section only with the consent of the
Commissioner, and the consent will apply only to stock options granted
in taxable years subsequent to the taxable year in which consent is
obtained.
(4) IDC share. A controlled participant's IDC share for a taxable
year is equal to the controlled participant's cost contribution for the
taxable year, divided by the sum of all IDCs for the taxable year. A
controlled participant's cost contribution for a taxable year means all
of the IDCs initially borne by the controlled participant, plus all of
the CST Payments that the participant makes to other controlled
participants, minus all of the CST Payments that the participant
receives from other controlled participants.
(5) Examples. The following examples illustrate this paragraph (d):
Example 1. Foreign parent (FP) and its U.S. subsidiary (USS) enter
into a CSA to develop a better mousetrap. USS and FP share the costs of
FP's R&D facility that will be exclusively dedicated to this research,
the salaries of the researchers at the facility, and overhead costs
attributable to the project. They also share the cost of a conference
facility that is at the disposal of the senior executive management of
each company. Based on the facts and circumstances, the cost of the
conference facility cannot be directly identified with, and is not
reasonably allocable to, the IDA. In this case, the cost of the
conference facility must be excluded from the amount of IDCs.
Example 2. U.S. parent (USP) and its foreign subsidiary (FS) enter
into a CSA to develop intangibles for producing a new device. USP and FS
share the costs of an R&D facility, the salaries of the facility's
researchers, and overhead costs attributable to the project. Although
USP also incurs costs related to field testing of the device, USP does
not include those costs in the IDCs that USP and FS will share under the
CSA. The Commissioner may determine, based on the facts and
circumstances, that the costs of field testing are IDCs that the
controlled participants must share.
Example 3. U.S. parent (USP) and its foreign subsidiary (FS) enter
into a CSA to develop a new process patent. USP assigns certain
employees to perform solely R&D to develop a new mathematical algorithm
to perform certain calculations. That algorithm will be used both to
develop the new process patent and to develop a new design patent the
development of which is outside the scope of the CSA. During years
covered by the CSA, USP compensates such employees with cash salaries,
stock-based compensation, or a combination of both. USP and FS
anticipate that the economic value attributable to the R&D will be
derived from the process patent and the design patent in a relative
proportion of 75% and 25%, respectively. Applying the principles of
paragraph (d)(2) of this section, 75% of the compensation of such
employees must be allocated to the development of the new process patent
and, thus, treated as IDCs. With respect to the cash salary
compensation, the IDC is 75% of the face value of the cash. With respect
to the stock-based compensation, the IDC is 75% of the value of the
stock-based compensation as determined under paragraph (d)(3)(iii) of
this section.
Example 4. Foreign parent (FP) and its U.S. subsidiary (USS) enter
into a CSA to develop a new computer source code. FP has an executive
officer who oversees a research facility and employees dedicated solely
to the IDA. The executive officer also oversees other research
facilities and employees unrelated to the IDA, and performs certain
corporate overhead functions. The full amount of the costs of the
research facility and employees dedicated solely to the IDA can be
directly identified with the IDA and, therefore, are IDCs. In addition,
based on the executive officer's records of time worked on various
matters, the controlled participants reasonably allocate 20% of the
executive officer's compensation to supervision of the facility and
employees dedicated to the IDA, 50% of the executive officer's
compensation to supervision of the facilities and employees unrelated to
the IDA, and 30% of the executive officer's compensation to corporate
overhead functions. The controlled participants also reasonably
determine that the results of the executive officer's corporate overhead
functions yield equal economic benefit to the IDA and the other business
activities of FP. Applying the principles of paragraph (d)(1) of this
section, the executive officer's compensation allocated to supervising
the facility and employees dedicated to the IDA (amounting to 20% of the
executive officer's
[[Page 680]]
total compensation) must be treated as IDCs. Applying the principles of
paragraph (d)(2) of this section, half of the executive officer's
compensation allocated to corporate overhead functions (that is, half of
30% of the executive officer's total compensation), must be treated as
IDCs. Therefore, a total of 35% (20% plus 15%) of the executive
officer's total compensation must be treated as IDCs.
(e) Reasonably anticipated benefits share--(1) Definition--(i) In
general. A controlled participant's share of reasonably anticipated
benefits is equal to its reasonably anticipated benefits divided by the
sum of the reasonably anticipated benefits, as defined in paragraph
(j)(1)(i) of this section, of all the controlled participants. RAB
shares must be updated to account for changes in economic conditions,
the business operations and practices of the participants, and the
ongoing development of intangibles under the CSA. For purposes of
determining RAB shares at any given time, reasonably anticipated
benefits must be estimated over the entire period, past and future, of
exploitation of the cost shared intangibles, and must reflect
appropriate updates to take into account the most reliable data
regarding past and projected future results available at such time. RAB
shares determined for a particular purpose shall not be further updated
for that purpose based on information not available at the time that
determination needed to be made. For example, RAB shares determined in
order to determine IDC shares for a particular taxable year (as set
forth in paragraphs (b)(1)(i) and (d)(4) of this section) shall not be
recomputed based on information not available at that time. Similarly,
RAB shares determined for the purpose of using a particular method such
as the acquisition price method (as set forth in paragraph (g)(5)(ii) of
this section) to evaluate the arm's length amount charged in a PCT shall
not be recomputed based on information not available at the date of that
PCT. However, nothing in this paragraph (e)(1)(i) shall limit the
Commissioner's use of subsequently available information for purposes of
its allocation determinations in accordance with the provisions of
paragraph (i) (Allocations by the Commissioner in connection with a CSA)
of this section.
(ii) Reliability. A controlled participant's RAB share must be
determined by using the most reliable estimate. In determining which of
two or more available estimates is most reliable, the quality of the
data and assumptions used in the analysis must be taken into account,
consistent with Sec. 1.482-1(c)(2)(ii) (Data and assumptions). Thus,
the reliability of an estimate will depend largely on the completeness
and accuracy of the data, the soundness of the assumptions, and the
relative effects of particular deficiencies in data or assumptions on
different estimates. If two estimates are equally reliable, no
adjustment should be made based on differences between the estimates.
The following factors will be particularly relevant in determining the
reliability of an estimate of RAB shares:
(A) The basis used for measuring benefits, as described in paragraph
(e)(2)(ii) of this section.
(B) The projections used to estimate benefits, as described in
paragraph (e)(2)(iii) of this section.
(iii) Examples. The following examples illustrate the principles of
this paragraph (e)(1):
Example 1. (i) USP and FS plan to conduct research to develop
Product Lines A and B. USP and FS reasonably anticipate respective
benefits from Product Line A of 100X and 200X and respective benefits
from Product Line B, respectively, of 300X and 400X. USP and FS thus
reasonably anticipate combined benefits from Product Lines A and B of
400X and 600X, respectively.
(ii) USP and FS could enter into a separate CSA to develop Product
Line A with respective RAB shares of 33\1/3\ percent and 66\2/3\ percent
(reflecting a ratio of 100X to 200X), and into a separate CSA to develop
Product Line B with respective RAB shares of 42\6/7\ percent and 57\1/7\
percent (reflecting a ratio of 300X to 400X). Alternatively, USP and FS
could enter into a single CSA to develop both Product Lines A and B with
respective RAB shares of 40 percent and 60 percent (in the ratio of 400X
to 600X). If the separate CSAs are chosen, then any costs for activities
that contribute to developing both Product Line A and Product Line B
will constitute IDCs of the respective CSAs as required by paragraphs
(d)(1) and (2) of this section.
Example 2. (i) USP, a US company, wholly owns foreign subsidiary,
FS. USP and FS enter into a CSA at the start of Year 1. The CSA's total
IDCs are $100,000 in each year for Years 1 through 4. In Year 1, USP
correctly
[[Page 681]]
estimates its RAB share as 50%, based on information available at the
time, and therefore correctly computes $50,000 as its cost contribution
for Year 1.
(ii) In Year 4, USP correctly estimates its RAB share to be 70%,
based on information available at the time and, therefore, correctly
computes $70,000 as its cost contribution for Year 4.
(iii) In Year 4, USP also files an amended return for Year 1 in
which USP deducts a cost contribution of $70,000, asserting that, for
this purpose, it should revise its Year 1 estimated RAB share to 70%
based on the information that is now available to it in Year 4. The
Commissioner determines that USP is incorrect for two reasons. First, a
RAB share determined for a particular purpose (here, to determine USP's
IDC shares and thus USP's cost contributions in Year 1) should not be
revised based on information not available to USP until Year 4. See
paragraph (e)(1)(i) of this section. Second, more generally, USP is not
permitted to file an amended return for this purpose under Sec. 1.482-
1(a)(3). Therefore, for both of these reasons, Commissioner adjusts
USP's amended return for Year 1 by disallowing $20,000 of the $70,000
deduction.
(2) Measure of benefits--(i) In general. In order to estimate a
controlled participant's RAB share, the amount of each controlled
participant's reasonably anticipated benefits must be measured on a
basis that is consistent for all such participants. See paragraph
(e)(2)(ii)(E) Example 9 of this section. If a controlled participant
transfers a cost shared intangible to another controlled taxpayer, other
than by way of a transfer described in paragraph (f) of this section,
that controlled participant's benefits from the transferred intangible
must be measured by reference to the transferee's benefits, disregarding
any consideration paid by the transferee to the controlled participant
(such as a royalty pursuant to a license agreement). Reasonably
anticipated benefits are measured either on a direct basis, by reference
to estimated benefits to be generated by the use of cost shared
intangibles (generally based on additional revenues plus cost savings
less any additional costs incurred), or on an indirect basis, by
reference to certain measurements that reasonably can be assumed to
relate to benefits to be generated. Such indirect bases of measurement
of anticipated benefits are described in paragraph (e)(2)(ii) of this
section. A controlled participant's reasonably anticipated benefits must
be measured on the basis, whether direct or indirect, that most reliably
determines RAB shares. In determining which of two bases of measurement
is most reliable, the factors set forth in Sec. 1.482-1(c)(2)(ii) (Data
and assumptions) must be taken into account. It normally will be
expected that the basis that provided the most reliable estimate for a
particular year will continue to provide the most reliable estimate in
subsequent years, absent a material change in the factors that affect
the reliability of the estimate. Regardless of whether a direct or
indirect basis of measurement is used, adjustments may be required to
account for material differences in the activities that controlled
participants undertake to exploit their interests in cost shared
intangibles. See Examples 4 and 7 of paragraph (e)(2)(ii)(E) of this
section.
(ii) Indirect bases for measuring anticipated benefits. Indirect
bases for measuring anticipated benefits from participation in a CSA
include the following:
(A) Units used, produced, or sold. Units of items used, produced, or
sold by each controlled participant in the business activities in which
cost shared intangibles are exploited may be used as an indirect basis
for measuring its anticipated benefits. This basis of measurement will
more reliably determine RAB shares to the extent that each controlled
participant is expected to have a similar increase in net profit or
decrease in net loss attributable to the cost shared intangibles per
unit of the item or items used, produced, or sold. This circumstance is
most likely to arise when the cost shared intangibles are exploited by
the controlled participants in the use, production, or sale of
substantially uniform items under similar economic conditions.
(B) Sales. Sales by each controlled participant in the business
activities in which cost shared intangibles are exploited may be used as
an indirect basis for measuring its anticipated benefits. This basis of
measurement will more reliably determine RAB shares to the extent that
each controlled participant is expected to have a similar increase in
net profit or decrease in net
[[Page 682]]
loss attributable to cost shared intangibles per dollar of sales. This
circumstance is most likely to arise if the costs of exploiting cost
shared intangibles are not substantial relative to the revenues
generated, or if the principal effect of using cost shared intangibles
is to increase the controlled participants' revenues (for example,
through a price premium on the products they sell) without affecting
their costs substantially. Sales by each controlled participant are
unlikely to provide a reliable basis for measuring RAB shares unless
each controlled participant operates at the same market level (for
example, manufacturing, distribution, etc.).
(C) Operating profit. Operating profit of each controlled
participant from the activities in which cost shared intangibles are
exploited, as determined before any expense (including amortization) on
account of IDCs, may be used as an indirect basis for measuring
anticipated benefits. This basis of measurement will more reliably
determine RAB shares to the extent that such profit is largely
attributable to the use of cost shared intangibles, or if the share of
profits attributable to the use of cost shared intangibles is expected
to be similar for each controlled participant. This circumstance is most
likely to arise when cost shared intangibles are closely associated with
the activity that generates the profit and the activity could not be
carried on or would generate little profit without use of those
intangibles.
(D) Other bases for measuring anticipated benefits. Other bases for
measuring anticipated benefits may in some circumstances be appropriate,
but only to the extent that there is expected to be a reasonably
identifiable relationship between the basis of measurement used and
additional revenue generated or net costs saved by the use of cost
shared intangibles. For example, a division of costs based on employee
compensation would be considered unreliable unless there were a
relationship between the amount of compensation and the expected
additional revenue generated or net costs saved by the controlled
participants from using the cost shared intangibles.
(E) Examples. The following examples illustrates this paragraph
(e)(2)(ii):
Example 1. Controlled parties A and B enter into a CSA to develop
product and process intangibles for already existing Product P. Without
such intangibles, A and B would each reasonably anticipate revenue, in
present value terms, of $100M from sales of Product P until it becomes
obsolete. With the intangibles, A and B each reasonably anticipate
selling the same number of units each year, but reasonably anticipate
that the price will be higher. Because the particular product intangible
is more highly regarded in A's market, A reasonably anticipates an
increase of $20M in present value revenue from the product intangible,
while B reasonably anticipates an increase of only $10M in present value
from the product intangible. Further, A and B each reasonably anticipate
spending an additional amount equal to $5M in present value in
production costs to include the feature embodying the product
intangible. Finally, A and B each reasonably anticipate saving an amount
equal to $2M in present value in production costs by using the process
intangible. A and B reasonably anticipate no other economic effects from
exploiting the cost shared intangibles. A's reasonably anticipated
benefits from exploiting the cost shared intangibles equal its
reasonably anticipated increase in revenue ($20M) plus its reasonably
anticipated cost savings ($2M) less its reasonably anticipated increased
costs ($5M), which equals $17M. Similarly, B's reasonably anticipated
benefits from exploiting the cost shared intangibles equal its
reasonably anticipated increase in revenue ($10M) plus its reasonably
anticipated cost savings ($2M) less its reasonably anticipated increased
costs ($5M), which equals $7M. Thus A's reasonably anticipated benefits
are $17M and B's reasonably anticipated benefits are $7M.
Example 2. Foreign Parent (FP) and U.S. Subsidiary (USS) both
produce a feedstock for the manufacture of various high-performance
plastic products. Producing the feedstock requires large amounts of
electricity, which accounts for a significant portion of its production
cost. FP and USS enter into a CSA to develop a new process that will
reduce the amount of electricity required to produce a unit of the
feedstock. FP and USS currently both incur an electricity cost of $2 per
unit of feedstock produced and rates for each are expected to remain
similar in the future. The new process, if it is successful, will reduce
the amount of electricity required by each company to produce a unit of
the feedstock by 50%. Switching to the new process would not require FP
or USS to incur significant investment or other costs. Therefore, the
cost savings each company is expected to achieve after implementing the
[[Page 683]]
new process are $1 per unit of feedstock produced. Under the CSA, FP and
USS divide the costs of developing the new process based on the units of
the feedstock each is anticipated to produce in the future. In this
case, units produced is the most reliable basis for measuring RAB shares
and dividing the IDCs because each controlled participant is expected to
have a similar $1 (50% of current charge of $2) decrease in costs per
unit of the feedstock produced.
Example 3. The facts are the same as in Example 2, except that
currently USS pays $3 per unit of feedstock produced for electricity
while FP pays $6 per unit of feedstock produced. In this case, units
produced is not the most reliable basis for measuring RAB shares and
dividing the IDCs because the participants do not expect to have a
similar decrease in costs per unit of the feedstock produced. The
Commissioner determines that the most reliable measure of RAB shares may
be based on units of the feedstock produced if FP's units are weighted
relative to USS's units by a factor of 2. This reflects the fact that FP
pays twice as much as USS for electricity and, therefore, FP's savings
of $3 per unit of the feedstock (50% reduction of current charge of $6)
would be twice USS's savings of $1.50 per unit of feedstock (50%
reduction of current charge of $3) from any new process eventually
developed.
Example 4. The facts are the same as in Example 3, except that to
supply the particular needs of the U.S. market USS manufactures the
feedstock with somewhat different properties than FP's feedstock. This
requires USS to employ a somewhat different production process than does
FP. Because of this difference, USS would incur significant construction
costs in order to adopt any new process that may be developed under the
cost sharing agreement. In this case, units produced is not the most
reliable basis for measuring RAB shares. In order to reliably determine
RAB shares, the Commissioner measures the reasonably anticipated
benefits of USS and FP on a direct basis. USS's reasonably anticipated
benefits are its reasonably anticipated total savings in electricity
costs, less its reasonably anticipated costs of adopting the new
process. FS's reasonably anticipated benefits are its reasonably
anticipated total savings in electricity costs.
Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into
a CSA to develop new anesthetic drugs. USP obtains the right to market
any resulting drugs in the United States and FS obtains the right to
market any resulting drugs in the rest of the world. USP and FS
determine RAB shares on the basis of their respective total anticipated
operating profit from all drugs under development. USP anticipates that
it will receive a much higher profit than FS per unit sold because the
price of the drugs is not regulated in the United States, whereas the
price of the drugs is regulated in many non-U.S. jurisdictions. In both
controlled participants' territories, the anticipated operating profits
are almost entirely attributable to the use of the cost shared
intangibles. In this case, the controlled participants' basis for
measuring RAB shares is the most reliable.
Example 6. (i) Foreign Parent (FP) and U.S. Subsidiary (USS)
manufacture and sell fertilizers. They enter into a CSA to develop a new
pellet form of a common agricultural fertilizer that is currently
available only in powder form. Under the CSA, USS obtains the rights to
produce and sell the new form of fertilizer for the U.S. market while FP
obtains the rights to produce and sell the new form of fertilizer in the
rest of the world. The costs of developing the new form of fertilizer
are divided on the basis of the anticipated sales of fertilizer in the
controlled participants' respective markets.
(ii) If the research and development is successful, the pellet form
will deliver the fertilizer more efficiently to crops and less
fertilizer will be required to achieve the same effect on crop growth.
The pellet form of fertilizer can be expected to sell at a price premium
over the powder form of fertilizer based on the savings in the amount of
fertilizer that needs to be used. This price premium will be a similar
premium per dollar of sales in each territory. If the research and
development is successful, the costs of producing pellet fertilizer are
expected to be approximately the same as the costs of producing powder
fertilizer and the same for both FP and USS. Both FP and USS operate at
approximately the same market levels, selling their fertilizers largely
to independent distributors.
(iii) In this case, the controlled participants' basis for measuring
RAB shares is the most reliable.
Example 7. The facts are the same as in Example 6, except that FP
distributes its fertilizers directly while USS sells to independent
distributors. In this case, sales of USS and FP are not the most
reliable basis for measuring RAB shares unless adjustments are made to
account for the difference in market levels at which the sales occur.
Example 8. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into
a CSA to develop materials that will be used to train all new entry-
level employees. FP and USS determine that the new materials will save
approximately ten hours of training time per employee. Because their
entry-level employees are paid on differing wage scales, FP and USS
decide that they should not measure benefits based on the number of
entry-level employees hired by each. Rather, they measure benefits based
on compensation paid to the entry-level employees hired by each. In this
case, the basis used for measuring RAB shares is the most reliable
because there is a direct relationship between compensation
[[Page 684]]
paid to new entry-level employees and costs saved by FP and USS from the
use of the new training materials.
Example 9. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and
Foreign Subsidiary 2 (FS2) enter into a CSA to develop computer software
that each will market and install on customers' computer systems. The
controlled participants measure benefits on the basis of projected sales
by USP, FS1, and FS2 of the software in their respective geographic
areas. However, FS1 plans not only to sell but also to license the
software to unrelated customers, and FS1's licensing income (which is a
percentage of the licensees' sales) is not counted in the projected
benefits. In this case, the basis used for measuring the benefits of
each controlled participant is not the most reliable because all of the
benefits received by controlled participants are not taken into account.
In order to reliably determine RAB shares, FS1's projected benefits from
licensing must be included in the measurement on a basis that is the
same as that used to measure its own and the other controlled
participants' projected benefits from sales (for example, all controlled
participants might measure their benefits on the basis of operating
profit).
(iii) Projections used to estimate benefits--(A) In general. The
reliability of an estimate of RAB shares also depends upon the
reliability of projections used in making the estimate. Projections
required for this purpose generally include a determination of the time
period between the inception of the research and development activities
under the CSA and the receipt of benefits, a projection of the time over
which benefits will be received, and a projection of the benefits
anticipated for each year in which it is anticipated that the cost
shared intangible will generate benefits. A projection of the relevant
basis for measuring anticipated benefits may require a projection of the
factors that underlie it. For example, a projection of operating profits
may require a projection of sales, cost of sales, operating expenses,
and other factors that affect operating profits. If it is anticipated
that there will be significant variation among controlled participants
in the timing of their receipt of benefits, and consequently benefit
shares are expected to vary significantly over the years in which
benefits will be received, it normally will be necessary to use the
present value of the projected benefits to reliably determine RAB
shares. See paragraph (g)(2)(v) of this section for best method
considerations regarding discount rates used for this purpose. If it is
not anticipated that benefit shares will significantly change over time,
current annual benefit shares may provide a reliable projection of RAB
shares. This circumstance is most likely to occur when the CSA is a
long-term arrangement, the arrangement covers a wide variety of
intangibles, the composition of the cost shared intangibles is unlikely
to change, the cost shared intangibles are unlikely to generate unusual
profits, and each controlled participant's share of the market is
stable.
(B) Examples. The following examples illustrate the principles of
this paragraph (e)(2)(iii):
Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a CSA to develop a new car model. The controlled participants plan
to spend four years developing the new model and four years producing
and selling the new model. USS and FP project total sales of $4 billion
and $2 billion, respectively, over the planned four years of
exploitation of the new model. The controlled participants determine RAB
shares for each year of 66\2/3\% for USS and 33\1/3\% for FP, based on
projected total sales.
(ii) USS typically begins producing and selling new car models a
year after FP begins producing and selling new car models. In order to
reflect USS's one-year lag in introducing new car models, a more
reliable projection of each participant's RAB share would be based on a
projection of all four years of sales for each participant, discounted
to present value.
Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into
a CSA to develop new and improved household cleaning products. Both
controlled participants have sold household cleaning products for many
years and have stable worldwide market shares. The products under
development are unlikely to produce unusual profits for either
controlled participant. The controlled participants determine RAB shares
on the basis of each controlled participant's current sales of household
cleaning products. In this case, the controlled participants' RAB shares
are reliably projected by current sales of cleaning products.
Example 3. The facts are the same as in Example 2, except that FS's
market share is rapidly expanding because of the business failure of a
competitor in its geographic area. The controlled participants' RAB
shares are not reliably projected by current sales of cleaning products.
FS's benefit projections should take into account its growth in market
share.
[[Page 685]]
Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into
a CSA to develop synthetic fertilizers and insecticides. FP and USS
share costs on the basis of each controlled participant's current sales
of fertilizers and insecticides. The market shares of the controlled
participants have been stable for fertilizers, but FP's market share for
insecticides has been expanding. The controlled participants'
projections of RAB shares are reliable with regard to fertilizers, but
not reliable with regard to insecticides; a more reliable projection of
RAB shares would take into account the expanding market share for
insecticides.
(f) Changes in participation under a CSA--(1) In general. A change
in participation under a CSA occurs when there is either a controlled
transfer of interests or a capability variation. A change in
participation requires arm's length consideration under paragraph
(a)(3)(ii) of this section, and as more fully described in this
paragraph (f).
(2) Controlled transfer of interests. A controlled transfer of
interests occurs when a participant in a CSA transfers all or part of
its interests in cost shared intangibles under the CSA in a controlled
transaction, and the transferee assumes the associated obligations under
the CSA. For example, a change in the territorial based divisional
interests or field of use based divisional interests, as described in
paragraph (b)(4), is a controlled transfer of interests. After the
controlled transfer of interests occurs, the CSA will still exist if at
least two controlled participants still have interests in the cost
shared intangibles. In such a case, the transferee will be treated as
succeeding to the transferor's prior history under the CSA as pertains
to the transferred interests, including the transferor's cost
contributions, benefits derived, and PCT Payments attributable to such
rights or obligations. A transfer that would otherwise constitute a
controlled transfer of interests for purposes of this paragraph (f)(2)
shall not constitute a controlled transfer of interests if it also
constitutes a capability variation for purposes of paragraph (f)(3) of
this section.
(3) Capability variation. A capability variation occurs when, in a
CSA in which interests in cost shared intangibles are divided as
described in paragraph (b)(4)(iv) of this section, the controlled
participants' division of interests or their relative capabilities or
capacities to benefit from the cost shared intangibles are materially
altered. For purposes of paragraph (a)(3)(ii) of this section, a
capability variation is considered to be a controlled transfer of
interests in cost shared intangibles, in which any controlled
participant whose RAB share decreases as a result of the capability
variation is a transferor, and any controlled participant whose RAB
share thus increases is the transferee of the interests in cost shared
intangibles.
(4) Arm's length consideration for a change in participation. In the
event of a change in participation, the arm's length amount of
consideration from the transferee, under the rules of Sec. Sec. 1.482-1
and 1.482-4 through 1.482-6 and paragraph (a)(3)(ii) of this section,
will be determined consistent with the reasonably anticipated
incremental change in the returns to the transferee and transferor
resulting from such change in participation. Such changes in returns
will themselves depend on the reasonably anticipated incremental changes
in the benefits from exploiting the cost shared intangibles, IDCs borne,
and PCT Payments (if any). However, any arm's length consideration
required under this paragraph (f)(4) with respect to a capability
variation shall be reduced as necessary to prevent duplication of an
adjustment already performed under paragraph (i)(2)(ii)(A) of this
section that resulted from the same capability variation. If an
adjustment has been performed already under this paragraph (f)(4) with
respect to a capability variation, then for purposes of any adjustment
to be performed under paragraph (i)(2)(ii)(A) of this section, the
controlled participants' projected benefit shares referred to in
paragraph (i)(2)(ii)(A) of this section shall be considered to be the
controlled participants' respective RAB shares after the capability
variation occurred.
(5) Examples. The following examples illustrate the principles of
this paragraph (f):
Example 1. X, Y, and Z are the only controlled participants in a
CSA. The CSA divides interests in cost shared intangibles on a
territorial basis as described in paragraph
[[Page 686]]
(b)(4)(ii) of this section. X is assigned the territories of the
Americas, Y is assigned the territory of the UK and Australia, and Z is
assigned the rest of the world. When the CSA is formed, X has a platform
contribution T. Under the PCTs for T, Y and Z are each obligated to pay
X royalties equal to five percent of their respective sales. Aside from
T, there are no platform contributions. Two years after the formation of
the CSA, Y transfers to Z its interest in cost shared intangibles
relating to the UK territory, and the associated obligations, in a
controlled transfer of interests described in paragraph (f)(2) of this
section. At that time the reasonably anticipated benefits from
exploiting cost shared intangibles in the UK have a present value of
$11M, the reasonably anticipated IDCs to be borne relating to the UK
territory have a present value of $3M, and the reasonably anticipated
PCT Payments to be made to X relating to sales in the UK territory have
a present value of $2M. As arm's length consideration for the change in
participation due to the controlled transfer of interests, Z must pay Y
compensation with an anticipated present value of $11M, less $3M, less
$2M, which equals $6M.
Example 2. As in Example 2 of paragraph (b)(4)(v) of this section,
companies P and S, both members of the same controlled group, enter into
a CSA to develop product Z. P and S agree to divide their interest in
product Z based on site of manufacturing. P will have exclusive and
perpetual rights in product Z manufactured in facilities owned by P. S
will have exclusive and perpetual rights to product Z manufactured in
facilities owned by S. P and S agree that neither will license
manufacturing rights in product Z to any related or unrelated party.
Both P and S maintain books and records that allow production at all
sites to be verified. Both own facilities that will manufacture product
Z and the relative capacities of these sites are known. All facilities
are currently operating at near capacity and are expected to continue to
operate at near capacity when product Z enters production so that it
will not be feasible to shift production between P's and S's facilities.
P and S have no plans to build new facilities and the lead time required
to plan and build a manufacturing facility precludes the possibility
that P or S will build a new facility during the period for which sales
of Product Z are expected. When the CSA is formed, P has a platform
contribution T. Under the PCT for T, S is obligated to pay P sales-based
royalties according to a certain formula. Aside from T, there are no
other platform contributions. Two years after the formation of the CSA,
owing to a change in plans not reasonably foreseeable at the time the
CSA was entered into, S acquires additional facilities F for the
manufacture of Product Z. Such acquisition constitutes a capability
variation described in paragraph (f)(3) of this section. Under this
capability variation, S's RAB share increases from 50% to 60%.
Accordingly, there is a compensable change in participation under
paragraph (f)(3) of this section.
(g) Supplemental guidance on methods applicable to PCTs--(1) In
general. This paragraph (g) provides supplemental guidance on applying
the methods listed in this paragraph (g)(1) for purposes of evaluating
the arm's length amount charged in a PCT. Each method will yield a value
for the compensation obligation of each PCT Payor consistent with the
product of the combined pre-tax value to all controlled participants of
the platform contribution that is the subject of the PCT and the PCT
Payor's RAB share. Each method must yield results consistent with
measuring the value of a platform contribution by reference to the
future income anticipated to be generated by the resulting cost shared
intangibles. The methods are--
(i) The comparable uncontrolled transaction method described in
Sec. 1.482-4(c), or the comparable uncontrolled services price method
described in Sec. 1.482-9(c), as further described in paragraph (g)(3)
of this section;
(ii) The income method, described in paragraph (g)(4) of this
section;
(iii) The acquisition price method, described in paragraph (g)(5) of
this section;
(iv) The market capitalization method, described in paragraph (g)(6)
of this section;
(v) The residual profit split method, described in paragraph (g)(7)
of this section; and
(vi) Unspecified methods, described in paragraph (g)(8) of this
section.
(2) Best method analysis applicable for evaluation of a PCT pursuant
to a CSA--(i) In general. Each method must be applied in accordance with
the provisions of Sec. 1.482-1, including the best method rule of Sec.
1.482-1(c), the comparability analysis of Sec. 1.482-1(d), and the
arm's length range of Sec. 1.482-1(e), except as those provisions are
modified in this paragraph (g).
(ii) Consistency with upfront contractual terms and risk
allocation--the investor model--(A) In general. Although all of the
factors entering into a best method analysis described in Sec. 1.482-
1(c)
[[Page 687]]
and (d) must be considered, specific factors may be particularly
relevant in the context of a CSA. In particular, the relative
reliability of an application of any method depends on the degree of
consistency of the analysis with the applicable contractual terms and
allocation of risk under the CSA and this section among the controlled
participants as of the date of the PCT, unless a change in such terms or
allocation has been made in return for arm's length consideration. In
this regard, a CSA involves an upfront division of the risks as to both
reasonably anticipated obligations and reasonably anticipated benefits
over the reasonably anticipated term of the CSA Activity. Accordingly,
the relative reliability of an application of a method also depends on
the degree of consistency of the analysis with the assumption that, as
of the date of the PCT, each controlled participant's aggregate net
investment in the CSA Activity (including platform contributions,
operating contributions, as such term is defined in paragraph (j)(1)(i)
of this section, operating cost contributions, as such term is defined
in paragraph (j)(1)(i) of this section, and cost contributions) is
reasonably anticipated to earn a rate of return (which might be
reflected in a discount rate used in applying a method) appropriate to
the riskiness of the controlled participant's CSA Activity over the
entire period of such CSA Activity. If the cost shared intangibles
themselves are reasonably anticipated to contribute to developing other
intangibles, then the period described in the preceding sentence
includes the period, reasonably anticipated as of the date of the PCT,
of developing and exploiting such indirectly benefited intangibles.
(B) Example. The following example illustrates the principles of
this paragraph (g)(2)(ii):
Example. (i) P, a U.S. corporation, has developed a software
program, DEF, which applies certain algorithms to reconstruct complete
DNA sequences from partially-observed DNA sequences. S is a wholly-owned
foreign subsidiary of P. On the first day of Year 1, P and S enter into
a CSA to develop a new generation of genetic tests, GHI, based in part
on the use of DEF. DEF is therefore a platform contribution of P for
which compensation is due from S pursuant to a PCT. S makes no platform
contributions to the CSA. Sales of GHI are projected to commence two
years after the inception of the CSA and then to continue for eight more
years. Based on industry experience, P and S are confident that GHI will
be replaced by a new type of genetic testing based on technology
unrelated to DEF or GHI and that, at that point, GHI will have no
further value. P and S project that that replacement will occur at the
end of Year 10.
(ii) For purposes of valuing the PCT for P's platform contribution
of DEF to the CSA, P and S apply a type of residual profit split method
that is not described in paragraph (g)(7) of this section and which,
accordingly, constitutes an unspecified method. See paragraph (g)(7)(i)
(last sentence) of this section. The principles of this paragraph (g)(2)
apply to any method for valuing a PCT, including the unspecified method
used by P and S.
(iii) Under the method employed by P and S, in each year, a portion
of the income from sales of GHI in S's territory is allocated to certain
routine contributions made by S. The residual of the profit or loss from
GHI sales in S's territory after the routine allocation step is divided
between P and S pro rata to their capital stocks allocable to S's
territory. Each controlled participant's capital stock is computed by
capitalizing, applying a capital growth factor to, and amortizing its
historical expenditures regarding DEF allocable to S's territory (in the
case of P), or its ongoing cost contributions towards developing GHI (in
the case of S). The amortization of the capital stocks is effected on a
straight-line basis over an assumed four-year life for the relevant
expenditures. The capital stocks are grown using an assumed growth
factor that P and S consider to be appropriate.
(iv) The assumption that all expenditures amortize on a straight-
line basis over four years does not appropriately reflect the principle
that as of the date of the PCT regarding DEF, every contribution to the
development of GHI, including DEF, is reasonably anticipated to have
value throughout the entire period of exploitation of GHI which is
projected to continue through Year 10. Under this method as applied by P
and S, the share of the residual profit in S's territory that is
allocated to P as a PCT Payment from S will decrease every year. After
Year 4, P's capital stock in DEF will necessarily be $0, so that P will
receive none of the residual profit or loss from GHI sales in S's
territory after Year 4 as a PCT Payment.
(v) As a result of this limitation of the PCT Payments to be made by
S, the anticipated return to S's aggregate investment in the CSA, over
the whole period of S's CSA Activity, is at a rate that is significantly
higher than the appropriate rate of return
[[Page 688]]
for S's CSA Activity (as determined by a reliable method). This
discrepancy is not consistent with the investor model principle that S
should anticipate a rate of return to its aggregate investment in the
CSA, over the whole period of its CSA Activity, appropriate for the
riskiness of its CSA Activity. The inconsistency of the method with the
investor model materially lessens its reliability for purposes of a best
method analysis. See Sec. 1.482-1(c)(2)(ii)(B).
(iii) Consistency of evaluation with realistic alternatives--(A) In
general. The relative reliability of an application of a method also
depends on the degree of consistency of the analysis with the assumption
that uncontrolled taxpayers dealing at arm's length would have evaluated
the terms of the transaction, and only entered into such transaction, if
no alternative is preferable. This condition is not met, therefore,
where for any controlled participant the total anticipated present value
of its income attributable to its entering into the CSA, as of the date
of the PCT, is less than the total anticipated present value of its
income that could be achieved through an alternative arrangement
realistically available to that controlled participant. In principle,
this comparison is made on a post-tax basis but, in many cases, a
comparison made on a pre-tax basis will yield equivalent results. See
also paragraph (g)(2)(v)(B)(1) of this section (Discount rate variation
between realistic alternatives).
(B) Examples. The following examples illustrate the principles of
this paragraph (g)(2)(iii):
Example 1. (i) P, a corporation, and S, a wholly-owned subsidiary of
P, enter into a CSA to develop a personal transportation device (the
product). Under the arrangement, P will undertake all of the R&D, and
manufacture and market the product in Country X. S will make CST
Payments to P for its appropriate share of P's R&D costs, and
manufacture and market the product in the rest of the world. P owns
existing patents and trade secrets that are reasonably anticipated to
contribute to the development of the product. Therefore the rights in
the patents and trade secrets are platform contributions for which
compensation is due from S as part of a PCT.
(ii) S's manufacturing and distribution activities under the CSA
will be routine in nature, and identical to the activities it would
undertake if it alternatively licensed the product from P.
(iii) Reasonably reliable estimates indicate that P could develop
the product without assistance from S and license the product outside of
Country X for a royalty of 20% of sales. Based on reliable financial
projections that include all future development costs and licensing
revenue that are allocable to the non-Country X market, and using a
discount rate appropriate for the riskiness of P's role as a licensor
(see paragraph (g)(2)(v) of this section), the post-tax present value of
this licensing alternative to P for the non-Country X market (measured
as of the date of the PCT) would be $500 million. Thus, based on this
realistic alternative, the anticipated post-tax present value under the
CSA to P in the non-Country X market (measured as of the date of the
PCT), taking into account anticipated development costs allocable to the
non-Country X market, and anticipated CST Payments and PCT Payments from
S, and using a discount rate appropriate for the riskiness of P's role
as a participant in the CSA, should not be less than $500 million.
Example 2. (i) The facts are the same as in Example 1, except that
there are no reliable estimates of the value to P from the licensing
alternative to the CSA. Further, reasonably reliable estimates indicate
that an arm's length return for S's routine manufacturing and
distribution activities is a 10% mark-up on total costs of goods sold
plus operating expenses related to those activities. Finally, the
Commissioner determines that the respective activities undertaken by P
and S (other than licensing payments, cost contributions, and PCT
Payments) would be identical regardless of whether the arrangement was
undertaken as a CSA (cost sharing alternative) or as a long-term
licensing arrangement (licensing alternative). In particular, in both
alternatives, P would perform all research activities and S would
undertake routine manufacturing and distribution activities associated
with its territory.
(ii) P undertakes an economic analysis that derives S's cost
contributions under the CSA, based on reliable financial projections.
Based on this and further economic analysis, P determines S's PCT
Payment as a certain lump sum amount to be paid as of the date of the
PCT (Date D).
(iii) Based on reliable financial projections that include S's cost
contributions and that incorporate S's PCT Payment, as computed by P,
and using a discount rate appropriate for the riskiness of S's role as a
CSA participant (see paragraphs (g)(2)(v) and (4)(vi)(F) of this
section), the anticipated post-tax net present value to S in the cost
sharing alternative (measured as of Date D) is $800 million. Further,
based on these same reliable projections (but incorporating S's
licensing payments instead of S's cost contributions and PCT Payment),
and using a discount rate appropriate for the riskiness of S's role
[[Page 689]]
as a long-term licensee, the anticipated post-tax net present value to S
in the licensing alternative (measured as of Date D) is $100 million.
Thus, S's anticipated post-tax net present value is $700 million greater
in the cost sharing alternative than in the licensing alternative. This
result suggests that P's anticipated post-tax present value must be
significantly less under the cost sharing alternative than under the
licensing alternative. This means that the reliability of P's analysis
as described in paragraph (ii) of this Example 2 is reduced, because P
would not be expected to enter into a CSA if its alternative of being a
long-term licensor is preferable.
Example 3. (i) The facts are the same as in paragraphs (i) and (ii)
of Example 2. In addition, based on reliable financial projections that
include S's cost contributions and S's PCT Payment, and using a discount
rate appropriate for the riskiness of S's role as a CSA participant, the
anticipated post-tax net present value to S under the CSA (measured as
of the date of the PCT) is $50 million. Also, instead of entering the
CSA, S has the realistic alternative of manufacturing and distributing
product Z unrelated to the personal transportation device, with the same
anticipated 10% mark-up on total costs that it would anticipate for its
routine activities in Example 2. Under its realistic alternative, at a
discount rate appropriate for the riskiness of S's role with respect to
product Z, S anticipates a present value of $100 million.
(ii) Because the lump sum PCT Payment made by S results in S having
a considerably lower anticipated net present value than S could achieve
through an alternative arrangement realistically available to it, the
reliability of P's calculation of the lump sum PCT Payment is reduced.
(iv) Aggregation of transactions. The combined effect of multiple
contemporaneous transactions, consisting either of multiple PCTs, or of
one or more PCT and one or more other transactions in connection with a
CSA that are not governed by this section (such as transactions
involving cross operating contributions or make-or-sell rights), may
require evaluation in accordance with the principles of aggregation
described in Sec. 1.482-1(f)(2)(i). In such cases, it may be that the
multiple transactions are reasonably anticipated, as of the date of the
PCT(s), to be so interrelated that the method that provides the most
reliable measure of an arm's length charge is a method under this
section applied on an aggregate basis for the PCT(s) and other
transactions. A section 482 adjustment may be made by comparing the
aggregate arm's length charge so determined to the aggregate payments
actually made for the multiple transactions. In such a case, it
generally will not be necessary to allocate separately the aggregate
arm's length charge as between various PCTs or as between PCTs and such
other transactions. However, such an allocation may be necessary for
other purposes, such as applying paragraph (i)(6) (Periodic adjustments)
of this section. An aggregate determination of the arm's length charge
for multiple transactions will often yield a payment for a controlled
participant that is equal to the aggregate value of the platform
contributions and other resources, capabilities, and rights covered by
the multiple transactions multiplied by that controlled participant's
RAB share. Because RAB shares only include benefits from cost shared
intangibles, the reliability of an aggregate determination of payments
for multiple transactions may be reduced to the extent that it includes
transactions covering resources, capabilities, and rights for which the
controlled participants' expected benefit shares differ substantially
from their RAB shares.
(v) Discount rate--(A) In general. The best method analysis in
connection with certain methods or forms of payment may depend on a rate
or rates of return used to convert projected results of transactions to
present value, or to otherwise convert monetary amounts at one or more
points in time to equivalent amounts at a different point or points in
time. For this purpose, a discount rate or rates should be used that
most reliably reflect the market-correlated risks of activities or
transactions and should be applied to the best estimates of the relevant
projected results, based on all the information potentially available at
the time for which the present value calculation is to be performed.
Depending on the particular facts and circumstances, the market-
correlated risk involved and thus, the discount rate, may differ among a
company's various activities or transactions. Normally, discount rates
are most reliably determined by reference to market information.
[[Page 690]]
(B) Considerations in best method analysis of discount rate--(1)
Discount rate variation between realistic alternatives. Realistic
alternatives may involve varying risk exposure and, thus, may be more
reliably evaluated using different discount rates. See paragraphs
(g)(4)(i)(F) and (vi)(F) of this section. In some circumstances, a party
may have less risk as a licensee of intangibles needed in its
operations, and so require a lower discount rate, than it would have by
entering into a CSA to develop such intangibles, which may involve the
party's assumption of additional risk in funding its cost contributions
to the IDA. Similarly, self-development of intangibles and licensing out
may be riskier for the licensor, and so require a higher discount rate,
than entering into a CSA to develop such intangibles, which would
relieve the licensor of the obligation to fund a portion of the IDCs of
the IDA.
(2) Implied discount rates. In some circumstances, the particular
discount rate or rates used for certain activities or transactions
logically imply that certain other activities will have a particular
discount rate or set of rates (implied discount rates). To the extent
that an implied discount rate is inappropriate in light of the facts and
circumstances, which may include reliable direct evidence of the
appropriate discount rate applicable for such other activities, the
reliability of any method is reduced where such method is based on the
discount rates from which such an inappropriate implied discount rate is
derived. See paragraphs (g)(4)(vi)(F)(2) and (g)(4)(viii), Example 8 of
this section.
(3) Discount rate variation between forms of payment. Certain forms
of payment may involve different risks than others. For example,
ordinarily a royalty computed on a profits base would be more volatile,
and so require a higher discount rate to discount projected payments to
present value, than a royalty computed on a sales base.
(4) Post-tax rate. In general, discount rate estimates that may be
inferred from the operations of the capital markets are post-tax
discount rates. Therefore, an analysis would in principle apply post-tax
discount rates to income net of expense items including taxes (post-tax
income). However, in certain circumstances the result of applying a
post-tax discount rate to post-tax income is equivalent to the product
of the result of applying a post-tax discount rate to income net of
expense items other than taxes (pre-tax income), and the difference of
one minus the tax rate (as defined in paragraph (j)(1)(i) of this
section). Therefore, in such circumstances, calculation of pre-tax
income, rather than post-tax income, may be sufficient. See, for
example, paragraph (g)(4)(i)(G) of this section.
(C) Example. The following example illustrates the principles of
this paragraph (g)(2)(v):
Example. (i) P and S form a CSA to develop intangible X, which will
be used in product Y. P will develop X, and S will make CST Payments as
its cost contributions. At the start of the CSA, P has a platform
contribution, for which S commits to make a PCT Payment of 5% of its
sales of product Y. As part of the evaluation of whether that PCT
Payment is arm's length, the Commissioner considers whether P had a more
favorable realistic alternative (see paragraph (g)(2)(iii) of this
section). Specifically, the Commissioner compares P's anticipated post-
tax discounted present value of the financial projections under the CSA
(taking into account S's PCT payment of 5% of its sale of product Y)
with P's anticipated post-tax discounted present value of the financial
projections under a reasonably available licensing alternative that
consists of developing intangible X on its own and then licensing X to S
or to an uncontrolled party similar to S. In undertaking the analysis,
the Commissioner determines that, because it would be funding the entire
development of the intangible, P undertakes greater risks in the
licensing alternative than in the cost sharing alternative (in the cost
sharing alternative P would be funding only part of the development of
the intangible).
(ii) The Commissioner determines that, as between the two scenarios,
all of the components of P's anticipated financial flows are identical,
except for the CST and PCT Payments under the CSA, compared to the
licensing payments under the licensing alternative. Accordingly, the
Commissioner concludes that the differences in market-correlated risks
between the two scenarios, and therefore the differences in discount
rates between the two scenarios, relate to the differences in these
components of the financial projections.
(vi) Financial projections. The reliability of an estimate of the
value of a
[[Page 691]]
platform or operating contribution in connection with a PCT will often
depend upon the reliability of projections used in making the estimate.
Such projections should reflect the best estimates of the items
projected (normally reflecting a probability weighted average of
possible outcomes and thus also reflecting non-market-correlated risk).
Projections necessary for this purpose may include a projection of
sales, IDCs, costs of developing operating contributions, routine
operating expenses, and costs of sales. Some method applications
directly estimate projections of items attributable to separate
development and exploitation by the controlled participants within their
respective divisions. Other method applications indirectly estimate
projections of items from the perspective of the controlled group as a
whole, rather than from the perspective of a particular participant, and
then apportion the items so estimated on some assumed basis. For
example, in some applications, sales might be directly projected by
division, but worldwide projections of other items such as operating
expenses might be apportioned among divisions in the same ratio as the
divisions' respective sales. Which approach is more reliable depends on
which provides the most reliable measure of an arm's length result,
considering the competing perspectives under the facts and circumstances
in light of the completeness and accuracy of the underlying data, the
reliability of the assumptions, and the sensitivity of the results to
possible deficiencies in the data and assumptions. For these purposes,
projections that have been prepared for non-tax purposes are generally
more reliable than projections that have been prepared solely for
purposes of meeting the requirements in this paragraph (g).
(vii) Accounting principles--(A) In general. Allocations or other
valuations done for accounting purposes may provide a useful starting
point but will not be conclusive for purposes of the best method
analysis in evaluating the arm's length charge in a PCT, particularly
where the accounting treatment of an asset is inconsistent with its
economic value.
(B) Examples. The following examples illustrate the principles of
this paragraph (g)(2)(vii):
Example 1. (i) USP, a U.S. corporation and FSub, a wholly-owned
foreign subsidiary of USP, enter into a CSA in Year 1 to develop
software programs with application in the medical field. Company X is an
uncontrolled software company located in the United States that is
engaged in developing software programs that could significantly enhance
the programs being developed by USP and FSub. Company X is still in a
startup phase, so it has no currently exploitable products or marketing
intangibles and its workforce consists of a team of software developers.
Company X has negligible liabilities and tangible property. In Year 2,
USP purchases Company X as part of an uncontrolled transaction in order
to acquire its in-process technology and workforce for purposes of the
development activities of the CSA. USP files a consolidated return that
includes Company X. For accounting purposes, $50 million of the $100
million acquisition price is allocated to the in-process technology and
workforce, and the residual $50 million is allocated to goodwill.
(ii) The in-process technology and workforce of Company X acquired
by USP are reasonably anticipated to contribute to developing cost
shared intangibles and therefore the rights in the in-process technology
and workforce of Company X are platform contributions for which FSub
must compensate USP as part of a PCT. In determining whether to apply
the acquisition price or another method for purposes of evaluating the
arm's length charge in the PCT, relevant best method analysis
considerations must be weighed in light of the general principles of
paragraph (g)(2) of this section. The allocation for accounting purposes
raises an issue as to the reliability of using the acquisition price
method in this case because it suggests that a significant portion of
the value of Company X's nonroutine contributions to USP's business
activities is allocable to goodwill, which is often difficult to value
reliably and which, depending on the facts and circumstances, might not
be attributable to platform contributions that are to be compensated by
PCTs. See paragraph (g)(5)(iv)(A) of this section.
(iii) Paragraph (g)(2)(vii)(A) of this section provides that
accounting treatment may be a starting point, but is not determinative
for purposes of assessing or applying methods to evaluate the arm's
length charge in a PCT. The facts here reveal that Company X has nothing
of economic value aside from its in-process technology and assembled
workforce. The $50 million of the acquisition price allocated to
goodwill for accounting purposes, therefore, is economically
attributable to either of, or both, the in-process technology
[[Page 692]]
and the workforce. That moots the potential issue under the acquisition
price method of the reliability of valuation of assets not to be
compensated by PCTs, since there are no such assets. Assuming the
acquisition price method is otherwise the most reliable method, the
aggregate value of Company X's in-process technology and workforce is
the full acquisition price of $100 million. Accordingly, the aggregate
value of the arm's length PCT Payments due from FSub to USP for the
platform contributions consisting of the rights in Company X's in-
process technology and workforce will equal $100 million multiplied by
FSub's RAB share.
Example 2. (i) The facts are the same as in Example 1, except that
Company X is a mature software business in the United States with a
successful current generation of software that it markets under a
recognized trademark, in addition to having the research team and new
generation software in process that could significantly enhance the
programs being developed under USP's and FSub's CSA. USP continues
Company X's existing business and integrates the research team and the
in-process technology into the efforts under its CSA with FSub. For
accounting purposes, the $100 million price for acquiring Company X is
allocated $50 million to existing software and trademark, $25 million to
in-process technology and research workforce, and the residual $25
million to goodwill and going concern value.
(ii) In this case an analysis of the facts indicates a likelihood
that, consistent with the allocation under the accounting treatment
(although not necessarily in the same amount), a significant amount of
the nonroutine contributions to the USP's business activities consist of
goodwill and going concern value economically attributable to the
existing U.S. software business rather than to the platform
contributions consisting of the rights in the in-process technology and
research workforce. In addition, an analysis of the facts indicates that
a significant amount of the nonroutine contributions to USP's business
activities consist of the make-or-sell rights under the existing
software and trademark, which are not platform contributions and might
be difficult to value. Accordingly, further consideration must be given
to the extent to which these circumstances reduce the relative
reliability of the acquisition price method in comparison to other
potentially applicable methods for evaluating the PCT Payment.
Example 3. (i) USP, a U.S. corporation, and FSub, a wholly-owned
foreign subsidiary of USP, enter into a CSA in Year 1 to develop Product
A. Company Y is an uncontrolled corporation that owns Technology X,
which is critical to the development of Product A. Company Y currently
markets Product B, which is dependent on Technology X. USP is solely
interested in acquiring Technology X, but is only able to do so through
the acquisition of Company Y in its entirety for $200 million in an
uncontrolled transaction in Year 2. For accounting purposes, the
acquisition price is allocated as follows: $120 million to Product B and
the underlying Technology X, $30 million to trademark and other
marketing intangibles, and the residual $50 million to goodwill and
going concern value. After the acquisition of Company Y, Technology X is
used to develop Product A. No other part of Company Y is used in any
manner. Immediately after the acquisition, product B is discontinued,
and, therefore, the accompanying marketing intangibles become worthless.
None of the previous employees of Company Y is retained.
(ii) The Technology X of Company Y acquired by USP is reasonably
anticipated to contribute to developing cost shared intangibles and is
therefore a platform contribution for which FSub must compensate USP as
part of a PCT. Although for accounting purposes a significant portion of
the acquisition price of Company Y was allocated to items other than
Technology X, the facts demonstrate that USP had no intention of using
and therefore placed no economic value on any part of Company Y other
than Technology X. If USP was willing to pay $200 million for Company Y
solely for purposes of acquiring Technology X, then assuming the
acquisition price method is otherwise the most reliable method, the
value of Technology X is the full $200 million acquisition price.
Accordingly, the value of the arm's length PCT Payment due from FSub to
USP for the platform contribution consisting of the rights in Technology
X will equal the product of $200 million and FSub's RAB share.
(viii) Valuations of subsequent PCTs--(A) Date of subsequent PCT.
The date of a PCT may occur subsequent to the inception of the CSA. For
example, an intangible initially developed outside the IDA may only
subsequently become a platform contribution because that later time is
the earliest date on which it is reasonably anticipated to contribute to
developing cost shared intangibles within the IDA. In such case, the
date of the PCT, and the analysis of the arm's length amount charged in
the subsequent PCT, is as of such later time.
(B) Best method analysis for subsequent PCT. In cases where PCTs
occur on different dates, the determination of the arm's length amount
charged, respectively, in the prior and subsequent PCTs must be
coordinated in a manner that provides the most reliable measure of an
arm's length result. In some
[[Page 693]]
circumstances, a subsequent PCT may be reliably evaluated independently
of other PCTs, as may be possible for example, under the acquisition
price method. In other circumstances, the results of prior and
subsequent PCTs may be interrelated and so a subsequent PCT may be most
reliably evaluated under the residual profit split method of paragraph
(g)(7) of this section. In those cases, for purposes of allocating the
present value of nonroutine residual divisional profit or loss, and so
determining the present value of the subsequent PCT Payments, in
accordance with paragraph (g)(7)(iii)(C) of this section, the PCT
Payor's interest in cost shared intangibles, both already developed and
in process, are treated as additional PCT Payor operating contributions
as of the date of the subsequent PCT.
(ix) Arm's length range--(A) In general. The guidance in Sec.
1.482-1(e) regarding determination of an arm's length range, as modified
by this section, applies in evaluating the arm's length amount charged
in a PCT under a transfer pricing method provided in this section
(applicable method). Section 1.482-1(e)(2)(i) provides that the arm's
length range is ordinarily determined by applying a single pricing
method selected under the best method rule to two or more uncontrolled
transactions of similar comparability and reliability although use of
more than one method may be appropriate for the purposes described in
Sec. 1.482-1(c)(2)(iii). The rules provided in Sec. 1.482-1(e) and
this section for determining an arm's length range shall not override
the rules provided in paragraph (i)(6) of this section for periodic
adjustments by the Commissioner. The provisions in paragraphs
(g)(2)(ix)(C) and (D) of this section apply only to applicable methods
that are based on two or more input parameters as described in paragraph
(g)(2)(ix)(B) of this section. For an example of how the rules of this
section for determining an arm's length range of PCT Payments are
applied, see paragraph (g)(4)(viii) of this section.
(B) Methods based on two or more input parameters. An applicable
method may determine PCT Payments based on calculations involving two or
more parameters whose values depend on the facts and circumstances of
the case (input parameters). For some input parameters (market-based
input parameters), the value is most reliably determined by reference to
data that derives from uncontrolled transactions (market data). For
example, the value of the return to a controlled participant's routine
contributions, as such term is defined in paragraph (j)(1)(i) of this
section, to the CSA Activity (which value is used as an input parameter
in the income method described in paragraph (g)(4) of this section) may
in some cases be most reliably determined by reference to the profit
level of a company with rights, resources, and capabilities comparable
to those routine contributions. See Sec. 1.482-5. As another example,
the value for the discount rate that reflects the riskiness of a
controlled participant's role in the CSA (which value is used as an
input parameter in the income method described in paragraph (g)(4) of
this section) may in some cases be most reliably determined by reference
to the stock beta of a company whose overall risk is comparable to the
riskiness of the controlled participant's role in the CSA.
(C) Variable input parameters. For some market-based input
parameters (variable input parameters), the parameter's value is most
reliably determined by considering two or more observations of market
data that have, or with adjustment can be brought to, a similar
reliability and comparability, as described in Sec. 1.482-1(e)(2)(ii)
(for example, profit levels or stock betas of two or more companies).
See paragraph (g)(2)(ix)(B) of this section.
(D) Determination of arm's length PCT Payment. For purposes of
applying this paragraph (g)(2)(ix), each input parameter is assigned a
single most reliable value, unless it is a variable input parameter as
described in paragraph (g)(2)(ix)(C) of this section. The determination
of the arm's length payment depends on the number of variable input
parameters.
(1) No variable input parameters. If there are no variable input
parameters, the arm's length PCT Payment is a single value determined by
using the single most reliable value determined for each input
parameter.
[[Page 694]]
(2) One variable input parameter. If there is exactly one variable
input parameter, then under the applicable method, the arm's length
range of PCT Payments is the interquartile range, as described in Sec.
1.482-1(e)(2)(iii)(C), of the set of PCT Payment values calculated by
selecting--
(i) Iteratively, the value of the variable input parameter that is
based on each observation as described in paragraph (g)(2)(ix)(C) of
this section; and
(ii) The single most reliable values for each other input parameter.
(3) More than one variable input parameter. If there are two or more
variable input parameters, then under the applicable method, the arm's
length range of PCT Payments is the interquartile range, as described in
Sec. 1.482-1(e)(2)(iii)(C), of the set of PCT Payment values calculated
iteratively using every possible combination of permitted choices of
values for the input parameters. For input parameters other than a
variable input parameter, the only such permitted choice is the single
most reliable value. For variable input parameters, such permitted
choices include any value that is--
(i) Based on one of the observations described in paragraph
(g)(2)(ix)(C) of this section; and
(ii) Within the interquartile range (as described in Sec. 1.482-
1(e)(2)(iii)(C)) of the set of all values so based.
(E) Adjustments. Section 1.482-1(e)(3), applied as modified by this
paragraph (g)(2)(ix), determines when the Commissioner may make an
adjustment to a PCT Payment due to the taxpayer's results being outside
the arm's length range. Adjustment will be to the median, as defined in
Sec. 1.482-1(e)(3). Thus, the Commissioner is not required to establish
an arm's length range prior to making an allocation under section 482.
(x) Valuation undertaken on a pre-tax basis. PCT Payments in general
may increase the PCT Payee's tax liability and decrease the PCT Payor's
tax liability. The arm's length amount of a PCT Payment determined under
the methods in this paragraph (g) is the value of the PCT Payment
itself, without regard to such tax effects. Therefore, the methods under
this section must be applied, with suitable adjustments if needed, to
determine the PCT Payments on a pre-tax basis. See paragraphs
(g)(2)(v)(B) and (4)(i)(G) of this section.
(3) Comparable uncontrolled transaction method. The comparable
uncontrolled transaction (CUT) method described in Sec. 1.482-4(c), and
the comparable uncontrolled services price (CUSP) method described in
Sec. 1.482-9(c), may be applied to evaluate whether the amount charged
in a PCT is arm's length by reference to the amount charged in a
comparable uncontrolled transaction. Although all of the factors
entering into a best method analysis described in Sec. 1.482-1(c) and
(d) must be considered, comparability and reliability under this method
are particularly dependent on similarity of contractual terms, degree to
which allocation of risks is proportional to reasonably anticipated
benefits from exploiting the results of intangible development, similar
period of commitment as to the sharing of intangible development risks,
and similar scope, uncertainty, and profit potential of the subject
intangible development, including a similar allocation of the risks of
any existing resources, capabilities, or rights, as well as of the risks
of developing other resources, capabilities, or rights that would be
reasonably anticipated to contribute to exploitation within the parties'
divisions, that is consistent with the actual allocation of risks
between the controlled participants as provided in the CSA in accordance
with this section. When applied in the manner described in Sec. 1.482-
4(c) or 1.482-9(c), the CUT or CUSP method will typically yield an arm's
length total value for the platform contribution that is the subject of
the PCT. That value must then be multiplied by each PCT Payor's
respective RAB share in order to determine the arm's length PCT Payment
due from each PCT Payor. The reliability of a CUT or CUSP that yields a
value for the platform contribution only in the PCT Payor's division
will be reduced to the extent that value is not consistent with the
total worldwide value of the platform contribution multiplied by the PCT
Payor's RAB share.
[[Page 695]]
(4) Income method--(i) In general--(A) Equating cost sharing and
licensing alternatives. The income method evaluates whether the amount
charged in a PCT is arm's length by reference to a controlled
participant's best realistic alternative to entering into a CSA. Under
this method, the arm's length charge for a PCT Payment will be an amount
such that a controlled participant's present value, as of the date of
the PCT, of its cost sharing alternative of entering into a CSA equals
the present value of its best realistic alternative. In general, the
best realistic alternative of the PCT Payor to entering into the CSA
would be to license intangibles to be developed by an uncontrolled
licensor that undertakes the commitment to bear the entire risk of
intangible development that would otherwise have been shared under the
CSA. Similarly, the best realistic alternative of the PCT Payee to
entering into the CSA would be to undertake the commitment to bear the
entire risk of intangible development that would otherwise have been
shared under the CSA and license the resulting intangibles to an
uncontrolled licensee. Paragraphs (g)(4)(i)(B) through (vi) of this
section describe specific applications of the income method, but do not
exclude other possible applications of this method.
(B) Cost sharing alternative. The PCT Payor's cost sharing
alternative corresponds to the actual CSA in accordance with this
section, with the PCT Payor's obligation to make the PCT Payments to be
determined and its commitment for the duration of the IDA to bear cost
contributions.
(C) Licensing alternative. The licensing alternative is derived on
the basis of a functional and risk analysis of the cost sharing
alternative, but with a shift of the risk of cost contributions to the
licensor. Accordingly, the PCT Payor's licensing alternative consists of
entering into a license with an uncontrolled party, for a term extending
for what would be the duration of the CSA Activity, to license the make-
or-sell rights in to-be-developed resources, capabilities, or rights of
the licensor. Under such license, the licensor would undertake the
commitment to bear the entire risk of intangible development that would
otherwise have been shared under the CSA. Apart from any difference in
the allocation of the risks of the IDA, the licensing alternative should
assume contractual provisions with regard to non-overlapping divisional
intangible interests, and with regard to allocations of other risks,
that are consistent with the actual CSA in accordance with this section.
For example, the analysis under the licensing alternative should assume
a similar allocation of the risks of any existing resources,
capabilities, or rights, as well as of the risks of developing other
resources, capabilities, or rights that would be reasonably anticipated
to contribute to exploitation within the parties' divisions, that is
consistent with the actual allocation of risks between the controlled
participants as provided in the CSA in accordance with this section.
Accordingly, the financial projections associated with the licensing and
cost sharing alternatives are necessarily the same except for the
licensing payments to be made under the licensing alternative and the
cost contributions and PCT Payments to be made under the CSA.
(D) Only one controlled participant with nonroutine platform
contributions. This method involves only one of the controlled
participants providing nonroutine platform contributions as the PCT
Payee. For a method under which more than one controlled participant may
be a PCT Payee, see the application of the residual profit method
pursuant to paragraph (g)(7) of this section.
(E) Income method payment forms. The income method may be applied to
determine PCT Payments in any form of payment (for example, lump sum,
royalty on sales, or royalty on divisional profit). For converting to
another form of payment, see generally paragraph (h) (Form of payment
rules) of this section.
(F) Discount rates appropriate to cost sharing and licensing
alternatives. The present value of the cost sharing and licensing
alternatives, respectively, should be determined using the appropriate
discount rates in accordance with paragraphs (g)(2)(v) and (g)(4)(vi)(F)
of this section. See, for example, Sec. 1.482-7(g)(2)(v)(B)(1)
(Discount
[[Page 696]]
rate variation between realistic alternatives). In circumstances where
the market-correlated risks as between the cost sharing and licensing
alternatives are not materially different, a reliable analysis may be
possible by using the same discount rate with respect to both
alternatives.
(G) The effect of taxation on determining the arm's length amount.
(1) In principle, the present values of the cost sharing and licensing
alternatives should be determined by applying post-tax discount rates to
post-tax income (including the post-tax value to the controlled
participant of the PCT Payments). If such approach is adopted, then the
post-tax value of the PCT Payments must be appropriately adjusted in
order to determine the arm's length amount of the PCT Payments on a pre-
tax basis. See paragraph (g)(2)(x) of this section.
(2) In certain circumstances, post-tax income may be derived as the
product of the result of applying a post-tax discount rate to pre-tax
income, and a factor equal to one minus the tax rate (as defined in
(j)(1)(i)). See paragraph (g)(2)(v)(B) of this section.
(3) To the extent that a controlled participant's tax rate is not
materially affected by whether it enters into the cost sharing or
licensing alternative (or reliable adjustments may be made for varying
tax rates), the factor (that is, one minus the tax rate) may be
cancelled from both sides of the equation of the cost sharing and
licensing alternative present values. Accordingly, in such circumstance
it is sufficient to apply post-tax discount rates to projections of pre-
tax income for the purpose of equating the cost sharing and licensing
alternatives. The specific applications of the income method described
in paragraphs (g)(4)(ii) through (iv) of this section and the examples
set forth in paragraph (g)(4)(viii) of this section assume that a
controlled participant's tax rate is not materially affected by whether
it enters into the cost sharing or licensing alternative.
(ii) Evaluation of PCT Payor's cost sharing alternative. The present
value of the PCT Payor's cost sharing alternative is the present value
of the stream of the reasonably anticipated residuals over the duration
of the CSA Activity of divisional profits or losses, minus operating
cost contributions, minus cost contributions, minus PCT Payments.
(iii) Evaluation of PCT Payor's licensing alternative--(A)
Evaluation based on CUT. The present value of the PCT Payor's licensing
alternative may be determined using the comparable uncontrolled
transaction method, as described in Sec. 1.482-4(c)(1) and (2). In this
case, the present value of the PCT Payor's licensing alternative is the
present value of the stream, over what would be the duration of the CSA
Activity under the cost sharing alternative, of the reasonably
anticipated residuals of the divisional profits or losses that would be
achieved under the cost sharing alternative, minus operating cost
contributions that would be made under the cost sharing alternative,
minus the licensing payments as determined under the comparable
uncontrolled transaction method.
(B) Evaluation based on CPM. The present value of the PCT Payor's
licensing alternative may be determined using the comparable profits
method, as described in Sec. 1.482-5. In this case, the present value
of the licensing alternative is determined as in paragraph
(g)(4)(iii)(A) of this section, except that the PCT Payor's licensing
payments, as defined in paragraph (j)(1)(i) of this section, are
determined in each period to equal the reasonably anticipated residuals
of the divisional profits or losses that would be achieved under the
cost sharing alternative, minus operating cost contributions that would
be made under the cost sharing alternative, minus market returns for
routine contributions, as defined in paragraph (j)(1)(i) of this
section. However, treatment of net operating contributions as operating
cost contributions shall be coordinated with the treatment of other
routine contributions pursuant to this paragraph so as to avoid
duplicative market returns to such contributions.
(iv) Lump sum payment form. Where the form of PCT Payment is a lump
sum as of the date of the PCT, then, based on paragraphs (g)(4)(i)
through (iii) of this section, the PCT Payment equals the difference
between--
[[Page 697]]
(A) The present value, using the discount rate appropriate for the
cost sharing alternative, of the stream of the reasonably anticipated
residuals over the duration of the CSA Activity of divisional profits or
losses, minus cost contributions and operating cost contributions; and
(B) The present value of the licensing alternative.
(v) Application of income method using differential income stream.
In some cases, the present value of an arm's length PCT Payment may be
determined as the present value, discounted at the appropriate rate, of
the PCT Payor's reasonably anticipated stream of additional positive or
negative income over the duration of the CSA Activity that would result
(before PCT Payments) from undertaking the cost sharing alternative
rather than the licensing alternative (differential income stream). See
Example 9 of paragraph (g)(4)(viii) of this section.
(vi) Best method analysis considerations. (A) Coordination with
Sec. 1.482-1(c). Whether results derived from this method are the most
reliable measure of an arm's length result is determined using the
factors described under the best method rule in Sec. 1.482-1(c). Thus,
comparability and the quality of data, the reliability of the
assumptions, and the sensitivity of the results to possible deficiencies
in the data and assumptions, must be considered in determining whether
this method provides the most reliable measure of an arm's length
result.
(B) Assumptions Concerning Tax Rates. This method will be more
reliable to the extent that the controlled participants' respective tax
rates are not materially affected by whether they enter into the cost
sharing or licensing alternative. Even if this assumption of invariant
tax rates across alternatives does not hold, this method may still be
reliable to the extent that reliable adjustments can be made to reflect
the variation in tax rates.
(C) Coordination with Sec. 1.482-4(c)(2). If the licensing
alternative is evaluated using the comparable uncontrolled transactions
method, as described in paragraph (g)(4)(iii)(A) of this section, any
additional comparability and reliability considerations stated in Sec.
1.482-4(c)(2) may apply.
(D) Coordination with Sec. 1.482-5(c). If the licensing alternative
is evaluated using the comparable profits method, as described in
paragraph (g)(4)(iii)(B) of this section, any additional comparability
and reliability considerations stated in Sec. 1.482-5(c) may apply.
(E) Certain Circumstances Concerning PCT Payor. This method may be
used even if the PCT Payor furnishes significant operating
contributions, or commits to assume the risk of significant operating
cost contributions, to the PCT Payor's division. However, in such a
case, any comparable uncontrolled transactions described in paragraph
(g)(4)(iii)(A) of this section, and any comparable transactions used
under Sec. 1.482-5(c) as described in paragraphs (g)(4)(iii)(B) of this
section, should be consistent with such contributions (or reliable
adjustments must be made for material differences).
(F) Discount rates--(1) Reflection of similar risk profiles of cost
sharing alternative and licensing alternative. Because the financial
projections associated with the licensing and cost sharing alternatives
are the same, except for the licensing payments to be made under the
licensing alternative and the cost contributions and PCT Payments to be
made under the cost sharing alternative, the analysis of the risk
profile and financial projections for a realistic alternative to the
cost sharing alternative must be closely associated with the risk
profile and financial projections associated with the cost sharing
alternative, differing only in the treatment of licensing payments, cost
contributions, and PCT Payments. When using discount rates in applying
the income method, this means that even if different discount rates are
warranted for the two alternatives, the risk profiles for the two
discount rates are closely related to each other because the discount
rate for the licensing alternative and the discount rate for the cost
sharing alternative are both derived from the single probability-
weighted financial projections associated with the CSA Activity. The
difference, if any, in market-correlated risks between the licensing and
cost sharing alternatives is due solely to
[[Page 698]]
the different effects on risks of the PCT Payor making licensing
payments under the licensing alternative, on the one hand, and the PCT
Payor making cost contributions and PCT Payments under the cost sharing
alternative, on the other hand. That is, the difference in the risk
profile between the two scenarios solely reflects the incremental risk,
if any, associated with the cost contributions taken on by the PCT Payor
in developing the cost shared intangible under the cost sharing
alternative, and the difference, if any, in risk associated with the
particular payment forms of the licensing payments and the PCT Payments,
in light of the fact that the licensing payments in the licensing
alternative are partially replaced by cost contributions and partially
replaced by PCT Payments in the cost sharing alternative, each with its
own payment form. An analysis under the income method that uses a
different discount rate for the cost sharing alternative than for the
licensing alternative will be more reliable the greater the extent to
which the difference, if any, between the two discount rates reflects
solely these differences in the risk profiles of these two alternatives.
See, for example, paragraph (g)(2)(iii), Example 2 of this section.
(2) Use of differential income stream as a consideration in
assessing the best method. An analysis under the income method that uses
a different discount rate for the cost sharing alternative than for the
licensing alternative will be more reliable the greater the extent to
which the implied discount rate for the projected present value of the
differential income stream is consistent with reliable direct evidence
of the appropriate discount rate applicable for activities reasonably
anticipated to generate an income stream with a similar risk profile to
the differential income stream. Such differential income stream is
defined as the stream of the reasonably anticipated residuals of the PCT
Payor's licensing payments to be made under the licensing alternative,
minus the PCT Payor's cost contributions to be made under the cost
sharing alternative. See Example 8 of paragraph (g)(4)(viii) of this
section.
(vii) Routine platform and operating contributions. For purposes of
this paragraph (g)(4), any routine contributions that are platform or
operating contributions, the valuation and PCT Payments for which are
determined and made independently of the income method, are treated
similarly to cost contributions and operating cost contributions,
respectively. Accordingly, wherever used in this paragraph (g)(4), the
term ``routine contributions'' shall not include routine platform or
operating contributions, and wherever the terms ``cost contributions''
and ``operating cost contributions'' appear in this paragraph, they
shall include net routine platform contributions and net routine
operating contributions, respectively. Net routine platform
contributions are the value of a controlled participant's total
reasonably anticipated routine platform contributions, plus its
reasonably anticipated PCT Payments to other controlled participants in
respect of their routine platform contributions, minus the reasonably
anticipated PCT Payments it is to receive from other controlled
participants in respect of its routine platform contributions. Net
routine operating contributions are the value of a controlled
participant's total reasonably anticipated routine operating
contributions, plus its reasonably anticipated arm's length compensation
to other controlled participants in respect of their routine operating
contributions, minus the reasonably anticipated arm's length
compensation it is to receive from other controlled participants in
respect of its routine operating contributions.
(viii) Examples. The following examples illustrate the principles of
this paragraph (g)(4):
Example 1. (i) For simplicity of calculation in this Example 1, all
financial flows are assumed to occur at the beginning of each period.
USP, a software company, has developed version 1.0 of a new software
application that it is currently marketing. In Year 1 USP enters into a
CSA with its wholly-owned foreign subsidiary, FS, to develop future
versions of the software application. Under the CSA, USP will have the
rights to exploit the future versions in the United States, and FS will
have the rights to exploit them in the rest of the world. The future
rights in version 1.0, and USP's development
[[Page 699]]
team, are reasonably anticipated to contribute to the development of
future versions and therefore the rights in version 1.0 and the research
and development team are platform contributions for which compensation
is due from FS as part of a PCT. USP does not transfer the current
exploitation rights in version 1.0 to FS. FS will not perform any
research or development activities and does not furnish any platform
contributions nor does it control any operating intangibles at the
inception of the CSA that would be relevant to the exploitation of
version 1.0 or future versions of the software.
(ii) FS undertakes financial projections in its territory of the
CSA:
----------------------------------------------------------------------------------------------------------------
(5) Operating
income under cost
(1) Year (2) Sales (3) Operating (4) Cost sharing
costs contributions alternative
(excluding PCT)
----------------------------------------------------------------------------------------------------------------
1............................................ 0 0 50 -50
2............................................ 0 0 50 -50
3............................................ 200 100 50 50
4............................................ 400 200 50 150
5............................................ 600 300 60 240
6............................................ 650 325 65 260
7............................................ 700 350 70 280
8............................................ 750 375 75 300
9............................................ 750 375 75 300
10........................................... 675 338 68 269
11........................................... 608 304 61 243
12........................................... 547 273 55 219
13........................................... 410 205 41 164
14........................................... 308 154 31 123
15........................................... 231 115 23 93
----------------------------------------------------------------------------------------------------------------
FS anticipates that activity on this application will cease after Year
15. The application was derived from software developed by Company Q, an
uncontrolled party. FS has a license under Company Q's copyright, but
that license expires after Year 15 and will not be renewed.
(iii) In evaluating the cost sharing alternative, FS concludes that
the cost sharing alternative represents a riskier alternative for FS
than the licensing alternative because, in cost sharing, FS will take on
the additional risks associated with cost contributions. Taking this
difference into account, FS concludes that the appropriate discount rate
to apply in assessing the licensing alternative, based on discount rates
of comparable uncontrolled companies undertaking comparable licensing
transactions, would be 13% per year, whereas the appropriate discount
rate to apply in assessing the cost sharing alternative would be 15% per
year. FS determines that the arm's length rate USP would have charged an
uncontrolled licensee for a license of future versions of the software
(if USP had further developed version 1.0 on its own) is 35% of the
sales price, as determined under the CUT method in Sec. 1.482-4(c). FS
also determines that the tax rate applicable to it will be the same in
the licensing alternative as in the CSA. Accordingly, the financial
projections associated with the licensing alternative are:
----------------------------------------------------------------------------------------------------------------
(11) Operating
income under cost
(10) Operating sharing
(6) Year (7) Sales (8) Operating (9) Licensing income under alternative minus
costs payments licensing operating income
alternative under licensing
alternative
----------------------------------------------------------------------------------------------------------------
1............................ 0 0 0 0 -50
2............................ 0 0 0 0 -50
3............................ 200 100 70 30 20
4............................ 400 200 140 60 90
5............................ 600 300 210 90 150
6............................ 650 325 228 97 163
7............................ 700 350 245 105 175
8............................ 750 375 263 112 188
9............................ 750 375 263 112 188
10........................... 675 338 236 101 168
11........................... 608 304 213 91 152
[[Page 700]]
12........................... 547 273 191 83 136
13........................... 410 205 144 61 103
14........................... 308 154 108 46 77
15........................... 231 115 81 35 58
----------------------------------------------------------------------------------------------------------------
(iv) Based on these projections and applying the appropriate
discount rate, FS determines that under the cost sharing alternative,
the present value of the stream of residuals of its anticipated
divisional profits, reduced by the anticipated operating cost
contributions and cost contributions, but not reduced by any PCT
Payments (that is, the stream of anticipated operating income as shown
in column 5) would be $889 million. Under the licensing alternative, the
present value of the stream of residuals of its anticipated divisional
profits and losses minus the operating cost contributions (that is, the
stream of anticipated operating income before licensing payments, which
is the present value of column 7 reduced by column 8) would be $1.419
billion, and the present value of the licensing payments would be $994
million. Therefore, the total value of the licensing alternative would
be $425 million. In order for the present value of the cost sharing
alternative to equal the present value of the licensing alternative, the
present value of the PCT Payments must equal $464 million. Therefore,
the taxpayer makes and reports PCT Payments with a present value of $464
million.
Example 2. Arm's length range. (i) The facts are the same as in
Example 1. The Commissioner accepts the financial projections undertaken
by FS. Further, the Commissioner determines that the licensing discount
rate and the CUT licensing rate are most reliably determined by
reference to comparable uncontrolled discount rates and license rates,
respectively. The observations that are in the interquartile range of
the respective input parameters (see paragraph (g)(2)(ix) of this
section) are as follows:
------------------------------------------------------------------------
Comparable
Observations that are within interquartile range uncontrolled
discount rate
------------------------------------------------------------------------
1..................................................... 11%
2..................................................... 12
3 (Median)............................................ 13
4..................................................... 15
5..................................................... 17
------------------------------------------------------------------------
------------------------------------------------------------------------
Comparable
Observations that are within interquartile range uncontrolled
licensing rate
------------------------------------------------------------------------
1..................................................... 30%
2..................................................... 32
3 (Median)............................................ 35
4..................................................... 37
5..................................................... 40
------------------------------------------------------------------------
(ii) Following the principles of paragraph (g)(2)(ix) of this
section, the Commissioner undertakes 25 different applications of the
income method, using each combination of the discount rate and licensing
rate parameters. In undertaking this analysis, the Commissioner assumes
that the ratio of the median discount rate for the cost sharing
alternative to the median discount rate for the licensing alternative
(that is, 15% to 13%) is maintained. The results of the 25 applications
of the income method, sorted in ascending order of calculated present
value of the PCT Payment, are as follows:
--------------------------------------------------------------------------------------------------------------------------------------------------------
Comparable
uncontrolled Comparable Comparable Calculated lump Interquartile range of PCT
INCOME METHOD APPLICATION NUMBER:: licensing uncontrolled CSA uncontrolled sum PCT payment payments
discount rate discount rate licensing rate
--------------------------------------------------------------------------------------------------------------------------------------------------------
1........................................... 17% 19.6% 30% 217
2........................................... 17 19.6 32 263
3........................................... 15 17.3 30 264
4........................................... 15 17.3 32 315
5........................................... 13 15 30 321
6........................................... 17 19.6 35 331
7........................................... 12 13.8 30 354 LQ = 354
8........................................... 17 19.6 37 376
9........................................... 13 15 32 378
10.......................................... 11 12.7 30 391 ..................................
11.......................................... 15 17.3 35 391
12.......................................... 12 13.8 32 415
[[Page 701]]
13.......................................... 15 17.3 37 442 Median = 442
14.......................................... 17 19.6 40 444
15.......................................... 11 12.7 32 455
16.......................................... 13 15 35 464
17.......................................... 12 13.8 35 505
18.......................................... 15 17.3 40 517
19.......................................... 13 15 37 520 UQ = 520
20.......................................... 11 12.7 35 551
21.......................................... 12 13.8 37 566
22.......................................... 13 15 40 605
23.......................................... 11 12.7 37 615
24.......................................... 12 13.8 40 655
25.......................................... 11 12.7 40 710
--------------------------------------------------------------------------------------------------------------------------------------------------------
(iii) Accordingly, the Commissioner determines that a taxpayer will
not be subject to adjustment if its initial (ex ante) determination of
the present value of PCT Payments is between $354 million and $520
million (the lower and upper quartile results as shown in the last
column). Because FS's determination of the present value of the PCT
Payments, $464 million, is within the interquartile range, no
adjustments are warranted.
Example 3. (i) For simplicity of calculation in this Example 3, all
financial flows are assumed to occur at the beginning of each period.
