Internal Revenue Bulletin 1997-7 (PDF rendition): IRS Revenue Rulings

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing. Whole bulletin rendition: numbered items are identified below; other legal material and publisher context remain included. This is not a new standalone advance release.

INCOME TAX
Rev. Rul. 97–8, page 4.
LIFO; price indexes; department stores.The Decem-
ber 1996 Bureau of Labor Statistics price indexes are
accepted for use by department stores employing the
retail inventory and last-in, first-out inventory methods
for valuing inventories for tax years ended on, or with
reference to, December 31, 1996.
T.D. 8700, page 5.
Final regulations under section 475 of the Code provide
guidance to enable taxpayers to comply with the mark-to-
market requirements applicable to dealers in securities.
T.D. 8701, page 23.
Final regulations provide rules for making the deemed
sale and deemed dividend elections under section 1291
of the Code.
T.D. 8707, page 17.
Final regulations under section 731 of the Code provide
rules for partnership distributions of marketable securi-
ties and for determining when those distributions are
taxable to the distributee partner.
REG–209040–88, page 34.
Proposed regulations under section 1295 permit certain
shareholders to make a special election, in lieu of the
election currently provided for under that section, for
certain preferred shares of a passive foreign investment
company (PFIC). A public hearing will be held on May 8,
1997.
REG–209817–96, page 41.
Proposed regulations under section 7701 of the Code
relate to the treatment of certain multiple-party financing
transactions in which one party realizes income from
leases or similar agreements and another party claims
deductions related to that income. A public hearing will
be held on April 29, 1997.
REG–249819–96, page 50.
Proposed regulations under sections 354, 355, and 356
of the Code relate to exchanges of stock and securities
in certain reorganizations. A public hearing will be held
on March 25, 1997.
REG–252231–96, page 52.
Proposed regulations under section 368 of the Code
provide that the continuity of shareholder interest re-
quirement for corporate reorganizations is satisfied if
the acquiring corporation furnishes consideration which
represents a proprietary interest in the affairs of the
acquiring corporation and such consideration represents
a substantial part of the value of the stock or properties
transferred. A public hearing will be held on May 7,
1997.
EXEMPT ORGANIZATIONS
Announcement 97–12, page 55.
A list is given of organizations now classified as private
foundations.
ADMINISTRATIVE
T.D. 8698, page 29.
Final regulations under section 6231 of the Code
provide guidance necessary for the designation or selec-
tion of a tax matters partner for partnerships, including
limited liability companies classified as partnerships.
Finding Lists begin on page 59.
Announcement of Disbarments and Suspensions begins on page 57.
Bulletin No. 1997–7
February 18, 1997
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.

Mission of the Service
The purpose of the Internal Revenue Service is to
collect the proper amount of tax revenue at the least
cost; serve the public by continually improving the
quality of our products and services; and perform in a
manner warranting the highest degree of public
confidence in our integrity, efficiency and fairness.
Statement of Principles
of Internal Revenue
Tax Administration
The function of the Internal Revenue Service is to
administer the Internal Revenue Code. Tax policy
for raising revenue is determined by Congress.
With this in mind, it is the duty of the Service to
carry out that policy by correctly applying the laws
enacted by Congress; to determine the reasonable
meaning of various Code provisions in light of the
Congressional purpose in enacting them; and to
perform this work in a fair and impartial manner,
with neither a government nor a taxpayer point of view.
At the heart of administration is interpretation of the
Code. It is the responsibility of each person in the
Service, charged with the duty of interpreting the
law, to try to find the true meaning of the statutory
provision and not to adopt a strained construction in
the belief that he or she is ‘‘protecting the revenue.’’
The revenue is properly protected only when we as-
certain and apply the true meaning of the statute.
The Service also has the responsibility of applying
and administering the law in a reasonable,
practical manner. Issues should only be raised by
examining officers when they have merit, never
arbitrarily or for trading purposes. At the same
time, the examining officer should never hesitate
to raise a meritorious issue. It is also important
that care be exercised not to raise an issue or to
ask a court to adopt a position inconsistent with
an established Service position.
Administration should be both reasonable and
vigorous. It should be conducted with as little
delay as possible and with great courtesy and
considerateness. It should never try to overreach,
and should be reasonable within the bounds of law
and sound administration. It should, however, be
vigorous in requiring compliance with law and it
should be relentless in its attack on unreal tax
devices and fraud.
2

Introduction
The Internal Revenue Bulletin is the authoritative instru-
ment of the Commissioner of Internal Revenue for
announcing official rulings and procedures of the Inter-
nal Revenue Service and for publishing Treasury Deci-
sions, Executive Orders, Tax Conventions, legislation,
court decisions, and other items of general interest. It is
published weekly and may be obtained from the Superin-
tendent of Documents on a subscription basis. Bulletin
contents of a permanent nature are consolidated semi-
annually into Cumulative Bulletins, which are sold on a
single-copy basis.
It is the policy of the Service to publish in the Bulletin all
substantive rulings necessary to promote a uniform
application of the tax laws, including all rulings that
supersede, revoke, modify, or amend any of those
previously published in the Bulletin. All published rulings
apply retroactively unless otherwise indicated. Proce-
dures relating solely to matters of internal management
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 Ser-
vice 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 unwar-
ranted 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 proce-
dures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be consid-
ered, 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.—1986 Code.
This part includes rulings and decisions based on
provisions of the Internal Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows:
Subpart A, Tax Conventions, and Subpart B, Legislation
and 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 Rulings. Bank Secrecy Act Administra-
tive Rulings are issued by the Department of the
Treasury’s Office of the Assistant Secretary (Enforce-
ment).
Part IV.—Items of General Interest.
With the exception of the Notice of Proposed Rulemak-
ing and the disbarment and suspension list included in
this part, none of these announcements are consoli-
dated in the Cumulative Bulletins.
The first Bulletin for each month includes an index for
the matters published during the preceding month.
These monthly indexes are cumulated on a quarterly and
semiannual basis, and are published in the first Bulletin
of the succeeding quarterly and semi-annual period,
respectively.
The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents U.S. Government Printing Office, Washington, D.C. 20402.
3

Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 472.—Last-in, First-out
Inventories
26 CFR 1.472–1: Last-in, first-out inventories.
LIFO; price indexes; department
stores.The December 1996 Bureau of
Labor Statistics price indexes are ac-
cepted for use by department stores
employing the retail inventory and last-
in, first-out inventory methods for valu-
ing inventories for tax years ended on,
or with reference to, December 31,
1996.
Rev. Rul. 97–8
The following Department Store In-
ventory Price Indexes for December
1996 were issued by the Bureau of
Labor Statistics on January 14, 1997.
The indexes are accepted by the Internal
Revenue Service, under § 1.472–1(k) of
the Income Tax Regulations and Rev.
Proc. 86–46, 1986–2 C.B. 739, for ap-
propriate application to inventories of
department stores employing the retail
inventory and last-in, first-out inventory
methods for tax years ended on, or with
reference to, December 31, 1996.
The Department Store Inventory Price
Indexes are prepared on a national basis
and include (a) 23 major groups of
departments, (b) three special combina-
tions of the major groups - soft goods,
durable goods, and miscellaneous goods,
and (c) a store total, which covers all
departments, including some not listed
separately, except for the following:
candy, foods, liquor, tobacco, and con-
tract departments.
BUREAU OF LABOR STATISTICS, DEPARTMENT STORE
INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS
(January 1941 = 100, unless otherwise noted)
Groups
Dec.
1995
Dec.
1996
Percent Change
from Dec. 1995
to Dec. 1996
1
1. Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .532.6538.71.1
2. Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . .633.5636.60.5
3. Women’s and Children’s Shoes. . . . . . . . . . . . . . . . . . . . . .625.6646.03.3
4. Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .891.0894.20.4
5. Infants’ Wear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .635.6616.823.0
6. Women’s Underwear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .521.6527.11.1
7. Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290.2287.221.0
8. Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . .559.9556.420.6
9. Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . .407.1404.420.7
10. Men’s Clothing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .602.1610.81.4
11. Men’s Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .561.6578.63.0
12. Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . .481.8483.50.4
13. Jewelry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .978.1965.321.3
14. Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .773.6779.40.7
15. Toilet Articles and Drugs. . . . . . . . . . . . . . . . . . . . . . . . . . .870.8904.33.8
16. Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . .669.0664.620.7
17. Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .564.5574.81.8
18. Housewares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .782.3806.13.0
19. Major Appliances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .246.1245.320.3
20. Radio and Television . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .79.178.121.3
21. Recreation and Education
2
. . . . . . . . . . . . . . . . . . . . . . . . . .112.8110.821.8
22. Home Improvements
2
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .123.7132.26.9
23. Auto Accessories
2
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .107.5107.320.2
Groups 1 - 15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . .585.1589.80.8
Groups 16 - 20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . .462.2466.61.0
Groups 21 - 23: Misc. Goods
2
. . . . . . . . . . . . . . . . . . . . . . . . . .113.3112.920.4
Store Total
3
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .543.7547.40.7
1
Absence of a minus sign before percentage change in this column signifies price increase.
2
Indexes on a January 1986=100 base.
3
The store total index covers all departments, including some not listed separately, except for the following: candy, foods, liquor, tobacco, and contract
departments.
DRAFTING INFORMATION
The principal author of this revenue
ruling is Stan Michaels of the Office of
Assistant Chief Counsel (Income Tax
and Accounting). For further information
regarding this revenue ruling, contact
Mr. Michaels on (202) 622-4970 (not a
toll-free call).
4

Section 475.—Mark to Market
Accounting Method for Dealers in
Securities
26 CFR 1.475(c)–1: Definitions—dealers in secu-
rities.
T.D. 8700
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Mark to Market for Dealers in
Securities
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final and temporary regula-
tions.
SUMMARY: This document contains fi-
nal regulations providing guidance to
enable taxpayers to comply with the
mark-to-market requirements applicable
to dealers in securities. The Revenue
Reconciliation Act of 1993 amended the
applicable tax law. These regulations
provide guidance to dealers in securities.
DATES: These final regulations are ef-
fective December 24, 1996, except para-
graph (a) of § 1.475(c)–1T is removed
effective December 24, 1996, and the
remainder of § 1.475(c)–1T is removed
effective January 23, 1997.
For dates of applicability, see
§ 1.475(e)–1.
FOR FURTHER INFORMATION
CONTACT: Robert B. Williams at
(202) 622–3960 or Jo Lynn Ricks at
(202) 622–3920 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information con-
tained in these final regulations has been
reviewed and approved by the Office of
Management and Budget in accordance
with the Paperwork Reduction Act (44
U.S.C. 3507) under control number
1545–1496. Responses to this collection
of information are required for a tax-
payer to obtain the benefit of an exemp-
tion from marking to market under
section 475 for those securities (see
§ 1.475(b)–2) and for a consolidated
group of taxpayers to obtain the benefit
of treating inter-member transactions as
customer transactions for purposes of
the definition of dealer in securities (the
intragroup-customer election, § 1.475-
(c)–1(a)(3)(iii)).
An agency may not conduct or spon-
sor, and a person is not required to
respond to, a collection of information
unless the collection of information dis-
plays a valid control number.
The estimated annual burden per
recordkeeper regarding § 1.475(b)–2
varies from .25 to 3 hours, depending
on individual circumstances, with an
estimated average of 1 hour. Section
1.475(b)–4 (formerly § 1.475(b)–2T),
which permitted a taxpayer to add or
remove certain identifications on or be-
fore January 31, 1994, does not impose
a recordkeeping burden into the future.
The estimated burden per respondent in
making the intragroup-customer election
in §§ 1.475(c)–1(a)(3)(iii) varies from
.25 to 1 hours, depending on individual
circumstances, with an estimated aver-
age of .5 hours.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to
theInternal Revenue Service,Attn:
IRS Reports Clearance Officer, T:FP,
Washington, DC 20224, and to theOf-
fice of Management and Budget,Attn:
Desk Officer for the Department of the
Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503.
Books or records relating to this col-
lection of information must be retained
as long as their contents may become
material in the administration of any
internal revenue law. Generally, tax re-
turns and tax return information are
confidential, as required by 26 U.S.C.
6103.
Background
This document contains final regula-
tions under section 475 (relating to
mark-to-market accounting for dealers in
securities). Section 475 was added by
section 13223 of the Revenue Reconcili-
ation Act of 1993, Public Law 103–66,
107 Stat. 481, and is effective for all
taxable years ending on or after Decem-
ber 31, 1993.
On December 29, 1993, temporary
regulations (T.D. 8505, [1994–1 C.B.
152] 58 FR 68747) (hereinafter some-
times referred to as the temporary regu-
lations) and cross-referenced proposed
regulations (FI–72–93, 58 FR 68798)
(hereinafter sometimes referred to as the
1993 proposed regulations) were pub-
lished to furnish guidance on several
issues, including the scope of exemp-
tions from the mark-to-market require-
ments, certain transitional issues relating
to the scope of exemptions, and the
meaning of the statutory termssecurity,
dealer in securities, andheld for invest-
ment. Various comments were received
regarding those regulations, and a hear-
ing was held on April 12, 1994.
Additional regulations were proposed
on January 4, 1995 (60 FR 397) (herein-
after sometimes referred to as the 1995
proposed regulations), and on June 20,
1996 (61 FR 31474) (hereinafter some-
times referred to as the 1996 proposed
regulations). The 1995 and 1996 pro-
posed regulations supplemented, and in
a few cases revised, the 1993 proposed
regulations. Hearings on the 1995 and
1996 proposed regulations were held on
May 3, 1995, and October 15, 1996,
respectively.
The final regulations in this document
generally adopt the 1993 proposed regu-
lations, as revised by the 1995 and 1996
proposed regulations, with certain
changes reflecting comments that were
received. These final regulations also
adopt additional portions of the 1995
proposed regulations. The sections that
are not adopted at this time remain
proposed.
The provisions governing mark to
market of debt instruments, which were
proposed in January 1995, attracted sub-
stantial comment. The IRS and Treasury
intend to finalize those regulations in a
substantially revised form in response to
those taxpayer comments.
Explanation of Provisions
Acquisition by a dealer of a security
with a substituted basis
The final regulations adopt without
change the provisions in the 1995 pro-
posed regulations that provide rules for
situations where a dealer in securities
receives a security with a basis in its
hands that is determined, in whole or in
part, either by reference to the basis of
the security in the hands of the
transferor or by reference to other prop-
erty held at any time by the dealer. In
these cases, section 475(a) applies only
to post-acquisition gain and loss with
respect to the security. That is, section
475(a) applies only to changes in value
of the security occurring after its acqui-
sition. See section 475(b)(3). The char-
acter of the mark-to-market gain or loss
is determined as provided under section
475(d)(3). The character of pre-
acquisition gain or loss (that is, the
built-in gain or loss at the date the
dealer acquires the security) and the
time for taking that gain or loss into
account are determined without regard
to section 475. The fact that a security
5

has a substituted basis in the dealer’s
hands does not affect the security’s date
of acquisition for purposes of determin-
ing the timeliness of an identification
under section 475(b).
Scope of Exemptions From Mark-To-
Market Requirement
Section 475(b) exempts certain securi-
ties from mark-to-market accounting un-
der section 475(a). Among the exempted
securities are those held for investment
and debt securities not held for sale.
Section 1.475(b)–1(a) of the regulations,
like the temporary rule that preceded it,
provides that held for investment, as
used in section 475(b)(1)(A), and not
held for sale, as used in section
475(b)(1)(B), have the same meaning.
The regulations provide that both terms
refer to a security that is not held by a
taxpayer primarily for sale to customers
in the ordinary course of the taxpayer’s
trade or business. By providing that a
security is held for investment (or not
held for sale) if it is not held primarily
for sale to customers in the ordinary
course of a trade or business, the regula-
tions adopt the concept of held for
investment in section 1236(a). Thus,
under these regulations, a dealer in
securities may identify as held for in-
vestment a security that it holds prima-
rily for sale to non-customers (for ex-
ample, a trading security). The IRS and
the Treasury believe that providing a
single standard for purposes of sections
475 and 1236 is consistent with the
purpose of section 475. These rules
apply to taxable years ending on or after
December 31, 1993.
The final regulations require a tax-
payer that identifies a security as ex-
empt from being marked to market to
state (on its books and records) whether
the security is, on the one hand, exempt
as held for investment or not held for
sale or, on the other hand, exempt
because it is a hedge of an item not
subject to mark to market. This regula-
tion applies to identifications made on
or after July 1, 1997.
The temporary and 1993 proposed
regulations provide that stock in a 50-
percent-controlled subsidiary, and inter-
ests in 50-percent-controlled partner-
ships and trusts, are deemed properly
identified as held for investment and
thus are excluded from mark-to-market
accounting. The 1996 proposed regula-
tions reproposed this rule with two
changes. First, the IRS believed that the
rationale for the rule applies equally to
equity interests in most related persons
and not just to persons controlled by the
taxpayer. Second, after considering vari-
ous comments received, the IRS pro-
posed that this rule prohibiting marking
a security to market should not apply if
two requirements are met: (1) the secu-
rity is actively traded on a national
securities exchange or through an
interdealer quotation system; and (2) the
taxpayer who marks owns less than 5
percent of all shares or interests of the
same class. Comments were requested
as to whether it is appropriate to allow
any equity interests in related parties to
be marked to market, and, if so, whether
the proposed limitations are the most
appropriate ones.
After considering the comments re-
ceived in response, the IRS and the
Treasury have decided to adopt the
provisions in the 1996 proposed regula-
tions with certain modifications. First,
the general threshold above which even
actively traded stock in a related party
may not be marked to market has been
increased from 5% to 15%. The 15%
limit, however, includes shares held both
by the dealer and by certain related
parties. Second, shares that a dealer
acquires from a related party cannot be
marked to market unless, after the time
they were acquired, both one full busi-
ness day has passed and there has been
significant trading in the security involv-
ing persons who are not related to the
taxpayer.
Section 475(b)(3) applies when a se-
curity has been exempt from marking to
market and the exemption then ceases to
apply. Thus, changes in a security’s
value that occur while section 475(a)
does not apply are suspended. This rule
has additional significance for certain
members of consolidated groups because
§ 1.1502–13(f)(6) disallows certain
losses recognized by members of con-
solidated groups on common parent
stock if the loss is not taken into
account pursuant to section 475(a).
The final regulations provide that,
except as determined by the Commis-
sioner, notional principal contracts and
derivative securities described in section
475(c)(2)(D) or (E) that are held by a
dealer in those securities are not eligible
to be exempted from mark-to-market
treatment as held for investment.
Under the temporary and 1993 pro-
posed regulations, however, an analo-
gous barrier to exemption from mark-to-
market treatment did not apply if the
taxpayer established unambiguously that
the security was acquired other than in
the taxpayer’s capacity as a dealer in
such securities. It was anticipated that
this exception would apply only in rare
instances. Commenters suggested an
easing of the standard for establishing
that a security was acquired other than
in the taxpayer’s capacity as a dealer in
such securities.
These suggestions are specifically re-
jected in the final regulations set forth
in § 1.475(b)–1(c). Instead, as described
above, to avoid uncertainty and ambigu-
ity, the rule barring exemption from
mark-to-market treatment for certain no-
tional principal contracts and derivative
securities applies unless the Commis-
sioner explicitly determines otherwise.
For securities acquired or entered into
before January 23, 1997, however, the
final regulations continue the rule found
in the temporary regulations.
Commenters suggested that changes
are needed to allow taxpayers that are
dealers in notional principal contracts
and derivative securities (described in
section 475(c)(2)(D) or (E)) to identify
as exempt from mark-to-market treat-
ment a notional principal contract or
derivative that is held as a hedge of a
position that is not marked to market.
No change was made to the tempo-
rary regulations to reflect these com-
ments because none was necessary. Sec-
tion 1.475(b)–1(c) limits exemptions
only under section 475(b)(1)(A) (con-
cerning securities held for investment).
Section 1.475(b)–1(c) does not limit
exemptions under section 475(b)(1)(C)
(concerning securities that are hedges of
non-mark-to-market positions). Although
the flush language at the end of section
475(b)(1) authorizes analogous regula-
tory limitations on exemption under sec-
tion 475(b)(1)(C), as of this time, no
such regulation has been issued or pro-
posed. Accordingly, if a dealer in no-
tional principal contracts or derivatives
enters into a notional principal contract
or derivative as a hedge of a position
that is not marked to market, the dealer
may properly identify it under section
475(b)(1)(C) as exempt from mark-to-
market treatment.
In response to comments, the final
regulations expand the securities that a
taxpayer may identify under section
475(b)(1)(C) as exempt from mark-to-
market accounting. Under the final regu-
lations, a taxpayer can identify as ex-
empt from mark-to-market treatment
under section 475(b)(1)(C) a security
that hedges a position of another mem-
ber of the taxpayer’s consolidated group
and meets the following three require-
6

ments: the security is a hedging transac-
tion within the meaning of § 1.1221–
2(b); the security is timely identified as
a hedging transaction under § 1.1221–
2(e) (including satisfaction of the re-
quirement that the hedged item be iden-
tified); and the security hedges a
position that is not marked to market
under section 475(a). Although identifi-
cation of the hedged item is not required
under § 1.1221–2 until some time after
the day the hedging transaction is en-
tered into, the identification of the hedge
under section 475(b)(2) must still be
made no later than the close of the day
on which the hedge is acquired, origi-
nated, or entered into.
Permitting taxpayers to identify these
securities as exempt from mark-to-
market accounting is consistent with the
single-entity approach of the consoli-
dated group hedging regulations under
§ 1.1221–2(d)(1). As a result of the
identification, the timing of the gain or
loss on the hedge is matched with the
timing of the gain or loss on the hedged
item without forcing taxpayers to use
back-to-back hedges and the separate-
entity election under § 1.1221–2(d)(2).
This rule is effective for hedges entered
into on or after January 23, 1997.
Exemptions—Transitional Issues
The final regulations adopt without
substantive change a number of transi-
tional rules relating to various exemp-
tion and identification issues. These
transitional rules, now found in
§ 1.475(b)–4, were contained in
§ 1.475(b)–2T of the temporary regula-
tions. A more complete description of
these provisions may be found in the
preamble of T.D. 8505 at 58 FR 68747
(1994–1 C.B. 152).
Dealer in Securities—the Dealer-
Customer Relationship
The final regulations retain the rules
in the 1995 proposed regulations con-
cerning the dealer-customer relationship.
Thus, the final regulations provide that
determination of whether a transaction is
with a customer is based on all of the
facts and circumstances. Further, under
section 475(c)(1)(B), the termdealer in
securitiesincludes a taxpayer that, in the
ordinary course of its trade or business,
regularly holds itself out as being will-
ing and able to enter into either side of
a transaction enumerated in section
475(c)(1)(B).
The final regulations retain the gen-
eral rule in the 1996 proposed regula-
tions that transactions with related per-
sons may be transactions with customers
for purposes of section 475. In response
to comments, however, in § 1.475(c)–
1(a)(3) the final regulations provide both
a special rule for members of a consoli-
dated group and an election for the rule
not to apply. If the special rule applies,
then, solely for purposes of determining
whether the taxpayer meets the defini-
tion of a dealer in securities, a taxpay-
er’s transactions with other members of
its consolidated group are not transac-
tions with customers. Thus, a member
whose only customers are other mem-
bers of its consolidated group generally
is not a dealer in securities. Treating
intragroup transactions as noncustomer
transactions is consistent with the
single-entity approach of §§ 1.1221–
2(d)(1) and 1.1502–13. (The IRS ex-
pects to provide additional guidance on
whether there are any circumstances in
which the special rule applies for other
purposes, such as whether a security
may be exempted from mark-to-market
treatment because it is not held for sale
to customers.)
A consolidated group may elect not to
apply the special rule. If a group has
made this intragroup customer election,
a member of a group may be a dealer in
securities even if its only customer
transactions are with other members of
its consolidated group. Once made, the
election continues for all subsequent
taxable years and may be revoked only
with the consent of the Commissioner.
These final regulations significantly
alter the proposed default rule for
intragroup transactions. Under the pro-
posed regulations, a taxpayer’s
intragroup transactions would have been
customer transactions for purposes of
section 475. Because the final regula-
tions reverse this rule (making
noncustomer status the default and re-
quiring an affirmative election to con-
sider intragroup transactions in applying
the dealer definition), the rules for
intragroup transactions are effective for
taxable years beginning on or after
December 24, 1996. (The general rule
for related party transactions other than
intragroup transactions is effective for
taxable years beginning on or after June
20, 1996.) The IRS will soon publish
guidance to assist taxpayers who may
have to change their methods of ac-
counting because their status as a dealer
changes as a result of the application of
§ 1.475(c)–1(a)(3).
For prior years, the Service generally
will not challenge a taxpayer’s treatment
of intragroup transactions as customer or
noncustomer transactions, provided the
taxpayer had a reasonable basis for its
treatment of the transactions and consis-
tently applied that basis from year to
year. In this regard, a taxpayer does not
fail this consistency requirement solely
because it changed its treatment of its
intragroup transactions in order: (1) to
avail itself of the separate-entity election
under the consolidated group hedging
regulations, or (2) to coincide with the
expected effective date of either Notice
96–12 (1996–10 I.R.B. 29) or the re-
lated party rules in the 1996 proposed
regulations. (If a taxpayer wishes to
change its treatment of prior open years
to be consistent with its status during
the first year that § 1.475(c)–1(a)(3)
applies, see § 301.9100–1T(a).)
Dealer in Securities—Sellers of Nonfi-
nancial Goods and Services
In general, the final regulations ex-
clude from dealer status any taxpayer
that would not be a dealer in securities
but for its purchases and sales of debt
instruments that, at the time of purchase
or sale, are customer debt with respect
to the taxpayer or another member of
the taxpayer’s consolidated group. A
debt instrument is customer debt at a
particular time with respect to a person
if three conditions are met: (1) the
person’s principal activity is selling
nonfinancial goods or providing
nonfinancial services; (2) the debt in-
strument was issued by a purchaser of
the goods or services at the time of
purchase of those items in order to
finance their purchase; and (3) at all
times after the debt instrument was
issued, it has been owned by the person
who sold the goods or services or by a
member of its consolidated group. If,
however, a taxpayer is a dealer in
securities despite this provision, cus-
tomer debt remains a security in the
taxpayer’s hands and must be marked to
market unless exempted by another rule.
The temporary regulations contain a
narrower provision—that a seller of
nonfinancial goods or services is not a
dealer in securities for purposes of sec-
tion 475 solely by virtue of extending
credit to its nonfinancial customers
(even if it sells the debt instruments so
acquired). In response to comments, the
final regulations extend this principle to
accommodate consolidated groups that
include both a seller of nonfinancial
goods or services and a captive finance
subsidiary.
7

The rule in the final regulations ex-
empting from dealer status most captive
finance subsidiaries of retailers and
other sellers of nonfinancial goods and
services applies to all taxable years
ending on or after December 31, 1993,
unless the taxpayer elects for the ex-
emption not to apply. If the election is
made, it continues for all subsequent
taxable years and may be revoked only
with the consent of the Commissioner.
Under the final regulations, there are
two additional circumstances in which
this exemption from dealer status does
not apply. The first is when, for pur-
poses of the inventory accounting rules
under section 471, the taxpayer accounts
for any security (as defined in section
475(c)(2)) as inventory. The second cir-
cumstance is when the taxpayer is not
itself the seller of nonfinancial goods
and services and the customer debt is
accounted for by the taxpayer or by a
member of its consolidated group under
a method that permits either the recogni-
tion of unrealized gains or losses or
deductions for additions to a reserve for
bad debts. This rule does not affect the
seller of nonfinancial goods and services
itself but is designed to prevent groups
from having one captive finance subsid-
iary that is treated as a nondealer and
another member of the group that is a
dealer or a financial institution that
accounts for customer debt under a
method that takes into account mark-to-
market gains or losses or reserve deduc-
tions.
Dealer in Securities—the Negligible
Sales Exemption
Under the final regulations, in gen-
eral, if a taxpayer purchases securities
from customers (including originating
loans in the ordinary course of the
taxpayer’s trade or business of originat-
ing loans) but engages in no more than
negligible sales of the securities so
acquired, the purchases do not cause the
taxpayer to be a dealer in securities.
This negligible sales rule does not apply
if the taxpayer so elects or accounts for
any security as inventory for purposes
of section 471. A taxpayer that would be
a dealer in securities but for the negli-
gible sales rule elects to be a dealer
simply by filing a federal income tax
return reflecting the application of sec-
tion 475(a) in computing its taxable
income. The final regulations differ
from the proposed regulations by explic-
itly making the negligible sales rule
elective.
In response to comments, the final
regulations clarify the test for determin-
ing negligible sales of debt instruments
acquired from customers. Under this
rule, a taxpayer has engaged in no more
than negligible sales of the debt instru-
ments (or portions of the debt instru-
ments) that it regularly purchases from
customers in the ordinary course of its
business if, and only if, during the year,
either (1) it sells all or part of fewer
than 60 debt instruments (regardless
how acquired), or (2) the total adjusted
basis of the debt instruments or portions
of debt instruments (regardless how ac-
quired) that it sells is less than 5 percent
of the total basis, immediately after
acquisition, of the debt instruments that
it acquires during the year.
This special test replaces the ex-
amples in the temporary regulations il-
lustrating the negligible sales provision.
Some commenters noted that
§ 1.475(c)–1T(b)(2)Example 1of the
temporary regulations is ambiguous be-
cause it refers to a taxpayer that both
‘‘retains almost all of the loans that it
acquires’’ and ‘‘sells fewer than 60
loans.’’ The final regulations eliminate
the ambiguity by making no reference to
how many loans are retained.
In response to comments, the final
regulations contain two special rules for
applying the negligible sales test to
members of a consolidated group. Under
the first rule, if a taxpayer is a member
of a consolidated group that has made
the intragroup-customer election, de-
scribed above, it must apply the negli-
gible sales test for debt instruments by
taking into account all of its sales of
debt instruments to other group mem-
bers. On the other hand, if the taxpayer
is a member of a consolidated group
that has not made the intragroup-
customer election, the negligible sales
test is satisfied if either of two criteria is
met: first, if the taxpayer satisfies the
negligible sales test, taking into account
all sales of debt instruments including
sales to other group members; or sec-
ond, if the taxpayer’s consolidated group
would satisfy the test if it were a single
corporation and the members of the
group were divisions of that corporation.
This group-wide approach to the negli-
gible sales test is consistent with the
single-entity approach of §§ 1.1221–
2(d)(1) and 1.1502–13.
Under a new rule in the final regula-
tions, if a debt instrument is qualita-
tively different from all of the debt
instruments that the taxpayer purchases
from customers, a sale of that debt
instrument does not count as one of the
60 instruments sold, and that debt in-
strument is not included in either the
numerator or the denominator under the
5% test. The regulations contain an
example that illustrates this principle.
The rules regarding the negligible
sales exemption are generally effective
for taxable years ending on or after
December 31, 1993. The special rules
for members of a consolidated group,
however, are effective for taxable years
beginning on or after January 23, 1997.
Further, a taxpayer may rely on the
rules set out in § 1.475(c)–1T(b) (as
contained in 26 CFR part 1 revised
April 1, 1996) for taxable years begin-
ning before January 23, 1997, provided
the taxpayer applies that paragraph rea-
sonably and consistently.
Dealer in Securities—Issuance of Life
Insurance Products
The final regulations adopt without
change a provision in the 1995 proposed
regulations to clarify that a life insur-
ance company does not become a dealer
in securities solely by selling annuity,
endowment, or life insurance contracts
to its customers.
Under the final regulations and the
December 28, 1993, proposed regula-
tions, a contract that is treated for
federal income tax purposes as an annu-
ity, endowment, or life insurance con-
tract is deemed to have been identified
as held for investment, and is therefore
not marked to market by the policy
holder. This rule was necessary because
variable life and annuity products fall
within the literal language of section
475(c)(2)(E). Because many life insur-
ance companies sell these insurance
contracts to their customers, some com-
menters on the 1993 proposal had asked
whether these life insurance companies
were dealers in securities. There is no
indication that Congress intended for a
life insurance company that was not
otherwise a dealer in securities to be
characterized as a dealer merely because
it sells life insurance policies to its
customers.
Several commenters requested that
certain activities not cause dealer status
under section 475 because those activi-
ties, although described by section 475,
traditionally had not been considered
dealer activities. Those comments were
generally rejected. Congress determined
that section 475 would bestow dealer
status on taxpayers who had not been
thought of as dealers prior to the enact-
8

ment of section 475. Thus, the final
regulations do not adopt proposals that
making and selling policy loans should
not cause an insurance company to be a
dealer in securities and that sales of
student loans or auto loans and sales of
loan participations should not be taken
into account in determining whether a
taxpayer is a dealer in securities. Of
course, if a lead bank never owns a
particular portion of a loan for tax
purposes (because some other participat-
ing lender always had the economic
benefits and burdens of that portion),
then the lead bank cannot sell that
portion to that other participating lender.
Thus, the lead bank is not a dealer in
securities by reason of these participa-
tions.
Definition of Security
Under the final regulations, certain
items are not securities within the mean-
ing of section 475(c)(2). These items
include both debt issued by the taxpayer
and any security (determined without
regard to this provision) if section 1032
bars recognition of gain or loss by the
taxpayer with respect to that security.
The final regulations adopt without
change the provisions in the 1995 pro-
posed regulations that exclude from the
definition of security all REMIC re-
sidual interests acquired on or after
January 4, 1995. This rule was adopted
because applying section 475 to residual
interests would undermine the Congres-
sional design for taxing REMIC income,
including the intended operation of sec-
tions 860C and 860E (relating to excess
inclusions).
Unlike the 1995 proposed regulations,
the temporary regulations excluded only
some residual interests from the defini-
tion of security. Specifically, the tempo-
rary regulations excluded only negative
value residual interests (NVRIs) in a
REMIC and other arrangements that are
determined to have substantially the
same economic effect as NVRIs. Under
the final regulations, this exclusion con-
tinues to apply to NVRIs acquired be-
fore January 4, 1995.
One commenter acknowledged the
tension between mark-to-market ac-
counting and the excess inclusion rules,
but proposed to address that problem in
another way. Under the commenter’s
proposal, a dealer would be permitted to
mark to market a residual interest, but
any loss resulting from the mark would
be taken into account only to the extent
that the loss exceeded the amount of
excess inclusion with respect to that
residual interest for the taxable year.
The IRS and Treasury believe that
this comment does not address the ten-
sion between mark-to-market accounting
and section 860C. Apart from the excess
inclusion rules, the REMIC provisions
contemplate income inclusions (and cor-
responding basis increases) that are not
necessarily associated with increases in
the value of the residual interest. Under
the commenter’s proposal, a dealer
could claim a loss by marking to market
a residual interest where the increased
basis in the interest resulted from an
allocation of REMIC income that was
unaccompanied by an increase in value.
Thus, the dealer could avoid its al-
locable share of REMIC income and
thereby frustrate the taxing regime con-
templated for residual interests.
Moreover, adopting this comment
would require additional, complex rules,
and the burden of administering those
rules would not be justified by the
potential benefit. For example, under the
proposal, a taxpayer would have one
basis in a residual interest for purposes
of section 475 and a different basis in
the residual interest for purposes of
section 860C(d). Also, adopting the pro-
posal would require rules to coordinate
losses that are limited under section 475
with losses that are limited under sec-
tion 860C(e)(2).
Some commenters suggested that cer-
tain types of assets should not be
marked to market because they may be
difficult to value. Under section 475,
however, ease of valuation is not rel-
evant in determining whether a security
is required to be marked to market.
Character of Gain or Loss
The regulations adopt without change
the proposed provision to clarify that
marking to market a security that is not
held in connection with a taxpayer’s
activities as a dealer in securities does
not affect the character of gain or loss
from that security.
In addition, under a new provision in
the final regulations that responds to
comments from taxpayers, if a dealer in
certain notional principal contracts or
derivative securities (described in sec-
tion 475(c)(2)(D) or (E)) marks those
securities to market because it is pre-
cluded from identifying them as exempt
from mark-to-market treatment on the
grounds that they are held for invest-
ment, the dealer recognizes ordinary
gain or loss with respect to those securi-
ties.
Effective Dates
These final regulations generally ap-
ply to taxable years ending on or after
December 31, 1993, except as otherwise
noted.
Miscellaneous
Some of the 1993 and 1995 proposed
regulations are reordered.
Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in EO 12866.
Therefore, a regulatory assessment is not
required. It also has been determined
that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does
not apply to these regulations. The col-
lection of information required by
§ 1.475(b)–2 was contained in a notice
of proposed rulemaking preceding these
regulations that was issued prior to
March 29, 1996. Moreover, it is hereby
certified that the collection of informa-
tion required by § 1.475(c)–1 of these
regulations (regarding the intragroup
customer election) does not have a sig-
nificant economic impact on a substan-
tial number of small entities. This certi-
fication is based upon the fact that the
election is generally attractive only to an
affiliated group of taxpayers that files a
consolidated return (generally large
businesses), that has elected separate
entity treatment under § 1.1221–2, and
that has an in-house hedge center or
securities dealer which deals solely with
other group members and which uses
mark-to-market accounting for book
purposes. Thus, the election is likely to
be made only by, and the collection of
information applies only to, a very small
number of large taxpayers. Therefore, a
Regulatory Flexibility Analysis under
the Regulatory Flexibility Act (5 U.S.C.
chapter 6) is not required. Pursuant to
section 7805(f) of the Internal Revenue
Code, the notice of proposed rulemaking
preceding these regulations was submit-
ted to the Small Business Administration
for comment on its impact on small
business.
Drafting Information
The principal authors of these regula-
tions are Robert B. Williams and Jo
Lynn Ricks, Office of Assistant Chief
9

