Internal Revenue Bulletin 2005-7 (PDF rendition): IRS Revenue Rulings

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Bulletin No. 200
5-7
February 14, 200
5
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
REG–117969–00, page 533.
Proposed regulations amend previously proposed regulations
that provided a functional definition of “statutory merger or
consolidation” under section 368(a)(1)(A) of the Code. These
proposed regulations delete the requirement that transactions
must be carried out under domestic law in order to qualify as
statutory mergers or consolidations. A public hearing is sched-
uled for May 19, 2005.
REG–1256
28–01, page 536.
Proposed
regulations amending the income tax regulations
under var
ious provisions of the Code to account for statu-
tory merg
ers and consolidations under section 368(a)(1)(A)
(includi
ng reorganizations described in section 368(a)(2)(D)
and (E)) i
nvolving one or more foreign corporations. The
regulat
ions are issued concurrently with proposed regulations
(REG–11
7969–00) that would amend the definition of a reorga-
nizatio
n under section 368(a)(1)(A) to include certain statutory
mergers
or consolidations effected pursuant to foreign law. A
public
hearing is scheduled for May 19, 2005.
Announcement 2005–12, page 555.
For purposes of the Archer MSA pilot program, under section
220(j)(2) of the Code, 2004 is not a cut-off year.
ADMINI
STRATIVE
Rev. Ru
l. 2005–10, page 492.
Partne
rship mergers.This ruling informs taxpayers that the
Treasu
ry Department and the Service intend to issue regula-
tions u
nder sections 704(c)(1)(B) and 737 of the Code imple-
menting the principles of Rev. Rul. 2004–43. Rev. Rul.
2004–43 revoked.
Notice 2005–11, page 493.
This notice provides interim guidance relating to section 6707A
of the Code, Penalty for failure to include reportable transac-
tion information with return, as added by the American Jobs
Creation Act of 2004. This notice states that a taxpayer may
incur a penalty under section 6707A with respect to each fail-
ure to disclose a reportable transaction within the time, and in
the form and manner, provided by section 6011 and its regu-
lations.
Notice 2005–12, page 494.
This notice provides interim guidance relating to section
6662A of the Code, Imposition of accuracy-related penalty
on understatements with respect to reportable transactions,
section 6662, Imposition of accuracy-related penalty on un-
derpayments, and section 6664, Definitions and special rules.
Notice 2005–14, page 498.
Income attributable to domestic production activities.
This notice provides interim guidance to taxpayers regarding
the deduction for income attributable to domestic production
activities under section 199 of the Code. Section 199 was en-
acted as part of the American Jobs Creation Act of 2004, and
allows a deduction equal to 3 percent (for 2005 and 2006)
of the lesser of the qualified production activities income of
thetaxpayerforthetaxableyear,orthetaxableincomeofthe
taxpayer for the taxable year, subject to certain limits. The ap-
plicable percentage rises to 6 percent for 2007, 2008, and
2009, and 9 percent for 2010 and subsequent years.
(Continued on the next page)
Fi
nding Lists begin on page ii.

Notice 2005–15, page 527.
This notice provides that the Treasury Department and the Ser-
vice intend to issue regulations involving partnerships under
sections 704(c)(1)(B) and 737 of the Code implementing the
principles of Rev. Rul. 2004–43, and that the regulations will
be effective for distributions occurring after the date on which
the notice is released to the public.
Rev. Proc. 2005–14, page 528.
Like-kind exchange of a principal residence.This proce-
dure provides guidance on applying the exclusion of gain from
the sale or exchange of a principal residence under section 121
oftheCodeandthenonrecognitionofgainfromtheexchange
of like-kind property under section 1031 to a single exchange
of property.
February 14, 20052005–7 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. Bulletin
contents are compiled semiannually into Cumulative Bulletins,
which are sold on a single-copy basis.
It is the policy of the Service to publish in the Bulletin all sub-
stantive rulings necessary to promote a uniform application 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.
2005–7 I.R.B.February 14, 2005

Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 121.—Exclusion
of Gain From Sale of
Principal Residence
26 CFR 1.121–1: Exclusion of gain from sale or ex-
change of a principal residence.
Guidance is provided on applying the exclusion of
gain from the sale or exchange of a principal resi-
dence under § 121 of the Code and the nonrecognition
of gain from the exchange of like-kind property under
§ 1031 of the Code to a single exchange of property.
See Rev. Proc. 2005-14, page 528.
Section 704.—Partner’s
Distributive Share
Partnership mergers.This ruling in-
forms taxpayers that the Treasury Depart-
ment and the Service intend to issue reg-
ulations under sections 704(c)(1)(B) and
737 of the Code implementing the princi-
ples of Rev. Rul. 2004–43. Rev. Rul.
2004–43 revoked.
Rev. Rul. 2005–10
Rev. Rul. 2004–43, 2004–18 I.R.B.
842, issued on April 12, 2004, addresses
the application of §§ 704(c)(1)(B) and 737
to § 704(c) gain or loss that is created in an
assets-over partnership merger. Rev. Rul.
2004–43 holds that § 704(c)(1)(B) applies
to newly created § 704(c) gain or loss in
property contributed by the transferor part-
nership to the continuing partnership in an
assets-over partnership merger, but does
not apply to newly created reverse § 704(c)
gain or loss resulting from a revaluation
of property in the continuing partnership.
The revenue ruling also holds that for pur-
poses of § 737(b), net precontribution gain
includes newly created § 704(c) gain or
loss in property contributed by the trans-
feror partnership to the continuing partner-
ship in an assets-over partnership merger,
but does not include newly created reverse
§ 704(c) gain or loss resulting from a reval-
uation of property in the continuing part-
nership.
Some commentators have argued
that Rev. Rul. 2004–43 is not consis-
tent with the current regulations under
§§ 704(c)(1)(B) and 737, and that the con-
clusions in the ruling should not be applied
retroactively. In response to these com-
ments, the Treasury Department and the
Service intend to issue regulations under
§§ 704(c)(1)(B) and 737 implementing the
principles of Rev. Rul. 2004–43. The reg-
ulations will be effective for distributions
occurring after January 19, 2005. See
Notice 2005–15, published in this issue of
the Internal Revenue Bulletin.
EFFECT ON OTHER REVENUE
RULING(S)
Rev. Rul. 2004–43 is revoked.
DRAFTING INFORMATION
The principal author of this revenue rul-
ing is Laura Fields of the Office of As-
sociate Chief Counsel (Passthroughs and
Special Industries).For further informa-
tion regarding this revenue ruling, con-
tact Ms. Fields at (202) 622–3050 (not a
toll-free call).
Section 1031.—Exchange
of Prope
rty Held for
Productive Use or
Investment
Guidance is provided on applying the exclusion of
gain from the sale or exchange of a principal resi-
dence under § 121 of the Code and the nonrecognition
of gain from the exchange of like-kind property under
§ 1031 of the Code to a single exchange of property.
See Rev. Proc. 2005-14, page 528.
2005–7 I.R.B.492February 14, 2005

Part III. Administrative, Procedural, and Miscellaneous
New Penalty Section 6707A
and Rescission Authority
Notice 2005–11
The purpose of this notice is to alert
taxpayers to new section 6707A of the
Internal Revenue Code. This notice an-
nounces that the Internal Revenue Service
and the Treasury Department will issue
regulations under section 6707A, which
will apply to returns and statements the
due date for which is after October 22,
2004, and provides guidance regarding the
imposition and rescission of penalties un-
der section 6707A. This notice also invites
comments from the public regarding rules
andstandardsrelatingtosection6707A.
BACKGROUND AND PRIOR LAW
Section 6011 and the regulations there-
under require a taxpayer that has partic-
ipated in a reportable transaction to dis-
close certain information with respect to
the reportable transaction with its tax re-
turn. Section 1.6011–4(b) of the Income
Tax Regulations describes six categories
of reportable transactions. One category
of reportable transactions is a transaction
that is the same as, or substantially similar
to, one of the types of transactions that the
Internal Revenue Service has determined
to be a tax avoidance transaction and iden-
tified by notice, regulation, or other form
of published guidance as a “listed transac-
tion.” Section 1.6011–4(b)(2).
Section 1.6011–4(d) requires that a
taxpayer file a disclosure statement on
Form 8886,Reportable Transaction Dis-
closure Statement, for each reportable
transaction in whichthe taxpayer partic-
ipated. Section 1.6011–4(e)(1) provides
that a reportable transaction disclosure
statement is due when the taxpayer files
an original or amended return that reflects
the taxpayer’s participation in a reportable
transaction. The taxpayer also must send a
copy of the disclosure statement to the IRS
Office of Tax Shelter Analysis (OTSA) at
the same time that the taxpayer first files
a disclosure statement with a return. In
certain circumstances, a taxpayer may be
deemed to have satisfied its disclosure
obligations by filing Schedule M–3,Net
Income (Loss) Reconciliation for Corpo-
rations With Total Assets of $10 Million or
More, as provided by Rev. Proc. 2004–45,
2004–31 I.R.B. 140 (August 2, 2004).
Section6011alsorequiresthedisclo-
sure of listed transactions under section
20.6011–4 of the Estate Tax Regulations,
section 25.6011–4 of the Gift Tax Regu-
lations, section 31.6011–4 of the Employ-
ment Tax Regulations, section 53.6011–4
of the Foundation and Similar Excise Tax
Regulations, section 54.6011–4 of the
Pension Excise Tax Regulations, and sec-
tion 56.6011–4 of the Public Charity Tax
on Excess Lobbying Expenditure Regula-
tions.
Prior to the enactment of section
6707A, there was no monetary penalty
for the failure by a taxpayer to disclose a
reportable transaction.
THE AMERICAN JOBS CREATION
ACT OF 2004
The American Jobs Creation Act of
2004, P.L. 108–357, 118 Stat. 1418 (the
Act) was enacted on October 22, 2004.
Section 811 of the Act added section
6707A to the Code to provide a monetary
penalty for the failure to include on any
return or statement any information re-
quired to be disclosed under section 6011
with respect to a reportable transaction.
Section 6707A(b)(1) provides that the
penalty for failure to include information
with respect to a reportable transaction,
other than a listed transaction, is $10,000
in the case of a natural person, and $50,000
in any other case. Section 6707A(b)(2)
provides that the penalty for failure to in-
clude information with respect to a listed
transaction is $100,000 in the case of a
natural person, and $200,000 in any other
case.
Section 6707A(d)(1) grants the Com-
missioner authority to rescind all or a
portion of any penalty imposed by sec-
tion 6707A if (1) the violation relates
to a reportable transaction that is not a
listed transaction and (2) rescission of the
penalty would promote compliance with
the requirements of the Code and effective
tax administration. Section 6707A(d)(2)
provides that the Commissioner’s deter-
mination whether to rescind the penalty
may not be reviewed in any judicial pro-
ceeding. The legislative history to section
6707A provides that “the IRS Commis-
sioner or his delegate can rescind (or
abate) the penalty.” H.R. Conf. Rep. No.
755, 108
th
Cong., 2d Sess. at 373 (2004).
Section 6707A(e) also provides that
a person that is required to file periodic
reports under section 13 or 15(d) of the Se-
curities Exchange Act of 1934, or required
to be consolidated with another person
for purposes of those reports, must dis-
close the requirement to pay the following
penalties in the reports to the Securities
and Exchange Commission for the peri-
ods specified by the Secretary: (1) the
penalty under section 6707A for failure
to disclose a listed transaction; (2) the 30
percent penalty under section 6662A for
an understatement attributable to an undis-
closed listed transaction or undisclosed
reportable avoidance transaction; and (3)
the 40 percent penaltyunder section 6662
for a gross valuation misstatement if the
30 percent penalty under section 6662A
would have applied, but for the applica-
tion of section 6662A(e)(2)(c)(ii). Section
6707A(e) also provides that the failure to
make a disclosure on reports filed with the
Securities and Exchange Commission as
required by the Secretary shall be treated
as a failure to include information with
respect to a listed transaction for which
the penalty under section 6707A applies.
The penalty under section 6707A is in
addition to any other potentially applica-
ble penalties, including accuracy-related
penalties under sections 6662 and 6662A.
The penalty under section 6707A will be
imposed regardless of whether the transac-
tion results in an underpayment of tax.
Section 6707A is effective for returns
and statements the due date for which is
after October 22, 2004.
INTERIM GUIDANCE
The Internal Revenue Service and the
Treasury Department intend to issue reg-
ulations providing rules under section
6707A. Because section 6707A is effec-
tive for returns and statements the due
date for which is after October 22, 2004,
however, the Service and Treasury are
providing the following interim guidance
regarding the imposition and rescission
of penalties under section 6707A. These
February 14, 20054932005–7 I.R.B.

interim rules will apply until further guid-
ance is issued.
A.Imposition of the Section 6707A
Penalty
The Service will impose a penalty un-
der section 6707A with respect to each
failure to disclose a reportable transaction
within the time and in the form and manner
provided by section 6011 and the regula-
tions thereunder. Accordingly, a taxpayer
will be subject to a penalty under section
6707A for: (1) the failure to attach a re-
portable transaction disclosure statement
to an original or amended return; or (2) the
failure to provide a copy of a disclosure
statement to OTSA, if required. A tax-
payer that fails to attach a reportable trans-
action disclosure statement to an original
or amended return and fails to provide a
copy of a required disclosure statement to
OTSA will be subject to a single penalty
under section 6707A. The following exam-
ples illustrate this provision:
Example 1: Taxpayer T was required to attach a
Form 8886 to its original return for the 2005 taxable
year and to send a copy of the Form 8886 to OTSA at
the time it filed its original return. T failed to attach
the Form 8886 to its return and failed to send a copy
of the Form 8886 to OTSA. Taxpayer T is subject to a
penalty under section 6707A for a failure to disclose
because Taxpayer T failed to comply with both of
the disclosure requirements. A penalty under section
6707A also would apply if T had failed to comply
with either of the two requirements.
Example 2:SameasExample 1, except that T
subsequently filed an amended return for 2005 that
reflects Taxpayer T’s participation in the reportable
transaction. Taxpayer T failed to attach a Form
8886 to the amended return as required by section
1.6011–4(e)(1). Accordingly, Taxpayer T is subject
to an additional penalty under section 6707A for
failing to disclose a reportable transaction.
The penalty under section 6707A ap-
plies to each failure to provide a disclosure
statement that is required to be attached to
an original or amended return filed after
October 22, 2004 (with a copy sent to
OTSA, if required), regardless of whether
the original return was due on or be-
fore October 22, 2004. Under section
1.6011–4(e)(1), a reportable transaction
disclosure statement is due upon the filing
of a return or amended return reflecting
a taxpayer’s participation in a reportable
transaction. Accordingly, a penalty under
section 6707A will not be imposed until
a taxpayer fails to provide the required
disclosure statement with an original or
amended return, or fails to provide a copy
to OTSA, if applicable, even if the return
is filed after the due date. In addition,
a penalty under section 6707A will not
be imposed if the disclosure statement is
attached to a return that is filed after the
due date for filing the return unless the
taxpayer fails to provide a copy of the dis-
closure statement to OTSA, if applicable.
B.Rescission Authority
If it has been determined that a tax-
payer failed to disclose a reportable trans-
action and a penalty is imposed under sec-
tion 6707A, section 6707A(d) authorizes
the Commissioner to rescind all or any
portion of a penalty imposed under sec-
tion 6707A only if (1) the violation re-
lates to a reportable transaction other than
a listed transaction and (2) rescission of the
penalty would promote compliance with
the requirements of the Code and effec-
tive tax administration. In determining
whether rescission would promote compli-
ance with the requirements of the Code and
effective tax administration, the Commis-
sioner (or his delegate) will take into ac-
count all of the relevant facts and circum-
stances, including: (1) whether the tax-
payer has a history of complying with the
tax laws; (2) whether the violation results
from an unintentional mistake of fact; and
(3) whether imposing the penalty would be
against equity and good conscience. The
Commissioner’s determination whether to
rescind a penalty in whole or in part is not
reviewable by the IRS Appeals Division or
any court.
REQUEST FOR COMMENTS
The Service and Treasury invite inter-
ested persons to submit comments regard-
ingrulesandstandardsrelatingtosection
6707A, including the factors that should
be considered in exercising the rescis-
sion authority under section 6707A(d).
Comments are also requested on how
voluntary, but untimely disclosures (e.g.,
if a taxpayer failed to make a required
disclosure upon filing a return, but sub-
sequently submits the required disclosure
statement) should be treated in applying
the section 6707A penalty. Comments are
encouraged to be submitted by February
28, 2005, to: Internal Revenue Service,
CC:PA:LPD:PR (Notice 2005–11), room
5203, P.O. Box 7604, Ben Franklin Sta-
tion, Washington, DC 20044. Submis-
sions also may be hand delivered Mon-
day through Friday between the hours of
8 a.m. and 4 p.m. to: CC:PA:LPD:PR (No-
tice 2005–11), Courier’s Desk, Internal
Revenue Service, 1111 Constitution Av-
enue, NW, Washington, DC. Alternatively,
taxpayers may submit electronic com-
ments directly to the IRS e-mail address:
notice.comments@irscounsel.treas.gov.
DRAFTING INFORMATION
The principal author of this notice
is Matthew S. Cooper of the Office of As-
sociate Chief Counsel (Procedure and Ad-
ministration), Administrative Provisions
and Judicial Practice Division. For further
information regarding this notice, con-
tact Matthew S. Cooper at 202–622–4940
(not a toll-free call).
Temporary Rules Under
Section 6662A and Sections
6662 and 6664, as Amended
Notice 2005–12
The purpose of this notice is to alert tax-
payers to the recent enactment of section
6662A and amendments to sections 6662
and 6664 of the Internal Revenue Code,
provide interim guidance relating to these
provisions and invite comments from the
public regarding the rules and standards re-
lating to section 6662A and sections 6662
and 6664, as amended.
BACKGROUND
The American Jobs Creation Act of
2004, Pub. L. No. 108–357, 118 Stat.
1418 (the Act), was enacted on October 22,
2004. Section 812 of the Act added section
6662A, which provides a new penalty for
understatements with respect to reportable
transactions. Section 812 also added sec-
tion 6664(d), which provides a defense
to the penalty under section 6662A if the
taxpayer acted with reasonable cause and
in good faith. Sections 812 and 819 of the
Act amended section 6662(d) to modify
the accuracy-related penalty under section
6662(d) for substantial understatements of
income tax.
2005–7 I.R.B.494February 14, 2005

(1)Section 6662A, Imposition of
Accuracy-Related Penalty on
Understatements with Respect to
Reportable Transactions.
Section 812 of the Act added section
6662A to the Code, which provides that a
20-percent accuracy-related penalty may
be imposed on any reportable transaction
understatement. Under section 6662A, a
“reportable transaction understatement”
means the sum of (1) the product of (A) the
amount of the increase (if any) in taxable
income which results from a difference
between the proper tax treatment of an
item to which section 6662A applies and
the taxpayer’s treatment of such item (as
shown on the taxpayer’s return of tax),
and (B) the highest rate of tax imposed
by section 1 (section 11 in the case of a
corporation), and (2) the amount of the
decrease (if any) in the aggregate amount
of credits determined under subtitle A
which results from a difference between
the taxpayer’s treatment of an item to
which section 6662A applies (as shown
on the taxpayer’s return of tax) and the
proper tax treatment of such item.
The penalty provided by section 6662A
applies only (1) to listed transactions and
(2) to reportable transactions (other than
a listed transaction) if a significant pur-
pose of the transaction is the avoidance or
evasion of Federal income tax. In addi-
tion, a higher 30-percent penalty applies
to a reportable transaction understatement
if a taxpayer does not adequately disclose,
in accordance with regulations prescribed
under section 6011, the relevant facts af-
fecting the tax treatment of the item giv-
ing rise to the reportable transaction un-
derstatement. The reasonable cause and
good faith defense is not available with re-
spect to the 30-percent penalty.SeeI.R.C.
§§ 6662A(c) and 6664(d)(2)(A).
Section 6662A(e)(3) sets forth a special
rule for amended returns. The tax treat-
ment on an amendment or supplement to
a return is not taken into account in deter-
mining the amount of a reportable trans-
action understatement if the amendment or
supplement is filed after the earlier of (1)
the date the taxpayer is first contacted by
theIRSregardinganexaminationofthere-
turn or (2) any other date specified by the
Secretary.
(2)Section 6662, Imposition of
Accuracy-Related Penalty on
Underpayments.
Section 6662(d) imposes a 20-percent
accuracy-related penalty for any substan-
tial understatement of income tax. Under
section 6662(d)(1)(B), as amended, in the
case of a corporation (other than an S cor-
poration or a personal holding company),
there is a substantial understatement of in-
come tax for any taxable year if the amount
of the understatement for the taxable year
exceeds the lesser of (1) 10 percent of the
tax required to be shown on the return for
the taxable year (or, if greater, $10,000),
or (2) $10,000,000. In the case of all other
taxpayers, an understatement is substantial
if it exceeds the greater of 10 percent of the
taxrequiredtobeshownonthereturnor
$5,000.
Under section 6662(d)(2), an under-
statement is the excess of (i) the amount
oftaxrequiredtobeshownonthereturn
for the taxable year over (ii) the amount of
taximposedwhichisshownonthereturn,
reduced by any rebate. This excess is de-
termined without regard to items to which
section 6662A applies. The reportable
transaction understatement, however, is
added to the understatement calculated
under section 6662(d)(2) for purposes of
determining whether an understatement
is substantial under section 6662(d)(1).
Under section 6662A(e)(1)(B), in the case
of an understatement, the addition to tax
under section 6662(a) applies only to the
excess of the amount of the substantial
understatement over the aggregate amount
of the reportable transaction understate-
ments. Accordingly, the accuracy-related
penalty attributable to substantial under-
statement of income tax does not apply to
an understatement on which the section
6662A penalty is imposed.
Section 6662A does not apply to any
portion of an understatement on which the
section 6663 fraud penalty or the section
6662(h) accuracy-related penalty for a
gross valuation misstatement is imposed.
Section 6662(e) (substantial valuation
misstatement) does not apply to any por-
tion of an understatement on which a
penalty under section 6662A is imposed.
Under section 6662(d)(2), as amended,
the understatement with respect to any
item attributable to a tax shelter item,
including tax shelter items of taxpayers
other than corporations, will not be re-
duced even if the taxpayer has substantial
authority and a reasonable belief that the
tax treatment of an item attributable to a
tax shelter item was more likely than not
the proper treatment. The taxpayer may,
however, demonstrate reasonable cause
and good faith under section 6664(c).
(3)Section 6664, Definitions and Special
Rules.
The accuracy-related penalty under
section 6662A does not apply with respect
to any portion of a reportable transac-
tion understatement if,pursuant to section
6664(d), it is shown that there was rea-
sonable cause and the taxpayer acted in
good faith with respect to that portion of
the understatement. A taxpayer does not
have reasonable cause and did not act in
good faith unless (1) the relevant facts
affecting the tax treatment of the item are
adequately disclosed in accordance with
regulations prescribed under section 6011;
(2) there is or was substantial authority;
and (3) the taxpayer reasonably believed
that its treatment of the item was more
likely than not the proper tax treatment. A
taxpayer is treated as having a reasonable
belief only if the belief is based on the
facts and the law that exist at the time the
return is filed and the belief relates solely
to the taxpayer’s chances of success on the
merits of the tax treatment of the issue.
An opinion of a tax advisor may not
be relied upon to establish the reasonable
belief of the taxpayer if the advisor or
the opinion is disqualified. A tax advi-
sor is disqualified if the tax advisor (1) is
a material advisor under section 6111, as
amended, and participates in the organiza-
tion, management, promotion, or sale of
the transaction or is related to any person
who so participates; (2) is compensated di-
rectly or indirectly by a material advisor
with respect to the transaction; (3) has a
fee arrangement with respect to the trans-
action that is contingent on all or part of the
intended tax benefits from the transaction
being sustained; or (4) has any other dis-
qualifying financial interest with respect to
the transaction as identified by the Secre-
tary.
An opinion is disqualified if the opin-
ion (1) is based on unreasonable factual
or legal assumptions (including assump-
tions as to future events); (2) unreason-
February 14, 20054952005–7 I.R.B.

ably relies on representations, statements,
findings or agreements of the taxpayer or
any other person; (3) does not identify and
consider all relevant facts; or (4) fails to
meet any other requirement as the Secre-
tary may prescribe.
INTERIM PROVISIONS
The Treasury Department and the IRS
intend to issue regulations implementing
the requirements of section 6662A and
sections 6662 and 6664, as amended. Sec-
tion 812 of the Act, which added section
6662A and amended sections 6662 and
6664 is effective for taxable years ending
after October 22, 2004. Section 819 of
the Act, which separately amended sec-
tion 6662, is effective for taxable years
beginning after October 22, 2004. The
Treasury Department and the IRS provide
the following interim rules to implement
the requirements of sections 6662, 6662A
and 6664. These interim rules will apply
until further guidance is issued.
(1)Adequate disclosure in accordance
with section 6011
As noted above, the 30-percent penalty
provided by section 6662A applies to a
reportable transaction understatement if
the taxpayer does not adequately disclose
the relevant facts affecting the tax treat-
ment of the item under section 6011. A
taxpayer has adequately disclosed the
facts for purposes of section 6662A, and
section 6664(d)(2)(A), if the taxpayer has
filed a disclosure statement in the form
and manner prescribed by Treas. Reg.
§ 1.6011–4(d) or the taxpayer has been
deemed to have satisfied its disclosure
obligations under Rev. Proc. 2004–45,
2004–31 I.R.B. 140 (August 2, 2004), as
applicable, or any other published guid-
ance prescribing the form and manner of
disclosure under section 6011.
(2)Special rule for amended returns
For purposes of determining the amount
of any reportable transaction understate-
ment, the IRS will not take into account an
amendment or supplement to a return filed
after the dates specified in Treas. Reg.
§ 1.6664–2(c)(3) and Notice 2004–38,
2004–21 I.R.B. 949 (May 24, 2004), or
any amendments thereto, which are the
dates after which a taxpayer may not file a
“qualified amended return.”
(3)Disqualified tax advisor
As stated above, a taxpayer may not
rely on the opinion of a disqualified tax ad-
visor to establish reasonable belief under
section 6664(d). A disqualified tax advisor
is any advisor who (a) is a material advisor
(under section 6111, as amended) and who
participates in the organization, manage-
ment, promotion or sale of the transaction
or is related (within the meaning of section
267(b) or 707(b)(1)) to any person who so
participates, (b) has a disqualified compen-
sation arrangement, or (c) has a disqualify-
ing financial interest identified by the Sec-
retary.
A material advisor is defined in
Treas. Reg. § 301.6112–1. In addi-
tion, the existing rules under Treas. Reg.
§ 301.6112–1(c)(2), (c)(3) and (d) (with-
out regard to the provisions relating to a
transaction required to be registered under
former section 6111), including the min-
imum fee amounts for listed transactions
under Treas. Reg. § 301.6112–1(c)(3)(ii),
shall apply.SeeNotice 2004–80, 2004–50
I.R.B. 963 (December 13, 2004). The def-
inition of material advisor, and the rules
described here, will apply for purposes of
section 6662A until the IRS issues further
guidance.
(a)Organization, Management,
Promotion or Sale
A material advisor participates in the
“organization” of a transaction if the advi-
sor:
(1) devises, creates, investigates or ini-
tiates the transaction or tax strategy;
(2) devises the business or financial
plans for the transaction or tax strategy;
(3) carries out those plans through ne-
gotiations or transactions with others; or
(4) performs acts relating to the devel-
opment or establishment of the transaction.
The performance of an act relating to the
development or establishment of a trans-
action includes preparing documents that
(A) establish the structure used in connec-
tion with the transaction,e.g., a partner-
ship agreement or articles of incorpora-
tion, (B) describe the transaction for use
in the promotion or sale of the transac-
tion,e.g., an offering memorandum, tax
opinion, prospectus, or other document de-
scribing the transaction, or (C) register the
transaction with any federal, state or local
government body.
A material advisor participates in the
“management” of a transaction if the ma-
terial advisor is involved in the decision-
making process regarding any business ac-
tivity with respect to the transaction. Par-
ticipation in the management of a trans-
action includes managing assets, directing
business activity, or acting as general part-
ner, trustee, director or officer of an entity
involved in the transaction.
A material advisor participates in the
“promotion or sale” of a transaction if the
material advisor is involved in the market-
ing of the transaction or tax strategy. Mar-
keting activities include: (1) soliciting, di-
rectly or through an agent, taxpayers to en-
ter into a transaction or tax strategy us-
ing direct contact, mail, telephone or other
means; (2) placing an advertisement for
the transaction in a newspaper, magazine,
or other publication or medium; or (3) in-
structing or advising others with respect to
marketing of the transaction or tax strat-
egy.
Consistent with the legislative history,
a tax advisor, including a material advi-
sor, will not be treated as participating
in the organization, management, promo-
tion or sale of a transaction if the tax ad-
visor’s only involvement is rendering an
opinion regarding the tax consequences of
the transaction. In the course of prepar-
ing a tax opinion, a tax advisor is permit-
ted to suggest modifications to the trans-
action, but the tax advisor may not sug-
gest material modifications to the trans-
action that assist the taxpayer in obtain-
ing the anticipated tax benefits. Merely
performing support services or ministerial
functions such as typing, photocopying, or
printing will not be considered participa-
tion in the organization, management, pro-
motion or sale of a transaction.
(b)Disqualified Compensation
Arrangements
As stated above, a disqualified tax ad-
visor includes a tax advisor who has a
disqualified compensation arrangement.
A disqualified compensation arrangement
includes (1) an arrangement by which the
advisor is compensated directly or indi-
rectly by a material advisor with respect
2005–7 I.R.B.496February 14, 2005

to the transaction or (2) a fee arrangement
with respect to the transaction that is con-
tingent on all or part of the intended tax
benefits from the transaction being sus-
tained.SeeI.R.C. § 6664(d)(3)(B)(ii).
Until further guidance is issued, a tax
advisor also will be treated as a disquali-
fied tax advisor, even if not a material advi-
sor, if the tax advisor has a referral fee or a
fee-sharing arrangement by which the ad-
visor is compensated directly or indirectly
by a material advisor. In addition, an ar-
rangement will be treated as a disqualified
compensation arrangement if there is an
agreement or understanding (oral or writ-
ten) with a material advisor of a reportable
transaction pursuant to which the tax advi-
sor is expected to render a favorable opin-
ion regarding the tax treatment of the trans-
action to any person referred by the ma-
terial advisor. A tax advisor will not be
treated as having a disqualified compen-
sation arrangement if a material advisor
merely recommends the tax advisor who
does not have an agreement or understand-
ing with the material advisor to render a
favorable opinion regarding the tax treat-
ment of a transaction.
In addition, a disqualified compensa-
tion arrangement includes a fee that is
contingent on all or part of the intended
tax benefits from the transaction being
sustained, including agreements that pro-
vide that (1) a taxpayer has the right to a
full or partial refund of fees if all or part of
the tax consequences from the transaction
are not sustained or (2) the amount of the
fee is contingent on the taxpayer’s realiza-
tion of tax benefits from the transaction.
Transactions described in Treas. Reg.
§ 1.6011–4(b)(4)(iii) do not give rise to a
disqualified compensation arrangement.
REQUEST FOR COMMENTS
The Treasury Department and the IRS
intend to issue regulations implementing
section 6662A and the amendments to sec-
tions 6662 and 6664 and invite interested
persons to submit comments regarding
rules and standards under sections 6662,
6662A and 6664 in general and on the
specific matters set forth below, including
particularly item 2 under “Definition and
Special Rules” regarding the extent to
which a tax advisor should be permitted
to suggest modifications to a transaction
without becoming a “disqualified tax ad-
visor.”
Section 6662A. Imposition of
Accuracy-Related Penalty on
Understatements with Respect to
Reportable Transactions.
1. Definition of “reportable transaction
understatement”;
2. Coordination of the reportable trans-
action understatement penalty with the
substantial understatement penalty, in-
cluding the methodology for calculating
the excess of the aggregate reportable
transaction understatement;
3. Coordination of the reportable trans-
action understatement penalty with the ac-
curacy-related penalty on underpayments,
including the penalty on underpayments
attributable to negligence or disregard of
rules or regulations, and the fraud penalty;
and
4. Special rules for amended returns,
including whether rules similar to the rules
provided in Rev. Proc. 94–69, 1994–2
C.B. 804, should apply.
Section 6664. Definitions and Special
Rules.
1. Definition of “disqualified tax advi-
sor,” including definition of “participates
in the management, organization, promo-
tion or sale of a transaction”;
2. Providing suggested modifications
regarding the transaction;
3. Definition of “disqualifying finan-
cial interest”;
4. Additional requirements relating to
“disqualified opinions.”
Comments are encouraged to be sub-
mitted by February 28, 2005, to: Internal
Revenue Service, CC:PA:LPD:PR (Notice
2005–12), room 5203, P.O. Box 7604, Ben
Franklin Station, Washington, DC 20224.
Submissions may be hand delivered Mon-
day through Friday between the hours of
8 a.m. and 4 p.m. to: CC:PA:LPD:PR (No-
tice 2005–12), Courier’s Desk, Internal
Revenue Service, 1111 Constitution Av-
enue, NW, Washington, DC. Alternatively,
taxpayers may submit electronic com-
ments directly to the IRS e-mail address:
notice.comments@irscounsel.treas.gov.
DRAFTING INFORMATION
The principal author of this notice
is Heather L. Dostaler of the Office of
Associate Chief Counsel (Procedure &
Administration), Administrative Provi-
sions and Judicial Practice Division. For
further information regarding this no-
tice, contact Heather L. Dostaler at (202)
622–4940 (not a toll-free call).
February 14, 20054972005–7 I.R.B.

Section 199.—Income
Attributable to Domestic
Production Activities
Notice 2005–14
CONTENTS
SECTION1.PURPOSE ....................................................................................... 502
SECTION 2. OV
ERVIEWOF§199 ............................................................................
502
.01In General........................................................................................... 502
.02Qualified Production Activities Income.................................................................. 502
.03Pass-thru Entities..................................................................................... 503
.04Individuals........................................................................................... 503
.05Patrons of Certain Cooperatives........................................................................ 503
.06Expan
ded Affiliated Groups............................................................................
503
.07Trade or Business Requirement......................................................................... 503
.08Alternative Minimum Tax.............................................................................. 503
.09 Authority to Prescribe Regulations...................................................................... 503
SECTION
3.EXPLANATIONOFINTERIMGUIDANCE........................................................
504
.01In General........................................................................................... 504
.02Wage Limitation...................................................................................... 504
(1)In general...................................................................................... 504
(2)Wages paid by other entities...................................................................... 504
(3)Acquisitions and dispositions of a trade or business (or major portion)................................ 504
(4)No
n-duplication rule............................................................................
504
(5)Definition of W–2 wages......................................................................... 504
(a)In general................................................................................ 504
(b)Methods for calculating W–2 wages......................................................... 504
.03Determining Qualified Production Activities Income...................................................... 504
.04Determining Domestic Production Gross Receipts........................................................ 505
(1
)In general......................................................................................
50
5
(2)Definition of “gross receipts.”.................................................................... 505
(3)Definition of “manufactured, produced, grown, or extracted.”........................................ 505
(a)In general................................................................................ 505
(b)Consistency with § 263A................................................................... 505
(4)Definition of “by the taxpayer.”.................................................................. 505
(5)Definition of “in whole or in significant part.”..................................................... 506
(a)In general................................................................................ 506
(b)Substantial in nature...................................................................... 506
(c)Safe harbor............................................................................... 507
(d)Certain activities and costs disregarded...................................................... 507
(6)Definition of “United States.”.................................................................... 507
(7)Definition of “derived from the lease, rental, license, sale, exchange, or other disposition of qualifying
production property.”.............................................................................. 507
(a)In general................................................................................ 507
(b)Allocation of gross receipts – embedded services.............................................. 508
(c)Advertising income........................................................................ 508
(d) Computer software........................................................................ 508
(8)Definition of “qualifying production property.”..................................................... 508
(a)In general................................................................................ 508
(b)Tangible personal property................................................................. 508
2005–7 I.R.B.498February 14, 2005

(c)Computer software........................................................................ 509
(i)In general.......................................................................... 509
(ii)Tangible personal property not included............................................... 509
(d)Sound recordings......................................................................... 509
(9)Definiti
on of “qualified film.”....................................................................
509
(a)In general................................................................................ 509
(b)Production personnel...................................................................... 509
(c)Compensation for services................................................................. 510
(d)Determination of 50 percent................................................................ 510
(10)Electricity, natural gas, and potable water........................................................ 510
(a)In gene
ral................................................................................
510
(b)Natural gas.............................................................................. 510
(c)Potable water............................................................................. 510
(11)Definition of “construction performed in the United States.”........................................ 510
(a)Construction of real property............................................................... 510
(b)Activities constituting construction.......................................................... 510
(c)Def
inition of “infrastructure.”..............................................................
511
(d)Definition of “substantial renovation.”...................................................... 511
(e)“Derived from construction.”.............................................................. 511
(i)In general.......................................................................... 511
(ii)Taxpayers deriving gross receipts from construction..................................... 511
(12)Definition of “engineering and architectural services.”............................................. 511
(a)I
n general................................................................................
511
(b)Performance of services in the United States.................................................. 511
(c)Construction projects within the United States................................................ 511
(13)Exception for sales of certain food and beverages.................................................. 511
.05Determining Costs.................................................................................... 511
(1)In general...................................................................................... 511
(2
)Allocation of cost of goods sold...................................................................
51
2
(3)Allocation and apportionment of deductions........................................................ 512
(a)Three alternative methods.................................................................. 512
(b)Treatment of certain deductions............................................................. 512
.06Application of § 199 to Pass-thru Entities................................................................ 512
(1)In general...................................................................................... 512
(2)Gain or loss from the disposition of an interest in a pass-thru entity................................... 513
(3)Effective date of § 199 for pass-thru entities........................................................ 513
.07Patrons of Agricultural and Horticultural Cooperatives................................................... 513
.08Expanded Affiliated Groups............................................................................ 513
(1)In general...................................................................................... 513
(2)Computation of expanded affiliated group’s § 199 deduction......................................... 513
(a)In general................................................................................ 513
(b)Attribution of activities.................................................................... 513
(c)Anti-avoidance rule....................................................................... 513
(3)Allocation of expanded affiliated group’s § 199 deduction............................................ 513
(4)Special rules for consolidated groups.............................................................. 513
(5)Identification of members of the expanded affiliated group........................................... 514
(6)Allocation of income and loss.................................................................... 514
(a)Prorataallocationmethod................................................................. 514
(b)Closing of the books method................................................................ 514
(7)Total § 199 deduction for a corporation that is a member of an expanded affiliated group for some or all of
its taxable year..................................................................................... 514
(8)Computation of § 199 deduction for members of expanded affiliated group with different taxable years.... 514
SECTION4.INTERIMGUIDANCE............................................................................ 514
.01In General........................................................................................... 514
.02Wage Limitation...................................................................................... 514
February 14, 20054992005–7 I.R.B.

(1)Rules of application............................................................................. 514
(a)In general................................................................................ 514
(b)No application in determining whether amounts are wages for employment tax purposes........... 514
(c)Application in case of taxpayer with short taxable year........................................ 514
(d)Acquisit
ions and dispositions of a trade or business (or major portion)..........................
515
(e)Non-duplication rule...................................................................... 515
(2)Definition of “W–2 wages.”...................................................................... 515
(a)In general................................................................................ 515
(b)Methods for calculating W–2 wages......................................................... 515
(i)Unmodified box method.............................................................. 515
(ii)Modif
iedBox1method..............................................................
515
(iii)Tracking wages method............................................................. 515
.03Determining Qualified Production Activities Income...................................................... 515
(1)In general...................................................................................... 515
(2)Allocation of gross receipts....................................................................... 515
(3)Treatment of advance payments.................................................................. 516
.04Det
ermining Domestic Production Gross Receipts........................................................
516
(1)In general...................................................................................... 516
(2)Definition of “gross receipts.”.................................................................... 516
(3)Definition of “manufactured, produced, grown, or extracted.”........................................ 516
(a)In general................................................................................ 516
(b)Consistency with § 263A................................................................... 516
(4)D
efinition of “by the taxpayer.”..................................................................
517
(5)Definition of “in whole or in significant part.”..................................................... 517
(a)In general................................................................................ 517
(b)Substantial in nature...................................................................... 517
(c)Safe harbor............................................................................... 517
(6)Definition of “United States.”.................................................................... 517
(7)Definition of “derived from the lease, rental, license, sale, exchange, or other disposition of qualifying
production property.”.............................................................................. 517
(a)In general................................................................................ 517
(b)Allocation of gross receipts – embedded services.............................................. 518
(c)Advertising income........................................................................ 518
(d)Computer software........................................................................ 518
(e) Exception for certain oil and gas partnerships................................................ 518
(8)Definition of “qualifying production property.”..................................................... 518
(a)In general................................................................................ 518
(b)Tangible personal property................................................................. 518
(c)Computer software........................................................................ 518
(d)Sound recordings......................................................................... 519
(9)Definition of “qualified film.”.................................................................... 519
(a)In general................................................................................ 519
(b)Compensation for services................................................................. 519
(c)Determination of 50 percent................................................................ 519
(d)Exception................................................................................ 519
(10)Electricity, natural gas, and potable water........................................................ 519
(a)In general................................................................................ 519
(b)Natural gas.............................................................................. 519
(c)Potable water............................................................................. 519
(d)Exceptions............................................................................... 519
(i)Electricity.......................................................................... 520
(ii)Natural gas........................................................................ 520
(iii)Potable water...................................................................... 520
(11)Definition of “construction performed in the United States.”........................................ 520
(a)Construction of real property............................................................... 520
(b)Activities constituting construction.......................................................... 520
2005–7 I.R.B.500February 14, 2005

(c)Definition of “infrastructure.”.............................................................. 520
(d)Definition of “substantial renovation.”...................................................... 520
(e)“Derived from construction.”.............................................................. 520
(12)Definition of “engineering and architectural services.”............................................. 520
(a)In genera
l................................................................................
520
(b)Engineering services...................................................................... 520
(c)Architectural services...................................................................... 520
(d)De minimis exception for performance of services in the United States........................... 521
(13)Exception for sales of certain food and beverages.................................................. 521
(14)Related persons................................................................................ 521
.05Determ
ining Costs....................................................................................
521
(1)In general...................................................................................... 521
(2)Costs of goods sold allocable to domestic production gross receipts................................... 521
(a)In general................................................................................ 521
(b)Allocating cost of goods sold............................................................... 521
(c)Special rules for imported items or services.................................................. 521
(3)Oth
er deductions allocable or apportionable to domestic production gross receipts.....................
521
(a)In general................................................................................ 521
(b)Rules that apply to all allocation and apportionment methods.................................. 522
(i)In general.......................................................................... 522
(ii)Losses............................................................................. 522
(iii)Net operating losses................................................................ 522
(iv)
Deductions not attributable to theactual conduct of a trade or business...................
522
(v)Deductions related to de minimis gross receipts and embedded services included in domestic
production gross receipts................................................................ 522
(c)Section 861 method........................................................................ 522
(i)In general.......................................................................... 522
(i
i)Deductions for charitable contributions................................................
52
2
(iii)Research and experimental expenditures.............................................. 522
(d)Simplified deduction method................................................................ 522
(4)Small business simplified overall method........................................................... 522
(a)In general................................................................................ 522
(b)Qualifying small taxpayer.................................................................. 522
(5)Average annual gross receipts.................................................................... 523
.06Application of § 199 to Pass-thru Entities................................................................ 523
(1)Allocations to partners, shareholders, and similar interest holders.................................... 523
(a)Partnerships.............................................................................. 523
(i)Determination at partner level........................................................ 523
(ii)Expenses........................................................................... 523
(iii)W–2 wages........................................................................ 523
(b)S corporations............................................................................ 523
(i)Determination at S corporation shareholder level........................................ 523
(ii)Expenses........................................................................... 524
(iii)W–2 wages........................................................................ 524
(2)Gain or loss from the disposition of an interest in a pass-thru entity. . ................................. 524
(3)Effective date of § 199 for pass-thru entities........................................................ 524
.07Patrons of Agricultural and Horticultural Cooperatives................................................... 524
.08Individuals........................................................................................... 524
.09Expanded Affiliated Groups............................................................................ 525
(1)In general...................................................................................... 525
(2)Computation of expanded affiliated group’s § 199 deduction......................................... 525
(a)In general................................................................................ 525
(b)Attribution of activities.................................................................... 525
(c)Anti-avoidance rule....................................................................... 525
(3)Allocation of expanded affiliated group’s § 199 deduction............................................ 525
(4)Special rules for consolidated groups.............................................................. 525
February 14, 20055012005–7 I.R.B.