USP, a U.S. software company, has developed version 1.0 of a new
software application, employed to store and retrieve complex data sets
in certain types of storage media. Version 1.0 is currently being
marketed. In Year 1, USP enters into a CSA with its wholly-owned foreign
subsidiary, FS, to develop future versions of the software application.
Under the CSA, USP will have the exclusive rights to exploit the future
versions in the U.S., and FS will have the exclusive rights to exploit
them in the rest of the world. USP's rights in version 1.0, and its
development team, are reasonably anticipated to contribute to the
development of future versions of the software application and,
therefore, the rights in version 1.0 are platform contributions for
which compensation is due from FS as part of a PCT. USP also transfers
the current exploitation rights in version 1.0 to FS and the arm's
length amount of the compensation for such transfer is determined in the
aggregate with the arm's length PCT Payments in this Example 3. FS does
not furnish any platform contributions to the CSA nor does it control
any operating intangibles at the inception of the CSA that would be
relevant to the exploitation of version 1.0 or future versions of the
software. It is reasonably anticipated that FS will have gross sales of
$1000X in its territory for 5 years attributable to its exploitation of
version 1.0 and the cost shared intangibles, after which time the
software application will be rendered obsolete and unmarketable by the
obsolescence of the storage medium technology to which it relates. FS's
costs reasonably attributable to the CSA, other than cost contributions
and operating cost contributions, are anticipated to be $250X per year.
Certain operating cost contributions that will be borne by FS are
reasonably anticipated to equal $200X per annum for 5 years. In
addition, FS is reasonably anticipated to pay cost contributions of
$200X per year as a controlled participant in the CSA.
(ii) FS concludes that its realistic alternative would be to license
software from an uncontrolled licensor that would undertake the
commitment to bear the entire risk of software development. Applying CPM
using the profit levels experienced by uncontrolled licensees with
contractual provisions and allocations of risk that are comparable to
those of FS's licensing alternative, FS determines that it could, as a
licensee, reasonably expect a (pre-tax) routine return equal to 14% of
gross sales or $140X per year for 5 years. The remaining net revenue
would be paid to the uncontrolled licensor as a license fee of $410X per
year. FS determines that the discount rate that would be applied to
determine the present value of income and costs attributable to its
participation in the licensing alternative would be 12.5% as compared to
the 15% discount rate that would be applicable in determining the
present value of the net income attributable to its participation in the
CSA (reflecting the increased risk borne by FS in bearing a share of the
R & D costs in the cost sharing alternative). FS also determines that
the tax rate applicable to it will be the same in the licensing
alternative as in the CSA.
(iii) On these facts, the present value to FS of entering into the
cost sharing alternative equals the present value of the annual
divisional profits ($1,000X minus $250X) minus operating cost
contributions ($200X) minus cost contributions ($200X) minus PCT
Payments, determined over 5 years by discounting at a discount rate of
15%. Thus, the
[[Page 702]]
present value of the residuals, prior to subtracting the present value
of the PCT Payments, is $1349X.
(iv) On these facts, the present value to FS of entering into the
licensing alternative would be $561X determined by discounting, over 5
years, annual divisional profits ($1,000X minus $250X) minus operating
cost contributions ($200X) and licensing payments ($410X) at a discount
rate of 12.5% per annum. The present value of the cost sharing
alternative must also equal $561X but equals $1349X prior to subtracting
the present value of the PCT Payments. Consequently, the PCT Payments
must have a present value of $788X.
Example 4. Pre-tax PCT Payment derived from post-tax information.
(i) For simplicity of calculation in this Example 4, it is assumed that
all payments are made at the end of each year. Domestic controlled
participant USP has developed a technology, Z, that it would like to
exploit for three years in a CSA. USP enters into a CSA with its wholly-
owned foreign subsidiary, FS, that provides for PCT Payments from FS to
USP with respect to USP's platform contribution to the CSA of Z in the
form of three annual installment payments due from FS to USP on the last
day of each of the first three years of the CSA. FS makes no platform
contributions to the CSA. Prior to entering into the CSA, FS considers
that it has the realistic alternative available to it of licensing Z
from USP rather than entering into a CSA with USP to further develop Z
for three years.
(ii) FS undertakes financial projections for both the licensing and
cost sharing alternatives for exploitation of Z in its territory of the
CSA. These projections are set forth in the following tables. The
example assumes that there is a reasonably anticipated effective tax
rate of 25% in each of years 1 through 3 under both the licensing and
cost sharing alternatives. FS determines that the appropriate post-tax
discount rate under the licensing alternative is 12.5%, and that the
appropriate post-tax discount rate under the cost sharing alternative is
15%.
----------------------------------------------------------------------------------------------------------------
Present value
Licensing alternative (12.5% DR) Year 1 Year 2 Year 3
----------------------------------------------------------------------------------------------------------------
(1) Sales............................... ................ $1000 $1100 $1210
(2) License Fee......................... ................ 400 440 484
(3) Operating costs..................... ................ 500 550 605
(4) Operating Income.................... $261 100 110 121
(5) Tax (25%)........................... ................ 25 28 30
(6) Post-tax income..................... $196 $75 $82 $91
----------------------------------------------------------------------------------------------------------------
Present value
Cost sharing alternative (15% DR) Year 1 Year 2 Year 3
----------------------------------------------------------------------------------------------------------------
(7) Sales............................... ................ $1000 $1100 $1210
(8) Cost Contributions.................. ................ 200 220 242
(9) PCT Payments........................ D A B C
(10) Operating costs.................... ................ 500 550 605
(11) Operating income excluding PCT..... $749 300 330 363
(12) Operating income................... H E F G
(13) Tax................................ ................ ................ ................
(14) Post-tax income excluding PCT...... $562 $225 $248 $272
(15) Post-tax income.................... L I J K
----------------------------------------------------------------------------------------------------------------
(iii) Under paragraph (g)(4) of this section, the arm's length
charge for a PCT Payment will be an amount such that a controlled
participant's present value, as of the date of the PCT of its cost
sharing alternative of entering into a CSA equals the present value of
its best realistic alternative. This requires that L, the present value
of the post-tax income under the CSA, equals the present value of the
post-tax income under the licensing alternative, or $196.
(iv) FS determines that PCT Payments for Z should be $196 in Year 1
(A), $215 in Year 2 (B), and $236 in Year 3 (C). By using these amounts
for A, B, and C in the table above, FS is able to derive the values of
E, F, G, I, J, and K in the table above. Based on these PCT Payments for
Z, the post-tax income will be $78 in Year 1 (I), $86 in Year 2 (J), and
$95 in Year 3 (K). When this post-tax income stream is discounted at the
appropriate rate for the cost sharing alternative (15%), the net present
value is $196 (L). The present value of the PCT Payments, when
discounted at the appropriate post-tax rate, is $488 (D).
(v) The Commissioner undertakes an audit of the PCT Payments made by
FS to USP for Z in Years 1 through 3. The Commissioner concludes that
the PCT Payments for Z are arm's length in accordance with this
paragraph (g)(4).
Example 5. Pre-tax PCT Payment derived from post-tax information.
(i) The facts are the same as in paragraphs (i) and (ii) of Example 4.
In addition, under this paragraph (g)(4), the arm's length charge for a
PCT Payment will be an amount such that a controlled participant's
present value, as of the date of
[[Page 703]]
the PCT of its cost sharing alternative equals the present value of its
best realistic alternative. This requires that L, the present value of
the post-tax income under the CSA, equals the present value of the post-
tax income under the licensing alternative, or $196.
(ii) FS determines that the post-tax present value of the cost
sharing alternative (excluding PCT Payments) is $562. The post-tax
present value of the licensing alternative is $196. Accordingly,
payments with a post-tax present value of $366 are required.
(iii) The Commissioner undertakes an audit of the PCT Payments made
by FS to USP for Z in Years 1 through 3. In correspondence to the
Commissioner, USP maintains that the arm's length PCT Payment for Z
should have a present value of $366 (D).
(iv) The Commissioner considers that if FS makes PCT Payments for Z
with a present value of $366, then the post-tax present value under the
CSA (considering the deductibility of the PCT Payments) will be $287,
substantially higher than the post-tax present value of the licensing
arrangement, $196. The Commissioner determines that, under the specific
facts and assumptions of this example, the present value of the post-tax
payments may be grossed up by a factor of (one minus the tax rate),
resulting in a present value of pre-tax payments of $488. Accordingly,
FS must make yearly PCT Payments (A, B, and C) such that the present
value of the Payments is $488 (D). (When FS's post-tax income after
these PCT Payments for Z is discounted at the appropriate rate for the
cost sharing alternative (15%), the net present value is $196 (L), which
is equal to the present value of post-tax income under the licensing
alternative.) The Commissioner concludes that the calculations that it
has made for the PCT Payments for Z are arm's length in accordance with
this paragraph (g)(4) and, accordingly, makes the appropriate
adjustments to USP's income tax return to account for the gross-up
required by paragraph (g)(2)(x) of this section.
Example 6. Pre-tax PCT Payment derived from pre-tax information. (i)
The facts are the same as in paragraphs (i) and (ii) of Example 4. In
addition, under paragraph (g)(4) of this section, the arm's length
charge for a PCT Payment will be an amount such that a controlled
participant's present value, as of the date of the PCT of its cost
sharing alternative of entering into a CSA equals the present value of
its best realistic alternative. This requires that ``L,'' the present
value of the post-tax income under the CSA, equals the present value of
the post-tax income under the licensing alternative, or $196.
(ii) Under the specific facts and assumptions of this Example 6 (see
paragraph (g)(4)(i)(G) of this section), and using the same (post-tax)
discount rates as in Example 4, the present value of pre-tax income
under the licensing alternative (that is, the operating income) is $261,
and the present value of pre-tax income under the cost sharing
alternative (excluding PCT Payments) is $749. Accordingly, FS determines
that its PCT Payments for Z should have a present value equal to the
difference between the two, or $488 (D). Such PCT Payments for Z result
in a present value of post-tax income under the cost sharing alternative
of $196 (L), which is equal to the present value of post-tax income
under the licensing alternative.
(iii) The Commissioner undertakes an audit of the PCT Payments for Z
made by FS to USP in Years 1 through 3. The Commissioner concludes that
the PCT Payments for Z are arm's length in accordance with this
paragraph (g)(4).
Example 7. Application of income method with a terminal value
calculation. (i) For simplicity of calculation in this Example 7, all
financial flows are assumed to occur at the beginning of each period.
USP's research and development team, Q, has developed a technology, Z,
for which it has several applications on the market now and several
planned for release at future dates. In Year 1, USP, enters into a CSA
with its wholly-owned subsidiary, FS, to develop future applications of
Z. Under the CSA, USP will have the rights to further develop and
exploit the future applications of Z in the United States, and FS will
have the rights to further develop and exploit the future applications
of Z in the rest of the world. Both Q and the rights to further develop
and exploit future applications of Z are reasonably anticipated to
contribute to the development of future applications of Z. Therefore,
both Q and the rights to further develop and exploit the future
applications of Z are platform contributions for which compensation is
due from FS to USP as part of a PCT. USP does not transfer the current
exploitation rights for current applications of Z to FS. FS will not
perform any research or development activities on Z and does not furnish
any platform contributions to the CSA, nor does it control any operating
intangibles at the inception of the CSA that would be relevant to the
exploitation of either current or future applications of Z.
(ii) At the outset of the CSA, FS undertakes an analysis of the PCTs
involving Q and the rights with respect to Z in order to determine the
arm's length PCT Payments owing from FS to USP under the CSA. In that
evaluation, FS concludes that the cost sharing alternative represents a
riskier alternative for FS than the licensing alternative. FS further
concludes that the appropriate discount rate to apply in assessing the
licensing alternative, based on discount rates of comparable
uncontrolled companies undertaking comparable licensing transactions,
would be 13% per annum, whereas the appropriate discount rate to apply
in assessing the cost sharing alternative would be
[[Page 704]]
14% per annum. FS undertakes financial projections and anticipates
making $100 million in sales during the first two years of the CSA in
its territory with sales in Years 3 through 8 increasing to $200
million, $400 million, $600 million, $650 million, $700 million, and
$750 million, respectively. After Year 8, FS expects its sales of all
products based upon exploitation of Z in the rest of the world to grow
at 3% per annum for the future. FS and USP do not anticipate cessation
of the CSA Activity with respect to Z at any determinable date. FS
anticipates that its manufacturing and distribution costs for exploiting
Z (including its operating cost contributions), will equal 60% of gross
sales of Z from Year 1 onwards, and anticipates its cost contributions
will equal $25 million per annum for Years 1 and 2, $50 million per
annum for Years 3 and 4, and 10% of gross sales per annum thereafter.
(iii) Based on this analysis, FS determines that the arm's length
royalty rate that USP would have charged an uncontrolled licensee for a
license of future applications of Z if USP had further developed future
applications of Z on its own is 30% of the sales price of the Z-based
product, as determined under the comparable uncontrolled transaction
method in Sec. 1.482-4(c). In light of the expected sales growth and
anticipation that the CSA Activity will not cease as of any determinable
date, FS's determination includes a terminal value calculation. FS
further determines that under the cost sharing alternative, the present
value of FS's divisional profits, reduced by the present values of the
anticipated operating cost contributions and cost contributions, would
be $1,361 million. Under the licensing alternative, the present value of
the operating divisional profits and losses, reduced by the operating
cost contributions, would be $2,113 million, and the present value of
the licensing payments would be $1,585 million. Therefore, the total
value of the licensing alternative would be $528 million. In order for
the present value of the cost sharing alternative to equal the present
value of the licensing alternative, the present value of the PCT
Payments must equal $833 million. Accordingly, FS pays USP a lump sum
PCT Payment of $833 million in Year 1 for USP's platform contributions
of Z and Q.
(iv) The Commissioner undertakes an audit of the PCTs and concludes,
based on his own analysis, that this lump sum PCT Payment is within the
interquartile range of arm's length results for these platform
contributions. The calculations made by FS in determining the PCT
Payment in this Example 7 are set forth in the following tables:
Cost Sharing Alternative
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year, TV = Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 TV
Terminal Value).
Discount Period................... 0 1 2 3 4 5 6 7 7
Items of Income/Expense at
Beginning of Year:
1 Sales....................... 100 100 200 400 600 650 700 750 (3% annual growth in
each year from
previous year).
2 Routine Cost and Operating 60 60 120 240 360 390 420 450 (60% of annual sales
Cost Contributions (60% of in row 1 for each
sales amount in row 1 of year).
relevant year).
3 Cost Contributions (10% of 25 25 50 50 60 65 70 75 (10% of annual sales
sales amount in row 1 for in row 1 for each
relevant year after Year 5). year).
4 Profit = amount in row 1 15 15 30 110 180 195 210 225 (row 1 minus rows 2
reduced by amounts in rows 2 and 3 for each
and 3. year).
5 PV (using 14% discount rate) 15 13.2 23.1 74.2 107 101 95.7 89.9 842.
----------------------------------------------------------------------------------------------------------------
6 TOTAL PV of Cost Sharing Alternative = Sum of all PV amounts in Row 5 for all Time Periods = $1,361
million..
----------------------------------------------------------------------------------------------------------------
Licensing Alternative
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year, TV = Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 TV
Terminal Value).
Discount Period................... 0 1 2 3 4 5 6 7 7
Items of Income/Expense at
Beginning of Year:
7 Sales....................... 100 100 200 400 600 650 700 750 (3% annual growth in
each year from
previous year).
[[Page 705]]
8 Routine Cost and Operating 60 60 120 240 360 390 420 450 (60% of annual sales
Cost Contributions (60% of in row 7 for each
sales amount in row 7 of year).
relevant year).
9 Operating Profit = amount in 40 40 80 160 240 260 280 300 (Row 7 minus row 8
Row 7 reduced by amount in for each year).
Row 8.
10 PV of row 9 (using 13% 40 35.4 62.7 111 147 141 135 128 1313.
discount rate).
----------------------------------------------------------------------------------------------------------------
11 TOTAL PV FOR ALL AMOUNTS IN ROW 10 = $2,112.7 million....................................................
----------------------------------------------------------------------------------------------------------------
12 Licensing Payments (30% of 30 30 60 120 180 195 210 225 (30% of amount in
sales amount in row 7). row 7 for each
year).
13 PV of amount in row 12 30 26.5 47 83.2 110 106 101 95.6 985.
(using 13% discount rate).
----------------------------------------------------------------------------------------------------------------
14 TOTAL PV FOR ALL AMOUNTS IN ROW 13 = $1,584.5 million.
15 TOTAL PV of Licensing Alternative = Row 11 minus Row 14 = $528 million.
----------------------------------------------------------------------------------------------------------------
Calculation of PCT Payment
------------------------------------------------------------------------
------------------------------------------------------------------------
16..................... TOTAL PV OF COST $1,361 million.
SHARING ALTERNATIVE
(FROM ROW 6 ABOVE) =.
17..................... TOTAL PV OF LICENSING $528 million.
ALTERNATIVE (FROM ROW
15 ABOVE) =.
18..................... LUMP SUM PCT PAYMENT = $833 million.
ROW 16 - ROW 17 =.
------------------------------------------------------------------------
Example 8. (i) The facts are the same as in Example 1, except that
the taxpayer determines that the appropriate discount rate for the cost
sharing alternative is 20%. In addition, the taxpayer determines that
the appropriate discount rate for the licensing alternative is 10%.
Accordingly, the taxpayer determines that the appropriate present value
of the PCT Payment is $146 million.
(ii) Based on the best method analysis described in Example 2, the
Commissioner determines that the taxpayer's calculation of the present
value of the PCT Payments is outside of the interquartile range (as
shown in the sixth column of Example 2), and thus warrants an
adjustment. Furthermore, in evaluating the taxpayer's analysis, the
Commissioner undertakes an analysis based on the difference in the
financial projections between the cost sharing and licensing
alternatives (as shown in column 11 of Example 1). This column shows the
anticipated differential income stream of additional positive or
negative income for FS over the duration of the CSA Activity that would
result from undertaking the cost sharing alternative (before any PCT
Payments) rather than the licensing alternative. This anticipated
differential income stream thus reflects the anticipated incremental
undiscounted profits to FS from the incremental activity of undertaking
the risk of developing the cost shared intangibles and enjoying the
value of its divisional interests. Taxpayer's analysis logically implies
that the present value of this stream must be $146 million, since only
then would FS have the same anticipated value in both the cost sharing
and licensing alternatives. A present value of $146 million implies that
the discount rate applicable to this stream is 34.4%. Based on a
reliable calculation of discount rates applicable to the anticipated
income streams of uncontrolled companies whose resources, capabilities,
and rights consist primarily of software applications intangibles and
research and development teams similar to USP's platform contributions
to the CSA, and which income streams, accordingly, may be reasonably
anticipated to reflect a similar risk profile to the differential income
stream, the Commissioner concludes that an appropriate discount rate for
the anticipated income stream associated with USP's platform
contributions (that is, the additional positive or negative income over
the duration of the CSA Activity that would result, before PCT Payments,
from switching from the licensing alternative to the cost sharing
alternative) is 16%, which is significantly less than 34.4%. This
conclusion further suggests that Taxpayer's analysis is unreliable. See
paragraphs (g)(2)(v)(B)(2) and (g)(4)(vi)(F)(1) and (2) of this section.
(iii) The Commissioner makes an adjustment of $296 million, so that
the present value of the PCT Payments is $442 million (the median
results as shown in column 6 of Example 2).
Example 9. The facts are the same as in Example 1, except that
additional data on discount rates are available that were not
[[Page 706]]
available in Example 1. The Commissioner determines the arm's length
charge for the PCT Payment by discounting at an appropriate rate the
differential income stream associated with the rights contributed by USP
in the PCT (that is, the stream of income in column (11) of Example 1).
Based on an analysis of a set of public companies whose resources,
capabilities, and rights consist primarily of resources, capabilities,
and rights similar to those contributed by USP in the PCT, the
Commissioner determines that 15% to 17% is an appropriate range of
discount rates to use to assess the value of the differential income
stream associated with the rights contributed by USP in the PCT. The
Commissioner determines that applying a discount rate of 17% to the
differential income stream associated with the rights contributed by USP
in the PCT yields a present value of $446 million, while applying a
discount rate of 15% to the differential income stream associated with
the rights contributed by USP in the PCT yields a present value of $510
million. Because the taxpayer's result, $464 million, is within the
interquartile range determined by the Commissioner, no adjustments are
warranted. See paragraphs (g)(2)(v)(B)(2), (g)(4)(v), and
(g)(4)(vi)(F)(1) of this section.
(5) Acquisition price method--(i) In general. The acquisition price
method applies the comparable uncontrolled transaction method of Sec.
1.482-4(c), or the comparable uncontrolled services price method
described in Sec. 1.482-9(c), to evaluate whether the amount charged in
a PCT, or group of PCTs, is arm's length by reference to the amount
charged (the acquisition price) for the stock or asset purchase of an
entire organization or portion thereof (the target) in an uncontrolled
transaction. The acquisition price method is ordinarily used where
substantially all the target's nonroutine contributions, as such term is
defined in paragraph (j)(1)(i) of this section, made to the PCT Payee's
business activities are covered by a PCT or group of PCTs.
(ii) Determination of arm's length charge. Under this method, the
arm's length charge for a PCT or group of PCTs covering resources,
capabilities, and rights of the target is equal to the adjusted
acquisition price, as divided among the controlled participants
according to their respective RAB shares.
(iii) Adjusted acquisition price. The adjusted acquisition price is
the acquisition price of the target increased by the value of the
target's liabilities on the date of the acquisition, other than
liabilities not assumed in the case of an asset purchase, and decreased
by the value of the target's tangible property on that date and by the
value on that date of any other resources, capabilities, and rights not
covered by a PCT or group of PCTs.
(iv) Best method analysis considerations. The comparability and
reliability considerations stated in Sec. 1.482-4(c)(2) apply.
Consistent with those considerations, the reliability of applying the
acquisition price method as a measure of the arm's length charge for the
PCT Payment normally is reduced if--
(A) A substantial portion of the target's nonroutine contributions
to the PCT Payee's business activities is not required to be covered by
a PCT or group of PCTs, and that portion of the nonroutine contributions
cannot reliably be valued;
(B) A substantial portion of the target's assets consists of
tangible property that cannot reliably be valued; or
(C) The date on which the target is acquired and the date of the PCT
are not contemporaneous.
(v) Example. The following example illustrates the principles of
this paragraph (g)(5):
Example. USP, a U.S. corporation, and its newly incorporated,
wholly-owned foreign subsidiary (FS) enter into a CSA at the start of
Year 1 to develop Group Z products. Under the CSA, USP and FS will have
the exclusive rights to exploit the Group Z products in the U.S. and the
rest of the world, respectively. At the start of Year 2, USP acquires
Company X for cash consideration worth $110 million. At this time USP's
RAB share is 60%, and FS's RAB share is 40% and is not reasonably
anticipated to change as a result of this acquisition. Company X joins
in the filing of a U.S. consolidated income tax return with USP. Under
paragraph (j)(2)(i) of this section, Company X and USP are treated as
one taxpayer for purposes of this section. Accordingly, the rights in
any of Company X's resources and capabilities that are reasonably
anticipated to contribute to the development activities of the CSA will
be considered platform contributions furnished by USP. Company X's
resources and capabilities consist of its workforce, certain technology
intangibles, $15 million of tangible property and other assets and $5
million in liabilities. The technology intangibles, as
[[Page 707]]
well as Company X's workforce, are reasonably anticipated to contribute
to the development of the Group Z products under the CSA and, therefore,
the rights in the technology intangibles and the workforce are platform
contributions for which FS must make a PCT Payment to USP. None of
Company X's existing intangible assets or any of its workforce are
anticipated to contribute to activities outside the CSA. For purposes of
this example, it is assumed that no additional adjustment on account of
tax liabilities is needed. Applying the acquisition price method, the
value of USP's platform contributions is the adjusted acquisition price
of $100 million ($110 million acquisition price plus $5 million
liabilities less $15 million tangible property and other assets). FS
must make a PCT Payment to USP for these platform contributions with a
reasonably anticipated present value of $40 million, which is the
product of $100 million (the value of the platform contributions) and
40% (FS's RAB share).
(6) Market capitalization method--(i) In general. The market
capitalization method applies the comparable uncontrolled transaction
method of Sec. 1.482-4(c), or the comparable uncontrolled services
price method described in Sec. 1.482-9(c), to evaluate whether the
amount charged in a PCT, or group of PCTs, is arm's length by reference
to the average market capitalization of a controlled participant (PCT
Payee) whose stock is regularly traded on an established securities
market. The market capitalization method is ordinarily used where
substantially all of the PCT Payee's nonroutine contributions to the PCT
Payee's business are covered by a PCT or group of PCTs.
(ii) Determination of arm's length charge. Under the market
capitalization method, the arm's length charge for a PCT or group of
PCTs covering resources, capabilities, and rights of the PCT Payee is
equal to the adjusted average market capitalization, as divided among
the controlled participants according to their respective RAB shares.
(iii) Average market capitalization. The average market
capitalization is the average of the daily market capitalizations of the
PCT Payee over a period of time beginning 60 days before the date of the
PCT and ending on the date of the PCT. The daily market capitalization
of the PCT Payee is calculated on each day its stock is actively traded
as the total number of shares outstanding multiplied by the adjusted
closing price of the stock on that day. The adjusted closing price is
the daily closing price of the stock, after adjustments for stock-based
transactions (dividends and stock splits) and other pending corporate
(combination and spin-off) restructuring transactions for which reliable
arm's length adjustments can be made.
(iv) Adjusted average market capitalization. The adjusted average
market capitalization is the average market capitalization of the PCT
Payee increased by the value of the PCT Payee's liabilities on the date
of the PCT and decreased by the value on such date of the PCT Payee's
tangible property and of any other resources, capabilities, or rights of
the PCT Payee not covered by a PCT or group of PCTs.
(v) Best method analysis considerations. The comparability and
reliability considerations stated in Sec. 1.482-4(c)(2) apply.
Consistent with those considerations, the reliability of applying the
comparable uncontrolled transaction method using the adjusted market
capitalization of a company as a measure of the arm's length charge for
the PCT Payment normally is reduced if--
(A) A substantial portion of the PCT Payee's nonroutine
contributions to its business activities is not required to be covered
by a PCT or group of PCTs, and that portion of the nonroutine
contributions cannot reliably be valued;
(B) A substantial portion of the PCT Payee's assets consists of
tangible property that cannot reliably be valued; or
(C) Facts and circumstances demonstrate the likelihood of a material
divergence between the average market capitalization of the PCT Payee
and the value of its resources, capabilities, and rights for which
reliable adjustments cannot be made.
(vi) Examples. The following examples illustrate the principles of
this paragraph (g)(6):
Example 1. (i) USP, a publicly traded U.S. company, and its newly
incorporated wholly-owned foreign subsidiary (FS) enter into a CSA on
Date 1 to develop software. At that time USP has in-process software but
has no software ready for the market. Under the CSA, USP and FS will
have the exclusive rights to exploit the software developed under the
CSA in the United States and the
[[Page 708]]
rest of the world, respectively. On Date 1, USP's RAB share is 70% and
FS's RAB share is 30%. USP's assembled team of researchers and its in-
process software are reasonably anticipated to contribute to the
development of the software under the CSA. Therefore, the rights in the
research team and in-process software are platform contributions for
which compensation is due from FS. Further, these rights are not
reasonably anticipated to contribute to any business activity other than
the CSA Activity.
(ii) On Date 1, USP had an average market capitalization of $205
million, tangible property and other assets that can be reliably valued
worth $5 million, and no liabilities. Aside from those assets, USP had
no assets other than its research team and in-process software. Applying
the market capitalization method, the value of USP's platform
contributions is $200 million ($205 million average market
capitalization of USP less $5 million of tangible property and other
assets). The arm's length value of the PCT Payments FS must make to USP
for the platform contributions, before any adjustment on account of tax
liability as described in paragraph (g)(2)(ii) of this section, is $60
million, which is the product of $200 million (the value of the platform
contributions) and 30% (FS's RAB share on Date 1).
Example 2. Aggregation with make-or-sell rights. (i) The facts are
the same as in Example 1, except that on Date 1 USP also has existing
software ready for the market. USP separately enters into a license
agreement with FS for make-or-sell rights for all existing software
outside the United States. No marketing has occurred, and USP has no
marketing intangibles. This license of current make-or-sell rights is a
transaction governed by Sec. 1.482-4. However, after analysis, it is
determined that the arm's length PCT Payments and the arm's length
payments for the make-or-sell license may be most reliably determined in
the aggregate using the market capitalization method, under principles
described in paragraph (g)(2)(iv) of this section, and it is further
determined that those principles are most reliably implemented by
computing the aggregate arm's length charge as the product of the
aggregate value of the existing and in-process software and FS's RAB
share on Date 1.
(ii) Applying the market capitalization method, the aggregate value
of USP's platform contributions and the make-or-sell rights in its
existing software is $250 million ($255 million average market
capitalization of USP less $5 million of tangible property and other
assets). The total arm's length value of the PCT Payments and licensing
payments FS must make to USP for the platform contributions and current
make-or-sell rights, before any adjustment on account of tax liability,
if any, is $75 million, which is the product of $250 million (the value
of the platform contributions and the make-or-sell rights) and 30% (FS's
RAB share on Date 1).
Example 3. Reduced reliability. The facts are the same as in Example
1 except that USP also has significant nonroutine assets that will be
used solely in a nascent business division that is unrelated to the
subject of the CSA and that cannot themselves be reliably valued. Those
nonroutine contributions are not platform contributions and accordingly
are not required to be covered by a PCT. The reliability of using the
market capitalization method to determine the value of USP's platform
contributions to the CSA is significantly reduced in this case because
that method would require adjusting USP's average market capitalization
to account for the significant nonroutine contributions that are not
required to be covered by a PCT.
(7) Residual profit split method--(i) In general. The residual
profit split method evaluates whether the allocation of combined
operating profit or loss attributable to one or more platform
contributions subject to a PCT is arm's length by reference to the
relative value of each controlled participant's contribution to that
combined operating profit or loss. The combined operating profit or loss
must be derived from the most narrowly identifiable business activity
(relevant business activity) of the controlled participants for which
data are available that include the CSA Activity. The residual profit
split method may not be used where only one controlled participant makes
significant nonroutine contributions (including platform or operating
contributions) to the CSA Activity. The provisions of Sec. 1.482-6
shall apply to CSAs only to the extent provided and as modified in this
paragraph (g)(7). Any other application to a CSA of a residual profit
method not described in paragraphs (g)(7)(ii) and (iii) of this section
will constitute an unspecified method for purposes of sections 482 and
6662(e) and the regulations under those sections.
(ii) Appropriate share of profits and losses. The relative value of
each controlled participant's contribution to the success of the
relevant business activity must be determined in a manner that reflects
the functions performed, risks assumed, and resources employed by each
participant in the relevant business activity, consistent with the best
method analysis described in
[[Page 709]]
Sec. 1.482-1(c) and (d). Such an allocation is intended to correspond
to the division of profit or loss that would result from an arrangement
between uncontrolled taxpayers, each performing functions similar to
those of the various controlled participants engaged in the relevant
business activity. The profit allocated to any particular controlled
participant is not necessarily limited to the total operating profit of
the group from the relevant business activity. For example, in a given
year, one controlled participant may earn a profit while another
controlled participant incurs a loss. In addition, it may not be assumed
that the combined operating profit or loss from the relevant business
activity should be shared equally, or in any other arbitrary proportion.
(iii) Profit split--(A) In general. Under the residual profit split
method, the present value of each controlled participant's residual
divisional profit or loss attributable to nonroutine contributions
(nonroutine residual divisional profit or loss) is allocated between the
controlled participants that each furnish significant nonroutine
contributions (including platform or operating contributions) to the
relevant business activity in that division.
(B) Determine nonroutine residual divisional profit or loss. The
present value of each controlled participant's nonroutine residual
divisional profit or loss must be determined to reflect the most
reliable measure of an arm's length result. The present value of
nonroutine residual divisional profit or loss equals the present value
of the stream of the reasonably anticipated residuals over the duration
of the CSA Activity of divisional profit or loss, minus market returns
for routine contributions, minus operating cost contributions, minus
cost contributions, using a discount rate appropriate to such residuals
in accordance with paragraph (g)(2)(v) of this section. As used in this
paragraph (g)(7), the phrase ``market returns for routine
contributions'' includes market returns for operating cost contributions
and excludes market returns for cost contributions.
(C) Allocate nonroutine residual divisional profit or loss--(1) In
general. The present value of nonroutine residual divisional profit or
loss in each controlled participant's division must be allocated among
all of the controlled participants based upon the relative values,
determined as of the date of the PCTs, of the PCT Payor's as compared to
the PCT Payee's nonroutine contributions to the PCT Payor's division.
For this purpose, the PCT Payor's nonroutine contribution consists of
the sum of the PCT Payor's nonroutine operating contributions and the
PCT Payor's RAB share of the PCT Payor's nonroutine platform
contributions. For this purpose, the PCT Payee's nonroutine contribution
consists of the PCT Payor's RAB share of the PCT Payee's nonroutine
platform contributions.
(2) Relative value determination. The relative values of the
controlled participants' nonroutine contributions must be determined so
as to reflect the most reliable measure of an arm's length result.
Relative values may be measured by external market benchmarks that
reflect the fair market value of such nonroutine contributions.
Alternatively, the relative value of nonroutine contributions may be
estimated by the capitalized cost of developing the nonroutine
contributions and updates, as appropriately grown or discounted so that
all contributions may be valued on a comparable dollar basis as of the
same date. If the nonroutine contributions by a controlled participant
are also used in other business activities (such as the exploitation of
make-or-sell rights described in paragraph (c)(4) of this section), an
allocation of the value of the nonroutine contributions must be made on
a reasonable basis among all the business activities in which they are
used in proportion to the relative economic value that the relevant
business activity and such other business activities are anticipated to
derive over time as the result of such nonroutine contributions.
(3) Determination of PCT Payments. Any amount of the present value
of a controlled participant's nonroutine residual divisional profit or
loss that is allocated to another controlled participant represents the
present value of the PCT Payments due to that other controlled
participant for its platform contributions to the relevant business
[[Page 710]]
activity in the relevant division. For purposes of paragraph (j)(3)(ii)
of this section, the present value of a PCT Payor's PCT Payments under
this paragraph shall be deemed reduced to the extent of the present
value of any PCT Payments owed to it from other controlled participants
under this paragraph (g)(7). The resulting remainder may be converted to
a fixed or contingent form of payment in accordance with paragraph (h)
(Form of payment rules) of this section.
(4) Routine platform and operating contributions. For purposes of
this paragraph (g)(7), any routine platform or operating contributions,
the valuation and PCT Payments for which are determined and made
independently of the residual profit split method, are treated similarly
to cost contributions and operating cost contributions, respectively.
Accordingly, wherever used in this paragraph (g)(7), the term ``routine
contributions'' shall not include routine platform or operating
contributions, and wherever the terms ``cost contributions'' and
``operating cost contributions'' appear in this paragraph (g)(7), they
shall include net routine platform contributions and net routine
operating contributions, respectively, as defined in paragraph
(g)(4)(vii) of this section. However, treatment of net operating
contributions as operating cost contributions shall be coordinated with
the treatment of other routine contributions pursuant to paragraphs
(g)(4)(iii)(B) and (7)(iii)(B) of this section so as to avoid
duplicative market returns to such contributions.
(iv) Best method analysis considerations--(A) In general. Whether
results derived from this method are the most reliable measure of the
arm's length result is determined using the factors described under the
best method rule in Sec. 1.482-1(c). Thus, comparability and quality of
data, reliability of assumptions, and sensitivity of results to possible
deficiencies in the data and assumptions, must be considered in
determining whether this method provides the most reliable measure of an
arm's length result. The application of these factors to the residual
profit split in the context of the relevant business activity of
developing and exploiting cost shared intangibles is discussed in
paragraphs (g)(7)(iv)(B) through (D) of this section.
(B) Comparability. The derivation of the present value of nonroutine
residual divisional profit or loss includes a carveout on account of
market returns for routine contributions. Thus, the comparability
considerations that are relevant for that purpose include those that are
relevant for the methods that are used to determine market returns for
the routine contributions.
(C) Data and assumptions. The reliability of the results derived
from the residual profit split is affected by the quality of the data
and assumptions used to apply this method. In particular, the following
factors must be considered:
(1) The reliability of the allocation of costs, income, and assets
between the relevant business activity and the controlled participants'
other activities that will affect the reliability of the determination
of the divisional profit or loss and its allocation among the controlled
participants. See Sec. 1.482-6(c)(2)(ii)(C)(1).
(2) The degree of consistency between the controlled participants
and uncontrolled taxpayers in accounting practices that materially
affect the items that determine the amount and allocation of operating
profit or loss affects the reliability of the result. See Sec. 1.482-
6(c)(2)(ii)(C)(2).
(3) The reliability of the data used and the assumptions made in
estimating the relative value of the nonroutine contributions by the
controlled participants. In particular, if capitalized costs of
development are used to estimate the relative value of nonroutine
contributions, the reliability of the results is reduced relative to the
reliability of other methods that do not require such an estimate. This
is because, in any given case, the costs of developing a nonroutine
contribution may not be related to its market value and because the
calculation of the capitalized costs of development may require the
allocation of indirect costs between the relevant business activity and
the controlled participant's other activities, which may affect the
reliability of the analysis.
[[Page 711]]
(D) Other factors affecting reliability. Like the methods described
in Sec. Sec. 1.482-3 through 1.482-5 and Sec. 1.482-9(c), the carveout
on account of market returns for routine contributions relies
exclusively on external market benchmarks. As indicated in Sec. 1.482-
1(c)(2)(i), as the degree of comparability between the controlled
participants and uncontrolled transactions increases, the relative
weight accorded the analysis under this method will increase. In
addition, to the extent the allocation of nonroutine residual divisional
profit or loss is not based on external market benchmarks, the
reliability of the analysis will be decreased in relation to an analysis
under a method that relies on market benchmarks. Finally, the
reliability of the analysis under this method may be enhanced by the
fact that all the controlled participants are evaluated under the
residual profit split. However, the reliability of the results of an
analysis based on information from all the controlled participants is
affected by the reliability of the data and the assumptions pertaining
to each controlled participant. Thus, if the data and assumptions are
significantly more reliable with respect to one of the controlled
participants than with respect to the others, a different method,
focusing solely on the results of that party, may yield more reliable
results.
(v) Examples. The following examples illustrate the principles of
this paragraph (g)(7):
Example 1. (i) For simplicity of calculation in this Example 1, all
financial flows are assumed to occur at the beginning of each period.
USP, a U.S. electronic data storage company, has partially developed
technology for a type of extremely small compact storage devices
(nanodisks) which are expected to provide a significant increase in data
storage capacity in various types of portable devices such as cell
phones, MP3 players, laptop computers and digital cameras. At the same
time, USP's wholly-owned subsidiary, FS, has developed significant
marketing intangibles outside the United States in the form of customer
lists, ongoing relations with various OEMs, and trademarks that are well
recognized by consumers due to a long history of marketing successful
data storage devices and other hardware used in various types of
consumer electronics. At the beginning of Year 1, USP enters into a CSA
with FS to develop nanodisk technologies for eventual commercial
exploitation. Under the CSA, USP will have the right to exploit
nanodisks in the United States, while FS will have the right to exploit
nanodisks in the rest of the world. The partially developed nanodisk
technologies owned by USP are reasonably anticipated to contribute to
the development of commercially exploitable nanodisks and therefore the
rights in the nanodisk technologies constitute platform contributions of
USP for which compensation is due under PCTs. FS does not have any
platform contributions for the CSA. Due to the fact that nanodisk
technologies have yet to be incorporated into any commercially available
product, neither USP nor FS transfers rights to make or sell current
products in conjunction with the CSA.
(ii) Because only in FS's territory do both controlled participants
make significant nonroutine contributions, USP and FS determine that
they need to determine the relative value of their respective
contributions to residual divisional profit or loss attributable to the
CSA Activity only in FS's territory. FS anticipates making no nanodisk
sales during the first year of the CSA in its territory with revenues in
Year 2 reaching $200 million. Revenues through Year 5 are reasonably
anticipated to increase by 50% per year. The annual growth rate for
revenues is then expected to decline to 30% per annum in Years 6 and 7,
20% per annum in Years 8 and 9 and 10% per annum in Year 10. Revenues
are then expected to decline 10% in Year 11 and 5% per annum,
thereafter. The routine costs (defined here as costs other than cost
contributions, routine platform and operating contributions, and
nonroutine contributions) that are allocable to this revenue in
calculating FS's divisional profit or loss, are anticipated to equal $40
million for the first year of the CSA and $130 for the second year and
$200 and $250 million in Years 3 and 4. Total operating expenses
attributable to product exploitation (including operating cost
contributions) equal 52% of sales per year. FS undertakes routine
distribution activities in its markets that constitute routine
contributions to the relevant business activity of exploiting nanodisk
technologies. USP and FS estimate that the total market return on these
routine contributions will amount to 6% of the routine costs. FS expects
its cost contributions to be $60 million in Year 1, rise to $100 million
in Years 2 and 3, and then decline again to $60 million in Year 4.
Thereafter, FS's cost contributions are expected to equal 10% of
revenues.
(iii) USP and FS determine the present value of the stream of the
reasonably anticipated residuals in FS's territory over the duration of
the CSA Activity of the divisional profit or loss (revenues minus
routine costs), minus the market returns for routine contributions, the
operating cost contributions,
[[Page 712]]
and the cost contributions. USP and FS determine, based on the
considerations discussed in paragraph (g)(2)(v) of this section, that
the appropriate discount rate is 17.5% per annum. Therefore, the present
value of the nonroutine residual divisional profit is $1,395 million.
(iv) After analysis, USP and FS determine that the relative value of
the nanodisk technologies contributed by USP to CSA (giving effect only
to its value in FS's territory) is roughly 150% of the value of FS's
marketing intangibles (which only have value in FS's territory).
Consequently, 60% of the nonroutine residual divisional profit is
attributable to USP's platform contribution. Therefore, FS's PCT
Payments should have an expected present value equal to $837 million (.6
x $1,395 million).
(v) The calculations for this Example 1 are displayed in the
following table:
--------------------------------------------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV = Terminal Value).................. Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 Y11 TV
Discount Period............................................... 0 1 2 3 4 5 6 7 8 9 10 10
[1] Sales..................................................... 0 200 300 450 675 878 1141 1369 1643 1807 1626
[2] Growth Rate............................................... ...... ...... 50% 50% 50% 30% 30% 20% 20% 10% -10%
[3] Exploitation Costs and Operating Cost Contributions (52% 40 130 200 250 351 456 593 712 854 940 846
of Sales [1])................................................
[4] Return on [3] (6% of [3])................................. 2.4 8 12 15 21 27 36 43 51 56 51
[5] Cost Contributions (10% of Sales [1] after Year 5)........ 60 100 100 60 68 88 114 137 164 181 163
[6] Residual Profit = [1] minus {[3] + [4] + [5]{time} ....... -102 -38 -12 125 235 306 398 477 573 630 567 2395
[7] Residual Profit [6] Discounted at 17.5% discount rate..... -102 -32 -9 77 124 137 151 154 158 148 113 477
--------------------------------------------------------------------------------------------------------------------------------------------------------
[8] Sum of all amounts in [7] for all time periods = $1,395 million
--------------------------------------------------------------------------------------------------------------------------------------------------------
[9] Relative value in FS's division of USP's nanotechnology to FS's marketing intangibles = 150%
--------------------------------------------------------------------------------------------------------------------------------------------------------
[10] Profit Split (USP)....................................... 60% = 1.5 x [11]
-----------------------------------------------------------------------------------------
[11] Profit Split (FS)........................................ 40%
-----------------------------------------------------------------------------------------
[12] FS's PCT Payments........................................ [8] x [10] = $1,395 million x 60% = $837 million
--------------------------------------------------------------------------------------------------------------------------------------------------------
[[Page 713]]
Example 2. (i) For simplicity of calculation in this Example 2, all
financial flows are assumed to occur at the beginning of each period.
USP is a U.S. automobile manufacturing company that has completed
significant research on the development of diesel-electric hybrid
engines that, if they could be successfully manufactured, would result
in providing a significant increased fuel economy for a wide variety of
motor vehicles. Successful commercialization of the diesel-electric
hybrid engine will require the development of a new class of advanced
battery that will be light, relatively cheap to manufacture and yet
capable of holding a substantial electric charge. FS, a foreign
subsidiary of USP, has completed significant research on developing
lithium-ion batteries that appear likely to have the requisite
characteristics. At the beginning of Year 1, USP enters into a CSA with
FS to further develop diesel-electric hybrid engines and lithium-ion
battery technologies for eventual commercial exploitation. Under the
CSA, USP will have the right to exploit the diesel-electric hybrid
engine and lithium-ion battery technologies in the United States, while
FS will have the right to exploit such technologies in the rest of the
world. The partially developed diesel-electric hybrid engine and
lithium-ion battery technologies owned by USP and FS, respectively, are
reasonably anticipated to contribute to the development of commercially
exploitable automobile engines and therefore the rights in both these
technologies constitute platform contributions of USP and of FS for
which compensation is due under PCTs. At the time of inception of the
CSA, USP owns operating intangibles in the form of self-developed
marketing intangibles which have significant value in the United States,
but not in the rest of the world, and that are relevant to exploiting
the cost shared intangibles. Similarly, FS owns self-developed marketing
intangibles which have significant value in the rest of the world, but
not in the United States, and that are relevant to exploiting the cost
shared intangibles. Although the new class of diesel-electric hybrid
engine using lithium-ion batteries is not yet ready for commercial
exploitation, components based on this technology are beginning to be
incorporated in current-generation gasoline-electric hybrid engines and
the rights to make and sell such products are transferred from USP to FS
and vice-versa in conjunction with the inception of the CSA, following
the same territorial division as in the CSA.
(ii) USP's estimated RAB share is 66.7%. During Year 1, it is
anticipated that sales in USP's territory will be $1000X in Year 1.
Sales in FS's territory are anticipated to be $500X. Thereafter, as
revenue from the use of components in gasoline-electric hybrids is
supplemented by revenues from the production of complete diesel-electric
hybrid engines using lithium-ion battery technology, anticipated sales
in both territories will increase rapidly at a rate of 50% per annum
through Year 4. Anticipated sales are then anticipated to increase at a
rate of 40% per annum for another 4 years. Sales are then anticipated to
increase at a rate of 30% per annum through Year 10. Thereafter, sales
are anticipated to decrease at a rate of 5% per annum for the
foreseeable future as new automotive drivetrain technologies displace
diesel-electric hybrid engines and lithium-ion batteries. Total
operating expenses attributable to product exploitation (including
operating cost contributions) equal 40% of sales per year for both USP
and FS. USP and FS estimate that the total market return on these
routine contributions to the CSA will amount to 6% of these operating
expenses. USP is expected to bear \2/3\ of the total cost contributions
for the foreseeable future. Cost contributions are expected to total
$375X in Year 1 (of which $250X are borne by USP) and increase at a rate
of 25% per annum through Year 6. In Years 7 through 10, cost
contributions are expected to increase 10% a year. Thereafter, cost
contributions are expected to decrease by 5% a year for the foreseeable
future.
(iii) USP and FS determine the present value of the stream of FS's
reasonably anticipated residual divisional profit, which is the stream
of FS's reasonably anticipated divisional profit or loss, minus the
market returns for routine contributions, minus operating cost
contributions, minus cost contributions. USP and FS determine, based on
the considerations discussed in paragraph (g)(2)(v) of this section,
that the appropriate discount rate is 12% per year. Therefore, the
present value of the nonroutine residual divisional profit in USP's
territory is $41,727X and in CFC's territory is $20,864X.
(iv) After analysis, USP and FS determine that, in the United States
the relative value of the technologies contributed by USP and FS to the
CSA and of the operating intangibles used by USP in the exploitation of
the cost shared intangibles (reported as equaling 100 in total), equals:
USP's platform contribution (59.5); FS's platform contribution (25.5);
and USP's operating intangibles (15). Consequently, the present value of
the arm's length amount of the PCT Payments that USP should pay to FS
for FS's platform contribution is $10,640X (.255 x $41,727X). Similarly,
USP and FS determine that, in the rest of the world, the relative value
of the technologies contributed by USP and FS to the CSA and of the
operating intangibles used by FS in the exploitation of the cost shared
intangibles can be divided as follows: USP's platform contribution (63);
FS's platform contribution (27); and FS's operating intangibles (10).
Consequently, the present value of the arm's length amount of the PCT
Payments that FS should pay to USP for
[[Page 714]]
USP's platform contribution is $13,144X (.63 x $20,864X). Therefore, FS
is required to make a net payment to USP with a present value of $2,504X
($13,144X - 10,640X).
(v) The calculations for this Example 2 are displayed in the
following tables:
Calculation of USP's PCT Payment to FS
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV = Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 TV
Terminal Value)...............
Discount Period................ 0 1 2 3 4 5 6 7 8 9 9
[1] Sales...................... 1000 1500 2250 3375 4725 6615 9261 12965 16855 21912
[2] Growth Rate................ ..... 50% 50% 50% 40% 40% 40% 40% 30% 30%
[3] Exploitation Costs and 400 600 900 1350 1890 2646 3704 5186 6742 8765
Operating Cost Contributions
(40% of Sales [1])............
[4] Return on [3] = 6% of [3].. 24 36 54 81 113 159 222 311 405 526
[5] Cost Contributions......... 250 313 391 488 610 763 839 923 1015 1117
[6] Residual Profit = [1] minus 326 552 905 1456 2111 3047 4495 6545 8693 11504 64287
{[3] + [4] + [5]{time} .......
[7] Residual Profit [6] 326 492 722 1036 1342 1729 2277 2961 3511 4148 23183
Discounted at 12% discount
rate..........................
----------------------------------------------------------------------------------------------------------------
[8] Sum of all amounts in [7] for all time periods = $41,727X
----------------------------------------------------------------------------------------------------------------
Profit Split for Calculation of USP's PCT Payment to FS: [Total of US contributions = 74.5%]
[9] USP's Platform Contribution = 59.5%
[10] FS's Platform Contribution = 25.5%
[11] USP's Operating Intangibles = 15%
----------------------------------------------------------------------------------------------------------------
[12] USP's PCT Payment to FS = [8] x [10] = $41,727X multiplied by 25.5% = $10,640X
----------------------------------------------------------------------------------------------------------------
Calculation of FS's Net PCT Payment to USF
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Time Period (Y = Year) (TV = Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 TV
Terminal Value).................
Discount Period.................. 0 1 2 3 4 5 6 7 8 9 9
[13] Sales....................... 500 750 1125 1688 2363 3308 4631 6483 8428 10956
[14] Growth Rate................. ..... 50% 50% 50% 40% 40% 40% 40% 30% 30%
[15] Exploitation Costs and 200 300 450 675 945 1323 1852 2593 3371 4382
Operating Cost Contributions
(40% of Sales [13]).............
[16] Return on [15] = 6% of [15]. 12 18 27 41 57 79 111 156 202 263
[17] Cost Contributions.......... 125 156 195 244 305 381 420 462 508 559
[18] Residual Profit = [13] minus 163 276 453 728 1056 1524 2248 3272 4347 5752 32144
{[15] + [16] + [17]{time} ......
[19] Residual Profit [18] 163 246 361 518 671 865 1139 1480 1755 2074 11591
Discounted at 12% discount rate.
----------------------------------------------------------------------------------------------------------------
[20] Sum of all amounts in [19] for all time periods = $20,864X
----------------------------------------------------------------------------------------------------------------
Profit Split for Calculation of FS's PCT Payment to USP: [Total of FS's contributions = 37%]
[21] USP's Platform Contribution = 63%
[22] FS's Platform Contribution = 27%
[23] FS's Operating Intangibles = 10%
----------------------------------------------------------------------------------------------------------------
[[Page 715]]
[24] FS's PCT Payment to USP = [20] x [21] = $20,864X multiplied by 63% = $13,144X
----------------------------------------------------------------------------------------------------------------
[25] FS's Net PCT Payment to USP = [24] minus [12] = $13,144X minus $10,640X = $2,504X..........................
----------------------------------------------------------------------------------------------------------------
(8) Unspecified methods. Methods not specified in paragraphs (g)(3)
through (7) of this section may be used to evaluate whether the amount
charged for a PCT is arm's length. Any method used under this paragraph
(g)(8) must be applied in accordance with the provisions of Sec. 1.482-
1 and of paragraph (g)(2) of this section. Consistent with the specified
methods, an unspecified method should take into account the general
principle that uncontrolled taxpayers evaluate the terms of a
transaction by considering the realistic alternatives to that
transaction, and only enter into a particular transaction if none of the
alternatives is preferable to it. Therefore, in establishing whether a
PCT achieved an arm's length result, an unspecified method should
provide information on the prices or profits that the controlled
participant could have realized by choosing a realistic alternative to
the CSA. See paragraph (k)(2)(ii)(J) of this section. As with any
method, an unspecified method will not be applied unless it provides the
most reliable measure of an arm's length result under the principles of
the best method rule. See Sec. 1.482-1(c) (Best method rule). In
accordance with Sec. 1.482-1(d) (Comparability), to the extent that an
unspecified method relies on internal data rather than uncontrolled
comparables, its reliability will be reduced. Similarly, the reliability
of a method will be affected by the reliability of the data and
assumptions used to apply the method, including any projections used.
(h) Form of payment rules--(1) CST Payments. CST Payments may not be
paid in shares of stock in the payor (or stock in any member of the
controlled group that includes the controlled participants).
(2) PCT Payments--(i) In general. The consideration under a PCT for
a platform contribution may take one or a combination of both of the
following forms:
(A) Payments of a fixed amount (fixed payments), either paid in a
lump sum payment or in installment payments spread over a specified
period, with interest calculated in accordance with Sec. 1.482-2(a)
(Loans or advances).
(B) Payments contingent on the exploitation of cost shared
intangibles by the PCT Payor (contingent payments). Accordingly,
controlled participants have flexibility to adopt a form and period of
payment, provided that such form and period of payment are consistent
with an arm's length charge as of the date of the PCT. See also
paragraphs (h)(2)(iv) and (3) of this section.
(ii) No PCT Payor Stock. PCT Payments may not be paid in shares of
stock in the PCT Payor (or stock in any member of the controlled group
that includes the controlled participants).
(iii) Specified form of payment--(A) In general. The form of payment
selected (subject to the rules of this paragraph (h)) for any PCT,
including, in the case of contingent payments, the contingent base and
structure of the payments as set forth in paragraph (h)(2)(iii)(B) of
this section, must be specified no later than the due date of the
applicable tax return (including extensions) for the later of the
taxable year of the PCT Payor or PCT Payee that includes the date of
that PCT.
(B) Contingent payments. In accordance with paragraph (k)(1)(iv)(A)
of this section, a provision of a written contract described in
paragraph (k)(1) of this section, or of the additional documentation
described in paragraph (k)(2) of this section, that provides for
payments for a PCT (or group of PCTs) to be contingent on the
exploitation of cost shared intangibles will be respected as consistent
with economic substance only if the allocation between the controlled
participants of the risks attendant on such form of payment is
determinable before the outcomes of such allocation that would
[[Page 716]]
have materially affected the PCT pricing are known or reasonably
knowable. A contingent payment provision must clearly and unambiguously
specify the basis on which the contingent payment obligations are to be
determined. In particular, the contingent payment provision must clearly
and unambiguously specify the events that give rise to an obligation to
make PCT Payments, the royalty base (such as sales or revenues), and the
computation used to determine the PCT Payments. The royalty base
specified must be one that permits verification of its proper use by
reference to books and records maintained by the controlled participants
in the normal course of business (for example, books and records
maintained for financial accounting or business management purposes).
(C) Examples. The following examples illustrate the principles of
this paragraph (h)(2).
Example 1. A CSA provides that PCT Payments with respect to a
particular platform contribution shall be contingent payments equal to
15% of the revenues from sales of products that incorporate cost shared
intangibles. The terms further permit (but do not require) the
controlled participants to adjust such contingent payments in accordance
with a formula set forth in the arrangement so that the 15% rate is
subject to adjustment by the controlled participants at their discretion
on an after-the-fact, uncompensated basis. The Commissioner may impute
payment terms that are consistent with economic substance with respect
to the platform contribution because the contingent payment provision
does not specify the computation used to determine the PCT Payments.
Example 2. Taxpayer, an automobile manufacturer, is a controlled
participant in a CSA that involves research and development to perfect
certain manufacturing techniques necessary to the actual manufacture of
a state-of-the-art, hybrid fuel injection system known as DRL337. The
arrangement involves the platform contribution of a design patent
covering DRL337. Pursuant to paragraph (h)(2)(iii)(B) of this section,
the CSA provides for PCT Payments with respect to the platform
contribution of the patent in the form of royalties contingent on sales
of automobiles that contain the DRL337 system. However, Taxpayer's
system of book- and record-keeping does not enable Taxpayer to track
which automobile sales involve automobiles that contain the DRL337
system. Because Taxpayer has not complied with paragraph (h)(2)(iii)(B)
of this section, the Commissioner may impute payment terms that are
consistent with economic substance and susceptible to verification by
the Commissioner.
Example 3. (i) Controlled participants A and B enter into a CSA that
provides for PCT Payments from A to B with respect to B's platform
contribution, Z, in the form of three annual installment payments due
from A to B on the last day of each of the first three years of the CSA.
(ii) On audit, based on all the facts and circumstances, the
Commissioner determines that the installment PCT Payments are consistent
with an arm's length charge as of the date of the PCT. Accordingly, the
Commissioner does not make an adjustment with respect to the PCT
Payments in any year.
Example 4. (i) The facts are the same as in Example 3 except that
the CSA contains an additional term with respect to the PCT Payments.
Under this provision, A and B further agreed that, if the present value
(as of the CSA Start Date) of A's actual divisional operating profit or
loss during the three-year period is less than the present value (as of
the CSA Start Date) of the divisional operating profit or loss that the
parties projected for A upon formation of the CSA for that period, then
the third installment payment shall be subject to a compensating
adjustment in the amount necessary to reduce the present value (as of
the CSA Start Date) of the aggregate PCT Payments for those three years
to the amount that would have been calculated if the actual results had
been used for the calculation instead of the projected results.
(ii) This provision further specifies that A will pay B an
additional amount, $Q, in the first year of the CSA to compensate B for
taking on additional downside risk through the contingent payment term
described in paragraph (i) of this Example 4.
(iii) During the first two years, A pays B installment payments as
agreed, as well as the additional amount, $Q. In the third year, A and B
determine that the present value (as of the CSA Start Date) of A's
actual divisional operating profit or loss during the three-year period
is less than the present value (as of the CSA Start Date) of the
divisional operating profit or loss that the parties projected for A
upon formation of the CSA for that period. A reduces the PCT Payment to
B in the third year in the amount necessary to reduce the present value
(as of the CSA Start Date) of the aggregate PCT Payments for those three
years to the amount that would have been calculated if the actual
results had been used for the calculation instead of the projected
results.
(iv) On audit, based on all the facts and circumstances, the
Commissioner determines that the installment PCT Payments agreed to be
paid by A to B were consistent with an arm's length charge as of the
date of the
[[Page 717]]
PCT. The Commissioner further determines that the contingency was
sufficiently specified such that its occurrence or nonoccurrence was
unambiguous and determinable; that the projections were reliable; and
that the contingency did, in fact, occur. Finally, the Commissioner
determines, based on all the facts and circumstances, that $Q was within
the arm's length range for the additional allocation of risk to B.
Accordingly, no adjustment is made with respect to the installment PCT
Payments, or the additional PCT Payment for the contingent payment term,
in any year.
Example 5. (i) The facts are the same as in Example 4 except that
the CSA states the amount that A will pay B for the contingent payment
term is $X, an amount that is less than $Q, and A pays B $X in the first
year of the CSA.
(ii) On audit, based on all the facts and circumstances, the
Commissioner determines that the installment PCT Payments agreed to be
paid by A to B were consistent with an arm's length charge as of the
date of the PCT. The Commissioner further determines that the
contingency was sufficiently specified such that its occurrence or
nonoccurrence was unambiguous and determinable; that the projections
were reliable; and that the contingency did, in fact, occur. However,
the Commissioner also determines, based on all the facts and
circumstances, that the additional PCT Payment of $X from A to B for the
contingent payment term was not an arm's length charge for the
additional allocation of risk as of the CSA Start Date in connection
with the contingent payment term. Accordingly, the Commissioner makes an
adjustment to B's results equal to the difference between $X and the
median of the arm's length range of charges for the contingent payment
term.
Example 6. (i) The facts are the same as in Example 3 except that A
and B further agreed that, if the present value (as of the CSA Start
Date) of A's actual divisional operating profit or loss during the
three-year period is either less or greater than the present value (as
of the CSA Start Date) of the divisional operating profit or loss that
the parties projected for A upon formation of the CSA for that period,
then A may make a compensating adjustment to the third installment
payment in the amount necessary to reduce (if actual divisional
operating profit or loss is less than the projections) or increase (if
actual divisional operating profit or loss exceeds the projections) the
present value (as of the CSA Start Date) of the aggregate PCT Payments
for those three years to the amount that would have been calculated if
the actual results had been used for the calculation instead of the
projected results.
(ii) On audit, the Commissioner determines that the contingent
payment term lacks economic substance under Sec. Sec. 1.482-
1(d)(3)(iii)(B) and 1.482-7(h)(2)(iii)(B). It lacks economic substance
because the allocation of the risks between A and B was indeterminate as
of the CSA Start Date due to the elective nature of the potential
compensating adjustments. Specifically, the parties agreed upfront only
that A might make compensating adjustments to the installment payments.
By the terms of the agreement, A could decide whether to make such
adjustments after the outcome of the risks was known or reasonably
knowable. Even though the contingency and potential compensating
adjustments were clearly defined in the CSA, no compensating adjustments
were required by the CSA regardless of the occurrence or nonoccurrence
of the contingency. As a result, the contingent payment terms did not
clearly and unambiguously specify the events that give rise to an
obligation to make PCT Payments, and, accordingly, the obligation to
make compensating adjustments pursuant to the contingency was
indeterminate. The contingent payment term allows the taxpayer to make
adjustments that are favorable to its overall tax position in those
years where the agreement allows it to make such adjustments, but
decline to exercise its right to make any adjustment in those years in
which such an adjustment would be unfavorable to its overall tax
position. Such terms do not reflect a substantive upfront allocation of
risk. In addition, the vagueness of the agreement makes it impossible to
determine whether such contingent payment term warrants an additional
arm's length charge and, if so, how much.
(iii) Accordingly, the Commissioner may disregard the contingent
payment term under Sec. Sec. 1.482-1(d)(3)(ii)(B)(1) and 1.482-
7(k)(1)(iv) and may impute other contractual terms in its place
consistent with the economic substance of the CSA.
Example 7. (i) The facts are the same as in Example 6 except that
the contingent payment term provides that, if the present value (as of
the CSA Start Date) of A's actual divisional operating profit or loss
during the three-year period is either less or greater than the present
value (as of the CSA Start Date) of the divisional operating profit or
loss that the parties projected for A upon formation of the CSA for that
period, then A will make a compensating adjustment to the third
installment payment. The CSA does not specify the amount of (or a
formula for) any such compensating adjustments.
(ii) On audit, the Commissioner determines that the contingent
payment term lacks economic substance under Sec. Sec. 1.482-
1(d)(3)(iii)(B) and 1.482-7(h)(2)(iii)(B). It lacks economic substance
because the allocation of the risks between A and B was indeterminate as
of the CSA Start Date due to the failure to specify the amount of (or a
formula for) the compensating adjustments that must be made if a
[[Page 718]]
contingency occurs. The basis on which the compensating adjustments were
to be determined was neither clear nor unambiguous. Even though the
contingency was clearly defined in the CSA and the requirement of a
compensating adjustment in the event of a contingency was clearly
specified in the CSA, the parties had no agreement regarding the amount
of such compensating adjustments. As a result, the computation used to
determine the PCT Payments was indeterminate. The parties could choose
to make a small positive compensating adjustment if the actual results
turned out to be much greater than the projections, and could choose to
make a significant negative compensating adjustment if the actual
results turned out to be less than the projections. Such terms do not
reflect a substantive upfront allocation of risk. In addition, the
vagueness of the agreement makes it impossible to determine whether such
contingent payment term warrants an additional arm's length charge and,
if so, how much.
(iii) Accordingly, the Commissioner may disregard the contingent
price term under Sec. Sec. 1.482-1(d)(3)(ii)(B)(1) and 1.482-
7(k)(1)(iv) and may impute other contractual terms in its place
consistent with economic substance of the CSA.
(iv) Conversion from fixed to contingent form of payment. With
regard to a conversion of a fixed present value to a contingent form of
payment, see paragraphs (g)(2)(v) (Discount rate) and (vi) (Financial
projections) of this section.
(3) Coordination of best method rule and form of payment. A method
described in paragraph (g)(1) of this section evaluates the arm's length
amount charged in a PCT in terms of a form of payment (method payment
form). For example, the method payment form for the acquisition price
method described in paragraph (g)(5) of this section, and for the market
capitalization method described in paragraph (g)(6) of this section, is
fixed payment. Applications of the income method provide different
method payment forms. See paragraphs (g)(4)(i)(E) and (iv) of this
section. The method payment form may not necessarily correspond to the
form of payment specified pursuant to paragraphs (h)(2)(iii) and
(k)(2)(ii)(l) of this section (specified payment form). The
determination under Sec. 1.482-1(c) of the method that provides the
most reliable measure of an arm's length result is to be made without
regard to whether the respective method payment forms under the
competing methods correspond to the specified payment form. If the
method payment form of the method determined under Sec. 1.482-1(c) to
provide the most reliable measure of an arm's length result differs from
the specified payment form, then the conversion from such method payment
form to such specified payment form will be made to the satisfaction of
the Commissioner.
(i) Allocations by the Commissioner in connection with a CSA--(1) In
general. The Commissioner may make allocations to adjust the results of
a controlled transaction in connection with a CSA so that the results
are consistent with an arm's length result, in accordance with the
provisions of this paragraph (i).
(2) CST allocations--(i) In general. The Commissioner may make
allocations to adjust the results of a CST so that the results are
consistent with an arm's length result, including any allocations to
make each controlled participant's IDC share, as determined under
paragraph (d)(4) of this section, equal to that participant's RAB share,
as determined under paragraph (e)(1) of this section. Such allocations
may result from, for purposes of CST determinations, adjustments to--
(A) Redetermine IDCs by adding any costs (or cost categories) that
are directly identified with, or are reasonably allocable to, the IDA,
or by removing any costs (or cost categories) that are not IDCs;
(B) Reallocate costs between the IDA and other business activities;
(C) Improve the reliability of the selection or application of the
basis used for measuring benefits for purposes of estimating a
controlled participant's RAB share;
(D) Improve the reliability of the projections used to estimate RAB
shares, including adjustments described in paragraph (i)(2)(ii) of this
section; and
(E) Allocate among the controlled participants any unallocated
interests in cost shared intangibles.
(ii) Adjustments to improve the reliability of projections used to
estimate RAB shares--(A) Unreliable projections. A significant
divergence between projected benefit shares and benefit shares
[[Page 719]]
adjusted to take into account any available actual benefits to date
(adjusted benefit shares) may indicate that the projections were not
reliable for purposes of estimating RAB shares. In such a case, the
Commissioner may use adjusted benefit shares as the most reliable
measure of RAB shares and adjust IDC shares accordingly. The projected
benefit shares will not be considered unreliable, as applied in a given
taxable year, based on a divergence from adjusted benefit shares for
every controlled participant that is less than or equal to 20% of the
participant's projected benefits share. Further, the Commissioner will
not make an allocation based on such divergence if the difference is due
to an extraordinary event, beyond the control of the controlled
participants, which could not reasonably have been anticipated at the
time that costs were shared. The Commissioner generally may adjust
projections of benefits used to calculate benefit shares in accordance
with the provisions of Sec. 1.482-1. In particular, if benefits are
projected over a period of years, and the projections for initial years
of the period prove to be unreliable, this may indicate that the
projections for the remaining years of the period are also unreliable
and thus should be adjusted. For purposes of this paragraph
(i)(2)(ii)(A), all controlled participants that are not U.S. persons are
treated as a single controlled participant. Therefore, an adjustment
based on an unreliable projection of RAB shares will be made to the IDC
shares of foreign controlled participants only if there is a matching
adjustment to the IDC shares of controlled participants that are U.S.
persons. Nothing in this paragraph (i)(2)(ii)(A) prevents the
Commissioner from making an allocation if a taxpayer did not use the
most reliable basis for measuring anticipated benefits. For example, if
the taxpayer measures its anticipated benefits based on units sold, and
the Commissioner determines that another basis is more reliable for
measuring anticipated benefits, then the fact that actual units sold
were within 20% of the projected unit sales will not preclude an
allocation under this section.
(B) Foreign-to-foreign adjustments. Adjustments to IDC shares based
on an unreliable projection also may be made among foreign controlled
participants if the variation between actual and projected benefits has
the effect of substantially reducing U.S. tax.
(C) Correlative adjustments to PCTs. Correlative adjustments will be
made to any PCT Payments of a fixed amount that were determined based on
RAB shares that are subsequently adjusted on a finding that they were
based on unreliable projections. No correlative adjustments will be made
to contingent PCT Payments regardless of whether RAB shares were used as
a parameter in the valuation of those payments.
(D) Examples. The following examples illustrate the principles of
this paragraph (i)(2)(ii):
Example 1. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into
a CSA to develop new food products, dividing costs on the basis of
projected sales two years in the future. In Year 1, USP and FS project
that their sales in Year 3 will be equal, and they divide costs
accordingly. In Year 3, the Commissioner examines the controlled
participants' method for dividing costs. USP and FS actually accounted
for 42% and 58% of total sales, respectively. The Commissioner agrees
that sales two years in the future provide a reliable basis for
estimating benefit shares. Because the differences between USP's and
FS's adjusted and projected benefit shares are less than 20% of their
projected benefit shares, the projection of future benefits for Year 3
is reliable.
Example 2. The facts are the same as in Example 1, except that in
Year 3 USP and FS actually accounted for 35% and 65% of total sales,
respectively. The divergence between USP's projected and adjusted
benefit shares is greater than 20% of USP's projected benefit share and
is not due to an extraordinary event beyond the control of the
controlled participants. The Commissioner concludes that the projected
benefit shares were unreliable, and uses adjusted benefit shares as the
basis for an adjustment to the cost shares borne by USP and FS.
Example 3. U.S. Parent (USP), a U.S. corporation, and its foreign
subsidiary (FS) enter into a CSA in Year 1. They project that they will
begin to receive benefits from cost shared intangibles in Years 4
through 6, and that USP will receive 60% of total benefits and FS 40% of
total benefits. In Years 4 through 6, USP and FS actually receive 50%
each of the total benefits. In evaluating the reliability of the
controlled participants'
[[Page 720]]
projections, the Commissioner compares the adjusted benefit shares to
the projected benefit shares. Although USP's adjusted benefit share
(50%) is within 20% of its projected benefit share (60%), FS's adjusted
benefit share (50%) is not within 20% of its projected benefit share
(40%). Based on this discrepancy, the Commissioner may conclude that the
controlled participants' projections were unreliable and may use
adjusted benefit shares as the basis for an adjustment to the cost
shares borne by USP and FS.
Example 4. Three controlled taxpayers, USP, FS1, and FS2 enter into
a CSA. FS1 and FS2 are foreign. USP is a domestic corporation that
controls all the stock of FS1 and FS2. The controlled participants
project that they will share the total benefits of the cost shared
intangibles in the following percentages: USP 50%; FS1 30%; and FS2 20%.
Adjusted benefit shares are as follows: USP 45%; FS1 25%; and FS2 30%.
In evaluating the reliability of the controlled participants'
projections, the Commissioner compares these adjusted benefit shares to
the projected benefit shares. For this purpose, FS1 and FS2 are treated
as a single controlled participant. The adjusted benefit share received
by USP (45%) is within 20% of its projected benefit share (50%). In
addition, the non-US controlled participant's adjusted benefit share
(55%) is also within 20% of their projected benefit share (50%).
Therefore, the Commissioner concludes that the controlled participant's
projections of future benefits were reliable, despite the fact that
FS2's adjusted benefit share (30%) is not within 20% of its projected
benefit share (20%).
Example 5. The facts are the same as in Example 4. In addition, the
Commissioner determines that FS2 has significant operating losses and
has no earnings and profits, and that FS1 is profitable and has earnings
and profits. Based on all the evidence, the Commissioner concludes that
the controlled participants arranged that FS1 would bear a larger cost
share than appropriate in order to reduce FS1's earnings and profits and
thereby reduce inclusions USP otherwise would be deemed to have on
account of FS1 under subpart F. Pursuant to paragraph (i)(2)(ii)(B) of
this section, the Commissioner may make an adjustment solely to the cost
shares borne by FS1 and FS2 because FS2's projection of future benefits
was unreliable and the variation between adjusted and projected benefits
had the effect of substantially reducing USP's U.S. income tax liability
(on account of FS1 subpart F income).
Example 6. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a CSA in 1996 to develop a new treatment for baldness. USS's
interest in any treatment developed is the right to produce and sell the
treatment in the U.S. market while FP retains rights to produce and sell
the treatment in the rest of the world. USS and FP measure their
anticipated benefits from the CSA based on their respective projected
future sales of the baldness treatment. The following sales projections
are used:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1............................................. 5 10
2............................................. 20 20
3............................................. 30 30
4............................................. 40 40
5............................................. 40 40
6............................................. 40 40
7............................................. 40 40
8............................................. 20 20
9............................................. 10 10
10............................................ 5 5
------------------------------------------------------------------------
(B) In Year 1, the first year of sales, USS is projected to have
lower sales than FP due to lags in U.S. regulatory approval for the
baldness treatment. In each subsequent year, USS and FP are projected to
have equal sales. Sales are projected to build over the first three
years of the period, level off for several years, and then decline over
the final years of the period as new and improved baldness treatments
reach the market.
(ii) To account for USS's lag in sales in the Year 1, the present
discounted value of sales over the period is used as the basis for
measuring benefits. Based on the risk associated with this venture, a
discount rate of 10 percent is selected. The present discounted value of
projected sales is determined to be approximately $154.4 million for USS
and $158.9 million for FP. On this basis USS and FP are projected to
obtain approximately 49.3% and 50.7% of the benefit, respectively, and
the costs of developing the baldness treatment are shared accordingly.
(iii)(A) In Year 6, the Commissioner examines the CSA. USS and FP
have obtained the following sales results through Year 5:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1............................................. 0 17
2............................................. 17 35
3............................................. 25 35
4............................................. 38 41
5............................................. 39 41
------------------------------------------------------------------------
(B) USS's sales initially grew more slowly than projected while FP's
sales grew more quickly. In each of the first three years of the period,
the share of total sales of at least one of the parties diverged by over
20% from its projected share of sales. However, by Year 5 both parties'
sales had leveled off at approximately their projected values. Taking
into account this leveling off of sales and
[[Page 721]]
all the facts and circumstances, the Commissioner determines that it is
appropriate to use the original projections for the remaining years of
sales. Combining the actual results through Year 5 with the projections
for subsequent years, and using a discount rate of 10%, the present
discounted value of sales is approximately $141.6 million for USS and
$187.3 million for FP. This result implies that USS and FP obtain
approximately 43.1% and 56.9%, respectively, of the anticipated benefits
from the baldness treatment. Because these adjusted benefit shares are
within 20% of the benefit shares calculated based on the original sales
projections, the Commissioner determines that, based on the difference
between adjusted and projected benefit shares, the original projections
were not unreliable. No adjustment is made based on the difference
between adjusted and projected benefit shares.
Example 7. (i) The facts are the same as in Example 6, except that
the actual sales results through Year 5 are as follows:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1............................................. 0 17
2............................................. 17 35
3............................................. 25 44
4............................................. 34 54
5............................................. 36 55
------------------------------------------------------------------------
(ii) Based on the discrepancy between the projections and the actual
results and on consideration of all the facts, the Commissioner
determines that for the remaining years the following sales projections
are more reliable than the original projections:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
6............................................. 36 55
7............................................. 36 55
8............................................. 18 28
9............................................. 9 14
10............................................ 4.5 7
------------------------------------------------------------------------
(iii) Combining the actual results through Year 5 with the
projections for subsequent years, and using a discount rate of 10%, the
present discounted value of sales is approximately $131.2 million for
USS and $229.4 million for FP. This result implies that USS and FP
obtain approximately 35.4% and 63.6%, respectively, of the anticipated
benefits from the baldness treatment. These adjusted benefit shares
diverge by greater than 20% from the benefit shares calculated based on
the original sales projections, and the Commissioner determines that,
based on the difference between adjusted and projected benefit shares,
the original projections were unreliable. The Commissioner adjusts cost
shares for each of the taxable years under examination to conform them
to the recalculated shares of anticipated benefits.
(iii) Timing of CST allocations. If the Commissioner makes an
allocation to adjust the results of a CST, the allocation must be
reflected for tax purposes in the year in which the IDCs were incurred.
When a CST payment is owed by one controlled participant to another
controlled participant, the Commissioner may make appropriate
allocations to reflect an arm's length rate of interest for the time
value of money, consistent with the provisions of Sec. 1.482-2(a)
(Loans or advances).
(3) PCT allocations. The Commissioner may make allocations to adjust
the results of a PCT so that the results are consistent with an arm's
length result in accordance with the provisions of the applicable
sections of the regulations under section 482, as determined pursuant to
paragraph (a)(2) of this section.
(4) Allocations regarding changes in participation under a CSA. The
Commissioner may make allocations to adjust the results of any
controlled transaction described in paragraph (f) of this section if the
controlled participants do not reflect arm's length results in relation
to any such transaction.
(5) Allocations when CSTs are consistently and materially
disproportionate to RAB shares. If a controlled participant bears IDC
shares that are consistently and materially greater or lesser than its
RAB share, then the Commissioner may conclude that the economic
substance of the arrangement between the controlled participants is
inconsistent with the terms of the CSA. In such a case, the Commissioner
may disregard such terms and impute an agreement that is consistent with
the controlled participants' course of conduct, under which a controlled
participant that bore a disproportionately greater IDC share received
additional interests in the cost shared intangibles. See Sec. Sec.
1.482-1(d)(3)(ii)(B) (Identifying contractual terms) and 1.482-
4(f)(3)(ii) (Identification of owner). Such additional interests will
consist of partial undivided interests in the other controlled
participant's interest in the cost shared intangible. Accordingly,
[[Page 722]]
that controlled participant must receive arm's length consideration from
any controlled participant whose IDC share is less than its RAB share
over time, under the provisions of Sec. Sec. 1.482-1 and 1.482-4
through 1.482-6 to provide compensation for the latter controlled
participants' use of such partial undivided interest.
(6) Periodic adjustments--(i) In general. Subject to the exceptions
in paragraph (i)(6)(vi) of this section, the Commissioner may make
periodic adjustments for an open taxable year (the Adjustment Year) and
for all subsequent taxable years for the duration of the CSA Activity
with respect to all PCT Payments, if the Commissioner determines that,
for a particular PCT (the Trigger PCT), a particular controlled
participant that owes or owed a PCT Payment relating to that PCT (such
controlled participant being referred to as the PCT Payor for purposes
of this paragraph (i)(6)) has realized an Actually Experienced Return
Ratio (AERR) that is outside the Periodic Return Ratio Range (PRRR). The
satisfaction of the condition stated in the preceding sentence is
referred to as a Periodic Trigger. See paragraphs (i)(6)(ii) through
(vi) of this section regarding the PRRR, the AERR, and periodic
adjustments. In determining whether to make such adjustments, the
Commissioner may consider whether the outcome as adjusted more reliably
reflects an arm's length result under all the relevant facts and
circumstances, including any information known as of the Determination
Date. The Determination Date is the date of the relevant determination
by the Commissioner. The failure of the Commissioner to determine for an
earlier taxable year that a PCT Payment was not arm's length will not
preclude the Commissioner from making a periodic adjustment for a
subsequent year. A periodic adjustment under this paragraph (i)(6) may
be made without regard to whether the taxable year of the Trigger PCT or
any other PCT remains open for statute of limitations purposes or
whether a periodic adjustment has previously been made with respect to
any PCT Payment.
(ii) PRRR. Except as provided in the next sentence, the PRRR will
consist of return ratios that are not less than .667 nor more than 1.5.
Alternatively, if the controlled participants have not substantially
complied with the documentation requirements referenced in paragraph (k)
of this section, as modified, if applicable, by paragraphs (m)(2) and
(3) of this section, the PRRR will consist of return ratios that are not
less than .8 nor more than 1.25.
(iii) AERR--(A) In general. The AERR is the present value of total
profits (PVTP) divided by the present value of investment (PVI). In
computing PVTP and PVI, present values are computed using the applicable
discount rate (ADR), and all information available as of the
Determination Date is taken into account.
(B) PVTP. The PVTP is the present value, as of the CSA Start Date,
as defined in section (j)(1)(i) of this section, of the PCT Payor's
actually experienced divisional profits or losses from the CSA Start
Date through the end of the Adjustment Year.
(C) PVI. The PVI is the present value, as of the CSA Start Date, of
the PCT Payor's investment associated with the CSA Activity, defined as
the sum of its cost contributions and its PCT Payments, from the CSA
Start Date through the end of the Adjustment Year. For purposes of
computing the PVI, PCT Payments means all PCT Payments due from a PCT
Payor before netting against PCT Payments due from other controlled
participants pursuant to paragraph (j)(3)(ii) of this section.
(iv) ADR--(A) In general. Except as provided in paragraph
(i)(6)(iv)(B) of this section, the ADR is the discount rate pursuant to
paragraph (g)(2)(v) of this section, subject to such adjustments as the
Commissioner determines appropriate.
