us-irs-revenue-rulings-irb-2004-6-pdf•Internal Revenue Bulletin 2004-6 (PDF rendition): IRS Revenue Rulings
Internal Revenue Bulletin 2004-6 (PDF rendition): IRS Revenue Rulings
us-irs-revenue-rulings-irb-2004-6-pdfInternal Revenue Bulletin 2004-6 (PDF rendition): IRS Revenue RulingsGuidance
Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing. Whole bulletin rendition: numbered items are identified below; other legal material and publisher context remain included. This is not a new standalone advance release.
Bulletin No. 200 4-6 February 9, 2004 HIGHLIGHTS OF THIS ISSUE These synopses are intended only as aids to the reader in identifying the subject matter covered. They may not be relied upon as authoritative interpretations. INCOME TAX Rev. Rul. 2004–9, page 428. Federal rates; adjusted federal rates; adjusted federal long-termrateandthelong-termexemptrate.For pur- poses of sections 382, 642, 1274, 1288, and other sections of the Code, tables set forth the rates for February 2004. T.D. 9104, page 406. Final regu lations under section 41 of the Code clarify the def- inition of qualified research contained in the credit for increas- ing resear ch activities. In addition, the regulations adopt the recordke eping requirements and the rules for excluded activi- ties as se t forth in the 2001 proposed regulations. T.D. 9105, page 419. REG–126459–03, page 437. Final, temporary, and proposed regulations under sections 167, 446, and 1016 of the Code provide rules for changes in determining depreciation or amortization. The regulations also provide guidance as to whether certain changes in depre- ciation or amortization are changes in methods of accounting. The regulations apply to changes made for taxable years ending on or after December 30, 2003. A public hearing on the proposed regulations is scheduled for April 7, 2004. T.D. 9108, page 429. Final regulations under section 6011 of the Code modify and clarify the rules relating to confidential transactions under reg- ulations section 1.6011–4(b)(3), and make minor conforming changes to the list maintenance rules under regulations section 301.6112–1. Notice 2004–11, page 434. This notice announces a pilot program that permits large and mid-size business taxpayers to enter into research credit recordkeeping agreements. Announcement 2004–9, page 441. This advance notice of proposed rulemaking (REG–153656–03) under section 41 of the Code in- vites comments relating to the definition of internal-use software contained in the credit for increasing research activities. In addition, the document provides guidance for taxpayers regarding the interim effective dates of the internal-use software rules. EMPLOYEE PLANS Rev. Rul. 2004–4, page 414. Employee stock ownership plans; S corporations; listed transactions.A finding of synthetic equity owned by a dis- qualified person in a nonallocation year of an ESOP, as those terms are defined in section 409(p) of the Code and regulations section 1.409(p)–1T, takes place in three distinct situations. In addition, the transactions described in this ruling, as well as substantially similar transactions, are designated as “listed transactions.” Notice 2004–10, page 433. Electronic delivery of Form 1099 and Form 5498 payee statements.This notice permits the electronic delivery of Form 1099–R, Form 1099–MSA, Form 1099–Q, Form 5498, Form 5498–ESA, and Form 5498–MSA payee statements by their respective due dates. (Continued on the next page) Announcements of Disbarments and Suspensions begin on page 439. Fi nding Lists begin on page ii. EXEMPT ORGANIZATIONS Notice 2004–10, page 433. Electronic delivery of Form 1099 and Form 5498 payee statements.This notice permits the electronic delivery of Form 1099–R, Form 1099–MSA, Form 1099–Q, Form 5498, Form 5498–ESA, and Form 5498–MSA payee statements by their respective due dates. ADMINISTRATIVE T.D. 9108, page 429. Final regulations under section 6011 of the Code modify and clarify the rules relating to confidential transactions under reg- ulations section 1.6011–4(b)(3), and make minor conforming changes to the list maintenance rules under regulations section 301.6112–1. Notice 2004–10, page 433. Electronic delivery of Form 1099 and Form 5498 payee statements.This notice permits the electronic delivery of Form 1099–R, Form 1099–MSA, Form 1099–Q, Form 5498, Form 5498–ESA, and Form 5498–MSA payee statements by their respective due dates. Announceme nt 2004–8, page 441. This announ cement corrects the user fee in Appendix A of Rev. Proc. 2004 –1 for a letter ruling request involving an extension of time to f ile Form 3115,Application for Change in Accounting Method.Th e correct user fee is $1,200, not $1,500. February 9, 20042004-6 I.R.B. The IRS Mission Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all. Introduction The Internal Revenue Bulletin is the authoritative instrument of the Commissioner of Internal Revenue for announcing official rulings and procedures of the Internal Revenue Service and for publishing Treasury Decisions, Executive Orders, Tax Conven- tions, legislation, court decisions, and other items of general interest. It is published weekly and may be obtained from the Superintendent of Documents on a subscription basis. Bul- letin contents are consolidated semiannually into Cumulative Bulletins, which are sold on a single-copy basis. It is the policy of the Service to publish in the Bulletin all sub- stantive rulings necessary to promote a uniform application of the tax laws, including all rulings that supersede, revoke, mod- ify, or amend any of those previously published in the Bulletin. All published rulings apply retroactively unless otherwise indi- cated. Procedures relating solely to matters of internal man- agement are not published; however, statements of internal practices and procedures that affect the rights and duties of taxpayers are published. Revenue rulings represent the conclusions of the Service on the application of the law to the pivotal facts stated in the revenue ruling. In those based on positions taken in rulings to taxpayers or technical advice to Service field offices, identifying details and information of a confidential nature are deleted to prevent unwarranted invasions of privacy and to comply with statutory requirements. Rulings and procedures reported in the Bulletin do not have the force and effect of Treasury Department Regulations, but they may be used as precedents. Unpublished rulings will not be relied on, used, or cited as precedents by Service personnel in the disposition of other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations, court decisions, rulings, and procedures must be considered, and Service personnel and others concerned are cautioned against reaching the same conclusions in other cases unless the facts and circumstances are substantially the same. The Bulletin is divided into four parts as follows: Part I.—19 86 Code. This part i ncludes rulings and decisions based on provisions of the Intern al Revenue Code of 1986. Part II.—Treaties and Tax Legislation. This part is divided into two subparts as follows: Subpart A, Tax Conventions and Other Related Items, and Subpart B, Leg- islation and Related Committee Reports. Part III.—Administrative, Procedural, and Miscellaneous. To the extent practicable, pertinent cross references to these subjects are contained in the other Parts and Subparts. Also included in this part are Bank Secrecy Act Administrative Rul- ings. Bank Secrecy Act Administrative Rulings are issued by the Department of the Treasury’s Office of the Assistant Sec- retary (Enforcement). Part IV .—Items of General Interest. This par t includes notices of proposed rulemakings, disbar- ment an d suspension lists, and announcements. The last Bulletin for each month includes a cumulative index for the matters published during the preceding months. These monthly indexes are cumulated on a semiannual basis, and are published in the last Bulletin of each semiannual period.* The c ontents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate. For sale by the Superintendent of Documents, U.S.Government Printing Office, Washington, DC 20402. * Beginning with Internal Revenue Bulletin 2003–43, we are publishing the index at the end of the month, rather than at the beginning. 2004-6 I.R.B.February 9, 2004 Part I. Rulings and Decisions Under the Internal Revenue Code of 1986 Section 41.—Credit for Increasing Research Activities 26 CFR 1.41–4: Qualified research for expenditures paid or incurred in taxable years ending on or after December 31, 2003. T.D. 9104 DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602 Credit for Increasing Research Activities AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: This document contains fi- nal regulations relating to the definition of qualified research under section 41(d) for the credit for increasing research activities. These final regulations reflect changes to section 41(d) made by the Tax Reform Act of 1986. DATES:Effective Dates: These regula- tions are effective January 2, 2004. Applicability Dates: For dates of appli- cability of these regulations, see §1.41–4 (e) and Effective Dates under SUPPLE- MENTARY INFORMATION. FOR FURTHER INFORMATION CONTACT: Nicole R. Cimino at (202) 622–3120 (not a toll-free number). SUPPLEMENTARY INFORMATION: Background On December 2, 1998, the Treasury De- partment and the IRS published in theFed- eral Registeranoticeofproposedrule- making (REG–105170–97, 1998–2 C.B. 729 [63 FR 66503]) under section 41 (1998 proposed regulations) relating to the credit for increasing research activities (research credit). The 1998 proposed regulations ad- dressed, in relevant part, (1) the definition of qualified research under section 41(d), (2) the application of the exclusions from the definition of qualified research, and (3) the application of the shrinking-back rule. Comments responding to the 1998 proposed regulations were received and a public hearing was held on April 29, 1999. On January 3, 2001, the Treasury De- partment and the IRS published in the Federal Registerfinal regulations re- lating, in relevant part, to the definition of qualified research under section 41(d) (T.D. 8930, 2001–1 C.B. 433 [66 FR 280]). In response to taxpayer concerns regarding T.D. 8930, on January 31, 2001, the Treasury Department and the IRS pub- lished Notice 2001–19, 2001–1 C.B. 784, announcing that the Treasury Department and the IRS would review T.D. 8930 and reconsider comments previously submit- ted in connection with the finalization of T.D. 8930. Notice 2001–19 also pro- vided that, upon the completion of the review, the Treasury Department and the IRS would announce changes to the reg- ulations, if any, in the form of proposed regulations. On December 26, 2001, the Treasury Department and the IRS published in the Federal Registera notice of proposed rulemaking (REG–112991–01, 2002–1 C. B. 404 [66 FR 66362]) reflecting the Treasury Department and the IRS’ review of T.D. 8930 (2001 proposed regulations). Comments responding to the 2001 pro- posed regulations were received and a public hearing was held on March 27, 2002. After considering the comments received and the statements made at the public hearing, portions of the 2001 pro- posed regulations are adopted as revised by this Treasury Decision. Explanation of Provisions This document amends 26 CFR part 1 to provide revised rules for the research credit under section 41. These final regula- tions generally retainthe provisions of the 2001 proposed regulations but clarify the provisions relating to the requirement in section 41(d)(1)(C) that qualified research be research “substantially all of the ac- tivities of which constitute elements of a process of experimentation.” These final regulations, however, do not contain final rules for research with respect to computer software “which is developed by (or for the benefit of) the taxpayer primarily for in- ternal use by the taxpayer” for purposes of section 41(d)(4)(E). Process of Experimentation—In General The Tax Reform Act of 1986, Public Law 99–514 (100 Stat. 2085) (the 1986 Act), which narrowed the definition of the termqualified research, amended the definition of qualified research by adding a process of experimentation requirement. Section 41(d)(1) provides that in order to constitute qualified research, substantially all of the activities of the research must constitute elements of a process of exper- imentation related to a new or improved function, performance, or reliability or quality. The legislative history to the 1986 Act explained that “[t]he determination of whether research is undertaken for the purpose of discovering information that is technological in nature depends on whether the process of experimenta- tion utilized in the research fundamentally relies on principles of the physical or bio- logical sciences, engineering, or computer science.” H.R. Conf. Rep. No. 99–841, at II–71 (1986). The legislative history further explained that the termprocess of experimentationmeans, “a process involving the evaluation of more than one alternative designed to achieve a re- sult where the means of achieving that result is uncertain at the outset.”Id.,at II–72. In addition, a process of experi- mentation may involve developing one or more hypotheses, testing and analyzing those hypotheses (through, for example, modeling or simulation), and refining or discarding the hypotheses as part of a sequential design process to develop the overall component.Id. The 1998 proposed regulations defined a process of experimentation as “a process to evaluate more than one alternative de- signed to achieve a result where the means of achieving that result are uncertain at the 2004-6 I.R.B.406February 9, 2004 outset.” Further, the 1998 proposed regu- lations specified that a process of exper- imentation is a four-step process requir- ing that the taxpayer: (i) develop one or more hypotheses designed to achieve the intended result; (ii) design a scientific ex- periment (that, where appropriate to the particular field of research, is intended to be replicable with an established experi- mental control) to test and analyze those hypotheses (through, for example, model- ing, simulation, or a systematic trial and error methodology); (iii) conduct the ex- periment and record the results; and (iv) refine or discard the hypotheses as part of a sequential design process to develop or improve the business component. Com- mentators generally objected to this pre- scribed four-step test arguing that it would not be appropriate for evaluating the qual- ification of certain commercial and indus- trial research activities. In response to these comments, the Treasury Department and the IRS in T.D. 8930 provided that taxpayers con- ducting a process of experimentation may, but were not required to, engage in the four-step process described in the 1998 proposed regulations, but eliminated, for this purpose, the specific recordation re- quirement. (As an addition to the general recordkeeping requirement under section 6001, T.D. 8930 instead included a con- temporaneous documentation requirement that was intended to be less burdensome than the specific recordation requirement. The contemporaneous documentation re- quirement in T.D. 8930 was eliminated in the 2001 proposed regulations.) Consis- tent with the legislative history, however, T.D. 8930 retained the underlying process of experimentation requirement in the 1998 proposed regulations by providing that a process of experimentation “is a process to evaluate more than one alter- native designed to achieve a result where the capability or method of achieving that result is uncertain at the outset.” The 2001 proposed regulations further clarified the definition of a process of ex- perimentation and provided, in relevant part, that “a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that re- sult, is uncertain as of the beginning of the taxpayer’s research activities.” More specifically, however, the general require- ment was modified in the 2001 proposed regulations to provide, first, that “a process of experimentation is a processdesigned to evaluateone or morealternatives to achieve a result.” (Emphasis added). The 2001 proposed regulations also provided that a process of experimentation may ex- ist if a taxpayer performs research to es- tablish the appropriate design of a busi- ness component even when the capabil- ity and method for developing or improv- ing the business component are not un- certain. The 2001 proposed regulations further stated that a taxpayer’s activities do not constitute elements of a process of experimentation where the capability and method of achieving the desired new or improved business component, and the ap- propriate design of the desired new or im- proved business component, are readily discernible and applicable as of the be- ginning of the taxpayer’s research activ- ities so that true experimentation in the scientific or laboratory sense would not have to be undertaken to test, analyze, and choose among viable alternatives. Fi- nally, the 2001 proposed regulations em- phasized that the determination of whether a taxpayer has engaged in a process of ex- perimentation was dependent on the facts and circumstances of the taxpayer’s re- search activities and, for this purpose, con- tained three non-dispositive and non-ex- clusive factors that tend to indicate that a taxpayer has engaged in a process of ex- perimentation. In response to the 2001 proposed reg- ulations, a number ofcommentators ex- pressed concern with the rules for the process of experimentation requirement, and, in particular, stated that the rules and terms used (includinguncertainty,appro- priate design,andreadily discernible and applicable) did not provide clear guidance for the requirement. More specifically, commentators stated that the termread- ily discernible and applicablewas highly subjective in nature, and thus arguably could be construed as a variant of the dis- covery test of T.D. 8930. In addition, one commentator expressed concern regard- ing the meaning and scope of the term uncertainand suggested adding examples illustrating the factors that tend to indicate that a taxpayer has engaged in a process of experimentation. Another commentator also noted that the 2001 proposed regula- tions appeared to allow the inclusion of all design costs as qualified research expen- ditures to the extent that the appropriate design of the desired result is never certain at the outset of the typical design process. The Treasury Department and the IRS continue to believe that the process of ex- perimentation test requires an evaluation of the facts and circumstances of a tax- payer’s research activities. As reflected by the changes made in the 2001 proposed regulations, this requirement is not in- tended to be inflexible or overly narrow. Nevertheless, the Treasury Department and the IRS continue to believe that the requirement in the 2001 proposed regu- lations that a process of experimentation is “aprocessdesigned to evaluate one or more alternativesto achieve a result” (emphasis added) implies that research activities must contain certain core el- ements in order to constitute a process of experimentation within the meaning of section 41(d)(1)(C). These final reg- ulations, therefore, make the following clarifications relating to the process of experimentation requirement in the 2001 proposed regulations. Process of Experimentation—Requirements The final regulations retain, but further clarify, the requirement in the 2001 pro- posed regulations that “a process of exper- imentation is a process designed to evalu- ate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activ- ities.” Further, the final regulations empha- size that the taxpayer’s activities must be directed at resolving uncertainty regarding the taxpayer’s development or improve- ment of a business component, and that the process of experimentation must fun- damentally rely on the principles of the physical or biological sciences, engineer- ing, or computer science in attempting to resolve the uncertainty. Although these concepts are stated explicitly in the 1986 legislative history and are implicit in the statute, they may not have been given ap- propriate or necessary weight in prior pro- posed or final guidance on the process of experimentation requirement. February 9, 20044072004-6 I.R.B. The final regulations, therefore, set out what the Treasury Department and the IRS have concluded to be the core ele- ments of a process of experimentation for purposes of the research credit. As noted above and consistent with the statute’s wording which requires purposeful activ- ity (i.e., “undertaken for the purpose of discovering information”), a taxpayer is required to identify the uncertainty regard- ing the development or improvement of a business component that is the object of the taxpayer’s research activities. A taxpayer is also required to identify one or more alternatives intended to eliminate that uncertainty. Additionally, a taxpayer is required to identify and to conduct a process of evaluating the alternatives. The final regulations provide that such a process may involve, for example, model- ing, simulation, or a systematic trial and error methodology. The final regulations further provide that a process of experimentation “mustbe an evaluative process and generallyshould be capable of evaluating more than one alternative.” (Emphasis added). Although the identification and evaluation of more than a single alternative is not required to satisfy the process of experimentation requirement, the Treasury Department and the IRS believe that a taxpayer’s activities, in order to qualify for the research credit, generally should be capable of evaluat- ing more than one alternative and, in any event, must be designed to evaluate the alternative, or alternatives, being consid- ered. The final regulations state that the mere existence of uncertainty regarding the de- velopment or improvement of a business component does not indicate that all of a taxpayer’s activitiesundertaken to achieve that new or improved business component constitute a process of experimentation, even if the taxpayer, in fact, does achieve the new or improved business component. The Treasury Department and the IRS believe that the inclusion of a separate process of experimentation requirement in the statute makes this proposition clear. However, the Treasury Department and the IRS have included this clarification in the final regulations out of concern that taxpayers have not been giving sufficient weight to the requirement that a taxpayer engage in a process designed to evaluate one or more alternatives to achieve a re- sult where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. In particular, this clarifica- tion is intended to indicate that merely demonstrating that uncertainty has been eliminated (e.g., the achievement of the appropriate design of a business compo- nent when such design was uncertain as of the beginning of a taxpayer’s activities) is insufficient to satisfy the process of experimentation requirement. A taxpayer bears the burden of demonstrating that its research activities additionally satisfy the process of experimentation requirement. As noted above, all of the facts and circumstances of a taxpayer’s research activities are taken into account to de- termine whether the taxpayer identified uncertainty concerning the development or improvement of a business component, identified one or more alternatives in- tended to eliminate that uncertainty, and identified and conducted a process of eval- uating the alternatives. Although the final regulations set out the core elements of a process of experimentation, how a tax- payer’s qualified research activities will reflect these core elements will depend on the facts and circumstances. These core elements will not necessarily occur in a strict, sequential order. A process of ex- perimentation is an evaluative process, and as such, often involves refining through- out much of the process the taxpayer’s understanding of the uncertainty the tax- payer is trying to address, modifying the alternatives being evaluated to eliminate that uncertainty, or modifying the process used to evaluate those alternatives. Accordingly, the final regulations do not provide detailed guidance as to how the regulatory provisions are to be applied to a given factual situation. Rather, the Trea- sury Department and the IRS have con- cluded that the application of these pro- visions will depend on the specific activ- ities being claimed by a taxpayer as quali- fied research, the nature of the taxpayer’s business and industry, and the uncertain- ties being addressed by the taxpayer’s re- search activities. The Treasury Depart- ment and the IRS believe that additional, industry-specific guidance may be appro- priate and request comments on the form of such guidance. The final regulations do not include the rule contained in the 2001 proposed regulations that a taxpayer’s activities do not constitute a process of experimentation where the capability and method of achiev- ing the desired new or improved business component, and the appropriate design of the desired new or improved business component, are readily discernible and applicable as of the beginning of the tax- payer’s research activities. A number of commentators expressed concern that this rule was too vague and susceptible to conflicting interpretations. In light of the clarifications made in these final regu- lations, the Treasury Department and the IRS have concluded that this rule is no longer necessary because such activities do not constitute a process of experimen- tation under the final regulations. As noted above, the 2001 proposed reg- ulations do not contain a specific record- keeping requirement beyond the require- ments set out in section 6001 and the reg- ulations thereunder. No change regarding recordkeeping is being made in these fi- nal regulations. The clarifications being made to the process of experimentation re- quirement do not impose any recordkeep- ing requirement on taxpayers beyond the requirements set out in section 6001 and the regulations thereunder. Process of Experimentation—Substantially all Requirement The 2001 proposed regulations retained the rule in T.D. 8930 that the “substantially all” requirement of section 41(d)(1)(C) is satisfiedonlyif80percentormoreofthe research activities, measured on a cost or other consistently applied reasonable ba- sis (and without regard to §1.41–2(d)(2)), constitute elements of a process of exper- imentation for a purpose described in sec- tion 41(d)(3). This requirement is applied separately to each business component. The Treasury Department and the IRS requested comments on the application of the substantially all rule and, in partic- ular, whether research expenses incurred for non-qualified purposes (i.e., relating to style, taste, cosmetic, or seasonal design factors) are includible in the credit compu- tation provided that substantially all of the research activities constitute elements of a process of experimentation for a qualified 2004-6 I.R.B.408February 9, 2004 purpose. After consideration of the com- ments received, the Treasury Department and the IRS have concluded that the sub- stantially all requirement can be satisfied even if some portion of a taxpayer’s activ- ities are not for a qualified purpose. Accordingly, these final regulations clarify the substantially all rule and pro- vide that the substantially all require- ment is satisfied if 20 percent or less of a taxpayer’s research activities do not constitute elements of a process of ex- perimentation for a purpose described in section 41(d)(3), so long as these remain- ing activities satisfy the requirements of section 41(d)(1)(A) and are not otherwise excluded under section 41(d)(4). Example (6) of §1.41–4(a)(8) of the 2001 proposed regulations has been modified to illustrate the application of this rule, and appears as example (4) in these final regulations. Other Issues Patent Safe Harbor Section 1.41–4(a)(3)(iii) of the 2001 proposed regulations generally provided that the issuance of certain patents is conclusive evidence that a taxpayer has discovered information that is technologi- cal in nature that is intended to eliminate uncertainty concerning the development or improvement of a business compo- nent. Some commentators requested that this patent safe harbor be expanded to cover all requirements contained in sec- tions 41(d)(1) and (3). After consideration of these comments, and in light of the clarifications being made in these final regulations to the provisions relating to the process of experimentation require- ment, the Treasury Department and the IRS continue to believe that the patent safe harbor is appropriately limited and, therefore, have not changed the patent safe harbor provision. Shrinking-Back Rule Some commentators expressed concern that the language of the shrinking-back rule in §1.41–4(b)(2) of the 2001 proposed regulations implied that not all of a tax- payer’s qualified research expenses would be eligible