(5)Identification of members of the expanded affiliated group........................................... 525
(6)Allocation of income and loss.................................................................... 525
(a)In general................................................................................ 525
(i)Pro rata allocation method........................................................... 525
(ii)Closing
of the books method..........................................................
525
(iii)Making the § 199 closing of the books election......................................... 525
(b)Coordination with rules relating to the allocation of income under § 1.1502–76(b)................ 525
(7)Total § 199 deduction for a corporation that is a member of an expanded affiliated group for some or all of
its taxable year..................................................................................... 525
(8)Computa
tion of § 199 deduction for members of expanded affiliated group with different taxable years....
526
.10Trade or Business Requirement......................................................................... 526
.11Coordination with Alternative Minimum Tax............................................................. 526
.12Special rules......................................................................................... 526
(1)Certain nonrecognition transactions............................................................... 526
(2)Section 1031 exchanges.......................................................................... 526
(3)Sect
ion 381 transactions.........................................................................
526
(4)Taxpayers with a 52–53 week taxable year......................................................... 526
SECTION5.EFFECTIVEDATE............................................................................... 526
SECTION6.REQUESTFORCOMMENTS..................................................................... 526
.01In General........................................................................................... 526
.02Addresses for Comments............................................................................... 527
.03Deadline for Submission of Comments.................................................................. 527
SECTION7.DRAFTINGINFORMATION. ..................................................................... 527
SECTION 1. PURPOSE
The Internal Revenue Service and
Treasury Department currently are de-
veloping regulations under § 199 of the
Internal Revenue Code, enacted as part of
the American Jobs Creation Act of 2004,
Pub. L. No. 108–357 (the Act), regarding
the deduction relating to income attrib-
utable to domestic production activities.
This notice provides interim guidance on
which taxpayers may rely until the regula-
tions are issued. The Service and Treasury
Department expect that the regulations
will incorporate the rules set forth in this
notice and will be effective for taxable
years beginning after December 31, 2004,
theeffectivedateof§199.See§ 102(e)
of the Act. This notice requests comments
on the interim guidance provided herein
and any additional guidance that should be
provided in regulations. Comments must
be received by March 31, 2005.
SECTION 2. OVERVIEW OF § 199
.01In General.(1) Section 199(a)(1)
allows a deduction equal to 9 percent
(3 percent in the case of taxable years be-
ginning in 2005 and 2006, and 6 percent
in the case of taxable years beginning in
2007, 2008, or 2009) of the lesser of (a)
the qualified production activities income
(QPAI) of the taxpayer for the taxable
year, or (b) taxable income (determined
without regard to § 199) for the taxable
year (or, in the case of an individual, under
§ 199(d)(2), adjusted gross income).
(2) Section 199(b)(1) limits the deduc-
tion for a taxable year to 50 percent of the
W–2 wages paid by the taxpayer during
the calendar year that ends in such taxable
year. For this purpose, § 199(b)(2) defines
the term “W–2 wages” to mean the sum
of the aggregate amounts the taxpayer is
required under § 6051(a)(3) and (8) to in-
clude on the Forms W–2 of the taxpayer’s
employees during the calendar year ending
during the taxpayer’s taxable year. Sec-
tion 199(b)(3) provides that the Secretary
shall prescribe rules for the application of
§199(b)inthecaseofanacquisitionor
disposition of a major portion of either a
trade or business or a separate unit of a
trade or business during the taxable year.
.02Qualified Production Activities In-
come. (1) Under § 199(c)(1), QPAI is the
excess of domestic production gross re-
ceipts (DPGR) over the sum of: (a) the cost
of goods sold (CGS) allocable to such re-
ceipts; (b) other deductions, expenses, or
losses directly allocable to such receipts;
and (c) a ratable portion of deductions, ex-
penses, and losses not directly allocable to
such receipts or another class of income.
(2) Section 199(c)(2) provides that
the Secretary shall prescribe rules for the
proper allocation of items of income, de-
duction, expense, and loss for purposes of
determining QPAI.
(3) Section 199(c)(3) provides special
rules for determining costs in computing
QPAI. Under these special rules, any item
or service brought into the United States
is treated as acquired by purchase, and its
cost is treated as not less than its value im-
mediately after it enters the United States.
A similar rule applies in determining the
adjusted basis of leased or rented prop-
erty when the lease or rental gives rise
to DPGR. If the property has been ex-
ported by the taxpayer for further manu-
facture, the increase in cost or adjusted ba-
sis must not exceed the difference between
the value of the property when exported
and its value when brought back into the
United States after further manufacture.
(4) Section 199(c)(4)(A) defines DPGR
to mean the taxpayer’s gross receipts that
are derived from: (a) any lease, rental,
license, sale, exchange, or other disposi-
2005–7 I.R.B.502February 14, 2005

tion of (i) qualifying production property
(QPP) that was manufactured, produced,
grown, or extracted (MPGE) by the tax-
payer in whole or in significant part within
the United States; (ii) any qualified film
produced by the taxpayer; or (iii) elec-
tricity, natural gas, or potable water pro-
duced by the taxpayer in the United States;
(b) construction performed in the United
States; or (c) engineering or architectural
services performed in the United States for
construction projects in the United States.
Section 199(c)(4)(B) excepts from DPGR
gross receipts of the taxpayer that are de-
rived from: (a) the sale of food and bev-
erages prepared by the taxpayer at a retail
establishment; and (b) the transmission or
distribution of electricity, natural gas, or
potable water.
(5) Section 199(c)(5) defines QPP to
mean: (a) tangible personal property; (b)
any computer software; and (c) any prop-
erty described in § 168(f)(4) (certain sound
recordings).
(6) Section 199(c)(6) defines a quali-
fied film to mean any property described
in § 168(f)(3) if not less than 50 percent of
the total compensation relating to produc-
tion of the property is compensation for
services performed in the United States
by actors, production personnel, directors,
and producers. The term does not include
property with respect to which records
are required to be maintained under 18
U.S.C. § 2257 (generally, films, video-
tapes, or other matter that depict actual
sexually explicit conduct and are pro-
duced in whole or in part with materials
that have been mailed or shipped in inter-
state or foreign commerce, or are shipped
or transported or are intended for shipment
or transportation in interstate or foreign
commerce).
(7) Section 199(c)(7) provides that
DPGR does not include any gross receipts
of the taxpayer derived from property
leased, licensed, or rented by the taxpayer
for use by any related person. A person is
treated as related to another person if both
persons are treated as a single employer
under either § 52(a) or (b) (without regard
to § 1563(b)), or § 414(m) or (o).
.03Pass-thru Entities. (1) Sec-
tion 199(d)(1) provides that, in the case
of an S corporation, partnership, estate
or trust, or other pass-thru entity, § 199
generally is applied at the shareholder,
partner, or similar level, except as oth-
erwise provided in rules applicable to
individuals and patrons of cooperatives.
Section 199(d)(1) further provides that the
Secretary shall prescribe rules for the ap-
plication of § 199, including rules relating
to: (a) restrictions on the allocation of the
deduction to taxpayers at the partner or
similar level; and (b) additional reporting
requirements.
(2) Notwithstanding the general rule
that § 199 is applied at the shareholder,
partner, or similar level, § 199(d)(1)(B)
provides that, for purposes of applying the
wage limitation of § 199(b), a shareholder,
partner, or similar person that is allocated
QPAI from an S corporation, partnership,
estate, trust, or other pass-thru entity is
also treated as having been allocated W–2
wages from such entity in an amount equal
to the lesser of: (i) such person’s allocable
share of such wages (without regard to
this rule) as determined under regulations
prescribed by the Secretary; or (ii) 2 times
9 percent (3 percent in the case of taxable
years beginning in 2005 and 2006, and 6
percent in the case of taxable years begin-
ning in 2007, 2008, or 2009) of the QPAI
allocated to such person for the taxable
year.
.04Individuals. In the case of individ-
uals, § 199(d)(2) provides that the deduc-
tion is equal to the applicable percent of the
lesser of the taxpayer’s (1) QPAI for the
taxable year, or (2) adjusted gross income
(AGI) for the taxable year determined after
applying §§ 86, 135, 137, 219, 221, 222,
and 469, and without regard to § 199.
.05Patrons of Certain Cooperatives.
(1) Section 199(d)(3) provides special
rules under which a taxpayer receiving
certain patronage dividends or certain
qualified per-unit retain allocations from
a cooperative (to which subchapter T ap-
plies)engagedintheMPGE,inwholeor
in significant part, or in the marketing, of
any agricultural or horticultural product
is allowed a deduction under § 199 with
respect to the amount of the patronage
dividends or qualified per-unit retain allo-
cations that are: (a) allocable to the portion
of the cooperative’s QPAI that would be
deductible by the cooperative; and (b)
designatedassuchbythecooperativeina
written notice mailed to its patrons during
the payment period described in § 1382.
Such an amount, however, does not reduce
the taxable income of the cooperative un-
der § 1382.
(2) In determining the portion of the co-
operative’s QPAI that would be deductible
by the cooperative, the cooperative’s tax-
able income is computed without taking
into account any deduction allowable un-
der § 1382(b) or (c) (relating to patron-
age dividends, per-unit retain allocations,
and nonpatronage distributions) and, in the
case of a cooperative engaged in marketing
agricultural and horticultural products, the
cooperative is treated as having MPGE, in
whole or in significant part, any QPP mar-
keted by the cooperative that its patrons
have MPGE.
.06Expanded Affiliated Groups.(1)
Section 199(d)(4)(A) provides that all
members of an expanded affiliated group
(EAG) are treated as a single corpo-
ration for purposes of § 199. Section
199(d)(4)(B) provides that an EAG is an
affiliated group as defined in § 1504(a),
determined by substituting “50 percent”
for “80 percent” each place it appears, and
withoutregardto§1504(b)(2)and(4).
(2) Section 199(d)(4)(C) provides that,
except as provided in regulations, the § 199
deduction is allocated among the members
of the EAG in proportion to each mem-
ber’s respective amount (if any) of QPAI.
.07Trade or Business Requirement.
Section 199(d)(5) provides that § 199 is
applied by taking into account only items
that are attributable to the actual conduct
of a trade or business.
.08Alternative Minimum Tax. Sec-
tion 199(d)(6) provides rules to coordinate
the deduction allowed under § 199 with the
alternative minimum tax (AMT) imposed
by § 55. The deduction is allowed for
purposes of the AMT, except that the de-
duction is equal to the applicable percent
of the lesser of the taxpayer’s: (1) QPAI,
determined without regard to subchapter
A,PartIV,oftheCode;or(2)alternative
minimum taxable income (AMTI). For
purposes of the preceding sentence, in the
case of an individual, AGI (determined
without regard to § 199) shall be substi-
tuted for AMTI.
.09Authority to Prescribe Regulations.
Section 199(d)(7) authorizes the Secretary
to prescribe such regulations as are neces-
sary to carry out the purposes of § 199.
February 14, 20055032005–7 I.R.B.

SECTION 3. EXPLANATION OF
INTERIM GUIDANCE
.01In General. Section 199 provides a
deduction from gross income for an appli-
cable percentage of QPAI subject to cer-
tain limits. Section 199 raises a num-
ber of complex issues. In general, the in-
terim guidance provided in this notice is
intended to balance the goals of: (1) ensur-
ing compliance with the intent and purpose
of § 199; and (2) providing clear, admin-
istrable rules that minimize, to the extent
possible, the administrative burden on tax-
payers and the Service.
.02Wage Limitation.(1)In general.
Section 4.02(1) of this notice provides
rules that are used in determining the
amount of “W–2 wages” of a taxpayer.
Section 4.02(1) provides that for purposes
of § 199(b)(2), the term “taxpayer” means
“employer.” Section 4.02(1) provides that
only amounts from Forms W–2, “Wage
and Tax Statement,” issued for employees
of the taxpayer for employment by the
taxpayer are included in calculating this
amount. For purposes of this calculation,
employees of the taxpayer are limited to
employees as defined by § 3121(d)(1) and
(d)(2) (that is, officers of a corporate tax-
payer and employees of the taxpayer under
the common law rules). Section 4.02(1)(b)
provides generally that any discussion of
the term “wages” in this notice is solely
for purposes of § 199 and has no appli-
cation in determining whether amounts
are wages for purposes of the Federal
Insurance Contributions Act (FICA), the
Federal Unemployment Tax Act (FUTA),
federal income tax withholding, or any
other wage related determination.
(2)Wages paid by other entities. Sec-
tion 4.02(1) of this notice provides that
a taxpayer may take into account wages
paid and reported by other entities to em-
ployees of that taxpayer for employment
by that taxpayer. Thus, a taxpayer may
take into account wages paid by agents
of the taxpayer on behalf of the taxpayer
to employees of the taxpayer that are in-
cluded on Forms W–2 issued by the agent.
A taxpayer also may take into account
wages paid by a person defined as an em-
ployer under § 3401(d)(1), to employees
of the taxpayer if the wages are included
on Forms W–2 issued by the § 3401(d)(1)
employer.
(3)Acquisitions and dispositions of a
tradeorbusiness(ormajorportion). Sec-
tion 4.02(1)(d) of this notice provides that
if a taxpayer (the successor) acquires the
major portion of a trade or business or the
major portion of a separate unit of a trade
or business from another taxpayer (the pre-
decessor), the successor may not take into
account wages paid to common law em-
ployees of the predecessor employer in re-
spect of services rendered to the prede-
cessor employer, even if those wages are
reported on Forms W–2 furnished by the
successor.
(4)Non-duplication rule. Section
4.02(1)(e) of this notice includes a
non-duplication rule, which provides that
amounts that are treated as W–2 wages
for any taxable year may not be treated
as W–2 wages for any other taxable year.
Thus, an amount of nonqualified deferred
compensation that is treated as W–2 wages
under the Unmodified Box Method in sec-
tion 4.02(2)(b)(i) for a taxable year may
not be treated as W–2 wages in any other
taxable year.
(5)Definition of W–2 wages.(a)In
general. Section 4.02(2) of this no-
tice provides rules for determining the
“W–2 wages” of a taxpayer. The term
“W–2 wages” includes amounts that are
required to be included on statements
under § 6051(a)(3) and (8) with respect
to employees of the taxpayer. Because
§ 6051(a)(3) and (8) include the total
amount of wages as defined in § 3401(a),
the total amount of elective deferrals
(within the meaning of § 402(g)(3)), the
compensation deferred under § 457, and
(for tax years beginning after December
31, 2005) the amount of designated Roth
contributions (as defined in § 402A), there
is no single box on the Form W–2 that
necessarily includes all these items of in-
formation without including other items.
Therefore, no single box on the Form W–2
meets the § 199(b)(2) definition of W–2
wages.
(b)Methods for calculating W–2 wages.
Because no single box on Form W–2 sat-
isfies the definition of W–2 wages under
§ 199(b)(2), section 4.02(2)(b) of this no-
tice provides three alternative methods for
calculating W–2 wages only for purposes
of § 199. The first option allows for a sim-
plified calculation while the last two op-
tions provide greater accuracy. Under the
first option, a taxpayer may treat as the
taxpayer’s W–2 wages under § 199(b)(2)
the lesser of (A) the total entries in Box
1 of all Forms W–2 filed with the Social
Security Administration (SSA) by the tax-
payer with respect to employees of the tax-
payer or (B) the total entries in Box 5 of
all Forms W–2 filed with the SSA by the
taxpayer with respect to employees of the
taxpayer. Under the second option, the
W–2 wages are calculated by subtracting
from the total amounts reported in Box 1 of
Forms W–2 with respect to employees of
the taxpayer (1) amounts that are included
in Box 1 that are not wages under § 3401(a)
and (2) items that are treated as wages un-
der § 3402(o) (for example, supplemen-
tal unemployment compensation benefits),
and then adding those elective deferrals
that are reported in Box 12 of Forms W–2
withCodesD,E,F,G,andS.Underthe
third option, a taxpayer may track the ac-
tual amount of wages subject to federal
income tax withholding, subtract supple-
mental unemployment compensation ben-
efits that were included in this amount, and
then add specific elective deferrals that are
reported in Box 12 of Forms W–2 with
CodesD,E,F,G,andS.
.03Determining Qualified Production
Activities Income.Section4.03ofthisno-
tice provides rules for determining a tax-
payer’s QPAI for the taxable year. This
notice provides that QPAI is determined
on an item-by-item basis (and not, for ex-
ample, on a division-by-division, a prod-
uct line-by-product line, or a transaction-
by-transaction basis) and is the sum of
the QPAI derived by the taxpayer from
each item. For purposes of this determi-
nation, QPAI from each item may be pos-
itive or negative. Section 4.04 provides
rules for determining a taxpayer’s DPGR,
the definition of the terms “gross receipts,”
“manufactured, produced, grown, or ex-
tracted,” “by the taxpayer,” “in whole or
in significant part,” and “derived from the
lease, rental, license, sale, exchange, or
other disposition of qualifying production
property,” as well as rules for determin-
ing whether propertyqualifies as QPP (that
is, tangible personal property, computer
software, and sound recordings).Seesec-
tion 3.04 for an explanation of these rules.
Section 4.05 provides rules for determin-
ing a taxpayer’s costs (including CGS) for
purposes of computing QPAI.Seesection
3.05 for an explanation of the rules relat-
ing to costs. Generally, if a taxpayer is
2005–7 I.R.B.504February 14, 2005

engaged exclusively in the manufacture of
QPP within the United States and has no
other sources of income, it is anticipated
that QPAI will equal taxable income.
.04Determining Domestic Production
Gross Receipts.(1)In general. Section
4.04 of this notice generally provides rules
for determining DPGR. A taxpayer must
determine the portion of its total gross
receipts that are DPGR. For example, if
a taxpayer manufactures QPP at a facility
inside the United States (that otherwise
qualifies under § 199) and QPP at a facil-
ity outside the United States, the taxpayer
generally must determine the portion of its
gross receipts that are attributable to QPP
manufactured inside the United States and
the portion of its gross receipts that are
attributable to QPP manufactured outside
the United States to determine the tax-
payer’s DPGR. However, section 4.03(2)
provides a safe harbor under which a
taxpayer with less than 5 percent of total
gross receipts from items other than DPGR
may treat all gross receipts as DPGR and
is therefore not required to allocate its
gross receipts. For example, interest
and late fees relating to QPP manufac-
tured in the United States by a taxpayer
and sold by the taxpayer on credit are
not DPGR, but may be treated as DPGR
if the taxpayer’s interest and late fees,
when aggregated with other non-DPGR,
are collectively less than 5 percent of
the taxpayer’s total gross receipts. The
Service and Treasury Department do not
believe that the interim guidance should
mandate a single method of determining
DPGR because the Service and Treasury
Department have not identified a single
method that would be appropriate for all
taxpayers. Accordingly, section 4.03(2)
provides that a taxpayer’s method for de-
termining DPGR and non-DPGR must
be a reasonable method that accurately
identifies the grossreceipts derived from
activities described in § 199(c)(4) based
on all of the information available to the
taxpayer to substantiate the allocation.
Among the factors that the Service will
take into consideration in determining
whether a taxpayer’s method is reasonable
is whether the taxpayer is using the most
accurate information available to the tax-
payer; the relationship between the gross
receipts and the base chosen; the accu-
racy of the method chosen as compared
with other possible methods; whether
themethodisusedbythetaxpayerfor
internal management or other business
purposes; whether the method is used for
other federal, state, or foreign income tax
purposes; the time, burden, and cost of
using various methods; and whether the
taxpayer applies the method consistently
from year to year. For example, a tax-
payer that uses a specific identification
method (that is, a method that specifically
identifies where the item was MPGE) for
any other purpose is required to use that
method to determine DPGR. Similarly, a
taxpayer that has the information readily
available to use a specific identification
method even if it does not use that method
for any other purpose generally is required
to use a specific identification method to
determine DPGR and the taxpayer’s use
of a different, less accurate method to de-
termine DPGR generally is not considered
reasonable. However, a taxpayer that does
not currently use a specific identification
method for any other purpose and does not
have the information readily available to
use the method generally is not required to
use that method to determine DPGR.See
section 3.05 for an explanation of rules
relating to the allocation of costs.
(2)Definition of “gross receipts.”For
purposes of § 199, section 4.04(2) of this
notice defines the term “gross receipts” us-
ing a definition that is derived from the
definition under § 1.448–1T(f)(2)(iv)(A).
In general, “gross receipts” for the taxable
year are those that are properly recognized
under the taxpayer’s accounting method
for federal income tax purposes.
(3)Definition of “manufactured, pro-
duced, grown, or extracted.”(a) In general.
In determining how this notice should de-
fine MPGE under § 199(c)(4)(A)(i)(I), the
Service and Treasury Department consid-
ered how those terms have been defined
under § 954 (see § 1.954–3(a)(4)(i) for
the definition of manufactured or pro-
duced), and how the same or similar terms
have been defined for purposes of § 38
(see § 1.48–1(d)(2)) and § 263A (see
§ 263A(g)(1) and § 1.263A–2(a)(1)(i)).
Even though these and similar terms are
used in other parts of the Code, the Ser-
vice and Treasury Department believe that
for this purpose the terms MPGE must be
construed in light of the specific policies
underlying § 199. Because the Service
and Treasury Department believe that
Congress intended for the deduction under
§ 199 to be available to taxpayers for a
wide variety of production activities, sec-
tion 4.04(3) of this notice defines MPGE
broadly to include all of the activities
specifically listed in §§199(c)(4)(A)(i)(I)
and 263A(g)(1), and in §§ 1.48–1(d)(2)
and 1.263A–2(a)(1)(i) (hereinafter re-
ferred to as “MPGE activities”). This
interpretation is solely for purposes of
§ 199, based on the authority provided to
the Secretary under § 199(d)(7), and does
not affect the construction of these terms
in other parts of the Code (for example,
§ 954(a)(1)(A)).
(b)Consistency with § 263A.TheSer-
vice and Treasury Department believe
that the term “producer” has been inter-
preted broadly under § 263A and includes
within its scope all of the MPGE activities.
Accordingly, the Service and Treasury De-
partment believe that if a taxpayer claims
it has MPGE QPP for the taxable year for
purposes of § 199(c)(4)(A)(i)(I), it is fun-
damentally inconsistent for the taxpayer to
claim it is not a “producer” under § 263A
with respect to the QPP for the taxable
year. Therefore, section 4.04(3)(b) of this
notice provides that a taxpayer that has
MPGE QPP for the taxable year should
also consistently treat itself as a producer
under § 263A with respect to the QPP
for the taxable year unless the taxpayer
is not subject to § 263A under the Code,
regulations, or other published guidance.
Taxpayers that currently are not properly
accounting for their production activities
under § 263A, and that wish to change
their method of accounting to comply
with the producer requirements of § 263A,
must follow the procedures of Rev. Proc.
97–27, 1997–1 C.B. 680 (as modified and
amplified by Rev. Proc. 2002–19, 2002–1
C.B. 696, as amplified and clarified by
Rev. Proc. 2002–54, 2002–2 C.B. 432), or
Rev. Proc. 2002–9, 2002–1 C.B. 327 (as
modified and clarified by Announcement
2002–17, 2002–1 C.B. 561, modified and
amplified by Rev. Proc. 2002–19, 2002–1
C.B. 696, and amplified, clarified, and
modified by Rev. Proc. 2002–54, 2002–2
C.B. 432), whichever applies.
(4)Definition of “by the taxpayer.”
With the exception of the rules applicable
to an EAG, the Service and Treasury De-
partment believe that the requirement of
§ 199(c)(4)(A)(i) that property be MPGE
“by the taxpayer” means that only one
taxpayer may claim the deduction under
February 14, 20055052005–7 I.R.B.

§ 199 with respect to the same function
performed with respect to the same prop-
erty. For example, if A enters into an
agreement with an unrelated customer B
to manufacture 100 widgets for B, only
one of the taxpayers is treated as hav-
ing MPGE the widgets for purposes of
§ 199(c)(4)(A)(i)(I). Section 4.04(4) of
this notice provides that in contract man-
ufacturing situations, if one taxpayer per-
forms activities that constitute the MPGE
of QPP or the production of a qualified
film, electricity, natural gas, or potable
water (collectively “qualifying activity”)
pursuant to a contract with an unrelated
party, then only the taxpayer that has
the benefits and burdens of ownership
of the property under federal income tax
principles during the period the qualifying
activity occurs is treated as engaging in the
qualifying activity. This standard is based
on the principles under § 936 and § 263A.
In considering which standard to apply in
contract manufacturing situations, the Ser-
vice and Treasury Department concluded
that it is not appropriate to treat property
as being manufactured by the customer
in a contract manufacturing situation if
the customer does not have the benefits
and burdens of owning the property under
federal income tax principles during the
period the qualifying activity occurs. This
rule applies even if the customer exercises
direct supervision and control over the
activities of the contractor or is treated
as a producer of the property pursuant
to § 263A(g)(2) for other reasons. If a
contractor does not have the benefits and
burdens of owning the property under
federal income tax principles during the
period the qualifying activity occurs, the
contractor is more appropriately viewed
as performing a service for the customer.
As a result, a contractor that does not sat-
isfy the “by the taxpayer” requirements
of § 199(c)(4)(A)(i) is considered to be
deriving gross receipts from the provi-
sion of services and the receipts are not
considered to be “derived from any lease,
rental, license, sale, exchange, or other
dispositionof”thepropertywithinthe
meaning of § 199(c)(4)(A)(i) (seesec-
tion 4.04(7)(a)). Thus, a taxpayer that
does not have the benefits and burdens of
ownership of the property under federal
income tax principles during the period
the qualifying activity occurs does not
qualify under the contract manufacturing
rule for purposes of § 199. To illustrate
this rule, if, in the example above, A owns
the widgets during the period the quali-
fying activity occurs (that is, A bears the
benefits and burdens of ownership under
federal income tax principles), the widgets
will be treated as manufactured by A and
not the unrelated customer B for purposes
of § 199(c)(4)(A)(i)(I). Conversely, if B is
the owner of the widgets (that is, B bears
the benefits and burdens under federal
income tax principles) during the period
the qualifying activity occurs, the widgets
will be treated as manufactured by B, not
A, for purposes of § 199(c)(4)(A)(i)(I).
Under this rule, either A or B may qualify
for the deduction, but both cannot obtain
the benefit of the deduction for the same
activity. No inference is intended concern-
ing the definition of “by the taxpayer” or
“contract manufacturing” for purposes of
any other provision of the Code.
(5)Definition of “in whole or in sig-
nificant part.”(a)In general. To qualify
for the § 199 deduction, QPP must be
MPGE “in whole or in significant part by
the taxpayer within the United States.”
Under § 199, the gross receipts that are
considered DPGR are not limited to the
gross receipts attributable to QPP MPGE
entirely by a taxpayer. For example, if
a taxpayer purchases partially manufac-
tured QPP from another taxpayer and
the taxpayer satisfies the “in whole or
in significant part” requirement with re-
spect to the manufacture of the QPP, the
taxpayer’s gross receipts derived from
the lease, rental, license, sale, exchange,
or other disposition of that QPP will be
considered DPGR (assuming all other
requirements of § 199(c) are met). Like-
wise, if a taxpayer imports QPP that it
partially manufactured outside the United
States, and the taxpayer satisfies the “in
whole or in significant part” requirement
with respect to its United States manufac-
turing activity associated with that QPP,
the taxpayer’s gross receipts derived from
the lease, rental, license, sale, exchange,
or other disposition of that QPP will be
considered DPGR (assuming all other re-
quirements of § 199(c) are met). Similarly,
if a taxpayer manufactures QPP in signifi-
cant part in the United States and exports
the goods for further manufacture outside
the United States, the taxpayer’s gross
receipts derived from the lease, rental, li-
cense, sale, exchange, or other disposition
of that QPP will be considered DPGR,
regardless of whether the QPP is imported
back into the United States prior to the
lease, rental, license, sale, exchange, or
other disposition of the QPP (and assum-
ing all other requirements of § 199(c) are
met).Seesection 4.04(7) of this notice for
a discussion of the definition of “derived
from the lease, rental, license, sale, ex-
change, or other disposition of qualifying
production property.”
(b)Substantial in nature. Section
4.04(5)(b) of this notice provides, gener-
ally, that the “in whole or in significant
part” requirement is satisfied if the tax-
payer’s MPGE activity within the United
States with respect to the QPP is “sub-
stantial in nature.” Whether a taxpayer’s
MPGE activity is “substantial in nature”
for purposes of § 199 generally depends
upon all of the facts and circumstances,
including the relative value added by, and
relative cost of, the taxpayer’s MPGE
activity in the United States, the nature
of the property, and the nature of the
MPGE activity that the taxpayer per-
forms in the United States. Although this
“substantial in nature” requirement ap-
plies on a facts and circumstances basis
like the “substantial in nature” require-
ment in § 1.954–3(a)(4)(iii), this “sub-
stantial in nature” requirement is not the
same as the requirements underlying the
“not the property which it purchased”
standard in § 1.954–3(a)(4). In partic-
ular, the substantial transformation test
of § 1.954–3(a)(4)(ii) is not relevant to
the determination of “substantial in na-
ture” for purposes of § 199(c)(4)(A)(i)(I).
The Service and Treasury Department
considered whether the general rule for
determining whether the taxpayer satis-
fies the “in whole or in significant part”
requirement should be based upon a sin-
gle, quantitative criterion, such as relative
value, or relative cost, of the United States
activity. However, the Service and Trea-
sury Department concluded that such a
general rule would not be suitable in all
circumstances. For example, assume that
a taxpayer purchases gemstones and pre-
cious metal and then uses these materials
to produce jewelry in the United States
(for example, by cutting and polishing the
gemstones, melting and shaping the metal,
and combining the finished materials).
The Service and Treasury Department
believe that the taxpayer is properly re-
2005–7 I.R.B.506February 14, 2005

garded as manufacturing or producing the
QPP in significant part within the United
States. The value added by the taxpayer’s
United States manufacturing, however,
may not be substantial when compared
to the value of the final product because
of the relatively high value of the pur-
chased materials. Similarly, the cost of the
taxpayer’s United States manufacturing
may not be substantial when compared to
the total cost of the product (and there-
fore also may not meet the safe harbor
discussed below). However, the nature
of the product, and the nature of the tax-
payer’s United States MPGE activity, is
such that the United States MPGE activity
is “substantial in nature.” Accordingly, the
Service and Treasury Department believe
that the “substantial in nature” test should
be applied by considering all of the facts
and circumstances.
(c)Safe harbor. Section 4.04(5)(c) of
this notice provides a safe harbor under
which a taxpayer will be treated as MPGE
property in whole or in significant part
within the United States if, in connection
with the property, conversion costs (direct
labor and related factory burden) to MPGE
the property are incurred by the taxpayer
within the United States and the costs ac-
count for 20 percent ormoreofthetotal
CGS of the property. This rule would op-
erate similarly to the safe harbor provided
under § 1.954–3(a)(4)(iii) for determining
whether, for purposes of computing for-
eign base company sales income, the sale
of property is treated as the sale of a man-
ufactured product rather than the sale of a
component part, when purchased compo-
nents constitute part of the property.
(d)Certain activities and costs disre-
garded. The Service and Treasury De-
partment believe that, in connection with
the MPGE of QPP, packaging, repackag-
ing, labeling, and minor assembly opera-
tions should not be considered in apply-
ing the general “substantial in nature” test,
and that the costs of those activities should
not be considered in applying the safe har-
bor. This rule is similar to the test ap-
plied in § 1.954–3(a)(4)(iii). For exam-
ple, a taxpayer whose United States activ-
ities consist solely of affixing a label to a
plastic bottle otherwise manufactured en-
tirely outside the United States will not be
regarded as having met the “in whole or
in significant part” requirement, regardless
of the value added to the bottle by the la-
bel or the relative cost incurred by the tax-
payer with respect to the labeling activity.
In addition, the Service and Treasury De-
partment do not believe it is appropriate to
regard a taxpayer as meeting the “in whole
or in significant part” requirement if the
taxpayer manufactures tangible personal
property entirely outside the United States,
even if the design and development activi-
ties that lead to the tangible personal prop-
erty occur entirely within the United States
because the design and development activ-
ities with respect to tangible personal prop-
erty give rise to the creation of an intan-
gible asset. Thus, with respect to tangible
personal property, design and development
activities also are disregarded for purposes
of the general “substantial in nature” test,
and the costs of those activities are dis-
regarded for purposes of the safe harbor
in section 4.04(5)(c) of this notice. How-
ever, with respect to computer software
and sound recordings, intangible property
that may constitute QPP under § 199, the
Service and Treasury Department believe
that a significant portion of the “produc-
tion” may be viewed as design and devel-
opment (for example, writing the program-
ming code in the case of computer soft-
ware, and recording and editing the master
copy in the case of sound recordings). Ac-
cordingly, in the case of computer software
and sound recordings, design and develop-
ment activities are not disregarded for pur-
poses of applying the “substantial in na-
ture” test and the costs of those activities
are not disregarded for purposes of the safe
harbor in section 4.04(5)(c).
(6)Definition of “United States.”
Section 7701(a)(9) generally provides
that, for purposes of the Code, the term
“United States” when used in a geograph-
ical sense includes only the 50 states and
the District of Columbia. For purposes of
§ 199, the term United States follows the
§ 7701(a)(9) definition and includes the
territorial waters of the United States and
the seabed and subsoil of those submarine
areas that are adjacent to the territorial wa-
ters of the United States and over which
the United States has exclusive rights, in
accordance with international law, with
respect to the exploration and exploitation
of natural resources. However, because
neither § 199 nor the legislative history
explicitly include possessions and territo-
ries of the United States or the airspace
over the United States and these areas
within the definition of United States,
the term “United States” does not in-
clude possessions and territories of the
United States or the airspace over the
United States and these areas for purposes
of § 199.See, for example, § 638 and
§ 301.7701(b)–1(c)(2)(ii).
(7)Definition of “derived from the
lease, rental, license, sale, exchange, or
other disposition of qualifying production
property.”(a)In general. Section 4.04(7)
of this notice provides that gross receipts
“derived from” an activity described in
section 4.04(3) are limited to the direct
proceeds from the lease, rental, license,
sale, exchange, or other disposition of
the QPP. Thus, for example, the “derived
from the sale of QPP” requirement is
met with respect to direct proceeds from
the sale of QPP manufactured in whole
or in significant part within the United
States by a taxpayer for sale (assuming all
other requirements of § 199(c) are met),
as well as for direct proceeds from the
sale of self-constructed QPP manufac-
tured in whole or in significant part in the
United States by a taxpayer and used in
the taxpayer’s trade or business (assum-
ing all other requirements of § 199(c) are
met) (seesection 3.05 for a discussion
of determining costs with respect to the
disposition of self-constructed assets). In
addition, business interruption insurance
and payments not to produce are treated
as gross receipts “derived from the lease,
rental, license, sale, exchange, or other
disposition of” an activity described in
section 4.04(7)(a) to the extent the pay-
ments are substitutes for gross receipts
that would be so treated (assuming all
other requirements of § 199(c) are met).
Except as provided in section 4.04(7)(c)
with respect to certain advertising income
and section 4.04(7)(e) with respect to cer-
tain oil and gas partnerships, the Service
and Treasury Department believe that no
other receipts are within the language of
§ 199(c)(4)(A)(i). For purposes of the
“derived from the lease, rental, license,
sale, exchange, or other disposition of”
requirement of § 199(c)(4)(A)(i), existing
federal income tax law principles apply
to determine whether a transaction is, in
substance, a lease, rental, license, sale,
exchange or other disposition, or whether
it is a service.Seefor example, Rev.
Rul 88–65, 1988–2 C.B. 32, which treats
a short-term rental as a service. For an
February 14, 20055072005–7 I.R.B.

explanation of the rules relating to de-
termining gross receipts “derived from”
construction performed in the United
States,seesection 3.04(11)(e).
(b)Allocation of gross receipts—em-
bedded services. With certain exceptions
discussed below, gross receipts derived
from the performance of services do not
qualify as DPGR. Accordingly, in the
case of the lease, rental, license, sale, ex-
change, or other disposition of property
that contains a service element (embedded
service), section 4.04(7)(b) of this notice
generally requires that the taxpayer allo-
cate the gross receipts (as well as the costs
—seesection 4.05) between the property
and the embedded service. The portion
of the gross receipts that are considered
“derived from the lease, rental, license,
sale, exchange, or other disposition” of
the property may not exceed the selling
price of the property without the service
element. Section 4.04(7)(b) provides two
exceptions to the allocation requirement.
First, a taxpayer may include in DPGR
gross receipts from a qualified warranty
(that is, a warranty that is provided in con-
nection with the sale of QPP if (1) in the
normal course of its business, the charge
for the warranty is included in the price
charged for the lease, rental, license, sale,
exchange, or other disposition of the QPP
and (2) the warranty is neither separately
offered by the taxpayer nor separately bar-
gained for with the customer (that is, the
customer cannot purchase the QPP without
the warranty)). Thisexception is consis-
tent with a similar exception provided in
section 3.07 of Rev. Proc. 71–21, 1971–2
C.B. 549 (modified and superseded by
Rev. Proc. 2004–34, 2004–22 I.R.B.
991), regarding the deferral of certain ad-
vance payments for services. Second, a
de minimisamount of gross receipts from
embedded services for each item of prop-
erty may qualify as DPGR. Ade minimis
amount of gross receipts from embedded
services is equal to less than 5 percent of
the gross receipts of the property. If one of
these exceptions is met, the gross receipts
derived from the lease, rental, license, sale,
exchange, or other disposition of property
and the gross receipts from the embedded
services are treated as “derived from the
lease, rental, license, sale, exchange, or
other disposition” of the property and are
treated as DPGR (assuming all other re-
quirements of § 199(c) are met). The 5
percentde minimisrule is consistent with
§ 1.451–5(a)(3), which generally provides
that if less than 5 percent of an advance
payment for goods is allocable to the pro-
vision of services, the portion so allocable
will be considered as an advance payment
for goods. For purposes of applying this
de minimisrule, the gross receipts from a
qualified warranty that are included in the
price charged for the lease, rental, license,
sale, exchange, or other disposition of
property are not treated as gross receipts
for services.
(c)Advertising income.TheService
and Treasury Department believe that ad-
vertising income attributable to the sale
or other disposition of newspapers and
magazines should be considered “derived
from” the sale or other disposition of the
newspapers and magazines because the
advertising income is inextricably linked
to the gross receipts derived from the lease,
rental, sale, exchange or other disposition
of the newspapers and magazines. For
example, a newspaper manufacturer’s re-
ceipts from an advertiser to publish display
advertising or classified advertisements in
its newspaper are treated as gross receipts
derived from the sale of the newspapers
for purposes of § 199 (assuming all other
requirements of § 199(c) are met).
(d)Computer software. The determina-
tion of whether a transfer of computer soft-
ware is a sale or exchange of property, a li-
cense generating royalty income, or a lease
generating rental income is made taking
into account all facts and circumstances.
The form adopted by the parties to a trans-
action, the classification of the transac-
tion under copyright law, and the physical
or electronic or other medium used to ef-
fectuate the transfer of computer software
are not determinative.See§ 1.861–18.
A service provided using computer soft-
ware that does not involve a transfer of the
computer software does not result in gross
receipts that are derived from the lease,
rental, license, sale, exchange, or other dis-
position of computer software. Thus, with
respect to computer software that is de-
veloped in the United States and sold to
customers who take delivery of the soft-
ware by downloading the software from
the Internet, the manufacturer’s gross re-
ceipts from the sales are DPGR (assuming
all other requirements of § 199(c) are met).
Except as provided in the safe harbor de-
scribed in section 3.04(7)(b) of this notice,
gross receipts derived by a taxpayer from
software that is merely offered for use to
customers online for a fee are not DPGR.
In addition, gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of computer software do
not include gross receipts derived from: (i)
providing customer support in connection
with the sale of computer software; (ii) on-
line services; or (iii) providing Internet ac-
cess or telephone services over the Inter-
net. These receipts are not DPGR because
these receipts are attributable to the provi-
sion of a service and are not derived from
the lease, rental, license, sale, exchange, or
other disposition of the software.
(8)Definition of “qualifying produc-
tion property.”(a)In general. Section
199(c)(5) provides that the term “qualify-
ing production property” includes: (1) tan-
gible personal property; (2) computer soft-
ware; and (3) sound recordings.
(b)Tangible personal property.The
definition of “tangible personal prop-
erty” provided in section 4.04(8)(b) of
this notice is derived primarily from,
and is generally consistent with, the def-
inition of that term under § 1.48–1(c).
Consistent with § 1.48–1(c), section
4.04(8)(b) provides that local law is
not controlling for purposes of deter-
mining whether property is tangible per-
sonal property under § 199(c)(5)(A). In
addition to many of the items specifi-
cally referenced in § 1.48–1(c), section
4.04(8)(b) includes in the term “tangible
personal property” videocassettes, com-
puter diskettes, books, and similar items.
See§ 1.263A–2(a)(2)(ii). No inference
is intended concerning whether these
items are tangible or intangible property
for purposes of any other section of the
Code (for example, § 197). Treating these
items as tangible personal property is con-
sistent with the definitions provided for
“computer software,” “sound recordings,”
and “qualified films,” that do not include
the tangible personal property (if any) in
which computer software, a sound record-
ing, or a qualified film is fixed. As a result,
“tangible personal property” excludes any
property that falls within the definition of
computer software, a sound recording, or
a qualified film. For example, a sale of a
computer game on a CD-ROM has both
a tangible personal property element (the
disc) and a computer software element
(the program fixed on the disc), but a sale
2005–7 I.R.B.508February 14, 2005

of the same program effected instead by
an internet download involves computer
software only.
(c)Computer software.(i)In general.
The definition of “computer software”
provided in section 4.04(8)(c) of this no-
tice is derived from the definition of that
term under § 1.197–2(c)(4)(iv), but also
includes the machine-readable coding for
video games and similar programs, regard-
less of whether the program is designed to
operate on a “computer” (as defined under
§ 168(i)(2)(B)). The term “computer soft-
ware” includes all property described in
section 4.04(8)(c). Thus, DPGR includes
the gross receipts from computer software
that was developed by the taxpayer, pro-
vided the gross receipts are derived from
the lease, rental, license, sale, exchange,
or other disposition of computer software
as required by § 199(c)(4)(A)(i).
(ii)Tangible personal property not in-
cluded. “Computer software” does not
include diskettes or other tangible prop-
erty on which machine-readable coding
is placed, as the property is considered
tangible personal property for purposes
of § 199. For example, assume B, who
is unrelated to A, develops software out-
side the United States and licenses the
rights to manufacture and distribute the
software to A, and A manufactures in
the United States compact discs encoded
with the software. Assume further that A
sells the compact discs encoded with the
software. A’s gross receipts from the sale
of the compact discs are derived in part
from the sale of tangible personal property
(the compact discs), and in part from the
sale of computer software. Therefore, A
must allocate its gross receipts between
those attributable to the software (which
are not DPGR) and those attributable to
the compact discs (which are DPGR, as-
suming all other requirements of § 199(c)
are met). Assume in the alternative that
A is an integrated software developer and
producer that designs the software outside
the United States and manufactures the
compact discs within the United States.
Assume further that A sells the compact
discs encoded with the software. A’s gross
receipts from the sale of the compact discs
are derived in part from the sale of tangi-
ble personal property (the compact discs),
and in part from the sale of computer soft-
ware. Therefore, A must allocate its gross
receipts between those attributable to the
software (which are not DPGR because
the software was developed outside the
United States) and those attributable to the
compact discs (which are DPGR, assum-
ing all other requirements of § 199(c) are
met).
(d)Sound recordings. Section 199(c)
(5)(C) provides that QPP includes any
property described in § 168(f)(4). Sec-
tion 4.04(8)(d) of this notice defines the
term “sound recording” consistent with
§ 168(f)(4). Consistent with the defini-
tions of computer software and qualified
films, the definition of “sound recording”
does not include tangible personal prop-
erty in which the sound recording is fixed,
such as a compact disc. This interpre-
tation does not affect any other section
of the Code (for example, § 168(f)(4)).
Consequently, the results in the examples
provided in section 3.04(8)(c)(ii) would
be the same if, instead of software, the ex-
amples involved the production of sound
recordings and compact discs that contain
the sound recordings.
(9)Definition of “qualified film.”(a)
In general. Section 199(c)(6) provides
that the term “qualified film” means any
property described in § 168(f)(3). Ac-
cordingly, section 4.04(9) of this notice
defines a “qualified film” to include any
motion picture film or video tape (other
than certain sexually explicit visual depic-
tions), as well as live or delayed televi-
sion programming (seeH.R. Conf. Rep.
No. 755, 108th Cong., 2d Sess. 273
(fn. 30) (2004) (Conference Report) (here-
inafter referred to collectively as “film”)
if not less than 50 percent of the total
compensation relating to the production of
the property is compensation for services
performed in the United States by actors,
production personnel, directors, and pro-
ducers. Qualified films include all prop-
erty described in section 4.04(9). Consis-
tent with the definitions of “computer soft-
ware” and “sound recordings,” the defini-
tion of “qualified film” is limited to the
master copy of the film (or other copy
from which the holder is licensed to make
and produce copies), and does not include
tangible personal property embodying the
qualified film, suchas DVDs or videocas-
settes. This interpretation does not affect
any other section of the Code (for exam-
ple, § 168(f)(3)). In no event will ticket
sales for viewing qualified films consti-
tute DPGR. Thus, for example, if A pro-
duces a qualified film, fixes the film to a
tangible medium purchased from an unre-
lated taxpayer, and leases or licenses the
qualified film and medium containing the
qualified film to unrelated commercial the-
aters, A’s gross receipts from the lease or
license of the qualified film are “derived
from”(i)theleaseoftangiblepersonal
property (the tangible medium on which
the copy is fixed), that are not DPGR, and
(ii) the license of the qualified film (the
right to publicly display the film), that are
DPGR. If, instead, A licenses a qualified
film to unrelated taxpayer B, and B re-
produces the film on DVDs or videocas-
settes manufactured by B in the United
States, B’s gross receipts from the sale
of the DVDs and videocassettes are “de-
rived from” the sale of (i) tangible per-
sonal property (the DVDs and videocas-
settes), that are DPGR, and (ii) the quali-
fied film (the motion picture fixed on the
DVDs and cassettes), that are not DPGR.
A taxpayer that merely writes a screenplay
or other similar material is not considered
to have produced a qualified film under
§ 199(c)(4)(A)(i)(II). Therefore, amounts
that a taxpayer receives from the sale of a
script or screenplay, even if it is developed
into a qualified film, are not gross receipts
“derived from” a qualified film. In addi-
tion, revenue from the sale of film-themed
merchandise is revenue from the sale of
tangible personal property, and not gross
receipts “derived from” a qualified film.
Finally, gross receipts derived from a li-
cense of the right to use the film charac-
ters are not gross receipts “derived from”
a qualified film.
(b)Production personnel. For purposes
of § 199(c)(6), the term “production per-
sonnel” includes all personnel (other than
actors, directors, and producers) who are
directly involved in the production of the
film. Thus, “production personnel” un-
der section 4.04(9)(a) of this notice in-
clude writers, choreographers and com-
posers providing services during the pro-
duction of a film, casting agents, camera
operators, set designers, lighting techni-
cians, make-up artists, and others whose
activities are directly related to the produc-
tion of the film. “Production personnel” do
not include, however, individuals whose
activities are ancillary to the production,
such as advertisers andpromoters, distrib-
utors, studio administrators and managers,
February 14, 20055092005–7 I.R.B.