(B) Publicly traded companies. If the PCT Payor meets the conditions
of paragraph (i)(6)(iv)(C) of this section, the ADR is the PCT Payor
WACC as of the date of the Trigger PCT. However, if the Commissioner
determines, or the controlled participants establish to the satisfaction
of the Commissioner, that a discount rate other than the PCT Payor WACC
better reflects the degree of risk of the CSA Activity as of such
[[Page 723]]
date, the ADR is such other discount rate.
(C) Publicly traded. A PCT Payor meets the conditions of this
paragraph (i)(6)(iv)(C) if--
(1) Stock of the PCT Payor is publicly traded; or
(2) Stock of the PCT Payor is not publicly traded, provided the PCT
Payor is included in a group of companies for which consolidated
financial statements are prepared; and a publicly traded company in such
group owns, directly or indirectly, stock in PCT Payor. Stock of a
company is publicly traded within the meaning of this paragraph
(i)(6)(iv)(C) if such stock is regularly traded on an established United
States securities market and the company issues financial statements
prepared in accordance with United States generally accepted accounting
principles for the taxable year.
(D) PCT Payor WACC. The PCT Payor WACC is the WACC, as defined in
paragraph (j)(1)(i) of this section, of the PCT Payor or the publicly
traded company described in paragraph (i)(6)(iv)(C)(2)(ii) of this
section, as the case may be.
(E) Generally accepted accounting principles. For purposes of
paragraph (i)(6)(iv)(C) of this section, a financial statement prepared
in accordance with a comprehensive body of generally accepted accounting
principles other than United States generally accepted accounting
principles is considered to be prepared in accordance with United States
generally accepted accounting principles provided that the amounts of
debt, equity, and interest expense are reflected in any reconciliation
between such other accounting principles and United States generally
accepted accounting principles required to be incorporated into the
financial statement by the securities laws governing companies whose
stock is regularly traded on United States securities markets.
(v) Determination of periodic adjustments. In the event of a
Periodic Trigger, subject to paragraph (i)(6)(vi) of this section, the
Commissioner may make periodic adjustments with respect to all PCT
Payments between all PCT Payors and PCT Payees for the Adjustment Year
and all subsequent years for the duration of the CSA Activity pursuant
to the residual profit split method as provided in paragraph (g)(7) of
this section, subject to the further modifications in this paragraph
(i)(6)(v). A periodic adjustment may be made for a particular taxable
year without regard to whether the taxable years of the Trigger PCT or
other PCTs remain open for statute of limitation purposes.
(A) In general. Periodic adjustments are determined by the following
steps:
(1) First, determine the present value, as of the date of the
Trigger PCT, of the PCT Payments under paragraph (g)(7)(iii)(C)(3) of
this section pursuant to the Adjusted RPSM as defined in paragraph
(i)(6)(v)(B) of this section (first step result).
(2) Second, convert the first step result into a stream of
contingent payments on a base of reasonably anticipated divisional
profits or losses over the entire duration of the CSA Activity, using a
level royalty rate (second step rate). See paragraph (h)(2)(iv) of this
section (Conversion from fixed to contingent form of payment). This
conversion is made based on all information known as of the
Determination Date.
(3) Third, apply the second step rate to the actual divisional
profit or loss for taxable years preceding and including the Adjustment
Year to yield a stream of contingent payments for such years, and
convert such stream to a present value as of the CSA Start Date under
the principles of paragraph (g)(2)(v) of this section (third step
result). For this purpose, the second step rate applied to a loss for a
particular year will yield a negative contingent payment for that year.
(4) Fourth, convert any actual PCT Payments up through the
Adjustment Year to a present value as of the CSA Start Date under the
principles of paragraph (g)(2)(v) of this section. Then subtract such
amount from the third step result. Determine the nominal amount in the
Adjustment Year that would have a present value as of the CSA Start Date
equal to the present value determined in the previous sentence to
determine the periodic adjustment in the Adjustment Year.
[[Page 724]]
(5) Fifth, apply the second step rate to the actual divisional
profit or loss for each taxable year after the Adjustment Year up to and
including the taxable year that includes the Determination Date to yield
a stream of contingent payments for such years. For this purpose, the
second step rate applied to a loss will yield a negative contingent
payment for that year. Then subtract from each such payment any actual
PCT Payment made for the same year to determine the periodic adjustment
for such taxable year.
(6) For each taxable year subsequent to the year that includes the
Determination Date, the periodic adjustment for such taxable year (which
is in lieu of any PCT Payment that would otherwise be payable for that
year under the taxpayer's position) equals the second step rate applied
to the actual divisional profit or loss for that year. For this purpose,
the second step rate applied to a loss for a particular year will yield
a negative contingent payment for that year.
(7) If the periodic adjustment for any taxable year is a positive
amount, then it is an additional PCT Payment owed from the PCT Payor to
the PCT Payee for such year. If the periodic adjustment for any taxable
year is a negative amount, then it is an additional PCT Payment owed by
the PCT Payee to the PCT Payor for such year.
(B) Adjusted RPSM as of Determination Date. The Adjusted RPSM is the
residual profit split method pursuant to paragraph (g)(7) of this
section applied to determine the present value, as of the date of the
Trigger PCT, of the PCT Payments under paragraph (g)(7)(iii)(C)(3) of
this section, with the following modifications.
(1) Actual results up through the Determination Date shall be
substituted for what otherwise were the projected results over such
period, as reasonably anticipated as of the date of the Trigger PCT.
(2) Projected results for the balance of the CSA Activity after the
Determination Date, as reasonably anticipated as of the Determination
Date, shall be substituted for what otherwise were the projected results
over such period, as reasonably anticipated as of the date of the
Trigger PCT.
(3) The requirement in paragraph (g)(7)(i) of this section, that at
least two controlled participants make significant nonroutine
contributions, does not apply.
(vi) Exceptions to periodic adjustments--(A) Controlled participants
establish periodic adjustment not warranted. No periodic adjustment will
be made under paragraphs (i)(6)(i) and (v) of this section if the
controlled participants establish to the satisfaction of the
Commissioner that all the conditions described in one of paragraphs
(i)(6)(vi)(A)(1) through (4) of this section apply with respect to the
Trigger PCT.
(1) Transactions involving the same platform contribution as in the
Trigger PCT.
(i) The same platform contribution is furnished to an uncontrolled
taxpayer under substantially the same circumstances as those of the
relevant Trigger PCT and with a similar form of payment as the Trigger
PCT;
(ii) This transaction serves as the basis for the application of the
comparable uncontrolled transaction method described in paragraph (g)(3)
of this section, in the first year and all subsequent years in which
substantial PCT Payments relating to the Trigger PCT were required to be
paid; and
(iii) The amount of those PCT Payments in that first year was arm's
length.
(2) Results not reasonably anticipated. The differential between the
AERR and the nearest bound of the PRRR is due to extraordinary events
beyond the control of the controlled participants that could not
reasonably have been anticipated as of the date of the Trigger PCT.
(3) Reduced AERR does not cause Periodic Trigger. The Periodic
Trigger would not have occurred had the PCT Payor's divisional profits
or losses used to calculate its PVTP both taken into account expenses on
account of operating cost contributions and routine platform
contributions, and excluded those profits or losses attributable to the
PCT Payor's routine contributions to its exploitation of cost shared
intangibles, nonroutine contributions to the
[[Page 725]]
CSA Activity, operating cost contributions, and routine platform
contributions.
(4) Increased AERR does not cause Periodic Trigger--(i) The Periodic
Trigger would not have occurred had the divisional profits or losses of
the PCT Payor used to calculate its PVTP included its reasonably
anticipated divisional profits or losses after the Adjustment Year from
the CSA Activity, including from its routine contributions, its
operating cost contributions, and its nonroutine contributions to that
activity, and had the cost contributions and PCT Payments of the PCT
Payor used to calculate its PVI included its reasonably anticipated cost
contributions and PCT Payments after the Adjustment Year. The reasonably
anticipated amounts in the previous sentence are determined based on all
information available as of the Determination Date.
(ii) For purposes of this paragraph (i)(6)(vi)(A)(4), the controlled
participants may, if they wish, assume that the average yearly
divisional profits or losses for all taxable years prior to and
including the Adjustment Year, in which there has been substantial
exploitation of cost shared intangibles resulting from the CSA
(exploitation years), will continue to be earned in each year over a
period of years equal to 15 minus the number of exploitation years prior
to and including the Determination Date.
(B) Circumstances in which Periodic Trigger deemed not to occur. No
Periodic Trigger will be deemed to have occurred at the times and in the
circumstances described in paragraph (i)(6)(vi)(B)(1) or (2) of this
section.
(1) 10-year period. In any year subsequent to the 10-year period
beginning with the first taxable year in which there is substantial
exploitation of cost shared intangibles resulting from the CSA, if the
AERR determined is within the PRRR for each year of such 10-year period.
(2) 5-year period. In any year of the 5-year period beginning with
the first taxable year in which there is substantial exploitation of
cost shared intangibles resulting from the CSA, if the AERR falls below
the lower bound of the PRRR.
(vii) Examples. The following examples illustrate the rules of this
paragraph (i)(6):
Example 1. (i) For simplicity of calculation in this Example 1, all
financial flows are assumed to occur at the beginning of the year. At
the beginning of Year 1, USP, a publicly traded U.S. company, and FS,
its wholly-owned foreign subsidiary, enter into a CSA to develop new
technology for cell phones. USP has a platform contribution, the rights
for an in-process technology that when developed will improve the
clarity of calls, for which compensation is due from FS. FS has no
platform contributions to the CSA, no operating contributions, and no
operating cost contributions. USP and FS agree to fixed PCT payments of
$40 million in Year 1 and $10 million per year for Years 2 through 10.
At the beginning of Year 1, the weighted average cost of capital of the
controlled group that includes USP and FS is 15%. In Year 9, the
Commissioner audits Years 5 through 7 of the CSA and considers whether
any periodic adjustments should be made. USP and FS have substantially
complied with the documentation requirements of paragraph (k) of this
section.
(ii) FS experiences the results reported in the following table from
its participation in the CSA through Year 7. In the table, all present
values (PV) are reported as of the CSA Start Date, which is the same as
the date of the PCT (and reflect a 15% discount rate as discussed in
paragraph (iii) of this Example 1). Thus, in any year the present value
of the cumulative investment is PVI and of the cumulative divisional
profit or loss is PVTP. All amounts in this table and the tables that
follow are reported in millions of dollars and cost contributions are
referred to as ``CCs'' (for simplicity of calculation in this Example 1,
all financial flows are assumed to occur at the beginning of the year).
----------------------------------------------------------------------------------------------------------------
a b c d e f g h
----------------------------------------------------------------------------------------------------------------
Divisional
Year Sales Non CC CCs PCT Investment profit or AERR (PVTP/
costs payments (d + e) loss (b-c) PVI) (g/f)
----------------------------------------------------------------------------------------------------------------
1........................... 0 0 15 40 55 0
2........................... 0 0 17 10 27 0
3........................... 0 0 18 10 28 0
4........................... 705 662 20 10 30 46
5........................... 886 718 22 10 32 168
[[Page 726]]
6........................... 1,113 680 24 10 34 433
7........................... 1,179 747 27 10 37 432
PV through Year 5........... 970 846 69 69 138 124 0.90
PV through Year 6........... 1,523 1,184 81 74 155 340 2.20
PV through Year 7........... 2,033 1,507 93 78 171 526 3.09
----------------------------------------------------------------------------------------------------------------
(iii) Because USP is publicly traded in the United States and is a
member of the controlled group to which FS (the PCT Payor) belongs, for
purposes of calculating the AERR for FS, the present values of its PVTP
and PVI are determined using an ADR of 15%, the weighted average cost of
capital of the controlled group. (It is assumed that no other rate was
determined or established, under paragraph (i)(6)(iv)(B) of this
section, to better reflect the relevant degree of risk.) At a 15%
discount rate, the PVTP, calculated as of Year 1, and based on actual
profits realized by FS through Year 7 from exploiting the new cell phone
technology developed by the CSA, is $526 million. The PVI, based on FS's
cost contributions and its PCT Payments, is $171 million. The AERR for
FS is equal to its PVTP divided by its PVI, $526 million/$171 million,
or 3.09. There is a Periodic Trigger because FS's AERR of 3.09 falls
outside the PRRR of .67 to 1.5, the applicable PRRR for controlled
participants complying with the documentation requirements of this
section.
(iv) At the time of the Determination Date, it is determined that
the first Adjustment Year in which a Periodic Trigger occurred was Year
6, when the AERR of FS was determined to be 2.20. It is also determined
that for Year 6 none of the exceptions to periodic adjustments described
in paragraph (i)(6)(vi) of this section applies. The Commissioner
exercises its discretion under paragraph (i)(6)(i) of this section to
make periodic adjustments using Year 6 as the Adjustment Year.
Therefore, the arm's length PCT Payments from FS to USP shall be
determined for each taxable year using the adjusted residual profit
split method described in paragraphs (g)(7) and (i)(6)(v)(B) of this
section. Periodic adjustments will be made for each year to the extent
the PCT Payments actually made by FS differ from the PCT Payment
calculation under the adjusted residual profit split method.
(v) It is determined, as of the Determination Date, that the cost
shared intangibles will be exploited through Year 10. FS's return for
routine contributions (determined by the Commissioner, based on the
return for comparable functions undertaken by comparable uncontrolled
companies, to be 8% of non-CC costs), and its actual and projected
results, are described in the following table.
--------------------------------------------------------------------------------------------------------------------------------------------------------
a b c d e f g
--------------------------------------------------------------------------------------------------------------------------------------------------------
Divisional
Year Sales Non-CC costs profit or loss CCs Routing return Residual
(b-c) proift (d-e-f)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1....................................................... 0 0 0 15 0 -15
2....................................................... 0 0 0 17 0 -17
3....................................................... 0 0 0 18 0 -18
4....................................................... 705 662 43 20 53 -30
5....................................................... 886 718 168 22 57 89
6....................................................... 1,113 680 433 24 54 355
7....................................................... 1,179 747 432 27 60 345
8....................................................... 1,238 822 416 29 66 321
9....................................................... 1,300 894 406 32 72 302
10...................................................... 1,365 974 391 35 78 278
Cumulative PV through Year 10 as of CSA Start Date...... 3,312 2,385 927 124 191 612
--------------------------------------------------------------------------------------------------------------------------------------------------------
(vi) The periodic adjustments are calculated in a series of steps
set out in paragraph (i)(6)(v)(A) of this section. First, a lump sum for
the PCT Payment is determined using the adjusted residual profit split
method. Under the method, based on the considerations discussed in
paragraph (g)(2)(v) of this section, the appropriate discount rate is
15% per year. The nonroutine residual divisional profit or loss
described in paragraph (g)(7)(iii)(B) of this section is $612 million.
Further, under paragraph (g)(7)(iii)(C) of this
[[Page 727]]
section, the entire nonroutine residual divisional profit constitutes
the PCT Payment because only USP has nonroutine contributions.
(vii) In step two, the first step result ($612 million) is converted
into a level royalty rate based on the reasonably anticipated divisional
profit or losses of the CSA Activity, the PV of which is reported in the
table above (net PV of divisional profit or loss for Years 1 through 10
is $927 million). Consequently, the step two result is a level royalty
rate of 66.0% ($612/$927) of the divisional profit in Years 1 through
10.
(viii) In step three, the Commissioner calculates the PCT Payments
due through Year 6 by applying the step two royalty rate to the actual
divisional profits for each year and then determines the aggregate PV of
these PCT Payments as of the CSA Start Date ($224 million as reported in
the following table). In step four, the PCT Payments actually made
through Year 6 are similarly converted to PV as of the CSA Start Date
($74 million) and subtracted from the amount determined in step three
($224 million--$74 million = $150 million). That difference of $150
million, representing a net PV as of the CSA Start Date, is then
converted to a nominal amount, as of the Adjustment Year, of equivalent
present value (again using a discount rate of 15%). That nominal amount
is $302 million (not shown in the table), and is the periodic adjustment
in Year 6.
----------------------------------------------------------------------------------------------------------------
a b c d e
----------------------------------------------------------------------------------------------------------------
Nominal royalty
Year Divisional profit Royalty rate due under adjusted Nominal payments
RPSM (b*c) made
----------------------------------------------------------------------------------------------------------------
Year 1.......................... 0 66.0 $0 $40
Year 2.......................... 0 66.0 0 10
Year 3.......................... 0 66.0 0 10
Year 4.......................... 43 66.0 28 10
Year 5.......................... 168 66.0 111 10
Year 6.......................... 433 66.0 286 10
Cumulative PV as of Year 1...... .................. .................. 224 74
----------------------------------------------------------------------------------------------------------------
(ix) Under step five, the royalties due from FS to USP for Year 7
(the year after the Adjustment Year) through Year 9 (the year including
the Determination Date) are determined. (These determinations are made
for Years 8 and 9 after the divisional profit for those years becomes
available.) For each year, the periodic adjustment is a PCT Payment due
in addition to the $10 million PCT Payment that must otherwise be paid
under the CSA as described in paragraph (i) of this Example 1. That
periodic adjustment is calculated as the product of the step two royalty
rate and the divisional profit, minus the $10 million that was otherwise
paid for that year. The calculations are shown in the following table:
--------------------------------------------------------------------------------------------------------------------------------------------------------
a b c d e f
--------------------------------------------------------------------------------------------------------------------------------------------------------
Divisional Royalty due PCT Payments Periodic
Year profit Royalty rate (b*c) otherwise paid adjustment d-e)
--------------------------------------------------------------------------------------------------------------------------------------------------------
7............................................................. 432 66.0% $285 $10 $275
8............................................................. 416 66.0 275 10 265
9............................................................. 406 66.0 268 10 258
--------------------------------------------------------------------------------------------------------------------------------------------------------
(x) Under step six, the periodic adjustment for Year 10 (the only
exploitation year after the year containing the Determination Date) will
be determined by applying the step two royalty rate to the divisional
profit. This periodic adjustment is a PCT Payment payable from FS to
USP, and is in lieu of the $10 payment otherwise due. The calculations
are shown in the following table, based on a divisional profit of $391
million. USP and FS experienced the following results in Year 10.
--------------------------------------------------------------------------------------------------------------------------------------------------------
PCT payment
called for under
Year Divisional Royalty rate Royalty due original Periodic
profit agreement but adjustment
not made
--------------------------------------------------------------------------------------------------------------------------------------------------------
10............................................................ 391 66.0% $258 $10 (not paid) $258
--------------------------------------------------------------------------------------------------------------------------------------------------------
[[Page 728]]
Example 2. The facts are the same as in paragraphs (i) through (iii)
of Example 1. At the time of the Determination Date, it is determined
that the first Adjustment Year in which a Periodic Trigger occurred was
Year 6, when the AERR of FS was determined to be 2.73. Upon further
investigation as to what may have caused the high return in FS's market,
the Commissioner learns that, in Years 4 through 6, USP's leading
competitors experienced severe, unforeseen disruptions in their supply
chains resulting in a significant increase in USP's and FS's market
share for cell phones. Further analysis determines that without this
unforeseen occurrence the Periodic Trigger would not have occurred.
Based on paragraph (i)(6)(vi)(A)(2) of this section, the Commissioner
determines to his satisfaction that no adjustments are warranted.
Example 3. (i) USP, a U.S. corporation, and its wholly-owned foreign
subsidiaries FS1, FS2, and FS3 enter into a CSA at the start of Year 1
to develop version 2.0 of a computer program. USP makes a platform
contribution, version 1.0 of the program (upon which version 2.0 will be
based), for which compensation is due from FS1, FS2, and FS3. None of
the foreign subsidiaries makes any platform contributions.
(ii) In Year 6, the Commissioner audits Years 3 through 5 of the CSA
and considers whether any periodic adjustments should be made. At the
time of the Determination Date, the Commissioner determines that the
first Adjustment Year in which a Periodic Trigger occurred was Year 3,
and further determines that none of the exceptions to periodic
adjustments described in paragraph (i)(6)(vi) of this section applies.
The Commissioner exercises his discretion under paragraph (i)(6)(i) of
this section to make periodic adjustments using Year 3 as the Adjustment
Year. Therefore, the arm's length PCT Payments from FS1, FS2, and FS3 to
USP shall be determined using the adjusted residual profit split method
described in paragraphs (g)(7)(v)(B) and (i)(6)(v)(B) of this section.
Periodic adjustments will be made for each year to the extent the PCT
Payments actually made by FS1, FS2, and FS3 differ from the PCT Payment
calculation under the adjusted residual profit split method.
(iii) The periodic adjustments are calculated in a series of steps
set out in paragraph (i)(6)(v)(A) of this section. First, a lump sum for
the PCT Payments is determined using the adjusted residual profit split
method. The following results are calculated (based on actual results
for years for which actual results are available and projected results
for all years thereafter) in order to apply the adjusted residual profit
split method (it is determined that the cost shared intangibles will be
exploited through Year 7, so the results reported in the following table
are cumulative values through Year 7):
----------------------------------------------------------------------------------------------------------------
Divisional profits Residual profits
(cumulative PV through (cumulative PV through
Participant year 7 as of the CSA year 7 as of the CSA
start date) start date)
----------------------------------------------------------------------------------------------------------------
FS1........................................................... $667 $314
FS2........................................................... 271 159
FS3........................................................... 592 295
----------------------------------------------------------------------------------------------------------------
Because only USP had nonroutine contributions, under paragraph
(g)(7)(iii)(C) of this section, the entire nonroutine residual
divisional profit constitutes the PCT Payment owed to USP. Therefore,
the present values (as of the CSA Start Date) of the PCT Payments owed
are as follows:
PCT Payment owed from FS1 to USP: $314 million
PCT Payment owed from FS2 to USP: $159 million
PCT Payment owed from FS3 to USP: $295 million
Pursuant to paragraph (i)(6)(v)(A) of this section, the steps in
paragraphs (i)(6)(v)(A)(2) through (7) of this section are performed
separately for the PCT Payments that are owed to USP by each of FS1,
FS2, and FS3.
(iv) First, the steps are performed with respect to FS1. In step
two, the first step result ($314 million) is converted into a level
royalty rate based on FS1's reasonably anticipated divisional profits or
losses through Year 7 (the PV of which is $667 million). Consequently,
the step two result is a level royalty rate of 47.1% ($314/$667) of the
divisional profits in Years 1 through 7. In step three, the Commissioner
calculates the PCT Payments due through Year 3 (the Adjustment Year) by
applying the step two royalty rate (47.1%) to FS1's actual divisional
profits for each year up to and including Year 3 and then determining
the aggregate PV of these PCT Payments as of Year 3. In step four, the
PCT Payments actually made by FS1 to USP through Year 3 are similarly
converted to a PV as of Year 3 and subtracted from the amount determined
in step three. That difference is the periodic adjustment in Year 3 with
respect to the PCT Payments made for Years 1 through 3 from FS1 to USP.
Under step five, the royalties due from FS1 to USP for Year 4 (the year
after the Adjustment Year) through Year 6 (the year including the
Determination Date) are determined. The
[[Page 729]]
periodic adjustment for each of these years is calculated as the product
of the step two royalty rate and the divisional profit for that year,
minus any actual PCT Payment made by FS1 to USP in that year. The
periodic adjustment for each such year is a PCT Payment due in addition
to the PCT Payment from FS1 to USP that was already made under the CSA.
Under step six, the periodic adjustment for Year 7 (the only
exploitation year after the year containing the Determination Date) will
be determined by applying the step two royalty rate to FS1's divisional
profit for that year. This periodic adjustment for Year 7 is a PCT
Payment payable from FS1 to USP and is in lieu of any PCT Payment from
FS1 to USP otherwise due.
(v) Next, the steps in paragraphs (i)(6)(v)(A)(2) through (7) of
this section are performed with respect to FS2. In step two, the first
step result ($159 million) is converted into a level royalty rate based
on FS2's reasonably anticipated divisional profits or losses through
Year 7 (the PV of which is $271 million). Consequently, the step two
result is a level royalty rate of 58.7% ($159/$271) of the divisional
profits in Years 1 through 7. In step three, the Commissioner calculates
the PCT Payments due through Year 3 (the Adjustment Year) by applying
the step two royalty rate (58.7%) to FS2's actual divisional profits for
each year up to and including Year 3 and then determining the aggregate
PV of these PCT Payments as of Year 3. In step four, the PCT Payments
actually made by FS2 to USP through Year 3 are similarly converted to a
PV as of Year 3 and subtracted from the amount determined in step three.
That difference is the periodic adjustment in Year 3 with respect to the
PCT Payments made for Years 1 through 3 from FS2 to USP. Under step
five, the royalties due from FS2 to USP for Year 4 (the year after the
Adjustment Year) through Year 6 (the year including the Determination
Date) are determined. The periodic adjustment for each of these years is
calculated as the product of the step two royalty rate and the
divisional profit for that year, minus any actual PCT Payment made by
FS2 to USP in that year. The periodic adjustment for each such year is a
PCT Payment due in addition to the PCT Payment from FS2 to USP that was
already made under the CSA. Under step six, the periodic adjustment for
Year 7 (the only exploitation year after the year containing the
Determination Date) will be determined by applying the step two royalty
rate to FS2's divisional profit for that year. This periodic adjustment
for Year 7 is a PCT Payment payable from FS2 to USP and is in lieu of
any PCT Payment from FS2 to USP otherwise due.
(vi) Finally, the steps in paragraphs (i)(6)(v)(A)(2) through (7) of
this section are performed with respect to FS3. In step two, the first
step result ($295 million) is converted into a level royalty rate based
on FS3's reasonably anticipated divisional profits or losses through
Year 7 (the PV of which is $592 million). Consequently, the step two
result is a level royalty rate of 49.8% ($295/$592) of the divisional
profits in Years 1 through 7. In step three, the Commissioner calculates
the PCT Payments due through Year 3 (the Adjustment Year) by applying
the step two royalty rate (49.8%) to FS3's actual divisional profits for
each year up to and including Year 3 and then determining the aggregate
PV of these PCT Payments as of Year 3. In step four, the PCT Payments
actually made by FS3 to USP through Year 3 are similarly converted to a
PV as of Year 3 and subtracted from the amount determined in step three.
That difference is the periodic adjustment in Year 3 with respect to the
PCT Payments made for Years 1 through 3 from FS3 to USP. Under step
five, the royalties due from FS3 to USP for Year 4 (the year after the
Adjustment Year) through Year 6 (the year including the Determination
Date) are determined. The periodic adjustment for each of these years is
calculated as the product of the step two royalty rate and the
divisional profit for that year, minus any actual PCT Payment made by
FS3 to USP in that year. The periodic adjustment for each such year is a
PCT Payment due in addition to the PCT Payment from FS3 to USP that was
already made under the CSA. Under step six, the periodic adjustment for
Year 7 (the only exploitation year after the year containing the
Determination Date) will be determined by applying the step two royalty
rate to FS3's divisional profit for that year. This periodic adjustment
for Year 7 is a PCT Payment payable from FS3 to USP and is in lieu of
any PCT Payment from FS3 to USP otherwise due.
(j) Definitions and special rules--(1) Definitions--(i) In general.
For purposes of this section--
------------------------------------------------------------------------
Main cross
Term Definition references
------------------------------------------------------------------------
Acquisition price........... .................... Sec. 1.482-
7(g)(5)(i).
Adjusted acquisition price.. .................... Sec. 1.482-
7(g)(5)(iii).
Adjusted average market .................... Sec. 1.482-
capitalization. 7(g)(6)(iv).
Adjusted benefit shares..... .................... Sec. 1.482-
7(i)(2)(ii)(A).
Adjusted RPSM............... .................... Sec. 1.482-
7(i)(6)(v)(B).
Adjustment Year............. .................... Sec. 1.482-
7(i)(6)(i).
ADR......................... .................... Sec. 1.482-
7(i)(6)(iv).
AERR........................ .................... Sec. 1.482-
7(i)(6)(iii).
[[Page 730]]
Applicable Method........... .................... Sec. 1.482-
7(g)(2)(ix)(A).
Average market .................... Sec. 1.482-
capitalization. 7(g)(6)(iii).
Benefits.................... Benefits mean the Sec. 1.482-
sum of additional 7(e)(1)(i).
revenue generated,
plus cost savings,
minus any cost
increases from
exploiting cost
shared intangibles.
Capability variation........ .................... Sec. 1.482-
7(f)(3).
Change in participation .................... Sec. 1.482-7(f).
under a CSA.
Consolidated group.......... .................... Sec. 1.482-
7(j)(2)(i).
Contingent payments......... .................... Sec. 1.482-
7(h)(2)(i)(B).
Controlled participant...... Controlled Sec. 1.482-
participant means a 7(a)(1).
controlled
taxpayer, as
defined under Sec.
1.482-1(i)(5),
that is a party to
the contractual
agreement that
underlies the CSA,
and that reasonably
anticipates that it
will derive
benefits, as
defined in
paragraph (e)(1)(i)
of this section,
from exploiting one
or more cost shared
intangibles.
Controlled transfer of .................... Sec. 1.482-
interests. 7(f)(2).
Cost contribution........... .................... Sec. 1.482-
7(d)(4).
Cost shared intangible...... Cost shared Sec. 1.482-7(b).
intangible means
any intangible,
within the meaning
of Sec. 1.482-
4(b), that is
developed by the
IDA, including any
portion of such
intangible that
reflects a platform
contribution.
Therefore, an
intangible
developed by the
IDA is a cost
shared intangible
even though the
intangible was not
always or was never
a reasonably
anticipated cost
shared intangible.
Cost sharing alternative.... .................... Sec. 1.482-
7(g)(4)(i)(B).
Cost sharing arrangement or .................... Sec. 1.482-7(a),
CSA. (b).
Cost sharing transactions or .................... Sec. 1.482-
CSTs. 7(a)(1), (b)(1)(i).
Cross operating A cross operating Sec. 1.482-
contributions. contribution is any 7(a)(3)(iii),
resource or (g)(2)(iv).
capability or
right, other than a
platform
contribution, that
a controlled
participant has
developed,
maintained, or
acquired prior to
the CSA Start Date,
or subsequent to
the CSA start date
by means other than
operating cost
contributions or
cost contributions,
that is reasonably
anticipated to
contribute to the
CSA Activity within
another controlled
participant's
division.
CSA Activity................ CSA Activity is the Sec. 1.482-
activity of 7(c)(2)(i).
developing and
exploiting cost
shared intangibles.
CSA Start Date.............. The CSA Start Date Sec. 1.482-
is the earlier of 7(i)(6)(iii)(B) and
the date of the CSA (k)(1)(ii) and
contract or the (iii).
first occurrence of
any IDC to which
the CSA applies, in
accordance with
Sec. 1.482-
7(k)(1)(iii).
CST Payments................ .................... Sec. 1.482-
7(b)(1).
Date of PCT................. .................... Sec. 1.482-
7(b)(3).
Determination Date.......... .................... Sec. 1.482-
7(i)(6)(i).
Differential income stream.. .................... Sec. 1.482-
7(g)(4)(vi)(F)(2).
Division.................... Division means the See definitions of
territory or other divisional profit
division that or loss, operating
serves as the basis contribution, and
of the division of operating cost
interests under the contribution.
CSA in the cost
shared intangibles
pursuant to Sec.
1.482-7(b)(4).
Divisional interest......... .................... Sec. 1.482-
7(b)(1)(iii),
(b)(4).
Divisional profit or loss... Divisional profit or Sec. 1.482-
loss means the 7(g)(4)(iii).
operating profit or
loss as separately
earned by each
controlled
participant in its
division from the
CSA Activity,
determined before
any expense
(including
amortization) on
account of cost
contributions,
operating cost
contributions,
routine platform
and operating
contributions,
nonroutine
contributions
(including platform
and operating
contributions), and
tax.
[[Page 731]]
Fixed payments.............. .................... Sec. 1.482-
7(h)(2)(i)(A).
Implied discount rate....... .................... Sec. 1.482-
7(g)(2)(v)(B)(2).
IDC share................... .................... Sec. 1.482-
7(d)(4).
Input parameters............ .................... Sec. 1.482-
7(g)(2)(ix)(B).
Intangible development .................... Sec. 1.482-
activity or IDA. 7(d)(1).
Intangible development costs .................... Sec. 1.482-
or IDCs. 7(a)(1), (d)(1).
Licensing alternative....... .................... Sec. 1.482-
7(g)(4)(i)(C).
Licensing payments.......... Licensing payments Sec. 1.482-
means payments 7(g)(4)(iii).
pursuant to the
licensing
obligations under
the licensing
alternative.
Make-or-sell rights......... .................... Sec. 1.482-
7(c)(4),
(g)(2)(iv).
Market-based input parameter .................... Sec. 1.482-
7(g)(2)(ix)(B).
Market returns for routine Market returns for Sec. 1.482-
contributions routine 7(g)(4), (g)(7).
contributions means
returns determined
by reference to the
returns achieved by
uncontrolled
taxpayers engaged
in activities
similar to the
relevant business
activity in the
controlled
participant's
division,
consistent with the
methods described
in Sec. Sec.
1.482-3, 1.482-4,
1.482-5, or Sec.
1.482-9(c).
Method payment form......... .................... Sec. 1.482-
7(h)(3).
Nonroutine contributions.... Nonroutine Sec. 1.482-7(g).
contributions means
a controlled
participant's
contributions to
the relevant
business activities
that are not
routine
contributions.
Nonroutine
contributions
ordinarily include
both nonroutine
platform
contributions and
nonroutine
operating
contributions used
by controlled
participants in the
commercial
exploitation of
their interests in
the cost shared
intangibles (for
example, marketing
intangibles used by
a controlled
participant in its
division to sell
products that are
based on the cost
shared intangible).
Nonroutine residual .................... Sec. 1.482-
divisional profit or loss. 7(g)(7)(iii).
Operating contributions..... An operating Sec. 1.482-
contribution is any 7(g)(2)(ii),
resource or (g)(4)(vi)(E),
capability or (g)(7)(iii)(A) and
right, other than a (C).
platform
contribution, that
a controlled
participant has
developed,
maintained, or
acquired prior to
the CSA Start Date,
or subsequent to
the CSA Start Date
by means other than
operating cost
contributions or
cost contributions,
that is reasonably
anticipated to
contribute to the
CSA Activity within
the controlled
participant's
division.
Operating cost contributions Operating cost Sec. 1.482-
contributions means 7(g)(2)(ii),
all costs in the (g)(4)(iii),
ordinary course of (g)(7)(iii)(B).
business on or
after the CSA Start
Date that, based on
analysis of the
facts and
circumstances, are
directly identified
with, or are
reasonably
allocable to,
developing
resources,
capabilities, or
rights (other than
reasonably
anticipated cost
shared intangibles)
that are reasonably
anticipated to
contribute to the
CSA Activity within
the controlled
participant's
division.
PCT Payee................... .................... Sec. 1.482-
7(b)(1)(ii).
PCT Payment................. .................... Sec. 1.482-
7(b)(1)(ii).
PCT Payor................... .................... Sec. 1.482-
7(b)(1)(ii),
(i)(6)(i).
PCT Payor WACC.............. .................... Sec. 1.482-
7(i)(6)(iv)(D).
Periodic adjustments........ .................... Sec. 1.482-
7(i)(6)(i).
Periodic Trigger............ .................... Sec. 1.482-
7(i)(6)(i).
Platform contribution .................... Sec. 1.482-
transaction or PCT. 7(a)(2),
(b)(1)(ii).
Platform contributions...... .................... Sec. 1.482-
7(c)(1).
Post-tax income............. .................... Sec. 1.482-
7(g)(2)(v)(B)(4),
(g)(4)(i)(G).
Pre-tax income.............. .................... Sec. 1.482-
7(g)(2)(v)(B)(4),
(g)(4)(i)(G).
Projected benefit shares.... .................... Sec. 1.482-
7(i)(2)(ii)(A).
PRRR........................ .................... Sec. 1.482-
7(i)(6)(ii).
[[Page 732]]
PVI......................... .................... Sec. 1.482-
7(i)(6)(iii)(C).
PVTP........................ .................... Sec. 1.482-
7(i)(6)(iii)(B).
Reasonably anticipated A controlled Sec. 1.482-
benefits. participant's 7(e)(1).
reasonably
anticipated
benefits mean the
benefits that
reasonably may be
anticipated to be
derived from
exploiting cost
shared intangibles.
For purposes of
this definition,
benefits mean the
sum of additional
revenue generated,
plus cost savings,
minus any cost
increases from
exploiting cost
shared intangibles.
Reasonably anticipated .................... Sec. 1.482-
benefits or RAB shares. 7(a)(1), (e)(1).
Reasonably anticipated cost .................... Sec. 1.482-
shared intangible. 7(d)(1)(ii).
Relevant business activity.. .................... Sec. 1.482-
7(g)(7)(i).
Routine contributions....... Routine Sec. 1.482-
contributions means 7(g)(4), (g)(7).
a controlled
participant's
contributions to
the relevant
business activities
that are of the
same or similar
kind to those made
by uncontrolled
taxpayers involved
in similar business
activities for
which it is
possible to
identify market
returns. Routine
contributions
ordinarily include
contributions of
tangible property,
services and
intangibles that
are generally owned
by uncontrolled
taxpayers engaged
in similar
activities. A
functional analysis
is required to
identify these
contributions
according to the
functions
performed, risks
assumed, and
resources employed
by each of the
controlled
participants.
Routine platform and .................... Sec. 1.482-
operating contributions, 7(g)(4)(vii), 1.482-
and net routine platform 7(g)(7)(iii)(C)(4).
and operating contributions.
Specified payment form...... .................... Sec. 1.482-
7(h)(3).
Stock-based compensation.... .................... Sec. 1.482-
7(d)(3).
Stock options............... .................... Sec. 1.482-
7(d)(3)(i).
Subsequent PCT.............. .................... Sec. 1.482-
7(g)(2)(viii).
Target...................... .................... Sec. 1.482-
7(g)(5)(i).
Tax rate.................... Reasonably Sec. 1.482-
anticipated 7(g)(2)(v)(B)(4)(ii
effective tax rate ), (g)(4)(i)(G).
with respect to the
pre-tax income to
which the tax rate
is being applied.
For example, under
the income method,
this rate would be
the reasonably
anticipated
effective tax rate
of the PCT Payor or
PCT Payee under the
cost sharing
alternative or the
licensing
alternative, as
appropriate.
Trigger PCT................. .................... Sec. 1.482-
7(i)(6)(i).
Variable input parameter.... .................... Sec. 1.482-
7(g)(2)(ix)(C).
WACC........................ WACC means weighted Sec. 1.482-
average cost of 7(i)(6)(iv)(D).
capital.
------------------------------------------------------------------------
(ii) Examples. The following examples illustrate certain definitions
in paragraph (j)(1)(i) of this section:
Example 1. Controlled participant. Foreign Parent (FP) is a foreign
corporation engaged in the extraction of a natural resource. FP has a
U.S. subsidiary (USS) to which FP sells supplies of this resource for
sale in the United States. FP enters into a CSA with USS to develop a
new machine to extract the natural resource. The machine uses a new
extraction process that will be patented in the United States and in
other countries. The CSA provides that USS will receive the rights to
exploit the machine in the extraction of the natural resource in the
United States, and FP will receive the rights in the rest of the world.
This resource does not, however, exist in the United States. Despite the
fact that USS has received the right to exploit this process in the
United States, USS is not a controlled participant because it will not
derive a benefit from exploiting the intangible developed under the CSA.
[[Page 733]]
Example 2. Controlled participants. (i) U.S. Parent (USP), one
foreign subsidiary (FS), and a second foreign subsidiary constituting
the group's research arm (R + D) enter into a CSA to develop
manufacturing intangibles for a new product line A. USP and FS are
assigned the exclusive rights to exploit the intangibles respectively in
the United States and the rest of the world, where each presently
manufactures and sells various existing product lines. R + D is not
assigned any rights to exploit the intangibles. R + D's activity
consists solely in carrying out research for the group. It is reliably
projected that the RAB shares of USP and FS will be 66\2/3\% and 33\1/
3\%, respectively, and the parties' agreement provides that USP and FS
will reimburse 66\2/3\% and 33\1/3\%, respectively, of the IDCs incurred
by R + D with respect to the new intangible.
(ii) R + D does not qualify as a controlled participant within the
meaning of paragraph (j)(1)(i) of this section, because it will not
derive any benefits from exploiting cost shared intangibles. Therefore,
R + D is treated as a service provider for purposes of this section and
must receive arm's length consideration for the assistance it is deemed
to provide to USP and FS, under the rules of paragraph (a)(3) of this
section and Sec. Sec. 1.482-4(f)(3)(iii) and (4), and 1.482-9, as
appropriate. Such consideration must be treated as IDCs incurred by USP
and FS in proportion to their RAB shares (that is, 66\2/3\% and 33\1/
3\%, respectively). R + D will not be considered to bear any share of
the IDCs under the arrangement.
Example 3. Cost shared intangible, reasonably anticipated cost
shared intangible. U.S. Parent (USP) has developed and currently
exploits an antihistamine, XY, which is manufactured in tablet form. USP
enters into a CSA with its wholly-owned foreign subsidiary (FS) to
develop XYZ, a new improved version of XY that will be manufactured as a
nasal spray. Work under the CSA is fully devoted to developing XYZ, and
XYZ is developed. During the development period, XYZ is a reasonably
anticipated cost shared intangible under the CSA. Once developed, XYZ is
a cost shared intangible under the CSA.
Example 4. Cost shared intangible. The facts are the same as in
Example 3, except that in the course of developing XYZ, the controlled
participants by accident discover ABC, a cure for disease D. ABC is a
cost shared intangible under the CSA.
Example 5. Reasonably anticipated benefits. Controlled parties A and
B enter into a cost sharing arrangement to develop product and process
intangibles for an already existing Product P. Without such intangibles,
A and B would each reasonably anticipate revenue, in present value
terms, of $100M from sales of Product P until it became obsolete. With
the intangibles, A and B each reasonably anticipate selling the same
number of units each year, but reasonably anticipate that the price will
be higher. Because the particular product intangible is more highly
regarded in A's market, A reasonably anticipates an increase of $20M in
present value revenue from the product intangible, while B reasonably
anticipates only an increase of $10M. Further, A and B each reasonably
anticipate spending an extra $5M present value in production costs to
include the feature embodying the product intangible. Finally, A and B
each reasonably anticipate saving $2M present value in production costs
by using the process intangible. A and B reasonably anticipate no other
economic effects from exploiting the cost shared intangibles. A's
reasonably anticipated benefits from exploiting the cost shared
intangibles equal its reasonably anticipated increase in revenue ($20M)
plus its reasonably anticipated cost savings ($2M) minus its reasonably
anticipated increased costs ($5M), which equals $17M. Similarly, B's
reasonably anticipated benefits from exploiting the cost shared
intangibles equal its reasonably anticipated increase in revenue ($10M)
plus its reasonably anticipated cost savings ($2M) minus its reasonably
anticipated increased costs ($5M), which equals $7M. Thus A's reasonably
anticipated benefits are $17M and B's reasonably anticipated benefits
are $7M.
(2) Special rules--(i) Consolidated group. For purposes of this
section, all members of the same consolidated group shall be treated as
one taxpayer. For these purposes, the term consolidated group means all
members of a group of controlled entities created or organized within a
single country and subjected to an income tax by such country on the
basis of their combined income.
(ii) Trade or business. A participant that is a foreign corporation
or nonresident alien individual will not be treated as engaged in a
trade or business within the United States solely by reason of its
participation in a CSA. See generally Sec. 1.864-2(a).
(iii) Partnership. A CSA, or an arrangement to which the
Commissioner applies the rules of this section, will not be treated as a
partnership to which the rules of subchapter K of the Internal Revenue
Code apply. See Sec. 301.7701-1(c) of this chapter.
(3) Character--(i) CST Payments. CST Payments generally will be
considered
[[Page 734]]
the payor's costs of developing intangibles at the location where such
development is conducted. For these purposes, IDCs borne directly by a
controlled participant that are deductible are deemed to be reduced to
the extent of any CST Payments owed to it by other controlled
participants pursuant to the CSA. Each cost sharing payment received by
a payee will be treated as coming pro rata from payments made by all
payors and will be applied pro rata against the deductions for the
taxable year that the payee is allowed in connection with the IDCs.
Payments received in excess of such deductions will be treated as in
consideration for use of the land and tangible property furnished for
purposes of the CSA by the payee. For purposes of the research credit
determined under section 41, CST Payments among controlled participants
will be treated as provided for intra-group transactions in Sec. 1.41-
6(i). Any payment made or received by a taxpayer pursuant to an
arrangement that the Commissioner determines not to be a CSA will be
subject to the provisions of Sec. Sec. 1.482-1 through 1.482-6 and
1.482-9. Any payment that in substance constitutes a cost sharing
payment will be treated as such for purposes of this section, regardless
of its characterization under foreign law.
(ii) PCT Payments. A PCT Payor's payment required under paragraph
(b)(1)(ii) of this section is deemed to be reduced to the extent of any
payments owed to it under such paragraph from other controlled
participants. Each PCT Payment received by a PCT Payee will be treated
as coming pro rata out of payments made by all PCT Payors. PCT Payments
will be characterized consistently with the designation of the type of
transaction pursuant to paragraphs (c)(3) and (k)(2)(ii)(H) of this
section. Depending on such designation, such payments will be treated as
either consideration for a transfer of an interest in intangible
property or for services.
(iii) Examples. The following examples illustrate this paragraph
(j)(3):
Example 1. U.S. Parent (USP) and its wholly owned Foreign Subsidiary
(FS) form a CSA to develop a miniature widget, the Small R. Based on RAB
shares, USP agrees to bear 40% and FS to bear 60% of the costs incurred
during the term of the agreement. The principal IDCs are operating costs
incurred by FS in Country Z of 100X annually, and costs incurred by USP
in the United States also of 100X annually. Of the total costs of 200X,
USP's share is 80X and FS's share is 120X so that FS must make a payment
to USP of 20X. The payment will be treated as a reimbursement of 20X of
USP's costs in the United States. Accordingly, USP's Form 1120 will
reflect an 80X deduction on account of activities performed in the
United States for purposes of allocation and apportionment of the
deduction to source. The Form 5471 ``Information Return of U.S. Persons
With Respect to Certain Foreign Corporations'' for FS will reflect a
100X deduction on account of activities performed in Country Z and a 20X
deduction on account of activities performed in the United States.
Example 2. The facts are the same as in Example 1, except that the
100X of costs borne by USP consist of 5X of costs incurred by USP in the
United States and 95X of arm's length rental charge, as described in
paragraph (d)(1)(iii) of this section, for the use of a facility in the
United States. The depreciation deduction attributable to the U.S.
facility is 7X. The 20X net payment by FS to USP will first be applied
in reduction pro rata of the 5X deduction for costs and the 7X
depreciation deduction attributable to the U.S. facility. The 8X
remainder will be treated as rent for the U.S. facility.
Example 3. (i) Four members (A, B, C, and D) of a controlled group
form a CSA to develop the next generation technology for their business.
Based on RAB shares, the participants agree to bear shares of the costs
incurred during the term of the agreement in the following percentages:
A 40%; B 15%; C 25%; and D 20%. The arm's length values of the platform
contributions they respectively own are in the following amounts for the
taxable year: A 80X; B 40X; C 30X; and D 30X. The provisional (before
offsets) and final PCT Payments among A, B, C, and D are shown in the
table as follows:
(All amounts stated in X's)
------------------------------------------------------------------------
A B C D
------------------------------------------------------------------------
Payments............................ <40
Sec. 1.482-8 Examples of the best method rule.
(a) Introduction. In accordance with the best method rule of Sec.
1.482-1(c), a method may be applied in a particular case only if the
comparability, quality of data, and reliability of assumptions under
that method make it more reliable than any other available measure of
the arm's length result. The following examples illustrate the
comparative analysis required to apply this rule. As with all of the
examples in these regulations, these examples are based on simplified
facts, are provided solely for purposes of illustrating the type of
analysis required under the relevant rule, and do not provide rules of
general application. Thus, conclusions reached in these examples as to
the relative reliability of methods are based on the assumed facts of
the examples, and are not general conclusions concerning the relative
reliability of any method.
(b) Examples.
Example 1. Preference for comparable uncontrolled price method.
Company A is the U.S. distribution subsidiary of Company B, a foreign
manufacturer of consumer electrical appliances. Company A purchases
toaster ovens from Company B for resale in the U.S. market. To exploit
other outlets for its toaster ovens, Company B also sells its toaster
ovens to Company C, an unrelated U.S. distributor of toaster ovens. The
products sold to Company A and Company C are identical in every respect
and there are no material differences between the transactions. In this
case application of the CUP method, using the sales of toaster ovens to
Company C, generally will provide a more reliable measure of an arm's
length result for the controlled sale of toaster ovens to Company A than
the application of any other method. See Sec. Sec. 1.482-1(c)(2)(i) and
-3(b)(2)(ii)(A).
Example 2. Resale price method preferred to comparable uncontrolled
price method. The facts are the same as in Example 1, except that the
toaster ovens sold to Company A are of substantially higher quality than
those sold to Company C and the effect on price of such quality
differences cannot be accurately determined. In addition, in order to
round out its line of consumer appliances Company A purchases blenders
from unrelated parties for resale in the United States. The blenders are
resold to substantially the same customers as the toaster ovens, have a
similar resale value to the toaster ovens, and are purchased under
similar terms and in similar volumes. The distribution functions
performed by Company A appear to be similar for toaster ovens and
blenders. Given the product differences between the toaster ovens,
application of the resale price method using the purchases and resales
of blenders as the uncontrolled comparables is likely to provide a more
reliable measure of an arm's length result than application of the
comparable uncontrolled price method using Company B's sales of toaster
ovens to Company C.
Example 3. Resale price method preferred to comparable profits
method. (i) The facts are the same as in Example 2 except that Company A
purchases all its products from Company B and Company B makes no
uncontrolled sales into the United States. However, six uncontrolled
U.S. distributors are identified that purchase a similar line of
products from unrelated parties. The uncontrolled distributors purchase
toaster ovens from unrelated parties, but there are significant
differences in the characteristics of the toaster ovens, including the
brandnames under which they are sold.
[[Page 741]]
(ii) Under the facts of this case, reliable adjustments for the
effect of the different brandnames cannot be made. Except for some
differences in payment terms and inventory levels, the purchases and
resales of toaster ovens by the three uncontrolled distributors are
closely similar to the controlled purchases in terms of the markets in
which they occur, the volume of the transactions, the marketing
activities undertaken by the distributor, inventory levels, warranties,
allocation of currency risk, and other relevant functions and risks.
Reliable adjustments can be made for the differences in payment terms
and inventory levels. In addition, sufficiently detailed accounting
information is available to permit adjustments to be made for
differences in accounting methods or in reporting of costs between cost
of goods sold and operating expenses. There are no other material
differences between the controlled and uncontrolled transactions.
(iii) Because reliable adjustments for the differences between the
toaster ovens, including the trademarks under which they are sold,
cannot be made, these uncontrolled transactions will not serve as
reliable measures of an arm's length result under the comparable
uncontrolled price method. There is, however, close functional
similarity between the controlled and uncontrolled transactions and
reliable adjustments have been made for material differences that would
be likely to affect gross profit. Under these circumstances, the gross
profit margins derived under the resale price method are less likely to
be susceptible to any unidentified differences than the operating profit
measures used under the comparable profits method. Therefore, given the
close functional comparability between the controlled and uncontrolled
transactions, and the high quality of the data, the resale price method
achieves a higher degree of comparability and will provide a more
reliable measure of an arm's length result. See Sec. 1.482-1(c) (Best
method rule).
Example 4. Comparable profits method preferred to resale price
method. The facts are the same as in Example 3, except that the
accounting information available for the uncontrolled comparables is not
sufficiently detailed to ensure consistent reporting between cost of
goods sold and operating expenses of material items such as discounts,
insurance, warranty costs, and supervisory, general and administrative
expenses. These expenses are significant in amount. Therefore, whether
these expenses are treated as costs of goods sold or operating expenses
would have a significant effect on gross margins. Because in this case
reliable adjustments can not be made for such accounting differences,
the reliability of the resale price method is significantly reduced.
There is, however, close functional similarity between the controlled
and uncontrolled transactions and reliable adjustments have been made
for all material differences other than the potential accounting
differences. Because the comparable profits method is not adversely
affected by the potential accounting differences, under these
circumstances the comparable profits method is likely to produce a more
reliable measure of an arm's length result than the resale price method.
See Sec. 1.482-1(c) (Best method rule).
Example 5. Cost plus method preferred to comparable profits method.
(i) USS is a U.S. company that manufactures machine tool parts and sells
them to its foreign parent corporation, FP. Four U.S. companies are
identified that also manufacture various types of machine tool parts but
sell them to uncontrolled purchasers.
(ii) Except for some differences in payment terms, the manufacture
and sales of machine tool parts by the four uncontrolled companies are
closely similar to the controlled transactions in terms of the functions
performed and risks assumed. Reliable adjustments can be made for the
differences in payment terms. In addition, sufficiently detailed
accounting information is available to permit adjustments to be made for
differences between the controlled transaction and the uncontrolled
comparables in accounting methods and in the reporting of costs between
cost of goods sold and operating expenses.
(iii) There is close functional similarity between the controlled
and uncontrolled transactions and reliable adjustments can be made for
material differences that would be likely to affect gross profit. Under
these circumstances, the gross profit markups derived under the cost
plus method are less likely to be susceptible to any unidentified
differences than the operating profit measures used under the comparable
profits method. Therefore, given the close functional comparability
between the controlled and uncontrolled transactions, and the high
quality of the data, the cost plus method achieves a higher degree of
comparability and will provide a more reliable measure of an arm's
length result. See Sec. 1.482-1(c) (Best method rule).
Example 6. Comparable profits method preferred to cost plus method.
The facts are the same as in Example 5, except that there are
significant differences between the controlled and uncontrolled
transactions in terms of the types of parts and components manufactured
and the complexity of the manufacturing process. The resulting
functional differences are likely to materially affect gross profit
margins, but it is not possible to identify the specific differences and
reliably adjust for their effect on gross profit. Because these
functional differences would be reflected in differences in operating
expenses, the operating profit measures used
[[Page 742]]
under the comparable profits method implicitly reflect to some extent
these functional differences. Therefore, because in this case the
comparable profits method is less sensitive than the cost plus method to
the potentially significant functional differences between the
controlled and uncontrolled transactions, the comparable profits method
is likely to produce a more reliable measure of an arm's length result
than the cost plus method. See Sec. 1.482-1(c) (Best method rule).
Example 7. Preference for comparable uncontrolled transaction
method. (i) USpharm, a U.S. pharmaceutical company, develops a new drug
Z that is a safe and effective treatment for the disease zeezee. USpharm
has obtained patents covering drug Z in the United States and in various
foreign countries. USpharm has also obtained the regulatory
authorizations necessary to market drug Z in the United States and in
foreign countries.
(ii) USpharm licenses its subsidiary in country X, Xpharm, to
produce and sell drug Z in country X. At the same time, it licenses an
unrelated company, Ydrug, to produce and sell drug Z in country Y, a
neighboring country. Prior to licensing the drug, USpharm had obtained
patent protection and regulatory approvals in both countries and both
countries provide similar protection for intellectual property rights.
Country X and country Y are similar countries in terms of population,
per capita income and the incidence of disease zeezee. Consequently,
drug Z is expected to sell in similar quantities and at similar prices
in both countries. In addition, costs of producing drug Z in each
country are expected to be approximately the same.
(iii) USpharm and Xpharm establish terms for the license of drug Z
that are identical in every material respect, including royalty rate, to
the terms established between USpharm and Ydrug. In this case the
district director determines that the royalty rate established in the
Ydrug license agreement is a reliable measure of the arm's length
royalty rate for the Xpharm license agreement. Given that the same
property is transferred in the controlled and uncontrolled transactions,
and that the circumstances under which the transactions occurred are
substantially the same, in this case the comparable uncontrolled
transaction method is likely to provide a more reliable measure of an
arm's length result than any other method. See Sec. 1.482-4(c)(2)(ii).
Example 8. Residual profit split method preferred to other methods.
(i) USC is a U.S. company that develops, manufactures and sells
communications equipment. EC is the European subsidiary of USC. EC is an
established company that carries out extensive research and development
activities and develops, manufactures and sells communications equipment
in Europe. There are extensive transactions between USC and EC. USC
licenses valuable technology it has developed to EC for use in the
European market but EC also licenses valuable technology it has
developed to USC. Each company uses components manufactured by the other
in some of its products and purchases products from the other for resale
in its own market.
(ii) Detailed accounting information is available for both USC and
EC and adjustments can be made to achieve a high degree of consistency
in accounting practices between them. Relatively reliable allocations of
costs, income and assets can be made between the business activities
that are related to the controlled transactions and those that are not.
Relevant marketing and research and development expenditures can be
identified and reasonable estimates of the useful life of the related
intangibles are available so that the capitalized value of the
intangible development expenses of USC and EC can be calculated. In this
case there is no reason to believe that the relative value of these
capitalized expenses is substantially different from the relative value
of the intangible property of USC and EC. Furthermore, comparables are
identified that could be used to estimate a market return for the
routine contributions of USC and EC. Based on these facts, the residual
profit split could provide a reliable measure of an arm's length result.
(iii) There are no uncontrolled transactions involving property that
is sufficiently comparable to much of the tangible and intangible
property transferred between USC and EC to permit use of the comparable
uncontrolled price method or the comparable uncontrolled transaction
method. Uncontrolled companies are identified in Europe and the United
States that perform somewhat similar activities to USC and EC; however,
the activities of none of these companies are as complex as those of USC
and EC and they do not use similar levels of highly valuable intangible
property that they have developed themselves. Under these circumstances,
the uncontrolled companies may be useful in determining a market return
for the routine contributions of USC and EC, but that return would not
reflect the value of the intangible property employed by USC and EC.
Thus, none of the uncontrolled companies is sufficiently similar so that
reliable results would be obtained using the resale price, cost plus, or
comparable profits methods. Moreover, no uncontrolled companies can be
identified that engaged in sufficiently similar activities and
transactions with each other to employ the comparable profit split
method.
(iv) Given the difficulties in applying the other methods, the
reliability of the internal
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data on USC and EC, and the fact that acceptable comparables are
available for deriving a market return for the routine contributions of
USC and EC, the residual profit split method is likely to provide the
most reliable measure of an arm's length result in this case.
Example 9. Comparable profits method preferred to profit split. (i)
Company X is a large, complex U.S. company that carries out extensive
research and development activities and manufactures and markets a
variety of products. Company X has developed a new process by which
compact disks can be fabricated at a fraction of the cost previously
required. The process is expected to prove highly profitable, since
there is a large market for compact disks. Company X establishes a new
foreign subsidiary, Company Y, and licenses it the rights to use the
process to fabricate compact disks for the foreign market as well as
continuing technical support and improvements to the process. Company Y
uses the process to fabricate compact disks which it supplies to related
and unrelated parties.
(ii) The process licensed to Company Y is unique and highly valuable
and no uncontrolled transfers of intangible property can be found that
are sufficiently comparable to permit reliable application of the
comparable uncontrolled transaction method. Company X is a large,
complex company engaged in a variety of activities that owns unique and
highly valuable intangible property. Consequently, no uncontrolled
companies can be found that are similar to Company X. Furthermore,
application of the profit split method in this case would involve the
difficult and problematic tasks of allocating Company X's costs and
assets between the relevant business activity and other activities and
assigning a value to Company X's intangible contributions. On the other
hand, Company Y performs relatively routine manufacturing and marketing
activities and there are a number of similar uncontrolled companies.
Thus, application of the comparable profits method using Company Y as
the tested party is likely to produce a more reliable measure of an
arm's length result than a profit split in this case.
Example 10. Cost of services plus method preferred to other methods.
(i) FP designs and manufactures consumer electronic devices that
incorporate advanced technology. In year 1, FP introduces Product X, an
entertainment device targeted primarily at the youth market. FP's
wholly-owned, exclusive U.S. distributor, USSub, sells Product X in the
U.S. market. USSub hires an independent marketing firm, Agency A, to
promote Product X in the U.S. market. Agency A has successfully promoted
other electronic products on behalf of other uncontrolled parties. USSub
executes a one-year, renewable contract with Agency A that requires it
to develop the market for Product X, within an annual budget set by
USSub. In years 1 through 3, Agency A develops advertising, buys media,
and sponsors events featuring Product X. Agency A receives a markup of
25% on all expenses of promoting Product X, with the exception of media
buys, which are reimbursed at cost. During year 3, sales of Product X
decrease sharply, as Product X is displaced by competitors' products. At
the end of year 3, sales of Product X are discontinued.
(ii) Prior to the start of year 4, FP develops a new entertainment
device, Product Y. Like Product X, Product Y is intended for sale to the
youth market, but it is marketed under a new trademark distinct from
that used for Product X. USSub decides to perform all U.S. market
promotion for Product Y. USSub hires key Agency A staff members who
handled the successful Product X campaign. To promote Product Y, USSub
intends to use methods similar to those used successfully by Agency A to
promote Product X (print advertising, media, event sponsorship, etc.).
FP and USSub enter into a one-year, renewable agreement concerning
promotion of Product Y in the U.S. market. Under the agreement, FP
compensates USSub for promoting Product Y, based on a cost of services
plus markup of A%. Third-party media buys by USSub in connection with
Product Y are reimbursed at cost.
(iii) Assume that under the contractual arrangements between FP and
USSub, the arm's length consideration for Product Y and the trademark or
other intangible property may be determined reliably under one or more
transfer pricing methods. At issue in this example is the separate
evaluation of the arm's length compensation for the year 4 promotional
activities performed by USSub pursuant to its contract with FP.
(iv) USSub's accounting records contain reliable data that
separately state the costs incurred to promote Product Y. A functional
analysis indicates that USSub's activities to promote Product Y in year
4 are similar to activities performed by Agency A during years 1 through
3 under the contract with USSub. In other respects, no material
differences exist in the market conditions or the promotional activities
performed in year 4, as compared to those in years 1 through 3.
(v) It is possible to identify uncontrolled distributors or
licensees of electronic products that perform, as one component of their
business activities, promotional activities similar to those performed
by USSub. However, it is unlikely that publicly available accounting
data from these companies would allow computation of the comparable
transactional costs or total services costs associated with the
marketing or promotional activities that these entities perform, as one
component of business activities. If that
[[Page 744]]
were possible, the comparable profits method for services might provide
a reliable measure of an arm's length result. The functional analysis of
the marketing activities performed by USSub in year 4 indicates that
they are similar to the activities performed by Agency A in years 1
through 3 for Product X. Because reliable information is available
concerning the markup on costs charged in a comparable uncontrolled
transaction, the most reliable measure of an arm's length price is the
cost of services plus method in Sec. 1.482-9(e).
Example 11. CPM for services preferred to other methods. (i) FP
manufactures furniture and accessories for residential use. FP sells its
products to retailers in Europe under the trademark, ``Moda.'' FP holds
all worldwide rights to the trademark, including in the United States.
USSub is FP's wholly-owned subsidiary in the U.S. market and the
exclusive U.S. distributor of FP's merchandise. Historically, USSub
dealt only with specialized designers in the U.S. market and advertised
in trade publications targeted to this market. Although items sold in
the U.S. and Europe are physically identical, USSub's U.S. customers
generally resell the merchandise as non-branded merchandise.
(ii) FP retains an independent firm to evaluate the feasibility of
selling FP's trademarked merchandise in the general wholesale and retail
market in the United States. The study concludes that this segment of
the U.S. market, which is not exploited by USSub, may generate
substantial profits. Based on this study, FP enters into a separate
agreement with USSub, which provides that USSub will develop this market
in the United States for the benefit of FP. USSub separately accounts
for personnel expenses, overhead, and out-of-pocket costs attributable
to the initial stage of the marketing campaign (Phase I). USSub receives
as compensation its costs, plus a markup of X%, for activities in Phase
I. At the end of Phase I, FP will evaluate the program. If success
appears likely, USSub will begin full-scale distribution of trademarked
merchandise in the new market segment, pursuant to agreements negotiated
with FP at that time.
(iii) Assume that under the contractual arrangements in effect
between FP and USSub, the arm's length consideration for the merchandise
and the trademark or other intangible property may be determined
reliably under one or more transfer pricing methods. At issue in this
example is the separate evaluation of the arm's length compensation for
the marketing activities conducted by USSub in years 1 and following.
(iv) A functional analysis reveals that USSub's activities consist
primarily of modifying the promotional materials created by FP,
negotiating media buys, and arranging promotional events. FP separately
compensates USSub for all Phase I activities, and detailed accounting
information is available regarding the costs of these activities. The
Phase I activities of USSub are similar to those of uncontrolled
companies that perform, as their primary business activity, a range of
advertising and media relations activities on a contract basis for
uncontrolled parties.
(v) No information is available concerning the comparable
uncontrolled prices for services in transactions similar to those
engaged in by FP and USSub. Nor is any information available concerning
uncontrolled transactions that would allow application of the cost of
services plus method. It is possible to identify uncontrolled
distributors or licensees of home furnishings that perform, as one
component of their business activities, promotional activities similar
to those performed by USSub. However, it is unlikely that publicly
available accounting data from these companies would allow computation
of the comparable transactional costs or total services costs associated
with the marketing or promotional activities that these entities
performed, as one component of their business activities. On the other
hand, it is possible to identify uncontrolled advertising and media
relations companies, the principal business activities of which are
similar to the Phase I activities of USSub. Under these circumstances,
the most reliable measure of an arm's length price is the comparable
profits method of Sec. 1.482-9(f). The uncontrolled advertising
comparables' treatment of material items, such as classification of
items as cost of goods sold or selling, general, and administrative
expenses, may differ from that of USSub. Such inconsistencies in
accounting treatment between the uncontrolled comparables and the tested
party, or among the comparables, are less important when using the ratio
of operating profit to total services costs under the comparable profits
method for services in Sec. 1.482-9(f). Under this method, the
operating profit of USSub from the Phase I activities is compared to the
operating profit of uncontrolled parties that perform general
advertising and media relations as their primary business activity.
Example 12. Residual profit split preferred to other methods. (i)
USP is a manufacturer of athletic apparel sold under the AA trademark,
to which FP owns the worldwide rights. USP sells AA trademark apparel in
countries throughout the world, but prior to year 1, USP did not sell
its merchandise in Country X. In year 1, USP acquires an uncontrolled
Country X company which becomes its wholly-owned subsidiary, XSub. USP
enters into an exclusive distribution arrangement with XSub in Country
X. Before being acquired by USP in year 1, XSub distributed athletic
apparel purchased from uncontrolled suppliers and resold that
merchandise to retailers. After being acquired by
[[Page 745]]
USP in year 1, XSub continues to distribute merchandise from
uncontrolled suppliers and also begins to distribute AA trademark
apparel. Under a separate agreement with USP, XSub uses its best efforts
to promote the AA trademark in Country X, with the goal of maximizing
sales volume and revenues from AA merchandise.
(ii) Prior to year 1, USP executed long-term endorsement contracts
with several prominent professional athletes. These contracts give USP
the right to use the names and likenesses of the athletes in any country
in which AA merchandise is sold during the term of the contract. These
contracts remain in effect for five years, starting in year 1. Before
being acquired by USP, XSub renewed a long-term agreement with
SportMart, an uncontrolled company that owns a nationwide chain of
sporting goods retailers in Country X. XSub has been SportMart's primary
supplier from the time that SportMart began operations. Under the
agreement, SportMart will provide AA merchandise preferred shelf-space
and will feature AA merchandise at no charge in its print ads and
seasonal promotions. In consideration for these commitments, USP and
XSub grant SportMart advance access to new products and the right to use
the professional athletes under contract with USP in SportMart
advertisements featuring AA merchandise (subject to approval of content
by USP).
(iii) Assume that it is possible to segregate all transactions by
XSub that involve distribution of merchandise acquired from uncontrolled
distributors (non-controlled transactions). In addition, assume that,
apart from the activities undertaken by USP and XSub to promote AA
apparel in Country X, the arm's length compensation for other functions
performed by USP and XSub in the Country X market in years 1 and
following can be reliably determined. At issue in this Example 12 is the
application of the residual profit split analysis to determine the
appropriate division between USP and XSub of the balance of the
operating profits from the Country X market, that is the portion
attributable to nonroutine contributions to the marketing and
promotional activities.
(iv) A functional analysis of the marketing and promotional
activities conducted in the Country X market, as described in this
example, indicates that both USP and XSub made nonroutine contributions
to the business activity. USP contributed the long-term endorsement
contracts with professional athletes. XSub contributed its long-term
contractual rights with SportMart, which were made more valuable by its
successful, long-term relationship with SportMart.
(v) Based on the facts and circumstances, including the fact that
both USP and XSub made valuable nonroutine contributions to the
marketing and promotional activities and an analysis of the availability
(or lack thereof) of comparable and reliable market benchmarks, the
Commissioner determines that the most reliable measure of an arm's
length result is the residual profit split method in Sec. 1.482-9(g).
The residual profit split analysis would take into account both routine
and nonroutine contributions by USP and XSub, in order to determine an
appropriate allocation of the combined operating profits in the Country
X market from the sale of AA merchandise and from related promotional
and marketing activities.
Example 13. Preference for acquisition price method. (i) USP
develops, manufacturers, and distributes pharmaceutical products. USP
and FS, USP's wholly-owned subsidiary, enter into a CSA to develop a new
oncological drug, Oncol. Immediately prior to entering into the CSA, USP
acquires Company X, an unrelated U.S. pharmaceutical company. Company X
is solely engaged in oncological pharmaceutical research, and its only
significant resources and capabilities are its workforce and its sole
patent, which is associated with Compound X, a promising molecular
compound derived from a rare plant, which USP reasonably anticipates
will contribute to developing Oncol. All of Company X researchers will
be engaged solely in research that is reasonably anticipated to
contribute to developing Oncol as well. The rights in the Compound X and
the commitment of Company X's researchers to the development of Oncol
are platform contributions for which compensation is due from FS as part
of a PCT.
(ii) In this case, the acquisition price method, based on the lump
sum price paid by USP for Company X, is likely to provide a more
reliable measure of an arm's length PCT Payment due to USP than the
application of any other method. See Sec. Sec. 1.482-4(c)(2) and 1.482-
7(g)(5)(iv)(A).
Example 14. Preference for market capitalization method. (i) Company
X is a publicly traded U.S. company solely engaged in oncological
pharmaceutical research and its only significant resources and
capabilities are its workforce and its sole patent, which is associated
with Compound Y, a promising molecular compound derived from a rare
plant. Company X has no marketable products. Company X enters into a CSA
with FS, a newly-formed foreign subsidiary, to develop a new oncological
drug, Oncol, derived from Compound Y. Compound Y is reasonably
anticipated to contribute to developing Oncol. All of Company X
researchers will be engaged solely in research that is reasonably
anticipated to contribute to developing Oncol under the CSA. The rights
in Compound Y and the commitment of Company X's researchers are platform
contributions for which compensation is due from FS as part of a PCT.
[[Page 746]]
(ii) In this case, given that Company X's platform contributions
covered by PCTs relate to its entire economic value, the application of
the market capitalization method, based on the market capitalization of
Company X, provides a reliable measure of an arm's length result for
Company X's PCTs to the CSA. See Sec. Sec. 1.482-4(c)(2) and 1.482-
7(g)(6)(v)(A).
Example 15. Preference for market capitalization method. (i)
MicroDent, Inc. (MDI) is a publicly traded company that developed a new
dental surgical microscope ScopeX-1, which drastically shortens many
surgical procedures. On January 1 of Year 1, MDI entered into a CSA with
a wholly-owned foreign subsidiary (FS) to develop ScopeX-2, the next
generation of ScopeX-1. In the CSA, divisional interests are divided on
a territorial basis. The rights associated with ScopeX-1, as well as
MDI's research capabilities are reasonably anticipated to contribute to
the development of ScopeX-2 and are therefore platform contributions for
which compensation is due from FS as part of a PCT. At the time of the
PCT, MDI's only product was the ScopeX-I microscope, although MDI was in
the process of developing ScopeX-2. Concurrent with the CSA, MDI
separately transfers exclusive and perpetual exploitation rights
associated with ScopeX-1 to FS in the same territory as assigned to FS
in the CSA.
(ii) Although the transactions between MDI and FS under the CSA are
distinct from the transactions between MDI and FS relating to the
exploitation rights for ScopeX-1, it is likely to be more reliable to
evaluate the combined effect of the transactions than to evaluate them
in isolation. This is because the combined transactions between MDI and
FS relate to all of the economic value of MDI (that is, the exploitation
rights and research rights associated with ScopeX-1, as well as the
research capabilities of MDI). In this case, application of the market
capitalization method, based on the enterprise value of MDI on January 1
of Year 1, is likely to provide a reliable measure of an arm's length
payment for the aggregated transactions. See Sec. Sec. 1.482-4(c)(2)
and 1.482-7(g)(6)(v)(A).
(iii) Notwithstanding that the market capitalization method provides
the most reliable measure of the aggregated transactions between MDI and
FS, see Sec. 1.482-7(g)(2)(iv) for further considerations of when
further analysis may be required to distinguish between the remuneration
to MDI associated with PCTs under the CSA (for research rights and
capabilities associated with ScopeX-1) and the remuneration to MDI for
the exploitation rights associated with ScopeX-1.
Example 16. Income method (applied using CPM) preferred to
acquisition price method. The facts are the same as in Example 13,
except that the acquisition occurred significantly in advance of
formation of the CSA, and reliable adjustments cannot be made for this
time difference. In addition, Company X has other valuable molecular
patents and associated research capabilities, apart from Compound X,
that are not reasonably anticipated to contribute to the development of
Oncol and that cannot be reliably valued. The CSA divides divisional
interests on a territorial basis. Under the terms of the CSA, USP will
undertake all R&D (consisting of laboratory research and clinical
testing) and manufacturing associated with Oncol, as well as the
distribution activities for its territory (the United States). FS will
distribute Oncol in its territory (the rest of the world). FS's
distribution activities are routine in nature, and the profitability
from its activities may be reliably determined from third-party
comparables. FS does not furnish any platform contributions. At the time
of the PCT, reliable (ex ante) financial projections associated with the
development of Oncol and its separate exploitation in each of USP's and
FSub's assigned geographical territories are undertaken. In this case,
application of the income method using CPM is likely to provide a more
reliable measure of an arm's length result than application of the
acquisition price method based on the price paid by USP for Company X.
See Sec. 1.482-7(g)(4)(vi) and (5)(iv)(C).
Example 17. Evaluation of alternative methods. (i) The facts are the
same as in Example 13, except that the acquisition occurred sometime
prior to the CSA, and Company X has some areas of promising research
that are not reasonably anticipated to contribute to developing Oncol.
For purposes of this example, the CSA is assumed to divide divisional
interests on a territorial basis. In general, the Commissioner
determines that the acquisition price data is useful in informing the
arm's length price, but not necessarily determinative. Under the terms
of the CSA, USP will undertake all R&D (consisting of laboratory
research and clinical testing) and manufacturing associated with Oncol,
as well as the distribution activities for its territory (the United
States). FS will distribute Oncol in its territory (the rest of the
world). FS's distribution activities are routine in nature, and the
profitability from its activities may be reliably determined from third-
party comparables. At the time of the PCT, financial projections
associated with the development of Oncol and its separate exploitation
in each of USP's and FSub's assigned geographical territories are
undertaken.
(ii) Under the facts, it is possible that the acquisition price
method or the income method using CPM might reasonably be applied.
Whether the acquisition price method or the income method provides the
most reliable evidence of the arm's length price of USP's contributions
depends on a number of
[[Page 747]]
factors, including the reliability of the financial projections, the
reliability of the discount rate chosen, and the extent to which the
acquisition price of Company X can be reliably adjusted to account for
changes in value over the time period between the acquisition and the
formation of the CSA and to account for the value of the in-process
research done by Company X that does not constitute platform
contributions to the CSA. See Sec. 1.482-7(g)(4)(vi) and (5)(iv)(A) and
(C).
Example 18. Evaluation of alternative methods. (i) The facts are the
same as in Example 17, except that FS has a patent on Compound Y, which
the parties reasonably anticipate will be useful in mitigating potential
side effects associated with Compound X and thereby contribute to the
development of Oncol. The rights in Compound Y constitute a platform
contribution for which compensation is due from USP as part of a PCT.
The value of FS's platform contribution cannot be reliably measured by
market benchmarks.
(ii) Under the facts, it is possible that either the acquisition
price method and the income method together or the residual profit split
method might reasonably be applied to determine the arm's length PCT
Payments due between USP and FS. Under the first option the PCT Payment
for the platform contributions related to Company X's workforce and
Compound X would be determined using the acquisition price method
referring to the lump sum price paid by USP for Company X. Because the
value of these platform contributions can be determined by reference to
a market benchmark, they are considered routine platform contributions.
Accordingly, under this option, the platform contribution related to
Compound Y would be the only nonroutine platform contribution and the
relevant PCT Payment is determined using the income method. Under the
second option, rather than looking to the acquisition price for Company
X, all the platform contributions are considered nonroutine and the RPSM
is applied to determine the PCT Payments for each platform contribution.
Under either option, the PCT Payments will be netted against each other.
(iii) Whether the acquisition price method together with the income
method or the residual profit split method provides the most reliable
evidence of the arm's length price of the platform contributions of USP
and FS depends on a number of factors, including the reliability of the
determination of the relative values of the platform contributions for
purposes of the RPSM, and the extent to which the acquisition price of
Company X can be reliably adjusted to account for changes in value over
the time period between the acquisition and the formation of the CSA and
to account for the value of the rights in the in-process research done
by Company X that does not constitute platform contributions to the CSA.
In these circumstances, it is also relevant to consider whether the
results of each method are consistent with each other, or whether one or
both methods are consistent with other potential methods that could be
applied. See Sec. 1.482-7(g)(4)(vi), (5)(iv), and (7)(iv).
(c) Effective/applicability date--(1) In general. Paragraphs (a) and
(b) Examples 10 through 12 of this section are generally applicable for
taxable years beginning after December 31, 2006. Paragraph (b) Examples
13 through 18 of this section are generally applicable on January 5,
2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraph (b) Examples 10,11, and
12 of this section to earlier taxable years in accordance with the rules
set forth in Sec. 1.482-9(n)(2).
[T.D. 8552, 59 FR 35028, July 8, 1994, as amended by T.D. 9278, 71 FR
44487, Aug. 4, 2006; T.D. 9441, 74 FR 388, Jan. 5, 2009; T.D. 9456, 74
FR 38845, Aug. 4, 2009; 74 FR 46346, Sept. 9, 2009; T.D. 9568, 76 FR
80134, Dec. 22, 2011]
Sec. 1.482-9 Methods to determine taxable income in connection
with a controlled services transaction.
(a) In general. The arm's length amount charged in a controlled
services transaction must be determined under one of the methods
provided for in this section. Each method must be applied in accordance
with the provisions of Sec. 1.482-1, including the best method rule of
Sec. 1.482-1(c), the comparability analysis of Sec. 1.482-1(d), and
the arm's length range of Sec. 1.482-1(e), except as those provisions
are modified in this section. The methods are--
(1) The services cost method, described in paragraph (b) of this
section;
(2) The comparable uncontrolled services price method, described in
paragraph (c) of this section;
(3) The gross services margin method, described in paragraph (d) of
this section;
(4) The cost of services plus method, described in paragraph (e) of
this section;
(5) The comparable profits method, described in Sec. 1.482-5 and in
paragraph (f) of this section;
(6) The profit split method, described in Sec. 1.482-6 and in
paragraph (g) of this section; and
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(7) Unspecified methods, described in paragraph (h) of this section.
(b) Services cost method--(1) In general. The services cost method
evaluates whether the amount charged for certain services is arm's
length by reference to the total services costs (as defined in paragraph
(j) of this section) with no markup. If a taxpayer applies the services
cost method in accordance with the rules of this paragraph (b), then it
will be considered the best method for purposes of Sec. 1.482-1(c), and
the Commissioner's allocations will be limited to adjusting the amount
charged for such services to the properly determined amount of such
total services costs.
(2) Eligibility for the services cost method. To apply the services
cost method to a service in accordance with the rules of this paragraph
(b), all of the following requirements must be satisfied with respect to
the service--
(i) The service is a covered service as defined in paragraph (b)(3)
of this section;
(ii) The service is not an excluded activity as defined in paragraph
(b)(4) of this section;
(iii) The service is not precluded from constituting a covered
service by the business judgment rule described in paragraph (b)(5) of
this section; and
(iv) Adequate books and records are maintained as described in
paragraph (b)(6) of this section.
(3) Covered services. For purposes of this paragraph (b), covered
services consist of a controlled service transaction or a group of
controlled service transactions (see Sec. 1.482-1(f)(2)(i) (aggregation
of transactions)) that meet the definition of specified covered services
or low margin covered services.
(i) Specified covered services. Specified covered services are
controlled services transactions that the Commissioner specifies by
revenue procedure. Services will be included in such revenue procedure
based upon the Commissioner's determination that the specified covered
services are support services common among taxpayers across industry
sectors and generally do not involve a significant median comparable
markup on total services costs. For the definition of the median
comparable markup on total services costs, see paragraph (b)(3)(ii) of
this section. The Commissioner may add to, subtract from, or otherwise
revise the specified covered services described in the revenue procedure
by subsequent revenue procedure, which amendments will ordinarily be
prospective only in effect.
(ii) Low margin covered services. Low margin covered services are
controlled services transactions for which the median comparable markup
on total services costs is less than or equal to seven percent. For
purposes of this paragraph (b), the median comparable markup on total
services costs means the excess of the arm's length price of the
controlled services transaction determined under the general section 482
regulations without regard to this paragraph (b), using the
interquartile range described in Sec. 1.482-1(e)(2)(iii)(C) and as
necessary adjusting to the median of such interquartile range, over
total services costs, expressed as a percentage of total services costs.