for the research credit as a re- sult of the application of the rule. This provisionhasbeenrevisedinthesefinal regulations to clarify that the rule is not intended to exclude qualified research ex- penses from the credit, but rather is in- tended to ensure that expenses attributable to qualified research activities are eligible for the research credit for purposes of sec- tion 41(d)(1). Research After Commercial Production Some commentators requested addi- tional clarification regarding the scope of the research after commercial production, adaptation, and duplication exclusions set out in section 41(d)(4)(A), (B) and (C), and §1.41–4(c)(2), (3) and (4) of the 2001 proposed regulations. After consid- eration of these comments, the Treasury Department and the IRS believe that the multitude of factual situations to which these exclusions might apply make it im- practical to provide additional clarification that is both meaningful and of broad appli- cation. The Treasury Department and the IRS believe these three specific exclusions do not cover research activities that other- wise satisfy the requirements for qualified research. Taxpayers, however, should carefully review (including, as appropri- ate, the application of the shrinking-back rule) research activities that might other- wise fall within these exclusions to ensure that only eligible activities are being in- cluded in their credit computations. One commentator expressed concern that the language of §1.41–4(c)(2)(iv), re- lating to the clinical testing of pharmaceu- tical products, could exclude from credit eligibility clinical trials performed under an arrangement where the Food and Drug Administration has granted conditional approval for a pharmaceutical product contingent upon the results of additional clinical trials. Another commentator ex- pressed concern that the language would exclude otherwise qualifying activities because the research was not required to be approved by the Food and Drug Ad- ministration. Section 1.41–4(c)(2)(iv) is not a rule of exclusion. As stated above, the Treasury Department and the IRS be- lieve that the research after commercial production exclusion (as well as the adap- tation and duplication exclusions) do not cover research activities, including these additional clinical trials, so long as such trials satisfy the requirements for qualified research. Gross Receipts These final regulations retain the broad definition of gross receipts contained in T.D. 8930. In response to Notice 2001–19, a number of commentators reiterated ear- lier comments that this definition was overly broad. As stated in the preamble to the 2001 proposed regulations, the Trea- sury Department and the IRS continue to believe that the definition of gross re- ceipts should be construed broadly, and, accordingly, no change has been made in these final regulations to the definition contained in T.D. 8930. Examples The examples in the regulations have been changed to remove references to “readily discernible and applicable.” While the Treasury Department and the IRS continue to believe that the activities inExamples 4and5of §1.41–4(a)(8) of the 2001 proposed regulations would not qualify under the final regulations, these examples were removed as the only pur- pose of these examples was to illustrate the “readily discernable and applicable” standard. Minor changes to the facts in Example 4of §1.41–4(a)(8) in the final regulations (Example 6of §1.41–4(a)(8) of the 2001 proposed regulations) were made to illustrate more clearly the application of the substantially all requirement of §1.41–4(a)(6). These changes do not indi- cate that the Treasury Department and the IRS believe that the integration activities removed from the example, as contained in the 2001 proposed regulations, are or are not qualified activities standing alone. The determination of whether activities are qualified research is based on the specific facts and circumstances of those activities. Additionally, minor changes were made to the examples in §1.41–4(c)(10) to re- move references to “readily discernable and applicable” and to make some clarifi- cations based on comments received.Ex- ample 1of §1.41–4(c)(10) was modified to remove the conclusion regarding qualifi- cation of expenses under section 174. Al- though the Treasury Department and the IRS continue to believe that the conclu- sion in the 2001 proposed regulations is correct, the Treasury Department and the IRS believe that the point illustrated in the removed portion of the example would be February 9, 20044092004-6 I.R.B. more appropriately addressed in guidance issued under section 174, rather than in guidance under section 41. Effective Date Notice 2001–19 stated, in relevant part, that the provisions of T.D. 8930, includ- ing any changes to T.D. 8930, would be effective no earlier than the date when the completion of the Treasury Department and the IRS’ review of T.D. 8930 was announced. The 2001 proposed regula- tions provided, in relevant part, that final regulations would apply to taxable years ending on or after December 26, 2001, the date the proposed regulations were published in theFederal Register. Because these finalregulations only clarify the provisions of the 2001 pro- posed regulations, these final regulations apply to taxable years ending on or af- ter December 31, 2003. For taxable years ending before December 31, 2003, the IRS will not challenge return positions that are consistent with these final regulations. Special Analyses It has been determined that these reg- ulations are not a significant regulatory action as defined in Executive Order 12866. It also has been determined that section 553(b) of the Administrative Pro- cedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because these regulations do not impose a col- lection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Act Analysis is not required. Pursuant to section 7805(f), the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Drafting Information The principal author of these regula- tions is Nicole R. Cimino of the Office of Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, personnel from other offices of the IRS and the Treasury Department participated in their development. ***** Adoption of Amendments to the Regulations Accordingly, 26 CFR parts 1 and 602 are amended as follows: PART I—INCOME TAXES Paragraph 1. The authority for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.41–0 is amended by revising the entries for §1.41–4 to read as follows: The revisions and additions read as fol- lows: §1.41–0 Table of contents. ***** §1.41–4 Qualified research for expenditures paid or incurred in taxable years ending on or after December 31, 2003. (a) Qualified research. (1) General rule. (2) Requirements of section 41(d)(1). (3) Undertaken for the purpose of discov- ering information. (i) In general. (ii) Application of the discovering infor- mation requirement. (iii) Patent safe harbor. (4) Technological in nature. (5) Process of experimentation. (i) In general. (ii) Qualified purpose. (6) Substantiallyall requirement. (7) Use of computers and information technology. (8) Illustrations. (b) Application of requirements for quali- fied research. (1) In general. (2) Shrinking-back rule. (3) Illustration. (c) Excluded activities. (1) In general. (2) Research after commercial production. (i) In general. (ii) Certain additional activities related to the business component. (iii) Activities related to production process or technique. (iv) Clinical testing. (3) Adaptation of existing business com- ponents. (4) Duplication of existing business com- ponent. (5) Surveys, studies, research relating to management functions, etc. (6) Internal use software for taxable years beginning on or after December 31, 1985. [Reserved]. (7) Activities outside the United States, Puerto Rico, and other possessions. (i) In general. (ii) Apportionment of in-house research expenses. (iii) Apportionment of contract research expenses. (8) Research in the social sciences, etc. (9) Research funded by any grant, contract, or otherwise. (10) Illustrations. (d) Recordkeeping for the research credit. (e) Effective dates. ***** Par. 3. Section 1.41–4 is amended as follows: 1. The section heading and paragraphs (a)(2)(iii), (a)(3), (a)(4), (a)(5), (a)(6), (a)(8), (b)(2), (b)(3), (c)(2)(iv), (c)(4), (c)(7)(ii), (c)(10), (d), and (e) are revised. 2. The heading of paragraph (c)(6) is re- vised and the text is removed and reserved. The revisions read as follows: §1.41–4 Qualified r esearch for expenditures paid o r incurred in taxable years ending on or a fter December 31, 2003. (a) * * * (2) * * * (iii) Substantially all of the activities of which constitute elements of a process of experimentation that relates to a qualified purpose. (3)Undertaken for the purpose of dis- covering information—(i)In general.For purposes of section 41(d) and this sec- tion, research must be undertaken for the purpose of discovering information that is technological in nature. Research is under- taken for the purpose of discovering infor- mation if it is intended to eliminate uncer- tainty concerning the development or im- provement of a business component. Un- certainty exists if the information available to the taxpayer does not establish the capa- bility or method for developing or improv- ing the business component, or the appro- priate design of the business component. 2004-6 I.R.B.410February 9, 2004 (ii)Application of the discovering in- formation requirement. A determination that research is undertaken for the purpose of discovering information that is techno- logical in nature doesnot require the tax- payer be seeking to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in the particular field of science or engineering in which the taxpayer is performing the re- search. In addition, a determination that research is undertaken for the purpose of discovering information that is technolog- ical in nature does not require that the tax- payer succeed in developing a new or im- proved business component. (iii)Patent safe harbor. For purposes of section 41(d) and paragraph (a)(3)(i) of this section, the issuance of a patent by the Patent and Trademark Office under the provisions of 35 U.S.C. 151 (other than a patent for design issued under the provi- sions of 35 U.S.C. 171) is conclusive evi- dence that a taxpayer has discovered infor- mation that is technological in nature that is intended to eliminate uncertainty con- cerning the development or improvement of a business component. However, the is- suance of such a patent is not a precondi- tion for credit availability. (4)Technological in nature. For pur- poses of section 41(d) and this section, information is technological in nature if the process of experimentation used to dis- cover such information fundamentally re- lies on principles of the physical or bio- logical sciences, engineering, or computer science. A taxpayer may employ exist- ing technologies and may rely on existing principles of the physical or biological sci- ences, engineering, or computer science to satisfy this requirement. (5)Process of experimentation—(i)In general. For purposes of section 41(d) and this section, a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the begin- ning of the taxpayer’s research activities. A process of experimentation must fun- damentally rely on the principles of the physical or biological sciences, engineer- ing, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to elimi- nate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology). A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative. A taxpayer may undertake a process of experimentation if there is no uncertainty concerning the taxpayer’s capability or method of achieving the desired result so long as the appropriate design of the desired result is uncertain as of the begin- ning of the taxpayer’s research activities. Uncertainty concerning the development or improvement of the business compo- nent (e.g., its appropriate design) does not establish that all activities undertaken to achieve that new or improved business component constitute a process of experi- mentation. (ii)Qualified purpose. For purposes of section 41(d) and this section, a process of experimentation is undertaken for a qual- ified purpose if it relates to a new or im- proved function, performance, reliability or quality of the business component. Re- search will not be treated as conducted for a qualified purpose if it relates to style, taste, cosmetic, or seasonal design factors. (6)Substantially all requirement.In order for activities to constitute qualified research under section 41(d)(1), substan- tially all of the activities must constitute elements of a process of experimentation that relates to a qualified purpose. The substantially all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is satisfied only if 80 percent or more of a taxpayer’s research activities, measured on a cost or other consistently applied reasonablebasis (and without regard to §1.41–2(d)(2)), constitute ele- ments of a process of experimentation for a purpose described in section 41(d)(3). Accordingly, if 80 percent (or more) of a taxpayer’s research activities with respect to a business component constitute ele- ments of a process of experimentation for a purpose described in section 41(d)(3), the substantially all requirement is satis- fied even if the remaining 20 percent (or less) of a taxpayer’s research activities with respect to the business component do not constitute elements of a process of experimentation for a purpose described in section 41(d)(3), so long as these re- maining research activities satisfy the requirements of section 41(d)(1)(A) and are not otherwise excluded under section 41(d)(4). The substantially all requirement is applied separately to each business com- ponent. ***** (8)Illustrations. The following exam- ples illustrate the application of paragraph (a)(5) of this section: Example 1.(i)Facts. X is engaged in the business of developing and manufacturing widgets. X wants to change the color of its blue widget to green. X ob- tains from various suppliers several different shades of green paint. X paints several sample widgets, and surveys X’s customers to determine which shade of green X’s customers prefer. (ii)Conclusion. X’s activities to change the color of its blue widget to green are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section because substantially all of X’s activities are not undertaken for a qualified purpose. All of X’s research activities are related to style, taste, cosmetic, or seasonal design factors. Example 2.(i)Facts. The facts are the same as inExample 1, except that X chooses one of the green paints. X obtains samples of the green paint from a supplier and determines that X must modify its painting process to accommodate the green paint because the green paint has different characteristics from other paints X has used. X obtains detailed data on the green paint from X’s paint supplier. X also consults with the manufacturer of X’s paint spraying machines. The manufacturer informs X that X must acquire a new nozzle that operates with the green paint X wants to use. X tests the nozzles to ensure that they work as specified by the manufacturer of the paint spraying machines. (ii)Conclusion. X’s activities to modify its paint- ing process are a separate business component un- der section 41(d)(2)(A). X’s activities to modify its painting process to change the color of its blue wid- get to green are not qualified research under section 41(d)(1) and paragraph (a)(5) of this section. X did not conduct a process of evaluating alternatives in or- der to eliminate uncertainty regarding the modifica- tion of its painting process. Rather, the manufacturer of the paint machines eliminated X’s uncertainty re- garding the modification of its painting process. X’s activities to test the nozzles to determine if the noz- zles work as specified by the manufacturer of the paint spraying machines are in the nature of routine or ordinary testing or inspection for quality control. Example 3.(i)Facts. X is engaged in the busi- ness of manufacturing food products and currently manufactures a large-shred version of a product. X seeks to modify its current production line to per- mit it to manufacture both alarge-shred version and a fine-shred version of one of its food products. A smaller, thinner shredding blade capable of produc- ing a fine-shred version of the food product, how- ever, is not commerciallyavailable. Thus, X must develop a new shredding blade that can be fitted onto its current production line. X is uncertain concerning the design of the new shredding blade, because the material used in its existing blade breaks when ma- February 9, 20044112004-6 I.R.B. chined into smaller, thinner blades. X engages in a systematic trial and error process of analyzing various blade designs and materials to determine whether the new shredding blade must be constructed of a differ- ent material from that of its existing shredding blade and, if so, what material will best meet X’s functional requirements. (ii)Conclusion. X’s activities to modify its cur- rent production line by developing the new shredding blade meet the requirements of qualified research as set forth in paragraph (a)(2) of this section. Sub- stantially all of X’s activities constitute elements of a process of experimentation because X evaluated al- ternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of the taxpayer’s research activities. X identified uncertain- ties related to the development of a business compo- nent, and identified alternatives intended to eliminate these uncertainties. Furthermore, X’s process of eval- uating identified alternatives was technological in na- ture, and was undertaken to eliminate the uncertain- ties. Example 4.(i)Facts. X is in the business of de- signing, developing and manufacturing automobiles. In response to government-mandated fuel economy requirements, X seeks to update its current model vehicle and undertakes to improve aerodynamics by lowering the hood of its current model vehicle. X de- termines, however, that lowering the hood changes the air flow under the hood, which changes the rate at which air enters the engine through the air intake sys- tem, and which reduces the functionality of the cool- ing system. X’s engineers are uncertain how to de- sign a lower hood to obtain the increased fuel econ- omy, while maintaining the necessary air flow un- der the hood. X designs, models, simulates, tests, refines, and re-tests several alternative designs for the hood and associated proposed modifications to both the air intake system and cooling system. This process enables X to eliminate the uncertainties re- lated to the integrated design of the hood, air intake system, and cooling system, and such activities con- stitute eighty-five percent of X’s total activities to up- date its current model vehicle. X then engages in additional activities that do not involve a process of evaluating alternatives in order to eliminate uncer- tainties. The additional activities constitute only fif- teen percent of X’s total activities to update its current model vehicle. (ii)Conclusion. In general, if eighty percent or more of a taxpayer’s research activities measured on a cost or other consistently applied reasonable basis constitute elements of a process of experimentation for a qualified purpose under section 41(d)(3)(A) and paragraph (a)(5)(ii) of this section, then the substantially all requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is satisfied. Substantially all of X’s activities constitute elements of a process of experimentation because X evaluated alternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of X’s research activities. X identified uncertainties related to the improvement of a business component and identified alternatives intended to eliminate these uncertainties. Furthermore, X’s process of evaluat- ing the identified alternatives was technological in nature and was undertaken to eliminate the uncer- tainties. Because substantially all (in this example, eighty-five percent) of X’s activities to update its cur- rent model vehicle constitute elements of a process of experimentation for a qualified purpose described in section 41(d)(3)(A), all of X’s activities to update its current model vehicle meet the requirements of qual- ifiedresearchassetforthinparagraph(a)(2)ofthis section, provided that X’s remaining activities (in this example, fifteen percent of X’s total activities) satisfy the requirements of section 41(d)(1)(A) and are not otherwise excluded under section 41(d)(4). (b)* * * (2)Shrinking-back rule. The require- ments of section 41(d) and paragraph (a) of this section are to be applied first at the level of the discrete business compo- nent, that is, the product, process, com- puter software, technique, formula, or in- vention to be held for sale, lease, or li- cense,orusedbythetaxpayerinatradeor business of the taxpayer. If these require- ments are not met at that level, then they apply at the most significant subset of el- ements of the product, process, computer software, technique, formula, or invention to be held for sale, lease, or license. This shrinking back of the product is to con- tinue until either a subset of elements of the product that satisfies the requirements is reached, or the most basic element of the product is reached and such element fails to satisfy the test. This shrinking-back rule is applied only if a taxpayer does not sat- isfy the requirements of section 41(d)(1) and paragraph (a)(2) of this section with respect to the overall business component. The shrinking-back rule is not itself ap- plied as a reason to exclude research ac- tivities from credit eligibility. (3)Illustration. The following example illustrates the application of this paragraph (b): Example. X, a motorcycle engine builder, devel- ops a new carburetor for use in a motorcycle engine. X also modifies an existing engine design for use with the new carburetor. Under the shrinking-back rule, the requirements of section 41(d)(1) and paragraph (a) of this section are applied first to the engine. If the modifications to the engine when viewed as a whole, including the development of the new carburetor, do not satisfy the requirements of section 41(d)(1) and paragraph (a) of this section, those requirements are applied to the next most significant subset of elements of the business component. Assuming that the next most significant subset of elements of the engine is the carburetor, the research activities in developing the new carburetor may constitute qualified research within the meaning of section 41(d)(1) and paragraph (a)ofthissection. (c) * * * (2) * * * (iv)Clinical testing. Clinical testing of a pharmaceutical product prior to its com- mercial production in the United States is not treated as occurring after the begin- ning of commercial production even if the product is commercially available in other countries. Additional clinical testing of a pharmaceutical product after a product has been approved for a specific therapeu- tic use by the Food and Drug Administra- tion and is ready for commercial produc- tion and sale is not treated as occurring af- ter the beginning of commercial produc- tion if such clinical testing is undertaken to establish new functional uses, character- istics, indications, combinations, dosages, or delivery forms for the product. A func- tional use, characteristic, indication, com- bination, dosage, or delivery form shall be considered new only if such functional use, characteristic,indication, combina- tion, dosage, or delivery form must be ap- proved by the Food and Drug Administra- tion. ***** (4)Duplication of existing business component. Activities relating to repro- ducing an existing business component (in whole or in part) from a physical exam- ination of the business component itself or from plans, blueprints, detailed specifi- cations, or publicly available information about the business component are not qualified research. This exclusion does not apply merely because the taxpayer ex- amines an existing business component in the course of developing its own business component. ***** (6)Internal use software for taxable years beginning on or after December 31, 1985.[Reserved]. (7) * * * (ii)Apportionment of in-house research expenses. In-house research expenses paid or incurred for qualified services performed both in the United States, the Commonwealth of Puerto Rico and other possessions of the United States and out- side the United States, the Commonwealth of Puerto Rico and other possessions of the United States must be apportioned be- tween the services performed in the United States, the Commonwealth of Puerto Rico and other possessions of the United States and the services performed outside the United States, the Commonwealth of 2004-6 I.R.B.412February 9, 2004 Puerto Rico and other possessions of the United States. Only those in-house research expenses apportioned to the ser- vices performed within the United States, the Commonwealth of Puerto Rico and other possessions of the United States are eligible to be treated as qualified research expenses, unless the in-house research ex- penses are wages and the 80 percent rule of §1.41–2(d)(2) applies. ***** (10)Illustrations. The following exam- ples illustrate provisions contained in para- graphs (c)(1) through (9) (excepting para- graphs (c)(6) of this section) of this sec- tion. No inference should be drawn from these examples concerning the application of section 41(d)(1) and paragraph (a) of this section to these facts. The examples are as follows: Example 1.(i)Facts. X, a tire manufacturer, de- velops a new material to use in its tires. X conducts research to determine the changes that will be neces- sary for X to modify its existing manufacturing pro- cesses to manufacture the new tire. X determines that the new tire material retains heat for a longer period of time than the materials X currently uses for tires, and, as a result, the new tire material adheres to the man- ufacturing equipment during tread cooling. X eval- uates several alternatives for processing the treads at cooler temperatures to address this problem, includ- ing a new type of belt for its manufacturing equip- ment to be used in tread cooling. Such a belt is not commercially available. Because X is uncertain of the belt design, X develops and conducts sophisti- cated engineering tests on several alternative designs for a new type of belt to be used in tread cooling until X successfully achieves a design that meets X’s re- quirements. X then manufactures a set of belts for its production equipment, installs the belts, and tests the belts to make sure they were manufactured correctly. (ii)Conclusion. X’s research with respect to the design of the new belts to be used in its manufacturing of the new tire may be qualified research under sec- tion 41(d)(1) and paragraph (a) of this section. How- ever, X’s expenses to implement the new belts, in- cluding the costs to manufacture, install, and test the belts were incurred after the belts met the taxpayer’s functional and economic requirements and are ex- cluded as research after commercial production un- der section 41(d)(4)(A) and paragraph (c)(2) of this section. Example 2.(i)Facts. For several years, X has manufactured and sold a particular kind of widget. X initiates a new research project to develop a new or improved widget. (ii)Conclusion. X’s activities to develop a new or improved widget are not excluded from the defini- tion of qualified research under section 41(d)(4)(A) and paragraph (c)(2) of this section. X’s activities re- lating to the development of a new or improved wid- get constitute a new research project to develop a new business component. X’s research activities relating to the development of the new or improved widget, a new business component, are not considered to be ac- tivities conducted after the beginning of commercial production under section 41(d)(4)(A) and paragraph (c)(2) of this section. Example 3.(i)Facts. X, a computer software de- velopment firm, owns all substantial rights in a gen- eral ledger accounting software core program that X markets and licenses to customers. X incurs expen- ditures in adapting the core software program to the requirements of C, one of X’s customers. (ii)Conclusion. Because X’s activities represent activities to adapt an existing software program to a particular customer’s requirement or need, X’s activ- ities are excluded from the definition of qualified re- search under section 41(d)(4)(B) and paragraph (c)(3) of this section. Example 4.(i)Facts.Thefactsarethesameas inExample 3, except that C pays X to adapt the core software program to C’s requirements. (ii)Conclusion. Because X’s activities are ex- cluded from the definition of qualified research un- der section 41(d)(4)(B) and paragraph (c)(3) of this section, C’s payments to X are not for qualified re- search and are not considered to be contract research expenses under section 41(b)(3)(A). Example 5.