studio security personnel, and personal as-
sistants to actors.
(c)Compensation for services.Under
section 4.04(9)(b) of this notice, compen-
sation for services includes all payments
for services performed by actors, produc-
tion personnel, directors, and producers,
including participations and residuals.See
Conference Report at 273 (fn. 31). In the
case of a taxpayer that uses the income
forecast method of § 167(g) and capi-
talizes participations and residuals into
the adjusted basis of the qualified film,
thetaxpayermustusethesameestimate
of participations and residuals for pur-
poses of § 199 that it uses for purposes of
§ 167(g). In the case of a taxpayer that
excludes participations and residuals from
adjusted basis of the qualified film under
§ 167(g)(7)(D)(i), the taxpayer must de-
termine the compensation expected to be
paid as participations and residuals based
on the total forecasted income used in
determining income forecast depreciation.
(d)Determination of 50 percent.The
Service and Treasury Department do not
believe that a single method of allocating
compensation between services performed
within the United States and services per-
formed outside the United States is ap-
propriate for all taxpayers. Accordingly,
section 4.04(9)(c) of this notice provides
that a taxpayer may use any reasonable
method of making the allocation. Among
the factors to be considered in determining
whether a taxpayer’s method of allocating
compensation is reasonable is whether the
taxpayer uses that method consistently.
(10)Electricity, natural gas, and
potable water.(a)In general.DPGR
includes gross receipts derived from any
lease, rental, license, sale, exchange, or
other disposition of electricity, natural gas,
or potable water produced by the taxpayer
in the United States (assuming all other
requirements of § 199(c) are met). DPGR
does not include, however, gross receipts
of the taxpayer derived from the transmis-
sion or distribution of these items. The
Conference Report at 272–3 (fn. 28) ex-
plains that an integrated producer that both
produces and delivers electricity, natural
gas, or potable water, must allocate its
gross receipts between: (i) production that
qualifies as DPGR; and (ii) distribution
and transmission (that do not qualify as
DPGR). Thus, section 4.04(10)(d) of this
notice generally requires such allocation.
However, if less than 5 percent of a tax-
payer’s gross receipts derived from a sale
of electricity, natural gas, or potable water
are attributable to the transmission and
distribution of such electricity, natural gas,
or potable water, then the gross receipts
derived from that sale that are attributable
to the transmission and distribution of
such items will be treated for purposes of
§199asbeingDPGR.
(b)Natural gas. Section 4.04(10)(b) of
this notice defines the term “natural gas”
in a manner consistent with § 613A(e)(2)
and generally includes only natural gas
extracted from a natural deposit. Thus,
natural gas would not include, for exam-
ple, methane gas extracted from a land-
fill. Consistent with the Conference Re-
port at 272–3 (fn. 28), section 4.04(10)(b)
provides that, in the case of natural gas,
production activities include all activities
involved in extracting natural gas from
the ground and processing the gas into
pipeline quality gas.
(c)Potable water. Section 4.04(10)(c)
of this notice provides that, consistent
with the Conference Report at 272–3
(fn. 28), production activities with respect
to potable water include the acquisition,
collection, and storage of raw water (un-
treated water), transportation of raw water
to a water treatment facility, and treat-
ment of raw water at such a facility. Thus,
gross receipts derived from any of these
activities performed in the United States
are included in DPGR (assuming all other
requirements of § 199(c) are met). DPGR
does not include, however, gross receipts
derived from the storage of potable wa-
ter after completion of treatment of the
potable water, or delivery of potable water
to customers. The Service and Treasury
Department believe that Congress in-
tended for the provision relating to potable
water to apply to water utilities, not to
taxpayers engaged in the trade or business
of producing bottled water. As a result,
for purposes of § 199 the production of
bottled water will be treated as the produc-
tion of tangible personal property under
§ 199(c)(5)(A) and not the production of
potable water under § 199(c)(4)(A)(i)(III).
Accordingly, with respect to a taxpayer
that produces bottled water in the United
States, the gross receipts from which
would otherwise qualify as DPGR, DPGR
also includes the grossreceipts attributable
to the distribution of the bottled water and
no allocation between the production and
distribution of the bottled potable water is
required.
(11)Definition of “construction per-
formed in the United States.”(a)Construc-
tion of real property. Section 4.04(11)(a)
of this notice defines the term “construc-
tion” under § 199(c)(4)(A)(ii) to mean the
construction of real property (that is, resi-
dential and commercial buildings (includ-
ing items that are structural components
of such buildings), inherently permanent
structures other than tangible property in
the nature of machinery, inherently perma-
nent land improvements, and infrastruc-
ture). Section 4.04(11)(a) makes clear that
local law is not controlling for purposes
of determining whether or not property is
real property for purposes of “construc-
tion” under § 199(c)(4)(A)(ii).SeeCon-
ference Report at 271 (fn. 26). Tangible
personal property (as defined under sec-
tion 4.04(8)(b)) (for example, appliances,
furniture and fixtures) that is sold as part
of a construction project is not considered
real property for this purpose. Under sec-
tion 4.04(11)(a), however, if more than 95
percent of the total gross receipts derived
by a taxpayer from a construction project
are attributable to real property (as defined
in § 1.263A–8(c)), the total gross receipts
derived by the taxpayer from the project
are DPGR from construction (assuming all
other requirements of § 199 are met).
(b)Activities constituting construction.
The Service and Treasury Department
believe the term “construction” includes
most activities that aretypically performed
in connection with the erection or substan-
tial renovation of real property, but does
not include tangential services such as
hauling trash and debris, and delivering
materials, even if the tangential services
are essential for construction. However,
if a taxpayer performing construction
also, in connection with the construction
project, provides tangential services such
as delivering materials to the construc-
tion site and removing its construction
debris, the gross receipts derived from
such tangential services are DPGR. Im-
proving land (for example, grading and
landscaping) and painting are activities
that are considered “construction,” but
only if they are performed in connection
with other activities (whether or not by the
same taxpayer) that constitute the erection
or substantial renovation of real property.
2005–7 I.R.B.510February 14, 2005

The term “construction” does not include
any activity that is within the definition of
“engineering and architectural services”
(seesection 4.04(11)(b) of this notice).
(c)Definition of “infrastructure.”
The term “infrastructure,” for pur-
poses of § 199, includes roads, power
lines, water systems, railroad spurs,
and communications facilities.See
§ 168(j)(4)(C)(ii). The term also includes
sewers, sidewalks, cable, and wiring.See
§ 1.263A–12(e)(2)(iii). The term also in-
cludes inherently permanent oil and gas
platforms.
(d)Definition of “substantial renova-
tion.”The Service and Treasury Depart-
ment believe that the standard to be applied
in determining whether there has been a
substantial renovation of real property is
the standard applied under § 263(a) to de-
termine whether a taxpayer’s activities re-
sult in permanent improvements or bet-
terments of property, such that the cost
of the activities must be capitalized. Ac-
cordingly, consistent with the rules under
§ 263(a), section 4.04(11)(d) of this notice
defines the term “substantial renovation”
to mean the renovation of a major com-
ponent or substantial structural part of real
property that materially increases the value
of the property, substantially prolongs the
useful life of the property, or adapts the
property to a new or different use.See
§ 263(a) and the regulations thereunder.
(e)“Derived from construction.”(i)In
general. Section 199(c)(4)(A)(ii) does not
provide that DPGR “derived from con-
struction” performed in the United States
are gross receipts derived from “any lease,
rental, license, sale, exchange, or other
disposition of” property. The Service and
Treasury Department believe that gross
receipts from the rental of real property
that the taxpayer constructs are not de-
rived from construction, but are instead
compensation for the use or forbearance
of the property. Accordingly, in the case
of construction, DPGR does not include
gross receipts from the lease or rental
of constructed real property. However,
DPGR may include the proceeds of a
sale, exchange, or other disposition of real
property constructed in the United States
(whether or not the property is sold im-
mediately after construction is completed)
if all other requirements of § 199(c) are
met. DPGR also includes compensation
received for construction services per-
formed in the United States (assuming all
other requirements of § 199(c) are met).
(ii)Taxpayers deriving gross receipts
from construction. The Service and Trea-
sury Department believe that it is appropri-
ate, in certain situations, for more than one
taxpayer to be regarded as deriving gross
receipts from construction with respect to
the same activity and the same construc-
tion project. For example, if X (who is
not in the trade or business of construction
and is the owner, under federal income tax
principles, of a building within the United
States) retains Y (a general contractor) to
oversee a “substantial renovation” of the
building, and Y retains Z (a subcontrac-
tor) to install a new electrical system in the
building as part of that substantial renova-
tion, the amounts that Y receives from X,
and amounts that Z receives from Y, qual-
ify as DPGR. The proceeds that X receives
from the subsequent sale of the building do
not qualify as DPGR because X did not en-
gage in any activity constituting construc-
tion.
(12)Definition of “engineering and ar-
chitectural services.”(a)In general.The
definitions provided in section 4.04(12) of
this notice of the terms “engineering ser-
vices” and “architectural services” for pur-
poses of § 199(c)(4)(A)(iii) are the same
as those provided in § 1.924(a)–1T(e)(5)
and –1T(e)(6) without regard to the spe-
cial rules of § 1.924(a)–1T(e)(2) and
–1T(e)(3). Section 199(c)(4)(A)(iii) pro-
vides that such services must be performed
in the United States for a construction
project in the United States. This notice
requires that: (1) the engineering or archi-
tectural services relate to real property; (2)
the services be performed in the United
States; and (3) the taxpayer providing
these services be able to substantiate that
the services relate to a construction project
within the United States.
(b)Performance of services in the
United States. Section 4.04(12)(d) of
this notice provides a safe harbor under
which, if, in connection with a construc-
tion project in the United States, the gross
receipts derived fromengineering or ar-
chitectural services(1) performed outside
the United States or (2) related to prop-
erty other than real property are less than
5 percent of the total gross receipts de-
rived from engineering or architectural
services performed by the taxpayer with
respect to the same construction project,
the receipts will be treated as DPGR de-
rived from engineering or architectural
services performed in the United States
for a construction project in the United
States (assuming all other requirements of
§199(c)aremet).
(c)Construction projects within the
United States. Gross receipts from en-
gineering or architectural services that
otherwise would qualify as DPGR will
not fail to qualify merely because the con-
struction project planned for the United
States ultimately isnot undertaken or com-
pleted.
(13)Exception for sales of certain food
and beverages. Under § 199(c)(4)(B),
DPGR does not include gross receipts de-
rived from the sale of food and beverages
prepared by the taxpayer at a retail estab-
lishment. For purposes of this rule, section
4.04(13) of this notice adopts a definition
of “retail establishment” that is similar to
the definition of “retail space” under § 110
(regarding qualified lessee construction
allowances for short-term leases). Un-
der this definition, a retail establishment
means real property leased, occupied, or
otherwise used by the taxpayer in its trade
or business of selling food or beverages to
the public and at which the taxpayer makes
retail sales. Thus, a taxpayer’s facility is
not a retail establishment if the taxpayer
only uses the facility to prepare food or
beverages for wholesale sale. However,
under a safe harbor provided in section
4.04(13), a facility at which food or bev-
erages are prepared will not be treated as a
retail establishment if less than 5 percent
of the total gross receipts of the taxpayer
for the taxable year that are derived from
the sale of food or beverages prepared at
the facility are attributable to retail sales
at the facility. If a taxpayer’s facility is
a retail establishment, then as a matter
of administrative grace, the Service and
Treasury Department will permit the tax-
payer to allocate its gross receipts between
gross receipts derived from the retail sale
of the food and beverages prepared and
sold at the retail establishment (which are
non-DPGR) and gross receipts derived
from the wholesale sale of the food and
beverages prepared at the retail establish-
ment (which are DPGR).
.05Determining Costs.(1)In general.
To determine its QPAI for the taxable
year, a taxpayer must reduce its DPGR
by the amount of CGS directly allocable
February 14, 20055112005–7 I.R.B.

to DPGR, the amount of deductions, ex-
penses, and losses (deductions) directly
allocable to DPGR and a ratable portion
of other deductions not directly alloca-
ble to DPGR, or another class of income.
Section 199(c)(2) directs the Secretary to
prescribe rules for the proper allocation
of these items. The legislative history of
§ 199 indicates that, when appropriate,
these rules should be similar to, and con-
sistent with, the relevant cost allocation
rules provided by §§ 263A and 861. A
taxpayer’s costs must be determined us-
ing the taxpayer’s accounting method for
federal income tax purposes. Section 4.05
of this notice provides rules for determin-
ing CGS directly allocable to DPGR and
rules to determine deductions allocated
and apportioned to DPGR. Pursuant to the
authority granted by § 199(c)(2), the cost
determination rules provided in section
4.05 do not differentiate between deduc-
tions directly allocable to DPGR under
§ 199(c)(1)(B)(ii) and other deductions
that are not directly allocable to DPGR
or another class of gross income under
§ 199(c)(1)(B)(iii).
(2)Allocation of cost of goods sold.
Section 4.05(2) of this notice provides
rules for determining the CGS directly
allocable to DPGR. Generally, CGS must
be specifically identified with, or directly
traced to, DPGR in accordance with the
taxpayer’s books and records. However,
if the taxpayer’s books and records do
not allow the taxpayer to identify the
CGS directly allocable to DPGR, the tax-
payer may use a reasonable method to
allocate CGS between DPGR and other
gross receipts. If a method is used to al-
locate gross receipts between DPGR and
non-DPGR, the taxpayer may not use a
different method for purposes of allocating
CGS. For purposes of § 199, CGS includes
the cost of inventoriable goods sold during
the year as well as the adjusted basis of
noninventory property sold or exchanged
during the year.
(3)Allocation and apportionment of
deductions.(a)Threealternativemeth-
ods. Section 4.05 of this notice pro-
vides three methods for allocating and
apportioning deductions. Under the first
method (the § 861 method), which is
available to all taxpayers, a taxpayer de-
termines the deductions allocated and
apportioned to DPGR by applying the
allocation and apportionment rules pro-
vided by §§ 1.861–8 through 1.861–17
and §§ 1.861–8T through 1.861–14T (the
§ 861 regulations) subject to the provisions
of this notice. This notice provides special
rules for apportioning certain charitable
deductions and research and experimenta-
tion deductions. The Service and Treasury
Department recognize that these allo-
cation and apportionment rules may be
burdensome to certain taxpayers that oth-
erwise would not be required to use these
rules, particularly for taxpayers that are
not currently using the section 861 cost
allocation regime. Accordingly, section
4.05 provides two alternative apportion-
ment methods for certain taxpayers, with
a goal of minimizing the need for smaller
taxpayers to devote additional resources
to compliance. Any taxpayer with aver-
age annual gross receipts of $25,000,000
or less may use the simplified deduction
method. Under the simplified deduction
method, a taxpayer’s deductions gen-
erally are ratably apportioned between
DPGR and other receipts based on rel-
ative gross receipts. The Service and
Treasury Department invite comments on
the appropriateness of the gross receipts
threshold for use of the simplified deduc-
tion method. Alternatively, a qualifying
small taxpayer may use the small business
simplified overall method to allocate CGS
and deductions to DPGR. A qualifying
small taxpayer is a taxpayer that has av-
erage annual gross receipts of $5,000,000
or less or a taxpayer that is eligible to use
the cash method as provided in Rev. Proc.
2002–28, 2002–1 C.B. 815. For purposes
of the simplified deduction method and the
small business simplified overall method,
a taxpayer meets the applicable average
annual gross receipts test if the average
annual gross receipts of the taxpayer for
the 3 taxable years (or, if fewer, the taxable
years during which the taxpayer was in ex-
istence) preceding the current taxable year
do not exceed the applicable gross receipts
threshold. Preceding taxable years are in-
cluded even if one or more of such taxable
years began before the effective date of
§ 199. In the case of any taxable year of
less than 12 months (a short taxable year),
the gross receipts must be annualized by
(a) multiplying the gross receipts for the
shortperiodby12and(b)dividingthere-
sult by the number of months in the short
period. Whether the members of an EAG
may use the simplified deduction method
or the small business simplified overall
method is determined by reference to the
average annual gross receipts of the EAG.
To compute the average annual gross re-
ceipts of an EAG, the gross receipts of
each member of the EAG for its taxable
year that ends with or within the taxable
year of the member that is computing its
§ 199 deduction are aggregated, regardless
of whether the computing member or the
non-computing member was a member of
the EAG during its entire taxable year. A
member of an EAG that qualifies to use
the simplified deduction method or the
small business simplified overall method
may do so only if all members of the EAG
agree to and use the same method.
(b)Treatment of certain deductions.
Section 4.05(3)(b) of this notice clari-
fies that certain deductions do not reduce
DPGR or gross income attributable to
DPGR under any of the three methods. A
loss generated by the sale of property re-
duces DPGR or gross income attributable
to DPGR only if the proceeds from the sale
of the property are, or would have been,
included in DPGR. A deduction allowed
under § 172 for a net operating loss is
not allocated or apportioned to DPGR or
gross income attributable to DPGR. Under
§ 199(d)(5), deductions not attributable to
the actual conduct of a trade or business
are not taken into account under § 199 and,
therefore, are not allocated or apportioned
to DPGR or gross income attributable to
DPGR.
.06Applicationof§199toPass-thru
Entities.(1)In general. In the case of
an S corporation, partnership, estate or
trust, or other pass-thru entity, § 199 is ap-
plied at the partner, shareholder or simi-
lar level. The Service and Treasury De-
partment believe that Congress intended
§ 199 to be applied in a manner consis-
tent with the economic arrangement of the
owners of a pass-thru entity. The Service
and Treasury Department believe that this
objective can be accomplished by allow-
ing each owner to compute its § 199 de-
duction by taking into account its distribu-
tive or proportionate share of the items (in-
cluding items of income, gain, loss, deduc-
tion, cost of goods sold allocated to such
items of income, and gross receipts that
are included in such items of income) al-
located or attributable, in accordance with
section 4.06 of this notice, to the pass-thru
entity’s activities described in § 199(c)(4)
2005–7 I.R.B.512February 14, 2005

(qualified production activities), provided
theitemsarenototherwisedisallowedby
the Code. For purposes of computing the
§ 199(b) limitation, an owner’s share of
W–2 wages of a pass-thru entity is the
lesser of the owner’s allocable share of the
pass-thru entity’s W–2 wages or 2 times
the applicable percentage of the owner’s
QPAI computed taking into account only
the items of the pass-thru entity allocated
to the owner for the taxable year. The
owner of the pass-thru entity will aggre-
gate its items of income or expense (in-
cluding W–2 wages) allocated or attrib-
utable to the pass-thru entity’s qualified
production activities, including those ex-
penses incurred by the owner of the pass-
thru entity directly that are allocated to the
pass-thru entity’s qualified production ac-
tivities, and the owner’s items of income or
expense (including W–2 wages) allocated
or attributable to its other qualified produc-
tion activities.
(2)Gain or loss from the disposition of
an interest in a pass-thru entity. Because
the sale of an interest in a pass-thru en-
tity does not reflect the realization of QPAI
by that entity, QPAI generally does not in-
clude gain or loss recognized on the sale,
exchange or other disposition of an interest
in the entity. However, if § 751(a) or (b)
applies, gain or loss allocated to assets of
the partnership the sale, exchange, or other
dispositionofwhichwouldgiverisetoan
item of QPAI is taken into account in com-
puting the partner’s § 199 deduction.
(3)Effective date of § 199 for pass-thru
entities. Section 199(e) provides that § 199
applies for taxable years beginning after
December 31, 2004. Accordingly, section
4.06(3) of this notice provides that § 199
only applies to taxable years of pass-thru
entities that begin on or after January 1,
2005. The Service and Treasury Depart-
ment recognize that a pass-thru entity will
need to provide certain information to its
owners to allow those persons to com-
pute the § 199 deduction. The Service
and Treasury Department intend to provide
rules relating to information reporting by
pass-thru entities in future guidance.
.07Patrons of Agricultural and Horti-
cultural Cooperatives. Section 4.07 of this
notice provides rules for the application of
§ 199 to agricultural and horticultural co-
operatives and their patrons. The Service
and Treasury Department recognize that a
cooperative will need to provide certain in-
formation to its patrons to allow the pa-
trons to compute the § 199 deduction. The
Service and Treasury Department intend to
provide rules relating to such information
reporting by cooperatives in future guid-
ance.
.08Expanded Affiliated Groups.(1)
In general. All members of an EAG are
treated as a single corporation for purposes
of § 199. An EAG is an affiliated group
as defined in § 1504(a), determined by
substituting “50 percent” for “80 percent”
each place it appears, and without regard to
§ 1504(b)(2) and (4). Therefore, a single
§ 199 deduction is computed for the EAG
and then that deduction is allocated among
members of the EAG.
(2)Computation of expanded affiliated
group’s § 199 deduction.(a)In general.
The Service and Treasury Department
believe that the § 199 deduction of the
EAG must be computed by aggregating
each member’s taxable income or loss,
QPAI, and W–2 wages. For this purpose,
amember’sQPAIisthemember’sDPGR
less the sum of the CGS allocable to the
receipts and other costs required to be
allocated under section 4.05 of this no-
tice. For purposes of this determination, a
member’s QPAI may be positive or nega-
tive. A member’s taxable income or loss
and QPAI shall be determined by reference
to the member’s methods of accounting.
However, pursuant to § 199(c)(7)(A), a
member’s DPGR shall not include any
gross receipts of the member derived from
property leased, licensed, or rented by it
for use by any related person as defined in
§ 199(c)(7)(B).
(b)Attribution of activities. For pur-
poses of determining whether gross re-
ceipts are DPGR, the Service and Trea-
sury Department believe that each mem-
ber of an EAG should be treated as con-
ducting the activities conducted by each
othermemberoftheEAG.Thus,ifCorpo-
ration X and Corporation Y are members
of the same EAG and X manufactures QPP
in the United States and sells the QPP to Y
and Y then sells the same item to an un-
related party, X’s production activities are
attributed to Y. Accordingly, the proceeds
of X’s sale to Y and Y’s sale to the unre-
lated party are DPGR for X and Y, respec-
tively (assuming all other requirements of
§ 199 are met).
(c)Anti-avoidance rule. Although
transactions between members of an EAG
are disregarded in computing the EAG’s
§ 199 deduction only to the extent pro-
vided in § 199(c)(7), if a transaction
between members of an EAG is engaged
in or structured with a principal purpose
of qualifying for, or modifying the amount
of, the § 199 deduction for one or more
members of the EAG, adjustments must be
made to eliminate the effect of the trans-
action on the computation of the § 199
deduction.
(3)Allocation of expanded affiliated
group’s § 199 deduction.TheEAG’s
§ 199 deduction is allocated among mem-
bers of the EAG in proportion to each
member’s QPAI, if any, regardless of
whether the EAG member has taxable
income or loss for the taxable year and
regardless of whether the EAG member
has W–2 wages for the taxable year. For
this purpose, if a member has negative
QPAI, the QPAI of the member shall be
treated as zero.
(4)Special rules for consolidated
groups. The Service and Treasury Depart-
ment believe that, for purposes of § 199,
if an EAG includes members of a consoli-
dated group (as defined in § 1.1502–1(h)),
the members of the consolidated group
should be treated as a single member of
the EAG. Therefore, if an EAG includes
corporations that are members of a con-
solidated group and corporations that are
not members of a consolidated group, in
computing the taxable income limitation
of the EAG, the consolidated taxable in-
come of the consolidated group, not the
separate taxable income of the members
of the consolidated group, is taken into
account. If all of the members of an EAG
are members of the same consolidated
group, the consolidated group’s § 199 de-
duction is determined based on the group’s
consolidated taxable income or loss, not
the separate taxableincome or loss of its
members. The § 199 deduction of a con-
solidated group (or the § 199 deduction
allocated to a consolidated group that is
a member of an EAG) must be allocated
to the members of the consolidated group
in proportion to each consolidated group
member’s QPAI, if any, regardless of
whether the consolidated group member
has separate taxable income or loss for the
taxable year and regardless of whether the
member has W–2 wages for the taxable
year. For purposes of allocating the § 199
deduction of a consolidated group among
February 14, 20055132005–7 I.R.B.

its members, if a consolidated group mem-
berhasnegativeQPAI,theQPAIofthe
member shall be treated as zero.
(5)Identification of members of the ex-
panded affiliated group. The Service and
Treasury Department believe that whether
a corporation is a member of an EAG must
be determined on a daily basis. Therefore,
a corporation may be a member of an EAG
on January 1 but not a member of the EAG
on January 2. If a corporation becomes or
ceases to be a member of an EAG, the cor-
poration is treated as becoming or ceasing
to be a member of the EAG at the end of
the day on which its status as a member
changes.
(6)Allocation of income and loss.A
corporation that is a member of an EAG
for only a portion of its taxable year must
allocate its taxable income or loss, QPAI,
and W–2 wages between the portion of the
taxable year during which it is a member
of the EAG and the portion of the tax-
able year during which it is not a mem-
ber of the EAG. In general, this allocation
of items must be made by using thepro
rataallocation method described in sec-
tion 4.09(6)(a)(i) of this notice. However,
the corporation may elect to use the clos-
ing of the books method described in sec-
tion 4.09(6)(a)(ii). Section 4.09(6)(a)(iii)
prescribes rules for the time and manner
of making the election to use the closing
of the books method.
(a)Pro rata allocation method.Under
thepro rataallocation method, an equal
portion of each of the taxable income or
loss, QPAI, and W–2 wages for the taxable
year is assigned to each day of the corpora-
tion’s taxable year. Then, those items as-
signed to those days during which the cor-
poration was a member of the EAG are ag-
gregated.
(b)Closing of the books method.Under
the closing of the books method, taxable
income or loss, QPAI, and W–2 wages for
the period during which the corporation
was a member of the EAG are computed
by treating the corporation’s taxable year
as two separate taxable years, the first of
which ends at the close of the day on which
the corporation’s status as a member of
the EAG changes and the second of which
begins at the beginning of the day after
the corporation’s status as a member of the
EAG changes.
(7)Total § 199 deduction for a corpo-
ration that is a member of an expanded af-
filiated group for some or all of its taxable
year. If a corporation is a member of an
EAG for its entire taxable year, the cor-
poration’s § 199 deduction for the taxable
year is the amount of the § 199 deduction
of the EAG allocated to the corporation by
the EAG. If a corporation is a member of
an EAG for a portion of its taxable year,
andiseithernotamemberofanyEAG,or
is a member of another EAG, or both, for
another portion of the taxable year, the cor-
poration’s § 199 deduction for the taxable
year is the sum of its § 199 deductions for
each portion of the taxable year.
(8)Computation of § 199 deduction for
members of Expanded Affiliated Group
with different taxable years.Ifmembers
of an EAG have different taxable years,
in computing the § 199 deduction of a
member (the “computing member”), with
respect to each member of the EAG, the
computing member is required to take
into account the taxable income or loss,
QPAI, and W–2 wages that are both (1)
attributable to the period during which the
member of the EAG and the computing
member are both members of the EAG,
and (2) taken into account in a taxable year
that begins after the effective date of § 199
and ends with or within the taxable year
of the computing member with respect to
which the § 199 deduction is computed.
SECTION 4. INTERIM GUIDANCE
.01In General. Under § 199(a)(1), a
taxpayer may deduct an amount equal to
9 percent (3 percent in the case of tax-
able years beginning in 2005 and 2006,
and 6 percent in the case of taxable years
beginning in 2007, 2008, or 2009) of the
lesser of the taxpayer’s QPAI (as defined
in section 4.03 of this notice) for the tax-
able year, or the taxpayer’s taxable income
(determined without regard to § 199) for
the taxable year. For purposes of the pre-
ceding sentence, the definition of taxable
income under § 63 shall apply.
.02Wage Limitation.(1)Rules of ap-
plication.(a)In general.Pursuantto
§ 199(b)(1), the amount of the deduction
allowable to the taxpayer under § 199(a)
for any taxable year shall not exceed 50
percent of the W–2 wages of the taxpayer.
For this purpose, except as provided in sec-
tion 4.02(1)(c) of this notice, the Forms
W–2 used in determining the amount of
W–2 wages are those issued for the cal-
endar year ending during the taxpayer’s
taxable year for wages paid to employ-
ees (or former employees) of the taxpayer
for employment by the taxpayer. For this
purpose and for purposes of section 4.02,
employees of the taxpayer are limited to
employees of the taxpayer as defined in
§ 3121(d)(1) and (d)(2) (that is, officers
of a corporate taxpayer and employees of
the taxpayer under the common law rules).
For purposes of § 199(b)(2), the term “tax-
payer” means “employer.” In determining
W–2 wages a taxpayer may take into ac-
count any wages paid by another entity and
reported by the other entity on Forms W–2
with the other entity as the employer listed
in Box c of the Forms W–2, provided that
the wages were paid to employees of the
taxpayer for employment by the taxpayer.
If the taxpayer is treated as an employer
described in § 3401(d)(1) because of con-
trol of the payment of wages (that is, the
taxpayer is not the common law employer
of the payee of the wages), the payment of
wages may not be included in determining
W–2 wages of the taxpayer. If the taxpayer
is paying wages as an agent of another en-
tity to individuals who are not employees
of the taxpayer, the wages may not be in-
cluded in determining the W–2 wages of
the taxpayer.
(b)No application in determining
whether amounts are wages for employ-
ment tax purposes. The discussion of
“wages” in this notice is for purposes of
§ 199 only and has no application in deter-
mining whether amounts are wages under
§ 3121(a) for purposes of the FICA, under
§ 3306(b) for purposes of the FUTA, under
§ 3401(a) for purposes of the Collection
of Income Tax at Source on Wages (fed-
eral income tax withholding), or any other
wage related determination.
(c)Application in case of taxpayer with
short taxable year. In the case of a tax-
payer with a short taxable year, subject to
the rules of section 4.02(1)(a) of this no-
tice, the W–2 wages of the taxpayer for
the short taxable year shall include those
wages paid during the short taxable year to
employees of the taxpayer as determined
under the tracking wages method. Under
the tracking wages method described in
section 4.02(2)(b)(iii), the taxpayer must
calculate W–2 wages by tracking wages
actually paid during the short taxable year
to employees, subject to the modifications
that in step (B) only the supplemental un-
2005–7 I.R.B.514February 14, 2005

employment compensation benefits paid
during the short taxable year are required
to be deducted and that in step (C) of such
method only the portions of the amounts
reportedinBox12,CodesD,E,F,G,and
S actually deferred or contributed during
the short taxable year may be included in
the W–2 wages.
(d)Acquisition or disposition of a trade
or business (or major portion).Ifatax-
payer (a successor) acquires the major por-
tion of a trade or business or the major por-
tion of a separate unit of a trade or business
from another taxpayer (a predecessor), the
W–2 wages of each of the successor and
predecessor for purposes of computing the
§ 199 deduction shall be computed pur-
suant to the rules of this notice, including
sections 4.02(1) and 4.02(2) of this notice,
regardless of whether the W–2 wages are
reported on Forms W–2 furnished by the
successor or Forms W–2 furnished by the
predecessor.
(e)Non-duplication rule. Amounts that
are treated as W–2 wages for a taxable year
under any method may not be treated as
W–2 wages of any other taxable year.
(2)Definition of “W–2 wages.”(a)In
general. Section 199(b)(2) defines W–2
wages for purposes of § 199(b)(1) as the
sum of the amounts required to be included
on statements under § 6051(a)(3) and (8)
with respect to employment of employees
of the taxpayer for the calendar year. Thus,
the term W–2 wages includes: (i) the total
amount of wages as defined in § 3401(a);
(ii) the total amount of elective deferrals
(within the meaning of § 402(g)(3)); (iii)
the compensation deferred under § 457;
and (iv) for tax years beginning after De-
cember 31, 2005, the amount of designated
Roth contributions (as defined in § 402A).
Under the 2004 and 2005 Form W–2, the
elective deferrals under § 402(g)(3) and
the amounts deferred under § 457 directly
correlate to coded items reported in Box
12 on Form W–2. Box 12, Code D is for
elective deferrals to a § 401(k) cash or de-
ferred arrangement; Box 12, Code E is for
elective deferrals under a § 403(b) salary
reduction agreement; Box 12, Code F is
for elective deferrals under a § 408(k)(6)
salary reduction Simplified Employee
Pension (SEP); Box 12, Code G is for
elective deferrals under a § 457(b) plan;
and Box 12, Code S is for employee salary
reduction contributions under a § 408(p)
SIMPLE (simple retirement account).
(b)Methods for calculating W–2 wages.
Taxpayers may use one of three methods
in calculating W–2 wages. These three
methods are subject to the non-duplica-
tion rule provided in section 4.02(1)(e) of
this notice, and the tracking wages method
is subject to the rule provided in section
4.02(1)(c), if applicable.
(i)Unmodified box method. Under this
method, W–2 wages are calculated by tak-
ing, without modification, the lesser of:
(A) The total entries in Box 1 of all
Forms W–2 filed with the SSA by the tax-
payer with respect to employees of the tax-
payer for employment by the taxpayer; or
(B) The total entries in Box 5 of all
Forms W–2 filed with the SSA by the tax-
payer with respect to employees of the tax-
payer for employment by the taxpayer.
(ii)Modified Box 1 method. Under this
method, the taxpayer makes modifications
to the total entries in Box 1 of Forms W–2
filed with respect to employees of the tax-
payer. W–2 wages under this method are
calculated as follows:
(A) Total the amounts in Box 1 of
Forms W–2 with respect to employees
of the taxpayer for employment by the
taxpayer;
(B) Subtract from the total in Step (A)
amounts included in Box 1 of Forms W–2
that are not wages for federal income tax
withholding purposes and amounts in-
cluded in Box 1 of Forms W–2 that are
treated as wages under § 3402(o) (for
example, supplemental unemployment
compensation benefits); and
(C) Add to the amount obtained after
Step (B) amounts that are reported in Box
12 of Forms W–2 with respect to employ-
ees of the taxpayer for employment by the
taxpayer and that are properly coded D, E,
F, G, or S.
(iii)Tracking wages method.Underthis
method, the taxpayer actually tracks total
wages subject to federal income tax with-
holding and makes appropriate modifica-
tions. W–2 wages under this method are
calculated as follows:
(A) Total the amounts of wages sub-
ject to federal income tax withholding that
are paid to employees of the taxpayer for
employment by the taxpayer and that are
reported on Forms W–2 for the calendar
year;
(B) Subtract from the total in Step
(A) the supplemental unemployment
compensation benefits (as defined in
§ 3402(o)(2)(A)) that were included in
the total in Step A; and
(C) Add to the amount obtained after
Step (B) amounts that are reported in Box
12 of Forms W–2 with respect to employ-
ees of the taxpayer for employment by the
taxpayer and that are properly coded D, E,
F, G or S.
.03Determining Qualified Produc-
tion Activities Income.(1)In general.
Section 199(c)(1) defines QPAI for any
taxable year as an amount equal to the ex-
cess (if any) of (A) the taxpayer’s DPGR
(as defined in section 4.04 of this notice),
over (B) the sum of (i) the CGS that are
allocable to such receipts (seesection
4.05), (ii) other deductions, expenses, or
losses directly allocable to such receipts
(seesection 4.05), and (iii) a ratable por-
tion of other deductions, expenses, and
losses that are not directly allocable to
such receipts or another class of income
(seesection 4.05). For purposes of § 199,
QPAI is determined on an item-by-item
basis (and not, for example, on a divi-
sion-by-division, product line-by-product
line, or transaction-by-transaction basis)
and is the sum of QPAI derived by the
taxpayer from each item. For purposes of
this determination, QPAI from each item
may be positive or negative. For example,
if a taxpayer manufactures a shirt and a hat
in the United States, and the QPAI derived
from the manufacture of the shirt is $3 and
the QPAI derived from the manufacture of
the hat is ($1), the taxpayer’s QPAI is $2.
(2)Allocation of gross receipts.Atax-
payer must determine the portion of its
gross receipts that are DPGR and the por-
tion of its gross receipts that are not DPGR.
For example, if a taxpayer leases, rents, li-
censes, sells, exchanges, or otherwise dis-
poses of QPP, the gross receipts of which
constitute DPGR, and engages in trans-
actions with respect to similar property,
the gross receipts of which do not con-
stitute DPGR, the taxpayer must allocate
its gross receipts from all the transactions
based on a reasonable method that is sat-
isfactory to the Secretary and that accu-
rately identifies thegross receipts that con-
stitute DPGR. Factors taken into consider-
ation in determining whether the method
is reasonable include whether the taxpayer
uses the most accurate information avail-
able; the relationship between the gross
receipts and the apportionment base cho-
sen; the accuracy of the method chosen
February 14, 20055152005–7 I.R.B.

as compared with other possible methods;
whether the method is used by the taxpayer
for internal management or other business
purposes; whether the method is used for
other federal, state, or foreign income tax
purposes; the time, burden, and cost of
using various methods; and whether the
taxpayer applies the method consistently
from year to year. All of a taxpayer’s
gross receipts are treated as DPGR if less
than 5 percent of the taxpayer’s total gross
receipts are non-DPGR (after application
of otherde minimissafe harbors provided
in section 4 of this notice that result in
gross receipts being treated as DPGR). If
the amount of the taxpayer’s gross receipts
that do not qualify as DPGR equals or ex-
ceeds 5 percent of the total gross receipts,
the taxpayer is required to allocate all gross
receipts between DPGR and non-DPGR.
For example, if a taxpayer only derives
gross receipts from the sale of gasoline re-
fined by the taxpayer in the United States
and the sale of gasoline the taxpayer ac-
quired (either by purchase or in exchange
for gasoline refined by the taxpayer in the
United States) from an unrelated party, the
taxpayer must allocate its gross receipts
between the gross receipts attributable to
the gasoline refined by the taxpayer in the
United States (that qualify as DPGR as-
suming all other requirements of § 199
are met) and the taxpayer’s gross receipts
derived from the resale of the acquired
gasoline (that do not qualify as DPGR) if
5 percent or more of the taxpayer’s total
gross receipts are not from the sale of gaso-
line refined by the taxpayer in the United
States. Similarly, a taxpayer that manu-
factures the same type of QPP at facili-
ties within the United States and outside
the United States must allocate its gross re-
ceipts between the receipts from the QPP
manufactured in the United States and re-
ceipts from the QPP not manufactured in
the United States if 5 percent or more of
its total gross receipts are non-DPGR.
(3)Treatment of advance payments.If
a taxpayer recognizes an advance payment
for goods, services, use of property, etc.,
in gross receipts in a taxable year ear-
lier than the taxable year the goods, ser-
vices, use of property, etc., to which the ad-
vance payment relates are delivered, per-
formed, provided, etc., the taxpayer must
accurately identify based on a reasonable
method that is satisfactory to the Secre-
tary whether the receipts (and correspond-
ing CGS and expenses) qualify as DPGR.
Seesection 4.03(2) of this notice for the
factors taken into consideration in deter-
mining whether the taxpayer’s method is
reasonable.
.04Determining Domestic Produc-
tion Gross Receipts.(1)In general.
Section 199(c)(4)(A) defines DPGR as
the gross receipts (as defined in section
4.04(2) of this notice) of the taxpayer that
are derived from (as defined in section
4.04(7)):
(a) Any lease, rental, license, sale, ex-
change, or other disposition of:
(i) QPP (as defined in section 4.04(8))
that is MPGE (as defined in section
4.04(3)) by the taxpayer (as defined in
section 4.04(4)) in whole or in significant
part (as defined in section 4.04(5)) within
the United States (as defined in section of
4.04(6)),
(ii) Any qualified film (as defined in
section 4.04(9)) produced by the taxpayer
(in accordance with section 4.04(9)), or
(iii) Electricity, natural gas, or potable
water (as defined in section 4.04(10)) pro-
duced by the taxpayer in the United States
(in accordance with section 4.04(10)),
(b) Construction (as defined in section
4.04(11)) performed in the United States
(in accordance with section 4.04(11)), or
(c) Engineering or architectural ser-
vices (as defined in section 4.04(12))
performed in the United States for con-
struction projects in the United States (in
accordance with 4.04(12)).
(2)Definition of “gross receipts.”The
term “gross receipts” means the taxpayer’s
receipts for the taxable year that are rec-
ognized under the taxpayer’s method of
accounting used in that taxable year for
federal income tax purposes. For this
purpose, gross receipts include total sales
(net of returns and allowances) and all
amounts received for services. In addi-
tion, gross receipts include any income
from investments, and from incidental or
outside sources. For example, gross re-
ceipts include interest (including original
issue discount and tax-exempt interest
within the meaning of § 103), dividends,
rents, royalties, and annuities, regard-
less of whether the amounts are derived
in the ordinary course of the taxpayer’s
trade of business. Gross receipts are not
reduced by CGS or by the cost of prop-
erty sold if such property is described in
§ 1221(a)(1), (2), (3), (4) or (5). Gross
receipts do not include the repayment of
a loan or similar instrument (for example,
a repayment of the principal amount of a
loan held by a commercial lender) and,
except to the extent of gain recognized,
do not include gross receipts derived from
a non-recognition transaction such as a
§ 1031 exchange. Finally, gross receipts
do not include amounts received by the
taxpayer with respect to sales tax or other
similar state and local taxes if, under the
applicable state or local law, the tax is
legally imposed on the purchaser of the
good or service, and the taxpayer merely
collects and remits the tax to the taxing au-
thority. If, in contrast, the tax is imposed
on the taxpayer under the applicable law,
then gross receipts include the amounts
received that are allocable to the payment
of such tax.
(3)Definition of “manufactured, pro-
duced, grown, or extracted.”(a)In gen-
eral. The terms MPGE in § 199(c)
(4)(A)(i)(I) include activities relating
to manufacturing, producing, growing,
extracting, installing, developing, improv-
ing, and creating QPP; making QPP out of
scrap, salvage, or junk material as well as
from new or raw material by processing,
manipulating, refining, or changing the
form of an article, or by combining or as-
sembling two or more articles; cultivating
soil, raising livestock, fishing, and mining
minerals. The terms also include storage,
handling or other processing activities
(other than transportation activities) within
the United States related to the sale, ex-
change or other disposition of agricultural
products, provided the products are con-
sumed in connection with, or incorporated
into, the MPGE of QPP whether or not by
the taxpayer. For example, assume A, B,
and C are unrelated taxpayers. A owns
grain storage bins in the United States in
whichitstoresforafeeB’scornthatwas
grown in the United States. B sells its corn
to C. C processes B’s corn into corn syrup
in the United States. The gross receipts
from A’s, B’s, and C’s activities are DPGR
from the MPGE of QPP.
(b)Consistency with § 263A.Atax-
payer that has MPGE QPP for the taxable
year should treat itself as a producer un-
der § 263A with respect to the QPP for
the taxable year unless the taxpayer is not
subject to § 263A under the Code, regu-
lations, or other published guidance. A
taxpayer that currently is not properly ac-
2005–7 I.R.B.516February 14, 2005

counting for its production activities under
§ 263A, and wishes to change its method
of accounting to comply with the producer
requirements of § 263A, must follow the
procedures of Rev. Proc. 97–27 or Rev.
Proc. 2002–9, whichever applies.
(4)Definition of “by the taxpayer.”
With the exception of the rules provided in
section 4.09(2)(b) of this notice applicable
to an EAG, if one taxpayer performs a
qualifying activity under § 199(c)(4)(A)(i)
pursuant to a contract with another party,
then only the taxpayer that has the benefits
and burdens of ownership of the property
under federal income tax principles during
the period the qualifying activity occurs
is treated as engaging in the qualifying
activity.
(5)Definition of “in whole or in signif-
icant part.”(a)In general. QPP described
in § 199(c)(4)(A)(i)(I) must be MPGE in
whole or in significant part by the tax-
payer within the United States. Except in
the case of a related person transaction un-
der § 199(c)(7), DPGR includes all of the
taxpayer’s gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of QPP for which the tax-
payer MPGE the QPP in whole or in sig-
nificant part in the United States. For ex-
ample, if a taxpayer imports QPP that is
partially manufactured, the taxpayer com-
pletes the manufacture of the QPP in the
United States, and the taxpayer’s comple-
tion of the manufacturing of the QPP in
the United States satisfies the “in signifi-
cant part” requirement, then the taxpayer’s
gross receipts from the sale of the QPP
qualify as DPGR (assuming all other re-
quirements of § 199(c) are met). In ad-
dition, if a taxpayer manufactures QPP in
significant part in the United States and ex-
ports the QPP for further manufacture out-
side the United States, the taxpayer’s gross
receipts derived from the lease, rental, li-
cense, sale, exchange, or other disposition
of that QPP will be considered DPGR, re-
gardless of whether the QPP is imported
back into the United States prior to the
lease, rental, license, sale, exchange, or
other disposition of the QPP (assuming all
other requirements of § 199(c) are met). If
a taxpayer enters into a contract with an-
other party and the taxpayer has the bene-
fits and burdens of ownership of the QPP
under federal income tax principles during
the period the MPGE activity occurs and
the taxpayer is considered to MPGE the
QPP under § 199, then the taxpayer must
determine whether the MPGE performed
by the other party on behalf of the taxpayer
is performed in whole or in significant part
within the United States.
(b)Substantial in nature.QPPwill
be treated as MPGE in significant part by
the taxpayer within the United States if
the MPGE of the QPP performed by the
taxpayer within the United States is sub-
stantial in nature taking into account all
the facts and circumstances, including the
relative value added by, and relative cost
of, the taxpayer’s MPGE activity in the
United States, the nature of the property,
and the nature of the MPGE activity that
the taxpayer performs in the United States.
Forexample,ifpropertyisMPGEbythe
taxpayer outside the United States or by
an unrelated party within the United States
and the property is used as a component
part of the QPP produced by the taxpayer
within the United States, the QPP (includ-
ing the component part) will be treated
as MPGE in significant part by the tax-
payer within the United States if the pro-
duction of the QPP performed by the tax-
payer within the United States is substan-
tial in nature. In addition, if a taxpayer
purchases unrefined oil extracted outside
theUnitedStatesbyanunrelatedpartyand
the taxpayer refines the oil in the United
States, the refining of the oil by the tax-
payer in the United States will be treated as
MPGE that is substantial in nature within
the United States. However, packaging,
repackaging, labeling, and minor assembly
operations do not qualify as substantial in
nature. In addition, development activities
and the creation or licensing of intangibles
do not qualify as substantial in nature for
any QPP other than computer software and
sound recordings.
(c)Safe harbor. A taxpayer will be
treated as having MPGE property in whole
or in significant part within the United
States if, in connection with the property,
conversion costs (direct labor and related
factory burden) to MPGE the property are
incurred by the taxpayer within the United
States and the costs account for 20 percent
or more of the total CGS of the property.
For purposes of this safe harbor, devel-
opment costs and the cost of any intangi-
bles do not qualify as conversion costs for
any QPP other than computer software and
sound recordings. In addition, the costs of
packaging, repackaging, labeling, and mi-
nor assembly operations do not qualify as
conversion costs.
(6)Definition of “United States.”For
purposes of § 199, the term “United States”
includes the 50 states, the District of Co-
lumbia, the territorial waters of the United
States, and the seabed and subsoil of those
submarine areas that are adjacent to the
territorial waters of the United States and
over which the United States has exclu-
sive rights, in accordance with interna-
tional law, with respect to the exploration
and exploitation of natural resources. The
term “United States” does not include pos-
sessions and territories of the United States
or the airspace over the United States and
these areas.
(7)Definition of “derived from the
lease, rental, license, sale, exchange, or
other disposition of qualifying production
property.”(a)In general. The term “de-
rived from the lease, rental, license, sale,
exchange, or other disposition of qualify-
ing production property” is defined as, and
limited to, the gross receipts directly from
the lease, rental, license, sale, exchange,
or other disposition of QPP. For example,
“derived from the sale of QPP” includes
gross receipts from the sale of QPP manu-
factured in whole or in significant part in
the United States by a taxpayer for sale,
as well as gross receipts from the sale
of self-constructed QPP manufactured in
whole or in significant part in the United
States by a taxpayer and used in the tax-
payer’s trade or business before being
sold. In addition, the proceeds from busi-
ness interruption insurance and payments
not to produce are treated as gross receipts
“derived from the lease, rental, license,
sale, exchange, or other disposition of
QPP” to the extent that they are substitutes
for gross receipts that would qualify as
DPGR. The value of property received
in an exchange of QPP that was MPGE
by the taxpayer for QPP that was MPGE
by an unrelated taxpayer is DPGR for the
taxpayer. The value of property acquired
by a taxpayer in exchange for QPP is gross
receipts derived from an exchange of the
QPP, and is DPGR if the QPP was MPGE
by the taxpayer in whole or in significant
part within the United States. However,
any gross receipts from the subsequent
sale by the taxpayer of the property that
the taxpayer acquired in the exchange are
not DPGR, because the taxpayer did not
MPGE the property acquired in the ex-
February 14, 20055172005–7 I.R.B.