(4) Excluded activity. The following types of activities are
excluded activities:
(i) Manufacturing.
(ii) Production.
(iii) Extraction, exploration, or processing of natural resources.
(iv) Construction.
(v) Reselling, distribution, acting as a sales or purchasing agent,
or acting under a commission or other similar arrangement.
(vi) Research, development, or experimentation.
(vii) Engineering or scientific.
(viii) Financial transactions, including guarantees.
(ix) Insurance or reinsurance.
(5) Not services that contribute significantly to fundamental risks
of business success or failure. A service cannot constitute a covered
service unless the taxpayer reasonably concludes in its business
judgment that the service does not contribute significantly to key
competitive advantages, core capabilities, or fundamental risks of
success or failure in one or more trades or businesses of the controlled
group, as defined in Sec. 1.482-1(i)(6). In evaluating the
reasonableness of the conclusion
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required by this paragraph (b)(5), consideration will be given to all
the facts and circumstances.
(6) Adequate books and records. Permanent books of account and
records are maintained for as long as the costs with respect to the
covered services are incurred by the renderer. Such books and records
must include a statement evidencing the taxpayer's intention to apply
the services cost method to evaluate the arm's length charge for such
services. Such books and records must be adequate to permit verification
by the Commissioner of the total services costs incurred by the
renderer, including a description of the services in question,
identification of the renderer and the recipient of such services, and
sufficient documentation to allow verification of the methods used to
allocate and apportion such costs to the services in question in
accordance with paragraph (k) of this section.
(7) Shared services arrangement--(i) In general. If the services
cost method is used to evaluate the amount charged for covered services,
and such services are the subject of a shared services arrangement, then
the arm's length charge to each participant for such services will be
the portion of the total costs of the services otherwise determined
under the services cost method of this paragraph (b) that is properly
allocated to such participant pursuant to the arrangement.
(ii) Requirements for shared services arrangement. A shared services
arrangement must meet the requirements described in this paragraph
(b)(7).
(A) Eligibility. To be eligible for treatment under this paragraph
(b)(7), a shared services arrangement must--
(1) Include two or more participants;
(2) Include as participants all controlled taxpayers that reasonably
anticipate a benefit (as defined under paragraph (l)(3)(i) of this
section) from one or more covered services specified in the shared
services arrangement; and
(3) Be structured such that each covered service (or each reasonable
aggregation of services within the meaning of paragraph (b)(7)(iii)(B)
of this section) confers a benefit on at least one participant in the
shared services arrangement.
(B) Allocation. The costs for covered services must be allocated
among the participants based on their respective shares of the
reasonably anticipated benefits from those services, without regard to
whether the anticipated benefits are in fact realized. Reasonably
anticipated benefits are benefits as defined in paragraph (l)(3)(i) of
this section. The allocation of costs must provide the most reliable
measure of the participants' respective shares of the reasonably
anticipated benefits under the principles of the best method rule. See
Sec. 1.482-1(c). The allocation must be applied on a consistent basis
for all participants and services. The allocation to each participant in
each taxable year must reasonably reflect that participant's respective
share of reasonably anticipated benefits for such taxable year. If the
taxpayer reasonably concluded that the shared services arrangement
(including any aggregation pursuant to paragraph (b)(7)(iii)(B) of this
section) allocated costs for covered services on a basis that most
reliably reflects the participants' respective shares of the reasonably
anticipated benefits attributable to such services, as provided for in
this paragraph (b)(7), then the Commissioner may not adjust such
allocation basis.
(C) Documentation. The taxpayer must maintain sufficient
documentation to establish that the requirements of this paragraph
(b)(7) are satisfied, and include--
(1) A statement evidencing the taxpayer's intention to apply the
services cost method to evaluate the arm's length charge for covered
services pursuant to a shared services arrangement;
(2) A list of the participants and the renderer or renderers of
covered services under the shared services arrangement;
(3) A description of the basis of allocation to all participants,
consistent with the participants' respective shares of reasonably
anticipated benefits; and
(4) A description of any aggregation of covered services for
purposes of the shared services arrangement, and an indication whether
this aggregation (if any) differs from the aggregation used
[[Page 750]]
to evaluate the median comparable markup for any low margin covered
services described in paragraph (b)(3)(ii) of this section.
(iii) Definitions and special rules--(A) Participant. A participant
is a controlled taxpayer that reasonably anticipates benefits from
covered services subject to a shared services arrangement that
substantially complies with the requirements described in this paragraph
(b)(7).
(B) Aggregation. Two or more covered services may be aggregated in a
reasonable manner taking into account all the facts and circumstances,
including whether the relative magnitude of reasonably anticipated
benefits of the participants sharing the costs of such aggregated
services may be reasonably reflected by the allocation basis employed
pursuant to paragraph (b)(7)(ii)(B) of this section. The aggregation of
services under a shared services arrangement may differ from the
aggregation used to evaluate the median comparable markup for any low
margin covered services described in paragraph (b)(3)(ii) of this
section, provided that such alternative aggregation can be implemented
on a reasonable basis, including appropriately identifying and isolating
relevant costs, as necessary.
(C) Coordination with cost sharing arrangements. To the extent that
an allocation is made to a participant in a shared services arrangement
that is also a participant in a cost sharing arrangement subject to
Sec. 1.482-7T, such amount with respect to covered services is first
allocated pursuant to the shared services arrangement under this
paragraph (b)(7). Costs allocated pursuant to a shared services
arrangement may (if applicable) be further allocated between the
intangible property development activity under Sec. 1.482-7T and other
activities of the participant.
(8) Examples. The application of this section is illustrated by the
following examples. No inference is intended whether the presence or
absence of one or more facts is determinative of the conclusion in any
example. For purposes of Examples 1 through 14, assume that Company P
and its subsidiaries, Company Q and Company R, are corporations and
members of the same group of controlled entities (PQR Controlled Group).
For purposes of Example 15, assume that Company P and its subsidiary,
Company S, are corporations and members of the same group of controlled
entities (PS Controlled Group). For purposes of Examples 16 through 24,
assume that Company P and its subsidiaries, Company X, Company Y, and
Company Z, are corporations and members of the same group of controlled
entities (PXYZ Group) and that Company P and its subsidiaries satisfy
all of the requirements for a shared services arrangement specified in
paragraphs (b)(7)(ii) and (iii) of this section.
Example 1. Data entry services. (i) Company P, Company Q, and
Company R own and operate hospitals. Each owns an electronic database of
medical information gathered by doctors and nurses during interviews and
treatment of its patients. All three databases are maintained and
updated by Company P's administrative support employees who perform data
entry activities by entering medical information from the paper records
of Company P, Company Q, and Company R into their respective databases.
(ii) Assume that these services relating to data entry are specified
covered services within the meaning of paragraph (b)(3)(i) of this
section. Under the facts and circumstances of the business of the PQR
Controlled Group, the taxpayer could reasonably conclude that these
services do not contribute significantly to the controlled group's key
competitive advantages, core capabilities, or fundamental risks of
success or failure in the group's business. If these services meet the
other requirements of this paragraph (b), Company P will be eligible to
charge these services to Company Q and Company R in accordance with the
services cost method.
Example 2. Data entry services. (i) Company P, Company Q, and
Company R specialize in data entry, data processing, and data
conversion. Company Q and Company R's data entry activities involve
converting medical information data contained in paper records to a
digital format. Company P specializes in data entry activities. This
specialization reflects, in part, proprietary quality control systems
and specially trained data entry experts used to ensure the highest
degree of accuracy of data entry services. Company P is engaged by
Company Q and Company R to perform these data entry activities for them.
Company Q and Company R then charge their customers for the data entry
activities performed by Company P.
(ii) Assume that these services performed by Company P relating to
data entry are
[[Page 751]]
specified covered services within the meaning of paragraph (b)(3)(i) of
this section. Under the facts and circumstances, the taxpayer is unable
to reasonably conclude that these services do not contribute
significantly to the controlled group's key competitive advantages, core
capabilities, or fundamental risks of success or failure in the group's
business. Company P is not eligible to charge these services to Company
Q and Company R in accordance with the services cost method.
Example 3. Recruiting services. (i) Company P, Company Q, and
Company R are manufacturing companies that sell their products to
unrelated retail establishments. Company P's human resources department
recruits mid-level managers and engineers for itself as well as for
Company Q and Company R by attending job fairs and other recruitment
events. For recruiting higher-level managers and engineers, each of
these companies uses recruiters from unrelated executive search firms.
(ii) Assume that these services relating to recruiting are specified
covered services within the meaning of paragraph (b)(3)(i) of this
section. Under the facts and circumstances of the business of the PQR
Controlled Group, the taxpayer could reasonably conclude that these
services do not contribute significantly to the controlled group's key
competitive advantages, core capabilities, or fundamental risks of
success or failure in the group's business. If these services meet the
other requirements of this paragraph (b), Company P will be eligible to
charge these services to Company Q and Company R in accordance with the
services cost method.
Example 4. Recruiting services. (i) Company Q and Company R are
executive recruiting service companies that are hired by other companies
to recruit professionals. Company P is a recruiting agency that is
engaged by Company Q and Company R to perform recruiting activities on
their behalf in certain geographic areas.
(ii) Assume that the services performed by Company P are specified
covered services within the meaning of paragraph (b)(3)(i) of this
section. Under the facts and circumstances, the taxpayer is unable to
reasonably conclude that these services do not contribute significantly
to the controlled group's key competitive advantages, core capabilities,
or fundamental risks of success or failure in the group's business.
Company P is not eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 5. Credit analysis services. (i) Company P is a manufacturer
and distributor of clothing for retail stores. Company Q and Company R
are distributors of clothing for retail stores. As part of its
operations, personnel in Company P perform credit analysis on its
customers. Most of the customers have a history of purchases from
Company P, and the credit analysis involves a review of the recent
payment history of the customer's account. For new customers, the
personnel in Company P perform a basic credit check of the customer
using reports from a credit reporting agency. On behalf of Company Q and
Company R, Company P performs credit analysis on customers who order
clothing from Company Q and Company R using the same method as Company P
uses for itself.
(ii) Assume that these services relating to credit analysis are
specified covered services within the meaning of paragraph (b)(3)(i) of
this section. Under the facts and circumstances of the business of the
PQR Controlled Group, the taxpayer could reasonably conclude that these
services do not contribute significantly to the controlled group's key
competitive advantages, core capabilities, or fundamental risks of
success or failure in the group's business. If these services meet the
other requirements of this paragraph (b), Company P will be eligible to
charge these services to Company Q and Company R in accordance with the
services cost method.
Example 6. Credit analysis services. (i) Company P, Company Q, and
Company R lease furniture to retail customers who present a significant
credit risk and are generally unable to lease furniture from other
providers. As part of its leasing operations, personnel in Company P
perform credit analysis on each of the potential lessees. The personnel
have developed special expertise in determining whether a particular
customer who presents a significant credit risk (as indicated by credit
reporting agencies) will be likely to make the requisite lease payments
on a timely basis. Also, as part of its operations, Company P performs
similar credit analysis services for Company Q and Company R, which
charge correspondingly high monthly lease payments.
(ii) Assume that these services relating to credit analysis are
specified covered services within the meaning of paragraph (b)(3)(i) of
this section. Under the facts and circumstances, the taxpayer is unable
to reasonably conclude that these services do not contribute
significantly to the controlled group's key competitive advantages, core
capabilities, or fundamental risks of success or failure in the group's
business. Company P is not eligible to charge these services to Company
Q and Company R in accordance with the services cost method.
Example 7. Credit analysis services. (i) Company P is a large full-
service bank, which provides products and services to corporate and
consumer markets, including unsecured loans, secured loans, lines of
credit, letters of credit, conversion of foreign currency, consumer
loans, trust services, and sales of certificates of deposit. Company Q
makes
[[Page 752]]
routine consumer loans to individuals, such as auto loans and home
equity loans. Company R makes only business loans to small businesses.
(ii) Company P performs credit analysis and prepares credit reports
for itself, as well as for Company Q and Company R. Company P, Company Q
and Company R regularly employ these credit reports in the ordinary
course of business in making decisions regarding extensions of credit to
potential customers (including whether to lend, rate of interest, and
loan terms).
(iii) Assume that these services relating to credit analysis are
specified covered services within the meaning of paragraph (b)(3)(i) of
this section. Under the facts and circumstances, the credit analysis
services constitute part of a ``financial transaction'' described in
paragraph (b)(4)(viii) of this section. Company P is not eligible to
charge these services to Company Q and Company R in accordance with the
services cost method.
Example 8. Data verification services. (i) Company P, Company Q and
Company R are manufacturers of industrial supplies. Company P's
accounting department performs periodic reviews of the accounts payable
information of Company P, Company Q and Company R, and identifies any
inaccuracies in the records, such as double-payments and double-charges.
(ii) Assume that these services relating to verification of data are
specified covered services within the meaning of paragraph (b)(3)(i) of
this section. Under the facts and circumstances of the business of the
PQR Controlled Group, the taxpayer could reasonably conclude that these
services do not contribute significantly to the controlled group's key
competitive advantages, core capabilities, or fundamental risks of
success or failure in the group's business. If these services meet the
other requirements of this paragraph (b), Company P will be eligible to
charge these services to Company Q and Company R in accordance with the
services cost method.
Example 9. Data verification services. (i) Company P gathers and
inputs information regarding accounts payable and accounts receivable
from unrelated parties and utilizes its own computer system to analyze
that information for purposes of identifying errors in payment and
receipts (data mining). Company P is compensated for these services
based on a fee that reflects a percentage of amounts collected by
customers as a result of the data mining services. These activities
constitute a significant portion of Company P's business. Company P
performs similar activities for Company Q and Company R by analyzing
their accounts payable and accounts receivable records.
(ii) Assume that these services relating to data mining are
specified covered services within the meaning of paragraph (b)(3)(i) of
this section. Under the facts and circumstances, the taxpayer is unable
to reasonably conclude that these services do not contribute
significantly to the controlled group's key competitive advantages, core
capabilities, or fundamental risks of success or failure in the group's
business. Company P is not eligible to charge these services to Company
Q and Company R in accordance with the services cost method.
Example 10. Legal services. (i) Company P is a domestic corporation
with two wholly-owned foreign subsidiaries, Company Q and Company R.
Company P and its subsidiaries manufacture and distribute equipment used
by industrial customers. Company P maintains an in-house legal
department consisting of attorneys experienced in a wide range of
business and commercial matters. Company Q and Company R maintain small
legal departments, consisting of attorneys experienced in matters that
most frequently arise in the normal course of business of Company Q and
Company R in their respective jurisdictions.
(ii) Company P seeks to maintain in-house legal staff with the
ability to address the majority of legal matters that arise in the
United States with respect to the operations of Company P, as well as
any U.S. reporting or compliance obligations of Company Q or Company R.
These include the preparation and review of corporate contracts relating
to, for example, product sales, equipment purchases and leases, business
liability insurance, real estate, employee salaries and benefits.
Company P relies on outside attorneys for major business transactions
and highly technical matters such as patent licenses. The in-house legal
staffs of Company Q and Company R are much more limited. It is necessary
for Company P to retain several local law firms to handle litigation and
business disputes arising from the activities of Company Q and Company
R. Although Company Q and Company R pay the fees of these law firms, the
hiring authority and general oversight of the firms' representation is
in the legal department of Company P.
(iii) In determining what portion of the legal expenses of Company P
may be allocated to Company Q and Company R, Company P first excludes
any expenses relating to legal services that constitute shareholder
activities and other items that are not properly analyzed as controlled
services. Assume that the remaining services relating to general legal
functions performed by in-house legal counsel are specified covered
services within the meaning of paragraph (b)(3)(i) of this section.
Under the facts and circumstances of the business of the PQR Controlled
Group, the taxpayer could reasonably conclude that these latter services
do not contribute significantly to the controlled group's key
competitive advantages, core capabilities, or fundamental risks of
success or
[[Page 753]]
failure in the group's business. If these services meet the other
requirements of this paragraph (b), Company P will be eligible to charge
these services to Company Q and Company R in accordance with the
services cost method.
Example 11. Legal services. (i) Company P is a domestic holding
company whose operating companies, Company Q and Company R, generate
electric power for consumers by operating nuclear plants. Assume that,
although Company P owns 100% of the stock of Companies Q and R, the
companies do not elect to file a consolidated Federal income tax return
with Company P.
(ii) Company P maintains an in-house legal department that includes
attorneys who are experts in the areas of Federal utilities regulation,
Federal labor and environmental law, and securities law. Companies Q and
R maintain their own, smaller in-house legal staffs comprising
experienced attorneys in the areas of state and local utilities
regulation, state labor and employment law, and general commercial law.
The legal department of Company P performs general oversight of the
legal affairs of the company and determines whether a particular matter
would be more efficiently handled by the Company P legal department, by
the legal staffs in the operating companies, or in rare cases, by
retained outside counsel. In general, Company P has succeeded in
minimizing duplication and overlap of functions between the legal staffs
of the various companies or by retained outside counsel.
(iii) The domestic nuclear power plant operations of Companies Q and
R are subject to extensive regulation by the U.S. Nuclear Regulatory
Commission (NRC). Operators are required to obtain pre-construction
approval, operating licenses, and, at the end of the operational life of
the nuclear reactor, nuclear decommissioning certificates. Company P
files consolidated financial statements on behalf of itself, as well as
Companies Q and R, with the United States Securities and Exchange
Commission (SEC). In these SEC filings, Company P discloses that failure
to obtain any of these licenses (and the related periodic renewals) or
agreeing to licenses on terms less favorable than those granted to
competitors would have a material adverse impact on the operations of
Company Q or Company R. Company Q and Company R do not have in-house
legal staff with experience in the NRC area. Company P maintains a group
of in-house attorneys with specialized expertise in the NRC area that
exclusively represents Company Q and Company R before the NRC. Although
Company P occasionally hires an outside law firm or industry expert to
assist on particular NRC matters, the majority of the work is performed
by the specialized legal staff of Company P.
(iv) Certain of the legal services performed by Company P constitute
duplicative or shareholder activities that do not confer a benefit on
the other companies and therefore do not need to be allocated to the
other companies, while certain other legal services are eligible to be
charged to Company Q and Company R in accordance with the services cost
method.
(v) Assume that the specialized legal services relating to nuclear
licenses performed by in-house legal counsel of Company P are specified
covered services within the meaning of paragraph (b)(3)(i) of this
section. Under the facts and circumstances, the taxpayer is unable to
reasonably conclude that these services do not contribute significantly
to the controlled group's key competitive advantages, core capabilities,
or fundamental risks of success or failure in the group's business.
Company P is not eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 12. Group of services. (i) Company P, Company Q, and Company
R are manufacturing companies that sell their products to unrelated
retail establishments. Company P has an enterprise resource planning
(ERP) system that maintains data relating to accounts payable and
accounts receivable information for all three companies. Company P's
personnel perform the daily operations on this ERP system such as
inputting data relating to accounts payable and accounts receivable into
the system and extracting data relating to accounts receivable and
accounts payable in the form of reports or electronic media and
providing those data to all three companies. Periodically, Company P's
computer specialists also modify the ERP system to adapt to changing
business functions in all three companies. Company P's computer
specialists make these changes by either modifying the underlying
software program or by purchasing additional software or hardware from
unrelated third party vendors.
(ii) Assume that the services relating to accounts payable and
accounts receivable are specified covered services within the meaning of
paragraph (b)(3)(i) of this section. Under the facts and circumstances
of the business of the PQR Controlled Group, the taxpayer could
reasonably conclude that these services do not contribute significantly
to the controlled group's key competitive advantages, core capabilities,
or fundamental risks of success or failure in the group's business. If
these services meet the other requirements of this paragraph (b),
Company P will be eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
[[Page 754]]
(iii) Assume that the services performed by Company P's computer
specialists that relate to modifying the ERP system are specifically
excluded from the services described in a revenue procedure referenced
in paragraph (b)(3) of this section as developing hardware or software
solutions (such as systems integration, Web site design, writing
computer programs, modifying general applications software, or
recommending the purchase of commercially available hardware or
software). If these services do not constitute low margin covered
services within the meaning of paragraph (b)(3)(ii) of this section,
then Company P is not eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 13. Group of services. (i) Company P manufactures and sells
widgets under an exclusive contract to Customer 1. Company Q and Company
R sell widgets under exclusive contracts to Customer 2 and Customer 3,
respectively. At least one year in advance, each of these customers can
accurately forecast its need for widgets. Using these forecasts, each
customer over the course of the year places orders for widgets with the
appropriate company, Company P, Company Q, or Company R. A customer's
actual need for widgets seldom deviates from that customer's forecasted
need.
(ii) It is most efficient for the PQR Controlled Group companies to
manufacture and store an inventory of widgets in advance of delivery.
Although all three companies sell widgets, only Company P maintains a
centralized warehouse for widgets. Pursuant to a contract, Company P
provides storage of these widgets to Company Q and Company R at an arm's
length price.
(iii) Company P's personnel also obtain orders from all three
companies' customers to draw up purchase orders for widgets as well as
make payment to suppliers for widget replacement parts. In addition,
Company P's personnel use data entry to input information regarding
orders and sales of widgets and replacement parts for all three
companies into a centralized computer system. Company P's personnel also
maintain the centralized computer system and extract data for all three
companies when necessary.
(iv) Assume that these services relating to tracking purchases and
sales of inventory are specified covered services within the meaning of
paragraph (b)(3)(i) of this section. Under the facts and circumstances
of the business of the PQR Controlled Group, the taxpayer could
reasonably conclude that these services do not contribute significantly
to the controlled group's key competitive advantages, core capabilities,
or fundamental risks of success or failure in the group's business. If
these services meet the other requirements of this paragraph (b),
Company P will be eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 14. Group of services. (i) Company P, Company Q, and Company
R assemble and sell gadgets to unrelated customers. Each of these
companies purchases the components necessary for assembly of the gadgets
from unrelated suppliers. As a service to its subsidiaries, Company P's
personnel obtain orders for components from all three companies, prepare
purchase orders, and make payment to unrelated suppliers for the
components. In addition, Company P's personnel use data entry to input
information regarding orders and sales of gadgets for all three
companies into a centralized computer. Company P's personnel also
maintain the centralized computer system and extract data for all three
companies on an as-needed basis. The services provided by Company P
personnel, in conjunction with the centralized computer system,
constitute a state-of-the-art inventory management system that allows
Company P to order components necessary for assembly of the gadgets on a
``just-in-time'' basis.
(ii) Unrelated suppliers deliver the components directly to Company
P, Company Q and Company R. Each company stores the components in its
own facilities for use in filling specific customer orders. The
companies do not maintain any inventory that is not identified in
specific customer orders. Because of the efficiencies associated with
services provided by personnel of Company P, all three companies are
able to significantly reduce their inventory-related costs. Company P's
Chief Executive Officer makes a statement in one of its press
conferences with industry analysts that its inventory management system
is critical to the company's success.
(iii) Assume that these services relating to tracking purchases and
sales of inventory are specified covered services within the meaning of
paragraph (b)(3)(i) of this section. Under the facts and circumstances,
the taxpayer is unable to reasonably conclude that these services do not
contribute significantly to the controlled group's key competitive
advantages, core capabilities, or fundamental risks of success or
failure in the group's business. Company P is not eligible to charge
these services to Company Q and Company R in accordance with the
services cost method.
Example 15. Low margin covered services. Company P renders certain
accounting services to Company S. Company P uses the services cost
method for the accounting services, and determines the amount charged as
its total cost of rendering the services, with no markup. Based on an
application of the section 482 regulations without regard to this
paragraph (b), the interquartile range of arm's length markups on total
services costs for these accounting services is between 3%
[[Page 755]]
and 9%, and the median is 6%. Because the median comparable markup on
total services costs is 6%, which is less than 7%, the accounting
services constitute low margin covered services within the meaning of
paragraph (b)(3)(ii) of this section.
Example 16. Shared services arrangement and reliable measure of
reasonably anticipated benefit (allocation key). (i) Company P operates
a centralized data processing facility that performs automated invoice
processing and order generation for all of its subsidiaries, Companies
X, Y, Z, pursuant to a shared services arrangement.
(ii) In evaluating the shares of reasonably anticipated benefits
from the centralized data processing services, the total value of the
merchandise on the invoices and orders may not provide the most reliable
measure of reasonably anticipated benefits shares, because value of
merchandise sold does not bear a relationship to the anticipated
benefits from the underlying covered services.
(iii) The total volume of orders and invoices processed may provide
a more reliable basis for evaluating the shares of reasonably
anticipated benefits from the data processing services. Alternatively,
depending on the facts and circumstances, total central processing unit
time attributable to the transactions of each subsidiary may provide a
more reliable basis on which to evaluate the shares of reasonably
anticipated benefits.
Example 17. Shared services arrangement and reliable measure of
reasonably anticipated benefit (allocation key). (i) Company P operates
a centralized center that performs human resources functions, such as
administration of pension, retirement, and health insurance plans that
are made available to employees of its subsidiaries, Companies X, Y, Z,
pursuant to a shared services arrangement.
(ii) In evaluating the shares of reasonably anticipated benefits
from these centralized services, the total revenues of each subsidiary
may not provide the most reliable measure of reasonably anticipated
benefit shares, because total revenues do not bear a relationship to the
shares of reasonably anticipated benefits from the underlying services.
(iii) Employee headcount or total compensation paid to employees may
provide a more reliable basis for evaluating the shares of reasonably
anticipated benefits from the covered services.
Example 18. Shared services arrangement and reliable measure of
reasonably anticipated benefit (allocation key). (i) Company P performs
human resource services (service A) on behalf of the PXYZ Group that
qualify for the services cost method. Under that method, Company P
determines the amount charged for these services pursuant to a shared
services arrangement based on an application of paragraph (b)(7) of this
section. Service A constitutes a specified covered service described in
a revenue procedure pursuant to paragraph (b)(3)(i) of this section. The
total services costs for service A otherwise determined under the
services cost method is 300.
(ii) Companies X, Y and Z reasonably anticipate benefits from
service A. Company P does not reasonably anticipate benefits from
service A. Assume that if relative reasonably anticipated benefits were
precisely known, the appropriate allocation of charges pursuant to
paragraph (k) of this section to Company X, Y and Z for service A is as
follows:
Service A
[Total cost 300]
------------------------------------------------------------------------
Company
------------------------------------------------------------------------
X....................................................... 150
Y....................................................... 75
Z....................................................... 75
------------------------------------------------------------------------
(iii) The total number of employees (employee headcount) in each
company is as follows:
Company X--600 employees.
Company Y--250 employees.
Company Z--250 employees.
(iv) Company P allocates the 300 total services costs of service A
based on employee headcount as follows:
Service A
[Total cost 300]
------------------------------------------------------------------------
Company
Allocation key -------------------------------
Headcount Amount
------------------------------------------------------------------------
X....................................... 600 164
Y....................................... 250 68
Z....................................... 250 68
------------------------------------------------------------------------
(v) Based on these facts, Company P may reasonably conclude that the
employee headcount allocation basis most reliably reflects the
participants' respective shares of the reasonably anticipated benefits
attributable to service A.
Example 19. Shared services arrangement and reliable measure of
reasonably anticipated benefit (allocation key). (i) Company P performs
accounts payable services (service B) on behalf of the PXYZ Group and
determines the amount charged for the services under such method
pursuant to a shared services arrangement based on an application of
paragraph (b)(7) of this section. Service B is a specified covered
service described in a revenue procedure pursuant to paragraph (b)(3)(i)
of this section. The total services costs for service B otherwise
determined under the services cost method is 500.
[[Page 756]]
(ii) Companies X, Y and Z reasonably anticipate benefits from
service B. Company P does not reasonably anticipate benefits from
service B. Assume that if relative reasonably anticipated benefits were
precisely known, the appropriate allocation of charges pursuant to
paragraph (k) of this section to Companies X, Y and Z for service B is
as follows:
Service B
[Total cost 500]
------------------------------------------------------------------------
Company
------------------------------------------------------------------------
X....................................................... 125
Y....................................................... 205
Z....................................................... 170
------------------------------------------------------------------------
(iii) The total number of employees (employee headcount) in each
company is as follows:
Company X--600.
Company Y--200.
Company Z--200.
(iv) The total number of transactions (transaction volume) with
uncontrolled customers by each company is as follows:
Company X--2,000.
Company Y--4,000.
Company Z--3,500.
(v) If Company P allocated the 500 total services costs of service B
based on employee headcount, the resulting allocation would be as
follows:
Service B
[Total cost 500]
------------------------------------------------------------------------
Company
Allocation key -------------------------------
Headcount Amount
------------------------------------------------------------------------
X....................................... 600 300
Y....................................... 200 100
Z....................................... 200 100
------------------------------------------------------------------------
(vi) In contrast, if Company P used volume of transactions with
uncontrolled customers as the allocation basis under the shared services
arrangement, the allocation would be as follows:
Service B
[Total cost 500]
------------------------------------------------------------------------
Company
-------------------------------
Allocation key Transaction
Volume Amount
------------------------------------------------------------------------
X....................................... 2,000 105
Y....................................... 4,000 211
Z....................................... 3,500 184
------------------------------------------------------------------------
(vii) Based on these facts, Company P may reasonably conclude that
the transaction volume, but not the employee headcount, allocation basis
most reliably reflects the participants' respective shares of the
reasonably anticipated benefits attributable to service B.
Example 20. Shared services arrangement and aggregation. (i) Company
P performs human resource services (service A) and accounts payable
services (service B) on behalf of the PXYZ Group that qualify for the
services cost method. Company P determines the amount charged for these
services under such method pursuant to a shared services arrangement
based on an application of paragraph (b)(7) of this section. Service A
and service B are specified covered services described in a revenue
procedure pursuant to paragraph (b)(3)(i) of this section. The total
services costs otherwise determined under the services cost method for
service A is 300 and for service B is 500; total services costs for
services A and B are 800. Company P determines that aggregation of
services A and B for purposes of the arrangement is appropriate.
(ii) Companies X, Y and Z reasonably anticipate benefits from
services A and B. Company P does not reasonably anticipate benefits from
services A and B. Assume that if relative reasonably anticipated
benefits were precisely known, the appropriate allocation of total
charges pursuant to paragraph (k) of this section to Companies X, Y and
Z for services A and B is as follows:
Services A and B
[Total cost 800]
------------------------------------------------------------------------
Company
------------------------------------------------------------------------
X....................................................... 350
Y....................................................... 100
Z....................................................... 350
------------------------------------------------------------------------
(iii) The total volume of transactions with uncontrolled customers
in each company is as follows:
Company X--2,000.
Company Y--4,000.
Company Z--4,000.
(iv) The total number of employees in each company is as follows:
Company X--600.
[[Page 757]]
Company Y--200.
Company Z--200.
(v) If Company P allocated the 800 total services costs of services
A and B based on transaction volume or employee headcount, the resulting
allocation would be as follows:
Aggregated Services AB
[Total cost 800]
----------------------------------------------------------------------------------------------------------------
Allocation key Allocation key
---------------------------------------------------------------
Company Transaction
volume Amount Headcount Amount
----------------------------------------------------------------------------------------------------------------
X............................................... 2,000 160 600 480
Y............................................... 4,000 320 200 160
Z............................................... 4,000 320 200 160
----------------------------------------------------------------------------------------------------------------
(vi) In contrast, if aggregated services AB were allocated by
reference to the total U.S. dollar value of sales to uncontrolled
parties (trade sales) by each company, the following results would
obtain:
Aggregated Services AB
[Total costs 800]
------------------------------------------------------------------------
Allocation key
-------------------------------
Company Trade sales
(millions) Amount
------------------------------------------------------------------------
X....................................... $400 314
Y....................................... 120 94
Z....................................... 500 392
------------------------------------------------------------------------
(vii) Based on these facts, Company P may reasonably conclude that
the trade sales, but not the transaction volume or the employee
headcount, allocation basis most reliably reflects the participants'
respective shares of the reasonably anticipated benefits attributable to
services AB.
Example 21. Shared services arrangement and aggregation. (i) Company
P performs services A through P on behalf of the PXYZ Group that qualify
for the services cost method. Company P determines the amount charged
for these services under such method pursuant to a shared services
arrangement based on an application of paragraph (b)(7) of this section.
All of these services A through P constitute either specified covered
services or low margin covered services described in paragraph (b)(3) of
this section. The total services costs for services A through P
otherwise determined under the services cost method is 500. Company P
determines that aggregation of services A through P for purposes of the
arrangement is appropriate.
(ii) Companies X and Y reasonably anticipate benefits from services
A through P and Company Z reasonably anticipates benefits from services
A through M but not from services N through P (Company Z performs
services similar to services N through P on its own behalf). Company P
does not reasonably anticipate benefits from services A through P.
Assume that if relative reasonably anticipated benefits were precisely
known, the appropriate allocation of total charges pursuant to paragraph
(k) of this section to Company X, Y, and Z for services A through P is
as follows:
----------------------------------------------------------------------------------------------------------------
Services A-M (cost Services N-P (cost Services A-P
Company 490) 10) (total cost 500)
----------------------------------------------------------------------------------------------------------------
X................................................... 90 5 95
Y................................................... 240 5 245
Z................................................... 160 160
----------------------------------------------------------------------------------------------------------------
(iii) The total volume of transactions with uncontrolled customers
in each company is as follows:
Company X--2,000.
Company Y--4,500.
Company Z--3,500.
(iv) Company P allocates the 500 total services costs of services A
through P based on transaction volume as follows:
Aggregated Services A-Z
[Total costs 500]
------------------------------------------------------------------------
Allocation key
-------------------------------
Company Transaction
volume Amount
------------------------------------------------------------------------
X....................................... 2,000 100
Y....................................... 4,500 225
Z....................................... 3,500 175
------------------------------------------------------------------------
(v) Based on these facts, Company P may reasonably conclude that the
transaction
[[Page 758]]
volume allocation basis most reliably reflects the participants'
respective shares of the reasonably anticipated benefits attributable to
services A through P.
Example 22. Renderer reasonably anticipates benefits. (i) Company P
renders services on behalf of the PXYZ Group that qualify for the
services cost method. Company P determines the amount charged for these
services under such method. Company P's share of reasonably anticipated
benefits from services A, B, C, and D is 20% of the total reasonably
anticipated benefits of all participants. Company P's total services
cost for services A, B, C, and D charged within the group is 100.
(ii) Based on an application of paragraph (b)(7) of this section,
Company P charges 80 which is allocated among Companies X, Y, and Z. No
charge is made to Company P under the shared services arrangement for
activities that it performs on its own behalf.
Example 23. Coordination with cost sharing arrangement. (i) Company
P performs human resource services (service A) on behalf of the PXYZ
Group that qualify for the services cost method. Company P determines
the amount charged for these services under such method pursuant to a
shared services arrangement based on an application of paragraph (b)(7)
of this section. Service A constitutes a specified covered service
described in a revenue procedure pursuant to paragraph (b)(3)(i) of this
section. The total services costs for service A otherwise determined
under the services cost method is 300.
(ii) Company X, Y, Z, and P reasonably anticipate benefits from
service A. Using a basis of allocation that is consistent with the
controlled participants' respective shares of the reasonably anticipated
benefits from the shared services, the total charge of 300 is allocated
as follows:
X--100.
Y--50.
Z--25.
P--125.
(iii) In addition to performing services, P undertakes 500 of R&D
and incurs manufacturing and other costs of 1,000.
(iv) Companies P and X enter into a cost sharing arrangement in
accordance with Sec. 1.482-7T. Under the arrangement, Company P will
undertake all intangible property development activities. All of Company
P's research and development (R&D) activity is devoted to the intangible
property development activity under the cost sharing arrangement.
Company P will manufacture, market, and otherwise exploit the product in
its defined territory. Companies P and X will share intangible property
development costs in accordance with their reasonably anticipated
benefits from the intangible property, and Company X will make payments
to Company P as required under Sec. 1.482-7T. Company X will
manufacture, market, and otherwise exploit the product in the rest of
the world.
(v) A portion of the charge under the shared services arrangement is
in turn allocable to the intangible property development activity
undertaken by Company P. The most reliable estimate of the proportion
allocable to the intangible property development activity is determined
to be 500 (Company P's R&D expenses) divided by 1,500 (Company P's total
non-covered services costs), or one-third. Accordingly, one-third of
Company P's charge of 125, or 42, is allocated to the intangible
property development activity. Companies P and X must share the
intangible property development costs of the cost shared intangible
property (including the charge of 42 that is allocated under the shared
services arrangement) in proportion to their respective shares of
reasonably anticipated benefits under the cost sharing arrangement. That
is, the reasonably anticipated benefit shares under the cost sharing
arrangement are determined separately from reasonably anticipated
benefit shares under the shared services arrangement.
Example 24. Coordination with cost sharing arrangement. (i) The
facts and analysis are the same as in Example 25, except that Company X
also performs intangible property development activities related to the
cost sharing arrangement. Using a basis of allocation that is consistent
with the controlled participants' respective shares of the reasonably
anticipated benefits from the shared services, the 300 of service costs
is allocated as follows:
X--100.
Y--50.
Z--25.
P--125.
(ii) In addition to performing services, Company P undertakes 500 of
R&D and incurs manufacturing and other costs of 1,000. Company X
undertakes 400 of R&D and incurs manufacturing and other costs of 600.
(iii) Companies P and X enter into a cost sharing arrangement in
accordance with Sec. 1.482-7T. Under the arrangement, both Companies P
and X will undertake intangible property development activities. All of
the research and development activity conducted by Companies P and X is
devoted to the intangible property development activity under the cost
sharing arrangement. Both Companies P and X will manufacture, market,
and otherwise exploit the product in their respective territories and
will share intangible property development costs in accordance with
their reasonably anticipated benefits from the intangible property, and
both will make payments as required under Sec. 1.482-7T.
(iv) A portion of the charge under the shared services arrangement
is in turn allocable to the intangible property development
[[Page 759]]
activities undertaken by Companies P and X. The most reliable estimate
of the portion allocable to Company P's intangible property development
activity is determined to be 500 (Company P's R&D expenses) divided by
1,500 (P's total non-covered services costs), or one-third. Accordingly,
one-third of Company P's allocated services cost method charge of 125,
or 42, is allocated to its intangible property development activity.
(v) In addition, it is necessary to determine the portion of the
charge under the shared services arrangement to Company X that should be
further allocated to Company X's intangible property development
activities under the cost sharing arrangement. The most reliable
estimate of the portion allocable to Company X's intangible property
development activity is 400 (Company X's R&D expenses) divided by 1,000
(Company X's costs), or 40%. Accordingly, 40% of the 100 that was
allocated to Company X, or 40, is allocated in turn to Company X's
intangible property development activities. Company X makes a payment to
Company P of 100 under the shared services arrangement and includes 40
of services cost method charges in the pool of intangible property
development costs.
(vi) The parties' respective contributions to intangible property
development costs under the cost sharing arrangement are as follows:
P: 500 + (0.333 * 125) = 542
X: 400 + (0.40 * 100) = 440
(c) Comparable uncontrolled services price method--(1) In general.
The comparable uncontrolled services price method evaluates whether the
amount charged in a controlled services transaction is arm's length by
reference to the amount charged in a comparable uncontrolled services
transaction.
(2) Comparability and reliability considerations--(i) In general.
Whether results derived from application of this method are the most
reliable measure of the arm's length result must be determined using the
factors described under the best method rule in Sec. 1.482-1(c). The
application of these factors under the comparable uncontrolled services
price method is discussed in paragraphs (c)(2)(ii) and (iii) of this
section.
(ii) Comparability--(A) In general. The degree of comparability
between controlled and uncontrolled transactions is determined by
applying the provisions of Sec. 1.482-1(d). Although all of the factors
described in Sec. 1.482-1(d)(3) must be considered, similarity of the
services rendered, and of the intangible property (if any) used in
performing the services, generally will have the greatest effects on
comparability under this method. In addition, because even minor
differences in contractual terms or economic conditions could materially
affect the amount charged in an uncontrolled transaction, comparability
under this method depends on close similarity with respect to these
factors, or adjustments to account for any differences. The results
derived from applying the comparable uncontrolled services price method
generally will be the most direct and reliable measure of an arm's
length price for the controlled transaction if an uncontrolled
transaction has no differences from the controlled transaction that
would affect the price, or if there are only minor differences that have
a definite and reasonably ascertainable effect on price and for which
appropriate adjustments are made. If such adjustments cannot be made, or
if there are more than minor differences between the controlled and
uncontrolled transactions, the comparable uncontrolled services price
method may be used, but the reliability of the results as a measure of
the arm's length price will be reduced. Further, if there are material
differences for which reliable adjustments cannot be made, this method
ordinarily will not provide a reliable measure of an arm's length
result.
(B) Adjustments for differences between controlled and uncontrolled
transactions. If there are differences between the controlled and
uncontrolled transactions that would affect price, adjustments should be
made to the price of the uncontrolled transaction according to the
comparability provisions of Sec. 1.482-1(d)(2). Specific examples of
factors that may be particularly relevant to application of this method
include--
(1) Quality of the services rendered;
(2) Contractual terms (for example, scope and terms of warranties or
guarantees regarding the services, volume, credit and payment terms,
allocation of risks, including any contingent-payment terms and whether
costs were incurred without a provision for current reimbursement);
(3) Intangible property (if any) used in rendering the services;
[[Page 760]]
(4) Geographic market in which the services are rendered or
received;
(5) Risks borne (for example, costs incurred to render the services,
without provision for current reimbursement);
(6) Duration or quantitative measure of services rendered;
(7) Collateral transactions or ongoing business relationships
between the renderer and the recipient, including arrangement for the
provision of tangible property in connection with the services; and
(8) Alternatives realistically available to the renderer and the
recipient.
(iii) Data and assumptions. The reliability of the results derived
from the comparable uncontrolled services price method is affected by
the completeness and accuracy of the data used and the reliability of
the assumptions made to apply the method. See Sec. 1.482-1(c) (best
method rule).
(3) Arm's length range. See Sec. 1.482-1(e)(2) for the
determination of an arm's length range.
(4) Examples. The principles of this paragraph (c) are illustrated
by the following examples:
Example 1. Internal comparable uncontrolled services price. Company
A, a United States corporation, performs shipping, stevedoring, and
related services for controlled and uncontrolled parties on a short-term
or as-needed basis. Company A charges uncontrolled parties in Country X
a uniform fee of $60 per container to place loaded cargo containers in
Country X on oceangoing vessels for marine transportation. Company A
also performs identical services in Country X for its wholly-owned
subsidiary, Company B, and there are no substantial differences between
the controlled and uncontrolled transactions. In evaluating the
appropriate measure of the arm's length price for the container-loading
services performed for Company B, because Company A renders
substantially identical services in Country X to both controlled and
uncontrolled parties, it is determined that the comparable uncontrolled
services price constitutes the best method for determining the arm's
length price for the controlled services transaction. Based on the
reliable data provided by Company A concerning the price charged for
services in comparable uncontrolled transactions, a loading charge of
$60 per cargo container will be considered the most reliable measure of
the arm's length price for the services rendered to Company B. See
paragraph (c)(2)(ii)(A) of this section.
Example 2. External comparable uncontrolled services price. (i) The
facts are the same as in Example 1, except that Company A performs
services for Company B, but not for uncontrolled parties. Based on
information obtained from unrelated parties (which is determined to be
reliable under the comparability standards set forth in paragraph (c)(2)
of this section), it is determined that uncontrolled parties in Country
X perform services comparable to those rendered by Company A to Company
B, and that such parties charge $60 per cargo container.
(ii) In evaluating the appropriate measure of an arm's length price
for the loading services that Company A renders to Company B, the $60
per cargo container charge is considered evidence of a comparable
uncontrolled services price. See paragraph (c)(2)(ii)(A) of this
section.
Example 3. External comparable uncontrolled services price. The
facts are the same as in Example 2, except that uncontrolled parties in
Country X render similar loading and stevedoring services, but only
under contracts that have a minimum term of one year. If the difference
in the duration of the services has a material effect on prices,
adjustments to account for these differences must be made to the results
of the uncontrolled transactions according to the provisions of Sec.
1.482-1(d)(2), and such adjusted results may be used as a measure of the
arm's length result.
Example 4. Use of valuable intangible property. (i) Company A, a
United States corporation in the biotechnology sector, renders research
and development services exclusively to its affiliates. Company B is
Company A's wholly-owned subsidiary in Country X. Company A renders
research and development services to Company B.
(ii) In performing its research and development services function,
Company A uses proprietary software that it developed internally.
Company A uses the software to evaluate certain genetically engineered
compounds developed by Company B. Company A owns the copyright on this
software and does not license it to uncontrolled parties.
(iii) No uncontrolled parties can be identified that perform
services identical or with a high degree of similarity to those
performed by Company A. Because there are material differences for which
reliable adjustments cannot be made, the comparable uncontrolled
services price method is unlikely to provide a reliable measure of the
arm's length price. See paragraph (c)(2)(ii)(A) of this section.
Example 5. Internal comparable. (i) Company A, a United States
corporation, and its subsidiaries render computer consulting services
relating to systems integration and networking to business clients in
various countries. Company A and its subsidiaries render only consulting
services, and do not manufacture computer hardware or software nor
distribute such products. The controlled
[[Page 761]]
group is organized according to industry specialization, with key
industry specialists working for Company A. These personnel typically
form the core consulting group that teams with consultants from the
local-country subsidiaries to serve clients in the subsidiaries'
respective countries.
(ii) Company A and its subsidiaries sometimes undertake engagements
directly for clients, and sometimes work as subcontractors to unrelated
parties on more extensive supply-chain consulting engagements for
clients. In undertaking the latter engagements with third party
consultants, Company A typically prices its services based on consulting
hours worked multiplied by a rate determined for each category of
employee. The company also charges, at no markup, for out-of-pocket
expenses such as travel, lodging, and data acquisition charges. The
Company has established the following schedule of hourly rates:
------------------------------------------------------------------------
Category Rate
------------------------------------------------------------------------
Project managers........................ $400 per hour.
Technical staff......................... $300 per hour.
------------------------------------------------------------------------
(iii) Thus, for example, a project involving 100 hours of the time
of project managers and 400 hours of technical staff time would result
in the following project fees (without regard to any out-of-pocket
expenses): ([100 hrs. x $400/hr.] + [400 hrs. x $300/hr.]) = $40,000 +
$120,000 = $160,000.
(iv) Company B, a Country X subsidiary of Company A, contracts to
perform consulting services for a Country X client in the banking
industry. In undertaking this engagement, Company B uses its own
consultants and also uses Company A project managers and technical staff
that specialize in the banking industry for 75 hours and 380 hours,
respectively. In determining an arm's length charge, the price that
Company A charges for consulting services as a subcontractor in
comparable uncontrolled transactions will be considered evidence of a
comparable uncontrolled services price. Thus, in this case, a payment of
$144,000, (or [75 hrs. x $400/hr.] + [380 hrs. x $300/hr.] = $30,000 +
$114,000) may be used as a measure of the arm's length price for the
work performed by Company A project mangers and technical staff. In
addition, if the comparable uncontrolled services price method is used,
then, consistent with the practices employed by the comparables with
respect to similar types of expenses, Company B must reimburse Company A
for appropriate out-of-pocket expenses. See paragraph (c)(2)(ii)(A) of
this section.
Example 6. Adjustments for differences. (i) The facts are the same
as in Example 5, except that the engagement is undertaken with the
client on a fixed fee basis. That is, prior to undertaking the
engagement Company B and Company A estimate the resources required to
undertake the engagement, and, based on hourly fee rates, charge the
client a single fee for completion of the project. Company A's portion
of the engagement results in fees of $144,000.
(ii) The engagement, once undertaken, requires 20% more hours by
each of Companies A and B than originally estimated. Nevertheless, the
unrelated client pays the fixed fee that was agreed upon at the start of
the engagement. Company B pays Company A $144,000, in accordance with
the fixed fee arrangement.
(iii) Company A often enters into similar fixed fee engagements with
clients. In addition, Company A's records for similar engagements show
that when it experiences cost overruns, it does not collect additional
fees from the client for the difference between projected and actual
hours. Accordingly, in evaluating whether the fees paid by Company B to
Company A are arm's length, it is determined that no adjustments to the
intercompany service charge are warranted. See Sec. 1.482-1(d)(3)(ii)
and paragraph (c)(2)(ii)(A) of this section.
(5) Indirect evidence of the price of a comparable uncontrolled
services transaction--(i) In general. The price of a comparable
uncontrolled services transaction may be derived based on indirect
measures of the price charged in comparable uncontrolled services
transactions, but only if--
(A) The data are widely and routinely used in the ordinary course of
business in the particular industry or market segment for purposes of
determining prices actually charged in comparable uncontrolled services
transactions;
(B) The data are used to set prices in the controlled services
transaction in the same way they are used to set prices in uncontrolled
services transactions of the controlled taxpayer, or in the same way
they are used by uncontrolled taxpayers to set prices in uncontrolled
services transactions; and
(C) The amount charged in the controlled services transaction may be
reliably adjusted to reflect differences in quality of the services,
contractual terms, market conditions, risks borne (including contingent-
payment terms), duration or quantitative measure of services rendered,
and other factors that may affect the price to which uncontrolled
taxpayers would agree.
(ii) Example. The following example illustrates this paragraph
(c)(5):
[[Page 762]]
Example. Indirect evidence of comparable uncontrolled services
price. (i) Company A is a United States insurance company. Company A's
wholly-owned Country X subsidiary, Company B, performs specialized risk
analysis for Company A as well as for uncontrolled parties. In
determining the price actually charged to uncontrolled entities for
performing such risk analysis, Company B uses a proprietary, multi-
factor computer program, which relies on the gross value of the policies
in the customer's portfolio, the relative composition of those policies,
their location, and the estimated number of personnel hours necessary to
complete the project. Uncontrolled companies that perform comparable
risk analysis in the same industry or market-segment use similar
proprietary computer programs to price transactions with uncontrolled
customers (the competitors' programs may incorporate different inputs,
or may assign different weights or values to individual inputs, in
arriving at the price).
(ii) During the taxable year subject to audit, Company B performed
risk analysis for uncontrolled parties as well as for Company A. Because
prices charged to uncontrolled customers reflected the composition of
each customer's portfolio together with other factors, the prices
charged in Company B's uncontrolled transactions do not provide a
reliable basis for determining the comparable uncontrolled services
price for the similar services rendered to Company A. However, in
evaluating an arm's length price for the studies performed by Company B
for Company A, Company B's proprietary computer program may be
considered as indirect evidence of the comparable uncontrolled services
price that would be charged to perform the services for Company A. The
reliability of the results obtained by application of this internal
computer program as a measure of an arm's length price for the services
will be increased to the extent that Company A used the internal
computer program to generate actual transaction prices for risk-analysis
studies performed for uncontrolled parties during the same taxable year
under audit; Company A used data that are widely and routinely used in
the ordinary course of business in the insurance industry to determine
the price charged; and Company A reliably adjusted the price charged in
the controlled services transaction to reflect differences that may
affect the price to which uncontrolled taxpayers would agree.
(d) Gross services margin method--(1) In general. The gross services
margin method evaluates whether the amount charged in a controlled
services transaction is arm's length by reference to the gross profit
margin realized in comparable uncontrolled transactions. This method
ordinarily is used in cases where a controlled taxpayer performs
services or functions in connection with an uncontrolled transaction
between a member of the controlled group and an uncontrolled taxpayer.
This method may be used where a controlled taxpayer renders services
(agent services) to another member of the controlled group in connection
with a transaction between that other member and an uncontrolled
taxpayer. This method also may be used in cases where a controlled
taxpayer contracts to provide services to an uncontrolled taxpayer
(intermediary function) and another member of the controlled group
actually performs a portion of the services provided.
(2) Determination of arm's length price--(i) In general. The gross
services margin method evaluates whether the price charged or amount
retained by a controlled taxpayer in the controlled services transaction
in connection with the relevant uncontrolled transaction is arm's length
by determining the appropriate gross profit of the controlled taxpayer.
(ii) Relevant uncontrolled transaction. The relevant uncontrolled
transaction is a transaction between a member of the controlled group
and an uncontrolled taxpayer as to which the controlled taxpayer
performs agent services or an intermediary function.
(iii) Applicable uncontrolled price. The applicable uncontrolled
price is the price paid or received by the uncontrolled taxpayer in the
relevant uncontrolled transaction.
(iv) Appropriate gross services profit. The appropriate gross
services profit is computed by multiplying the applicable uncontrolled
price by the gross services profit margin in comparable uncontrolled
transactions. The determination of the appropriate gross services profit
will take into account any functions performed by other members of the
controlled group, as well as any other relevant factors described in
Sec. 1.482-1(d)(3). The comparable gross services profit margin may be
determined by reference to the commission in an uncontrolled
transaction, where that commission is stated as a percentage of the
price charged in the uncontrolled transaction.
[[Page 763]]
(v) Arm's length range. See Sec. 1.482-1(e)(2) for determination of
the arm's length range.
(3) Comparability and reliability considerations--(i) In general.
Whether results derived from application of this method are the most
reliable measure of the arm's length result must be determined using the
factors described under the best method rule in Sec. 1.482-1(c). The
application of these factors under the gross services margin method is
discussed in paragraphs (d)(3)(ii) and (iii) of this section.
(ii) Comparability--(A) Functional comparability. The degree of
comparability between an uncontrolled transaction and a controlled
transaction is determined by applying the comparability provisions of
Sec. 1.482-1(d). A gross services profit provides compensation for
services or functions that bear a relationship to the relevant
uncontrolled transaction, including an operating profit in return for
the investment of capital and the assumption of risks by the controlled
taxpayer performing the services or functions under review. Therefore,
although all of the factors described in Sec. 1.482-1(d)(3) must be
considered, comparability under this method is particularly dependent on
similarity of services or functions performed, risks borne, intangible
property (if any) used in providing the services or functions, and
contractual terms, or adjustments to account for the effects of any such
differences. If possible, the appropriate gross services profit margin
should be derived from comparable uncontrolled transactions by the
controlled taxpayer under review, because similar characteristics are
more likely found among different transactions by the same controlled
taxpayer than among transactions by other parties. In the absence of
comparable uncontrolled transactions involving the same controlled
taxpayer, an appropriate gross services profit margin may be derived
from transactions of uncontrolled taxpayers involving comparable
services or functions with respect to similarly related transactions.
(B) Other comparability factors. Comparability under this method is
not dependent on close similarity of the relevant uncontrolled
transaction to the related transactions involved in the uncontrolled
comparables. However, substantial differences in the nature of the
relevant uncontrolled transaction and the relevant transactions involved
in the uncontrolled comparables, such as differences in the type of
property transferred or service provided in the relevant uncontrolled
transaction, may indicate significant differences in the services or
functions performed by the controlled and uncontrolled taxpayers with
respect to their respective relevant transactions. Thus, it ordinarily
would be expected that the services or functions performed in the
controlled and uncontrolled transactions would be with respect to
relevant transactions involving the transfer of property within the same
product categories or the provision of services of the same general type
(for example, information-technology systems design). Furthermore,
significant differences in the intangible property (if any) used by the
controlled taxpayer in the controlled services transaction as distinct
from the uncontrolled comparables may also affect the reliability of the
comparison. Finally, the reliability of profit measures based on gross
services profit may be adversely affected by factors that have less
effect on prices. For example, gross services profit may be affected by
a variety of other factors, including cost structures or efficiency (for
example, differences in the level of experience of the employees
performing the service in the controlled and uncontrolled transactions).
Accordingly, if material differences in these factors are identified
based on objective evidence, the reliability of the analysis may be
affected.
(C) Adjustments for differences between controlled and uncontrolled
transactions. If there are material differences between the controlled
and uncontrolled transactions that would affect the gross services
profit margin, adjustments should be made to the gross services profit
margin, according to the comparability provisions of Sec. 1.482-
1(d)(2). For this purpose, consideration of the total services costs
associated with functions performed and risks assumed may be necessary
because differences in functions performed are often reflected in these
costs. If there
[[Page 764]]
are differences in functions performed, however, the effect on gross
services profit of such differences is not necessarily equal to the
differences in the amount of related costs. Specific examples of factors
that may be particularly relevant to this method include--
(1) Contractual terms (for example, scope and terms of warranties or
guarantees regarding the services or function, volume, credit and
payment terms, and allocation of risks, including any contingent-payment
terms);
(2) Intangible property (if any) used in performing the services or
function;
(3) Geographic market in which the services or function are
performed or in which the relevant uncontrolled transaction takes place;
and
(4) Risks borne, including, if applicable, inventory-type risk.
(D) Buy-sell distributor. If a controlled taxpayer that performs an
agent service or intermediary function is comparable to a distributor
that takes title to goods and resells them, the gross profit margin
earned by such distributor on uncontrolled sales, stated as a percentage
of the price for the goods, may be used as the comparable gross services
profit margin.
(iii) Data and assumptions--(A) In general. The reliability of the
results derived from the gross services margin method is affected by the
completeness and accuracy of the data used and the reliability of the
assumptions made to apply this method. See Sec. 1.482-1(c) (best method
rule).
(B) Consistency in accounting. The degree of consistency in
accounting practices between the controlled transaction and the
uncontrolled comparables that materially affect the gross services
profit margin affects the reliability of the results under this method.
(4) Examples. The principles of this paragraph (d) are illustrated
by the following examples:
Example 1. Agent services. Company A and Company B are members of a
controlled group. Company A is a foreign manufacturer of industrial
equipment. Company B is a U.S. company that acts as a commission agent
for Company A by arranging for Company A to make direct sales of the
equipment it manufactures to unrelated purchasers in the U.S. market.
Company B does not take title to the equipment but instead receives from
Company A commissions that are determined as a specified percentage of
the sales price for the equipment that is charged by Company A to the
unrelated purchaser. Company B also arranges for direct sales of similar
equipment by unrelated foreign manufacturers to unrelated purchasers in
the U.S. market. Company B charges these unrelated foreign manufacturers
a commission fee of 5% of the sales price charged by the unrelated
foreign manufacturers to the unrelated U.S. purchasers for the
equipment. Information regarding the comparable agent services provided
by Company B to unrelated foreign manufacturers is sufficiently complete
to conclude that it is likely that all material differences between the
controlled and uncontrolled transactions have been identified and
adjustments for such differences have been made. If the comparable gross
services profit margin is 5% of the price charged in the relevant
transactions involved in the uncontrolled comparables, then the
appropriate gross services profit that Company B may earn and the arm's
length price that it may charge Company A for its agent services is
equal to 5% of the applicable uncontrolled price charged by Company A in
sales of equipment in the relevant uncontrolled transactions.
Example 2. Agent services. The facts are the same as in Example 1,
except that Company B does not act as a commission agent for unrelated
parties and it is not possible to obtain reliable information concerning
commission rates charged by uncontrolled commission agents that engage
in comparable transactions with respect to relevant sales of property.
It is possible, however, to obtain reliable information regarding the
gross profit margins earned by unrelated parties that briefly take title
to and then resell similar property in uncontrolled transactions, in
which they purchase the property from foreign manufacturers and resell
the property to purchasers in the U.S. market. Analysis of the facts and
circumstances indicates that, aside from certain minor differences for
which adjustments can be made, the uncontrolled parties that resell
property perform similar functions and assume similar risks as Company B
performs and assumes when it acts as a commission agent for Company A's
sales of property. Under these circumstances, the gross profit margin
earned by the unrelated distributors on the purchase and resale of
property may be used, subject to any adjustments for any material
differences between the controlled and uncontrolled transactions, as a
comparable gross services profit margin. The appropriate gross services
profit that Company B may earn and the arm's length price that it may
charge Company A for its agent services is therefore equal to this
comparable gross services margin, multiplied by the applicable
uncontrolled price charged by Company A in
[[Page 765]]
its sales of equipment in the relevant uncontrolled transactions.
Example 3. Agent services. (i) Company A and Company B are members
of a controlled group. Company A is a U.S. corporation that renders
computer consulting services, including systems integration and
networking, to business clients.
(ii) In undertaking engagements with clients, Company A in some
cases pays a commission of 3% of its total fees to unrelated parties
that assist Company A in obtaining consulting engagements. Typically,
such fees are paid to non-computer consulting firms that provide
strategic management services for their clients. When Company A obtains
a consulting engagement with a client of a non-computer consulting firm,
Company A does not subcontract with the other consulting firm, nor does
the other consulting firm play any role in Company A's consulting
engagement.
(iii) Company B, a Country X subsidiary of Company A, assists
Company A in obtaining an engagement to perform computer consulting
services for a Company B banking industry client in Country X. Although
Company B has an established relationship with its Country X client and
was instrumental in arranging for Company A's engagement with the
client, Company A's particular expertise was the primary consideration
in motivating the client to engage Company A. Based on the relative
contributions of Companies A and B in obtaining and undertaking the
engagement, Company B's role was primarily to facilitate the consulting
engagement between Company A and the Country X client. Information
regarding the commissions paid by Company A to unrelated parties for
providing similar services to facilitate Company A's consulting
engagements is sufficiently complete to conclude that it is likely that
all material differences between these uncontrolled transactions and the
controlled transaction between Company B and Company A have been
identified and that appropriate adjustments have been made for any such
differences. If the comparable gross services margin earned by unrelated
parties in providing such agent services is 3% of total fees charged in
the relevant transactions involved in the uncontrolled comparables, then
the appropriate gross services profit that Company B may earn and the
arm's length price that it may charge Company A for its agent services
is equal to this comparable gross services margin (3%), multiplied by
the applicable uncontrolled price charged by Company A in its relevant
uncontrolled consulting engagement with Company B's client.
Example 4. Intermediary function. (i) The facts are the same as in
Example 3, except that Company B contracts directly with its Country X
client to provide computer consulting services and Company A performs
the consulting services on behalf of Company B. Company A does not enter
into a consulting engagement with Company B's Country X client. Instead,
Company B charges its Country X client an uncontrolled price for the
consulting services, and Company B pays a portion of the uncontrolled
price to Company A for performing the consulting services on behalf of
Company B.
(ii) Analysis of the relative contributions of Companies A and B in
obtaining and undertaking the consulting contract indicates that Company
B functioned primarily as an intermediary contracting party, and the
gross services margin method is the most reliable method for determining
the amount that Company B may retain as compensation for its
intermediary function with respect to Company A's consulting services.
In this case, therefore, because Company B entered into the relevant
uncontrolled transaction to provide services, Company B receives the
applicable uncontrolled price that is paid by the Country X client for
the consulting services. Company A technically performs services for
Company B when it performs, on behalf of Company B, the consulting
services Company B contracted to provide to the Country X client. The
arm's length amount that Company A may charge Company B for performing
the consulting services on Company B's behalf is equal to the applicable
uncontrolled price received by Company B in the relevant uncontrolled
transaction, less Company B's appropriate gross services profit, which
is the amount that Company B may retain as compensation for performing
the intermediary function.
(iii) Reliable data concerning the commissions that Company A paid
to uncontrolled parties for assisting it in obtaining engagements to
provide consulting services similar to those it has provided on behalf
of Company B provide useful information in applying the gross services
margin method. However, consideration should be given to whether the
third party commission data may need to be adjusted to account for any
additional risk that Company B may have assumed as a result of its
function as an intermediary contracting party, compared with the risk it
would have assumed if it had provided agent services to assist Company A
in entering into an engagement to provide its consulting service
directly. In this case, the information regarding the commissions paid
by Company A to unrelated parties for providing agent services to
facilitate its performance of consulting services for unrelated parties
is sufficiently complete to conclude that all material differences
between these uncontrolled transactions and the controlled performance
of an intermediary function, including possible differences in the
amount of risk assumed in connection with performing that function, have
been identified and that appropriate adjustments have been made. If
[[Page 766]]
the comparable gross services margin earned by unrelated parties in
providing such agent services is 3% of total fees charged in Company B's
relevant uncontrolled transactions, then the appropriate gross services
profit that Company B may retain as compensation for performing an
intermediary function (and the amount, therefore, that is deducted from
the applicable uncontrolled price to arrive at the arm's length price
that Company A may charge Company B for performing consulting services
on Company B's behalf) is equal to this comparable gross services margin
(3%), multiplied by the applicable uncontrolled price charged by Company
B in its contract to provide services to the uncontrolled party.
Example 5. External comparable. (i) The facts are the same as in
Example 4, except that neither Company A nor Company B engages in
transactions with third parties that facilitate similar consulting
engagements.
(ii) Analysis of the relative contributions of Companies A and B in
obtaining and undertaking the contract indicates that Company B's role
was primarily to facilitate the consulting arrangement between Company A
and the Country X client. Although no reliable internal data are
available regarding comparable transactions with uncontrolled entities,
reliable data exist regarding commission rates for similar facilitating
services between uncontrolled parties. These data indicate that a 3%
commission (3% of total engagement fee) is charged in such transactions.
Information regarding the uncontrolled comparables is sufficiently
complete to conclude that it is likely that all material differences
between the controlled and uncontrolled transactions have been
identified and adjusted for. If the appropriate gross services profit
margin is 3% of total fees, then an arm's length result of the
controlled services transaction is for Company B to retain an amount
equal to 3% of total fees paid to it.
(e) Cost of services plus method--(1) In general. The cost of
services plus method evaluates whether the amount charged in a
controlled services transaction is arm's length by reference to the
gross services profit markup realized in comparable uncontrolled
transactions. The cost of services plus method is ordinarily used in
cases where the controlled service renderer provides the same or similar
services to both controlled and uncontrolled parties. This method is
ordinarily not used in cases where the controlled services transaction
involves a contingent-payment arrangement, as described in paragraph
(i)(2) of this section.
(2) Determination of arm's length price--(i) In general. The cost of
services plus method measures an arm's length price by adding the
appropriate gross services profit to the controlled taxpayer's
comparable transactional costs.
(ii) Appropriate gross services profit. The appropriate gross
services profit is computed by multiplying the controlled taxpayer's
comparable transactional costs by the gross services profit markup,
expressed as a percentage of the comparable transactional costs earned
in comparable uncontrolled transactions.
(iii) Comparable transactional costs. Comparable transactional costs
consist of the costs of providing the services under review that are
taken into account as the basis for determining the gross services
profit markup in comparable uncontrolled transactions. Depending on the
facts and circumstances, such costs typically include all compensation
attributable to employees directly involved in the performance of such
services, materials and supplies consumed or made available in rendering
such services, and may include as well other costs of rendering the
services. Comparable transactional costs must be determined on a basis
that will facilitate comparison with the comparable uncontrolled
transactions. For that reason, comparable transactional costs may not
necessarily equal total services costs, as defined in paragraph (j) of
this section, and in appropriate cases may be a subset of total services
costs. Generally accepted accounting principles or Federal income tax
accounting rules (where Federal income tax data for comparable
transactions or business activities are available) may provide useful
guidance but will not conclusively establish the appropriate comparable
transactional costs for purposes of this method.
(iv) Arm's length range. See Sec. 1.482-1(e)(2) for determination
of an arm's length range.
(3) Comparability and reliability considerations--(i) In general.
Whether results derived from the application of this method are the most
reliable measure of the arm's length result must be determined using the
factors described
[[Page 767]]
under the best method rule in Sec. 1.482-1(c).
(ii) Comparability--(A) Functional comparability. The degree of
comparability between controlled and uncontrolled transactions is
determined by applying the comparability provisions of Sec. 1.482-1(d).
A service renderer's gross services profit provides compensation for
performing services related to the controlled services transaction under
review, including an operating profit for the service renderer's
investment of capital and assumptions of risks. Therefore, although all
of the factors described in Sec. 1.482-1(d)(3) must be considered,
comparability under this method is particularly dependent on similarity
of services or functions performed, risks borne, intangible property (if
any) used in providing the services or functions, and contractual terms,
or adjustments to account for the effects of any such differences. If
possible, the appropriate gross services profit markup should be derived
from comparable uncontrolled transactions of the same taxpayer
participating in the controlled services transaction because similar
characteristics are more likely to be found among services provided by
the same service provider than among services provided by other service
providers. In the absence of such services transactions, an appropriate
gross services profit markup may be derived from comparable uncontrolled
services transactions of other service providers. If the appropriate
gross services profit markup is derived from comparable uncontrolled
services transactions of other service providers, in evaluating
comparability the controlled taxpayer must consider the results under
this method expressed as a markup on total services costs of the
controlled taxpayer, because differences in functions performed may be
reflected in differences in service costs other than those included in
comparable transactional costs.
(B) Other comparability factors. Comparability under this method is
less dependent on close similarity between the services provided than
under the comparable uncontrolled services price method. Substantial
differences in the services may, however, indicate significant
functional differences between the controlled and uncontrolled
taxpayers. Thus, it ordinarily would be expected that the controlled and
uncontrolled transactions would involve services of the same general
type (for example, information-technology systems design). Furthermore,
if a significant amount of the controlled taxpayer's comparable
transactional costs consists of service costs incurred in a tax
accounting period other than the tax accounting period under review, the
reliability of the analysis would be reduced. In addition, significant
differences in the value of the services rendered, due for example to
the use of valuable intangible property, may also affect the reliability
of the comparison. Finally, the reliability of profit measures based on
gross services profit may be adversely affected by factors that have
less effect on prices. For example, gross services profit may be
affected by a variety of other factors, including cost structures or
efficiency-related factors (for example, differences in the level of
experience of the employees performing the service in the controlled and
uncontrolled transactions). Accordingly, if material differences in
these factors are identified based on objective evidence, the
reliability of the analysis may be affected.
(C) Adjustments for differences between the controlled and
uncontrolled transactions. If there are material differences between the
controlled and uncontrolled transactions that would affect the gross
services profit markup, adjustments should be made to the gross services
profit markup earned in the comparable uncontrolled transaction
according to the provisions of Sec. 1.482-1(d)(2). For this purpose,
consideration of the comparable transactional costs associated with the
functions performed and risks assumed may be necessary, because
differences in the functions performed are often reflected in these
costs. If there are differences in functions performed, however, the
effect on gross services profit of such differences is not necessarily
equal to the differences in the amount of related comparable
transactional costs. Specific examples of the factors that may be
particularly relevant to this method include--
[[Page 768]]
(1) The complexity of the services;
(2) The duration or quantitative measure of services;
(3) Contractual terms (for example, scope and terms of warranties or
guarantees provided, volume, credit and payment terms, allocation of
risks, including any contingent-payment terms);
(4) Economic circumstances; and
(5) Risks borne.
(iii) Data and assumptions--(A) In general. The reliability of the
results derived from the cost of services plus method is affected by the
completeness and accuracy of the data used and the reliability of the
assumptions made to apply this method. See Sec. 1.482-1(c) (Best method
rule).
(B) Consistency in accounting. The degree of consistency in
accounting practices between the controlled transaction and the
uncontrolled comparables that materially affect the gross services
profit markup affects the reliability of the results under this method.
Thus, for example, if differences in cost accounting practices would
materially affect the gross services profit markup, the ability to make
reliable adjustments for such differences would affect the reliability
of the results obtained under this method. Further, reliability under
this method depends on the extent to which the controlled and
uncontrolled transactions reflect consistent reporting of comparable
transactional costs. For purposes of this paragraph (e)(3)(iii)(B), the
term comparable transactional costs includes the cost of acquiring
tangible property that is transferred (or used) with the services, to
the extent that the arm's length price of the tangible property is not
separately evaluated as a controlled transaction under another
provision.
(4) Examples. The principles of this paragraph (e) are illustrated
by the following examples:
Example 1. Internal comparable. (i) Company A designs and assembles
information-technology networks and systems. When Company A renders
services for uncontrolled parties, it receives compensation based on
time and materials as well as certain other related costs necessary to
complete the project. This fee includes the cost of hardware and
software purchased from uncontrolled vendors and incorporated in the
final network or system, plus a reasonable allocation of certain
specified overhead costs incurred by Company A in providing these
services. Reliable accounting records maintained by Company A indicate
that Company A earned a gross services profit markup of 10% on its time,
materials and specified overhead in providing design services during the
year under examination on information technology projects for
uncontrolled entities.
(ii) Company A designed an information-technology network for its
Country X subsidiary, Company B. The services rendered to Company B are
similar in scope and complexity to services that Company A rendered to
uncontrolled parties during the year under examination. Using Company
A's accounting records (which are determined to be reliable under
paragraph (e)(3) of this section), it is possible to identify the
comparable transactional costs involved in the controlled services
transaction with reference to the costs incurred by Company A in
rendering similar design services to uncontrolled parties. Company A's
records indicate that it does not incur any additional types of costs in
rendering similar services to uncontrolled customers. The data available
are sufficiently complete to conclude that it is likely that all
material differences between the controlled and uncontrolled
transactions have been identified and adjusted for. Based on the gross
services profit markup data derived from Company A's uncontrolled
transactions involving similar design services, an arm's length result
for the controlled services transaction is equal to the price that will
allow Company A to earn a 10% gross services profit markup on its
comparable transactional costs.
Example 2. Inability to adjust for differences in comparable
transactional costs. The facts are the same as in Example 1, except that
Company A's staff that rendered the services to Company B consisted
primarily of engineers in training status or on temporary rotation from
other Company A subsidiaries. In addition, the Company B network
incorporated innovative features, including specially designed software
suited to Company B's requirements. The use of less-experienced
personnel and staff on temporary rotation, together with the special
features of the Company B network, significantly increased the time and
costs associated with the project as compared to time and costs
associated with similar projects completed for uncontrolled customers.
These factors constitute material differences between the controlled and
the uncontrolled transactions that affect the determination of Company
A's comparable transactional costs associated with the controlled
services transaction, as well as the gross services profit
[[Page 769]]
markup. Moreover, it is not possible to perform reliable adjustments for
these differences on the basis of the available accounting data. Under
these circumstances, the reliability of the cost of services plus method
as a measure of an arm's length price is substantially reduced.
Example 3. Operating loss by reference to total services costs. The
facts and analysis are the same as in Example 1, except that an
unrelated Company C, instead of Company A, renders similar services to
uncontrolled parties and publicly available information indicates that
Company C earned a gross services profit markup of 10% on its time,
materials and certain specified overhead in providing those services. As
in Example 1, Company A still provides services for its Country X
subsidiary, Company B. In accordance with the requirements in paragraph
(e)(3)(ii) of this section, the taxpayer performs additional analysis
and restates the results of Company A's controlled services transaction
with its Country X subsidiary, Company B, in the form of a markup on
Company A's total services costs. This analysis by reference to total
services costs shows that Company A generated an operating loss on the
controlled services transaction, which indicates that functional
differences likely exist between the controlled services transaction
performed by Company A and uncontrolled services transactions performed
by Company C, and that these differences may not be reflected in the
comparable transactional costs. Upon further scrutiny, the presence of
such functional differences between the controlled and uncontrolled
transactions may indicate that the cost of services plus method does not
provide the most reliable measure of an arm's length result under the
facts and circumstances.
Example 4. Internal comparable. (i) Company A, a U.S. corporation,
and its subsidiaries perform computer consulting services relating to
systems integration and networking for business clients in various
countries. Company A and its subsidiaries render only consulting
services and do not manufacture or distribute computer hardware or
software to clients. The controlled group is organized according to
industry specialization, with key industry specialists working for
Company A. These personnel typically form the core consulting group that
teams with consultants from the local-country subsidiaries to serve
clients in the subsidiaries' respective countries.
(ii) On some occasions, Company A and its subsidiaries undertake
engagements directly for clients. On other occasions, they work as
subcontractors for uncontrolled parties on more extensive consulting
engagements for clients. In undertaking the latter engagements with
third-party consultants, Company A typically prices its services at four
times the compensation costs of its consultants, defined as the
consultants' base salary plus estimated fringe benefits, as defined in
this table:
------------------------------------------------------------------------
Category Rate
------------------------------------------------------------------------
Project managers.......................... $100 per hour.
Technical staff........................... $75 per hour.
------------------------------------------------------------------------
(iii) In uncontrolled transactions, Company A also charges the
customer, at no markup, for out-of-pocket expenses such as travel,
lodging, and data acquisition charges. Thus, for example, a project
involving 100 hours of time from project managers, and 400 hours of
technical staff time would result in total compensation costs to Company
A of (100 hrs. x $100/hr.) + (400 hrs. x $75/hr.) = $10,000 + $30,000 =
$40,000. Applying the markup of 300%, the total fee charged would thus
be (4 x $40,000), or $160,000, plus out-of-pocket expenses.
(iv) Company B, a Country X subsidiary of Company A, contracts to
render consulting services to a Country X client in the banking
industry. In undertaking this engagement, Company B uses its own
consultants and also uses the services of Company A project managers and
technical staff that specialize in the banking industry for 75 hours and
380 hours, respectively. The data available are sufficiently complete to
conclude that it is likely that all material differences between the
controlled and uncontrolled transactions have been identified and
adjusted for. Based on reliable data concerning the compensation costs
to Company A, an arm's length result for the controlled services
transaction is equal to $144,000. This is calculated as follows: [4 x
(75 hrs. x $100/hr.)] + [4 x (380 hrs. x $75/hr.)] = $30,000 + $114,000
= $144,000, reflecting a 300% markup on the total compensation costs for
Company A project managers and technical staff. In addition, consistent
with Company A's pricing of uncontrolled transactions, Company B must
reimburse Company A for appropriate out-of-pocket expenses incurred in
performing the services.
(f) Comparable profits method--(1) In general. The comparable
profits method evaluates whether the amount charged in a controlled
transaction is arm's length, based on objective measures of
profitability (profit level indicators) derived from uncontrolled
taxpayers that engage in similar business activities under similar
circumstances. The rules in Sec. 1.482-5 relating to the comparable
profits method apply to controlled services transactions, except as
modified in this paragraph (f).
(2) Determination of arm's length result--(i) Tested party. This
paragraph (f)
[[Page 770]]
applies where the relevant business activity of the tested party as
determined under Sec. 1.482-5(b)(2) is the rendering of services in a
controlled services transaction. Where the tested party determined under
Sec. 1.482-5(b)(2) is instead the recipient of the controlled services,
the rules under this paragraph (f) are not applicable to determine the
arm's length result.
(ii) Profit level indicators. In addition to the profit level
indicators provided in Sec. 1.482-5(b)(4), a profit level indicator
that may provide a reliable basis for comparing operating profits of the
tested party involved in a controlled services transaction and
uncontrolled comparables is the ratio of operating profit to total
services costs (as defined in paragraph (j) of this section).
(iii) Comparability and reliability considerations--Data and
assumptions--Consistency in accounting. Consistency in accounting
practices between the relevant business activity of the tested party and
the uncontrolled service providers is particularly important in
determining the reliability of the results under this method, but less
than in applying the cost of services plus method. Adjustments may be
appropriate if materially different treatment is applied to particular
cost items related to the relevant business activity of the tested party
and the uncontrolled service providers. For example, adjustments may be
appropriate where the tested party and the uncontrolled comparables use
inconsistent approaches to classify similar expenses as ``cost of goods
sold'' and ``selling, general, and administrative expenses.'' Although
distinguishing between these two categories may be difficult, the
distinction is less important to the extent that the ratio of operating
profit to total services costs is used as the appropriate profit level
indicator. Determining whether adjustments are necessary under these or
similar circumstances requires thorough analysis of the functions
performed and consideration of the cost accounting practices of the
tested party and the uncontrolled comparables. Other adjustments as
provided in Sec. 1.482-5(c)(2)(iv) may also be necessary to increase
the reliability of the results under this method.
(3) Examples. The principles of this paragraph (f) are illustrated
by the following examples:
Example 1. Ratio of operating profit to total services costs as the
appropriate profit level indicator. (i) A Country T parent firm, Company
A, and its Country Y subsidiary, Company B, both engage in manufacturing
as their principal business activity. Company A also performs certain
advertising services for itself and its affiliates. In year 1, Company A
renders advertising services to Company B.
(ii) Based on the facts and circumstances, it is determined that the
comparable profits method will provide the most reliable measure of an
arm's length result. Company A is selected as the tested party. No data
are available for comparable independent manufacturing firms that render
advertising services to third parties. Financial data are available,
however, for ten independent firms that render similar advertising
services as their principal business activity in Country X. The ten
firms are determined to be comparable under Sec. 1.482-5(c). Neither
Company A nor the comparable companies use valuable intangible property
in rendering the services.
(iii) Based on the available financial data of the comparable
companies, it cannot be determined whether these comparable companies
report costs for financial accounting purposes in the same manner as the
tested party. The publicly available financial data of the comparable
companies segregate total services costs into cost of goods sold and
sales, general and administrative costs, with no further segmentation of
costs provided. Due to the limited information available regarding the
cost accounting practices used by the comparable companies, the ratio of
operating profits to total services costs is determined to be the most
appropriate profit level indicator. This ratio includes total services
costs to minimize the effect of any inconsistency in accounting
practices between Company A and the comparable companies.
Example 2. Application of the operating profit to total services
costs profit level indicator. (i) Company A is a foreign subsidiary of
Company B, a U.S. corporation. Company B is under examination for its
year 1 taxable year. Company B renders management consulting services to
Company A. Company B's consulting function includes analyzing Company
A's operations, benchmarking Company A's financial performance against
companies in the same industry, and to the extent necessary, developing
a strategy to improve Company A's operational performance. The
accounting records of Company B allow reliable identification of the
total services costs of the consulting staff associated with the
management consulting services rendered to
[[Page 771]]
Company A. Company A reimburses Company B for its costs associated with
rendering the consulting services, with no markup.
(ii) Based on all the facts and circumstances, it is determined that
the comparable profits method will provide the most reliable measure of
an arm's length result. Company B is selected as the tested party, and
its rendering of management consulting services is identified as the
relevant business activity. Data are available from ten domestic
companies that operate in the industry segment involving management
consulting and that perform activities comparable to the relevant
business activity of Company B. These comparables include entities that
primarily perform management consulting services for uncontrolled
parties. The comparables incur similar risks as Company B incurs in
performing the consulting services and do not make use of valuable
intangible property or special processes.