(i)Facts. The facts are the same as in Example 3, except that C’s own employees adapt the core software program to C’s requirements. (ii)Conclusion. Because C’s employees’ activ- ities to adapt the core software program to C’s re- quirements are excluded from the definition of qual- ified research under section 41(d)(4)(B) and para- graph (c)(3) of this section, the wages C paid to its employees do not constitute in-house research ex- penses under section 41(b)(2)(A). Example 6.(i)Facts. X manufacturers and sells rail cars. Because rail cars have numerous specifi- cations related to performance, reliability and qual- ity, rail car designs are subject to extensive, complex testing in the scientific or laboratory sense. B orders passenger rail cars from X. B’s rail car requirements differ from those of X’s other existing customers only in that B wants fewer seats in its passenger cars and a higher quality seating material and carpet that are commercially available. X manufactures rail cars meeting B’s requirements. (ii)Conclusion. X’s activities to manufacture rail cars for B are excluded from the definition of qualified research. The rail car sold to B was not a new business component, but merely an adapta- tion of an existing business component that did not require a process of experimentation. Thus, X’s activities to manufacture rail cars for B are excluded from the definition of qualified research under sec- tion 41(d)(4)(B) and paragraph (c)(3) of this section because X’s activities represent activities to adapt an existing business component to a particular cus- tomer’s requirement or need. Example 7.(i)Facts. X, a manufacturer, un- dertakes to create a manufacturing process for a new valve design. X determines that it requires a special- ized type of robotic equipment to use in the manufac- turing process for its new valves. Such robotic equip- ment is not commercially available, and X, therefore, purchases the existing robotic equipment for the pur- pose of modifying it to meet its needs. X’s engineers identify uncertainty that is technological in nature concerning how to modify the existing robotic equip- ment to meet its needs. X’s engineers develop sev- eral alternative designs, and conduct experiments us- ing modeling and simulation in modifying the robotic equipment and conduct extensive scientific and lab- oratory testing of design alternatives. As a result of this process, X’s engineers develop a design for the robotic equipment that meets X’s needs. X constructs and installs the modified robotic equipment on its manufacturing process. (ii)Conclusion. X’s research activities to de- termine how to modify X’s robotic equipment for its manufacturing process are not excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of this section, provided that X’s research activities satisfy the re- quirements of section 41(d)(1). Example 8.(i)Facts. An existing gasoline ad- ditive is manufactured by Y using three ingredients, A, B, and C. X seeks to develop and manufacture its own gasoline additive that appears and functions in a manner similar to Y’s additive. To develop its own additive, X first inspects the composition of Y’s addi- tive, and uses knowledge gained from the inspection to reproduce A and B in the laboratory. Any differ- ences between ingredients A and B that are used in Y’s additive and those reproduced by X are insignif- icant and are not material to the viability, effective- ness, or cost of A and B. X desires to use with A and B an ingredient that has a materially lower cost than ingredient C. Accordingly, X engages in a process of experimentation to develop, analyze and test poten- tial alternative formulations of the additive. (ii)Conclusion. X’s activities in analyzing and reproducing ingredients A and B involve duplication of existing business components and are excluded from the definition of qualified research under section 41(d)(4)(C) and paragraph (c)(4) of this section. X’s experimentation activities to develop potential alter- native formulations of the additive do not involve du- plication of an existing business component and are not excluded from the definition of qualified research under section 41(d)(4)(C) and paragraph (c)(4) of this section. Example 9.(i)Facts. X,amanufacturingcor- poration, undertakes to restructure its manufacturing organization. X organizes a team to design an organi- zational structure that will improve X’s business op- erations. The team includes X’s employees as well as outside management consultants. The team stud- ies current operations, interviews X’s employees, and studies the structure of other manufacturing facilities to determine appropriate modifications to X’s current business operations. The team develops a recommen- dation of proposed modifications which it presents to X’s management. X’s management approves the team’s recommendation and begins to implement the proposed modifications. (ii)Conclusion. X’s activities in developing and implementing the new management structure are ex- cluded from the definition of qualified research un- der section 41(d)(4)(D) and paragraph (c)(5) of this section. Qualified research does not include activi- ties relating to management functions or techniques including management organization plans and man- agement-based changes in production processes. Example 10.(i)Facts. X, an insurance company, develops a new life insurance product. In the course of developing the product, X engages in research with respect to the effect of pricing and tax consequences on demand for the product, the expected volatility of February 9, 20044132004-6 I.R.B. interest rates, and the expected mortality rates (based on published data and prior insurance claims). (ii)Conclusion. X’s activities related to the new product represent researchin the social sciences (in- cluding economics and business management) and are thus excluded from the definition of qualified research under section 41(d)(4)(G) and paragraph (c)(8) of this section. (d)Recordkeeping for the research credit. A taxpayer claiming a credit un- der section 41 must retain records in sufficiently usable form and detail to sub- stantiate that the expenditures claimed are eligible for the credit. For the rules gov- erning record retention, see §1.6001–1. To facilitate compliance and administration, the IRS and taxpayers may agree to guide- lines for the keeping of specific records for purposes of substantiating research credits. (e)Effective dates. Thissectionisap- plicable for taxable years ending on or af- ter December 31, 2003. PART 602—OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT Par. 4. The authority citation for part 602 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 5. In §602.101, paragraph (b) is amended by removing the entry from the table for §1.41–4(d). Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved December 18, 2003. Pamela F. Olson, Assistant Secretary of the Treasury. (Filed by the Office of the Federal Register on December 31, 2003, 8:45 a.m., and published in the issue of the Federal Register for January 2, 2004, 69 F.R. 22) Section 42.—Low-Income Housing Credit The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 280G.—Golden Parachute Payments Federal short-term, mid-term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 382.—Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change The adjusted applicable federal long-term rate is set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 40 9.—Qualifi- cations for Tax Credit Employee Stock Own- ership Plans 26 CFR 1.409(p)–1T: Prohibited allocation of secu- rities in an S corporation. (Also, §§ 1361, 4975, 4979A, 6011, 6111, and 6112; §§ 54.4975–11, 1.6011–4, 301.6111–2, and 301.6112–1.) Employee stock ownership plans; S corporations; listed transactions.A finding of synthetic equity owned by a disqualified person in a nonallocation year of an ESOP, as those terms are defined in section 409(p) of the Code and regulations section 1.409(p)–1T, takes place in three distinct situations. In addition, the trans- actions described in this ruling, as well as substantially similar transactions, are designated as “listed transactions.” Rev. Rul. 2004–4 ISSUES In the three situations described below, (1) are the individuals disqualified per- sons within the meaning of § 409(p)(4) of the Internal Revenue Code (the Code), (2) does the related employee stock ownership plan (ESOP) have a nonallocation year within the meaning of § 409(p)(3), and (3) are any disqualified persons treated as owning synthetic equity within the mean- ing of § 409(p)(5)? FACTS Situation 1 Before 2003, Individuals A and B own, either directly or indirectly, in whole or in part, a domestic professional services cor- poration. In addition, before 2003, indi- viduals C, D, and E each owns, either di- rectly or indirectly, in whole or in part, his or her own domestic professional services corporation. A, B, C, D, and E (Taxpayers) are employees of their respective domes- tic professional services corporations (Ser- vice Recipient Corporations). In 2003, a new corporation (S Corp) is formed, and elects to be treated as a sub- chapter S corporation. S Corp forms a subsidiary corporation for each Taxpayer (QSubs A through E), and files a qualified subchapter S subsidiary (QSub) election for each subsidiary. S Corp contributes cash in exchange for 100 percent of the is- sued and outstanding stock of each QSub. Each Taxpayer is designated as an officer and investment manager for Taxpayer’s re- spective QSub. In addition, each QSub grants its respective Taxpayer a nonqual- ified stock option to acquire substantially all or a majority of the shares of the QSub. AtthesametimethatSCorpisformed, it establishes a plan (ESOP) which is de- signed to be an employee stock ownership plan (within the meaning of § 4975(e)(7)) and which holds 100 percent of the stock of S Corp. All the employees of S Corp and the QSubs participate in the ESOP, with the exception of Taxpayers A through E. Taxpayers A through E and their sup- port staff terminate their existing employ- ment relationship with their respective Ser- vice Recipient Corporations and become employees of the respective QSub. The customers of Taxpayers A through E stop doing business with the Service Recipi- ent Corporations and begin doing business with the respective QSub of Taxpayers A through E. Taxpayers A through E receive salary payments from their respective QSub, in an amount substantially less than the in- come to S Corp generated by the busi- ness activities of that Taxpayer after de- duction for expenses. S Corp treats the subsidiaries as valid QSubs, and treats the income generated by each QSub each year, and earnings thereon, as earned by S Corp. The payments to the Taxpayers for cur- rent salary are deducted by S Corp as an ordinary and necessary business expense. However, since S Corp is wholly owned by an ESOP holding S corporation stock, S Corp’s net earnings arenot taxed currently. 2004-6 I.R.B.414February 9, 2004 Amounts of income to S Corp generated by the business activities of each Taxpayer (net of expenses) but not paid to Taxpayers within 2 1 /2months after the end of the year accumulate in each Taxpayer’s respective QSub, for example, in a brokerage account in each subsidiary, over which the respec- tive Taxpayer has investment control as the investment manager of the subsidiary. A through E can access the amounts accumu- latedintheirrespectiveQSubbyexercis- ing their option to purchase shares in the QSub. If each Taxpayer’s option to pur- chase shares of QSub stock were synthetic equity of S Corp (determined in accor- dance with § 1.409(p)–1T(f)(4)(ii)), then each Taxpayer would own at least 10 per- cent of the sum of the outstanding shares of S Corp plus the synthetic equity shares of S Corp. Situation 2 The facts are the same as inSituation 1, except that instead of 5 individuals, there are 11 individuals (Taxpayers A through K) each of whom is an employee of a Service Recipient Corporation owned ei- ther directly or indirectly, in whole or in part, by that Taxpayer. As inSituation 1, amounts of income to S Corp generated by the business activities of each Taxpayer (net of expenses) but not paid to the Tax- payer accumulate in each Taxpayer’s re- spective QSub, andeach Taxpayer has the right to acquire stock in that Taxpayer’s QSub under the same terms as described in Situation 1. If each Taxpayer’s option to purchase shares of QSub stock were syn- thetic equity of S Corp, then each Taxpayer would own less than 10 percent of the sum of the outstanding shares of S Corp plus the synthetic equity shares of S Corp. Situation 3 Before 2003, Corporation M is an S corporation with 200 employees, wholly owned by an ESOP that was established after March 14, 2001, in which substan- tially all of its employees participate. Be- fore 2003, Individual A (Taxpayer) oper- ated a professional services corporation as a separate business. In 2003, Corporation M forms a QSub for A by contributing cash in exchange for 100 percent of the issued and outstanding stock of the QSub. As in Situation 1, A and A’s support staff ter- minate their existing employment relation- ship with A’s Service Recipient Corpora- tion and become employees of the QSub; A’s customers become customers of the QSub; amounts of income to S Corp gen- erated by the business activities of A (net of expenses) but not paid to A accumulate in A’s QSub; and A has the right to acquire stock in the QSub under the same terms as described inSituation 1. A does not par- ticipate in the Corporation M ESOP. If A’s option to purchase shares of the QSub were synthetic equity of S Corp, then A would own less than 10 percent of the total of the outstanding shares of S Corp plus the syn- thetic equity shares of S Corp. LAW Section 4975(e)(7) provides that an ESOP is a defined contribution plan that is designed to invest primarily in qual- ifying employer securities and that is either a stock bonus plan which is qual- ified, or a stock bonus plan and money purchase pension plan both of which are qualified, under § 401(a). A plan is not treated as an ESOP under the Code unless it meets the following requirements, to the extent applicable: § 409(h) (relating to participants’ right to receive employer securities; put options); § 409(o) (relat- ing to participants’ distribution rights and payment requirements); § 409(n) (relating to securities received in transactions to which § 1042 applies); § 409(p) (relating to prohibited allocations of securities in an S corporation); § 664(g) (relating to qualified gratuitous transfers of qualified employer securities); and § 409(e) (re- lating to participants’ voting rights if the employer has a registration-type class of securities). As authorized by § 4975(e)(7), additional requirements are imposed under § 54.4975–11 of the Excise Tax Regula- tions. Section 1361(b)(1)(B) provides that an S corporation may not have as a share- holder a person that is not an estate, a trust describedin§1361(c)(2),anorganization described in § 1361(c)(6), or an individual. In 1996, § 1361(c)(6) was amended to per- mit a qualified plan under § 401(a) to be a shareholder in an S corporation. Section 1316(a) of the Small Business Job Protec- tion Act of 1996 (SBJPA) (110 Stat. 1755) (1996). Section 1361(b)(3)(A) provides that, for purposes of title 26 of the U.S. Code, a corporation that is a qualified Subchapter S subsidiary will not be treated as a sepa- rate corporation and all assets, liabilities, and items of income, deduction and credit of the corporation are treated as assets, liabilities, and such items (as the case may be) of the S corporation. Section 511(a)(1) imposes a tax on the unrelated business taxable income (as defined in § 512(a)) of organizations described in § 511(a)(2), which include plans that qualify under § 401(a). Section 512(e)(1) provides that if an organization described in § 1361(c)(6) holds stock in an S corporation, the interest is treated as an interest in an unrelated trade or business and, notwithstanding the organization’s general tax-exempt status, all items of in- come, loss, or deduction taken into account under § 1366(a) and any gain or loss on the disposition of the stock in the S corpo- ration are taken into account in computing the unrelated business taxable income of the organization. In 1997, § 512(e) was amended to provide that § 512(e) does not apply to employer securities (within the meaning of § 409(l)) held by an ESOP described in § 4975(e)(7). Section 1523 of the Taxpayer Relief Act of 1997 (TRA ’97) (111 Stat. 788) (1997). Accordingly, S corporation income allocable to stock held by an ESOP is not subject to regular income or unrelated business income tax. Congress became aware that the tax exemption for earnings on S corporation stock held by an ESOP may lead to in- appropriate tax deferral or avoidance in some cases. In order to address these con- cerns, Congress enacted § 409(p) as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) (115 Stat. 38) (2001). Section 409(p) is effective for plan years beginning after December 31, 2004. However, pursuant to section 656(d)(2) of EGTRRA, § 409(p) of the Code is effective for plan years ending after March 14, 2001, for an ESOP that is established after that date, or if the em- ployer securities held by the plan consist of stock in an S corporation that did not have an S election in effect on that date. Notice 2002–2, Q&A–15, 2002–1 C.B. 285, provides that an S corporation does not have an election in effect on March 14, 2001, unless a valid election was actually filed on or before that date and is effective with respect to such corporation on or before that date. Temporary and proposed February 9, 20044152004-6 I.R.B. regulations under § 409(p) were issued on July 21, 2003 (T.D. 9081, 2003–35 I.R.B. 420; REG–129709–03, 2003–35 I.R.B. 506, September 2, 2003), effective gen- erally for plan years ending after October 20, 2003. Section 409(p) is intended to limit the tax benefits of ESOPs maintained by S cor- porations unless the ESOP provides mean- ingful benefits to rank-and-file employees. As explained in the legislative history: The Committee continues to believe that S corporations should be able to en- courage employee ownership through an ESOP. The Committee does not be- lieve, however, that ESOPs should be used by S corporation owners to obtain inappropriate tax deferral or avoidance. Specifically, the Committee believes that the tax deferral opportunities pro- vided by an S corporation ESOP should be limited to those situations in which there is broad-based employee cover- age under the ESOP and the ESOP ben- efits rank-and-file employees as well as highly compensated employees and his- torical owners. H. R. Rep. No. 107–51, part 1, at 100 (2001). Sections 409(p) and 4979A apply if a nonallocation year occurs in an em- ployee stock ownership plan, as defined in § 4975(e)(7), that holds shares of stock of an S corporation that are employer se- curities as defined in § 409(l). Section 409(p)(1) requires that an ESOP holding employer securities consisting of stock in an S corporation must provide that no por- tion of the assets of the plan attributable to (or allocable in lieu of) such employer securities may, during a nonallocation year, accrue (or be allocated directly or indirectly under any plan of the employer meeting the requirements of § 401(a)) for the benefit of any disqualified person, as defined in § 409(p). Under § 409(p)(3), (4), and (5), a “non- allocation year” means a plan year of an ESOP during which, at any time, the ESOP holds any employer securities that are shares of an S corporation and either: 1) disqualified persons own at least 50 per- cent of the number of outstanding shares of stock in the S corporation (including deemed-owned ESOP shares), or 2) dis- qualified persons own at least 50 percent of the aggregate number of outstanding shares of stock (including deemed-owned ESOP shares) and synthetic equity in the S corporation. For these purposes, the rules of § 318(a) apply to determine ownership of shares in the S corporation (includ- ing deemed-owned ESOP shares) and synthetic equity. However, § 318(a)(4) (relating to options to acquire stock) is disregarded and, in applying § 318(a)(1), the members of an individual’s family include members of the individual’s fam- ily specified in § 409(p)(4)(D). In addi- tion, an individual is treated as owning deemed-owned ESOP shares of that indi- vidual notwithstanding the employee trust exception in § 318(a)(2)(B)(i). As indicated by the legislative history above, § 409(p) is intended to limit the tax benefits of ESOPs maintained by S cor- porations unless the ESOP provides broad based coverage for, and meaningful bene- fits to, rank-and-file employees. See H.R. Rep. No. 107–51, part 1, at 100 (2001). Accordingly, Congress added § 409(p)(7), recognizing that the structure of § 409(p) was not expected to be sufficient in all cases to ensure broad-based coverage for, and meaningful benefits to, rank-and-file employees. Section 409(p)(7)(A) thus authorizes the Secretary to prescribe such regulations as may be necessary to carry out the purposes of § 409(p). Section 409(p)(7)(B) provides that the Secretary may, by regulation or other guidance of general applicability, provide that a nonal- location year occurs in any case in which the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion of § 409(p). The legislative history to § 409(p) includes the following with respect to exercise of this authority: For example, this might apply if more than 10 independent businesses are combined in an S corporation owned by an ESOP in order to take advantage of the income tax treatment of S corpo- rationsownedbyanESOP. H. R. Conf. Rep. No. 107–84, at 277 (2001). Pursuant to § 409(p)(7)(B), § 1.409(p)– 1T(c)(3) of the Temporary Income Tax Regulations provides that the Commis- sioner, in revenue rulings, notices and other guidance published in the Internal Revenue Bulletin, may provide that a nonallocation year occurs in any case in which the principal purpose of the owner- ship structure of an Scorporation consti- tutes an avoidance or evasion of § 409(p). For any year that is a nonallocation year, taking into account the legislative his- tory cited above, § 1.409(p)–1T(c)(3) also provides that this exercise of authority includes the authorityto treat any person as a disqualified person. Under § 409(p)(4), a disqualified per- son is any person for whom: 1) the number of such person’s deemed-owned ESOP shares is at least 10 percent of the num- ber of deemed-owned ESOP shares of the S corporation; 2) the aggregate number of such person’s deemed-owned ESOP shares and synthetic equity shares is at least 10 percent of the aggregate number of deemed-owned ESOP and synthetic eq- uity shares of the S corporation; 3) the ag- gregate number of deemed-owned ESOP shares of such person and of the mem- bers of such person’s family is at least 20 percent of the number of deemed-owned ESOP shares of the S corporation; or 4) the aggregate number of deemed-owned ESOP shares and synthetic equity shares of such person and of the members of such person’s family is at least 20 percent of the aggregate number of deemed-owned ESOP and synthetic equity shares of the S corporation. Section 409(p)(4)(C) defines “deemed- owned ESOP shares” to mean, with respect to any person: 1) any shares of stock in the S corporation constituting employer secu- rities that are allocated to such person’s ac- count under the ESOP; and 2) such per- son’s share of the stock in the S corpora- tion that is held by the ESOP but is not allocated to the account of any participant or beneficiary (with such person’s share to be determined in the same proportion as the most recent stock allocation under the ESOP). Section 1.409(p)–1T(f)(1), interpreting § 409(p)(5), provides that the determina- tion of whether someone is a disqualified person and whether a plan year is a non- allocation year is made without regard to “synthetic equity” attributable to that per- son and is also made separately taking into account synthetic equity. For purposes of § 409(p) and § 1.409(p)–1T, synthetic eq- uity is treated as owned by a person in the same manner as stock is treated as owned by a person, directly or under the rules of § 318(a)(2) and (3). Section 409(p)(6)(C) defines “syn- thetic equity” to include any stock op- 2004-6 I.R.B.416February 9, 2004 tion, warrant, restricted stock, deferred issuance stock right, stock appreciation right payable in stock, or similar interest or right that gives the holder the right to acquire or receive stock of the S cor- poration in the future. Synthetic equity also includes a right to a future payment (payable in cash or any other form other than stock of the S corporation) from an S corporation that is based on the value of the stock of the S corporation or ap- preciationinsuchvalue,suchasastock appreciation right with respect to stock of an S corporation that is payable in cash or a phantom stock unit with respect to stock of an S corporation that is payable in cash. Section 1.409(p)–1T(f)(2)(iv) provides a rule treating nonqualified deferred com- pensation as synthetic equity. Specifically, that section of the temporary regulations provides that synthetic equity also includes any remuneration for services rendered to the S corporation, or a related entity, to which § 404(a)(5) applies (including re- muneration for which a deduction would be permitted under § 404(a)(5) if separate accounts were maintained), any right to re- ceive property (to which § 83 applies) in a future year for the performance of services to an S corporation, or related entity, and anytransferofproperty(towhich§83ap- plies) in connection with the performance of services to an S corporation, or a related entity, to the extent that the property is not substantially vested within the meaning of § 1.83–3(i) of the Income Tax Regulations by the end of the plan year in which trans- ferred. Section 1.409(p)–1T(f)(2)(iv) also provides that synthetic equity includes any other remuneration for services rendered to the S corporation, or a related entity, un- der a plan, method or arrangement, defer- ring the receipt of compensation to a date that is after the 15th day of the 3d calen- dar month after the end of entity’s taxable year in which the related services are ren- dered, other than a plan that is an eligi- ble retirement plan within the meaning of § 402(c)(7)(B). Pursuant to the authority in § 409(p)(7), § 1.409(p)–1T(f)(2)(iii)(A) provides that synthetic equity also includes a right to acquire stock or other similar interests in a related entity if such interests in the related entity are the only significant asset of the S corporation and the S corpora- tion is the only significant owner of the related entity. Whether an asset is the only significant asset of the S corporation or the S corporation is the only signifi- cant owner of the related entity depends on the relevant facts and circumstances. Section 1.409(p)–1T(f)(2)(iii)(A)(4) pro- vides that a related entity means any entity in which the S corporation holds an interest and which is a partnership, a trust, an eligible entity that is disre- garded as an entity that is separate from its owner under § 301.7701–3 of the Proce- dure and Administration Regulations or a Qualified Subchapter S Subsidiary under § 1361(b)(3). Pursuant to the authority in § 409(p)(7), § 1.409(p)–1T(f)(2)(iii)(C) provides that the Commissioner may, if necessary to carry out the purposes of § 409(p), through revenue rulings, notices, and other guid- ance published in the Internal Revenue Bulletin, provide that synthetic equity in- cludes a right to acquire stock or other similar interests in a related entity in cases in which such interests in the related entity are not the only significant asset of the S corporation or the S corporation is not the only significant owner of the related entity. Section 1.409(p)–1T(f)(4)(ii) provides that, in the case of synthetic equity that is determined by reference to shares of stock (or other similar interests) in a related en- tity, the person who is entitled to the syn- thetic equity is treated as owning shares of stock in the S corporation with the same aggregate value as the number of shares of stock (or similar interests) of the related entity (with such value determined without regard to any lapse restriction as defined at § 1.83–3(i)). Section 4979A imposes a 50 percent ex- cise tax in certain cases, including an allo- cation of employer securities that is pro- hibited by § 409(p), the ownership of any synthetic equity by a disqualified person during a nonallocation year, and the occur- rence of the first nonallocation year of an ESOP, as described in § 4979A(e)(2)(C). Section 4979(A)(c)(1)(A) provides for this excise tax to be paid by the employer spon- soring the ESOP. ANALYSIS In each situation described above, the ownership structure of the S corporation is designed to allow one or more Taxpay- ers, each operating a business for that Tax- payer’s own benefit, to take advantage of the tax-exempt