Counsel (Financial Institutions and
Products), IRS. However, other person-
nel from the IRS and Treasury Depart-
ment participated in their development.
* * * * *
26 CFR Part 602
Reporting and recordkeeping require-
ments.
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by removing the
entries for §§ 1.475(b)–1T, 1.475(b)–2T,
1.475(c)–1T, 1.475(c)–2T, 1.475(d)–1T,
and 1.475(e)–1T and adding entries in
numerical order to read as follows:
Authority: 26 U.S.C. 7805. * * *
Section 1.475(a)–3 also issued under
26 U.S.C. 475(e).
Section 1.475(b)–1 also issued under
26 U.S.C. 475(b)(4) and 26 U.S.C.
475(e).
Section 1.475(b)–2 also issued under
26 U.S.C. 475(b)(2) and 26 U.S.C.
475(e).
Section 1.475(b)–4 also issued under
26 U.S.C. 475(b)(2), 26 U.S.C. 475(e),
and 26 U.S.C. 6001.
Section 1.475(c)–1 also issued under
26 U.S.C. 475(e).
Section 1.475(c)–2 also issued under
26 U.S.C. 475(e) and 26 U.S.C.
860G(e).
Section 1.475(d)–1 also issued under
26 U.S.C. 475(e).
Section 1.475(e)–1 also issued under
26 U.S.C. 475(e). * * *
Sections 1.475(b)–1T, 1.475(b)–2T,
1.475(c)–1T, 1.475(c)–2T, 1.475(d)–1T,
and 1.475(e)–1T [Removed]
Par. 2. Sections 1.475(b)–1T,
1.475(b)–2T, 1.475(c)–2T, 1.475(d)–1T,
and 1.475(e)–1T are removed.
Par. 2a. Paragraph (a) of § 1.475(c)–
1T is removed effective December 24,
1996, and the remainder of § 1.475(c)–
1T is removed January 23, 1997.
Par. 3. Sections 1.475–0, 1.475(a)–3,
1.475(b)–1, 1.475(b)–(2), 1.475(b)–4,
1.475(c)–1, 1.475(c)–2, 1.475(d)–1, and
1.475(e)–1 are added to read as follows:
§ 1.475–0 Table of contents.
This section lists the major captions
in §§ 1.475(a)–3, 1.475(b)–1,
1.475(b)–2, 1.475(b)–4, 1.475(c)–1,
1.475(c)–2, 1.475(d)–1, and 1.475(e)–1.
§ 1.475(a)–1 [Reserved]
§ 1.475(a)–2 [Reserved]
§ 1.475(a)–3 Acquisition by a dealer of
a security with a substituted basis.
(a) Scope.
(b) Rules.
§ 1.475(b)–1 Scope of exemptions from
mark-to-market requirement.
(a) Securities held for investment or
not held for sale.
(b) Securities deemed identified as
held for investment.
(1) In general.
(2) Relationships.
(i) General rule.
(ii) Attribution.
(iii) Trusts treated as partnerships.
(3) Securities traded on certain estab-
lished financial markets.
(4) Changes in status.
(i) Onset of prohibition against mark-
ing.
(ii) Termination of prohibition against
marking.
(iii) Examples.
(c) Securities deemed not held for
investment; dealers in notional principal
contracts and derivatives.
(d) Special rule for hedges of another
member’s risk.
(e) Transitional rules.
(1) Stock, partnership, and beneficial
ownership interests in certain controlled
corporations, partnerships, and trusts be-
fore January 23, 1997.
(i) In general.
(ii) Control defined.
(iii) Applicability.
(2) Dealers in notional principal con-
tracts and derivatives acquired before
January 23, 1997.
(i) General rule.
(ii) Exception for securities not ac-
quired in dealer capacity.
(iii) Applicability.
§ 1.475(b)–2 Exemptions—identifica-
tion requirements.
(a) Identification of the basis for ex-
emption.
(b) Time for identifying a security
with a substituted basis.
(c) Integrated transactions under
§ 1.1275–6.
(1) Definitions.
(2) Synthetic debt held by a taxpayer
as a result of legging in.
(3) Securities held after legging out.
§ 1.475(b)–3 [Reserved]
§ 1.475(b)–4 Exemptions—transitional
issues.
(a) Transitional identification.
(1) Certain securities previously iden-
tified under section 1236.
(2) Consistency requirement for other
securities.
(b) Corrections on or before January
31, 1994.
(1) Purpose.
(2) To conform to § 1.475(b)–1(a).
(i) Added identifications.
(ii) Limitations.
(3) To conform to § 1.475(b)–1(c).
(c) Effect of corrections.
§ 1.475(c)–1 Definitions—dealer in se-
curities.
(a) Dealer-customer relationship.
(1) [Reserved].
(2) Transactions described in section
475(c)(1)(B).
(i) In general.
(ii) Examples.
(3) Related parties.
(i) General rule.
(ii) Special rule for members of a
consolidated group.
(iii) The intragroup-customer election.
(A) Effect of election.
(B) Making and revoking the elec-
tion.
(iv) Examples.
(b) Sellers of nonfinancial goods and
services.
(1) Purchases and sales of customer
paper.
(2) Definition of customer paper.
(3) Exceptions.
(4) Election not to be governed by
the exception for sellers of nonfinancial
goods or services.
(i) Method of making the election.
(A) Taxable years ending after De-
cember 24, 1996.
(B) Taxable years ending on or be-
fore December 24, 1996.
(ii) Continued applicability of an
election.
(c) Taxpayers that purchase securities
from customers but engage in no more
than negligible sales of the securities.
(1) Exemption from dealer status.
(i) General rule.
(ii) Election to be treated as a dealer.
(2) Negligible sales.
(3) Special rules for members of a
consolidated group.
10

(i) Intragroup-customer election in ef-
fect.
(ii) Intragroup-customer election not
in effect.
(4) Special rules.
(5) Example.
(d) Issuance of life insurance prod-
ucts.
§ 1.475(c)–2 Definitions—security.
(a) Items that are not securities.
(b) Synthetic debt that § 1.1275–6(b)
treats the taxpayer as holding.
(c) Negative value REMIC residuals
acquired before January 4, 1995.
(1) Description.
(2) Special rules applicable to nega-
tive value REMIC residuals acquired
before January 4, 1995.
§ 1.475(d)–1 Character of gain or loss.
(a) Securities never held in connec-
tion with the taxpayer’s activities as a
dealer in securities.
(b) Ordinary treatment for notional
principal contracts and derivatives held
by dealers in notional principal contracts
and derivatives.
§ 1.475(e)–1 Effective dates.
§ 1.475(a)–3 Acquisition by a dealer of
a security with a substituted basis.
(a)Scope. This section applies if—
(1) A dealer in securities acquires a
security that is subject to section 475(a)
and the dealer’s basis in the security is
determined, in whole or in part, by
reference to the basis of that security in
the hands of the person from whom the
security was acquired; or
(2) A dealer in securities acquires a
security that is subject to section 475(a)
and the dealer’s basis in the security is
determined, in whole or in part, by
reference to other property held at any
time by the dealer.
(b)Rules. If this section applies to a
security—
(1) Section 475(a) applies only to
changes in value of the security occur-
ring after the acquisition; and
(2) Any built-in gain or loss with
respect to the security (based on the
difference between the fair market value
of the security on the date the dealer
acquired it and its basis to the dealer on
that date) is taken into account at the
time, and has the character, provided by
the sections of the Internal Revenue
Code that would apply to the built-in
gain or loss if section 475(a) did not
apply to the security.
§ 1.475(b)–1 Scope of exemptions from
mark-to-market requirement.
(a)Securities held for investment or
not held for sale.Except as otherwise
provided by this section and subject to
the identification requirements of section
475(b)(2), a security is held for invest-
ment (within the meaning of section
475(b)(1)(A)) or not held for sale
(within the meaning of section
475(b)(1)(B)) if it is not held by the
taxpayer primarily for sale to customers
in the ordinary course of the taxpayer’s
trade or business.
(b)Securities deemed identified as
held for investment— (1)In general.
The following items held by a dealer in
securities are per se held for investment
within the meaning of section
475(b)(1)(A) and are deemed to be
properly identified as such for purposes
of section 475(b)(2)—
(i) Except as provided in paragraph
(b)(3) of this section, stock in a corpora-
tion, or a partnership or beneficial own-
ership interest in a widely held or
publicly traded partnership or trust, to
which the taxpayer has a relationship
specified in paragraph (b)(2) of this
section; or
(ii) A contract that is treated for
federal income tax purposes as an annu-
ity, endowment, or life insurance con-
tract (see sections 72, 817, and 7702).
(2)Relationships—(i)General rule.
The relationships specified in this para-
graph (b)(2) are—
(A) Those described in section
267(b)(2), (3), (10), (11), or (12); or
(B) Those described in section
707(b)(1)(A) or (B).
(ii)Attribution. The relationships de-
scribed in paragraph (b)(2)(i) of this
section are determined taking into ac-
count sections 267(c) and 707(b)(3), as
appropriate.
(iii)Trusts treated as partnerships.
For purposes of this paragraph (b)(2),
the phrasepartnership or trustis substi-
tuted for the wordpartnershipin sec-
tions 707(b)(1) and (3), and a reference
to beneficial ownership interest is added
to each reference to capital interest or
profits interest in those sections.
(3)Securities traded on certain es-
tablished financial markets.Paragraph
(b)(1)(i) of this section does not apply
to a security if—
(i) The security is actively traded
within the meaning of § 1.1092(d)–1(a)
taking into account only established fi-
nancial markets identified in
§ 1.1092(d)–1(b)(1)(i) or (ii) (describing
national securities exchanges and
interdealer quotation systems);
(ii) Less than 15 percent of all of the
outstanding shares or interests in the
same class are held by the taxpayer and
all persons having a relationship to the
taxpayer that is specified in paragraph
(b)(2) of this section; and
(iii) If the security was acquired (e.g.,
on original issue) from a person having
a relationship to the taxpayer that is
specified in paragraph (b)(2) of this
section, then, after the time the security
was acquired—
(A) At least one full business day has
passed, and
(B) There has been significant trading
involving persons not having a relation-
ship to the taxpayer that is specified in
paragraph (b)(2) of this section.
(4)Changes in status—(i)Onset of
prohibition against marking—(A) Once
paragraph (b)(1) of this section begins
to apply to the security and for so long
as it continues to apply, section 475(a)
does not apply to the security in the
hands of the taxpayer.
(B) If a security has not been timely
identified under section 475(b)(2) and,
after the last day on which such an
identification would have been timely,
paragraph (b)(1) of this section begins
to apply to the security, then the dealer
must recognize gain or loss on the
security as if it were sold for its fair
market value as of the close of business
of the last day before paragraph (b)(1)
of this section begins to apply to the
security, and gain or loss is taken into
account at that time.
(ii)Termination of prohibition against
marking. If a taxpayer did not timely
identify a security under section
475(b)(2), and paragraph (b)(1) of this
section applies to the security on the last
day on which such an identification
would have been timely but thereafter
ceases to apply—
(A) An identification of the security
under section 475(b)(2) is timely if
made on or before the close of the day
paragraph (b)(1) of this section ceases to
apply; and
(B) Unless the taxpayer timely identi-
fies the security under section 475(b)(2)
(taking into account the additional time
for identification that is provided by
paragraph (b)(4)(ii)(A) of this section),
section 475(a) applies to changes in
value of the security after the cessation
in the same manner as under section
475(b)(3).
(iii)Examples. These examples illus-
trate this paragraph (b)(4):
11

Example 1. Onset of prohibition against mark-
ing—(A)Facts.CorporationHowns 75 percent of
the stock of corporationD, a dealer in securities
within the meaning of section 475(c)(1). On
December 1, 1995,Dacquired less than half of
the stock in corporationX.Ddid not identify the
stock for purposes of section 475(b)(2). On July
17, 1996,Hacquired from other persons 70
percent of the stock ofX. As a result,DandX
became related within the meaning of paragraph
(b)(2)(i) of this section. The stock ofXis not
described in paragraph (b)(3) of this section
(concerning some securities traded on certain
established financial markets).
(B)Holding.Under paragraph (b)(4)(i) of this
section,Drecognizes gain or loss on itsXstock
as if the stock were sold for its fair market value
at the close of business on July 16, 1996, and the
gain or loss is taken into account at that time. As
with any application of section 475(a), proper
adjustment is made in the amount of any gain or
loss subsequently realized. After July 16, 1996,
section 475(a) does not apply toD’sXstock while
paragraph (b)(1)(i) of this section (concerning the
relationship betweenXandD) continues to apply.
Example 2. Termination of prohibition against
marking; retained securities identified as held for
investment—(A)Facts.On July 1, 1996, corpora-
tionHowned 60 percent of the stock of corpora-
tionYand all of the stock of corporationD, a
dealer in securities within the meaning of section
475(c)(1). Thus,DandYare related within the
meaning of paragraph (b)(2)(i) of this section.
Also on July 1, 1996,Dacquired, as an invest-
ment, 10 percent of the stock ofY. The stock ofY
is not described in paragraph (b)(3) of this section
(concerning some securities traded on certain
established financial markets). WhenDacquired
its shares ofYstock, it did not identify them for
purposes of section 475(b)(2). On December 24,
1996,Didentified its shares ofYstock as held for
investment under section 475(b)(2). On December
30, 1996,Hsold all of its shares of stock inYto
an unrelated party. As a result,DandYceased to
be related within the meaning of paragraph
(b)(2)(i) of this section.
(B)Holding.Under paragraph (b)(4)(ii)(A) of
this section, identification of theYshares is timely
if done on or before the close of December 30,
1996. BecauseDtimely identified itsYshares
under section 475(b)(2), it continues after Decem-
ber 30, 1996, to refrain from marking to market its
Ystock.
Example 3. Termination of prohibition against
marking; retained securities not identified as held
for investment— (A)Facts.The facts are the same
as inExample 2above, except thatDdid not
identify its stock inYfor purposes of section
475(b)(2) on or before December 30, 1996. Thus,
Ddid not timely identify these securities under
section 475(b)(2) (taking into account the addi-
tional time for identification provided in paragraph
(b)(4)(ii)(A) of this section).
(B)Holding.Under paragraph (b)(4)(ii)(B) of
this section, section 475(a) applies to changes in
value ofD’sYstock after December 30, 1996, in
the same manner as under section 475(b)(3). Thus,
any appreciation or depreciation that occurred
while the securities were prohibited from being
marked to market is suspended. Further, section
475(a) applies only to those changes occurring
after December 30, 1996.
Example 4. Acquisition of actively traded stock
from related party—(A)Facts. CorporationPis
the parent of a consolidated group whose taxable
year is the calendar year, and corporationM, a
member of that group, is a dealer in securities
within the meaning of section 475(c)(1). Corpora-
tionMregularly acts as a market maker with
respect to common and preferred stock of corpora-
tionP. CorporationPhas outstanding 2,000,000
shares of seriesXpreferred stock, which are
traded on a national securities exchange. During
the business day on December 29, 1997, corpora-
tionPsold 100,000 shares of seriesXpreferred
stock to corporationMfor $100 per share. Subse-
quently, also on December 29, 1997, persons not
related to corporationMengaged in significant
trading of the seriesXpreferred stock. At the
close of business on December 30, 1997, the fair
market value of seriesXstock was $99 per share.
At the close of business on December 31, 1997,
the fair market value of seriesXstock was $98.50
per share. CorporationMsold the seriesXstock
on the exchange on January 2, 1998. At all
relevant times, corporationMand all persons
related toMowned less than 15% of the outstand-
ing seriesXpreferred stock.
(B)Holding.The 100,000 shares of seriesX
preferred stock held by corporationMare not
subject to mark-to-market treatment under section
475(a) on December 29, 1997, because at that
time the stock was held for less than one full
business day and is therefore treated as properly
identified as held for investment. At the close of
business on December 30, 1997, that prohibition
on marking ceases to apply, and section 475(b)(3)
begins to apply. The built-in loss is suspended,
and subsequent appreciation and depreciation are
subject to section 475(a). Accordingly, when cor-
porationMmarks the seriesXstock to market at
the close of business on December 31, 1997,
under section 475(a) it recognizes and takes into
account a loss of $.50 per share. Under section
475(b)(3), when corporationMsells the seriesX
stock on January 2, 1998, it takes into account the
suspended loss, that is, the difference between the
$100 per share it paid corporationPfor that stock
and the $99-per-share fair market value when
section 475(b)(1) ceased to be apply to the stock.
No deduction, however, is allowed for that loss.
(See § 1.1502–13(f)(6), under which no deduction
is allowed to a member of a consolidated group
for a loss with respect to a share of stock of the
parent of that consolidated group, if the member
does not take the gain or loss into account
pursuant to section 475(a).)
(c)Securities deemed not held for
investment; dealers in notional principal
contracts and derivatives—(1) Except as
otherwise determined by the Commis-
sioner in a revenue ruling, revenue pro-
cedure, or letter ruling, section
475(b)(1)(A) (exempting from mark-to-
market accounting certain securities that
are held for investment) does not apply
to a security if—
(i) The security is described in sec-
tion 475(c)(2)(D) or (E) (describing cer-
tain notional principal contracts and de-
rivative securities); and
(ii) The taxpayer is a dealer in such
securities.
(2) See § 1.475(d)–1(b) for a rule
concerning the character of gain or loss
on securities described in this paragraph
(c).
(d)Special rule for hedges of another
member’s risk.A taxpayer may identify
under section 475(b)(1)(C) (exempting
certain hedges from mark-to-market ac-
counting) a security that hedges a posi-
tion of another member of the taxpay-
er’s consolidated group if the security
meets the following requirements—
(1) The security is a hedging transac-
tion within the meaning of § 1.1221–
2(b);
(2) The security is timely identified
as a hedging transaction under
§ 1.1221–2(e) (including identification
of the hedged item); and
(3) The security hedges a position
that is not marked to market under
section 475(a).
(e)Transitional rules—(1)Stock,
partnership, and beneficial ownership
interests in certain controlled corpora-
tions, partnerships, and trusts before
January 23, 1997— (i)In general. The
following items held by a dealer in
securities are per se held for investment
within the meaning of section
475(b)(1)(A) and are deemed to be
properly identified as such for purposes
of section 475(b)(2)—
(A) Stock in a corporation that the
taxpayer controls (within the meaning of
paragraph (e)(1)(ii) of this section); or
(B) A partnership or beneficial own-
ership interest in a widely held or
publicly traded partnership or trust that
the taxpayer controls (within the mean-
ing of paragraph (e)(1)(ii) of this sec-
tion).
(ii)Control defined. Control means
the ownership, directly or indirectly
through persons described in section
267(b) (taking into account section
267(c)), of—
(A) 50 percent or more of the total
combined voting power of all classes of
stock entitled to vote; or
(B) 50 percent or more of the capital
interest, the profits interest, or the ben-
eficial ownership interest in the widely
held or publicly traded partnership or
trust.
(iii)Applicability. The rules of this
paragraph (e)(1) apply only before Janu-
ary 23, 1997.
(2)Dealers in notional principal con-
tracts and derivatives acquired before
January 23, 1997—(i)General rule.
Section 475(b)(1)(A) (exempting certain
securities from mark-to-market account-
ing) does not apply to a security if—
(A) The security is described in sec-
tion 475(c)(2)(D) or (E) (describing cer-
tain notional principal contracts and de-
rivative securities); and
(B) The taxpayer is a dealer in such
securities.
12

(ii)Exception for securities not ac-
quired in dealer capacity.This para-
graph (e)(2) does not apply if the tax-
payer establishes unambiguously that the
security was not acquired in the taxpay-
er’s capacity as a dealer in such securi-
ties.
(iii)Applicability. The rules of para-
graph (e)(2) apply only to securities
acquired before January 23, 1997.
§ 1.475(b)–2 Exemptions—identifica-
tion requirements.
(a)Identification of the basis for ex-
emption.An identification of a security
as exempt from mark to market does not
satisfy section 475(b)(2) if it fails to
state whether the security is described
in—
(1) Either of the first two subpara-
graphs of section 475(b)(1) (identifying
a security as held for investment or not
held for sale); or
(2) The third subparagraph thereof
(identifying a security as a hedge).
(b)Time for identifying a security
with a substituted basis.For purposes of
determining the timeliness of an identifi-
cation under section 475(b)(2), the date
that a dealer acquires a security is not
affected by whether the dealer’s basis in
the security is determined, in whole or
in part, either by reference to the basis
of the security in the hands of the
person from whom the security was
acquired or by reference to other prop-
erty held at any time by the dealer. See
§ 1.475(a)–3 for rules governing how
the dealer accounts for such a security if
this identification is not made.
(c)Integrated transactions under
§ 1.1275–6— (1)Definitions.The fol-
lowing terms are used in this paragraph
(c) with the meanings that are given to
them by § 1.1275–6: integrated transac-
tion, legging into, legging out, qualify-
ing debt instrument, § 1.1275–6 hedge,
and synthetic debt instrument.
(2)Synthetic debt held by a taxpayer
as a result of legging in.If a taxpayer is
treated as the holder of a synthetic debt
instrument as the result of legging into
an integrated transaction, then, for pur-
poses of the timeliness of an identifica-
tion under section 475(b)(2), the syn-
thetic debt instrument is treated as
having the same acquisition date as the
qualifying debt instrument. A pre-leg-in
identification of the qualifying debt in-
strument under section 475(b)(2) applies
to the integrated transaction as well.
(3)Securities held after legging out.
If a taxpayer legs out of an integrated
transaction, then, for purposes of the
timeliness of an identification under sec-
tion 475(b)(2), the qualifying debt in-
strument, or the § 1.1275–6 hedge, that
remains in the taxpayer’s hands is gen-
erally treated as having been acquired,
originated, or entered into, as the case
may be, immediately after the leg-out. If
any loss or deduction determined under
§ 1.1275–6(d)(2)(ii)(B) is disallowed by
§ 1.1275–6(d)(2)(ii)(D) (which disal-
lows deductions when a taxpayer legs
out of an integrated transaction within
30 days of legging in), then, for pur-
poses of this section and section
475(b)(2), the qualifying debt instrument
that remains in the taxpayer’s hands is
treated as having been acquired on the
same date that the synthetic debt instru-
ment was treated as having been ac-
quired.
§ 1.475(b)–4 Exemptions—transitional
issues.
(a)Transitional identification—(1)
Certain securities previously identified
under section 1236.If, as of the close of
the last taxable year ending before De-
cember 31, 1993, a security was identi-
fied under section 1236 as a security
held for investment, the security is
treated as being identified as held for
investment for purposes of section
475(b).
(2)Consistency requirement for other
securities.In the case of a security
(including a security described in sec-
tion 475(c)(2)(F)) that is not described
in paragraph (a)(1) of this section and
that was held by the taxpayer as of the
close of the last taxable year ending
before December 31, 1993, the security
is treated as having been properly iden-
tified under section 475(b)(2) or
475(c)(2)(F)(iii) if the information con-
tained in the dealer’s books and records
as of the close of that year supports the
identification. If there is any ambiguity
in those records, the taxpayer must, no
later than January 31, 1994, place in its
records a statement resolving this ambi-
guity and indicating unambiguously
which securities are to be treated as
properly identified. Any information that
supports treating a security as having
been properly identified under section
475(b)(2) or (c)(2)(F)(iii) must be ap-
plied consistently from one security to
another.
(b)Corrections on or before January
31, 1994—(1)Purpose.This paragraph
(b) allows a taxpayer to add or remove
certain identifications covered by
§ 1.475(b)–1.
(2)To conform to § 1.475(b)–1(a)—
(i)Added identifications.To the extent
permitted by paragraph (b)(2)(ii) of this
section, a taxpayer may identify as be-
ing described in section 475(b)(1)(A) or
(B)—
(A) A security that was held for
immediate sale but was not held prima-
rily for sale to customers in the ordinary
course of the taxpayer’s trade or busi-
ness (for example, a trading security); or
(B) An evidence of indebtedness that
was not held for sale to customers in the
ordinary course of the taxpayer’s trade
or business and that the taxpayer in-
tended to hold for less than one year.
(ii)Limitations.An identification de-
scribed in paragraph (b)(2)(i) of this
section is permitted only if—
(A) Prior to December 28, 1993, the
taxpayer did not identify as being de-
scribed in section 475(b)(1)(A) or (B)
any of the securities described in para-
graph (b)(2)(i) of this section;
(B) The taxpayer identifies every se-
curity described in paragraph (b)(2)(i) of
this section for which a timely identifi-
cation of the security under section
475(b)(2) cannot be made after the date
on which the taxpayer makes these
added identifications; and
(C) The identification is made on or
before January 31, 1994.
(3)To conform to § 1.475(b)–1(c).
On or before January 31, 1994, a tax-
payer described in § 1.475(b)–
1(e)(2)(i)(B) may remove an identifica-
tion under section 475(b)(1)(A) of a
security described in § 1.475(b)–
1(e)(2)(i)(A).
(c)Effect of corrections.An identifi-
cation added under paragraph (a)(2) or
(b)(2) of this section is timely for
purposes of section 475(b)(2) or
(c)(2)(F)(iii). An identification removed
under paragraph (a)(2) or (b)(3) of this
section does not subject the taxpayer to
the provisions of section 475(d)(2).
§ 1.475(c)–1 Definitions—dealer in se-
curities.
(a)Dealer-customer relationship.
Whether a taxpayer is transacting busi-
ness with customers is determined on
the basis of all of the facts and circum-
stances.
(1) [Reserved].
(2)Transactions described in section
475(c)(1)(B)—(i)In general.For pur-
poses of section 475(c)(1)(B), the term
13

dealer in securitiesincludes, but is not
limited to, a taxpayer that, in the ordi-
nary course of the taxpayer’s trade or
business, regularly holds itself out as
being willing and able to enter into
either side of a transaction enumerated
in section 475(c)(1)(B).
(ii)Examples.The following ex-
amples illustrate the rules of this para-
graph (a)(2). In the following examples,
Bis a bank and is not a member of a
consolidated group:
Example 1. Bregularly offers to enter into
interest rate swaps with other persons in the
ordinary course of its trade or business. B is
willing to enter into interest rate swaps under
which it either pays a fixed interest rate and
receives a floating rate or pays a floating rate and
receives a fixed rate. B is a dealer in securities
under section 475(c)(1)(B), and the counterparties
are its customers.
Example 2. B, in the ordinary course of its
trade or business, regularly holds itself out as
being willing and able to enter into either side of
positions in a foreign currency with other banks in
the interbank market. B’s activities in the foreign
currency make it a dealer in securities under
section 475(c)(1)(B), and the other banks in the
interbank market are its customers.
Example 3. Bengages in frequent transactions
in a foreign currency in the interbank market.
Unlike the facts inExample 2, however,Bdoes
not regularly hold itself out as being willing and
able to enter into either side of positions in the
foreign currency, and all ofB’s transactions are
driven by its internal need to adjust its position in
the currency. No other circumstances are present
to suggest thatBis a dealer in securities for
purposes of section 475(c)(1)(B).B’s activity in
the foreign currency does not qualify it as a dealer
in securities for purposes of section 475(c)(1)(B),
and its transactions in the interbank market are not
transactions with customers.
(3)Related parties—(i)General rule.
Except as provided in paragraph
(a)(3)(ii) of this section (concerning
transactions between members of a con-
solidated group, as defined in § 1.1502–
1(h)), a taxpayer’s transactions with re-
lated persons may be transactions with
customers for purposes of section 475.
For example, if a taxpayer, in the ordi-
nary course of the taxpayer’s trade or
business, regularly holds itself out to its
foreign subsidiaries or other related per-
sons as being willing and able to enter
into either side of transactions enumer-
ated in section 475(c)(1)(B), the tax-
payer is a dealer in securities within the
meaning of section 475(c)(1), even if it
engages in no other transactions with
customers.
(ii)Special rule for members of a
consolidated group.Solely for purposes
of paragraph (c)(1) of section 475 (con-
cerning the definition of dealer in secu-
rities) and except as provided in para-
graph (a)(3)(iii) of this section, a
taxpayer’s transactions with other mem-
bers of its consolidated group are not
with customers. Accordingly, notwith-
standing paragraph (a)(2) of this section,
the fact that a taxpayer regularly holds
itself out to other members of its con-
solidated group as being willing and
able to enter into either side of a
transaction enumerated in section
475(c)(1)(B) does not cause the taxpayer
to be a dealer in securities within the
meaning of section 475(c)(1)(B).
(iii)The intragroup-customer elec-
tion—(A)Effect of election.If a consoli-
dated group makes the intragroup-
customer election, paragraph (a)(3)(ii) of
this section (special rule for members of
a consolidated group) does not apply to
the members of the group. Thus, a
member of a group that has made this
election may be a dealer in securities
within the meaning of section 475(c)(1)
even if its only customer transactions
are with other members of its consoli-
dated group.
(B)Making and revoking the elec-
tion.Unless the Commissioner otherwise
prescribes, the intragroup-customer elec-
tion is made by filing a statement that
says, ‘‘[Insert name and employer iden-
tification number of common parent]
hereby makes the Intragroup-Customer
Election (as described in § 1.475(c)–
1(a)(3)(iii) of the income tax regula-
tions) for the taxable year ending [de-
scribe the last day of the year] and for
subsequent taxable years.’’ The state-
ment must be signed by the common
parent and attached to the timely filed
federal income tax return for the con-
solidated group for that taxable year.
The election applies for that year and
continues in effect for subsequent years
until revoked. The election may be
revoked only with the consent of the
Commissioner.
(iv)Examples.The following ex-
amples illustrate this paragraph (a)(3):
General Facts. HC, a hedging center, provides
interest rate hedges to all of the members of its
affiliated group (as defined in section 1504(a)(1)).
Because of the efficiencies created by having a
centralized risk manager, group policy prohibits
members other thanHCfrom entering into deriva-
tive interest rate positions with outside parties.HC
regularly holds itself out as being willing and able
to, and in fact does, enter into either side of
interest rate swaps with its fellow members.HC
periodically computes its aggregate position and
hedges the net risk with an unrelated party.HC
does not otherwise enter into interest rate positions
with persons that are not members of the affiliated
group.HCattempts to operate at cost, and the
terms of its swaps do not factor in any risk of
default by the affiliate. Thus,HC’s affiliates
receive somewhat more favorable terms then they
would receive from an unrelated swaps dealer (a
fact that may subjectHCand its fellow members
to reallocation of income under section 482). No
other circumstances are present to suggest thatHC
is a dealer in securities for purposes of section
475(c)(1)(B).
Example 1. General rule for related persons.In
addition to theGeneral Factsstated above, as-
sume thatHC’s affiliated group has not elected
under section 1501 to file a consolidated return.
Under paragraph (a)(3)(i) of this section,HC’s
transactions with its affiliates can be transactions
with customers for purposes of section 475(c)(1).
Thus, under paragraph (a)(2)(i) of this section,HC
is a dealer in securities within the meaning of
section 475(c)(1)(B), and the members of the
group with which it does business are its custom-
ers.
Example 2. Special rule for members of a
consolidated group.In addition to theGeneral
Factsstated above, assume thatHC’s affiliated
group has elected to file consolidated returns and
has not made the intragroup-customer election.
Under paragraph (a)(3)(ii) of this section,HC’s
interest rate swap transactions with the members
of its consolidated group are not transactions with
customers for purposes of determining whether
HCis a dealer in securities within the meaning of
section 475(c)(1). Further, the fact thatHCregu-
larly holds itself out to members of its consoli-
dated group as being willing and able to enter into
either side of a transaction enumerated in section
475(c)(1)(B) does not causeHCto be a dealer in
securities within the meaning of section
475(c)(1)(B). Because no other circumstances are
present to suggest thatHCis a dealer in securities
for purposes of section 475(c)(1)(B),HCis not a
dealer in securities.
Example 3. Intragroup-customer election.In
addition to theGeneral Factsstated above, as-
sume thatHC’s affiliated group has elected to file
a consolidated return but has also made the
intragroup-customer election under paragraph
(a)(3)(iii) of this section. Thus, the analysis and
result are the same as inExample 1.
(b)Sellers of nonfinancial goods and
services— (1)Purchases and sales of
customer paper.Except as provided in
paragraph (b)(3) of this section, if a
taxpayer would not be a dealer in
securities within the meaning of section
475(c)(1) but for its purchases and sales
of debt instruments that, at the time of
purchase or sale, are customer paper
with respect to either the taxpayer or a
corporation that is a member of the
same consolidated group (as defined in
§ 1.1502–1(h)) as the taxpayer, then for
purposes of section 475 the taxpayer is
not a dealer in securities.
(2)Definition of customer paper.A
debt instrument is customer paper with
respect to a person at a point in time
if—
(i) The person’s principal activity is
selling nonfinancial goods or providing
nonfinancial services;
(ii) The debt instrument was issued
by a purchaser of the goods or services
at the time of the purchase of those
goods or services in order to finance the
purchase; and
14