(iii) Based on the available financial data of the comparables, it
cannot be determined whether the comparables report their costs for
financial accounting purposes in the same manner as Company B reports
its costs in the relevant business activity. The available financial
data for the comparables report only an aggregate figure for costs of
goods sold and operating expenses, and do not segment the underlying
services costs. Due to this limitation, the ratio of operating profits
to total services costs is determined to be the most appropriate profit
level indicator.
(iv) For the taxable years 1 through 3, Company B shows the
following results for the services performed for Company A:
----------------------------------------------------------------------------------------------------------------
Year 1 Year 2 Year 3 Average
----------------------------------------------------------------------------------------------------------------
Revenues........................................ 1,200,000 1,100,000 1,300,000 1,200,000
Cost of Goods Sold.............................. 100,000 100,000 N/A 66,667
Operating Expenses.............................. 1,100,000 1,000,000 1,300,000 1,133,333
Operating Profit................................ 0 0 0 0
----------------------------------------------------------------------------------------------------------------
(v) After adjustments have been made to account for identified
material differences between the relevant business activity of Company B
and the comparables, the average ratio for the taxable years 1 through 3
of operating profit to total services costs is calculated for each of
the uncontrolled service providers. Applying each ratio to Company B's
average total services costs from the relevant business activity for the
taxable years 1 through 3 would lead to the following comparable
operating profit (COP) for the services rendered by Company B:
------------------------------------------------------------------------
OP/Total
service Company B
Uncontrolled service provider costs COP
(percent)
------------------------------------------------------------------------
Company 1................................... 15.75 $189,000
Company 2................................... 15.00 180,000
Company 3................................... 14.00 168,000
Company 4................................... 13.30 159,600
Company 5................................... 12.00 144,000
Company 6................................... 11.30 135,600
Company 7................................... 11.25 135,000
Company 8................................... 11.18 134,160
Company 9................................... 11.11 133,320
Company 10.................................. 10.75 129,000
------------------------------------------------------------------------
(vi) The available data are not sufficiently complete to conclude
that it is likely that all material differences between the relevant
business activity of Company B and the comparables have been identified.
Therefore, an arm's length range can be established only pursuant to
Sec. 1.482-1(e)(2)(iii)(B). The arm's length range is established by
reference to the interquartile range of the results as calculated under
Sec. 1.482-1(e)(2)(iii)(C), which consists of the results ranging from
$168,000 to $134,160. Company B's reported average operating profit of
zero ($0) falls outside this range. Therefore, an allocation may be
appropriate.
(vii) Because Company B reported income of zero, to determine the
amount, if any, of the allocation, Company B's reported operating profit
for year 3 is compared to the comparable operating profits derived from
the comparables' results for year 3. The ratio of operating profit to
total services costs in year 3 is calculated for each of the comparables
and applied to Company B's year 3 total services costs to derive the
following results:
------------------------------------------------------------------------
OP/Total
service
Uncontrolled service provider costs (for Company B
year 3) COP
(percent)
------------------------------------------------------------------------
Company 1................................... 15.00 $195,000
Company 2................................... 14.75 191,750
Company 3................................... 14.00 182,000
Company 4................................... 13.50 175,500
Company 5................................... 12.30 159,900
Company 6................................... 11.05 143,650
Company 7................................... 11.03 143,390
Company 8................................... 11.00 143,000
Company 9................................... 10.50 136,500
Company 10.................................. 10.25 133,250
------------------------------------------------------------------------
(viii) Based on these results, the median of the comparable
operating profits for year 3 is $151,775. Therefore, Company B's income
for year 3 is increased by $151,775, the difference between Company B's
reported operating profit for year 3 of zero and the median of the
comparable operating profits for year 3.
[[Page 772]]
Example 3. Material difference in accounting for stock-based
compensation. (i) Taxpayer, a U.S. corporation the stock of which is
publicly traded, performs controlled services for its wholly-owned
subsidiaries. The arm's length price of these controlled services is
evaluated under the comparable profits method for services in paragraph
(f) of this section by reference to the net cost plus profit level
indicator (PLI). Taxpayer is the tested party under paragraph (f)(2)(i)
of this section. The Commissioner identifies the most narrowly
identifiable business activity of the tested party for which data are
available that incorporate the controlled transaction (the relevant
business activity). The Commissioner also identifies four uncontrolled
domestic service providers, Companies A, B, C, and D, each of which
performs exclusively activities similar to the relevant business
activity of Taxpayer that is subject to analysis under paragraph (f) of
this section. The stock of Companies A, B, C, and D is publicly traded
on a U.S. stock exchange. Assume that Taxpayer makes an election to
apply these regulations to earlier taxable years.
(ii) Stock options are granted to the employees of Taxpayer that
engage in the relevant business activity. Assume that, as determined
under a method in accordance with U.S. generally accepted accounting
principles, the fair value of such stock options attributable to the
employees' performance of the relevant business activity is 500 for the
taxable year in question. In evaluating the controlled services,
Taxpayer includes salaries, fringe benefits, and related compensation of
these employees in ``total services costs,'' as defined in paragraph (j)
of this section. Taxpayer does not include any amount attributable to
stock options in total services costs, nor does it deduct that amount in
determining ''reported operating profit'' within the meaning of Sec.
1.482-5(d)(5), for the year under examination.
(iii) Stock options are granted to the employees of Companies A, B,
C, and D. Under a fair value method in accordance with U.S. generally
accepted accounting principles, the comparables include in total
compensation the value of the stock options attributable to the
employees' performance of the relevant business activity for the annual
financial reporting period, and treat this amount as an expense in
determining operating profit for financial accounting purposes. The
treatment of employee stock options is summarized in the following
table:
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Stock options
option fair value expensed
compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................ 1,000 500 0
Company A....................................................... 7,000 2,000 2,000
Company B....................................................... 4,300 250 250
Company C....................................................... 12,000 4,500 4,500
Company D....................................................... 15,000 2,000 2,000
----------------------------------------------------------------------------------------------------------------
(iv) A material difference in accounting for stock-based
compensation (within the meaning of Sec. 1.482-7T(d)(3)(i)) exists.
Analysis indicates that this difference would materially affect the
measure of an arm's length result under this paragraph (f). In making an
adjustment to improve comparability under Sec. Sec. 1.482-1(d)(2) and
1.482-5(c)(2)(iv), the Commissioner includes in total services costs of
the tested party the total compensation costs of 1,500 (including stock
option fair value). In addition, the Commissioner calculates the net
cost plus PLI by reference to the financial-accounting data of Companies
A, B, C, and D, which take into account compensatory stock options.
Example 4. Material difference in utilization of stock-based
compensation. (i) The facts are the same as in paragraph (i) of Example
3.
(ii) No stock options are granted to the employees of Taxpayer that
engage in the relevant business activity. Thus, no deduction for stock
options is made in determining ``reported operating profit'' (within the
meaning of Sec. 1.482-5(d)(5)) for the taxable year under examination.
(iii) Stock options are granted to the employees of Companies A, B,
C, and D, but none of these companies expense stock options for
financial accounting purposes. Under a method in accordance with U.S.
generally accepted accounting principles, however, Companies A, B, C,
and D disclose the fair value of the stock options for financial
accounting purposes. The utilization and treatment of employee stock
options is summarized in the following table:
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Stock options
option fair value expensed
compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................ 1,000 0 N/A
[[Page 773]]
Company A....................................................... 7,000 2,000 0
Company B....................................................... 4,300 250 0
Company C....................................................... 12,000 4,500 0
Company D....................................................... 15,000 2,000 0
----------------------------------------------------------------------------------------------------------------
(iv) A material difference in the utilization of stock-based
compensation (within the meaning of Sec. 1.482-7T(d)(3)(i)) exists.
Analysis indicates that these differences would materially affect the
measure of an arm's length result under this paragraph (f). In
evaluating the comparable operating profits of the tested party, the
Commissioner uses Taxpayer's total services costs, which include total
compensation costs of 1,000. In considering whether an adjustment is
necessary to improve comparability under Sec. Sec. 1.482-1(d)(2) and
1.482-5(c)(2)(iv), the Commissioner recognizes that the total
compensation provided to employees of Taxpayer is comparable to the
total compensation provided to employees of Companies A, B, C, and D.
Because Companies A, B, C, and D do not expense stock-based compensation
for financial accounting purposes, their reported operating profits must
be adjusted in order to improve comparability with the tested party. The
Commissioner increases each comparable's total services costs, and also
reduces its reported operating profit, by the fair value of the stock-
based compensation incurred by the comparable company.
(v) The adjustments to the data of Companies A, B, C, and D
described in paragraph (iv) of this Example 4 are summarized in the
following table:
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Total services Operating Net cost plus
option fair value costs (A) profit (B) PLI (B/A)
compensation (Percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
Company A................... 7,000 2,000 25,000 6,000 24.00
Company B................... 4,300 250 12,500 2,500 20.00
Company C................... 12,000 4,500 36,000 11,000 30.56
Company D................... 15,000 2,000 27,000 7,000 25.93
As adjusted:
Company A................... 7,000 2,000 27,000 4,000 14.81
Company B................... 4,300 250 12,750 2,250 17.65
Company C................... 12,000 4,500 40,500 6,500 16.05
Company D................... 15,000 2,000 29,000 5,000 17.24
----------------------------------------------------------------------------------------------------------------
Example 5. Non-material difference in utilization of stock-based
compensation. (i) The facts are the same as in paragraph (i) of Example
3.
(ii) Stock options are granted to the employees of Taxpayer that
engage in the relevant business activity. Assume that, as determined
under a method in accordance with U.S. generally accepted accounting
principles, the fair value of such stock options attributable to the
employees' performance of the relevant business activity is 50 for the
taxable year. Taxpayer includes salaries, fringe benefits, and all other
compensation of these employees (including the stock option fair value)
in ``total services costs,'' as defined in paragraph (j) of this
section, and deducts these amounts in determining ``reported operating
profit'' within the meaning of Sec. 1.482-5(d)(5), for the taxable year
under examination.
(iii) Stock options are granted to the employees of Companies A, B,
C, and D, but none of these companies expense stock options for
financial accounting purposes. Under a method in accordance with U.S.
generally accepted accounting principles, however, Companies A, B, C,
and D disclose the fair value of the stock options for financial
accounting purposes. The utilization and treatment of employee stock
options is summarized in the following table:
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Stock options
option fair value expensed
compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................ 1,000 50 50
Company A....................................................... 7,000 100 0
Company B....................................................... 4,300 40 0
[[Page 774]]
Company C....................................................... 12,000 130 0
Company D....................................................... 15,000 75 0
----------------------------------------------------------------------------------------------------------------
(iv) Analysis of the data reported by Companies A, B, C, and D
indicates that an adjustment for differences in utilization of stock-
based compensation would not have a material effect on the determination
of an arm's length result.
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Total services Operating Net cost plus
option fair value costs (A) profit (B) PLI (B/A)
compensation (percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
Company A................... 7,000 100 25,000 6,000 24.00
Company B................... 4,300 40 12,500 2,500 20.00
Company C................... 12,000 130 36,000 11,000 30.56
Company D................... 15,000 75 27,000 7,000 25.93
As adjusted:
Company A................... 7,000 100 25,100 5,900 23.51
Company B................... 4,300 40 12,540 2,460 19.62
Company C................... 12,000 130 36,130 10,870 30.09
Company D................... 15,000 75 27,075 6,925 25.58
----------------------------------------------------------------------------------------------------------------
(v) Under the circumstances, the difference in utilization of stock-
based compensation would not materially affect the determination of the
arm's length result under this paragraph (f). Accordingly, in
calculating the net cost plus PLI, no comparability adjustment is made
to the data of Companies A, B, C, or D pursuant to Sec. Sec. 1.482-
1(d)(2) and 1.482-5(c)(2)(iv).
Example 6. Material difference in comparables' accounting for stock-
based compensation. (i) The facts are the same as in paragraph (i) of
Example 3.
(ii) Stock options are granted to the employees of Taxpayer that
engage in the relevant business activity. Assume that, as determined
under a method in accordance with U.S. generally accepted accounting
principles, the fair value of such stock options attributable to
employees' performance of the relevant business activity is 500 for the
taxable year. Taxpayer includes salaries, fringe benefits, and all other
compensation of these employees (including the stock option fair value)
in ``total services costs,'' as defined in paragraph (j) of this
section, and deducts these amounts in determining ``reported operating
profit'' (within the meaning of Sec. 1.482-5(d)(5)) for the taxable
year under examination.
(iii) Stock options are granted to the employees of Companies A, B,
C, and D. Companies A and B expense the stock options for financial
accounting purposes in accordance with U.S. generally accepted
accounting principles. Companies C and D do not expense the stock
options for financial accounting purposes. Under a method in accordance
with U.S. generally accepted accounting principles, however, Companies C
and D disclose the fair value of these options in their financial
statements. The utilization and accounting treatment of options are
depicted in the following table:
----------------------------------------------------------------------------------------------------------------
Salary and
other non- Stock options Stock options
option fair value expensed
compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................ 1,000 500 500
Company A....................................................... 7,000 2,000 2,000
Company B....................................................... 4,300 250 250
Company C....................................................... 12,000 4,500 0
Company D....................................................... 15,000 2,000 0
----------------------------------------------------------------------------------------------------------------
(iv) A material difference in accounting for stock-based
compensation (within the meaning of Sec. 1.482-7T(d)(3)(i)) exists.
Analysis indicates that this difference would materially affect the
measure of the arm's length result under paragraph (f) of this section.
In evaluating the comparable operating profits of the tested party, the
Commissioner includes in
[[Page 775]]
total services costs Taxpayer's total compensation costs of 1,500
(including stock option fair value of 500). In considering whether an
adjustment is necessary to improve comparability under Sec. Sec. 1.482-
1(d)(2) and 1.482-5(c)(2)(iv), the Commissioner recognizes that the
total employee compensation (including stock options provided by
Taxpayer and Companies A, B, C, and D) provides a reliable basis for
comparison. Because Companies A and B expense stock-based compensation
for financial accounting purposes, whereas Companies C and D do not, an
adjustment to the comparables' operating profit is necessary. In
computing the net cost plus PLI, the Commissioner uses the financial-
accounting data of Companies A and B, as reported. The Commissioner
increases the total services costs of Companies C and D by amounts equal
to the fair value of their respective stock options, and reduces the
operating profits of Companies C and D accordingly.
(v) The adjustments described in paragraph (iv) of this Example 6
are depicted in the following table. For purposes of illustration, the
unadjusted data of Companies A and B are also included.
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Total services Operating Net cost plus
option fair value costs (A) profit (B) PLI (B/A)
compensation (percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
Company A................... 7,000 2,000 27,000 4,000 14.80
Company B................... 4,300 250 12,750 2,250 17.65
As adjusted:
Company C................... 12,000 4,500 40,500 6,500 16.05
Company D................... 15,000 2,000 29,000 5,000 17.24
----------------------------------------------------------------------------------------------------------------
(g) Profit split method--(1) In general. The profit split method
evaluates whether the allocation of the combined operating profit or
loss attributable to one or more controlled transactions is arm's length
by reference to the relative value of each controlled taxpayer's
contribution to that combined operating profit or loss. The relative
value of each controlled taxpayer's contribution is determined in a
manner that reflects the functions performed, risks assumed and
resources employed by such controlled taxpayer in the relevant business
activity. For application of the profit split method (both the
comparable profit split and the residual profit split), see Sec. 1.482-
6. The residual profit split method may not be used where only one
controlled taxpayer makes significant nonroutine contributions.
(2) Examples. The principles of this paragraph (g) are illustrated
by the following examples:
Example 1. Residual profit split. (i) Company A, a corporation
resident in Country X, auctions spare parts by means of an interactive
database. Company A maintains a database that lists all spare parts
available for auction. Company A developed the software used to run the
database. Company A's database is managed by Company A employees in a
data center located in Country X, where storage and manipulation of data
also take place. Company A has a wholly-owned subsidiary, Company B,
located in Country Y. Company B performs marketing and advertising
activities to promote Company A's interactive database. Company B
solicits unrelated companies to auction spare parts on Company A's
database, and solicits customers interested in purchasing spare parts
online. Company B owns and maintains a computer server in Country Y,
where it receives information on spare parts available for auction.
Company B has also designed a specialized communications network that
connects its data center to Company A's data center in Country X. The
communications network allows Company B to enter data from uncontrolled
companies on Company A's database located in Country X. Company B's
communications network also allows uncontrolled companies to access
Company A's interactive database and purchase spare parts. Company B
bore the risks and cost of developing this specialized communications
network. Company B enters into contracts with uncontrolled companies and
provides the companies access to Company A's database through the
Company B network.
(ii) Analysis of the facts and circumstances indicates that both
Company A and Company B possess valuable intangible property that they
use to conduct the spare parts auction business. Company A bore the
economic risks of developing and maintaining software and the
interactive database. Company B bore the economic risks of developing
the necessary technology to transmit information from its server to
Company A's data center, and to allow uncontrolled companies to access
Company A's database. Company B helped to enhance the value of Company
A's
[[Page 776]]
trademark and to establish a network of customers in Country Y. In
addition, there are no market comparables for the transactions between
Company A and Company B to reliably evaluate them separately. Given the
facts and circumstances, the Commissioner determines that a residual
profit split method will provide the most reliable measure of an arm's
length result.
(iii) Under the residual profit split method, profits are first
allocated based on the routine contributions of each taxpayer. Routine
contributions include general sales, marketing or administrative
functions performed by Company B for Company A for which it is possible
to identify market returns. Any residual profits will be allocated based
on the nonroutine contributions of each taxpayer. Since both Company A
and Company B provided nonroutine contributions, the residual profits
are allocated based on these contributions.
Example 2. Residual profit split. (i) Company A, a Country 1
corporation, provides specialized services pertaining to the processing
and storage of Level 1 hazardous waste (for purposes of this example,
the most dangerous type of waste). Under long-term contracts with
private companies and governmental entities in Country 1, Company A
performs multiple services, including transportation of Level 1 waste,
development of handling and storage protocols, recordkeeping, and
supervision of waste-storage facilities owned and maintained by the
contracting parties. Company A's research and development unit has also
developed new and unique processes for transport and storage of Level 1
waste that minimize environmental and occupational effects. In addition
to this novel technology, Company A has substantial know-how and a long-
term record of safe operations in Country 1.
(ii) Company A's subsidiary, Company B, has been in operation
continuously for a number of years in Country 2. Company B has
successfully completed several projects in Country 2 involving Level 2
and Level 3 waste, including projects with government-owned entities.
Company B has a license in Country 2 to handle Level 2 waste (Level 3
does not require a license). Company B has established a reputation for
completing these projects in a responsible manner. Company B has
cultivated contacts with procurement officers, regulatory and licensing
officials, and other government personnel in Country 2.
(iii) Country 2 government publishes invitations to bid on a project
to handle the country's burgeoning volume of Level 1 waste, all of which
is generated in government-owned facilities. Bidding is limited to
companies that are domiciled in Country 2 and that possess a license
from the government to handle Level 1 or Level 2 waste. In an effort to
submit a winning bid to secure the contract, In an effort to submit a
winning bid to secure the contract, Company B points to its Level 2
license and its record of successful completion of projects, and also
demonstrates to Country 2 government that it has access to substantial
technical expertise pertaining to processing of Level 1 waste.
(iv) Company A enters into a long-term technical services agreement
with Company B. Under this agreement, Company A agrees to supply to
Company B project managers and other technical staff who have detailed
knowledge of Company A's proprietary Level 1 remediation techniques.
Company A commits to perform under any long-term contracts entered into
by Company B. Company B agrees to compensate Company A based on a markup
on Company A's marginal costs (pro rata compensation and current
expenses of Company A personnel). In the bid on the Country 2 contract
for Level 1 waste remediation, Company B proposes to use a multi-
disciplinary team of specialists from Company A and Company B. Project
managers from Company A will direct the team, which will also include
employees of Company B and will make use of physical assets and
facilities owned by Company B. Only Company A and Company B personnel
will perform services under the contract. Country 2 grants Company B a
license to handle Level 1 waste.
(v) Country 2 grants Company B a five-year, exclusive contract to
provide processing services for all Level 1 hazardous waste generated in
County 2. Under the contract, Company B is to be paid a fixed price per
ton of Level 1 waste that it processes each year. Company B undertakes
that all services provided will meet international standards applicable
to processing of Level 1 waste. Company B begins performance under the
contract.
(vi) Analysis of the facts and circumstances indicates that both
Company A and Company B make nonroutine contributions to the Level 1
waste processing activity in Country 2. In addition, it is determined
that reliable comparables are not available for the services that
Company A provides under the long-term contract, in part because those
services incorporate specialized knowledge and process intangible
property developed by Company A. It is also determined that reliable
comparables are not available for the Level 2 license in Country 2, the
successful track record, the government contacts with Country 2
officials, and other intangible property that Company B provided. In
view of these facts, the Commissioner determines that the residual
profit split method for services in paragraph (g) of this section
provides the most reliable means of evaluating the arm's length results
for the transaction. In evaluating the appropriate returns to Company A
and Company B
[[Page 777]]
for their respective contributions, the Commissioner takes into account
that the controlled parties incur different risks, because the contract
between the controlled parties provides that Company A will be
compensated on the basis of marginal costs incurred, plus a markup,
whereas the contract between Company B and the government of Country 2
provides that Company B will be compensated on a fixed-price basis per
ton of Level 1 waste processed.
(vii) In the first stage of the residual profit split, an arm's
length return is determined for routine activities performed by Company
B in Country 2, such as transportation, recordkeeping, and
administration. In addition, an arm's length return is determined for
routine activities performed by Company A (administrative, human
resources, etc.) in connection with providing personnel to Company B.
After the arm's length return for these functions is determined,
residual profits may be present. In the second stage of the residual
profit split, any residual profit is allocated by reference to the
relative value of the nonroutine contributions made by each taxpayer.
Company A's nonroutine contributions include its commitment to perform
under the contract and the specialized technical knowledge made
available through the project managers under the services agreement with
Company B. Company B's nonroutine contributions include its licenses to
handle Level 1 and Level 2 waste in Country 2, its knowledge of and
contacts with procurement, regulatory and licensing officials in the
government of Country 2, and its record in Country 2 of successfully
handling non-Level 1 waste.
(h) Unspecified methods. Methods not specified in paragraphs (b)
through (g) of this section may be used to evaluate whether the amount
charged in a controlled services transaction is arm's length. Any method
used under this paragraph (h) must be applied in accordance with the
provisions of Sec. 1.482-1. Consistent with the specified methods, an
unspecified method should take into account the general principle that
uncontrolled taxpayers evaluate the terms of a transaction by
considering the realistic alternatives to that transaction, including
economically similar transactions structured as other than services
transactions, and only enter into a particular transaction if none of
the alternatives is preferable to it. For example, the comparable
uncontrolled services price method compares a controlled services
transaction to similar uncontrolled transactions to provide a direct
estimate of the price to which the parties would have agreed had they
resorted directly to a market alternative to the controlled services
transaction. Therefore, in establishing whether a controlled services
transaction achieved an arm's length result, an unspecified method
should provide information on the prices or profits that the controlled
taxpayer could have realized by choosing a realistic alternative to the
controlled services transaction (for example, outsourcing a particular
service function, rather than performing the function itself). As with
any method, an unspecified method will not be applied unless it provides
the most reliable measure of an arm's length result under the principles
of the best method rule. See Sec. 1.482-1(c). Therefore, in accordance
with Sec. 1.482-1(d) (comparability), to the extent that an unspecified
method relies on internal data rather than uncontrolled comparables, its
reliability will be reduced. Similarly, the reliability of a method will
be affected by the reliability of the data and assumptions used to apply
the method, including any projections used.
Example. (i) Company T, a U.S. corporation, develops computer
software programs including a real estate investment program that
performs financial analysis of commercial real properties. Companies U,
V, and W are owned by Company T. The primary business activity of
Companies U, V, and W is commercial real estate development. For
business reasons, Company T does not sell the computer program to its
customers (on a compact disk or via download from Company T's server
through the Internet). Instead, Company T maintains the software program
on its own server and allows customers to access the program through the
Internet by using a password. The transactions between Company T and
Companies U, V, and W are structured as controlled services transactions
whereby Companies U, V, and W obtain access via the Internet to Company
T's software program for financial analysis. Each year, Company T
provides a revised version of the computer program including the most
recent data on the commercial real estate market, rendering the old
version obsolete.
(ii) In evaluating whether the consideration paid by Companies U, V,
and W to Company T was arm's length, the Commissioner may consider,
subject to the best method rule of Sec. 1.482-1(c), Company T's
alternative of selling the computer program to Companies U, V, and W on
a compact disk or
[[Page 778]]
via download through the Internet. The Commissioner determines that the
controlled services transactions between Company T and Companies U, V,
and W are comparable to the transfer of a similar software program on a
compact disk or via download through the Internet between uncontrolled
parties. Subject to adjustments being made for material differences
between the controlled services transactions and the comparable
uncontrolled transactions, the uncontrolled transfers of tangible
property may be used to evaluate the arm's length results for the
controlled services transactions between Company T and Companies U, V,
and W.
(i) Contingent-payment contractual terms for services--(1)
Contingent-payment contractual terms recognized in general. In the case
of a contingent-payment arrangement, the arm's length result for the
controlled services transaction generally would not require payment by
the recipient to the renderer in the tax accounting period in which the
service is rendered if the specified contingency does not occur in that
period. If the specified contingency occurs in a tax accounting period
subsequent to the period in which the service is rendered, the arm's
length result for the controlled services transaction generally would
require payment by the recipient to the renderer on a basis that
reflects the recipient's benefit from the services rendered and the
risks borne by the renderer in performing the activities in the absence
of a provision that unconditionally obligates the recipient to pay for
the activities performed in the tax accounting period in which the
service is rendered.
(2) Contingent-payment arrangement. For purposes of this paragraph
(i), an arrangement will be treated as a contingent-payment arrangement
if it meets all of the requirements in paragraph (i)(2)(i) of this
section and is consistent with the economic substance and conduct
requirement in paragraph (i)(2)(ii) of this section.
(i) General requirements--(A) Written contract. The arrangement is
set forth in a written contract entered into prior to, or
contemporaneous with, the start of the activity or group of activities
constituting the controlled services transaction.
(B) Specified contingency. The contract states that payment for a
controlled services transaction is contingent (in whole or in part) upon
the happening of a future benefit (within the meaning of Sec. 1.482-
9(l)(3)) for the recipient directly related to the activity or group of
activities. For purposes of the preceding sentence, whether the future
benefit is directly related to the activity or group of activities is
evaluated based on all the facts and circumstances.
(C) Basis for payment. The contract provides for payment on a basis
that reflects the recipient's benefit from the services rendered and the
risks borne by the renderer.
(ii) Economic substance and conduct. The arrangement, including the
contingency and the basis for payment, is consistent with the economic
substance of the controlled transaction and the conduct of the
controlled parties. See Sec. 1.482-1(d)(3)(ii)(B).
(3) Commissioner's authority to impute contingent-payment terms.
Consistent with the authority in Sec. 1.482-1(d)(3)(ii)(B), the
Commissioner may impute contingent-payment contractual terms in a
controlled services transaction if the economic substance of the
transaction is consistent with the existence of such terms.
(4) Evaluation of arm's length charge. Whether the amount charged in
a contingent-payment arrangement is arm's length will be evaluated in
accordance with this section and other applicable regulations under
section 482. In evaluating whether the amount charged in a contingent-
payment arrangement for the manufacture, construction, or development of
tangible or intangible property owned by the recipient is arm's length,
the charge determined under the rules of Sec. Sec. 1.482-3 and 1.482-4
for the transfer of similar property may be considered. See Sec. 1.482-
1(f)(2)(ii).
(5) Examples. The principles of this paragraph (i) are illustrated
by the following examples:
Example 1. (i) Company X is a member of a controlled group that has
operated in the pharmaceutical sector for many years. In year 1, Company
X enters into a written services agreement with Company Y, another
member of the controlled group, whereby Company X will perform certain
research and development activities for Company Y. The parties enter
into the agreement before Company X undertakes any of
[[Page 779]]
the research and development activities covered by the agreement. At the
time the agreement is entered into, the possibility that any new
products will be developed is highly uncertain and the possible market
or markets for any products that may be developed are not known and
cannot be estimated with any reliability. Under the agreement, Company Y
will own any patent or other rights that result from the activities of
Company X under the agreement and Company Y will make payments to
Company X only if such activities result in commercial sales of one or
more derivative products. In that event, Company Y will pay Company X,
for a specified period, x% of Company Y's gross sales of each of such
products. Payments are required with respect to each jurisdiction in
which Company Y has sales of such a derivative product, beginning with
the first year in which the sale of a product occurs in the jurisdiction
and continuing for six additional years with respect to sales of that
product in that jurisdiction.
(ii) As a result of research and development activities performed by
Company X for Company Y in years 1 through 4, a compound is developed
that may be more effective than existing medications in the treatment of
certain conditions. Company Y registers the patent rights with respect
to the compound in several jurisdictions in year 4. In year 6, Company Y
begins commercial sales of the product in Jurisdiction A and, in that
year, Company Y makes the payment to Company X that is required under
the agreement. Sales of the product continue in Jurisdiction A in years
7 through 9 and Company Y makes the payments to Company X in years 7
through 9 that are required under the agreement.
(iii) The years under examination are years 6 through 9. In
evaluating whether the contingent-payment terms will be recognized, the
Commissioner considers whether the conditions of paragraph (i)(2) of
this section are met and whether the arrangement, including the
specified contingency and basis of payment, is consistent with the
economic substance of the controlled services transaction and with the
conduct of the controlled parties. The Commissioner determines that the
contingent-payment arrangement is reflected in the written agreement
between Company X and Company Y; that commercial sales of products
developed under the arrangement represent future benefits for Company Y
directly related to the controlled services transaction; and that the
basis for the payment provided for in the event such sales occur
reflects the recipient's benefit and the renderer's risk. Consistent
with Sec. 1.482-1(d)(3)(ii)(B) and (iii)(B), the Commissioner
determines that the parties' conduct over the term of the agreement has
been consistent with their contractual allocation of risk; that Company
X has the financial capacity to bear the risk that its research and
development services may be unsuccessful and that it may not receive
compensation for such services; and that Company X exercises managerial
and operational control over the research and development, such that it
is reasonable for Company X to assume the risk of those activities.
Based on all these facts, the Commissioner determines that the
contingent-payment arrangement is consistent with economic substance.
(iv) In determining whether the amount charged under the contingent-
payment arrangement in each of years 6 through 9 is arm's length, the
Commissioner evaluates under this section and other applicable rules
under section 482 the compensation paid in each year for the research
and development services. This analysis takes into account that under
the contingent-payment terms Company X bears the risk that it might not
receive payment for its services in the event that those services do not
result in marketable products and the risk that the magnitude of its
payment depends on the magnitude of product sales, if any. The
Commissioner also considers the alternatives reasonably available to the
parties in connection with the controlled services transaction. One such
alternative, in view of Company X's willingness and ability to bear the
risk and expenses of research and development activities, would be for
Company X to undertake such activities on its own behalf and to license
the rights to products successfully developed as a result of such
activities. Accordingly, in evaluating whether the compensation of x% of
gross sales that is paid to Company X during the first four years of
commercial sales of derivative products is arm's length, the
Commissioner may consider the royalties (or other consideration) charged
for intangible property that are comparable to those incorporated in the
derivative products and that resulted from Company X's research and
development activities under the contingent-payment arrangement.
Example 2. (i) The facts are the same as in Example 1, except that
no commercial sales ever materialize with regard to the patented
compound so that, consistent with the agreement, Company Y makes no
payments to Company X in years 6 through 9.
(ii) Based on all the facts and circumstances, the Commissioner
determines that the contingent-payment arrangement is consistent with
economic substance, and the result (no payments in years 6 through 9) is
consistent with an arm's length result.
Example 3. (i) The facts are the same as in Example 1, except that,
in the event that Company X's activities result in commercial sales of
one or more derivative products by Company Y, Company Y will pay Company
X a fee equal to the research and development costs borne by Company X
plus an amount
[[Page 780]]
equal to x% of such costs, with the payment to be made in the first year
in which any such sales occur. The x% markup on costs is within the
range, ascertainable in year 1, of markups on costs of independent
contract researchers that are compensated under terms that
unconditionally obligate the recipient to pay for the activities
performed in the tax accounting period in which the service is rendered.
In year 6, Company Y makes the single payment to Company X that is
required under the arrangement.
(ii) The years under examination are years 6 through 9. In
evaluating whether the contingent-payment terms will be recognized, the
Commissioner considers whether the requirements of paragraph (i)(2) of
this section were met at the time the written agreement was entered into
and whether the arrangement, including the specified contingency and
basis for payment, is consistent with the economic substance of the
controlled services transaction and with the conduct of the controlled
parties. The Commissioner determines that the contingent-payment terms
are reflected in the written agreement between Company X and Company Y
and that commercial sales of products developed under the arrangement
represent future benefits for Company Y directly related to the
controlled services transaction. However, in this case, the Commissioner
determines that the basis for payment provided for in the event such
sales occur (costs of the services plus x%, representing the markup for
contract research in the absence of any nonpayment risk) does not
reflect the recipient's benefit and the renderer's risks in the
controlled services transaction. Based on all the facts and
circumstances, the Commissioner determines that the contingent-payment
arrangement is not consistent with economic substance.
(iii) Accordingly, the Commissioner determines to exercise its
authority to impute contingent-payment contractual terms that accord
with economic substance, pursuant to paragraph (i)(3) of this section
and Sec. 1.482-1(d)(3)(ii)(B). In this regard, the Commissioner takes
into account that at the time the arrangement was entered into, the
possibility that any new products would be developed was highly
uncertain and the possible market or markets for any products that may
be developed were not known and could not be estimated with any
reliability. In such circumstances, it is reasonable to conclude that
one possible basis of payment, in order to reflect the recipient's
benefit and the renderer's risks, would be a charge equal to a
percentage of commercial sales of one or more derivative products that
result from the research and development activities. The Commissioner in
this case may impute terms that require Company Y to pay Company X a
percentage of sales of the products developed under the agreement in
each of years 6 through 9.
(iv) In determining an appropriate arm's length charge under such
imputed contractual terms, the Commissioner conducts an analysis under
this section and other applicable rules under section 482, and considers
the alternatives reasonably available to the parties in connection with
the controlled services transaction. One such alternative, in view of
Company X's willingness and ability to bear the risks and expenses of
research and development activities, would be for Company X to undertake
such activities on its own behalf and to license the rights to products
successfully developed as a result of such activities. Accordingly, for
purposes of its determination, the Commissioner may consider the
royalties (or other consideration) charged for intangible property that
are comparable to those incorporated in the derivative products that
resulted from Company X's research and development activities under the
contingent-payment arrangement.
(j) Total services costs. For purposes of this section, total
services costs means all costs of rendering those services for which
total services costs are being determined. Total services costs include
all costs in cash or in kind (including stock-based compensation) that,
based on analysis of the facts and circumstances, are directly
identified with, or reasonably allocated in accordance with the
principles of paragraph (k)(2) of this section to, the services. In
general, costs for this purpose should comprise provision for all
resources expended, used, or made available to achieve the specific
objective for which the service is rendered. Reference to generally
accepted accounting principles or Federal income tax accounting rules
may provide a useful starting point but will not necessarily be
conclusive regarding inclusion of costs in total services costs. Total
services costs do not include interest expense, foreign income taxes (as
defined in Sec. 1.901-2(a)), or domestic income taxes.
(k) Allocation of costs--(1) In general. In any case where the
renderer's activity that results in a benefit (within the meaning of
paragraph (l)(3) of this section) for one recipient in a controlled
services transaction also generates a benefit for one or more other
members of a controlled group (including the benefit, if any, to the
renderer), and the amount charged under this section
[[Page 781]]
in the controlled services transaction is determined under a method that
makes reference to costs, costs must be allocated among the portions of
the activity performed for the benefit of the first mentioned recipient
and such other members of the controlled group under this paragraph (k).
The principles of this paragraph (k) must also be used whenever it is
appropriate to allocate and apportion any class of costs (for example,
overhead costs) in order to determine the total services costs of
rendering the services. In no event will an allocation of costs based on
a generalized or non-specific benefit be appropriate.
(2) Appropriate method of allocation and apportionment--(i)
Reasonable method standard. Any reasonable method may be used to
allocate and apportion costs under this section. In establishing the
appropriate method of allocation and apportionment, consideration should
be given to all bases and factors, including, for example, total
services costs, total costs for a relevant activity, assets, sales,
compensation, space utilized, and time spent. The costs incurred by
supporting departments may be apportioned to other departments on the
basis of reasonable overall estimates, or such costs may be reflected in
the other departments' costs by applying reasonable departmental
overhead rates. Allocations and apportionments of costs must be made on
the basis of the full cost, as opposed to the incremental cost.
(ii) Use of general practices. The practices used by the taxpayer to
apportion costs in connection with preparation of statements and
analyses for the use of management, creditors, minority shareholders,
joint venturers, clients, customers, potential investors, or other
parties or agencies in interest will be considered as potential
indicators of reliable allocation methods, but need not be accorded
conclusive weight by the Commissioner. In determining the extent to
which allocations are to be made to or from foreign members of a
controlled group, practices employed by the domestic members in
apportioning costs among themselves will also be considered if the
relationships with the foreign members are comparable to the
relationships among the domestic members of the controlled group. For
example, if for purposes of reporting to public stockholders or to a
governmental agency, a corporation apportions the costs attributable to
its executive officers among the domestic members of a controlled group
on a reasonable and consistent basis, and such officers exercise
comparable control over foreign members of the controlled group, such
domestic apportionment practice will be considered in determining the
allocations to be made to the foreign members.
(3) Examples. The principles of this paragraph (k) are illustrated
by the following examples:
Example 1. Company A pays an annual license fee of 500x to an
uncontrolled taxpayer for unlimited use of a database within the
corporate group. Under the terms of the license with the uncontrolled
taxpayer, Company A is permitted to use the database for its own use and
in rendering research services to its subsidiary, Company B. Company B
obtains benefits from the database that are similar to those that it
would obtain if it had independently licensed the database from the
uncontrolled taxpayer. Evaluation of the arm's length charge (under a
method in which costs are relevant) to Company B for the controlled
services that incorporate use of the database must take into account the
full amount of the license fee of 500x paid by Company A, as reasonably
allocated and apportioned to the relevant benefits, although the
incremental use of the database for the benefit of Company B did not
result in an increase in the license fee paid by Company A.
Example 2. (i) Company A is a consumer products company located in
the United States. Companies B and C are wholly-owned subsidiaries of
Company A and are located in Countries B and C, respectively. Company A
and its subsidiaries manufacture products for sale in their respective
markets. Company A hires a consultant who has expertise regarding a
manufacturing process used by Company A and its subsidiary, Company B.
Company C, the Country C subsidiary, uses a different manufacturing
process, and accordingly will not receive any benefit from the outside
consultant hired by Company A. In allocating and apportioning the cost
of hiring the outside consultant (100), Company A determines that sales
constitute the most appropriate allocation key.
(ii) Company A and its subsidiaries have the following sales:
[[Page 782]]
----------------------------------------------------------------------------------------------------------------
Company A B C Total
----------------------------------------------------------------------------------------------------------------
Sales....................................... 400 100 200 700
----------------------------------------------------------------------------------------------------------------
(iii) Because Company C does not obtain any benefit from the
consultant, none of the costs are allocated to it. Rather, the costs of
100 are allocated and apportioned ratably to Company A and Company B as
the entities that obtain a benefit from the campaign, based on the total
sales of those entities (500). An appropriate allocation of the costs of
the consultant is as follows:
------------------------------------------------------------------------
Company A B Total
------------------------------------------------------------------------
Allocation....................... 400/500 100/500
Amount........................... 80 20 100
------------------------------------------------------------------------
(l) Controlled services transaction--(1) In general. A controlled
services transaction includes any activity (as defined in paragraph
(l)(2) of this section) by one member of a group of controlled taxpayers
(the renderer) that results in a benefit (as defined in paragraph (l)(3)
of this section) to one or more other members of the controlled group
(the recipient(s)).
(2) Activity. An activity includes the performance of functions,
assumptions of risks, or use by a renderer of tangible or intangible
property or other resources, capabilities, or knowledge, such as
knowledge of and ability to take advantage of particularly advantageous
situations or circumstances. An activity also includes making available
to the recipient any property or other resources of the renderer.
(3) Benefit--(i) In general. An activity is considered to provide a
benefit to the recipient if the activity directly results in a
reasonably identifiable increment of economic or commercial value that
enhances the recipient's commercial position, or that may reasonably be
anticipated to do so. An activity is generally considered to confer a
benefit if, taking into account the facts and circumstances, an
uncontrolled taxpayer in circumstances comparable to those of the
recipient would be willing to pay an uncontrolled party to perform the
same or similar activity on either a fixed or contingent-payment basis,
or if the recipient otherwise would have performed for itself the same
activity or a similar activity. A benefit may result to the owner of
intangible property if the renderer engages in an activity that is
reasonably anticipated to result in an increase in the value of that
intangible property. Paragraphs (l)(3)(ii) through (v) of this section
provide guidelines that indicate the presence or absence of a benefit
for the activities in the controlled services transaction.
(ii) Indirect or remote benefit. An activity is not considered to
provide a benefit to the recipient if, at the time the activity is
performed, the present or reasonably anticipated benefit from that
activity is so indirect or remote that the recipient would not be
willing to pay, on either a fixed or contingent-payment basis, an
uncontrolled party to perform a similar activity, and would not be
willing to perform such activity for itself for this purpose. The
determination whether the benefit from an activity is indirect or remote
is based on the nature of the activity and the situation of the
recipient, taking into consideration all facts and circumstances.
(iii) Duplicative activities. If an activity performed by a
controlled taxpayer duplicates an activity that is performed, or that
reasonably may be anticipated to be performed, by another controlled
taxpayer on or for its own account, the activity is generally not
considered to provide a benefit to the recipient, unless the duplicative
activity itself provides an additional benefit to the recipient.
(iv) Shareholder activities. An activity is not considered to
provide a benefit if the sole effect of that activity is either to
protect the renderer's capital investment in the recipient or in other
members of the controlled group, or to facilitate compliance by the
renderer with reporting, legal, or regulatory requirements applicable
specifically to the renderer, or both. Activities in the nature of day-
to-day management generally do not relate to protection of the
renderer's capital investment. Based on analysis of the facts and
circumstances, activities in connection with a corporate reorganization
may be
[[Page 783]]
considered to provide a benefit to one or more controlled taxpayers.
(v) Passive association. A controlled taxpayer generally will not be
considered to obtain a benefit where that benefit results from the
controlled taxpayer's status as a member of a controlled group. A
controlled taxpayer's status as a member of a controlled group may,
however, be taken into account for purposes of evaluating comparability
between controlled and uncontrolled transactions.
(4) Disaggregation of transactions. A controlled services
transaction may be analyzed as two separate transactions for purposes of
determining the arm's length consideration, if that analysis is the most
reliable means of determining the arm's length consideration for the
controlled services transaction. See the best method rule under Sec.
1.482-1(c).
(5) Examples. The principles of this paragraph (l) are illustrated
by the following examples. In each example, assume that Company X is a
U.S. corporation and Company Y is a wholly-owned subsidiary of Company X
in Country B.
Example 1. In general. In developing a worldwide advertising and
promotional campaign for a consumer product, Company X pays for and
obtains designation as an official sponsor of the Olympics. This
designation allows Company X and all its subsidiaries, including Company
Y, to identify themselves as sponsors and to use the Olympic logo in
advertising and promotional campaigns. The Olympic sponsorship campaign
generates benefits to Company X, Company Y, and other subsidiaries of
Company X.
Example 2. Indirect or remote benefit. Based on recommendations
contained in a study performed by its internal staff, Company X
implements certain changes in its management structure and the
compensation of managers of divisions located in the United States. No
changes were recommended or considered for Company Y in Country B. The
internal study and the resultant changes in its management may increase
the competitiveness and overall efficiency of Company X. Any benefits to
Company Y as a result of the study are, however, indirect or remote.
Consequently, Company Y is not considered to obtain a benefit from the
study.
Example 3. Indirect or remote benefit. Based on recommendations
contained in a study performed by its internal staff, Company X decides
to make changes to the management structure and management compensation
of its subsidiaries, in order to increase their profitability. As a
result of the recommendations in the study, Company X implements
substantial changes in the management structure and management
compensation scheme of Company Y. The study and the changes implemented
as a result of the recommendations are anticipated to increase the
profitability of Company X and its subsidiaries. The increased
management efficiency of Company Y that results from these changes is
considered to be a specific and identifiable benefit, rather than remote
or speculative.
Example 4. Duplicative activities. At its corporate headquarters in
the United States, Company X performs certain treasury functions for
Company X and for its subsidiaries, including Company Y. These treasury
functions include raising capital, arranging medium and long-term
financing for general corporate needs, including cash management. Under
these circumstances, the treasury functions performed by Company X do
not duplicate the functions performed by Company Y's staff. Accordingly,
Company Y is considered to obtain a benefit from the functions performed
by Company X.
Example 5. Duplicative activities. The facts are the same as in
Example 4, except that Company Y's functions include ensuring that the
financing requirements of its own operations are met. Analysis of the
facts and circumstances indicates that Company Y independently
administers all financing and cash-management functions necessary to
support its operations, and does not utilize financing obtained by
Company X. Under the circumstances, the treasury functions performed by
Company X are duplicative of similar functions performed by Company Y's
staff, and the duplicative functions do not enhance Company Y's
position. Accordingly, Company Y is not considered to obtain a benefit
from the duplicative activities performed by Company X.
Example 6. Duplicative activities. Company X's in-house legal staff
has specialized expertise in several areas, including intellectual
property. The intellectual property legal staff specializes in
technology licensing, patents, copyrights, and negotiating and drafting
intellectual property agreements. Company Y is involved in negotiations
with an unrelated party to enter into a complex joint venture that
includes multiple licenses and cross-licenses of patents and copyrights.
Company Y retains outside counsel that specializes in intellectual
property law to review the transaction documents. Company Y does not
have in-house counsel of its own to review intellectual property
transaction documents. Outside counsel advises that the terms for the
proposed transaction are advantageous to Company Y and that the
contracts are valid and fully enforceable. Company X's intellectual
property legal staff possess valuable knowledge of Company Y's
[[Page 784]]
patents and technological achievements. They are capable of identifying
particular scientific attributes protected under patent that strengthen
Company Y's negotiating position, and of discovering flaws in the
patents offered by the unrelated party. To reduce risk associated with
the transaction, Company X's intellectual property legal staff reviews
the transaction documents before Company Y executes the contracts.
Company X's intellectual property legal staff also separately evaluates
the patents and copyrights with respect to the licensing arrangements
and concurs in the opinion provided by outside counsel. The activities
performed by Company X substantially duplicate the legal services
obtained by Company Y, but they also reduce risk associated with the
transaction in a way that confers an additional benefit on Company Y.
Example 7. Shareholder activities. Company X is a publicly held
corporation. U.S. laws and regulations applicable to publicly held
corporations such as Company X require the preparation and filing of
periodic reports that show, among other things, profit and loss
statements, balance sheets, and other material financial information
concerning the company's operations. Company X, Company Y and each of
the other subsidiaries maintain their own separate accounting
departments that record individual transactions and prepare financial
statements in accordance with their local accounting practices. Company
Y, and the other subsidiaries, forward the results of their financial
performance to Company X, which analyzes and compiles these data into
periodic reports in accordance with U.S. laws and regulations. Because
Company X's preparation and filing of the reports relate solely to its
role as an investor of capital or shareholder in Company Y or to its
compliance with reporting, legal, or regulatory requirements, or both,
these activities constitute shareholder activities and therefore Company
Y is not considered to obtain a benefit from the preparation and filing
of the reports.
Example 8. Shareholder activities. The facts are the same as in
Example 7, except that Company Y's accounting department maintains a
general ledger recording individual transactions, but does not prepare
any financial statements (such as profit and loss statements and balance
sheets). Instead, Company Y forwards the general ledger data to Company
X, and Company X analyzes and compiles financial statements for Company
Y, as well as for Company X's overall operations, for purposes of
complying with U.S. reporting requirements. Company Y is subject to
reporting requirements in Country B similar to those applicable to
Company X in the United States. Much of the data that Company X analyzes
and compiles regarding Company Y's operations for purposes of complying
with the U.S. reporting requirements are made available to Company Y for
its use in preparing reports that must be filed in Country B. Company Y
incorporates these data, after minor adjustments for differences in
local accounting practices, into the reports that it files in Country B.
Under these circumstances, because Company X's analysis and compilation
of Company Y's financial data does not relate solely to its role as an
investor of capital or shareholder in Company Y, or to its compliance
with reporting, legal, or regulatory requirements, or both, these
activities do not constitute shareholder activities.
Example 9. Shareholder activities. Members of Company X's internal
audit staff visit Company Y on a semiannual basis in order to review the
subsidiary's adherence to internal operating procedures issued by
Company X and its compliance with U.S. anti-bribery laws, which apply to
Company Y on account of its ownership by a U.S. corporation. Because the
sole effect of the reviews by Company X's audit staff is to protect
Company X's investment in Company Y, or to facilitate Company X's
compliance with U.S. anti-bribery laws, or both, the visits are
shareholder activities and therefore Company Y is not considered to
obtain a benefit from the visits.
Example 10. Shareholder activities. Country B recently enacted
legislation that changed the foreign currency exchange controls
applicable to foreign shareholders of Country B corporations. Company X
concludes that it may benefit from changing the capital structure of
Company Y, thus taking advantage of the new foreign currency exchange
control laws in Country B. Company X engages an investment banking firm
and a law firm to review the Country B legislation and to propose
possible changes to the capital structure of Company Y. Because Company
X's retention of the firms facilitates Company Y's ability to pay
dividends and other amounts and has the sole effect of protecting
Company X's investment in Company Y, these activities constitute
shareholder activities and Company Y is not considered to obtain a
benefit from the activities.
Example 11. Shareholder activities. The facts are the same as in
Example 10, except that Company Y bears the full cost of retaining the
firms to evaluate the new foreign currency control laws in Country B and
to make appropriate changes to its stock ownership by Company X. Company
X is considered to obtain a benefit from the rendering by Company Y of
these activities, which would be shareholder activities if conducted by
Company X (see Example 10).
Example 12. Shareholder activities. The facts are the same as in
Example 10, except that the new laws relate solely to corporate
governance in Country B, and Company X retains the law firm and
investment banking
[[Page 785]]
firm in order to evaluate whether restructuring would increase Company
Y's profitability, reduce the number of legal entities in Country B, and
increase Company Y's ability to introduce new products more quickly in
Country B. Because Company X retained the law firm and the investment
banking firm primarily to enhance Company Y's profitability and the
efficiency of its operations, and not solely to protect Company X's
investment in Company Y or to facilitate Company X's compliance with
Country B's corporate laws, or to both, these activities do not
constitute shareholder activities.
Example 13. Shareholder activities. Company X establishes detailed
personnel policies for its subsidiaries, including Company Y. Company X
also reviews and approves the performance appraisals of Company Y's
executives, monitors levels of compensation paid to all Company Y
personnel, and is involved in hiring and firing decisions regarding the
senior executives of Company Y. Because this personnel-related activity
by Company X involves day-to-day management of Company Y, this activity
does not relate solely to Company X's role as an investor of capital or
a shareholder of Company Y, and therefore does not constitute a
shareholder activity.
Example 14. Shareholder activities. Each year, Company X conducts a
two-day retreat for its senior executives. The purpose of the retreat is
to refine the long-term business strategy of Company X and its
subsidiaries, including Company Y, and to produce a confidential
strategy statement. The strategy statement identifies several potential
growth initiatives for Company X and its subsidiaries and lists general
means of increasing the profitability of the company as a whole. The
strategy statement is made available without charge to Company Y and the
other subsidiaries of Company X. Company Y independently evaluates
whether to implement some, all, or none of the initiatives contained in
the strategy statement. Because the preparation of the strategy
statement does not relate solely to Company X's role as an investor of
capital or a shareholder of Company Y, the expense of preparing the
document is not a shareholder expense.
Example 15. Passive association/benefit. Company X is the parent
corporation of a large controlled group that has been in operation in
the information-technology sector for ten years. Company Y is a small
corporation that was recently acquired by the Company X controlled group
from local Country B owners. Several months after the acquisition of
Company Y, Company Y obtained a contract to redesign and assemble the
information-technology networks and systems of a large financial
institution in Country B. The project was significantly larger and more
complex than any other project undertaken to date by Company Y. Company
Y did not use Company X's marketing intangible property to solicit the
contract, and Company X had no involvement in the solicitation,
negotiation, or anticipated execution of the contract. For purposes of
this section, Company Y is not considered to obtain a benefit from
Company X or any other member of the controlled group because the
ability of Company Y to obtain the contract, or to obtain the contract
on more favorable terms than would have been possible prior to its
acquisition by the Company X controlled group, was due to Company Y's
status as a member of the Company X controlled group and not to any
specific activity by Company X or any other member of the controlled
group.
Example 16. Passive association/benefit. The facts are the same as
in Example 15, except that Company X executes a performance guarantee
with respect to the contract, agreeing to assist in the project if
Company Y fails to meet certain mileposts. This performance guarantee
allowed Company Y to obtain the contract on materially more favorable
terms than otherwise would have been possible. Company Y is considered
to obtain a benefit from Company X's execution of the performance
guarantee.
Example 17. Passive association/benefit. The facts are the same as
in Example 15, except that Company X began the process of negotiating
the contract with the financial institution in Country B before
acquiring Company Y. Once Company Y was acquired by Company X, the
contract with the financial institution was entered into by Company Y.
Company Y is considered to obtain a benefit from Company X's negotiation
of the contract.
Example 18. Passive association/benefit. The facts are the same as
in Example 15, except that Company X sent a letter to the financial
institution in Country B, which represented that Company X had a certain
percentage ownership in Company Y and that Company X would maintain that
same percentage ownership interest in Company Y until the contract was
completed. This letter allowed Company Y to obtain the contract on more
favorable terms than otherwise would have been possible. Since this
letter from Company X to the financial institution simply affirmed
Company Y's status as a member of the controlled group and represented
that this status would be maintained until the contract was completed,
Company Y is not considered to obtain a benefit from Company X's
furnishing of the letter.
Example 19. Passive association/benefit. (i) S is a company that
supplies plastic containers to companies in various industries. S
establishes the prices for its containers through a price list that
offers customers discounts based solely on the volume of containers
purchased.
[[Page 786]]
(ii) Company X is the parent corporation of a large controlled group
in the information technology sector. Company Y is a wholly-owned
subsidiary of Company X located in Country B. Company X and Company Y
both purchase plastic containers from unrelated supplier S. In year 1,
Company X purchases 1 million units and Company Y purchases 100,000
units. S, basing its prices on purchases by the entire group, completes
the order for 1.1 million units at a price of $0.95 per unit, and
separately bills and ships the orders to each company. Companies X and Y
undertake no bargaining with supplier S with respect to the price
charged, and purchase no other products from supplier S.
(iii) R1 and its wholly-owned subsidiary R2 are a controlled group
of taxpayers (unrelated to Company X or Company Y) each of which carries
out functions comparable to those of Companies X and Y and undertakes
purchases of plastic containers from supplier S, identical to those
purchased from S by Company X and Company Y, respectively. S, basing its
prices on purchases by the entire group, charges R1 and R2 $0.95 per
unit for the 1.1 million units ordered. R1 and R2 undertake no
bargaining with supplier S with respect to the price charged, and
purchase no other products from supplier S.
(iv) U is an uncontrolled taxpayer that carries out comparable
functions and undertakes purchases of plastic containers from supplier S
identical to Company Y. U is not a member of a controlled group,
undertakes no bargaining with supplier S with respect to the price
charged, and purchases no other products from supplier S. U purchases
100,000 plastic containers from S at the price of $1.00 per unit.
(v) Company X charges Company Y a fee of $5,000, or $0.05 per unit
of plastic containers purchased by Company Y, reflecting the fact that
Company Y receives the volume discount from supplier S.
(vi) In evaluating the fee charged by Company X to Company Y, the
Commissioner considers whether the transactions between R1, R2, and S or
the transactions between U and S provide a more reliable measure of the
transactions between Company X, Company Y and S. The Commissioner
determines that Company Y's status as a member of a controlled group
should be taken into account for purposes of evaluating comparability of
the transactions, and concludes that the transactions between R1, R2,
and S are more reliably comparable to the transactions between Company
X, Company Y, and S. The comparable charge for the purchase was $0.95
per unit. Therefore, obtaining the plastic containers at a favorable
rate (and the resulting $5,000 savings) is entirely due to Company Y's
status as a member of the Company X controlled group and not to any
specific activity by Company X or any other member of the controlled
group. Consequently, Company Y is not considered to obtain a benefit
from Company X or any other member of the controlled group.
Example 20. Disaggregation of transactions. (i) X, a domestic
corporation, is a pharmaceutical company that develops and manufactures
ethical pharmaceutical products. Y, a Country B corporation, is a
distribution and marketing company that also performs clinical trials
for X in Country B. Because Y does not possess the capability to conduct
the trials, it contracts with a third party to undertake the trials at a
cost of $100. Y also incurs $25 in expenses related to the third-party
contract (for example, in hiring and working with the third party).
(ii) Based on a detailed functional analysis, the Commissioner
determines that Y performed functions beyond merely facilitating the
clinical trials for X, such as audit controls of the third party
performing those trials. In determining the arm's length price, the
Commissioner may consider a number of alternatives. For example, for
purposes of determining the arm's length price, the Commissioner may
determine that the intercompany service is most reliably analyzed on a
disaggregated basis as two separate transactions: in this case, the
contract between Y and the third party could constitute an internal CUSP
with a price of $100. Y would be further entitled to an arm's length
remuneration for its facilitating services. If the most reliable method
is one that provides a markup on Y's costs, then ``total services cost''
in this context would be $25. Alternatively, the Commissioner may
determine that the intercompany service is most reliably analyzed as a
single transaction, based on comparable uncontrolled transactions
involving the facilitation of similar clinical trial services performed
by third parties. If the most reliable method is one that provides a
markup on all of Y's costs, and the base of the markup determined by the
comparable companies includes the third-party clinical trial costs, then
such a markup would be applied to Y's total services cost of $125.
Example 21. Disaggregation of transactions. (i) X performs a number
of administrative functions for its subsidiaries, including Y, a
distributor of widgets in Country B. These services include those
relating to working capital (inventory and accounts receivable/payable)
management. To facilitate provision of these services, X purchases an
ERP system specifically dedicated to optimizing working capital
management. The system, which entails significant third-party costs and
which includes substantial intellectual property relating to its
software, costs $1,000.
(ii) Based on a detailed functional analysis, the Commissioner
determines that in providing administrative services for Y, X performed
functions beyond merely operating
[[Page 787]]
the ERP system itself, since X was effectively using the ERP as an input
to the administrative services it was providing to Y. In determining
arm's length price for the services, the Commissioner may consider a
number of alternatives. For example, if the most reliable uncontrolled
data is derived from companies that use similar ERP systems purchased
from third parties to perform similar administrative functions for
uncontrolled parties, the Commissioner may determine that a CPM is the
best method for measuring the functions performed by X, and, in
addition, that a markup on total services costs, based on the markup
from the comparable companies, is the most reliable PLI. In this case,
total services cost, and the basis for the markup, would include
appropriate reflection of the ERP costs of $1,000. Alternatively, X's
functions may be most reliably measured based on comparable uncontrolled
companies that perform similar administrative functions using their
customers' own ERP systems. Under these circumstances, the total
services cost would equal X's costs of providing the administrative
services excluding the ERP cost of $1,000.
(m) Coordination with transfer pricing rules for other
transactions--(1) Services transactions that include other types of
transactions. A transaction structured as a controlled services
transaction may include other elements for which a separate category or
categories of methods are provided, such as a loan or advance, a rental,
or a transfer of tangible or intangible property. See Sec. Sec. 1.482-
1(b)(2) and 1.482-2(a), (c), and (d). Whether such an integrated
transaction is evaluated as a controlled services transaction under this
section or whether one or more elements should be evaluated separately
under other sections of the section 482 regulations depends on which
approach will provide the most reliable measure of an arm's length
result. Ordinarily, an integrated transaction of this type may be
evaluated under this section and its separate elements need not be
evaluated separately, provided that each component of the transaction
may be adequately accounted for in evaluating the comparability of the
controlled transaction to the uncontrolled comparables and, accordingly,
in determining the arm's length result in the controlled transaction.
See Sec. 1.482-1(d)(3).
(2) Services transactions that effect a transfer of intangible
property. A transaction structured as a controlled services transaction
may in certain cases include an element that constitutes the transfer of
intangible property or may result in a transfer, in whole or in part, of
intangible property. Notwithstanding paragraph (m)(1) of this section,
if such element relating to intangible property is material to the
evaluation, the arm's length result for the element of the transaction
that involves intangible property must be corroborated or determined by
an analysis under Sec. 1.482-4.
(3) Coordination with rules governing cost sharing arrangements.
Section 1.482-7 provides the specific methods to be used to determine
arm's length results of controlled transactions in connection with a
cost sharing arrangement. This section provides the specific methods to
be used to determine arm's length results of a controlled service
transaction, including in an arrangement for sharing the costs and risks
of developing intangibles other than a cost sharing arrangement covered
by Sec. 1.482-7. In the case of such an arrangement, consideration of
the principles, methods, comparability, and reliability considerations
set forth in Sec. 1.482-7 is relevant in determining the best method,
including an unspecified method, under this section, as appropriately
adjusted in light of the differences in the facts and circumstances
between such arrangement and a cost sharing arrangement.
(4) Other types of transactions that include controlled services
transactions. A transaction structured other than as a controlled
services transaction may include one or more elements for which separate
pricing methods are provided in this section. Whether such an integrated
transaction is evaluated under another section of the section 482
regulations or whether one or more elements should be evaluated
separately under this section depends on which approach will provide the
most reliable measure of an arm's length result. Ordinarily, a single
method may be applied to such an integrated transaction, and the
separate services component of the transaction need not be separately
analyzed under this section, provided that the controlled services may
be adequately accounted for in
[[Page 788]]
evaluating the comparability of the controlled transaction to the
uncontrolled comparables and, accordingly, in determining the arm's
length results in the controlled transaction. See Sec. 1.482-1(d)(3).
(5) Examples. The principles of this paragraph (m) are illustrated
by the following examples:
Example 1. (i) U.S. parent corporation Company X enters into an
agreement to maintain equipment of Company Y, a foreign subsidiary. The
maintenance of the equipment requires the use of spare parts. The cost
of the spare parts necessary to maintain the equipment amounts to
approximately 25 percent of the total costs of maintaining the
equipment. Company Y pays a fee that includes a charge for labor and
parts.
(ii) Whether this integrated transaction is evaluated as a
controlled services transaction or is evaluated as a controlled services
transaction and the transfer of tangible property depends on which
approach will provide the most reliable measure of an arm's length
result. If it is not possible to find comparable uncontrolled services
transactions that involve similar services and tangible property
transfers as the controlled transaction between Company X and Company Y,
it will be necessary to determine the arm's length charge for the
controlled services, and then to evaluate separately the arm's length
charge for the tangible property transfers under Sec. 1.482-1 and
Sec. Sec. 1.482-3 through 1.482-6. Alternatively, it may be possible to
apply the comparable profits method of Sec. 1.482-5 to evaluate the
arm's length profit of Company X or Company Y from the integrated
controlled transaction. The comparable profits method may provide the
most reliable measure of an arm's length result if uncontrolled parties
are identified that perform similar, combined functions of maintaining
and providing spare parts for similar equipment.
Example 2. (i) U.S. parent corporation Company X sells industrial
equipment to its foreign subsidiary, Company Y. In connection with this
sale, Company X renders to Company Y services that consist of
demonstrating the use of the equipment and assisting in the effective
start-up of the equipment. Company X structures the integrated
transaction as a sale of tangible property and determines the transfer
price under the comparable uncontrolled price method of Sec. 1.482-
3(b).
(ii) Whether this integrated transaction is evaluated as a transfer
of tangible property or is evaluated as a controlled services
transaction and a transfer of tangible property depends on which
approach will provide the most reliable measure of an arm's length
result. In this case, the controlled services may be similar to services
rendered in the transactions used to determine the comparable
uncontrolled price, or they may appropriately be considered a difference
between the controlled transaction and comparable transactions with a
definite and reasonably ascertainable effect on price for which
appropriate adjustments can be made. See Sec. 1.482-1(d)(3)(ii)(A)(6).
In either case, application of the comparable uncontrolled price method
to evaluate the integrated transaction may provide a reliable measure of
an arm's length result, and application of a separate transfer pricing
method for the controlled services element of the transaction is not
necessary.
Example 3. (i) The facts are the same as in Example 2 except that,
after assisting Company Y in start-up, Company X also renders ongoing
services, including instruction and supervision regarding Company Y's
ongoing use of the equipment. Company X structures the entire
transaction, including the incremental ongoing services, as a sale of
tangible property, and determines the transfer price under the
comparable uncontrolled price method of Sec. 1.482-3(b).
(ii) Whether this integrated transaction is evaluated as a transfer
of tangible property or is evaluated as a controlled services
transaction and a transfer of tangible property depends on which
approach will provide the most reliable measure of an arm's length
result. It may not be possible to identify comparable uncontrolled
transactions in which a seller of merchandise renders services similar
to the ongoing services rendered by Company X to Company Y. In such a
case, the incremental services in connection with ongoing use of the
equipment could not be taken into account as a comparability factor
because they are not similar to the services rendered in connection with
sales of similar tangible property. Accordingly, it may be necessary to
evaluate separately the transfer price for such services under this
section in order to produce the most reliable measure of an arm's length
result. Alternatively, it may be possible to apply the comparable
profits method of Sec. 1.482-5 to evaluate the arm's length profit of
Company X or Company Y from the integrated controlled transaction. The
comparable profits method may provide the most reliable measure of an
arm's length result if uncontrolled parties are identified that perform
the combined functions of selling equipment and rendering ongoing after-
sale services associated with such equipment. In that case, it would not
be necessary to separately evaluate the transfer price for the
controlled services under this section.
Example 4. (i) Company X, a U.S. corporation, and Company Y, a
foreign corporation, are members of a controlled group. Both
[[Page 789]]
companies perform research and development activities relating to
integrated circuits. In addition, Company Y manufactures integrated
circuits. In years 1 through 3, Company X engages in substantial
research and development activities, gains significant know-how
regarding the development of a particular high-temperature resistant
integrated circuit, and memorializes that research in a written report.
In years 1 through 3, Company X generates overall net operating losses
as a result of the expenditures associated with this research and
development effort. At the beginning of year 4, Company X enters into a
technical assistance agreement with Company Y. As part of this
agreement, the researchers from Company X responsible for this project
meet with the researchers from Company Y and provide them with a copy of
the written report. Three months later, the researchers from Company Y
apply for a patent for a high-temperature resistant integrated circuit
based in large part upon the know-how obtained from the researchers from
Company X.
(ii) The controlled services transaction between Company X and
Company Y includes an element that constitutes the transfer of
intangible property (such as, know-how). Because the element relating to
the intangible property is material to the arm's length evaluation, the
arm's length result for that element must be corroborated or determined
by an analysis under Sec. 1.482-4.
(6) Global dealing operations. [Reserved]
(n) Effective/applicability date--(1) In general. This section is
generally applicable for taxable years beginning after July 31, 2009. In
addition, a person may elect to apply the provisions of this section to
earlier taxable years. See paragraph (n)(2) of this section.
(2) Election to apply regulations to earlier taxable years--(i)
Scope of election. A taxpayer may elect to apply Sec. 1.482-1(a)(1),
(b)(2)(i), (d)(3)(ii)(C) Examples 3 through 6, (d)(3)(v), (f)(2)(ii)(A),
(f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii) Example 1, (i), (j)(6)(i) and
(j)(6)(ii), Sec. 1.482-2(b), (f)(1) and (2), Sec. 1.482-4(f)(3)(i)(A),
(f)(3)(ii) Examples 1 and 2, (f)(4), (h)(1) and (2), Sec. 1.482-
6(c)(2)(ii)(B)(1), (c)(2)(ii)(D), (c)(3)(i)(A), (c)(3)(i)(B),
(c)(3)(ii)(D), and (d), Sec. 1.482-8(b) Examples 10 through 12, (c)(1)
and (c)(2), Sec. 1.482-9(a) through (m)(2), and (m)(4) through (n)(2),
Sec. 1.861-8(a)(5)(ii), (b)(3), (e)(4), (f)(4)(i), (g) Examples 17, 18,
and 30, Sec. 1.6038A-3(a)(3) Example 4 and (i), Sec. 1.6662-
6(d)(2)(ii)(B), (d)(2)(iii)(B)(4), (d)(2)(iii)(B)(6), and (g), and Sec.
31.3121(s)-1(c)(2)(iii) and (d) of this chapter to any taxable year
beginning after September 10, 2003. Such election requires that all of
the provisions of such sections be applied to such taxable year and all
subsequent taxable years (earlier taxable years) of the taxpayer making
the election.
(ii) Effect of election. An election to apply the regulations to
earlier taxable years has no effect on the limitations on assessment and
collection or on the limitations on credit or refund (see Chapter 66 of
the Internal Revenue Code).
(iii) Time and manner of making election. An election to apply the
regulations to earlier taxable years must be made by attaching a
statement to the taxpayer's timely filed U.S. tax return (including
extensions) for its first taxable year beginning after July 31, 2009.
(iv) Revocation of election. An election to apply the regulations to
earlier taxable years may not be revoked without the consent of the
Commissioner.
[T.D. 9456, 74 FR 38846, Aug. 4, 2009, as amended by 74 FR 46345, Sept.
9, 2009; T.D. 9568, 76 FR 80136, Dec. 22, 2011]
Sec. 1.483-1 Interest on certain deferred payments.
(a) Amount constituting interest in certain deferred payment
transactions--(1) In general. Except as provided in paragraph (c) of
this section, section 483 applies to a contract for the sale or exchange
of property if the contract provides for one or more payments due more
than 1 year after the date of the sale or exchange, and the contract
does not provide for adequate stated interest. In general, a contract
has adequate stated interest if the contract provides for a stated rate
of interest that is at least equal to the test rate (determined under
Sec. 1.483-3) and the interest is paid or compounded at least annually.
Section 483 may apply to a contract whether the contract is express
(written or oral) or implied. For purposes of section 483, a sale or
exchange is any transaction treated as a sale or exchange for tax
purposes. In addition, for purposes of section 483, property includes
debt instruments and investment units, but does not include money,
services, or the right to use property. For the treatment of certain
obligations given in exchange for services or the use of property, see
sections
[[Page 790]]
404 and 467. For purposes of this paragraph (a), money includes
functional currency and, in certain circumstances, nonfunctional
currency. See Sec. 1.988-2(b)(2) for circumstances when nonfunctional
currency is treated as money rather than as property.
(2) Treatment of contracts to which section 483 applies--(i)
Treatment of unstated interest. If section 483 applies to a contract,
unstated interest under the contract is treated as interest for tax
purposes. Thus, for example, unstated interest is not treated as part of
the amount realized from the sale or exchange of property (in the case
of the seller), and is not included in the purchaser's basis in the
property acquired in the sale or exchange.
(ii) Method of accounting for interest on contracts subject to
section 483. Any stated or unstated interest on a contract subject to
section 483 is taken into account by a taxpayer under the taxpayer's
regular method of accounting (e.g., an accrual method or the cash
receipts and disbursements method). See Sec. Sec. 1.446-1, 1.451-1, and
1.461-1. For purposes of the preceding sentence, the amount of interest
(including unstated interest) allocable to a payment under a contract to
which section 483 applies is determined under Sec. 1.446-2(e).
(b) Definitions--(1) Deferred payments. For purposes of the
regulations under section 483, a deferred payment means any payment that
constitutes all or a part of the sales price (as defined in paragraph
(b)(2) of this section), and that is due more than 6 months after the
date of the sale or exchange. Except as provided in section 483(c)(2)
(relating to the treatment of a debt instrument of the purchaser), a
payment may be made in the form of cash, stock or securities, or other
property.
(2) Sales price. For purposes of section 483, the sales price for
any sale or exchange is the sum of the amount due under the contract
(other than stated interest) and the amount of any liability included in
the amount realized from the sale or exchange. See Sec. 1.1001-2. Thus,
the sales price for any sale or exchange includes any amount of unstated
interest under the contract.
(c) Exceptions to and limitations on the application of section
483--(1) In general. Sections 483(d), 1274(c)(4), and 1275(b) contain
exceptions to and limitations on the application of section 483.
(2) Sales price of $3,000 or less. Section 483(d)(2) applies only if
it can be determined at the time of the sale or exchange that the sales
price cannot exceed $3,000, regardless of whether the sales price
eventually paid for the property is less than $3,000.
(3) Other exceptions and limitations--(i) Certain transfers subject
to section 1041. Section 483 does not apply to any transfer of property
subject to section 1041 (relating to transfers of property between
spouses or incident to divorce).
(ii) Treatment of certain obligees. Section 483 does not apply to an
obligee under a contract for the sale or exchange of personal use
property (within the meaning of section 1275(b)(3)) in the hands of the
obligor and that evidences a below-market loan described in section
7872(c)(1).
(iii) Transactions involving certain demand loans. Section 483 does
not apply to any payment under a contract that evidences a demand loan
that is a below-market loan described in section 7872(c)(1).
(iv) Transactions involving certain annuity contracts. Section 483
does not apply to any payment under an annuity contract described in
section 1275(a)(1)(B) (relating to annuity contracts excluded from the
definition of debt instrument).
(v) Options. Section 483 does not apply to any payment under an
option to buy or sell property.
(d) Assumptions. If a debt instrument is assumed, or property is
taken subject to a debt instrument, in connection with a sale or
exchange of property, the debt instrument is treated for purposes of
section 483 in a manner consistent with the rules of Sec. 1.1274-5.
(e) Aggregation rule. For purposes of section 483, all sales or
exchanges that are part of the same transaction (or a series of related
transactions) are treated as a single sale or exchange, and all
contracts calling for deferred payments arising from the same
transaction (or a series of related transactions) are treated as a
single contract. This rule, however, generally only applies to contracts
and to sales
[[Page 791]]
or exchanges involving a single buyer and a single seller.
(f) Effective date. This section applies to sales and exchanges that
occur on or after April 4, 1994. Taxpayers, however, may rely on this
section for sales and exchanges that occur after December 21, 1992, and
before April 4, 1994.
[T.D. 8517, 59 FR 4805, Feb. 2, 1994]
Sec. 1.483-2 Unstated interest.
(a) In general--(1) Adequate stated interest. For purposes of
section 483, a contract has unstated interest if the contract does not
provide for adequate stated interest. A contract does not provide for
adequate stated interest if the sum of the deferred payments exceeds--
(i) The sum of the present values of the deferred payments and the
present values of any stated interest payments due under the contract;
or
(ii) In the case of a cash method debt instrument (within the
meaning of section 1274A(c)(2)) received in exchange for property in a
potentially abusive situation (as defined in Sec. 1.1274-3), the fair
market value of the property reduced by the fair market value of any
consideration other than the debt instrument, and reduced by the sum of
all principal payments that are not deferred payments.
(2) Amount of unstated interest. For purposes of section 483,
unstated interest means an amount equal to the excess of the sum of the
deferred payments over the amount described in paragraph (a)(1)(i) or
(a)(1)(ii) of this section, whichever is applicable.
(b) Operational rules--(1) In general. For purposes of paragraph (a)
of this section, rules similar to those in Sec. 1.1274-2 apply to
determine whether a contract has adequate stated interest and the amount
of unstated interest, if any, on the contract.
(2) Present value. For purposes of paragraph (a) of this section,
the present value of any deferred payment or interest payment is
determined by discounting the payment from the date it becomes due to
the date of the sale or exchange at the test rate of interest applicable
to the contract in accordance with Sec. 1.483-3.
(c) Examples. The following examples illustrate the rules of this
section.
Example 1. Contract that does not have adequate stated interest. On
January 1, 1995, A sells B nonpublicly traded property under a contract
that calls for a $100,000 payment of principal on January 1, 2005, and
10 annual interest payments of $9,000 on January 1 of each year,
beginning on January 1, 1996. Assume that the test rate of interest is
9.2 percent, compounded annually. The contract does not provide for
adequate stated interest because it does not provide for interest equal
to 9.2 percent, compounded annually. The present value of the deferred
payments is $98,727.69. As a result, the contract has unstated interest
of $1,272.31 ($100,000 - $98,727.69).
Example 2. Contract that does not have adequate stated interest; no
interest for initial short period. On May 1, 1996, A sells B nonpublicly
traded property under a contract that calls for B to make a principal
payment of $200,000 on December 31, 1998, and semiannual interest
payments of $9,000, payable on June 30 and December 31 of each year,
beginning on December 31, 1996. Assume that the test rate of interest is
9 percent, compounded semiannually. Even though the contract calls for a
stated rate of interest no lower than the test rate of interest, the
contract does not provide for adequate stated interest because the
stated rate of interest does not apply for the short period from May 1,
1996, through June 30, 1996.
Example 3. Potentially abusive situation. (i) Facts. In a
potentially abusive situation, a contract for the sale of nonpublicly
traded personal property calls for the issuance of a cash method debt
instrument (as defined in section 1274A(c)(2)) with a stated principal
amount of $700,000, payable in 5 years. No other consideration is given.
The debt instrument calls for annual payments of interest over its
entire term at a rate of 9.2 percent, compounded annually (the test rate
of interest applicable to the debt instrument). Thus, the present value
of the deferred payment and the interest payments is $700,000. Assume
that the fair market value of the property is $500,000.
(ii) Amount of unstated interest. A cash method debt instrument
received in exchange for property in a potentially abusive situation
provides for adequate stated interest only if the sum of the deferred
payments under the instrument does not exceed the fair market value of
the property. Because the deferred payment ($700,000) exceeds the fair
market value of the property ($500,000), the debt instrument does not
provide for adequate stated interest. Therefore, the debt instrument has
unstated interest of $200,000.
Example 4. Variable rate debt instrument with adequate stated
interest; variable rate as of the issue date greater than the test rate.
(i) Facts. A contract for the sale of nonpublicly traded property calls
for the issuance of a debt instrument in the principal amount of $75,000
[[Page 792]]
due in 10 years. The debt instrument calls for interest payable
semiannually at a rate of 3 percentage points above the yield on 6-month
Treasury bills at the mid-point of the semiannual period immediately
preceding each interest payment date. Assume that the interest rate is a
qualified floating rate and that the debt instrument is a variable rate
debt instrument within the meaning of Sec. 1.1275-5.
(ii) Adequate stated interest. Under paragraph (b)(1) of this
section, rules similar to those in Sec. 1.1274-2(f) apply to determine
whether the debt instrument has adequate stated interest. Assume that
the test rate of interest applicable to the debt instrument is 9
percent, compounded semiannually. Assume also that the yield on 6-month
Treasury bills on the date of the sale is 8.89 percent, which is greater
than the yield on 6-month Treasury bills on the first date on which
there is a binding written contract that substantially sets forth the
terms under which the sale is consummated. Under Sec. 1.1274-2(f), the
debt instrument is tested for adequate stated interest as if it provided
for a stated rate of interest of 11.89 percent (3 percent plus 8.89
percent), compounded semiannually, payable over its entire term. Because
the test rate of interest is 9 percent, compounded semiannually, and the
debt instrument is treated as providing for stated interest of 11.89
percent, compounded semiannually, the debt instrument provides for
adequate stated interest.
(d) Effective date. This section applies to sales and exchanges that
occur on or after April 4, 1994. Taxpayers, however, may rely on this
section for sales and exchanges that occur after December 21, 1992, and
before April 4, 1994.
[T.D. 8517, 59 FR 4806, Feb. 2, 1994]
Sec. 1.483-3 Test rate of interest applicable to a contract.
(a) General rule. For purposes of section 483, the test rate of
interest for a contract is the same as the test rate that would apply
under Sec. 1.1274-4 if the contract were a debt instrument. Paragraph
(b) of this section, however, provides for a lower test rate in the case
of certain sales or exchanges of land between related individuals.
(b) Lower rate for certain sales or exchanges of land between
related individuals--(1) Test rate. In the case of a qualified sale or
exchange of land between related individuals (described in section
483(e)), the test rate is not greater than 6 percent, compounded
semiannually, or an equivalent rate based on an appropriate compounding
period.
(2) Special rules. The following rules and definitions apply in
determining whether a sale or exchange is a qualified sale under section
483(e):
(i) Definition of family members. The members of an individual's
family are determined as of the date of the sale or exchange. The
members of an individual's family include those individuals described in
section 267(c)(4) and the spouses of those individuals. In addition, for
purposes of section 267(c)(4), full effect is given to a legal adoption,
ancestor means parents and grandparents, and lineal descendants means
children and grandchildren.
(ii) $500,000 limitation. Section 483(e) does not apply to the
extent that the stated principal amount of the debt instrument issued in
the sale or exchange, when added to the aggregate stated principal
amount of any other debt instruments to which section 483(e) applies
that were issued in prior qualified sales between the same two
individuals during the same calendar year, exceeds $500,000. See Example
3 of paragraph (b)(3) of this section.
(iii) Other limitations. Section 483(e) does not apply if the
parties to a contract include persons other than the related individuals
and the parties enter into the contract with an intent to circumvent the
purposes of section 483(e). In addition, if the property sold or
exchanged includes any property other than land, section 483(e) applies
only to the extent that the stated principal amount of the debt
instrument issued in the sale or exchange is attributable to the land
(based on the relative fair market values of the land and the other
property).
(3) Examples. The following examples illustrate the rules of this
paragraph (b).