change, even if that property is QPP that
had been MPGE within the United States
by the other party to the exchange.
(b)Allocation of gross receipts—em-
bedded services. Except with respect to
construction or engineering or architec-
tural services described in § 199(c)(4)(ii)
and (iii), gross receipts “derived from” the
performance of services do not qualify as
DPGR. In the case of an embedded service,
that is, a service the price of which is in-
cluded in the amount charged for the lease,
rental, license, sale, exchange, or other dis-
position of property, DPGR includes only
the receipts from the lease, rental, license,
sale, exchange, or other disposition of the
property and not any receipts attributable
to the embedded service (assuming all
other requirements of § 199(c) are met).
There are two exceptions to this general
rule regarding embedded services. First, a
taxpayer may include in DPGR (assuming
all other requirements of § 199(c) are met)
gross receipts from a qualified warranty
(that is, a warranty that is provided in con-
nection with the sale of QPP if (1) in the
normal course of its business, the charge
for the warranty is included in the price
charged for the lease, rental, license, sale,
exchange, or other disposition of the QPP
and (2) the warranty is neither separately
offered by the taxpayer nor separately bar-
gained for with the customer (that is, the
customer cannot purchase the QPP with-
out the warranty)). Second, ade minimis
amount of gross receipts from embedded
services for each item of property may
qualify as DPGR. Ade minimisamount
of gross receipts from embedded services
is less than 5 percent of the gross receipts
derived from the lease, rental, license,
sale, exchange, or other disposition of the
property. For purposes of applying thisde
minimistest, gross receipts from qualified
warranties are not treated as gross receipts
for services.
(c)Advertising income. Gross receipts
that are “derived from” the sale or other
disposition of newspapers and magazines
include advertising income. For example,
a newspaper manufacturer’s gross receipts
from an advertiser to publish display ad-
vertising or classified advertisements in its
newspaper are treated as gross receipts de-
rived from the sale of the newspapers (as-
suming all other requirements of § 199 are
met).
(d)Computer software. Gross receipts
derived from computer software (as de-
fined in section 4.04(8)(c)) do not include
gross receipts derived from Internet ac-
cess services, online services, customer
support, telephone services, games played
through a website, provider-controlled
software online access services, and other
services that do not constitute the lease,
rental, license, sale, exchange, or other
disposition of computer software that was
developed by the taxpayer.
(e)Exception for certain oil and gas
partnerships. If a partnership is engaged
solely in the extraction, refining, process-
ing, etc., of oil or gas and distributes the
oil or gas or products derived from the oil
or gas (products) to its partners who then
sell the oil or gas or products, then, for pur-
poses of § 199, the gross receipts derived
by the partners from the sale of the oil or
gas or products are treated as gross receipts
derived by the partnership from the MPGE
of QPP. The partnership must follow the
rules provided in section 4.06 of this no-
tice regarding the application of § 199 to
pass-thru entities to ensure that the costs
attributable to oil or gas or products are
properly taken into account.
(8)Definition of “qualifying produc-
tion property.”(a) In general. Qualifying
production property includes: (1) tan-
gible personal property, as defined in
section 4.04(8)(b); (2) computer software,
as defined in section 4.04(8)(c); and (3)
sound recordings, as defined in section
4.04(8)(d).
(b)Tangible personal property.The
term “tangible personal property” is
any tangible property other than land,
buildings, (including items that are
structural components of such build-
ings) and any property described un-
der § 199(c)(4)(A)(i)(II) and (III), or
§ 199(c)(5)(B) and (C). Thus, qualified
films, computer software, and sound
recordings are not tangible personal prop-
erty regardless of whether they are fixed
on a tangible medium. However, the tangi-
ble medium on which the property is fixed
(for example, a videocassette, a computer
diskette, or other similar tangible item) is
tangible personal property. In determin-
ing whether property is “tangible personal
property,” the fact that property is personal
property or tangible property under local
law is not controlling. Conversely, prop-
erty may be tangible personal property for
purposes of § 199(c)(5)(A) even though
under local law the property is considered
a fixture and therefore real property. Thus,
property such as production machinery,
printing presses, transportation and office
equipment, refrigerators, grocery coun-
ters, testing equipment, display racks and
shelves, and neon and other signs that is
contained in or attached to a building con-
stitutes tangible personal property for pur-
poses of § 199(c)(5)(A). Further, property
that is in the nature of machinery (other
than structural components of a building)
is tangible personal property even though
located outside a building. Thus, for ex-
ample, a gasoline pump, hydraulic car lift,
or automatic vending machine, although
annexed to the ground, is considered tan-
gible personal property. A structure that
is property in the nature of machinery
or is essentially an item of machinery or
equipment is not an inherently permanent
structure and is tangible personal property.
In the case, however, of a building or in-
herently permanent structure that includes
property in the nature of machinery as a
structural component, the property in the
nature of machinery is real property. The
term “tangible personal property” does
not include the creation of copyrighted
material such as a manuscript in a form
other than in a tangible medium.
(c)Computer software. The term “com-
puter software” means any program or rou-
tine or any sequence of machine-readable
code that is designed to cause a computer
to perform a desired function or set of
functions, and the documentation required
to describe and maintain that program or
routine. Computer software also includes
the machine-readable coding for video
games and similar programs, regardless
of whether the program is designed to
operate on a “computer” (as defined in
§ 168(i)(2)(B)). If the medium in which
the software is contained, whether writ-
ten, magnetic, or otherwise, is tangible,
then such medium is considered tangible
personal property for purposes of § 199.
Therefore, if a taxpayer develops a soft-
ware program that it reproduces and sells
on diskettes, the program fixed on the
diskette is treated as computer software,
and the diskette is treated as tangible per-
sonal property. Computer programs of all
classes, for example, operating systems,
executive systems, monitors, compilers
and translators, assembly routines, and
2005–7 I.R.B.518February 14, 2005

utility programs as well as application
programs, are included. Computer soft-
ware also includes any incidental and
ancillary rights that are necessary to effect
the acquisition of the title to, the owner-
ship of, or the right to use the computer
software, and that are used only in connec-
tion with that specific computer software.
Such incidental and ancillary rights are
not included in the definition of trademark
or trade name under § 1.197–2(b)(10)(i).
For example, a trademark or trade name
that is ancillary to the ownership or use
of a specific computer software program
in the taxpayer’s trade or business and is
not acquired for the purpose of marketing
the computer software is included in the
definition of computer software and is not
included in the definition of trademark
or trade name. Computer software does
not include any data or information base
unless the data base or item is in the public
domain and is incidental to a computer
program. For this purpose, a copyrighted
or proprietary data or information base is
treated as in the public domain if its avail-
ability through the computer program does
not contribute significantly to the cost of
the program. For example, if a word-pro-
cessing program includes a dictionary
feature that may be used to spell-check
a document or any portion thereof, the
entire program (including the dictionary
feature) is computer software regardless
of the form in which the dictionary feature
is maintained or stored.
(d)Sound recordings. The term “sound
recordings” means any works that result
from the fixation of a series of musical,
spoken, or other sounds. If the medium
(such as compact discs, tapes, or other
phonorecordings) in which the sounds are
embodied is tangible, the medium is con-
sidered tangible personal property for pur-
poses of § 199. Therefore, the sale of
an audio cassette involves both a sound
recording (the sounds fixed on the tape)
and tangible personal property (the cas-
sette itself).Seesection 4.04(8)(c) of this
notice. The term “sound recordings” does
not include the creation of copyrighted ma-
terial in a form otherthan a sound record-
ing, such as lyrics or music written on pa-
perorothersimilarmaterial.
(9)Definition of “qualified film.”(a)In
general. The term “qualified film” means
any motion picture film, video tape, or
live or delayed television programming if
not less than 50 percent of the total com-
pensation relating to the production of the
property is compensation for services per-
formed in the United States by actors, pro-
duction personnel, directors, and produc-
ers. The term “production personnel” in-
cludes writers, choreographers and com-
posers providing services during the pro-
duction of a film, casting agents, camera
operators, set designers, lighting techni-
cians, make-up artists, and others whose
activities are directly related to the produc-
tion of the film. “Production personnel” do
not include, however, individuals whose
activities are ancillary to the production,
such as advertisers and promoters, distrib-
utors, studio administrators and managers,
studio security personnel, and personal as-
sistants to actors. If the medium on which
a qualified film is fixed is tangible (such as
a DVD), such medium is treated as tangi-
ble personal property. Therefore, a DVD
copy of a motion picture consists of both
a qualified film (the motion picture con-
tent embodied in the disc) and tangible per-
sonal property (the disc itself).
(b)Compensation for services.The
term “compensation for services” means
all payments for services performed by
actors, production personnel, directors,
and producers, including participations
and residuals. In the case of a taxpayer
that uses the income forecast method of
§ 167(g) and capitalizes participations
and residuals into the adjusted basis of
the qualified film, the taxpayer must use
the same estimate of participations and
residuals for purposes of § 199 that it uses
for purposes of § 167(g). In the case of
a taxpayer that excludes participations
and residuals from adjusted basis of the
qualified film under § 167(g)(7)(D)(i), the
taxpayer must determine the compensa-
tion expected to be paid as participations
and residuals based on the total forecasted
income used in determining income fore-
cast depreciation.
(c)Determination of 50 percent.Atax-
payer may use any reasonable method of
making the allocation. Among the factors
to be considered in determining whether a
taxpayer’s method of allocating compen-
sation is reasonable is whether the tax-
payer uses that method consistently.
(d)Exception. A “qualified film” does
not include property with respect to which
records are required to be maintained un-
der 18 U.S.C. § 2257. Section 2257 of
Title 18 requires maintenance of certain
records with respect to any book, maga-
zine, periodical, film, videotape, or other
matter that (1) contains one or more visual
depictions made after November 1, 1990,
of actual sexually explicit conduct and (2)
is produced in whole or in part with materi-
als that have been mailed or shipped in in-
terstate or foreign commerce, or is shipped
or transported or is intended for shipment
or transportation in interstate or foreign
commerce.
(10)Electricity, natural gas, and
potable water.(a)In general.DPGR
includes gross receipts derived from any
lease, rental, license, sale, exchange, or
other disposition of electricity, natural gas,
or potable water produced by the taxpayer
in the United States (assuming all other
requirements of § 199(c) are met). DPGR
does not include gross receipts of the tax-
payer derived from the transmission or
distribution of these items.
(b)Natural gas. The term “natural
gas” includes only natural gas extracted
from a natural deposit and does not in-
clude, for example, methane gas extracted
from a landfill. In the case of natural gas,
production activities include all activities
involved in extracting natural gas from
the ground and processing the gas into
pipeline quality gas.
(c)Potable water. The term “potable
water” means unbottled drinking water. In
the case of potable water, production ac-
tivities include the acquisition, collection,
and storage of raw water (untreated water),
transportation of raw water to a water treat-
ment facility, and treatment of raw water at
such a facility. Gross receipts attributable
to any of these activities are included in
DPGR (assuming all other requirements of
§ 199(c) are met). DPGR does not include,
however, gross receipts derived from the
storage of potable water after completion
of treatment of the potable water, or deliv-
ery of potable water to customers.
(d)Exceptions. In the case of an
integrated producerthat both produces
and delivers electricity, natural gas, or
potable water, the taxpayer must allo-
cate its gross receipts between production
(DPGR) and distribution and transmis-
sion (non-DPGR). However, if less than
5 percent of a taxpayer’s gross receipts
derived from a sale of electricity, natural
gas, or potable water are attributable to the
transmission or distribution of the elec-
February 14, 20055192005–7 I.R.B.

tricity, natural gas, or potable water, then
the gross receipts derived from that sale
that are attributable to the transmission
and distribution of theelectricity, natural
gas, or potable water will be treated for
purposes of § 199 as being DPGR (assum-
ing all other requirements of § 199(c) are
met).
(i)Electricity. Gross receipts attribut-
able to the transmission of electricity from
the generating facility to a point of local
distribution and gross receipts attributable
to the distribution of electricity to final
customers are not DPGR.
(ii)Natural gas. Gross receipts attribut-
able to the transmission of pipeline quality
gas from a natural gas field (or from a natu-
ral gas processing plant) to a local distribu-
tion company’s citygate (or to another cus-
tomer) are not DPGR. Likewise, gross re-
ceipts of a local gas distribution company
attributable to distribution from the city-
gate to the local customers are not DPGR.
(iii)Potable water. Gross receipts at-
tributable to the storage of potable wa-
ter after completion of treatment of the
potable water, as well as gross receipts at-
tributable to the transmission and distribu-
tion of potable water, are not DPGR.
(11)Definition of “construction per-
formed in the United States.”(a) Construc-
tion of real property.The term “construc-
tion” means the construction or erection of
real property (that is, residential and com-
mercial buildings (including items that are
structural components of such buildings),
inherently permanent structures other than
tangible personal property in the nature
of machinery (seesection 4.04(8)(b) of
this notice), inherently permanent land im-
provements, and infrastructure) by a tax-
payer that is in a trade or business that
is considered construction for purposes of
the North American Industry Classifica-
tion System (NAICS codes). Tangible per-
sonal property (as defined under section
4.04(8)(b)) (for example, appliances, fur-
niture and fixtures) that is sold as part
of a construction project is not consid-
ered real property for this purpose. How-
ever, if more than 95 percent of the total
gross receipts derived by a taxpayer from
a construction project are derived from real
property (as definedin § 1.263A–8(c)),
then the total gross receipts derived by the
taxpayer from the project are DPGR from
construction (assuming all other require-
ments of § 199(c) are met). In determin-
ing whether property is “real property,” the
fact that property is real property under
local law is not controlling. Conversely,
property may be real property for purposes
of § 199(c)(4)(A)(ii) even though under lo-
cal law the property is considered tangible
personal property.
(b)Activities constituting construction.
Activities constituting construction in-
clude activities performed in connection
with a project to erect or substantially
renovate real property, but do not include
tangential services such as hauling trash
and debris, and delivering materials, even
if the tangential services are essential
for construction. However, if the tax-
payer performing construction also, in
connection with the construction project,
provides tangential services such as de-
livering materials to the construction site
and removing its construction debris, the
gross receipts derived from the tangen-
tial services are DPGR. Improving land
(for example, grading and landscaping)
and painting are activities constituting
construction only if these activities are
performed in connection with other activi-
ties (whether or not by the same taxpayer)
that constitute the erection or substantial
renovation of real property. The taxpayer
engaged in these activities must make a
reasonable inquiry to determine whether
the activity relates to the erection or sub-
stantial renovation of real property. The
term “construction” does not include any
activity that is within the definition of
“engineering and architectural services”
(seesection 4.04(12) of this notice).
(c)Definition of “infrastructure.”The
term “infrastructure” includes roads,
power lines, water systems, railroad spurs,
communications facilities, sewers, side-
walks, cable, and wiring. The term also
includes inherently permanent oil and gas
platforms.
(d)Definition of “substantial renova-
tion.”The term “substantial renovation”
means the renovation of a major compo-
nent or substantial structural part of real
property that materially increases the value
of the property, substantially prolongs the
useful life of the property, or adapts the
property to a new or different use.
(e)“Derived from construction.”As-
suming all other requirements of § 199(c)
are met, DPGR derived from the con-
struction of real property performed in
the United States includes the proceeds
from the sale, exchange, or other dispo-
sition of real property constructed by the
taxpayer in the United States (whether
or not the property is sold immediately
after construction is completed). DPGR
derived from the construction of real prop-
erty also includes compensation for the
performance of construction services by
the taxpayer in the United States. How-
ever, DPGR derived from the construction
of real property does not include gross
receipts from the lease or rental of real
property constructed by the taxpayer or
gross receipts attributable to the sale or
other disposition of land.
(12)Definition of “Engineering and
architectural services.”(a)In general.
DPGR includes gross receipts derived
from engineering or architectural services
performed in the United States for con-
struction projects in the United States (as-
suming all other requirements of § 199(c)
are met). The engineering or architectural
services must relate toreal property, must
be performed in the United States, and the
taxpayer providing these services must
be able to substantiate that the services
relate to a construction project within
the United States. DPGR includes gross
receipts derived fromengineering or ar-
chitectural services even if the planned
construction project is not undertaken or
is not completed (subject to the taxpayer
substantiating that the services relate to
aconstructionproject that would have
been within the United States if it had
been undertaken and assuming all other
requirements of § 199(c) are met).
(b)Engineering services. Engineering
services in connection with any con-
struction project include any professional
services requiring engineering educa-
tion, training, and experience and the
application of special knowledge of the
mathematical, physical, or engineering
sciences to those professional services
such as consultation, investigation, eval-
uation, planning, design, or responsible
supervision of construction for the pur-
pose of assuring compliance with plans,
specifications, and design.
(c)Architectural services. Architec-
tural services in connection with any
construction project include the offering
or furnishing of any professional services
such as consultation, planning, aesthetic
and structural design, drawings and spec-
ifications, or responsible supervision of
2005–7 I.R.B.520February 14, 2005

construction (for the purpose of assuring
compliance with plans,specifications, and
design) or erection, in connection with any
construction project.
(d)De minimis exception for perfor-
mance of services in the United States.
If gross receipts derived from engineer-
ing or architectural services (1) performed
outside the United States or (2) related
to property other than real property for
a construction project inside the United
States total less than 5 percent of the total
gross receipts of the taxpayer derived from
engineering or architectural services per-
formed by the taxpayer with regard to the
same construction project, such receipts
will be treated as DPGR.
(13)Exception for sales of certain food
and beverages. DPGR does not include
gross receipts of the taxpayer that are de-
rived from the sale of food or beverages
prepared by the taxpayer at a retail estab-
lishment. A “retail establishment” is de-
fined as real property leased, occupied, or
otherwise used by the taxpayer in its trade
or business of selling food or beverages to
the public at which retail sales are made. A
facility at which food or beverages are pre-
pared will not be treated as a retail estab-
lishment if less than 5 percent of the food
or beverages that are sold at that facility
during the taxable year are retail sales. If a
taxpayer’s facility is a retail establishment,
then, as a matter of administrative grace,
the taxpayer may allocate its gross receipts
between gross receipts derived from the re-
tail sale of the food and beverages prepared
and sold at the retail establishment (which
are non-DPGR) and gross receipts derived
from the wholesale sale of the food and
beverages prepared at the retail establish-
ment (which are DPGR). The exception for
sales of certain food and beverages also ap-
plies to food and beverages for non-human
consumption.
(14)Related persons. Section 199(c)(7)
provides that DPGR does not include any
gross receipts of the taxpayer derived from
property leased, licensed, or rented by the
taxpayer for use by any related person. A
person is treated as related to another per-
son if both persons are treated as a single
employer under either § 52(a) or (b) (with-
out regard to § 1563(b)), or § 414 (m) or
(o).
.05Determining Costs.(1)In gen-
eral. To determine its QPAI for the taxable
year, a taxpayer must reduce its DPGR
by the amount of CGS directly allocable
to DPGR, the amount of deductions di-
rectly allocable to DPGR and a ratable por-
tion of other deductions not directly al-
locable to DPGR, or another class of in-
come. Section 4.05(2) of this notice pro-
vides rules for determining CGS directly
allocable to DPGR. Section 4.05(3) pro-
vides rules for determining the deductions
allocated and apportioned to DPGR and a
ratable portion of deductions not directly
allocable to DPGR or another class of in-
come. Section 4.05(3) generally provides
that a taxpayer must determine deductions
allocated and apportioned to DPGR using
the rules of the regulations under § 861
of the Code. Section 4.05(3) provides,
however, that a taxpayer with average an-
nual gross receipts of $25,000,000 or less
may determine deductions apportionable
to DPGR using the simplified deduction
method. Section 4.05(4) provides a simpli-
fied overall method that a qualifying small
taxpayer may use to allocate and apportion
CGS and deductions to DPGR. Consistent
with the rule in section 4.09(1) that treats
all members of an EAG as a single corpo-
ration for purposes of § 199, whether the
members of an EAG may use the simpli-
fied deduction method or the small busi-
ness simplified overall method is deter-
mined at the EAG level. In addition, a
member of an EAG that may use the sim-
plified deduction method or the small busi-
ness simplified overall method may do so
only if all members of the EAG agree to
and use the same method.
(2)Cost of goods sold allocable to do-
mestic production gross receipts.(a) In
general. Section 199(c)(1)(B)(i) requires a
taxpayer to reduce DPGR by the CGS di-
rectly allocable to DPGR. A taxpayer must
allocate CGS in accordance with this sec-
tion 4.05(2) of this notice or, if applica-
ble, section 4.05(4). CGS is equal to be-
ginning inventory plus purchases and pro-
duction costs incurred during the taxable
year less ending inventory. For purposes
of § 199, CGS allocable to DPGR includes
the costs that would have been included in
ending inventory under the principles of
§§ 263A, 471, and 472 if the goods sold
during the taxable year were on hand at
the end of the taxable year. CGS alloca-
ble to DPGR includes inventory valuation
adjustments such as writedowns under the
lower of cost or market method. For pur-
poses of § 199, CGS also includes the ad-
justed basis of noninventory property, the
gross receipts from the sale or other dispo-
sition of which are included in DPGR.
(b)Allocating cost of goods sold.Ifa
taxpayer can identify from its books and
records CGS allocable to DPGR, CGS
allocable to DPGR is that amount. How-
ever, if a taxpayer’s books and records
do not allow the taxpayer to identify
CGS allocable to DPGR, the taxpayer
must use a reasonable method to allocate
CGS between DPGR and other gross re-
ceipts. If a taxpayer uses a method to
allocate gross receipts between DPGR and
non-DPGR, the taxpayer may not use a
different method for purposes of allocating
CGS. In other cases, whether an alloca-
tion method is reasonable is based on all
of the facts and circumstances including
the relationship between CGS and the base
chosen; the accuracy of the method chosen
as compared with other possible methods;
whether the method is used by the tax-
payer for internal management and other
business purposes; whether the method is
used for other federal or state income tax
purposes; the availability of costing infor-
mation; and the time, burden, and cost of
using various methods. Depending on the
facts and circumstances, reasonable meth-
ods may include methods based on gross
receipts, number of units sold, number of
units produced, or total production costs.
(c)Special rules for imported items
or services. Under § 199(c)(3), the cost
of any item or service brought into the
United States is treated as not less than
its value immediately after it entered the
United States for purposes of determining
the CGS to be used in the computation
of QPAI. When an item or service is
brought into the United States that had
been exported by the taxpayer for further
manufacture, the increase in cost may not
exceed the difference between the value
of the property when exported and the
value of the property when brought back
into the United States after further man-
ufacture. For this purpose, the value of
property is its customs value as defined in
§ 1059A(b)(1).
(3)Other deductions allocable or
apportionable to domestic production
gross receipts.(a)In general. Section
199(c)(1)(B)(ii) and (iii) requires a tax-
payer to reduce DPGR by deductions that
are directly allocable to DPGR, and a
ratable portion of deductions that are not
February 14, 20055212005–7 I.R.B.

directly allocable to DPGR or another
class of income. Any cost that may not be
taken into account in computing taxable
income for the taxable year is not treated
as a deduction for purposes of this sec-
tion. A taxpayer generally must allocate
and apportion these deductions using the
rules provided in the § 861 regulations,
subject to the rules provided in this section
4.05(3) (the § 861 method). In lieu of the
§ 861 method, a taxpayer with average an-
nual gross receipts of $25,000,000 or less
may apportion these deductions using the
simplified deduction method. A taxpayer
electing the simplified deduction method
must use that method for all deductions.
See also section 4.05(4) for the small busi-
ness simplified overall method available
to a qualified small taxpayer.
(b)Rules that apply to all alloca-
tion and apportionment methods.(i)In
general. The rules provided in section
4.05(3)(b)(ii) through (v) apply to losses,
net operating losses, and certain other
deductions when allocating and appor-
tioning deductions to DPGR or gross
income attributable to DPGR under the
§ 861 method (section 4.05(3)(c)), the
simplified deduction method (section
4.05(3)(d)), or the small business simpli-
fied overall method (section 4.05(4)).
(ii)Losses. A deduction under § 165
for a loss related to property (including
theft, casualty, or abandonment losses) is
allocated or apportioned to DPGR or gross
income attributable to DPGR only if the
proceeds from the sale of the property are,
or would have been, included in DPGR.
(iii)Net operating losses. A deduc-
tion allowed under § 172 for a net oper-
ating loss is not allocated or apportioned
to DPGR or gross income attributable to
DPGR.
(iv)Deductions not attributable to the
actual conduct of a trade or business.De-
ductions not attributable to the actual con-
duct of a trade or business are not allocated
or apportioned to DPGR or gross income
attributable to DPGR.See§ 199(d)(5). For
example, the standard deduction provided
by § 63(c) and the deduction for personal
exemptions provided by § 151 are not al-
located or apportioned to DPGR or gross
income attributable to DPGR.
(v)Deductions related to de minimis
gross receipts and embedded services
included in domestic production gross re-
ceipts. If a taxpayer is permitted to treat
non-DPGR as DPGR pursuant to a safe
harbor orde minimisrule provided in this
notice (e.g., section 4.03(2) or section
4.04(10)(d) of this notice), deductions re-
lated to such non-DPGR treated as DPGR
must be allocated or apportioned to DPGR
or gross income attributable to DPGR.
If the gross receipts related to embed-
ded services are included in DPGR under
section 4.04(7), the deductions related to
providing such services must be allocated
or apportioned to DPGR or gross income
attributable to DPGR.
(c)Section 861 method. (i) In gen-
eral. A taxpayer must allocate and ap-
portion its deductions using the allocation
and apportionment rules provided by the
§ 861 regulations, subject to the modifi-
cations provided in section 4.05(3)(b)(ii)
through (v) and section 4.05(3)(c)(ii) and
(iii) of this notice. Under this method,
§ 199 is treated as an “operative section”
described in § 1.861–8(f). Accordingly,
the taxpayer applies the rules of the § 861
regulations to allocate and apportion de-
ductions (including its distributive shares
of deductions) to gross income attributable
to DPGR. Generally, the taxpayer allocates
deductions to the relevant class of gross in-
come and apportions (if necessary) such
deductions within the class of gross in-
come between gross income attributable to
DPGR (the statutory grouping) and other
income (the residual grouping). The § 861
regulations generally are applied on a sin-
gle entity basis, although the rules are ap-
plied on the basis of the affiliated group (as
determined under the § 861 regulations)
for certain expenses such as interest ex-
pense and research and experimental ex-
penses. Consistent with these rules, alloca-
tion and apportionment of deductions gen-
erally are determined on an aggregate basis
by the owner of the pass-thru entity.See
for example, §§ 1.861–9T(e) and –17(f).
If the taxpayer uses the allocation and ap-
portionment rules of the § 861 regulations
for another operative section of the Code,
it must use the same method of allocation
and the same principles for apportionment
for purposes of all operative sections (sub-
ject to, in the case of the § 861 method,
the rules provided in section 4.05(3)(b)(ii)
through (v) and section 4.05(3)(c)(ii) and
(iii)ofthisnotice).See§ 1.861–8(f)(2)(i).
(ii)Deductions for charitable contribu-
tions. Deductions for charitable contribu-
tions (as allowed under §§ 170, 873(b)(2),
and 882(c)(1)(B)) must be ratably appor-
tioned between gross income attributable
to DPGR and other gross income based on
the relative amounts of gross income. For
individuals, this provision applies solely
to deductions for charitable contributions
that are attributable to the actual conduct
of a trade or business.
(iii)Research and experimental expen-
ditures. Research and experimental expen-
ditures must be allocated and apportioned
in accordance with § 1.861–17. Because
an apportionment based on geographic
sources is not required for purposes of
§ 199, the exclusive apportionment rule of
§ 1.861–17(b) does not apply for purposes
of the § 861 method.
(d)Simplified deduction method.A
taxpayer with average annual gross re-
ceipts (as defined in section 4.05(5) of
this notice) of $25,000,000 or less may
use the simplified deduction method.
Under the simplified deduction method,
except as provided in section 4.05(3)(b)
of this notice, a taxpayer’s deductions
are ratably apportioned between DPGR
and non-DPGR based on relative gross
receipts. Accordingly, the amount of de-
ductions apportioned to DPGR is equal
to the same proportion of the deductions
that the amount of DPGR bears to total
gross receipts. In the case of an owner of a
pass-thru entity, the simplified deduction
method (including whether the method
may be used) is applied at the level of
the owner of the pass-thru entity taking
into account the owner’s DPGR, receipts,
and other items from all sources including
its distributive or allocable share of those
items of the pass-thru entity.
(4)Small business simplified overall
method.(a)In general. A qualifying
small taxpayer may use the small business
simplified overall method to allocate and
apportion CGS and deductions between
DPGR and non-DPGR. Under the small
business simplified overall method, a tax-
payer’s total CGS and deductions (except
as provided in section 4.05(3)(b) of this
notice) are ratablyapportioned between
DPGR and other receipts based on relative
gross receipts. Accordingly, the amount
of CGS and deductions apportioned to
DPGR is equal to the same proportion of
CGS and deductions that the amount of
DPGR bears to total gross receipts.
(b)Qualifying small taxpayer.Forpur-
poses of section 4.05(4)(a) of this notice,
2005–7 I.R.B.522February 14, 2005

a qualifying small taxpayer is a taxpayer
that has average annual gross receipts (as
described in section 4.05(5) of this notice)
of $5,000,000 or less or a taxpayer that is
eligible to use the cash method as provided
in Rev. Proc. 2002–28, 2002–1 C.B. 815.
(That is, any taxpayer with average annual
gross receipts of $10,000,000 or less that is
not prohibited from using the cash method
under § 448, including a partnership, an S
corporation, a C corporation, or an individ-
ual.)
(5)Average annual gross receipts.
For purposes of the simplified deduction
method in section 4.05(3)(d) of this notice
and the small business simplified overall
method in section 4.05(4), average annual
gross receipts means the average annual
gross receipts of the taxpayer for the 3
taxable years (or, if fewer, the taxable
years during which the taxpayer was in
existence) preceding the current taxable
year, even if one or more of such taxable
years began before the effective date of
§ 199. In the case of any taxable year of
less than 12 months (a short taxable year),
the gross receipts shall be annualized by
(a) multiplying the gross receipts for the
shortperiodby12and(b)dividingthe
result by the number of months in the
short period. Whether the members of an
EAG may use the simplified deduction
method or the small business simplified
overall method is determined by reference
to the average annual gross receipts of
the EAG. To compute the average annual
gross receipts of an EAG, the gross re-
ceipts of each member of the EAG for its
taxable year that ends with or within the
taxable year of the computing member (as
defined in section 4.09(8) of this notice)
are aggregated, regardless of whether the
computing member or the non-computing
member was a member of the EAG during
its entire taxable year. A member of an
EAG that qualifies to use the simplified
deduction method or the small business
simplified overall method may do so only
if all members of the EAG agree to and
use the same method.
.06Application of § 199 to Pass-thru
Entities.(1)Allocations to partners,
shareholders, and similar interest hold-
ers.(a)Partnerships.(i)Determination at
partner level. The § 199 deduction is de-
termined at the partner level. As a result,
each partner must compute its deduc-
tion separately. Each partner is allocated,
in accordance with §§ 702 and 704, its
share of items (including items of income,
gain, loss, deduction, cost of goods sold
allocated to such items of income, and
gross receipts that are included in such
items of income) allocated or attributable
to the partnership’s activities described
in § 199(c)(4) (qualified production ac-
tivities), along with any other items of
income, gain, loss, deduction or credit of
the partnership. To determine its § 199
deduction for the taxable year, a partner
aggregates its share of the items allocated
or attributable to the partnership’s qual-
ified production activities, any expenses
incurred by the partner directly that are
allocated to the partnership’s qualified
production activities, and those items of
the partner that are allocated or attrib-
utable to qualified production activities
from sources other than the partnership. A
partnership may specially allocate items
of income, gain, loss, or deduction allo-
cated or attributable to the partnership’s
qualified production activities, subject to
the rules of § 1.704–1(b), including the
rules for determining substantial economic
effect under § 1.704–1(b)(2)(iii).
(ii)Expenses. Each partner must take
into account the partner’s distributive
share of expenses allocated to the quali-
fied production activities of the partner-
ship, regardless of whether the partnership
otherwise has taxable income. However,
expenses of a partnership that otherwise
would be taken into account for purposes
of computing the partner’s § 199 deduc-
tion shall only be taken into account if
and to the extent the partner’s distributive
share of the losses and deductions from
all of the partnership’s activities is not
disallowed by §§ 465, 469, 704(d), or any
other provision of the Code. In the event
that only a portion of the partner’s dis-
tributive share of the losses or deductions
are allowed for a taxable year, a propor-
tionate share of the losses or deductions
that reflect expenses allocated to the part-
nership’s qualified production activities,
determined in a manner consistent with
§§ 465, 469 and 704(d), shall be taken into
account for purposes of computing the
§ 199 deduction for that taxable year. To
the extent that any of the disallowed losses
or deductions are allowed in a later taxable
year, the partner shall take into account
a proportionate share of the expenses re-
flected in those losses or deductions in
computing its QPAI for that later taxable
year.
(iii)W–2 wages. Under § 199(d)(1)(B),
a partner’s share of W–2 wages of the part-
nership for purposes of determining the
partner’s § 199(b) limitation is the lesser of
the partner’s allocable share of the wages
(without regard to § 199(d)(1)(B)) as de-
termined under regulations prescribed by
the Secretary, or 2 times 9 percent (3 per-
cent in the case of taxable years beginning
in 2005 and 2006, and 6 percent in the
case of taxable years beginning in 2007,
2008, or 2009) of the QPAI computed tak-
ing into account only the items of the part-
nership allocated to the partner for the tax-
able year of the partnership. In determin-
ing a partner’s share of the W–2 wages of
a partnership, allocations by the partner-
ship of W–2 wages, otherwise meeting the
requirements of § 704(b), shall be taken
into account by the partner for purposes of
§ 199(d)(1)(B). Thus, a partner’s share of
W–2 wages of the partnership is the lesser
of the amount of W–2 wages allocated to
the partner under § 704, or 2 times the
applicable percentage of the QPAI com-
puted taking into account only the items of
the partnership allocated to the partner for
the taxable year of the partnership, deter-
mined at the partner level, in accordance
with section 4.06(1)(a)(i) and (ii), by ref-
erence to the partner’s distributive or al-
locable share of the partnership’s items of
income, gain, loss or deduction (including
gross receipts and costs of goods sold), al-
located or attributable to qualified produc-
tion activities, and expenses incurred di-
rectly by the partner which are allocated to
the partnership’s qualified production ac-
tivities, for the taxable year. Each partner
must aggregate the W–2 wages allocated
from the partnership with its W–2 wages
from other sources for purposes of com-
puting the partner’s § 199(b) limitation for
the taxable year. However, if QPAI com-
puted taking into account only the items of
the partnership allocated to the partner for
the taxable year is not greater than zero,
the partner may not take into account any
W–2 wages of the partnership for purposes
of computing the wage limitation under
§ 199(b) for the taxable year.
(b)S corporations.(i)Determination
at S corporation shareholder level.The
§ 199 deduction is determined at the share-
holder level. As a result, each shareholder
must compute its deduction separately.
February 14, 20055232005–7 I.R.B.

Each shareholder is allocated, in accor-
dance with § 1366, itspro ratashare of
items (including items of income, gain,
loss, and deduction) allocated or attribut-
able to the qualified production activities
of the S corporation. To the extent that
such items represent items relevant to
the computation of the § 199 deduction
(for example, DPGR, CGS, other items
allocable to DPGR, or W–2 wages of the
S corporation), the shareholder will take
such items into account in computing its
§ 199 deduction. To compute its § 199
deduction for the taxable year, the share-
holder will aggregate itspro ratashare of
items allocated or attributable to the S cor-
poration’s qualified production activities,
and those items of the shareholder that
are allocated or attributable to qualified
production activities from sources other
than the S corporation.
(ii)Expenses. Each shareholder must
take into account itspro ratashare of ex-
penses allocated to the qualified produc-
tion activities of the S corporation, regard-
less of whether the S corporation other-
wise has taxable income. However, ex-
penses of the S corporation that otherwise
would be taken into account for purposes
of computing the shareholder’s § 199 de-
duction shall only be taken into account if
and to the extent the shareholder’spro rata
share of the losses or deductions from all of
the S corporation’s activities are not dis-
allowed by §§ 465, 469, 1366(d), or any
other provision of the Code. In the event
that only a portion of the shareholder’s
pro ratashare of the losses or deductions
is allowed for a taxable year, a propor-
tionate share of the losses or deductions
that reflect expenses allocated to the S cor-
poration’s qualified production activities,
determined in a manner consistent with
§§ 465, 469, and 1366(d), shall be taken
into account for purposes of computing the
§ 199 deduction for that taxable year. To
the extent that any of the disallowed losses
or deductions are allowed in a later tax-
able year, the shareholder shall take into
account a proportionate share of the ex-
penses reflected in those losses or deduc-
tions in computing its QPAI for that later
taxable year.
(iii)W–2 wages. Under § 199(d)(1)(B),
an S corporation shareholder’s share of
W–2 wages of the S corporation for pur-
poses of determining the shareholder’s
§ 199(b) limitation is the lesser of the
shareholder’s allocable share of the wages
(without regard to § 199(d)(1)(B)) as de-
termined under regulations prescribed by
the Secretary, or 2 times 9 percent (3 per-
cent in the case of taxable years beginning
in 2005 and 2006, and 6 percent in the case
of taxable years beginning in 2007, 2008,
or 2009) of the QPAI computed taking
into account only the items of the S cor-
poration allocated to the shareholder for
the taxable year. Each shareholder must
aggregate the W–2 wages allocated from
the S corporation with its W–2 wages from
other sources for purposes of computing
its § 199(b) limitation for the taxable year.
However, if the shareholder is not allo-
cated positive QPAI computed taking into
account only the items of the S corporation
allocated to the shareholder for the taxable
year, the shareholder may not take into
account any W–2 wages of the S corpora-
tion for purposes of computing the wage
limitation under § 199(b) for the taxable
year.
(2)Gain or loss from the disposition of
an interest in a pass-thru entity.QPAIgen-
erally does not include gain or loss recog-
nized on the sale, exchange, or other dis-
position of an interest in the entity. How-
ever, if § 751(a) or (b) applies, gain or
loss allocable to assets of the partnership
the sale, exchange, or other disposition of
which would give rise to QPAI is taken into
account in computing the partner’s § 199
deduction.
(3)Effective date of § 199 for pass-thru
entities. Section 199(e) provides that § 199
applies for taxable years beginning on or
after January 1, 2005. Accordingly, § 199
does not apply to taxable years of pass-thru
entities that begin before January 1, 2005.
For example, assume a pass-thru entity has
a taxable year beginning July 1, 2004, and
ending June 30, 2005, and the owners of
the pass-thru entity have taxable years be-
ginning January 1, 2005, and ending De-
cember 31, 2005. The provisions of § 199
do not apply to the pass-thru entity until
the first date of its first taxable year begin-
ning on or after January 1, 2005. Thus,
§ 199 applies to the pass-thru entity for
its taxable year beginning July 1, 2005.
The owners of the pass-thru entity include
their allocable orpro ratashare of items
allocated or attributable to the qualified
production activities of the pass-thru en-
tity, for purposes of determining their re-
spective § 199 deductions for their taxable
years ending December 31, 2006.
.07Patrons of Agricultural and Horti-
cultural Cooperatives. Section 199(d)(3)
and this section 4.07 apply in the case of a
cooperative (to which Part I of Subchapter
T applies), that is engaged in (1) the MPGE
in whole or in significant part of any agri-
cultural or horticultural product, or (2) the
marketing of agricultural or horticultural
products. Under § 199(d)(3) and this sec-
tion, if any amount of a patronage dividend
or qualified per-unit retain allocation paid
in qualified per-unit retain certificates de-
scribed in § 1385 is received by a patron
from such a cooperative, and such amount
is allocable to QPAI of the cooperative that
is deductible under § 199(a) and section
4.01 of this notice by the cooperative, then
the amount is deductible from the gross in-
come of the patron. Such an amount, how-
ever, does not reduce the taxable income of
the cooperative under § 1382. In order for
the member to qualify for the deduction,
§ 199(d)(3)(A)(ii) requires the cooperative
to designate the patron’s portion of the in-
come allocable to QPAI of the organization
in a written notice mailed by the coopera-
tive to its patron during the payment period
described in § 1382(d) (that is, no later than
the 15th day of the ninth month following
the close of the taxable year). In determin-
ing the portion of the cooperative’s QPAI
that would be deductible by the coopera-
tive under § 199(a) and section 4.01, the
cooperative’s taxable income is computed
without taking into account any deduction
allowable under § 1382(b) or (c) relating
to patronage dividends, per-unit retain al-
locations, and nonpatronage distributions
and, in the case of a cooperative engaged
in the marketing of agricultural and horti-
cultural products, the cooperative is treated
as having MPGE in whole or in significant
part any QPP marketed by the cooperative
that its patrons have MPGE. For purposes
of § 199, agricultural or horticultural prod-
ucts also include fertilizer, diesel fuel and
other supplies used in agricultural or horti-
cultural production that are MPGE by the
cooperative.
.08Individuals. In the case of individ-
uals, § 199(d)(2) provides that the deduc-
tion is equal to the applicable percent of the
lesserofthetaxpayer’s(1)QPAIforthe
taxable year, or (2) adjusted gross income
(AGI) for the taxable year determined after
2005–7 I.R.B.524February 14, 2005

applying §§ 86, 135, 137, 219, 221, 222,
and469,andwithoutregardto§199.
.09Expanded Affiliated Groups.(1)
In general. All members of an EAG are
treated as a single corporation for purposes
of § 199. An EAG is an affiliated group
as defined in § 1504(a), determined by
substituting “50 percent” for “80 percent”
each place it appears, and without regard
to § 1504(b)(2) and (4).
(2)Computation of expanded affiliated
group’s § 199 deduction.(a)In general.
The § 199 deduction for an EAG is de-
termined by aggregating each member’s
taxable income or loss, QPAI, and W–2
wages. For this purpose, a member’s QPAI
is the member’s DPGR less the sum of the
CGS allocable to such receipts and other
costs required to be allocated under sec-
tion 4.05 of this notice. For purposes of
this determination, a member’s QPAI may
be positive or negative. A member’s tax-
able income or loss and QPAI shall be
determined by reference to the member’s
method of accounting.
(b)Attribution of activities. Each mem-
ber of an EAG is treated as conducting the
activities conducted by each other mem-
ber of the EAG. For example, Corpora-
tion A and Corporation B are members of
thesameEAGbutdonotfileaconsoli-
dated return. A is engaged solely in the
trade or business of manufacturing QPP in
the United States. B is a reseller of the
QPP manufactured by A. Without regard
to the activities conducted by A, B would
not qualify for the § 199 deduction. How-
ever, because B is a member of the EAG
that includes A, B is treated as conducting
A’s manufacturing activities. Accordingly,
B’s gross receipts attributable to its sale of
the QPP it purchases from A are DPGR
(assuming all other requirements of § 199
are met).
(c)Anti-avoidance rule. If a transaction
between members of an EAG is engaged
in or structured with a principle purpose
of qualifying for, or modifying the amount
of, the § 199 deduction for one or more
members of the EAG, adjustments must be
made to eliminate the effect of the transac-
tion on the computation of the § 199 de-
duction.
(3)Allocation of expanded affiliated
group’s § 199 deduction.TheEAG’s
§ 199 deduction is allocated among mem-
bers of the EAG in proportion to each
member’s QPAI, if any, regardless of
whether the EAG member has taxable
income or loss for the taxable year and
regardless of whether the EAG member
has W–2 wages. For this purpose, if a
member has negative QPAI, the QPAI of
the member shall be treated as zero.
(4)Special rules for consolidated
groups. For purposes of § 199, a con-
solidated group is treated as a single mem-
ber of the EAG. Therefore, if an EAG
includes corporations that are members
of a consolidated group and corporations
that are not members of a consolidated
group, in computing the taxable income
limitation of the EAG, the consolidated
taxable income of the consolidated group,
not the separate taxable income of the
members of the consolidated group, is
taken into account. If all of the members
of an EAG are members of the same con-
solidated group, the consolidated group’s
§ 199 deduction is determined based on
the group’s consolidated taxable income
or loss, not the separate taxable income or
loss of its members. The § 199 deduction
of a consolidated group (or the § 199 de-
duction allocated to a consolidated group
thatisamemberofanEAG)mustbeallo-
cated to the members of the consolidated
group in proportion to each consolidated
group member’s QPAI, if any, regardless
of whether the consolidated group member
has separate taxable income or loss for the
taxable year and regardless of whether the
member has W–2 wages for the taxable
year. For purposes of allocating the § 199
deduction of a consolidated group among
its members, if a consolidated group mem-
ber has negative QPAI, the QPAI of the
member shall be treated as zero.
(5)Identification of members of the ex-
panded affiliated group. A corporation
must determine whether it is a member of
an EAG on a daily basis. If a corporation
becomes or ceases to be a member of an
EAG, the corporation is treated as becom-
ing or ceasing to be a member of the EAG
at the end of the day on which its status as
a member changes.
(6)Allocation of income and loss.(a)
In general. A corporation that is a mem-
ber of an EAG for only a portion of its tax-
able year must allocate its taxable income
or loss, QPAI, and W–2 wages between the
portion of the taxable year during which it
is a member of the EAG and the portion
of the taxable year during which it is not
a member of the EAG. In general, this al-
location of items must be made by using
thepro rataallocation method described in
section 4.09(6)(a)(i) of this notice. How-
ever, the corporation may elect to use the
closing of the books method described in
section 4.09(6)(a)(ii).
(i)Pro rata allocation method. Under
thepro rataallocation method, an equal
portion of each of the taxable income or
loss, QPAI, and W–2 wages for the taxable
year is assigned to each day of the corpora-
tion’s taxable year. Then, those items as-
signed to those days during which the cor-
poration was a member of the EAG are ag-
gregated.
(ii)Closing of the books method. Under
the closing of the books method, taxable
income or loss, QPAI, and W–2 wages for
the period during which the corporation
was a member of the EAG are computed
by treating the corporation’s taxable year
as two separate taxable years, the first of
which ends at the close of the day on which
the corporation’s status as a member of
the EAG changes and the second of which
begins at the beginning of the day after
the corporation’s status as a member of the
EAG changes.
(iii)Making the § 199 closing of the
books election. A corporation makes the
§ 199 closing of the books election by
making the following statement: “The
§ 199 closing of the books election is
hereby made with respect to [insert name
of corporation and itsemployer identifica-
tion number] with respect to the following
periods [insert dates of two periods be-
tween which items are allocated pursuant
to the closing of the books method].” The
statement must be filed with the corpora-
tion’s timely filed (including extensions)
federal income tax return for the taxable
year that includes the periods that are
subject to the election. Once made, an
election under this section 4.09(6)(a)(iii)
is irrevocable.
(b)Coordination with rules relat-
ing to the allocation of income under
§ 1.1502–76(b). If § 1.1502–76 (relating
to the taxable year of members of a consol-
idated group) applies to a corporation that
is a member of an EAG, any allocation of
items required under this section 4.09(6) is
made only after the allocation of the cor-
poration’s items pursuant to § 1.1502–76.
(7)Total § 199 deduction for a corpo-
ration that is a member of an expanded af-
filiated group for some or all of its taxable
February 14, 20055252005–7 I.R.B.