(iii) At all times since the debt instru-
ment was issued, it has been held either
by the person selling those goods or
services or by a corporation that is a
member of the same consolidated group
as that person.
(3)Exceptions.Paragraph (b)(1) of
this section does not apply if—
(i) For purposes of section 471, the
taxpayer accounts for any security (as
defined in section 475(c)(2)) as inven-
tory;
(ii) The taxpayer is subject to an
election under paragraph (b)(4) of this
section; or
(iii) The taxpayer is not described in
paragraph (b)(2)(i) of this section and
one or more debt instruments that are
customer paper with respect to a corpo-
ration that is a member of the same
consolidated group as the taxpayer are
accounted for by the taxpayer, or by a
corporation that is a member of the
same consolidated group as the tax-
payer, in a manner that allows recogni-
tion of unrealized gains or losses or
deductions for additions to a reserve for
bad debts.
(4)Election not to be governed by
the exception for sellers of nonfinancial
goods or services—(i)Method of mak-
ing the election.Unless the Commis-
sioner otherwise prescribes, an election
under this paragraph (b)(4) must be
made in the manner, and at the time,
prescribed in this paragraph (b)(4)(i).
The taxpayer must file with the Internal
Revenue Service a statement that says,
‘‘[Insert name and taxpayer identifica-
tion number of the taxpayer] hereby
elects not to be governed by
§ 1.475(c)–1(b)(1) of the income tax
regulations for the taxable year ending
[describe the last day of the year] and
for subsequent taxable years.’’
(A)Taxable years ending after De-
cember 24, 1996.If the first taxable
year subject to an election under this
paragraph (b)(4) ends after December
24, 1996, the statement must be attached
to a timely filed federal income tax
return for that taxable year.
(B)Taxable years ending on or be-
fore December 24, 1996.If the first
taxable year subject to an election under
this paragraph (b)(4) ends on or before
December 24, 1996, and the election
changes the taxpayer’s taxable income
for any taxable year the federal income
tax return for which was filed before
February 24, 1997, the statement must
be attached to an amended return for the
earliest such year that is so affected, and
that amended return (and an amended
return for any other such year that is so
affected) must be filed not later than
June 23, 1997. If the first taxable year
subject to an election under this para-
graph (b)(4) ends on or before Decem-
ber 24, 1996, but the taxpayer is not
described in the preceding sentence, the
statement must be attached to the first
federal income tax return that is for a
taxable year subject to the election and
that is filed on or after February 24,
1997.
(ii)Continued applicability of an
election.An election under this para-
graph (b)(4) continues in effect for
subsequent taxable years until revoked.
The election may be revoked only with
the consent of the Commissioner.
(c)Taxpayers that purchase securities
from customers but engage in no more
than negligible sales of the securities—
(1)Exemption from dealer status—(i)
General rule.A taxpayer that regularly
purchases securities from customers in
the ordinary course of a trade or busi-
ness (including regularly making loans
to customers in the ordinary course of a
trade or business of making loans) but
engages in no more than negligible sales
of the securities so acquired is not a
dealer in securities within the meaning
of section 475(c)(1) unless the taxpayer
elects to be so treated or, for purposes
of section 471, the taxpayer accounts for
any security (as defined in section
475(c)(2)) as inventory.
(ii)Election to be treated as a dealer.
A taxpayer described in paragraph
(c)(1)(i) of this section elects to be
treated as a dealer in securities by filing
a federal income tax return reflecting
the application of section 475(a) in
computing its taxable income.
(2)Negligible sales.Solely for pur-
poses of paragraph (c)(1) of this section,
a taxpayer engages in negligible sales of
debt instruments that it regularly pur-
chases from customers in the ordinary
course of its business if, and only if,
during the taxable year, either—
(i) The taxpayer sells all or part of
fewer than 60 debt instruments, regard-
less how acquired; or
(ii) The total adjusted basis of the
debt instruments (or parts of debt instru-
ments), regardless how acquired, that
the taxpayer sells is less than 5 percent
of the total basis, immediately after
acquisition, of the debt instruments that
it acquires in that year.
(3)Special rules for members of a
consolidated group— (i)Intragroup-
customer election in effect.If a taxpayer
is a member of a consolidated group
that has made the intragroup-customer
election (described in paragraph
(a)(3)(iii) of this section), the negligible
sales test in paragraph (c)(2) of this
section takes into account all of the
taxpayer’s sales of debt instruments to
other group members.
(ii)Intragroup-customer election not
in effect.If a taxpayer is a member of a
consolidated group that has not made
the intragroup-customer election (de-
scribed in paragraph (a)(3)(iii) of this
section), the taxpayer satisfies the negli-
gible sales test in paragraph (c)(2) of
this section if either—
(A) The test is satisfied by the tax-
payer, taking into account sales of debt
instruments to other group members (as
in paragraph (c)(3)(i) of this section); or
(B) The test is satisfied by the group,
treating the members of the group as if
they were divisions of a single corpora-
tion.
(4)Special rules.Whether sales of
securities are negligible is determined
without regard to—
(i) Sales of securities that are necessi-
tated by exceptional circumstances and
that are not undertaken as recurring
business activities;
(ii) Sales of debt instruments that
decline in quality while in the taxpay-
er’s hands and that are sold pursuant to
an established policy of the taxpayer to
dispose of debt instruments below a
certain quality; or
(iii) Acquisitions and sales of debt
instruments that are qualitatively differ-
ent from all debt instruments that the
taxpayer purchases from customers in
the ordinary course of its business.
(5)Example.The following example
illustrates paragraph (c)(4)(iii) of this
section:
Example.I, an insurance company, regularly
makes policy loans to its customers but does not
sell them.I, however, actively trades Treasury
securities. No other circumstances are present to
suggest thatIis a dealer in securities for purposes
of section 475(c)(1). Since the Treasuries are
qualitatively different from the policy loans thatI
originates, under paragraph (c)(4)(iii) of this sec-
tion,Idisregards the purchases and sales of
Treasuries in applying the negligible sales test in
paragraph (c)(2) of this section.
(d)Issuance of life insurance prod-
ucts.A life insurance company that is
not otherwise a dealer in securities
within the meaning of section 475(c)(1)
does not become a dealer in securities
solely because it regularly issues life
insurance products to its customers in
the ordinary course of a trade or busi-
ness. For purposes of the preceding
sentence, the termlife insurance product
15

means a contract that is treated for
federal income tax purposes as an annu-
ity, endowment, or life insurance con-
tract. See sections 72, 817, and 7702.
§ 1.475(c)–2 Definitions—security.
(a)Items that are not securities.The
following items are not securities within
the meaning of section 475(c)(2) with
respect to a taxpayer and, therefore, are
not subject to section 475—
(1) A security (determined without
regard to this paragraph (a)) if section
1032 prevents the taxpayer from recog-
nizing gain or loss with respect to that
security;
(2) A debt instrument issued by the
taxpayer (including a synthetic debt in-
strument, within the meaning of
§ 1.1275–6(b)(4), that § 1.1275–6(b)
treats the taxpayer as having issued); or
(3) A REMIC residual interest, or an
interest or arrangement that is deter-
mined by the Commissioner to have
substantially the same economic effect,
if the residual interest or the interest or
arrangement is acquired on or after
January 4, 1995.
(b)Synthetic debt that § 1.1275–6(b)
treats the taxpayer as holding.If
§ 1.1275–6 treats a taxpayer as the
holder of a synthetic debt instrument
(within the meaning of § 1.1275–
6(b)(4)), the synthetic debt instrument is
a security held by the taxpayer within
the meaning of section 475(c)(2)(C).
(c)Negative value REMIC residuals
acquired before January 4, 1995.A
REMIC residual interest that is de-
scribed in paragraph (c)(1) of this sec-
tion or an interest or arrangement that is
determined by the Commissioner to
have substantially the same economic
effect is not a security within the mean-
ing of section 475(c)(2).
(1)Description.A residual interest in
a REMIC is described in this paragraph
(c)(1) if, on the date the taxpayer ac-
quires the residual interest, the present
value of the anticipated tax liabilities
associated with holding the interest ex-
ceeds the sum of—
(i) The present value of the expected
future distributions on the interest; and
(ii) The present value of the antici-
pated tax savings associated with hold-
ing the interest as the REMIC generates
losses.
(2)Special rules applicable to nega-
tive value REMIC residuals acquired
before January 4, 1995.Solely for pur-
poses of this paragraph (c)—
(i) If a transferee taxpayer acquires a
residual interest with a basis determined
by reference to the transferor’s basis,
then the transferee is deemed to acquire
the interest on the date the transferor
acquired it (or is deemed to acquire it
under this paragraph (c)(2)(i)).
(ii) Anticipated tax liabilities, ex-
pected future distributions, and antici-
pated tax savings are determined under
the rules in § 1.860E–2(a)(3) and with-
out regard to the operation of section
475.
(iii) Present values are determined
under the rules in § 1.860E–2(a)(4).
§ 1.475(d)–1 Character of gain or loss.
(a)Securities never held in connec-
tion with the taxpayer’s activities as a
dealer in securities.If a security is
never held in connection with the tax-
payer’s activities as a dealer in securi-
ties, section 475(d)(3)(A) does not affect
the character of gain or loss from the
security, even if the taxpayer fails to
identify the security under section
475(b)(2).
(b)Ordinary treatment for notional
principal contracts and derivatives held
by dealers in notional principal con-
tracts and derivatives.Section
475(d)(3)(B)(ii) (concerning the charac-
ter of gain or loss with respect to a
security held by a person other than in
connection with its activities as a dealer
in securities) does not apply to a secu-
rity if § 1.475(b)–1(c) and the absence
of a determination by the Commissioner
prevent section 475(b)(1)(A) from ap-
plying to the security.
§ 1.475(e)–1 Effective dates.
(a) and (b) [Reserved].
(c) Section 1.475(a)–3 (concerning
acquisition by a dealer of a security
with a substituted basis) applies to secu-
rities acquired, originated, or entered
into on or after January 4, 1995.
(d) Except as provided elsewhere in
this paragraph (d), § 1.475(b)‘‘1 (con-
cerning the scope of exemptions from
the mark-to-market requirement) applies
to taxable years ending on or after
December 31, 1993.
(1) Section 1.475(b)’’1(b) applies as
follows:
(i) Section 1.475(b)‘‘1(b)(1)(i) (con-
cerning equity interests issued by a
related person) applies beginning June
19, 1996. If, on June 18, 1996, a
security is subject to mark-to-market
accounting and, on June 19, 1996,
§ 1.475(b)–1(b)(1) begins to apply to
the security solely because of the effec-
tive dates in this paragraph (d) (rather
than because of a change in facts), then
the rules of § 1.475(b)–1(b)(4)(i)(A)
(concerning the prohibition against
marking) apply, but § 1.475(b)–
1(b)(4)(i)(B) (imposing a mark to mar-
ket on the day before the onset of the
prohibition) does not apply.
(ii) Section 1.475(b)–1(b)(2) (con-
cerning relevant relationships for pur-
poses of determining whether equity
interests in related persons are prohib-
ited from being marked to market) ap-
plies beginning June 19, 1996.
(iii) Section 1.475(b)’’1(b)(3) (con-
cerning certain actively traded securi-
ties) applies beginning June 19, 1996, to
securities held on or after that date,
except for securities described in
§ 1.475(b)‘‘1(e)(1)(i) (concerning equity
interests issued by controlled entities). If
a security is described in
§ 1.475(b)’’1(e)(1)(i), § 1.475(b)-
‘‘1(b)(3) applies only on or after Janu-
ary 23, 1997, if the security is held on
or after that date. If § 1.475(b)’’1(b)(1)
ceases to apply to a security by virtue of
the operation of this paragraph
(d)(1)(iii), the rules of § 1.475(b)‘‘1(b)-
(4)(ii) apply to the cessation.
(iv) Except to the extent provided in
paragraph (d)(1) of this section,
§ 1.475(b)’’1(b)(4) (concerning changes
in status) applies beginning June 19,
1996.
(2) Section 1.475(b)‘‘1(c) (concerning
securities deemed not held for invest-
ment by dealers in notional principal
contracts and derivatives) applies to se-
curities acquired on or after January 23,
1997.
(3) Section 1.475(b)–1(d) (concerning
the special rule for hedges of another
member’s risk) is effective for securities
acquired, originated, or entered into on
or after January 23, 1997.
(e) Section 1.475(b)–2 (concerning
identification of securities that are ex-
empt from mark to market treatment)
applies as follows:
(1) Section 1.475(b)–2(a) (concerning
the general rules for identification of
basis for exemption from mark to mar-
ket treatment) applies to identifications
made on or after July 1, 1997.
(2) Section 1.475(b)–2(b) (concerning
time for identifying a security with a
substituted basis) applies to securities
acquired, originated, or entered into on
or after January 4, 1995.
(3) Section 1.475(b)–2(c) (concerning
identification in the context of integrated
transactions under § 1.1275–6) applies
16

on and after August 13, 1996 (the
effective date of § 1.1275–6).
(f) [Reserved].
(g) Section 1.475(b)–4 (concerning
transitional issues relating to exemp-
tions) applies to taxable years ending on
or after December 31, 1993.
(h) Section 1.475(c)–1 applies as fol-
lows:
(1) Except as otherwise provided in
this paragraph (h)(1), § 1.475(c)–1(a)
(concerning the dealer-customer rela-
tionship) applies to taxable years begin-
ning on or after January 1, 1995.
(i) [Reserved].
(ii) Section 1.475(c)–1(a)(2)(ii) (illus-
trating rules concerning the dealer-
customer relationship) applies to taxable
years beginning on or after June 20,
1996.
(iii) (A) Section 1.475(c)–1(a)(3) ap-
plies to taxable years beginning on or
after June 20, 1996, except for transac-
tions between members of the same
consolidated group.
(B) For transactions between mem-
bers of the same consolidated group,
paragraph § 1.475(c)–1(a)(3) applies to
taxable years beginning on or after
December 24, 1996.
(2) Section 1.475(c)–1(b) (concerning
sellers of nonfinancial goods and ser-
vices) applies to taxable years ending on
or after December 31, 1993.
(3) Except as otherwise provided in
this paragraph (h)(3), § 1.475(c)–1(c)
(concerning taxpayers that purchase se-
curities but engage in no more than
negligible sales of the securities) applies
to taxable years ending on or after
December 31, 1993.
(i) Section 1.475(c)–1(c)(3) (special
rules for members of a consolidated
group) is effective for taxable years
beginning on or after December 24,
1996.
(ii) A taxpayer may rely on the rules
set out in § 1.475(c)–1T(b) (as con-
tained in 26 CFR part 1 revised April 1,
1996) for taxable years beginning before
January 23, 1997, provided the taxpayer
applies that paragraph reasonably and
consistently.
(4) Section 1.475(c)–1(d) (concerning
the issuance of life insurance products)
applies to taxable years beginning on or
after January 1, 1995.
(i) Section 1.475(c)–2 (concerning the
definition of security) applies to taxable
years ending on or after December 31,
1993. By its terms, however,
§ 1.475(c)–2(a)(3) applies only to re-
sidual interests or to interests or ar-
rangements that are acquired on or after
January 4, 1995; and the integrated
transactions that are referred to in
§§ 1.475(c)–2(a)(2) and 1.475(c)–2(b)
exist only after August 13, 1996 (the
effective date of § 1.1275–6).
(j) Section 1.475(d)–1 (concerning
the character of gain or loss) applies to
taxable years ending on or after Decem-
ber 31, 1993.
PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 4. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 5. In § 602.101 paragraph (c) is
amended by:
1. Removing the following entry
from the table:
§ 602.101 OMB Control numbers.
* * * * *
(c) * * *
CFR part or section whereCurrent OMB
identified and describedcontrol No.
* * * * *
1.475(b)–2T . . . . . . . . . . . . . . . 1545–1422
* * * * *
2. Adding an entry in numerical order
to the table to read as follows:
§ 602.101 OMB Control numbers.
* * * * *
(c) * * *
CFR part or section whereCurrent OMB
identified and describedcontrol No.
* * * * *
1.475(b)–4. . . . . . . . . . . . . . . . . 1545–1496
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved December 6, 1996.
Donald C. Lubick,
Acting Assistant Secretary of the
Treasury.
(Filed by the Office of the Federal Register on
December 23, 1996, 8:45 a.m., and published in
the issue of the Federal Register for December 24,
1996, 61 F.R. 67715)
Section 731.—Extent of
Recognition of Gain or Loss on
Distribution
26 CFR 1.731–2: Partnership distribution of mar-
ketable securities.
T.D. 8707
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
Distribution of Marketable
Securities by a Partnership
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains
final regulations providing rules for
partnership distributions of marketable
securities under section 731(c) of the
Internal Revenue Code of 1986, as
amended, and for determining when
those distributions are taxable to the
distributee partner. The regulations re-
flect changes to the law made by the
Uruguay Round Agreements Act enacted
on December 8, 1994.
DATES: These regulations are effective
on December 26, 1996.
FOR FURTHER INFORMATION CON-
TACT: Terri A. Belanger or William M.
Kostak at (202) 622–3080 (not a toll-
free number).
SUPPLEMENTARY INFORMATION:
Background
This document amends 26 CFR part 1
to provide rules relating to the treatment
of partnership distributions of market-
able securities under section 731(c). Un-
der section 731(a), in the case of a
distribution by a partnership to a part-
ner, gain is recognized to the partner
only to the extent that any money
distributed exceeds the adjusted basis of
the partner’s interest in the partnership.
Prior to the enactment of section 731(c),
marketable securities were not consid-
ered money and, therefore, the distribu-
tion of marketable securities by a part-
nership to a partner was not a taxable
event. Section 731(c) now treats a part-
nership distribution of marketable secu-
rities as a distribution of money and as
a taxable event if the value of the
distributed securities exceeds the ad-
justed basis of the partner’s interest in
the partnership. Section 731(c) also pro-
vides several exceptions to the general
17

rule that a distribution of marketable
securities will be treated as a distribu-
tion of money.
On January 2, 1996, the IRS pub-
lished in theFederal Register(61 FR
28) a notice of proposed rulemaking
(PS–2–95) to provide guidance regard-
ing section 731(c). A number of public
comments were received concerning the
proposed regulations. However, the pub-
lic hearing scheduled for April 3, 1996,
was cancelled because no one requested
to speak. After consideration of the
written comments received, the proposed
regulations are adopted as revised by
this Treasury decision.
Explanation of Provisions
I. General background
The proposed regulations provide
rules for determining when and the
extent to which a distribution of market-
able securities by a partnership to a
partner will be treated as a distribution
of money for purposes of section 731(a).
Although modified in response to com-
ments, the final regulations generally
adopt the rules contained in the pro-
posed regulations.
II. Public comments
Several comments requested that the
IRS reconsider the requirement in
§ 1.731–2(d)(2)(ii) of the proposed
regulations that a marketable security
must be actively traded on the date of
distribution to qualify for the ‘‘nonrec-
ognition transaction’’ exception to sec-
tion 731(c). Because of this rule, finan-
cial instruments (securities) that are
treated as marketable securities under
section 731(c)(2)(B) on the date of
distribution, but that are not actively
traded, would not qualify for this excep-
tion. Commentators suggested that the
final regulations should not include this
requirement or should include a more
narrowly drafted provision. In response
to these comments, the final regulations
provide that a security that falls within
the definition of marketable security
may qualify for the exceptions under
§ 1.731–2(d) of the final regulations
even if the security is not actively
traded on the date of distribution. An
anti-stuffing rule has been added to
address the concern to which the
actively-traded requirement of the pro-
posed regulations was directed.
Several comments also suggested that
§ 1.731–2(d)(2) of the proposed regula-
tions should allow a de minimis amount
of cash and marketable securities to be
transferred in a nonrecognition transac-
tion. The final regulations provide that if
the value of money and marketable
securities transferred in a nonrecognition
transaction is less than 20 percent of the
total amount of all property transferred
in exchange for the distributed security,
the entire value of the distributed secu-
rity will qualify for the nonrecognition
transaction exception under § 1.731–
2(d)(1)(ii) of the final regulations.
Several commentators also suggested
that the five-year rules of § 1.731–
2(d)(2) and (3) of the proposed regula-
tions be eliminated. Section 1.731–
2(d)(2) of the proposed regulations
provided that a marketable security that
was acquired in a nonrecognition trans-
action in exchange for other property
and distributed within five years by the
partnership would not be subject to
section 731(c). Section 1.731–2(d)(3) of
the proposed regulations provided that a
marketable security that was acquired by
the partnership before it became actively
traded would also not be subject to
section 731(c) if it was distributed by
the partnership within five years of
becoming actively traded. One commen-
tator, for example, argued that a security
is no less a substitute for the underlying
assets in a nonrecognition transaction
after five years than before five years.
These five- year rules were included in
the proposed regulations because of ad-
ministrative concerns. For example, it
may be difficult, after the passage of
many years, for taxpayers or the IRS to
determine the circumstances in which a
partnership acquired a particular secu-
rity. Moreover, it is not clear whether
certain exceptions should apply to a
distribution of securities if those securi-
ties were acquired by a partnership
many years ago and are now distributed
to a partner who was not a partner at
the time the securities were acquired.
These administrative concerns remain
valid, and a five year time limitation
provides a reasonable and simple solu-
tion to such problems. Therefore, the
final regulations retain both five-year
rules.
One comment requested clarification
regarding whether a section 708(b)(1)-
(B) termination affects a partnership’s
qualification for the exceptions under
§ 1.731–2(d) and (e) of the regulations.
Another commentator suggested that the
regulations be modified to provide that
marketable securities will not be treated
as money when there is a deemed
distribution of marketable securities by
the terminating partnership as the result
of a section 708(b)(1)(B) termination. In
response to these comments, the final
regulations provide that a section
708(b)(1)(B) termination does not have
any effect on a partnership’s qualifica-
tion for the exceptions under section
731(c). In addition, a deemed distribu-
tion occurring as a result of a section
708(b)(1)(B) termination will not be
subject to section 731(c).
Several comments suggested that the
10-percent test in the investment part-
nership look-through rule under
§ 1.731–2(e)(4) of the proposed regula-
tions should be modified or eliminated.
A partnership can qualify for the invest-
ment partnership exception only if it has
never been engaged in a trade or busi-
ness and substantially all of its assets
are investment assets. Under the pro-
posed regulations, a partnership is
treated as engaged in a trade or business
engaged in by, or as holding a propor-
tionate share of the assets of, a lower-
tier partnership in which the partnership
holds a partnership interest unless the
upper-tier partnership does not partici-
pate in the management of the lower-
tier partnership and the interest held by
the upper-tier partnership is less than 10
percent of the total profits and capital
interests in the lower-tier partnership.
According to the comments, the require-
ment that the upper-tier partnership not
participate in the management of the
lower-tier partnership should be suffi-
cient to ensure passive ownership of the
interest in the lower-tier partnership.
The commentators further argued that
ownership of more than 10 percent of
the capital and profits interest in a
lower-tier partnership may still be con-
sistent with passive ownership. After
consideration of these comments, the
final regulations modify the rule in the
proposed regulations to increase the
threshold ownership percentage amount
from 10 to 20 percent.
In response to a comment, the final
regulations clarify that an interest in a
lower-tier partnership that qualifies for
the exception to the investment partner-
ship ‘‘look-through’’ rule is treated as
eligible property for purposes of deter-
mining whether the partner who contrib-
uted the lower-tier partnership interest is
an eligible partner of the upper-tier
investment partnership.
One commentator recommended that
the regulations include an example that
illustrates the section 732(a)(2) ordering
rules for distributions that include
money, marketable securities and other
property, and to clarify whether market-
18

able securities are treated as money for
purposes of section 732(a)(2). Because
the statute and the regulations provide
that marketable securities are treated as
money only for purposes of sections
731(a)(1) and 737, no additional ex-
amples are necessary.
One comment suggested that the ef-
fective date of the regulations should be
the same as the effective date of section
731(c) because the regulations contain
guidance for the various exceptions pro-
vided for by the Internal Revenue Code.
In response to this comment, the final
regulations provide that, for the period
between the effective date of the statu-
tory provision and the effective date of
these regulations, taxpayers may apply
the rules contained in these regulations.
Another comment suggested that the
final regulations should make clear that
the rules in the investment partnership
exception apply with respect to all prop-
erty contributed to, or held by, a partner-
ship at any time (including any period
prior to the enactment of section
731(c)). The IRS and Treasury believe
that this is sufficiently clear from the
statutory language, and an explicit state-
ment to this effect in these regulations is
not necessary and may be confusing.
One comment requested that the regu-
lations provide several examples illus-
trating abusive transactions intended to
be covered by the anti-abuse rules of
§ 1.731–2(h), and that these rules be
coordinated with the general anti-abuse
rules of § 1.701–2. After consideration
of this comment, it has been determined
that the text of the regulations ad-
equately describes several situations that
would be considered abusive under
these rules, and that additional examples
are unnecessary.
In response to several comments, the
final regulations clarify that the 90 per-
cent test of § 1.731–2(c)(2)(i) and the
20 percent test of § 1.731–2(c)(2)(ii) are
determined using the gross value of the
entity’s assets, disregarding any debt
that may encumber or otherwise be
allocable to those assets, other than debt
that is incurred to acquire property with
a principal purpose of avoiding or re-
ducing the effect of section 731(c).
Finally, the regulations clarify the
interaction of the limitation on gain rule
in section 731(c)(3)(B) and the various
exceptions listed in paragraph (d). The
regulations provide that any gain or loss
on a distributed security that qualifies
for an exception is not taken into ac-
count in determining the distributee
partner’s limitation on gain.
III. Effective dates
In general, section 731(c) applies to
distributions made after December 8,
1994. These regulations are effective for
distributions made on or after December
26, 1996. However, taxpayers may ap-
ply the rules of this section to distribu-
tions made after December 8, 1994, and
before December 26, 1996.
Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in EO 12866.
Therefore, a regulatory assessment is not
required. It also has been determined
that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does
not apply to these regulations, and be-
cause the notice of proposed rulemaking
preceding the regulations was issued
prior to March 29, 1996, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does
not apply. Pursuant to section 7805(f) of
the Internal Revenue Code, the notice of
proposed rulemaking preceding these
regulations was submitted to the Small
Business Administration for comment on
its impact on small business.
Drafting Information
The principal authors of these regula-
tions are Terri A. Belanger and William
M. Kostak, Office of Assistant Chief
Counsel (Passthroughs and Special In-
dustries), IRS. However, other personnel
from the IRS and Treasury Department
participated in their development.
* * * * *
Adoption of Amendments to the Regula-
tions
Accordingly, 26 CFR part 1 is
amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding an entry in
numerical order to read as follows:
Authority: 26 U.S.C. 7805. * * *
Section 1.731–2 also issued under 26
U.S.C. 731(c). * * *
Par. 2. Section 1.731–2 is added to
read as follows:
§ 1.731–2 Partnership distributions of
marketable securities.
(a)Marketable securities treated as
money. Except as otherwise provided in
section 731(c) and this section, for pur-
poses of sections 731(a)(1) and 737, the
termmoneyincludes marketable securi-
ties and such securities are taken into
account at their fair market value as of
the date of the distribution.
(b)Reduction of amount treated as
money—(1)Aggregation of securities.
For purposes of section 731(c)(3)(B)
and this paragraph (b), all marketable
securities held by a partnership are
treated as marketable securities of the
same class and issuer as the distributed
security.
(2)Amount of reduction. The amount
of the distribution of marketable securi-
ties that is treated as a distribution of
money under section 731(c) and para-
graph (a) of this section is reduced (but
not below zero) by the excess, if any,
of—
(i) The distributee partner’s distribu-
tive share of the net gain, if any, which
would be recognized if all the market-
able securities held by the partnership
were sold (immediately before the trans-
action to which the distribution relates)
by the partnership for fair market value;
over
(ii) The distributee partner’s distribu-
tive share of the net gain, if any, which
is attributable to the marketable securi-
ties held by the partnership immediately
after the transaction, determined by us-
ing the same fair market value as used
under paragraph (b)(2)(i) of this section.
(3)Distributee partner’s share of net
gain. For purposes of section
731(c)(3)(B) and paragraph (b)(2) of
this section, a partner’s distributive
share of net gain is determined—
(i) By taking into account any basis
adjustments under section 743(b) with
respect to that partner;
(ii) Without taking into account any
special allocations adopted with a prin-
cipal purpose of avoiding the effect of
section 731(c) and this section; and
(iii) Without taking into account any
gain or loss attributable to a distributed
security to which paragraph (d)(1) of
this section applies.
(c)Marketable securities—(1)In
general. For purposes of section 731(c)
and this section, the termmarketable
securitiesis defined in section 731(c)(2).
(2)Actively traded. For purposes of
section 731(c) and this section, a finan-
cial instrument is actively traded (and
thus is a marketable security) if it is of
a type that is, as of the date of distribu-
tion, actively traded within the meaning
of section 1092(d)(1). Thus, for ex-
ample, ifXYZcommon stock is listed on
a national securities exchange, particular
shares ofXYZcommon stock that are
distributed by a partnership are market-
19

able securities even if those particular
shares cannot be resold by the
distributee partner for a designated pe-
riod of time.
(3)Interests in an entity—
(i)Substantially all. For purposes of
section 731(c)(2)(B)(v) and this section,
substantially all of the assets of an
entity consist (directly or indirectly) of
marketable securities, money, or both
only if 90 percent or more of the assets
of the entity (by value) at the time of
the distribution of an interest in the
entity consist (directly or indirectly) of
marketable securities, money, or both.
(ii)Less than substantially all. For
purposes of section 731(c)(2)(B)(vi) and
this section, an interest in an entity is a
marketable security to the extent that the
value of the interest is attributable (di-
rectly or indirectly) to marketable secu-
rities, money, or both, if less than 90
percent but 20 percent or more of the
assets of the entity (by value) at the
time of the distribution of an interest in
the entity consist (directly or indirectly)
of marketable securities, money, or both.
(4)Value of assets. For purposes of
section 731(c) and this section, the value
of the assets of an entity is determined
without regard to any debt that may
encumber or otherwise be allocable to
those assets, other than debt that is
incurred to acquire an asset with a
principal purpose of avoiding or reduc-
ing the effect of section 731(c) and this
section.
(d)Exceptions—(1)In general. Ex-
cept as otherwise provided in paragraph
(d)(2) of this section, section 731(c) and
this section do not apply to the distribu-
tion of a marketable security if—
(i) The security was contributed to
the partnership by the distributee part-
ner;
(ii) The security was acquired by the
partnership in a nonrecognition transac-
tion, and the following conditions are
satisfied—
(A) The value of any marketable se-
curities and money exchanged by the
partnership in the nonrecognition trans-
action is less than 20 percent of the
value of all the assets exchanged by the
partnership in the nonrecognition trans-
action; and
(B) The partnership distributed the
security within five years of either the
date the security was acquired by the
partnership or, if later, the date the
security became marketable; or
(iii) The security was not a market-
able security on the date acquired by the
partnership, and the following conditions
are satisfied—
(A) The entity that issued the security
had no outstanding marketable securities
at the time the security was acquired by
the partnership;
(B) The security was held by the
partnership for at least six months be-
fore the date the security became mar-
ketable; and
(C) The partnership distributed the
security within five years of the date the
security became marketable.
(2)Anti-stuffing rule. Paragraph
(d)(1) of this section does not apply to
the extent that 20 percent or more of the
value of the distributed security is attrib-
utable to marketable securities or money
contributed (directly or indirectly) by
the partnership to the entity to which the
distributed security relates after the se-
curity was acquired by the partnership
(other than marketable securities con-
tributed by the partnership that were
originally contributed to the partnership
by the distributee partner). For purposes
of this paragraph (d)(2), money contrib-
uted by the distributing partnership does
not include any money deemed contrib-
uted by the partnership as a result of
section 752.
(3)Successor security. Section 731(c)
and this section apply to the distribution
of a marketable security acquired by the
partnership in a nonrecognition transac-
tion in exchange for a security the
distribution of which immediately prior
to the exchange would have been ex-
cepted under this paragraph (d) only to
the extent that section 731(c) and this
section otherwise would have applied to
the exchanged security.
(e)Investment partnerships—(1)In
general. Section 731(c) and this section
do not apply to the distribution of
marketable securities by an investment
partnership (as defined in section
731(c)(3)(C)(i)) to an eligible partner (as
defined in section 731(c)(3)(C)(iii)).
(2)Eligible partner—(i)Contributed
services. For purposes of section
731(c)(3)(C)(iii) and this section, a part-
ner is not treated as a partner other than
an eligible partner solely because the
partner contributed services to the part-
nership.
(ii)Contributed partnership interests.
For purposes of determining whether a
partner is an eligible partner under sec-
tion 731(c)(3)(C), if the partner has
contributed to the investment partnership
an interest in another partnership that
meets the requirements of paragraph
(e)(4)(i) of this section after the contri-
bution, the contributed interest is treated
as property specified in section
731(c)(3)(C)(i).
(3)Trade or business activities. For
purposes of section 731(c)(3)(C) and
this section, a partnership is not treated
as engaged in a trade or business by
reason of—
(i) Any activity undertaken as an in-
vestor, trader, or dealer in any asset
described in section 731(c)(3)(C)(i), in-
cluding the receipt of commitment fees,
break-up fees, guarantee fees, director’s
fees, or similar fees that are customary
in and incidental to any activities of the
partnership as an investor, trader, or
dealer in such assets;
(ii) Reasonable and customary man-
agement services (including the receipt
of reasonable and customary fees in
exchange for such management services)
provided to an investment partnership
(within the meaning of section
731(c)(3)(C)(i)) in which the partnership
holds a partnership interest; or
(iii) Reasonable and customary ser-
vices provided by the partnership in
assisting the formation, capitalization,
expansion, or offering of interests in a
corporation (or other entity) in which
the partnership holds or acquires a sig-
nificant equity interest (including the
provision of advice or consulting ser-
vices, bridge loans, guarantees of obli-
gations, or service on a company’s
board of directors), provided that the
anticipated receipt of compensation for
the services, if any, does not represent a
significant purpose for the partnership’s
investment in the entity and is incidental
to the investment in the entity.
(4)Partnership tiers. For purposes of
section 731(c)(3)(C)(iv) and this section,
a partnership (upper-tier partnership) is
not treated as engaged in a trade or
business engaged in by, or as holding
(instead of a partnership interest) a
proportionate share of the assets of, a
partnership (lower-tier partnership) in
which the partnership holds a partner-
ship interest if—
(i) The upper-tier partnership does
not actively and substantially participate
in the management of the lower-tier
partnership; and
(ii) The interest held by the upper-tier
partnership is less than 20 percent of the
total profits and capital interests in the
lower-tier partnership.
(f)Basis rules—(1)Partner’s basis—
(i)Partner’s basis in distributed securi-
ties. The distributee partner’s basis in
20

distributed marketable securities with re-
spect to which gain is recognized by
reason of section 731(c) and this section
is the basis of the security determined
under section 732, increased by the
amount of such gain. Any increase in
the basis of the marketable securities
attributable to gain recognized by reason
of section 731(c) and this section is
allocated to marketable securities in pro-
portion to their respective amounts of
unrealized appreciation in the hands of
the partner before such increase.
(ii)Partner’s basis in partnership in-
terest. The basis of the distributee part-
ner’s interest in the partnership is deter-
mined under section 733 as if no gain
were recognized by the partner on the
distribution by reason of section 731(c)
and this section.
(2)Basis of partnership property. No
adjustment is made to the basis of
partnership property under section 734
as a result of any gain recognized by a
partner, or any step-up in the basis in
the distributed marketable securities in
the hands of the distributee partner, by
reason of section 731(c) and this sec-
tion.
(g)Coordination with other sec-
tions—(1)Sections 704(c)(1)(B) and
737—(i)In general. If a distribution
results in the application of sections
731(c) and one or both of sections
704(c)(1)(B) and 737, the effect of the
distribution is determined by applying
section 704(c)(1)(B) first, section 731(c)
second, and finally section 737.
(ii)Section 704(c)(1)(B). The basis of
the distributee partner’s interest in the
partnership for purposes of determining
the amount of gain, if any, recognized
by reason of section 731(c) (and for
determining the basis of the marketable
securities in the hands of the distributee
partner) includes the increase or de-
crease, if any, in the partner’s basis that
occurs under section 704(c)(1)(B)(iii) as
a result of a distribution to another
partner of property contributed by the
distributee partner in a distribution that
is part of the same distribution as the
marketable securities.
(iii)Section 737—(A)Marketable se-
curities as other property. A distribution
of marketable securities is treated as a
distribution of property other than
money for purposes of section 737 to
the extent that the marketable securities
are not treated as money under section
731(c). In addition, marketable securities
contributed to the partnership are treated
as property other than money in deter-
mining the contributing partner’s net
precontribution gain under section
737(b).
(B)Basis increase under section 737.
The basis of the distributee partner’s
interest in the partnership for purposes
of determining the amount of gain, if
any, recognized by reason of section
731(c) (and for determining the basis of
the marketable securities in the hands of
the distributee partner) does not include
the increase, if any, in the partner’s
basis that occurs under section 737(c)(1)
as a result of a distribution of property
to the distributee partner in a distribu-
tion that is part of the same distribution
as the marketable securities.
(2)Section 708(b)(1)(B). If a partner-
ship termination occurs under section
708(b)(1)(B), the successor partnership
will be treated as if there had been no
termination for purposes of section
731(c) and this section. Accordingly, a
section 708(b)(1)(B) termination will not
affect whether a partnership qualifies for
any of the exceptions in paragraphs (d)
and (e) of this section. In addition, a
deemed distribution that may occur as a
result of a section 708(b)(1)(B) termina-
tion will not be subject to section 731(c)
and this section.
(h)Anti-abuse rule. The provisions of
section 731(c) and this section must be
applied in a manner consistent with the
purpose of section 731(c) and the sub-
stance of the transaction. Accordingly, if
a principal purpose of a transaction is to
achieve a tax result that is inconsistent
with the purpose of section 731(c) and
this section, the Commissioner can re-
cast the transaction for Federal tax pur-
poses as appropriate to achieve tax
results that are consistent with the pur-
pose of section 731(c) and this section.
Whether a tax result is inconsistent with
the purpose of section 731(c) and this
section must be determined based on all
the facts and circumstances. For ex-
ample, under the provisions of this para-
graph (h)—
(1) A change in partnership alloca-
tions or distribution rights with respect
to marketable securities may be treated
as a distribution of the marketable secu-
rities subject to section 731(c) if the
change in allocations or distribution
rights is, in substance, a distribution of
the securities;
(2) A distribution of substantially all
of the assets of the partnership other
than marketable securities and money to
some partners may also be treated as a
distribution of marketable securities to
the remaining partners if the distribution
of the other property and the withdrawal
of the other partners is, in substance,
equivalent to a distribution of the securi-
ties to the remaining partners; and
(3) The distribution of multiple prop-
erties to one or more partners at differ-
ent times may also be treated as part of
a single distribution if the distributions
are part of a single plan of distribution.
(i) [Reserved]
(j)Examples. The following examples
illustrate the rules of this section. Unless
otherwise specified, all securities held
by a partnership are marketable securi-
ties within the meaning of section
731(c); the partnership holds no market-
able securities other than the securities
described in the example; all distribu-
tions by the partnership are subject to
section 731(a) and are not subject to
sections 704(c)(1)(B), 707(a)(2)(B),
751(b), or 737; and no securities are
eligible for an exception to section
731(c). The examples read as follows:
Example 1. Recognition of gain.(i)AandB
form partnershipABas equal partners.Acontrib-
utes property with a fair market value of $1,000
and an adjusted tax basis of $250.Bcontributes
$1,000 cash.ABsubsequently purchases Security
Xfor $500 and immediately distributes the secu-
rity toAin a current distribution. The basis inA’s
interest in the partnership at the time of distribu-
tion is $250.
(ii) The distribution of SecurityXis treated as a
distribution of money in an amount equal to the
fair market value of SecurityXon the date of
distribution ($500). (The amount of the distribu-
tion that is treated as money is not reduced under
section 731(c)(3)(B) and paragraph (b) of this
section because, if SecurityXhad been sold
immediately before the distribution, there would
have been no gain recognized byABandA’s
distributive share of the gain would therefore have
been zero.) As a result,Arecognizes $250 of gain
under section 731(a)(1) on the distribution ($500
distribution of money less $250 adjusted tax basis
inA’s partnership interest).
Example 2. Reduction in amount treated as
money—in general.(i)AandBform partnership
ABas equal partners.ABsubsequently distributes
SecurityXtoAin a current distribution. Immedi-
ately before the distribution,ABheld securities
with the following fair market values, adjusted tax
bases, and unrecognized gain or loss:
ValueBasis Gain (Loss)
SecurityX1007030
SecurityY1008020
SecurityZ100110(10)
(ii) IfABhad sold the securities for fair market
value immediately before the distribution toA, the
partnership would have recognized $40 of net gain
($30 gain on SecurityXplus $20 gain on Security
Yminus $10 loss on SecurityZ).A’s distributive
share of this gain would have been $20 (one-half
of $40 net gain). IfABhad sold the remaining
securities immediately after the distribution of
SecurityXtoA, the partnership would have $10
of net gain ($20 of gain on SecurityYminus $10
loss on SecurityZ).A’s distributive share of this
gain would have been $5 (one-half of $10 net
gain). As a result, the distribution resulted in a
21