Example 1. On January 1, 1995, A sells land to B, A's child, for
$650,000. The contract for sale calls for B to make a $250,000 down
payment and issue a debt instrument with a stated principal amount of
$400,000. Because the stated principal amount of the debt instrument is
less than $500,000, the sale is a qualified sale and section 483(e)
applies to the debt instrument.
Example 2. The facts are the same as in Example 1 of paragraph
(b)(3) of this section, except that on June 1, 1995, A sells additional
[[Page 793]]
land to B under a contract that calls for B to issue a debt instrument
with a stated principal amount of $100,000. The stated principal amount
of this debt instrument ($100,000) when added to the stated principal
amount of the prior debt instrument ($400,000) does not exceed $500,000.
Thus, section 483(e) applies to both debt instruments.
Example 3. The facts are the same as in Example 1 of paragraph
(b)(3) of this section, except that on June 1, 1995, A sells additional
land to B under a contract that calls for B to issue a debt instrument
with a stated principal amount of $150,000. The stated principal amount
of this debt instrument when added to the stated principal amount of the
prior debt instrument ($400,000) exceeds $500,000. Thus, for purposes of
section 483(e), the debt instrument issued in the sale of June 1, 1995,
is treated as two separate debt instruments: a $100,000 debt instrument
(to which section 483(e) applies) and a $50,000 debt instrument (to
which section 1274, if otherwise applicable, applies).
(c) Effective date. This section applies to sales and exchanges that
occur on or after April 4, 1994. Taxpayers, however, may rely on this
section for sales and exchanges that occur after December 21, 1992, and
before April 4, 1994.
[T.D. 8517, 59 FR 4807, Feb. 2, 1994]
Sec. 1.483-4 Contingent payments.
(a) In general. This section applies to a contract for the sale or
exchange of property (the overall contract) if the contract provides for
one or more contingent payments and the contract is subject to section
483. This section applies even if the contract provides for adequate
stated interest under Sec. 1.483-2. If this section applies to a
contract, interest under the contract is generally computed and
accounted for using rules similar to those that would apply if the
contract were a debt instrument subject to Sec. 1.1275-4(c).
Consequently, all noncontingent payments under the overall contract are
treated as if made under a separate contract, and interest accruals on
this separate contract are computed under rules similar to those
contained in Sec. 1.1275-4(c)(3). Each contingent payment under the
overall contract is characterized as principal and interest under rules
similar to those contained in Sec. 1.1275-4(c)(4). However, any
interest, or amount treated as interest, on a contract subject to this
section is taken into account by a taxpayer under the taxpayer's regular
method of accounting (e.g., an accrual method or the cash receipts and
disbursements method).
(b) Examples. The following examples illustrate the provisions of
paragraph (a) of this section:
Example 1. Deferred payment sale with contingent interest. (i)
Facts. On December 31, 1996, A sells depreciable personal property to B.
As consideration for the sale, B issues to A a debt instrument with a
maturity date of December 31, 2001. The debt instrument provides for a
principal payment of $200,000 on the maturity date, and a payment of
interest on December 31 of each year, beginning in 1997, equal to a
percentage of the total gross income derived from the property in that
year. However, the total interest payable on the debt instrument over
its entire term is limited to a maximum of $50,000. Assume that on
December 31, 1996, the short-term applicable Federal rate is 4 percent,
compounded annually, and the mid-term applicable Federal rate is 5
percent, compounded annually.
(ii) Treatment of noncontingent payment as separate contract. Each
payment of interest is a contingent payment. Accordingly, under
paragraph (a) of this section, for purposes of applying section 483 to
the debt instrument, the right to the noncontingent payment of $200,000
is treated as a separate contract. The amount of unstated interest on
this separate contract is equal to $43,295, which is the amount by which
the payment ($200,000) exceeds the present value of the payment
($156,705), calculated using the test rate of 5 percent, compounded
annually. The $200,000 payment is thus treated as consisting of a
payment of interest of $43,295 and a payment of principal of $156,705.
The interest is includible in A's gross income, and deductible by B,
under their respective methods of accounting.
(iii) Treatment of contingent payments. Assume that the amount of
the contingent payment that is paid on December 31, 1997, is $20,000.
Under paragraph (a) of this section, the $20,000 payment is treated as a
payment of principal of $19,231 (the present value, as of the date of
sale, of the $20,000 payment, calculated using a test rate equal to 4
percent, compounded annually) and a payment of interest of $769. The
$769 interest payment is includible in A's gross income, and deductible
by B, in their respective taxable years in which the payment occurs. The
amount treated as principal gives B additional basis in the property on
December 31, 1997. The remaining contingent payments on the debt
instrument are accounted for similarly, using a test rate of 4 percent,
compounded annually, for the payments made on December 31, 1998, and
December 31, 1999, and a test rate of
[[Page 794]]
5 percent, compounded annually, for the payments made on December 31,
2000, and December 31, 2001.
Example 2. Contingent stock payout. (i) Facts. M Corporation and N
Corporation each owns one-half of the stock of O Corporation. On
December 31, 1996, pursuant to a reorganization qualifying under section
368(a)(1)(B), M acquires the one-half interest of O held by N in
exchange for 30,000 shares of M voting stock and a non-assignable right
to receive up to 10,000 additional shares of M's voting stock during the
next 3 years, provided the net profits of O exceed certain amounts
specified in the contract. No interest is provided for in the contract.
No additional shares are received in 1997 or in 1998. In 1999, the
annual earnings of O exceed the specified amount, and, on December 31,
1999, an additional 3,000 M voting shares are transferred to N. The fair
market value of the 3,000 shares on December 31, 1999, is $300,000.
Assume that on December 31, 1996, the short-term applicable Federal rate
is 4 percent, compounded annually. M and N are calendar year taxpayers.
(ii) Allocation of interest. Section 1274 does not apply to the
right to receive the additional shares because the right is not a debt
instrument for federal income tax purposes. As a result, the transfer of
the 3,000 M voting shares to N is a deferred payment subject to section
483 and a portion of the shares is treated as unstated interest under
that section. The amount of interest allocable to the shares is equal to
the excess of $300,000 (the fair market value of the shares on December
31, 1999) over $266,699 (the present value of $300,000, determined by
discounting the payment at the test rate of 4 percent, compounded
annually, from December 31, 1999, to December 31, 1996). As a result,
the amount of interest allocable to the payment of the shares is $33,301
($300,000-$266,699). Both M and N take the interest into account in
1999.
(c) Effective date. This section applies to sales and exchanges that
occur on or after August 13, 1996.
[T.D. 8674, 61 FR 30138, June 14, 1996]
regulations applicable for taxable years beginning on or before april
21, 1993
Sec. 1.482-1A Allocation of income and deductions among taxpayers.
(a) Definitions. When used in this section and in Sec. 1.482-2--
(1) The term ``organization'' includes any organization of any kind,
whether it be a sole proprietorship, a partnership, a trust, an estate,
an association, or a corporation (as each is defined or understood in
the Internal Revenue Code or the regulations thereunder), irrespective
of the place where organized, where operated, or where its trade or
business is conducted, and regardless of whether domestic or foreign,
whether exempt, whether affiliated, or whether a party to a consolidated
return.
(2) The term ``trade'' or ``business'' includes any trade or
business activity of any kind, regardless of whether or where organized,
whether owned individually or otherwise, and regardless of the place
where carried on.
(3) The term ``controlled'' includes any kind of control, direct or
indirect, whether legally enforceable, and however exercisable or
exercised. It is the reality of the control which is decisive, not its
form or the mode of its exercise. A presumption of control arises if
income or deductions have been arbitrarily shifted.
(4) The term ``controlled taxpayer'' means any one of two or more
organizations, trades, or businesses owned or controlled directly or
indirectly by the same interests.
(5) The terms ``group'' and ``group of controlled taxpayers'' mean
the organizations, trades, or businesses owned or controlled by the same
interests.
(6) The term ``true taxable income'' means, in the case of a
controlled taxpayer, the taxable income (or, as the case may be, any
item or element affecting taxable income) which would have resulted to
the controlled taxpayer, had it in the conduct of its affairs (or, as
the case may be, in the particular contract, transaction, arrangement,
or other act) dealt with the other member or members of the group at
arm's length. It does not mean the income, the deductions, the credits,
the allowances, or the item or element of income, deductions, credits,
or allowances, resulting to the controlled taxpayer by reason of the
particular contract, transaction, or arrangement, the controlled
taxpayer, or the interests controlling it, chose to make (even though
such contract, transaction, or arrangement be legally binding upon the
parties thereto).
(b) Scope and purpose. (1) The purpose of section 482 is to place a
controlled taxpayer on a tax parity with an uncontrolled taxpayer, by
determining,
[[Page 795]]
according to the standard of an uncontrolled taxpayer, the true taxable
income from the property and business of a controlled taxpayer. The
interests controlling a group of controlled taxpayers are assumed to
have complete power to cause each controlled taxpayer so to conduct its
affairs that its transactions and accounting records truly reflect the
taxable income from the property and business of each of the controlled
taxpayers. If, however, this has not been done, and the taxable incomes
are thereby understated, the district director shall intervene, and, by
making such distributions, apportionments, or allocations as he may deem
necessary of gross income, deductions, credits, or allowances, or of any
item or element affecting taxable income, between or among the
controlled taxpayers constituting the group, shall determine the true
taxable income of each controlled taxpayer. The standard to be applied
in every case is that of an uncontrolled taxpayer dealing at arm's
length with another uncontrolled taxpayer.
(2) Section 482 and this section apply to the case of any controlled
taxpayer, whether such taxpayer makes a separate or a consolidated
return. If a controlled taxpayer makes a separate return, the
determination is of its true separate taxable income. If a controlled
taxpayer is a party to a consolidated return, the true consolidated
taxable income of the affiliated group and the true separate taxable
income of the controlled taxpayer are determined consistently with the
principles of a consolidated return.
(3) Section 482 grants no right to a controlled taxpayer to apply
its provisions at will, nor does it grant any right to compel the
district director to apply such provisions. It is not intended (except
in the case of the computation of consolidated taxable income under a
consolidated return) to effect in any case such a distribution,
apportionment, or allocation of gross income, deductions, credits, or
allowances, or any item of gross income, deductions, credits, or
allowances, as would produce a result equivalent to a computation of
consolidated taxable income under subchapter A, chapter 6 of the Code.
(c) Application. Transactions between one controlled taxpayer and
another will be subjected to special scrutiny to ascertain whether the
common control is being used to reduce, avoid, or escape taxes. In
determining the true taxable income of a controlled taxpayer, the
district director is not restricted to the case of improper accounting,
to the case of a fraudulent, colorable, or sham transaction, or to the
case of a device designed to reduce or avoid tax by shifting or
distorting income, deductions, credits, or allowances. The authority to
determine true taxable income extends to any case in which either by
inadvertence or design the taxable income, in whole or in part, of a
controlled taxpayer, is other than it would have been had the taxpayer
in the conduct of his affairs been an uncontrolled taxpayer dealing at
arm's length with another uncontrolled taxpayer.
(d) Method of allocation. (1) The method of allocating,
apportioning, or distributing income, deductions, credits, and
allowances to be used by the district director in any case, including
the form of the adjustments and the character and source of amounts
allocated, shall be determined with reference to the substance of the
particular transactions or arrangements which result in the avoidance of
taxes or the failure to clearly reflect income. The appropriate
adjustments may take the form of an increase or decrease in gross
income, increase or decrease in deductions (including depreciation),
increase or decrease in basis of assets (including inventory), or any
other adjustment which may be appropriate under the circumstances. See
Sec. 1.482-2 for specific rules relating to methods of allocation in
the case of several types of business transactions.
(2) Whenever the district director makes adjustments to the income
of one member of a group of controlled taxpayers (such adjustments being
referred to in this paragraph as ``primary'' adjustments) he shall also
make appropriate correlative adjustments to the income of any other
member of the group involved in the allocation. The correlative
adjustment shall actually be made if the U.S. income tax liability of
the other member would be affected
[[Page 796]]
for any pending taxable year. Thus, if the district director makes an
allocation of income, he shall not only increase the income of one
member of the group, but shall decrease the income of the other member
if such adjustment would have an effect on the U.S. income tax liability
of the other member for any pending taxable year. For the purposes of
this subparagraph, a ``pending taxable year'' is any taxable year with
respect to which the U.S. income tax return of the other member has been
filed by the time the allocation is made, and with respect to which a
credit or refund is not barred by the operation of any law or rule of
law. If a correlative adjustment is not actually made because it would
have no effect on the U.S. income tax liability of the other member
involved in the allocation for any pending taxable year, such adjustment
shall nevertheless be deemed to have been made for the purpose of
determining the U.S. income tax liability of such member for a later
taxable year, or for the purposes of determining the U.S. income tax
liability of any person for any taxable year. The district director
shall furnish to the taxpayer with respect to which the primary
adjustment is made a written statement of the amount and nature of the
correlative adjustment which is deemed to have been made. For purposes
of this subparagraph, a primary adjustment shall not be considered to
have been made (and therefore a correlative adjustment is not required
to be made) until the first occurring of the following events with
respect to the primary adjustment:
(i) The date of assessment of the tax following execution by the
taxpayer of a Form 870 (Waiver of Restrictions on Assessment and
Collection of Deficiency in Tax and Acceptance of Overassessment) with
respect to such adjustment,
(ii) Acceptance of a Form 870-AD (Offer of Waiver of Restriction on
Assessment and Collection Deficiency in Tax and Acceptance of
Overassessment),
(iii) Payment of the deficiency,
(iv) Stipulation in the Tax Court of the United States, or
(v) Final determination of tax liability by offer-in-compromise,
closing agreement, or court action.
The principles of this subparagraph may be illustrated by the following
examples in each of which it is assumed that X and Y are members of the
same group of controlled entities and that they regularly compute their
incomes on the basis of a calendar year:
Example 1. Assume that in 1968 the district director proposes to
adjust X's income for 1966 to reflect an arm's length rental charge for
Y's use of X's tangible property in 1966; that X consents to an
assessment reflecting such adjustment by executing a Waiver, Form 870;
and that an assessment of the tax with respect to such adjustment is
made in 1968. The primary adjustment is therefore considered to have
been made in 1968. Assume further that both X and Y are United States
corporations and that Y had net operating losses in 1963, 1964, 1965,
1966, and 1967. Although a correlative adjustment would not have an
effect on Y's U.S. income tax liability for any pending taxable year, an
adjustment increasing Y's net operating loss for 1966 shall be deemed to
have been made for the purposes of determining Y's U.S. income tax
liability for 1968 or a later taxable year to which the increased
operating loss may be carried. The district director shall notify X in
writing of the amount and nature of the adjustment which is deemed to
have been made to Y.
Example 2. Assume that X and Y are United States corporations; that
X is in the business of rendering engineering services; that in 1968 the
district director proposes to adjust X's income for 1966 to reflect an
arm's length fee for the rendition of engineering services by X in 1966
relating to the construction of Y's factory; that X consents to an
assessment reflecting such adjustment by executing a Waiver, Form 870;
and that an assessment of the tax with respect to such adjustment is
made in 1968. Assume further that fees for such services would properly
constitute a capital expenditure by Y, and that Y does not place the
factory in service until 1969. Although a correlative adjustment
(increase in basis) would not have an effect on Y's U.S. income tax
liability for a pending taxable year, an adjustment increasing the basis
of Y's assets for 1966 shall be deemed to have been made in 1968 for the
purpose of computing allowable depreciation or gain or loss on
disposition for 1969 and any future taxable year. The district director
shall notify X in writing of the amount and nature of the adjustment
which is deemed to have been made to Y.
Example 3. Assume that X is a U.S. taxpayer and Y is a foreign
taxpayer not engaged in a trade or business in the United
[[Page 797]]
States; that in 1968 the district director proposes to adjust X's income
for 1966 to reflect an arm's length interest charge on a loan made to Y;
that X consents to an assessment reflecting such allocation by executing
a Waiver, Form 870; and that an assessment of the tax with respect to
such adjustment is made in 1968. Although a correlative adjustment would
not have an effect on Y's U.S. income tax liability, an adjustment in
Y's income for 1966 shall be deemed to have been made in 1968 for the
purposes of determining the amount of Y's earnings and profits for 1966
and subsequent years, and of any other effect it may have on any
person's U.S. income tax liability for any taxable year. The district
director shall notify X in writing of the amount and nature of the
allocation which is deemed to have been made to Y.
(3) In making distributions, apportionments, or allocations between
two members of a group of controlled entities with respect to particular
transactions, the district director shall consider the effect upon such
members of an arrangement between them for reimbursement within a
reasonable period before or after the taxable year if the taxpayer can
establish that such an arrangement in fact existed during the taxable
year under consideration. The district director shall also consider the
effect of any other nonarm's length transaction between them in the
taxable year which, if taken into account, would result in a setoff
against any allocation which would otherwise be made, provided the
taxpayer is able to establish with reasonable specificity that the
transaction was not at arm's length and the amount of the appropriate
arm's length charge. For purposes of the preceding sentence, the term
arm's length refers to the amount which was charged or would have been
charged in independent transactions with unrelated parties under the
same or similar circumstances considering all the relevant facts and
without regard to the rules found in Sec. 1.482-2 by which certain
charges are deemed to be equal to arm's length. For example, assume that
one member of a group performs services which benefit a second member,
which would in itself require an allocation to reflect an arm's length
charge for the performance of such services. Assume further that the
first member can establish that during the same taxable year the second
member engages in other nonarm's length transactions which benefit the
first member, such as by selling products to the first member at a
discount, or purchasing products from the first member at a premium, or
paying royalties to the first member in an excessive amount. In such
case, the value of the benefits received by the first member as a result
of the other activities will be set-off against the allocation which
would otherwise be made. If the effect of the set-off is to change the
characterization or source of the income or deductions, or otherwise
distort taxable income, in such a manner as to affect the United States
tax liability of any member, allocations will be made to reflect the
correct amount of each category of income or deductions. In order to
establish that a set-off to the adjustments proposed by the district
director is appropriate, the taxpayer must notify the district director
of the basis of any claimed set-off at any time before the expiration of
the period ending 30 days after the date of a letter by which the
district director transmits an examination report notifying the taxpayer
of proposed adjustments or before July 16, 1968, whichever is later. The
principles of this subparagraph may be illustrated by the following
examples, in each of which it is assumed that P and S are calendar year
corporations and are both members of the same group of controlled
entities:
Example 1. P performs services in 1966 for the benefit of S in
connection with S's manufacture and sale of a product. S does not pay P
for such services in 1966, but in consideration for such services,
agrees in 1966 to pay P a percentage of the amount of sales of the
product in 1966 through 1970. In 1966 it appeared this agreement would
provide adequate consideration for the services. No allocation will be
made with respect to the services performed by P.
Example 2. P renders services to S in connection with the
construction of S's factory. An arm's length charge for such services,
determined under paragraph (b) of Sec. 1.482-2, would be $100,000.
During the same taxable year P makes available to S a machine to be used
in such construction. P bills S $125,000 for the services, but does not
bill for the use of the machine. No allocation will be made with respect
to the excessive charge for services or the undercharge for the machine
if P can establish that the excessive charge for services was equal to
an arm's length charge for the use of the machine, and if the taxable
[[Page 798]]
income and income tax liabilities of P and S are not distorted.
Example 3. Assume the same facts as in Example 2, except that, if P
had reported $25,000 as rental income and $25,000 less service income,
it would have been subject to the tax on personal holding companies.
Allocations will be made to reflect the correct amounts of rental income
and service income.
(4) If the members of a group of controlled taxpayers engage in
transactions with one another, the district director may distribute,
apportion, or allocate income, deductions, credits, or allowances to
reflect the true taxable income of the individual members under the
standards set forth in this section and in Sec. 1.482-2 notwithstanding
the fact that the ultimate income anticipated from a series of
transactions may not be realized or is realized during a later period.
For example, if one member of a controlled group sells a product at less
than an arm's length price to a second member of the group in one
taxable year and the second member resells the product to an unrelated
party in the next taxable year, the district director may make an
appropriate allocation to reflect an arm's length price for the sale of
the product in the first taxable year, notwithstanding that the second
member of the group had not realized any gross income from the resale of
the product in the first year. Similarly, if one member of a group lends
money to a second member of the group in a taxable year, the district
director may make an appropriate allocation to reflect an arm's length
charge for interest during such taxable year even if the second member
does not realize income during such year. The provisions of this
subparagraph apply even if the gross income contemplated from a series
of transactions is never, in fact, realized by the other members.
(5) Section 482 may, when necessary to prevent the avoidance of
taxes or to clearly reflect income, be applied in circumstances
described in sections of the Code (such as section 351) providing for
nonrecognition of gain or loss. See, for example, ``National Securities
Corporation v. Commissioner of Internal Revenue'', 137 F. 2d 600 (3d
Cir. 1943), cert. denied 320 U.S. 794 (1943).
(6) If payment or reimbursement for the sale, exchange, or use of
property, the rendition of services, or the advance of other
consideration among members of a group of controlled entities was
prevented, or would have been prevented, at the time of the transaction
because of currency or other restrictions imposed under the laws of any
foreign country, any distributions, apportionments, or allocations which
may be made under section 482 with respect to such transactions may be
treated as deferrable income or deductions, providing the taxpayer has,
for the year to which the distributions, apportionments, or allocations
relate, elected to use a method of accounting in which the reporting of
deferrable income is deferred until the income ceases to be deferrable
income. Under such method of accounting, referred to in this section as
the deferred income method of accounting, any payments or reimbursements
which were prevented or would have been prevented, and any deductions
attributable directly or indirectly to such payments or reimbursements,
shall be deferred until they cease to be deferrable under such method of
accounting. If such method of accounting has not been elected with
respect to the taxable year to which the allocations under section 482
relate, the taxpayer may elect such method with respect to such
allocations (but not with respect to other deferrable income) at any
time before the first occurring of the following events with respect to
the allocations:
(i) Execution by the taxpayer of Form 870 (Waiver of Restrictions on
Assessment and Collection of Deficiency in Tax and Acceptance of
Overassessment);
(ii) Expiration of the period ending 30 days after the date of a
letter by which the district director transmits an examination report
notifying the taxpayer of proposed adjustments reflecting such
allocations or before July 16, 1968, whichever is later; or
(iii) Execution of a closing agreement or offer-in-compromise.
The principles of this subparagraph may be illustrated by the following
example in which it is assumed that X, a domestic corporation, and Y, a
foreign corporation, are members of the same group of controlled
entities:
[[Page 799]]
Example. X, which is in the business of rendering a certain type of
service to unrelated parties, renders such services for the benefit of Y
in 1965. The direct and indirect costs allocable to such services are
$60,000, and an arm's length charge for such services is $100,000.
Assume that the district director proposes to increase X's income by
$100,000, but that the country in which Y is located would have blocked
payment in 1965 for such services. If, prior to the first occurring of
the events described in subdivisions (i), (ii), or (iii) of this
subparagraph, X elects to use the deferred income method of accounting
with respect to such allocation, the $100,000 allocation and the $60,000
of costs are deferrable until such amounts cease to be deferrable under
X's method of accounting.
[T.D. 6595, 27 FR 3598, Apr. 14, 1962, as amended by T.D. 6952, 33 FR
5848, Apr. 16, 1968. Redesignated by T.D. 8470, 58 FR 5271, Jan. 21,
1993]
Sec. 1.482-2A Determination of taxable income in specific situations.
(a)-(c) For applicable rules, see Sec. 1.482-2T (a) through (c).
(d) Transfer or use of intangible property--(1) In general. (i)
Except as otherwise provided in subparagraph (4) of this paragraph,
where intangible property or an interest therein is transferred, sold,
assigned, loaned, or otherwise made available in any manner by one
member of a group of controlled entities (referred to in this paragraph
as the transferor) to another member of the group (referred to in this
paragraph as the transferee) for other than an arm's length
consideration, the district director may make appropriate allocations to
reflect an arm's length consideration for such property or its use.
Subparagraph (2) of this paragraph provides rules for determining the
form an amount of an appropriate allocation, subparagraph (3) of this
paragraph provides a definition of ``intangible property'', and
subparagraph (4) of this paragraph provides rules with respect to
certain cost-sharing arrangements in connection with the development of
intangible property. For purposes of this paragraph, an interest in
intangible property may take the form of the right to use such property.
(ii)(a) In the absence of a bona fide cost-sharing arrangement (as
defined in subparagraph (4) of this paragraph), where one member of a
group of related entities undertakes the development of intangible
property as a developer within the meaning of (c) of this subdivision,
no allocation with respect to such development activity shall be made
under the rules of this paragraph or any other paragraph of this section
(except as provided in (b) of this subdivision) until such time as any
property developed, or any interest therein, is or is deemed to be
transferred, sold, assigned, loaned, or otherwise made available in any
manner by the developer to a related entity in a transfer subject to the
rules of this paragraph. Where a member of the group other than the
developer acquires an interest in the property developed by virtue of
obtaining a patent or copyright, or by any other means, the developer
shall be deemed to have transferred such interest in such property to
the acquiring member in a transaction subject to the rules of this
paragraph. For example, if one member of a group (the developer)
undertakes to develop a new patentable product and the costs of
development are incurred by that entity over a period of 3 years, no
allocation with respect to that entity's activity shall be made during
such period. The amount of any allocation that may be appropriate at the
expiration of such development period when, for example, the patent on
the product is transferred, or deemed transferred, to a related entity
for other than an arm's length consideration, shall be determined in
accordance with the rules of this paragraph.
(b) Where one member of a group renders assistance in the form of
loans, services, or the use of tangible or intangible property to a
developer in connection with an attempt to develop intangible property,
the amount of any allocation that may be appropriate with respect to
such assistance shall be determined in accordance with the rules of the
appropriate paragraph or paragraphs of this section. Thus, where one
entity allows a related entity, which is the developer, to use tangible
property, such as laboratory equipment, in connection with the
development of intangible property, the amount of any allocation that
may be appropriate with respect to such use shall be determined in
accordance with
[[Page 800]]
the rules of paragraph (c) of this section. In the event that the
district director does not exercise his discretion to make allocations
with respect to the assistance rendered to the developer, the value of
the assistance shall be allowed as a set-off against any allocation that
the district director may make under this paragraph as a result of the
transfer of the intangible property to the entity rendering the
assistance.
(c) The determination as to which member of a group of related
entities is a developer and which members of the group are rendering
assistance to the developer in connection with its development
activities shall be based upon all the facts and circumstances of the
individual case. Of all the facts and circumstances to be taken into
account in making this determination, greatest weight shall be given to
the relative amounts of all the direct and indirect costs of development
and the corresponding risks of development borne by the various members
of the group, and the relative values of the use of any intangible
property of members of the group which is made available without
adequate consideration for use in connection with the development
activity, which property is likely to contribute to a substantial extent
in the production of intangible property. For this purpose, the risk to
be borne with respect to development activity is the possibility that
such activity will not result in the production of intangible property
or that the intangible property produced will not be of sufficient value
to allow for the recovery of the costs of developing it. A member will
not be considered to have borne the costs and corresponding risks of
development unless such member is committed to bearing such costs in
advance of, or contemporaneously with, their incurrence and without
regard to the success of the project. Other factors that may be relevant
in determining which member of the group is the developer include the
location of the development activity, the capabilities of the various
members to carry on the project independently, and the degree of control
over the project exercised by the various members.
(d) The principles of this subdivision (ii) may be illustrated by
the following examples in which it is assumed that X and Y are corporate
members of the same group:
Example 1. X, at the request of Y, undertakes to develop a new
machine which will function effectively in the climate in which Y's
factory is located. Y agrees to bear all the direct and indirect costs
of the project whether or not X successfully develops the machine.
Assume that X does not make any of its own intangible property available
for use in connection with the project. The machine is successfully
developed and Y obtains possession of the intangible property necessary
to produce such machine. Based on the facts and circumstances as stated,
Y shall be considered to be the developer of the intangible property
and, therefore, Y shall not be treated as having obtained the property
in a transfer subject to the rules of this paragraph. Any amount which
may be allocable with respect to the assistance rendered by X shall be
determined in accordance with the rules of (b) of this subdivision.
Example 2. Assume the same facts as in Example 1 except that Y
agrees to reimburse X for its costs only in the event that the property
is successfully developed. In such case X is the developer and Y is
deemed to have received the property in a transfer subject to the rules
of this paragraph. Therefore, the district director may make an
allocation to reflect an arm's length consideration for such property.
Example 3. In 1967 X undertakes to develop product M in its research
and development department. X incurs direct and indirect costs of $1
million per year in connection with the project in 1967, 1968, and 1969.
In connection with the project, X employs the formula for compound N,
which it owns, and which is likely to contribute substantially to the
success of the project. The value of the use of the formula for compound
N in connection with this project is $750,000. In 1968, 4 chemists
employed by Y spend 6 months working on the project in X's laboratory.
The salary and other expenses connected with the chemists' employment
for that period ($100,000) are paid by Y, for which no charge is made to
X. In 1969, product M is perfected and Y obtains patents thereon. X is
considered to be the developer of product M since, among other things,
it bore the greatest relative share of the costs and risks incurred in
connection with this project and made available intangible property
(formula for compound N) which was likely to contribute substantially in
the development of product M. Accordingly, no allocation with respect to
X's development activity should be made before 1969. The property is
deemed to have been transferred to Y at that time by
[[Page 801]]
virtue of the fact that Y obtained the patent rights to product M. In
such case the district director may make an allocation to reflect an
arm's length consideration for such transfer. In the event that the
district director makes such an allocation and he has not made or does
not make an allocation for 1968 with respect to the services of the
chemists in accordance with the principles of paragraph (b) of this
section, the value of the assistance shall be allowed as a set-off
against the amount of the allocation reflecting an arm's length
consideration for the transfer of the intangible property.
(2) Arm's length consideration. (i) An arm's length consideration
shall be in a form which is consistent with the form which would be
adopted in transactions between unrelated parties under the same
circumstances. To the extent appropriate, an arm's length consideration
may take any one or more of the following forms:
(a) Royalties based on the transferee's output, sales, profits, or
any other measure;
(b) Lump-sum payments; or
(c) Any other form, including reciprocal licensing rights, which
might reasonably have been adopted by unrelated parties under the
circumstances, provided that the parties can establish that such form
was adopted pursuant to an arrangement which in fact existed between
them.
However, where the transferee pays nominal or no consideration for the
property or interest therein and where the transferor has retained a
substantial interest in the property, an allocation shall be presumed
not to take the form of a lump-sum payment.
(ii) In determining the amount of an arm's length consideration, the
standard to be applied is the amount that would have been paid by an
unrelated party for the same intangible property under the same
circumstances. Where there have been transfers by the transferor to
unrelated parties involving the same or similar intangible property
under the same or similar circumstances the amount of the consideration
for such transfers shall generally be the best indication of an arm's
length consideration.
(iii) Where a sufficiently similar transaction involving an
unrelated party cannot be found, the following factors, to the extent
appropriate (depending upon the type of intangible property and the form
of the transfer), may be considered in arriving at the amount of the
arm's length consideration:
(a) The prevailing rates in the same industry or for similar
property,
(b) The offers of competing transferors or the bids of competing
transferees,
(c) The terms of the transfer, including limitations on the
geographic area covered and the exclusive or nonexclusive character of
any rights granted,
(d) The uniqueness of the property and the period for which it is
likely to remain unique,
(e) The degree and duration of protection afforded to the property
under the laws of the relevant countries.
(f) Value of services rendered by the transferor to the transferee
in connection with the transfer within the meaning of paragraph (b)(8)
of this section,
(g) Prospective profits to be realized or costs to be saved by the
transferee through its use or subsequent transfer of the property,
(h) The capital investment and starting up expenses required of the
transferee,
(i) The next subdivision is (j),
(j) The availability of substitutes for the property transferred,
(k) The arm's length rates and prices paid by unrelated parties
where the property is resold or sublicensed to such parties,
(l) The costs incurred by the transferor in developing the property,
and
(m) Any other fact or circumstance which unrelated parties would
have been likely to consider in determining the amount of an arm's
length consideration for the property.
(3) Definition of intangible property. (i) Solely for the purposes
of this section, intangible property shall consist of the items
described in subdivision (ii) of this subparagraph, provided that such
items have substantial value independent of the services of individual
persons.
(ii) The items referred to in subdivision (i) of this subparagraph
are as follows:
(a) Patents, inventions, formulas, processes, designs, patterns, and
other similar items;
[[Page 802]]
(b) Copyrights, literary, musical, or artistic compositions, and
other similar items;
(c) Trademarks, trade names, brand names, and other similar items;
(d) Franchises, licenses, contracts, and other similar items;
(e) Methods, programs, systems, procedures, campaigns, surveys,
studies, forecasts, estimates, customer lists, technical data, and other
similar items.
(4) Sharing of costs and risks. Where a member of a group of
controlled entities acquires an interest in intangible property as a
participating party in a bona fide cost sharing arrangement with respect
to the development of such intangible property, the district director
shall not make allocations with respect to such acquisition except as
may be appropriate to reflect each participant's arm's length share of
the costs and risks of developing the property. A bona fide cost sharing
arrangement is an agreement, in writing, between two or more members of
a group of controlled entities providing for the sharing of the costs
and risks of developing intangible property in return for a specified
interest in the intangible property that may be produced. In order for
the arrangement to qualify as a bona fide arrangement, it must reflect
an effort in good faith by the participating members to bear their
respective shares of all the costs and risks of development on an arm's
length basis. In order for the sharing of costs and risk to be
considered on an arm's length basis, the terms and conditions must be
comparable to those which would have been adopted by unrelated parties
similarly situated had they entered into such an arrangement. If an oral
cost sharing arrangement, entered into prior to April 16, 1968, and
continued in effect after that date, is otherwise in compliance with the
standards prescribed in this subparagraph, it shall constitute a bona
fide cost sharing arrangement if it is reduced to writing prior to
January 1, 1969.
(e) Sales of tangible property--(1) In general. (i) Where one member
of a group of controlled entities (referred to in this paragraph as the
``seller'') sells or otherwise disposes of tangible property to another
member of such group (referred to in this paragraph as the ``buyer'') at
other than an arm's length price (such a sale being referred to in this
paragraph as a ``controlled sale''), the district director may make
appropriate allocations between the seller and the buyer to reflect an
arm's length price for such sale or disposition. An arm's length price
is the price that an unrelated party would have paid under the same
circumstances for the property involved in the controlled sale. Since
unrelated parties normally sell products at a profit, an arm's length
price normally involves a profit to the seller.
(ii) Subparagraphs (2), (3), and (4) of this paragraph describe
three methods of determining an arm's-length price and the standards for
applying each method. They are, respectively, the comparable
uncontrolled price method, the resale price method, and the cost-plus
method. In addition, a special rule is provided in subdivision (v) of
this subparagraph for use (notwithstanding any other provision of this
subdivision) in determining an arm's-length price for an ore or mineral.
If there are comparable uncontrolled sales as defined in subparagraph
(2) of this paragraph, the comparable uncontrolled price method must be
utilized because it is the method likely to result in the most accurate
estimate of an arm's-length price (for the reason that it is based upon
the price actually paid by unrelated parties for the same or similar
products). If there are no comparable uncontrolled sales, then the
resale price method must be utilized if the standards for its
application are met because it is the method likely to result in the
next most accurate estimate in such instances (for the reason that, in
such instances, the arm's-length price determined under such method is
based more directly upon actual arm's-length transactions than is the
cost-plus method). A typical situation where the resale price method may
be required is where a manufacturer sells products to a related
distributor which, without further processing, resells the products in
uncontrolled transactions. If all the standards for the mandatory
application of the resale price method are not
[[Page 803]]
satisfied, then, as provided in subparagraph (3)(iii) of this paragraph,
either that method or the cost-plus method may be used, depending upon
which method is more feasible and is likely to result in a more accurate
estimate of an arm's-length price. A typical situation where the cost-
plus method may be appropriate is where a manufacturer sells products to
a related entity which performs substantial manufacturing, assembly, or
other processing of the product or adds significant value by reason of
its utilization of its intangible property prior to resale in
uncontrolled transactions.
(iii) Where the standards for applying one of the three methods of
pricing described in subdivision (ii) of this subparagraph are met, such
method must, for the purposes of this paragraph, be utilized unless the
taxpayer can establish that, considering all the facts and
circumstances, some method of pricing other than those described in
subdivision (ii) of this subparagraph is clearly more appropriate. Where
none of the three methods of pricing described in subdivision (ii) of
this subparagraph can reasonably be applied under the facts and
circumstances as they exist in a particular case, some appropriate
method of pricing other than those described in subdivision (ii) of this
subparagraph, or variations on such methods, can be used.
(iv) The methods of determining arm's length prices described in
this section are stated in terms of their application to individual
sales of property. However, because of the possibility that a taxpayer
may make controlled sales of many different products, or many separate
sales of the same product, it may be impractical to analyze every sale
for the purposes of determining the arm's length price. It is therefore
permissible to determine or verify arm's length prices by applying the
appropriate methods of pricing to product lines or other groupings where
it is impractical to ascertain an arm's length price for each product or
sale. In addition, the district director may determine or verify the
arm's length price of all sales to a related entity by employing
reasonable statistical sampling techniques.
(v) The price for a mineral product which is sold at the stage at
which mining or extraction ends shall be determined under the provisions
of Sec. Sec. 1.613-3 and 1.613-4.
(2) Comparable uncontrolled price method. (i) Under the method of
pricing described as the ``comparable uncontrolled price method'', the
arm's length price of a controlled sale is equal to the price paid in
comparable uncontrolled sales, adjusted as provided in subdivision (ii)
of this subparagraph.
(ii) ``Uncontrolled sales'' are sales in which the seller and the
buyer are not members of the same controlled group. These include (a)
sales made by a member of the controlled group to an unrelated party,
(b) sales made to a member of the controlled group by an unrelated
party, and (c) sales made in which the parties are not members of the
controlled group and are not related to each other. However,
uncontrolled sales do not include sales at unrealistic prices, as for
example where a member makes uncontrolled sales in small quantities at a
price designed to justify a nonarm's length price on a large volume of
controlled sales. Uncontrolled sales are considered comparable to
controlled sales if the physical property and circumstances involved in
the uncontrolled sales are identical to the physical property and
circumstances involved in the controlled sales, or if such properties
and circumstances are so nearly identical that any differences either
have no effect on price, or such differences can be reflected by a
reasonable number of adjustments to the price of uncontrolled sales. For
this purpose, differences can be reflected by adjusting prices only
where such differences have a definite and reasonably ascertainable
effect on price. If the differences can be reflected by such adjustment,
then the price of the uncontrolled sale as adjusted constitutes the
comparable uncontrolled sale price. Some of the differences which may
affect the price of property are differences in the quality of the
product, terms of sale, intangible property associated with the sale,
time of sale, and the level of the market and the geographic market in
which the sale takes place. Whether and to what extent differences in
the various properties and
[[Page 804]]
circumstances affect price, and whether differences render sales
noncomparable, depends upon the particular circumstances and property
involved. The principles of this subdivision may be illustrated by the
following examples, in each of which it is assumed that X makes both
controlled and uncontrolled sales of the identical property:
Example 1. Assume that the circumstances surrounding the controlled
and the uncontrolled sales are identical, except for the fact that the
controlled sales price is a delivered price and the uncontrolled sales
are made f.o.b. X's factory. Since differences in terms of
transportation and insurance generally have a definite and reasonably
ascertainable effect on price, such differences do not normally render
the uncontrolled sales noncomparable to the controlled sales.
Example 2. Assume that the circumstances surrounding the controlled
and uncontrolled sales are identical, except for the fact that X affixes
its valuable trademark in the controlled sales, and does not affix its
trademark in uncontrolled sales. Since the effects on price of
differences in intangible property associated with the sale of tangible
property, such as trademarks, are normally not reasonably ascertainable,
such differences would normally render the uncontrolled sales
noncomparable.
Example 3. Assume that the circumstances surrounding the controlled
and uncontrolled sales are identical, except for the fact that X, a
manufacturer of business machines, makes certain minor modifications in
the physical properties of the machines to satisfy safety specifications
or other specific requirements of a customer in controlled sales, and
does not make these modifications in uncontrolled sales. Since minor
physical differences in the product generally have a definite and
reasonably ascertainable effect on prices, such differences do not
normally render the uncontrolled sales noncomparable to the controlled
sales.
(iii) Where there are two or more comparable uncontrolled sales
susceptible of adjustment as defined in subdivision (ii) of this
subparagraph, the comparable uncontrolled sale or sales requiring the
fewest and simplest adjustments provided in subdivision (ii) of this
subparagraph should generally be selected. Thus, for example, if a
taxpayer makes comparable uncontrolled sales of a particular product
which differ from the controlled sale only with respect to the terms of
delivery, and makes other comparable uncontrolled sales of the product
which differ from the controlled sale with respect to both terms of
delivery and terms of payment, the comparable uncontrolled sales
differing only with respect to terms of delivery should be selected as
the comparable uncontrolled sale.
(iv) One of the circumstances which may affect the price of property
is the fact that the seller may desire to make sales at less than a
normal profit for the primary purpose of establishing or maintaining a
market for his products. Thus, a seller may be willing to reduce the
price of a product, for a time, in order to introduce his product into
an area or in order to meet competition. However, controlled sales may
be priced in such a manner only if such price would have been charged in
an uncontrolled sale under comparable circumstances. Such fact may be
demonstrated by showing that the buyer in the controlled sale made
corresponding reductions in the resale price to uncontrolled purchasers,
or that such buyer engaged in substantially greater sales promotion
activities with respect to the product involved in the controlled sale
than with respect to other products. For example, assume X, a
manufacturer of batteries, commences to sell car batteries to Y, a
subsidiary of X, for resale in a new market. In its existing markets X's
batteries sell to independent retailers at $20 per unit, and X sells
them to wholesalers at $17 per unit. Y also sells X's batteries to
independent retailers at $20 per unit. X's batteries are not known in
the new market in which Y is operating. In order to engage competitively
in the new market Y incurs selling and advertising costs substantially
higher than those incurred for its sales of other products. Under these
circumstances X may sell to Y, for a time, at less than $17 to take into
account the increased selling and advertising activities of Y in
penetrating and establishing the new market. This may be done even
though it may result in a transfer price from X to Y which is below X's
full costs of manufacturing the product.
(3) Resale price method. (i) Under the pricing method described as
the ``resale price method'', the arm's length price
[[Page 805]]
of a controlled sale is equal to the applicable resale price (as defined
in subdivision (iv) or (v) of this subparagraph), reduced by an
appropriate markup, and adjusted as provided in subdivision (ix) of this
subparagraph. An appropriate markup is computed by multiplying the
applicable resale price by the appropriate markup percentage as defined
in subdivision (vi) of this subparagraph. Thus, where one member of a
group of controlled entities sells property to another member which
resells the property in uncontrolled sales, if the applicable resale
price of the property involved in the uncontrolled sale is $100 and the
appropriate markup percentage for resales by the buyer is 20 percent,
the arm's length price of the controlled sale is $80 ($100 minus 20
percent x $100), adjusted as provided in subdivision (ix) of this
subparagraph.
(ii) The resale price method must be used to compute an arm's length
price of a controlled sale if all the following circumstances exist:
(a) There are no comparable uncontrolled sales as defined in
subparagraph (2) of this paragraph.
(b) An applicable resale price, as defined in subdivision (iv) or
(v) of this subparagraph, is available with respect to resales made
within a reasonable time before or after the time of the controlled
sale.
(c) The buyer (reseller) has not added more than an insubstantial
amount to the value of the property by physically altering the product
before resale. For this purpose packaging, repacking, labeling, or minor
assembly of property does not constitute physical alteration.
(d) The buyer (reseller) has not added more than an insubstantial
amount to the value of the property by the use of intangible property.
See Sec. 1.482-2(d)(3) for the definition of intangible property.
(iii) Notwithstanding the fact that one or both of the requirements
of subdivision (ii) (c) or (d) of this subparagraph may not be met, the
resale price method may be used if such method is more feasible and is
likely to result in a more accurate determination of an arm's length
price than the use of the cost plus method. Thus, even though one of the
requirements of such subdivision is not satisfied, the resale price
method may nevertheless be more appropriate than the cost plus method
because the computations and evaluations required under the former
method may be fewer and easier to make than under the latter method. In
general, the resale price method is more appropriate when the functions
performed by the seller are more extensive and more difficult to
evaluate than the functions performed by the buyer (reseller). The
principle of this subdivision may be illustrated by the following
examples in each of which it is assumed that corporation X developed a
valuable patent covering product M which it manufactures and sells to
corporation Y in a controlled sale, and for which there is no comparable
uncontrolled sale:
Example 1. Corporation Y adds a component to product M and resells
the assembled product in an uncontrolled sale within a reasonable time
after the controlled sale of product M. Assume further that the addition
of the component added more than an insubstantial amount to the value of
product M, but that Y's function in purchasing the component and
assembling the product prior to sale was subject to reasonably precise
valuation. Although the controlled sale and resale does not meet the
requirements of subdivision (ii)(c) of this subparagraph, the resale
price method may be used under the circumstances because that method
involves computations and evaluations which are fewer and easier to make
than under the cost plus method. This is because X's use of a patent may
be more difficult to evaluate in determining an appropriate gross profit
percentage under the cost plus method, than is evaluation of Y's
assembling function in determining the appropriate markup percentage
under the resale price method.
Example 2. Corporation Y resells product M in an uncontrolled sale
within a reasonable time after the controlled sale after attaching its
valuable trademark to it. Assume further that it can be demonstrated
through comparison with other uncontrolled sales of Y that the addition
of Y's trademark to a product usually adds 25 percent to the markup on
its sales. On the other hand, the effect of X's use of its patent is
difficult to evaluate in applying the cost plus method because no
reasonable standard of comparison is available. Although the controlled
sale and resale does not meet the requirements of subdivision (ii)(d) of
this subparagraph, the resale price method may be used because that
method involves computations and evaluation which are fewer and easier
to make than
[[Page 806]]
under the cost plus method. That is because, under the circumstances,
X's use of a patent is more difficult to evaluate in determining an
appropriate gross profit percentage under the cost plus method, than is
evaluation of the use of Y's trademark in determining the appropriate
markup percentage under the resale price method.
(iv) For the purposes of this subparagraph the ``applicable resale
price'' is the price at which it is anticipated that property purchased
in the controlled sale will be resold by the buyer in an uncontrolled
sale. The ``applicable resale price'' will generally be equal to either
the price at which current resales of the same property are being made
or the resale price of the particular item of property involved.
(v) Where the property purchased in the controlled sale is resold in
another controlled sale, the ``applicable resale price'' is the price at
which such property is finally resold in an uncontrolled sale, providing
that the series of sales as a whole meets all the requirements of
subdivision (ii) of this subparagraph or that the resale price method is
used pursuant to subdivision (iii) of this subparagraph. In such case,
the determination of the appropriate markup percentage shall take into
account the function or functions performed by all members of the group
participating in the series of sales and resales. Thus, if X sells a
product to Y in a controlled sale, Y sells the product to Z in a
controlled sale, and Z sells the product in an uncontrolled sale, the
resale price method must be used if Y and Z together have not added more
than an insubstantial amount to the value of the product through
physical alteration or the application of intangible property, and the
final resale occurs within a reasonable time of the sale from X to Y. In
such case, the applicable resale price is the price at which Z sells the
product in the uncontrolled sale, and the appropriate markup percentage
shall take into account the functions performed by both Y and Z.
(vi) For the purposes of this subparagraph, the appropriate markup
percentage is equal to the percentage of gross profit (expressed as a
percentage of sales) earned by the buyer (reseller) or another party on
the resale of property which is both purchased and resold in an
uncontrolled transaction, which resale is most similar to the applicable
resale of the property involved in the controlled sale. The following
are the most important characteristics to be considered in determining
the similarity of resales:
(a) The type of property involved in the sales. For example: machine
tools, men's furnishings, small household appliances.
(b) The functions performed by the reseller with respect to the
property. For example: packaging, labeling, delivering, maintenance of
inventory, minor assembly, advertising, selling at wholesale, selling at
retail, billing, maintenance of accounts receivable, and servicing.
(c) The effect on price of any intangible property utilized by the
reseller in connection with the property resold. For example: patents,
trademarks, trade names.
(d) The geographic market in which the functions are performed by
the reseller.
In general, the similarity to be sought relates to the probable effect
upon the markup percentage of any differences in such characteristics
between the uncontrolled purchases and resales on the one hand and the
controlled purchases and resales on the other hand. Thus, close physical
similarity of the property involved in the sales compared is not
required under the resale price method since a lack of close physical
similarity is not necessarily indicative of dissimilar markup
percentages.
(vii) Whenever possible, markup percentages should be derived from
uncontrolled purchases and resales of the buyer (reseller) involved in
the controlled sale, because similar characteristics are more likely to
be found among different resales of property made by the same reseller
than among sales made by other resellers. In the absence of resales by
the same buyer (reseller) which meet the standards of subdivision (vi)
of this subparagraph, evidence of an appropriate markup percentage may
be derived from resales by other resellers selling in the same or a
similar market in which the controlled buyer (reseller) is selling
providing such resellers perform comparable functions. Where the
function performed by the reseller is similar to the
[[Page 807]]
function performed by a sales agent which does not take title, such
sales agent will be considered a reseller for the purpose of determining
an appropriate markup percentage under this subparagraph and the
commission earned by such sales agent, expressed as a percentage of the
sales price of the goods, may constitute the appropriate markup
percentage. If the controlled buyer (reseller) is located in a foreign
country and information on resales by other resellers in the same
foreign market is not available, then markup percentages earned by
United States resellers performing comparable functions may be used. In
the absence of data on markup percentages of particular sales or groups
of sales, the prevailing markup percentage in the particular industry
involved may be appropriate.
(viii) In calculating the markup percentage earned on uncontrolled
purchases and resales, and in applying such percentage to the applicable
resale price to determine the appropriate markup, the same elements
which enter into the computation of the sales price and the costs of
goods sold of the property involved in the comparable uncontrolled
purchases and resales should enter into such computation in the case of
the property involved in the controlled purchases and resales. Thus, if
freight-in and packaging expense are elements of the cost of goods sold
in comparable uncontrolled purchases, then such elements should also be
taken into account in computing the cost of goods sold of the controlled
purchase. Similarly, if the comparable markup percentage is based upon
net sales (after reduction for returns and allowances) of uncontrolled
resellers, such percentage must be applied to net sales of the buyer
(reseller).
(ix) In determining an arm's length price appropriate adjustment
must be made to reflect any material differences between the
uncontrolled purchases and resales used as the basis for the calculation
of the appropriate markup percentage and the resales of property
involved in the controlled sale. The differences referred to in this
subdivision are those differences in functions or circumstances which
have a definite and reasonably ascertainable effect on price. The
principles of this subdivision may be illustrated by the following
example:
Example. Assume that X and Y are members of the same group of
controlled entities and that Y purchases electric mixers from X and
electric toasters from uncontrolled entities. Y performs substantially
similar functions with respect to resales of both the mixers and the
toasters, except that it does not warrant the toasters, but does provide
a 90-day warranty for the mixers. Y normally earns a gross profit on
toasters of 20 percent of gross selling price. The 20-percent gross
profit on the resale of toasters is an appropriate markup percentage,
but the price of the controlled sale computed with reference to such
rate must be adjusted to reflect the difference in terms (the warranty).
(4) Cost plus method. (i) Under the pricing method described as the
``cost plus method'', the arm's length price of a controlled sale of
property shall be computed by adding to the cost of producing such
property (as computed in subdivision (ii) of this subparagraph), an
amount which is equal to such cost multiplied by the appropriate gross
profit percentage (as computed in subdivision (iii) of this
subparagraph), plus or minus any adjustments as provided in subdivision
(v) of this subparagraph.
(ii) For the purposes of this subparagraph, the cost of producing
the property involved in the controlled sale, and the costs which enter
into the computation of the appropriate gross profit percentage shall be
computed in a consistent manner in accordance with sound accounting
practices for allocating or apportioning costs, which neither favors nor
burdens controlled sales in comparison with uncontrolled sales. Thus, if
the costs used in computing the appropriate gross profit percentage are
comprised of the full cost of goods sold, including direct and indirect
costs, then the cost of producing the property involved in the
controlled sales must be comprised of the full cost of goods sold,
including direct and indirect costs. On the other hand, if the costs
used in computing the appropriate gross profit percentage are comprised
only of direct costs, the cost of producing the property involved in the
controlled sale must be comprised only of direct costs. The term ``cost
of producing'', as used in this subparagraph,
[[Page 808]]
includes the cost of acquiring property which is held for resale.
(iii) For the purposes of this subparagraph, the appropriate gross
profit percentage is equal to the gross profit percentage (expressed as
a percentage of cost) earned by the seller or another party on the
uncontrolled sale or sales of property which are most similar to the
controlled sale in question. The following are the most important
characteristics to be considered in determining the similarity of the
uncontrolled sale or sales:
(a) The type of property involved in the sales. For example: machine
tools, men's furnishings, small household appliances.
(b) The functions performed by the seller with respect to the
property sold. For example: contract manufacturing, product assembly,
selling activity, processing, servicing, delivering.
(c) The effect of any intangible property used by the seller in
connection with the property sold. For example: patents, trademarks,
trade names.
(d) The geographic market in which the functions are performed by
the seller. In general, the similarity to be sought relates to the
probable effect upon the margin of gross profit of any differences in
such characteristics between the uncontrolled sales and the controlled
sale. Thus, close physical similarity of the property involved in the
sales compared is not required under the cost plus method since a lack
of close physical similarity is not necessarily indicative of dissimilar
profit margins. See subparagraph (2)(iv) of this paragraph, relating to
sales made at less than a normal profit for the primary purpose of
establishing or maintaining a market.
(iv) Whenever possible, gross profit percentages should be derived
from uncontrolled sales made by the seller involved in the controlled
sale, because similar characteristics are more likely to be found among
sales of property made by the same seller than among sales made by other
sellers. In the absence of such sales, evidence of an appropriate gross
profit percentage may be derived from similar uncontrolled sales by
other sellers whether or not such sellers are members of the controlled
group. Where the function performed by the seller is similar to the
function performed by a purchasing agent which does not take title, such
purchasing agent will be considered a seller for the purpose of
determining an appropriate gross profit percentage under this
subparagraph and the commission earned by such purchasing agent,
expressed as a percentage of the purchase price of the goods, may
constitute the appropriate gross profit percentage. In the absence of
data on gross profit percentages of particular sales or groups of sales
which are similar to the controlled sale, the prevailing gross profit
percentages in the particular industry involved may be appropriate.
(v) Where the most similar sale or sales from which the appropriate
gross profit percentage is derived differ in any material respect from
the controlled sale, the arm's length price which is computed by
applying such percentage must be adjusted to reflect such differences to
the extent such differences would warrant an adjustment of price in
uncontrolled transactions. The differences referred to in this
subdivision are those differences which have a definite and reasonably
ascertainable effect on price.
(Sec. 385 and 7805 of the Internal Revenue Code of 1954 (83 Stat. 613
and 68A Stat. 917; 26 U.S.C. 385 and 7805))
[T.D. 6952, 33 FR 5849, Apr. 16, 1968]
Editorial Note: For Federal Register citations affecting Sec.
1.482-2A, see the List of CFR Sections Affected, which appears in the
Finding Aids section of the printed volume and at www.govinfo.gov.
Regulations applicable on or before January 4, 2009.
Sec. 1.482-7A Methods to determine taxable income in connection
with a cost sharing arrangement.
(a) In general--(1) Scope and application of the rules in this
section. A cost sharing arrangement is an agreement under which the
parties agree to share the costs of development of one or more
intangibles in proportion to their shares of reasonably anticipated
benefits from their individual exploitation of the interests in the
intangibles assigned to them under the arrangement.
[[Page 809]]
A taxpayer may claim that a cost sharing arrangement is a qualified cost
sharing arrangement only if the agreement meets the requirements of
paragraph (b) of this section. Consistent with the rules of Sec. 1.482-
1(d)(3)(ii)(B) (Identifying contractual terms), the district director
may apply the rules of this section to any arrangement that in substance
constitutes a cost sharing arrangement, notwithstanding a failure to
comply with any requirement of this section. A qualified cost sharing
arrangement, or an arrangement to which the district director applies
the rules of this section, will not be treated as a partnership to which
the rules of subchapter K apply. See Sec. 301.7701-3(e) of this
chapter. Furthermore, a participant that is a foreign corporation or
nonresident alien individual will not be treated as engaged in trade or
business within the United States solely by reason of its participation
in such an arrangement. See generally Sec. 1.864-2(a).
(2) Limitation on allocations. The district director shall not make
allocations with respect to a qualified cost sharing arrangement except
to the extent necessary to make each controlled participant's share of
the costs (as determined under paragraph (d) of this section) of
intangible development under the qualified cost sharing arrangement
equal to its share of reasonably anticipated benefits attributable to
such development, under the rules of this section. If a controlled
taxpayer acquires an interest in intangible property from another
controlled taxpayer (other than in consideration for bearing a share of
the costs of the intangible's development), then the district director
may make appropriate allocations to reflect an arm's length
consideration for the acquisition of the interest in such intangible
under the rules of Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6. See
paragraph (g) of this section. An interest in an intangible includes any
commercially transferable interest, the benefits of which are
susceptible of valuation. See Sec. 1.482-4(b) for the definition of an
intangible.
(3) Coordination with Sec. 1.482-1. A qualified cost sharing
arrangement produces results that are consistent with an arm's length
result within the meaning of Sec. 1.482-1(b)(1) if, and only if, each
controlled participant's share of the costs (as determined under
paragraph (d) of this section) of intangible development under the
qualified cost sharing arrangement equals its share of reasonably
anticipated benefits attributable to such development (as required by
paragraph (a)(2) of this section) and all other requirements of this
section are satisfied.
(4) Cross references. Paragraph (c) of this section defines
participant. Paragraph (d) of this section defines the costs of
intangible development. Paragraph (e) of this section defines the
anticipated benefits of intangible development. Paragraph (f) of this
section provides rules governing cost allocations. Paragraph (g) of this
section provides rules governing transfers of intangibles other than in
consideration for bearing a share of the costs of the intangible's
development. Rules governing the character of payments made pursuant to
a qualified cost sharing arrangement are provided in paragraph (h) of
this section. Paragraph (i) of this section provides accounting
requirements. Paragraph (j) of this section provides administrative
requirements. Paragraph (k) of this section provides an effective date.
Paragraph (l) provides a transition rule.
(b) Qualified cost sharing arrangement. A qualified cost sharing
arrangement must--
(1) Include two or more participants;
(2) Provide a method to calculate each controlled participant's
share of intangible development costs, based on factors that can
reasonably be expected to reflect that participant's share of
anticipated benefits;
(3) Provide for adjustment to the controlled participants' shares of
intangible development costs to account for changes in economic
conditions, the business operations and practices of the participants,
and the ongoing development of intangibles under the arrangement; and
(4) Be recorded in a document that is contemporaneous with the
formation (and any revision) of the cost sharing arrangement and that
includes--
(i) A list of the arrangement's participants, and any other member
of the controlled group that will benefit from
[[Page 810]]
the use of intangibles developed under the cost sharing arrangement;
(ii) The information described in paragraphs (b)(2) and (b)(3) of
this section;
(iii) A description of the scope of the research and development to
be undertaken, including the intangible or class of intangibles intended
to be developed;
(iv) A description of each participant's interest in any covered
intangibles. A covered intangible is any intangible property that is
developed as a result of the research and development undertaken under
the cost sharing arrangement (intangible development area);
(v) The duration of the arrangement; and
(vi) The conditions under which the arrangement may be modified or
terminated and the consequences of such modification or termination,
such as the interest that each participant will receive in any covered
intangibles.
(c) Participant--(1) In general. For purposes of this section, a
participant is a controlled taxpayer that meets the requirements of this
paragraph (c)(1) (controlled participant) or an uncontrolled taxpayer
that is a party to the cost sharing arrangement (uncontrolled
participant). See Sec. 1.482-1(i)(5) for the definitions of controlled
and uncontrolled taxpayers. A controlled taxpayer may be a controlled
participant only if it--
(i) Reasonably anticipates that it will derive benefits from the use
of covered intangibles;
(ii) Substantially complies with the accounting requirements
described in paragraph (i) of this section; and
(iii) Substantially complies with the administrative requirements
described in paragraph (j) of this section.
(iv) The following example illustrates paragraph (c)(1)(i) of this
section:
Example. Foreign Parent (FP) is a foreign corporation engaged in the
extraction of a natural resource. FP has a U.S. subsidiary (USS) to
which FP sells supplies of this resource for sale in the United States.
FP enters into a cost sharing arrangement with USS to develop a new
machine to extract the natural resource. The machine uses a new
extraction process that will be patented in the United States and in
other countries. The cost sharing arrangement provides that USS will
receive the rights to use the machine in the extraction of the natural
resource in the United States, and FP will receive the rights in the
rest of the world. This resource does not, however, exist in the United
States. Despite the fact that USS has received the right to use this
process in the United States, USS is not a qualified participant because
it will not derive a benefit from the use of the intangible developed
under the cost sharing arrangement.
(2) Treatment of a controlled taxpayer that is not a controlled
participant--(i) In general. If a controlled taxpayer that is not a
controlled participant (within the meaning of this paragraph (c))
provides assistance in relation to the research and development
undertaken in the intangible development area, it must receive
consideration from the controlled participants under the rules of Sec.
1.482-4(f)(3)(iii) (Allocations with respect to assistance provided to
the owner). For purposes of paragraph (d) of this section, such
consideration is treated as an operating expense and each controlled
participant must be treated as incurring a share of such consideration
equal to its share of reasonably anticipated benefits (as defined in
paragraph (f)(3) of this section).
(ii) Example. The following example illustrates this paragraph
(c)(2):
Example. (i) U.S. Parent (USP), one foreign subsidiary (FS), and a
second foreign subsidiary constituting the group's research arm (R + D)
enter into a cost sharing agreement to develop manufacturing intangibles
for a new product line A. USP and FS are assigned the exclusive rights
to exploit the intangibles respectively in the United States and the
rest of the world, where each presently manufactures and sells various
existing product lines. R + D is not assigned any rights to exploit the
intangibles. R + D's activity consists solely in carrying out research
for the group. It is reliably projected that the shares of reasonably
anticipated benefits of USP and FS will be 66\2/3\% and 33\1/3\,
respectively, and the parties' agreement provides that USP and FS will
reimburse 66\2/3\% and 33\1/3\%, respectively, of the intangible
development costs incurred by R + D with respect to the new intangible.
(ii) R + D does not qualify as a controlled participant within the
meaning of paragraph (c) of this section, because it will not derive any
benefits from the use of covered intangibles. Therefore, R + D is
treated as a service provider for purposes of this section and must
receive arm's length consideration for the assistance it is deemed to
provide to USP and FS, under the rules of Sec. 1.482-4(f)(3)(iii).
[[Page 811]]
Such consideration must be treated as intangible development costs
incurred by USP and FS in proportion to their shares of reasonably
anticipated benefits (i.e., 66\2/3\% and 33\1/3\%, respectively). R + D
will not be considered to bear any share of the intangible development
costs under the arrangement.
(3) Treatment of consolidated group. For purposes of this section,
all members of the same affiliated group (within the meaning of section
1504(a)) that join in the filing of a consolidated return for the
taxable year under section 1501 shall be treated as one taxpayer.
(d) Costs--(1) Intangible development costs. For purposes of this
section, a controlled participant's costs of developing intangibles for
a taxable year mean all of the costs incurred by that participant
related to the intangible development area, plus all of the cost sharing
payments it makes to other controlled and uncontrolled participants,
minus all of the cost sharing payments it receives from other controlled
and uncontrolled participants. Costs incurred related to the intangible
development area consist of the following items: operating expenses as
defined in Sec. 1.482-5(d)(3), other than depreciation or amortization
expense, plus (to the extent not included in such operating expenses, as
defined in Sec. 1.482-5(d)(3)) the charge for the use of any tangible
property made available to the qualified cost sharing arrangement. If
tangible property is made available to the qualified cost sharing
arrangement by a controlled participant, the determination of the
appropriate charge will be governed by the rules of Sec. 1.482-2(c)
(Use of tangible property). Intangible development costs do not include
the consideration for the use of any intangible property made available
to the qualified cost sharing arrangement. See paragraph (g)(2) of this
section. If a particular cost contributes to the intangible development
area and other areas or other business activities, the cost must be
allocated between the intangible development area and the other areas or
business activities on a reasonable basis. In such a case, it is
necessary to estimate the total benefits attributable to the cost
incurred. The share of such cost allocated to the intangible development
area must correspond to covered intangibles' share of the total
benefits. Costs that do not contribute to the intangible development
area are not taken into account.
(2) Stock-based compensation--(i) In general. For purposes of this
section, a controlled participant's operating expenses include all costs
attributable to compensation, including stock-based compensation. As
used in this section, the term stock-based compensation means any
compensation provided by a controlled participant to an employee or
independent contractor in the form of equity instruments, options to
acquire stock (stock options), or rights with respect to (or determined
by reference to) equity instruments or stock options, including but not
limited to property to which section 83 applies and stock options to
which section 421 applies, regardless of whether ultimately settled in
the form of cash, stock, or other property.
(ii) Identification of stock-based compensation related to
intangible development. The determination of whether stock-based
compensation is related to the intangible development area within the
meaning of paragraph (d)(1) of this section is made as of the date that
the stock-based compensation is granted. Accordingly, all stock-based
compensation that is granted during the term of the qualified cost
sharing arrangement and is related at date of grant to the development
of intangibles covered by the arrangement is included as an intangible
development cost under paragraph (d)(1) of this section. In the case of
a repricing or other modification of a stock option, the determination
of whether the repricing or other modification constitutes the grant of
a new stock option for purposes of this paragraph (d)(2)(ii) will be
made in accordance with the rules of section 424(h) and related
regulations.
(iii) Measurement and timing of stock-based compensation expense--
(A) In general. Except as otherwise provided in this paragraph
(d)(2)(iii), the operating expense attributable to stock-based
compensation is equal to the amount allowable to the controlled
participant as a deduction for Federal income tax purposes with respect
to that stock-based compensation (for example, under section 83(h)) and
is taken into account as an operating expense under
[[Page 812]]
this section for the taxable year for which the deduction is allowable.
(1) Transfers to which section 421 applies. Solely for purposes of
this paragraph (d)(2)(iii)(A), section 421 does not apply to the
transfer of stock pursuant to the exercise of an option that meets the
requirements of section 422(a) or 423(a).
(2) Deductions of foreign controlled participants. Solely for
purposes of this paragraph (d)(2)(iii)(A), an amount is treated as an
allowable deduction of a controlled participant to the extent that a
deduction would be allowable to a United States taxpayer.
(3) Modification of stock option. Solely for purposes of this
paragraph (d)(2)(iii)(A), if the repricing or other modification of a
stock option is determined, under paragraph (d)(2)(ii) of this section,
to constitute the grant of a new stock option not related to the
development of intangibles, the stock option that is repriced or
otherwise modified will be treated as being exercised immediately before
the modification, provided that the stock option is then exercisable and
the fair market value of the underlying stock then exceeds the price at
which the stock option is exercisable. Accordingly, the amount of the
deduction that would be allowable (or treated as allowable under this
paragraph (d)(2)(iii)(A)) to the controlled participant upon exercise of
the stock option immediately before the modification must be taken into
account as an operating expense as of the date of the modification.
(4) Expiration or termination of qualified cost sharing arrangement.
Solely for purposes of this paragraph (d)(2)(iii)(A), if an item of
stock-based compensation related to the development of intangibles is
not exercised during the term of a qualified cost sharing arrangement,
that item of stock-based compensation will be treated as being exercised
immediately before the expiration or termination of the qualified cost
sharing arrangement, provided that the stock-based compensation is then
exercisable and the fair market value of the underlying stock then
exceeds the price at which the stock-based compensation is exercisable.
Accordingly, the amount of the deduction that would be allowable (or
treated as allowable under this paragraph (d)(2)(iii)(A)) to the
controlled participant upon exercise of the stock-based compensation
must be taken into account as an operating expense as of the date of the
expiration or termination of the qualified cost sharing arrangement.
(B) Election with respect to options on publicly traded stock--(1)
In general. With respect to stock-based compensation in the form of
options on publicly traded stock, the controlled participants in a
qualified cost sharing arrangement may elect to take into account all
operating expenses attributable to those stock options in the same
amount, and as of the same time, as the fair value of the stock options
reflected as a charge against income in audited financial statements or
disclosed in footnotes to such financial statements, provided that such
statements are prepared in accordance with United States generally
accepted accounting principles by or on behalf of the company issuing
the publicly traded stock.
(2) Publicly traded stock. As used in this paragraph (d)(2)(iii)(B),
the term publicly traded stock means stock that is regularly traded on
an established United States securities market and is issued by a
company whose financial statements are prepared in accordance with
United States generally accepted accounting principles for the taxable
year.
(3) Generally accepted accounting principles. For purposes of this
paragraph (d)(2)(iii)(B), a financial statement prepared in accordance
with a comprehensive body of generally accepted accounting principles
other than United States generally accepted accounting principles is
considered to be prepared in accordance with United States generally
accepted accounting principles provided that either--
(i) The fair value of the stock options under consideration is
reflected in the reconciliation between such other accounting principles
and United States generally accepted accounting principles required to
be incorporated into the financial statement by the securities laws
governing companies whose stock is regularly traded on United States
securities markets; or
[[Page 813]]
(ii) In the absence of a reconciliation between such other
accounting principles and United States generally accepted accounting
principles that reflects the fair value of the stock options under
consideration, such other accounting principles require that the fair
value of the stock options under consideration be reflected as a charge
against income in audited financial statements or disclosed in footnotes
to such statements.
(4) Time and manner of making the election. The election described
in this paragraph (d)(2)(iii)(B) is made by an explicit reference to the
election in the written cost sharing agreement required by paragraph
(b)(4) of this section or in a written amendment to the cost sharing
agreement entered into with the consent of the Commissioner pursuant to
paragraph (d)(2)(iii)(C) of this section. In the case of a qualified
cost sharing arrangement in existence on August 26, 2003, the election
must be made by written amendment to the cost sharing agreement not
later than the latest due date (with regard to extensions) of a Federal
income tax return of any controlled participant for the first taxable
year beginning after August 26, 2003, and the consent of the
Commissioner is not required.
(C) Consistency. Generally, all controlled participants in a
qualified cost sharing arrangement taking options on publicly traded
stock into account under paragraph (d)(2)(iii)(A) or (B) of this section
must use that same method of measurement and timing for all options on
publicly traded stock with respect to that qualified cost sharing
arrangement. Controlled participants may change their method only with
the consent of the Commissioner and only with respect to stock options
granted during taxable years subsequent to the taxable year in which the
Commissioner's consent is obtained. All controlled participants in the
qualified cost sharing arrangement must join in requests for the
Commissioner's consent under this paragraph. Thus, for example, if the
controlled participants make the election described in paragraph
(d)(2)(iii)(B) of this section upon the formation of the qualified cost
sharing arrangement, the election may be revoked only with the consent
of the Commissioner, and the consent will apply only to stock options
granted in taxable years subsequent to the taxable year in which consent
is obtained. Similarly, if controlled participants already have granted
stock options that have been or will be taken into account under the
general rule of paragraph (d)(2)(iii)(A) of this section, then except in
cases specified in the last sentence of paragraph (d)(2)(iii)(B)(4) of
this section, the controlled participants may make the election
described in paragraph (d)(2)(iii)(B) of this section only with the
consent of the Commissioner, and the consent will apply only to stock
options granted in taxable years subsequent to the taxable year in which
consent is obtained.
(3) Examples. The following examples illustrate this paragraph (d):
Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into
a qualified cost sharing arrangement to develop a better mousetrap. USS
and FP share the costs of FP's research and development facility that
will be exclusively dedicated to this research, the salaries of the
researchers, and reasonable overhead costs attributable to the project.
They also share the cost of a conference facility that is at the
disposal of the senior executive management of each company but does not
contribute to the research and development activities in any measurable
way. In this case, the cost of the conference facility must be excluded
from the amount of intangible development costs.
Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into
a qualified cost sharing arrangement to develop a new device. USP and FS
share the costs of a research and development facility, the salaries of
researchers, and reasonable overhead costs attributable to the project.
USP also incurs costs related to field testing of the device, but does
not include them in the amount of intangible development costs of the
cost sharing arrangement. The district director may determine that the
field testing costs are intangible development costs that must be
shared.
(e) Anticipated benefits--(1) Benefits. Benefits are additional
income generated or costs saved by the use of covered intangibles.
(2) Reasonably anticipated benefits. For purposes of this section, a
controlled participant's reasonably anticipated benefits are the
aggregate benefits that it reasonably anticipates that it will derive
from covered intangibles.
[[Page 814]]
(f) Cost allocations--(1) In general. For purposes of determining
whether a cost allocation authorized by paragraph (a)(2) of this section
is appropriate for a taxable year, a controlled participant's share of
intangible development costs for the taxable year under a qualified cost
sharing arrangement must be compared to its share of reasonably
anticipated benefits under the arrangement. A controlled participant's
share of intangible development costs is determined under paragraph
(f)(2) of this section. A controlled participant's share of reasonably
anticipated benefits under the arrangement is determined under paragraph
(f)(3) of this section. In determining whether benefits were reasonably
anticipated, it may be appropriate to compare actual benefits to
anticipated benefits, as described in paragraph (f)(3)(iv) of this
section.
(2) Share of intangible development costs--(i) In general. A
controlled participant's share of intangible development costs for a
taxable year is equal to its intangible development costs for the
taxable year (as defined in paragraph (d) of this section), divided by
the sum of the intangible development costs for the taxable year (as
defined in paragraph (d) of this section) of all the controlled
participants.
(ii) Example. The following example illustrates this paragraph
(f)(2):
Example. (i) U.S. Parent (USP), Foreign Subsidiary (FS), and
Unrelated Third Party (UTP) enter into a cost sharing arrangement to
develop new audio technology. In the first year of the arrangement, the
controlled participants incur $2,250,000 in the intangible development
area, all of which is incurred directly by USP. In the first year, UTP
makes a $250,000 cost sharing payment to USP, and FS makes a $800,000
cost sharing payment to USP, under the terms of the arrangement. For
that year, the intangible development costs borne by USP are $1,200,000
(its $2,250,000 intangible development costs directly incurred, minus
the cost sharing payments it receives of $250,000 from UTP and $800,000
from FS); the intangible development costs borne by FS are $800,000 (its
cost sharing payment); and the intangible development costs borne by all
of the controlled participants are $2,000,000 (the sum of the intangible
development costs borne by USP and FS of $1,200,000 and $800,000,
respectively). Thus, for the first year, USP's share of intangible
development costs is 60% ($1,200,000 divided by $2,000,000), and FS's
share of intangible development costs is 40% ($800,000 divided by
$2,000,000).
(ii) For purposes of determining whether a cost allocation
authorized by paragraph Sec. 1.482-7(a)(2) is appropriate for the first
year, the district director must compare USP's and FS's shares of
intangible development costs for that year to their shares of reasonably
anticipated benefits. See paragraph (f)(3) of this section.
(3) Share of reasonably anticipated benefits--(i) In general. A
controlled participant's share of reasonably anticipated benefits under
a qualified cost sharing arrangement is equal to its reasonably
anticipated benefits (as defined in paragraph (e)(2) of this section),
divided by the sum of the reasonably anticipated benefits (as defined in
paragraph (e)(2) of this section) of all the controlled participants.
The anticipated benefits of an uncontrolled participant will not be
included for purposes of determining each controlled participant's share
of anticipated benefits. A controlled participant's share of reasonably
anticipated benefits will be determined using the most reliable estimate
of reasonably anticipated benefits. In determining which of two or more
available estimates is most reliable, the quality of the data and
assumptions used in the analysis must be taken into account, consistent
with Sec. 1.482-1(c)(2)(ii) (Data and assumptions). Thus, the
reliability of an estimate will depend largely on the completeness and
accuracy of the data, the soundness of the assumptions, and the relative
effects of particular deficiencies in data or assumptions on different
estimates. If two estimates are equally reliable, no adjustment should
be made based on differences in the results. The following factors will
be particularly relevant in determining the reliability of an estimate
of anticipated benefits--
(A) The reliability of the basis used for measuring benefits, as
described in paragraph (f)(3)(ii) of this section; and
(B) The reliability of the projections used to estimate benefits, as
described in paragraph (f)(3)(iv) of this section.
(ii) Measure of benefits. In order to estimate a controlled
participant's share of anticipated benefits from covered intangibles,
the amount of benefits that each of the controlled participants is
reasonably anticipated to derive from
[[Page 815]]
covered intangibles must be measured on a basis that is consistent for
all such participants. See paragraph (f)(3)(iii)(E), Example 8, of this
section. If a controlled participant transfers covered intangibles to
another controlled taxpayer, such participant's benefits from the
transferred intangibles must be measured by reference to the
transferee's benefits, disregarding any consideration paid by the
transferee to the controlled participant (such as a royalty pursuant to
a license agreement). Anticipated benefits are measured either on a
direct basis, by reference to estimated additional income to be
generated or costs to be saved by the use of covered intangibles, or on
an indirect basis, by reference to certain measurements that reasonably
can be assumed to be related to income generated or costs saved. Such
indirect bases of measurement of anticipated benefits are described in
paragraph (f)(3)(iii) of this section. A controlled participant's
anticipated benefits must be measured on the most reliable basis,
whether direct or indirect. In determining which of two bases of
measurement of reasonably anticipated benefits is most reliable, the
factors set forth in Sec. 1.482-1(c)(2)(ii) (Data and assumptions) must
be taken into account. It normally will be expected that the basis that
provided the most reliable estimate for a particular year will continue
to provide the most reliable estimate in subsequent years, absent a
material change in the factors that affect the reliability of the
estimate. Regardless of whether a direct or indirect basis of
measurement is used, adjustments may be required to account for material
differences in the activities that controlled participants undertake to
exploit their interests in covered intangibles. See Example 6 of
paragraph (f)(3)(iii)(E) of this section.
(iii) Indirect bases for measuring anticipated benefits. Indirect
bases for measuring anticipated benefits from participation in a
qualified cost sharing arrangement include the following:
(A) Units used, produced or sold. Units of items used, produced or
sold by each controlled participant in the business activities in which
covered intangibles are exploited may be used as an indirect basis for
measuring its anticipated benefits. This basis of measurement will be
more reliable to the extent that each controlled participant is expected
to have a similar increase in net profit or decrease in net loss
attributable to the covered intangibles per unit of the item or items
used, produced or sold. This circumstance is most likely to arise when
the covered intangibles are exploited by the controlled participants in
the use, production or sale of substantially uniform items under similar
economic conditions.
(B) Sales. Sales by each controlled participant in the business
activities in which covered intangibles are exploited may be used as an
indirect basis for measuring its anticipated benefits. This basis of
measurement will be more reliable to the extent that each controlled
participant is expected to have a similar increase in net profit or
decrease in net loss attributable to covered intangibles per dollar of
sales. This circumstance is most likely to arise if the costs of
exploiting covered intangibles are not substantial relative to the
revenues generated, or if the principal effect of using covered
intangibles is to increase the controlled participants' revenues (e.g.,
through a price premium on the products they sell) without affecting
their costs substantially. Sales by each controlled participant are
unlikely to provide a reliable basis for measuring benefits unless each
controlled participant operates at the same market level (e.g.,
manufacturing, distribution, etc.).
(C) Operating profit. Operating profit of each controlled
participant from the activities in which covered intangibles are
exploited may be used as an indirect basis for measuring its anticipated
benefits. This basis of measurement will be more reliable to the extent
that such profit is largely attributable to the use of covered
intangibles, or if the share of profits attributable to the use of
covered intangibles is expected to be similar for each controlled
participant. This circumstance is most likely to arise when covered
intangibles are integral to the activity that generates the profit and
the activity could not be carried on or would generate little profit
without use of those intangibles.
[[Page 816]]
(D) Other bases for measuring anticipated benefits. Other bases for
measuring anticipated benefits may, in some circumstances, be
appropriate, but only to the extent that there is expected to be a
reasonably identifiable relationship between the basis of measurement
used and additional income generated or costs saved by the use of
covered intangibles. For example, a division of costs based on employee
compensation would be considered unreliable unless there were a
relationship between the amount of compensation and the expected income
of the controlled participants from the use of covered intangibles.
(E) Examples. The following examples illustrate this paragraph
(f)(3)(iii):
Example 1. Foreign Parent (FP) and U.S. Subsidiary (USS) both
produce a feedstock for the manufacture of various high-performance
plastic products. Producing the feedstock requires large amounts of
electricity, which accounts for a significant portion of its production
cost. FP and USS enter into a cost sharing arrangement to develop a new
process that will reduce the amount of electricity required to produce a
unit of the feedstock. FP and USS currently both incur an electricity
cost of X% of its other production costs and rates for each are expected
to remain similar in the future. How much the new process, if it is
successful, will reduce the amount of electricity required to produce a
unit of the feedstock is uncertain, but it will be about the same amount
for both companies. Therefore, the cost savings each company is expected
to achieve after implementing the new process are similar relative to
the total amount of the feedstock produced. Under the cost sharing
arrangement FP and USS divide the costs of developing the new process
based on the units of the feedstock each is anticipated to produce in
the future. In this case, units produced is the most reliable basis for
measuring benefits and dividing the intangible development costs because
each participant is expected to have a similar decrease in costs per
unit of the feedstock produced.
Example 2. The facts are the same as in Example 1, except that USS
pays X% of its other production costs for electricity while FP pays 2X%
of its other production costs. In this case, units produced is not the
most reliable basis for measuring benefits and dividing the intangible
development costs because the participants do not expect to have a
similar decrease in costs per unit of the feedstock produced. The
district director determines that the most reliable measure of benefit
shares may be based on units of the feedstock produced if FP's units are
weighted relative to USS's units by a factor of 2. This reflects the
fact that FP pays twice as much as USS as a percentage of its other
production costs for electricity and, therefore, FP's savings per unit
of the feedstock would be twice USS's savings from any new process
eventually developed.