status of the S corporation that results from the ownership of its out- standing stock by the ESOP. The owner- ship structure thereby avoids current taxa- tion of the profits of each Taxpayer’s sepa- rate business, while each Taxpayer retains the right to at least 50 percent of the busi- ness through the right to acquire shares in the QSub. Because the profits of each business are being segregated and accumu- lated in each Taxpayer’s QSub, the ESOP is owner of the business only in form, not in substance, to the extent that the Tax- payer has a right to the profits by exercis- ing the Taxpayer’s option to acquire the shares of the QSub. Thus, the ESOP is not providing benefits to rank-and-file em- ployees that reflect its ownership share in the S corporation. InSituation 1, each Taxpayer is using options on QSub stock to retain ownership of his or her separate business, with the profits of that business being segregated from the profits of the businesses of the other QSubs. In this way, the structure is designed to divert the profits of each busi- ness away from the ESOP. If each QSub were an S corporation directly owned by an ESOP, each Taxpayer’s right to acquire shares of that corporation would be syn- thetic equity pursuant to § 409(p)(6)(C). Accordingly, the structure described in Situation 1is similar to other forms of syn- thetic equity, such as the right to acquire stockinarelatedentitythatistheonlysig- nificant asset of an S Corporation (owned by an ESOP). Further, the economic ef- fect is similar to nonqualified deferred compensation for services rendered to the QSub which is declared to be synthetic equity in § 1.409(p)–1T(f)(2)(iv). Consequently, the options granted to each Taxpayer inSituation 1to ac- quire shares in the QSub for that Tax- payer’s business should be treated as synthetic equity in S Corp. Ac- cordingly, pursuant to the authority in § 1.409(p)–1T(f)(2)(iii)(C), the Commis- sioner in this revenue ruling provides that the options are synthetic equity. Because these options are synthetic equity inSit- uation 1, each Taxpayer is a 10 percent owner of the number of deemed-owned shares of S Corp, Taxpayers A through E are thus disqualified persons, and, because disqualified persons A through E own an aggregate of at least 50 percent of the February 9, 20044172004-6 I.R.B. shares, 2003 is a nonallocation year for the ESOP. A group of individuals with the same right to acquire the accumulated profits of their businesses as described inSitu- ation 1should not avoid the application of § 409(p) merely because each individ- ual’s right to acquire the accumulated prof- its of that individual’s business does not have a value equal to at least 10 percent of the value of S Corp because more than 10 separate businesses are combined (as de- scribed inSituation 2). In fact, Congress anticipated the combining of more than 10 businesses as a means of avoiding the ap- plication of § 409(p) and gave this own- ership structure as an example of the type of situation where exercise of the authority granted in § 409(p)(7)(B) would be appro- priate. Further, an individual with the same right to acquire the accumulated profits of that individual’s business, similar to the rights described inSituation 1, should not avoid the application of § 409(p) merely because the business is combined, as inSit- uation 3, with the business of an S corpo- ration owned by an ESOP that otherwise fulfills Congressional intent by providing broad-based coverage and benefits to rank- and-file employees. The rank-and-file em- ployees inSituation 3are not sharing in the profits of the Taxpayer’s separate business through the ESOP’s ownership share to the extent that the profits of that business are being accumulated for the benefit of that Taxpayer. With respect to that Taxpayer’s separate business, the ownership structure of the S corporation is designed to avoid or evade the application of § 409(p). In all three situations, the accumulation of profits for the benefit of a specific indi- vidual is comparable to the operation of an S corporation owned by an ESOP. More- over, as inSituation 1,ifanyoneofthese businesses were the only business activity of S Corp, the option held by the taxpayers would be synthetic equity which would re- sult in a nonallocation year and each tax- payer being a disqualified person if those shares of synthetic equity were at least 50 percent of the shares of stock of S Corp plus the total synthetic equity shares. Accordingly, pursuant to the authority of § 409(p)(7)(B) and § 1.409(p)–1T(c)(3), the Commissioner provides in this revenue ruling that a nonallocation year occurs and the individual is a disqualified person in any case in which (i) shares of an S corpo- ration are employer securities held by an ESOP, (ii) the profits of the S corporation generated by the business activities of a specific individual are accumulated and held for the benefit of that individual in a QSub or similar entity (such as a limited liability company), (iii) these profits are notpaidtotheindividual as compensation within 2 1 /2months after the end of the year in which earned, and (iv) the individual has rights to acquire shares of stock (or similar interests) of the QSub or similar entity representing 50 percent or more of the fair market value of the stock of such QSub or similar entity. In addition, pursuant to the authority in § 1.409(p)–1T(f)(2)(iii)(C), the Commissioner in this revenue ruling provides that such individual’s right to ac- quire shares of stock (or similar interests) of the QSub or similar entity is synthetic equity. For purposes of this paragraph, the rights of the individual are determined after taking into account the attribution rules of § 409(p). As a result, inSituations 2 and 3,the Taxpayer’s right to acquire the shares of the QSub is syntheticequity, each indi- vidual Taxpayer (A through K inSituation 2,andAinSituation 3) is a disqualified person, and a nonallocation year occurs. The respective Taxpayers inSituations 2 and 3are disqualified persons regardless of whether, at any time, a particular Tax- payer owns synthetic equity shares of S Corp equal to at least 10 percent of the sum of the outstanding shares of S Corp plus the synthetic equity shares of S Corp. The same conclusions would apply with respect toSituations 1, 2, and 3even if the support staff of the Taxpayers were to con- tinue to be employed by their respective Service Recipient Corporations, the Ser- vice Recipient Corporations were to con- tinue to provide substantially the same ser- vices for their customers, any of the Tax- payers or their support staff were to be em- ployees of S Corp (instead of employees of a QSub), or any of the Taxpayers were to participate in the ESOP. Treasury and the Service intend to re- flect the guidance in this revenue ruling in regulations under § 409(p), effective for plan years ending after October 20, 2003. It is expected that the regulations would apply to similar transactions that have the effect of reserving profits from an individ- ual’s business activities to provide similar tax benefits to the individual, either with theuseofaQSuborthroughtheuseofan- other method. In appropriate cases, the Service may challenge other tax benefits claimed by any taxpayer involved in this type of busi- ness structure. For example, in the appro- priate case, the Service may take the po- sition for income tax purposes that, even though the Taxpayer purported to trans- fer his or her business (including the em- ployment of his or her support staff) to the QSub, the Taxpayer never relinquished ownership of his or her business and, there- fore, the Taxpayer should still be taxed on the profits. The Service might also take the position that the subsidiary is not a QSub. Alternatively, if the support staff of the Taxpayers were to continue to be employed by their respective Service Re- cipient Corporations, and the Service Re- cipient Corporations were to continue to provide substantially the same services for their customers, the Service might assert that each Taxpayer continues to be em- ployed by their respective Service Recip- ient Corporation, with the related tax con- sequences. HOLDINGS With respect toSituation 1, for purposes of §§ 409(p) and 4979A, (1) A through E are disqualified persons with respect to the ESOP, (2) the ESOP has a nonallocation year, and (3) the options to acquire stock in QSubs A through E are synthetic equity to which the § 4979A excise tax applies. With respect toSituation 2, for purposes of §§ 409(p) and 4979A, (1) A through K are disqualified persons with respect to the ESOP, (2) the ESOP has a nonallocation year, and (3) A through K are each treated as owning synthetic equity in the form of each individual’s option to acquire shares of the corresponding QSub. With respect toSituation 3, for purposes of §§ 409(p) and 4979A, (1) A is a disqual- ified person with respect to the ESOP, (2) the ESOP has a nonallocation year, and (3) A is treated as owning synthetic equity in the form of A’s option to acquire shares of the corresponding QSub. EFFECTIVEDATEAND TRANSITION RULE This revenue ruling applies for plan years ending after October 20, 2003, but 2004-6 I.R.B.418February 9, 2004 this revenue ruling (including the listing in the Listed Transactions section below) is not effective before March 15, 2004 if (i) all interests in a QSub held by individuals who would be disqualified persons under this revenue ruling are distributed to those individuals as compensation on or before March 15, 2004, and (ii) no such individ- ual has been a participant in the ESOP at any time after October 20, 2003, and before March 15, 2004. In addition, for purposes of the excise tax under § 4979A, an individual’s interest in a QSub that con- stitutes synthetic equity under this revenue ruling will be disregarded to the extent such interest is distributed to the individ- ual as compensation on or before March 15, 2004. LISTED TRANSACTIONS Arrangements that are the same as, or substantially similar to, the fol- lowing transaction are identified as “listed transactions” for purposes of §§ 1.6011–4(b)(2), 301.6111–2(b)(2) and 301.6112–1(b)(2) effective January 23, 2004, the date this document was released to the public: Any transaction in which (i) at least 50 percent of the outstanding shares of an S corporation are employer securities held by an ESOP, (ii) the profits of the S corporation generated by the busi- ness activities of a specific individual are accumulated and held for the benefit of that individual in a QSub or similar entity (such as a limited liability company), (iii) these profits are not paid to the individual as compensation within 2 1 /2months after the end of the year in which earned, and (iv) the individual has rights to acquire shares of stock (or similar interests) of the QSub or similar entity representing 50 percent or more of the fair market value of the stock of such QSub or similar entity. For purposes of the preceding sentence, the rights of an individual are determined after taking into account the attribution rules of § 409(p). These arrangements are identified as “listed transactions” with respect to the S corporation and each indi- vidual who is a disqualified person under this revenue ruling. Independent of their classification as “listed transactions,” transactions that are the same as, or substantially similar to, the transactions described in the preced- ing paragraph may already be subject to the disclosure requirements of § 6011 (§ 1.6011–4), the tax shelter registration requirements of § 6111 (§§ 301.6111–1T, 301.6111–2), or the list maintenance re- quirementsof§6112(§301.6112–1). Persons required to register these tax shelters under § 6111 who have failed to do so may be subject to the penalty un- der § 6707(a). Persons required to main- tain lists of investors under § 6112 who have failed to do so (or who fail to provide such lists when requested by the IRS) may be subject to the penalty under § 6708(a). In addition, the IRS may impose penal- ties on parties involved in this transac- tion or substantially similar transactions, including the accuracy-related penalty un- der § 6662. The Service and the Treasury recognize that some taxpayers may have filed tax re- turns taking the position that they were en- titled to the purported tax benefits of the type of transaction described in this rev- enue ruling. These taxpayers should con- sult with a tax advisor to ensure that their transactions are disclosed properly and to take appropriate corrective action. DRAFTING INFORMATION The principal authors of this revenue ruling are Robert Gertner of the Employee Plans, Tax Exempt and Government En- tities Division and John Ricotta of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Govern- ment Entities). For further information, Employee Plans’ taxpayer assistance tele- phone service at 1–877–829–5500 (a toll-free call) between the hours of 8:00 a.m. and 6:30 p.m. Eastern Time, Monday through Friday or contact Mr. Gertner at (202) 283–9888 (not a toll-free call). Section 412.—Minimum Funding Standards The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 446.—General Rule for Methods of Accounting 26 CFR 1.446–1: General rule for methods of ac- counting. T.D. 9105 DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 Changes in Computing Depreciation AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final and temporary regula- tions. SUMMARY: This document contains reg- ulations relating to a change in comput- ing depreciation or amortization as well as a change from a nondepreciable or non- amortizable asset to a depreciable or amor- tizable asset (or vice versa). Specifically, these regulations provide guidance to any taxpayer that makes a change in depre- ciation or amortization on whether such change is a change in method of account- ing under section 446(e) of the Internal Revenue Code and on the application of section 1016(a)(2) in determining whether the change is a change in method of ac- counting. The text of these temporary reg- ulations also serves as the text of the pro- posed regulations (REG–126459–03) set forth in the notice of proposed rulemaking on this subject in this issue of the Bulletin. DATES:Effective Dates:Theseregula- tions are effective January 2, 2004. Applicability Dates: For dates of applicability, see §§1.167(e)–1T(e), 1.446(e)–1T(e)(4), and 1.1016–3T(j). FOR FURTHER INFORMATION CONTACT: Sara Logan or Douglas Kim, (202) 622–3110 (not a toll-free number). SUPPLEMENTARY INFORMATION: Background This document contains amendments to 26 CFR part 1 to provide regulations un- der sections 167, 446(e), and 1016(a)(2) of the Internal Revenue Code (Code). February 9, 20044192004-6 I.R.B. These regulations provide the changes in depreciation or amortization that are, and are not, a change in method of accounting under §1.446–1(e). Additionally, these regulations amend §1.167(e)–1 to pro- vide that certain changes in depreciation method for property for which depreci- ation is determined only under section 167 are made without the consent of the Commissioner of Internal Revenue, and amend §1.1016–3 to provide that section 1016(a)(2) does not permanently affect a taxpayer’s lifetime income for purposes of determining whether a change in de- preciation or amortization is a change in method of accounting. Explanation of Provisions Background Section 446 provides in general that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes the taxpayer’s income in keeping the tax- payer’s books. Section 446(e) provides that, except as otherwise expressly pro- vided in chapter 1 of the Code, a taxpayer who changes the method of accounting on the basis of which the taxpayer regu- larly computes the taxpayer’s income in keeping the taxpayer’sbooks shall, before computing the taxpayer’s taxable income under the new method, secure the consent of the Secretary. Section 1.446–1(e)(2)(ii)(a)providesin pertinent part that a change in method of accounting includes a change in the over- all plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. A material item is any item that in- volves the proper time for the inclusion of the item in income or the taking of a de- duction. However, §1.446–1(e)(2)(ii)(b) provides in pertinent part that a change in method of accounting does not include an adjustment in the useful life of a deprecia- ble asset. Although such adjustment may involve the question of the proper time for the taking of a deduction, such item is tra- ditionally corrected by adjustments in the current and future years. Section 1.167(e)–1(a) provides that in general, any change in the method of com- puting the depreciation allowances with respect to a particular account (other than achangeinmethodpermittedorrequired by reason of the operation of former sec- tion 167(j)(2) and §1.167(j)–3(c)) is a change in method of accounting, and such a change will be permitted only with the consent of the Commissioner, except that certain changes to the straight line method of depreciation will be permitted with- out consent as provided in former section 167(e)(1), (2), and (3). Any request for a change in method of depreciation shall be made in accordance with section 446 and the regulations under section 446. In 1996, the IRS issued Rev. Proc. 96–31, 1996–1 C.B. 714, providing that a change from not claiming the depreciation or amortization allowable to claiming the depreciation or amortization allowable is a change in method of accounting for which the consent of the Commissioner of Inter- nal Revenue is required. InKurzet v. Commissioner, 222 F.2d 830, 842–845 (10 th Cir. 2000), the tax- payer sought to change the classification of property under section 168 from nonres- idential real property to 15-year property thereby resulting in a change in recovery period from 31.5 years to 15 years. The Tenth Circuit held that a change in recov- ery period under section 168 is a change in method of accounting under section 446(e). In reaching its holding, the Tenth Circuit considered the taxpayer’s argu- ment that a change in recovery period is analogous to a change in useful life, but concluded that the Commissioner’s in- terpretation of §1.446–1(e)(2)(ii) in Rev. Proc. 96–31 as requiring a taxpayer to obtain permission for a change in recovery period is not plainly erroneous or incon- sistent with §1.446–1(e)(2)(ii). InBrookshire Brothers Holding, Inc. & Subsidiaries v. Commissioner, 320 F.3d 507 (5 th Cir. 2003),aff’g. T.C. Memo. 2001–150,reh’g en banc denied,65Fed. Appx. 511 (5 th Cir. 2003), the Fifth Cir- cuit held that a change in classification of property under section 168 is not a change in method of accounting under section 446(e) because the change is the functional equivalent of a change in use- ful life thereby resulting in the change falling under the useful life exception in §1.446–1(e)(2)(ii)(b). The Eighth Cir- cuit inO’Shaughnessy v. Commissioner, 332F.3d1125(8 th Cir. 2003),rev’g in part2002–1 U.S.T.C. (CCH) ¶50,235 (D. Minn. 2001), adopted the analysis inBrookshireand held that a change in classification of property under section 168 falls within the useful life exception and, thus, does not constitute a change in method of accounting under section 446(e). Further, inGreen Forest Manufactur- ingInc.v.Commissioner, T.C. Memo. 2003–75, the Tax Court extended its rea- soning inBrookshire. The court held that a change in computing depreciation from the general depreciation system in section 168(a) to the alternative depreciation sys- tem in section 168(g) is a change in classi- fication that falls within the useful life ex- ception and, therefore, is not a change in method of accounting. As a result of these decisions, there is inconsistent treatment of taxpayers with respect to whether a change in comput- ing depreciation under section 168 is a change in method of accounting under section 446(e). These regulations clarify the changes in depreciation or amortiza- tion (depreciation) that are (and are not) changes in method of accounting under section 446(e). Scope The regulations provide the changes in depreciation for property for which depre- ciation is determined under section 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or former section 168, of the Code that are (and are not) changes in method of accounting under section 446(e). The regulations also clarify that the rules in §1.167(e)–1 with respect to a change in the depreciation method made without the consent of the Commissioner apply only to property for which depreciation is determined under section 167 (other than under section 168, section 1400I, section 1400L, or former section 168). Changes in Depreciation that are Changes in Method of Accounting In general, the regulations provide that a change in the depreciation method, pe- riod of recovery, or convention of a depre- ciable or amortizable asset is a change in method of accounting. This change may be the result of, for example, a change in the classification of property under section 168(e) or a change in computing deprecia- tion from the general depreciation system 2004-6 I.R.B.420February 9, 2004 under section 168(a) to the alternative de- preciation system of section 168(g). Fur- ther, a change to or from claiming the ad- ditional first year depreciation deduction provided by section 168(k) or 1400L(b) is a change in method of accounting under certain circumstances. The regulations clarify that the use- ful life exception, which has been moved from §1.446–1(e)(2)(ii)(b)to §1.446–1T(e)(2)(ii)(d), applies only to property for which the depreciation is de- termined under section 167 (other than under section 168, section 1400I, section 1400L, or former section 168). However, a change to or from a useful life (or recov- ery period or amortization period) that is specifically assigned by the Code, the reg- ulations under the Code, or other guidance published in the Internal Revenue Bulletin is a change in method of accounting. The regulations also provide that a change in salvage value to zero for a de- preciable or amortizable asset for which the salvage value is expressly treated as zero by the Code, the regulations under the Code, or other guidance published in the Internal Revenue Bulletin, is treated as a change in method of accounting. Any other change in salvage value is not treated as a change in method of accounting. Further, the regulations provide that a change in the accounting for depreciable or amortizable assets from single asset accounting to multiple asset accounting (pooling), or vice versa, or from one type of multiple asset accounting (pooling) to a different type of multiple asset ac- counting (pooling) is a change in method of accounting. Also, for depreciable or amortizable assets that are mass assets accounted for in multiple asset accounts or pools, a change in the method of iden- tifying which assets have been disposed is a change in method of accounting (for example, from specific identification to a first-in, first-out method). Finally, the regulations provide that a change in the treatment of an asset from nondepreciable or nonamortizable (nonde- preciable) to depreciable or amortizable (depreciable), or vice versa, is a change in method of accounting. For example, a change in the treatment of an asset that was used entirely in the taxpayer’s trade or business and was never held for sale from being treated as inventory to being treated as depreciable property is a change in method of accounting. Exceptions The regulations provide that a change in computing depreciation allowances in the taxable year in which the use of property changes in the hands of the same taxpayer is not a change in method of accounting. The regulations also provide that the making of a late depreciation election or the revocation of a timely valid depreci- ation election generally is not a change in method of accounting. This rule also applies to the making of a late election or the revocation of a timely valid elec- tion under section 13261(g)(2) or (3) of the Revenue Reconciliation Act of 1993 (107 Stat. 312, 540) (relating to amorti- zable section 197 intangibles). To make a late depreciation election or to revoke a timely valid depreciation election, a tax- payer must submit a request for a private letter ruling. Elections made under section 168(b)(2)(C), 168(b)(3)(D), or 168(g)(7) are irrevocable. Finally, the regulations provide that any change in the placed-in-service date of a depreciable or amortizable asset is not treated as a change in method of account- ing. Item Being Changed The regulations clarify that for purposes of changes in depreciation, the item be- ing changed is the depreciation treatment of each individual depreciable or amorti- zable asset. However, the item is the de- preciation treatment of each vintage ac- count with respect to depreciable assets for which depreciation is determined under §1.167(a)–11 (CLADR property). Further, a change in computing depreciation under section 167 (other than a change under sec- tion 168, section 1400I, section 1400L, or former section 168) is permitted only with respect to all assets in a particular account (as defined in §1.167(a)–7) or vintage ac- count. Special Rules The regulations also provide rules for the following: (1) a change from a declining balance method under section 168(b)(1) or (2) to the straight line method; (2) changes in certain depreciation meth- ods under section 167 (other than under section 168, section 1400I, section 1400L, or former section 168); and (3) section 481 adjustments. With respect to a change from the 200-percent or 150-percent declining bal- ance method under section 168(b)(1) or (2) to the straight line method, the regu- lations provide that this change may be made without the consent of the Commis- sioner in the first taxable year in which the depreciation allowance under the straight line method is greater than the deprecia- tion allowance under the declining balance method. With respect to changes in deprecia- tion methods under section 167 (other than under section 168, section 1400I, section 1400L, or former section 168), the regu- lations provide cross-references to regula- tions under section 167 that allow certain depreciation method changes to be made without the consent of the Commissioner. With respect to section 481 adjust- ments, the regulations also clarify that except as otherwise expressly provided by the Code, the regulations under the Code, or other guidance published in the Internal Revenue Bulletin, a change from one permissible method of computing de- preciation to another permissible method of computing depreciation for a deprecia- ble or amortizable asset is implemented on either a cut-off method (as described in section 2.06 of Rev. Proc. 97–27, 1997–1 C.B. 680, and in section 2.06 of Rev. Proc. 2002–9, 2002–1 C.B. 327) 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). Because no items are duplicated or omitted from income when the cut-off method or the modified cut-off method is used to effect the change in method of accounting, no section 481 adjustment is required or permitted. How- ever, a change froman impermissible method of computing depreciation to a permissible method of computing depre- ciation results in a negative or positive section 481 adjustment because the ad- justed depreciable basis of the asset as of the beginning of the year of change is changed as a result of the change in com- puting depreciation.Similarly, a change in the treatment of an asset from nonde- preciable to depreciable (or vice versa) or February 9, 20044212004-6 I.R.B. a change from expensing to depreciating an asset (or vice versa) will also result in a negative or positive section 481 adjust- ment. Application of the Allowed or Allowable Rule to Changes in Method of Accounting Section 1016(a)(2) provides that the ba- sisofpropertyisadjustedinrespectof any period since February 28, 1913, for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent of the amount allowed as deductions in computing taxable income and resulting in a reduction for any taxable year of the tax- payer’s taxes, but not less than the amount allowable. Concurrently with the issuance of these regulations, the IRS and Treasury Depart- ment will issue a revenue procedure that will allow a taxpayer to change the tax- payer’s method of determining deprecia- tion for a depreciable or amortizable as- set after its disposition if the taxpayer did not take into account any depreciation al- lowance, or did take into account some de- preciation but less than the depreciation al- lowable, for the asset in computing taxable income in the year of disposition or in prior taxable years. Because the taxpayer is per- mitted to claim the allowable depreciation not taken into account for this asset, the taxpayer’s lifetime income is not perma- nently affected by the “allowed or allow- able” rule under section 1016(a)(2). Ac- cordingly, the regulations provide that sec- tion 1016(a)(2) does not permanently af- fect a taxpayer’s lifetime income for pur- poses of determining whether a change in depreciation is a change in method of ac- counting under section 446(e) and the reg- ulations under section 446(e). The revenue procedure also will revise the depreciation changes included in Rev. Proc. 2002–9, 2002–1 C.B. 327, the au- tomatic change in method of accounting revenue procedure, to conform with these regulations and will waive the application of Rev. Rul. 90–38, 1990–1 C.B. 57, for changes in depreciation made under Rev. Proc. 97–27, 1997–1 C.B. 680, or Rev. Proc. 2002–9. Special Analyses It has been determined that this Trea- sury decision is not a significant regula- tory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been deter- mined that section 553(b) of the Admin- istrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For the applicability of the Regulatory Flexi- bility Act (5 U.S.C. chapter 6), refer to the Special Analyses section of the preamble to the cross-reference notice of proposed rulemaking published in theFederal Reg- ister. Pursuant to section 7805(f) of the Code, these temporary regulations will be submitted to the Chief Counsel for Advo- cacy of the Small Business Administration for comment on its impact on small busi- ness. Drafting Information The principal author of these regula- tions is Sara Logan, Office of Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development. ***** Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.167(e)–1 is amended by: 1. Revising paragraph (a). 