decrease of $15 inA’s distributive share of the net
gain inAB’s securities ($20 net gain before
distribution minus $5 net gain after distribution).
(iii) Under paragraph (b) of this section, the
amount of the distribution of SecurityXthat is
treated as a distribution of money is reduced by
$15. The distribution of SecurityXis therefore
treated as a distribution of $85 of money toA
($100 fair market value of SecurityXminus $15
reduction).
Example 3. Reduction in amount treated as
money—carried interest. (i)AandBform partner-
shipAB.Acontributes $1,000 and provides sub-
stantial services to the partnership in exchange for
a 60 percent interest in partnership profits.B
contributes $1,000 in exchange for a 40 percent
interest in partnership profits.ABsubsequently
distributes SecurityXtoAin a current distribu-
tion. Immediately before the distribution,ABheld
securities with the following fair market values,
adjusted tax bases, and unrecognized gain:
ValueBasisGain
SecurityX1008020
SecurityY1009010
(ii) IfABhad sold the securities for fair market
value immediately before the distribution toA, the
partnership would have recognized $30 of net gain
($20 gain on SecurityXplus $10 gain on Security
Y).A’s distributive share of this gain would have
been $18 (60 percent of $30 net gain). IfABhad
sold the remaining securities immediately after the
distribution of SecurityXtoA, the partnership
would have $10 of net gain ($10 gain on Security
Y).A’s distributive share of this gain would have
been $6 (60 percent of $10 net gain). As a result,
the distribution resulted in a decrease of $12 in
A’s distributive share of the net gain inAB’s
securities ($18 net gain before distribution minus
$6 net gain after distribution).
(iii) Under paragraph (b) of this section, the
amount of the distribution of SecurityXthat is
treated as a distribution of money is reduced by
$12. The distribution of SecurityXis therefore
treated as a distribution of $88 of money toA
($100 fair market value of SecurityXminus $12
reduction).
Example 4. Reduction in amount treated as
money—change in partnership allocations. (i)Ais
admitted to partnershipABCas a partner with a 1
percent interest in partnership profits. At the time
ofA’s admission,ABCheld no securities.ABC
subsequently acquires SecurityX.A’s interest in
partnership profits is subsequently increased to 2
percent for securities acquired after the increase.A
retains a 1 percent interest in all securities ac-
quired before the increase.ABCthen acquires
SecuritiesYandZand later distributes SecurityX
toAin a current distribution. Immediately before
the distribution, the securities held byABChad
the following fair market values, adjusted tax
bases, and unrecognized gain or loss:
ValueBasis Gain (Loss)
SecurityX1,000500500
SecurityY1,000800200
SecurityZ1,0001,100(100)
(ii) IfABChad sold the securities for fair
market value immediately before the distribution
toA, the partnership would have recognized $600
of net gain ($500 gain on SecurityXplus $200
gain on SecurityYminus $100 loss on Security
Z).A’s distributive share of this gain would have
been $7 (1 percent of $500 gain on SecurityX
plus 2 percent of $200 gain on SecurityYminus 2
percent of $100 loss on SecurityZ).
(iii) IfABChad sold the remaining securities
immediately after the distribution of SecurityXto
A, the partnership would have $100 of net gain
($200 gain on SecurityYminus $100 loss on
SecurityZ).A’s distributive share of this gain
would have been $2 (2 percent of $200 gain on
SecurityYminus 2 percent of $100 loss on
SecurityZ). As a result, the distribution resulted in
a decrease of $5 inA’s distributive share of the
net gain inABC’s securities ($7 net gain before
distribution minus $2 net gain after distribution).
(iv) Under paragraph (b) of this section, the
amount of the distribution of SecurityXthat is
treated as a distribution of money is reduced by
$5. The distribution of SecurityXis therefore
treated as a distribution of $995 of money toA
($1000 fair market value of SecurityXminus $5
reduction).
Example 5. Basis consequences—distribution of
marketable security. (i)AandBform partnership
ABas equal partners.Acontributes nondepreciable
real property with a fair market value and adjusted
tax basis of $100.
(ii)ABsubsequently distributes SecurityXwith
a fair market value of $120 and an adjusted tax
basis of $90 toAin a current distribution. At the
time of distribution, the basis inA’s interest in the
partnership is $100. The amount of the distribution
that is treated as money is reduced under section
731(c)(3)(B) and paragraph (b)(2) of this section
by $15 (one- half of $30 net gain in SecurityX).
As a result,Arecognizes $5 of gain under section
731(a) on the distribution (excess of $105 distribu-
tion of money over $100 adjusted tax basis inA’s
partnership interest).
(iii)A’s adjusted tax basis in SecurityXis $95
($90 adjusted basis of SecurityXdetermined
under section 732(a)(1) plus $5 of gain recognized
byAby reason of section 731(c)). The basis inA’s
interest in the partnership is $10 as determined
under section 733 ($100 pre-distribution basis
minus $90 basis allocated to SecurityXunder
section 732).
Example 6. Basis consequences—distribution of
marketable security and other property. (i)Aand
Bform partnershipABas equal partners.A
contributes nondepreciable real property, with a
fair market value of $100 and an adjusted tax
basis of $10.
(ii)ABsubsequently distributes SecurityXwith
a fair market value and adjusted tax basis of $40
toAin a current distribution and, as part of the
same distribution,ABdistributes PropertyZtoA
with an adjusted tax basis and fair market value of
$40. At the time of distribution, the basis inA’s
interest in the partnership is $10.Arecognizes $30
of gain under section 731(a) on the distribution
(excess of $40 distribution of money over $10
adjusted tax basis inA’s partnership interest).
(iii)A’s adjusted tax basis in SecurityXis $35
($5 adjusted basis determined under section
732(a)(2) plus $30 of gain recognized byAby
reason of section 731(c)).A’s basis in PropertyZ
is $5, as determined under section 732(a)(2). The
basis inA’s interest in the partnership is $0 as
determined under section 733 ($10 pre-distribution
basis minus $10 basis allocated between Security
Xand PropertyZunder section 732).
(iv)AB’s adjusted tax basis in the remaining
partnership assets is unchanged unless the partner-
ship has a section 754 election in effect. IfAB
made such an election, the aggregate basis ofAB’s
assets would be increased by $70 (the difference
between the $80 combined basis of SecurityXand
PropertyZin the hands of the partnership before
the distribution and the $10 combined basis of the
distributed property in the hands ofAunder
section 732 after the distribution). Under section
731(c)(5), no adjustment is made to partnership
property under section 734 as a result of any gain
recognized byAby reason of section 731(c) or as
a result of any step-up in basis in the distributed
marketable securities in the hands ofAby reason
of section 731(c).
Example 7. Coordination with section 737.(i)A
andBform partnershipAB.Acontributes Property
A, nondepreciable real property with a fair market
value of $200 and an adjusted basis of $100 in
exchange for a 25 percent interest in partnership
capital and profits.ABowns marketable Security
X.
(ii) Within five years of the contribution of
PropertyA,ABsubsequently distributes Security
X, with a fair market value of $120 and an
adjusted tax basis of $100, toAin a current
distribution that is subject to section 737. As part
of the same distribution,ABdistributes PropertyY
toAwith a fair market value of $20 and an
adjusted tax basis of $0. At the time of distribu-
tion, there has been no change in the fair market
value of PropertyAor the adjusted tax basis in
A’s interest in the partnership.
(iii) IfABhad sold SecurityXfor fair market
value immediately before the distribution toA, the
partnership would have recognized $20 of gain.
A’s distributive share of this gain would have been
$5 (25 percent of $20 gain). BecauseABhas no
other marketable securities,A’s distributive share
of gain in partnership securities after the distribu-
tion would have been $0. As a result, the distribu-
tion resulted in a decrease of $5 inA’s share of
the net gain inAB’s securities ($5 net gain before
distribution minus $0 net gain after distribution).
Under paragraph (b)(2) of this section, the amount
of the distribution of SecurityXthat is treated as a
distribution of money is reduced by $5. The
distribution of SecurityXis therefore treated as a
distribution of $115 of money toA($120 fair
market value of SecurityXminus $5 reduction).
The portion of the distribution of the marketable
security that is not treated as a distribution of
money ($5) is treated as other property for
purposes of section 737.
(iv)Arecognizes total gain of $40 on the
distribution.Arecognizes $15 of gain under
section 731(a)(1) on the distribution of the portion
of SecurityXtreated as money ($115 distribution
of money less $100 adjusted tax basis inA’s
partnership interest).Arecognizes $25 of gain
under section 737 on the distribution of PropertyY
and the portion of SecurityXthat is not treated as
money.A’s section 737 gain is equal to the lesser
of (i)A’s precontribution gain ($100) or (ii) the
excess of the fair market value of property
received ($20 fair market value of PropertyYplus
$5 portion of SecurityXnot treated as money)
over the adjusted basis inA’s interest in the
partnership immediately before the distribution
($100) reduced (but not below zero) by the
amount of money received in the distribution
($115).
(v)A’s adjusted tax basis in SecurityXis $115
($100 basis of SecurityXdetermined under sec-
tion 732(a) plus $15 of gain recognized by reason
of section 731(c)).A’s adjusted tax basis in
PropertyYis $0 under section 732(a). The basis in
A’s interest in the partnership is $25 ($100 basis
before distribution minus $100 basis allocated to
SecurityXunder section 732(a) plus $25 gain
recognized under section 737).
(k)Effective date. This section ap-
plies to distributions made on or after
December 26, 1996. However, taxpayers
may apply the rules of this section to
22

distributions made after December 8,
1994, and before December 26, 1996.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved November 27, 1996.
Donald C. Lubick,
Assistant Secretary of the
Treasury (Tax Policy).
(Filed by the Office of the Federal Register on
December 24, 1996, 8:45 a.m., and published in
the issue of the Federal Register for December 26,
1996, 61 F.R. 67936)
Section 1291.—Interest on Tax
Deferral
26 CFR 1291–9: Deemed dividend election.
T.D. 8701
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Treatment of Shareholders of
Certain Passive Foreign Investment
Companies
AGENCY: Internal Revenue Service
(IRS), Treasury
ACTION: Final and temporary regula-
tions.
SUMMARY: This document contains fi-
nal regulations that provide rules for
making the deemed sale and deemed
dividend elections under section
1291(d)(2). These regulations reflect
changes to the law made by the Tax
Reform Act of 1986 and the Technical
and Miscellaneous Revenue Act of
1988, and apply to a shareholder of a
passive foreign investment company
(PFIC) that elects under section 1295 to
treat the PFIC as a qualified electing
fund (QEF) for a taxable year after the
first taxable year during the sharehold-
er’s holding period that the foreign
corporation was a PFIC.
DATES: These regulations are effective
December 27, 1996.
Applicability: For the specific dates
of applicability, see §§ 1.1291–9(k) and
1.1291–10(i).
FOR FURTHER INFORMATION
CONTACT: Gayle Novig, (202) 622–
3880 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information con-
tained in these final regulations have
been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork Reduc-
tion Act (44 U.S.C. 3507) under control
numbers 1545–1028 and 1545– 1304.
All of these paperwork requirements
will be consolidated under control num-
ber 1545–1507. Responses to these col-
lections of information are mandatory.
An agency may not conduct or spon-
sor, and a person is not required to
respond to, a collection of information
unless the collection of information dis-
plays a valid control number.
The estimated annual burden per re-
spondent varies from .75 hour to 1 hour,
depending on individual circumstances,
with an estimated average of .76 hour.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to
theInternal Revenue Service,Attn:
IRS Reports Clearance Officer, T:FP,
Washington, DC 20224, and to theOf-
fice of Management and Budget,Attn:
Desk Officer for the Department of the
Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503.
Books or records relating to this col-
lection of information must be retained
as long as their contents may become
material in the administration of any
internal revenue law. Generally, tax re-
turns and tax return information are
confidential, as required by 26 U.S.C.
6103.
Background
This document contains final regula-
tions to be added to the Income Tax
Regulations (26 CFR part 1) under
section 1291(d)(2) of the Internal Rev-
enue Code. The final regulations provide
rules for making a deemed sale or
deemed dividend election to purge a
shareholder’s holding period of stock of
a PFIC of those taxable years during
which the PFIC was not a QEF. The Tax
Reform Act of 1986 added section
1291(d)(2)(A), relating to the deemed
sale election, effective for taxable years
of foreign corporations beginning after
December 31, 1986. The Technical and
Miscellaneous Revenue Act of 1988
amended section 1291(d)(2) to add new
section 1291(d)(2)(B), relating to the
deemed dividend election, effective for
taxable years of foreign corporations
beginning after December 31, 1986.
On March 2, 1988, temporary regula-
tions (T.D. 8178 [1988–1 C.B. 313])
relating to the deemed sale election
under section 1291(d)(2)(A), in addition
to elections under sections 1294, 1295,
and 1297, were published in theFederal
Register(53 FR 6770). A notice of
proposed rulemaking (INTL–941–86
[1988–1 C.B. 916]) cross-referencing
the temporary regulations was also pub-
lished in theFederal Registerfor the
same day (53 FR 6781).
On April 1, 1992, temporary regula-
tions (T.D. 8404 [1992–1 C.B. 296])
relating to both the deemed sale and
deemed dividend elections under section
1291(d)(2)(A) and (B), were published
in theFederal Register(57 FR 10992).
A notice of proposed rulemaking
(INTL–941–86; INTL–656–87; INTL–
704–87 [1992–1 C.B. 1124]) cross-
referencing the temporary regulations
was published in theFederal Register
for the same day (57 FR 11024).
Written comments responding to these
notices were received. No public hearing
was held for the notice of proposed
rulemaking published on March 2, 1988.
A public hearing was held November
23, 1992, for the notice of proposed
rulemaking published April 1, 1992.
After consideration of all the comments,
the proposed regulations under section
1291(d)(2) are adopted as revised by
this Treasury decision, and the corre-
sponding temporary regulations are re-
moved. Substantive revisions are dis-
cussed below. All other revisions are
stylistic, and are primarily intended to
conform the regulations under
§ 1.1291–10 to those under § 1.1291–9.
Explanation of Provisions and Revisions
and Summary of Comments
1. Introduction
A shareholder of a foreign corporation
that qualifies as a PFIC under the
income or asset test of section 1296 is
subject to the special interest charge
regime of section 1291 with respect to
certain distributions by the PFIC and
dispositions of the stock of the PFIC.
Provided the PFIC complies with certain
election requirements, a shareholder may
elect under section 1295 to treat the
PFIC as a QEF. If the election is made,
the shareholder is subject to the current
inclusion regime of section 1293. If the
shareholder makes the section 1295
election for the first year of its holding
period for the foreign corporation during
23

which year the foreign corporation is a
PFIC, the shareholder is only subject to
PFIC taxation under the current inclu-
sion regime. Such a PFIC is apedigreed
QEFwith respect to the shareholder.
However, if the shareholder makes the
section 1295 election for a later year,
the shareholder is subject to both the
interest charge regime of section 1291
and the current inclusion regime of
section 1293. Such a PFIC is an
unpedigreed QEFwith respect to the
shareholder. To limit its PFIC taxation
to the current inclusion regime of sec-
tion 1293, a shareholder that makes the
section 1295 election may also make a
section 1291(d)(2) election to purge its
holding period of the years, or parts of
years, before the effective date of the
QEF election during which the foreign
corporation was a PFIC (nonQEF years).
Thereafter, the PFIC will be treated as a
pedigreed QEF with respect to the
shareholder.
Section 1291(d)(2) provides two
methods to purge the nonQEF years
from a shareholder’s holding period of
PFIC stock. A shareholder may elect
under section 1291(d)(2)(A) to be
treated as having sold the stock of the
PFIC. The gain on the deemed sale is
subject to the interest charge regime and
therefore taxed as an excess distribution
under section 1291. Alternatively, if the
PFIC is a controlled foreign corporation
(CFC), any U.S. person that is a share-
holder of the PFIC may elect under
section 1291(d)(2)(B) to be treated as
receiving a dividend in the amount of its
pro rata share of the post-1986 undis-
tributed earnings and profits of the
PFIC. The deemed dividend is taxed to
the shareholder as an excess distribution
under the interest charge regime. If
either election is made, the shareholder’s
holding period is treated, for purposes of
the PFIC rules, as beginning on the date
of the deemed sale or dividend (qualifi-
cation date).
2. Revisions to the Regulations
Section 1.1291–9 provides the rules
for making the deemed dividend elec-
tion under section 1291(d)(2)(B) with
respect to a PFIC that is a CFC. Section
1.1291–10 provides the rules for making
the deemed sale election under section
1291(d)(2)(A). The final regulations
generally follow the proposed regula-
tions with the exceptions described be-
low.
a. Qualification Date
The 1988 temporary regulations under
§ 1.1291–10T provided that, in general,
the date of the deemed sale, referred to
as the qualification date, is the first day
of the first taxable year of the corpora-
tion that it is treated as a QEF under
section 1295 (first QEF year). However,
the temporary and proposed amend-
ments to § 1.1291–10T published in
1992 changed the qualification date for
elections made after May 1, 1992, to the
first day of the taxable year for which
the shareholder made the QEF election
(shareholder’s election year). Similarly,
under the temporary and proposed
§ 1.1291–9 regulations, the qualification
date is the first day of the shareholder’s
election year.
Commenters described a potential
problem with the designation of the first
day of the shareholder’s election year as
the qualification date where the corpora-
tion and the shareholder have different
taxable years. In this circumstance, the
purging election would not avoid appli-
cation of the interest charge regime to
distributions and dispositions during the
period between the first day of the
corporation’s first QEF year and the first
day of the shareholder’s election year.
In response to comments, the final
regulations adopt the definition of quali-
fication date used in the 1988 temporary
regulations for purposes of both the
deemed sale and deemed dividend elec-
tions made on or after January 27, 1997.
For the period after March 31, 1995, to
January 26, 1997, the final regulations
adopt the definition of qualification date
of the 1992 temporary regulations. In
addition, the final regulations permit a
shareholder that made the deemed sale
or deemed dividend election after May
1, 1992 and on or before January 27,
1997, to amend its election and treat the
deemed sale or deemed dividend as
occurring on the first day of the PFIC’s
first QEF year, provided the periods of
limitations on assessment for the taxable
year that includes that date and for the
shareholder’s election year have not ex-
pired.
In response to comments, the final
regulations also clarify that if the share-
holder’s holding period under section
1223 includes the first day of the first
QEF year, the shareholder will be
treated as holding the stock on that date.
Therefore, the shareholder may make a
section 1291(d)(2) election for the first
QEF year.
b. Elections made with respect to
former PFICs
Section 1.1291–9(h) of the proposed
regulations provides that a shareholder
cannot apply the deemed dividend rules
of section 1291(d)(2)(B) to purge PFIC
taint, pursuant to section 1297(b)(1),
from the stock of a foreign corporation
that no longer is a PFIC under either the
asset or income test of section 1296(a),
but whose stock nevertheless is treated
as stock of a PFIC with respect to a
shareholder pursuant to section
1297(b)(1) (former PFIC). In addition,
the proposed regulations provide that the
section 1291(d)(2)(B) election cannot be
made with respect to a corporation that
will not qualify as a PFIC under section
1296(a)(1) or (2) in the first QEF year.
Several commenters disagreed with
the position taken in § 1.1291–9(h) of
the proposed regulations. Section
1.1291– 9(i)(1) of the final regulations
does not accept these comments and
adopts the rule of the proposed regula-
tion denying application of the rules of
section 1291(d)(2)(B) for purposes of a
section 1297(b)(1) election. In addition,
§ 1.1291–9(i)(2) modifies the rule of
proposed regulation § 1.1291–9(h)(2) to
clarify that the section 1295 and 1291-
(d)(2)(B) elections cannot be made with
respect to a former PFIC. Section
1.1291–10(h) of the final regulations
adopts a similar rule, clarifying that a
shareholder of a former PFIC cannot
make the section 1295 and 1291(d)-
(2)(A) elections. Thus, section 1295 and
section 1291(d)(2) elections may only
be made with respect to a foreign
corporation that is a PFIC by definition
under section 1296. Accordingly, the
deemed sale election of section 1297-
(b)(1) remains the only means by which
a shareholder may purge a former PFIC
of its PFIC taint.
c. Qualification as a CFC
The final regulations, in response to
comments, clarify that a shareholder
may make the deemed dividend election
provided the PFIC qualifies as a CFC
for its first QEF year.
d. Time for making the elections
In response to comments, the final
regulations clarify the time for making
the deemed sale and dividend elections.
The regulations provide that if the
shareholder and the PFIC have the same
taxable year, and therefore the first day
of the shareholder’s election year and
the qualification date are the same, the
24

shareholder may make the election in
the same return in which it makes the
section 1295 election or in an amended
return. The regulations also provide that
if the shareholder and the PFIC have
different taxable years and therefore the
qualification date precedes the first day
of the shareholder’s election year, the
shareholder must make the deemed sale
or deemed dividend election in an
amended return. If the shareholder is
making the section 1291(d)(2) election
in an amended return, the amended
return must be filed within three years
of the due date, as extended under
section 6081, for the return for the
taxable year that includes the qualifica-
tion date.
e. Post-1986 accumulated earnings and
profits
The proposed regulations provide that
the shareholder’s old holding period for
purposes of the PFIC rules ends on the
qualification date, but also provide that
its new holding period begins on the
qualification date. These rules may have
caused confusion concerning the last
day of the holding period for purposes
of determining post-1986 accumulated
earnings and profits. The final regula-
tions revise the holding period rules to
provide that the shareholder’s holding
period ends on the day before the
qualification date for purposes of calcu-
lating the amount of the deemed divi-
dend.
Special Analyses
It has been determined that this Trea-
sury Decision is not a significant regula-
tory action as defined in EO 12866.
Therefore, a regulatory assessment is not
required. It also has been determined
that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does
not apply to these regulations, and be-
cause the notice of proposed rulemaking
preceding the regulations was issued
prior to March 29, 1996, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does
not apply. These regulations, which have
a retroactive effective date, satisfy the
Administrative Procedure Act’s require-
ment in section 553(d) for good cause
because they provide necessary guidance
for the period after March 31, 1995, and
because they are not detrimental to
taxpayers. These regulations are neces-
sary because they provide taxpayers
with the rules needed to make the
elections under section 1291(d)(2). Pur-
suant to section 7805(f) of the Internal
Revenue Code, the notices of proposed
rulemaking preceding these regulations
were submitted to the Small Business
Administration for comment on their
impact on small business.
Drafting Information
The principal author of these regula-
tions is Gayle Novig, Office of the
Associate Chief Counsel (International).
However, other personnel from the IRS
and Treasury Department participated in
their development.
* * * * *
26 CFR Part 602
Reporting and recordkeeping require-
ments.
Adoption of Amendments to the Regula-
tions
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by removing the
entry for section 1.1291–9T and the
entry for sections 1.1291–10T, 1.1294–
1T, 1.1295–1T, and 1.1297–3T, and by
adding entries in numerical order to read
as follows:
Authority: 26 U.S.C. 7805 ***
Section 1.1291–9 also issued under 26
U.S.C. 1291(d)(2).
Section 1.1291–10 also issued under
26 U.S.C. 1291(d)(2).
Section 1.1294–1T also issued under
26 U.S.C. 1294.
Section 1.1297–3T also issued under
26 U.S.C. 1297(b)(1).***
Par. 2. Section 1.1291–0 is added to
read as follows:
§ 1.1291–0 Treatment of shareholders
of certain passive foreign investment
companies; table of contents.
This section contains a listing of the
headings for §§ 1.1291–9 and 1.1291–
10.
§ 1.1291–9 Deemed dividend election.
(a) Deemed dividend election.
(1) In general.
(2) Post-1986 earnings and profits de-
fined.
(i) In general.
(ii) Pro rata share of post-1986 earn-
ings and profits attributable to share-
holder’s stock.
(A) In general.
(B) Reduction for previously taxed
amounts.
(b) Who may make the election.
(c) Time for making the election.
(d) Manner of making the election.
(1) In general.
(2) Attachment to Form 8621
(e) Qualification date.
(1) In general.
(2) Elections made after March 31,
1995, and before January 27, 1997.
(i) In general.
(ii) Exception.
(3) Examples.
(f) Adjustment to basis.
(g) Treatment of holding period.
(h) Coordination with section 959(e).
(i) Election inapplicable to share-
holder of former PFIC.
(1) Coordination with section
1297(b)(1).
(2) Former PFIC.
(j) Definitions.
(1) Passive foreign investment com-
pany (PFIC).
(2) Types of PFICs.
(i) Qualified electing fund (QEF).
(ii) Pedigreed QEF.
(iii) Unpedigreed QEF.
(iv) Former PFIC.
(3) Shareholder.
(k) Effective date.
§ 1.1291–10 Deemed sale election.
(a) Deemed sale election.
(b) Who may make the election.
(c) Time for making the election.
(d) Manner of making the election.
(e) Qualification date.
(1) In general.
(2) Elections made after March 31,
1995, and before January 27, 1997.
(i) In general.
(ii) Exception.
(f) Adjustments to basis.
(1) In general.
(2) Adjustment to basis for section
1293 inclusion with respect to deemed
sale election made after March 31,
1995, and before January 27, 1997.
(g) Treatment of holding period.
(h) Election inapplicable to share-
holder of former PFIC.
(i) Effective date.
§ 1.1291–0T [Amended]
Par. 3. Section 1.1291–0T is amended
as follows:
1. Remove from the introductory text
the language ‘‘1.1291–9T, 1.1291–
10T,’’.
2. Remove the entries for § 1.1291–
9T and § 1.1291–10T from the table.
25

Par. 4. Section 1.1291–9 is added to
read as follows:
§ 1.1291–9 Deemed dividend election.
(a)Deemed dividend election—(1)In
general.This section provides rules for
making the election under section
1291(d)(2)(B) (deemed dividend elec-
tion). Under that section, a shareholder
(as defined in paragraph (j)(3) of this
section) of a PFIC that is an unped-
igreed QEF may elect to include in
income as a dividend the shareholder’s
pro rata share of the post-1986 earnings
and profits of the PFIC attributable to
the stock held on the qualification date
(as defined in paragraph (e) of this
section), provided the PFIC is a con-
trolled foreign corporation (CFC) within
the meaning of section 957(a) for the
taxable year for which the shareholder
elects under section 1295 to treat the
PFIC as a QEF (section 1295 election).
If the shareholder makes the deemed
dividend election, the PFIC will become
a pedigreed QEF with respect to the
shareholder. The deemed dividend is
taxed under section 1291 as an excess
distribution received on the qualification
date. The excess distribution determined
under this paragraph (a) is allocated
under section 1291(a)(1)(A) only to
those days in the shareholder’s holding
period during which the foreign corpora-
tion qualified as a PFIC. For purposes
of the preceding sentence, the holding
period of the PFIC stock with respect to
which the election is made ends on the
day before the qualification date. For the
definitions of PFIC, QEF, unpedigreed
QEF, and pedigreed QEF, see paragraph
(j)(1) and (2) of this section.
(2)Post-1986 earnings and profits
defined—(i)In general.For purposes of
this section, the term post-1986 earnings
and profits means the undistributed
earnings and profits, within the meaning
of section 902(c)(1), as of the day
before the qualification date, that were
accumulated and not distributed in tax-
able years of the PFIC beginning after
1986 and during which it was a PFIC,
but without regard to whether the earn-
ings relate to a period during which the
PFIC was a CFC.
(ii)Pro rata share of post-1986 earn-
ings and profits attributable to share-
holder’s stock—(A)In general.A share-
holder’s pro rata share of the post-1986
earnings and profits of the PFIC attrib-
utable to the stock held by the share-
holder on the qualification date is the
amount of post-1986 earnings and prof-
its of the PFIC accumulated during any
portion of the shareholder’s holding pe-
riod ending at the close of the day
before the qualification date and attrib-
utable, under the principles of section
1248 and the regulations under that
section, to the PFIC stock held on the
qualification date.
(B)Reduction for previously taxed
amounts.A shareholder’s pro rata share
of the post-1986 earnings and profits of
the PFIC does not include any amount
that the shareholder demonstrates to the
satisfaction of the Commissioner (in the
manner provided in paragraph (d)(2) of
this section) was, pursuant to another
provision of the law, previously included
in the income of the shareholder, or of
another U.S. person if the shareholder’s
holding period of the PFIC stock in-
cludes the period during which the stock
was held by that other U.S. person.
(b)Who may make the election.A
shareholder of an unpedigreed QEF that
is a CFC for the taxable year of the
PFIC for which the shareholder makes
the section 1295 election may make the
deemed dividend election provided the
shareholder held stock of that PFIC on
the qualification date. A shareholder is
treated as holding stock of the PFIC on
the qualification date if its holding pe-
riod with respect to that stock under
section 1223 includes the qualification
date. A shareholder may make the
deemed dividend election without regard
to whether the shareholder is a United
States shareholder within the meaning of
section 951(b). A deemed dividend elec-
tion may be made by a shareholder
whose pro rata share of the post-1986
earnings and profits of the PFIC attrib-
utable to the PFIC stock held on the
qualification date is zero.
(c)Time for making the election.The
shareholder makes the deemed dividend
election in the shareholder’s return for
the taxable year that includes the quali-
fication date. If the shareholder and the
PFIC have the same taxable year, the
shareholder makes the deemed dividend
election in either the original return for
the taxable year for which the share-
holder makes the section 1295 election,
or in an amended return for that year. If
the shareholder and the PFIC have dif-
ferent taxable years, the deemed divi-
dend election must be made in an
amended return for the taxable year that
includes the qualification date. If the
deemed dividend election is made in an
amended return, the amended return
must be filed by a date that is within
three years of the due date, as extended
under section 6081, of the original re-
turn for the taxable year that includes
the qualification date.
(d)Manner of making the election—
(1)In general.A shareholder makes the
deemed dividend election by filing Form
8621 and the attachment to Form 8621
described in paragraph (d)(2) of this
section with the return for the taxable
year of the shareholder that includes the
qualification date, reporting the deemed
dividend as an excess distribution pursu-
ant to section 1291(a)(1), and paying the
tax and interest due on the excess
distribution. A shareholder that makes
the deemed dividend election after the
due date of the return (determined with-
out regard to extensions) for the taxable
year that includes the qualification date
must pay additional interest, pursuant to
section 6601, on the amount of the
underpayment of tax for that year.
(2)Attachment to Form 8621.The
shareholder must attach a schedule to
Form 8621 that demonstrates the calcu-
lation of the shareholder’s pro rata share
of the post-1986 earnings and profits of
the PFIC that is treated as distributed to
the shareholder on the qualification date
pursuant to this section. If the share-
holder is claiming an exclusion from its
pro rata share of the post-1986 earnings
and profits for an amount previously
included in its income or the income of
another U.S. person, the shareholder
must include the following information:
(i) The name, address, and taxpayer
identification number of each U.S. per-
son that previously included an amount
in income, the amount previously in-
cluded in income by each such U.S.
person, the provision of the law pursu-
ant to which the amount was previously
included in income, and the taxable year
of inclusion of each amount; and
(ii) A description of the transaction
pursuant to which the shareholder ac-
quired, directly or indirectly, the stock
of the PFIC from another U.S. person,
and the provisions of law pursuant to
which the shareholder’s holding period
includes the period the other U.S. per-
son held the CFC stock.
(e)Qualification date—(1)In gen-
eral.Except as otherwise provided in
this paragraph (e), the qualification date
is the first day of the PFIC’s first
taxable year as a QEF (first QEF year).
(2)Elections made after March 31,
1995, and before January 27, 1997—(i)
In general.The qualification date for
deemed dividend elections made after
March 31, 1995, and before January 27,
1997, is the first day of the sharehold-
26

er’s election year. The shareholder’s
election year is the taxable year of the
shareholder for which it made the sec-
tion 1295 election.
(ii)Exception.A shareholder who
made the deemed dividend election after
May 1, 1992, and before January 27,
1997, may elect to change its qualifica-
tion date to the first day of the first
QEF year, provided the periods of limi-
tations on assessment for the taxable
year that includes that date and for the
shareholder’s election year have not ex-
pired. A shareholder changes the qualifi-
cation date by filing amended returns,
with revised Forms 8621 and the attach-
ments described in paragraph (d)(2) of
this section, for the shareholder’s elec-
tion year and the shareholder’s taxable
year that includes the first day of the
first QEF year, and making all appropri-
ate adjustments and payments.
(3)Examples.The rules of this para-
graph (e) are illustrated by the following
examples:
Example 1—(i)Eligibility to make deemed divi-
dend election.A is a U.S. person who files its
income tax return on a calendar year basis. On
January 2, 1994, A purchased one percent of the
stock of M, a PFIC with a taxable year ending
November 30. M was both a CFC and a PFIC, but
not a QEF, for all of its taxable years. On
December 3, 1996, M made a distribution to its
shareholders. A received $100, all of which A
reported in its 1996 return as an excess distribu-
tion as provided in section 1291(a)(1). A decides
to make the section 1295 election in A’s 1997
taxable year to treat M as a QEF effective for M’s
taxable year beginning December 1, 1996. Be-
cause A did not make the section 1295 election in
1994, the first year in its holding period of M
stock that M qualified as a PFIC, M would be an
unpedigreed QEF and A would be subject to both
sections 1291 and 1293. A, however, may elect
under section 1291(d)(2) to purge the years M was
not a QEF from A’s holding period. If A makes
the section 1291(d)(2) election, the December 3
distribution will not be taxable under section
1291(a). Because M is a CFC, even though A is
not a U.S. shareholder within the meaning of
section 951(b), A may make the deemed dividend
election under section 1291(d)(2)(B).
(ii)Making the election.Under paragraph (e)(1)
of this section, the qualification date, and therefore
the date of the deemed dividend, is December 1,
1996. Accordingly, to make the deemed dividend
election, A must file an amended return for 1996,
and include the deemed dividend in income in that
year. As a result, M will be a pedigreed QEF as of
December 1, 1996, and the December 3, 1996,
distribution will not be taxable as an excess
distribution. Therefore, in its amended return, A
may report the December 3, 1996, distribution
consistent with section 1293 and the general rules
applicable to corporate distributions.
Example 2.X, a U.S. person, owned a five
percent interest in the stock of FC, a PFIC with a
taxable year ending June 30. X never made the
section 1295 election with respect to FC. X
transferred her interest in FC to her granddaughter,
Y, a U.S. person, on February 14, 1996. The
transfer qualified as a gift for federal income tax
purposes, and no gain was recognized on the
transfer (see Regulation Project INTL–656–87,
published in 1992–1 C.B. 1124; see
§ 601.601(d)(2)(ii)(b) of this chapter). As pro-
vided in section 1223(2), Y’s holding period
includes the period that X held the FC stock. Y
decides to make the section 1295 election in her
1996 return to treat FC as a QEF for its taxable
year beginning July 1, 1995. However, because
Y’s holding period includes the period that X held
the FC stock, and FC was a PFIC but not a QEF
during that period, FC will be an unpedigreed
QEF with respect to Y unless Y makes a section
1291(d)(2) election. Although Y did not actually
own the stock of FC on the qualification date
(July 1, 1995), Y’s holding period includes that
date. Therefore, provided FC is a CFC for its
taxable year beginning July 1, 1995, Y may make
a section 1291(d)(2)(B) election to treat FC as a
pedigreed QEF.
(f)Adjustment to basis.A shareholder
that makes the deemed dividend election
increases its adjusted basis of the stock
of the PFIC owned directly by the
shareholder by the amount of the
deemed dividend. If the shareholder
makes the deemed dividend election
with respect to a PFIC of which it is an
indirect shareholder, the shareholder’s
adjusted basis of the stock or other
property owned directly by the share-
holder, through which ownership of the
PFIC is attributed to the shareholder, is
increased by the amount of the deemed
dividend. In addition, solely for pur-
poses of determining the subsequent
treatment under the Code and regula-
tions of a shareholder of the stock of the
PFIC, the adjusted basis of the direct
owner of the stock of the PFIC is
increased by the amount of the deemed
dividend.
(g)Treatment of holding period.For
purposes of applying sections 1291
through 1297 to the shareholder after
the deemed dividend, the shareholder’s
holding period of the stock of the PFIC
begins on the qualification date. For
other purposes of the Code and regula-
tions, this holding period rule does not
apply.
(h)Coordination with section 959(e).
For purposes of section 959(e), the
entire deemed dividend is treated as
included in gross income under section
1248(a).
(i)Election inapplicable to share-
holder of former PFIC—(1)Coordina-
tion with section 1297(b)(1).The rules
of this section do not apply to an
election made under section 1297(b)(1).
(2)Former PFIC.A shareholder may
not make the section 1295 and deemed
dividend elections if the foreign corpo-
ration is a former PFIC (as defined in
paragraph (j)(2)(iv) of this section) with
respect to the shareholder. For the rules
regarding the election by a shareholder
of a former PFIC, see § 1.1297–3T.
(j)Definitions—(1)Passive foreign
investment company (PFIC).A passive
foreign investment company (PFIC) is a
foreign corporation that satisfies either
the income test of section 1296(a)(1) or
the asset test of section 1296(a)(2). A
corporation will not be treated as a
PFIC with respect to a shareholder for
those days included in the shareholder’s
holding period when the shareholder, or
a person whose holding period of the
stock is included in the shareholder’s
holding period, was not a United States
person within the meaning of section
7701(a)(30).
(2)Types of PFICs—(i)Qualified
electing fund (QEF).A PFIC is a quali-
fied electing fund (QEF) with respect to
a shareholder that has elected, under
section 1295, to be taxed currently on
its share of the PFIC’s earnings and
profits pursuant to section 1293.
(ii)Pedigreed QEF.A PFIC is a
pedigreed QEF with respect to a share-
holder if the PFIC has been a QEF with
respect to the shareholder for all taxable
years during which the corporation was
a PFIC that are included wholly or
partly in the shareholder’s holding pe-
riod of the PFIC stock.
(iii)Unpedigreed QEF.A PFIC is an
unpedigreed QEF for a taxable year if—
(A) An election under section 1295 is
in effect for that year;
(B) The PFIC has been a QEF with
respect to the shareholder for at least
one, but not all, of the taxable years
during which the corporation was a
PFIC that are included wholly or partly
in the shareholder’s holding period of
the PFIC stock; and
(C) The shareholder has not made an
election under section 1291(d)(2) and
this section or § 1.1291–10 with respect
to the PFIC to purge the nonQEF years
from the shareholder’s holding period.
(iv)Former PFIC.A foreign corpora-
tion is a former PFIC with respect to a
shareholder if the corporation satisfies
neither the income test of section
1296(a)(1) nor the asset test of section
1296(a)(2), but whose stock, held by
that shareholder, is treated as stock of a
PFIC, pursuant to section 1297(b)(1),
because at any time during the share-
holder’s holding period of the stock the
corporation was a PFIC that was not a
QEF.
(3)Shareholder.A shareholder is a
U.S. person that is a direct or indirect
shareholder as defined in Regulation
Project INTL–656–87 published in
27