year. If a corporation is a member of an
EAG for its entire taxable year, the cor-
poration’s § 199 deduction for the taxable
year is the amount of the § 199 deduction
allocated to the corporation by the EAG. If
a corporation is a member of an EAG for a
portion of its taxable year, and is either not
amemberofanyEAG,orisamemberof
another EAG, or both, for another portion
of the taxable year, the corporation’s § 199
deduction for the taxable year is the sum
of its § 199 deductions for each portion of
the taxable year. For example, Corpora-
tions X and Y, calendar year corporations,
are members of the same EAG for the en-
tire 2005 taxable year. Corporation Z, also
a calendar year corporation, is a member of
the EAG, of which X and Y are members,
for the first half of 2005 and not a member
of any EAG for the second half of 2005.
During the 2005 taxable year, Z does not
join in the filing of a consolidated return.
Z makes a § 199 closing of the books elec-
tion. As a result, Z has $100 of QPAI and
$80 of taxable income that is allocated to
the first half of the taxable year, and ($200)
of QPAI and a $150 taxable loss that is al-
located to the second half of the taxable
year. Taking into account Z’s QPAI and
taxable income allocated to the first half
of the taxable year pursuant to the § 199
closing of the books election, the EAG has
positive QPAI and taxable income for the
taxable year and W–2 wages in excess of
the § 199(b) wage limitation. Because the
EAG has both positive QPAI and taxable
income and sufficient W–2 wages, and be-
cause Z has positive QPAI for the first half
of the year, a portion of the EAG’s § 199
deduction is allocated to Z. Z is allowed no
§ 199 deduction for the second half of the
taxable year. Thus, despite the fact that Z
has ($100) of QPAI and a $70 taxable loss
for the entire 2005 taxable year, Z is still
entitledtoa§199deductionforthetaxable
year equal to the § 199 deduction allocated
to Z as a member of the EAG.
(8)Computation of § 199 deduction for
members of expanded affiliated group with
different taxable years. If members of an
EAG have different taxable years, in de-
termining the § 199 deduction of a member
(the “computing member”), with respect to
each group member, the computing mem-
ber is required to take into account the tax-
able income or loss, QPAI, and W–2 wages
that are both (1) attributable to the period
during which the member of the EAG and
the computing member are both members
of the EAG and (2) taken into account in
a taxable year that begins after the effec-
tive date of § 199 and ends with or within
the taxable year of the computing member
with respect to which the § 199 deduction
is computed.
.10Trade or Business Requirement.
Section 199(d)(5) provides that § 199 is
applied by taking into account only items
that are attributable to the actual conduct
of a trade or business.
.11Coordination with Alternative Mini-
mum Tax. Section 199(d)(6) provides rules
to coordinate the deduction allowed under
§ 199 with the AMT imposed by § 55. The
deduction is allowed for purposes of the
AMT, except that the deduction is equal to
the applicable percent of the lesser of the
taxpayer’s: (1) QPAI, determined with-
out regard to subchapter A, Part IV, of
the Code; or (2) AMTI (determined with-
out regard to § 199), for the taxable year.
For purposes of the preceding sentence, in
the case of an individual, AGI (determined
without regard to § 199) shall be substi-
tuted for AMTI.
.12Special rules.(1)Certain non-
recognition transactions. Except as pro-
videdinsection4.09ofthenotice(the
rules applicable to EAGs), if property is
transferredbythetaxpayertoanentityina
transaction to which § 351 or 721 applies,
then whether the gross receipts derived
by the entity are DPGR shall be deter-
mined based on the activities performed
by the entity without regard to the activi-
ties performed by the taxpayer prior to the
contribution of the property to the entity.
(2)Section 1031 exchanges.Ifatax-
payer exchanges property for replacement
property in a transaction to which § 1031
applies, then whether the gross receipts de-
rived from the lease, rental, license, sale,
exchange, or other disposition of the re-
placement property are DPGR shall be de-
termined based solely on the activities per-
formed by the taxpayer.
(3)Section 381 transactions.Ifacorpo-
ration (the acquiring corporation) acquires
the assets of another corporation (the tar-
get corporation) in a transaction to which
§ 381(a) applies, the acquiring corporation
shall be treated as performing those ac-
tivities of the target corporation with re-
spect to the acquired assets of the target
corporation. Therefore, to the extent that
the acquired assets of the target corpora-
tion would have given rise to DPGR if
leased, rented, licensed, sold, exchanged,
or otherwise disposed of by the target cor-
poration, then the assets will give rise to
DPGR if leased, rented, licensed, sold, ex-
changed, or otherwise disposed of by the
acquiring corporation (assuming all other
requirements of § 199(c) are met).
(4)Taxpayers with a 52–53 week tax-
able year. For purposes of applying
§ 1.441–2(c)(1) in the case of a taxpayer
using a 52–53 week taxable year, any ref-
erence in § 199(a)(2) (the phase-in rule)
to a taxable year “beginning after” a par-
ticular calendar year means a taxable year
beginning after December 31st of that
year. Similarly, any reference to a taxable
year “beginning in” a particular calendar
year means a taxable year beginning after
December 31st of the preceding calendar
year. For example, a 52–53 week taxable
year that begins on December 26, 2004, is
deemed to begin on January 1, 2005, and
the transition percentage for that taxable
year is 3 percent.
SECTION 5. EFFECTIVE DATE
This notice applies to taxable years be-
ginning after December 31, 2004.
SECTION 6. REQUEST FOR
COMMENTS
.01In General. The Service and Trea-
sury Department invite taxpayers to sub-
mit written comments on issues relating to
§ 199 and this notice. In particular, the Ser-
vice and Treasury Department encourage
taxpayers to submit written comments on
the following issues:
(1) The Service and Treasury Depart-
ment are aware that several provisions of
the Code and regulations require computa-
tions based upon taxable income, and that
there is confusion concerning the order in
which these provisions are to be applied.
Taxpayers are invited to submit a list of
all provisions of the Code, regulations, and
other administrative guidance (if any) that
require computations based upon taxable
income, and the order in which taxpayers
believe they should be applied;
(2) The Service and Treasury Depart-
ment are concerned that there may be situ-
ations in which a contractor does not bear
the benefits and burdens of ownership with
respect to property (for example, for se-
curity reasons), but nevertheless should
2005–7 I.R.B.526February 14, 2005

be regarded as satisfying the “by the tax-
payer” requirement of § 199(c)(4)(A)(i).
Taxpayers are invited to submit comments
on such situations;
(3) The Service and Treasury Depart-
ment request comments on the application
of §199 to trusts and estates. In partic-
ular, comments are requested on whether
the apportionment of distributable net in-
come between the trust and estate and its
beneficiaries should govern the determina-
tion of the §199 deduction for the taxable
year, what rules should apply if there is
no distributable net income for the taxable
year, how these rules should be applied
to split-interest trusts, and the information
reporting requirements that should be im-
posed on the trust or estate and its ben-
eficiaries. Comments are also requested
ontheapplicationof§199topass-thruen-
tities other than partnerships, S corpora-
tions, trusts and estates;
(4) The Service and Treasury Depart-
ment request comments on whether tax-
payers should be able to change any allo-
cation or apportionment method of gross
receipts or deductions on an amended re-
turn and whether there should be restric-
tions on a taxpayer’s ability to change from
one method to another;
(5) The Service and Treasury Depart-
ment request comments on whether addi-
tional modifications or clarifications to the
§ 861 method would be appropriate, in-
cluding modifications relating to the deter-
mination of the “affiliated group” for pur-
poses of allocating and apportioning ex-
penses that are allocated and apportioned
on an affiliated group basis;
(6) The Service and Treasury Depart-
ment request comments regarding whether
members of an EAG should be required
to use the same method of allocating
and apportioning deductions to DPGR. If
members of an EAG were to be able to
use different methods of allocating and
apportioning deductions, the Service and
Treasury Department request comments
regarding whether a member’s ability to
use the simplified deduction method or the
small business simplified overall method
shoulddependontheaverage annual gross
receipts of that member alone or the ag-
gregate average annual gross receipts of
all members of the EAG;
(7) The Service and Treasury Depart-
ment request comments related to the ap-
plication of § 199 to computer software;
and
(8) The Service and Treasury Depart-
ment invite comments on the appropri-
ateness of the $25,000,000 gross receipts
threshold for use of the simplified deduc-
tion method.
.02Addresses for Comments.Send
submissions to: CC:PA:LPD:PR (Notice
2005–14), room 5203, Internal Revenue
Service, PO Box 7604, Ben Franklin
Station, Washington, DC 20044. Sub-
missions may be hand-delivered Monday
through Friday between the hours of
8 a.m. and 4 p.m. to CC:PA:LPD:PR (No-
tice 2005–14), Courier’s Desk, Internal
Revenue Service, 1111 Constitution Av-
enue, NW, Washington, DC. Submissions
may also be sent electronically via the
Internet to the following e-mail address:
Notice.comments@irscounsel.treas.gov.
Include the notice number (Notice
2005–14) in the subject line.
.03Deadline for Submission of Com-
ments. Comments must be received on or
before March 31, 2005.
SECTION 7. DRAFTING
INFORMATION
The principal authors of this notice are
Paul Handleman and Lauren Ross Taylor
of the Office of Associate Chief Counsel
(Passthroughs and Special Industries). For
further information regarding this notice,
contact Mr. Handleman or Ms. Taylor at
(202) 622–3040 (not a toll-free call). For
further information regarding the applica-
tion of § 199 to pass-through entities, con-
tact James Quinn of the Office of Associate
Chief Counsel (Passthroughs and Special
Industries) at (202) 622–3080; regard-
ing the determination of costs generally,
contact Scott Rabinowitz of the Office of
Associate Chief Counsel (Income Tax and
Accounting) at (202) 622–4970; regard-
ing the cost allocation rules under § 861,
contact Bethany Ingwalson of the Office
of Associate Chief Counsel (International)
at (202) 622–3850; regarding expanded
affiliated groups, contact Lisa Fuller of
the Office of Associate Chief Counsel
(Corporate) at (202) 622–7750; or regard-
ing the definition of W–2 wages, contact
Alfred Kelley of the Office of Associate
Chief Counsel (Tax Exempt and Gov-
ernment Entities) at (202) 622–6040 (not
toll-free calls).
Partnership Anti-Mixing Bowl
Regulations
Notice 2005–15
The Internal Revenue Service intends to
promulgate regulations under §§ 704 and
737 of the Internal Revenue Code to ad-
dress the income tax consequences of dis-
tributions of property following partner-
ship mergers.
BACKGROUND
Rev. Rul. 2004–43, 2004–18 I.R.B.
842, holds that new § 704(c) gain or loss
is created when assets are contributed by
the transferor partnership to the con-
tinuing partnership in an assets-over
merger. Rev. Rul. 2004–43 also holds
that § 704(c)(1)(B) applies to the newly
created § 704(c) gain or loss in property
contributed by the transferor partnership
to the continuing partnership in an as-
sets-over partnership merger, but does not
apply to reverse § 704(c) gain or loss re-
sulting from a revaluation of property in
the continuing partnership. In addition,
Rev. Rul. 2004–43 holds that for purposes
of § 737(b), net precontribution gain in-
cludes the newly created § 704(c) gain or
loss in property contributed by the trans-
feror partnership to the continuing partner-
ship in an assets-over partnership merger,
but does not include reverse § 704(c) gain
or loss resulting from a revaluation of
property in the continuing partnership.
Some commentators have argued
that Rev. Rul. 2004–43 is not consis-
tent with the current regulations under
§§ 704(c)(1)(B) and 737, and that the con-
clusions in the ruling should not be applied
retroactively. In response to these com-
ments, the Treasury Department and the
Service intend to issue regulations under
§§ 704(c)(1)(B) and 737 implementing the
principles of the ruling. The regulations
will be effective fordistributions occur-
ring after January 19, 2005. Rev. Rul.
2005–10, published in this issue of the
Internal Revenue Bulletin, revokes Rev.
Rul. 2004–43.
February 14, 20055272005–7 I.R.B.

DESCRIPTION OF REGULATIONS
The regulations will apply the princi-
ples of Rev. Rul. 2004–43 to distributions
of property following assets-over partner-
ship mergers. The regulations will ap-
ply to distributions of property with newly
created § 704(c) gain or loss whether or
not that gain or loss is treated as reverse
§ 704(c) gain or loss as the result of a
revaluation by the transferor partnership.
The regulations also will apply to distri-
butions of property with original § 704(c)
gain or loss that existed upon contribution
to the transferor partnership. However, the
regulations will provide that if the trans-
feror partnership in an assets-over merger
holds contributed property with original
§ 704(c) gain or loss, the seven year pe-
riods in §§ 704(c)(1)(B) and 737 do not
restart with respect to that gain or loss as
a result of the merger.
The regulations will provide that
§ 704(c)(1)(B) does not apply to newly
created § 704(c) gain or loss in property
contributed by the transferor partnership
to the continuing partnership in an as-
sets-over partnership merger involving
partnerships owned by the same owners
in the same proportions. In addition, the
regulations will provide that for purposes
of § 737, net precontribution gain does not
include newly created § 704(c) gain or loss
in property contributedbythetransferor
partnership to the continuing partnership
in an assets-over partnership merger in-
volving partnerships owned by the same
owners in the same proportions. In order
for merging partnerships to qualify for the
exceptions described in this paragraph,
each partner’s percentage interest in the
transferor partnership’s capital, profits,
losses, distributions, liabilities, and all
other items must be the same as the part-
ner’s percentage interest in those items of
the continuing partnership.
EFFECTIVE DATES
The regulations will be effective for
distributions from partnerships made after
January 19, 2005.
REQUEST FOR COMMENTS
Comments are requested regarding
whether there are any other commonly
owned partnerships that should be ex-
cepted from the principles of Rev. Rul.
2004–43, and, if so, under what circum-
stances the exceptions should apply. Com-
ments are specifically requested regarding
the application of §§ 704(c)(1)(B) and
737, including the previously contributed
property exception of § 737(d)(1), to a dis-
tribution of property, after an assets-over
partnership merger, to a partner who had
been a partner in the transferor partner-
ship, where the distributed property was
held by the transferor partnership prior to
the merger. Comments are also requested
regarding whether the continuing partner-
ship may apply a § 704(c) method to orig-
inal § 704(c) gain or loss that is different
than the method applied by the transferor
partnership, and whether the continuing
partnership may apply a § 704(c) method
to newly created § 704(c) gain or loss that
is different than the method that it applies
to original § 704(c) gain or loss.
Comments are also requested regard-
ing whether there are any additional issues
that should be addressed in the regulations.
For example, comments are requested re-
garding whether the regulations should
apply the principles of §§ 704(c)(1)(B)
and 737 to reverse section 704(c) gain or
loss. Comments are also requested regard-
ing whether the tiered partnership rule of
§ 1.704–3(a)(9) of the Income Tax Regu-
lations should be modified or expanded to
provide rules, similar to those applicable
to assets-over partnership mergers, for the
application of §§ 704(c)(1)(B) and 737, as
well as § 704(c)(1)(A), to tiered partner-
ship arrangements.
Commentsmaybesubmittedonor
before July 19, 2005, to Internal Revenue
Service, PO Box 7604, Washington, DC
20044, Attn: CC:PA:LPD:PR (Notice
2005–15), Room 5203. Submissions may
also be hand-delivered Monday through
Friday between the hours of 8 a.m. and
4 p.m. to the Courier’s Desk at 1111
Constitution Avenue, NW, Washington
DC 20224, Attn: CC:PA:LPD:PR (No-
tice 2005–15), Room 5203. Submissions
may also be sent electronically via the
internet to the following email address:
Notice.comments@irscounsel.treas.gov.
Include the notice number (Notice
2005–15) in the subject line.
The principal author of this notice is
Laura Fields of the Office of Associate
Chief Counsel (Passthroughs & Special In-
dustries). For furtherinformation regard-
ing this notice, contact Ms. Fields at (202)
622–3050 (not a toll-free call).
26 CFR 601.105: Examination of returns and claims
for refund, credit, or abatement; determination of
correct tax liability.
(Also Part 1, §§ 121, 1031; 1.121–1, 1.1031(a)–1.)
Rev. Proc. 2005–14
SECTION 1. PURPOSE
This revenue procedure provides guid-
ance on the application of §§ 121 and 1031
of the Internal Revenue Code to a single
exchange of property.
SECTION 2. BACKGROUND
.01 Section 121(a) provides that a tax-
payer may exclude gain realized on the
sale or exchange of property if the property
was owned and used as the taxpayer’s prin-
cipal residence for at least 2 years during
the 5-year period ending on the date of the
sale or exchange. Section 121(b) provides
generally that the amount of the exclu-
sion is limited to $250,000 ($500,000 for
certain joint returns). Under § 121(d)(6),
any gain attributable to depreciation ad-
justments (as defined in § 1250(b)(3)) for
periods after May 6, 1997, is not eligible
for the exclusion. This limitation applies
only to depreciation allocable to the por-
tion of the property to which the § 121 ex-
clusion applies. See § 121–1(d)(1).
.02 Section 121(d), as amended by
§ 840 of the American Jobs Creation Act
of 2004, Pub. L. 108–357, provides that,
ifataxpayeracquiredpropertyinanex-
change to which § 1031 applied, the § 121
exclusion will not apply if the sale or ex-
change of the property occurs during the
5-year period beginning on the date of the
acquisition of the property. This provision
is effective for sales or exchanges after
October 22, 2004.
.03 Under § 1.121–1(e) of the Income
Tax Regulations, a taxpayer who uses a
portion of a property for residential pur-
poses and a portion of the property for
business purposes is treated as using the
entire property as thetaxpayer’s princi-
pal residence for purposes of satisfying the
2-year use requirement if the residential
and business portions of the property are
within the same dwelling unit. The term
“dwelling unit” has the same meaning as
2005–7 I.R.B.528February 14, 2005

in § 280A(f)(1), but does not include ap-
purtenant structures or other property. If,
however, the business portion of the prop-
erty is separate from the dwelling unit used
for residential purposes, the gain alloca-
ble to the business portion of the property
is not excludable unless the taxpayer has
also met the 2-year use requirement for the
business portion of the property.
.04 Section 1.121–1(e)(3) provides
that, for purposes of determining the
amount of gain allocable to the residential
and business portions of the property, the
taxpayer must allocate the basis and the
amount realized using the same method
of allocation the taxpayer used to deter-
mine depreciation adjustments (as defined
in § 1250(b)(3)). Allocation based on
the square footage of the residential and
business portions of the property is an
appropriate method of allocating the basis
and the amount realized.Poague v. United
States, 66 A.F.T.R.2d (RIA) 5825 (E.D.
Va. 1990),aff’d, 947 F.2d 942 (4th Cir.
1991).
.05 Section 1031(a) provides that no
gain or loss is recognized on the exchange
of property held for productive use in a
trade or business or for investment (re-
linquished property) if the property is ex-
changed solely for property of like kind
(replacement property) that is to be held ei-
ther for productive use in a trade or busi-
ness or for investment. Under § 1031(b),
if a taxpayer also receives cash or prop-
erty that is not like-kind property (boot) in
an exchange that otherwise qualifies un-
der § 1031(a), the taxpayer must recog-
nize gain to the extent of the boot. Section
1031 does not apply to property that is used
solely as a personal residence.
.06 Section 1012 provides that the ba-
sis of property is its cost. The basis of
property acquired in an exchange is its fair
market value, unless otherwise provided
in the Code or regulations (for example,
§ 1031(d)). SeePhiladelphia Park Amuse-
mentCo.v.UnitedStates, 126 F. Supp.
184 (Ct. Cl. 1954).
.07 Under § 1031(d), the basis of the re-
placement property is the same as the basis
of the relinquished property, decreased by
the amount of cash received and increased
by the amount of gain recognized by the
taxpayer in the exchange.
.08 Neither § 121 nor § 1031 addresses
the application of both provisions to a
single exchange of property. Section
121(d)(5)(B), however, provides rules for
applying § 121 and another nonrecognition
provision, § 1033, toa single replacement
of property. Under § 1033, in general, gain
is recognized only to the extent the amount
realized from a compulsory or involuntary
conversion of property exceeds the cost
of qualifying replacement property, and
the basis of the replacement property is its
cost reduced by the amount of the gain not
recognized.
.09 Section 121(d)(5)(B) provides that,
in applying § 1033, the amount realized
from the sale or exchange of property is
treated as the amount determined without
regard to § 121, reduced by the amount
of gain excluded under § 121. Under
§ 121(d)(5)(B), the amount realized from
an exchange of a taxpayer’s principal res-
idence for purposes of applying § 1033 is
the fair market value of the relinquished
property reduced by the amount of the
gain excluded from gross income under
§ 121. Thus, Congress concluded that
for exchanges meeting the requirements
of both § 121 and § 1033, (1) the § 121
exclusion should be applied to gain from
the exchange before the application of
§ 1033, (2) for purposes of determining
gain that may be deferred under § 1033,
the § 121 exclusion should be applied first
against amounts received by the taxpayer
that are not reinvested in the replacement
property (amounts equivalent to boot that
would result in gain recognition absent
the application of § 121), and (3) the gain
excluded under § 121 should be added in
the calculation of the taxpayer’s basis in
the replacement property. See S. Rep. No.
830, 88
th
Cong., 2d Sess. 52–53, 1964–1
C.B. (Part 2) 505, 556–7 (“the basis of the
taxpayer in the newly acquired residence
will be his basis for the old residence in-
creased by any exclusion of gain obtained
by him under the provision which is rein-
vested in the new residence”); H.R. Rep.
No. 749, 88
th
Cong., 1
st
Sess. 47, 1964–1
C.B. (Part 2) 125, 171.
SECTION 3. SCOPE
This revenue procedure applies to tax-
payers who exchange property that satis-
fies the requirements for both the exclu-
sion of gain from the exchange of a prin-
cipal residence under § 121 and the non-
recognition of gain on the exchange of
like-kind properties under § 1031. Thus,
this revenue procedure applies only to tax-
payers who satisfy the held for productive
use in a trade or business or for investment
requirement of § 1031(a)(1) with respect to
the relinquished business property and the
replacement business property (as defined
below).
SECTION 4. APPLICATION
.01In general. Taxpayers within the
scope of this revenue procedure may ap-
ply both the exclusion of gain from the
exchange of a principal residence under
§ 121 and the nonrecognition of gain from
the exchange of like-kind properties under
§1031toanexchangeofpropertybyap-
plying the procedures set forth in this sec-
tion 4.
.02Computation of gain.
(1)Application of § 121 before § 1031.
Section 121 must be applied to gain real-
ized before applying § 1031.
(2)Application of § 1031 to gain attrib-
utable to depreciation. Under § 121(d)(6),
the § 121 exclusion does not apply to gain
attributable to depreciation deductions for
periods after May 6, 1997, claimed with re-
spect to the business or investment portion
of a residence. However, § 1031 may ap-
ply to such gain.
(3)Treatment of boot.Inapply-
ing § 1031, cash or other non-like kind
property (boot) received in exchange for
property used in the taxpayer’s trade or
business or held for investment (the relin-
quished business property), is taken into
account only to the extent the boot exceeds
the gain excluded under § 121 with respect
to the relinquished business property.
.03Computation of basis. In determin-
ing the basis of the property received in
the exchange to be used in the taxpayer’s
trade or business or held for investment
(the replacement business property), any
gain excluded under § 121 is treated as
gain recognized by the taxpayer. Thus,
under § 1031(d), the basis of the replace-
ment business property is increased by any
gain attributable to the relinquished busi-
ness property that is excluded under § 121.
SECTION 5. EXAMPLES
In each example below, the taxpayer
is an unmarried individual and the prop-
erty or a portion of the property has been
used in the taxpayer’s trade or business or
February 14, 20055292005–7 I.R.B.

held for investment within the meaning of
§ 1031(a) as well as used as a principal res-
idence as required under § 121.
Example 1. (i) Taxpayer A buys a house for
$210,000 that A uses as A’s principal residence from
2000 to 2004. From 2004 until 2006, A rents the
house to tenants and claims depreciation deductions
of $20,000. In 2006, A exchanges the house for
$10,000 of cash and a townhouse with a fair market
value of $460,000 that A intends to rent to tenants.
A realizes gain of $280,000 on the exchange.
(ii) A’s exchange of a principal residence that A
rents for less than 3 years for a townhouse intended
for rental and cash satisfies the requirements of both
§§ 121 and 1031. Section 121 does not require the
property to be the taxpayer’s principal residence on
the sale or exchange date. Because A owns and uses
the house as A’s principal residence for at least 2 years
during the 5-year period prior to the exchange, A may
exclude gain under § 121. Because the house is in-
vestment property at the time of the exchange, A may
defer gain under § 1031.
(iii) Under section 4.02(1) of this revenue pro-
cedure, A applies § 121 to exclude $250,000 of the
$280,000 gain before applying the nonrecognition
rules of § 1031. A may defer the remaining gain
of $30,000, including the $20,000 gain attributable
to depreciation, under § 1031. See section 4.02(2)
of this revenue procedure. Although A receives
$10,000 of cash (boot) in the exchange, A is not
required to recognize gain because the boot is taken
into account for purposes of § 1031(b) only to the
extent the boot exceeds the amount of excluded gain.
See section 4.02(3) of this revenue procedure.
These results are illustrated as follows.
Amount realized
.................................
$470,000
Less:Adjustedbasis ....................
$190,000
Realizedgain .....................
$280,000
Less:Gainexcludedunder§121 ..........
$250,000
Gaintobedeferred.................
$30,000
(iv) A’s basis in the replacement property is
$430,000, which is equal to the basis of the re-
linquished property at the time of the exchange
($190,000) increased by the gain excluded under
§ 121 ($250,000), and reduced by the cash A re-
ceives ($10,000)). See section 4.03 of this revenue
procedure.
Example 2. (i) Taxpayer B buys a prop-
erty for $210,000. The property consists of two
separate dwelling units (within the meaning of
§ 1.121–1(e)(2)), a house and a guesthouse. From
2001 until 2006, B uses the house as B’s principal
residence and uses the guesthouse as an office in B’s
trade or business. Based on the square footage of the
respective parts of the property, B allocates 2/3 of
the basis of the property to the house and 1/3 to the
guesthouse. In 2006, B exchanges the entire property
for a residence and a separate property that B intends
to use as an office. The total fair market value of B’s
replacement properties is $360,000. The fair market
value of the replacement residence is $240,000 and
the fair market value of the replacement business
property is $120,000, which is equal to the fair mar-
ket value of the relinquished business property. From
2001 to 2006, B claims depreciation deductions of
$30,000 for the business use. B realizes gain of
$180,000 on the exchange.
(ii) Under § 121, B may exclude gain of $100,000
allocable to the residential portion of the house (2/3
of $360,000 amount realized, or $240,000, minus
2/3 of $210,000 basis, or $140,000) because B meets
the ownership and use requirements for that portion
of the property. Because the guesthouse is business
property separate from the dwelling unit and B has
not met the use requirements for the guesthouse,
B may not exclude the gain allocable to the guest-
house under § 1.121–1(e). However, because the fair
market value of the replacement business property
is equal to the fair market value of the relinquished
business property and B receives no boot, B may
defer the remaining gain of $80,000 (1/3 of $360,000
amount realized, or $120,000, minus $40,000 ad-
justed basis, which is 1/3 of $210,000 basis, or
$70,000, adjusted by $30,000 depreciation) under
§ 1031.
These results are illustrated as follows:
Total property2/3 residential property1/3 business property
Amount realized
$360,000$240,000$120,000
Basis
$210,000$140,000$ 70,000
Depreciation adjustment
$ 30,000$ 30,000
Adjusted basis
$180,000$140,000$ 40,000
Realized gain
$180,000$100,000$ 80,000
Gain excluded under § 121
$100,000$100,000
Gain deferred under § 1031
$ 80,000$ 80,000
(iii) Because no portion of the gain attributable
to the relinquished business property is excluded un-
der § 121 and B receives no boot and recognizes no
gain or loss in the exchange, B’s basis in the replace-
ment business property is equal to B’s basis in the
relinquished business property at the time of the ex-
change ($40,000). B’s basis in the replacement res-
idential property is the fair market value of the re-
placement residential property at the time of the ex-
change ($240,000).
Example 3. (i) Taxpayer C buys a property for
$210,000. The property consists of a house that con-
stitutes a single dwelling unit under § 1.121–1(e)(2).
From 2001 until 2006, C uses 2/3 of the house (by
square footage) as C’s principal residence and uses
1/3 of the house as an office in C’s trade or business.
In 2006, C exchanges the entire property for a resi-
dence and a separate property that C intends to use as
an office in C’s trade or business. The total fair mar-
ket value of C’s replacement properties is $360,000.
The fair market value of the replacement residence
is $240,000 and the fair market value of the replace-
ment business property is $120,000, which is equal
to the fair market value of the business portion of the
relinquished property. From 2001 to 2006, C claims
depreciation deductions of $30,000 for the business
use. C realizes gain of $180,000 on the exchange.
(ii) Under § 121, C may exclude the gain of
$100,000 allocable to the residential portion of the
house (2/3 of $360,000 amount realized, or $240,000,
minus 2/3 of $210,000 basis, or $140,000) because
C meets the ownership and use requirements for that
portion of the property.
(iii) The remaining gain of $80,000 (1/3 of
$360,000 amount realized, or $120,000, minus
$40,000 adjusted basis, which is 1/3 of $210,000
basis, or $70,000, adjusted by $30,000 depreciation)
is allocable to the business portion of the house
(the office). Under section 4.02(1) of this revenue
procedure, C applies § 121 before applying the non-
recognition rules of § 1031. Under § 1.121–1(e),
C may exclude $50,000 of the gain allocable to the
office because the office and residence are part of a
single dwelling unit. C may not exclude that portion
of the gain ($30,000) attributable to depreciation
2005–7 I.R.B.530February 14, 2005

deductions, but may defer the remaining gain of
$30,000 under § 1031.
These results are illustrated as follows:
Total property2/3 residential property1/3 business property
Amount realized
$360,000$240,000$120,000
Basis
$210,000$140,000$ 70,000
Depreciation adjustment
$ 30,000$ 30,000
Adjusted basis
$180,000$140,000$ 40,000
Realized gain
$180,000$100,000$ 80,000
Gain excluded under § 121
$150,000$100,000$ 50,000
Gain deferred under § 1031
$ 30,000$ 30,000
(iv) C’s basis in the replacement residential
property is the fair market value of the replacement
residential property at the time of the exchange
($240,000). C’s basis in the replacement business
property is $90,000, which is equal to C’s basis in
the relinquished business property at the time of the
exchange ($40,000), increased by the gain excluded
under § 121 attributable to the relinquished business
property ($50,000). See section 4.03 of this revenue
procedure.
Example 4. (i) The facts are the same as inExam-
ple 3except that C also receives $10,000 of cash in
the exchange and the fair market value of the replace-
ment business property is $110,000, which is $10,000
less than the fair market value of the business portion
of the relinquished property ($120,000).
(ii) Under § 121, C may exclude the gain of
$100,000 allocable to the residential portion of the
house (2/3 of $360,000 amount realized, or $240,000,
minus 2/3 of $210,000 basis, or $140,000).
(iii) The remaining gain of $80,000 (1/3 of
$360,000 amount realized, or $120,000, minus
$40,000 adjusted basis) is allocable to the business
portion of the house. Under section 4.02(1) of this
revenue procedure, C applies § 121 to exclude gain
before applying the nonrecognition rules of § 1031.
Under § 1.121–1(e), C may exclude $50,000 of the
gain allocable to the business portion of the house
but may not exclude the $30,000 of gain attributable
to depreciation deductions. Under section 4.02(2)
of this revenue procedure, C may defer the $30,000
of gain under § 1031. Although C receives $10,000
of cash (boot) in the exchange, C is not required to
recognize gain because the boot is taken into account
for purposes of § 1031(b) only to the extent the boot
exceeds the amount of excluded gain attributable to
the relinquished business property. See 4.02(3) of
this revenue procedure.
These results are illustrated as follows:
Total property2/3 residential property1/3 business property
Amount realized
$360,000$240,000$110,000 + 10,000
Basis
$210,000$140,000$ 70,000
Depreciation adjustment
$ 30,000$ 30,000
Adjusted basis
$180,000$140,000$ 40,000
Realized gain
$180,000$100,000$ 80,000
Gain excluded under § 121
$150,000$100,000$ 50,000
Gain deferred under § 1031
$ 30,000$ 30,000
(iv) C’s basis in the replacement residential
property is the fair market value of the replacement
residential property at the time of the exchange
($240,000). C’s basis in the replacement business
property is $80,000, which is equal to C’s basis in the
relinquished business property ($40,000), increased
by the gain excluded under § 121 ($50,000), and
reduced by the cash ($10,000) received. See section
4.03 of this revenue procedure.
Example 5. (i)ThefactsarethesameasinEx-
ample 3except that the total fair market value of the
replacement properties is$540,000. The fair market
value of the replacement residence is $360,000, the
fair market value of the replacement business prop-
erty is $180,000, and C realizes gain of $360,000 on
the exchange.
(ii) Under § 121, C may exclude the gain of
$220,000 allocable to the residential portion of the
house (2/3 of $540,000 amount realized, or $360,000,
minus 2/3 of $210,000 basis, or $140,000).
(iii) The remaining gain of $140,000 (1/3 of
$540,000 amount realized, or $180,000, minus
$40,000 adjusted basis) is allocable to the business
portion of the house. Under section 4.02(1) of this
revenue procedure, C excludes the gain before ap-
plying the nonrecognition rules of § 1031. Under
§ 1.121–1(e), C may exclude $30,000 of the gain
allocable to the business portion, at which point C
will have excluded the maximum limitation amount
of $250,000. C may defer the remaining gain of
$110,000 ($140,000 realized gain minus the $30,000
gain excluded under § 121), including the $30,000
gain attributable to depreciation, under § 1031.
These results are illustrated as follows:
February 14, 20055312005–7 I.R.B.

Total property2/3 residential property1/3 business property
Amount realized
$540,000$360,000$180,000
Basis
$210,000$140,000$ 70,000
Depreciation adjustment
$ 30,000$ 30,000
Adjusted basis
$180,000$140,000$ 40,000
Realized gain
$360,000$220,000$140,000
Gain excluded under § 121
$250,000$220,000$ 30,000
Gain deferred under § 1031
$110,000$110,000
(iv) C’s basis in the replacement residential
property is the fair market value of the replacement
residential property at the time of the exchange
($360,000). C’s basis in the replacement business
property is $70,000, which is equal to C’s basis in
the relinquished business property ($40,000), in-
creased by the amount of the gain excluded under
§ 121 ($30,000). See section 4.03 of this revenue
procedure.
Example 6. (i)ThefactsarethesameasinEx-
ample 3except that the total fair market value of the
replacement properties is $750,000. The fair market
value of the replacement residence is $500,000, the
fair market value of the replacement business prop-
erty is $250,000, and C realizes gain of $570,000 on
the exchange.
(ii) The gain allocable to the residential portion
is $360,000 (2/3 of $750,000 amount realized, or
$500,000, minus 2/3 of $210,000 basis, or $140,000).
C may exclude gain of $250,000 from gross income
under § 121. C must include in income the gain
of $110,000 allocable to the residential portion that
exceeds the § 121(b) exclusion limitation amount.
(iii) The remaining gain of $210,000 (1/3 of
$750,000 amount realized, or $250,000, minus
$40,000 adjusted basis) is allocable to the business
portion of the house. C may defer the $210,000
of gain, including the $30,000 gain attributable to
depreciation, under § 1031.
These results are illustrated as follows:
Total property2/3 residential property1/3 business property
Amount realized
$750,000$500,000$250,000
Basis
$210,000$140,000$ 70,000
Depreciation adjustment
$ 30,000$ 30,000
Adjusted basis
$180,000$140,000$ 40,000
Realized gain
$570,000$360,000$210,000
Gain excluded under § 121
$250,000$250,000
Gain deferred under § 1031
$210,000$210,000
Gain recognized
$110,000$110,000
(iv) C’s basis in the replacement residential
property is the fair market value of the replacement
residential property at the time of the exchange
($500,000). C’s basis in the replacement business
property is $40,000, which is equal to C’s basis in
the relinquished business property at the time of the
exchange.
SECTION 6. EFFECTIVE DATE
This revenue procedure is effective Jan-
uary 27, 2005. However, taxpayers may
apply this revenue procedure in taxable
years for which the period of limitation on
refund or credit under § 6511 has not ex-
pired.
DRAFTING INFORMATION
The principal author of this revenue
procedure is Sara Paige Shepherd of the
Office of Associate Chief Counsel (In-
come Tax & Accounting). For further
information regarding this revenue pro-
cedure, contact Ms. Shepherd at (202)
622–4960 (not a toll-free call).
2005–7 I.R.B.532February 14, 2005

Part IV. Items of General Interest
Amendment of Previously
Proposed Regulations and
Notice of Public Hearing
Statutory Mergers and
Consolidations
REG–117969–00
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Amendment of previously pro-
posed regulations and notice of public
hearing.
SUMMARY: This document amends pre-
viously proposed regulations published in
theFederal Registeron January 24, 2003
(REG–126485–01, 2003–1 C.B. 542, 68
FR 3477) by cross-reference to temporary
regulations. Those regulations define the
termstatutory merger or consolidationas
that term is used in section 368(a)(1)(A).
This notice of proposed rulemaking affects
corporations engaging in mergers and con-
solidations and their shareholders. It is be-
ing issued concurrently with proposed reg-
ulations under sections 358, 367, and 884.
(See REG–125628–01 in this issue of the
Bulletin).
DATES: Written and electronic comments
and requests to speak and outlines of top-
ics to be discussed at the public hearing
scheduled for May 19, 2005, to be held in
the IRS Auditorium (7
th
Floor) must be re-
ceived by April 28, 2005.
ADDRESSES: Send submissions to
CC:PA:LPD:PR(REG–117969–00),
Room 5203, Internal Revenue Ser-
vice, POB 7604, Ben Franklin Sta-
tion, Washington, DC 20044. Submis-
sions may be hand delivered Monday
through Friday between the hours of
8 a.m. and 4 p.m. to: CC:PA:LPD:PR
(REG–117969–00), Courier’s Desk, In-
ternal Revenue Service, 1111 Constitution
Avenue, NW, Washington, DC, or sent
electronically, via the IRS Internet site at
www.irs.gov/regsor via the Federal eRule-
making Portal atwww.regulations.gov
(IRS-REG–117969–00). The public hear-
ingwillbeheldintheIRSAuditorium(7
th
Floor), Internal Revenue Building, 1111
Constitution Avenue, NW, Washington,
DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed reg-
ulations, Vincent Daly, (202) 622–7770;
concerning submissions, the hearing, or
placement on the building access list to
attend the hearing, Robin Jones, (202)
622–7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background and Explanation of
Provisions
Before 1934, the termmerger,asused
in the reorganization provisions, included
statutory mergers as well as other combi-
nations of corporate entities. In 1934, Con-
gress amended the definition of a reorga-
nization to provide separately forstatutory
mergers or consolidationsand for the other
types of transactions previously included
in the definition of amerger. There is no
indication in the legislative history of the
1934 changes to the definition of a reorga-
nization that Congress intended to exclude
transactions effected under foreign law.
In 1935, Treasury regulations inter-
preted the termstatutory mergerunder
the revised provision to mean a merger
or consolidation effected pursuant to the
corporation laws of a State or Territory
or the District of Columbia. The require-
ment that the transaction be effected under
domestic law remains in place, with mi-
nor variations. The Treasury Department
and IRS believe that this interpretation
is reasonable; nevertheless, the Treasury
Department and IRS believe that a re-
examination is warranted in light of the
purposes of the statute and changes in
domestic and foreign law since 1935.
The states have revised their laws to of-
fer a greater variety of business entities
and greater flexibility in effecting busi-
ness combinations. Accordingly, the Trea-
sury Department and IRS thought it ad-
visable to define a merger or consolida-
tion functionally, to supplement the refer-
ence to state law. Accordingly, the Trea-
sury Department and IRS developed and
proposed such a functional definition in
2003. See Notice of Proposed Rulemak-
ing (REG–126485–01, 2003–1 C.B. 542
[68 FR 3477]), cross-referencing tempo-
rary regulations (T.D. 9038, 2003–1, C.B.
524 [68 FR 3384]) (January 24, 2003).
Many foreign jurisdictions now have
merger or consolidation statutes that op-
erate in material respects like those of the
states,i.e., all assets and liabilities move
by operation of law. The Treasury De-
partment and IRS believe that transactions
effected pursuant to these statutes should
be treated as reorganizations if they satisfy
the functional criteriaapplicable to trans-
actions under domestic statutes.
This document proposes a revised def-
inition of a statutory merger or consolida-
tion. The previously proposed definition
of a statutory merger required that it be a
transaction effected “pursuant to the laws
of the United States or a State or the Dis-
trict of Columbia.” See REG–126485–01
(2003–1 C.B. 542 [68 FR 3477]). The
new proposed definition contained in this
document replaces the quoted language
with “pursuant to the statute or statutes
necessary to effect the merger or con-
solidation.” This proposed change would
allow a transaction effected pursuant to
the statutes of a foreign jurisdiction or of
a United States possession to qualify as
a statutory merger or consolidation under
section 368(a)(1)(A), provided it other-
wise qualifies as a reorganization. The
phrasestatute or statutesis not intended
to prevent transactions effected pursuant
to legislation from qualifying as mergers
or consolidations where such legislation
is supplemented by administrative or case
law.
This notice of proposed rule-
making also proposes to remove
§1.368–2(b)(1)(iii) of the previously pro-
posed regulations. That section imposes
limitations on the use of disregarded enti-
ties in statutory mergers or consolidations
when certain entities are not organized
under the laws of the United States or a
State or the District of Columbia.
Although this document revises the
terms of the proposed definition of a statu-
tory merger or consolidation for purposes
of section 368, the provisions of the tem-
porary regulations will remain in effect
until this proposal is incorporated in tem-
porary or final regulations after notice and
comment.
February 14, 20055332005–7 I.R.B.