2. Adding new paragraph (e). The addition and revision read as fol- lows: §1.167(e)–1 Change in method. (a)In general. [Reserved]. For further guidance, see §1.167(e)–1T(a). ***** (e)Effective date. [Reserved]. For fur- ther guidance, see the first two sentences of §1.167(e)–1T(e). Par. 3. Section 1.167(e)–1T is added to read as follows: §1.167(e)–1T Change in method (temporary). (a)In general. (1) Any change in the method of computing the depreciation allowances with respect to a particular account (other than a change in method permitted or required by reason of the operation of former section 167(j)(2) and §1.167(j)–3(c)) is a change in method of accounting, and such a change will be permitted only with the consent of the Commissioner, except that certain changes to the straight line method of depreciation will be permitted without consent as pro- vided in former section 167(e)(1), (2), and (3). Except as provided in paragraphs (c) and (d) of this section, a change in method of computing depreciation will be permitted only with respect to all the assets contained in a particular account as defined in §1.167(a)–7. Any change in the percentage of the current straight line rate under the declining balance method, for example, from 200 percent of the straight line rate to any other percent of the straight line rate, or any change in the interest fac- torusedinconnectionwithacompound interest or sinking fund method, will con- stitute a change in method of depreciation. Any request for a change in method of depreciation shall be made in accordance with section 446(e) and the regulations un- der section 446(e). For rules covering the use of depreciation methods by acquiring corporations in the case of certain corpo- rate acquisitions, see section 381(c)(6) and the regulations under section 381(c)(6). (2) Paragraphs (b), (c), and (d) of this section apply to property for which de- preciation is determined under section 167 (other than under section 168, section 1400I, section 1400L, or under section 168 prior to its amendment by the Tax Reform Act of 1986 (100 Stat. 2121)) of the Internal Revenue Code. (b) through (d) [Reserved]. For further guidance, see §1.167(e)–1(b) through (d). (e)Effective date. This section applies on or after December 30, 2003. For the ap- plicability of regulations before December 30, 2003, see §1.167(e)–1 in effect prior to December 30, 2003 (§1.167(e)–1 as con- tained in 26 CFR part 1 edition revised as of April 1, 2003). The applicability of this section expires on or before December 29, 2006. Par. 4. Section 1.446–1 is amended by: 1. Revising paragraphs (e)(2)(ii)(a), (e)(2)(ii)(b), and (e)(2)(iii). 2. Adding new paragraphs (e)(2)(ii)(d) and (e)(4). 2004-6 I.R.B.422February 9, 2004 The additions and revisions read as fol- lows: §1.446–1 General rule for methods of accounting. ***** (e) * * * (2) * * * (ii) (a) [Reserved]. For further guid- ance, see §1.446–1T(e)(2)(ii)(a). (b) [Reserved]. For further guidance, see §1.446–1T(e)(2)(ii)(b). ***** (d)Changes involving depreciable or amortizable assets.[Reserved].Forfur- ther guidance, see §1.446–1T(e)(2)(ii)(d). (iii)Examples. [Reserved]. For further guidance, see §1.446–1T(e)(2)(iii). ***** (4)Effective date. [Reserved]. For fur- ther guidance, see §1.446(e)–1T(e)(4)(i) and (ii). Par. 5. Section 1.446–1T is added to read as follows: §1.446–1T General rule for methods of accounting (temporary). (a) through (e)(2)(i) [Reserved]. For further guidance, see §1.446–1(a) through (e)(2)(i). (e)(2)(ii)(a) A change in the method of accounting includes a change in the over- all plan of accounting for gross income or deductions or a change in the treatment ofanymaterialitemusedinsuchover- all plan. Althougha method of account- ing may exist under this definition with- out the necessity of a pattern of consis- tent treatment of an item, in most instances a method of accounting is not established for an item without such consistent treat- ment. A material item is any item that in- volves the proper time for the inclusion of the item in income or the taking of a de- duction. Changes in method of account- ing include a change from the cash re- ceipts and disbursement method to an ac- crual method, or vice versa, a change in- volving the method or basis used in the valuation of inventories (see sections 471 and 472 and the regulations under sec- tions 471 and 472), a change from the cash or accrual method to a long-term contract method, or vice versa (see §1.460–4), cer- tain changes in computing depreciation or amortization (see paragraph (e)(2)(ii)(d)of this section), a change involving the adop- tion, 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 Code specifi- cally require that the consent of the Com- missioner must be obtained before adopt- ing such a change. (b) A change in method of accounting does not include correction of mathemati- cal or posting errors, or errors in the com- putation of tax liability (such as errors in computation of the foreign tax credit, net operating loss, percentage depletion, or in- vestment 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 in- clusion of the item of income or the tak- ing of a deduction. For example, correc- tions of items that are deducted as inter- est or salary, but that are in fact payments of dividends, and of items that are de- ducted as business expenses, but which 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. Al- though such adjustment may involve the question of the proper time for the tak- ing of a deduction, such items are tradi- tionally corrected by adjustment in the cur- rent and future years. For the treatment of the adjustment of the addition to a bad debt reserve (for example, for banks un- der 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 re- sulting from a change in underlying facts. For further guidance on changes involv- ing depreciable or amortizable assets, see paragraph (e)(2)(ii)(d)ofthissectionand §1.1016–3T(h). (c) [Reserved]. For further guidance, see §1.446–1(e)(2)(ii)(c). (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(b), or 1400L(c), or to section 168 prior to its amendment by the Tax Reform Act of 1986 (100 Stat. 2121) (former sec- tion 168). (2)Changes in depreciation or amorti- zation that are a change in method of ac- counting. Except as provided in paragraph (e)(2)(ii)(d)(3) of this section, a change in the treatment of an asset from nondepre- ciable 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 follow- ing 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 amorti- zable asset. (ii) A change from not claiming to claiming the additional first year deprecia- tion deduction provided by section 168(k) or 1400L(b) for, and the resulting change to the amount otherwise allowable as a depreciation deduction for the remain- ing adjusted depreciable basis (or similar basis) of, qualified property, 50-percent bonus depreciation property, or qualified New York Liberty Zone property, provided the taxpayer did not make the election out of the additional first year depreciation de- duction (or did not make a deemed election out of the additional first year depreciation deduction; for further guidance, see Rev. Proc. 2002–33, 2002–1 C.B. 963, Rev. Proc. 2003–50, 2003–29 I.R.B. 119, and §601.601(d)(2)(ii)(b)ofthischapter)for the class of property in which the qualified property, the 50-percent bonus deprecia- tion property, or the qualified New York Liberty Zone property is included. (iii) A change from claiming the 30-per- cent additional first year depreciation deduction to claiming the 50-percent addi- tional first year depreciation deduction for 50-percent bonus depreciation property (provided the property is not included in any class of property for which the tax- payer elected the 30-percent, instead of the 50-percent, additional first year de- preciation deduction) or a change from claiming the 50-percent additional first year depreciation deduction to claiming the 30-percent additional first year depre- February 9, 20044232004-6 I.R.B. ciation deduction for qualified property (including propertythat is included in a class of property for which the tax- payer elected the 30-percent, instead of the 50-percent, additional first year de- preciation deduction) or qualified New York Liberty Zone property, and the re- sulting change to the amount otherwise allowable as a depreciation deduction for the property’s remaining adjusted de- preciable basis (or similar basis). This paragraph (e)(2)(ii)(d)(2)(iii)doesnotap- ply if a taxpayer is making a late election or revoking a timely valid election under section 168(k) or 1400L(b) (see paragraph (e)(2)(ii)(d)(3)(iii)ofthissection). (iv) A change from claiming to not claiming the additional first year depre- ciation deduction for an asset that is not qualified property, 50-percent bonus de- preciation property, or qualified New York Liberty Zone property, and the resulting change to the amount otherwise allowable as a depreciation deduction for the prop- erty’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 Code (for example, §1.197–2(f)(1)(ii)), or other guidance pub- lished in the Internal Revenue Bulletin. (vi) A change in the accounting for de- preciable or amortizable assets from a sin- gle asset account to a multiple asset ac- count (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 as- sets that are mass assets accounted for in multiple asset accounts or pools, a change in the method of identifying which as- sets have been disposed. For purposes of this paragraph (e)(2)(ii)(d)(2)(vii), the termmass assetsmeans a mass or group of individual items of depreciable or amorti- zable assets that are not necessarily homo- geneous, each of which is minor in value relative to the total value of the mass or group, numerous in quantity, usually ac- counted for only on a total dollar or quan- tity 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 des- ignate by publication in theFederal Regis- teror in the Internal Revenue Bulletin (see §601.601(d)(2) of this chapter). (3)Changes in depreciation or amor- tization that are not a change in method of accounting—(i)Useful life.Anadjust- ment in the useful life of a depreciable or amortizable asset forwhich depreciation is determined under section 167 (other than under section 168, section 1400I, sec- tion 1400L, or former section 168) is not a change in method of accounting. This adjustment in useful life is corrected by adjustments in the taxable year in which the conditions known to exist at the end of that taxable year changed thereby re- sultinginaredeterminationoftheuseful life under §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 assess- ment), and in subsequent taxable years. In other situations, the adjustment in useful life may be corrected by adjustments in the earliest taxable year open under the period of limitation for assessment un- der section 6501(a) or the earliest taxable year under examination by the Internal Revenue Service (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 §1.167(a)–1(b)), the taxpayer may correct the adjustment in useful life by adjustments in the current and subsequent taxable years. This para- graph (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 197), the regulations under the Code, or other guidance published in the Internal Revenue Bulletin and, therefore, such change is a change in method of account- ing (unless paragraph (e)(2)(ii)(d)(3)(v)of this section applies). (ii)Change in use. A change in com- puting depreciation or amortization al- lowances 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 elec- tion or the revocation of a timely valid de- preciation or amortization election is not a change in method of accounting, except as otherwise expressly provided by the In- ternal Revenue Code, the regulations un- der the 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 Recon- ciliation Act of 1993 (107 Stat. 312, 540) (relating to amortizable section 197 intan- gibles). A taxpayer may request consent to make a late election or revoke a timely validelectionbysubmittingarequestfora private letter ruling. (iv)Salvage value. Except as provided under paragraph (e)(2)(ii)(d)(2)(v)ofthis section, a change in salvage value of a de- preciable or amortizable asset is not treated as a change in method of accounting. (v)Placed-in-service date. Any change in the placed-in-service date of a depre- ciable or amortizable asset is not treated as a change in method of accounting. The change in placed-in-service date 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. (vi) Any other change in depreciation or amortization as the Secretary may desig- nate by publication in theFederal Regis- teror in the Internal Revenue Bulletin (see §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)ap- plies, the item being changed generally is the depreciation treatment of each individ- ual depreciable or amortizable asset. How- ever, the item is the depreciation treatment of each vintage account with respect to a depreciable asset for which depreciation is 2004-6 I.R.B.424February 9, 2004 determined under §1.167(a)–11 (CLADR property). Further, a change in comput- ing depreciation or amortization under sec- tion 167 (other than under section 168, sec- tion 1400I, section 1400L, or former sec- tion 168) is permitted only with respect to all assets in a particular account (as defined in §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)ap- plies— (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 depre- ciation allowancesover the remaining recovery period (for further guidance, see section 6.06 of Rev. Proc. 87–57, 1987–2 C.B. 687, and §601.601(d)(2)(ii)(b)ofthis chapter). (ii)Depreciation method changes for section 167 property.Foradepre- ciable or amortizable asset for which depreciation is determined under sec- tion 167 (other than under section 168, section 1400I, section 1400L, or for- mer section 168), see §1.167(e)–1T(b), (c), and (d) for the changes in depre- ciationmethodthatarepermittedtobe made without the consent of the Com- missioner. For CLADR property, see §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 §1.167(a)–11(b)(4)(iii)(c) for how to correct an incorrect classification or char- acterization of CLADR property. (iii)Section 481 adjustment. Except as otherwise expressly provided by the Inter- nal Revenue Code, the regulations under the 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 com- puting depreciation or amortization for an asset because this change is implemented by either a cut-off method (for further guidance, 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 §601.601(d)(2)(ii)(b)ofthischapter)ora modified cut-off method (under which the adjusted depreciable basis of the asset as of the beginning of the year of change is re- covered using the new permissible method of accounting), as appropriate. However, achangefromanimpermissiblemethodof computing depreciation or amortization to a permissible method of computing depre- ciation 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 de- preciable or amortizable (or vice versa) or a change in the treatment of an asset from expensing to depreciating (or vice versa) results in a section 481 adjustment. (iii)Examples. The rules of this para- graph (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 disburse- ments 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 Fed- eral 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 inwhich 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 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 account- ing for inventories. Example 6. A taxpayer in the manufacturing busi- ness has for many taxable years valued its inventories at cost. However, cost has been improperly computed since no overhead costs have been included in valu- ing the inventories at cost. The failure to allocate an appropriate portion of overhead to the value of inven- tories is contrary to the requirement of the Internal Revenue Code and the regulations under the Code. A change requiring appropriate allocation of overhead is a change in method of accounting because it in- volves 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 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 in- ventories 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 2000, A1, a calendar year taxpayer engaged in the trade or business of manufactur- ing 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 did not make any elections under section 168 on its 2000 Federal tax return. As a result, on its 2000, 2001, and 2002 February 9, 20044252004-6 I.R.B. federal tax returns, A1 depreciated the $10,000,000 under the general depreciation system of section 168(a), using the straight line method of deprecia- tion, a 39-year recovery period, and the mid-month convention. In 2003, A1 completes a cost segrega- tion 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 2000 as 5-year prop- erty under section 168(e) and depreciated on A1’s 2000, 2001, and 2002 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. Pur- suant to paragraph (e)(2)(ii)(d)(2)(i)ofthissection, 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)ofthissectiondoesnot apply because the assets are depreciated under sec- tion 168. Example 10. In 1996, B, a calendar year tax- payer, purchased and placed in service new equip- ment 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 depre- ciated 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 2003, the IRS examines B’s 2000 Federal income tax return and changes the de- preciation of the equipment to the alternative depreci- ation system, using the straight line method of depre- ciation, a 20-year recoveryperiod, 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 excep- tion under paragraph (e)(2)(ii)(d)(3)(i) of this section does not apply because the assets are depreciated un- der section 168. Example 11. In May 2001, C, a calendar year tax- payer, purchased and placed in service equipment for use in its trade or business. C never held this equip- ment for sale. However, C incorrectly treated the equipment as inventory on its 2001 and 2002 Federal tax returns. In 2003, C realizes that the equipment should have been treated as a depreciable asset. Pur- suant to paragraph (e)(2)(ii)(d)(2)ofthissection,C’s change in the treatment of the equipment from inven- tory to a depreciable asset is a change in method of accounting. This method change results in a section 481 adjustment. Example 12. Since 2001, 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 §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 sec- tion 481 adjustment because the change is from one permissible method to another permissible method. Example 13. Since 2000, E, a calendar year tax- payer, 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 ba- sis 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 identi- fication. Because of changes in E’s recordkeeping in 2003, it is impracticable for E to continue to iden- tify 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)ofthissec- tion, this change is a change in method of account- ing. This method change results in no section 481 adjustment because the change is from one permissi- ble method to another permissible method. Example 14. In August 2001, F, a calendar tax- payer, 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 made no elections under section 168 on its 2001 Fed- eral tax return. As a result, on its 2001 and 2002 Fed- eral tax returns, F depreciated the copier under the general depreciation system of section 168(a), using the 200-percent declining balance method of depre- ciation, a 7-year recovery period, and the half-year convention. In 2003, F realizes that the copier is 5-year property and should have been depreciated on its 2001 and 2002 Federal tax returns under the general depreciation system using a 5-year recovery period rather than a 7-year recovery period. Pur- suant 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 ex- ception under paragraph (e)(2)(ii)(d)(3)(i)ofthissec- tion does not apply because the copier is depreciated under section 168. Example 15. In 1998, 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 useful life of 13 years. In 2003, because of chang- ing conditions, G changes the remaining useful life of the intangible asset to 2 years. Pursuant to para- graph (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 sec- tion 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 Code, or other guid- ance published in the Internal Revenue Bulletin. Example 16. In July 2001, H, a calendar year tax- payer, purchased and placedin service “off-the-shelf” computer software and a new computer. The cost of the new computer and computer software are sepa- rately 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 2001 Federal tax return, H elected to depreciate its 5-year property placed in service in 2001 under the alterna- tive depreciation system of section 168(g). 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 depreci- ation system, using the straight line method of depre- ciation, a 5-year recoveryperiod, and the half-year convention. In 2003, H realizes that the cost of the software should have been amortized under section 167(f)(1), using the straight line method of depre- ciation, a 36-month useful life, and a monthly con- vention. H’s change from 5-years to 36-months is a change in method of accounting because H is chang- ing to a useful life that is specifically assigned by sec- tion 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 September 15, 2001, I2, a cal- endar 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 un- der section 168(e) with a class life of 9 years and is qualified property under section 168(k). I2 did not place in service any other depreciable property in 2001. Section 168(g)(1)(A) through (D) do not ap- ply to the equipment. I2 intended to elect the alter- native depreciation system under section 168(g) for 5-year property placed in service in 2001. However, I2 did not make the election. Instead, I2 deducted on its 2001 Federal tax return the 30-percent additional first year depreciation attributable to the equipment and, on its 2001 and 2002 Federal tax returns, depre- ciated the remaining adjusted depreciable basis of the equipment under the general depreciation system un- der 168(a), using the 200-percent declining balance method, a 5-year recovery period, and the half-year convention. In 2003, I2 realizes its failure to make the alternative depreciation system election in 2001 and files a Form 3115 to change its method of depreci- ating the remaining adjusted depreciable basis of the 2001 equipment to the alternative depreciation sys- tem. Because this equipment is not required to be de- preciated 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 (2001) and, consequently, I2 is attempting to make a late election under section 168(g)(7). Accord- ingly, I2’s change to the alternative depreciation sys- tem 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 un- der §301.9100–3 of this chapter, requesting an exten- sion of time to make the alternative depreciation sys- tem election on its 2001 Federal tax return. (3) [Reserved]. For further guidance, see §1.446–1(e)(3). (4)Effective date—(i)In general.Ex- cept as provided in paragraphs (e)(3)(iii) and (e)(4)(ii) of this section, paragraph (e) of this section applies on or after Decem- ber 30, 2003. For the applicability of reg- ulations before December 30, 2003, see 2004-6 I.R.B.426February 9, 2004 §1.446–1(e) in effect prior to December 30, 2003 (§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 para- graph (e)(2)(ii)(d) of this section, para- graph (e)(2)(iii)Examples 9through17 of this section, the addition of the lan- guage “certain changes in computing de- preciation or amortization (see paragraph (e)(2)(ii)(d) of this section)” to the last sen- tence of paragraph (e)(2)(ii)(a)ofthissec- tion, and the removal of all language re- garding useful life and the sentence “On the other hand, a correction to require de- preciation in lieu of a deduction for the cost of a class of depreciable assets which had been consistently treated as an expense in the year of purchase involves the question of the proper timing of an item, and is to be treated as a change in method of ac- counting” from paragraph (e)(2)(ii)(b)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 for taxable years 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 for taxable years ending on or after December 30, 2003. (iii) The applicability of paragraph (e) of this section expires on or before December 29, 2006. Par. 6. Section 1.1016–3 is amended by: 1. Redesignating paragraph (h) as para- graph (i). 2. Adding new paragraphs (h) and (j). The additions read as follows: §1.1016–3 Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 28, 1913. ***** (h)Application to a change in method of accounting. [Reserved]. For further guidance, see §1.1016–3T(h). ***** (j)Effective date. [Reserved]. For fur- ther guidance, see §1.1016–3T(j)(1) and (2). Par. 7. Section 1.1016–3T is added to read as follows: §1.1016–3T Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 28, 1913 (temporary). (a) through (g) [Reserved]. For further guidance, see §1.1016–3(a) through (g). (h)Application to a change in method of accounting. For purposes of determining whether a change in depreciation or amor- tization for propertysubject to section 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or to section 168 prior to its amendment by the Tax Reform Act of 1986 (100 Stat. 2121) (former section 168) is a change in method of accounting under section 446(e) and the regulations under section 446(e), section 1016(a)(2) does not permanently affect a taxpayer’s lifetime income. (i) [Reserved]. For further guidance, see §1.1016–3(i). (j)Effective date—(1)In general.Ex- cept as provided in paragraph (j)(2) of this section, this section applies on or after De- cember 30, 2003. For the applicability of regulations before December 30, 2003, see §1.1016–3 in effect prior to December 30, 2003 (§1.1016–3 as contained in 26 CFR part 1 edition revised as of April 1, 2003). (2)Depreciation or amortization changes. Paragraph (h) of this section applies to a change in depreciation or amortization for property subject to sec- tion 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or former section 168 for tax- able years ending on or after December 30, 2003. (3) The applicability of this section ex- pires on or before December 29, 2006. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved December 18, 2003. Pamela F. Olson, Assistant Secretary of the Treasury (Tax Policy). (Filed by the Office of the Federal Register on December 30, 2003, 8:45 a.m., and published in the issue of the Federal Register for January 2, 2004, 69 F.R. 5) Section 467.—Certain Payments for the Use of Property or Services The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 468.—Special Rules for Mining and Solid Waste Reclamation and Closing Costs The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 482.—Allocation of Income and Deductions Among Taxpayers Federal short-term, mid-term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 483.—Interest on Certain Deferred Payments The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 642.—Special Rules for Credits and Deductions Federal short-term, mid-term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 807.—Rules for Certain Reserves The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 846.—Discounted Unpaid Losses Defined The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. February 9, 20044272004-6 I.R.B. Section 1274.