1992–1 C.B. 1124; see § 601.601(d)-
(2)(ii)(b) of this chapter.
(k)Effective date.The rules of this
section are applicable as of April 1,
1995.
§ 1.1291–9T [Removed]
Par. 5. Section 1.1291–9T is re-
moved.
Par. 6. Section 1.1291–10 is added to
read as follows:
§ 1.1291–10 Deemed sale election.
(a)Deemed sale election.This sec-
tion provides rules for making the elec-
tion under section 1291(d)(2)(A)
(deemed sale election). Under that sec-
tion, a shareholder (as defined in
§ 1.1291–9(j)(3)) of a PFIC that is an
unpedigreed QEF may elect to recognize
gain with respect to the stock of the
unpedigreed QEF held on the qualifica-
tion date (as defined in paragraph (e) of
this section). If the shareholder makes
the deemed sale election, the PFIC will
become a pedigreed QEF with respect to
the shareholder. A shareholder that
makes the deemed sale election is
treated as having sold, for its fair market
value, the stock of the PFIC that the
shareholder held on the qualification
date. The gain recognized on the
deemed sale is taxed under section 1291
as an excess distribution received on the
qualification date. In the case of an
election made by an indirect share-
holder, the amount of gain to be recog-
nized and taxed as an excess distribution
is the amount of gain that the direct
owner of the stock of the PFIC would
have realized on an actual sale or other
disposition of the stock of the PFIC
indirectly owned by the shareholder.
Any loss realized on the deemed sale is
not recognized. For the definitions of
PFIC, QEF, unpedigreed QEF, and pedi-
greed QEF, see § 1.1291–9(j)(1) and
(2).
(b)Who may make the election.A
shareholder of an unpedigreed QEF may
make the deemed sale election provided
the shareholder held stock of that PFIC
on the qualification date. A shareholder
is treated as holding stock of the PFIC
on the qualification date if its holding
period with respect to that stock under
section 1223 includes the qualification
date. A deemed sale election may be
made by a shareholder that would real-
ize a loss on the deemed sale.
(c)Time for making the election.The
shareholder makes the deemed sale elec-
tion in the shareholder’s return for the
taxable year that includes the qualifica-
tion date. If the shareholder and the
PFIC have the same taxable year, the
shareholder makes the deemed sale elec-
tion in either the original return for the
taxable year for which the shareholder
makes the section 1295 election, or in
an amended return for that year. If the
shareholder and the PFIC have different
taxable years, the deemed sale election
must be made in an amended return for
the taxable year that includes the quali-
fication date. If the deemed sale election
is made in an amended return, the
amended return must be filed by a date
that is within three years of the due
date, as extended under section 6081, of
the original return for the taxable year
that includes the qualification date.
(d)Manner of making the election.A
shareholder makes the deemed sale elec-
tion by filing Form 8621 with the return
for the taxable year of the shareholder
that includes the qualification date, re-
porting the gain as an excess distribu-
tion pursuant to section 1291(a), and
paying the tax and interest due on the
excess distribution. A shareholder that
makes the deemed sale election after the
due date of the return (determined with-
out regard to extensions) for the taxable
year that includes the qualification date
must pay additional interest, pursuant to
section 6601, on the amount of the
underpayment of tax for that year. A
shareholder that realizes a loss on the
deemed sale reports the loss on Form
8621, but does not recognize the loss.
(e)Qualification date—(1)In gen-
eral.Except as otherwise provided in
this paragraph (e), the qualification date
is the first day of the PFIC’s first
taxable year as a QEF (first QEF year).
(2)Elections made after March 31,
1995, and before January 27, 1997—(i)
In general.The qualification date for
deemed sale elections made after March
31, 1995, and before January 27, 1997,
is the first day of the shareholder’s
election year. The shareholder’s election
year is the taxable year of the share-
holder for which it made the section
1295 election.
(ii)Exception.A shareholder who
made the deemed sale election after
May 1, 1992, and before January 27,
1997, may elect to change its qualifica-
tion date to the first day of the first
QEF year, provided the periods of limi-
tations on assessment for the taxable
year that includes that date and for the
shareholder’s election year have not ex-
pired. A shareholder changes the qualifi-
cation date by filing amended returns,
with revised Forms 8621, for the share-
holder’s election year and the sharehold-
er’s taxable year that includes the first
day of the first QEF year, and making
all appropriate adjustments and pay-
ments.
(f)Adjustments to basis—(1)In gen-
eral.A shareholder that makes the
deemed sale election increases its ad-
justed basis of the PFIC stock owned
directly by the amount of gain recog-
nized on the deemed sale. If the share-
holder makes the deemed sale election
with respect to a PFIC of which it is an
indirect shareholder, the shareholder’s
adjusted basis of the stock or other
property owned directly by the share-
holder, through which ownership of the
PFIC is attributed to the shareholder, is
increased by the amount of gain recog-
nized by the shareholder. In addition,
solely for purposes of determining the
subsequent treatment under the Code
and regulations of a shareholder of the
stock of the PFIC, the adjusted basis of
the direct owner of the stock of the
PFIC is increased by the amount of gain
recognized on the deemed sale. A share-
holder shall not adjust the basis of any
stock with respect to which the share-
holder realized a loss on the deemed
sale.
(2)Adjustment of basis for section
1293 inclusion with respect to deemed
sale election made after March 31,
1995, and before January 27, 1997.For
purposes of determining the amount of
gain recognized with respect to a
deemed sale election made after March
31, 1995, and before January 27, 1997,
by a shareholder that treats the first day
of the shareholder’s election year as the
qualification date, the adjusted basis of
the stock deemed sold includes the
shareholder’s section 1293(a) inclusion
attributable to the period beginning with
the first day of the PFIC’s first QEF
year and ending on the day before the
qualification date.
(g)Treatment of holding period.For
purposes of applying sections 1291
through 1297 to the shareholder after
the deemed sale, the shareholder’s hold-
ing period of the stock of the PFIC
begins on the qualification date, without
regard to whether the shareholder recog-
nized gain on the deemed sale. For other
purposes of the Code and regulations,
this holding period rule does not apply.
(h)Election inapplicable to share-
holder of former PFIC.A shareholder
may not make the section 1295 and
deemed sale elections if the foreign
corporation is a former PFIC (as defined
28

in § 1.1291–9(j)(2)(iv)) with respect to
the shareholder. For the rules regarding
the election by a shareholder of a
former PFIC, see 1.1297–3T.
(i)Effective date.The rules of this
section are applicable as of April 1,
1995.
§ 1.1291–10T [Removed]
Par. 7. Section 1.1291–10T is re-
moved.
PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 8. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
§ 602.101 [Amended]
Par. 9. In § 602.101, paragraph (c) is
amended by removing the entries for
1.1291–9T and 1.1291–10T from the
table and adding entries in numerical
order to the table to read as follows:
§ 602.101 OMB Control numbers.
* * * * *
(c) * * *
CFR part or section whereCurrent OMB
identified and describedcontrol No.
* * * * *
1.1291–9 . . . . . . . . . . . . . . . . . . 1545–1507
1.1291–10 . . . . . . . . . . . . . . . . . 1545–1507
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved December 12, 1996.
Donald C. Lubick,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on
December 26, 1996, 8:45 a.m., and published in
the issue of the Federal Register for December 27,
1996, 61 F.R. 68149)
Section 6231.—Definitions and
Special Rules
26 CFR 301.6231(a)(7)–1: Designation or selec-
tion of tax matters partner.
T.D. 8698
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 301 and 602
Selection of Tax Matters Partner
for Limited Liability Companies
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains
final regulations giving guidance neces-
sary for the designation or selection of a
tax matters partner for partnerships in-
cluding limited liability companies clas-
sified as partnerships.
DATES: These regulations are effective
December 23, 1996. For dates of appli-
cability of these regulations, see
§ 301.6231(a)(7)–2(c).
FOR FURTHER INFORMATION CON-
TACT: D. Lindsay Russell, (202) 622–
3050 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information con-
tained in these final regulations have
been reviewed and approved by the
Office of Management and Budget in
accordance with the Paperwork Reduc-
tion Act (44 U.S.C. 3507) under control
number 1545–0790. Responses to these
collections of information enable the
designation, and the termination of the
designation, of a tax matters partner for
a partnership.
An agency may not conduct or spon-
sor, and a person is not required to
respond to, a collection of information
unless the collection of information dis-
plays a valid control number.
The estimated annual burden per re-
spondent varies from .50 hour to 1 hour,
depending on individual circumstances,
with an estimated average of .75 hour.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to
theInternal Revenue Service, Attn:
IRS Reports Clearance Officer, T:FP,
Washington, DC 20224, and to theOf-
fice of Management and Budget, Attn:
Desk Officer for the Department of the
Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503.
Books or records relating to this col-
lection of information must be retained
as long as their contents may become
material in the administration of any
internal revenue law. Generally, tax re-
turns and tax return information are
confidential, as required by 26 U.S.C.
6103.
Background
Prior to the enactment of the Tax
Equity and Fiscal Responsibility Act of
1982 (TEFRA), adjustments attributable
to the tax items of a partnership were
made at the partner level. Section 402 of
TEFRA added sections 6221 through
6231 to the Internal Revenue Code to
allow for consolidated administrative
and judicial proceedings to determine
the tax treatment of partnership items at
the partnership level. Under this consoli-
dated proceeding, the tax matters partner
of a partnership represents the partner-
ship before the IRS in all tax matters for
a specific taxable year.
Section 6231(a)(7) provides that the
tax matters partner of a partnership is
the general partner designated as the tax
matters partner as provided in regula-
tions or, if no general partner is desig-
nated, the general partner having the
largest profits interest in the partnership
at the close of the taxable year involved
(largest-profits-interest rule). Section
6231(a)(7) also provides that, if no
general partner is designated and the
Commissioner determines that it is im-
practicable to apply the largest-profits-
interest rule, the partner selected by the
Commissioner is treated as the tax mat-
ters partner.
On April 18, 1986, a notice of pro-
posed rulemaking (LR–205–82) con-
cerning sections 6221 through 6231 and
section 6233 was published in theFed-
eral Register(51 FR 13231). The no-
tice of proposed rulemaking included
guidance concerning designating tax
matters partners. Several comments on
the proposed regulations were received,
but no public hearing was requested and
none was held. Temporary regulations
identical to the proposed regulations in
LR–205–82 were published in theFed-
eral Register(52 FR 6779) on March 5,
1987.
On February 29, 1988, the IRS pub-
lished Rev. Proc. 88–16 (1988–1 C.B.
691). This revenue procedure describes
circumstances under which the IRS will
determine that it is impracticable to
apply the largest-profits-interest rule and
describes the criteria the IRS will con-
sider in selecting a tax matters partner
for the partnership.
Since the enactment of TEFRA, all
states and several foreign jurisdictions
have enacted laws providing for the
formation of limited liability companies
(LLCs). LLCs in most jurisdictions may
be classified for Federal tax purposes
either as partnerships or associations
29

that are taxable as corporations. For
LLCs that are classified as partnerships
for Federal tax purposes, it is necessary
to determine the tax matters partner for
the LLC.
On October 30, 1995, a notice of
proposed rulemaking (PS–34–92) con-
cerning section 6231(a)(7) was pub-
lished in theFederal Register(60 FR
55228). The notice of proposed
rulemaking amended proposed regula-
tions to consolidate certain guidance
necessary to determine the tax matters
partner for partnerships. The notice of
proposed rulemaking also proposed
guidance concerning the designation or
selection of a tax matters partner for
limited liability companies classified as
partnerships. No public hearing was re-
quested or held, and no written com-
ments were received.
Explanation of Provisions
The regulations concerning the desig-
nation or selection of tax matters part-
ners proposed by LR–205–82 and PS–
34–92 are adopted, with minor stylistic
changes, by this Treasury decision. The
corresponding temporary regulations are
removed.
Effect on Other Documents
Rev. Proc. 88–16 is obsolete as of
December 23, 1996.
Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in EO 12866.
Therefore, a regulatory assessment is not
required. It also has been determined
that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does
not apply to these regulations, and be-
cause the notice of proposed rulemaking
preceding the regulations was issued
prior to March 29, 1996, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does
not apply.
Drafting Information
The principal author of these regula-
tions is D. Lindsay Russell, Office of
Assistant Chief Counsel (Passthroughs
and Special Industries). However, other
personnel from the IRS and Treasury
Department participated in their devel-
opment.
* * * * *
26 CFR Part 602
Reporting and recordkeeping require-
ments.
Adoption of Amendments to the Regula-
tions
Accordingly, 26 CFR parts 301 and
602 are amended as follows:
PART 301—PROCEDURE AND AD-
MINISTRATION
Paragraph 1. The authority citation for
part 301 is amended by removing the
entry for section 301.6231(a)(7)–1T and
adding entries in numerical order to read
as follows:
Authority: 26 U.S.C. 7805 * * *
Section 301.6231(a)(7)–1 also issued
under 26 U.S.C. 6230 (i) and (k).
Section 301.6231(a)(7)–2 also issued
under 26 U.S.C. 6230 (i) and (k). * * *
Par. 2. Section 301.6231(a)(7)–1T is
removed.
Par. 3. Section 301.6231(a)(7)–1 is
added to read as follows:
§ 301.6231(a)(7)–1 Designation or se-
lection of tax matters partner.
(a)In general.A partnership may
designate a partner as its tax matters
partner for a specific taxable year only
as provided in this section. Similarly,
the designation of a partner as the tax
matters partner for a specific taxable
year may be terminated only as pro-
vided in this section. If a partnership
does not designate a general partner as
the tax matters partner for a specific
taxable year, or if the designation is
terminated without the partnership des-
ignating another general partner as the
tax matters partner, the tax matters part-
ner is the partner determined under this
section.
(b)Person who may be designated
tax matters partner—(1)General re-
quirement.A person may be designated
as the tax matters partner of a partner-
ship for a taxable year only if that
person—
(i) Was a general partner in the part-
nership at some time during the taxable
year for which the designation is made;
or
(ii) Is a general partner in the part-
nership as of the time the designation is
made.
(2)Limitation on designation of tax
matters partner who is not a United
States person.If any United States per-
son would be eligible under paragraph
(a) of this section to be designated as
the tax matters partner of a partnership
for a taxable year, no person who is not
a United States person may be desig-
nated as the tax matters partner of the
partnership for that year without the
consent of the Commissioner. For the
definition ofUnited States person, see
section 7701(a)(30).
(c)Designation of tax matters part-
ner at time partnership return is filed.
The partnership may designate a tax
matters partner for a partnership taxable
year on the partnership return for that
taxable year in accordance with the
instructions for that form.
(d)Certification by current tax mat-
ters partner of selection of successor.If
a partner properly designated as the tax
matters partner of a partnership for a
partnership taxable year under this sec-
tion certifies that another partner has
been selected as the tax matters partner
of the partnership for that taxable year,
that other partner is thereby designated
as the tax matters partner for that year.
The current tax matters partner shall
make the certification by filing with the
service center with which the partner-
ship return is filed a statement that—
(1) Identifies the partnership, the
partner filing the statement, and the
successor tax matters partner by name,
address, and taxpayer identification
number;
(2) Specifies the partnership taxable
year to which the designation relates;
(3) Declares that the partner filing the
statement has been properly designated
as the tax matters partner of the partner-
ship for the partnership taxable year and
that that designation is in effect immedi-
ately before the filing of the statement;
(4) Certifies that the other named
partner has been selected as the tax
matters partner of the partnership for
that taxable year in accordance with the
partnership’s procedure for making that
selection; and
(5) Is signed by the partner filing the
statement.
(e)Designation by general partners
with majority interest.The partnership
may designate a tax matters partner for
a partnership taxable year at any time
after the filing of a partnership return
for that taxable year by filing a state-
ment with the service center with which
the partnership return was filed. The
statement shall—
(1) Identify the partnership and the
designated partner by name, address,
and taxpayer identification number;
(2) Specify the partnership taxable
year to which the designation relates;
(3) Declare that it is a designation of
a tax matters partner for the taxable year
specified; and
(4) Be signed by persons who were
general partners at the close of the year
30

and were shown on the return for that
year to hold more than 50 percent of the
aggregate interest in partnership profits
held by all general partners as of the
close of that taxable year. For purposes
of this paragraph (e)(4), all limited part-
nership interests held by general part-
ners shall be included in determining the
aggregate interest in partnership profits
held by such general partners.
(f)Designation by partners with ma-
jority interest under certain circum-
stances—(1)In general.A tax matters
partner may be designated for a partner-
ship taxable year under this paragraph
(f) only if, at the time the designation is
made, each partner who was a general
partner at the close of such partnership
taxable year is described in one or more
of paragraphs (f)(1)(i) through (iv) of
this section as follows:
(i) The general partner is dead, or, if
the general partner is an entity, has been
liquidated or dissolved;
(ii) The general partner has been ad-
judicated by a court of competent juris-
diction to be no longer capable of
managing his or her person or estate;
(iii) The general partner’s partnership
items have become nonpartnership items
under section 6231(b); or
(iv) The general partner is no longer
a partner in the partnership.
(2)Method of making designation.A
tax matters partner for a partnership
taxable year may be designated under
this paragraph (f) at any time after the
filing of the partnership return for such
taxable year by filing a written state-
ment with the service center with which
the partnership return was filed. The
statement shall—
(i) Identify the partnership and the
designated tax matters partner by name,
address, and taxpayer identification
number;
(ii) Specify the partnership taxable
year to which the designation relates;
(iii) Declare that it is a designation of
a tax matters partner for the partnership
taxable year specified; and
(iv) Be signed by persons who were
partners at the close of such taxable
year and were shown on the return for
that year to hold more than 50 percent
of the aggregate interest in partnership
profits held by all partners as of the
close of such taxable year.
(g)Designation of alternate tax mat-
ters partner.If an individual is desig-
nated as the tax matters partner of a
partnership under paragraph (c), (d), (e),
or (f) of this section, the document by
which that individual is designated may
also designate an alternate tax matters
partner who will become tax matters
partner upon the occurrence of one or
more of the events described in para-
graph (l)(1)(i) or (ii) of this section. The
person designated as the alternate tax
matters partner becomes the tax matters
partner as of the time the designation of
the tax matters partner is terminated
under paragraph (l)(1)(i) or (ii) of this
section. The designation of a person as
the alternate tax matters partner shall
have no effect in any other case.
(h)Prior designations superseded.A
designation of a tax matters partner for
a partnership taxable year under para-
graphs (d), (e), or (f) of this section
shall supersede all prior designations of
a tax matters partner for that year,
including a prior designation of an alter-
nate tax matters partner under paragraph
(g) of this section.
(i)Resignation of designated tax mat-
ters partner.A person designated as the
tax matters partner of a partnership
under this section may resign at any
time by a written statement to that
effect. The statement shall specify the
partnership taxable year to which the
resignation relates and shall identify the
partnership and the tax matters partner
by name, address, and taxpayer identifi-
cation number. The statement shall also
be signed by the resigning tax matters
partner and shall be filed with the
service center with which the partner-
ship return was filed.
(j)Revocation of designation.The
partnership may revoke the designation
of the tax matters partner for a partner-
ship taxable year at any time after the
filing of a partnership return for that
taxable year by filing a statement with
the service center with which the part-
nership return was filed. The statement
shall—
(1) Identify by name, address, and
taxpayer identification number the part-
nership and the general partner whose
designation as tax matters partner is
being revoked;
(2) Specify the partnership taxable
year to which the revocation relates;
(3) Declare that it is a revocation of a
designation of the tax matters partner
for the taxable year specified; and
(4) Be signed by the persons de-
scribed in paragraph (e)(4) of this sec-
tion, or, if at the time that the revocation
is made, each partner who was a general
partner at the close of the partnership
taxable year to which the revocation
relates is described in one or more of
paragraphs (f)(1)(i) through (iv) of this
section, by the persons described in
paragraph (f)(2)(iv) of this section.
(k)When designation, etc., becomes
effective—(1)In general.Except as oth-
erwise provided in paragraph (k)(2) of
this section, a designation, resignation,
or revocation provided for in this sec-
tion becomes effective on the day that
the statement required by the applicable
paragraph of this section is filed.
(2)Notice of proceeding mailed.If a
notice of beginning of an administrative
proceeding with respect to a partnership
taxable year is mailed before the date on
which a statement of designation, resig-
nation, or revocation provided for in this
section with respect to that taxable year
is filed, the Service is not required to
give effect to such designation, resigna-
tion, or revocation until 30 days after
the statement is filed.
(l)Termination of designation—(1)In
general.A designation of a tax matters
partner for a taxable year under this
section shall remain in effect until—
(i) The death of the designated tax
matters partner;
(ii) An adjudication by a court of
competent jurisdiction that the indi-
vidual designated as the tax matters
partner is no longer capable of manag-
ing the individual’s person or estate;
(iii) The liquidation or dissolution of
the tax matters partner, if the tax matters
partner is an entity;
(iv) The partnership items of the tax
matters partner become nonpartnership
items under section 6231(c) (relating to
special enforcement areas); or
(v) The day on which—
(A) The resignation of the tax matters
partner under paragraph (i) of this sec-
tion;
(B) A subsequent designation under
paragraph (d), (e), or (f) of this section;
or
(C) A revocation of the designation
under paragraph (j) of this section be-
comes effective.
(2)Actions by the tax matters partner
before termination of designation.The
termination of the designation of a part-
ner as the tax matters partner under
paragraph (l)(1) of this section does not
affect the validity of any action taken by
that partner as tax matters partner before
the designation is terminated. For ex-
ample, if that tax matters partner had
previously consented to an extension of
the period for assessments under section
6229(b)(1)(B), that extension remains
valid even after termination of the des-
ignation.
31

(m)Tax matters partner where no
partnership designation made—(1)In
general.The tax matters partner for a
partnership taxable year shall be deter-
mined under this paragraph (m) if—
(i) The partnership has not designated
a tax matters partner under this section
for that taxable year; or
(ii) The partnership has designated a
tax matters partner under this section for
that taxable year, that designation has
been terminated under paragraph (l)(1)
of this section, and the partnership has
not made a subsequent designation un-
der this section for that taxable year.
(2)General partner having the larg-
est profits interest is the tax matters
partner.The tax matters partner for any
partnership taxable year to which this
paragraph (m) applies is the general
partner having the largest profits interest
in the partnership at the close of that
taxable year (or where there is more
than one such partner, the one of such
partners whose name would appear first
in an alphabetical listing). For purposes
of this paragraph (m)(2), all limited
partnership interests held by a general
partner shall be included in determining
that general partner’s profits interest in
the partnership. For purposes of this
paragraph (m)(2), the general partner
with the largest profits interest is deter-
mined based on the year-end profits
interests reported on the Schedules K–1
filed with the partnership income tax
return for the taxable year for which the
determination is being made.
(3)Termination of designation.A
designation of a tax matters partner for
a partnership taxable year under this
paragraph (m) shall remain in effect
until the earlier of the occurrence of one
or more of the events described in
paragraphs (l)(1)(i) through (iv) of this
section or the day on which a designa-
tion under paragraph (d), (e), or (f) of
this section becomes effective. If a des-
ignation of a tax matters partner for a
partnership taxable year is terminated
under this paragraph (m)(3) and the
partnership has not subsequently desig-
nated a tax matters partner for that
taxable year under paragraph (d), (e), or
(f) of this section, the tax matters part-
ner for that taxable year shall be deter-
mined under paragraph (m)(2) of this
section, and, for purposes of applying
paragraph (m)(2) of this section, the
general partner whose designation was
so terminated shall be treated as having
no profits interest in the partnership for
that taxable year.
(n)Selection of tax matters partner
by Commissioner when impracticable to
apply the largest-profits-interest rule.If
the partnership has not designated a tax
matters partner under this section for the
taxable year and it is impracticable (as
determined under paragraph (o) of this
section) to apply the largest-profits-
interest rule of paragraph (m)(2) of this
section, the Commissioner will select a
tax matters partner as described in para-
graph (p) of this section.
(o)Impracticability of largest-profits-
interest rule.It is impracticable to apply
the largest-profits-interest rule of para-
graph (m)(2) of this section if, on the
date the rule is applied, any one of the
following three conditions is met:
(1)General partner with the largest
profits interest is not apparent.The
general partner with the largest profits
interest is not apparent from the Sched-
ules K–1 and is not otherwise readily
determinable.
(2)Each general partner is deemed
to have no profits interest in the part-
nership.Each general partner is deemed
to have no profits interest in the partner-
ship under paragraph (m)(3) of this
section (concerning termination of a
designation under the largest-profits-
interest rule) because of the occurrence
of one or more of the events described
in paragraphs (l)(1)(i) through (iv) of
this section (involving death, adjudica-
tion of incompetency, liquidation, and
conversion of partnership items to
nonpartnership items).
(3)General partner with the largest
profits interest is disqualified.The gen-
eral partner with the largest profits inter-
est determined under paragraph (m)(2)
of this section—
(i) Has been notified of suspension
from practice before the Internal Rev-
enue Service;
(ii) Is incarcerated;
(iii) Is residing outside the United
States, its possessions, or territories; or
(iv) Cannot be located or cannot per-
form the functions of a tax matters
partner for any reason, except that lack
of cooperation with the Internal Rev-
enue Service by the general partner with
the largest profits interest is not a basis
for finding that the partner cannot per-
form the functions of a tax matters
partner.
(p)Commissioner’s selection of the
tax matters partner—(1)When the gen-
eral partner with the largest profits
interest is not apparent.If it is impracti-
cable under paragraph (o)(1) of this
section to apply the largest-profits-
interest rule of paragraph (m)(2) of this
section, the Commissioner will select (in
accordance with the notification proce-
dures set forth in paragraph (r) of this
section) as the tax matters partner any
person who was a general partner at any
time during the taxable year under ex-
amination.
(2)When each general partner is
deemed to have no profits interest in the
partnership.If it is impracticable under
paragraph (o)(2) of this section to apply
the largest-profits-interest rule of para-
graph (m)(2) of this section, the Com-
missioner will select a partner (including
a general or limited partner) as the tax
matters partner in accordance with the
criteria set forth in paragraph (q) of this
section. The Commissioner will notify
both the partner selected and the part-
nership of the selection, effective as of
the date specified in the notice.
(3)When the general partner with
the largest profits interest is disquali-
fied—(i)In general.Except as otherwise
provided in paragraph (p)(3)(ii) of this
section, if it is impracticable under para-
graph (o)(3) of this section to apply the
largest-profits-interest rule of paragraph
(m)(2) of this section, the Commissioner
will treat each general partner who fits
the criteria contained in paragraph (o)(3)
of this section as having no profits
interest in the partnership for the taxable
year and will select (in accordance with
the notification procedures set forth in
paragraph (r) of this section) a tax
matters partner from the remaining per-
sons who were general partners at any
time during the taxable year.
(ii)Partner selected if no general
partner may be selected.If all general
partners during the taxable year either
are treated as having no profits interest
in the partnership for the taxable year
under paragraph (m)(3) of this section
(concerning termination of a designation
under the largest-profits-interest rule) or
are described in paragraph (o)(3) of this
section (general partner with the largest
profits interest is disqualified), the Com-
missioner will select a partner (including
a general or limited partner) as the tax
matters partner in accordance with the
criteria set forth in paragraph (q) of this
section. The Commissioner will notify
both the partner selected and the part-
nership of the selection, effective as of
the date specified in the notice.
(q)Criteria for selecting a partner as
tax matters partner—(1)In general.The
Commissioner will select a partner as
the tax matters partner under paragraph
(p)(2) or (3)(ii) of this section only if
32

the partner was a partner in the partner-
ship at the close of the taxable year
under examination.
(2)Criteria to be considered.The
Commissioner may consider the follow-
ing criteria in selecting a partner as the
tax matters partner:
(i) The general knowledge of the
partner in tax matters and the adminis-
trative operation of the partnership.
(ii) The partner’s access to the books
and records of the partnership.
(iii) The profits interest held by the
partner.
(iv) The views of the partners having
a majority interest in the partnership
regarding the selection.
(v) Whether the partner is a partner
of the partnership at the time the tax-
matters-partner selection is made.
(vi) Whether the partner is a United
States person (within the meaning of
section 7701(a)(30)).
(3)Limited restriction on subsequent
designation of a tax matters partner by
the partnership.For purposes of para-
graphs (p)(2) and (3)(ii) of this section,
the partnership cannot designate a part-
ner who is not a general partner to serve
as tax matters partner in lieu of a
partner selected by the Commissioner.
(r)Notification of partnership—(1)In
general.If the Commissioner selects a
tax matters partner under the provisions
of paragraph (p)(1) or (3)(i) of this
section, the Commissioner will notify
both the partner selected and the part-
nership of the selection, effective as of
the date specified in the notice.
(2)Limited opportunity for partner-
ship to designate the tax matters part-
ner.(i) Before the Commissioner selects
a tax matters partner under paragraphs
(p)(1) and (3)(i) of this section, the
Commissioner will notify the partner-
ship by mail that, after 30 days from the
date of the notice, the Commissioner
will make a determination that it is
impracticable to apply the largest-
profits-interest rule of paragraph (m)(2)
of this section and will select the tax
matters partner unless a prior designa-
tion is made by the partnership. This
delay in making the determination will
permit the partnership to designate a tax
matters partner under paragraph (e) of
this section (designation by general part-
ners with a majority interest) or para-
graph (f) of this section (designation by
partners with a majority interest under
certain circumstances), thereby avoiding
a selection made by the Commissioner.
(ii) During the 30-day period and
prior to a tax-matters-partner designation
by the partnership, the Commissioner
will communicate with the partnership
by sending all correspondence or notices
to ‘‘The Tax Matters Partner’’ in care of
the partnership at the partnership’s ad-
dress.
(iii) Any subsequent designation of a
tax matters partner by the partnership
after the 30-day period will become
effective as provided under paragraph
(k)(2) of this section (concerning desig-
nations made after a notice of beginning
of administrative proceeding is mailed).
(s)Effective date.This section applies
to all designations, selections, and termi-
nations of a tax matters partner occur-
ring on or after December 23, 1996.
Par. 4. Section 301.6231(a)(7)–2 is
added to read as follows:
§ 301.6231(a)(7)–2 Designation or se-
lection of tax matters partner for a
limited liability company (LLC).
(a)In general.Solely for purposes of
applying section 6231(a)(7) and
§ 301.6231(a)(7)–1 to an LLC, only a
member-manager of an LLC is treated
as a general partner, and a member of
an LLC who is not a member-manager
is treated as a partner other than a
general partner.
(b)Definitions—(1)LLC.Solely for
purposes of this section, LLC means an
organization—
(i) Formed under a law that allows
the limitation of the liability of all
members for the organization’s debts
and other obligations within the mean-
ing of § 301.7701–3(b)(2)(ii); and
(ii) Classified as a partnership for
Federal tax purposes.
(2)Member.Solely for purposes of
this section,membermeans any person
who owns an interest in an LLC.
(3)Member-manager.Solely for pur-
poses of this section,member-manager
means a member of an LLC who, alone
or together with others, is vested with
the continuing exclusive authority to
make the management decisions neces-
sary to conduct the business for which
the organization was formed. Generally,
an LLC statute may permit the LLC to
choose management by one or more
managers (whether or not members) or
by all of the members. If there are no
elected or designated member-managers
(as so defined in this paragraph (b)(3))
of the LLC, each member will be
treated as a member-manager for pur-
poses of this section.
(c)Effective date.This section ap-
plies to all designations, selections, and
terminations of a tax matters partner of
an LLC occurring on or after December
23, 1996. Any other reasonable designa-
tion or selection of a tax matters partner
of an LLC is binding for periods prior
to December 23, 1996.
PART 602—OMB CONTROL NUM-
BERS UNDER THE PAPERWORK
REDUCTION ACT
Par. 5. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 6. In § 602.101, paragraph (c) is
amended by adding the entry
‘‘301.6231(a)(7)–1....1545–0790’’ in nu-
merical order to the table.
Michael P. Dolan,
Acting Commissioner of Internal
Revenue.
Approved November 8, 1996.
Donald C. Lubick,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on
December 20, 1996, 8:45 a.m., and published in
the issue of the Federal Register for December 23,
1996, 61 F.R. 67454)
33

Part IV. Items of General Interest
Notice of Proposed Rulemaking
and Notice of Public Hearing
Qualified Electing Fund Elections
REG–209040–88
AGENCY: Internal Revenue Service
(IRS), Treasury
ACTION: Notice of proposed rulemak-
ing and notice of public hearing.
SUMMARY: This document contains
proposed regulations permitting certain
shareholders to make a special election
under section 1295, in lieu of the elec-
tion currently provided for under that
section, with respect to certain preferred
shares of a passive foreign investment
company (PFIC). A shareholder that
makes a special election must account
for dividend income on the shares sub-
ject to the special election under special
income inclusion rules, rather than under
the general income inclusion rules of
section 1293. This document also pro-
vides notice of a public hearing on these
proposed regulations.
DATES: Written comments must be re-
ceived by March 24, 1997. Requests to
speak and outlines of oral comments to
be discussed at the public hearing
scheduled for May 8, 1997, at 10:00
a.m. must be received by April 17,
1997.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (REG–209040–88),
room 5226, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington, DC 20044. Submissions may be
hand delivered between the hours of 8
a.m. and 5 p.m. to: CC:DOM:CORP:R
REG–209040–88), Courier’s Desk, In-
ternal Revenue Service, 1111 Constitu-
tion Avenue, NW, Washington, DC. Al-
ternatively, taxpayers may submit
comments electronically via the Internet
by selecting the ‘‘Tax Regs’’ option on
the IRS Home Page, or by submitting
comments directly to the IRS Internet
site at http://www.irs.ustreas.gov/prod/
tax_regs/comments.html. The public
hearing will be held in room 3313,
Internal Revenue Building, 1111 Consti-
tution Avenue, NW, Washington, DC.
FOR FURTHER INFORMATION CON-
TACT: Concerning the regulations,
Judith Cavell Cohen, (202) 622–3880;
concerning submissions and the hearing,
Evangelista Lee, (202) 622–7190 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information con-
tained in this notice of proposed
rulemaking has been submitted to the
Office of Management and Budget for
review in accordance with the Paper-
work Reduction Act of 1995 (44 U.S.C.
3507(d)). Comments on the collection of
information should be sent to theOffice
of Management and Budget, Attn:
Desk Officer for the Department of the
Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503, with copies to theInternal Rev-
enue Service, Attn: IRS Reports Clear-
ance Officer, T:FP, Washington, DC
20224. Comments on the collection of
information should be received by Feb-
ruary 24, 1997. Comments are specifi-
cally requested concerning:
Whether the proposed collection of in-
formation is necessary for the proper
performance of the functions of the
Internal Revenue Service, including
whether the information will have prac-
tical 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
enhanced;
How the burden of complying with the
proposed collection of information may
be minimized, including through the
application of automated collection tech-
niques 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 proposed regu-
lation § 1.1295–2(c)(3) and proposed
regulation § 1.1295–2(e) and (f). This
information will notify the Commis-
sioner that certain shareholders have
made the special election. In addition,
this information will enable the IRS to
determine if a shareholder qualifies for
the special election and is satisfying the
income inclusion requirements of pro-
posed regulation § 1.1293–2. The col-
lection of information is mandatory. The
likely respondents are individuals, busi-
nesses, and other for-profit organiza-
tions.
Estimated total annual reporting/
recordkeeping burden: 600 hours. The
estimated annual burden per respondent
varies from 21 minutes to 8.3 hours,
depending on individual circumstances,
with an estimated average of 35 min-
utes.
Estimated number of respondents: 1030.
Estimated annual frequency of re-
sponses: On occasion.
An agency may not conduct or spon-
sor, and a person is not required to
respond to, a collection of information
unless the collection of information dis-
plays a valid control number assigned
by the Office of Management and Bud-
get.
Books or records relating to a collec-
tion of information must be retained as
long as their contents may become ma-
terial in the administration of any inter-
nal revenue law. Generally, tax returns
and tax return information are confiden-
tial, as required by 26 U.S.C. 6103.
Background
This document contains proposed In-
come Tax Regulations (26 CFR part 1)
under sections 1293 and 1295 of the
Internal Revenue Code. Sections 1293
and 1295 were added by the Tax Re-
form Act of 1986 (the Act) and were
amended by the Technical and Miscella-
neous Revenue Act of 1988 (TAMRA).
The sections, as amended, were effec-
tive for taxable years of foreign corpora-
tions beginning after December 31,
1986. Section 1293 also was amended
by the Omnibus Reconciliation Act of
1993 (OBRA). Guidance for making the
section 1295 election was provided in
proposed regulation § 1.1295–1 and No-
tice 88–125, 1988–2 C.B. 535. Guidance
regarding the annual income inclusion
rule for shareholders making a section
1295 election was provided in proposed
regulation § 1.1293–1.
Explanation of Provisions
Special Preferred Section 1295 Election
1. Introduction
The passive foreign investment com-
pany (PFIC) rules of the Code are
designed to eliminate potential tax de-
ferral opportunities associated with eq-
uity investments by United States per-
sons in foreign corporations that have
substantial levels of passive income or
assets. The PFIC rules eliminate tax
deferral opportunities by applying the
section 1291 interest charge regime to
PFIC shareholders that fail to make a
341997–7 I.R.B.