Section 1.368–2(b)(1)(B)(iv),Exam-
ples 1and2in the previously proposed
regulations each specified that one of
the parties to the transaction described
in the example “is not treated as own-
ing any assets of an entity that is dis-
regarded as an entity separate from its
owner for Federal tax purposes.” The
results in those examples would be the
same in each case whether or not a party
to the transaction held such assets. See
§1.368–2(b)(1)(B)(iv),Example 3in the
previously proposed regulations. To avoid
any possible implicationtothecontrary,
the Treasury Department and IRS propose
removal of the sentence specifying that
condition from each example. The Trea-
sury Department and IRS are continuing
to study other comments received on the
earlier proposed regulations.
A notice of proposed rulemaking
proposing amendments to the regulations
under sections 358, 367, and 884 (includ-
ing special rules for determining basis and
holding period in certain transactions in-
volving one or more foreign corporations)
is being published simultaneously with
the publication of this notice of proposed
rulemaking. See REG–125628–01 in this
issue of the Bulletin.
Proposed Effective Date
These regulations are proposed to apply
to transactions occurring after the date fi-
nal regulations are published in theFed-
eral Register.
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.
Because the regulations do not impose a
collection of information on small entities,
the Regulatory Flexibility Act (5 U.S.C.
chapter 6) does not apply. Pursuant to 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 regulations
and on how they can be made easier to un-
derstand. All comments will be available
for public inspection and copying.
A public hearing has been scheduled for
May 19, 2005, beginning at 10 a.m. in the
IRS Auditorium (7
th
Floor), Internal Rev-
enue Building, 1111 Constitution Avenue,
NW, Washington, DC. Due to building se-
curity procedures, visitors must enter at the
Constitution Avenueentrance. In addition,
all visitors must present photo identifica-
tion to enter the building. Because of ac-
cess restrictions, visitors will not be ad-
mitted beyond the immediate entrance area
more than 30 minutes before the hearing
starts. For information about having your
name placed on the building access list
to attend the hearing, see the FOR FUR-
THER INFORMATION CONTACT por-
tion of this preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish to
present oral comments must submit writ-
ten or electronic comments and an out-
line of the topics to be discussed and the
time to be devoted to each topic (a signed
original and eight (8) copies) by April 28,
2005. A period of 10 minutes will be
allotted to each person for making com-
ments. An agenda showing the scheduling
of the speakers will be prepared after the
deadline for receiving outlines has passed.
Copies of the agenda will be available free
of charge at the hearing.
Drafting Information
The principal author of these regula-
tions is Vincent Daly, Office of the As-
sociate Chief Counsel (Corporate). How-
ever, other personnel from the IRS and
Treasury Department participated in their
development.
*****
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 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Paragraph (b)(1) of §1.368–2
as proposed on January 24, 2003, at 68 FR
3477, is proposed to be revised to read as
follows:
§1.368–2 Definition of terms.
*****
(b)(1)(i)Definitions. The following
definitions apply for purposes of this para-
graph (b)(1):
(A)Disregarded entity. A disregarded
entity is a business entity (as defined in
§301.7701–2(a) of this chapter) that is
disregarded as an entity separate from its
owner for Federal tax purposes. Examples
of disregarded entities include a domestic
single member limited liability company
that does not elect to be classified as a
corporation for Federal tax purposes, a
corporation (as defined in §301.7701–2(b)
of this chapter) that is a qualified REIT
subsidiary (within the meaning of section
856(i)(2)), and a corporation that is a qual-
ified subchapter S subsidiary (within the
meaning of section 1361(b)(3)(B)).
(B)Combining entity. A combining en-
tity is a business entity that is a corporation
(as defined in §301.7701–2(b) of this chap-
ter) that is not a disregarded entity.
(C)Combining unit. A combining unit
is composed solely of a combining entity
and all disregarded entities, if any, the as-
sets of which are treated as owned by such
combining entity for Federal tax purposes.
(ii)Statutory merger or consolida-
tion generally. For purposes of section
368(a)(1)(A), a statutory merger or consol-
idation is a transaction effected pursuant
to the statute or statutes necessary to ef-
fect the merger or consolidation, in which
transaction, as a result of the operation
of such statute or statutes, the following
events occur simultaneously at the effec-
tive time of the transaction—
(A) All of the assets (other than those
distributed in the transaction) and liabili-
ties (except to the extent satisfied or dis-
2005–7 I.R.B.534February 14, 2005

charged in the transaction) of each mem-
ber of one or more combining units (each
a transferor unit) become the assets and li-
abilities of one or more members of one
other combining unit (the transferee unit);
and
(B) The combining entity of each trans-
feror unit ceases its separate legal exis-
tence for all purposes; provided, however,
that this requirement will be satisfied even
if, under applicable law, after the effective
time of the transaction, the combining en-
tity of the transferor unit (or its officers,
directors, or agents) may act or be acted
against, or a member of the transferee unit
(or its officers, directors, or agents) may
act or be acted against in the name of
the combining entity of the transferor unit,
provided that such actions relate to assets
or obligations of the combining entity of
the transferor unit that arose, or relate to
activities engaged in by such entity, prior
to the effective time of the transaction, and
such actions are not inconsistent with the
requirements of paragraph (b)(1)(ii)(A) of
this section.
(iii)Examples. The following examples
illustrate the rules of paragraph (b)(1) of
this section. In each of the examples, ex-
cept as otherwise provided, each of V, Y,
and Z is a C corporation. X is a limited li-
ability company. Except as otherwise pro-
vided, X is wholly owned by Y and is dis-
regarded as an entity separate from Y for
Federal tax purposes. The examples are as
follows:
Example 1.Divisive transaction pursuant to a
merger statute. (i) Under State W law, Z transfers
some of its assets and liabilities to Y, retains the re-
mainder of its assets and liabilities, and remains in
existence following the transaction. The transaction
qualifies as a merger under State W corporate law.
(ii) The transaction does not satisfy the require-
ments of paragraph (b)(1)(ii)(A) of this section be-
cause all of the assets and liabilities of Z, the com-
bining entity of the transferor unit, do not become the
assets and liabilities of Y, the combining entity and
sole member of the transferee unit. In addition, the
transaction does not satisfy the requirements of para-
graph (b)(1)(ii)(B) of this section because the sepa-
rate legal existence of Z does not cease for all pur-
poses. Accordingly, the transaction does not qualify
as a statutory merger or consolidation under section
368(a)(1)(A).
Example 2.Merger of a target corporation into a
disregarded entity in exchange for stock of the owner.
(i) Under State W law, Z merges into X. Pursuant to
such law, the following events occur simultaneously
at the effective time of the transaction: all of the as-
sets and liabilities of Z become the assets and liabil-
ities of X and Z’s separate legal existence ceases for
all purposes. In the merger, the Z shareholders ex-
change their stock of Z for stock of Y.
(ii) The transaction satisfies the requirements of
paragraph (b)(1)(ii) of thissection because the trans-
action is effected pursuant to State W law and the
following events occur simultaneously at the effec-
tive time of the transaction: all of the assets and li-
abilities of Z, the combining entity and sole member
of the transferor unit, become the assets and liabil-
ities of one or more members of the transferee unit
that is comprised of Y, the combining entity of the
transferee unit, and X, a disregarded entity the assets
of which Y is treated as owning for Federal tax pur-
poses, and Z ceases its separate legal existence for all
purposes. Accordingly, the transaction qualifies as a
statutory merger or consolidation for purposes of sec-
tion 368(a)(1)(A).
Example 3.Merger of a target S corporation that
owns a QSub into a disregarded entity. (i) The facts
are the same as inExample 2, except that Z is an S
corporation and owns all of the stock of U, a QSub.
(ii) The deemed formation by Z of U pursuant
to §1.1361–5(b)(1) (as a consequence of the termi-
nation of U’s QSub election) is disregarded for Fed-
eral income tax purposes. The transaction is treated
as a transfer of the assets of U to X, followed by X’s
transfer of these assets to U in exchange for stock
of U. See §1.1361–5(b)(3),Example 9. The transac-
tion will, therefore, satisfy the requirements of para-
graph (b)(1)(ii) of this section because the transac-
tion is effected pursuant to State W law and the fol-
lowing events occur simultaneously at the effective
time of the transaction: all of the assets and liabili-
ties of Z and U, the sole members of the transferor
unit, become the assets and liabilities of one or more
members of the transferee unit that is comprised of Y,
the combining entity of the transferee unit, and X, a
disregarded entity the assets of which Y is treated as
owning for Federal tax purposes, and Z ceases its sep-
arate legal existence for all purposes. Moreover, the
deemed transfer of the assets of U in exchange for U
stock does not cause the transaction to fail to qualify
as a statutory merger or consolidation. See section
368(a)(2)(C). Accordingly, the transaction qualifies
as a statutory merger or consolidation for purposes of
section 368(a)(1)(A).
Example 4.Triangular merger of a target corpo-
ration into a disregarded entity. (i) The facts are the
same as inExample 2, except that V owns 100 per-
cent of the outstanding stock of Y and, in the merger
of Z into X, the Z shareholders exchange their stock
of Z for stock of V. In the transaction, Z transfers sub-
stantially all of its properties to X.
(ii) The transaction is not prevented from qualify-
ing as a statutory merger or consolidation under sec-
tion 368(a)(1)(A), provided the requirements of sec-
tion 368(a)(2)(D) are satisfied. Because the assets of
X are treated for Federal tax purposes as the assets of
Y, Y will be treated as acquiring substantially all of
the properties of Z in the merger for purposes of deter-
mining whether the merger satisfies the requirements
of section 368(a)(2)(D). As a result, the Z sharehold-
ers that receive stock of V will be treated as receiving
stock of a corporation that is in control of Y, the com-
bining entity of the transferee unit that is the acquir-
ing corporation for purposes of section 368(a)(2)(D).
Accordingly, the merger will satisfy the requirements
of section 368(a)(2)(D).
Example 5.Merger of a target corporation into a
disregarded entity owned by a partnership.(i)The
facts are the same as inExample 2, except that Y
is organized as a partnership under the laws of State
W and is classified as a partnership for Federal tax
purposes.
(ii) The transaction does not satisfy the require-
ments of paragraph (b)(1)(ii)(A) of this section. All
of the assets and liabilities of Z, the combining entity
and sole member of the transferor unit, do not become
the assets and liabilities of one or more members of
a transferee unit because neither X nor Y qualifies as
a combining entity. Accordingly, the transaction can-
not qualify as a statutory merger or consolidation for
purposes of section 368(a)(1)(A).
Example 6.Merger of a disregarded entity into a
corporation. (i) Under State W law, X merges into Z.
Pursuant to such law, the following events occur si-
multaneously at the effective time of the transaction:
all of the assets and liabilities of X (but not the assets
and liabilities of Y other than those of X) become the
assets and liabilities of Z and X’s separate legal exis-
tence ceases for all purposes.
(ii) The transaction does not satisfy the require-
ments of paragraph (b)(1)(ii)(A) of this section be-
cause all of the assets and liabilities of a transferor
unit do not become the assets and liabilities of one or
more members of the transferee unit. The transaction
also does not satisfy the requirements of paragraph
(b)(1)(ii)(B) of this section because X does not qual-
ify as a combining entity. Accordingly, the transac-
tion cannot qualify as a statutory merger or consoli-
dation for purposes of section 368(a)(1)(A).
Example 7.Merger of a corporation into a dis-
regarded entity in exchange for interests in the disre-
garded entity. (i) Under State W law, Z merges into
X. Pursuant to such law, the following events occur
simultaneously at the effective time of the transac-
tion: all of the assets and liabilities of Z become the
assets and liabilities of X and Z’s separate legal exis-
tence ceases for all purposes. In the merger of Z into
X, the Z shareholders exchange their stock of Z for in-
terests in X so that, immediately after the merger, X is
not disregarded as an entity separate from Y for Fed-
eral tax purposes. Following the merger, pursuant to
§301.7701–3(b)(1)(i) of this chapter, X is classified
as a partnership for Federal tax purposes.
(ii) The transaction does not satisfy the require-
ments of paragraph (b)(1)(ii)(A) of this section
because immediately after the merger X is not
disregarded as an entity separate from Y and, con-
sequently, all of the assets and liabilities of Z, the
combining entity of the transferor unit, do not become
the assets and liabilities of one or more members of a
transferee unit. Accordingly, the transaction cannot
qualify as a statutory merger or consolidation for
purposes of section 368(a)(1)(A).
Example 8.Merger transaction preceded by dis-
tribution. (i) Z operates two unrelated businesses,
Business P and Business Q, each of which represents
50 percent of the value of the assets of Z. Y desires to
acquire and continue operating Business P, but does
not want to acquire Business Q. Pursuant to a sin-
gle plan, Z sells Business Q for cash to parties unre-
lated to Z and Y in a taxable transaction, and then dis-
tributes the proceeds of the salepro ratato its share-
holders. Then, pursuant to State W law, Z merges into
Y. Pursuant to such law, the following events occur si-
multaneously at the effective time of the transaction:
February 14, 20055352005–7 I.R.B.

all of the assets and liabilities of Z related to Business
P become the assets and liabilities of Y and Z’s sep-
arate legal existence ceases for all purposes. In the
merger, the Z shareholders exchange their Z stock for
Ystock.
(ii) The transaction satisfies the requirements of
paragraph (b)(1)(ii) of this section because the trans-
action is effected pursuant to State W law and the fol-
lowing events occur simultaneously at the effective
time of the transaction: all of the assets and liabil-
ities of Z, the combining entity and sole member of
the transferor unit, become the assets and liabilities of
Y, the combining entity and sole member of the trans-
feree unit, and Z ceases its separate legal existence for
all purposes. Accordingly, the transaction qualifies
as a statutory merger or consolidation for purposes of
section 368(a)(1)(A).
Example 9.Transaction effected pursuant to for-
eign statutes. (i) Z and Y are entities organized under
the laws of Country Q and classified as corporations
for Federal tax purposes. Z and Y combine. Pursuant
to statutes of Country Q the following events occur
simultaneously: all of the assets and liabilities of Z
become the assets and liabilities of Y and Z’s sepa-
rate legal existence ceases for all purposes.
(ii) The transaction satisfies the requirements of
paragraphs (b)(1)(ii) of this section because the trans-
action is effected pursuant to statutes of Country Q
and the following events occur simultaneously at the
effective time of the transaction: all of the assets
and liabilities of Z, the combining entity of the trans-
feror unit, become the assets and liabilities of Y, the
combining entity and sole member of the transferee
unit, and Z ceases its separate legal existence for all
purposes. Accordingly, the transaction qualifies as a
statutory merger or consolidation for purposes of sec-
tion 368(a)(1)(A).
(iv)Effective dates. This paragraph
(b)(1) applies to transactions occurring af-
ter the date these regulations are published
as final regulations in theFederal Regis-
ter. For rules regarding statutory merg-
ers or consolidations on or after January
24, 2003, and before these regulations are
published as final regulations in theFed-
eral Register, see §1.368–2T(b)(1). For
rules regarding statutory mergers or con-
solidations before January 24, 2003, see
§1.368–2(b)(1) as it applies before January
24, 2003 (see 26 CFR part 1, revised April
1, 2002).
*****
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on January 4,
2005, 8:45 a.m., and published in the issue of the Federal
Register for January 5, 2005, 70 F.R. 746)
Notice of Proposed
Rulemaking
Revision of Income Tax
Regulations Under Sections
358, 367, and 884 Dealing
With Statutory Mergers or
Consolidations Under Section
368(a)(1)(A) Involving One or
More Foreign Corporations
REG–125628–01
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking.
SUMMARY: This document contains
proposed regulations amending the in-
come tax regulations under various pro-
visions of the Internal Revenue Code
(Code) to account for statutory merg-
ers and consolidations under section
368(a)(1)(A) (including reorganizations
described in section 368(a)(2)(D) and (E))
involving one or more foreign corpora-
tions. These proposed regulations are
issued concurrently with proposed reg-
ulations (REG–117969–00) that would
amend the definition of a reorganization
under section 368(a)(1)(A) to include cer-
tain statutory mergers or consolidations
effected pursuant to foreign law.
DATES: Written and electronic com-
ments and requests to speak and outlines of
topics to be discussed at the public hearing
scheduled for May 19, 2005, at 10:00 a.m.
must be received by April 28, 2005.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR (REG–125628–01), room
5203, Internal Revenue Service, P.O. Box
7604, Ben Franklin Station, Washing-
ton, DC 20044. Submissions may be
hand delivered Monday through Friday
betweenthehoursof8a.m. and4p.m.
to: CC:PA:LPD:PR (REG–125628–01),
Courier’s Desk, Internal Revenue Service,
1111 Constitution Avenue, NW, Wash-
ington, DC, or sent electronically, via the
IRS Internet site at:www.irs.gov/regs
or via the Federal eRulemaking Por-
tal atwww.regulations.gov(IRS and
REG–125628–01). The public hearing
will be held in the Auditorium, Internal
Revenue Building, 1111 Constitution Av-
enue, NW, Washington, DC.
FOR FURTHER INFORMATION
CONTACT:Concerning the pro-
posed regulations, Robert W. Lorence,
Jr., (202) 622–3860; concerning submis-
sions, the hearing, or placement on the
building access list to attend the hear-
ing, Guy Traynor, (202) 622–7180 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained
in this notice of proposed rulemaking has
been submitted to the Office of Manage-
ment and Budget for review in accordance
with the Paperwork Reduction Act (44
U.S.C. 3507(d)). Comments on the col-
lection of information should be sent to the
Office of Management and Budget, Attn:
Desk Officer for the Department of the
Treasury, Office of Information and Reg-
ulatory Affairs, Washington, DC 20503,
with copies to theInternal Revenue Ser-
vice, Attn: IRS Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP, Washington, DC
20224. Comments on the collection of in-
formation should be received no later than
March 7, 2005. Comments are specifically
requested concerning:
Whether the proposed collection of in-
formation is necessary for the proper per-
formance of the functions of the IRS, in-
cluding whether the information will have
practical utility;
The accuracy of the estimated burden
associated with the proposed collection of
information (see below);
How the quality, utility, and clarity of
the information to be collected may be en-
hanced;
How the burden of complying with the
proposed collection of information can be
minimized, including through the appli-
cation of automated collection techniques
or other forms of information technology;
and
Estimates of capital or start-up costs
and costs of operation, maintenance, and
purchase of services to provide informa-
tion.
The collection of information
in this proposed regulation is in
§1.367(a)–3(d)(2)(vi)(B)(1)(ii). This in-
formation is required to inform the IRS
2005–7 I.R.B.536February 14, 2005

of a domestic corporation that is claiming
an exception from the application of sec-
tion 367(a) and (d) to certain transfers of
property to a foreign corporation that is
re-transferred by the foreign corporation
to a domestic corporation controlled by
the foreign corporation. The information
is in the form of a statement attached to the
domestic corporation’s U.S. income tax
return for the year of the transfer certifying
that if the foreign corporation disposes of
the stock of the domestic controlled cor-
poration with a tax avoidance purpose, the
domestic corporation will file an income
tax return (or amended return, as the case
may be) reporting gain. The collection
of information is mandatory. The likely
respondents are domestic corporations.
Estimated total annual reporting bur-
den: 50 hours.
Estimated average annual burden hours
per respondent: 1 hour.
Estimated number of respondents: 50.
Estimated annual frequency of re-
sponses: on occasion.
An agency may not conduct or sponsor,
and a person is not required to respond to, a
collection of information unless it displays
a valid control number assigned by the Of-
fice 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
Section 368(a)(1)(A) defines a reorga-
nization to include a statutory merger
or consolidation (A reorganization).
For transactions completed before Jan-
uary 24, 2003, regulations under section
368(a)(1)(A) provided that a reorganiza-
tion was a merger or consolidation effected
pursuant to the corporation law of the
United States or a State or Territory or the
District of Columbia. See §1.368–2(b)(1),
as in effect before January 24, 2003.
On January 24, 2003, the IRS and the
Treasury Department issued proposed reg-
ulations (REG–126485–01, 2003–1 C.B.
542 [68 FR 3477]) and temporary regula-
tions (T.D. 9038, 2003–1 C.B. 524 [68 FR
3384]), revising the definition of a statu-
tory merger or consolidation. The pro-
posed and temporary regulations define a
statutory merger or consolidation in a man-
ner intended to ensure that those transac-
tions are not divisive in nature. Accord-
ingly, the regulationsgenerally require that
all the assets and liabilities of the merged
corporation (other than assets distributed
or liabilities discharged in the transaction)
are transferred to the acquiring corporation
and that the separate legal identity of the
merged corporation ceases to exist in the
transaction.
Pursuant to a notice of proposed rule-
making (proposed section 368 regula-
tions) published contemporaneously with
this document, the IRS and Treasury are
proposing further revisions to the defini-
tion of a statutory merger or consolidation
to take into account those transactions
effected pursuant to foreign law. The pro-
posed section 368 regulations amend the
2003 proposed regulations and provide
that an A reorganization may occur, if cer-
tain conditions are satisfied, pursuant to
the laws of a foreign jurisdiction, includ-
ing a U.S. possession.
In light of this change, this document
contains proposed amendments to the reg-
ulations under certain international Code
provisions (sections 367, 884, and 6038B)
to account for statutory mergers and con-
solidations involving one or more foreign
corporations. Current international tax
regulations are premised on an A reor-
ganization being limited to a statutory
merger or consolidation involving do-
mestic corporations effected pursuant to
domestic law. See,e.g., Rev. Rul. 57–465,
1957–2 C.B. 250. As a result, conforming
changes must be made to these interna-
tional tax regulations to ensure that they
apply appropriately to statutory mergers
and consolidations effected pursuant to
foreign law. The proposed regulations
also modify the section 367(a) and (b)
regulations to address several other related
issues.
Explanation of Provisions
A.Basis and Holding Period Rules
The proposed regulations provide basis
and holding period rules for certain trans-
actions involving foreign corporations
with section 1248 shareholders in order to
preserve relevant section 1248 amounts. A
section 1248 shareholder is a U.S. person
that satisfies the ownership requirements
of section 1248(a) with respect to a foreign
corporation. Section 1248(a) applies to a
U.S. person that owns stock (directly, in-
directly, or constructively) with 10 percent
or more of the voting power in the foreign
corporation at any time during the 5-year
period ending on the sale or exchange of
the stock when the foreign corporation was
a controlled foreign corporation (CFC).
Gain recognized by a section 1248 share-
holder on the sale or exchange of stock
of the foreign corporation is included in
gross income as a dividend to the extent of
the earnings and profits of the foreign cor-
poration that are attributable to the stock
sold or exchanged and that were accumu-
lated while the stock was held by the U.S.
person when the foreign corporation was
a CFC (the section 1248 amount).
The IRS and Treasury believe that
it is important to preserve section 1248
amounts in certain nonrecognition ex-
changes of foreign corporation stock.
Preservation of section 1248 amounts is a
function of the holding period and basis in
the stock of the foreign corporation being
exchanged. One of the underlying policies
of section 367(b) is the preservation of
the potential application of section 1248
in connection with certain nonrecognition
exchanges. H. Rep. No. 94–658, 94
th
Cong., 1
st
Sess., at 242 (Nov. 12, 1975).
These proposed regulations provide ba-
sis and holding period rules to preserve
section 1248 amounts in the context of
certain section 354 exchanges and certain
triangular reorganizations.
The basis and holding period rules of
the proposed regulations also apply to a
foreign corporate shareholder of a foreign
corporation that is a party to the reorgani-
zation, provided that the foreign corporate
shareholder has at least one U.S. person
that is a section 1248 shareholder with re-
spect to the foreign corporate shareholder
and to the foreign corporation. This rule
is necessary to preserve application of sec-
tion 964(e) to the foreign corporate share-
holder with respect to lower-tier foreign
corporations. Under section 964(e), if a
CFC sells or exchanges stock in another
foreign corporation, gain recognized on
the sale or exchange is included in the in-
come of the CFC as a dividend to the same
extent that it would have been included
under section 1248(a) if the CFC were a
U.S. person. Such dividend income may
February 14, 20055372005–7 I.R.B.

be treated as subpart F income that is in-
cluded in the income of U.S. shareholders
of the CFC.
1.Section 354 exchanges
The proposed regulations apply to cer-
tain section 354 exchanges involving for-
eign corporations, including exchanges of
multiple blocks of stock. The proposed
regulations preserve the bases and hold-
ing periods in different blocks of stock in
certain foreign target corporations by re-
quiring the exchanging shareholder to es-
tablish the particular shares of stock that
were received in exchange for shares of
a particular block of target stock. If the
exchanging shareholder cannot establish
the particular shares of target stock that
were received for shares of a particular
block of stock, then the shareholder must
designate which shares of stock were re-
ceived in exchange for shares of a par-
ticular block of stock, provided that the
designation is consistent with the terms of
the exchange. These tracing methods are
used to determine the resulting tax con-
sequences when stock received in a non-
recognition exchange is subsequently sold
or otherwise exchanged. If the exchanging
shareholder cannot establish, and does not
designate, the particular shares received,
the shareholder is treated as selling or oth-
erwise exchanging a share received in a
nonrecognition exchange for a share that
was purchased or acquired at the earliest
time.
The IRS and Treasury recently pub-
lished proposed section 358 regulations
(REG–116564–03, 2004–20 I.R.B. 927)
that determine the basis of stock or secu-
rities received in section 354 exchanges
(proposed section 358 regulations). The
proposed section 358 regulations gener-
ally provide that the basis of each share of
stock or security received in an exchange
to which section 354, 355, or 356 applies
will be the same as the basis of the share
of stock or security exchanged therefor.
For these purposes, the determination of
which share of stock or security is received
in exchange for a particular share of stock
or security is made in accordance with the
terms of the exchange or distribution.
These proposed regulations apply the
principles of the proposed section 358 reg-
ulations to certain exchanges of stock of
a foreign corporation by either a section
1248 shareholder, or a foreign corporate
shareholder where at least one U.S. person
is a section 1248 shareholder with respect
to such foreign corporate shareholder and
to the foreign corporation whose shares are
exchanged (collectively and individually,
section 367(b) shareholder), to ensure the
preservation of section 1248 amounts. The
proposed regulations also include specific
guidance on the shareholder’s holding pe-
riod in the stock received in the section
354 exchange. The proposed regulations
do not, however, apply to distributions de-
scribedinsection355.
Consistent with the proposed section
358 regulations, the proposed regulations
hereunder would not apply to section 351
exchanges or to exchanges to which both
section 351 and section 354 (or section
356) apply, if, in addition to stock being
received, other property is received or lia-
bilities are assumed. This limitation is in-
tended to prevent a conflict between the
rules for determining basis in a section 351
exchange (including the application of sec-
tion 357(c)) and the rules proposed in this
document. The IRS and Treasury are con-
sidering approaches for the preservation of
section 1248 amounts in section 351 trans-
actions in which liabilities are assumed or
other property is received, and comments
are requested in this regard.
In addition, the IRS and Treasury are
considering developing specific rules for
situations in which stock of the foreign ac-
quiring corporation is not issued in the ex-
change (for example, when the exchanging
shareholder owns all the stock of the for-
eign acquiring corporation). One possible
approach may be for eachexisting share of
stock in that corporation to be divided into
portions to account for the different basis
and holding periods of the stock of the for-
eign acquiring corporation and the stock of
the acquired corporation in order to pre-
serve section 1248 amounts. Comments
are requested regarding this approach or
possible alternative approaches.
2.Triangular reorganizations
The proposed regulations provide spe-
cial basis and holding period rules for tri-
angular reorganizations where the merg-
ing or surviving corporation is a foreign
corporation with a section 367(b) share-
holder. These rules apply to reorganiza-
tions described in section 368(a)(1)(A) and
(a)(2)(D) (forward triangular merger) and
to parenthetical section 368(a)(1)(C) reor-
ganizations. In these transactions, the sur-
viving corporation (S) acquires substan-
tially all the assets of the acquired corpora-
tion (T), and the T shareholders exchange
their T stock for stock of the corporation
(P) that is in control (within the meaning
of section 368(c)) of S. These rules also
apply to reorganizations described in sec-
tion 368(a)(1)(A) and (a)(2)(E) (reverse
triangular merger). In a reverse triangu-
lar merger, S, a controlled subsidiary of P,
merges into T, the surviving corporation,
and the T shareholders exchange their T
stock for stock of P.
Under current regulations, in a forward
triangular merger or a parenthetical C re-
organization, P’s basis in its S stock is ad-
justed as if P had acquired the T assets di-
rectly from T in a section 362(b) exchange
and then had transferred the T assets to
S in a transaction in which P’s basis in
S stock is determined under section 358.
See §1.358–6(c)(1) (commonly referred to
as the “over-the-top” basis rules). Under
current regulations, in a reverse triangu-
lar merger, P’s basis in the T stock it re-
ceives immediately after the transaction is
equal to its basis in its S stock immedi-
ately before the transaction adjusted as if T
had merged into S in a forward triangular
merger and the over-the-top basis rules had
applied. See §1.358–6(c)(2). If a reverse
triangular merger also qualifies as a section
351 transfer or a section 368(a)(1)(B) reor-
ganization, P can determine its basis in its
S stock either by using the over-the-top ba-
sis rules as described in the prior sentence
or by treating P as if it had acquired the T
stock from the former shareholders of T in
a transaction in which basis is determined
under section 362(b) (carryover stock ba-
sis).
The IRS and Treasury are concerned
that, in certain exchanges involving for-
eign corporations, application of the over-
the-top basis rules would not properly pre-
serve the section 1248 or 964(e) amounts
with respect to the stock of S or T. The
proposed regulations provide that, in de-
termining the stock basis of the surviving
corporation in certain triangular reorgani-
zations, outside stock basis will be used
instead of inside asset basis pursuant to
§1.358–6(c). For example, in the case of
a forward triangular merger (or a paren-
thetical C reorganization), where P is a do-
2005–7 I.R.B.538February 14, 2005

mestic corporation, S is a foreign corpo-
ration, T is a foreign corporation, and T
has a section 1248 shareholder, the basis
and holding period in the T stock, not the
T assets, are used to determine P’s basis
in the S stock. The same rules apply to
certain reverse triangular mergers, where
S merges into T with T surviving. In that
case, P’s basis in the T stock immediately
after the transaction would reflect the basis
and holding period of the T stock instead of
the T assets.
Under this stock basis approach for tri-
angular reorganizations, the proposed reg-
ulations provide for a divided basis and
holding period in each share of stock in
the surviving corporation to reflect the rel-
evant section 1248 amounts in the S stock
and T stock. In particular, each share of S
stock in a forward triangular merger, and
each share of T stock in a reverse trian-
gular merger, where P is a section 367(b)
shareholder immediately after the transac-
tion, is divided into portions reflecting the
basis and holding period of the S stock and
the T stock before the transaction. How-
ever, the proposed regulations contain ade
minimisexception to this rule. Under this
exception, if the value of the S stock im-
mediately before the transaction isde min-
imis(for example, where S is a corpora-
tion formed to facilitate the transaction),
then each share of the surviving corpora-
tion is not divided; instead, the basis of the
S stock is added to the basis of the stock
of the surviving corporation held by P. The
value of the S stock would bede minimis
for this purpose if it is less than 1 percent
of the value of the surviving corporation (S
or T) immediately after the transaction.
If there are two or more blocks of stock
in T or S held by a section 367(b) share-
holder immediately before the transaction,
then each share of the surviving corpora-
tion (S or T) is further divided to account
for each block of stock. If two or more
blocks of stock are held by one or more
shareholders that are not section 367(b)
shareholders, then shares in these blocks
are aggregated into one divided portion
for basis purposes. If none of the S or
T shareholders is a section 367(b) share-
holder, then the over-the-top basis rules of
§1.358–6 apply instead of the rules in these
proposed regulations.
The proposed regulations provide spe-
cial rules when stock of the surviving cor-
poration has a divided basis and holding
period. Earnings and profits accumulated
prior to the reorganization are attributed
to a divided portion of a share of stock
basedontheblockofstockwhosebasis
and holding period the divided portion re-
flects. Post-reorganization earnings and
profits are attributed to each divided share
ofstockpursuanttosection1248andthe
regulations thereunder. The amount of
earnings and profits attributed to a divided
share of stock pursuant to section 1248 are
further attributed to a divided portion of
such share of stock based on its fair market
value in relation to the other divided por-
tions. Finally, shares of stock are no longer
divided into separate portions if section
1248 or 964(e) becomes inapplicable to a
subsequent sale or exchange of the stock.
The special basis rules in these pro-
posed regulations apply to all triangular
reorganizations where T has at least one
section 367(b) shareholder, even if such
shareholders own less than a controlling
interest in T. The IRS and Treasury are
considering whether the current basis rules
of §1.358–6 should apply in cases where
section 367(b) shareholders do not own a
substantial percentage of the stock of T, or
whether taxpayers should be permitted to
elect to apply the current basis rules un-
der §1.358–6 to determine P’s basis in the
stock of the surviving corporation (S or
T), provided that all section 367(b) share-
holders of T include in income the section
1248 amounts with respect to the stock ex-
changed. Comments are requested in this
regard.
The use of stock basis to determine
P’s basis in the surviving corporation also
presents administrative concerns when a
portion of the stock of T is widely held. In
the case of a reorganization described in
section 368(a)(1)(B), which presents simi-
lar issues, Rev. Proc. 81–70, 1981–2 C.B.
729, provides that statistical sampling
techniques, if appropriate, are permitted
to determine the basis of stock received
by the acquiring corporation. In this re-
gard, the IRS and Treasury recently have
requested comments whether Rev. Proc.
81–70 should be revised to reflect changes
in the marketplace since its publication.
See Notice 2004–44, 2004–28 I.R.B. 32.
Comments are requested on expanding
this guidance to apply under the proposed
regulations, for example in cases where
blocks of T stock are held by persons that
are not section 367(b) shareholders and
such shares are aggregated into a single
divided portion for basis and holding pe-
riod purposes.
B.Exceptions to the Application of
Section 367(a)
Under section 367(a), a U.S. person rec-
ognizes gain, but not loss, on the transfer
of property to a foreign corporation in an
exchange described in section 351, 354,
356, or 361, unless an exception applies.
Section 367(a), however, does not apply
to a section 354 exchange by a U.S. per-
son of: (1) stock of a foreign corporation
in a section 368(a)(1)(E) reorganization; or
(2) stock of a domestic or foreign corpora-
tion for stock of a foreign corporation in
an asset reorganization described in sec-
tion 368(a)(1)(C), (D), or (F) that is not
treated as an indirect stock transfer under
§1.367(a)–3(a).
The proposed regulations amend
§1.367(a)–3(a) so that this exception to the
application of section 367(a) also applies
to A reorganizations (including forward
and reverse triangular mergers). In ad-
dition, the proposed regulations clarify
that §1.367(a)–3(a) applies to exchanges
described in section 356, as well as in
section 354. Section 356 applies to an ex-
change that would qualify as a section 354
exchange except for the fact that money or
other property is received in the exchange.
Taxpayers have questioned why the ex-
ception to the application of section 367(a)
in §1.367(a)–3(a) includes exchanges of
stock but not exchanges of securities in
section 368(a)(1)(E) reorganizations and
certain asset reorganizations. The IRS
and Treasury believethat it is appropri-
ate to provide comparable treatment for
exchanges of securities in this context. Ac-
cordingly, Notice 2005–6, 2005–5 I.R.B.
448), published contemporaneously with
these proposed regulations, announces
that the IRS and Treasury intend to amend
§1.367(a)–3(a) to apply the exception from
section 367(a) to exchanges of stock or
securities. Notice 2005–6 applies to trans-
fers of securities after January 5, 2005.
Taxpayers also may apply the provisions
of the notice to transfers of securities oc-
curring on or after July 20, 1998, and on
or before January 5, 2005. In applying
this notice, however, taxpayers must do so
consistently to all transactions within its
scope.
February 14, 20055392005–7 I.R.B.

The proposed regulations also provide
rules concerning the application of sec-
tion 367(a) to reverse triangular mergers,
where stock of P, a corporation that con-
trols the merging corporation S, is treated
as transferred (along with any other prop-
erty of S) to the surviving corporation T in
a section 361 transfer. If S is a domestic
corporation and T is a foreign corporation,
section 367(a) applies to the transfer by S
of the P stock to T, unless an exception ap-
plies.
The IRS and Treasury believe that, if
the stock of P is provided to S pursuant
to the plan of reorganization, the section
361 transfer of the P stock from S to T
should not be subject to section 367(a), and
the proposed regulations so provide. If P
does not provide its stock to S pursuant
to the plan of reorganization, then the P
stock will be treated as property of S and
the transfer of such stock will be subject to
section 367(a).
The IRS and Treasury intend to amend
the regulations under section 6038B to
conform with the changes made in these
regulations.
C.Concurrent Application of Section
367(a) and (b)
The proposed regulations modify the
current application of section 367(a) and
(b) to transactions that require the inclu-
sion in income of the all earnings and prof-
its amount under section 367(b). Sec-
tion 1.367(a)–3(b)(2) provides rules for the
concurrent application of section 367(a)
and (b) to transfers of stock of a foreign
corporation. This may occur, for exam-
ple, when a U.S. shareholder exchanges
stock of a foreign corporation (foreign ac-
quired corporation) for stock of another
foreign corporation (foreign acquiring cor-
poration). See §1.367(a)–3(b)(1). It may
also occur when an acquiring corporation
(foreign or domestic) acquires the assets
of a foreign acquired corporation, and the
U.S. shareholder exchanges stock of the
foreign acquired corporation for stock of
the foreign parent of the acquiring corpo-
ration in a triangular reorganization.
The U.S. person’s exchange of stock of
the foreign acquired corporation for stock
of either the foreign acquiring corporation
or the foreign parent is subject to section
367(a). See §1.367(a)–3(b) and (d). If the
exchanging U.S. shareholder owns 5 per-
cent or more (by vote or value) of the stock
of the foreign acquiring corporation or the
foreign parent immediately after the ex-
change, the shareholder recognizes gain, if
any, under section 367(a), unless the share-
holder enters into a gain recognition agree-
ment as provided in §1.367(a)–8. If the
exchanging shareholder is not a 5-percent
shareholder, then the exchanging share-
holder does not recognize gain, if any, on
the exchange.
The U.S. shareholder’s exchange de-
scribed above also may be subject to
section 367(b). If the exchanging U.S.
shareholder is a section 1248 shareholder
of the foreign acquired corporation, and
the stock of the foreign acquiring corpo-
ration (or its foreign parent corporation)
is not stock in a corporation that is a
CFC as to which the U.S. shareholder is
a section 1248 shareholder immediately
after the exchange, then the exchanging
shareholder must include in income the
section 1248 amount with respect to the
stock exchanged. See §1.367(b)–4. If,
instead, a domestic acquiring corporation
acquires the assets of a foreign acquired
corporation, and the U.S. shareholder
exchanges stock of the foreign acquired
corporation for stock of the foreign parent
of the acquiring corporation in a triangu-
lar reorganization, then the exchanging
shareholder must include in income the all
earnings and profits amount with respect
to the stock of the acquired corporation.
See §1.367(b)–3. Unlike the section
1248 amount, the all earnings and profits
amount is not limited by the shareholder’s
gain inherent in the stock of the foreign
acquired corporation.
In cases where section 367(a) and (b)
apply concurrently to a transaction, exist-
ing §1.367(a)–3(b)(2) provides that sec-
tion 367(b) will not apply if the transfer is
taxable under section 367(a). If the trans-
fer is taxable under section 367(a), the ex-
changing U.S. shareholder will recognize
gain inherent in the exchanged stock (sub-
ject to recharacterization as dividend in-
come under section 1248). If the transfer is
not taxable under section 367(a), because
the exchanging U.S. shareholder either is
not a 5-percent shareholder or enters into
a gain recognition agreement, then section
367(b) applies and the exchange is subject
to either §1.367(b)–3 or 1.367(b)–4 at the
shareholder level.
Questions with respect to the concur-
rent application of section 367(a) and (b)
have arisen in situations that otherwise
would require inclusion of the all earnings
and profits amount under §1.367(b)–3.
If the all earnings and profits amount is
greater than the section 367(a) gain with
respect to the stock of the foreign ac-
quired corporation,under current law the
exchanging shareholder effectively may
elect to be taxed on the lesser amount of
gain under section 367(a) simply by fail-
ing to file a gain recognition agreement. In
that case, section 367(b) would not apply
and the shareholder would avoid inclusion
in income of the greater all earnings and
profits amount.
The ability to elect to recognize the
lesser gain inherent in the stock exchanged
in such cases is inconsistent with the poli-
cies of section 367(b) that apply to inbound
transactions, including preventing conver-
sion of tax deferral into tax forgiveness and
ensuring that the domestic acquiring cor-
poration’s section 381 carryover basis re-
flects an after-tax amount. Accordingly,
the IRS and Treasury believe that the all
earnings and profits amount provisions un-
der §1.367(b)–3 should not operate elec-
tively in these cases. The proposed regu-
lations require that, for exchanges subject
to §1.367(b)–3 and section 367(a), section
367(b) would apply before section 367(a).
In that case, inclusion of the all earnings
and profits amount would increase the ex-
changing shareholder’s stock basis for pur-
poses of computing the shareholder’s gain
under section 367(a). Thus, if the all earn-
ings and profits amount exceeds the inher-
ent gain in the exchanged stock, gain is
not recognized under section 367(a). If the
transaction does not involve inclusion of
the all earnings and profits amount (for ex-
ample, if §1.367(b)–4 applies), the exist-
ing ordering rulescontinue to apply.
D.Parenthetical Section 368(a)(1)(B)
Reorganizations
In a parenthetical reorganization under
section 368(a)(1)(B), if a U.S. shareholder
exchanges stock of an acquired corpora-
tion for voting stock of a foreign corpo-
ration that controls (within the meaning
of section 368(c)) the acquiring corpo-
ration, the U.S. shareholder is treated as
making an indirect transfer of stock of the
acquiredcorporationtotheforeigncon-
2005–7 I.R.B.540February 14, 2005

trolling corporation in a transfer subject to
section 367(a). See §1.367(a)–3(d)(1)(iii).
This result occurs even if the acquiring
corporation is domestic. If the U.S. share-
holder owns five percent or more (by vote
or value) of the stock of the foreign con-
trolling corporation, the shareholder must
recognize gain inherent in the exchanged
stock, unless a gain recognition agreement
is filed. A gain recognition agreement
filed with respect to the transfer may be
triggered (and gain on the initial transfer
of stock will be recognized) if the for-
eign controlling corporation disposes of
the stock of the acquiring corporation,
or the acquiring corporation disposes of
the stock of the acquired corporation,
within 5 years of the initial transfer. See
§1.367(a)–3(d)(2)(ii).
The proposed regulations revise the in-
direct stock transfer rules to include trian-
gular section 368(a)(1)(B) reorganizations
in which a U.S. shareholder exchanges
stock of the acquired corporation for vot-
ing stock of a domestic corporation that
controls a foreign acquiring corporation.
In such a case, the gain recognition agree-
ment may be triggered if the domestic con-
trolling corporation disposes of the stock
of the foreign acquiring corporation, or
the foreign acquiring corporation disposes
of the stock of the acquired corporation,
within 5 years of the initial transfer.
E.Transfers of Assets Following Certain
Asset Reorganizations
If a U.S. shareholder exchanges stock
or securities of an acquired corporation
for stock or securities of a foreign ac-
quiring corporation in a reorganization
described in section 368(a)(1)(C), and the
foreign acquiring corporation transfers all
or part of the assets of the acquired cor-
poration to a subsidiary controlled (within
the meaning of section 368(c)) by the
foreign acquiring corporation in a trans-
action described in section 368(a)(2)(C),
the U.S. shareholder is treated, for pur-
poses of section 367(a), as transferring the
stock of the acquired corporation to the
foreign acquiring corporation to the extent
of the assets transferred to the controlled
subsidiary. §1.367(a)–3(d)(1)(v). Section
368(a)(2)(C) provides that a transaction
otherwise qualifying as a reorganization
under section 368(a)(1)(A), (B), (C), and
(G) will not be disqualified because all or
part of the assets or stock acquired in the
transaction are transferred to a corporation
controlled by the acquiring corporation.
On August 16, 2004, the IRS and Trea-
sury issued proposed regulations under
§1.368–2(k) that permit assets or stock
acquired in any reorganization under
section 368(a)(1) to be transferred to a
corporation controlled by the acquiring
corporation without disqualifying the re-
organization. Prior to these proposed
regulations, the IRS and Treasury issued
Rev. Rul. 2002–85, 2002–2 C.B. 986,
which extended this treatment to sec-
tion 368(a)(1)(D) reorganizations. Notice
2002–77, 2002–2 C.B. 997, issued con-
temporaneously with Rev. Rul. 2002–85,
provided that §1.367(a)–3(d)(1)(v) would
be amended to treat transactions described
in Rev. Rul. 2002–85 as indirect stock
transfers, if the transfer of assets by the
acquiring corporation to its controlled
subsidiary occurred pursuant to the plan
of reorganization.
The effect of the proposed regulations
under §1.368–2(k) is to permit transfers of
assets or stock to a controlled subsidiary in
reorganizations not specifically identified
or mentioned in section 368(a)(2)(C) (sec-
tion 368(a)(1)(D) and (F) reorganizations).
The proposed regulations amend the indi-
rect stock transfer rules to conform to the
changes in the section 368 regulations. As
a result, the proposed regulations provide
that the transfer of assets to a controlled
subsidiary subsequent to an asset reorgani-
zation under section 368(a)(1) would con-
stitute an indirect transfer of stock, pro-
vided the transfer of assets by the foreign
acquiring corporation to its controlled sub-
sidiary occurs as part of the same transac-
tion.
F.Indirect Transfers Involving a Change
in Domestic or Foreign Status of Acquired
Corporation
As indicated above, under existing
§1.367(a)–3(d)(1)(v), a U.S. shareholder
of an acquired corporation is treated as
transferring the stock of the acquired cor-
poration to the foreign acquiring corpora-
tion to the extent of the assets transferred
to the controlled subsidiary. Thus, if the
acquired corporation is foreign, the U.S.
shareholder is treatedas transferring stock
of a foreign corporation to the foreign
acquiring corporation in a transaction
that is subject to the §1.367(a)–3(b) stock
transfer rules. If the acquired corpora-
tion is domestic, the U.S. shareholder is
treated as transferring stock of a domestic
corporation to the foreign acquiring cor-
poration in a transaction that is subject to
§1.367(a)–3(c). This deemed transfer of
domestic stock prevails even if the con-
trolled subsidiary is foreign. Similar rules
apply to parentheticalC reorganizations.
Some commentators have suggested
that the determination of whether domes-
tic or foreign stock is deemed transferred
should be based on the status of the con-
trolled subsidiary, rather than the status
of the acquired corporation. Under this
approach, if the acquired corporation were
domestic and the controlled subsidiary
were foreign, the U.S. shareholders would
be deemed to transfer foreign corporation
stock subject to §1.367(a)–3(b), rather
than domestic corporation stock subject to
§1.367(a)–3(c). The IRS and Treasury be-
lieve that, consistent with the framework
of the current regulations, it is appropriate
for the rules to continue to apply based on
the stock that is owned and exchanged by
the U.S. person in the transaction (rather
than on the stock of the controlled sub-
sidiary). The IRS and Treasury are consid-
ering the application of §§1.367(a)–3(b),
1.367(a)–3(c), and 1.367(a)–8 to situations
where the foreign acquiring corporation
transfers assets of the acquired corpora-
tion to multiple controlled subsidiaries
(including both domestic and foreign sub-
sidiaries), comments are requested in this
regard.
G.Coordination of the Indirect Stock
Transfer Rules and the Asset Transfer
Rules
In the case of an indirect stock transfer
that also involves a transfer of assets by a
domestic corporation to a foreign corpora-
tion, §1.367(a)–3(d)(2)(vi) generally pro-
vides that section 367(a) and (d) apply to
the transfer of assets prior to application
of the indirect stock transfer rules. How-
ever, section 367(a) does not apply to such
transfers to the extent that the foreign ac-
quiring corporation transfers the assets re-
ceived in the asset transfer to a domestic
corporation controlled (within the mean-
ing of section 368(c)) by the foreign ac-
quiring corporation in a transfer described
in section 368(a)(2)(C) or in a transfer de-
February 14, 20055412005–7 I.R.B.

scribed in section 351, provided the do-
mestic transferee’s basis in the assets is no
greater than the basis that the domestic ac-
quired corporation had in such assets. The
initial asset transfer to the foreign corpora-
tion is not subject to section 367(a) in such
cases because the assets re-transferred to
the domestic corporation remain subject to
U.S. corporate tax.
The IRS and Treasury are concerned
that asset reorganizations subject to this
coordination rule may be used to facilitate
corporate inversion transactions. An in-
version generally involves a U.S. multina-
tional corporation reincorporating outside
the United States for tax purposes (either
as a foreign corporation or as a subsidiary
of a new foreign corporation). The IRS
and Treasury also are concerned that the
coordination rule might be used to facil-
itate divisive transactions. The proposed
regulations address both of these concerns
by modifying the scope of the coordination
rule.
The revised coordination rule operates
as follows. Section 367(a) and (d) gener-
ally apply to the transfer of assets to a for-
eign corporation even if the foreign cor-
poration transfers all or part of the assets
received to a controlled domestic corpora-
tion. This general rule, however, is subject
to two exceptions which do not require in-
come recognition under section 367(a) and
(d) on the transfer of assets to the foreign
corporation to the extent that assets are
re-transferred to the domestic controlled
corporation.
The first exception applies if the do-
mestic acquired corporation is controlled
(within the meaning of section 368(c)) by 5
or fewer domestic corporations, appropri-
ate basis adjustments as provided in sec-
tion 367(a)(5) are made to the stock of
the foreign acquiringcorporation, and any
other conditions provided in regulations
under section 367(a)(5) are satisfied. Al-
though there currently are no regulations
under section 367(a)(5), this exception will
incorporate any conditions or limitations
in future regulations once published.
In cases where the first exception does
not apply, the second exception applies if
the following two conditions are satisfied:
(1) the indirect transfer of stock of the do-
mestic acquired corporation satisfies the
requirements of §1.367(a)–3(c)(1)(i), (ii),
and (iv), and (c)(6);and (2) the domestic
acquired corporation attaches a statement
(described below) to its tax return for the
taxable year of the transfer.
The statement that the domestic ac-
quired corporation files must certify that, if
the foreign acquiring corporation disposes
of any stock of the domestic controlled
corporation with a principal purpose of
avoiding U.S. tax that would have been
imposed on the domestic acquired corpo-
ration had it disposed of the re-transferred
assets, the domestic acquired corporation
will amend its return for the year of the
initial transaction and recognize gain (de-
scribed below). The disposition of stock
is presumed to have a principal purpose
of tax avoidance if the disposition occurs
within 2 years of the transfer. The pre-
sumption may be rebutted, however, if the
domestic acquired corporation (or the for-
eign acquiring corporation on its behalf)
demonstrates to the satisfaction of the
Commissioner that the transaction did not
have a principal purpose of tax avoidance.
If the domestic acquired corporation
recognizes gain pursuant to the statement,
it is treated as if, immediately prior to the
exchange, it had transferred the re-trans-
ferred assets, including any intangible
assets, directly to a domestic corporation
in exchange for stock of the corporation in
a transaction that is treated as a section 351
exchange, and immediately sold the stock
to an unrelated party at fair market value
in a sale in which it recognizes gain, if
any, but not loss. For purposes of this rule,
the deemed transfer to a domestic corpo-
ration is treated as a section 351 exchange
regardless of whether all the requirements
for nonrecognition under section 351 are
otherwise satisfied. Treating the domes-
tic acquired corporation as recognizing
gain on the disposition of stock, rather
than assets, is intended to approximate the
consequences that would have resulted
had the domestic acquired corporation
transferred the assets to a corporation
and sold the stock received in such trans-
fer prior to the outbound reorganization.
In addition, this treatment is consistent
with other provisions that address divisive
transactions. See,e.g., section 355(e) and
§1.367(e)-(2)(b)(2)(iii).
The basis that the foreign acquiring
corporation has in the stock of the do-
mestic controlled corporation is increased
by the amount of gain recognized by the
domestic acquired corporation under these
rules immediately prior to its disposition;
however, the basis of the re-transferred
assets held by the domestic controlled
corporation will not be increased by such
gain. Finally, the anti-abuse provision
under §1.367(d)–1T(g)(6) will not ap-
plytointangiblepropertyincludedinthe
re-transferred assets.
H.Application of Section 367(b)
Regulations to Certain Triangular
Reorganizations
Section 367(b) applies to exchanges un-
der sections 332, 351, 354, 355, 356, and
361 (except to the extent described in sec-
tion 367(a)(1)) in which the status of a for-
eign corporation as a corporation for tax
purposes is necessary for application of the
relevant nonrecognition provisions. Ex-
cept as provided in regulations, under sec-
tion 367(b) a foreign corporation that is a
party to such an exchange is considered
to be a corporation for tax purposes, and
therefore the parties involved in the trans-
action are eligible fornonrecognition treat-
ment.
Section 1.367(b)–4 applies to acquisi-
tions by a foreign corporation (the foreign
acquiring corporation) of the stock or as-
sets of another foreign corporation (the for-
eign acquired corporation) in certain non-
recognition exchanges (a section 367(b)
exchange). Consistent with section 1248,
§1.367(b)–4(b)(1)(i)addresses exchanges
by a section 1248 shareholder (or, in cer-
tain cases, a CFC shareholder that has a
section 1248 shareholder), and generally
requires such a shareholder to include in
income its section 1248 amount as a re-
sult of a section 367(b) exchange, if im-
mediately after the exchange (i) the stock
received in the exchange is not stock in
a corporation that is a controlled foreign
corporation as to which the section 1248
shareholder described above is a section
1248 shareholder, or (ii) the foreign ac-
quiring corporation or the foreign acquired
corporation (if any, such as in a transac-
tion described in section 368(a)(1)(B) or
351), is not a controlled foreign corpora-
tion as to which the section 1248 share-
holder described above is a section 1248
shareholder.
Therefore, in a triangular reorganiza-
tion (such as a triangular reorganization
described in section 368(a)(1)(C)) that is
within the scope of §1.367(b)–4, a section
367(b) shareholder must include in income
2005–7 I.R.B.542February 14, 2005

the section 1248 amount if, for example,
it receives stock of a domestic corporation
in exchange for its stock in a controlled
foreign corporation. This is the case be-
cause, immediately after the exchange, the
section 367(b) shareholder does not hold
stock in a corporation that is a controlled
foreign corporation as to which such share-
holder is a section 367(b) shareholder.
Pursuant to the basis rules con-
tained in this proposed regulation under
§1.367(b)–13, the section 1248 amount
with respect to the stock of the foreign
acquired corporation that is exchanged
can be properly preserved in the stock of
a foreign corporation owned by a domes-
tic corporation when the section 367(b)
shareholder receives stock of the domestic
corporation in a triangular reorganization.
Consequently, the proposed regulations
provide that a section 367(b) shareholder
receiving stock of a domestic corporation
in a triangular reorganization is not re-
quired to include in income the section
1248 amount under §1.367(b)–4(b)(1)(i),
provided that the domestic corporation,
immediately after the exchange, is a sec-
tion 1248 shareholder of the surviving
corporation (or in the case of a parenthet-
ical section 368(a)(1)(B) reorganization,
of the acquired corporation) that is itself a
controlled foreign corporation.
I.Application of Section 367(b)
Regulations to Certain Outbound
Reorganizations
If a domestic corporation is a section
1248 shareholder with respect to a foreign
corporation and transfers the stock in such
foreign corporation to another foreign cor-
poration in a section 361 transfer, the do-
mestic corporation must include in income
the section 1248 amount, if any, with re-
spect to the stock of the transferred for-
eign corporation. See section 1248(f)(1)
and §1.367(b)–4(b)(2)(ii),Example 4.
Taxpayers have commented that this
rule may result in income inclusions in
some cases where the section 1248 amount
could be preserved, such that a current in-
clusion may not be necessary or appropri-
ate. The IRS and Treasury are considering
the application of section 367(a)(5) and
section 1248(f)(1) to such transactions, in
conjunction with §1.367(b)–13 of these
regulations, to preserve section 1248
amounts, and comments are requested
in this regard. The IRS and Treasury
also are considering, and request com-
ments, on situations in which there are
multiple shareholders (including minority
shareholders) of the domestic corporation;
multiple assets (including appreciated and
depreciated assets being transferred as part
of the section 361 transfer); and liabili-
tiesbeingassumedinconnectionwiththe
transaction.
J.Nonrecognition Transactions under the
FIRPTA and PFIC Provisions
Section 897(a) generally treats gain or
loss from the disposition of a U.S. real
property interest by a nonresident alien
individual or a foreign corporation as
gain or loss that is effectively connected
with the conduct of a trade or business
within the United States. Sections 897(d)
and (e) provide rules that apply section
897 in the context of distributions and
nonrecognition exchanges of U.S. real
property interests. Temporary regulations
were issued under sections 897(d) and
(e) providing guidance on the applica-
tion of section 897 to certain corporate
transactions involving U.S. real property
interests. See §1.897–5T, 1.897–6T, and
Notice 89–85, 1989–2 C.B. 403. These
rules do not specifically address A reor-
ganizations because such regulations were
based on A reorganizations being limited
to statutory mergers between domestic
corporations. The IRS and Treasury in-
tend to revise these regulations to reflect
A reorganizations and welcome comments
on revisions that are necessary to apply
these regulations to A reorganizations, as
well as comments on other issues under
the regulations.
Section 1291(f) provides authority to
issue regulations concerning the exchange
of stock in a passive foreign investment
company (PFIC) in a nonrecognition
transaction. Proposed regulations were
published in theFederal Register(57
FR 11047) on April 1, 1992, providing
rules for the disposition of PFIC stock
by U.S. shareholders in nonrecognition
exchanges. See §1.1291–6 of the pro-
posed regulations. The application of
these proposed regulations is based on A
reorganizations being limited to statutory
mergers between domestic corporations.
The IRS and Treasury intend to revise
these proposed regulations to reflect A re-
organizations and welcome comments on
revisions that are necessary in this regard,
as well as comments on other issues under
these regulations.
Proposed Effective Date
Except as otherwise specified, these
regulations are proposed to apply to trans-
actions occurring after the date these reg-
ulations are published as final regulations
in theFederal Register.
Special Analyses
The IRS and the Treasury Department
have determined that this notice of pro-
posed rulemaking is not a significant regu-
latory action as defined in Executive Or-
der 12866. Therefore, a regulatory as-
sessment pursuant to that Order is not re-
quired. It has also been determined that
section 553(b) of the Administrative Pro-
cedure Act (5 U.S.C. chapter 5) does not
apply to these regulations, and that because
this regulation does not impose a collec-
tion of information on small entities, the
Regulatory Flexibility Act (5 U.S.C. chap-
ter 6) does not apply. Pursuant to section
7805(f) of the Code, this regulation 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 regulations
and on how they can be made easier to un-
derstand. All comments will be available
for public inspection and copying.
A public hearing has been scheduled for
May 19, 2005, beginning at 10:00 a.m. in
the Auditorium, Internal Revenue Build-
ing, 1111 Constitution Avenue, NW, Wash-
ington, DC. Due to building security pro-
cedures, visitors must enter at the Consti-
tution Avenue entrance. In addition, all
visitors must present photo identification
to enter the building. Because of access
restrictions, visitors will not be admitted
beyond the immediateentrance area more
February 14, 20055432005–7 I.R.B.