—Determi- nation of Issue Price in the Case of Certain Debt Instru- ments Issued for Property (Also sections 42, 280G, 382, 412, 467, 468, 482, 483, 642, 807, 846, 1288, 7520, 7872.) Federal rates; adjusted federal rates; adjusted federal long-term rate and the long-term exempt rate.For purposes of sections 382, 642, 1274, 1288, and other sections of the Code, tables set forth the rates for February 2004. Rev. Rul. 2004–9 This revenue ruling provides various prescribed rates for federal income tax purposes for February 2004 (the current month). Table 1 contains the short-term, mid-term, and long-term applicable fed- eral rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the ap- propriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for de- termining the present value of annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520. REV. RUL. 2004–9 TABLE 1 Applicable Federal Rates (AFR) for February 2004 Period for Compounding AnnualSemiannualQuarterlyMonthly Short-Term AFR1.62%1.61%1.61%1.60% 110% AFR1.78%1.77%1.77%1.76% 120% AFR1.94%1.93%1.93%1.92% 130% AFR2.10%2.09%2.08%2.08% Mid-Term AFR3.44%3.41%3.40%3.39% 110% AFR3.79%3.75%3.73%3.72% 120% AFR4.13%4.09%4.07%4.06% 130% AFR4.48%4.43%4.41%4.39% 150% AFR5.19%5.12%5.09%5.07% 175% AFR6.06%5.97%5.93%5.90% Long-Term AFR4.94%4.88%4.85%4.83% 110% AFR5.44%5.37%5.33%5.31% 120% AFR5.95%5.86%5.82%5.79% 130% AFR6.44%6.34%6.29%6.26% REV. RUL. 2004–9 TABLE 2 Adjusted AFR for February 2004 Period for Compounding AnnualSemiannualQuarterlyMonthly Short-term adjusted AFR 1.41%1.41%1.41%1.41% Mid-term adjusted AFR2.64%2.62%2.61%2.61% Long-term adjusted AFR 4.31%4.26%4.24%4.22% 2004-6 I.R.B.428February 9, 2004 REV. RUL. 2004–9 TABLE 3 Rates Under Section 382 for February 2004 Adjusted federal long-term rate for the current month4.31% Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the current month and the prior two months.)4.58% REV. RUL. 2004–9 TABLE 4 Appropriate Percentages Under Section 42(b)(2) for February 2004 Appropriate percentage for the 70% present value low-income housing credit7.97% Appropriate percentage for the 30% present value low-income housing credit3.42% REV. RUL. 2004–9 TABLE 5 Rate Under Section 7520 for February 2004 Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest4.2% Section 1288.—Treatment of Original Issue Discounts on Tax-Exempt Obligations The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 1361.—S Corpora- tion Defined 26 CFR 1.1361–4: Effect on QSub election. Whether an Employee Stock Ownership Plan may be a shareholder in an S corporation. See Rev. Rul. 2004-4, page 414. Section 4975.—Tax on Prohibited Transactions 26 CFR 54.4975–11: “ESOP” requirements. Whether, under each of the three situations de- scribed therein, the Employee Stock Ownership Plan of an S corporation has a nonallocation year within the meaning of section 409(p)(3) of the Internal Rev- enue Code. See Rev. Rul. 2004-4, page 414. Section 4979A.—Tax on Certain Prohibited Allocations of Qualified Securities Whether transactions involving an S corporation ESOP and the ownership by a disqualified person of synthetic equity in a nonallocation year of the ESOP give rise to the excise tax described in section 4979A. See Rev. Rul. 2004-4, page 414. Section 6011.—General Requirement of Return, S tatement or List 26 CFR 1.6011–4: Requirement of statement disclos- ing participation in certain transactions by taxpay- ers. Whether transactions involving an S corporation ESOP and the ownership by a disqualified person of synthetic equity in a nonallocation year of the ESOP is a listed transaction. See Rev. Rul. 2004-4, page 414. 26 CFR 1.6011–4: Requirement of statement disclos- ing participation in certain transactions by taxpay- ers. T.D. 9108 DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 301 Confidential Transactions AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: These final regulations mod- ify and clarify the rules relating to confi- dential transactions under the Income Tax Regulations, and make minor conforming changes to the list maintenance rules under the Procedure and Administration Regula- tions. These regulations affect taxpayers participating in reportable transactions and persons responsible for maintaining and furnishing lists of investors in reportable transactions. DATES:Effective Date:These regulations are effective December 29, 2003. Applicability Date:For dates of applicability, see§1.6011–4(h) and §301.6112–1. FOR FURTHER INFORMATION CONTACT: Tara P. Volungis or Charlotte Chyr, 202–622–3070 (not a toll-free number). SUPPLEMENTARY INFORMATION: Paperwork Reduction Act The collections of information con- tained in these regulations have been previously reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Re- duction Act of 1995 (44 U.S.C. 3507(d)) under control numbers 1545–1685 and 1545–1686. February 9, 20044292004-6 I.R.B. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collec- tion of information displays a valid OMB control number assigned by the Office of Management and Budget. Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103. Background This document amends 26 CFR parts 1 and 301 by modifying and clarifying the rules relating to the disclosure of re- portable transactionsby certain taxpayers on their Federal income tax returns under section 6011 and by making conforming changes to the rules under section 6112. On October 17, 2002, the IRS is- sued temporary and proposed regulations modifying the rules under sections 6011, 6111, and 6112 (T.D. 9017, 2002–2 C.B. 815; REG–103735–00, REG–154117–02, REG–154116–02,REG–154115–02, REG–154429–02,REG–154423–02, REG–154426–02,REG–110311–98, 2002–2 C.B. 832; T.D. 9018, 2002–2 C.B 823; REG–103736–00, 2002–2 C.B. 834) (the October 2002 regulations). The October 2002 regulations were published in theFederal Register(67 FR 64799, 67 FR 64840; 67 FR 64807, 67 FR 64842) on October 22, 2002. On December 11, 2002, and on January 7, 2003, the IRS and Trea- sury Department held a public hearing on these regulations. On February 28, 2003, the IRS issued final regulations under sec- tions 6011, 6111, and 6112 (T.D. 9046, 2003–1 C.B. 614) (the February 2003 reg- ulations). The February 2003 regulations were published in theFederal Register (68 FR 10161) on March 4, 2003. Since finalizing the disclosure regula- tions, the IRS and Treasury Department have received numerous comments con- cerning the confidentiality filter. The IRS and Treasury Department received requests to exclude certain transactions from the scope of the confidentiality fil- ter, and requests to modify the language of the regulation itself. After reviewing these comments, the IRS and Treasury Department have decided to narrow the confidentiality filter under §1.6011–4(b) (3). Explanation of Provisions Section 1.6011–4(b)(3) provides that certain transactions are identified as con- fidential transactions. Confidential trans- actions are reportable transactions that are subject to the disclosure rules under §1.6011–4 and the list maintenance rules under §301.6112–1. Currently, a confi- dential transaction is a transaction that is offered under conditions of confidential- ity. The confidentiality filter generally provides a presumption of non-confiden- tiality if the taxpayer receives written authorization to disclose the tax treatment and tax structure of the transaction. The IRS and Treasury Department have concluded that the confidentiality filter should be limited to situations in which an advisor is paid a large fee and imposes a limitation on disclosure that protects the confidentiality of the advi- sor’s tax strategies. The IRS and Treasury Department believe that the confidential- ity filter should not apply to transactions in which confidentiality is imposed by a party to the transaction acting in such capacity. Accordingly, the confidentiality filter has been narrowed to reflect this policy. Further, the exceptions and pre- sumption language have been removed because the IRS and Treasury Department have concluded that they no longer are necessary under this narrower rule. Con- forming changes have been made to the rules under §301.6112–1. The IRS and Treasury Department also have made minor clarifying changes under §1.6011–4. The regulations clarify that a return includes amended returns for pur- poses of determining when a disclosure must be made. The IRS and Treasury De- partment will continue to accept comments and will make other changes as appropri- ate. Special Analyses It has been determined that this Trea- sury decision is not a significant regula- tory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has been determined pursuant to 5 U.S.C. 553(b)(B) that notice and public procedure are unnecessary and contrary to the public interest. These final regulations substantially reduce taxpayer compliance burdens by limiting the scope of transactions subject to the disclosure re- quirements of §1.6011–4. For the same reason, pursuant to 5 U.S.C. 553(d)(1) and (3) a delayed effective date for these fi- nal regulations is not required. Because no notice of proposed rulemaking is required, the provisions of the Regulatory Flexibil- ity Act (5 U.S.C. chapter 6) do not apply. However, the IRS and Treasury Depart- ment welcome comments on whether these final regulations impose additional costs and compliance burdens on small busi- nesses. Any such comments should pro- vide specific information concerning those costs and burdens. In addition, the IRS and Treasury Department will consider hold- ing a public hearing concerning these regu- lations if there is sufficient interest from af- fected parties. Pursuant to section 7805(f) of the Internal Revenue Code, these regu- lations were submitted to the Chief Coun- sel for Advocacy of the Small Business Administration for comment on their im- pact on small business. Draftin g Information The principal authors of these regula- tions are Tara P. Volungis and Charlotte Chyr, Office of the Associate Chief Coun- sel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development. ***** Adoption of Amendments to the Regulations Accordingly, 26 CFR parts 1 and 301 are amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.6011–4 is amended as follows: 1. Paragraph (b)(3) is revised. 2. Paragraph (e)(1) is amended by re- moving the second sentence and replacing it with two new sentences in its place. 3. Paragraphs (e)(2)(i) and (h) are re- vised. The revisions and additions read as fol- lows: 2004-6 I.R.B.430February 9, 2004 §1.6011–4 Requirement of statement disclosing participation in certain transactions by taxpayers. ***** (b)***** (3)Confidential transactions—(i)In general. A confidential transaction is a transaction that is offered to a taxpayer under conditions of confidentiality and for which the taxpayer has paid an advisor a minimum fee. (ii)Conditions of confidentiality.A transaction is considered to be offered to a taxpayer under conditions of confiden- tiality if the advisor who is paid the min- imum fee places a limitation on disclosure by the taxpayer of the tax treatment or tax structure of the transaction and the limi- tation on disclosure protects the confiden- tiality of that advisor’s tax strategies. A transaction is treatedas confidential even if the conditions of confidentiality are not legally binding on the taxpayer. A claim that a transaction is proprietary or exclu- sive is not treated as a limitation on dis- closure if the advisor confirms to the tax- payer that there is no limitation on disclo- sure of the tax treatment or tax structure of the transaction. (iii)Minimum fee. For purposes of this paragraph (b)(3), the minimum fee is: (A) $250,000 for a transaction if the taxpayer is a corporation. (B) $50,000 for all other transactions unless the taxpayer is a partnership or trust, all of the owners or beneficiaries of which are corporations (looking through any partners or beneficiaries that are them- selves partnerships or trusts), in which case the minimum fee is $250,000. (iv)Determination of minimum fee.For purposes of this paragraph (b)(3), a mini- mum fee includes all fees for a tax strategy or for services for advice (whether or not tax advice) or for the implementation of a transaction. These fees include consid- eration in whatever form paid, whether in cash or in kind, for services to analyze the transaction (whether or not related to the tax consequences of the transaction), for services to implement the transaction, for services to document the transaction, and for services to prepare tax returns to the ex- tent that the fees exceed the fees customary for return preparation. For purposes of this paragraph (b)(3), a taxpayer also is treated as paying fees to an advisor if the taxpayer knows or should know that the amount it pays will be paid indirectly to the advisor, such as through a referral fee or fee-shar- ing arrangement. A fee does not include amounts paid to a person, including an ad- visor, in that person’s capacity as a party to the transaction. For example, a fee does not include reasonable charges for the use of capital or the sale or use of property. (v)Related parties. For purposes of this paragraph (b)(3), persons who bear a relationship to each other as described in section 267(b) or 707(b) will be treated as thesameperson. ***** (e) * * * (1) * * * In addition, the disclosure statement for a reportable transaction must be attached to each amended return that reflects a taxpayer’s participation in a re- portable transaction. A copy of the disclo- sure statement must be sent to OTSA at the same time that any disclosure statement is firstfiledbythetaxpayer.*** (2) * * * (i)Listed transactions. If a transaction becomes a listed transaction after the fil- ing of a taxpayer’s tax return (including an amended return) reflecting either tax con- sequences or a tax strategy described in the published guidance listing the transac- tion (or a tax benefit derived from tax con- sequences or a tax strategy described in the published guidance listing the transac- tion) and before the end of the period of limitations for the final return (whether or not already filed) reflecting the tax conse- quences, tax strategy, or tax benefit, then a disclosure statement must be filed as an at- tachment to the taxpayer’s tax return next filed after the date the transaction is listed regardless of whether the taxpayer partici- patedinthetransactioninthatyear. ***** (h)Effective dates. This section applies to Federal income tax returns filed after February 28, 2000. However, paragraphs (b)(3), (e)(1), and (e)(2)(i) of this section applytotransactionsenteredintoonoraf- ter December 29, 2003. All the rules in this section may be relied upon for trans- actions entered into on or after January 1, 2003, and before December 29, 2003. Oth- erwise, the rules that apply with respect to transactions entered into before December 29, 2003, are contained in §1.6011–4 in ef- fect prior to December 29, 2003, (see 26 CFR part 1 revised as of April 1, 2003). PART 301—PROCEDURE AND ADMINISTRATION Par. 3. The authority citation for part 301 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 4. In §301.6112–1, paragraph (c)(3)(iii) is amended by revising the first sentence, removing the words “for advice or implementation” from the third sen- tence, and adding two sentences after the third sentence, to read as follows: §301.6112–1 Requirement to prepare, maintain, and furnish lists with respect to potentially abusive tax shelters. ***** (c) * * * (3) * * * (iii) * * * In determining whether the minimum fee threshold is satisfied, all fees for a tax strategy or for services for advice (whether or not tax advice) or for the im- plementation of a transaction that is a po- tentially abusive tax shelter are taken into account.***Afeedoesnotinclude amounts paid to a person, including an ad- visor, in that person’s capacity as a party to the transaction. For example, a fee does not include reasonable charges for the use of capital or the sale or use of property. *** ***** Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved December 18, 2003. Pamela F. Olson, Assistant Secretary of the Treasury. (Filed by the Office of the Federal Register on December 29, 2003, 8:45 a.m., and published in the issue of the Federal Register for December 30, 2003, 68 F.R. 75128) Section 6111.—Registra- tion of Tax Shelters 26 CFR 301.6111–2: Confidential corporate tax shelters. Whether transactions involving an S corporation ESOP and the ownership by a disqualified person of synthetic equity in a nonallocation year of the ESOP February 9, 20044312004-6 I.R.B. is a listed transaction. See Rev. Rul. 2004-4, page 414. Section 6112.—Organizers and Sellers of Potentially Abusive Tax Sh elters Must Keep Lists of Investors 26 CFR 301.611 2–1: Requirement to prepare, main- tain and furn ish lists with respect to potentially abu- sive tax shel ters. Whether a lis t must be maintained identifying each person who wa s sold an interest in transactions in- volving an S corporation ESOP and the ownership by a disqualified person of synthetic equity in a nonallo- cation year of the ESOP. See Rev. Rul. 2004-4, page 414. Section 7520.—Valuation Tables The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. Section 7872.—Treatment of Loans With Below-Market Interest Rates The adjusted applicable federal short-term, mid- term, and long-term rates are set forth for the month of February 2004. See Rev. Rul. 2004-9, page 428. 2004-6 I.R.B.432February 9, 2004 Part III. Administrative, Procedural, and Miscellaneous Electronic Delivery of Form 1099 and Form 5498 Payee Statements Notice 2004–10 I. Purpose and Scope This notice provides guidance to spon- sors or administrators of retirement plans or qualified tuition programs (QTPs), em- ployers of simplified employee pensions (SEPs), or trustees, custodians, or issuers of traditional Individual Retirement Ar- rangements (IRAs), Roth IRAs, Coverdell education savings accounts (CESAs), or Archer Medical Savings Accounts (Archer MSAs) regarding the electronic delivery of payee statements to recipients. Specifi- cally, this notice provides that a furnisher of a Form 1099 or a Form 5498 relat- ing to the reporting of contributions and distributions of pensions, SEPs, tradi- tional IRAs, Roth IRAs, QTPs, CESAs, and Archer MSAs may deliver electroni- cally the payee statementsrequiredtobe furnished to recipients for 2003 and sub- sequent years. II. Background Section 220(h) of the Internal Revenue Code provides that the Secretary may re- quire the trustee of an Archer MSA to make such reports regarding the account to the Secretary and to the account holder with respect to contributions, distributions, and such other matters as the Secretary de- termines appropriate.The required reports must be filed at the time and in the manner and furnished to the individuals at the time and in the manner prescribed by the Secre- tary. Section 408(i) provides that the trustee of an IRA and the issuer of an endowment contract described in § 408(b) or an indi- vidual retirement annuity must make such reports regarding theaccount, contract, or annuity to the Secretary and to the indi- viduals for whom the account, contract, or annuity is, or is to be, maintained with respect to contributions (and the years to which they relate), distributions aggregat- ing $10 or more in any calendar year, and such other matters as the Secretary may re- quire. These reports must be filed at the time and in the manner the Secretary pre- scribes and must be furnished to individu- als not later than January 31 of the calendar year following the calendar year to which the reports relate and in the manner pre- scribed by the Secretary. Section 408(l) provides that an em- ployer who makes contributions on behalf of employees to a SEP must provide re- ports with respect to such contributions as the Secretary may require. The required reports must be filed at the time and in the manner and furnished to employees at the time and in the manner prescribed by the Secretary. Section 529(d) provides that each offi- cer or employee having control of a § 529 QTP must make such reports regarding the program to the Secretary and to designated beneficiaries with respect to contributions, distributions, or such other matters as the Secretary may require. The required re- ports must be filed at the time and in the manner and furnished to the individuals at thetimeandinthemannerprescribedby the Secretary. Section 530(h) provides that the trustee of a CESA must make reports regarding the account to the Secretary and to the ben- eficiary of the account with respect to con- tributions, distributions, or such other mat- ters as the Secretary may require. The re- quired reports must be filed at the time and in the manner and furnished to the indi- viduals at the time and in the manner pre- scribed by the Secretary. Section 6047(d)(1) provides for the Secretary by forms or regulations to re- quire the plan sponsor or administrator from which designated distributions may be made and the issuer of a contract under which designated distributions may be made to make returns and reports regard- ing the plan or contract to the Secretary and to participants andbeneficiaries of the plan or contract and such other persons as the Secretary may by regulations pre- scribe. Section 6047(d)(2) provides that the reports must be in the form, be made at such time, and contain such information as the Secretary may prescribe by forms or regulations. Under § 3405(e)(1), a desig- nated distribution generally includes any distribution or payment from or under a § 401 qualified plan, a § 403(b) tax-shel- tered annuity, a § 457 governmental plan, an IRA, and a commercial annuity. Section 401 of the Job Creation and Worker Assistance Act of 2002, Pub. L. No. 107–147, 116 Stat. 21, 40 (2002), pro- vides that any person required to furnish a statement under any section of subpart B of part III of subchapter A of chapter 61 of the Internal Revenue Code for any tax- able year ending after the date of the enact- ment of the Act, may electronically furnish such statement (without regard to any first class mailing requirement) to any recipient who has consented to the electronic provi- sion of the statement in a manner similar to the one permitted under the regulations is- sued under § 6051 of the Internal Revenue Code or in such other manner as provided by the Secretary. In accordance with this provision, part H of the 2003 General In- structions for Forms 1099, 1098, 5498, and W–2G, under the heading “Electronic re- cipient statements,” provides that if a fur- nisher is required by sections 6041 through 6050T to furnish a written statement of an informationreturntoarecipient, then the furnisher may provide the payee statement electronically instead of on paper if the re- quirements specified in the instructions are satisfied. The Secretary also has the authority to permit the electronic furnishing of Forms 1099 and 5498 payee statements relating to pensions, SEPs, traditional IRAs, Roth IRAs, QTPs, CESAs, and Archer MSAs. However, the 2003 General Instructions for Forms 1099, 1098, 5498, and W–2G do not provide that payee statements for re- porting contributions and distributions of pensions, traditional IRAs, Roth IRAs, and Archer MSAs may be furnished electroni- cally. III. Permitted Electronic Delivery of Payee Statements This notice provides that, until further guidance is published, notwithstanding part H of the 2003 General Instructions for Forms 1099, 1098, 5498, and W–2G, a sponsor or administrator of a retirement plan or a QTP, an employer of a SEP, or a trustee, custodian, or issuer of an IRA, a Roth IRA, a CESA, or an Archer MSA may furnish the required Form 1099 or Form 5498 payee statements electroni- February 9, 20044332004-6 I.R.B. cally to recipients if the furnisher satisfies the consent, format, posting, and noti- fication requirements described in part H of the 2003 General Instructions for Forms 1099, 1098, 5498, and W–2G and furnishes such payee statements by their respective due dates. This notice hereby modifies part H of the 2003 General Instructions for Forms 1099, 1098, 5498, and W–2G by permit- ting the electronic delivery of the Form 1099–R, Form 1099–MSA, Form 1099–Q, Form 5498, Form 5498–ESA, and Form 5498–MSA payee statements by their re- spective due dates. IV. Effective Date This notice is applicable with respect to Form 1099–R, Form 1099–MSA, Form 1099–Q, Form 5498, Form 5498–ESA, and Form 5498–MSA payee statements required to be furnished to recipients for 2003 and subsequent years. V. Effect on Other Documents The document entitled 2003 General In- structions for Forms 1099, 1098, 5498, and W–2G is hereby modified. Drafting Information The principal author of this notice is Pamela R. Kinard of the Office of the Di- vision Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury participated in its develop- ment. For further information regarding this notice, contact Pamela R. Kinard at (202) 622–6060 (not a toll-free number). Recordkeeping Agreement Pilot Program Involving Credit for Increasing Research Activities Notice 2004–11 SECTION 1. PURPOSE This notice announces a pilot program that will permit the Internal Revenue Ser- vice (Service) and large and mid-size busi- ness taxpayers to enter into research credit recordkeeping agreements (RCRAs). If a taxpayer complies with the terms of a RCRA, then the Service will deem the tax- payer to have satisfied the recordkeeping requirements of section 6001 of the In- ternal Revenue Code (Code) for purposes of the credit for increasing research ac- tivities under section 41 (research credit). A RCRA does not relieve the taxpayer of its section 6001 recordkeeping obligations for purposes of any other provision of the Code. The purposes of the pilot program are to develop and evaluate a procedure: 1. To resolve issues concerning the type and amount of documents that a tax- payer must maintain, retain, and produce to satisfy the recordkeeping requirements of section 6001 for the research credit; and 2. To reduce the costs, burdens, and de- lays frequently encountered by taxpayers and the Service in examinations involving the research credit. SECTION 2. DESCRIPTION OF THE PILOT PROGRAM The Large and Mid-Size Business Op- erating Division (LMSB) will administer the pilot program. The pilot program is available to LMSB taxpayers who have claimed the research credit on a timely filed original Form 1120,“U.S. Corpora- tion Income Tax Return,”series return if the return is currently under examination. LMSB anticipates that it may select five to ten applicants for participation in the pilot program. LMSB intends to establish a team to work with selected applicants to resolve the type and amount of documents that each of these taxpayers must maintain, re- tain, and produce with respect to the tax- able years covered by the RCRA to satisfy the recordkeeping requirements of section 6001 for the researchcredit. Pilot program participants may be asked to evaluate the pilot program. The Service will evaluate the program and it may be extended, with modifications, on a permanent basis. SECTION 3. DESCRIPTION OF A RCRA The Service and a taxpayer will enter into a RCRA through a letter of under- standing signed by the Industry Director. The letter of understanding will specify the type and amount of documents that the tax- payer must maintain, retain, and produce to be deemed to satisfy the recordkeeping requirements of section 6001 for the re- search credit. A RCRA may cover up to three consec- utive taxable years ending after the date of the RCRA’s issuance. A RCRA will not cover the following businesses or taxpay- ers: 1. Any trade or business (or major por- tion of any trade or business) acquired by the taxpayer after the RCRA was issued; 2. Any corporation that joined the tax- payer’s controlled group of corporations after the RCRA was issued, see I.R.C. § 41(f)(1)(A); and 3. Any trade or business (whether or not incorporated) that was not under common control with the taxpayer on the date the RCRA was issued, see I.R.C. § 41(f)(1)(B). SECTION 4. REQUEST TO PARTICIPATE IN THE RCRA PILOT PROGRAM .01Contentofrequest. A taxpayer must submit a written re- quest to participate in the pilot program to the Team Manager assigned to the exam- ination. Taxpayers should submit the re- quest on or before May 10, 2004. The re- quest to participate in the RCRA pilot pro- gram must contain the following informa- tion: 1. The names, addresses, telephone numbers, and taxpayer identification num- bers of all members of the taxpayer’s con- trolled group of corporations and trades or businesses under common control with the taxpayer; 2. The name, title, address, and tele- phone number of a contact person and a properly executed Form 2848,“Power of Attorney and Declaration of Representa- tive,”if the information contact is an au- thorized representative of the taxpayer; 3. The location of the person responsi- ble for the taxpayer’s tax matters; 4. The location of the taxpayer’s re- search credit records; 5. A discussion of the taxpayer’s suitability for the pilot program and any unique benefits that may result from a RCRA with the taxpayer; 6. A statement that the taxpayer agrees that interviews