section 1295 annual income inclusion
election (section 1295 election). In gen-
eral, the section 1291 interest charge
regime applies to the ‘‘extraordinary’’
portion of any distribution received by
the shareholder, and any gain recognized
on a disposition of shares.
The PFIC rules apply to investments
in both common and preferred shares of
a PFIC. Preferred shares, unlike com-
mon shares, generally provide for lim-
ited dividend and liquidation or redemp-
tion rights, and thus do not participate
significantly in corporate growth. Ac-
cordingly, preferred shares of a PFIC
generally do not afford U.S. investors
with the same potential for U.S. tax
deferral as common shares of a PFIC.
Preferred shareholders, like common
shareholders, may make the section
1295 election to avoid the interest
charge regime of section 1291. Share-
holders that make the section 1295
election are required under section 1293
to include in income annually, as ordi-
nary income, their pro rata share of the
PFIC’s ordinary earnings and, as long-
term capital gain, their pro rata share of
the PFIC’s net capital gain for the year.
In order to determine their pro rata
share of ordinary earnings and net capi-
tal gain, shareholders that have made a
section 1295 election must obtain cer-
tain U.S. tax accounting information
from the PFIC regarding the PFIC’s
earnings. If this information is not avail-
able, the shareholders cannot make the
section 1295 election. If the requisite
information is available, the annual in-
formation reporting and collection re-
quirements associated with the section
1295 election may render the election
impractical for smaller investors. Be-
cause preferred shares often do not
afford investors with significant tax-
deferral opportunity, commenters have
suggested that the current section 1295
election regime should be simplified for
certain types of preferred shares.
The proposed regulations adopt a spe-
cial section 1295 election regime that
would require holders of certain pre-
ferred shares of a PFIC that elect to be
subject to the regime to accrue annually
ordinary dividend income with respect
to the preferred shares regardless of the
holder’s pro rata share of ordinary earn-
ings or net capital gain of the PFIC for
the year. Because shareholders would
accrue income regardless of the earnings
and net capital gain of the PFIC, share-
holders that elect to be subject to the
regime would not have to report and
collect any U.S. tax accounting informa-
tion regarding the PFIC in order to
make the special section 1295 election.
The proposed regulations are issued
under two sections of the Code. Section
1.1295–2 of the proposed regulations
provides rules for making a QEF elec-
tion under the special proposed section
1295 election regime (special preferred
QEF election). Section 1.1293–2 de-
scribes the annual income inclusion
rules for shareholders that have made
the special preferred QEF election.
The proposed regulations would apply
only with respect to qualifying preferred
shares issued after the date the proposed
regulations are finalized.
2. Rules for making the special pre-
ferred QEF election
Under proposed regulation § 1.1295–
2(a), the special preferred QEF election
may be made in lieu of the section 1295
election described in proposed regula-
tion § 1.1295–1 and Notice 88–125,
1988–2 C.B. 535 (regular section 1295
election), with respect to certain types of
preferred shares (qualified preferred
shares) by certain holders satisfying pre-
scribed ownership requirements.
The special preferred QEF election
may only be made with respect to
qualified preferred shares as defined in
proposed regulation § 1.1295–2(b). To
ensure that the special preferred QEF
election cannot be used for tax avoid-
ance purposes and to reduce complexity,
the proposed regulations define qualified
preferred shares narrowly to include
only a limited class of preferred shares
likely to be marketed to U.S. retail
investors. Although the definition of
qualified preferred shares includes both
cumulative and non-cumulative pre-
ferred shares, the definition excludes
various types of preferred shares, includ-
ing preferred shares denominated in a
foreign currency and preferred shares
issued at a significant discount to their
liquidation or redemption amounts. The
PFIC issuing the preferred shares must
represent that it intends to pay dividends
currently. Proposed regulation
§ 1.1295–2(b) provides additional re-
strictions with respect to preferred
shares acquired in secondary market
transactions.
Proposed regulation § 1.1295–2(c)
describes shareholders who may make
the election. Under proposed regulation
§ 1.1295–2(c)(1), any United States per-
son that acquires qualified preferred
shares for cash or in certain nonrecogni-
tion transactions and that holds such
shares directly may make the election.
United States persons that are pass-
through entities, including partnerships,
S corporations, trusts and estates, may
qualify as shareholders.
The special preferred QEF election
regime is narrowly targeted to eliminate
certain of the information reporting and
collection requirements associated with
the existing section 1295 election and
annual inclusion rules for U.S. retail
investors in preferred shares of PFICs.
Treasury and the Service believe that the
special preferred QEF election regime
should only apply with respect to for-
eign corporations that are not expected
to be in a position to provide U.S. tax
accounting information to shareholders.
Accordingly, proposed regulation
§ 1.1295–2(c)(2) provides that the spe-
cial preferred QEF election does not
apply to holders of preferred shares in a
PFIC that is a controlled foreign corpo-
ration. Further, proposed regulation
§ 1.1295–2(c)(3) provides that the spe-
cial preferred QEF election does not
apply to holders that own 5 percent or
more of the vote or value of any class
of shares of the PFIC. Holders of five
percent or more of the vote or value of
any class of shares generally are not the
type of retail investor that the proposed
regulations are designed to assist. Such
holders may only make the section 1295
election provided under current rules.
Proposed regulation § 1.1295–2(c)(3)
requires the corporation to provide to
electing shareholders a statement, di-
rectly or in a disclosure document gen-
erally available to all U.S. shareholders,
either that it is or that it reasonably
believes that it is a PFIC and that it is
not a controlled foreign corporation.
Shareholders that fail to receive such a
statement are not permitted to make a
special preferred QEF election
Proposed regulation § 1.1295–2(d)
describes the effect of the special pre-
ferred QEF election. Proposed regulation
§ 1.1295–2(d)(1) provides that shares
subject to a special preferred QEF elec-
tion will be treated as shares of a
pedigreed QEF (as defined in proposed
regulation § 1.1291–1(b)(2)(ii)) for all
taxable years of the foreign corporation
that are included wholly or partly in the
shareholder’s holding period of the
shares. Under the proposed regulations,
the election will apply to all qualified
preferred shares of a foreign corporation
owned directly by the shareholder that
are acquired in the taxable year with
respect to which the election is made.
Although a special preferred QEF elec-
tion will not apply automatically to
351997–7 I.R.B.

qualified preferred shares acquired in
subsequent taxable years of a share-
holder, the proposed regulations permit
the shareholder to make separate special
preferred QEF elections with respect to
qualified preferred shares acquired in
later years.
Proposed regulation § 1.1295–2(d)(2)
provides that the special preferred QEF
election regime applies whether or not
the foreign corporation is a PFIC in any
year subsequent to the year of the
election. Accordingly, shareholders that
make the special preferred QEF election
must make annual § 1.1293–2 income
inclusions, as provided in proposed
regulation § 1.1295–2(d)(3), even if the
foreign corporation does not qualify as a
PFIC for a particular year.
Proposed regulation § 1.1295–2(e)
specifies the time and manner of making
the special preferred QEF election. In
order to make the special preferred QEF
election, a shareholder files Form 8621
(Return by a Shareholder of a Passive
Foreign Investment Company or Quali-
fied Electing Fund), for the taxable year
of the election, checking the appropriate
box in Form 8621, Part I, for making
the section 1295 election, and indicating
in the margin of Part I that the share-
holder is making a special preferred
QEF election with respect to certain
specified shares. In addition, the share-
holder must attach to Form 8621 a brief
statement containing the information and
representations contained in proposed
regulation § 1.1295–2(e)(2)(ii). Under
proposed regulation § 1.1295–2(f), in
subsequent years, the shareholder must
file Form 8621 with respect to the
foreign corporation but need not attach
any statement to the form. For all
taxable years covered by the election,
the shareholder must report on Line 6a
of Part II of Form 8621 the amount
includible under proposed regulation
§ 1.1293–2 with respect to qualified
preferred shares subject to a special
preferred QEF election.
Proposed regulation § 1.1293–2(g)
states that a sale, exchange or other
disposition of shares subject to a special
preferred QEF election terminates the
election with respect to those shares.
Also, the Commissioner may terminate
or invalidate an election if a shareholder
fails to satisfy the initial or ongoing
requirements of the election. For ex-
ample, the Commissioner may terminate
or invalidate a special preferred QEF
election if the shareholder owns five
percent or more of the vote or value of
any class of shares of the PFIC at any
time during the period that the share-
holder owns qualified preferred shares
subject to the election. A shareholder
may not itself terminate a special pre-
ferred QEF election.
3. Annual inclusion rules for electing
shareholders
Under proposed regulation § 1.1293–
2(a), a shareholder that has made a
special preferred QEF election must
make annual income inclusions with
respect to qualified preferred shares sub-
ject to the election. Unlike the annual
income inclusions provided under sec-
tion 1293 and proposed regulation
§ 1.1293–1, the annual inclusions under
the special preferred QEF election re-
gime are determined without regard to
the shareholder’s pro rata share of the
foreign corporation’s ordinary earnings
or net capital gains.
Proposed regulation § 1.1293–2(b)
provides rules for determining the
amount that a shareholder must include
in income annually under the special
preferred QEF election regime. Under
the proposed regulations, this annual
amount consists of two components. The
first component is an annual inclusion
amount based on a ratable daily portion
of dividend income that accrues on the
qualified preferred shares (annual divi-
dend amount). This ratable inclusion
rule for the annual dividend amount is
analogous to the rule for inclusion of
income with respect to periodic pay-
ments on notional principal contracts
under § 1.446–3. The second compo-
nent of the preferred QEF amount arises
only in respect of fixed term preferred
shares, as described proposed regulation
§ 1.1295–2(b)(vii), acquired in a sec-
ondary market transaction, and is calcu-
lated based on the ratable inclusion of
the excess, if any, of the redemption
price of the shares over the acquisition
cost of the shares (preferred discount
amount). This ratable inclusion rule for
the preferred discount amount is analo-
gous to the rule for the ratable inclusion
of market discount on certain debt under
section 1276(b)(1). The Service and
Treasury solicit comments regarding the
income inclusion rules of the proposed
regulations, including comments as to
whether foreign corporations and their
agents could effectively assist holders in
complying with the income inclusion
rules applicable to preferred discount.
Proposed regulation § 1.1293–2(c)
provides certain special rules regarding
the annual income inclusion required
under proposed regulation § 1.1293–
2(a). Under § 1.1293–2(c)(1), annual
amounts are included in income by
shareholders irrespective of the PFIC’s
earnings and profits. In this regard, the
special preferred QEF election differs
from the regular section 1295 election in
that shareholders making the special
preferred QEF election must accrue the
annual amount as ordinary income even
if the amount exceeds the shareholder’s
pro rata share of the foreign corpora-
tion’s earnings and profits. Proposed
regulation § 1.1293–2(c)(3) requires the
shareholder to include the annual divi-
dend amount as ordinary income regard-
less of whether any portion of the
PFIC’s earnings for the year represents
net capital gain. Proposed regulation
§ 1.1293–2(c)(4) provides rules for the
tax-free distribution of previously taxed
amounts. Proposed regulation § 1.1293–
2(c)(5) provides certain basis adjustment
rules similar to the basis adjustment rule
of section 1293(d). Finally, proposed
regulation § 1.1293–2(c)(6) provides
rules intended to limit the effect of a
special preferred QEF election to the
shareholder making the election. Ac-
cordingly, a special preferred QEF elec-
tion will not affect the foreign corpora-
tion’s calculation of its earnings and
profits, and will have no consequences
for shareholders that have not made a
special preferred QEF election.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in
Executive Order 12866. Therefore, a
regulatory assessment is not required. It
is hereby certified that these regulations
do not have a significant economic
impact on a substantial number of small
entities. This certification is based on
the fact that these regulations represent
a wholly elective simpler alternative to
the section 1295 election described in
§ 1.1295–1 and Notice 88–125, 1988–2
C.B. 535, and impose a lighter collec-
tion of information burden. Further, the
requirement that electing shareholders
indicate their special election on Form
8621 annually and attach a statement,
providing certain information in the first
year of the election only, is minimal and
will not impose a significant economic
impact on electing shareholders. There-
fore, a Regulatory Flexibility Analysis
under the Regulatory Flexibility Act (5
U.S.C. chapter 6) is not required. Pursu-
ant to section 7805(f) of the Internal
Revenue Code, this notice of proposed
rulemaking will be submitted to the
361997–7 I.R.B.

Chief Counsel for Advocacy of the
Small Business Administration for com-
ment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consider-
ation will be given to any written com-
ments (a signed original and eight (8)
copies) that are submitted timely to the
IRS. All comments will be available for
public inspection and copying.
A public hearing has been scheduled
for May 8, 1997, at 10:00 a.m. in room
3313, Internal Revenue Building, 1111
Constitution Avenue, NW, Washington
DC. Because of access restrictions, visi-
tors will not be admitted beyond the
Internal Revenue Building lobby more
than 15 minutes before the hearing
starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral
comments at the hearing must submit
written comments by March 24, 1997,
and submit an outline of the topics to be
discussed and the time to be devoted to
each topic (signed original and eight (8)
copies) by April 17, 1997.
A period of 10 minutes will be allot-
ted to each person for making com-
ments.
An agenda showing the schedule of
speakers will be prepared after the dead-
line 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 Judith Cavell Cohen of the
Office of Associate Chief Counsel (In-
ternational). However, other personnel
from the IRS and Treasury Department
participated in their development.
* * * * *
Proposed Amendments to the Regula-
tions
Accordingly, 26 CFR part 1 is pro-
posed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding an entry in
numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1293–2 also issued under 26
U.S.C. 1297(f).
Section 1.1295–2 also issued under 26
U.S.C. 1297(f). * * *
Par. 2. Section 1.1293–2 is added to
read as follows:
§ 1.1293–2 Special Inclusion Rules for
Special Preferred QEF Election
(a)In general.A shareholder (includ-
ing a shareholder that is a pass-through
entity, as described in § 1.1295–2(c)(1))
that makes a special preferred QEF
election under § 1.1295–2 must, regard-
less of the shareholder’s method of
accounting, include in income in respect
of each share subject to the election, an
annual amount (preferred QEF amount)
determined according to the rules of
paragraph (b) of this section. A share-
holder that makes a special preferred
QEF election must include the preferred
QEF amount in income under this sec-
tion for each year in which the taxpayer
continues to hold a share that is subject
to the election. The rules of this section
apply in lieu of the general rules of
section 1293 and § 1.1293–1.
1
(b)Preferred QEF amount—(1)In
general.The preferred QEF amount for
any share subject to a special preferred
QEF election is the sum of the ratable
daily portion of each periodic dividend
amount (as described in paragraph (b)(2)
of this section) on the share for the
taxable year of the shareholder to which
that portion relates, plus the preferred
discount amount (as defined below), if
any, for the taxable year. For purposes
of this section, the preferred discount
amount for a taxable year is the amount
that bears the same ratio to the total
amount of preferred discount (as de-
scribed in § 1.1295–2(b)(2)(i)) on the
share as the number of days that the
taxpayer held the share in the taxable
year bears to the number of days after
the date the taxpayer acquired the share
and up to (and including) the share’s
redemption date as established under the
principles of § 1.305–5(b). Notwith-
standing the preceding sentence, the pre-
ferred discount amount for a taxable
year is zero if the preferred discount on
the share at the time of its acquisition
by the shareholder was less than an
amount equal to 1/4 of 1 percent of the
redemption price of the stock, multiplied
by the number of complete years from
the date of acquisition of the stock to
the redemption date of the stock.
(2)Periodic dividend amount.A peri-
odic dividend amount is the amount
payable with respect to a share, whether
on a cumulative or noncumulative basis,
for a period (wholly or partly within the
shareholder’s taxable year) for which
dividends on the share are calculated
based upon the redemption or liquida-
tion price of the share multiplied by a
fixed percentage rate.
(c)Special rules of application—(1)
Earnings and profits disregarded.The
amounts to be included in income pur-
suant to this section are determined
without regard to the earnings and prof-
its of the foreign corporation with re-
spect to which the special preferred
QEF election applies.
(2)Year of inclusion.The shareholder
includes the preferred QEF amount in
its taxable year without regard to the
taxable year of the foreign corporation
with respect to which the special pre-
ferred QEF election applies.
(3)Character of inclusions.The
shareholder includes all preferred QEF
amounts in income as ordinary earnings.
(4)Treatment of distributions.Distri-
butions received by a shareholder on
shares subject to a special preferred
QEF election that are paid out of earn-
ings and profits of the foreign corpora-
tion are not included in gross income of
the shareholder to the extent the distri-
butions do not exceed the preferred QEF
amounts (other than any portion of
preferred QEF amounts consisting of
preferred discount amounts) previously
includible in income pursuant to this
section. These distributions will, how-
ever, be treated as dividends for all
other purposes of the Code and regula-
tions. Amounts distributed to a share-
holder with respect to shares subject to
a special preferred QEF election that
exceed amounts previously included in
income under this section with respect
to such shares are treated for all pur-
poses of the Code and regulations as a
distribution of property subject to the
rules of section 301.
(5)Basis adjustment rules.The ad-
justed basis of a shareholder in shares
that are subject to a special preferred
QEF election shall be—
(i) Increased by any amount that is
included in the gross income of the
shareholder under paragraph (a) of this
section; and
(ii) Decreased by any dividends (not
to exceed the amount included in gross
income under paragraph (a) of this sec-
tion) actually paid to the shareholder in
respect of such shares.
(6)Effect limited to electing share-
holder.This section does not apply to
the foreign corporation with respect to
which a special preferred QEF election
1
This proposed regulation was published on April
1, 1992, at 57 Fed. Reg. 11024.
371997–7 I.R.B.

applies. Accordingly, the provisions of
this section will not affect the foreign
corporation’s calculation of its earnings
and profits for any purpose of the Code
or regulations. In addition, the rules of
this section apply only for purposes of
determining the tax consequences for
holders of shares subject to the election.
Thus, the election shall have no effect
on the application of the Code or regu-
lations with respect to the tax conse-
quences of the ownership of shares that
are not subject to the election, including
for purposes of determining whether any
distributions from the foreign corpora-
tion with respect to such shares should
be treated as having been included in
the income of any United States person
pursuant to section 1293(c) or section
959.
(d)Examples.The following ex-
amples illustrate the rules of paragraphs
(a), (b) and (c) of this section. Although
these examples assume a 30-day month,
360-day year, any reasonable counting
method may be used to compute the
length of accrual periods. For purposes
of simplicity, the relevant amounts as
stated are rounded to two decimal
places. However, the computations do
not reflect any such rounding conven-
tion. The examples are as follows:
Example 1. Preferred QEF amount—(i)Facts.
(A) On May 1, 1998, A, an individual who files
his returns on a calendar year basis, purchased for
$10,000 in a single secondary market transaction
100 shares of nonconvertible Class A $100 par
value preferred stock (the Class A Stock) of FC, a
foreign corporation with a taxable year ending on
March 31.
(B) The terms of the Class A Stock provide for
a mandatory redemption of the Class A Stock by
the issuer at par on June 1, 2012. The Class A
Stock is not redeemable pursuant to an issuer call
or holder put on any other date. Each share of
Class A Stock provides for a semi-annual cumula-
tive distribution payable in dollars on June 1 and
December 1 equal to one-half the product of the
par value of the Class A Stock and the applicable
annual dollar LIBOR in effect on the distribution
date immediately prior to the relevant distribution
date. The shares of the Class A stock are qualified
preferred shares in the hands of A. A purchases no
other qualified preferred shares of FC during its
1998 or 1999 taxable years.
(C) A made a special preferred QEF election
for A’s taxable year ended December 31, 1998,
which applies to the Class A Stock acquired by A
on May 1, 1998. FC is a PFIC under section 1296
for its taxable year ending March 31, 1999, but
FC is not a PFIC for its taxable year ending
March 31, 2000. FC paid no current dividends on
June 1, 1998, and December 1, 1998, paid the
June 1, 1999, dividend currently on June 1, 1999,
together with accumulated distributions from June
1, 1998, and December 1, 1998, and paid the
December 1, 1999, dividend currently on Decem-
ber 1, 1999. The applicable annual LIBOR is 8
percent on December 1, 1997, 7 percent on June
1, 1998, 9 percent on December 1, 1998, 10
percent on June 1, 1999, and 9 percent on
December 1, 1999. FC had sufficient earnings and
profits, within the meaning of section 312, for its
taxable year ending on March 31, 2000, so that
actual distributions to all shareholders of Class A
Stock in that year were treated as paid out of
earnings and profits of FC.
(ii)Tax consequences to A for A’s taxable year
ending December 31, 1998.As required under
paragraph (a) of this section, A must include in
gross income for its 1998 taxable year the 1998
preferred QEF amount. The preferred QEF
amount, as determined under paragraph (b) of this
section, for A’s 1998 taxable year is the ratable
portion of each periodic dividend amount for that
year. For 1998, there are three periodic dividend
amounts: The periodic dividend amount for the
period from December 1, 1997, to June 1, 1998
(periodic dividend amount 1), the periodic divi-
dend amount for the period from June 1, 1998, to
December 1, 1998 (periodic dividend amount 2),
and the periodic dividend amount for the period
from December 1, 1998, to June 1, 1999 (periodic
dividend amount 3). Periodic dividend amount 1
in respect of each share owned by A is $4 (1/2
multiplied by the applicable annual LIBOR of 8
percent set on December 1, 1997, multiplied by
the $100 amount payable on redemption). Because
A acquired the shares on May 1, 1998, A’s ratable
portion of periodic dividend amount 1 for 1998 is
approximately $.67 (30/180 multiplied by $4) per
share. Periodic dividend amount 2 in respect of
each share owned by A is $3.50 (1/2 multiplied by
the applicable annual LIBOR of 7 percent set on
June 1, 1998, multiplied by $100). Because A
owned the shares for the entire period associated
with periodic dividend amount 2, A’s ratable
portion of periodic dividend amount 2 for 1998 is
the full $3.50 per share. Periodic dividend amount
3 in respect of each share owned by A is $4.50
(1/2 multiplied by the applicable annual LIBOR of
9 percent set on December 1, 1998, multiplied by
$100). Because the portion of 1998 associated
with periodic dividend amount 3 is only the month
of December, 1998, A’s ratable portion of periodic
dividend amount 3 for 1998 is approximately $.75
(30/180 multiplied by $4.50). Accordingly, A’s
preferred QEF amount for 1998 is approximately
$4.92 ($.67 + $3.5 + $.75) per share. A must
include approximately $492 (approximately $4.92
per share, multiplied by 100 shares) in income as
ordinary earnings for its 1998 tax year even
though FC paid no actual dividend to shareholders
of Class A Stock for the period in 1998 during
which A held the Class A Stock.
(iii) Tax consequences to A for A’s taxable year
ending December 31, 1999. As required under
paragraph (a) of this section, A includes in gross
income for its 1999 taxable year its preferred QEF
amount for 1999. The preferred QEF amount, as
determined under paragraph (b) of this section, for
A’s 1999 taxable year is the ratable portion of
each periodic dividend amount for that year. For
1999, there are three periodic dividend amounts:
The periodic dividend amount for the period from
December 1, 1998, to June 1, 1999 (periodic
dividend amount 1), the periodic dividend amount
for the period from June 1, 1999, to December 1,
1999 (periodic dividend amount 2), and the peri-
odic dividend amount for the period from Decem-
ber 1, 1999, to June 1, 2000 (periodic dividend
amount 3). Periodic dividend amount 1 in respect
of each share owned by A is $4.50 (1/2 multiplied
by the applicable annual LIBOR of 9 percent set
on December 1, 1998, multiplied by $100). Be-
cause A held each share of Class A Stock for five
months in 1999 for the period associated with
periodic dividend amount 1, A’s ratable portion of
periodic dividend amount 1 for 1999 is approxi-
mately $3.75 (150/180 multiplied by $4.50). Peri-
odic dividend amount 2 in respect of each share
owned by A is $5 (1/2 multiplied by the applicable
annual LIBOR of 10 percent set on June 1, 1999,
multiplied by $100). Because A owned the share
for the entire period associated with periodic
dividend amount 2, A’s ratable portion of periodic
dividend amount 2 for 1999 is the full $5.
Periodic dividend amount 3 in respect of each
share owned by A is $4.50 (1/2 multiplied by the
applicable annual LIBOR of 9 percent set on
December 1, 1999, multiplied by $100). Because
A held each share of Class A Stock for one month
in 1999 for the period associated with periodic
dividend amount 3, A’s ratable portion of periodic
dividend amount 3 for 1999 is approximately $.75
(30/180 multiplied by $4.50). Accordingly, A’s
preferred QEF amount for 1998 is approximately
$9.50 ($3.75 + $5 + $.75). A must include
approximately $950 ($9.50 per share, multiplied
by 100 shares) in income as ordinary income for
its 1999 taxable year even though FC was not a
PFIC for FC’s taxable year ending in 2000. The
current distributions and arrearages actually paid
to A with respect to the Class A Stock are not
includible in income by A under paragraph (c)(4)
of this section because they constitute amounts
previously included in income.
Example 2. Preferred Discount—(i)Facts.The
facts are the same as inExample 1except that A
acquired the 100 shares of Class A Stock for
$9000.
(ii)Tax Consequences to A for A’s taxable year
ending December 31, 1998.(A) Because the Class
A Stock is fixed term preferred stock (as described
in § 1.1295–2(b)(1)(vii)) and A acquired each
share of the Class A stock with $10 of preferred
discount, as described in § 1.1295–2(b)(2), A’s
preferred QEF amount to be included by A for the
taxable year consists of the sum of the ratable
daily portion of each periodic dividend amount, as
calculated in paragraph (d)(ii) ofExample 1of this
section, plus the preferred discount amount de-
scribed in paragraph (b)(1) of this section.
(B) The preferred discount amount with respect
to each share is approximately $.47 ($10 multi-
plied by 240 days/5070 days to maturity). A must
include approximately $47 ($.47 per share, multi-
plied by 100 shares), together with the amount
calculated in paragraph (d)(ii) ofExample 1of this
section, in income as ordinary earnings for its
1998 tax year even though FC paid no actual
dividend to shareholders of Class A Shares for the
period in 1998 during which A held the Class A
Stock.
(iii)Tax consequences to A for A’s taxable year
ending December 31, 1999.The portion of the
preferred discount on each share includible under
paragraph (a) of this section is approximately $.71
($10 multiplied by 360 days/5070 days to matu-
rity). A must include this amount, together with
the amount calculated in paragraph (d)(iii) of
Example 1of this section, in income as ordinary
earnings for its 1999 tax year even though FC was
not a PFIC for FC’s taxable year ending in 2000.
The current distributions and arrearages actually
paid to A in 1999 with respect to the Class A
Stock are not includible in income by A under
paragraph (c)(4) of this section, because they
constitute amounts previously included in income.
(e)Effective date.The rules under
this section apply with respect to quali-
fied preferred stock subject to a special
preferred QEF election made after the
381997–7 I.R.B.

date that is 30 days after the date of
publication of this document as a final
regulation.
Par. 3. Section 1.1295–2 is added to
read as follows:
§ 1.1295–2 Special Preferred QEF
Election.
(a)In general.This section provides
rules permitting certain shareholders to
make a special election under section
1295 (special preferred QEF election) in
lieu of the election described in
§ 1.1295–1
2
and Notice 88–125, 1988–2
C.B. 535 (see § 601.601(d)(2)(ii)(b) of
this chapter), with respect to certain
preferred shares (qualified preferred
shares) of a foreign corporation that
certifies either that it is a PFIC (as
defined in § 1.1291–1(b)(1)(i))
3
or that
it reasonably believes that it is a PFIC.
In order to make a special preferred
QEF election, a shareholder must satisfy
the stock ownership requirement of
paragraph (c)(2) of this section. A spe-
cial preferred QEF election of a share-
holder applies only to those qualified
preferred shares acquired and held di-
rectly by the shareholder in the taxable
year of the shareholder for which the
election is made. A shareholder making
a special preferred QEF election must
account for dividend income on shares
subject to the election under the special
income inclusion rules described in
§ 1.1293–2, rather than under the gen-
eral income inclusion rules of section
1293 and § 1.1293–1. In addition, for
purposes of determining the tax conse-
quences of owning shares subject to the
special preferred QEF election, an elect-
ing shareholder must treat the foreign
corporation as a PFIC for the entire
period during which the shareholder
continues to hold any of such shares.
Paragraph (b) of this section defines
qualified preferred share. Paragraph (c)
of this section provides rules for deter-
mining who may make the special pre-
ferred QEF election. Paragraph (d) of
this section provides rules concerning
the effect of the election. Paragraph (e)
of this section provides rules for the
time and manner of making the election.
Paragraph (f) of this section sets forth
the annual reporting requirement for the
election. Paragraph (g) of this section
provides rules concerning the possible
termination or invalidation of the elec-
tion. For the applicability date of this
section, see paragraph (h) of this sec-
tion.
(b)Qualified preferred share de-
fined—(1)In general.For purposes of
this section, a share of a foreign corpo-
ration is a qualified preferred share only
if—
(i) The share was originally issued
for cash or in exchange for qualified
preferred shares of the foreign corpora-
tion in a transaction to which section
354(a)(1) applied;
(ii) If the share were to constitute a
debt obligation, the share would be in
registered form within the meaning of
§ 5f.103–1(c) of this chapter;
(iii) All amounts payable with respect
to the share are denominated in U.S.
dollars and are not determined by refer-
ence to the value of a currency other
than the U.S. dollar;
(iv) The share is limited and pre-
ferred as to dividends and does not
participate in corporate growth to any
significant extent within the meaning of
section 1504(a)(4)(B);
(v) The share has a fixed redemption
or liquidation price;
(vi) The share provides for cumula-
tive or noncumulative dividend rights
that are limited to an annual (or shorter
period) amount computed by multiply-
ing either the redemption or liquidation
price of the share by a specified index
described in § 1.446–3(c)(2)(i), (iii), or
(iv) (specified index), or by a specified
index periodically re-established pursu-
ant to an auction reset mechanism, set in
advance of the period with respect to
which the specified index applies;
(vii) If the share may be redeemed
under circumstances described in
§ 1.305–5(b) such that redemption pre-
mium (as described in § 1.305–5(b))
could be treated under section 305(c) as
a constructive distribution (fixed term
preferred stock), the share was not is-
sued with redemption premium exceed-
ing the de minimis amount described in
section 305(c)(1) and § 1.305–5(b)(1);
(viii) If the share may not be re-
deemed under circumstances described
in § 1.305–5(b) such that redemption
premium would not be treated under
section 305 as a constructive distribution
(perpetual preferred stock), the share
does not provide shareholders with the
right to receive an amount upon liquida-
tion or redemption that exceeds the
issue price of the share (as determined
under the principles of section 1273(b))
by an amount in excess of 5 percent of
such liquidation or redemption amount;
(ix) If redeemable, the share is re-
deemable only in whole and not in part
and is not subject to mandatory redemp-
tion within five years of the issue date
of the share. Further, the share is not
subject to a holder put or issuer call
that, based on all the facts and circum-
stances as of the issue date of the share,
is more likely than not to be exercised
at a time within five years of the issue
date;
(x) If convertible, the share is not
convertible into a share other than a
share meeting all the conditions set forth
in paragraphs (b)(1)(i) through (b)(1)(ix)
of this section; and
(xi) The issuer of the share has indi-
cated in an offering document relating
to the original issuance of the share or
in a written statement available to U.S.
holders that the issuer has no current
intention or belief that it will not pay
dividends on the share on a current
basis and that the share meets the
conditions set forth in paragraphs
(b)(1)(i) through (b)(1)(x) of this section
and this paragraph (b)(1)(xi).
(2)Special rules for shares acquired
in secondary market transactions—(i)
Fixed term preferred stock.A share of
fixed term preferred stock (as described
in paragraph (b)(1)(vii) of this section)
that satisfies the conditions set forth in
paragraph (b)(1) of this section and that
is acquired in a transaction other than in
connection with the initial issuance of
the share (a secondary market transac-
tion), shall constitute a qualified pre-
ferred share with respect to a share-
holder, but only if the shareholder
acquires the share for cash and the share
has preferred discount (as defined be-
low) that is less than or equal to an
amount equal to 1 percent of the re-
demption price, multiplied by the num-
ber of complete years from the date of
acquisition of the share to the redemp-
tion date as established under the prin-
ciples of § 1.305–5(b). Sales of shares
to bond houses, brokers, or similar per-
sons or organizations acting in the ca-
pacity as underwriters, placement
agents, or wholesalers are ignored for
purposes of determining whether a share
is acquired in connection with the initial
issuance of the share. For purposes of
this section, the preferred discount for a
share is the excess of the redemption
price of the share payable on the re-
demption date over the shareholder’s
acquisition cost for the share.
(ii)Perpetual preferred stock.A share
of perpetual preferred stock, within the
meaning of paragraph (b)(1)(viii) of this
2
This proposed regulation was published on April
1, 1992, at 57 Fed. Reg. 11024.
3
This proposed regulation was published on April
1, 1992, at 57 Fed. Reg. 11024.
391997–7 I.R.B.

section, that satisfies the conditions set
forth in paragraph (b)(1) of this section
and that is acquired in a secondary
market transaction, shall constitute a
qualified preferred share with respect to
the shareholder, but only if the share-
holder acquires the share for cash and
the amount payable upon liquidation of
the share exceeds the shareholder’s ac-
quisition cost for the share by an
amount less than or equal to 10 percent
of such liquidation amount.
(iii)Examples.The following ex-
amples illustrate the rules of this para-
graph (b)(2).
Example 1—(i)Facts.On May 1, 1998, A, an
individual who files her return on a calendar year
basis, purchases for $9000 cash in a single
secondary market transaction (as defined in para-
graph (b)(2)(i) of this section) 100 shares of
nonconvertible Class A $100 par value preferred
stock (Class A Stock) of FC, a foreign corporation
with a taxable year ending March 31. The terms of
the Class A Stock satisfy all the conditions
described in paragraph (b)(1) of this section and
provide for a mandatory redemption of the Class A
Stock by the issuer in U.S. dollars at par on June
1, 2012. The Class A Stock is not redeemable
pursuant to an issuer call or holder put on any
other date.
(ii)Analysis.In order for A to make a special
preferred QEF election with respect to the Class A
Stock acquired by A, the Class A Stock acquired
must constitute qualified preferred shares. Al-
though the Class A Stock meets the requirements
for qualified preferred shares set forth in para-
graph (b)(1) of this section, the stock also must
satisfy the requirements described in paragraph
(b)(2) because A acquired the stock in a secondary
market transaction. Because the terms of the Class
A Stock provide that the stock will be redeemed
by the issuer on June 1, 2012, the stock constitutes
fixed term preferred stock within the meaning of
paragraph (b)(1)(vii) of this section. A purchased
the Class A Stock for $90 per share, representing a
$10 discount ($100 June 1, 2012, per share
redemption price less $90 acquisition cost). Be-
cause this $10 discount, which constitutes pre-
ferred discount within the meaning of paragraph
(b)(2)(i) of this section, is less than $14 (1 percent
of the redemption price multiplied by 14 (the
number of complete years until the mandatory
redemption date)), the Class A Stock acquired by
A satisfies the conditions of paragraph (b)(2)(i) of
this section and therefore constitutes qualified
preferred shares.
Example 2—(i)Facts.The facts are the same as
inExample 1, except that A acquires the 100
shares of Class A Stock for $8000.
(ii)Analysis.In this case, A purchased the Class
A Stock for $80 per share, representing a $20
discount ($100 June 1, 2012, redemption price less
$80 acquisition cost). Because this $20 of pre-
ferred discount is greater than $14 (1 percent of
the redemption price multiplied by 14 (the number
of complete years until the mandatory redemption
date)), the Class A Stock fails to satisfy the
conditions of paragraph (b)(2)(i) of this section
and therefore fails to qualify as qualified preferred
shares.
(c)Who may make the election—(1)
In general.A U.S. person that acquires
qualified preferred shares for cash or in
a nonrecognition transaction described
in § 1.1291–6(a)
4
(nonrecognition trans-
action) and that holds such shares di-
rectly may make a special preferred
QEF election, provided that, in the case
of shares acquired in a nonrecognition
transaction, either the qualified preferred
shares are treated as stock of a pedi-
greed QEF, as defined in § 1.1291–
1(b)(2)(ii), immediately prior to the non-
recognition transaction, or the gain, if
any, realized on the transaction would
be recognized under § 1.1291–6(b) with
respect to the nonrecognition transac-
tion. A special preferred QEF election
will not apply to any shares with respect
to which the electing shareholder is an
indirect shareholder, within the meaning
of § 1.1291–1(b)(8). Solely for purposes
of this section, partnerships, S corpora-
tions, trusts and estates (pass-through
entities) that directly own qualified pre-
ferred shares are treated as shareholders
that may make a special preferred QEF
election. A shareholder may not make a
special preferred QEF election if at any
time the shareholder made a section
1295 election (other than a special pre-
ferred QEF election) with respect to the
foreign corporation. A shareholder may
not make a special preferred QEF elec-
tion unless the shareholder satisfies the
stock ownership requirements set forth
in paragraph (c)(2) of this section, and
the shareholder receives from the for-
eign corporation the statement described
in paragraph (c)(3) of this section.
(2)Ownership requirement.A holder
of qualified preferred shares of a foreign
corporation may make a special pre-
ferred QEF election only if, at all times
during the taxable year of the share-
holder, the shareholder does not own,
directly, indirectly, or constructively,
within the meaning of section 958, five
percent or more of the vote or value of
any class of stock of the foreign corpo-
ration. The five percent vote or value
limitation must be satisfied for each
taxable year of the shareholder during
which the shareholder continues to hold
shares subject to the special preferred
QEF election.
(3)Statement from corporation.A
shareholder may make the special pre-
ferred QEF election only if the foreign
corporation has provided a written state-
ment relating to the taxable year of the
corporation that ends with or within the
taxable year of the shareholder for
which the election is made certifying
either that the foreign corporation is, or
that it reasonably believes that it is, a
PFIC, and that it is not a controlled
foreign corporation within the meaning
of section 957(a) for such taxable year
of the corporation. The statement must
be provided directly to the electing
shareholder or in a disclosure or other
document generally available to all U.S.
holders. Electing shareholders must re-
tain a copy of the statement for their
records.
(d)Effect of election—(1)In general.
Unless terminated or invalidated pursu-
ant to paragraph (g) of this section,
shares subject to a special preferred
QEF election will be treated as shares of
a pedigreed QEF (as defined in
§ 1.1291–1(b)(2)(ii)) for all taxable
years of the foreign corporation that are
included wholly or partly in the share-
holder’s holding period of the shares. A
special preferred QEF election applies to
all qualified preferred shares owned di-
rectly by the shareholder that are ac-
quired in the taxable year of the elec-
tion. Separate special preferred QEF
elections may be made for qualified
preferred shares acquired in other tax-
able years of the taxpayer. A special
preferred QEF election is personal to the
shareholder that made the election and
does not apply to a transferee of the
shares. A shareholder that has made a
special preferred QEF election may not
make, with respect to the foreign corpo-
ration, any other election permitted un-
der sections 1291 through 1297 and the
regulations under those sections, includ-
ing a section 1295 election as described
in § 1.1295–1 and Notice 88–125,
1988–2C.B.535(see
§ 601.601(d)(2)(ii)(b) of this chapter),
for any period during which the special
preferred QEF election remains in effect
with respect to any shares of the share-
holder.
(2)Continued PFIC Characteriza-
tion.By making the special preferred
QEF election, the shareholder agrees to
treat the foreign corporation as a PFIC
with respect to qualified preferred shares
subject to the election at all times
during its holding period for such
shares, without regard to whether the
foreign corporation is a PFIC for any
taxable year of the foreign corporation
during which the preferred QEF election
remains in effect.
(3)Section 1293 inclusions.For each
taxable year of the shareholder to which
an election under this section applies,
the shareholder must include in income
the preferred QEF amount, as defined in
4
This proposed regulation was published on April
1, 1992, at 57 Fed. Reg. 11024.
401997–7 I.R.B.