Example 3. The facts are the same as in Example 2, except that to
supply the particular needs of the U.S. market USS manufactures the
feedstock with somewhat different properties than FP's feedstock. This
requires USS to employ a somewhat different production process than does
FP. Because of this difference, it will be more costly for USS to adopt
any new process that may be developed under the cost sharing agreement.
In this case, units produced is not the most reliable basis for
measuring benefit shares. In order to reliably determine benefit shares,
the district director offsets the reasonably anticipated costs of
adopting the new process against the reasonably anticipated total
savings in electricity costs.
Example 4. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into
a cost sharing arrangement to develop new anesthetic drugs. USP obtains
the right to use any resulting patent in the U.S. market, and FS obtains
the right to use the patent in the European market. USP and FS divide
costs on the basis of anticipated operating profit from each patent
under development. USP anticipates that it will receive a much higher
profit than FS per unit sold because drug prices are uncontrolled in the
U.S., whereas drug prices are regulated in many European countries. In
this case, the controlled taxpayers' basis for measuring benefits is the
most reliable.
Example 5. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) both
manufacture and sell fertilizers. They enter into a cost sharing
arrangement to develop a new pellet form of a common agricultural
fertilizer that is currently available only in powder form. Under the
cost sharing arrangement, USS obtains the rights to produce and sell the
new form of fertilizer for the U.S. market while FP obtains the rights
to produce and sell the fertilizer for the rest of the world. The costs
of developing the new form of fertilizer are divided on the basis of the
anticipated sales of fertilizer in the participants' respective markets.
(ii) If the research and development is successful the pellet form
will deliver the fertilizer more efficiently to crops and less
fertilizer will be required to achieve the same effect on crop growth.
The pellet form of fertilizer can be expected to sell at a price premium
over the powder form of fertilizer based on the savings in the amount of
fertilizer that needs to be used. If the research and development is
successful, the costs of producing pellet fertilizer are expected to be
[[Page 817]]
approximately the same as the costs of producing powder fertilizer and
the same for both FP and USS. Both FP and USS operate at approximately
the same market levels, selling their fertilizers largely to independent
distributors.
(iii) In this case, the controlled taxpayers' basis for measuring
benefits is the most reliable.
Example 6. The facts are the same as in Example 5, except that FP
distributes its fertilizers directly while USS sells to independent
distributors. In this case, sales of USS and FP are not the most
reliable basis for measuring benefits unless adjustments are made to
account for the difference in market levels at which the sales occur.
Example 7. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into
a cost sharing arrangement to develop materials that will be used to
train all new entry-level employees. FP and USS determine that the new
materials will save approximately ten hours of training time per
employee. Because their entry-level employees are paid on differing wage
scales, FP and USS decide that they should not divide costs based on the
number of entry-level employees hired by each. Rather, they divide costs
based on compensation paid to the entry-level employees hired by each.
In this case, the basis used for measuring benefits is the most reliable
because there is a direct relationship between compensation paid to new
entry-level employees and costs saved by FP and USS from the use of the
new training materials.
Example 8. U.S. Parent (USP), Foreign Subsidiary 1 (FS1) and Foreign
Subsidiary 2 (FS2) enter into a cost sharing arrangement to develop
computer software that each will market and install on customers'
computer systems. The participants divide costs on the basis of
projected sales by USP, FS1, and FS2 of the software in their respective
geographic areas. However, FS1 plans not only to sell but also to
license the software to unrelated customers, and FS1's licensing income
(which is a percentage of the licensees' sales) is not counted in the
projected benefits. In this case, the basis used for measuring the
benefits of each participant is not the most reliable because all of the
benefits received by participants are not taken into account. In order
to reliably determine benefit shares, FS1's projected benefits from
licensing must be included in the measurement on a basis that is the
same as that used to measure its own and the other participants'
projected benefits from sales (e.g., all participants might measure
their benefits on the basis of operating profit).
(iv) Projections used to estimate anticipated benefits--(A) In
general. The reliability of an estimate of anticipated benefits also
depends upon the reliability of projections used in making the estimate.
Projections required for this purpose generally include a determination
of the time period between the inception of the research and development
and the receipt of benefits, a projection of the time over which
benefits will be received, and a projection of the benefits anticipated
for each year in which it is anticipated that the intangible will
generate benefits. A projection of the relevant basis for measuring
anticipated benefits may require a projection of the factors that
underlie it. For example, a projection of operating profits may require
a projection of sales, cost of sales, operating expenses, and other
factors that affect operating profits. If it is anticipated that there
will be significant variation among controlled participants in the
timing of their receipt of benefits, and consequently benefit shares are
expected to vary significantly over the years in which benefits will be
received, it may be necessary to use the present discounted value of the
projected benefits to reliably determine each controlled participant's
share of those benefits. If it is not anticipated that benefit shares
will significantly change over time, current annual benefit shares may
provide a reliable projection of anticipated benefit shares. This
circumstance is most likely to occur when the cost sharing arrangement
is a long-term arrangement, the arrangement covers a wide variety of
intangibles, the composition of the covered intangibles is unlikely to
change, the covered intangibles are unlikely to generate unusual
profits, and each controlled participant's share of the market is
stable.
(B) Unreliable projections. A significant divergence between
projected benefit shares and actual benefit shares may indicate that the
projections were not reliable. In such a case, the district director may
use actual benefits as the most reliable measure of anticipated
benefits. If benefits are projected over a period of years, and the
projections for initial years of the period prove to be unreliable, this
may indicate that the projections for the remaining years of the period
are also unreliable and thus should be adjusted. Projections will not be
considered unreliable based on a divergence between a controlled
[[Page 818]]
participant's projected benefit share and actual benefit share if the
amount of such divergence for every controlled participant is less than
or equal to 20% of the participant's projected benefit share. Further,
the district director will not make an allocation based on such
divergence if the difference is due to an extraordinary event, beyond
the control of the participants, that could not reasonably have been
anticipated at the time that costs were shared. For purposes of this
paragraph, all controlled participants that are not U.S. persons will be
treated as a single controlled participant. Therefore, an adjustment
based on an unreliable projection will be made to the cost shares of
foreign controlled participants only if there is a matching adjustment
to the cost shares of controlled participants that are U.S. persons.
Nothing in this paragraph (f)(3)(iv)(B) will prevent the district
director from making an allocation if the taxpayer did not use the most
reliable basis for measuring anticipated benefits. For example, if the
taxpayer measures anticipated benefits based on units sold, and the
district director determines that another basis is more reliable for
measuring anticipated benefits, then the fact that actual units sold
were within 20% of the projected unit sales will not preclude an
allocation under this section.
(C) Foreign-to-foreign adjustments. Notwithstanding the limitations
on adjustments provided in paragraph (f)(3)(iv)(B) of this section,
adjustments to cost shares based on an unreliable projection also may be
made solely among foreign controlled participants if the variation
between actual and projected benefits has the effect of substantially
reducing U.S. tax.
(D) Examples. The following examples illustrate this paragraph
(f)(3)(iv):
Example 1. (i) Foreign Parent (FP) and U.S. Subsidiary (USS) enter
into a cost sharing arrangement to develop a new car model. The
participants plan to spend four years developing the new model and four
years producing and selling the new model. USS and FP project total
sales of $4 billion and $2 billion, respectively, over the planned four
years of exploitation of the new model. Cost shares are divided for each
year based on projected total sales. Therefore, USS bears 66\2/3\% of
each year's intangible development costs and FP bears 33\1/3\% of such
costs.
(ii) USS typically begins producing and selling new car models a
year after FP begins producing and selling new car models. The district
director determines that in order to reflect USS's one-year lag in
introducing new car models, a more reliable projection of each
participant's share of benefits would be based on a projection of all
four years of sales for each participant, discounted to present value.
Example 2. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into
a cost sharing arrangement to develop new and improved household
cleaning products. Both participants have sold household cleaning
products for many years and have stable market shares. The products
under development are unlikely to produce unusual profits for either
participant. The participants divide costs on the basis of each
participant's current sales of household cleaning products. In this
case, the participants' future benefit shares are reliably projected by
current sales of cleaning products.
Example 3. The facts are the same as in Example 2, except that FS's
market share is rapidly expanding because of the business failure of a
competitor in its geographic area. The district director determines that
the participants' future benefit shares are not reliably projected by
current sales of cleaning products and that FS's benefit projections
should take into account its growth in sales.
Example 4. Foreign Parent (FP) and U.S. Subsidiary (USS) enter into
a cost sharing arrangement to develop synthetic fertilizers and
insecticides. FP and USS share costs on the basis of each participant's
current sales of fertilizers and insecticides. The market shares of the
participants have been stable for fertilizers, but FP's market share for
insecticides has been expanding. The district director determines that
the participants' projections of benefit shares are reliable with regard
to fertilizers, but not reliable with regard to insecticides; a more
reliable projection of benefit shares would take into account the
expanding market share for insecticides.
Example 5. U.S. Parent (USP) and Foreign Subsidiary (FS) enter into
a cost sharing arrangement to develop new food products, dividing costs
on the basis of projected sales two years in the future. In year 1, USP
and FS project that their sales in year 3 will be equal, and they divide
costs accordingly. In year 3, the district director examines the
participants' method for dividing costs. USP and FS actually accounted
for 42% and 58% of total sales, respectively. The district director
agrees that sales two years in the future provide a reliable basis for
estimating benefit shares. Because the differences between USP's and
FS's actual and projected
[[Page 819]]
benefit shares are less than 20% of their projected benefit shares, the
projection of future benefits for year 3 is reliable.
Example 6. The facts are the same as in Example 5, except that the
in year 3 USP and FS actually accounted for 35% and 65% of total sales,
respectively. The divergence between USP's projected and actual benefit
shares is greater than 20% of USP's projected benefit share and is not
due to an extraordinary event beyond the control of the participants.
The district director concludes that the projection of anticipated
benefit shares was unreliable, and uses actual benefits as the basis for
an adjustment to the cost shares borne by USP and FS.
Example 7. U.S. Parent (USP), a U.S. corporation, and its foreign
subsidiary (FS) enter a cost sharing arrangement in year 1. They project
that they will begin to receive benefits from covered intangibles in
years 4 through 6, and that USP will receive 60% of total benefits and
FS 40% of total benefits. In years 4 through 6, USP and FS actually
receive 50% each of the total benefits. In evaluating the reliability of
the participants' projections, the district director compares these
actual benefit shares to the projected benefit shares. Although USP's
actual benefit share (50%) is within 20% of its projected benefit share
(60%), FS's actual benefit share (50%) is not within 20% of its
projected benefit share (40%). Based on this discrepancy, the district
director may conclude that the participants' projections were not
reliable and may use actual benefit shares as the basis for an
adjustment to the cost shares borne by USP and FS.
Example 8. Three controlled taxpayers, USP, FS1 and FS2 enter into a
cost sharing arrangement. FS1 and FS2 are foreign. USP is a United
States corporation that controls all the stock of FS1 and FS2. The
participants project that they will share the total benefits of the
covered intangibles in the following percentages: USP 50%; FS1 30%; and
FS2 20%. Actual benefit shares are as follows: USP 45%; FS1 25%; and FS2
30%. In evaluating the reliability of the participants' projections, the
district director compares these actual benefit shares to the projected
benefit shares. For this purpose, FS1 and FS2 are treated as a single
participant. The actual benefit share received by USP (45%) is within
20% of its projected benefit share (50%). In addition, the non-US
participants' actual benefit share (55%) is also within 20% of their
projected benefit share (50%). Therefore, the district director
concludes that the participants' projections of future benefits were
reliable, despite the fact that FS2's actual benefit share (30%) is not
within 20% of its projected benefit share (20%).
Example 9. The facts are the same as in Example 8. In addition, the
district director determines that FS2 has significant operating losses
and has no earnings and profits, and that FS1 is profitable and has
earnings and profits. Based on all the evidence, the district director
concludes that the participants arranged that FS1 would bear a larger
cost share than appropriate in order to reduce FS1's earnings and
profits and thereby reduce inclusions USP otherwise would be deemed to
have on account of FS1 under subpart F. Pursuant to Sec. 1.482-7
(f)(3)(iv)(C), the district director may make an adjustment solely to
the cost shares borne by FS1 and FS2 because FS2's projection of future
benefits was unreliable and the variation between actual and projected
benefits had the effect of substantially reducing USP's U.S. income tax
liability (on account of FS1 subpart F income).
Example 10. (i)(A) Foreign Parent (FP) and U.S. Subsidiary (USS)
enter into a cost sharing arrangement in 1996 to develop a new treatment
for baldness. USS's interest in any treatment developed is the right to
produce and sell the treatment in the U.S. market while FP retains
rights to produce and sell the treatment in the rest of the world. USS
and FP measure their anticipated benefits from the cost sharing
arrangement based on their respective projected future sales of the
baldness treatment. The following sales projections are used:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1997.................................................... 5 10
1998.................................................... 20 20
1999.................................................... 30 30
2000.................................................... 40 40
2001.................................................... 40 40
2002.................................................... 40 40
2003.................................................... 40 40
2004.................................................... 20 20
2005.................................................... 10 10
2006.................................................... 5 5
------------------------------------------------------------------------
(B) In 1997, the first year of sales, USS is projected to have lower
sales than FP due to lags in U.S. regulatory approval for the baldness
treatment. In each subsequent year USS and FP are projected to have
equal sales. Sales are projected to build over the first three years of
the period, level off for several years, and then decline over the final
years of the period as new and improved baldness treatments reach the
market.
(ii) To account for USS's lag in sales in the first year, the
present discounted value of sales over the period is used as the basis
for measuring benefits. Based on the risk associated with this venture,
a discount rate of 10 percent is selected. The present discounted value
of projected sales is determined to be approximately $154.4 million for
USS and $158.9 million for FP. On this basis USS and FP are projected to
obtain approximately
[[Page 820]]
49.3% and 50.7% of the benefit, respectively, and the costs of
developing the baldness treatment are shared accordingly.
(iii) (A) In the year 2002 the district director examines the cost
sharing arrangement. USS and FP have obtained the following sales
results through the year 2001:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1997.................................................... 0 17
1998.................................................... 17 35
1999.................................................... 25 41
2000.................................................... 38 41
2001.................................................... 39 41
------------------------------------------------------------------------
(B) USS's sales initially grew more slowly than projected while FP's
sales grew more quickly. In each of the first three years of the period
the share of total sales of at least one of the parties diverged by over
20% from its projected share of sales. However, by the year 2001 both
parties' sales had leveled off at approximately their projected values.
Taking into account this leveling off of sales and all the facts and
circumstances, the district director determines that it is appropriate
to use the original projections for the remaining years of sales.
Combining the actual results through the year 2001 with the projections
for subsequent years, and using a discount rate of 10%, the present
discounted value of sales is approximately $141.6 million for USS and
$187.3 million for FP. This result implies that USS and FP obtain
approximately 43.1% and 56.9%, respectively, of the anticipated benefits
from the baldness treatment. Because these benefit shares are within 20%
of the benefit shares calculated based on the original sales
projections, the district director determines that, based on the
difference between actual and projected benefit shares, the original
projections were not unreliable. No adjustment is made based on the
difference between actual and projected benefit shares.
Example 11. (i) The facts are the same as in Example 10, except that
the actual sales results through the year 2001 are as follows:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
1997.................................................... 0 17
1998.................................................... 17 35
1999.................................................... 25 44
2000.................................................... 34 54
2001.................................................... 36 55
------------------------------------------------------------------------
(ii) Based on the discrepancy between the projections and the actual
results and on consideration of all the facts, the district director
determines that for the remaining years the following sales projections
are more reliable than the original projections:
Sales
[In millions of dollars]
------------------------------------------------------------------------
Year USS FP
------------------------------------------------------------------------
2002................................................... 36 55
2003................................................... 36 55
2004................................................... 18 28
2005................................................... 9 14
2006................................................... 4.5 7
------------------------------------------------------------------------
(iii) Combining the actual results through the year 2001 with the
projections for subsequent years, and using a discount rate of 10%, the
present discounted value of sales is approximately $131.2 million for
USS and $229.4 million for FP. This result implies that USS and FP
obtain approximately 35.4% and 63.6%, respectively, of the anticipated
benefits from the baldness treatment. These benefit shares diverge by
greater than 20% from the benefit shares calculated based on the
original sales projections, and the district director determines that,
based on the difference between actual and projected benefit shares, the
original projections were unreliable. The district director adjusts
costs shares for each of the taxable years under examination to conform
them to the recalculated shares of anticipated benefits.
(4) Timing of allocations. If the district director reallocates
costs under the provisions of this paragraph (f), the allocation must be
reflected for tax purposes in the year in which the costs were incurred.
When a cost sharing payment is owed by one member of a qualified cost
sharing arrangement to another member, the district director may make
appropriate allocations to reflect an arm's length rate of interest for
the time value of money, consistent with the provisions of Sec. 1.482-
2(a) (Loans or advances).
(g) Allocations of income, deductions or other tax items to reflect
transfers of intangibles (buy-in)--(1) In general. A controlled
participant that makes intangible property available to a qualified cost
sharing arrangement will be treated as having transferred interests in
such property to the other controlled participants, and such other
controlled participants must make buy-in payments to it, as provided in
paragraph (g)(2) of this section. If the other controlled participants
fail to make such payments, the district director may make appropriate
allocations, under the provisions of Sec. Sec. 1.482-1 and 1.482-4
[[Page 821]]
through 1.482-6, to reflect an arm's length consideration for the
transferred intangible property. Further, if a group of controlled
taxpayers participates in a qualified cost sharing arrangement, any
change in the controlled participants' interests in covered intangibles,
whether by reason of entry of a new participant or otherwise by reason
of transfers (including deemed transfers) of interests among existing
participants, is a transfer of intangible property, and the district
director may make appropriate allocations, under the provisions of
Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6, to reflect an arm's
length consideration for the transfer. See paragraphs (g) (3), (4), and
(5) of this section. Paragraph (g)(6) of this section provides rules for
assigning unassigned interests under a qualified cost sharing
arrangement.
(2) Pre-existing intangibles. If a controlled participant makes pre-
existing intangible property in which it owns an interest available to
other controlled participants for purposes of research in the intangible
development area under a qualified cost sharing arrangement, then each
such other controlled participant must make a buy-in payment to the
owner. The buy-in payment by each such other controlled participant is
the arm's length charge for the use of the intangible under the rules of
Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6, multiplied by the
controlled participant's share of reasonably anticipated benefits (as
defined in paragraph (f)(3) of this section). A controlled participant's
payment required under this paragraph (g)(2) is deemed to be reduced to
the extent of any payments owed to it under this paragraph (g)(2) from
other controlled participants. Each payment received by a payee will be
treated as coming pro rata out of payments made by all payors. See
paragraph (g)(8), Example 4, of this section. Such payments will be
treated as consideration for a transfer of an interest in the intangible
property made available to the qualified cost sharing arrangement by the
payee. Any payment to or from an uncontrolled participant in
consideration for intangible property made available to the qualified
cost sharing arrangement will be shared by the controlled participants
in accordance with their shares of reasonably anticipated benefits (as
defined in paragraph (f)(3) of this section). A controlled participant's
payment required under this paragraph (g)(2) is deemed to be reduced by
such a share of payments owed from an uncontrolled participant to the
same extent as by any payments owed from other controlled participants
under this paragraph (g)(2). See paragraph (g)(8), Example 5, of this
section.
(3) New controlled participant. If a new controlled participant
enters a qualified cost sharing arrangement and acquires any interest in
the covered intangibles, then the new participant must pay an arm's
length consideration, under the provisions of Sec. Sec. 1.482-1 and
1.482-4 through 1.482-6, for such interest to each controlled
participant from whom such interest was acquired.
(4) Controlled participant relinquishes interests. A controlled
participant in a qualified cost sharing arrangement may be deemed to
have acquired an interest in one or more covered intangibles if another
controlled participant transfers, abandons, or otherwise relinquishes an
interest under the arrangement, to the benefit of the first participant.
If such a relinquishment occurs, the participant relinquishing the
interest must receive an arm's length consideration, under the
provisions of Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6, for its
interest. If the controlled participant that has relinquished its
interest subsequently uses that interest, then that participant must pay
an arm's length consideration, under the provisions of Sec. Sec. 1.482-
1 and 1.482-4 through 1.482-6, to the controlled participant that
acquired the interest.
(5) Conduct inconsistent with the terms of a cost sharing
arrangement. If, after any cost allocations authorized by paragraph
(a)(2) of this section, a controlled participant bears costs of
intangible development that over a period of years are consistently and
materially greater or lesser than its share of reasonably anticipated
benefits, then the district director may conclude that the economic
substance of the arrangement between the controlled participants is
inconsistent with the terms of the cost sharing arrangement. In such a
case, the district director may disregard such terms and impute an
[[Page 822]]
agreement consistent with the controlled participants' course of
conduct, under which a controlled participant that bore a
disproportionately greater share of costs received additional interests
in covered intangibles. See Sec. 1.482-1(d)(3)(ii)(B) (Identifying
contractual terms) and Sec. 1.482- 4(f)(3)(ii) (Identification of
owner). Accordingly, that participant must receive an arm's length
payment from any controlled participant whose share of the intangible
development costs is less than its share of reasonably anticipated
benefits over time, under the provisions of Sec. Sec. 1.482-1 and
1.482-4 through 1.482-6.
(6) Failure to assign interests under a qualified cost sharing
arrangement. If a qualified cost sharing arrangement fails to assign an
interest in a covered intangible, then each controlled participant will
be deemed to hold a share in such interest equal to its share of the
costs of developing such intangible. For this purpose, if cost shares
have varied materially over the period during which such intangible was
developed, then the costs of developing the intangible must be measured
by their present discounted value as of the date when the first such
costs were incurred.
(7) Form of consideration. The consideration for an acquisition
described in this paragraph (g) may take any of the following forms:
(i) Lump sum payments. For the treatment of lump sum payments, see
Sec. 1.482-4(f)(5) (Lump sum payments);
(ii) Installment payments. Installment payments spread over the
period of use of the intangible by the transferee, with interest
calculated in accordance with Sec. 1.482-2(a) (Loans or advances); and
(iii) Royalties. Royalties or other payments contingent on the use
of the intangible by the transferee.
(8) Examples. The following examples illustrate allocations
described in this paragraph (g):
Example 1. In year one, four members of a controlled group enter
into a cost sharing arrangement to develop a commercially feasible
process for capturing energy from nuclear fusion. Based on a reliable
projection of their future benefits, each cost sharing participant bears
an equal share of the costs. The cost of developing intangibles for each
participant with respect to the project is approximately $1 million per
year. In year ten, a fifth member of the controlled group joins the cost
sharing group and agrees to bear one-fifth of the future costs in
exchange for part of the fourth member's territory reasonably
anticipated to yield benefits amounting to one-fifth of the total
benefits. The fair market value of intangible property within the
arrangement at the time the fifth company joins the arrangement is $45
million. The new member must pay one-fifth of that amount (that is, $9
million total) to the fourth member from whom it acquired its interest
in covered intangibles.
Example 2. U.S. Subsidiary (USS), Foreign Subsidiary (FS) and
Foreign Parent (FP) enter into a cost sharing arrangement to develop new
products within the Group X product line. USS manufactures and sells
Group X products in North America, FS manufactures and sells Group X
products in South America, and FP manufactures and sells Group X
products in the rest of the world. USS, FS and FP project that each will
manufacture and sell a third of the Group X products under development,
and they share costs on the basis of projected sales of manufactured
products. When the new Group X products are developed, however, USS
ceases to manufacture Group X products, and FP sells its Group X
products to USS for resale in the North American market. USS earns a
return on its resale activity that is appropriate given its function as
a distributor, but does not earn a return attributable to exploiting
covered intangibles. The district director determines that USS's share
of the costs (one-third) was greater than its share of reasonably
anticipated benefits (zero) and that it has transferred an interest in
the intangibles for which it should receive a payment from FP, whose
share of the intangible development costs (one-third) was less than its
share of reasonably anticipated benefits over time (two-thirds). An
allocation is made under Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6
from FP to USS to recognize USS' one-third interest in the intangibles.
No allocation is made from FS to USS because FS did not exploit USS's
interest in covered intangibles.
Example 3. U.S. Parent (USP), Foreign Subsidiary 1 (FS1), and
Foreign Subsidiary 2 (FS2) enter into a cost sharing arrangement to
develop a cure for the common cold. Costs are shared USP-50%, FS1-40%
and FS2-10% on the basis of projected units of cold medicine to be
produced by each. After ten years of research and development, FS1
withdraws from the arrangement, transferring its interests in the
intangibles under development to USP in exchange for a lump sum payment
of $10 million. The district director may review this lump sum payment,
under the provisions of Sec. 1.482-4(f)(5), to ensure that the amount
is commensurate with the income attributable to the intangibles.
[[Page 823]]
Example 4. (i) Four members A, B, C, and D of a controlled group
form a cost sharing arrangement to develop the next generation
technology for their business. Based on a reliable projection of their
future benefits, the participants agree to bear shares of the costs
incurred during the term of the agreement in the following percentages:
A 40%; B 15%; C 25%; and D 20%. The arm's length charges, under the
rules of Sec. Sec. 1.482-1 and 1.482-4 through 1.482-6, for the use of
the existing intangible property they respectively make available to the
cost sharing arrangement are in the following amounts for the taxable
year: A 80X; B 40X; C 30X; and D 30X. The provisional (before offsets)
and final buy-in payments/receipts among A, B, C, and D are shown in the
table as follows:
[All amounts stated in X's]
------------------------------------------------------------------------
A B C D
------------------------------------------------------------------------
Payments........................ <40
Sec. Sec. 1.484-1.500 [Reserved]
[[Page 827]]
FINDING AIDS
--------------------------------------------------------------------
A list of CFR titles, subtitles, chapters, subchapters and parts and
an alphabetical list of agencies publishing in the CFR are included in
the CFR Index and Finding Aids volume to the Code of Federal Regulations
which is published separately and revised annually.
Table of CFR Titles and Chapters
Alphabetical List of Agencies Appearing in the CFR
Table of OMB Control Numbers
List of CFR Sections Affected
[[Page 829]]
Table of CFR Titles and Chapters
(Revised as of April 1, 2019)
Title 1--General Provisions
I Administrative Committee of the Federal Register
(Parts 1--49)
II Office of the Federal Register (Parts 50--299)
III Administrative Conference of the United States (Parts
300--399)
IV Miscellaneous Agencies (Parts 400--599)
VI National Capital Planning Commission (Parts 600--699)
Title 2--Grants and Agreements
Subtitle A--Office of Management and Budget Guidance
for Grants and Agreements
I Office of Management and Budget Governmentwide
Guidance for Grants and Agreements (Parts 2--199)
II Office of Management and Budget Guidance (Parts 200--
299)
Subtitle B--Federal Agency Regulations for Grants and
Agreements
III Department of Health and Human Services (Parts 300--
399)
IV Department of Agriculture (Parts 400--499)
VI Department of State (Parts 600--699)
VII Agency for International Development (Parts 700--799)
VIII Department of Veterans Affairs (Parts 800--899)
IX Department of Energy (Parts 900--999)
X Department of the Treasury (Parts 1000--1099)
XI Department of Defense (Parts 1100--1199)
XII Department of Transportation (Parts 1200--1299)
XIII Department of Commerce (Parts 1300--1399)
XIV Department of the Interior (Parts 1400--1499)
XV Environmental Protection Agency (Parts 1500--1599)
XVIII National Aeronautics and Space Administration (Parts
1800--1899)
XX United States Nuclear Regulatory Commission (Parts
2000--2099)
XXII Corporation for National and Community Service (Parts
2200--2299)
XXIII Social Security Administration (Parts 2300--2399)
XXIV Department of Housing and Urban Development (Parts
2400--2499)
XXV National Science Foundation (Parts 2500--2599)
XXVI National Archives and Records Administration (Parts
2600--2699)
[[Page 830]]
XXVII Small Business Administration (Parts 2700--2799)
XXVIII Department of Justice (Parts 2800--2899)
XXIX Department of Labor (Parts 2900--2999)
XXX Department of Homeland Security (Parts 3000--3099)
XXXI Institute of Museum and Library Services (Parts 3100--
3199)
XXXII National Endowment for the Arts (Parts 3200--3299)
XXXIII National Endowment for the Humanities (Parts 3300--
3399)
XXXIV Department of Education (Parts 3400--3499)
XXXV Export-Import Bank of the United States (Parts 3500--
3599)
XXXVI Office of National Drug Control Policy, Executive
Office of the President (Parts 3600--3699)
XXXVII Peace Corps (Parts 3700--3799)
LVIII Election Assistance Commission (Parts 5800--5899)
LIX Gulf Coast Ecosystem Restoration Council (Parts 5900--
5999)
Title 3--The President
I Executive Office of the President (Parts 100--199)
Title 4--Accounts
I Government Accountability Office (Parts 1--199)
Title 5--Administrative Personnel
I Office of Personnel Management (Parts 1--1199)
II Merit Systems Protection Board (Parts 1200--1299)
III Office of Management and Budget (Parts 1300--1399)
IV Office of Personnel Management and Office of the
Director of National Intelligence (Parts 1400--
1499)
V The International Organizations Employees Loyalty
Board (Parts 1500--1599)
VI Federal Retirement Thrift Investment Board (Parts
1600--1699)
VIII Office of Special Counsel (Parts 1800--1899)
IX Appalachian Regional Commission (Parts 1900--1999)
XI Armed Forces Retirement Home (Parts 2100--2199)
XIV Federal Labor Relations Authority, General Counsel of
the Federal Labor Relations Authority and Federal
Service Impasses Panel (Parts 2400--2499)
XVI Office of Government Ethics (Parts 2600--2699)
XXI Department of the Treasury (Parts 3100--3199)
XXII Federal Deposit Insurance Corporation (Parts 3200--
3299)
XXIII Department of Energy (Parts 3300--3399)
XXIV Federal Energy Regulatory Commission (Parts 3400--
3499)
XXV Department of the Interior (Parts 3500--3599)
XXVI Department of Defense (Parts 3600--3699)
[[Page 831]]
XXVIII Department of Justice (Parts 3800--3899)
XXIX Federal Communications Commission (Parts 3900--3999)
XXX Farm Credit System Insurance Corporation (Parts 4000--
4099)
XXXI Farm Credit Administration (Parts 4100--4199)
XXXIII Overseas Private Investment Corporation (Parts 4300--
4399)
XXXIV Securities and Exchange Commission (Parts 4400--4499)
XXXV Office of Personnel Management (Parts 4500--4599)
XXXVI Department of Homeland Security (Parts 4600--4699)
XXXVII Federal Election Commission (Parts 4700--4799)
XL Interstate Commerce Commission (Parts 5000--5099)
XLI Commodity Futures Trading Commission (Parts 5100--
5199)
XLII Department of Labor (Parts 5200--5299)
XLIII National Science Foundation (Parts 5300--5399)
XLV Department of Health and Human Services (Parts 5500--
5599)
XLVI Postal Rate Commission (Parts 5600--5699)
XLVII Federal Trade Commission (Parts 5700--5799)
XLVIII Nuclear Regulatory Commission (Parts 5800--5899)
XLIX Federal Labor Relations Authority (Parts 5900--5999)
L Department of Transportation (Parts 6000--6099)
LII Export-Import Bank of the United States (Parts 6200--
6299)
LIII Department of Education (Parts 6300--6399)
LIV Environmental Protection Agency (Parts 6400--6499)
LV National Endowment for the Arts (Parts 6500--6599)
LVI National Endowment for the Humanities (Parts 6600--
6699)
LVII General Services Administration (Parts 6700--6799)
LVIII Board of Governors of the Federal Reserve System
(Parts 6800--6899)
LIX National Aeronautics and Space Administration (Parts
6900--6999)
LX United States Postal Service (Parts 7000--7099)
LXI National Labor Relations Board (Parts 7100--7199)
LXII Equal Employment Opportunity Commission (Parts 7200--
7299)
LXIII Inter-American Foundation (Parts 7300--7399)
LXIV Merit Systems Protection Board (Parts 7400--7499)
LXV Department of Housing and Urban Development (Parts
7500--7599)
LXVI National Archives and Records Administration (Parts
7600--7699)
LXVII Institute of Museum and Library Services (Parts 7700--
7799)
LXVIII Commission on Civil Rights (Parts 7800--7899)
LXIX Tennessee Valley Authority (Parts 7900--7999)
LXX Court Services and Offender Supervision Agency for the
District of Columbia (Parts 8000--8099)
LXXI Consumer Product Safety Commission (Parts 8100--8199)
LXXIII Department of Agriculture (Parts 8300--8399)
[[Page 832]]
LXXIV Federal Mine Safety and Health Review Commission
(Parts 8400--8499)
LXXVI Federal Retirement Thrift Investment Board (Parts
8600--8699)
LXXVII Office of Management and Budget (Parts 8700--8799)
LXXX Federal Housing Finance Agency (Parts 9000--9099)
LXXXIII Special Inspector General for Afghanistan
Reconstruction (Parts 9300--9399)
LXXXIV Bureau of Consumer Financial Protection (Parts 9400--
9499)
LXXXVI National Credit Union Administration (Parts 9600--
9699)
XCVII Department of Homeland Security Human Resources
Management System (Department of Homeland
Security--Office of Personnel Management) (Parts
9700--9799)
XCVIII Council of the Inspectors General on Integrity and
Efficiency (Parts 9800--9899)
XCIX Military Compensation and Retirement Modernization
Commission (Parts 9900--9999)
C National Council on Disability (Parts 10000--10049)
CI National Mediation Board (Part 10101)
Title 6--Domestic Security
I Department of Homeland Security, Office of the
Secretary (Parts 1--199)
X Privacy and Civil Liberties Oversight Board (Parts
1000--1099)
Title 7--Agriculture
Subtitle A--Office of the Secretary of Agriculture
(Parts 0--26)
Subtitle B--Regulations of the Department of
Agriculture
I Agricultural Marketing Service (Standards,
Inspections, Marketing Practices), Department of
Agriculture (Parts 27--209)
II Food and Nutrition Service, Department of Agriculture
(Parts 210--299)
III Animal and Plant Health Inspection Service, Department
of Agriculture (Parts 300--399)
IV Federal Crop Insurance Corporation, Department of
Agriculture (Parts 400--499)
V Agricultural Research Service, Department of
Agriculture (Parts 500--599)
VI Natural Resources Conservation Service, Department of
Agriculture (Parts 600--699)
VII Farm Service Agency, Department of Agriculture (Parts
700--799)
VIII Grain Inspection, Packers and Stockyards
Administration (Federal Grain Inspection Service),
Department of Agriculture (Parts 800--899)
[[Page 833]]
IX Agricultural Marketing Service (Marketing Agreements
and Orders; Fruits, Vegetables, Nuts), Department
of Agriculture (Parts 900--999)
X Agricultural Marketing Service (Marketing Agreements
and Orders; Milk), Department of Agriculture
(Parts 1000--1199)
XI Agricultural Marketing Service (Marketing Agreements
and Orders; Miscellaneous Commodities), Department
of Agriculture (Parts 1200--1299)
XIV Commodity Credit Corporation, Department of
Agriculture (Parts 1400--1499)
XV Foreign Agricultural Service, Department of
Agriculture (Parts 1500--1599)
XVI Rural Telephone Bank, Department of Agriculture (Parts
1600--1699)
XVII Rural Utilities Service, Department of Agriculture
(Parts 1700--1799)
XVIII Rural Housing Service, Rural Business-Cooperative
Service, Rural Utilities Service, and Farm Service
Agency, Department of Agriculture (Parts 1800--
2099)
XX Local Television Loan Guarantee Board (Parts 2200--
2299)
XXV Office of Advocacy and Outreach, Department of
Agriculture (Parts 2500--2599)
XXVI Office of Inspector General, Department of Agriculture
(Parts 2600--2699)
XXVII Office of Information Resources Management, Department
of Agriculture (Parts 2700--2799)
XXVIII Office of Operations, Department of Agriculture (Parts
2800--2899)
XXIX Office of Energy Policy and New Uses, Department of
Agriculture (Parts 2900--2999)
XXX Office of the Chief Financial Officer, Department of
Agriculture (Parts 3000--3099)
XXXI Office of Environmental Quality, Department of
Agriculture (Parts 3100--3199)
XXXII Office of Procurement and Property Management,
Department of Agriculture (Parts 3200--3299)
XXXIII Office of Transportation, Department of Agriculture
(Parts 3300--3399)
XXXIV National Institute of Food and Agriculture (Parts
3400--3499)
XXXV Rural Housing Service, Department of Agriculture
(Parts 3500--3599)
XXXVI National Agricultural Statistics Service, Department
of Agriculture (Parts 3600--3699)
XXXVII Economic Research Service, Department of Agriculture
(Parts 3700--3799)
XXXVIII World Agricultural Outlook Board, Department of
Agriculture (Parts 3800--3899)
XLI [Reserved]
XLII Rural Business-Cooperative Service and Rural Utilities
Service, Department of Agriculture (Parts 4200--
4299)
[[Page 834]]
Title 8--Aliens and Nationality
I Department of Homeland Security (Immigration and
Naturalization) (Parts 1--499)
V Executive Office for Immigration Review, Department of
Justice (Parts 1000--1399)
Title 9--Animals and Animal Products
I Animal and Plant Health Inspection Service, Department
of Agriculture (Parts 1--199)
II Grain Inspection, Packers and Stockyards
Administration (Packers and Stockyards Programs),
Department of Agriculture (Parts 200--299)
III Food Safety and Inspection Service, Department of
Agriculture (Parts 300--599)
Title 10--Energy
I Nuclear Regulatory Commission (Parts 0--199)
II Department of Energy (Parts 200--699)
III Department of Energy (Parts 700--999)
X Department of Energy (General Provisions) (Parts
1000--1099)
XIII Nuclear Waste Technical Review Board (Parts 1300--
1399)
XVII Defense Nuclear Facilities Safety Board (Parts 1700--
1799)
XVIII Northeast Interstate Low-Level Radioactive Waste
Commission (Parts 1800--1899)
Title 11--Federal Elections
I Federal Election Commission (Parts 1--9099)
II Election Assistance Commission (Parts 9400--9499)
Title 12--Banks and Banking
I Comptroller of the Currency, Department of the
Treasury (Parts 1--199)
II Federal Reserve System (Parts 200--299)
III Federal Deposit Insurance Corporation (Parts 300--399)
IV Export-Import Bank of the United States (Parts 400--
499)
V (Parts 500--599) [Reserved]
VI Farm Credit Administration (Parts 600--699)
VII National Credit Union Administration (Parts 700--799)
VIII Federal Financing Bank (Parts 800--899)
IX Federal Housing Finance Board (Parts 900--999)
X Bureau of Consumer Financial Protection (Parts 1000--
1099)
XI Federal Financial Institutions Examination Council
(Parts 1100--1199)
XII Federal Housing Finance Agency (Parts 1200--1299)
XIII Financial Stability Oversight Council (Parts 1300--
1399)
[[Page 835]]
XIV Farm Credit System Insurance Corporation (Parts 1400--
1499)
XV Department of the Treasury (Parts 1500--1599)
XVI Office of Financial Research (Parts 1600--1699)
XVII Office of Federal Housing Enterprise Oversight,
Department of Housing and Urban Development (Parts
1700--1799)
XVIII Community Development Financial Institutions Fund,
Department of the Treasury (Parts 1800--1899)
Title 13--Business Credit and Assistance
I Small Business Administration (Parts 1--199)
III Economic Development Administration, Department of
Commerce (Parts 300--399)
IV Emergency Steel Guarantee Loan Board (Parts 400--499)
V Emergency Oil and Gas Guaranteed Loan Board (Parts
500--599)
Title 14--Aeronautics and Space
I Federal Aviation Administration, Department of
Transportation (Parts 1--199)
II Office of the Secretary, Department of Transportation
(Aviation Proceedings) (Parts 200--399)
III Commercial Space Transportation, Federal Aviation
Administration, Department of Transportation
(Parts 400--1199)
V National Aeronautics and Space Administration (Parts
1200--1299)
VI Air Transportation System Stabilization (Parts 1300--
1399)
Title 15--Commerce and Foreign Trade
Subtitle A--Office of the Secretary of Commerce (Parts
0--29)
Subtitle B--Regulations Relating to Commerce and
Foreign Trade
I Bureau of the Census, Department of Commerce (Parts
30--199)
II National Institute of Standards and Technology,
Department of Commerce (Parts 200--299)
III International Trade Administration, Department of
Commerce (Parts 300--399)
IV Foreign-Trade Zones Board, Department of Commerce
(Parts 400--499)
VII Bureau of Industry and Security, Department of
Commerce (Parts 700--799)
VIII Bureau of Economic Analysis, Department of Commerce
(Parts 800--899)
IX National Oceanic and Atmospheric Administration,
Department of Commerce (Parts 900--999)
XI National Technical Information Service, Department of
Commerce (Parts 1100--1199)
[[Page 836]]
XIII East-West Foreign Trade Board (Parts 1300--1399)
XIV Minority Business Development Agency (Parts 1400--
1499)
Subtitle C--Regulations Relating to Foreign Trade
Agreements
XX Office of the United States Trade Representative
(Parts 2000--2099)
Subtitle D--Regulations Relating to Telecommunications
and Information
XXIII National Telecommunications and Information
Administration, Department of Commerce (Parts
2300--2399) [Reserved]
Title 16--Commercial Practices
I Federal Trade Commission (Parts 0--999)
II Consumer Product Safety Commission (Parts 1000--1799)
Title 17--Commodity and Securities Exchanges
I Commodity Futures Trading Commission (Parts 1--199)
II Securities and Exchange Commission (Parts 200--399)
IV Department of the Treasury (Parts 400--499)
Title 18--Conservation of Power and Water Resources
I Federal Energy Regulatory Commission, Department of
Energy (Parts 1--399)
III Delaware River Basin Commission (Parts 400--499)
VI Water Resources Council (Parts 700--799)
VIII Susquehanna River Basin Commission (Parts 800--899)
XIII Tennessee Valley Authority (Parts 1300--1399)
Title 19--Customs Duties
I U.S. Customs and Border Protection, Department of
Homeland Security; Department of the Treasury
(Parts 0--199)
II United States International Trade Commission (Parts
200--299)
III International Trade Administration, Department of
Commerce (Parts 300--399)
IV U.S. Immigration and Customs Enforcement, Department
of Homeland Security (Parts 400--599) [Reserved]
Title 20--Employees' Benefits
I Office of Workers' Compensation Programs, Department
of Labor (Parts 1--199)
II Railroad Retirement Board (Parts 200--399)
III Social Security Administration (Parts 400--499)
[[Page 837]]
IV Employees' Compensation Appeals Board, Department of
Labor (Parts 500--599)
V Employment and Training Administration, Department of
Labor (Parts 600--699)
VI Office of Workers' Compensation Programs, Department
of Labor (Parts 700--799)
VII Benefits Review Board, Department of Labor (Parts
800--899)
VIII Joint Board for the Enrollment of Actuaries (Parts
900--999)
IX Office of the Assistant Secretary for Veterans'
Employment and Training Service, Department of
Labor (Parts 1000--1099)
Title 21--Food and Drugs
I Food and Drug Administration, Department of Health and
Human Services (Parts 1--1299)
II Drug Enforcement Administration, Department of Justice
(Parts 1300--1399)
III Office of National Drug Control Policy (Parts 1400--
1499)
Title 22--Foreign Relations
I Department of State (Parts 1--199)
II Agency for International Development (Parts 200--299)
III Peace Corps (Parts 300--399)
IV International Joint Commission, United States and
Canada (Parts 400--499)
V Broadcasting Board of Governors (Parts 500--599)
VII Overseas Private Investment Corporation (Parts 700--
799)
IX Foreign Service Grievance Board (Parts 900--999)
X Inter-American Foundation (Parts 1000--1099)
XI International Boundary and Water Commission, United
States and Mexico, United States Section (Parts
1100--1199)
XII United States International Development Cooperation
Agency (Parts 1200--1299)
XIII Millennium Challenge Corporation (Parts 1300--1399)
XIV Foreign Service Labor Relations Board; Federal Labor
Relations Authority; General Counsel of the
Federal Labor Relations Authority; and the Foreign
Service Impasse Disputes Panel (Parts 1400--1499)
XV African Development Foundation (Parts 1500--1599)
XVI Japan-United States Friendship Commission (Parts
1600--1699)
XVII United States Institute of Peace (Parts 1700--1799)
Title 23--Highways
I Federal Highway Administration, Department of
Transportation (Parts 1--999)
[[Page 838]]
II National Highway Traffic Safety Administration and
Federal Highway Administration, Department of
Transportation (Parts 1200--1299)
III National Highway Traffic Safety Administration,
Department of Transportation (Parts 1300--1399)
Title 24--Housing and Urban Development
Subtitle A--Office of the Secretary, Department of
Housing and Urban Development (Parts 0--99)
Subtitle B--Regulations Relating to Housing and Urban
Development
I Office of Assistant Secretary for Equal Opportunity,
Department of Housing and Urban Development (Parts
100--199)
II Office of Assistant Secretary for Housing-Federal
Housing Commissioner, Department of Housing and
Urban Development (Parts 200--299)
III Government National Mortgage Association, Department
of Housing and Urban Development (Parts 300--399)
IV Office of Housing and Office of Multifamily Housing
Assistance Restructuring, Department of Housing
and Urban Development (Parts 400--499)
V Office of Assistant Secretary for Community Planning
and Development, Department of Housing and Urban
Development (Parts 500--599)
VI Office of Assistant Secretary for Community Planning
and Development, Department of Housing and Urban
Development (Parts 600--699) [Reserved]
VII Office of the Secretary, Department of Housing and
Urban Development (Housing Assistance Programs and
Public and Indian Housing Programs) (Parts 700--
799)
VIII Office of the Assistant Secretary for Housing--Federal
Housing Commissioner, Department of Housing and
Urban Development (Section 8 Housing Assistance
Programs, Section 202 Direct Loan Program, Section
202 Supportive Housing for the Elderly Program and
Section 811 Supportive Housing for Persons With
Disabilities Program) (Parts 800--899)
IX Office of Assistant Secretary for Public and Indian
Housing, Department of Housing and Urban
Development (Parts 900--1699)
XII Office of Inspector General, Department of Housing and
Urban Development (Parts 2000--2099)
XV Emergency Mortgage Insurance and Loan Programs,
Department of Housing and Urban Development (Parts
2700--2799) [Reserved]
XX Office of Assistant Secretary for Housing--Federal
Housing Commissioner, Department of Housing and
Urban Development (Parts 3200--3899)
XXIV Board of Directors of the HOPE for Homeowners Program
(Parts 4000--4099) [Reserved]
XXV Neighborhood Reinvestment Corporation (Parts 4100--
4199)
[[Page 839]]
Title 25--Indians
I Bureau of Indian Affairs, Department of the Interior
(Parts 1--299)
II Indian Arts and Crafts Board, Department of the
Interior (Parts 300--399)
III National Indian Gaming Commission, Department of the
Interior (Parts 500--599)
IV Office of Navajo and Hopi Indian Relocation (Parts
700--899)
V Bureau of Indian Affairs, Department of the Interior,
and Indian Health Service, Department of Health
and Human Services (Part 900--999)
VI Office of the Assistant Secretary, Indian Affairs,
Department of the Interior (Parts 1000--1199)
VII Office of the Special Trustee for American Indians,
Department of the Interior (Parts 1200--1299)
Title 26--Internal Revenue
I Internal Revenue Service, Department of the Treasury
(Parts 1--End)
Title 27--Alcohol, Tobacco Products and Firearms
I Alcohol and Tobacco Tax and Trade Bureau, Department
of the Treasury (Parts 1--399)
II Bureau of Alcohol, Tobacco, Firearms, and Explosives,
Department of Justice (Parts 400--699)
Title 28--Judicial Administration
I Department of Justice (Parts 0--299)
III Federal Prison Industries, Inc., Department of Justice
(Parts 300--399)
V Bureau of Prisons, Department of Justice (Parts 500--
599)
VI Offices of Independent Counsel, Department of Justice
(Parts 600--699)
VII Office of Independent Counsel (Parts 700--799)
VIII Court Services and Offender Supervision Agency for the
District of Columbia (Parts 800--899)
IX National Crime Prevention and Privacy Compact Council
(Parts 900--999)
XI Department of Justice and Department of State (Parts
1100--1199)
Title 29--Labor
Subtitle A--Office of the Secretary of Labor (Parts
0--99)
Subtitle B--Regulations Relating to Labor
I National Labor Relations Board (Parts 100--199)
[[Page 840]]
II Office of Labor-Management Standards, Department of
Labor (Parts 200--299)
III National Railroad Adjustment Board (Parts 300--399)
IV Office of Labor-Management Standards, Department of
Labor (Parts 400--499)
V Wage and Hour Division, Department of Labor (Parts
500--899)
IX Construction Industry Collective Bargaining Commission
(Parts 900--999)
X National Mediation Board (Parts 1200--1299)
XII Federal Mediation and Conciliation Service (Parts
1400--1499)
XIV Equal Employment Opportunity Commission (Parts 1600--
1699)
XVII Occupational Safety and Health Administration,
Department of Labor (Parts 1900--1999)
XX Occupational Safety and Health Review Commission
(Parts 2200--2499)
XXV Employee Benefits Security Administration, Department
of Labor (Parts 2500--2599)
XXVII Federal Mine Safety and Health Review Commission
(Parts 2700--2799)
XL Pension Benefit Guaranty Corporation (Parts 4000--
4999)
Title 30--Mineral Resources
I Mine Safety and Health Administration, Department of
Labor (Parts 1--199)
II Bureau of Safety and Environmental Enforcement,
Department of the Interior (Parts 200--299)
IV Geological Survey, Department of the Interior (Parts
400--499)
V Bureau of Ocean Energy Management, Department of the
Interior (Parts 500--599)
VII Office of Surface Mining Reclamation and Enforcement,
Department of the Interior (Parts 700--999)
XII Office of Natural Resources Revenue, Department of the
Interior (Parts 1200--1299)
Title 31--Money and Finance: Treasury
Subtitle A--Office of the Secretary of the Treasury
(Parts 0--50)
Subtitle B--Regulations Relating to Money and Finance
I Monetary Offices, Department of the Treasury (Parts
51--199)
II Fiscal Service, Department of the Treasury (Parts
200--399)
IV Secret Service, Department of the Treasury (Parts
400--499)
V Office of Foreign Assets Control, Department of the
Treasury (Parts 500--599)
VI Bureau of Engraving and Printing, Department of the
Treasury (Parts 600--699)
VII Federal Law Enforcement Training Center, Department of
the Treasury (Parts 700--799)
[[Page 841]]
VIII Office of Investment Security, Department of the
Treasury (Parts 800--899)
IX Federal Claims Collection Standards (Department of the
Treasury--Department of Justice) (Parts 900--999)
X Financial Crimes Enforcement Network, Department of
the Treasury (Parts 1000--1099)
Title 32--National Defense
Subtitle A--Department of Defense
I Office of the Secretary of Defense (Parts 1--399)
V Department of the Army (Parts 400--699)
VI Department of the Navy (Parts 700--799)
VII Department of the Air Force (Parts 800--1099)
Subtitle B--Other Regulations Relating to National
Defense
XII Defense Logistics Agency (Parts 1200--1299)
XVI Selective Service System (Parts 1600--1699)
XVII Office of the Director of National Intelligence (Parts
1700--1799)
XVIII National Counterintelligence Center (Parts 1800--1899)
XIX Central Intelligence Agency (Parts 1900--1999)
XX Information Security Oversight Office, National
Archives and Records Administration (Parts 2000--
2099)
XXI National Security Council (Parts 2100--2199)
XXIV Office of Science and Technology Policy (Parts 2400--
2499)
XXVII Office for Micronesian Status Negotiations (Parts
2700--2799)
XXVIII Office of the Vice President of the United States
(Parts 2800--2899)
Title 33--Navigation and Navigable Waters
I Coast Guard, Department of Homeland Security (Parts
1--199)
II Corps of Engineers, Department of the Army, Department
of Defense (Parts 200--399)
IV Saint Lawrence Seaway Development Corporation,
Department of Transportation (Parts 400--499)
Title 34--Education
Subtitle A--Office of the Secretary, Department of
Education (Parts 1--99)
Subtitle B--Regulations of the Offices of the
Department of Education
I Office for Civil Rights, Department of Education
(Parts 100--199)
II Office of Elementary and Secondary Education,
Department of Education (Parts 200--299)
III Office of Special Education and Rehabilitative
Services, Department of Education (Parts 300--399)
[[Page 842]]
IV Office of Career, Technical and Adult Education,
Department of Education (Parts 400--499)
V Office of Bilingual Education and Minority Languages
Affairs, Department of Education (Parts 500--599)
[Reserved]
VI Office of Postsecondary Education, Department of
Education (Parts 600--699)
VII Office of Educational Research and Improvement,
Department of Education (Parts 700--799)
[Reserved]
Subtitle C--Regulations Relating to Education
XI (Parts 1100--1199) [Reserved]
XII National Council on Disability (Parts 1200--1299)
Title 35 [Reserved]
Title 36--Parks, Forests, and Public Property
I National Park Service, Department of the Interior
(Parts 1--199)
II Forest Service, Department of Agriculture (Parts 200--
299)
III Corps of Engineers, Department of the Army (Parts
300--399)
IV American Battle Monuments Commission (Parts 400--499)
V Smithsonian Institution (Parts 500--599)
VI [Reserved]
VII Library of Congress (Parts 700--799)
VIII Advisory Council on Historic Preservation (Parts 800--
899)
IX Pennsylvania Avenue Development Corporation (Parts
900--999)
X Presidio Trust (Parts 1000--1099)
XI Architectural and Transportation Barriers Compliance
Board (Parts 1100--1199)
XII National Archives and Records Administration (Parts
1200--1299)
XV Oklahoma City National Memorial Trust (Parts 1500--
1599)
XVI Morris K. Udall Scholarship and Excellence in National
Environmental Policy Foundation (Parts 1600--1699)
Title 37--Patents, Trademarks, and Copyrights
I United States Patent and Trademark Office, Department
of Commerce (Parts 1--199)
II U.S. Copyright Office, Library of Congress (Parts
200--299)
III Copyright Royalty Board, Library of Congress (Parts
300--399)
IV National Institute of Standards and Technology,
Department of Commerce (Parts 400--599)
Title 38--Pensions, Bonuses, and Veterans' Relief
I Department of Veterans Affairs (Parts 0--199)
II Armed Forces Retirement Home (Parts 200--299)
[[Page 843]]
Title 39--Postal Service
I United States Postal Service (Parts 1--999)
III Postal Regulatory Commission (Parts 3000--3099)
Title 40--Protection of Environment
I Environmental Protection Agency (Parts 1--1099)
IV Environmental Protection Agency and Department of
Justice (Parts 1400--1499)
V Council on Environmental Quality (Parts 1500--1599)
VI Chemical Safety and Hazard Investigation Board (Parts
1600--1699)
VII Environmental Protection Agency and Department of
Defense; Uniform National Discharge Standards for
Vessels of the Armed Forces (Parts 1700--1799)
VIII Gulf Coast Ecosystem Restoration Council (Parts 1800--
1899)
Title 41--Public Contracts and Property Management
Subtitle A--Federal Procurement Regulations System
[Note]
Subtitle B--Other Provisions Relating to Public
Contracts
50 Public Contracts, Department of Labor (Parts 50-1--50-
999)
51 Committee for Purchase From People Who Are Blind or
Severely Disabled (Parts 51-1--51-99)
60 Office of Federal Contract Compliance Programs, Equal
Employment Opportunity, Department of Labor (Parts
60-1--60-999)
61 Office of the Assistant Secretary for Veterans'
Employment and Training Service, Department of
Labor (Parts 61-1--61-999)
62--100 [Reserved]
Subtitle C--Federal Property Management Regulations
System
101 Federal Property Management Regulations (Parts 101-1--
101-99)
102 Federal Management Regulation (Parts 102-1--102-299)
103--104 [Reserved]
105 General Services Administration (Parts 105-1--105-999)
109 Department of Energy Property Management Regulations
(Parts 109-1--109-99)
114 Department of the Interior (Parts 114-1--114-99)
115 Environmental Protection Agency (Parts 115-1--115-99)
128 Department of Justice (Parts 128-1--128-99)
129--200 [Reserved]
Subtitle D--Other Provisions Relating to Property
Management [Reserved]
Subtitle E--Federal Information Resources Management
Regulations System [Reserved]
Subtitle F--Federal Travel Regulation System
300 General (Parts 300-1--300-99)
301 Temporary Duty (TDY) Travel Allowances (Parts 301-1--
301-99)
[[Page 844]]
302 Relocation Allowances (Parts 302-1--302-99)
303 Payment of Expenses Connected with the Death of
Certain Employees (Part 303-1--303-99)
304 Payment of Travel Expenses from a Non-Federal Source
(Parts 304-1--304-99)
Title 42--Public Health
I Public Health Service, Department of Health and Human
Services (Parts 1--199)
II--III [Reserved]
IV Centers for Medicare & Medicaid Services, Department
of Health and Human Services (Parts 400--699)
V Office of Inspector General-Health Care, Department of
Health and Human Services (Parts 1000--1099)
Title 43--Public Lands: Interior
Subtitle A--Office of the Secretary of the Interior
(Parts 1--199)
Subtitle B--Regulations Relating to Public Lands
I Bureau of Reclamation, Department of the Interior
(Parts 400--999)
II Bureau of Land Management, Department of the Interior
(Parts 1000--9999)
III Utah Reclamation Mitigation and Conservation
Commission (Parts 10000--10099)
Title 44--Emergency Management and Assistance
I Federal Emergency Management Agency, Department of
Homeland Security (Parts 0--399)
IV Department of Commerce and Department of
Transportation (Parts 400--499)
Title 45--Public Welfare
Subtitle A--Department of Health and Human Services
(Parts 1--199)
Subtitle B--Regulations Relating to Public Welfare
II Office of Family Assistance (Assistance Programs),
Administration for Children and Families,
Department of Health and Human Services (Parts
200--299)
III Office of Child Support Enforcement (Child Support
Enforcement Program), Administration for Children
and Families, Department of Health and Human
Services (Parts 300--399)
IV Office of Refugee Resettlement, Administration for
Children and Families, Department of Health and
Human Services (Parts 400--499)
[[Page 845]]
V Foreign Claims Settlement Commission of the United
States, Department of Justice (Parts 500--599)
VI National Science Foundation (Parts 600--699)
VII Commission on Civil Rights (Parts 700--799)
VIII Office of Personnel Management (Parts 800--899)
IX Denali Commission (Parts 900--999)
X Office of Community Services, Administration for
Children and Families, Department of Health and
Human Services (Parts 1000--1099)
XI National Foundation on the Arts and the Humanities
(Parts 1100--1199)
XII Corporation for National and Community Service (Parts
1200--1299)
XIII Administration for Children and Families, Department
of Health and Human Services (Parts 1300--1399)
XVI Legal Services Corporation (Parts 1600--1699)
XVII National Commission on Libraries and Information
Science (Parts 1700--1799)
XVIII Harry S. Truman Scholarship Foundation (Parts 1800--
1899)
XXI Commission of Fine Arts (Parts 2100--2199)
XXIII Arctic Research Commission (Parts 2300--2399)
XXIV James Madison Memorial Fellowship Foundation (Parts
2400--2499)
XXV Corporation for National and Community Service (Parts
2500--2599)
Title 46--Shipping
I Coast Guard, Department of Homeland Security (Parts
1--199)
II Maritime Administration, Department of Transportation
(Parts 200--399)
III Coast Guard (Great Lakes Pilotage), Department of
Homeland Security (Parts 400--499)
IV Federal Maritime Commission (Parts 500--599)
Title 47--Telecommunication
I Federal Communications Commission (Parts 0--199)
II Office of Science and Technology Policy and National
Security Council (Parts 200--299)
III National Telecommunications and Information
Administration, Department of Commerce (Parts
300--399)
IV National Telecommunications and Information
Administration, Department of Commerce, and
National Highway Traffic Safety Administration,
Department of Transportation (Parts 400--499)
V The First Responder Network Authority (Parts 500--599)
[[Page 846]]
Title 48--Federal Acquisition Regulations System
1 Federal Acquisition Regulation (Parts 1--99)
2 Defense Acquisition Regulations System, Department of
Defense (Parts 200--299)
3 Department of Health and Human Services (Parts 300--
399)
4 Department of Agriculture (Parts 400--499)
5 General Services Administration (Parts 500--599)
6 Department of State (Parts 600--699)
7 Agency for International Development (Parts 700--799)
8 Department of Veterans Affairs (Parts 800--899)
9 Department of Energy (Parts 900--999)
10 Department of the Treasury (Parts 1000--1099)
12 Department of Transportation (Parts 1200--1299)
13 Department of Commerce (Parts 1300--1399)
14 Department of the Interior (Parts 1400--1499)
15 Environmental Protection Agency (Parts 1500--1599)
16 Office of Personnel Management, Federal Employees
Health Benefits Acquisition Regulation (Parts
1600--1699)
17 Office of Personnel Management (Parts 1700--1799)
18 National Aeronautics and Space Administration (Parts
1800--1899)
19 Broadcasting Board of Governors (Parts 1900--1999)
20 Nuclear Regulatory Commission (Parts 2000--2099)
21 Office of Personnel Management, Federal Employees
Group Life Insurance Federal Acquisition
Regulation (Parts 2100--2199)
23 Social Security Administration (Parts 2300--2399)
24 Department of Housing and Urban Development (Parts
2400--2499)
25 National Science Foundation (Parts 2500--2599)
28 Department of Justice (Parts 2800--2899)
29 Department of Labor (Parts 2900--2999)
30 Department of Homeland Security, Homeland Security
Acquisition Regulation (HSAR) (Parts 3000--3099)
34 Department of Education Acquisition Regulation (Parts
3400--3499)
51 Department of the Army Acquisition Regulations (Parts
5100--5199)
52 Department of the Navy Acquisition Regulations (Parts
5200--5299)
53 Department of the Air Force Federal Acquisition
Regulation Supplement (Parts 5300--5399)
[Reserved]
54 Defense Logistics Agency, Department of Defense (Parts
5400--5499)
57 African Development Foundation (Parts 5700--5799)
61 Civilian Board of Contract Appeals, General Services
Administration (Parts 6100--6199)
99 Cost Accounting Standards Board, Office of Federal
Procurement Policy, Office of Management and
Budget (Parts 9900--9999)
[[Page 847]]
Title 49--Transportation
Subtitle A--Office of the Secretary of Transportation
(Parts 1--99)
Subtitle B--Other Regulations Relating to
Transportation
I Pipeline and Hazardous Materials Safety
Administration, Department of Transportation
(Parts 100--199)
II Federal Railroad Administration, Department of
Transportation (Parts 200--299)
III Federal Motor Carrier Safety Administration,
Department of Transportation (Parts 300--399)
IV Coast Guard, Department of Homeland Security (Parts
400--499)
V National Highway Traffic Safety Administration,
Department of Transportation (Parts 500--599)
VI Federal Transit Administration, Department of
Transportation (Parts 600--699)
VII National Railroad Passenger Corporation (AMTRAK)
(Parts 700--799)
VIII National Transportation Safety Board (Parts 800--999)
X Surface Transportation Board (Parts 1000--1399)
XI Research and Innovative Technology Administration,
Department of Transportation (Parts 1400--1499)
[Reserved]
XII Transportation Security Administration, Department of
Homeland Security (Parts 1500--1699)
Title 50--Wildlife and Fisheries
I United States Fish and Wildlife Service, Department of
the Interior (Parts 1--199)
II National Marine Fisheries Service, National Oceanic
and Atmospheric Administration, Department of
Commerce (Parts 200--299)
III International Fishing and Related Activities (Parts
300--399)
IV Joint Regulations (United States Fish and Wildlife
Service, Department of the Interior and National
Marine Fisheries Service, National Oceanic and
Atmospheric Administration, Department of
Commerce); Endangered Species Committee
Regulations (Parts 400--499)
V Marine Mammal Commission (Parts 500--599)
VI Fishery Conservation and Management, National Oceanic
and Atmospheric Administration, Department of
Commerce (Parts 600--699)
[[Page 849]]
Alphabetical List of Agencies Appearing in the CFR
(Revised as of April 1, 2019)
CFR Title, Subtitle or
Agency Chapter
Administrative Conference of the United States 1, III
Advisory Council on Historic Preservation 36, VIII
Advocacy and Outreach, Office of 7, XXV
Afghanistan Reconstruction, Special Inspector 5, LXXXIII
General for
African Development Foundation 22, XV
Federal Acquisition Regulation 48, 57
Agency for International Development 2, VII; 22, II
Federal Acquisition Regulation 48, 7
Agricultural Marketing Service 7, I, IX, X, XI
Agricultural Research Service 7, V
Agriculture, Department of 2, IV; 5, LXXIII
Advocacy and Outreach, Office of 7, XXV
Agricultural Marketing Service 7, I, IX, X, XI
Agricultural Research Service 7, V
Animal and Plant Health Inspection Service 7, III; 9, I
Chief Financial Officer, Office of 7, XXX
Commodity Credit Corporation 7, XIV
Economic Research Service 7, XXXVII
Energy Policy and New Uses, Office of 2, IX; 7, XXIX
Environmental Quality, Office of 7, XXXI
Farm Service Agency 7, VII, XVIII
Federal Acquisition Regulation 48, 4
Federal Crop Insurance Corporation 7, IV
Food and Nutrition Service 7, II
Food Safety and Inspection Service 9, III
Foreign Agricultural Service 7, XV
Forest Service 36, II
Grain Inspection, Packers and Stockyards 7, VIII; 9, II
Administration
Information Resources Management, Office of 7, XXVII
Inspector General, Office of 7, XXVI
National Agricultural Library 7, XLI
National Agricultural Statistics Service 7, XXXVI
National Institute of Food and Agriculture 7, XXXIV
Natural Resources Conservation Service 7, VI
Operations, Office of 7, XXVIII
Procurement and Property Management, Office of 7, XXXII
Rural Business-Cooperative Service 7, XVIII, XLII
Rural Development Administration 7, XLII
Rural Housing Service 7, XVIII, XXXV
Rural Telephone Bank 7, XVI
Rural Utilities Service 7, XVII, XVIII, XLII
Secretary of Agriculture, Office of 7, Subtitle A
Transportation, Office of 7, XXXIII
World Agricultural Outlook Board 7, XXXVIII
Air Force, Department of 32, VII
Federal Acquisition Regulation Supplement 48, 53
Air Transportation Stabilization Board 14, VI
Alcohol and Tobacco Tax and Trade Bureau 27, I
Alcohol, Tobacco, Firearms, and Explosives, 27, II
Bureau of
AMTRAK 49, VII
American Battle Monuments Commission 36, IV
American Indians, Office of the Special Trustee 25, VII
Animal and Plant Health Inspection Service 7, III; 9, I
[[Page 850]]
Appalachian Regional Commission 5, IX
Architectural and Transportation Barriers 36, XI
Compliance Board
Arctic Research Commission 45, XXIII
Armed Forces Retirement Home 5, XI
Army, Department of 32, V
Engineers, Corps of 33, II; 36, III
Federal Acquisition Regulation 48, 51
Bilingual Education and Minority Languages 34, V
Affairs, Office of
Blind or Severely Disabled, Committee for 41, 51
Purchase from People Who Are
Broadcasting Board of Governors 22, V
Federal Acquisition Regulation 48, 19
Career, Technical, and Adult Education, Office 34, IV
of
Census Bureau 15, I
Centers for Medicare & Medicaid Services 42, IV
Central Intelligence Agency 32, XIX
Chemical Safety and Hazardous Investigation 40, VI
Board
Chief Financial Officer, Office of 7, XXX
Child Support Enforcement, Office of 45, III
Children and Families, Administration for 45, II, III, IV, X, XIII
Civil Rights, Commission on 5, LXVIII; 45, VII
Civil Rights, Office for 34, I
Council of the Inspectors General on Integrity 5, XCVIII
and Efficiency
Court Services and Offender Supervision Agency 5, LXX
for the District of Columbia
Coast Guard 33, I; 46, I; 49, IV
Coast Guard (Great Lakes Pilotage) 46, III
Commerce, Department of 2, XIII; 44, IV; 50, VI
Census Bureau 15, I
Economic Analysis, Bureau of 15, VIII
Economic Development Administration 13, III
Emergency Management and Assistance 44, IV
Federal Acquisition Regulation 48, 13
Foreign-Trade Zones Board 15, IV
Industry and Security, Bureau of 15, VII
International Trade Administration 15, III; 19, III
National Institute of Standards and Technology 15, II; 37, IV
National Marine Fisheries Service 50, II, IV
National Oceanic and Atmospheric 15, IX; 50, II, III, IV,
Administration VI
National Technical Information Service 15, XI
National Telecommunications and Information 15, XXIII; 47, III, IV
Administration
National Weather Service 15, IX
Patent and Trademark Office, United States 37, I
Secretary of Commerce, Office of 15, Subtitle A
Commercial Space Transportation 14, III
Commodity Credit Corporation 7, XIV
Commodity Futures Trading Commission 5, XLI; 17, I
Community Planning and Development, Office of 24, V, VI
Assistant Secretary for
Community Services, Office of 45, X
Comptroller of the Currency 12, I
Construction Industry Collective Bargaining 29, IX
Commission
Consumer Financial Protection Bureau 5, LXXXIV; 12, X
Consumer Product Safety Commission 5, LXXI; 16, II
Copyright Royalty Board 37, III
Corporation for National and Community Service 2, XXII; 45, XII, XXV
Cost Accounting Standards Board 48, 99
Council on Environmental Quality 40, V
Court Services and Offender Supervision Agency 5, LXX; 28, VIII
for the District of Columbia
Customs and Border Protection 19, I
Defense Contract Audit Agency 32, I
Defense, Department of 2, XI; 5, XXVI; 32,
Subtitle A; 40, VII
Advanced Research Projects Agency 32, I
Air Force Department 32, VII
[[Page 851]]
Army Department 32, V; 33, II; 36, III;
48, 51
Defense Acquisition Regulations System 48, 2
Defense Intelligence Agency 32, I
Defense Logistics Agency 32, I, XII; 48, 54
Engineers, Corps of 33, II; 36, III
National Imagery and Mapping Agency 32, I
Navy Department 32, VI; 48, 52
Secretary of Defense, Office of 2, XI; 32, I
Defense Contract Audit Agency 32, I
Defense Intelligence Agency 32, I
Defense Logistics Agency 32, XII; 48, 54
Defense Nuclear Facilities Safety Board 10, XVII
Delaware River Basin Commission 18, III
Denali Commission 45, IX
Disability, National Council on 5, C; 34, XII
District of Columbia, Court Services and 5, LXX; 28, VIII
Offender Supervision Agency for the
Drug Enforcement Administration 21, II
East-West Foreign Trade Board 15, XIII
Economic Analysis, Bureau of 15, VIII
Economic Development Administration 13, III
Economic Research Service 7, XXXVII
Education, Department of 2, XXXIV; 5, LIII
Bilingual Education and Minority Languages 34, V
Affairs, Office of
Career, Technical, and Adult Education, Office 34, IV
of
Civil Rights, Office for 34, I
Educational Research and Improvement, Office 34, VII
of
Elementary and Secondary Education, Office of 34, II
Federal Acquisition Regulation 48, 34
Postsecondary Education, Office of 34, VI
Secretary of Education, Office of 34, Subtitle A
Special Education and Rehabilitative Services, 34, III
Office of
Educational Research and Improvement, Office of 34, VII
Election Assistance Commission 2, LVIII; 11, II
Elementary and Secondary Education, Office of 34, II
Emergency Oil and Gas Guaranteed Loan Board 13, V
Emergency Steel Guarantee Loan Board 13, IV
Employee Benefits Security Administration 29, XXV
Employees' Compensation Appeals Board 20, IV
Employees Loyalty Board 5, V
Employment and Training Administration 20, V
Employment Policy, National Commission for 1, IV
Employment Standards Administration 20, VI
Endangered Species Committee 50, IV
Energy, Department of 2, IX; 5, XXIII; 10, II,
III, X
Federal Acquisition Regulation 48, 9
Federal Energy Regulatory Commission 5, XXIV; 18, I
Property Management Regulations 41, 109
Energy, Office of 7, XXIX
Engineers, Corps of 33, II; 36, III
Engraving and Printing, Bureau of 31, VI
Environmental Protection Agency 2, XV; 5, LIV; 40, I, IV,
VII
Federal Acquisition Regulation 48, 15
Property Management Regulations 41, 115
Environmental Quality, Office of 7, XXXI
Equal Employment Opportunity Commission 5, LXII; 29, XIV
Equal Opportunity, Office of Assistant Secretary 24, I
for
Executive Office of the President 3, I
Environmental Quality, Council on 40, V
Management and Budget, Office of 2, Subtitle A; 5, III,
LXXVII; 14, VI; 48, 99
National Drug Control Policy, Office of 2, XXXVI; 21, III
National Security Council 32, XXI; 47, 2
[[Page 852]]
Presidential Documents 3
Science and Technology Policy, Office of 32, XXIV; 47, II
Trade Representative, Office of the United 15, XX
States
Export-Import Bank of the United States 2, XXXV; 5, LII; 12, IV
Family Assistance, Office of 45, II
Farm Credit Administration 5, XXXI; 12, VI
Farm Credit System Insurance Corporation 5, XXX; 12, XIV
Farm Service Agency 7, VII, XVIII
Federal Acquisition Regulation 48, 1
Federal Aviation Administration 14, I
Commercial Space Transportation 14, III
Federal Claims Collection Standards 31, IX
Federal Communications Commission 5, XXIX; 47, I
Federal Contract Compliance Programs, Office of 41, 60
Federal Crop Insurance Corporation 7, IV
Federal Deposit Insurance Corporation 5, XXII; 12, III
Federal Election Commission 5, XXXVII; 11, I
Federal Emergency Management Agency 44, I
Federal Employees Group Life Insurance Federal 48, 21
Acquisition Regulation
Federal Employees Health Benefits Acquisition 48, 16
Regulation
Federal Energy Regulatory Commission 5, XXIV; 18, I
Federal Financial Institutions Examination 12, XI
Council
Federal Financing Bank 12, VIII
Federal Highway Administration 23, I, II
Federal Home Loan Mortgage Corporation 1, IV
Federal Housing Enterprise Oversight Office 12, XVII
Federal Housing Finance Agency 5, LXXX; 12, XII
Federal Housing Finance Board 12, IX
Federal Labor Relations Authority 5, XIV, XLIX; 22, XIV
Federal Law Enforcement Training Center 31, VII
Federal Management Regulation 41, 102
Federal Maritime Commission 46, IV
Federal Mediation and Conciliation Service 29, XII
Federal Mine Safety and Health Review Commission 5, LXXIV; 29, XXVII
Federal Motor Carrier Safety Administration 49, III
Federal Prison Industries, Inc. 28, III
Federal Procurement Policy Office 48, 99
Federal Property Management Regulations 41, 101
Federal Railroad Administration 49, II
Federal Register, Administrative Committee of 1, I
Federal Register, Office of 1, II
Federal Reserve System 12, II
Board of Governors 5, LVIII
Federal Retirement Thrift Investment Board 5, VI, LXXVI
Federal Service Impasses Panel 5, XIV
Federal Trade Commission 5, XLVII; 16, I
Federal Transit Administration 49, VI
Federal Travel Regulation System 41, Subtitle F
Financial Crimes Enforcement Network 31, X
Financial Research Office 12, XVI
Financial Stability Oversight Council 12, XIII
Fine Arts, Commission of 45, XXI
Fiscal Service 31, II
Fish and Wildlife Service, United States 50, I, IV
Food and Drug Administration 21, I
Food and Nutrition Service 7, II
Food Safety and Inspection Service 9, III
Foreign Agricultural Service 7, XV
Foreign Assets Control, Office of 31, V
Foreign Claims Settlement Commission of the 45, V
United States
Foreign Service Grievance Board 22, IX
Foreign Service Impasse Disputes Panel 22, XIV
Foreign Service Labor Relations Board 22, XIV
Foreign-Trade Zones Board 15, IV
Forest Service 36, II
General Services Administration 5, LVII; 41, 105
[[Page 853]]
Contract Appeals, Board of 48, 61
Federal Acquisition Regulation 48, 5
Federal Management Regulation 41, 102
Federal Property Management Regulations 41, 101
Federal Travel Regulation System 41, Subtitle F
General 41, 300
Payment From a Non-Federal Source for Travel 41, 304
Expenses
Payment of Expenses Connected With the Death 41, 303
of Certain Employees
Relocation Allowances 41, 302
Temporary Duty (TDY) Travel Allowances 41, 301
Geological Survey 30, IV
Government Accountability Office 4, I
Government Ethics, Office of 5, XVI
Government National Mortgage Association 24, III
Grain Inspection, Packers and Stockyards 7, VIII; 9, II
Administration
Gulf Coast Ecosystem Restoration Council 2, LIX; 40, VIII
Harry S. Truman Scholarship Foundation 45, XVIII
Health and Human Services, Department of 2, III; 5, XLV; 45,
Subtitle A
Centers for Medicare & Medicaid Services 42, IV
Child Support Enforcement, Office of 45, III
Children and Families, Administration for 45, II, III, IV, X, XIII
Community Services, Office of 45, X
Family Assistance, Office of 45, II
Federal Acquisition Regulation 48, 3
Food and Drug Administration 21, I
Indian Health Service 25, V
Inspector General (Health Care), Office of 42, V
Public Health Service 42, I
Refugee Resettlement, Office of 45, IV
Homeland Security, Department of 2, XXX; 5, XXXVI; 6, I; 8,
I
Coast Guard 33, I; 46, I; 49, IV
Coast Guard (Great Lakes Pilotage) 46, III
Customs and Border Protection 19, I
Federal Emergency Management Agency 44, I
Human Resources Management and Labor Relations 5, XCVII
Systems
Immigration and Customs Enforcement Bureau 19, IV
Transportation Security Administration 49, XII
HOPE for Homeowners Program, Board of Directors 24, XXIV
of
Housing and Urban Development, Department of 2, XXIV; 5, LXV; 24,
Subtitle B
Community Planning and Development, Office of 24, V, VI
Assistant Secretary for
Equal Opportunity, Office of Assistant 24, I
Secretary for
Federal Acquisition Regulation 48, 24
Federal Housing Enterprise Oversight, Office 12, XVII
of
Government National Mortgage Association 24, III
Housing--Federal Housing Commissioner, Office 24, II, VIII, X, XX
of Assistant Secretary for
Housing, Office of, and Multifamily Housing 24, IV
Assistance Restructuring, Office of
Inspector General, Office of 24, XII
Public and Indian Housing, Office of Assistant 24, IX
Secretary for
Secretary, Office of 24, Subtitle A, VII
Housing--Federal Housing Commissioner, Office of 24, II, VIII, X, XX
Assistant Secretary for
Housing, Office of, and Multifamily Housing 24, IV
Assistance Restructuring, Office of
Immigration and Customs Enforcement Bureau 19, IV
Immigration Review, Executive Office for 8, V
Independent Counsel, Office of 28, VII
Independent Counsel, Offices of 28, VI
Indian Affairs, Bureau of 25, I, V
Indian Affairs, Office of the Assistant 25, VI
Secretary
[[Page 854]]
Indian Arts and Crafts Board 25, II
Indian Health Service 25, V
Industry and Security, Bureau of 15, VII
Information Resources Management, Office of 7, XXVII
Information Security Oversight Office, National 32, XX
Archives and Records Administration
Inspector General
Agriculture Department 7, XXVI
Health and Human Services Department 42, V
Housing and Urban Development Department 24, XII, XV
Institute of Peace, United States 22, XVII
Inter-American Foundation 5, LXIII; 22, X
Interior, Department of 2, XIV
American Indians, Office of the Special 25, VII
Trustee
Endangered Species Committee 50, IV
Federal Acquisition Regulation 48, 14
Federal Property Management Regulations System 41, 114
Fish and Wildlife Service, United States 50, I, IV
Geological Survey 30, IV
Indian Affairs, Bureau of 25, I, V
Indian Affairs, Office of the Assistant 25, VI
Secretary
Indian Arts and Crafts Board 25, II
Land Management, Bureau of 43, II
National Indian Gaming Commission 25, III
National Park Service 36, I
Natural Resource Revenue, Office of 30, XII
Ocean Energy Management, Bureau of 30, V
Reclamation, Bureau of 43, I
Safety and Enforcement Bureau, Bureau of 30, II
Secretary of the Interior, Office of 2, XIV; 43, Subtitle A
Surface Mining Reclamation and Enforcement, 30, VII
Office of
Internal Revenue Service 26, I
International Boundary and Water Commission, 22, XI
United States and Mexico, United States
Section
International Development, United States Agency 22, II
for
Federal Acquisition Regulation 48, 7
International Development Cooperation Agency, 22, XII
United States
International Joint Commission, United States 22, IV
and Canada
International Organizations Employees Loyalty 5, V
Board
International Trade Administration 15, III; 19, III
International Trade Commission, United States 19, II
Interstate Commerce Commission 5, XL
Investment Security, Office of 31, VIII
James Madison Memorial Fellowship Foundation 45, XXIV
Japan-United States Friendship Commission 22, XVI
Joint Board for the Enrollment of Actuaries 20, VIII
Justice, Department of 2, XXVIII; 5, XXVIII; 28,
I, XI; 40, IV
Alcohol, Tobacco, Firearms, and Explosives, 27, II
Bureau of
Drug Enforcement Administration 21, II
Federal Acquisition Regulation 48, 28
Federal Claims Collection Standards 31, IX
Federal Prison Industries, Inc. 28, III
Foreign Claims Settlement Commission of the 45, V
United States
Immigration Review, Executive Office for 8, V
Independent Counsel, Offices of 28, VI
Prisons, Bureau of 28, V
Property Management Regulations 41, 128
Labor, Department of 2, XXIX; 5, XLII
Employee Benefits Security Administration 29, XXV
Employees' Compensation Appeals Board 20, IV
Employment and Training Administration 20, V
Employment Standards Administration 20, VI
Federal Acquisition Regulation 48, 29
Federal Contract Compliance Programs, Office 41, 60
of
[[Page 855]]
Federal Procurement Regulations System 41, 50
Labor-Management Standards, Office of 29, II, IV
Mine Safety and Health Administration 30, I
Occupational Safety and Health Administration 29, XVII
Public Contracts 41, 50
Secretary of Labor, Office of 29, Subtitle A
Veterans' Employment and Training Service, 41, 61; 20, IX
Office of the Assistant Secretary for
Wage and Hour Division 29, V
Workers' Compensation Programs, Office of 20, I, VII
Labor-Management Standards, Office of 29, II, IV
Land Management, Bureau of 43, II
Legal Services Corporation 45, XVI
Libraries and Information Science, National 45, XVII
Commission on
Library of Congress 36, VII
Copyright Royalty Board 37, III
U.S. Copyright Office 37, II
Local Television Loan Guarantee Board 7, XX
Management and Budget, Office of 5, III, LXXVII; 14, VI;
48, 99
Marine Mammal Commission 50, V
Maritime Administration 46, II
Merit Systems Protection Board 5, II, LXIV
Micronesian Status Negotiations, Office for 32, XXVII
Military Compensation and Retirement 5, XCIX
Modernization Commission
Millennium Challenge Corporation 22, XIII
Mine Safety and Health Administration 30, I
Minority Business Development Agency 15, XIV
Miscellaneous Agencies 1, IV
Monetary Offices 31, I
Morris K. Udall Scholarship and Excellence in 36, XVI
National Environmental Policy Foundation
Museum and Library Services, Institute of 2, XXXI
National Aeronautics and Space Administration 2, XVIII; 5, LIX; 14, V
Federal Acquisition Regulation 48, 18
National Agricultural Library 7, XLI
National Agricultural Statistics Service 7, XXXVI
National and Community Service, Corporation for 2, XXII; 45, XII, XXV
National Archives and Records Administration 2, XXVI; 5, LXVI; 36, XII
Information Security Oversight Office 32, XX
National Capital Planning Commission 1, IV, VI
National Counterintelligence Center 32, XVIII
National Credit Union Administration 5, LXXXVI; 12, VII
National Crime Prevention and Privacy Compact 28, IX
Council
National Drug Control Policy, Office of 2, XXXVI; 21, III
National Endowment for the Arts 2, XXXII
National Endowment for the Humanities 2, XXXIII
National Foundation on the Arts and the 45, XI
Humanities
National Geospatial-Intelligence Agency 32, I
National Highway Traffic Safety Administration 23, II, III; 47, VI; 49, V
National Imagery and Mapping Agency 32, I
National Indian Gaming Commission 25, III
National Institute of Food and Agriculture 7, XXXIV
National Institute of Standards and Technology 15, II; 37, IV
National Intelligence, Office of Director of 5, IV; 32, XVII
National Labor Relations Board 5, LXI; 29, I
National Marine Fisheries Service 50, II, IV
National Mediation Board 5, CI; 29, X
National Oceanic and Atmospheric Administration 15, IX; 50, II, III, IV,
VI
National Park Service 36, I
National Railroad Adjustment Board 29, III
National Railroad Passenger Corporation (AMTRAK) 49, VII
National Science Foundation 2, XXV; 5, XLIII; 45, VI
Federal Acquisition Regulation 48, 25
National Security Council 32, XXI
[[Page 856]]
National Security Council and Office of Science 47, II
and Technology Policy
National Technical Information Service 15, XI
National Telecommunications and Information 15, XXIII; 47, III, IV, V
Administration
National Transportation Safety Board 49, VIII
Natural Resources Conservation Service 7, VI
Natural Resource Revenue, Office of 30, XII
Navajo and Hopi Indian Relocation, Office of 25, IV
Navy, Department of 32, VI
Federal Acquisition Regulation 48, 52
Neighborhood Reinvestment Corporation 24, XXV
Northeast Interstate Low-Level Radioactive Waste 10, XVIII
Commission
Nuclear Regulatory Commission 2, XX; 5, XLVIII; 10, I
Federal Acquisition Regulation 48, 20
Occupational Safety and Health Administration 29, XVII
Occupational Safety and Health Review Commission 29, XX
Ocean Energy Management, Bureau of 30, V
Oklahoma City National Memorial Trust 36, XV
Operations Office 7, XXVIII
Overseas Private Investment Corporation 5, XXXIII; 22, VII
Patent and Trademark Office, United States 37, I
Payment From a Non-Federal Source for Travel 41, 304
Expenses
Payment of Expenses Connected With the Death of 41, 303
Certain Employees
Peace Corps 2, XXXVII; 22, III
Pennsylvania Avenue Development Corporation 36, IX
Pension Benefit Guaranty Corporation 29, XL
Personnel Management, Office of 5, I, XXXV; 5, IV; 45,
VIII
Human Resources Management and Labor Relations 5, XCVII
Systems, Department of Homeland Security
Federal Acquisition Regulation 48, 17
Federal Employees Group Life Insurance Federal 48, 21
Acquisition Regulation
Federal Employees Health Benefits Acquisition 48, 16
Regulation
Pipeline and Hazardous Materials Safety 49, I
Administration
Postal Regulatory Commission 5, XLVI; 39, III
Postal Service, United States 5, LX; 39, I
Postsecondary Education, Office of 34, VI
President's Commission on White House 1, IV
Fellowships
Presidential Documents 3
Presidio Trust 36, X
Prisons, Bureau of 28, V
Privacy and Civil Liberties Oversight Board 6, X
Procurement and Property Management, Office of 7, XXXII
Public Contracts, Department of Labor 41, 50
Public and Indian Housing, Office of Assistant 24, IX
Secretary for
Public Health Service 42, I
Railroad Retirement Board 20, II
Reclamation, Bureau of 43, I
Refugee Resettlement, Office of 45, IV
Relocation Allowances 41, 302
Research and Innovative Technology 49, XI
Administration
Rural Business-Cooperative Service 7, XVIII, XLII
Rural Development Administration 7, XLII
Rural Housing Service 7, XVIII, XXXV
Rural Telephone Bank 7, XVI
Rural Utilities Service 7, XVII, XVIII, XLII
Safety and Environmental Enforcement, Bureau of 30, II
Saint Lawrence Seaway Development Corporation 33, IV
Science and Technology Policy, Office of 32, XXIV
Science and Technology Policy, Office of, and 47, II
National Security Council
Secret Service 31, IV
Securities and Exchange Commission 5, XXXIV; 17, II
[[Page 857]]
Selective Service System 32, XVI
Small Business Administration 2, XXVII; 13, I
Smithsonian Institution 36, V
Social Security Administration 2, XXIII; 20, III; 48, 23
Soldiers' and Airmen's Home, United States 5, XI
Special Counsel, Office of 5, VIII
Special Education and Rehabilitative Services, 34, III
Office of
State, Department of 2, VI; 22, I; 28, XI
Federal Acquisition Regulation 48, 6
Surface Mining Reclamation and Enforcement, 30, VII
Office of
Surface Transportation Board 49, X
Susquehanna River Basin Commission 18, VIII
Tennessee Valley Authority 5, LXIX; 18, XIII
Trade Representative, United States, Office of 15, XX
Transportation, Department of 2, XII; 5, L
Commercial Space Transportation 14, III
Emergency Management and Assistance 44, IV
Federal Acquisition Regulation 48, 12
Federal Aviation Administration 14, I
Federal Highway Administration 23, I, II
Federal Motor Carrier Safety Administration 49, III
Federal Railroad Administration 49, II
Federal Transit Administration 49, VI
Maritime Administration 46, II
National Highway Traffic Safety Administration 23, II, III; 47, IV; 49, V
Pipeline and Hazardous Materials Safety 49, I
Administration
Saint Lawrence Seaway Development Corporation 33, IV
Secretary of Transportation, Office of 14, II; 49, Subtitle A
Transportation Statistics Bureau 49, XI
Transportation, Office of 7, XXXIII
Transportation Security Administration 49, XII
Transportation Statistics Bureau 49, XI
Travel Allowances, Temporary Duty (TDY) 41, 301
Treasury, Department of the 2, X;5, XXI; 12, XV; 17,
IV; 31, IX
Alcohol and Tobacco Tax and Trade Bureau 27, I
Community Development Financial Institutions 12, XVIII
Fund
Comptroller of the Currency 12, I
Customs and Border Protection 19, I
Engraving and Printing, Bureau of 31, VI
Federal Acquisition Regulation 48, 10
Federal Claims Collection Standards 31, IX
Federal Law Enforcement Training Center 31, VII
Financial Crimes Enforcement Network 31, X
Fiscal Service 31, II
Foreign Assets Control, Office of 31, V
Internal Revenue Service 26, I
Investment Security, Office of 31, VIII
Monetary Offices 31, I
Secret Service 31, IV
Secretary of the Treasury, Office of 31, Subtitle A
Truman, Harry S. Scholarship Foundation 45, XVIII
United States and Canada, International Joint 22, IV
Commission
United States and Mexico, International Boundary 22, XI
and Water Commission, United States Section
U.S. Copyright Office 37, II
Utah Reclamation Mitigation and Conservation 43, III
Commission
Veterans Affairs, Department of 2, VIII; 38, I
Federal Acquisition Regulation 48, 8
Veterans' Employment and Training Service, 41, 61; 20, IX
Office of the Assistant Secretary for
Vice President of the United States, Office of 32, XXVIII
Wage and Hour Division 29, V
Water Resources Council 18, VI
Workers' Compensation Programs, Office of 20, I, VII
World Agricultural Outlook Board 7, XXXVIII
[[Page 859]]
Table of OMB Control Numbers
The OMB control numbers for chapter I of title 26 were consolidated into
Sec. Sec. 601.9000 and 602.101 at 50 FR 10221, Mar. 14, 1985. At 61 FR
58008, Nov. 12, 1996, Sec. 601.9000 was removed. Section 602.101 is
reprinted below for the convenience of the user.