and the inspection of the taxpayer’s books and records under the RCRA procedures (seeSection 6): (1) do 2004-6 I.R.B.434February 9, 2004 not constitute an examination or an inspec- tion of books of account for purposes of section 7605(b) or any administrative pro- visions adopted by the Service, and (2) will not preclude or impede a later examination of a return or inspection of records under section 7602 or any administrative provi- sions adopted by the Service for any tax- able year. 7. A statement that the Service need not comply with any applicable procedural re- strictions (including providing notice un- der section 7605(b)) before beginning an examination or inspection under RCRA procedures (seeSection 6); and 8. A statement that the taxpayer is will- ing to participate in the pilot program and to evaluate the pilot program. .02Signature. The taxpayer or the taxpayer’s autho- rized representativemust sign the request to participate in the RCRA pilot program. The request must include a copy of Form 2848 if the request is signed by an autho- rized representative. .03No user fee. The Service will not charge a user fee for a RCRA request during the pilot pro- gram. SECTION 5. RECOMMENDATION ANDSELECTIONPROCESSFOR PARTICIPATION IN THE RCRA PILOT PROGRAM .01Team Manager’s role. Team Managers will forward a copy of the taxpayer’s written request to partici- pate in the pilot program to: 1. The Industry Director for the LMSB industry group with jurisdiction over the taxpayer; 2. The Director, Pre-filing and Techni- cal Guidance, for LMSB; and 3. The Director, Field Specialists, for LMSB. .02Recommendation process. The Team Manager will recommend whether LMSB should accept the taxpayer to participate in the pilot program. The Team Manager will consider the following factors: 1. The taxpayer’s cooperation with the Service in the past; 2. The resources needed for the Ser- vice to evaluate the taxpayer’s records and recordkeeping systems; and 3. The potential benefits of a RCRA. .03Selection process. The selection of a taxpayer for the pi- lot program is subject to the approval of the Industry Director and the concurrence of the Director, Pre-filing and Technical Guidance. In addition to the factors set forth in Section 5.02, the following factors will be considered in selecting taxpayers to participate in the pilot program: 1. The potential to provide a cross- section of industries; and 2. The probability of the parties com- pleting a RCRA within a reasonable period of time. .04Communication with the taxpayer. The Industry Director or Director, Field Operations, will contact the taxpayer within 14 days after receipt of the request to discuss the taxpayer’s suitability for the pilot program. LMSB will notify the taxpayer in writing whether the taxpayer has been selected to participate in the pilot program. If LMSB does not select the tax- payer, the taxpayer has no right to appeal the decision. SECTION 6. TERMS OF A RCRA The LMSB team and the taxpayer will negotiate the terms of the RCRA. The LMSB team and the taxpayer will take into account the taxpayer’s current record- keeping systems, records created during research activities, and records used to track costs associated with research activ- ities. A RCRA may require a taxpayer to create and retain records that it does not currently create and retain. The Service will enter into a RCRA only if it deter- mines that the records to be maintained, retained, and produced under the RCRA satisfy the requirements of section 6001 for the research credit. SECTION 7. APPROVAL OF A RCRA The terms of the RCRA negotiated by the LMSB team and the taxpayer are sub- ject to the approval of the Industry Direc- tor and the concurrence of the Director, Pre-filing and Technical Guidance, and the Director, Field Specialists. If the Industry Director approves the negotiated RCRA, the Industry Director will sign a letter of understanding evidencing the terms of the RCRA. SECTION 8. EFFECT OF A RCRA The taxpayer must maintain, retain, and produce records in accordance with the terms and conditions in the RCRA. The taxpayer’s compliance with the RCRA es- tablishes only that the taxpayer has sat- isfied the recordkeeping requirements of section 6001 for the research credit and does not establish that any amounts will be treated as qualified research expenses for purposes of section 41(b). With respect to the taxable years cov- ered by the RCRA, a RCRA does not limit the Service’s ability to request non-recorded information during exam- inations through interviews and other information gathering methods. In ad- dition, the Service during examinations may request non-recorded information, through interviews and other information gathering methods, as well as recorded information not identified in the RCRA, to verify the information contained in doc- uments required under the RCRA if the Service has reason to question the infor- mation’s accuracyor reliability. A taxpayer may terminate the RCRA at any time. The Industry Director may terminate the RCRA if the Service deter- mines that the taxpayer has not complied with the terms of the RCRA. The taxpayer may not appeal an Industry Director’s de- cision to terminate a RCRA. SECTION 9. EFFECTIVE DATE The pilot program is effective on Feb- ruary 9, 2004. SECTION 10. COMMENTS The Service invites interested persons to comment on the pilot program. Inter- ested persons should send comments to: Internal Revenue Service Attn: Large and Mid-Size Business Division LM:Q Mint Building, 3rd Floor, M–3–148 1111 Constitution Avenue, NW Washington, D.C. 20224 SECTION 11. PAPERWORK REDUCTION ACT The collection of information contained in this notice has been reviewed and ap- proved by the Office of Management and Budget in accordance with the Paperwork February 9, 20044352004-6 I.R.B. Reduction Act (44 U.S.C. 3507) under control number 1545–1859. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number. The collection of information in this no- tice is in Section 4. This information is required to submit a request to participate in the RCRA Pilot Program. This infor- mation will be used to enable the Service to determine whether the applicant is suit- able for participation in the RCRA Pilot Program. The collection of information is voluntary to obtain a benefit. The likely re- spondents are businesses or other for profit institutions. The estimated total annual reporting burden is 1,170 hours. The estimated annual burden per re- spondent varies from 5 hours to 126 hours, depending on individual circumstances, with an estimated average of 18 hours. The estimated number of respondents is 65. The estimated annual frequency of re- sponses is on occasion. Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally tax returns and tax return information are confidential, as required by 26 U.S.C. 6103. SECTION 12. CONTACT INFORMATION The principal author of this notice is Michael Hara of the Office of Associate Chief Counsel (Procedure and Administra- tion), Administrative Provisions and Judi- cial Practice Division. Mr. Hara may be contacted at (202) 622–4910 (not a toll- free number). For information regarding the RCRA Pilot Program, contact Hugh Whitledge, Engineer Technical Advisor, of the LMSB Pre-filing and Technical Guidance Office at (972) 308–7115 (not a toll-free number). Taxpayers interested in participating in the pilot program, or with questions about the pilot program, may also contact the Team Manager assigned to the examination of the taxpayer before submitting a request to participate in the pilot program. 2004-6 I.R.B.436February 9, 2004 Part IV. Items of General Interest Notice of Proposed Rulemaking; Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulations and Notice of Public Hearing Changes in Computing Depreciation REG–126459–03 AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking; Notice of proposed rulemaking by cross- reference to temporary regulations and no- tice of public hearing. SUMMARY: In this issue of the Bulletin, the IRS is issuing temporary regulations (T.D. 9105) under sections 446(e) and 1016(a)(2) of the Internal Revenue Code relating to a change in computing depreci- ation or amortization as well as a change from a nondepreciable or nonamortiz- able asset to a depreciable or amortizable asset (or vice versa). The text of those temporary regulations also serves as the text of these proposed regulations. This document also provides notice of a public hearing on these proposed regulations. DATES: Written or electronic comments must be received by April 1, 2004. Out- lines of topics to be discussed at the public hearing scheduled for April 7, 2004, at 10 a.m. must be received by March 17, 2004. ADDRESSES: Send submissions to CC:PA:LPD:PR (REG–126459–03), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washing- ton, DC 20044. Alternatively, submis- sions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–126459–03), Courier's Desk, Inter- nal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the IRS Internet site at: http://www.irs.gov/regs. FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Sara Logan or Douglas Kim, (202) 622–3110; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Sonya Cruse, (202) 622–4693 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background Temporary regulations (T.D. 9105) in this issue of the Bulletin amend 26 CFR part 1 relating to sections 167, 446, and 1016 of the Internal Revenue Code (Code). The temporary regulations provide guid- ance under section 446(e) on whether a change in computing depreciation or amor- tization as well as a change from a non- depreciable or nonamortizable asset to a depreciable or amortizable asset (or vice versa) is a change in method of accounting that requires the consent of the Commis- sioner. The text of those temporary regulations also serves as the text of these proposed regulations. The preamble to the tempo- rary regulations explains the temporary regulations and these proposed regula- tions. Special Analyses It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory as- sessment is not required. It also has been determined that section 553(b) of the Ad- ministrative Procedure Act (5 U.S.C. chap- ter 5) does not apply to these regulations and, because these regulations do not im- pose on small entities a collection of infor- mation requirement, the Regulatory Flex- ibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to sec- tion 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advo- cacy of the Small Business Administration for comment on its impact on small busi- ness. Comments and Public Hearing Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department specifically request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing has been scheduled for April 7, 2004, beginning at 10:00 a.m. in the Auditorium, 7th Floor, Internal Rev- enue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Be- cause of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about having your name placed on the build- ing access list to attend the hearing, see theFOR FURTHER INFORMATION CONTACTsection of this preamble. The rules of 26 CFR 601.601(a)(3) ap- ply to the hearing. Persons who wish to present oral comments at the hearing must submit an outline of the topics to be dis- cussed and the time to be devoted to each topic (signed original and eight (8) copies) by March 17, 2004. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the sched- uling of the speakers will be prepared af- ter the deadline for receiving outlines has passed. Copies of the agenda will be avail- able free of charge at the hearing. Drafting Information The principal author of these regula- tions is Sara Logan, Office of Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development. ***** February 9, 20044372004-6 I.R.B. Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is proposed to be amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 reads as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.167(e)–1 is amended by revising paragraphs (a) and (e) to read as follows: §1.167(e)–1 Change in method. (a) [The text of the proposed amend- ment to §1.167(e)–1(a) is the same as the text of §1.167(e)–1T(a) published else- where in this issue of the Bulletin]. ***** (e)Effective date. This section applies on or after December 30, 2003. For the ap- plicability of regulations before December 30, 2003, see §1.167(e)–1 in effect prior to December 30, 2003 (§1.167(e)–1 as con- tained in 26 CFR part 1 edition revised as of April 1, 2003). Par. 3. Section 1.446–1 is amended by revising paragraphs (e)(2)(ii)(a), (e)(2)(ii)(b), (e)(2)(ii)(d), (e)(2)(iii), and (e)(4) to read as follows: §1.446–1 General rule for methods of accounting. ***** (e) * * * (2) * * * (ii)(a)and(b) [The text of the pro- posed amendment to §1.446–1(e)(2)(ii)(a) and (b) is the same as the text of §1.446–1T(e)(2)(ii)(a)and(b)published elsewhere in this issue of the Bulletin]. ***** (d) [The text of this paragraph (e)(2)(ii)(d) is the same as the text of §1.446–1T(e)(2)(ii)(d) published else- where in this issue of the Bulletin]. (iii) [The text of the proposed amend- ment to §1.446–1(e)(2)(iii) is the same as the text of §1.446–1T(e)(2)(iii) published elsewhere in this issue of the Bulletin]. ***** (4)Effective date—(i)In general.Ex- cept as provided in paragraphs (e)(3)(iii) and (e)(4)(ii) of this section, paragraph (e) of this section applies on or after Decem- ber 30, 2003. For the applicability of reg- ulations before December 30, 2003, see §1.446–1(e) in effect prior to December 30, 2003 (§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 para- graph (e)(2)(ii)(d)ofthissection,para- graph (e)(2)(iii)Examples 9through17 of this section, the addition of the lan- guage “certain changes in computing de- preciation or amortization (see paragraph (e)(2)(ii)(d) of this section)” to the last sen- tence of paragraph (e)(2)(ii)(a)ofthissec- tion, and the removal of all language re- gardingusefullifeandthesentence“On the other hand, a correction to require de- preciation in lieu of a deduction for the cost of a class of depreciable assets which had been consistently treated as an expense in the year of purchase involves the question of the proper timing of an item, and is to be treated as a change in method of ac- counting” from paragraph (e)(2)(ii)(b)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 for taxable years 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 for taxable years ending on or after December 30, 2003. Par. 4. Section 1.1016–3 is amended by revising paragraphs (h) and (j) to read as follows: §1.1016–3 Exhaustion, wear and tear, obsolescence, amortization, and depletion for periods since February 28, 1913. ***** (h) [The text of the proposed amend- ment to §1.1016–3(h) is the same as the text of §1.1016–3T(h) published else- where in this issue of the Bulletin]. ***** (j)Effective date—(1)In general.Ex- cept as provided in paragraph (j)(2) of this section, this section applies on or after De- cember 30, 2003. For the applicability of regulations before December 30, 2003, see §1.1016–3 in effect prior to December 30, 2003 (§1.1016–3 as contained in 26 CFR part 1 edition revised as of April 1, 2003). (2)Depreciation or amortization changes. Paragraph (h) of this section applies to a change in depreciation or amortization for property subject to sec- tion 167, 168, 197, 1400I, 1400L(b), or 1400L(c), or former section 168 for tax- able years ending on or after December 30, 2003. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. (Filed by the Office of the Federal Register on December 30, 2003, 8:45 a.m., and published in the issue of the Federal Register for January 2, 2004, 69 F.R. 42) 2004-6 I.R.B.438February 9, 2004 Announcement of Disciplinary Actions Involving Attorneys, Certified Public Accountants, Enrolled Agents, and Enrolled Actuaries — Suspensions, Censures, Disbarments, and Resignations Announcement 2004-6 Under Title 31, Code of Federal Regu- lations, Part 10, attorneys, certified public accountants, enrolled agents, and enrolled actuaries may not accept assistance from, or assist, any person who is under disbar- ment or suspension from practice before the Internal Revenue Service if the assis- tance relates to a matter constituting prac- tice before the Internal Revenue Service and may not knowingly aid or abet another person to practice before the Internal Rev- enue Service during a period of suspen- sion, disbarment, or ineligibility of such other person. To enable attorneys, certified public accountants, enrolled agents, and enrolled actuaries to identify persons to whom these restrictions apply, the Director, Of- fice of Professional Responsibility will announce in the Internal Revenue Bulletin their names, their city and state, their pro- fessional designation, the effective date of disciplinary action, and the period of suspension. This announcement will ap- pear in the weekly Bulletin at the earliest practicable date after such action and will continue to appear in the weekly Bulletins for five successive weeks. Disbarments From Practice Before the Internal Revenue Service After Notice and an Opportunity for a Proceeding Under Title 31, Code of Federal Regu- lations, Part 10, after notice and an oppor- tunity for a proceeding before an adminis- trative law judge, the following individu- als have been disbarred from practice be- fore the Internal Revenue Service: NameAddressDesignationEffective Date Baxley II, MiltonGainesville, FLCPAOctober 24, 2003 Consent Suspensions From Practice Before the Internal Revenue Service Under Title 31, Co de of Federal Regu- lations, Part 10, an attorney, certified pub- lic accountant, e nrolled agent, or enrolled actuary, in order to avoid institution or con- clusion of a proc eeding for his or her dis- barment or suspe nsion from practice be- fore the Interna l Revenue Service, may of- fer his or her con sent to suspension from such practice. Th eDirector,OfficeofPro- fessional Respon sibility, in his discretion, may suspend an att orney, certified public accountant, enro lled agent or enrolled ac- tuary in accorda nce with the consent of- fered. The following in dividuals have been placed under con sent suspension from practice before t he Internal Revenue Ser- vice: NameAddressDesignationDate of Suspen sion Nietupski, John E.Springfield, MAEnrolled AgentIndefinite from October 15, 2005 Roberts, Dennis C.Oklahoma City, OKAttorneyIndefinite from October 27, 2003 February 9, 20044392004-6 I.R.B. NameAddressDesignationDate of Suspension Waldo-Grant, Barbara A.Grand Rapids, MIEnrolled AgentIndefinite from November 1, 2003 Naylor, Dale C.El Cajon, CAEnrolled AgentIndefinite from November 12, 2003 Schlude, Richard M.Wilkes Barre, PAEnrolled AgentIndefinite from November 19, 2003 Stern, Samuel L.Robbinsdale, MNAttorneyIndefinite from November 19, 2003 Robles, MichaelDallas, TXCPAIndefinite from December 1, 2003 Young Jr., Donald A.Redondo Beach, CAEnrolled AgentDecember 1, 2003 to August 31, 2004 Hitchcock, William C.Irvine, CAEnrolled AgentIndefinite from December 30, 2003 Willms, Bryant E.Lee Summit, MOEnrolled AgentJanuary 1, 2004 to December 31, 2004 Expedited Suspensions From Practice Before the Internal Revenue Service Under Title 31, Code of Federal Regu- lations, Part 10, the Director, Office of Pro- fessional Responsibility, is authorized to immediately suspend from practice before the Internal RevenueService any practi- tioner who, within five years from the date the expedited proceeding is instituted (1) has had a license to practice as an attor- ney, certified public accountant, or actuary suspended or revoked for cause or (2) has been convicted of certain crimes. The following individuals have been placed under suspension from practice be- fore the Internal Revenue Service by virtue of the expedited proceeding provisions: NameAddressDesignationDate of Suspension Greene, MarvinChicago, ILCPAIndefinite from October 21, 2003 Bolusky, Eric B.Perkins, OKAttorneyIndefinite from October 21, 2003 Crutchfield Jr., ErnestLatty, OHEnrolled AgentIndefinite from October 21, 2003 2004-6 I.R.B.440February 9, 2004 NameAddressDesignationDate of Suspension Covey, CharlesGladstone, MOCPAIndefinite from October 23, 2003 Prosperi, Arnold P.Jupiter Island, FLAttorneyIndefinite from November 24, 2003 Lucas, ChristopherOverlandPark, KSAttorneyIndefinite from November 24, 2003 Ramsey, Henry A.Burnet, TXCPAIndefinite from December 15, 2003 Resignations of Enrolled Agents Under Title 31, Code of Federal Regu- lations, Part 10, an enrolled agent, in or- der to avoid the institution or conclusion of a proceeding for his or her disbarment or suspension from practice before the In- ternal Revenue Service, may offer his or her resignation as an enrolled agent. The Director, Office of Professional Responsi- bility, in his discretion, may accept the of- fered resignation. The Director, Office of Professional Responsibility, has accepted offers of res- ignation as an enrolled agent from the following individuals: NameAddressDate of Resignation Pettyplace, Edward F.Sacramento, CAJanuary 30, 2004 Correction of User Fee in Appendix A of Rev. Proc. 2004–1 Announcement 2004–8 Section (3)(b)(ii) of Appendix A of Rev. Proc. 2004–1, 2004–1 I.R.B. 1, 62 (January 5, 2004) incorrectly provides that the user fee is $1,500 for a letter ruling re- quest involving an extension of time to file Form 3115,“Application for Change in Accounting Method,”under § 301.9100–3. The correct user fee is $1,200, not $1,500. For further information regarding this announcement, contact George Bowden at (202) 622–3400 (not a toll-free call). C redit for Increasing Research A ctivities A nnouncement 2004–9 A GENCY: Internal Revenue Service (IRS), Treasury. ACTION: Advance notice of proposed rulemaking. SUMMARY: This document invites comments from the public regarding certain rules and standards relating to internal-use software under section 41(d)(4)(E) of the Internal Revenue Code (REG–153656–03). All materials submit- ted will be available for public inspection and copying. This document also ad- dresses the effective date for final rules relating to internal-use software. DATES: Comments are requested on or before March 2, 2004. ADDRESSES: Send written comments to: Internal Revenue Service, Attn: CC:PA:LPD:PR [REG–153656–03], room 5203, POB 7604, Ben Franklin Station, Washington, DC 20044. In the alternative, taxpayers may submit comments in writ- ing, by hand delivery to CC:PA:LPD:PR [REG–153656–03], Courier’s Desk, In- ternal Revenue Service, 1111 Constitution Ave., NW, Washington, DC, or elec- tronically, via the IRS Internet site at: www.irs.gov/regs. FOR FURTHER INFORMATION CONTACT: Nicole R. Cimino at (202) 622–3120 (not a toll-free number). SUPPLEMENTARY INFORMATION: Introduction On December 31, 2003, the Treasury Department and the IRS issued final reg- ulations (T.D. 9104, 2004–6 I.R.B. 406) for the credit for increasing research ac- tivities under section 41 (research credit). February 9, 20044412004-6 I.R.B. T.D. 9104 provides rules relating to the definition ofqualified researchunder section 41(d) but does not finalize rules relating to internal-use software under section 41(d)(4)(E). This advance notice of proposed rulemaking (ANPRM) in- vites comments from the public regarding the proposed regulations issued in 2001 relating to internal-use software under section 41(d)(4)(E). Although the Trea- sury Department and the IRS welcome comments on all aspects of those proposed regulations, the Treasury Department and the IRS specifically request comments concerning the definition of internal-use software. In addition, the Treasury De- partment and the IRS request comments on whether final rules relating to internal-use software should have retroactive effect. Background Section 41(d)(4)(E) provides that, ex- cept to the extent provided by regulations, research with respect to computer software which is developed by (or for the bene- fit of) the taxpayer primarily for internal use by the taxpayer (internal-use software) is excluded from the definition of quali- fied research under section 41(d). (Soft- ware that is developed for use in an activity which constitutes qualified research and software that is developed for use in a pro- duction process with respect to which the general credit eligibility requirements are satisfied are not excluded as internal-use software under the provisions of section 41(d)(4)(E).) The statutory exclusion for internal-use software and the regulatory exceptions to this exclusion have been the subject of a series of proposed and final regulations. Legislative History The legislative history to the Tax Re- form Act of 1986, Public Law 99–514 (100 Stat. 2085) (1986 Act), states that “the costs of developing software are not eli- gibleforthecreditwherethesoftwareis used internally, for example, in general and administrative functions (such as pay- roll, bookkeeping, or personnel manage- ment) or in providing noncomputer ser- vices (such as accounting, consulting, or banking services) except to the extent per- mitted by Treasury regulations.” See H.R. Conf. Rep. No. 841, at II–73 (1986 leg- islative history). The 1986 legislative his- tory further states that Congress intended that regulations would make the costs of new or improved internal-use software eli- gible for the credit only if the research sat- isfies, in addition to the general require- ments for credit eligibility, an additional, three-part high threshold of innovation test (i.e., that the software was innovative, that the software development involved signif- icant economic risk, and that the software was not commercially available for use by the taxpayer). Congress has extended the research credit a number of times since the 1986 Act but has not made any changes to the statutory definition of qualified research or to the statutory exclusion for inter- nal-use software in section 41(d)(4)(E). When Congress extended the research credit in the Tax Relief Extension Act of 1999, Public Law 106–170 (113 Stat. 1860) (1999 Act), however, the legislative history stated the following with respect to internal-use software: The conferees further note the rapid pace of technological advance, espe- cially in service-related industries, and urge the Secretary to consider carefully the comments he has and may receive in promulgating regulations in connection with what constitutes “internal use” with regard to software expenditures. The conferees also wish to observe that software research, that otherwise satisfies the requirements of section 41, which is undertaken to support the provision of a service, should not be deemed “internal use” solely because the business component involves the provision of a service. H.R. Conf. Rep. No. 106–478, at 132 (1999). 1997 Proposed Regulations On January 2, 1997, the Treasury De- partment and the IRS published proposed regulations (REG–209494–90, 1997–1 C.B. 723 [62 FR 81]) in theFederal Reg- isterunder section 41 relating to inter- nal-use software (1997 proposed regula- tions). In relevant part, the 1997 proposed regulations stated: Research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer’s internal use is eligi- ble for the research credit only if the software satisfies the requirements of paragraph (e)(2) of this section. Gener- ally, research with respect to computer software is not eligible for the research credit where software is used internally, for example, in general and administra- tive functions (such as payroll, book- keeping, or personnel management) or in providing noncomputer services (such as accounting, consulting, or banking services). Prop. §1.41–4(e)(1) (1997). The 1997 proposed regulations con- tained an exception to the internal-use software rules for certain software devel- oped by the taxpayer as a part of a new or improved package of computer soft- ware and hardware developed together as a single product. Such software would not be subject to the high threshold of innovation requirements for internal-use software under the 1997 proposed regu- lations. The 1997 proposed regulations, however, did not contain a specific defini- tion of internal-use software. Instead, the 1997 proposed regulations provided that the determination of whether software was internal-use software would depend on the facts and circumstances of each case: All relevant facts and circumstances are to be considered in determining if com- puter software is developed primarily for the taxpayer’s internal use. If com- puter software is developed primarily for the taxpayer’s internal use, the re- quirements of this paragraph (e) apply even though the taxpayer intends to, or subsequently does, sell, lease, or li- cense the computer software. Prop. §1.41–4(e)(4) (1997). 