§ 1.1293–2, in the manner and under
the rules provided in that section.
(e)Time for and manner of making
the special preferred QEF election—(1)
Time for making the election.A special
preferred QEF election must be made on
or before the due date, as extended, for
filing the shareholder’s return for the
taxable year during which the share-
holder acquired the qualified preferred
shares for which the election is being
made. A special preferred QEF election
may not be made for those shares at any
other time pursuant to any other provi-
sion of the Code or regulations.
(2)Manner of making the election—
(i)In general.A shareholder makes the
special preferred QEF election under
this section for all qualified preferred
shares of a foreign corporation acquired
during the shareholder’s taxable year by
checking the appropriate box in Form
8621 (Return by a Shareholder of a
Passive Foreign Investment Company or
Qualified Electing Fund), Part I, for
making the section 1295 election, and
indicating in the margin of Part I that
the shareholder is making a special
preferred QEF election with respect to
certain specified shares. The shareholder
also must report the preferred QEF
amount for the taxable year of the
election on Line 6a of Part II of Form
8621. In addition, the shareholder must
attach to Form 8621 the statement (pre-
ferred QEF statement) described in para-
graph (e)(2)(ii) of this section, signed by
the shareholder under penalties of per-
jury, stating that the information and
representations provided in the preferred
QEF statement are true, correct, and
complete to the best of the shareholder’s
knowledge and belief.
(ii)Preferred QEF statement con-
tents.The preferred QEF statement must
include the following information and
representations:
(A) The first taxable year of the
shareholder for which the special pre-
ferred QEF election is made;
(B) The number of shares subject to
the election, their acquisition date(s) and
acquisition price(s), and the class desig-
nation(s) of the shares;
(C) A representation by the share-
holder that it did not at any time during
its taxable year own directly, indirectly,
or constructively, within the meaning of
section 958, five percent or more of the
vote or value of any class of stock of
the foreign corporation with respect to
which the election applies;
(D) A representation by the share-
holder that it has obtained the written
statement described in paragraph (c)(3)
of this section; and
(E) A representation by the share-
holder that it has never made a section
1295 election other than a special pre-
ferred QEF election with respect to the
foreign corporation.
(f)Annual reporting requirement.For
each taxable year of a shareholder dur-
ing which the shareholder holds shares
of a foreign corporation subject to one
or more special preferred QEF elections,
the shareholder must file Form 8621
with respect to the foreign corporation
regardless of whether the foreign corpo-
ration is or is not a PFIC under section
1296 during any portion of the taxable
year. The shareholder must indicate in
the margin of Part I of Form 8621 the
number of special preferred QEF elec-
tions of the shareholder that remain in
effect with respect to the foreign corpo-
ration. In addition, the shareholder must
report, on Line 6a of Part II of Form
8621, the aggregate of the preferred
QEF amounts for all relevant special
preferred QEF elections in effect for the
taxable year.
(g)Termination or invalidation of
election—(1)In general.A sale, ex-
change or other disposition of a share
that is subject to a special preferred
QEF election will terminate the special
preferred QEF election with respect to
that share. In addition, the Commis-
sioner may, in the Commissioner’s dis-
cretion, terminate or invalidate a special
preferred QEF election if a shareholder
that made the election fails to satisfy the
initial or ongoing requirements of the
election. Once made, a special preferred
QEF election may not be terminated or
invalidated by the shareholder.
(2)Effect of termination or invalida-
tion.Termination of a special preferred
QEF election by the Commissioner will
be effective on the first day of the
shareholder’s first taxable year follow-
ing the last taxable year of the share-
holder for which the requirements of the
election are satisfied. For purposes of
sections 1291 through 1297 and the
regulations thereunder, the holding pe-
riod of qualified preferred shares subject
to an election that has been terminated
will be treated as beginning on the
effective date of the termination. A
shareholder that has made an election
that is invalidated by the Commissioner
will be treated for purposes of sections
1291 through 1297 and the regulations
thereunder as if the shareholder never
made the election.
(h)Effective date.An election under
this section may only be made with
respect to qualified preferred shares that
are issued after the date that is 30 days
after the date of publication of this
document as a final regulation.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
(Filed by the Office of the Federal Register on
December 23, 1996, 8:45 a.m., and published in
the issue of the Federal Register for December 24,
1996, F.R. 67752)
Notice of Proposed Rulemaking
and Notice of Public Hearing
Treatment of Obligation-Shifting
Transactions
REG–209817–96
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemak-
ing and notice of public hearing.
SUMMARY: This document contains
proposed regulations relating to the
treatment of certain multiple-party fi-
nancing transactions in which one party
realizes income from leases or similar
agreements and another party claims
deductions related to that income. In
order to prevent tax avoidance, the pro-
posed regulations recharacterize these
transactions in a manner that clearly
reflects income. The proposed regula-
tions affect only persons that engage in
these transactions. The regulations gen-
erally do not apply to routine transac-
tions lacking characteristics of tax
avoidance. This document also provides
notice of a public hearing on the pro-
posed regulations.
DATES: Written comments, requests to
appear, and outlines of topics to be
discussed at the public hearing sched-
uled for April 29, 1997, at 10 a.m. must
be received by April 8, 1997.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (REG–209817–96),
Room 5226, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington, DC 20044. Submissions may be
hand delivered between the hours of 8
a.m. and 5 p.m. to: CC:DOM:CORP:R
(REG–209817–96), Courier’s Desk, In-
ternal Revenue Service, 1111 Constitu-
tion Avenue NW, Washington, DC. Al-
411997–7 I.R.B.

ternatively, taxpayers may submit
comments electronically via the Internet
by selecting the ‘‘Tax Regs’’ option of
the IRS Home Page, or by submitting
comments directly to the IRS Internet
site at http://www.irs.ustreas.gov/prod/
tax_regs/comments.html. The public
hearing will be held in the IRS Audito-
rium, Internal Revenue Building, 7th
Floor, 1111 Constitution Avenue NW,
Washington, DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed
regulations, Jonathan Zelnik at (202)
622–3940; concerning submissions and
the hearing, Christina Vasquez at (202)
622–7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information con-
tained in this notice of proposed
rulemaking has been submitted to the
Office of Management and Budget for
review in accordance with the Paper-
work Reduction Act of 1995 (44 U.S.C.
3507(d)). Comments on the collection of
information should be sent to theOffice
of Management and Budget,Attn:
Desk Officer for the Department of the
Treasury, Office of Information and
Regulatory Affairs, Washington, DC
20503, with copies to theInternal Rev-
enue Service,Attn: IRS Reports Clear-
ance Officer, T:FP, Washington, DC
20224. Comments on the collection of
information should be received by April
8, 1997. Comments are specifically re-
quested concerning:
Whether the proposed collection of
information is necessary for the proper
performance of the functions of the
Internal Revenue Service, including
whether the collection will have a prac-
tical 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
enhanced;
How the burden of complying with
the proposed collection of information
may be minimized, including through
the application 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 service to provide informa-
tion.
The collection of information is in
§ 1.7701(l)–2(j). This information is re-
quired by the IRS to verify pass-through
entity compliance with § 1.7701(l)–2.
This information will be used to deter-
mine whether the amount of tax has
been computed correctly. The collection
of information is mandatory. The likely
recordkeepers are businesses and other
organizations. Estimated total annual
recordkeeping burden: 500 hours. Esti-
mated average annual burden per
recordkeeper: 5 hours. Estimated num-
ber of recordkeepers: 100.
An agency may not conduct or spon-
sor, and a person is not required to
respond to, a collection of information
unless the collection of information dis-
plays a valid control number.
Books or records relating to a collec-
tion of information must be retained as
long as their contents may become ma-
terial in the administration of any inter-
nal revenue law. Generally, tax returns
and tax information are confidential, as
required by 26 U.S.C. 6103.
Background
The IRS and Treasury Department
have become aware of multiple-party
financing transactions (‘‘stripping trans-
actions’’) intended to allow one party to
realize income from a lease or similar
agreement and to allow another party to
report deductions related to that income
(for example, cost recovery or rental
expenses). Notice 95–53, 1995–2 C.B.
334, describes several examples of these
transactions, including transferred basis
transactions, transfers of partnership in-
terests, and variations involving licenses,
service contracts, and prepayment, front-
loading, and retention of rights to re-
ceive future payments.
Notice 95–53 states the position of
the IRS that the claimed tax treatment
of these transactions improperly sepa-
rates income from related deductions
and that the transactions do not produce
the tax consequences desired by the
parties. The notice also states that regu-
lations will be issued under section
7701(l) of the Internal Revenue Code
recharacterizing stripping transactions
any significant element of which is
entered into or undertaken on or after
October 13, 1995. The notice requested
comments regarding those regulations.
The IRS received only one set of
comments in response to Notice 95–53.
Those comments recommended that the
regulations under section 7701(l) ad-
dress a broader class of transactions
than was described in the notice. Spe-
cifically, they recommended that the
regulations defer the recognition of in-
come in circumstances where there is an
advance receipt or assignment of future
income and there is the potential for the
transactions to become stripping transac-
tions. They also recommended that the
regulations recharacterize these transac-
tions without regard to whether there is
a tax avoidance purpose. The comments
reflected a desire for the regulations to
produce an economic accrual of income
and to enable taxpayers to determine the
proper tax accounting for their transac-
tions without regard to subsequent
events.
The proposed regulations generally
follow the notice and do not expand the
class of transactions subject to
recharacterization. The regulations do
not require taxpayers to make any as-
sumptions as to subsequent events. They
are intended to produce tax results that
conform to the economic substance of
the transactions that they address. Fur-
thermore, the regulations generally apply
to transactions whether or not the parties
have a tax avoidance purpose.
Explanation of Provisions
1. General approach
Section 7701(l) authorizes the Secre-
tary to ‘‘prescribe regulations rechar-
acterizing any multiple-party financing
transaction as a transaction directly
among any 2 or more of such parties
where the Secretary determines that
such recharacterization is appropriate to
prevent avoidance of any tax imposed
by [the Internal Revenue Code].’’ The
proposed regulations recharacterize
transactions in which the transferee
(‘‘the assuming party’’) assumes obliga-
tions or acquires property subject to
obligations under an existing lease or
similar agreement and the transferor
(‘‘the property provider’’) or any other
party has already received or retains the
right to receive amounts that are al-
locable to periods after the transfer. The
recharacterization reflects the general
principle that a taxpayer who is treated
for federal income tax purposes as the
owner of rental property must recognize
income that accrues during its period of
ownership.See,e.g.,Steinway & Sons v.
Commissioner, 46 T.C. 375 (1966),acq.,
1967–2 C.B. 3;Alstores Realty Corp. v.
Commissioner, 46 T.C. 363 (1966),acq.,
1967–2 C.B. 1.
For the period in which an assuming
party in such a transaction is a party to
421997–7 I.R.B.

the lease or similar agreement, the
recharacterization requires the assuming
party to report income on a level-rent
basis calculated using the rules of the
constant rental accrual method described
in § 1.467–3(d) as proposed on June 3,
1996 (IA–292–84, 61 FR 27834,
27844). Thus, the assuming party is
required to recognize rental income for
the period in which it owns the property
or leasehold interest. In addition, the
transaction is recharacterized to include
additional consideration in the form of a
note provided by the assuming party to
the property provider for the transfer of
the property, resulting in interest income
and expense for which the parties must
account as appropriate. The property
provider also must adjust its income for
any differences between amounts it rec-
ognized and amounts it would have
recognized if it had reported income on
a level-rent basis for the periods that it
owned the property or leasehold interest.
Finally, to account for any differences in
timing or amount between payments the
property provider actually receives after
the transaction and payments treated as
being made to the property provider
under the note from the assuming party,
the property provider is treated as an
obligor or obligee under a second loan,
for which the property provider must
account accordingly.
2. Obligation-shifting transactions
The proposed regulations are not in-
tended to recharacterize transactions
with little potential for tax avoidance.
Taken together, the definition of
‘‘obligation-shifting transaction’’ and the
enumerated exceptions limit the scope
of the regulations to transactions that are
not routine and that involve shifting of
substantial amounts of income away
from the taxpayer that recognizes deduc-
tions related to the income.
The proposed regulations apply to
obligation-shifting transactions, which
are defined as any transaction in which
an assuming party assumes a property
provider’s obligations to a property user
(or acquires property subject to a prop-
erty provider’s obligations to a property
user) under a lease or similar agreement
if the property provider or any other
party has already received, or retains the
right to receive, amounts that are al-
locable to periods after the transaction.
The regulations define obligations under
a lease or similar agreement as includ-
ing a continuing obligation to make
property available to the lessee or the
ultimate user of the property. These
obligations typically give rise to deduc-
tions, such as for cost recovery or, in
the case of a master-lease/sublease ar-
rangement, for payments under a master
lease. The advance receipt of amounts
that are allocable to periods after the
obligation-shifting transaction often re-
sults in accelerated taxable income for
the recipient. Thus, the definition de-
scribes transactions in which there is the
potential for one party to recognize
income but a different party to recog-
nize deductions associated with that in-
come.
In some transactions identified in No-
tice 95–53, one party sells, assigns, or
otherwise transfers to a third party the
right to receive future payments under a
lease and includes as current income the
amount received as consideration for the
transfer. The underlying property (sub-
ject to the lease) is later transferred in a
transaction intended to qualify as a
transferred basis transaction. These
transactions are within the scope of the
regulations because the property trans-
feree assumes obligations or acquires
the property subject to the obligation to
make the property available to the lessee
and the property transferor already re-
ceived amounts that are allocable to
periods after the transaction by reason
of the assignment of rights to receive
future payments. In other transactions,
the property transferor does not assign
the right to future rental amounts but
instead receives prepayment from the
lessee or retains the right to receive
future amounts over time. Both varia-
tions likewise are within the scope of
the regulations.
The proposed regulations adopt an
aggregate view of partnerships, treating
each partner as having a proportionate
share of the rights and obligations of the
partnership. Thus, for example, if a
partnership assigns its right to receive
future amounts under a lease and allo-
cates to its current partners the amount
recognized, a later transfer of a partner-
ship interest is an obligation-shifting
transaction because the transferee part-
ner assumes an allocable share of the
partnership’s obligation to make the
property available to the lessee and
because the transferor partner is treated
as having already received amounts that
are allocable to periods after the transac-
tion. SeeExample 3of the proposed
regulations. In appropriate cases, the
IRS may assert other authorities to pre-
vent the use of a partnership to effect an
improper separation of income from
related deductions.See,e.g., § 1.701–
2(d) (Example 7).
The proposed regulations also gener-
ally treat an obligation-shifting transac-
tion as occurring if a subsidiary that is a
member of a consolidated group be-
comes a nonmember at a time when the
subsidiary has received payments under
a lease or similar agreement that are
allocable to periods after the transaction.
3. Lease or similar agreement
Under the proposed regulations, an
obligation-shifting transaction involves a
lease or similar agreement. The regula-
tions define this term broadly to include
any contract for the use or enjoyment of
tangible or intangible property, including
leaseholds, licenses, other non-fee inter-
ests in property, and other contracts
(including service contracts) involving
the use or enjoyment of property if the
value of that use or enjoyment is more
thande minimis.The proposed regula-
tions, therefore, do not apply to service
contracts that do not involve the use or
enjoyment of property. The definition of
obligation-shifting transaction, however,
does not restrict the IRS’s ability to
challenge these transactions under other
authorities. For instance, even if a trans-
action is not within the scope of the
proposed regulation, the IRS may chal-
lenge it under one or more of the
authorities identified in Notice 95–53.
The IRS requests comments on
whether additional guidance is needed
on the definition of lease or similar
agreement.
4. Exceptions
The proposed regulations are not in-
tended to recharacterize otherwise rou-
tine transactions, such as the incorpora-
tion of an entire line of business that
does not involve significant shifting of
income and deductions. See Rev. Rul.
80–198, 1980–2 C.B. 113, subject to the
limitations described therein. Accord-
ingly, the regulations provide a number
of objective exceptions that generally
will protect routine transactions from
recharacterization. The regulations do
not apply to transactions in which the
amounts that are allocable to future
periods but are not transferred are less
than or equal to $100,000. The regula-
tions do not apply to transactions in
which total payments (including the ag-
gregate expected future value of all
contingent consideration) under the lease
or similar agreement are not reasonably
431997–7 I.R.B.

expected to exceed $250,000. The regu-
lations do not apply to transactions in
which the fair market value of the
property that is subject to the lease or
similar agreement and is transferred in
the obligation-shifting transaction, plus
the value of the amounts that are al-
ready received or retained by the prop-
erty provider but are allocable to periods
after the obligation-shifting transaction,
is less than ten percent of the total
assets (other than Class I and Class II
assets as described in § 1.1060–1T(d)
and debt issued by the property pro-
vider) transferred by the property pro-
vider in the transaction. The regulations
do not apply to transactions in which
the lease or similar agreement is a
disqualified leaseback or long-term
agreement within the meaning of
§ 1.467–3(b). The regulations do not
apply to transactions described in sec-
tion 381(a), unless the transaction is
deemed to be an obligation-shifting
transaction under proposed § 1.7701(l)–
2(k). Finally, the regulations provide
that a transaction is exempt from
recharacterization if the parties to the
transaction establish to the satisfaction
of the Commissioner that the transaction
does not present a significant potential
for tax avoidance.
Because the purpose of recharacteri-
zation under section 7701(l) is to pre-
vent tax avoidance, these objective ex-
ceptions are unavailable for transactions
entered into with a principal purpose of
substantially reducing the present value
of the aggregate tax liability of the
property provider, the assuming party,
and any other party whose taxable in-
come is determined by reference to the
taxable income of the property provider
or the assuming party.
5. Recharacterization
The proposed regulations recharacter-
ize an obligation-shifting transaction in
order to ensure that the property pro-
vider and the assuming party both report
the income from the underlying property
allocable to their respective periods of
ownership.
For purposes of determining the
amounts that are allocable to periods
under the lease or similar agreement, the
proposed regulations apply a rent-
leveling process based on the constant
rental accrual method described in
§ 1.467–3(d) to all amounts that are
treated as payable under the lease or
similar agreement. At the time of the
obligation-shifting transaction, the level
rental amount is determined for the
entire term of the lease or similar agree-
ment using 110 percent of the applicable
Federal rate based on that term. The
amounts that are treated as payable
under the lease or similar agreement at
the time of the obligation-shifting trans-
action are the amounts that have already
been paid to the property provider and
the future amounts that, immediately
before the obligation-shifting transac-
tion, are payable to the property pro-
vider. Thus, if the property provider
assigns the right to receive payments to
a third party in exchange for consider-
ation, the consideration is treated as an
amount received under the lease or
similar agreement. Because the property
provider no longer has the right to
receive the payments assigned to the
third party, those payments (whether
past or future) are not treated as
amounts that are payable to the property
provider for purposes of calculating the
level rental amount.
The proposed regulations recharacter-
ize an obligation-shifting transaction by
treating the assuming party and the
property provider as follows:
The assuming party is treated as ac-
quiring the right to receive all amounts
that are allocable to periods after the
obligation-shifting transaction. The as-
suming party includes these amounts in
income for the periods that it owns the
property.
To reflect the amounts that the assum-
ing party is treated as receiving under
the recharacterization but that it does
not actually receive, the assuming party
also is treated as providing additional
consideration to the property provider in
the form of a note (a ‘‘section 7701(l)
note’’). The original principal balance of
the section 7701(l) note equals the ex-
cess of the present value of the amounts
that are allocable to periods after the
obligation-shifting transaction over the
present value of the amounts that are
payable to the assuming party.
The property provider must adjust its
income to the extent that it accounted
for income under the lease or similar
agreement before the obligation-shifting
transaction in a manner inconsistent
with the level-rent method described
above. The adjustment, which can in-
crease or decrease the property provid-
er’s income, equals the principal balance
of the section 467 loan that would have
existed if the property provider had been
using the constant rental accrual method
to account for amounts under the lease
or similar agreement that are allocable
to periods before the obligation-shifting
transaction, reduced by any existing sec-
tion 467 loan if the lease or similar
agreement is a section 467 rental agree-
ment. The constant rental amount is
calculated using the amounts that are
treated as payable under the lease or
similar agreement.
Finally, to account for any differences
in timing or amount between payments
the property provider actually receives
after the obligation-shifting transaction
and payments treated as being made to
the property provider under the section
7701(l) note, the property provider is
treated as a party to a loan (a ‘‘section
7701(l) rent-leveling loan’’). The section
7701(l) rent-leveling loan is created at
the time of the obligation-shifting trans-
action. Its balance at that time equals
the section 467 loan that would have
existed if the property provider had been
using the constant rental accrual method
to account for amounts under the lease
or similar agreement that are allocable
to periods before the obligation-shifting
transaction. Thus, in the periods after
the obligation-shifting transaction, the
property provider must account for any
interest expense or income resulting
from the section 7701(l) rent-leveling
loan, in addition to any interest income
or expense resulting from the section
7701(l) note.
Although section 467 may not apply
to an obligation-shifting transaction, the
effect of the proposed regulations is to
recharacterize the transaction to produce
the constant rental amount and associ-
ated loans that the parties would have
been treated as having if the lease or
similar agreement had been a section
467 rental agreement (modified to re-
flect the amounts already received or
payable to the property provider imme-
diately before the obligation-shifting
transaction) and had been subject to the
constant rental accrual method. Thus,
the assuming party is treated as if it had
purchased the property in part with a
note, had obtained the right to receive
rental amounts on the constant rental
accrual method during its ownership of
the property, and had used those
amounts to service the note. For the
property provider, the proposed regula-
tions provide a recharacterization that is
similar (but not identical) to the treat-
ment required when a lessor disposes of
property subject to a section 467 rental
agreement that was accounted for under
the constant rental accrual method.
The proposed regulations provide the
exclusive recharacterization of an
441997–7 I.R.B.

obligation-shifting transaction for a
property provider and an assuming
party. Thus, if an obligation-shifting
transaction is recharacterized under this
section and the lease or similar agree-
ment is a section 467 rental agreement,
the rules of this section supersede the
rules of §§ 1.467–1 through 1.467–8 as
proposed on June 3, 1996 (IA–292–84,
61 FR 27834) for the property provider
(the transferor) and the assuming party
(the transferee). The assuming party’s
income after the obligation-shifting
transaction is determined under this sec-
tion and not under § 1.467–7(e)(1).
Similarly, the rules provided in
§ 1.467–7(e)(2) for determining the
amount of the section 467 loan for the
period after the transfer, the amount
realized by the property provider, and
the assuming party’s basis in the prop-
erty do not apply to obligation-shifting
transactions recharacterized by this sec-
tion.
The recharacterization does not affect
the property user or rent factor (if any),
because, even though they are parties to
the multiple-party financing transaction,
no adjustment to their treatment of the
transaction is necessary to prevent the
avoidance of tax.Cf.§ 1.881–
3(a)(3)(ii)(A) (limiting purposes for
which conduit financing arrangements
are recharacterized). Thus, if the lease
or similar agreement is a section 467
rental agreement, the property user must
continue to take section 467 rent and
section 467 interest into account without
regard to the obligation-shifting transac-
tion and the recharacterization under this
section.See§ 1.467–7(e)(1).
6. Issues not addressed
The proposed regulations do not ad-
dress transactions in which a taxpayer
assigns rights to future income but does
not transfer the underlying property to
another taxpayer, except as provided in
the special rules regarding pass-through
entities and consolidated groups.
7. Proposed effective date
Notice 95–53 states that the regula-
tions under section 7701(l) will be ef-
fective ‘‘with respect to stripping trans-
actions any significant element of which
is entered into or undertaken on or after
October 13, 1995.’’ The regulations are
proposed to adopt the effective date
stated in the notice.
Special Analyses
It is hereby certified that these regula-
tions do not have a significant economic
impact on a substantial number of small
entities. This certification is based on
the understanding of the IRS that the
total number of entities engaging in
transactions affected by these regula-
tions is not substantial and, of those
entities, most are not small entities
within the meaning of the Regulatory
Flexibility Act (5 U.S.C. chapter 6).
Therefore, a Regulatory Flexibility
Analysis is not required. It has been
determined that this notice of proposed
rulemaking is not a significant regula-
tory action as defined in E.O. 12866.
Therefore, a regulatory assessment is not
required. Pursuant to section 7805(f) of
the Internal Revenue Code, this notice
of proposed rulemaking will be submit-
ted to the Chief Counsel for Advocacy
of the Small Business Administration for
comments on its impact on small busi-
nesses.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consider-
ation will be given to any written com-
ments (a signed original and eight (8)
copies) that are submitted timely to the
IRS. All comments will be available for
public inspection and copying.
A public hearing has been scheduled
for April 29, 1997, at 10 a.m. in the IRS
Auditorium, Internal Revenue Building,
7th Floor, 1111 Constitution Avenue
NW, Washington, DC. Because of ac-
cess restrictions, visitors will not be
admitted beyond the building lobby
more than 15 minutes before the hearing
starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral
comments at the hearing must submit
written comments and submit an outline
of the topics to be discussed and the
time to be devoted to each topic (a
signed original and eight (8) copies) by
April 8, 1997.
A period of 10 minutes will be allot-
ted 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 Jonathan R. Zelnik, Office of
the Assistant Chief Counsel (Financial
Institutions & Products). However, other
personnel from the IRS and Treasury
Department participated in their devel-
opment.
* * * * *
Proposed Amendments to the Regula-
tions
Accordingly, 26 CFR part 1 is pro-
posed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation
for part 1 is amended by adding an
entry in numerical order to read as
follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.7701(l)–2 also issued under
26 U.S.C. 7701(l). * * *
Par. 2. Section 1.7701(l)–1 is
amended as follows:
1. Paragraphs (b)(6) and (b)(7) are
revised.
2. Paragraph (b)(8) is added.
The revisions and addition reads as
follows:
§ 1.7701(l)–1 Conduit financing ar-
rangements.
* * * * *
(b) * * *
* * * * *
(6) Section 1.6038A–3(b)(5);
(7) Section 1.6038A–3(c)(2)(vii); and
(8) Section 1.7701(l)–2.
Par. 3. Section 1.7701(l)–2 is added
under the center heading ‘‘General Actu-
arial Valuations’’ to read as follows:
§ 1.7701(l)–2 Treatment of obligation-
shifting transactions.
(a)Purpose.The purpose of this sec-
tion is to prevent avoidance of tax by
parties participating in multiple-party fi-
nancing transactions that involve an as-
sumption of obligations under a lease or
similar agreement. This section should
be interpreted in a manner consistent
with this purpose.
(b)In general.Obligation-shifting
transactions as defined in paragraph
(h)(1) of this section are recharacterized
in the manner described in paragraph (d)
of this section unless an exception in
paragraph (c) of this section applies.
(c)Exceptions—(1)In general.Para-
graph (d) of this section does not apply
if any of the following is satisfied:
(i) The aggregate amounts that have
already been received by or are payable
to the property provider but are al-
locable to periods (including partial pe-
riods) after the obligation-shifting trans-
451997–7 I.R.B.

action (as determined under paragraph
(g) of this section) are less than or equal
to $100,000.
(ii) The sum of the aggregate pay-
ments (including contingent payments)
under the lease or similar agreement and
the aggregate value of other consider-
ation (including contingent consider-
ation) to be received under the lease or
similar agreement is not reasonably ex-
pected to exceed $250,000. The rules of
§ 1.467–1(c)(4)(ii)
1
apply in determin-
ing the amount described in this para-
graph (c)(1)(ii).
(iii) The fair market value of the
leased property is less than ten percent
of the aggregate fair market value of all
of the property (excluding Class I assets
as described in § 1.1060–1T(d)(1),
Class II assets as described in
§ 1.1060–1T(d)(2)(i), and debt issued
by the property provider) that the prop-
erty provider transfers to the assuming
party as part of the same transaction or
series of related transactions. For this
purpose, the fair market value of the
leased property is the sum of—
(A) The fair market value of the
property subject to the lease or similar
agreement and transferred in the
obligation-shifting transaction, plus
(B) The value of the amounts that
have already been received under the
lease or similar agreement or are re-
tained by the property provider or any
other party but are allocable to periods
(including partial periods) after the
obligation-shifting transaction.
(iv) The agreement(s) between the
property provider and the property user
is a disqualified leaseback or long-term
agreement within the meaning of
§ 1.467–3(b).
2
(v) The transaction is described in
section 381(a), unless the transaction is
deemed to be an obligation-shifting
transaction under paragraph (k) of this
section.
(vi) The Commissioner determines
that the transaction does not substan-
tially reduce the present value of the tax
liability of the assuming party or other-
wise result in the avoidance of tax.
(2)Limitation on exceptions.The ex-
ceptions listed in paragraph (c)(1) of
this section do not apply to obligation-
shifting transactions entered into with a
principal purpose of substantially reduc-
ing the present value of the aggregate
tax liability of the assuming party, the
property provider, and any person whose
taxable income is determined (in whole
or in part) by reference to the taxable
income of the property provider or the
assuming party.
(d)Recharacterization of obligation-
shifting transaction—(1)In general.In
order to clearly reflect the income of the
assuming party and the property pro-
vider, an obligation-shifting transaction
is recharacterized as follows:
(i)Assuming party treated as receiv-
ing all allocable rents.The assuming
party is treated as acquiring the right to
receive (and as receiving when due) all
amounts under the lease or similar
agreement that are allocable (as deter-
mined under paragraph (g) of this sec-
tion) to periods (including partial peri-
ods) after the obligation-shifting
transaction. Thus, the assuming party
must include these amounts in income
in the periods to which they are al-
locable.
(ii)Assuming party treated as issuing
section 7701(l) note.The assuming party
is treated as issuing to the property
provider, as additional consideration in
the obligation-shifting transaction, a sec-
tion 7701(l) note, with terms as de-
scribed in paragraph (e) of this section.
Accordingly, the assuming party and the
property provider must account for in-
terest expense and income from the
section 7701(l) note in the periods (in-
cluding partial periods) following the
obligation-shifting transaction.
(2)Section 7701(l) rent-leveling loan
and adjustment to property provider’s
income—(i)Section 7701(l) rent-leveling
loan.To account for any differences in
timing or amount between payments
actually received by the property pro-
vider after the obligation-shifting trans-
action and payments (as described in
paragraph (e)(3) of this section) treated
as being made under the section 7701(l)
note, the property provider is treated as
a party to a section 7701(l) rent-leveling
loan, with terms as described in para-
graph (f) of this section. Accordingly,
the property provider must account for
interest expense or income (as appropri-
ate) in the periods (including partial
periods) following the obligation-
shifting transaction.
(ii)Adjustment to property provider’s
income.To account for any differences
between amounts previously included by
the property provider and amounts that
are allocable to periods before the
obligation-shifting transaction, on the
date on which the obligation-shifting
transaction is consummated, the property
provider must treat as an item of ex-
pense or income (as appropriate)—
(A) The principal balance of the sec-
tion 7701(l) rent-leveling loan, minus
(B) The principal balance (plus inter-
est not already included in the principal
balance) of the property provider’s sec-
tion 467 loan (if any) as determined
under the principles of § 1.467–4(a)(4)
3
and existing as of that date.
(3)Exclusive recharacterization.If
the lease or similar agreement is a
section 467 rental agreement, the prop-
erty provider and the assuming party
must account for the recharacterized
transaction under the provisions of this
section and not under the provisions of
§§ 1.467–1 through 1.467–8.
4
(e)Section 7701(l) note—(1)Princi-
pal.On the date on which the
obligation-shifting transaction is con-
summated, the principal balance of the
section 7701(l) note equals the excess
of—
(i) The present value of the amounts
that are allocable to periods (including
partial periods) after the obligation-
shifting transaction, over
(ii) The present value of the amounts
that are payable to the assuming party.
(2)Present value, yield, and com-
pounding period.For purposes of para-
graph (e)(1) of this section, present
value is determined under the rules of
§ 1.467–2(d). The yield of the section
7701(l) note equals 110 percent of the
applicable Federal rate on the date on
which the obligation-shifting transaction
is consummated, based on the remaining
term of the lease or similar agreement.
The compounding period for determin-
ing both the original principal balance
and the yield must equal the period used
in determining the amounts that are
allocable (as determined under para-
graph (g) of this section) to periods
under the lease or similar agreement.
(3)Repayment schedule—(i)Amount.
The payment for each period under the
section 7701(l) note is—
(A) The amount that is taken into
account by the assuming party under
paragraph (d)(1)(i) of this section, minus
1
This section appears in proposed regulations
published on June 3, 1996 (IA–292–84, 61 FR
27834, 27839).
2
This section appears in proposed regulations
published on June 3, 1996 (IA–292–84, 61 FR
27834, 27844).
3
This section appears in proposed regulation pub-
lished on June 3, 1996 (IA–292–84, 61 FR 27834,
27845).
4
These sections appear in proposed regulations
published on June 3, 1996 (IA–292–84, 61 FR
27834).
5
This section appears in proposed regulations
published on June 3, 1996 (IA–292–84, 61 FR
27834, 27842).
461997–7 I.R.B.