PART 602_OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT--
Table of Contents
Sec. 602.101 OMB Control numbers.
(a) Purpose. This part collects and displays the control numbers
assigned to collections of information in Internal Revenue Service
regulations by the Office of Management and Budget (OMB) under the
Paperwork Reduction Act of 1980. The Internal Revenue Service intends
that this part comply with the requirements of Sec. Sec. 1320.7(f),
1320.12, 1320.13, and 1320.14 of 5 CFR part 1320 (OMB regulations
implementing the Paperwork Reduction Act), for the display of control
numbers assigned by OMB to collections of information in Internal
Revenue Service regulations. This part does not display control numbers
assigned by the Office of Management and Budget to collections of
information of the Bureau of Alcohol, Tobacco, and Firearms.
(b) Display.
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
1.1(h)-1(e)................................................ 1545-1654
1.25-1T.................................................... 1545-0922
1545-0930
1.25-2T.................................................... 1545-0922
1545-0930
1.25-3T.................................................... 1545-0922
1545-0930
1.25-4T.................................................... 1545-0922
1.25-5T.................................................... 1545-0922
1.25-6T.................................................... 1545-0922
1.25-7T.................................................... 1545-0922
1.25-8T.................................................... 1545-0922
1.25A-1.................................................... 1545-1630
1.28-1..................................................... 1545-0619
1.31-2..................................................... 1545-0074
1.32-2..................................................... 1545-0074
1.32-3..................................................... 1545-1575
1.36B-5.................................................... 1545-2232
1.37-1..................................................... 1545-0074
1.37-3..................................................... 1545-0074
1.41-2..................................................... 1545-0619
1.41-3..................................................... 1545-0619
1.41-4A.................................................... 1545-0074
1.41-4 (b) and (c)......................................... 1545-0074
1.41-8(b).................................................. 1545-1625
1.41-8(d).................................................. 1545-0732
1.41-9..................................................... 1545-0619
1.42-1T.................................................... 1545-0984
1545-0988
1.42-5..................................................... 1545-1357
1.42-6..................................................... 1545-1102
1.42-8..................................................... 1545-1102
1.42-10.................................................... 1545-1102
1.42-13.................................................... 1545-1357
1.42-14.................................................... 1545-1423
1.42-17.................................................... 1545-1357
1.42-18.................................................... 1545-2088
1.43-3(a)(3)............................................... 1545-1292
1.43-3(b)(3)............................................... 1545-1292
1.44B-1.................................................... 1545-0219
1.45D-1.................................................... 1545-1765
1.45G-1.................................................... 1545-2031
1.46-1..................................................... 1545-0123
1545-0155
1.46-3..................................................... 1545-0155
1.46-4..................................................... 1545-0155
1.46-5..................................................... 1545-0155
1.46-6..................................................... 1545-0155
1.46-8..................................................... 1545-0155
1.46-9..................................................... 1545-0155
1.46-10.................................................... 1545-0118
1.47-1..................................................... 1545-0155
1545-0166
1.47-3..................................................... 1545-0155
1545-0166
1.47-4..................................................... 1545-0123
1.47-5..................................................... 1545-0092
1.47-6..................................................... 1545-0099
1.48-3..................................................... 1545-0155
1.48-4..................................................... 1545-0155
1545-0808
1.48-5..................................................... 1545-0155
1.48-6..................................................... 1545-0155
1.48-12.................................................... 1545-0155
1545-1783
1.50A-1.................................................... 1545-0895
1.50A-2.................................................... 1545-0895
1.50A-3.................................................... 1545-0895
1.50A-4.................................................... 1545-0895
1.50A-5.................................................... 1545-0895
1.50A-6.................................................... 1545-0895
1.50A-7.................................................... 1545-0895
1.50B-1.................................................... 1545-0895
1.50B-2.................................................... 1545-0895
1.50B-3.................................................... 1545-0895
1.50B-4.................................................... 1545-0895
1.50B-5.................................................... 1545-0895
1.51-1..................................................... 1545-0219
[[Page 860]]
1545-0241
1545-0244
1545-0797
1.52-2..................................................... 1545-0219
1.52-3..................................................... 1545-0219
1.56(g)-1.................................................. 1545-1233
1.57-5..................................................... 1545-0227
1.58-1..................................................... 1545-0175
1.59-1..................................................... 1545-1903
1.61-2..................................................... 1545-0771
1.61-4..................................................... 1545-0187
1.61-15.................................................... 1545-0074
1.62-2..................................................... 1545-1148
1.63-1..................................................... 1545-0074
1.66-4..................................................... 1545-1770
1.67-2T.................................................... 1545-0110
1.67-3..................................................... 1545-1018
1.67-3T.................................................... 1545-0118
1.71-1T.................................................... 1545-0074
1.72-4..................................................... 1545-0074
1.72-6..................................................... 1545-0074
1.72-9..................................................... 1545-0074
1.72-17.................................................... 1545-0074
1.72-17A................................................... 1545-0074
1.72-18.................................................... 1545-0074
1.74-1..................................................... 1545-1100
1.79-2..................................................... 1545-0074
1.79-3..................................................... 1545-0074
1.83-2..................................................... 1545-0074
1.83-5..................................................... 1545-0074
1.83-6..................................................... 1545-1448
1.103-10................................................... 1545-0123
1545-0940
1.103A-2................................................... 1545-0720
1.105-4.................................................... 1545-0074
1.105-5.................................................... 1545-0074
1.105-6.................................................... 1545-0074
1.108-4.................................................... 1545-1539
1.108-5.................................................... 1545-1421
1.108-7.................................................... 1545-2155
1.108(i)-1................................................. 1545-2147
1.108(i)-2................................................. 1545-2147
1.110-1.................................................... 1545-1661
1.117-5.................................................... 1545-0869
1.118-2.................................................... 1545-1639
1.119-1.................................................... 1545-0067
1.120-3.................................................... 1545-0057
1.121-1.................................................... 1545-0072
1.121-2.................................................... 1545-0072
1.121-3.................................................... 1545-0072
1.121-4.................................................... 1545-0072
1545-0091
1.121-5.................................................... 1545-0072
1.127-2.................................................... 1545-0768
1.132-2.................................................... 1545-0771
1.132-5.................................................... 1545-0771
1.132-9(b)................................................. 1545-1676
1.141-1.................................................... 1545-1451
1.141-12................................................... 1545-1451
1.142-2.................................................... 1545-1451
1.142(f)(4)-1.............................................. 1545-1730
1.148-0.................................................... 1545-1098
1.148-1.................................................... 1545-1098
1.148-2.................................................... 1545-1098
1545-1347
1.148-3.................................................... 1545-1098
1545-1347
1.148-4.................................................... 1545-1098
1545-1347
1.148-5.................................................... 1545-1098
1545-1490
1.148-6.................................................... 1545-1098
1545-1451
1.148-7.................................................... 1545-1098
1545-1347
1.148-8.................................................... 1545-1098
1.148-11................................................... 1545-1098
1545-1347
1.149(e)-1................................................. 1545-0720
1.150-1.................................................... 1545-1347
1.151-1.................................................... 1545-0074
1.152-3.................................................... 1545-0071
1545-1783
1.152-4.................................................... 1545-0074
1.152-4T................................................... 1545-0074
1.162-1.................................................... 1545-0139
1.162-2.................................................... 1545-0139
1.162-3.................................................... 1545-0139
1.162-4.................................................... 1545-0139
1.162-5.................................................... 1545-0139
1.162-6.................................................... 1545-0139
1.162-7.................................................... 1545-0139
1.162-8.................................................... 1545-0139
1.162-9.................................................... 1545-0139
1.162-10................................................... 1545-0139
1.162-11................................................... 1545-0139
1.162-12................................................... 1545-0139
1.162-13................................................... 1545-0139
1.162-14................................................... 1545-0139
1.162-15................................................... 1545-0139
1.162-16................................................... 1545-0139
1.162-17................................................... 1545-0139
1.162-18................................................... 1545-0139
1.162-19................................................... 1545-0139
1.162-20................................................... 1545-0139
1.162-24................................................... 1545-2115
1.162-27................................................... 1545-1466
1.163-5.................................................... 1545-0786
1545-1132
1.163-8T................................................... 1545-0995
1.163-10T.................................................. 1545-0074
1.163-13................................................... 1545-1491
1.163(d)-1................................................. 1545-1421
1.165-1.................................................... 1545-0177
1.165-2.................................................... 1545-0177
1.165-3.................................................... 1545-0177
1.165-4.................................................... 1545-0177
1.165-5.................................................... 1545-0177
1.165-6.................................................... 1545-0177
1.165-7.................................................... 1545-0177
1.165-8.................................................... 1545-0177
1.165-9.................................................... 1545-0177
1.165-10................................................... 1545-0177
1.165-11................................................... 1545-0074
1545-0177
1545-0786
1.165-12................................................... 1545-0786
1.166-1.................................................... 1545-0123
1.166-2.................................................... 1545-1254
1.166-4.................................................... 1545-0123
1.166-10................................................... 1545-0123
1.167(a)-5T................................................ 1545-1021
1.167(a)-7................................................. 1545-0172
1.167(a)-11................................................ 1545-0152
1545-0172
1.167(a)-12................................................ 1545-0172
1.167(d)-1................................................. 1545-0172
1.167(e)-1................................................. 1545-0172
1.167(f)-11................................................ 1545-0172
1.167(l)-1................................................. 1545-0172
1.168(d)-1................................................. 1545-1146
1.168(i)-1................................................. 1545-1331
1.168-5.................................................... 1545-0172
1.169-4.................................................... 1545-0172
[[Page 861]]
1.170-1.................................................... 1545-0074
1.170-2.................................................... 1545-0074
1.170-3.................................................... 1545-0123
1.170A-1................................................... 1545-0074
1.170A-2................................................... 1545-0074
1.170A-4(A)(b)............................................. 1545-0123
1.170A-8................................................... 1545-0074
1.170A-9................................................... 1545-0052
1545-0074
1.170A-11.................................................. 1545-0074
1545-0123
1545-1868
1.170A-12.................................................. 1545-0020
1545-0074
1.170A-13.................................................. 1545-0074
1545-0754
1545-0908
1545-1431
1.170A-13(f)............................................... 1545-1464
1.170A-14.................................................. 1545-0763
1.170A-15.................................................. 1545-1953
1.170A-16.................................................. 1545-1953
1.170A-17.................................................. 1545-1953
1.170A-18.................................................. 1545-1953
1.171-4.................................................... 1545-1491
1.171-5.................................................... 1545-1491
1.172-1.................................................... 1545-0172
1.172-13................................................... 1545-0863
1.173-1.................................................... 1545-0172
1.174-3.................................................... 1545-0152
1.174-4.................................................... 1545-0152
1.175-3.................................................... 1545-0187
1.175-6.................................................... 1545-0152
1.179-2.................................................... 1545-1201
1.179-3.................................................... 1545-1201
1.179-5.................................................... 1545-0172
1545-1201
1.179B-1T.................................................. 1545-2076
1.179C-1................................................... 1545-2103
1.179C-1T.................................................. 1545-2103
1.180-2.................................................... 1545-0074
1.181-1.................................................... 1545-2059
1.181-2.................................................... 1545-2059
1.181-3.................................................... 1545-2059
1.182-6.................................................... 1545-0074
1.183-1.................................................... 1545-0195
1.183-2.................................................... 1545-0195
1.183-3.................................................... 1545-0195
1.183-4.................................................... 1545-0195
1.190-3.................................................... 1545-0074
1.194-2.................................................... 1545-0735
1.194-4.................................................... 1545-0735
1.195-1.................................................... 1545-1582
1.197-1T................................................... 1545-1425
1.197-2.................................................... 1545-1671
1.199-6.................................................... 1545-1966
1.213-1.................................................... 1545-0074
1.215-1T................................................... 1545-0074
1.217-2.................................................... 1545-0182
1.243-3.................................................... 1545-0123
1.243-4.................................................... 1545-0123
1.243-5.................................................... 1545-0123
1.248-1.................................................... 1545-0172
1.261-1.................................................... 1545-1041
1.263(a)-1................................................. 1545-2248
1.263(a)-3................................................. 1545-2248
1.263(a)-5................................................. 1545-1870
1.263(e)-1................................................. 1545-0123
1.263A-1................................................... 1545-0987
1.263A-1T.................................................. 1545-0187
1.263A-2................................................... 1545-0987
1.263A-3................................................... 1545-0987
1.263A-8(b)(2)(iii)........................................ 1545-1265
1.263A-9(d)(1)............................................. 1545-1265
1.263A-9(f)(1)(ii)......................................... 1545-1265
1.263A-9(f)(2)(iv)......................................... 1545-1265
1.263A-9(g)(2)(iv)(C)...................................... 1545-1265
1.263A-9(g)(3)(iv)......................................... 1545-1265
1.265-1.................................................... 1545-0074
1.265-2.................................................... 1545-0123
1.266-1.................................................... 1545-0123
1.267(f)-1................................................. 1545-0885
1.268-1.................................................... 1545-0184
1.274-1.................................................... 1545-0139
1.274-2.................................................... 1545-0139
1.274-3.................................................... 1545-0139
1.274-4.................................................... 1545-0139
1.274-5.................................................... 1545-0771
1.274-5A................................................... 1545-0139
1545-0771
1.274-5T................................................... 1545-0074
1545-0172
1545-0771
1.274-6.................................................... 1545-0139
1545-0771
1.274-6T................................................... 1545-0074
1545-0771
1.274-7.................................................... 1545-0139
1.274-8.................................................... 1545-0139
1.279-6.................................................... 1545-0123
1.280C-4................................................... 1545-1155
1.280F-3T.................................................. 1545-0074
1.280G-1................................................... 1545-1851
1.281-4.................................................... 1545-0123
1.302-4.................................................... 1545-0074
1.305-3.................................................... 1545-0123
1.305-5.................................................... 1545-1438
1.307-2.................................................... 1545-0074
1.312-15................................................... 1545-0172
1.316-1.................................................... 1545-0123
1.331-1.................................................... 1545-0074
1.332-4.................................................... 1545-0123
1.332-6.................................................... 1545-2019
1.336-2.................................................... 1545-2125
1.336-4.................................................... 1545-2125
1.337(d)-1................................................. 1545-1160
1.337(d)-2................................................. 1545-1160
1545-1774
1.337(d)-4................................................. 1545-1633
1.337(d)-5................................................. 1545-1672
1.337(d)-6................................................. 1545-1672
1.337(d)-7................................................. 1545-1672
1.338-2.................................................... 1545-1658
1.338-5.................................................... 1545-1658
1.338-10................................................... 1545-1658
1.338-11................................................... 1545-1990
1.338(h)(10)-1............................................. 1545-1658
1.338(i)-1................................................. 1545-1990
1.351-3.................................................... 1545-2019
1.355-5.................................................... 1545-2019
1.362-2.................................................... 1545-0123
1.362-4.................................................... 1545-2247
1.367(a)-1T................................................ 1545-0026
1.367(a)-2T................................................ 1545-0026
1.367(a)-3................................................. 1545-0026
1545-1478
1.367(a)-3T................................................ 1545-2183
1.367(a)-6T................................................ 1545-0026
1.367(a)-7................................................. 1545-2183
1.367(a)-7T................................................ 1545-2183
1.367(a)-8................................................. 1545-1271
1545-2056
1545-2183
1.367(b)-1................................................. 1545-1271
[[Page 862]]
1.367(b)-3T................................................ 1545-1666
1.367(d)-1T................................................ 1545-0026
1.367(e)-1................................................. 1545-1487
1.367(e)-2................................................. 1545-1487
1.368-1.................................................... 1545-1691
1.368-3.................................................... 1545-2019
1.371-1.................................................... 1545-0123
1.371-2.................................................... 1545-0123
1.374-3.................................................... 1545-0123
1.381(b)-1................................................. 1545-0123
1.381(c)(4)-1.............................................. 1545-0123
1545-0152
1545-0879
1.381(c)(5)-1.............................................. 1545-0123
1545-0152
1.381(c)(6)-1.............................................. 1545-0123
1545-0152
1.381(c)(8)-1.............................................. 1545-0123
1.381(c)(10)-1............................................. 1545-0123
1.381(c)(11)-1(k).......................................... 1545-0123
1.381(c)(13)-1............................................. 1545-0123
1.381(c)(17)-1............................................. 1545-0045
1.381(c)(22)-1............................................. 1545-1990
1.381(c)(25)-1............................................. 1545-0045
1.382-1T................................................... 1545-0123
1.382-2.................................................... 1545-0123
1.382-2T................................................... 1545-0123
1.382-3.................................................... 1545-1281
1545-1345
1.382-4.................................................... 1545-1120
1.382-6.................................................... 1545-1381
1.382-8.................................................... 1545-1434
1.382-9.................................................... 1545-1120
1545-1260
1545-1275
1545-1324
1.382-11................................................... 1545-2019
1.382-91................................................... 1545-1260
1545-1324
1.383-1.................................................... 1545-0074
1545-1120
1.401-1.................................................... 1545-0020
1545-0197
1545-0200
1545-0534
1545-0710
1.401(a)-11................................................ 1545-0710
1.401(a)-20................................................ 1545-0928
1.401(a)-31................................................ 1545-1341
1.401(a)-50................................................ 1545-0710
1.401(a)(9)-1.............................................. 1545-1573
1.401(a)(9)-3.............................................. 1545-1466
1.401(a)(9)-4.............................................. 1545-1573
1.401(a)(9)-6.............................................. 1545-2234
1.401(a)(31)-1............................................. 1545-1341
1.401(b)-1................................................. 1545-0197
1.401(f)-1................................................. 1545-0710
1.401(k)-1................................................. 1545-1039
1545-1069
1545-1669
1545-1930
1.401(k)-2................................................. 1545-1669
1.401(k)-3................................................. 1545-1669
1.401(k)-4................................................. 1545-1669
1.401(m)-3................................................. 1545-1699
1.401-14................................................... 1545-0710
1.402(c)-2................................................. 1545-1341
1.402(f)-1................................................. 1545-1341
1545-1632
1.402A-1................................................... 1545-1992
1.403(b)-1................................................. 1545-0710
1.403(b)-3................................................. 1545-0996
1.403(b)-7................................................. 1545-1341
1.403(b)-10................................................ 1545-2068
1.404(a)-12................................................ 1545-0710
1.404A-2................................................... 1545-0123
1.404A-6................................................... 1545-0123
1.408-2.................................................... 1545-0390
1.408-5.................................................... 1545-0747
1.408-6.................................................... 1545-0203
1545-0390
1.408-7.................................................... 1545-0119
1.408(q)-1................................................. 1545-1841
1.408A-2................................................... 1545-1616
1.408A-4................................................... 1545-1616
1.408A-5................................................... 1545-1616
1.408A-7................................................... 1545-1616
1.410(a)-2................................................. 1545-0710
1.410(d)-1................................................. 1545-0710
1.411(a)-11................................................ 1545-1471
1545-1632
1.411(d)-4................................................. 1545-1545
1.411(d)-6................................................. 1545-1477
1.412(c)(1)-2.............................................. 1545-0710
1.412(c)(2)-1.............................................. 1545-0710
1.412(c)(3)-2.............................................. 1545-0710
1.414(c)-5................................................. 1545-0797
1.414(r)-1................................................. 1545-1221
1.415-2.................................................... 1545-0710
1.415-6.................................................... 1545-0710
1.417(a)(3)-1.............................................. 1545-0928
1.417(e)-1................................................. 1545-1471
1545-1724
1.417(e)-1T................................................ 1545-1471
1.419A(f)(6)-1............................................. 1545-1795
1.422-1.................................................... 1545-0820
1.430(f)-1................................................. 1545-2095
1.430(g)-1................................................. 1545-2095
1.430(h)(2)-1.............................................. 1545-2095
1.432(e)(9)-1T............................................. 1545-2260
1.436-1.................................................... 1545-2095
1.441-2.................................................... 1545-1748
1.442-1.................................................... 1545-0074
1545-0123
1545-0134
1545-0152
1545-0820
1545-1748
1.443-1.................................................... 1545-0123
1.444-3T................................................... 1545-1036
1.444-4.................................................... 1545-1591
1.446-1.................................................... 1545-0074
1545-0152
1.446-4(d)................................................. 1545-1412
1.448-1(g)................................................. 1545-0152
1.448-1(h)................................................. 1545-0152
1.448-1(i)................................................. 1545-0152
1.448-2.................................................... 1545-1855
1.448-2T................................................... 1545-0152
1545-1855
1.451-1.................................................... 1545-0091
1.451-4.................................................... 1545-0123
1.451-5.................................................... 1545-0074
1.451-6.................................................... 1545-0074
1.451-7.................................................... 1545-0074
1.453-1.................................................... 1545-0152
1.453-2.................................................... 1545-0152
1.453-8.................................................... 1545-0152
1545-0228
1.453A-1................................................... 1545-0152
1545-1134
1.453A-3................................................... 1545-0963
1.454-1.................................................... 1545-0074
1.455-2.................................................... 1545-0152
[[Page 863]]
1.455-6.................................................... 1545-0123
1.456-2.................................................... 1545-0123
1.456-6.................................................... 1545-0123
1.456-7.................................................... 1545-0123
1.457-8.................................................... 1545-1580
1.458-1.................................................... 1545-0879
1.458-2.................................................... 1545-0152
1.460-1.................................................... 1545-1650
1.460-6.................................................... 1545-1031
1545-1572
1545-1732
1.461-1.................................................... 1545-0074
1.461-2.................................................... 1545-0096
1.461-4.................................................... 1545-0917
1.461-5.................................................... 1545-0917
1.463-1T................................................... 1545-0916
1.465-1T................................................... 1545-0712
1.466-1T................................................... 1545-0152
1.466-4.................................................... 1545-0152
1.468A-3................................................... 1545-1269
1545-1378
1545-1511
1.468A-3(h), 1.468A-7, and 1.468A-8(d)..................... 1545-2091
1.468A-4................................................... 1545-0954
1.468A-7................................................... 1545-0954
1545-1511
1.468A-8................................................... 1545-1269
1.468B-1................................................... 1545-1631
1.468B-1(j)................................................ 1545-1299
1.468B-2(k)................................................ 1545-1299
1.468B-2(l)................................................ 1545-1299
1.468B-3(b)................................................ 1545-1299
1.468B-3(e)................................................ 1545-1299
1.468B-5(b)................................................ 1545-1299
1.468B-9................................................... 1545-1631
1.469-1.................................................... 1545-1008
1.469-2T................................................... 1545-0712
1545-1091
1.469-4T................................................... 1545-0985
1545-1037
1.469-7.................................................... 1545-1244
1.471-2.................................................... 1545-0123
1.471-5.................................................... 1545-0123
1.471-6.................................................... 1545-0123
1.471-8.................................................... 1545-0123
1.471-11................................................... 1545-0123
1545-0152
1.472-1.................................................... 1545-0042
1545-0152
1.472-2.................................................... 1545-0152
1.472-3.................................................... 1545-0042
1.472-5.................................................... 1545-0152
1.472-8.................................................... 1545-0028
1545-0042
1545-1767
1.475(a)-4................................................. 1545-1945
1.481-4.................................................... 1545-0152
1.481-5.................................................... 1545-0152
1.482-1.................................................... 1545-1364
1.482-4.................................................... 1545-1364
1.482-7.................................................... 1545-1364
1545-1794
1.482-9(b)................................................. 1545-2149
1.501(a)-1................................................. 1545-0056
1545-0057
1.501(c)(3)-1.............................................. 1545-0056
1.501(c)(9)-5.............................................. 1545-0047
1.501(c)(17)-3............................................. 1545-0047
1.501(e)-1................................................. 1545-0814
1.501(r)-3................................................. 1545-0047
1.501(r)-4................................................. 1545-0047
1.501(r)-6................................................. 1545-0047
1.503(c)-1................................................. 1545-0047
1545-0052
1.505(c)-1T................................................ 1545-0916
1.506-1T................................................... 1545-2268
1.507-1.................................................... 1545-0052
1.507-2.................................................... 1545-0052
1.508-1.................................................... 1545-0052
1545-0056
1.509(a)-3................................................. 1545-0047
1.509(a)-4................................................. 1545-2157
1.509(a)-5................................................. 1545-0047
1.509(c)-1................................................. 1545-0052
1.512(a)-1................................................. 1545-0687
1.512(a)-4................................................. 1545-0047
1545-0687
1.521-1.................................................... 1545-0051
1545-0058
1.527-2.................................................... 1545-0129
1.527-5.................................................... 1545-0129
1.527-6.................................................... 1545-0129
1.527-9.................................................... 1545-0129
1.528-8.................................................... 1545-0127
1.533-2.................................................... 1545-0123
1.534-2.................................................... 1545-0123
1.542-3.................................................... 1545-0123
1.545-2.................................................... 1545-0123
1.545-3.................................................... 1545-0123
1.547-2.................................................... 1545-0045
1545-0123
1.547-3.................................................... 1545-0123
1.561-1.................................................... 1545-0044
1.561-2.................................................... 1545-0123
1.562-3.................................................... 1545-0123
1.563-2.................................................... 1545-0123
1.564-1.................................................... 1545-0123
1.565-1.................................................... 1545-0043
1545-0123
1.565-2.................................................... 1545-0043
1.565-3.................................................... 1545-0043
1.565-5.................................................... 1545-0043
1.565-6.................................................... 1545-0043
1.585-1.................................................... 1545-0123
1.585-3.................................................... 1545-0123
1.585-8.................................................... 1545-1290
1.597-2.................................................... 1545-1300
1.597-4.................................................... 1545-1300
1.597-6.................................................... 1545-1300
1.597-7.................................................... 1545-1300
1.611-2.................................................... 1545-0099
1.611-3.................................................... 1545-0007
1545-0099
1545-1784
1.612-4.................................................... 1545-0074
1.612-5.................................................... 1545-0099
1.613-3.................................................... 1545-0099
1.613-4.................................................... 1545-0099
1.613-6.................................................... 1545-0099
1.613-7.................................................... 1545-0099
1.613A-3................................................... 1545-0919
1.613A-3(e)................................................ 1545-1251
1.613A-3(l)................................................ 1545-0919
1.613A-5................................................... 1545-0099
1.613A-6................................................... 1545-0099
1.614-2.................................................... 1545-0099
1.614-3.................................................... 1545-0099
1.614-5.................................................... 1545-0099
1.614-6.................................................... 1545-0099
1.614-8.................................................... 1545-0099
1.617-1.................................................... 1545-0099
1.617-3.................................................... 1545-0099
1.617-4.................................................... 1545-0099
1.631-1.................................................... 1545-0007
[[Page 864]]
1.631-2.................................................... 1545-0007
1.641(b)-2................................................. 1545-0092
1.642(c)-1................................................. 1545-0092
1.642(c)-2................................................. 1545-0092
1.642(c)-5................................................. 1545-0074
1.642(c)-6................................................. 1545-0020
1545-0074
1545-0092
1.642(g)-1................................................. 1545-0092
1.642(i)-1................................................. 1545-0092
1.645-1.................................................... 1545-1578
1.663(b)-2................................................. 1545-0092
1.664-1.................................................... 1545-0196
1.664-1(a)(7).............................................. 1545-1536
1.664-1(c)................................................. 1545-2101
1.664-2.................................................... 1545-0196
1.664-3.................................................... 1545-0196
1.664-4.................................................... 1545-0020
1545-0196
1.665(a)-0A through
1.665(g)-2A................................................ 1545-0192
1.666(d)-1A................................................ 1545-0092
1.671-4.................................................... 1545-1442
1.671-5.................................................... 1545-1540
1.701-1.................................................... 1545-0099
1.702-1.................................................... 1545-0074
1.703-1.................................................... 1545-0099
1.704-2.................................................... 1545-1090
1.706-1.................................................... 1545-0074
1545-0099
1545-0134
1.706-1T................................................... 1545-0099
1.706-4(f)................................................. 1545-0123
1.707-3(c)(2).............................................. 1545-1243
1.707-5(a)(7)(ii).......................................... 1545-1243
1.707-6(c)................................................. 1545-1243
1.707-8.................................................... 1545-1243
1.708-1.................................................... 1545-0099
1.732-1.................................................... 1545-0099
1545-1588
1.736-1.................................................... 1545-0074
1.743-1.................................................... 1545-0074
1545-1588
1.751-1.................................................... 1545-0074
1545-0099
1545-0941
1.752-2.................................................... 1545-1905
1.752-5.................................................... 1545-1090
1.752-7.................................................... 1545-1843
1.754-1.................................................... 1545-0099
1.755-1.................................................... 1545-0099
1.761-2.................................................... 1545-1338
1.801-1.................................................... 1545-0123
1545-0128
1.801-3.................................................... 1545-0123
1.801-5.................................................... 1545-0128
1.801-8.................................................... 1545-0128
1.804-4.................................................... 1545-0128
1.811-2.................................................... 1545-0128
1.812-2.................................................... 1545-0128
1.815-6.................................................... 1545-0128
1.818-4.................................................... 1545-0128
1.818-5.................................................... 1545-0128
1.818-8.................................................... 1545-0128
1.819-2.................................................... 1545-0128
1.822-5.................................................... 1545-1027
1.822-6.................................................... 1545-1027
1.822-8.................................................... 1545-1027
1.822-9.................................................... 1545-1027
1.826-1.................................................... 1545-1027
1.826-2.................................................... 1545-1027
1.826-3.................................................... 1545-1027
1.826-4.................................................... 1545-1027
1.826-6.................................................... 1545-1027
1.831-3.................................................... 1545-0123
1.832-4.................................................... 1545-1227
1.832-5.................................................... 1545-0123
1.848-2(g)(8).............................................. 1545-1287
1.848-2(h)(3).............................................. 1545-1287
1.848-2(i)(4).............................................. 1545-1287
1.851-2.................................................... 1545-1010
1.851-4.................................................... 1545-0123
1.852-1.................................................... 1545-0123
1.852-4.................................................... 1545-0123
1545-0145
1.852-6.................................................... 1545-0123
1545-0144
1.852-7.................................................... 1545-0074
1.852-9.................................................... 1545-0074
1545-0123
1545-0144
1545-0145
1545-1783
1.852-11................................................... 1545-1094
1.853-3.................................................... 1545-2035
1.853-4.................................................... 1545-2035
1.854-2.................................................... 1545-0123
1.855-1.................................................... 1545-0123
1.856-2.................................................... 1545-0123
1545-1004
1.856-6.................................................... 1545-0123
1.856-7.................................................... 1545-0123
1.856-8.................................................... 1545-0123
1.857-8.................................................... 1545-0123
1.857-9.................................................... 1545-0074
1.858-1.................................................... 1545-0123
1.860-2.................................................... 1545-0045
1.860-4.................................................... 1545-0045
1545-1054
1545-1057
1.860E-1................................................... 1545-1675
1.860E-2(a)(5)............................................. 1545-1276
1.860E-2(a)(7)............................................. 1545-1276
1.860E-2(b)(2)............................................. 1545-1276
1.860G-2................................................... 1545-2110
1.861-2.................................................... 1545-0089
1.861-3.................................................... 1545-0089
1.861-4.................................................... 1545-1900
1.861-8.................................................... 1545-0126
1.861-8(e)(6) and (g)...................................... 1545-1224
1.861-9T................................................... 1545-0121
1545-1072
1.861-18................................................... 1545-1594
1.863-1.................................................... 1545-1476
1.863-3.................................................... 1545-1476
1545-1556
1.863-3A................................................... 1545-0126
1.863-4.................................................... 1545-0126
1.863-7.................................................... 1545-0132
1.863-8.................................................... 1545-1718
1.863-9.................................................... 1545-1718
1.864-4.................................................... 1545-0126
1.871-1.................................................... 1545-0096
1.871-6.................................................... 1545-0795
1.871-7.................................................... 1545-0089
1.871-10................................................... 1545-0089
1545-0165
1.874-1.................................................... 1545-0089
1.881-4.................................................... 1545-1440
1.882-4.................................................... 1545-0126
1.883-0.................................................... 1545-1677
1.883-1.................................................... 1545-1677
1.883-2.................................................... 1545-1677
1.883-3.................................................... 1545-1677
[[Page 865]]
1.883-4.................................................... 1545-1677
1.883-5.................................................... 1545-1677
1.884-0.................................................... 1545-1070
1.884-1.................................................... 1545-1070
1.884-2.................................................... 1545-1070
1.884-2T................................................... 1545-0126
1545-1070
1.884-4.................................................... 1545-1070
1.884-5.................................................... 1545-1070
1.892-1T................................................... 1545-1053
1.892-2T................................................... 1545-1053
1.892-3T................................................... 1545-1053
1.892-4T................................................... 1545-1053
1.892-5T................................................... 1545-1053
1.892-6T................................................... 1545-1053
1.892-7T................................................... 1545-1053
1.897-2.................................................... 1545-0123
1545-0902
1.897-3.................................................... 1545-0123
1.897-5T................................................... 1545-0902
1.897-6T................................................... 1545-0902
1.901-2.................................................... 1545-0746
1.901-2A................................................... 1545-0746
1.901-3.................................................... 1545-0122
1.902-1.................................................... 1545-0122
1545-1458
1.904-1.................................................... 1545-0121
1545-0122
1.904-2.................................................... 1545-0121
1545-0122
1.904-3.................................................... 1545-0121
1.904-4.................................................... 1545-0121
1.904-5.................................................... 1545-0121
1.904-7.................................................... 1545-2104
1.904-7T................................................... 1545-2104
1.904(f)-1................................................. 1545-0121
1545-0122
1.904(f)-2................................................. 1545-0121
1.904(f)-3................................................. 1545-0121
1.904(f)-4................................................. 1545-0121
1.904(f)-5................................................. 1545-0121
1.904(f)-6................................................. 1545-0121
1.904(f)-7................................................. 1545-1127
1.905-2.................................................... 1545-0122
1.905-3T................................................... 1545-1056
1.905-4T................................................... 1545-1056
1.905-5T................................................... 1545-1056
1.911-1.................................................... 1545-0067
1545-0070
1.911-2.................................................... 1545-0067
1545-0070
1.911-3.................................................... 1545-0067
1545-0070
1.911-4.................................................... 1545-0067
1545-0070
1.911-5.................................................... 1545-0067
1545-0070
1.911-6.................................................... 1545-0067
1545-0070
1.911-7.................................................... 1545-0067
1545-0070
1.913-13................................................... 1545-0067
1.921-1T................................................... 1545-0190
1545-0884
1545-0935
1545-0939
1.921-2.................................................... 1545-0884
1.927(a)-1T................................................ 1545-0935
1.927(d)-2T................................................ 1545-0935
1.931-1.................................................... 1545-0074
1545-0123
1.934-1.................................................... 1545-0782
1.935-1.................................................... 1545-0074
1545-0087
1545-0803
1.936-1.................................................... 1545-0215
1545-0217
1.936-4.................................................... 1545-0215
1.936-5.................................................... 1545-0704
1.936-6.................................................... 1545-0215
1.936-7.................................................... 1545-0215
1.936-10(c)................................................ 1545-1138
1.937-1.................................................... 1545-1930
1.952-2.................................................... 1545-0126
1.953-2.................................................... 1545-0126
1.954-1.................................................... 1545-1068
1.954-2.................................................... 1545-1068
1.955-2.................................................... 1545-0123
1.955-3.................................................... 1545-0123
1.955A-2................................................... 1545-0755
1.955A-3................................................... 1545-0755
1.956-1.................................................... 1545-0704
1.956-2.................................................... 1545-0704
1.959-1.................................................... 1545-0704
1.959-2.................................................... 1545-0704
1.960-1.................................................... 1545-0122
1.962-2.................................................... 1545-0704
1.962-3.................................................... 1545-0704
1.964-1.................................................... 1545-0126
1545-0704
1545-1072
1545-2104
1.964-3.................................................... 1545-0126
1.970-2.................................................... 1545-0126
1.985-2.................................................... 1545-1051
1545-1131
1.985-3.................................................... 1545-1051
1.987-1.................................................... 1545-2265
1.987-3.................................................... 1545-2265
1.987-9.................................................... 1545-2265
1.987-10................................................... 1545-2265
1.988-0.................................................... 1545-1131
1.988-1.................................................... 1545-1131
1.988-2.................................................... 1545-1131
1.988-3.................................................... 1545-1131
1.988-4.................................................... 1545-1131
1.988-5.................................................... 1545-1131
1.988-6.................................................... 1545-1831
1.992-1.................................................... 1545-0190
1545-0938
1.992-2.................................................... 1545-0190
1545-0884
1545-0938
1.992-3.................................................... 1545-0190
1545-0938
1.992-4.................................................... 1545-0190
1545-0938
1.993-3.................................................... 1545-0938
1.993-4.................................................... 1545-0938
1.994-1.................................................... 1545-0938
1.995-5.................................................... 1545-0938
1.1001-1................................................... 1545-1902
1.1012-1................................................... 1545-0074
1545-1139
1.1014-4................................................... 1545-0184
1.1015-1................................................... 1545-0020
1.1017-1................................................... 1545-1539
1.1031(d)-1T............................................... 1545-1021
1.1033(a)-2................................................ 1545-0184
1.1033(g)-1................................................ 1545-0184
1.1039-1................................................... 1545-0184
1.1041-1T.................................................. 1545-0074
1.1041-2................................................... 1545-1751
1.1042-1T.................................................. 1545-0916
[[Page 866]]
1.1044(a)-1................................................ 1545-1421
1.1045-1................................................... 1545-1893
1.1060-1................................................... 1545-1658
1545-1990
1.1071-1................................................... 1545-0184
1.1071-4................................................... 1545-0184
1.1081-4................................................... 1545-0028
1545-0046
1545-0123
1.1081-11.................................................. 1545-2019
1.1082-1................................................... 1545-0046
1.1082-2................................................... 1545-0046
1.1082-3................................................... 1545-0046
1545-0184
1.1082-4................................................... 1545-0046
1.1082-5................................................... 1545-0046
1.1082-6................................................... 1545-0046
1.1083-1................................................... 1545-0123
1.1092(b)-1T............................................... 1545-0644
1.1092(b)-2T............................................... 1545-0644
1.1092(b)-3T............................................... 1545-0644
1.1092(b)-4T............................................... 1545-0644
1.1092(b)-5T............................................... 1545-0644
1.1211-1................................................... 1545-0074
1.1212-1................................................... 1545-0074
1.1221-2................................................... 1545-1480
1.1231-1................................................... 1545-0177
1545-0184
1.1231-2................................................... 1545-0177
1545-0184
1.1231-2................................................... 1545-0074
1.1232-3................................................... 1545-0074
1.1237-1................................................... 1545-0184
1.1239-1................................................... 1545-0091
1.1242-1................................................... 1545-0184
1.1243-1................................................... 1545-0123
1.1244(e)-1................................................ 1545-0123
1545-1447
1.1245-1................................................... 1545-0184
1.1245-2................................................... 1545-0184
1.1245-3................................................... 1545-0184
1.1245-4................................................... 1545-0184
1.1245-5................................................... 1545-0184
1.1245-6................................................... 1545-0184
1.1248-7................................................... 1545-0074
1.1248(f)-2................................................ 1545-2183
1.1248(f)-3T............................................... 1545-2183
1.1250-1................................................... 1545-0184
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1.1274-3(d)................................................ 1545-1353
1.1274-5(b)................................................ 1545-1353
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1.1368-1(f)(4)............................................. 1545-1139
1.1368-1(g)(2)............................................. 1545-1139
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1.1502-77B................................................. 1545-1699
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20.6161-1.................................................. 1545-0015
1545-0181
20.6161-2.................................................. 1545-0015
1545-0181
20.6163-1.................................................. 1545-0015
20.6166-1.................................................. 1545-0181
20.6166A-1................................................. 1545-0015
20.6166A-3................................................. 1545-0015
20.6324A-1................................................. 1545-0754
20.7520-1.................................................. 1545-1343
20.7520-2.................................................. 1545-1343
20.7520-3.................................................. 1545-1343
20.7520-4.................................................. 1545-1343
22.0....................................................... 1545-0015
25.2511-2.................................................. 1545-0020
25.2512-2.................................................. 1545-0020
25.2512-3.................................................. 1545-0020
25.2512-5.................................................. 1545-0020
25.2512-9.................................................. 1545-0020
25.2513-1.................................................. 1545-0020
25.2513-2.................................................. 1545-0020
1545-0021
25.2513-3.................................................. 1545-0020
25.2518-2.................................................. 1545-0959
25.2522(a)-1............................................... 1545-0196
25.2522(c)-3............................................... 1545-0020
1545-0196
25.2523(a)-1............................................... 1545-0020
1545-0196
25.2523(f)-1............................................... 1545-0015
25.2701-2.................................................. 1545-1241
25.2701-4.................................................. 1545-1241
25.2701-5.................................................. 1545-1273
25.2702-5.................................................. 1545-1485
25.2702-6.................................................. 1545-1273
25.6001-1.................................................. 1545-0020
1545-0022
25.6011-1.................................................. 1545-0020
25.6019-1.................................................. 1545-0020
25.6019-2.................................................. 1545-0020
25.6019-3.................................................. 1545-0020
25.6019-4.................................................. 1545-0020
25.6060-1(a)(1)............................................ 1545-1231
25.6061-1.................................................. 1545-0020
25.6065-1.................................................. 1545-0020
25.6075-1.................................................. 1545-0020
25.6081-1.................................................. 1545-0020
25.6091-1.................................................. 1545-0020
25.6091-2.................................................. 1545-0020
25.6107-1.................................................. 1545-1231
25.6151-1.................................................. 1545-0020
25.6161-1.................................................. 1545-0020
25.7520-1.................................................. 1545-1343
25.7520-2.................................................. 1545-1343
25.7520-3.................................................. 1545-1343
25.7520-4.................................................. 1545-1343
26.2601-1.................................................. 1545-0985
26.2632-1.................................................. 1545-0985
1545-1892
26.2642-1.................................................. 1545-0985
26.2642-2.................................................. 1545-0985
26.2642-3.................................................. 1545-0985
[[Page 871]]
26.2642-4.................................................. 1545-0985
26.2642-6.................................................. 1545-1902
26.2652-2.................................................. 1545-0985
26.2654-1.................................................. 1545-1902
26.2662-1.................................................. 1545-0015
1545-0985
26.2662-2.................................................. 1545-0985
26.6060-1(a)(1)............................................ 1545-1231
26.6107-1.................................................. 1545-1231
31.3102-3.................................................. 1545-0029
1545-0059
1545-0065
31.3121(b)(19)-1........................................... 1545-0029
31.3121(d)-1............................................... 1545-0004
31.3121(i)-1............................................... 1545-0034
31.3121(r)-1............................................... 1545-0029
31.3121(s)-1............................................... 1545-0029
31.3121(v)(2)-1............................................ 1545-1643
31.3302(a)-2............................................... 1545-0028
31.3302(a)-3............................................... 1545-0028
31.3302(b)-2............................................... 1545-0028
31.3302(e)-1............................................... 1545-0028
31.3306(c)(18)-1........................................... 1545-0029
31.3401(a)-1............................................... 1545-0029
31.3401(a)(6).............................................. 1545-1484
31.3401(a)(6)-1............................................ 1545-0029
1545-0096
1545-0795
31.3401(a)(7)-1............................................ 1545-0029
31.3401(a)(8)(A)-1 ........................................ 1545-0029
1545-0666
31.3401(a)(8)(C)-1 ........................................ 1545-0029
31.3401(a)(15)-1........................................... 1545-0182
31.3401(c)-1............................................... 1545-0004
31.3402(b)-1............................................... 1545-0010
31.3402(c)-1............................................... 1545-0010
31.3402(f)(1)-1............................................ 1545-0010
31.3402(f)(2)-1............................................ 1545-0010
1545-0410
31.3402(f)(3)-1............................................ 1545-0010
31.3402(f)(4)-1............................................ 1545-0010
31.3402(f)(4)-2............................................ 1545-0010
31.3402(f)(5)-1............................................ 1545-0010
1545-1435
31.3402(h)(1)-1............................................ 1545-0029
31.3402(h)(3)-1............................................ 1545-0010
1545-0029
31.3402(h)(4)-1............................................ 1545-0010
31.3402(i)-(1)............................................. 1545-0010
31.3402(i)-(2)............................................. 1545-0010
31.3402(k)-1............................................... 1545-0065
31.3402(l)-(1)............................................. 1545-0010
31.3402(m)-(1)............................................. 1545-0010
31.3402(n)-(1)............................................. 1545-0010
31.3402(o)-2............................................... 1545-0415
31.3402(o)-3............................................... 1545-0008
1545-0010
1545-0415
1545-0717
31.3402(p)-1............................................... 1545-0415
1545-0717
31.3402(q)-1............................................... 1545-0238
1545-0239
31.3404-1.................................................. 1545-0029
31.3405(c)-1............................................... 1545-1341
31.3406(a)-1............................................... 1545-0112
31.3406(a)-2............................................... 1545-0112
31.3406(a)-3............................................... 1545-0112
31.3406(a)-4............................................... 1545-0112
31.3406(b)(2)-1............................................ 1545-0112
31.3406(b)(2)-2............................................ 1545-0112
31.3406(b)(2)-3............................................ 1545-0112
31.3406(b)(2)-4............................................ 1545-0112
31.3406(b)(2)-5............................................ 1545-0112
31.3406(b)(3)-1............................................ 1545-0112
31.3406(b)(3)-2............................................ 1545-0112
31.3406(b)(3)-3............................................ 1545-0112
31.3406(b)(3)-4............................................ 1545-0112
31.3406(b)(4)-1............................................ 1545-0112
31.3406(c)-1............................................... 1545-0112
31.3406(d)-1............................................... 1545-0112
31.3406(d)-2............................................... 1545-0112
31.3406(d)-3............................................... 1545-0112
31.3406(d)-4............................................... 1545-0112
31.3406(d)-5............................................... 1545-0112
31.3406(e)-1............................................... 1545-0112
31.3406(f)-1............................................... 1545-0112
31.3406(g)-1............................................... 1545-0096
1545-0112
1545-1819
31.3406(g)-2............................................... 1545-0112
31.3406(g)-3............................................... 1545-0112
31.3406(h)-1............................................... 1545-0112
31.3406(h)-2............................................... 1545-0112
31.3406(h)-3............................................... 1545-0112
31.3406(i)-1............................................... 1545-0112
31.3501(a)-1T.............................................. 1545-0771
31.3503-1.................................................. 1545-0024
31.3504-1.................................................. 1545-0029
31.6001-1.................................................. 1545-0798
31.6001-2.................................................. 1545-0034
1545-0798
31.6001-3.................................................. 1545-0798
31.6001-4.................................................. 1545-0028
31.6001-5.................................................. 1545-0798
31.6001-6.................................................. 1545-0029
1459-0798
31.6011(a)-1............................................... 1545-0029
1545-0034
1545-0035
1545-0059
1545-0074
1545-0256
1545-0718
1545-2097
31.6011(a)-2............................................... 1545-0001
1545-0002
31.6011(a)-3............................................... 1545-0028
31.6011(a)-3A.............................................. 1545-0955
31.6011(a)-4............................................... 1545-0034
1545-0035
1545-0718
1545-1413
1545-2097
31.6011(a)-5............................................... 1545-0028
1545-0718
1545-2097
31.6011(a)-6............................................... 1545-0028
31.6011(a)-7............................................... 1545-0074
31.6011(a)-8............................................... 1545-0028
31.6011(a)-9............................................... 1545-0028
31.6011(a)-10.............................................. 1545-0112
31.6011(b)-1............................................... 1545-0003
31.6011(b)-2............................................... 1545-0029
31.6051-1.................................................. 1545-0008
1545-0182
1545-0458
1545-1729
31.6051-2.................................................. 1545-0008
31.6051-3.................................................. 1545-0008
31.6053-1.................................................. 1545-0029
1545-0062
1545-0064
1545-0065
[[Page 872]]
1545-1603
31.6053-2.................................................. 1545-0008
31.6053-3.................................................. 1545-0065
1545-0714
31.6053-4.................................................. 1545-0065
1545-1603
31.6060-1(a)(1)............................................ 1545-1231
31.6065(a)-1............................................... 1545-0029
31.6071(a)-1............................................... 1545-0001
1545-0028
1545-0029
31.6071(a)-1A.............................................. 1545-0955
31.6081(a)-1............................................... 1545-0008
1545-0028
31.6091-1.................................................. 1545-0028
1545-0029
31.6107-1.................................................. 1545-1231
31.6157-1.................................................. 1545-0955
31.6205-1.................................................. 1545-0029
1545-2097
31.6301(c)-1AT............................................. 1545-0035
1545-0112
1545-0257
31.6302-1.................................................. 1545-1413
31.6302-2.................................................. 1545-1413
31.6302-3.................................................. 1545-1413
31.6302-4.................................................. 1545-1413
31.6302(c)-2............................................... 1545-0001
1545-0257
31.6302(c)-2A.............................................. 1545-0955
31.6302(c)-3............................................... 1545-0257
31.6402(a)-2............................................... 1545-0256
1545-2097
31.6413(a)-1............................................... 1545-0029
1545-2097
31.6413(a)-2............................................... 1545-0029
1545-0256
1545-2097
31.6413(c)-1............................................... 1545-0029
1545-0171
31.6414-1.................................................. 1545-0029
1545-2097
32.1....................................................... 1545-0029
1545-0415
32.2....................................................... 1545-0029
35a.3406-2................................................. 1545-0112
35a.9999-5................................................. 1545-0029
36.3121(l)(1)-1............................................ 1545-0137
36.3121(l)(1)-2............................................ 1545-0137
36.3121(l)(3)-1............................................ 1545-0123
36.3121(1)(7)-1............................................ 1545-0123
36.3121(1)(10)-1........................................... 1545-0029
36.3121(1)(10)-3........................................... 1545-0029
36.3121(1)(10)-4........................................... 1545-0257
40.6060-1(a)(1)............................................ 1545-1231
40.6107-1.................................................. 1545-1231
40.6302(c)-3(b)(2)(ii)..................................... 1545-1296
40.6302(c)-3(b)(2)(iii).................................... 1545-1296
40.6302(c)-3(e)............................................ 1545-1296
40.6302(c)-3(f)(2)(ii)..................................... 1545-1296
41.4481-1.................................................. 1545-0143
41.4481-2.................................................. 1545-0143
41.4483-3.................................................. 1545-0143
41.6001-1.................................................. 1545-0143
41.6001-2.................................................. 1545-0143
41.6001-3.................................................. 1545-0143
41.6060-1(a)(1)............................................ 1545-1231
41.6071(a)-1............................................... 1545-0143
41.6081(a)-1............................................... 1545-0143
41.6091-1.................................................. 1545-0143
41.6107-1.................................................. 1545-1231
41.6109-1.................................................. 1545-0143
41.6151(a)-1............................................... 1545-0143
41.6156-1.................................................. 1545-0143
41.6161(a)(1)-1............................................ 1545-0143
44.4401-1.................................................. 1545-0235
44.4403-1.................................................. 1545-0235
44.4412-1.................................................. 1545-0236
44.4901-1.................................................. 1545-0236
44.4905-1.................................................. 1545-0236
44.4905-2.................................................. 1545-0236
44.6001-1.................................................. 1545-0235
44.6011(a)-1............................................... 1545-0235
1545-0236
44.6060-1(a)(1)............................................ 1545-1231
44.6071-1.................................................. 1545-0235
44.6091-1.................................................. 1545-0235
44.6107-1.................................................. 1545-1231
44.6151-1.................................................. 1545-0235
44.6419-1.................................................. 1545-0235
44.6419-2.................................................. 1545-0235
46.4371-4.................................................. 1545-0023
46.4374-1.................................................. 1545-0023
46.4375-1.................................................. 1545-2238
46.4376-1.................................................. 1545-2238
46.4701-1.................................................. 1545-0023
1545-0257
48.4041-4.................................................. 1545-0023
48.4041-5.................................................. 1545-0023
48.4041-6.................................................. 1545-0023
48.4041-7.................................................. 1545-0023
48.4041-9.................................................. 1545-0023
48.4041-10................................................. 1545-0023
48.4041-11................................................. 1545-0023
48.4041-12................................................. 1545-0023
48.4041-13................................................. 1545-0023
48.4041-19................................................. 1545-0023
48.4041-20................................................. 1545-0023
48.4041-21................................................. 1545-1270
48.4042-2.................................................. 1545-0023
48.4052-1.................................................. 1545-1418
48.4061(a)-1............................................... 1545-0023
48.4061(a)-2............................................... 1545-0023
48.4061(b)-3............................................... 1545-0023
48.4064-1.................................................. 1545-0014
1545-0242
48.4071-1.................................................. 1545-0023
48.4073-1.................................................. 1545-0023
48.4073-3.................................................. 1545-0023
1545-1074
1545-1087
48.4081-2.................................................. 1545-1270
1545-1418
48.4081-3.................................................. 1545-1270
1545-1418
1545-1897
48.4081-4(b)(2)(ii)........................................ 1545-1270
48.4081-4(b)(3)(i)......................................... 1545-1270
48.4081-4(c)............................................... 1545-1270
48.4081-6(c)(1)(ii)........................................ 1545-1270
48.4081-7.................................................. 1545-1270
1545-1418
48.4082-1T................................................. 1545-1418
48.4082-2.................................................. 1545-1418
48.4082-6.................................................. 1545-1418
48.4082-7.................................................. 1545-1418
48.4101-1.................................................. 1545-1418
48.4101-1T................................................. 1545-1418
48.4101-2.................................................. 1545-1418
48.4161(a)-1............................................... 1545-0723
48.4161(a)-2............................................... 1545-0723
48.4161(a)-3............................................... 1545-0723
48.4161(b)-1............................................... 1545-0723
48.4216(a)-2............................................... 1545-0023
[[Page 873]]
48.4216(a)-3............................................... 1545-0023
48.4216(c)-1............................................... 1545-0023
48.4221-1.................................................. 1545-0023
48.4221-2.................................................. 1545-0023
48.4221-3.................................................. 1545-0023
48.4221-4.................................................. 1545-0023
48.4221-5.................................................. 1545-0023
48.4221-6.................................................. 1545-0023
48.4221-7.................................................. 1545-0023
48.4222(a)-1............................................... 1545-0014
1545-0023
48.4223-1.................................................. 1545-0023
1545-0257
1545-0723
48.6302(c)-1............................................... 1545-0023
1545-0257
48.6412-1.................................................. 1545-0723
48.6416(a)-1............................................... 1545-0023
1545-0723
48.6416(a)-2............................................... 1545-0723
48.6416(a)-3............................................... 1545-0723
48.6416(b)(1)-1............................................ 1545-0723
48.6416(b)(1)-2............................................ 1545-0723
48.6416(b)(1)-3............................................ 1545-0723
48.6416(b)(1)-4............................................ 1545-0723
48.6416(b)(2)-1............................................ 1545-0723
48.6416(b)(2)-2............................................ 1545-0723
48.6416(b)(2)-3............................................ 1545-0723
1545-1087
48.6416(b)(2)-4............................................ 1545-0723
48.6416(b)(3)-1............................................ 1545-0723
48.6416(b)(3)-2............................................ 1545-0723
48.6416(b)(3)-3............................................ 1545-0723
48.6416(b)(4)-1............................................ 1545-0723
48.6416(b)(5)-1............................................ 1545-0723
48.6416(c)-1............................................... 1545-0723
48.6416(e)-1............................................... 1545-0023
1545-0723
48.6416(f)-1............................................... 1545-0023
1545-0723
48.6416(g)-1............................................... 1545-0723
48.6416(h)-1............................................... 1545-0723
48.6420(c)-2............................................... 1545-0023
48.6420(f)-1............................................... 1545-0023
48.6420-1.................................................. 1545-0162
1545-0723
48.6420-2.................................................. 1545-0162
1545-0723
48.6420-3.................................................. 1545-0162
1545-0723
48.6420-4.................................................. 1545-0162
1545-0723
48.6420-5.................................................. 1545-0162
1545-0723
48.6420-6.................................................. 1545-0162
1545-0723
48.6421-0.................................................. 1545-0162
1545-0723
48.6421-1.................................................. 1545-0162
1545-0723
48.6421-2.................................................. 1545-0162
1545-0723
48.6421-3.................................................. 1545-0162
1545-0723
48.6421-4.................................................. 1545-0162
1545-0723
48.6421-5.................................................. 1545-0162
1545-0723
48.6421-6.................................................. 1545-0162
1545-0723
48.6421-7.................................................. 1545-0162
1545-0723
48.6424-0.................................................. 1545-0723
48.6424-1.................................................. 1545-0723
48.6424-2.................................................. 1545-0723
48.6424-3.................................................. 1545-0723
48.6424-4.................................................. 1545-0723
48.6424-5.................................................. 1545-0723
48.6424-6.................................................. 1545-0723
48.6427-0.................................................. 1545-0723
48.6427-1.................................................. 1545-0023
1545-0162
1545-0723
48.6427-2.................................................. 1545-0162
1545-0723
48.6427-3.................................................. 1545-0723
48.6427-4.................................................. 1545-0723
48.6427-5.................................................. 1545-0723
48.6427-8.................................................. 1545-1418
48.6427-9.................................................. 1545-1418
48.6427-10................................................. 1545-1418
48.6427-11................................................. 1545-1418
49.4251-1.................................................. 1545-1075
49.4251-2.................................................. 1545-1075
49.4251-4(d)(2)............................................ 1545-1628
49.4253-3.................................................. 1545-0023
49.4253-4.................................................. 1545-0023
49.4264(b)-1............................................... 1545-0023
1545-0224
1545-0225
1545-0226
1545-0230
1545-0257
1545-0912
49.4271-1(d)............................................... 1545-0685
49.5000B-1................................................. 1545-2177
51.2(f)(2)(ii)............................................. 1545-2209
51.7....................................................... 1545-2209
52.4682-1(b)(2)(iii)....................................... 1545-1153
52.4682-2(b)............................................... 1545-1153
1545-1361
52.4682-2(d)............................................... 1545-1153
1545-1361
52.4682-3(c)(2)............................................ 1545-1153
52.4682-3(g)............................................... 1545-1153
52.4682-4(f)............................................... 1545-0257
1545-1153
52.4682-5(d)............................................... 1545-1361
52.4682-5(f)............................................... 1545-1361
53.4940-1.................................................. 1545-0052
1545-0196
53.4942(a)-1............................................... 1545-0052
53.4942(a)-2............................................... 1545-0052
53.4942(a)-3............................................... 1545-0052
53.4942(b)-3............................................... 1545-0052
53.4945-1.................................................. 1545-0052
53.4945-4.................................................. 1545-0052
53.4945-5.................................................. 1545-0052
53.4945-6.................................................. 1545-0052
53.4947-1.................................................. 1545-0196
53.4947-2.................................................. 1545-0196
53.4948-1.................................................. 1545-0052
53.4958-6.................................................. 1545-1623
53.4961-2.................................................. 1545-0024
53.4963-1.................................................. 1545-0024
53.6001-1.................................................. 1545-0052
53.6011-1.................................................. 1545-0049
1545-0052
1545-0092
1545-0196
53.6060-1(a)(1)............................................ 1545-1231
53.6065-1.................................................. 1545-0052
53.6071-1.................................................. 1545-0049
53.6081-1.................................................. 1545-0066
[[Page 874]]
1545-0148
53.6107-1.................................................. 1545-1231
53.6161-1.................................................. 1545-0575
54.4975-7.................................................. 1545-0575
54.4977-1T................................................. 1545-0771
54.4980B-6................................................. 1545-1581
54.4980B-7................................................. 1545-1581
54.4980B-8................................................. 1545-1581
54.4980F-1................................................. 1545-1780
54.6011-1.................................................. 1545-0575
54.6011-1T................................................. 1545-0575
54.6060-1(a)(1)............................................ 1545-1231
54.6107-1.................................................. 1545-1231
54.9801-3.................................................. 1545-1537
54.9801-4.................................................. 1545-1537
54.9801-5.................................................. 1545-1537
54.9801-6.................................................. 1545-1537
54.9812-1T................................................. 1545-2165
54.9815-1251T.............................................. 1545-2178
54.9815-2711T.............................................. 1545-2179
54.9815-2712T.............................................. 1545-2180
54.9815-2714T.............................................. 1545-2172
54.9815-2715............................................... 1545-2229
54.9815-2719AT............................................. 1545-2181
54.9815-2719T.............................................. 1545-2182
55.6001-1.................................................. 1545-0123
55.6011-1.................................................. 1545-0123
1545-0999
1545-1016
55.6060-1(a)(1)............................................ 1545-1231
55.6061-1.................................................. 1545-0999
55.6071-1.................................................. 1545-0999
55.6107-1.................................................. 1545-1231
56.4911-6.................................................. 1545-0052
56.4911-7.................................................. 1545-0052
56.4911-9.................................................. 1545-0052
56.4911-10................................................. 1545-0052
56.6001-1.................................................. 1545-1049
56.6011-1.................................................. 1545-1049
56.6060-1(a)(1)............................................ 1545-1231
56.6081-1.................................................. 1545-1049
56.6107-1.................................................. 1545-1231
56.6161-1.................................................. 1545-0257
1545-1049
57.2(e)(2)(i).............................................. 1545-2249
145.4051-1................................................. 1545-0745
145.4052-1................................................. 1545-0120
1545-0745
1545-1076
145.4061-1................................................. 1545-0224
1545-0230
1545-0257
1545-0745
156.6001-1................................................. 1545-1049
156.6011-1................................................. 1545-1049
156.6060-1(a)(1)........................................... 1545-1231
156.6081-1................................................. 1545-1049
156.6107-1................................................. 1545-1231
156.6161-1................................................. 1545-1049
157.6001-1................................................. 1545-1824
157.6011-1................................................. 1545-1824
157.6060-1(a)(1)........................................... 1545-1231
157.6081-1................................................. 1545-1824
157.6107-1................................................. 1545-1231
157.6161-1................................................. 1545-1824
301.6011-2................................................. 1545-0225
1545-0350
1545-0387
1545-0441
1545-0957
301.6011(g)-1.............................................. 1545-2079
301.6017-1................................................. 1545-0090
301.6034-1................................................. 1545-0092
301.6036-1................................................. 1545-0013
1545-0773
301.6047-1................................................. 1545-0367
1545-0957
301.6056-1................................................. 1545-2251
301.6056-2................................................. 1545-2251
301.6057-1................................................. 1545-0710
301.6057-2................................................. 1545-0710
301.6058-1................................................. 1545-0710
301.6059-1................................................. 1545-0710
301.6103(c)-1.............................................. 1545-1816
301.6103(n)-1.............................................. 1545-1841
301.6103(p)(2)(B)-1........................................ 1545-1757
301.6104(a)-1.............................................. 1545-0495
301.6104(a)-5.............................................. 1545-0056
301.6104(a)-6.............................................. 1545-0056
301.6104(b)-1.............................................. 1545-0094
1545-0742
301.6104(d)-1.............................................. 1545-1655
301.6104(d)-2.............................................. 1545-1655
301.6104(d)-3.............................................. 1545-1655
301.6109-1................................................. 1545-0003
1545-0295
1545-0367
1545-0387
1545-0957
1545-1461
1545-2242
301.6109-3................................................. 1545-1564
301.6110-3................................................. 1545-0074
301.6110-5................................................. 1545-0074
301.6111-1T................................................ 1545-0865
1545-0881
301.6111-2................................................. 1545-0865
1545-1687
301.6112-1................................................. 1545-0865
1545-1686
301.6112-1T................................................ 1545-0865
1545-1686
301.6114-1................................................. 1545-1126
1545-1484
301.6222(a)-2.............................................. 1545-0790
301.6222(b)-1.............................................. 1545-0790
301.6222(b)-2.............................................. 1545-0790
301.6222(b)-3.............................................. 1545-0790
301.6223(b)-1.............................................. 1545-0790
301.6223(c)-1.............................................. 1545-0790
301.6223(e)-2.............................................. 1545-0790
301.6223(g)-1.............................................. 1545-0790
301.6223(h)-1.............................................. 1545-0790
301.6224(b)-1.............................................. 1545-0790
301.6224(c)-1.............................................. 1545-0790
301.6224(c)-3.............................................. 1545-0790
301.6227(c)-1.............................................. 1545-0790
301.6227(d)-1.............................................. 1545-0790
301.6229(b)-2.............................................. 1545-0790
301.6230(b)-1.............................................. 1545-0790
301.6230(e)-1.............................................. 1545-0790
301.6231(a)(1)-1........................................... 1545-0790
301.6231(a)(7)-1........................................... 1545-0790
301.6231(c)-1.............................................. 1545-0790
301.6231(c)-2.............................................. 1545-0790
301.6316-4................................................. 1545-0074
301.6316-5................................................. 1545-0074
301.6316-6................................................. 1545-0074
301.6316-7................................................. 1545-0029
301.6324A-1................................................ 1545-0015
301.6361-1................................................. 1545-0024
1545-0074
301.6361-2................................................. 1545-0024
301.6361-3................................................. 1545-0074
[[Page 875]]
301.6402-2................................................. 1545-0024
1545-0073
1545-0091
301.6402-3................................................. 1545-0055
1545-0073
1545-0091
1545-0132
1545-1484
301.6402-5................................................. 1545-0928
301.6404-1................................................. 1545-0024
301.6404-2T................................................ 1545-0024
301.6404-3................................................. 1545-0024
301.6405-1................................................. 1545-0024
301.6501(c)-1.............................................. 1545-1241
1545-1637
301.6501(d)-1.............................................. 1545-0074
1545-0430
301.6511(d)-1.............................................. 1545-0024
1545-0582
301.6511(d)-2.............................................. 1545-0024
1545-0582
301.6511(d)-3.............................................. 1545-0024
1545-0582
301.6652-2................................................. 1545-0092
301.6685-1................................................. 1545-0092
301.6689-1T................................................ 1545-1056
301.6707-1T................................................ 1545-0865
1545-0881
301.6708-1T................................................ 1545-0865
301.6712-1................................................. 1545-1126
301.6903-1................................................. 1545-0013
1545-1783
301.6905-1................................................. 1545-0074
301.7001-1................................................. 1545-0123
301.7101-1................................................. 1545-1029
301.7207-1................................................. 1545-0092
301.7216-2................................................. 1545-0074
301.7216-2(o).............................................. 1545-1209
301.7425-3................................................. 1545-0854
301.7430-2(c).............................................. 1545-1356
301.7502-1................................................. 1545-1899
301.7507-8................................................. 1545-0123
301.7507-9................................................. 1545-0123
301.7513-1................................................. 1545-0429
301.7517-1................................................. 1545-0015
301.7605-1................................................. 1545-0795
301.7623-1................................................. 1545-0409
1545-1534
301.7654-1................................................. 1545-0803
301.7701-3................................................. 1545-1486
301.7701-4................................................. 1545-1465
301.7701-7................................................. 1545-1600
301.7701-16................................................ 1545-0795
301.7701(b)-1.............................................. 1545-0089
301.7701(b)-2.............................................. 1545-0089
301.7701(b)-3.............................................. 1545-0089
301.7701(b)-4.............................................. 1545-0089
301.7701(b)-5.............................................. 1545-0089
301.7701(b)-6.............................................. 1545-0089
301.7701(b)-7.............................................. 1545-0089
1545-1126
301.7701(b)-9.............................................. 1545-0089
301.7705-1T................................................ 1545-2266
301.7705-2T................................................ 1545-2266
301.7805-1................................................. 1545-0805
301.9000-5................................................. 1545-1850
301.9001-1................................................. 1545-0220
301.9100-2................................................. 1545-1488
301.9100-3................................................. 1545-1488
301.9100-4T................................................ 1545-0016
1545-0042
1545-0074
1545-0129
1545-0172
1545-0619
301.9100-6T................................................ 1545-0872
301.9100-7T................................................ 1545-0982
301.9100-8................................................. 1545-1112
301.9100-11T............................................... 1545-0123
301.9100-12T............................................... 1545-0026
1545-0074
1545-0172
1545-1027
301.9100-14T............................................... 1545-0046
301.9100-15T............................................... 1545-0046
301.9100-16T............................................... 1545-0152
302.1-7.................................................... 1545-0024
305.7701-1................................................. 1545-0823
305.7871-1................................................. 1545-0823
420.0-1.................................................... 1545-0710
Part 509................................................... 1545-0846
Part 513................................................... 1545-0834
Part 514................................................... 1545-0845
Part 521................................................... 1545-0848
601.104.................................................... 1545-0233
601.105.................................................... 1545-0091
601.201.................................................... 1545-0019
1545-0819
601.204.................................................... 1545-0152
601.401.................................................... 1545-0257
601.504.................................................... 1545-0150
601.601.................................................... 1545-0800
601.602.................................................... 1545-0295
1545-0387
1545-0957
601.702.................................................... 1545-0429
------------------------------------------------------------------------
(26 U.S.C. 7805)
[T.D. 8011, 50 FR 10222, Mar. 14, 1985]
Editorial Note: For Federal Register citations affecting Sec.
602.101, see the List of CFR Sections Affected, which appears in the
Finding Aids section of the printed volume and at www.govinfo.gov.
[[Page 877]]
List of CFR Sections Affected
All changes in this volume of the Code of Federal Regulations (CFR) that
were made by documents published in the Federal Register since January
1, 2014 are enumerated in the following list. Entries indicate the
nature of the changes effected. Page numbers refer to Federal Register
pages. The user should consult the entries for chapters, parts and
subparts as well as sections for revisions.
For changes to this volume of the CFR prior to this listing, consult the
annual edition of the monthly List of CFR Sections Affected (LSA). The
LSA is available at www.govinfo.gov For changes to this volume of the
CFR prior to 2001, see the ``List of CFR Sections Affected, 1949-1963,
1964-1972, 1973-1985, and 1986-2000'' published in 11 separate volumes.
The ``List of CFR Sections Affected 1986-2000'' is available at
www.govinfo.gov.
2014
26 CFR
79 FR
Page
Chapter I
1.469-11 (b)(3)(iv)(C)(1) and (3) Example 4 correctly revised......18159
1.471-3 (e) and (g) added; undesignated text designated as (f)......2098
1.471-8 Revised....................................................48036
2015
26 CFR
80 FR
Page
Chapter I
1.446-3 (j) redesignated as (j)(1); (g)(4), (6) Examples 2, 3, 4
and new (j)(1) heading revised; (j)(2) and (k) added.......26440
(k) correctly removed..........................................34051
1.446-3T Added.....................................................26440
(j)(2) correctly revised.......................................61308
1.482-0 Amended....................................................55540
1.482-1 (f)(2)(i) and (ii)(B) revised; (j)(7) added................55541
1.482-1T Added.....................................................55541
2016
26 CFR
81 FR
Page
Chapter I
1.446-7 Added......................................................44512
2017
26 CFR
82 FR
Page
Chapter I
1.467-7 (c)(2) revised; (c)(4) amended..............................6238
1.467-9 Heading revised; (f) added..................................6238
2018
26 CFR
83 FR
Page
Chapter I
1.471-3 (b) revised................................................58498
2019
(Regulations published from January 1, 2019, through April 1, 2019)
26 CFR
84 FR
Page
Chapter I
1.441-1 (b)(2)(i)(A) removed........................................9234
1.453-4 Removed.....................................................9235
1.453-5 Removed.....................................................9235
1.453-6 Removed.....................................................9235
1.453-10 Removed....................................................9235
1.453A-0 Amended....................................................9235
1.453A-1 (a) amended................................................9235
1.453A-2 Removed....................................................9235
1.475-0 Amended.....................................................9235
1.475(b)-4 Removed..................................................9235
1.475(g)-1 (h) removed..............................................9235
[[Page 878]]
[all]