2001 Final Regulations (T.D. 8930) On January 3, 2001, the Treasury De- partment and the IRS published in theFed- eral Registerfinal regulations (T.D. 8930, 2001–1 C.B. 433 [66 FR 280]) relating, in relevant part, to the definition of inter- nal-use software for purposes of section 41(d)(4)(E). With respect to the general definition of internal-use software, T.D. 8930 provided: Software is developed primarily for the taxpayer’s internal use if the software is to be used internally, for example, in general administrative functions of the taxpayer (such as payroll, bookkeeping, 2004-6 I.R.B.442February 9, 2004 or personnel management) or in pro- viding noncomputer services (such as accounting, consulting, or banking ser- vices). If computer software is devel- oped primarily for the taxpayer’s inter- nal use, the requirements of this para- graph (c)(6) apply even though the tax- payer intends to, or subsequently does, sell, lease, or license the computer soft- ware. §1.41–4(c)(6)(iv). T.D. 8930, therefore, did not provide a specific definition of internal-use software but instead identi- fied two general categories of software as examples of internal-use software: soft- ware “used internally” and software used “in providing noncomputer services.” T.D. 8930 eliminated the general facts and cir- cumstances standard contained in the 1997 proposed regulations. The preamble to T.D. 8930 addressed the requests made by some commentators that the definition of internal-use software exclude software used to deliver a service to customers and software that includes an interface with customers or the public. The preamble stated that after careful analy- sis of the legislative history, the Treasury Department and the IRS had concluded that such broad exclusions would be in- consistent with the statutory mandate, be- cause the exclusion would extend to some software that Congress clearly intended to treat as internal-use software. The pream- ble, however, continued by highlighting changes that had been made in T.D. 8930 to take into account the commentators’ con- cerns as well as the legislative history to the 1999 Act. First, T.D. 8930 provided that the high threshold of innovation test applicable to internal-use software does not apply to software used to provide computer ser- vices (defined in T.D. 8930 generally as a service offered by a taxpayer to customers who conduct business with the taxpayer primarily for the use of the taxpayer’s computer or software technology). In contrast, software used to provide a non- computer service (defined in T.D. 8930 generally as a service other than a com- puter service, even if such other service is enabled, supported, or facilitated by com- puter or software technology) would be subject to the high threshold of innovation test under T.D. 8930. Second, T.D. 8930 contained a new ex- ception to the high threshold of innova- tion test for internal-use software for soft- ware used to provide a noncomputer ser- vice if the software, among other things, contained features or improvements not yet offered by a taxpayer’s competitors. In describing this exception, the preamble to T.D. 8930 stated: This exercise of regulatory authority [to create the exception for certain soft- ware used to provide non-computer ser- vices] is based on a determination that the development of software containing features or improvements that are not available from a taxpayer’s competitors and that provide a demonstrable com- petitive advantage is more likely to in- crease the innovative qualities and ef- ficiency of the U.S. economy (by gen- erating knowledge that can be used by other service providers) than is the de- velopment of software used to provide noncomputer services containing fea- tures or improvements that are already offered by others. IRS and Treasury be- lieve that drawing such a line is an ap- propriate way to administer the credit with a view to identifying and facilitat- ing the credit availability for software with the greatest potential for benefit- ing the U.S. economy, an important ra- tionale for the research credit. In response to taxpayer concerns, on January 31, 2001, the Treasury De- partment and the IRS published Notice 2001–19, 2001–1 C.B. 784, announcing that the Treasury Department and the IRS would review T.D. 8930 and reconsider comments previously submitted in con- nection with the finalization of T.D. 8930. 2001 Proposed Regulations On December 26, 2001, the Treasury Department and the IRS published in the Federal Registera notice of proposed rulemaking (REG–112991–01, 2002–1 C.B. 404 [66 FR 66362]) reflecting their review of T.D. 8930 (2001 proposed reg- ulations). The 2001 proposed regula- tions revised the definition of internal-use software as compared to the definitions contained in the 1997 proposed regula- tions and T.D. 8930. The definition in the 2001 proposed regulations was based on a presumption that turns on whether the software is developed to be commercially sold, leased, licensed, or otherwise mar- keted for separately stated consideration: Unless computer software is devel- oped to be commercially sold, leased, licensed, or otherwise marketed, for separately stated consideration to un- related third parties, computer software is presumed developed by (or for the benefit of) the taxpayer primarily for the taxpayer’s internal use. For exam- ple, the computer software may serve general and administrative functions of the taxpayer, or may be used in pro- viding a noncomputer service. General and administrative functions include, but are not limited to, functions such as payroll, bookkeeping, financial man- agement, financial reporting, personnel management, sales and marketing, fixed asset accounting, inventory man- agement and cost accounting. Com- puter software that is developed to be commercially sold, leased, licensed, or otherwise marketed, for separately stated consideration to unrelated third parties is not developed primarily for the taxpayer’s internal use. The re- quirements of this paragraph (c)(6) apply to computer software that is de- veloped primarily for the taxpayer’s internal use even though the taxpayer subsequently sells, leases, licenses, or otherwise markets the computer soft- ware for separately stated consideration to unrelated third parties. Prop. §1.41–4(c)(6)(iv) (2001) (emphasis added). As explained in the preamble to the 2001 proposed regulations, this “sepa- rately stated consideration” standard re- flected the Treasury Department and the IRS’ determination that software that is sold, leased, licensed, or otherwise mar- keted, for separately stated consideration to unrelated third parties is software that is intended to be used primarily by the cus- tomers of the taxpayer, whereas software that does not satisfy this requirement is software that is intended to be used pri- marily by the taxpayer for its internal use or in connection with a noncomputer ser- vice provided by the taxpayer. The 2001 proposed regulations modified the hard- ware-software exception and continued to provide that software used to provide com- puter services was not required to satisfy the additional qualification requirements imposed on internal-use software. The new proposed regulations, however, elim- inated the specialrule in T.D. 8930 for February 9, 20044432004-6 I.R.B. certain software used to provide noncom- puter services. The preamble to the 2001 proposed regulations explained that “[d]ue to other revisions contained in these pro- posed regulations, Treasury and the IRS believe that the computer software tar- geted by this rule generally would be credit eligible without this rule.” The preamble to the 2001 proposed regulations also addressed the continued concerns expressed by some commen- tators that the definition of internal-use software should not include software used to deliver a service to customers and software that includes an interface with customers or the public. In addition to re- peating the Treasury Department and IRS’ concern that such exclusions may conflict with Congress’ intent regarding software used in the provision of noncomputer ser- vices, the preamble stated that an exclu- sion for software that includes an interface with customers or the public would en- tail substantial administrative difficulties and “may inappropriately permit certain categories of costs (e.g., certain web site development costs) to constitute qualified research expenses without having to sat- isfy the high threshold of innovation test.” Discussion Prior regulatory guidance generally reflects three approaches to the definition of internal-use software. First, the 1997 proposed regulations closely mirrored the language contained in the legislative history but did not provide a specific def- inition of internal-use. Instead, the 1997 proposed regulations used the “general and administrative functions” and “non- computer services” language from the legislative historyas examples of inter- nal-use software and provided that the determination of whether particular soft- ware was internal-use software required an evaluation of “all relevant facts and circumstances.” T. D. 8930 then attempted to provide greater specificity regarding the defini- tion of internal-use software. Although T.D. 8930 eliminated the facts and cir- cumstances test in the 1997 proposed regulations, T.D. 8930 continued to pro- vide a general definition of internal-use software that incorporated the legislative history’s examples of general and admin- istrative functions and non-computer ser- vices. Additionally, T.D. 8930 provided that software used by the taxpayer to pro- vide “computer services” was not subject to the high threshold of innovation test applicable to internal-use software, and provided definitions ofcomputer services andnoncomputer services. The exception for computer services software, however, required a determination of the primary reason why a taxpayer’s customers con- duct business with the taxpayer. T.D. 8930 also applied this exception to certain software used to provide “noncomputer services” provided that the software sat- isfied additional requirements intended to identify software containing new features or improvements that provide a competi- tive advantage to the taxpayer. Finally, the 2001 proposed regulations prescribed a bright-line, separately-stated consideration rule for determining which software is treated as internal-use soft- ware for purposes of the research credit. (The 2001 proposed regulations retained the exception for software used to pro- vide computer services, but removed the special rule for noncomputer services. Additionally, the 2001 proposed regula- tions expanded upon the list of general and administrative functions contained in the legislative history and expanded the ex- ception for integrated software-hardware products.) The purpose of this rule was to provide a clear definition of internal-use software that could be readily applied by taxpayers and more readily administered by the IRS. Numerous comments were received in response to the 1997 proposed regulations, T.D. 8930 and Notice 2001–19, and the 2001 proposed regulations regarding the provisions relating to internal-use soft- ware. Although commentators addressed virtually all aspects of the internal-use software provisions in the various itera- tions of regulations, most of the comments focused on the definition of internal-use software. As previously stated, many commentators believed that the definition of internal-use software should exclude any software used to deliver a service to customers and any software that includes an interface with customers or the pub- lic. Some commentators suggested, as an alternative, that the statutory production process exception be extended to software used in connection with the provision of services. With respect to the definition of in- ternal-use software in the 2001 proposed regulations, commentators stated that the separately-statedconsideration test was a poor indication of when computer software was developed “primarily for internal use by the taxpayer” and directly conflicted with the legislative history to the 1999 Act. In support of a narrower definition of internal-use software, these commentators pointed to technological advancements and changes to the role of computer software in business activities since the exclusion for internal-use soft- ware was enacted in 1986, including the increased development of computer soft- ware by taxpayers, the increased use of computer software in all aspects of busi- ness activity, and the role of computer software (often integrated across a busi- ness) in providing goods and services in addition to the internal operations of a business. Commentators further argued that the definition should be based on the underlying functionality of the software (i.e., whether the software, in light of the facts and circumstances, is used to deliver services or goods to a taxpayer’s cus- tomers). Commentators urged that a func- tionality rule is preferable to a bright-line rule (such as the separately-stated con- sideration rule in T.D. 8930) even though a bright-line rule provided a clearer rule for identifying internal-use software for purposes of the research credit. The Treasury Department and the IRS are continuing to consider the concerns raised by commentators in response to the definition of internal-use software contained in the 2001 proposed regu- lations, including the concern that the separately-stated consideration test is over-inclusive. Nevertheless, the Trea- sury Department and the IRS are con- cerned that the alternatives, including expanded or modified exceptions, pro- posed by commentators generally would make the definition of internal-use soft- ware more complex without providing additional clarity. Several commentators suggested similar definitions that would exclude software that, for example, is “integral and essential” to the provision of services with integral defined as soft- ware that directly “enables, supports, or facilitates” a service. Some commentators suggested a definition that would exclude software that is “primarily used” by cus- 2004-6 I.R.B.444February 9, 2004 tomers, suppliers, or other third parties. Other commentators suggested a defini- tion that would limit internal-use software to software that is developed primarily for use in general and administrative func- tions that enable, facilitate, or support the taxpayer’s conduct of the taxpayer’s trade or business, but would exclude cer- tain customer interface software. These suggestions would introduce many terms (includingenable,support,facilitate,pri- marily) that, due to their subjective nature, the Treasury Department and the IRS be- lieve would be prone to controversy and could not be readily applied by taxpayers or administered by the IRS. Another com- mentator suggested limiting the definition of internal-use software to software used to perform a specifically enumerated list of general and administrative functions. Some commentators, however, have noted that the often highlyintegrated nature of software development today makes it difficult, if not impossible, to divide software development projects into sepa- rate components, and thus a list approach may not be administrable. Finally, as part of their review of these comments, the Treasury Department and the IRS also re- viewed the possibility of using definitions of internal-use software contained in prior guidance. In light of the statute, the legislative his- tory, the history of the regulations regard- ing internal-use software, and the com- ments received, the Treasury Department and the IRS have decided not to finalize in T.D. 9104 the provisions in the 2001 pro- posed regulations relating to internal-use software. Instead, the Treasury Depart- ment and the IRS are issuing this ANPRM to solicit further comments regarding the definition of internal-use software as well as other provisions affecting the qualifi- cation of internal-use software for the re- search credit. The Treasury Department and the IRS are mindful that Congress specifically intended that computer soft- ware “developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer” be subject to additional re- quirements before the software could qual- ify for the research credit. At the same time, the Treasury Department and the IRS recognize that there have been changes in computer software, and its role in busi- ness activity, since the mid-1980s. In light of these changes, the Treasury Department and the IRS are concerned about the diffi- culty of effecting Congressional intent be- hind the exclusion for internal-use soft- ware with respect to computer software be- ing developed today. Despite Congress’ broad grant of regulatory authority in sec- tion 41(d)(4)(E), the Treasury Department and the IRS believe that this authority may not be broad enough to resolve those diffi- culties. Accordingly, the Treasury Department and the IRS request comments regarding a definition of internal-use software that appropriately reflects the statute and leg- islative history, can be readily applied by taxpayersandreadilyadministeredbythe IRS, and is flexible enough to provide con- tinuing application into the future. In sub- mitting comments, commentators are in- vited to address any of the definitions in- cluded in prior guidance as well as other definitions that have been proposed to the Treasury Department and the IRS by com- mentators. In addressing these alternatives, com- mentators also are invited to discuss how software development efforts that en- compass both internal-use software and non-internal use software should be ad- dressed under any particular definition. The Treasury Department and the IRS are concerned that the tendency toward the integration of software across many func- tions of a taxpayer’s business activities may make it difficult for both taxpayers and the IRS to separate internal-use soft- ware from non-internal use software (or software not subject to additional qualifi- cation requirements) under any particular definition of internal-use software. In addition, the Treasury Department and the IRS are concerned that a definition of internal-use software that relies upon the “primary” or “principal” use of that software would be difficult to apply and administer. The Treasury Department and the IRS’ continuing goal is that any final rule must provide clear, objective guidance on what software is treated as internal-use software for purposes of the research credit. Effective Dates On December 31, 2003, the Treasury Department and the IRS issued final reg- ulations (T.D. 9104) relating to the defi- nition of qualified research under section 41(d). The final regulations apply to tax- able years ending on or after December 31, 2003. The final regulations do not con- tain final rules for research with respect to computer software “which is developed by (or for the benefit of) the taxpayer pri- marily for internal use by the taxpayer” for purposes of section 41(d)(4)(E) (i.e.,inter- nal-use software). The Treasury Department and the IRS have announced in prior guidance, includ- ing Notice 87–12, 1987–1 C.B. 432, and more recently in the 2001 proposed regu- lations, that final regulations relating to in- ternal-use software generally will be effec- tive for taxable years beginning after De- cember 31, 1985. In light of the length of time that has passed since 1986, as well as the developments with respect to computer software discussed in this ANPRM, the Treasury Department and the IRS request comments on whether final regulations re- lating to internal-use software should have any retroactive effect. With respect to internal-use software for taxable years beginning after Decem- ber 31, 1985, and until further guidance is published in theFederal Register,tax- payers may continue to rely upon all of the provisions relating to internal-use software in the 2001 proposed regulations (66 FR 66362). Alternatively, taxpayers may con- tinue to rely upon all of the provisions re- lating to internal-use software in T.D. 8930 (66 FR 280). For example, taxpayers rely- ing upon the internal-use software rules of T.D. 8930 must also apply the “discovery test” as set forth in T.D. 8930. Request for Public Comment The Treasury Department and the IRS invite interested persons to submit com- ments (in the manner described in the ADDRESSES caption) on issues arising under the provisions for internal-use soft- ware. The Treasury Department and the IRS invite comments that address any of the definitions included in prior guidance as well as other definitions that have been proposed to the Treasury Department and the IRS by commentators. Specifically, the Treasury Department and the IRS in- vite comments that provide a definition of internal-use software that— 1. Appropriately reflects the statute and legislative history; February 9, 20044452004-6 I.R.B. 2. Can be readily applied by taxpayers and readily administered by the IRS; and 3. Is flexible enough to provide contin- uing application in the future. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. (Filed by the Office of the Federal Register on December 31, 2003, 8:45 a.m., and published in the issue of the Federal Register for January 2, 2004, 69 F.R. 43) 2004-6 I.R.B.446February 9, 2004 Definition of Terms Revenue rulings and revenue procedures (hereinafter referred to as “rulings”) that have an effect on previous rulings use the following defined terms to describe the ef- fect: Amplifieddescribes a situation where no change is being made in a prior pub- lished position, but the prior position is be- ingextendedtoapplytoavariationofthe fact situation set forth therein. Thus, if an earlier ruling held that a principle ap- plied to A, and the new ruling holds that the same principle also applies to B, the earlier ruling is amplified. (Compare withmodi- fied,below). Clarifiedis used in those instances where the language in a prior ruling is be- ing made clear because the language has caused, or may cause, some confusion. It is not used where a position in a prior ruling is being changed. Distinguisheddescribes a situation where a ruling mentions a previously pub- lished ruling and points out an essential difference between them. Modifiedis used where the substance of a previously published position is being changed. Thus, if a prior ruling held that a principle applied to A but not to B, and the new ruling holds that it applies to both A and B, the prior ruling is modified because it corrects a published position. (Compare withamplifiedandclarified, above). Obsoleteddescribes a previously pub- lished ruling that is not considered deter- minative with respect to future transac- tions. This term is most commonly used in a ruling that lists previously published rul- ings that are obsoleted because of changes in laws or regulations. A ruling may also be obsoleted because the substance has been included in regulations subsequently adopted. Revokeddescribes situations where the position in the previously published ruling is not correct and the correct position is beingstatedinanewruling. Supersededdescribes a situation where the new ruling does nothing more than re- state the substance and situation of a previ- ously published ruling (or rulings). Thus, the term is used to republish under the 1986 Code and regulations the same po- sition published under the 1939 Code and regulations. The term is also used when it is desired to republish in a single rul- ing a series of situations, names, etc., that were previously published over a period of time in separate rulings. If the new rul- ing does more than restate the substance of a prior ruling, a combination of terms is used. For example,modifiedandsu- persededdescribes a situation where the substance of a previously published ruling is being changed in part and is continued without change in part and it is desired to restate the valid portion of the previously published ruling in a new ruling that is self contained. In this case, the previously pub- lished ruling is first modified and then, as modified, is superseded. Supplementedis used in situations in which a list, such as a list of the names of countries, is published in a ruling and that list is expanded by adding further names in subsequent rulings. After the original rul- ing has been supplemented several times, a new ruling may be published that includes the list in the original ruling and the ad- ditions, and supersedes all prior rulings in the series. Suspendedis used in rare situations to show that the previous published rul- ings will not be applied pending some future action such as the issuance of new or amended regulations, the outcome of cases in litigation, or the outcome of a Service study. Abbreviations The fol lowing abbreviations in current use and for merly used will appear in material publis hedintheBulletin. A—Individual. Acq.—A cquiescence. B—Individual. BE—Beneficiary. BK—Bank . B.T.A.—Board of Tax Appeals. C—Individual. C.B.—Cu mulative Bulletin. CFR—Code of Federal Regulations. CI—City. COOP—Coo perative. Ct.D.—Court Decision. CY—County. D—Decede nt. DC—Dummy Corporation. DE—Donee. Del. Order —Delegation Order. DISC—Domestic International Sales Corporation. DR—Donor. E—Estate. EE—Employee. E.O.—Executive Order. ER—Emp loyer. ERISA—Employee Retirement Income Security Act. EX—Executor. F—Fiduc iary. FC—Foreign Country. FICA—Federal Insurance Contributions Act. FISC—Fo reign International Sales Company. FPH—Foreign Personal Holding Company. F.R.—Federal Register. FUTA—Fed eral Unemployment Tax Act. FX—Foreign corporation. G.C.M.—Chief Counsel’s Memorandum. GE—Grante e. GP—General Partner. GR—Grantor. IC—Insura nce Company. I.R.B.—Internal Revenue Bulletin. LE—Lessee. LP—Limited Partner. LR—Lessor. M—Minor. Nonacq.—No nacquiescence. O—Organization. P—Parent Corporation. PHC—Persona l Holding Company. PO—Possession of the U.S. PR—Partner. PRS—Pa rtnership. PTE—Prohibited Transaction Exemption. Pub. L.—Public Law. REIT—Re al Estate Investment Trust. Rev. Proc.—Revenue Procedure. Rev. Rul.—Revenue Ruling. S—Subsi diary. S.P.R.—Statement of Procedural Rules. Stat.—Statutes at Large. T—Target Corporation. T.C.—Tax Court. T.D.—Treasury Decision. TFE—Trans feree. TFR—Transferor. T.I.R.—Technical Information Release. TP—Taxpay er. TR—Trust. TT—Trustee. U.S.C.—Uni ted States Code. X—Corporation. Y—Corporation. Z—Corporat ion. February 9, 2004i2004-6 I.R.B. Numerical Finding List 1 Bulletins 2004–1 through 2004–6 Announcements: 2004-1, 2004-1 I.R.B.254 2004-2, 2004-3 I.R.B.322 2004-3, 2004-2 I.R.B.294 2004-4, 2004-4 I.R.B.357 2004-5, 2004-4 I.R.B.362 2004-6, 2004-3 I.R.B.322 2004-7, 2004-4 I.R.B.365 2004-8, 2004-6 I.R.B.441 2004-9, 2004-6 I.R.B.441 Notices: 2004-1, 2004-2 I.R.B.268 2004-2, 2004-2 I.R.B.269 2004-3, 2004-5 I.R.B.391 2004-4, 2004-2 I.R.B.273 2004-6, 2004-3 I.R.B.308 2004-7, 2004-3 I.R.B.310 2004-8, 2004-4 I.R.B.333 2004-9, 2004-4 I.R.B.334 2004-10, 2004-6 I.R.B.433 2004-11, 2004-6 I.R.B.434 Proposed Regulations: REG-116664-01, 2004-3 I.R.B.319 REG-122379-02, 2004-5 I.R.B.392 REG-139845-02, 2004-5 I.R.B.397 REG-126459-03, 2004-6 I.R.B.437 REG-156232-03, 2004-5 I.R.B.399 Revenue Procedures: 2004-1, 2004-1 I.R.B.1 2004-2, 2004-1 I.R.B.83 2004-3, 2004-1 I.R.B.114 2004-4, 2004-1 I.R.B.125 2004-5, 2004-1 I.R.B.167 2004-6, 2004-1 I.R.B.197 2004-7, 2004-1 I.R.B.237 2004-8, 2004-1 I.R.B.240 2004-9, 2004-2 I.R.B.275 2004-10, 2004-2 I.R.B.288 2004-11, 2004-3 I.R.B.311 2004-13, 2004-4 I.R.B.335 Revenue Rulings: 2004-1, 2004-4 I.R.B.325 2004-2, 2004-2 I.R.B.265 2004-4, 2004-6 I.R.B.414 2004-5, 2004-3 I.R.B.295 2004-6, 2004-4 I.R.B.328 2004-7, 2004-4 I.R.B.327 2004-9, 2004-6 I.R.B.428 Treasury Decisions: 9099, 2004-2 I.R.B.255 9100, 2004-3 I.R.B.297 9101, 2004-5 I.R.B.376 9102, 2004-5 I.R.B.366 9103, 2004-3 I.R.B.306 9104, 2004-6 I.R.B.406 9105, 2004-6 I.R.B.419 9106, 2004-5 I.R.B.384 9108, 2004-6 I.R.B.429 1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2003–27 through 2003–52 is in Internal Revenue Bulletin 2003–52, dated December 29, 2003. 2004-6 I.R.B.iiFebruary 9, 2004 Findings List of Current Actions on Previously Published Items 1 Bulletins 2004–1 through 2004–6 Proposed Regulations: REG-115037-00 Corrected by Ann. 2004-7, 2004-4 I.R.B.365 REG-143321-02 Withdrawn by REG-156232-03, 2004-5 I.R.B.399 REG-146893-02 Corrected by Ann. 2004-7, 2004-4 I.R.B.365 Revenue Procedures: 2000-38 Modified by Rev. Proc. 2004-11, 2004-3 I.R.B.311 2000-50 Modified by Rev. Proc. 2004-11, 2004-3 I.R.B.311 2002-9 Modified by Rev. Proc. 2004-11, 2004-3 I.R.B.311 2002-71 Superseded by Rev. Proc. 2004-13, 2004-4 I.R.B.335 2003-1 Superseded by Rev. Proc. 2004-1, 2004-1 I.R.B.1 2003-2 Superseded by Rev. Proc. 2004-2, 2004-1 I.R.B.83 2003-3 As amplified by Rev. Proc. 2003-14, and as modified by Rev. Proc. 2003-48 superseded by Rev. Proc. 2004-3, 2004-1 I.R.B.114 2003-4 Superseded by Rev. Proc. 2004-4, 2004-1 I.R.B.125 2003-5 Superseded by Rev. Proc. 2004-5, 2004-1 I.R.B.167 2003-6 Superseded by Rev. Proc. 2004-6, 2004-1 I.R.B.197 2003-7 Superseded by Rev. Proc. 2004-7, 2004-1 I.R.B.237 Revenue Procedures— Continued: 2003-8 Superseded by Rev. Proc. 2004-8, 2004-1 I.R.B.240 2004-1 Corrected by Ann. 2004-8, 2004-6 I.R.B.441 1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2003–27 through 2003–52 is in Internal Revenue Bulletin 2003–52, dated December 29, 2003. February 9, 2004iii2004-6 I.R.B. *U.S. Government Printing Office: 2004—304–774/60121
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