than 30 minutes before the hearing starts.
For information about having your name
placed on the building access list to attend
the hearing, see the FOR FURTHER IN-
FORMATION CONTACT portion of this
preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish to
presentoralcommentsmustsubmitwrit-
ten or electronic comments and an out-
line of the topics to be discussed and the
time to be devoted to each topic (a signed
original and eight (8) copies) by April 28,
2005. A period of 10 minutes will be
allotted to each person for making com-
ments. An agenda showing the scheduling
of the speakers will be prepared after the
deadline for receiving outlines has passed.
Copies of the agenda will be available free
of charge at the hearing.
Drafting Information
The principal author of these regula-
tions is Robert W. Lorence, Jr., of the Of-
fice of Associate Chief Counsel (Interna-
tional). However, other personnel from
the IRS and Treasury Department partic-
ipated in their development.
*****
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 continues to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. In section 1.358–1, paragraph
(a) is amended by adding a sentence at the
end of the paragraph to read as follows:
§1.358–1 Basis to distributees.
(a)***Inthecaseofcertainsection
354 or 356 exchanges of stock in a foreign
corporation, §1.367(b)–13 applies instead
of the rules of §1.358–2.
*****
Par. 3. In §1.358–6, paragraph (e) is
amended by adding a sentence at the end
of the paragraph to read as follows:
§1.358–6 Stock basis in certain triangular
reorganizations.
*****
(e) * * * For certain triangular reorga-
nizations where the surviving corporation
(S or T) is foreign, see §1.367(b)–13.
*****
Par. 4. Section 1.367(a)–3 is amended
as follows:
1. In paragraph (a), remove the third
and fourth sentences, and add five sen-
tences in their place.
2. Revise paragraph (b)(2)(i).
3. Revise paragraph (c)(5)(vi).
4. In paragraph (d)(1), introductory
text, first sentence, add the parenthetical
“(or in a domestic corporation in control
of a foreign acquiring corporation in a tri-
angular section 368(a)(1)(B) reorganiza-
tion)” after the words “for stock or secu-
rities in a foreign corporation”.
5. In paragraph (d)(1), introductory
text, remove the last sentence and add three
sentences in its place.
6. In paragraph (d)(1)(i), remove the
last sentence and add a sentence in its
place.
7. In paragraph (d)(1)(ii), add a sen-
tence at the end of the paragraph.
8. Paragraph (d)(1)(iii) is revised.
9. In paragraph (d)(1)(iv), remove the
language “Example 7”andadd“Example
8” in its place, and remove “Example 11”
and add “Example 14” in its place.
10. Revise paragraph (d)(1)(v).
11. Revise paragraphs (d)(2)(i) and
(ii).
12. In paragraph (d)(2)(iv), last sen-
tence, remove the language “Example 4”
and add “Examples 5and5A” in its place.
13. Revise paragraph (d)(2)(v)(C).
14. Redesignate paragraph (d)(2)(v)
(D) as paragraph (d)(2)(v)(F).
15. Add new paragraphs (d)(2)(v)(D)
and (E).
16. Revise paragraph (d)(2)(vi).
17. In paragraph (d)(3), redesignate the
examples as follows and add the following
new examples:
RedesignateAsAdd
Example 12Example 16
Example 15
Examples 11and11AExamples 14and14A
Examples 10and10AExamples 13and13A
Example 9Example 12
Examples 10and11
Example 8Example 9
Examples 7,7A,7B,and7CExamples 8,8A,8B,and8C
Examples 6and6AExamples 7and7A
Examples 5,5A,and5BExamples 6,6A,and6B
Examples 6Cand6D
Example 4Example 5
Example 5A
2005–7 I.R.B.544February 14, 2005

RedesignateAsAdd
Example 3Example 4
Example 2Example 3
Example 2
18. In paragraph (d)(3), newly desig-
natedExample 6A, paragraph (i), the first
and last sentences are revised.
19. In paragraph (d)(3), newly desig-
natedExample 6BandExample 9are re-
vised.
20. In paragraph (d)(3), for each of
the newly designated examples listed in
the first column, replace the language in
the second column with the language in the
third column:
Redesignated ExamplesRemoveAdd
Example 6A, paragraph (i), first sentenceExample 5Example 6
Example 7, paragraph (i)Example 5Example 6
Example 7A, paragraph (i) and paragraph
(ii), penultimate sentence
Example 6Example 7
Example 8, paragraph (i)Example 5Example 6
Example 8A, paragraph (i)Example 7Example 8
Example 8B, paragraph (i)Example 7Example 8
Example 8C, paragraph (i)Example 7Example 8
Example 12, paragraph (i), third sentenceExample 9Example 12
Example 13A, paragraph (i) and paragraph
(ii), first sentence
Example 10Example 13
Example 14A, paragraph (i)Example 11Example 14
22. In paragraph (e)(1), remove the
first sentence and add two sentences in its
place.
The revisions and additions are as fol-
lows:
§1.367(a)–3 Treatment of transfers of
stock or securities to foreign corporations.
*****
(a) * * * However, if, in an exchange
described in section 354 or 356, a U.S.
person exchanges stock of a foreign cor-
poration in a reorganization described in
section 368(a)(1)(E), or a U.S. person ex-
changes stock of a domestic or foreign cor-
poration for stock of a foreign corporation
pursuant to an asset reorganization that is
not treated as an indirect stock transfer un-
der paragraph (d) of this section, such sec-
tion 354 or 356 exchange is not a trans-
fer to a foreign corporation subject to sec-
tion 367(a). See paragraph (d)(3),Exam-
ple 16, of this section. For purposes of this
section, an asset reorganization is defined
as a reorganization described in section
368(a)(1) involving a transfer of assets un-
der section 361. If, in a transfer described
in section 361, a domestic merging corpo-
ration transfers stock of a controlling cor-
poration to a foreign surviving corporation
in a reorganization described in sections
368(a)(1)(A) and (a)(2)(E), such section
361 transfer is not subject to section 367(a)
if the stock of the controlling corporation
is provided to the merging corporation by
the controlling corporation pursuant to the
plan of reorganization; a section 361 trans-
fer of other property, including stock of
the controlling corporation not provided
by the controlling corporation pursuant to
the plan of reorganization, by the domestic
merging corporation to the foreign surviv-
ing corporation pursuant to such a reorga-
nization is subject to section 367(a). For
special basis and holding period rules in-
volving foreign corporations that are par-
ties to certain reorganizations under sec-
tion 368(a)(1), see §1.367(b)–13.* * *
(b) * * *
(2) * * *
(i)In general. A transfer of foreign
stock or securities described in section
367(a) and the regulations thereunder as
well as in section 367(b) and the regula-
tions thereunder shall be subject concur-
rently to sections 367(a) and (b) and the
regulations thereunder, except as provided
in paragraph (b)(2)(i)(A) or (B) of this
section. See paragraph (d)(3),Example
11, of this section.
(A) If a foreign corporation transfers as-
sets to a domestic corporation in a transac-
tion to which §1.367(b)–3(a) and (b) and
the indirect stock transfer rules of para-
graph (d) of this section apply, then the sec-
tion 367(b) rules shall apply prior to the
section 367(a) rules. See paragraph (d)(3),
Example 15, of this section. This para-
graph (b)(2)(i)(A) applies only to transac-
tions occurring after the date these regula-
tions are published as final regulations in
theFederal Register.
(B) Except as provided in paragraph
(b)(2)(i)(A) of this section, section 367(b)
and the regulations thereunder shall not ap-
ply if the foreign corporation is not treated
February 14, 20055452005–7 I.R.B.

as a corporation under section 367(a)(1).
See paragraph (d)(3),Example 14,ofthis
section.
*****
(c) * * *
(5) * * *
(vi)Transferee foreign corpora-
tion. Except as provided in paragraph
(d)(1)(iii)(B) of this section, the transferee
foreign corporation shall be the foreign
corporation that issues stock or securities
to the U.S. person in the exchange.
*****
(d) * * *
(1) * * * For examples of the concur-
rent application of the indirect stock trans-
fer rules under section 367(a) and the rules
of section 367(b), see paragraph (d)(3),Ex-
amples 14and15of this section. For
purposes of this paragraph (d), if a cor-
poration acquiring assets in a reorganiza-
tion described in section 368(a)(1) trans-
fers all or a portion of such assets to a cor-
poration controlled (within the meaning of
section 368(c)) by the acquiring corpora-
tion as part of the same transaction, the
subsequent transfer of assets to the con-
trolled corporation will be referred to as
a controlled asset transfer. See section
368(a)(2)(C).
(i) * * * See paragraph (d)(3),Ex-
ample 1of this section for an example
of a reorganization described in sections
368(a)(1)(A) and (a)(2)(D) involving
domestic acquired and acquiring corpora-
tions, and see paragraph (d)(3),Example
10of this section for an example involv-
ing a domestic acquired corporation and a
foreign acquiring corporation.
(ii) * * * See paragraph (d)(3),Ex-
ample 2of this section for an example
of a reorganization described in sections
368(a)(1)(A) and (a)(2)(E) involving do-
mestic acquired and acquiring corpora-
tions, and see paragraph (d)(3),Example
11of this section for an example involv-
ing a domestic acquired corporation and a
foreign acquiring corporation.
(iii)Triangular reorganizations de-
scribedinsection368(a)(1)(B)—(A) A
U.S. person exchanges stock of the ac-
quired corporation for voting stock of a
foreign corporation that is in control (as
defined in section 368(c)) of the acquiring
corporation in a reorganization described
in section 368(a)(1)(B). See paragraph
(d)(3),Example 5of this section.
(B) A U.S. person exchanges stock of
the acquired corporation for voting stock
of a domestic corporation that is in control
(as defined in section 368(c)) of a foreign
acquiring corporation in a reorganization
described in section 368(a)(1)(B).
(1) For purposes of paragraphs (b) and
(c) of this section, the foreign acquiring
corporation is considered to be the trans-
feree foreign corporation even though the
U.S. transferor receives stock of the do-
mestic controlling corporation in the ex-
change.
(2) If stock of a foreign acquired cor-
poration is exchanged for the voting stock
of a domestic corporation in control of a
foreign acquiring corporation, then the ex-
change will be subject to the rules of para-
graph (b) of this section. If the exchang-
ing shareholder is a section 1248 share-
holder with respect to the foreign acquired
corporation, the indirect transfer will be
subject to sections 367(a) and (b) con-
currently. For the application of section
367(b) to the exchange, see §§1.367(b)–4
and 1.367(b)–13(c).
(3) If stock of a domestic acquired cor-
poration is exchanged for the voting stock
of a domestic corporation in control of a
foreign acquiring corporation, then the ex-
change will be subject to the rules of para-
graph (c) of this section.
(4) For purposes of applying the
gain recognition agreement provisions
of paragraph (d)(2) of this section and
§1.367(a)–8, the domestic controlling cor-
poration will be treated as the transferee
foreign corporation. Thus, a disposition
of foreign acquiring corporation stock by
the domestic controlling corporation, or a
disposition of acquired corporation stock
by the foreign acquiring corporation,
will trigger the gain recognition agree-
ment. See paragraph (d)(3),Example 5A
of this section.
(5) This paragraph (d)(1)(iii)(B) ap-
plies only to transactions occurring after
the date these regulations are published
as final regulations in theFederal Regis-
ter.
*****
(v)Transfers of assets to subsidiaries
in certain section 368(a)(1) reorganiza-
tions. A U.S. person exchanges stock or
securities of a corporation (the acquired
corporation) for stock or securities of a
foreign acquiring corporation in an asset
reorganization (other than a triangular
section 368(a)(1)(C) reorganization de-
scribed in paragraph (d)(1)(iv) of this
section or a reorganization described in
sections 368(a)(1)(A) and (a)(2)(D) or
(a)(2)(E) described inparagraphs (d)(1)(i)
or (ii) of this section) that is followed by
a controlled asset transfer. In the case of
a transaction described in this paragraph
(d)(1)(v) in which some but not all of
the assets of the acquired corporation are
transferred in a controlled asset transfer,
the transaction shall be considered to be
an indirect transfer of stock or securities
subject to this paragraph (d) only to the
extent of the assets so transferred. The
remaining assets shall be treated as having
been transferred in an asset transfer rather
than an indirect stock transfer, and such
asset transfer shall be subject to the other
provisions of section 367, including sec-
tions 367(a)(1), (3), and (5), and (d) if the
acquired corporation is a domestic corpo-
ration. See paragraph (d)(3),Examples
6Aand6Bof this section.
*****
(2) * * *
(i)Transferee foreign corporation.Ex-
cept as provided in paragraph (d)(1)(iii)(B)
of this section, the transferee foreign cor-
poration shall be the foreign corporation
that issues stock or securities to the U.S.
person in the exchange.
(ii)Transferred corporation.The
transferred corporation shall be the ac-
quiring corporation, except as provided in
this paragraph (d)(2)(ii). In the case of a
triangular section 368(a)(1)(B) reorgani-
zation described in paragraph (d)(1)(iii)
of this section, the transferred corpora-
tion shall be the acquired corporation. In
the case of an indirect stock transfer de-
scribed in paragraph (d)(1)(i), (ii), or (iv)
of this section followed by a controlled
asset transfer, or an indirect stock transfer
described in paragraph (d)(1)(v) of this
section, the transferred corporation shall
be the controlled corporation to which
the assets are transferred. In the case of
successive section 351 transfers described
in paragraph (d)(1)(vi) of this section, the
transferred corporation shall be the corpo-
ration to which the assets are transferred
in the final section 351 transfer. The
transferred property shall be the stock or
securities of the transferred corporation,
as appropriate under the circumstances.
2005–7 I.R.B.546February 14, 2005

*****
(v) * * *
(C) In the case of an asset reorganiza-
tion followed by a controlled asset transfer,
as described in paragraph (d)(1)(v) of this
section, the assets of the acquired corpora-
tion that are transferred to the corporation
controlled by the acquiring corporation;
(D) In the case of a triangular reorga-
nization described in section 368(a)(1)(C)
followed by a controlled asset transfer,
or a reorganization described in sections
368(a)(1)(A) and (a)(2)(D) followed by
a controlled asset transfer, the assets of
the acquired corporation including those
transferred to the corporation controlled
by the acquiring corporation;
(E) In the case of a reorganization
described in sections 368(a)(1)(A) and
(a)(2)(E) followed by a controlled asset
transfer, the assets of the acquiring corpo-
ration including those transferred to the
corporation controlled by the acquiring
corporation; and
*****
(vi)Coordination between asset trans-
fer rules and indirect stock transfer
rules—(A)General rule. If, pursuant
to any of the transactions described in
paragraph (d)(1) of this section, a U.S.
person transfers (or is deemed to transfer)
assets to a foreign corporation in an ex-
change described in section 351 or 361,
the rules of section 367, including sections
367(a)(1), (a)(3), and (a)(5), as well as
section 367(d), and the regulations there-
under shall apply prior to the application
of the rules of this section.
(B)Exceptions.(1) If a transaction
is described in paragraph (d)(2)(vi)(A) of
this section, sections 367(a) and (d) shall
not apply to the extent a domestic cor-
poration (domestic acquired corporation)
transfers its assets toa foreign corporation
(foreign acquiring corporation) in an asset
reorganization, and such assets (re-trans-
ferred assets) are transferred to a domes-
tic corporation (domestic controlled cor-
poration) controlled (within the meaning
of section 368(c)) by the foreign acquiring
corporation as part of the same transaction,
provided that the domestic controlled cor-
poration’s basis in such assets is no greater
than the basis that the domestic acquired
corporation had in such assets and the con-
ditions contained in either of the following
paragraphs are satisfied:
(i) The domestic acquired corpora-
tion is controlled (within the meaning of
section 368(c)) by 5 or fewer domestic
corporations, appropriate basis adjust-
mentsasprovidedinsection367(a)(5)are
made to the stock of the foreign acquir-
ing corporation, and any other conditions
as provided in regulations under section
367(a)(5) are satisfied. For purposes of
determining whether the domestic ac-
quired corporation is controlled by 5 or
fewer domestic corporations, all members
of the same affiliated group within the
meaning of section 1504 shall be treated
as 1 corporation.
(ii) The requirements of paragraphs
(c)(1)(i), (ii), and (iv), and (c)(6) of this
section are satisfied with respect to the
indirect transfer of stock in the domestic
acquired corporation, and the domestic
acquired corporation attaches a statement
described in paragraph (d)(2)(vi)(C) of
this section to its U.S. income tax return
for the taxable year of the transfer.
(2) Sections 367(a) and (d) shall not
apply to transfers described in paragraph
(d)(1)(vi) of this section where a U.S. per-
son transfers assets to a foreign corpora-
tion in a section 351 exchange, to the ex-
tent that such assets are transferred by such
foreign corporation to a domestic corpora-
tion in another section 351 exchange, but
only if the domestic transferee’s basis in
the assets is no greater than the basis that
the U.S. transferor had in such assets.
(C)Required statement. The statement
required by paragraph (d)(2)(vi)(B)(1)(ii)
of this section shall be entitled “Required
Statement under §1.367(a)–3(d) for As-
sets Transferred to a Domestic Corpora-
tion” and shall be signed under penalties
of perjury by an authorized officer of the
domestic acquired corporation and by an
authorized officer of the foreign acquir-
ing corporation. The required statement
shall contain a certification that, if the for-
eign acquiring corporation disposes of any
stock of the domestic controlled corpora-
tion in a transaction described in paragraph
(d)(2)(vi)(D) of this section, the domestic
acquired corporation shall recognize gain
as described in paragraph (d)(2)(vi)(E)(1)
of this section. The domestic acquired cor-
poration (or the foreign acquiring corpo-
ration on behalf of the domestic acquired
corporation) shall file a U.S. income tax re-
turn (or an amended U.S. tax return, as the
case may be) for the year of the transfer re-
porting such gain.
(D)Gain recognition transaction.(1)
A transaction described in this paragraph
(d)(2)(vi)(D) is one where a principal pur-
pose of the transfer by the domestic ac-
quired corporation is the avoidance of U.S.
tax that would have been imposed on the
domestic acquired corporation on the dis-
position of the re-transferred assets. A
transfer may have a principal purpose of
tax avoidance even though the tax avoid-
ance purpose is outweighed by other pur-
poses when taken together.
(2) For purposes of paragraph
(d)(2)(vi)(D)(1) of this section, a transac-
tion is deemed to have a principal purpose
of tax avoidance if the foreign acquiring
corporation disposes of any stock of the
domestic controlled corporation (whether
in a recognition or non-recognition trans-
action) within 2 years of the transfer. The
rule in this paragraph (d)(2)(vi)(D)(2)shall
not apply if the domestic acquired corpora-
tion (or the foreign acquiring corporation
on behalf of the domestic acquired corpo-
ration) demonstrates to the satisfaction of
the Commissioner that the avoidance of
U.S. tax was not a principal purpose of the
transaction.
(E)Amount of gain recognized and
other matters.(1) In the case of a transac-
tion described in paragraph (d)(2)(vi)(D)
of this section, solely for purposes of this
paragraph (d)(2)(vi)(E), the domestic ac-
quired corporation shall be treated as if,
immediately prior to the transfer, it trans-
ferred the re-transferred assets, including
any intangible assets, directly to a domes-
tic corporation in exchange for stock of
such domestic corporation in a transaction
that is treated as a section 351 exchange,
and immediately sold such stock to an un-
related party for its fair market value in a
sale in which it shall recognize gain, if any
(but not loss). Any gain recognized by the
domestic acquired corporation pursuant to
this paragraph (d)(2)(vi)(E) will increase
the basis that the foreign acquiring cor-
poration has in the stock of the domestic
controlled corporation immediately before
the transaction described in paragraph
(d)(2)(vi)(D) of this section, but will not
increase the basis of the re-transferred
assets held by the domestic controlled cor-
poration. Section 1.367(d)–1T(g)(6) shall
not apply with respect to any intangible
February 14, 20055472005–7 I.R.B.

property included in the re-transferred as-
sets described in the preceding sentence.
(2) If additional tax is required to be
paid as a result of a transaction described
in paragraph (d)(2)(vi)(D) of this section,
then interest must be paid on that amount
at rates determined under section 6621
with respect to the period between the date
prescribed for filing the domestic acquired
corporation’s income tax return for the
year of the transfer and the date on which
the additional tax for that year is paid.
(F)Examples. For illustrations of the
rules in paragraph (d)(2)(vi) of this sec-
tion, see paragraph (d)(3),Examples 6B,
6C,6D,9,and13Aof this section.
(G)Effective dates. Paragraph (d)(2)
(vi) of this section applies only to trans-
actions occurring after the date these
regulations are published as final reg-
ulations in theFederal Register.See
§1.367(a)–3(d)(2)(vi), as contained in 26
CFR Part 1 revised as of April 1, 2004,
for transactions occurring on or after July
20, 1998, until the date these regulations
are published as final regulations in the
Federal Register.
(3) * * *
Example 2. Section 368(a)(1)(A)/(a)(2)(E) re-
organization—(i)Facts. The facts are the same as
inExample 1, except that Newco merges into W and
Newco receives stock of W which it distributes to F
in a reorganization described in sections 368(a)(1)(A)
and (a)(2)(E). Pursuant tothe reorganization, A re-
ceives 40 percent of the stock of F in an exchange
described in section 354.
(ii)Result. The consequences of the transfer are
similar to those described inExample 1. Pursuant
to paragraph (d)(1)(ii) of this section, the reorganiza-
tion is subject to the indirect stock transfer rules. F
is treated as the transferee foreign corporation, and
W is treated as the transferred corporation. Provided
that the requirements of paragraph (c)(1) of this sec-
tion are satisfied, including the requirement that A
enter into a five-year gain recognition agreement as
described in §1.367(a)–8, A’s exchange of W stock
for F stock under section 354 will not be subject to
section 367(a)(1).
*****
Example 5A. Triangular section 368(a)(1)(B) re-
organization—(i)Facts. The facts are the same as
inExample 5, except that F is a domestic corporation
and S is a foreign corporation.
(ii)Result. U’s exchange of Y stock for stock of
F, a domestic corporation in control of S, the foreign
acquiring corporation, is treated as an indirect transfer
of Y stock to a foreign corporation under paragraph
(d)(1)(iii) of this section. U’s exchange of Y stock
for F stock will not be subject to section 367(a)(1)
provided that all of the requirements of paragraph
(c)(1) are satisfied, including the requirement that U
enter in a five-year gain recognition agreement. In
satisfying the 50 percent or less ownership require-
ments of paragraph (c)(1)(i) and (ii) of this section,
U’s indirect ownership of S stock (through its direct
ownership of F stock) will determine whether the re-
quirement of paragraph (c)(1)(i) is satisfied and will
be taken into account in determining whether the re-
quirement of paragraph (c)(1)(ii) is satisfied. See
paragraph (c)(4)(iv)). For purposes of applying the
gain recognition agreement provisions of paragraph
(d)(2) of this section and §1.367(a)–8, F is treated as
the transferee foreign corporation. The gain recogni-
tion agreement would be triggered if F sold all or a
portionofthestockofS,orifSsoldalloraportion
of the stock of Y.
*****
Example 6A. Section 368(a)(1)(C) reorganization
followed by a controlled asset transfer—(i)Facts.
ThefactsarethesameasinExample 6, except that
the transaction is structured as a section 368(a)(1)(C)
reorganization, followed by a controlled asset trans-
fer, and R is a foreign corporation. * * * F then con-
tributes Businesses B and C to R in a controlled asset
transfer. * * *
*****
Example 6B. Section 368(a)(1)(C) reorganization
followed by a controlled asset transfer to a domestic
controlled corporation—(i)Facts. The facts are the
same as inExample 6A, except that R is a domestic
corporation.
(ii)Result.AsinExample 6A, the outbound trans-
fer of the Business A assets to F is not affected by
the rules of this paragraph (d) and is subject to the
general rules under section 367. However, the Busi-
ness A assets qualify for the section 367(a)(3) active
trade or business exception. The Business B and C
assets are part of an indirect stock transfer under this
paragraph (d) but must first be tested under sections
367(a) and (d). The Business B assets qualify for
the active trade or business exception under section
367(a)(3); the Business C assets do not. However,
pursuant to paragraph (d)(2)(vi)(B) of this section, the
Business C assets are not subject to section 367(a) or
(d), provided that the basis of the Business C assets in
the hands of R is no greater than the basis of the assets
in the hands of Z, and appropriate basis adjustments
are made pursuant to section 367(a)(5) to the stock
of F held by V. (In this case, no adjustments are re-
quired because, pursuant to section 358, V takes a ba-
sis of $30 in the stock of F, which is equal to V’s pro-
portionate share of the basis in the assets of Z ($30)
transferred to F.) V also is deemed to make an indi-
rect transfer of stock underthe rules of paragraph (d).
To preserve non-recognition treatment under section
367(a), V must enter into a 5-year gain recognition
agreement in the amount of $50, the amount of the ap-
preciation in the Business B and C assets, as the trans-
fer of such assets by Z was not taxable under section
367(a)(1) and constituted an indirect stock transfer.
Example 6C. Section 368(a)(1)(C) reorganization
followed by a controlled asset transfer to a domestic
controlled corporation—(i)Facts. The facts are the
same as inExample 6B, except that Z is owned by in-
dividuals, none of whom qualify as five-percent tar-
get shareholders with respect to Z within the meaning
of paragraph (c)(5)(iii) of this section. The following
additional facts are present. No U.S. persons that are
either officers or directors of Z own any stock of F
immediately after the transfer. F is engaged in an ac-
tive trade or business outside the United States that
satisfies the test set forth in paragraph (c)(3) of this
section.
(ii)Result. The transfer of the Business A as-
sets is not affected by the rules of this paragraph (d).
However, the transfer of such assets is subject to gain
recognition under section 367(a)(1), because the sec-
tion 367(a)(3) active trade or business exception is
inapplicable pursuant to section 367(a)(5). The Busi-
ness B and C assets are part of an indirect stock trans-
fer under this paragraph (d) but must first be tested
under sections 367(a) and (d). The transfer of the
Business B assets (which otherwise would satisfy the
section 367(a)(3) active trade or business exception)
generally is subject to section 367(a)(1) pursuant to
section 367(a)(5). The transfer of the Business C as-
sets generally is subject to sections 367(a)(1) and (d).
However, pursuant to paragraph (d)(2)(vi)(B) of this
section, the transfer of the Business B and C assets is
not subject to sections 367(a)(1) and (d), provided the
basis of the Business B and C assets in the hands of R
is no greater than the basis in the hands of Z and cer-
tain other requirements are satisfied. Since Z is not
controlled within the meaning of section 368(c) by
5 or fewer domestic corporations, the indirect trans-
fer of Z stock must satisfy the requirements of para-
graphs (c)(1)(i), (ii), and (iv), and (c)(6) of this sec-
tion, and Z must attach a statement described in para-
graph (d)(2)(vi)(C) of this section to its U.S. income
tax return for the taxable year of the transfer. In gen-
eral, the statement must contain a certification that,
if F disposes of the stock of R (in a recognition or
nonrecognition transaction) and a principal purpose
of the transfer is the avoidance of U.S. tax that would
have been imposed on Z on the disposition of the
Business B and C assets transferred to R, then Z (or F
on behalf of Z) will file a return (or amended return as
the case may be) recognizing gain ($50), as if, imme-
diately prior to the reorganization, Z transferred the
Business B and C assets to a domestic corporation in
exchange for stock in a transaction treated as a section
351 exchange and immediately sold such stock to an
unrelated party for its fair market value. A transac-
tion is deemed to have a principal purpose of U.S. tax
avoidance if F disposes of R stock within two years of
the transfer, unless Z (or F on behalf of Z) can rebut
the presumption to the satisfaction of the Commis-
sioner. See paragraph (d)(2)(vi)(D)(2) of this section.
With respect to the indirect transfer of Z stock, the
requirements of paragraphs (c)(1)(i), (ii), and (iv) of
this section are satisfied. Thus, assuming Z attaches
the statement described in paragraph (d)(2)(vi)(C) of
this section to its U.S. income tax return and satisfies
the reporting requirements of (c)(6) of this section,
the transfer of Business B and C assets is not subject
to section 367(a) or (d).
Example 6D. Section 368(a)(1)(C) reorgani-
zation followed by a controlled asset transfer to a
domestic controlled corporation—(i)Facts.The
facts are the same as inExample 6C, except that the
Z shareholders receive 60 percent of the F stock in
exchange for their Z stock in the reorganization.
(ii)Result. The requirement of paragraph (c)(1)(i)
of this section is not satisfied because the Z share-
holders that are U.S. persons do not receive 50
percent or less of the total voting power and the
total value of the stock of F in the transaction. Ac-
cordingly, Z shareholdersthat are U.S. persons are
subject to section 367(a)(1) on their exchange of
Z stock for F stock pursuant to the reorganization.
2005–7 I.R.B.548February 14, 2005

For the same reason, the conditions of paragraph
(d)(2)(vi)(B)(1)(ii)ofthissectionarenotmet. Ac-
cordingly, the transfer of Business B and C assets is
subject to sections 367(a)(1) and (d), even though
such assets are re-transferredtoR,adomesticcorpo-
ration. As inExample 6C, the transfer of Business A
assets, which is not affected by the rules of paragraph
(d) of this section, is subject to gain recognition
under sections 367(a)(1) and (5).
*****
Example 9. Concurrent application with a con-
trolled asset transfer—(i)Facts. The facts are the
same as inExample 8, except that R transfers the
Business A assets to M, a wholly owned domestic
subsidiary of R, in a controlled asset transfer. In ad-
dition, V’s basis in its Z stock is $90.
(ii)Result. Pursuant to paragraph (d)(2)(vi)(B) of
this section, sections 367(a) and (d) do not apply to
Z’s transfer of the Business A assets to R, because
such assets are re-transferred to M, a domestic corpo-
ration, provided that the basis of the Business A as-
sets in the hands of M is no greater than the basis of
the assets in the hands of Z, and certain other require-
ments are satisfied. Because Z is controlled (within
the meaning of section 368(c)) by V, a domestic cor-
poration, appropriate basisadjustments must be made
pursuant to section 367(a)(5) to the stock of F held by
V. (In this case, no adjustments are required because,
pursuant to section 358, V takes a basis of $90 in the
stock of F, which is less than V’s proportionate share
of the basis in the assets of Z ($100) transferred to R.)
Section 367(a)(1) does not apply to Z’s transfer of its
Business B assets to R (which are not re-transferred
to M) because such assets qualify for an exception
to gain recognition under section 367(a)(3). With re-
spect to the indirect transfer of Z stock, such trans-
fer is not subject to gain recognition under section
367(a)(1) if the requirements of paragraph (c) of this
section are satisfied, including the requirement that
V enter into a 5-year gain recognition agreement and
comply with the requirements of §1.367(a)–8 with re-
spect to the gain ($100) realized on the Z stock. Un-
der paragraphs (d)(2)(i) and (ii) of this section, the
transferee foreign corporation is F and the transferred
corporationisM.Pursuanttoparagraph(d)(2)(iv)of
this section, a disposition by F of the stock of R, or
a disposition by R of the stock of M, will trigger the
gain recognition agreement. To determine whether an
asset disposition constitutes a deemed disposition of
the transferred corporation’s stock under the rules of
§1.367(a)–8(e)(3)(i), both the Business A assets in M
and the Business B assets in R must be considered.
Example 10. Concurrent application in sec-
tion 368(a)(1)(A)/(a)(2)(D) reorganization—(i)
Facts. The facts are the same as inExample 8,
except that R acquires all of the assets of Z in a
reorganization described in sections 368(a)(1)(A)
and (a)(2)(D). Pursuant to the reorganization, V
receives 30 percent of the stock of F in a section 354
exchange.
(ii)Result. The consequences of the transaction
are similar to those inExample 8. The assets of Busi-
nesses A and B that are transferred to R must be tested
under section 367(a) prior to the consideration of the
indirect stock transfer rules of this paragraph (d). The
Business B assets qualify for the active trade or busi-
ness exception under section 367(a)(3). Because the
Business A assets do not qualify for the exception,
Z must recognize $40 of gain under section 367(a)
on the transfer of Business A assets to R. Because
V and Z file a consolidated return, V’s basis in the
stock of Z is increased from $100 to $140 as a result
of Z’s $40 gain. V’s indirect transfer of Z stock will
be taxable under section 367(a) unless V enters into
a gain recognition agreement in the amount of $60
($200 value of Z stock less $140 adjusted basis) and
the other requirements of paragraph (c)(1) of this sec-
tion are satisfied.
Example 11. Section 368(a)(1)(A)/(a)(2)(E) re-
organization—(i)Facts. F, a foreign corporation,
owns all the stock of D, a domestic corporation. V, a
domestic corporation, owns all the stock of Z, a for-
eign corporation. V has a basis of $100 in the stock
of Z which has a fair market value of $200. D is
an operating corporation with assets valued at $100
with a basis of $60. In a reorganization described in
sections 368(a)(1)(A) and (a)(2)(E), D merges into Z,
and V exchanges its Z stock for 55 percent of the out-
standing F stock.
(ii)Result. Under paragraph (d)(1)(ii) of this
section, V is treated as making an indirect transfer
of Z stock to F. V’s exchange of Z stock for F stock
will be taxable under section 367(a) (and section
1248 will be applicable) if V fails to enter into a
5-year gain recognition agreement in accordance
with the requirements of §1.367(a)–8. Under para-
graph (b)(2) of this section, if V enters into a gain
recognition agreement, the exchange will be subject
to the provisions of section 367(b) and the regula-
tions thereunder as well as section 367(a). Under
§1.367(b)–4(b) of this chapter, however, no income
inclusion is required because both F and Z are con-
trolled foreign corporations with respect to which
V is a section 1248 shareholder immediately after
the exchange. Under paragraphs (d)(2)(i) and (ii) of
this section, the transferee foreign corporation is F,
and the transferred corporation is Z (the acquiring
corporation). If F disposes (within the meaning of
§1.367(a)–8(e)) of all (or a portion) of Z stock within
the 5-year term of the agreement (and V has not
made a valid election under §1.367(a)–8(b)(1)(vii)),
V is required to file an amended return for the year
of the transfer and include in income, with interest,
the gain realized but not recognized on the initial
section 354 exchange. To determine whether Z (the
transferred corporation) disposes of substantially
all of its assets, the assets of Z immediately prior
to the transaction are taken into account, pursuant
to paragraph (d)(2)(v)(B) of this section. Because
D is owned by F, a foreign corporation, section
367(a)(5) precludes any assets of D from qualifying
for nonrecognition under section 367(a)(3). Thus, D
recognizes $40 of gain on the transfer of its assets to
Z under section 367(a)(1).
*****
Example 15. Concurrent application of indirect
stock transfer rules and section 367(b)—(i)Facts.F,
a foreign corporation, owns all of the stock of Newco,
a domestic corporation. P, a domestic corporation,
owns all of the stock of FC, a foreign corporation. P’s
basis in the stock of FC is $50 and the value of FC
stock is $100. The all earnings and profits amount
with respect to the FC stock held by P is $60. See
§1.367(b)–2(d). In a reorganization described in
sections 368(a)(1)(A) and (a)(2)(D) (and paragraph
(d)(1)(i) of this section), Newco acquires all of the
properties of FC, and P exchanges its stock in FC for
20 percent of the stock in F.
(ii)Result. Because a domestic corporation,
Newco, acquires the assets of a foreign corpo-
ration,FC,inanassetreorganizationtowhich
§1.367(b)–3(a) and (b) and the indirect stock rules
of paragraph (d) of this section apply, the section
367(b) rules apply before the section 367(a) rules
apply. See §1.367(a)–3(b)(2)(i)(A). Under the rules
of section 367(b), P must include in income the all
earnings and profits amount of $60 with respect
to its FC stock. See §1.367(b)–3. Although P’s
exchange of FC stock for F stock under section 354
is an indirect stock transfer, no gain is recognized
under section 367(a), because P’s basis in the FC
stock is increased by the amount ($60) included
in income under the rules of section 367(b). See
§1.367(b)–2(e)(3)(ii). Alternatively, if P’s all earn-
ings and profits amount were $30, then the amount
of the income inclusion and basis adjustment under
the rules of section 367(b) would be $30, and the
amount of gain subject to section 367(a)(1) would be
$20 unless P entered into a 5-year gain recognition
agreement in accordance with §1.367(a)–8.
*****
(e) * * *
(1)In general. Except as provided in
paragraphs (b)(2)(i)(A), (d)(1)(iii)(B), and
(d)(2)(vi)(G), or in this paragraph (e), the
rules in paragraphs (a), (b), and (d) of this
section apply to transfers occurring on or
after July 20, 1998. The rules in para-
graphs (a) and (d) of this section, as they
apply to section 368(a)(1)(A) reorganiza-
tions (including reorganizations described
in section 368(a)(2)(D) or (E)) involving
a foreign acquiring or acquired corpora-
tion, apply only to transfers occurring af-
ter the date these regulations are published
as final regulations in theFederal Regis-
ter.***
*****
Par. 5. Section 1.367(a)–8 is amended
as follows:
1. In paragraphs (c)(2) and (d), remove
the words “district director” and add “Di-
rector of Field Operations” in their place.
2. In paragraph (e)(1)(i), a sentence is
added after the first sentence.
The addition reads as follows:
§1.367(a)–8 Gain recognition agreement
requirements.
*****
(e) * * *
(1) * * *
(i) * * * It also includes an in-
direct disposition of the stock of the
transferred corporation as described in
§1.367(a)–3(d)(2)(iv). * * *
*****
February 14, 20055492005–7 I.R.B.

Par. 6. In §1.367(b)–1(a), remove the
third and fourth sentences and add a sen-
tence in their place to read as follows:
§1.367(b)–1 Other transfers.
(a) * * * For rules coordinating the con-
current application of sections 367(a) and
(b), including the extent to which section
367(b) does not apply if the foreign corpo-
ration is not treated as a corporation under
section 367(a), see §1.367(a)–3(b)(2)(i).
***
*****
Par. 7. In §1.367(b)–3(b)(3)(ii), revise
paragraph (i) ofExample 5to read as fol-
lows:
§1.367(b)–3 Repatriation of foreign
corporate assets in certain nonrecognition
transactions.
*****
(b) * * *
(3) * * *
(ii) * * *
Example 5—(i)Facts. DC1, a domestic corpo-
ration, owns all of the outstanding stock of FC1, a
foreign corporation. FC1 owns all of the outstand-
ing stock of FC2, a foreign corporation. The all earn-
ings and profits amount with respect to the FC2 stock
owned by FC1 is $20. In a reorganization described
in section 368(a)(1)(A), DC2, a domestic corporation
unrelated to FC1 or FC2, acquires all of the assets
and liabilities of FC2 pursuant to a State W merger.
FC2 receives DC2 stock and distributes such stock to
FC1. The FC2 stock held by FC1 is canceled, and
FC2 ceases its separate legal existence.
*****
Par. 8. Section 1.367(b)–4 is amended
as follows.
1. Paragraph (a) is revised.
2. Redesignate paragraph (b)(1)(ii) as
paragraph (b)(1)(iii), and add new para-
graph (b)(1)(ii).
3. In newly designated paragraph
(b)(1)(iii), afterExample 3,addExamples
3Aand3B.
The revisions and additions read as fol-
lows:
§1.367(b)–4 Acquisition of foreign
corporate stock or assets by a foreign
corporation in certain nonrecognition
transactions.
(a)Scope. This section applies to an ac-
quisition by a foreign corporation (the for-
eign acquiring corporation) of the stock or
assets of a foreign corporation (the foreign
acquired corporation) in an exchange de-
scribed in section 351 or a reorganization
described in section 368(a)(1). In the case
of a reorganization described in sections
368(a)(1)(A) and (a)(2)(E), this section ap-
plies if stock of the foreign surviving cor-
poration is exchanged for stock of a for-
eign corporation in control of the merging
corporation; in such a case, the foreign sur-
viving corporation is treated as a foreign
acquired corporation for purposes of this
section. A foreign corporation that under-
goes a reorganization described in section
368(a)(1)(E) is treated as both the foreign
acquired corporation and foreign acquir-
ing corporation for purposes of this sec-
tion. See §1.367(a)–3(b)(2) for transac-
tions subject to the concurrent application
of this section and section 367(a).
(b) * * *
(1) * * *
(ii)Exception. In the case of a trian-
gular reorganization described in section
368(a)(1)(B) or (C), or a reorganization
described in sections 368(a)(1)(A) and
(a)(2)(D) or (E), an exchange is not de-
scribed in paragraph (b)(1)(i) of this sec-
tion if the stock received in the exchange
is stock of a domestic corporation and,
immediately after the exchange, such do-
mestic corporation is a section 1248 share-
holder of the acquired corporation (in the
case of a triangular section 368(a)(1)(B)
reorganization) or the surviving corpo-
ration (in the case of a reorganization
described in sections 368(a)(1)(A) and
(a)(2)(D) or (E)) and such acquired or sur-
viving corporation is a controlled foreign
corporation. See paragraph (b)(1)(iii) of
this section,Example 3Bfor an illustration
of this rule.
(iii) * * *
Example 3A.(i)Facts. The facts are the same
as inExample 3, except that FC1 merges into FC2
in a reorganization described in sections 368(a)(1)(A)
and (a)(2)(E). Pursuant to the reorganization, DC ex-
changes its FC2 stock for stock of FP.
(ii)Result. The result is similar to the result in
Example 3. The transfer is an indirect stock transfer
subject to section 367(a). See §1.367(a)–3(d)(1)(ii).
Accordingly, DC’s exchange of FC2 stock for FP
stock will be taxable under section 367(a) (and sec-
tion 1248 will be applicable) if DC fails to enter into a
gain recognition agreement. If DC enters into a gain
recognition agreement, the exchange will be subject
to the provisions of section 367(b) and the regula-
tions thereunder, as well as section 367(a). If FP and
FC2 are controlled foreign corporations as to which
DC is a (direct or indirect) section 1248 shareholder
immediately after the reorganization, then paragraph
(b)(1)(i) of this section does not apply to require
inclusion in income of the section 1248 amount
and the amount of the gain recognition agreement
is the amount of gain realized on the indirect stock
transfer. If FP or FC2 is not a controlled foreign
corporation as to which DC is a (direct or indirect)
section 1248 shareholder immediately after the ex-
change, then DC must include in income the section
1248 amount ($20) attributable to the FC2 stock that
DC exchanged. Under these circumstances, the gain
recognition agreement would be the amount of gain
realized on the indirect transfer, less the $20 section
1248 income inclusion.
Example 3B.(i)Facts. The facts are the same as
Example 3, except that USP, a domestic corporation,
owns the controlling interest (within the meaning of
section 368(c)) in FC1 stock. FC2 merges into FC1
in a reorganization described in sections 368(a)(1)(A)
and (a)(2)(D). Pursuant to the reorganization, DC
exchanges its FC2 stock for USP stock.
(ii)Result. Because DC receives stock of a do-
mestic corporation, USP, in the section 354 exchange,
the transfer is not an indirect stock transfer subject
to section 367(a). Accordingly, the exchange will
be subject only to the provisions of section 367(b)
and the regulations thereunder. Under paragraph
(b)(1)(ii)(A) of this section, because the stock re-
ceived is stock of a domestic corporation (USP) and,
immediately after the exchange, USP is a section
1248 shareholder of FC1 (the acquiring corporation)
and FC1 is a controlled foreign corporation, the
exchange is not described in paragraph (b)(1)(i) of
this section and DC includes no amount in its gross
income. See §1.367(b)–13(b) and (c) for the basis
and holding period rules applicable to this transac-
tion, which cause USP’s adjusted basis and holding
period in the stock of FC1 after the transaction to
reflect the basis and holding period that DC had in
its FC2 stock.
*****
Par. 9. In §1.367(b)–6, paragraph
(a)(1), add a sentence to the end to read as
follows:
§1.367(b)–6 Effective dates and
coordination rules.
(a) * * *
(1) * * * The rules of §§1.367(b)–3 and
1.367(b)–4, as they apply to reorganiza-
tions described in section 368(a)(1)(A) (in-
cluding reorganizations described in sec-
tion 368(a)(2)(D) or (E)) involving a for-
eign acquiring or foreign acquired corpo-
ration, apply only to transfers occurring af-
ter the date these regulations are published
as final regulations in theFederal Regis-
ter.
*****
Par. 10. Section 1.367(b)–13 is added
to read as follows:
2005–7 I.R.B.550February 14, 2005

§1.367(b)–13 Special rules for
determining basis and holding period.
(a)Scope and definitions—(1)Scope.
This section provides special basis and
holding period rules for certain transac-
tions involving the acquisition of property
by a foreign acquiring corporation in
nonrecognition exchanges. Special rules
apply to determine the basis and holding
period of stock in a foreign corporation re-
ceived by certain shareholders in a section
354 or 356 exchange. In addition, special
rules apply to determine the basis and
holding period of stock of certain foreign
surviving corporations held by a control-
ling corporation whose stock is issued in
an exchange under section 354 or 356 in
a triangular reorganization. This section
applies to transactions that are subject to
section 367(b) as well as section 367(a),
including transactions concurrently sub-
ject to sections 367(a) and (b).
(2)Definitions. For purposes of this
section, the following definitions apply:
(i) A foreign acquired corporation is
a foreign corporation whose stock or
assets are acquired by a foreign corpo-
ration in a reorganization described in
section 368(a)(1). In a reverse triangular
merger, where T is a foreign corpora-
tion, T is treated as a foreign acquired
corporation. A foreign corporation that
undergoes a reorganization described in
section 368(a)(1)(E) is treated as a foreign
acquired corporation.
(ii) A block of stock has the meaning
provided in §1.1248–2(b).
(iii) A triangular reorganization
is a reorganization described in
§1.358–6(b)(2)(i), (ii), or (iii) (but
not a reorganization described in
§1.358–6(b)(2)(iv)). A triangular C
reorganization, a forward triangular
merger, and a reverse triangular merger
each is a reorganization described in
§1.358–6(b)(2)(i), (ii), or (iii), respec-
tively. For purposes of triangular reorga-
nizations—
(A) P is a corporation that is a party to
a reorganization that is in control (within
the meaning of section 368(c)) of another
party to the reorganization and whose
stock is transferred pursuant to the reorga-
nization;
(B) S is a corporation that is a party to
the reorganization and that is controlled by
P; and
(C) T is a corporation that is another
party to the reorganization.
(b)Determination of basis and holding
period for exchanges of foreign stock—(1)
Application. Except as provided in para-
graph (b)(4) of this section, this paragraph
(b) applies to a shareholder that exchanges
stock of a foreign acquired corporation in
an exchange under section 354 or 356 for
stock of a controlled foreign corporation,
if—
(i) Immediately before the exchange ei-
ther such shareholder is a section 1248
shareholder with respect to the foreign ac-
quired corporation, or such shareholder is
a foreign corporation and a United States
person is a section 1248 shareholder with
respect to both such foreign corporation
and the foreign acquired corporation; and
(ii) The exchange is not described in
§1.367(b)–4(b)(1)(i), (2)(i), or (3).
(2)Basis and holding period rules—(i)
If a shareholder surrenders a share of stock
in an exchange under the terms of section
354 or 356, the basis and holding period
of each share of stock received in the ex-
change shall be the same as the basis and
holding period of the allocable portion of
the share or shares of stock exchanged
therefor, as adjusted under §1.358–1 (such
that the section 1248 amount of each share
of stock exchanged is preserved in the
share or shares of stock received). If more
than one share of stock is received in ex-
change for one share of stock, the basis
of the share of stock surrendered shall be
allocated to the shares of stock received in
the exchange in proportion to the fair mar-
ket value of the shares of stock received. If
one share of stock is received in respect of
more than one share of stock or a fraction
of a share of stock is received, the basis of
the shares of stock surrendered must be al-
located to the share of stock received, or a
fraction thereof received, in a manner that
reflects, to the greatest extent possible,
that a share of stock is received in respect
of shares of stock acquired on the same
date and at the same price. The provisions
of this paragraph may be applied, to the
extent possible, on the basis of blocks of
stock.
(ii) If a shareholder that purchased or
acquired shares of stock in a corporation
on different dates or at different prices ex-
changes such shares of stock under the
terms of section 354 or 356, and the share-
holder is not able to identify which partic-
ular share or shares of stock (or portion of
a share of stock) is received in exchange
foraparticularshareorsharesofstock,the
shareholder may designate which share or
shares of stock is received in exchange for
a particular share or shares of stock, pro-
vided that such designation is consistent
with the terms of the exchange or distribu-
tion. The designation must be made on or
before the first date on which the basis of
a share of stock received is relevant. The
basis of a share received, for example, is
relevant when such share is sold or oth-
erwise transferred.The designation will
be binding for purposes of determining the
Federal tax consequences of any sale or
transfer of a share received. If the share-
holder fails to make a designation, then
the shareholder will not be able to identify
which share is sold or transferred for pur-
poses of determining the basis of property
sold or transferred under section 1012 and
§1.1012–1(c) and, instead, will be treated
as selling or transferring the share received
in respect of the earliest share purchased or
acquired. See paragraph (e),Example 1of
this section for an illustration of this para-
graph (b).
(3) In the case of a triangular reorgani-
zation, this paragraph (b) applies only to
the exchange of T stock for P stock by
T shareholders. See paragraph (c) of this
section to determine the basis and holding
period of stock of the surviving corpora-
tion (S or T) held by P immediately after a
triangular reorganization.
(4) Paragraphs (b)(1) through (3) of this
section shall not apply to determine the ba-
sis of a share of stock received by a share-
holder in an exchange described in both
section 351 and section 354 or 356, if, in
connection with the exchange, the share-
holder exchanges property for stock in an
exchange to which neither section 354 nor
356 applies or liabilities of the shareholder
are assumed.
(c)Determination of basis and holding
period for triangular reorganizations—(1)
Application. In the case of a triangular
reorganization, this paragraph (c) applies,
if—
(i) In the case of a reverse triangular
merger—
(A) Immediately before the transaction,
either P is a section 1248 shareholder with
respect to S, or P is a foreign corpora-
tion and a United States person is a sec-
February 14, 20055512005–7 I.R.B.

tion 1248 shareholder with respect to both
PandS;and
(B) P’s exchange of S stock is not de-
scribed in §1.367(b)–3(a) and (b) or in
§1.367(b)–4(b)(1)(i), (2)(i), or (3); or
(ii)(A) Immediately before the transac-
tion, a shareholder of T is either a section
1248 shareholder with respect to T or a for-
eign corporation and a United States per-
son is a section 1248 shareholder with re-
spect to both such foreign corporation and
T; and
(B) With respect to at least one of
the exchanging shareholders described
in paragraph (c)(1)(ii)(A) of this sec-
tion, the exchange of T stock is not de-
scribed in §1.367(b)–3(a) and (b) or in
§1.367(b)–4(b)(1)(i), (2)(i), or (3).
(2)Basis and holding period rules.In
the case of a triangular reorganization de-
scribed in this paragraph (c), each share
of stock of the surviving corporation (S
or T) held by P must be divided into por-
tions attributable to the S stock and the
T stock immediately before the exchange.
See paragraph (e) of this section,Examples
2through5for illustrations of this rule.
(i)Portions attributable to S stock—(A)
In the case of a forward triangular merger
or a triangular C reorganization, the basis
and holding period of the portion of each
share of surviving corporation stock attrib-
utable to the S stock is the basis and hold-
ing period of such share of stock immedi-
ately before the exchange.
(B) In the case of a reverse triangular
merger, the basis and holding period of the
portion of each share of surviving corpo-
ration stock attributable to the S stock is
the basis and the holding period immedi-
ately before the exchange of a proportion-
ate amount of the S stock to which the
portion relates. If P is a shareholder de-
scribed in paragraph (c)(1)(i)(A) of this
section with respect to S, and P exchanges
two or more blocks of S stock pursuant to
the transaction, then each share of the sur-
viving corporation (T)attributable to the S
stock must be further divided into separate
portions to account for the separate blocks
of stock in S.
(C)IfthevalueofSstockimmediately
before the triangular reorganization is less
than one percent of the value of the sur-
viving corporation stock immediately after
the triangular reorganization, then P may
determine its basis in the surviving corpo-
rationstockbyapplyingtherulesofpara-
graph (c)(2)(ii) of this section to determine
the basis and holding period of the sur-
viving corporation stock attributable to the
T stock, and then increasing the basis of
each share of surviving corporation stock
by the proportionate amount of P’s aggre-
gate basis in the S stock immediately be-
fore the exchange (without dividing the
stock of the surviving corporation into sep-
arate portions attributable to the S stock).
(ii)Portions attributable to T
stock—(A) If any exchanging share-
holder of T stock is described in para-
graph (c)(1)(ii) of this section, the basis
and holding period of the portion of each
share of stock in the surviving corporation
attributable to the T stock is the basis and
holding period immediately before the
exchange of a proportionate amount of the
T stock to which such portion relates. If
any exchanging shareholder of T stock is
described in paragraph (c)(1)(ii) of this
section, and such shareholder exchanges
two or more blocks of T stock pursuant to
the transaction, then each share of surviv-
ing corporation stock attributable to the T
stock must be further divided into separate
portions to account for the separate blocks
of T stock.
(B) If no exchanging shareholder of T
stock is described in paragraph (c)(1)(ii)
of this section, the rules of §1.358–6(c)
apply to determine the basis of the portion
of each share of the surviving corporation
attributable to T immediately before the
exchange.
(d)Special rules applicable to divided
shares of stock—(1)In general—(i) Shares
of stock in different blocks can be aggre-
gated into one divided portion for basis
purposes, if such shares immediately be-
fore the exchange are owned by one or
more shareholders that are—
(A) Neither section 1248 shareholders
with respect to the corporation nor foreign
corporate shareholders; or
(B) Foreign corporate shareholders,
provided that no United States persons are
section 1248 shareholders with respect to
both such foreign corporate shareholders
and the corporation.
(ii) For purposes of determining the
amount of gain realized on the sale or ex-
change of stock that has a divided portion
pursuant to paragraph (c) of this section,
any amount realized on such sale or ex-
change will be allocated to each divided
portion of the stock based on the relative
fair market value of the stock to which
the portion is attributable at the time the
portions were created.
(iii) Shares of stock will no longer be
required to be divided if section 1248 or
section 964(e) would not apply to a dispo-
sition or exchange of such stock.
(2)Pre-exchange earnings and prof-
its. All earnings and profits (or deficits)
accumulated by a foreign corporation be-
fore the reorganization and attributable to
a share (or block) of stock for purposes of
section 1248 are attributable to the divided
portion of stock with the basis and hold-
ing period of that share (or block). See
§1.367(b)–4(d).
(3)Post-exchange earnings and prof-
its. Any earnings and profits (or deficits)
accumulated by the surviving corporation
subsequent to the reorganization are at-
tributed to each divided share of stock pur-
suant to section 1248 and the regulations
thereunder. The amount of earnings and
profits (or deficits) attributable to a divided
share of stock is further attributed to the di-
vided portions of such share of stock based
on the relative fair market value of each di-
vided portion of stock.
(e)Examples. The rules of this section
are illustrated by the following examples:
Example 1.(i)Facts. US1 is a domestic corpo-
ration that owns all the stock of FT, a foreign corpora-
tion with 100 shares of stock outstanding. Each share
of FT stock is valued at $10x. Because US1 acquired
the stock of FT at two different dates, US1 owns two
blocks of FT stock for purposes of section 1248. The
first block consists of 60 shares. The shares in the first
block have a basis of $300x ($5x per share), a hold-
ing period of 10 years, and $240x ($4x per share) of
earnings and profits attributable to the shares for pur-
poses of section 1248. The second block consists of
40 shares. The shares in the second block have a ba-
sis of $600x ($15x per share), a holding period of 2
years, and $80x ($2x per share) of earnings and prof-
its attributable to the shares for purposes of section
1248. US2, a domestic corporation, owns all of the
stock of FP, a foreign corporation, which owns all of
the stock of FS, a foreign corporation. FT merges into
FS with FS surviving in a reorganization described in
section 368(a)(1)(A). Pursuant to the reorganization,
US1 receives 50 shares of FS stock with a value of
$1,000x for its FT stock in an exchange that qualifies
for nonrecognition under section 354.
(ii)Basis and holding period determination—(A)
US1 is a section 1248 shareholder of FT immediately
before the exchange and exchanges its FT stock for
stock of a controlled foreign corporation (FS) as to
which US1 is a section 1248 shareholder immediately
after the exchange. US1 is not required to include
income under §1.367(b)–4(b) with respect to the ex-
change. Accordingly, the basis and holding period of
the FS stock received by US1 is determined pursuant
to paragraph (b) of this section.
2005–7 I.R.B.552February 14, 2005

(B) Pursuant to paragraph (b) of this section, 30
shares of the FS stock received by US1 in the reor-
ganization (valued at $20x per share and exchanged
for US1’s first block of 60 shares of FT stock) have a
basis of $300x ($10x per share), a holding period of
10 years, and $240x of earnings and profits ($8x per
share) attributable to suchshares for purposes of sec-
tion 1248. In addition, 20 shares of the FS stock (val-
ued at $20 per share and exchanged for US1’s sec-
ond block of 40 shares of FT stock) have a basis of
$600x ($30x per share), a holding period of 2 years,
and $80x of earnings and profits ($4x per share) at-
tributable to such shares for purposes of section 1248.
(iii)Subsequent Disposition. Assume, subse-
quent to the exchange, US1 disposes of 20 shares of
FS stock. On or before the date of the disposition
when the basis of the F1 shares received by US1
becomes relevant, US1 can designate the 20 shares
from the first block, the second block, or from any
combination of shares in both blocks.
Example 2.(i)Facts. The facts are the same as in
Example 1, except that US1 receives 50 shares of FP
stock (instead of FS stock) with a value of $1,000x in
exchange for its FT stock. Accordingly, the merger of
FT into FS qualifies as forward triangular merger, and
immediately after the exchange US1 is a section 1248
shareholder with respect to FP and FS. Additionally,
prior to the transaction, FP owned two blocks of FS
stock. Each block consisted of 10 shares with a value
of $200x ($20x per share). The shares in the first
block had a basis of $50x ($5x per share), a holding
period of 10 years, and $50x ($5x per share) of earn-
ings and profits attributable to such shares for pur-
poses of section 1248. The shares in the second block
had a basis of $100x ($10x per share), a holding pe-
riod of 5 years, and $20x ($2x per share) of earnings
and profits attributable to such shares for purposes of
section 1248.
(ii)Basis and holding period determination.(A)
The basis and holding period of the FP shares re-
ceived by US1 in the exchange are determined pur-
suant to paragraph (b) of this section and are identical
to the results inExample 1.
(B)(1) US1 is a section 1248 shareholder of
FT immediately before the transaction. More-
over, US1 is not required to include income under
§1.367(b)–3(b) or 1.367(b)–4(b) as described in
paragraph (c)(2) of this section. Accordingly, the
basis and holding period of the FS stock held by FP
immediately after the triangular reorganization is
determined pursuant to paragraph (c) of this section.
(2) Pursuant to paragraph (c) of this section, each
share of FS stock is divided into portions attributable
to the basis and holding period of the FS stock held by
FP immediately before the exchange (the FS portion)
and the FT stock held by US1 immediately before the
exchange (the FT portion). The basis and holding pe-
riod of the FS portion is the basis and holding period
of the FS stock held by FP immediately before the
exchange. Thus, each shareof FS stock in the first
block has a portion with a basis of $5x, a value of
$20x, a holding period of 10 years, and $5x of earn-
ings and profits attributable to such portion for pur-
poses of section 1248. Each share of FS stock in the
second block has a portion with a basis of $10x, a
value of $20x, a holding period of 5 years, and $2x
of earnings and profits attributable to such portion for
purposes of section 1248.
(3) Because the exchanging shareholder of FT
stock (US1) is a section 1248 shareholder, the hold-
ing period and basis of the FT portion is the hold-
ing period and the proportionate amount of the ba-
sis of the FT stock immediately before the exchange
to which such portion relates. Further, because US1
exchanged two blocks of FT stock, the FT portion
must be divided into two separate portions attribut-
able to the two blocks of FT stock. Thus, each share
of FS stock will have a second portion with a basis
of $15x ($300x basis / 20 shares), a value of $30x
($600x value / 20 shares), a holding period of 10
years, and $12x of earnings and profits ($240x / 20
shares) attributable to such portion for purposes of
section 1248. Each share of FS stock will have a
third portion with a basis of $30x ($600x basis / 20
shares), a value of $20x ($400x value / 20 shares), a
holding period of 2 years, and $4x of earnings and
profits ($80x / 20 shares) attributable to such portion
for purposes of section 1248.
(iii) Assume, immediately after the transaction,
FP disposes of a share of FS stock from the first block.
When FP disposes of any share of its FS stock, it is
treated as disposing of each divided portion of such
share. With respect to the first portion (attributable
to the FS stock), FP recognizes a gain of $15x ($20x
value - $5x basis), $5x of which is treated as a divi-
dend under section 1248. With respect to the second
portion (attributable to the first block of FT stock), FP
recognizes a gain of $15x ($30x value - $15x basis),
$12x of which is treated as a dividend under section
1248. With respect to the third portion (attributable to
the second block of FT stock), FP recognizes a capi-
tal loss of $10x ($20x value - $30x basis).
(iv) Assume further, immediately after the trans-
action, FP also disposes of a share of stock from the
second block of FS stock. With respect to the first
portion (attributable to the FS stock), FP recognizes a
gain of $10x ($20x value - $10x basis), $2x of which
is treated as a dividend under section 1248. With re-
spect to the second portion (attributable to the first
block of FT stock), FP recognizes a gain of $15x
($30x value - $15x basis), $12x of which is treated
as a dividend under section 1248. With respect to
the third portion (attributable to the second block of
FT stock), FP recognizes a capital loss of $10x ($20x
value - $30x basis).
Example 2A.(i)Facts. The facts are the same as
inExample 2, except that FS merges into FT with
FT surviving in a reverse triangular merger. Pursuant
to the merger, US1 receives FP stock with a value
of $1,000x in exchange for its FT stock, and FP re-
ceives 10 shares of FT stock with a value of $1,400x
in exchange for its FS stock. Immediately after the
exchange, US1 is a section 1248 shareholder with re-
spect to FP and FT.
(ii)Basis and holding period determination—(A)
The basis and holding period of the FP shares re-
ceived by US1 and the stock of the surviving corpora-
tionheldbyFParethesameasinExample 2, except
that each share of the surviving corporation (FT, in-
stead of FS) will be divided into four portions instead
of three portions. Because FP exchanges two blocks
of FS stock, the FS portion must be divided into two
separate portions attributable to the two blocks of FS
stock. Because US1 exchanges two blocks of FT
stock, the FT portion must be divided into two sep-
arate portions attributable to the two blocks of FT
stock.
(B) Thus, each share of the surviving corpora-
tion (FT) will have a first portion (attributable to the
first block of FS stock) with a basis of $5x ($50x /
10 shares), a value of $20x ($200x / 10 shares), a
holding period of 10 years, and $5x of earnings and
profits ($50x / 10 shares) attributable to such portion
for purposes of section 1248. Each share of FT stock
will have a second portion (attributable to the second
block of FS stock) with a basis of $10x ($100x / 10
shares), a value of $20x ($200x / 10 shares), a hold-
ing period of 5 years, and $2x of earnings and prof-
its ($20x / 10 shares) attributable to such portion for
purposes of section 1248. Moreover, each share of FT
stock will have a third portion (attributable to the first
block of FT stock) with a basis of $30x ($300x basis /
10 shares), a value of $60x ($600x value / 10 shares),
a holding period of 10 years, and $24x of earnings and
profits ($240x / 10 shares) attributable to such portion
for purposes of section 1248. Lastly, each share of
FT stock will have a fourth portion (attributable to the
second block of FT stock) with a basis of $60x ($600x
basis / 10 shares), a value of $40x ($400x value / 10
shares), a holding period of 2 years, and $8x of earn-
ings and profits ($80x / 10 shares) attributable to such
portion for purposes of section 1248.
Example 3.(i)Facts. USP, a domestic corpora-
tion, owns all the stock of FS, a foreign corporation
with 10 shares of stock outstanding. Each share of FS
stock has a value of $10x, a basis of $5x, a holding
period of 10 years, and $7x of earnings and profits at-
tributable to such share for purposes of section 1248.
FP, a foreign corporation, owns the stock of FT, an-
other foreign corporation. FP and FT do not have any
section 1248 shareholders. FT has assets with a value
of $100x, a basis of $50x, and no liabilities. The FT
stock held by FP has a value of $100x and a basis
of $75x. FT merges into FS with FS surviving in a
forward triangular merger. Pursuant to the reorgani-
zation, FP receives USP stock with a value of $100x
in exchange for its FT stock.
(ii)Basis and holding period determination—(A)
Because USP is a section 1248 shareholder of FS im-
mediately before the transaction, the basis and hold-
ing period of the FS stock held by USP immediately
after the triangular reorganization is determined pur-
suant to paragraph (c) of this section.
(B) Pursuant to paragraph (c) of this section, each
share of FS stock is divided into portions attributable
to the basis and holding period of the FS stock held
by USP immediately before the exchange (the FS por-
tion) and the basis of FT’s net assets (the FT portion)
immediately before the exchange. The basis of FT’s
net assets (and not FT stock) is used to determine the
FT portion because FT doesnot have a section 1248
shareholder immediately before the transaction. As
a result, the rules of §1.358–6(c) apply to determine
the basis of the FT portion of each share of FS stock.
The basis and holding period of the FS portion is the
basis and holding period of the FS stock held by USP
immediately before the exchange. Thus, each share
of FS stock has a portion with a basis of $5x, a value
of $10x, and a holding period of 10 years. The ba-
sis of the FT portion is the basis of the FT assets to
which such portion relates. Thus, each share of FS
stock has a second portion with a basis of $5x ($50x
basis in FT’s assets / 10 shares) and a value of $10x
($100x value of FT’s assets / 10 shares). All of FS’s
earnings and profits prior to the transaction ($70x) is
attributed solely to the FS portion in each share of FS
February 14, 20055532005–7 I.R.B.

stock. The FS portion of each share of FS stock has
earnings and profits of $7x ($70x / 10 shares) attribut-
able to such portion for purposes of section 1248. As
a result of each share of stock being divided into por-
tions, the basis of the FS stock is not averaged with
the basis of the FT assets to increase the section 1248
amount with respect to the stock of the surviving cor-
poration (FS).
Example 4.(i)Facts. US, a domestic corporation,
owns all of the stock of FT, a foreign corporation.
The FT stock held by US constitutes a single block
of stock with a value of $1,000x, a basis of $600x,
and holding period of 5 years. USP, a domestic cor-
poration, forms FS, a foreign corporation, pursuant
to the plan of reorganization and capitalizes it with
$10x of cash. FS merges into FT with FT surviving
in a reverse triangular merger and a reorganization de-
scribed in section 368(a)(1)(B). Pursuant to the reor-
ganization, US receives USP stock with a value of
$1,000x in exchange for its FT stock, and USP re-
ceives 10 shares of FT stock with a value of $1,010x
in exchange for its FS stock.
(ii)Basis and holding period determination.(A)
US and USP are section 1248 shareholders of FT and
FS, respectively, immediately before the transaction.
Neither US nor USP is required to include income un-
der §1.367(b)–3(b) or 1.367(b)–4(b) as described in
paragraph (c)(2) of this section. The basis and hold-
ingperiodoftheFTstockheldbyUSPisdetermined
pursuant to paragraph (c) of this section.
(B) Pursuant to paragraph (c) of this section,
because the exchanging shareholder of FT stock
(US) is a section 1248 shareholder of FT, each share
of the surviving corporation (FT) has a proportionate
amount of the basis and holding period of the FT
stock immediately before the exchange to which such
share relates. Thus, theportion of each share of FT
stock attributable to the FT stock has a basis of $60x
($600x basis / 10 shares), a value of $100x ($1,000x
value / 10 shares), and a holding period of 5 years.
Because the value of FS stock immediately before
the triangular reorganization ($10x) is less than one
percent of the value of the surviving corporation
(FT) immediately after the triangular reorganization
($1,010x), USP may determine its basis in the stock
of the surviving corporation (FT) by increasing the
basis of each share of FT stock by the proportionate
amount of USP’s aggregate basis in the FS stock
immediately before the exchange (without dividing
each share of FT stock into separate portions to ac-
count for FS and FT). If USP so elects, USP’s basis
in each share of FT stock is increased by $1x ($10x
basis in FS stock / 10 shares). As a result, each share
of FT stock has a basis of $61x, a value of $101x,
and a holding period of 5 years.
Example 5.(i)Facts. US, a domestic corpora-
tion, owns all of the stock of FT, a foreign corpora-
tion. The FT stock held by US constitutes one block
of stock with a basis of $170x, a value of $200x, a
holding period of 5 years, and $10x of earnings and
profits attributable to such stock for purposes of sec-
tion 1248. FP, a foreign corporation, owns all the
stock of FS, a foreign corporation. FS has 10 shares
of stock outstanding. No United States person is a
section 1248 shareholder with respect to FP or FS.
The FS stock held by FP has a value of $100x and a
basis of $50x ($5x per share). FT merges into FS with
FS surviving in a forward triangular merger. Pursuant
to the merger, US receives FP stock with a value of
$200x for its FT stock in an exchange that qualifies
for non-recognition under section 354. FP is a con-
trolled foreign corporation and US is a section 1248
shareholder with respect to FP and FS immediately
after the exchange.
(ii)Basis and holding period determination.(A)
Because US is a section 1248 shareholder of FT im-
mediately before the transaction, and US is not re-
quired to include income under §§1.367(b)–3(b) and
1.367(b)–4(b) as described in paragraph (c)(2) of this
section, the basis and holding period of the FS stock
held by FP immediately after the triangular reorgani-
zation is determined pursuant to paragraph (c) of this
section.
(B) Pursuant to paragraph (c) of this section, each
share of FS stock is divided into portions attributable
to the basis and holding period of the FS stock held by
FP immediately before the exchange (the FS portion)
and the FT stock held by US immediately before the
exchange (the FT portion). The basis and holding pe-
riod of the FS portion is the basis and holding period
of the FS stock held by FP immediately before the
exchange. Thus, each share of FS stock has a por-
tion with a basis of $5x and a value of $10x. Because
the exchanging shareholder of FT stock (US) is a sec-
tion 1248 shareholder of FT, the basis and holding
period of the FT portion is the proportionate amount
of the basis and the holding period of the FT stock
immediately before the exchange to which such por-
tion relates. Thus, each share of FS stock will have
a second portion with a basis of $17x ($170x basis /
10 shares), a value of $20x ($200x value / 10 shares),
a holding period of 5 years, and $1x of earnings and
profits ($10x earnings and profits / 10 shares) attrib-
utable to such portion for purposes of section 1248.
(iii)Subsequent disposition.(A)Severalyears
after the merger, FP disposes of all of its FS stock in
a transaction governed by section 964(e). At the time
of the disposition, FS stock has decreased in value to
$210x (a post-merger reduction in value of $90x), and
FS has incurred a post-merger deficit in earnings and
profits of $30x.
(B) Pursuant to paragraph (d)(1)(ii) of this sec-
tion, for purposes of determining the amount of gain
realized on the sale or exchange of stock that has a
divided portion, any amount realized on such sale
or exchange is allocated to each divided portion of
the stock based on the relative fair market value of
the stock to which the portion is attributable at the
time the portions were created. Immediately before
the merger, the value of the FS stock in relation to
the value of both the FS stock and the FT stock was
one-third ($100x / ($100x plus $200x)). Likewise,
immediately before the merger, the value of the FT
stockinrelationtothevalueofboththeFTstock
and the FS stock was two-thirds ($200x / $100x plus
$200x). Accordingly, one-third of the $210x amount
realized is allocated to the FS portion of each share
andtwo-thirdstotheFTportionofeachshare.Thus,
the amount realized allocated to the FS portion of
each share is $7x (one-third of $210x divided by 10
shares). The amount realized allocated to the FT por-
tion of each share is $14x (two-thirds of $210x di-
vided by 10 shares).
(C) Pursuant to paragraph (d)(3) of this section,
any earnings and profits (or deficits) accumulated by
the surviving corporation subsequent to the reorgani-
zation are attributed to the divided portions of shares
of stock based on the relative fair market value of
each divided portion of stock. Accordingly, one-third
of the post-merger earnings and profits deficit of $30x
is allocated to the FS portion of each share and two-
thirds to the FT portion of each share. Thus, the
deficit in earnings and profits allocated to the FS por-
tion of each share is $1x (one-third of $30x divided
by 10 shares). The deficit inearnings and profits al-
located to the FT portion of each share is $2x (two-
thirds of $30x divided by 10 shares).
(D) When FP disposes of its FS stock, FP is
treated as disposing of each divided portion of a
share of stock. With respect to the FS portion of
each share of stock, FP recognizes a gain of $2x ($7x
value - $5x basis), which is not recharacterized as
a dividend because a deficit in earnings and profits
of $1x is attributable to such portion for purposes of
section 1248. With respect to the FT portion of each
share of stock, FP recognizes a loss of $3x ($14x
value - $17x basis).
(e)Effective date. This section applies
to exchanges occurring after the date these
regulations are published as final regula-
tions in theFederal Register.
Par. 11. Section 1.884–2 is amended
as follows:
1. Paragraphs (c)(3) through (c)(6)
(i)(A) are revised.
2. Paragraphs (c)(6)(i)(B), (C), and (D)
are added.
3. Paragraphs (c)(6)(ii) through (f) are
revised.
4. Paragraph (g) is amended by adding
a sentence at the end.
The revisions and additions read as fol-
lows:
§1.884–2 Special rules for termination
or incorporation of a U.S. trade or
business or liquidation or reorganization
of a foreign corporation or its domestic
subsidiary.
*****
(c)(3) through (c)(6)(i)(A) [Re-
served].For further guidance, see
§1.884–2T(c)(3) through (c)(6)(i)(A).
(c)(6)(i)(B) Shareholders of the trans-
feree (or of the transferee’s parent in
the case of a triangular reorganization
described in section 368(a)(1)(C) or
a reorganization described in sections
368(a)(1)(A) and 368(a)(2)(D) or (E))
who in the aggregate owned more than
25 percent of the value of the stock of the
transferor at any time within the 12-month
period preceding the close of the year in
which the section 381(a) transaction oc-
curs sell, exchange or otherwise dispose
of their stock or securities in the transferee
at any time during a period of three years
2005–7 I.R.B.554February 14, 2005

from the close of the taxable year in which
the section 381(a) transaction occurs.
(c)(6)(i)(C) In the case of a triangu-
lar reorganization described in section
368(a)(1)(C) or a reorganization described
in sections 368(a)(1)(A) and 368(a)(2)(D)
or (E), the transferee’s parent sells, ex-
changes, or otherwise disposes of its stock
or securities in the transferee at any time
during a period of three years from the
close of the taxable year in which the sec-
tion 381(a) transaction occurs.
(c)(6)(i)(D) A corporation related to
any such shareholder or the shareholder it-
self if it is a corporation (subsequent to an
event described in paragraph (c)(6)(i)(A)
or (B) of this section) or the transferee’s
parent (subsequent to an event described
in paragraph (c)(6)(i)(C) of this section),
uses, directly or indirectly, the proceeds or
property received in such sale, exchange
or disposition, or property attributable
thereto, in the conduct of a trade or busi-
ness in the United States at any time during
a period of three years from the date of sale
in the case of a disposition of stock in the
transferor, or from the close of the taxable
year in which the section 381(a) transac-
tion occurs in the case of a disposition
of the stock or securities in the transferee
(or the transferee’s parent in the case of
a triangular reorganization described in
section 368(a)(1)(C) or a reorganization
described in sections 368(a)(1)(A) and
(a)(2)(D) or (E)). Where this paragraph
(c)(6)(i) applies, the transferor’s branch
profits tax liability for the taxable year in
which the section 381(a) transaction oc-
curs shall be determined under §1.884–1,
taking into account all the adjustments
in U.S. net equity that result from the
transfer of U.S. assets and liabilities to the
transferee pursuant to the section 381(a)
transaction, without regard to any provi-
sions in this paragraph (c). If an event
described in paragraph (c)(6)(i)(A), (B),
or (C) of this section occurs after the close
of the taxable year in which the section
381(a) transaction occurs, and if additional
branch profits tax is required to be paid
by reason of the application of this para-
graph (c)(6)(i), then interest must be paid
on that amount at the underpayment rates
determined under section 6621(a)(2), with
respect to the period between the date that
was prescribed for filing the transferor’s
income tax return for the year in which the
section 381(a) transaction occurs and the
date on which the additional tax for that
year is paid. Any such additional tax lia-
bility together with interest thereon shall
be the liability of the transferee within the
meaning of section 6901 pursuant to sec-
tion 6901 and the regulations there under.
(c)(6)(ii) through (f) [Reserved]. For
further guidance, see §1.884–2T(c)(6)(ii)
through (f).
(g)***Paragraphs(c)(6)(i)(B),(C),
and (D), are applicable for tax years be-
ginning after December 31, 1986, except
that such paragraphs are applicable to
transactions occurring after the date these
regulations are published as final regula-
tions in theFederal Registerin the case
of reorganizations described in sections
368(a)(1)(A) and 368(a)(2)(D) or (E).
Par. 12. In §1.884–2T, paragraphs
(c)(6)(i)(B), (C), and (D) are revised to
read as follows:
§1.884–2T Special rules for termination
or incorporation of a U.S. trade or
business or liquidation or reorganization
of a foreign corporation or its domestic
subsidiary (Temporary).
*****
(c) * * *
(6) * * *
(i) * * *
(B), (C), and (D) [Reserved]. For fur-
ther guidance, see §1.884–2(c)(6)(i)(B),
(C), and (D).
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on January 4,
2005, 8:45 a.m., and published in the issue of the Federal
Register for January 5, 2005, 70 F.R. 749)
Archer MSAs
Announcement 2005–12
PURPOSE
Sections 220(i) and (j) of the Internal
Revenue Code provide that if the num-
ber of Archer Medical Savings Account
(Archer MSA) returns filed for 2003 or
a statutorily specified projection of the
number of Archer MSA returns that will
be filed for 2004 exceeds 750,000, then
February 1, 2005, is a “cut-off” date for
the Archer MSA pilot project. The Inter-
nal Revenue Service (IRS) has determined
that the applicable number of Archer MSA
returns filed for 2003 is 60,832 and that the
applicable number of Archer MSA returns
projected to be filed for 2004 is 56,492
(after reduction in each case for statutorily
specified exclusions, such as the exclu-
sion for previously uninsured taxpayers).
Consequently, February 1, 2005, is not a
“cut-off” date and 2004 is not a “cut-off’
year for the Archer MSA pilot project.
BACKGROUND
The Health Insurance Portability and
Accountability Act of1996 added section
220 to the Code to permit eligible individu-
als to establish Archer MSAs under a pilot
project effective January 1, 1997. The
pilot project, as amended by The Working
Families Tax Relief Act of 2004 (WFTRA)
§ 322, has a scheduled “cut-off” year of
2005, but may have an earlier “cut-off”
year if the number of individuals who
have established Archer MSAs exceeds
certain numerical limitations. Trustees’
reports for Archer MSAs established from
January 1, 2004, through June 30, 2004,
were due no later than January 3, 2005.
IRS is required to publish a determination
of whether 2004 is a “cut-off” year no
later than February 1, 2005. See sections
220(i) and (j) as amended by WFTRA;
Ann. 2004–82, 2004–45 I.R.B. 834.
If a year is a “cut-off” year, section
220(i)(1) generallyprovides that no in-
dividual will be eligible for a deduction
or exclusion for Archer MSA contribu-
tions for any taxable year beginning af-
ter the “cut-off’ year unless the individ-
ual (A) was an active Archer MSA partic-
ipant for any taxable year ending on or be-
fore the close of the “cut-off” year, or (B)
first became an active Archer MSA par-
ticipant for a taxable year ending after the
“cut-off” year by reason of coverage under
a high deductible health plan of an Archer
MSA-participating employer.
Section 220(j)(2)(A) provides that the
numerical limitation for 2004 is exceeded
if the number of Archer MSA returns filed
on or before April 15, 2004, for taxable
years ending with or within the 2003 cal-
endar year, plus the Secretary’s estimate
of the number of Archer MSA returns for
those taxable years which will be filed
after April 15, 2004, exceeds 750,000.
February 14, 20055552005–7 I.R.B.

For this purpose, section 220(j)(2)(A) pro-
vides that a tax return is an Archer MSA
return for a taxable year if any exclusion
is claimed under section 106(b) or any
deduction is claimed under section 220
for that taxable year. Section 220(j)(2)(B)
provides, as an alternative test, that the
numerical limitation for 2004 is also ex-
ceeded if the sum of 90 percent of the
Archer MSA returns for 2003 plus the
product of 2.5 and the number of Archer
MSAs for taxable years beginning in 2004
that are establishedduring the portion of
2004 preceding July 1(based on reports
by Archer MSA trusteesand custodians),
exceeds 750,000.
Under section 220(j)(3), in determining
whether any calendar year is a “cut-off”
year, the Archer MSA of any previously
uninsured individual is not taken into ac-
count. In addition, section 220(j)(4)(D)
specifies that, to theextent practical, all
Archer MSAs established by an individual
are aggregated and two married individu-
als opening separate Archer MSAs are to
be treated as having a single Archer MSA
for purposes of determining the number of
Archer MSAs.
A total of 66,015 tax returns reporting
an excludable or deductible contribution to
an Archer MSA for the 2003 taxable year
were filed by April 15, 2004. Of this to-
tal, 15,513 taxpayers were reported as be-
ing previously uninsured. It has been es-
timated that an additional 13,220 tax re-
turns reporting Archer MSA contributions
for the 2003 taxable year have been or
will be filed after April 15, 2004, includ-
ing 2,890 taxpayers who were previously
uninsured. Accordingly, it has been deter-
mined that there were 79,235 (66,015 plus
13,220) Archer MSA returns for 2003. Of
this total, 18,403 (15,513 plus 2,890) were
for taxpayers reported as being previously
uninsured. As a result, 60,832 (79,235 mi-
nus 18,403) Archer MSA returns count to-
ward the applicable statutory limitation for
2004 Archer MSA returns of 750,000.
Based on the Forms 8851 filed on or
before January 3, 2005, by Archer MSA
trustees and custodians, it has been deter-
mined that 4,062 taxpayers who did not
have Archer MSA contributions for 2003
established Archer MSAs for 2004 during
the portion of 2004 preceding July 1. Of
this total, 3,362 taxpayers were reported
by trustees and custodians as previously
uninsured, and therefore are not taken into
account in determining whether 2004 is a
“cut-off” year. In addition, 3 taxpayers
were reported by trustees and custodians
as excludable from the count because his
or her spouse also established an Archer
MSA. Accordingly, the applicable number
of Archer MSAs established from January
1, 2004, through June 30, 2004, is 697
(4,062 minus (3,362 plus 3)). The alterna-
tive limitation for 2004 (90 percent of the
applicable number of Archer MSA returns
for 2003 plus the product of 2.5 and the
number of applicableArcher MSAs estab-
lished from January 1, 2004, through June
30, 2004) is 56,492 (90 percent of 60,832
plus 2.5 multiplied by 697), which is less
than the statutory limit of 750,000. Thus,
2004 is not a “cut-off” year for the Archer
MSA pilot project by reason of either the
2004 Archer MSA returns test of section
220(j)(2)(A) or the alternative test of sec-
tion 220(j)(2)(B) of the Code.
Questions regarding this announcement
may be directed to Elizabeth Purcell in
the Office of Division Counsel/Associate
Chief Counsel (Tax Exempt and Govern-
ment Entities) at (202) 622–6080 (not a
toll-free number).
2005–7 I.R.B.556February 14, 2005

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 14, 2005i2005–7 I.R.B.

Numerical Finding List
1
Bulletins 2005–1 through 2005–7
Announcements:
2005-1, 2005-1 I.R.B.257
2005-2, 2005-2 I.R.B.319
2005-3, 2005-2 I.R.B.270
2005-4, 2005-2 I.R.B.319
2005-5, 2005-3 I.R.B.353
2005-6, 2005-4 I.R.B.377
2005-7, 2005-4 I.R.B.377
2005-8, 2005-4 I.R.B.380
2005-9, 2005-4 I.R.B.380
2005-10, 2005-5 I.R.B.450
2005-11, 2005-5 I.R.B.451
2005-12, 2005-7 I.R.B.555
Notices:
2005-1, 2005-2 I.R.B.274
2005-2, 2005-3 I.R.B.337
2005-3, 2005-5 I.R.B.447
2005-4, 2005-2 I.R.B.289
2005-5, 2005-3 I.R.B.337
2005-6, 2005-5 I.R.B.448
2005-7, 2005-3 I.R.B.340
2005-8, 2005-4 I.R.B.368
2005-9, 2005-4 I.R.B.369
2005-10, 2005-6 I.R.B.474
2005-11, 2005-7 I.R.B.493
2005-12, 2005-7 I.R.B.494
2005-14, 2005-7 I.R.B.498
2005-15, 2005-7 I.R.B.527
Proposed Regulations:
REG-117969-00, 2005-7 I.R.B.533
REG-125628-01, 2005-7 I.R.B.536
REG-129709-03, 2005-3 I.R.B.351
REG-139683-04, 2005-4 I.R.B.371
REG-152945-04, 2005-6 I.R.B.484
REG-159824-04, 2005-4 I.R.B.372
Revenue Procedures:
2005-1, 2005-1 I.R.B.1
2005-2, 2005-1 I.R.B.86
2005-3, 2005-1 I.R.B.118
2005-4, 2005-1 I.R.B.128
2005-5, 2005-1 I.R.B.170
2005-6, 2005-1 I.R.B.200
2005-7, 2005-1 I.R.B.240
2005-8, 2005-1 I.R.B.243
2005-9, 2005-2 I.R.B.303
2005-10, 2005-3 I.R.B.341
2005-11, 2005-2 I.R.B.307
2005-12, 2005-2 I.R.B.311
2005-14, 2005-7 I.R.B.528
Revenue Rulings:
2005-1, 2005-2 I.R.B.258
2005-2, 2005-2 I.R.B.259
2005-3, 2005-3 I.R.B.334
2005-4, 2005-4 I.R.B.366
2005-5, 2005-5 I.R.B.445
2005-6, 2005-6 I.R.B.471
2005-7, 2005-6 I.R.B.464
2005-8, 2005-6 I.R.B.466
2005-9, 2005-6 I.R.B.470
2005-10, 2005-7 I.R.B.492
Tax Conventions:
2005-3, 2005-2 I.R.B.270
Treasury Decisions:
9164, 2005-3 I.R.B.320
9165, 2005-4 I.R.B.357
9167, 2005-2 I.R.B.261
9168, 2005-4 I.R.B.354
9169, 2005-5 I.R.B.381
9170, 2005-4 I.R.B.363
9171, 2005-6 I.R.B.452
9172, 2005-6 I.R.B.468
1
A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2004–27 through 2004–52 is in Internal Revenue Bulletin
2004–52, dated December 27, 2004.
2005–7 I.R.B.iiFebruary 14, 2005

Finding List of Current Actions on
Previously Published Items
1
Bulletins 2005–1 through 2005–7
Notices:
88-30
Obsoleted by
Notice 2005-4, 2005-2 I.R.B.289
88-132
Obsoleted by
Notice 2005-4, 2005-2 I.R.B.289
89-29
Obsoleted by
Notice 2005-4, 2005-2 I.R.B.289
89-38
Obsoleted by
Notice 2005-4, 2005-2 I.R.B.289
Proposed Regulations:
REG-149519-03
Corrected by
Ann. 2005-11, 2005-5 I.R.B.451
REG-114726-04
Corrected by
Ann. 2005-10, 2005-5 I.R.B.450
Revenue Procedures:
98-16
Modified and superseded by
Rev. Proc. 2005-11, 2005-2 I.R.B.307
2001-22
Superseded by
Rev. Proc. 2005-12, 2005-2 I.R.B.311
2002-9
Modified and amplified by
Rev. Proc. 2005-9, 2005-2 I.R.B.303
2004-1
Superseded by
Rev. Proc. 2005-1, 2005-1 I.R.B.1
2004-2
Superseded by
Rev. Proc. 2005-2, 2005-1 I.R.B.86
2004-3
Superseded by
Rev. Proc. 2005-3, 2005-1 I.R.B.118
2004-4
Superseded by
Rev. Proc. 2005-4, 2005-1 I.R.B.128
2004-5
Superseded by
Rev. Proc. 2005-5, 2005-1 I.R.B.170
Revenue Procedures— Continued:
2004-6
Superseded by
Rev. Proc. 2005-6, 2005-1 I.R.B.200
2004-7
Superseded by
Rev. Proc. 2005-7, 2005-1 I.R.B.240
2004-8
Superseded by
Rev. Proc. 2005-8, 2005-1 I.R.B.243
2004-35
Corrected by
Ann. 2005-4, 2005-2 I.R.B.319
2004-60
Superseded by
Rev. Proc. 2005-10, 2005-3 I.R.B.341
Revenue Rulings:
92-63
Modified and superseded by
Rev. Rul. 2005-3, 2005-3 I.R.B.334
95-63
Modified and superseded by
Rev. Rul. 2005-3, 2005-3 I.R.B.334
2004-43
Revoked by
Rev. Rul. 2005-10, 2005-7 I.R.B.492
2004-103
Superseded by
Rev. Rul. 2005-3, 2005-3 I.R.B.334
1
A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2004–27 through 2004–52 is in Internal Revenue Bulletin 2004–52, dated December 27,
2004.
February 14, 2005iii2005–7 I.R.B.
*U.S. Government Printing Office: 2005—310–365/70002