(B) The amount received by the as-
suming party for that period.
(ii)Timing.The timing of section
7701(l) note payments, as determined
under paragraph (e)(3)(i) of this section,
is the same as the timing of the pay-
ments taken into account by the assum-
ing party under paragraph (d)(1)(i) of
this section.
(4)Debt for all purposes.A section
7701(l) note is debt for all purposes of
the Internal Revenue Code. The princi-
pal balance of the section 7701(l) note
after the obligation-shifting transaction
may be positive or negative. If the
principal balance is positive, the note
represents an amount owed by the as-
suming party to the property provider,
and if the principal balance is negative,
the note represents an amount owed by
the property provider to the assuming
party.
(f)Section 7701(l) rent-leveling
loan—(1)Principal.On the date on
which the obligation-shifting transaction
is consummated, the principal balance of
the section 7701(l) rent-leveling loan
equals the principal balance (plus any
interest not already included in the prin-
cipal balance) of the section 467 loan as
determined under § 1.467–4(b) that
would have existed as of that date if—
(i) The amounts payable under the
lease or similar agreement were the
amounts described in paragraphs (g)(1)
and (g)(2) of this section, and
(ii) The property provider had re-
ported all items of income and expense
with respect to the lease or similar
agreement by applying the constant
rental accrual method described in
§ 1.467–3(d) and by determining the
section 467 rent for each period in
accordance with § 1.467–1(d)(2)(i).
(2)Yield and compounding period.
The yield of the section 7701(l) rent-
leveling loan equals 110 percent of the
applicable Federal rate on the date on
which the obligation-shifting transaction
is consummated, based on the original
term of the lease or similar agreement.
The compounding period for determin-
ing the yield must equal the period used
in determining the amounts that are
allocable (as determined under para-
graph (g) of this section) to periods
under the lease or similar agreement.
(3)Repayment schedule—(i)Amount.
The property provider’s payment (or
receipt) for each period under the sec-
tion 7701(l) rent-leveling loan is—
(A) The amount (as described in
paragraph (e)(3)(i) of this section)
treated as paid in satisfaction of the
section 7701(l) note, minus
(B) The amount received by the
property provider under the lease or
similar agreement for that period.
(ii)Timing.The timing of section
7701(l) rent-leveling loan payments, as
determined under paragraph (f)(3)(i) of
this section, is governed by paragraph
(g) of this section (and thus, is the same
as the timing of the payments taken into
account by the assuming party under
paragraph (d)(1)(i) of this section).
(4)Debt for all purposes.A section
7701(l) rent-leveling loan is debt for all
purposes of the Internal Revenue Code.
The principal balance of the section
7701(l) rent-leveling loan may be posi-
tive or negative. If the principal balance
is positive, the amount represents a loan
on which the property provider is the
obligee, and if the principal balance is
negative, the amount represents a loan
on which the property provider is the
obligor.
(g)Determining amounts that are al-
locable to periods under the lease or
similar agreement.The amounts that are
allocable to periods under a lease or
similar agreement are determined (im-
mediately before the obligation-shifting
transaction is consummated) by applying
the constant rental accrual method de-
scribed in § 1.467–3(d) from the incep-
tion of the lease or similar agreement
based on—
(1) The amounts that have already
been received under the lease or similar
agreement, and
(2) The amounts that are payable un-
der the lease or similar agreement.
(h)Definitions.The following defini-
tions apply solely for purposes of this
section.
(1) Anobligation-shifting transaction
is any transaction in which an assuming
party assumes a property provider’s ob-
ligations to a property user (or acquires
property subject to a property provider’s
obligations to a property user) under a
lease or similar agreement if the prop-
erty provider or any other party has
already received, or retains the right to
receive, amounts that are allocable to
periods after the transaction.
(2) Aproperty useris any person
with the right to use property under a
lease or similar agreement.
(3) Aproperty provideris any person
(other than an assuming party in its
capacity as such) that is obligated to
make property available to a property
user on account of a lease or similar
agreement.
(4) Anassuming partyis any person
that assumes obligations or acquires
property subject to obligations under an
existing lease or similar agreement with
a property user.
(5) Alease or similar agreementis
any contract for the use or enjoyment of
tangible or intangible property, including
leaseholds, licenses, other non-fee inter-
ests in property, and other contracts
(including service contracts) involving
the use or enjoyment of property if the
fair market value of that use or enjoy-
ment is more than de minimis.
(6)Obligations under a lease or
similar agreementinclude the continuing
obligation to make property subject to a
lease or similar agreement available to a
property user. To the extent that an
assuming party assumes obligations of a
property provider or acquires property
subject to obligations of a property
provider, the obligations shall not there-
after be treated as obligations of the
property provider.
(7)Amounts that have already been
received under the lease or similar
agreementinclude consideration re-
ceived (as of the date on which the
obligation-shifting transaction is con-
summated) for assigning the rights to
receive payments under the lease or
similar agreement.
(8)Amounts that are payable under
the lease or similar agreementdo not
include payments the rights to which
have been assigned in an arm’s-length
transaction to an unrelated third person
in exchange for consideration.
(9) Asection 7701(l) noteis indebt-
edness arising from the recharacteriza-
tion described in paragraph (d)(1)(ii) of
this section. The terms of a section
7701(l) note are described in paragraph
(e) of this section.
(10) Asection 7701(l) rent-leveling
loanis indebtedness arising from the
recharacterization described in paragraph
(d)(2)(i) of this section. The terms of a
section 7701(l) rent-leveling loan are
described in paragraph (f) of this sec-
tion.
(i)Reserved.
(j)Pass-through entity look-through
rule.For purposes of determining
whether any person is a property user, a
property provider, or an assuming party,
the person is treated as having the rights
and obligations of any pass-through en-
tity in which the person is a partner,
shareholder, beneficiary, or other partici-
pant, but only to the extent of the
person’s allocable share of pass-through
entity items relating to the property. The
471997–7 I.R.B.

pass-through entity must reflect the re-
quired recharacterization on its books.
(k)Consolidated group rule.For pur-
poses of this section, if a subsidiary is a
member of a consolidated group and the
subsidiary or a successor becomes a
nonmember (other than in a transaction
described in § 1.1502–13(j)(5)), the
nonmember (whether or not a separate
legal entity) will be treated as a separate
corporation that acquires the assets and
assumes the obligations of the subsid-
iary. For example, assume that P sells
all the stock of S, previously a wholly-
owned subsidiary of P and a member of
the P consolidated group, and that, at
the time of the sale, S already has
received amounts under a lease that are
allocable to periods after the sale. Under
this paragraph (k), an obligation-shifting
transaction occurs when S becomes a
nonmember. S, as a nonmember, is
treated as having assumed the obliga-
tions under the lease. Therefore, S must
adjust its income as provided in para-
graph (d)(2)(ii) of this section immedi-
ately before it becomes a nonmember of
the consolidated group. After the sale, S
is treated as both a property provider
and an assuming party in the obligation-
shifting transaction.
(l)Reserved.
(m)Examples.The following ex-
amples illustrate the rules of this sec-
tion. Each example assumes that all
taxpayers use the calendar year as the
taxable year, all payment periods are the
calendar year, and none of the rental
agreements are disqualified leasebacks
or long-term agreements under § 1.467–
3(b). Except as otherwise provided,
none of the exceptions in paragraph
(c)(1) of this section apply. The ex-
amples read as follows:
Example 1. Retained rents; section 351 trans-
fer—(i)Facts.(A) On January 1, 2001, A leases
property to B for a five-year period. The lease
provides for rent of $10,000,000 per year, payable
annually on December 31.
(B) On January 1, 2002, A transfers the leased
property to D in exchange for D preferred stock. A
retains the right to receive the remaining four
years of rent from B. As part of the same
transaction, C transfers $100,000,000 to D in
exchange for D common stock. After the transac-
tion, A and C own 100 percent of the stock of D.
Assume the transaction meets all of the require-
ments of section 351. C and D are members of the
same consolidated group as defined in § 1.1502–
1(h). One hundred ten percent of the applicable
Federal rate based on annual compounding is 7
percent.
(ii)Obligation-shifting transaction.B is a prop-
erty user because B has the right to use the
property under the lease with A. A is a property
provider because A is obligated to make the
property available to B on account of the lease. D
is an assuming party because in the January 1,
2002, transaction D acquires the property subject
to A’s obligations under the lease to make the
property available to B for the remaining four
years of the lease. The transaction is an obligation-
shifting transaction because D is an assuming
party and A retains the right to receive rent from
B allocable to periods after the transaction.
(iii)Recharacterization.As of January 1, 2002,
the transaction is recharacterized as follows:
(A) Under the constant rental accrual method
described in § 1.467–3(d), the amount accruing
for each calendar year period under the lease is
$10,000,000. D is treated as acquiring the right to
receive the amounts allocable to the four periods
after the obligation-shifting transaction. Thus, in
2002, 2003, 2004, and 2005, D must recognize
$10,000,000 rental income.
(B) The principal balance of the section 7701(l)
note equals $33,872,112.56, with a yield equal to
7 percent based on annual compounding. As part
of the obligation-shifting transaction, D is treated
as having given A the section 7701(l) note as
additional consideration. The amount of the sec-
tion 7701(l) note is treated as ‘‘other property’’
transferred from D to A in the section 351
exchange. D is treated as making section 7701(l)
note payments to A. A has interest income on the
section 7701(l) note. D has interest expense on the
section 7701(l) note. A and D account for the
section 7701(l) note as follows:
Section 7701(l) note
Taxable
year ending
Beginning
balancePaymentInterestPrincipal
12/31/02$33,872,112.56$10,000,000.00$2,371,047.88$7,628,952.12
12/31/03$26,243,160.44$10,000,000.00$1,837,021.23$8,162,978.77
12/31/04$18,080,181.67$10,000,000.00$1,265,612.72$8,734,387.28
12/31/05$ 9,345,794.39$10,000,000.00$ 654,205.61$9,345,794.39
(C) Because the amount A recognized in the
year before the obligation-shifting transaction
equals the amount A would have recognized under
the constant rental accrual method, A’s adjustment
to income on the consummation of the obligation-
shifting transaction is $0.
(D) At the time of the obligation-shifting trans-
action, the principal balance of the section 7701(l)
rent-leveling loan equals $0. Furthermore, because
the amounts A actually receives each year after the
obligation-shifting transaction, $10,000,000, equal
the amounts D is treated as paying A under the
section 7701(l) note, $10,000,000, the balance of
the section 7701(l) rent-leveling loan equals $0 for
all periods after the obligation-shifting transaction.
Thus, A has no interest income or expense arising
from the section 7701(l) rent-leveling loan.
Example 2. Rents already received; section 351
transfer—(i) Facts.(A) On January 1, 2001, X
leases property to Y for a seven-year period. The
XY lease provides for rent of $900,000 per year,
payable annually on December 31. Also on Janu-
ary 1, 2001, Y leases the property to Z for a
five-year period. The YZ lease provides for rent
payable on December 31 of each year as follows:
$800,000 in 2001, $900,000 in 2002, $1,000,000
in 2003, $1,100,000 in 2004, and $1,200,000 in
2005.
(B) On December 31, 2001, Y sells to F the
right to receive all rents from Z for 2002 through
2005. F pays Y $3,146,345.27. Y includes the
$3,146,345.27 as ordinary income.
(C) On January 1, 2002, Y contributes to S
cash of $2,500,000, Y’s rights and obligations
under the lease with X, and Y’s rights and
obligations under the lease with Z in exchange for
S preferred stock. As part of the same transaction,
P transfers cash of $7,500,000 to S in exchange
for S common stock. After the transaction, Y and
P own 100 percent of the stock of S. Assume the
transaction meets all of the requirements of section
351. S and P are members of the same consoli-
dated group as defined in § 1.1502–1(h). One
hundred ten percent of the applicable Federal rate
based on annual compounding is 10 percent.
(ii)Obligation-shifting transaction.Z is a prop-
erty user because Z has the right to use the
property under the YZ lease. Y is a property
provider because Y is obligated to make the
property available to Z. S is an assuming party
because in the January 1, 2002, transaction, S
assumes Y’s obligations under the YZ lease to
make the property available for the remaining four
years of the lease. The transaction is an obligation-
shifting transaction because S is an assuming party
and Y has already received amounts allocable to
periods after the transaction (Y sold to F the right
to receive rent payments under the YZ lease for
2002 through 2005).
(iii)Recharacterization.As of January 1, 2002,
the transaction is recharacterized as follows:
(A) Under the constant rental accrual method
described in § 1.467–3(d), the amount accruing
for each calendar year period under the YZ lease
is $946,396.31, based on the $800,000 Y received
from Z on December 31, 2001, and the
$3,146,345.27 Y received from F on December 31,
2001. S is treated as acquiring the right to receive
the amounts allocable to the four periods after the
obligation-shifting transaction. Thus, S must rec-
ognize $946,396.31 of rental income for each of
the four periods following the obligation-shifting
transaction.
(B) The principal balance of the section 7701(l)
note equals $2,999,948.96, with a yield equal to
10 percent based on annual compounding. As part
of the obligation-shifting transaction, S is treated
as having given Y the section 7701(l) note as
additional consideration. The amount of the sec-
tion 7701(l) note is treated as ‘‘other property’’
481997–7 I.R.B.

transferred from S to Y in the section 351
exchange. S is treated as making section 7701(l)
note payments to Y. Y has interest income on the
section 7701(l) note. S has interest expense on the
section 7701(l) note. S and Y account for the
section 7701(l) note as follows:
Section 7701(l) note
Taxable
year ending
Beginning
balancePaymentInterestPrincipal
12/31/02$2,999,948.96$946,396.31$299,994.90$646,401.41
12/31/03$2,353,547.55$946,396.31$235,354.75$711,041.56
12/31/04$1,642,505.99$946,396.31$164,250.60$782,145.71
12/31/05$ 860,360.28$946,396.31$ 86,036.03$860,360.28
(C) At the time of the obligation-shifting trans-
action, the principal balance of the section 467
loan that would have existed if Y had reported all
items of income and expense by applying the
constant rental accrual method equals negative
$2,999,948.96. Thus, in computing its income on
the consummation of the obligation-shifting trans-
action, Y must take into account an expense equal
to $2,999,948.96.
(D) At the time of the obligation-shifting trans-
action, the principal balance of the section 7701(l)
rent-leveling loan equals negative $2,999,948.96.
Y must account for the section 7701(l) rent-
leveling loan as follows:
Section 7701(l) rent-leveling loan
Taxable
year ending
Beginning
balancePaymentInterestPrincipal
12/31/02($2,999,948.96)($946,396.31)($299,994.90)($646,401.41)
12/31/03($2,353,547.55)($946,396.31)($235,354.75)($711,041.56)
12/31/04($1,642,505.99)($946,396.31)($164,250.60)($782,145.71)
12/31/05($ 860,360.28)($946,396.31)($ 86,036.03)($860,360.28)
Example 3. Rents already received; sale of a
partnership interest—(i)Facts.(A) On January 1,
2001, A, B, and C form partnership PRS by
contributing $3,600,000, $396,000, and $4,000,
respectively, for proportionate interests (90.0 per-
cent, 9.9 percent, and 0.1 percent, respectively) in
the capital and profits of PRS. On the same day,
PRS purchases property for $4,000,000 and leases
the property to X for a five-year period. The lease
provides for rent payable on December 31 of each
year as follows: $800,000 in 2001, $900,000 in
2002, $1,000,000 in 2003, $1,100,000 in 2004,
and $1,200,000 in 2005.
(B) On December 31, 2001, PRS sells to F the
right to receive all rents from X for 2002 through
2005. F pays PRS $3,146,345.27. PRS treats the
$3,146,345.27 as ordinary income allocated
$2,831,710.74 to A, $311,488.18 to B, and
$3,146.35 to C. One hundred ten percent of the
applicable Federal rate based on annual com-
pounding is 10 percent.
(C) Immediately following the sale of the rents,
A sells its entire partnership interest to D based on
the fair market value of 90 percent of PRS’s
assets. PRS does not have an election in effect
under section 754.
(ii)Obligation-shifting transaction.X is a prop-
erty user because X has the right to use the
property under the lease with PRS. A is a property
provider as to its share of the partnership’s
obligations under the lease to make the property
available to X. D is an assuming party because D
acquires A’s partnership interest subject to A’s
share of the partnership’s obligations under the
lease with X to make the property available for
the remaining four years of the agreement. The
transaction is an obligation-shifting transaction
because D is an assuming party and A has already
received income allocable to periods after the
transaction (A received allocations of income from
the sale of the right to receive rents under the
lease in 2002 through 2005). Thus, D is treated as
assuming 90 percent of the partnership’s obliga-
tions under the lease.
(iii)Recharacterization.As of January 1, 2002,
the transaction is recharacterized as follows:
(A) Under the constant rental accrual method
described in § 1.467–3(d), the amount accruing
for each calendar year period under the lease is
$946,396.31, based on the $800,000 PRS received
from X and the $3,146,345.27 PRS received from
F. A’s share of the amount payable in each
calendar year period under the lease is
$851,756.68 (90 percent of $946,396.31). D is
treated as acquiring the right to A’s 90 percent
share of the amounts allocable to the four periods
after the obligation-shifting transaction. Thus, D
must recognize $851,756.68 of rental income for
each of the four periods following the obligation-
shifting transaction.
(B) The principal balance of the section 7701(l)
note equals $2,699,954.06, with a yield equal to
10 percent based on annual compounding. As part
of the obligation-shifting transaction, D is treated
as having given A the section 7701(l) note as
additional consideration. D is treated as making
section 7701(l) note payments to A. A has interest
income on the section 7701(l) note. D has interest
expense on the section 7701(l) note. A and D
account for the section 7701(l) note as follows:
Section 7701(l) note
Taxable
year ending
Beginning
balancePaymentInterestPrincipal
12/31/02$2,699,954.06$851,756.68$269,995.41$581,761.27
12/31/03$2,118,192.79$851,756.68$211,819.28$639,937.40
12/31/04$1,478,255.39$851,756.68$147,825.54$703,931.14
12/31/05$ 774,324.25$851,756.68$ 77,432.42$774,324.26
(C) At the time of the obligation-shifting trans-
action, the principal balance of the section 467
loan that would have existed if PRS had reported
all items of income and expense by applying the
constant rental accrual method equals negative
$2,999,948.96. Thus, in computing its income on
the consummation of the obligation-shifting trans-
action, A must take into account an expense equal
to $2,699,954.06 (90 percent of $2,999,948.96).
(D) At the time of the obligation shifting
transaction, the principal balance of the section
7701(l) rent-leveling loan equals negative
$2,699,954.06. A must account for the section
7701(l) rent-leveling loan as follows:
491997–7 I.R.B.

Section 7701(l) rent-leveling loan
Taxable
year ending
Beginning
balancePaymentInterestPrincipal
12/31/02($2,699,954.06)($851,756.68)($269,995.41)($581,761.27)
12/31/03($2,118,192.79)($851,756.68)($211,819.28)($639,937.40)
12/31/04($1,478,255.39)($851,756.68)($147,825.54)($703,931.14)
12/31/05($ 774,324.25)($851,756.68)($ 77,432.42)($774,324.26)
Example 4. Exception where aggregate amounts
retained or already received are less than or equal
to $100,000; section 351 transfer—(i)Facts.(A)
On January 1, 2001, A leases property to B for a
five-year period. The lease provides for rent of
$1,000,000 for 2001, and $875,000 for the each of
the remaining four years of the lease. Rent is
payable annually on December 31.
(B) On January 1, 2002, A transfers the leased
property along with the right to receive rent
payments for 2002 through 2005 to D in exchange
for D preferred stock. As part of the same
transaction, C transfers $1,000,000 to D in ex-
change for D common stock. After the transaction,
A and C own 100 percent of the stock of D.
Assume that the transaction meets all of the
requirements of section 351. C and D are mem-
bers of the same consolidated group as described
in § 1.1502–1(h). Assume that A, C, and D did
not enter into the transaction with a principal
purpose of substantially reducing the present value
of their aggregate tax liabilities. One hundred ten
percent of the applicable Federal rate based on
annual compounding is 7 percent.
(ii)Obligation-shifting transaction.A is a prop-
erty provider because it is obligated to make
property available to B on account of a lease or
similar agreement. B is a property user because it
has the right to use property under its lease with
A. D is an assuming party because, in the January
1, 2002, transaction, it acquires the property
subject to A’s obligation to make the property
available to B for the remaining term of the lease.
The transaction between A and D is an obligation-
shifting transaction because D is an assuming
party and A retains the right to receive amounts
from B allocable to periods after the transaction.
(iii)Availability of exception.Even though the
transaction between A and D is an obligation-
shifting transaction, it is not recharacterized under
this section. As of the date of the transaction, A
has already received $1,000,000. Under the con-
stant rental accrual method described in § 1.467–
3(d), the constant rental amount accruing for each
calendar year during the lease is $903,491.90. The
aggregate amount that has already been received
by A but that is allocable to periods after the
obligation-shifting transaction is $1,000,000 minus
$903,491.90, or $96,508.10. Because this amount
is less than $100,000, the transaction is excepted
from recharacterization under paragraph (c)(1)(i)
of this section.
Example 5. Exception where fair market value
of leased property is less than 10 percent of value
of all property transferred; incorporation of exist-
ing business—(i)Facts.(A) On January 1, 2001,
A leases property to B for a five-year period. The
lease provides for rent of $1,000,000 per year,
payable annually on December 31.
(B) On January 1, 2003, the fair market value
of the leased property is $4,000,000. On that date,
A transfers the property, together with $3,000,000
of Class I and Class II assets and other property
with a fair market value of $39,000,000, in
exchange for all of the common stock of C. A
retains the right to receive the remaining three rent
payments from B. The fair market value of the
rent payments retained by A is $2,486,851.99
(based on a discount rate of 10 percent). The fair
market value of the property subject to the lease
and transferred to B, reflecting A’s retention of the
right to the remaining three rent payments, is
$1,513,148.01. Assume that the transaction meets
all of the requirements of section 351. Assume
that A and C did not enter into the transaction
with a principal purpose of substantially reducing
the present value of their aggregate tax liabilities.
(ii)Obligation-shifting transaction.A is a prop-
erty provider because it is obligated to make
property available to B on account of a lease or
similar agreement. B is a property user because it
has the right to use property under its lease with
A. C is an assuming party because, in the January
1, 2003, transaction, it acquires the property
subject to A’s obligation to make the property
available to B for the remaining three years of the
lease. The transaction between A and C is an
obligation-shifting transaction because C is an
assuming party and A retains the right to receive
amounts from B allocable to periods after the
transaction.
(iii)Availability of exception.Even though the
transaction between A and C is an obligation-
shifting transaction, it is not recharacterized under
this section. The fair market value of the leased
property equals $4,000,000. The fair market value
of the property subject to the lease and transferred
to B is $1,513,148.01, and the fair market value of
the rents retained is $2,486,851.99. The aggregate
fair market value of all of the property transferred,
excluding Class I assets, Class II assets, and debt
issued by the property provider, as part of the
same transaction is $43,000,000 ($4,000,000
leased property plus $39,000,000 other property,
excluding Class I assets, Class II assets, and debt
issued by the property provider). Because the
value of the leased property, $4,000,000, is less
than 10 percent of $43,000,000, the transaction is
excepted from recharacterization under paragraph
(c)(1)(iii) of this section.
(n)Effective date.This section ap-
plies to obligation-shifting transactions
any significant element of which was
entered into or undertaken on or after
October 13, 1995.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
(Filed by the Office of the Federal Register on
December 26, 1996, 8:45 a.m., and published in
the issue of the Federal Register for December 27,
1996, 61 F.R. 68175)
Notice of Proposed Rulemaking
and Notice of Public Hearing
Reorganizations; Receipt of
Securities
REG–249819–96
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemak-
ing and notice of public hearing.
SUMMARY: This document contains
proposed regulations relating to the re-
ceipt, as part of a reorganization, of
rights to acquire stock of a corporation
that is a party to the reorganization. This
document also provides notice of a
public hearing on these regulations.
DATES: Written comments must be re-
ceived by March 23, 1997. Requests to
appear and outlines of topics to be
discussed at the public hearing sched-
uled for March 25, 1997, must be
received by March 4, 1997.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R [REG–249819–96],
room 5228, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington, DC 20044. In the alternative,
submissions may be hand delivered be-
tween the hours of 8 a.m. and 5 p.m. to:
CC:DOM:CORP:R [REG–249819–96],
Courier’s Desk, Internal Revenue Ser-
vice, 1111 Constitution Avenue NW,
Washington, DC, or, electronically, via
the IRS Internet site at: http://
www.irs.ustreas.gov/prod/tax_regs/
comments.html.
The public hearing will be held in the
Commissioner’s Conference Room,
room 3313, 1111 Constitution Avenue
NW, Washington, DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed
regulations, Michael J. Danbury, (202)
622–7750; concerning submissions and
the public hearing, Evangelista Lee at
(202) 622–7190 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
A. General information
This document contains proposed
amendments to the Income Tax Regula-
tions (26 CFR part 1) under sections
354, 355, and 356 of the Internal Rev-
501997–7 I.R.B.

enue Code of 1986 (Code), relating to
exchanges of stock and securities in
certain reorganizations. In particular, the
proposed regulations address the receipt,
as part of a reorganization, of rights to
acquire stock of a corporation that is a
party to the reorganization.
Section 354 generally provides for the
nonrecognition of gain or loss from the
exchange of stock or securities in a
corporation that is a party to a reorgani-
zation for stock or securities in the same
corporation or in another corporation
that is a party to the reorganization.
Gain realized on an exchange of securi-
ties is not recognized provided that the
principal amount of the securities re-
ceived does not exceed the principal
amount of any securities surrendered
pursuant to the plan of reorganization.
Section 355 provides for the nonrec-
ognition of gain or loss upon a distribu-
tion by a corporation with respect to its
stock of stock in a controlled corpora-
tion, or an exchange of securities in a
controlled corporation for its securities.
As in the case of a transaction described
in section 354, gain realized on an
exchange of securities is not recognized
provided that the principal amount of
the securities received does not exceed
the principal amount of the securities
surrendered pursuant to the plan of
reorganization.
Section 356 provides rules for recog-
nition of gain, but not loss, if a share-
holder or security holder receives
nonqualifying property (i.e., boot) as
well as qualifying property in a transac-
tion to which section 354 or 355 would
otherwise apply. In particular, realized
gain is recognized in an amount not in
excess of the fair market value of the
excess principal amount of the securities
received over the principal amount of
any securities surrendered as part of the
plan of reorganization.
B. Existing regulations
Existing regulations under sections
354 and 355 provide that stock rights
and stock warrants are not included in
the term ‘‘stock or securities.’’ Prior to
the promulgation of these regulations in
1955, the treatment of such instruments
was unclear. Although the Supreme
Court had held that stock warrants do
not constitute ‘‘stock’’ for purposes of
determining whether a transaction is a
reorganization, the Board of Tax Ap-
peals had held that stock warrants did
constitute ‘‘securities’’ for purposes of
section 112(b)(3) of the 1932 Act (a
predecessor to section 354 of the Code).
CompareHelvering v. Southwest Con-
solidated Corp., 315 U.S. 194 (1942),
withRaymond v. Commissioner, 37
B.T.A. 423 (1938).
Since 1955, courts have avoided con-
cluding whether stock rights or stock
warrants constitute ‘‘securities’’ for pur-
poses of sections 354 and 355. See, e.g.,
Carlberg v. United States, 281 F.2d 507,
509 n.3 (8th Cir. 1960);Bateman v.
Commissioner, 40 T.C. 408 (1963);Es-
tate of Smith v. Commissioner, 63 T.C.
722 (1975).
C. Reasons for Change
A purpose of the reorganization provi-
sions of the Code is to defer the recog-
nition of gain and loss in certain read-
justments of corporate structure.
Generally, the Code extends nonrecogni-
tion to an exchange of stock which
effects only a readjustment of continu-
ing interest in modified corporate form.
Although a right to acquire stock is not
stock, the IRS and Treasury believe that
it may generally represent a form of
investment in the capital structure of the
corporation that justifies nonrecognition
treatment as a security under sections
354 and 355. Other provisions of the
Code expressly acknowledge the role
that stock rights play in the capital
structure of a corporation. See, e.g.,
sections 317 and 1032. Accordingly, the
proposed regulations provide that for
purposes of sections 354 and 355 the
term securities includes ‘‘rights to ac-
quire stock’’ issued by a corporation that
is a party to a reorganization.
Explanation of Provisions
A. Scope of proposed rules
The proposed regulations treat rights
to acquire stock issued by a corporation
that is a party to a reorganization as
securities of the corporation. For this
purpose, the term ‘‘rights to acquire
stock’’ of an issuing corporation has the
same meaning as the term has in sec-
tions 305(d)(1) and 317(a). It does not
include rights exercisable against per-
sons other than the issuer of the stock,
or rights that relate to property other
than stock of the issuer of the rights. As
under current law, a conversion privilege
contained in a stock or debt instrument
generally will not be considered a sepa-
rate property right received as part of
the reorganization. See Rev. Rul. 69–
265 (1969–1 C.B. 109).
B. Consequences upon receipt of stock
rights
For purposes of sections 354, 355 and
356, the proposed regulations treat rights
to acquire stock as securities having no
principal amount. As a result, a taxpayer
will not be required to recognize any
gain under section 356 upon the receipt
of a stock right. This will generally be
the case regardless of whether the tax-
payer surrenders stock, stock rights, or
debt securities.
C. Effect on other authorities
The proposed rules apply only for the
purpose of determining the amount of
gain to be recognized in connection with
exchanges occurring pursuant to transac-
tions otherwise qualifying under section
368 or 355. They do not address issues
concerning the qualification of a trans-
action under section 368 or 355. For
example, the proposed rules do not
permit rights to acquire stock to be
taken into account in determining conti-
nuity of shareholder interest. SeeSouth-
west Consolidated Corp.(stock options
are not stock).
The proposed rules have no effect on
other Code provisions governing the
treatment of stock options or similar
interests for other purposes. Thus, for
example, the treatment of an instrument
under these rules is not relevant in
determining whether the holder of the
instrument is treated as holding stock of
the issuer for various purposes. See,
e.g., sections 318(a)(4), 382(k)(6), and
1504(a)(5). Similarly, an instrument
treated as a stock right under these rules
may be subject to special rules under
other provisions of the Code or regula-
tions relating to compensation related
stock options. See, e.g., sections 83 and
421–424 and the regulations thereunder.
Nor is any inference intended as to the
treatment of an exchange, substitution,
or assumption of such options under
current law.
D. Proposed effective dates
The proposed regulations change a
long-standing regulatory position. To af-
ford taxpayers the opportunity to plan
for the change, these regulations are
proposed to be effective 60 days after
the Treasury decision adopting these
rules as final regulations is filed with
the Office of theFederal Register.
511997–7 I.R.B.

E. Comments regarding need for further
guidance
Comments are requested as to
whether additional guidance is needed
with respect to the scope of these regu-
lations and the general treatment of
rights to acquire stock. For example,
comments are invited with respect to:
the need for additional guidance or
special rules to address transactions in-
volving exchanges, substitutions, or as-
sumptions of compensation related stock
options; the application of section 306
to the transfer of a right to acquire
common stock if the right is received
tax-free pursuant to section 305 or 354;
whether section 302 should apply to the
cash settlement or repurchase of a stock
right, for example by treating the holder
as having purchased the stock pursuant
to the terms of the right and the issuer
as having then redeemed that stock for
cash; and any other administrative guid-
ance which may be helpful in light of
these proposed rules, including sugges-
tions as to existing revenue rulings or
revenue procedures that should be modi-
fied, reconsidered, or revoked. Note that
comments outside of the scope of these
regulations will be considered as sug-
gestions for other future guidance.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in
Executive Order 12866. Therefore, a
regulatory assessment is not required. It
has also been determined that section
553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) does not apply
to these regulations. Because the regula-
tion does not impose a collection of
information on small entities, the Regu-
latory Flexibility Act (5 U.S.C. chapter
6) does not apply. Pursuant to section
7805(f) of the Code, this notice of
proposed rulemaking will be submitted
to the Chief Counsel for Advocacy 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, consider-
ation will be given to any comments
submitted timely (in the manner de-
scribed under the ADDRESSES caption)
to the IRS. All comments will be avail-
able for public inspection and copying.
A public hearing is scheduled for
March 25, 1997, at 10 a.m., in the
Commissioner’s Conference Room,
room 3313. Because of access restric-
tions, visitors will not be admitted be-
yond the Internal Revenue Building
lobby more than 15 minutes before the
hearing starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons who wish to present oral
comments at the hearing must submit an
outline of the topics to be discussed by
March 4, 1997.
A period of 10 minutes will be allot-
ted 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 David B. Friedel, formerly of
the Office of Assistant Chief Counsel
(Corporate). However, other personnel
from the IRS and Treasury Department
participated in their development.
* * * * *
Proposed Amendments to the Regula-
tions
Accordingly, 26 CFR part 1 is pro-
posed 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. Section 1.354–1 is amended by
revising paragraph (e) to read as fol-
lows:
§ 1.354–1 Exchanges of stock and se-
curities in certain reorganizations.
* * * * *
(e) For purposes of section 354, the
termsecuritiesincludes rights issued by
a party to the reorganization (theissuing
corporation) to acquire its stock. For
purposes of this section and section
356(d)(2)(B), a right to acquire stock
has no principal amount. This paragraph
(e) applies to exchanges occurring on or
after the day that is 60 days after the
Treasury decision adopting these regula-
tions is filed with theFederal Register.
Par 3. Section 1.355–1 is amended by
removing the last sentence of paragraph
(b) and adding paragraph (c) to read as
follows:
§ 1.355–1 Distribution of stock and se-
curities of a controlled corporation.
* * * * *
(c)Stock rights.For purposes of sec-
tion 355, the termsecuritiesincludes
rights to acquire the stock of the distrib-
uting corporation or the controlled cor-
poration (theissuing corporation). For
purposes of this section and section
356(d)(2)(B), a right to acquire stock
has no principal amount. This paragraph
(c) applies to distributions occurring on
or after the day that is 60 days after the
Treasury decision adopting these regula-
tions is filed with theFederal Register.
Par 4. Section 1.356–3 is amended
by:
1. Redesignating existing paragraph
(b) as paragraph (c).
2. Adding a new paragraph (b) to
read as follows:
§ 1.356–3 Rules for treatment of secu-
rities as ‘‘other property’’.
* * * * *
(b) For purposes of this section, a
right to acquire stock of the issuing
corporation is treated as a security with
no principal amount. Thus, such right is
notother propertywhen received in a
transaction to which section 356 applies
(regardless of whether securities are sur-
rendered in the exchange). This para-
graph (b) applies to transactions occur-
ring on or after the day that is 60 days
after the Treasury decision adopting
these regulations is filed with the Fed-
eral Register.
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
(Filed by the Office of the Federal Register on
December 20, 1996, 8:45 a.m., and published in
the issue of the Federal Register for December 23,
1996, 61 F.R. 67508)
Notice of Proposed Rulemaking
and Notice of Public Hearing
Continuity of Interest
REG–252231–96
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemak-
ing and notice of public hearing.
SUMMARY: This document contains
proposed regulations providing that the
continuity of shareholder interest re-
quirement for corporate reorganizations
is satisfied if the acquiring corporation
521997–7 I.R.B.

furnishes consideration which represents
a proprietary interest in the affairs of the
acquiring corporation and such consider-
ation represents a substantial part of the
value of the stock or properties trans-
ferred. Dispositions of stock of the ac-
quiring corporation by a former target
shareholder generally are not taken into
account in determining whether continu-
ity of shareholder interest has been
satisfied. This document also provides
notice of a public hearing on these
proposed regulations.
DATES: Comments must be received
by March 24, 1997. Requests to speak
and outlines of topics to be discussed at
the public hearing scheduled for
Wednesday, May 7, 1997 must be re-
ceived by Wednesday, April 16, 1997.
ADDRESSES: Send submissions to:
CC:DOM:CORP:R (REG–252231–96),
room 5228, Internal Revenue Service,
POB 7604, Ben Franklin Station, Wash-
ington, DC 20044. In the alternative,
submissions may be hand delivered be-
tween the hours of 8 a.m. and 5 p.m. to
CC:DOM:CORP:R (REG–252231–96),
Courier’s Desk, Internal Revenue Ser-
vice, 1111 Constitution Avenue NW,
Washington, DC. Alternatively, taxpay-
ers may submit comments electronically
via the Internet by selecting the ‘‘Tax
Regs’’ option on the IRS Home Page, or
by submitting comments directly to the
IRS Internet site at http://www.irs.
ustreas.gov/prod/tax_regs/comments.
html. The public hearing will be held in
the Auditorium, Internal Revenue Build-
ing, 1111 Constitution Avenue NW,
Washington, DC.
FOR FURTHER INFORMATION
CONTACT: Concerning the regulations,
Phoebe Bennett, (202) 622–7750; con-
cerning submissions and the hearing,
Christina Vasquez, (202) 622–6808 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION:
This document contains proposed
amendments to the Income Tax Regula-
tions (26 CFR part 1) under section 368.
The proposed regulations provide that
the continuity of shareholder interest
(COSI) requirement is satisfied if the
acquiring corporation furnishes consider-
ation which represents a proprietary in-
terest in the affairs of the acquiring
corporation and such consideration rep-
resents a substantial part of the value of
the stock or properties transferred.
Background
The Internal Revenue Code of 1986
(Code) provides general nonrecognition
treatment for reorganizations specifically
described in section 368 of the Code.
Literal compliance with the statutory
requirements is not sufficient for non-
recognition. For example, to qualify as a
reorganization the COSI requirement
must also be satisfied.
The early statutory definitions of reor-
ganizations did not specify the type of
consideration required for a transaction
to qualify as a reorganization. As a
result, a transaction may have satisfied
the literal definition of a reorganization
even if the transaction resembled a sale.
To prevent such transactions from quali-
fying as reorganizations, the COSI re-
quirement was established by the courts
to ensure that the consideration fur-
nished by the acquiring corporation rep-
resented a proprietary interest in the
affairs of the acquiring corporation and
that such consideration represented a
substantial part of the value of the stock
or properties transferred. SeeHelvering
v. Minnesota Tea Co., 296 U.S. 378
(1935);Pinellas Ice & Cold Storage Co.
v. Commissioner, 287 U.S. 462 (1933);
Cortland Specialty Co. v. Commissioner,
60 F.2d 937 (2d Cir. 1932), cert. denied
288 U.S. 599 (1933). ‘‘Reorganization,
merger and consolidation are words in-
dicating corporate readjustments of ex-
isting interests. They all differ funda-
mentally from a sale where the vendor
corporation parts with its interest for
cash and receives nothing more.’’
Cortland, 60 F.2d at 939.
The cases that gave rise to the COSI
requirement did not involve situations in
which shareholders of the target corpo-
ration disposed of stock consideration
from the acquiring corporation after
having received it. In those cases, the
relevant inquiry was whether the acquir-
ing corporation furnished the proper
type of consideration in the reorganiza-
tion. Over the years, issues have arisen
regarding whether the COSI requirement
is satisfied if the target shareholders, as
contemplated at the time of the reorga-
nization, subsequently dispose of the
stock received from the acquiring corpo-
ration. CompareMcDonald’s Restau-
rants of Illinois, Inc. v. Commissioner,
688 F.2d 520 (7th Cir. 1982), rev’g
McDonald’s of Zion v. Commissioner, 76
T.C. 972 (1981), withPenrod v. Com-
missioner, 88 T.C. 1415 (1987). Various
bar associations have asked the Treasury
Department and the IRS to provide
guidance to clarify existing law and
reduce uncertainty in applying COSI
principles in the context of
postreorganization sales. See New York
State Bar Association Tax Section,
Postreorganization Continuity of Inter-
est, reprinted in 73 Tax Notes 481
(1996); Committee on Taxation of Cor-
porations of the Association of the Bar
of the City of New York, Postreorgan-
ization Transactions and Continuity of
Shareholder Interest, reprinted in 72 Tax
Notes 1401 (1996).
Explanation of Proposed Regulations
The proposed regulations provide that
the COSI requirement is satisfied if the
acquiring corporation furnishes consider-
ation in the reorganization that repre-
sents a proprietary interest in the affairs
of the acquiring corporation and such
consideration represents a substantial
part of the value of the stock or proper-
ties transferred. Dispositions of stock of
the acquiring corporation by a former
target shareholder generally are not
taken into account in determining
whether COSI has been satisfied. How-
ever, the proposed regulations empha-
size that all facts and circumstances
must be considered in determining
whether the acquiring corporation has in
substance furnished the required consid-
eration. For example, if the acquiring
corporation or a related party (within the
meaning of section 707(b)(1) or section
267(b) (without regard to section
267(e))) purchases the acquiring corpo-
ration stock shortly after the reorganiza-
tion, all of the facts and circumstances
may indicate that the transaction should
be properly recast to treat the acquiring
corporation as furnishing cash in the
reorganization, in which case the reorga-
nization would not satisfy the COSI
requirement. This approach refocuses
the COSI requirement on its initial pur-
pose of ensuring that the acquiring cor-
poration furnishes the proper type of
consideration and also promotes simplic-
ity and administrability in applying the
COSI requirement.
Effect on Other Authorities
The proposed regulations do not spe-
cifically address the effect on COSI of
dispositions of target stock before a
transaction potentially qualifying as a
reorganization. See, e.g.,King Enter-
prises, Inc. v. United States, 418 F.2d
511 (Ct. Cl. 1969);J.E. Seagram Corp.
v. Commissioner, 104 T.C. 75 (1995);
Superior Coach of Florida, Inc. v. Com-
531997–7 I.R.B.

missioner, 80 T.C. 895 (1983);Yoc
Heating Corp. v. Commissioner, 61 T.C.
168 (1973). The Treasury Department
and IRS are studying this question and
also the role of the COSI requirement in
section 368(a)(1)(D) reorganizations and
section 355 transactions. See § 1.355–
2(c). The Treasury Department and IRS
solicit comments on these issues.
Effect on Other Documents
The IRS will modify or obsolete
publications as necessary to conform
with this regulation as of the date of
publication in theFederal Registerof
the final regulations. See, e.g., Rev.
Proc. 86–42 (1986–2 C.B. 722); Rev.
Proc. 77–37 (1977–2 C.B. 568). The
IRS solicits comments as to whether
other publications should be modified or
obsoleted.
Proposed Effective Date
The revisions and additions in the
proposed regulations apply to transac-
tions occurring after these regulations
are published as final regulations in the
Federal Register, except that they shall
not apply to any transactions occurring
pursuant to a written agreement which is
(subject to customary conditions) bind-
ing on or before these regulations are
published as final regulations in the
Federal Register.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in EO
12866. Therefore, a regulatory assess-
ment is not required. It also has been
determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these
regulations, and because the regulation
does not impose a collection of informa-
tion on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does
not apply. Pursuant to section 7805(f) of
the Internal Revenue Code, this notice
of proposed rulemaking will be submit-
ted to the Chief Counsel for Advocacy
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, consider-
ation will be given to any written com-
ments (a signed original and eight cop-
ies) or comments transmitted via
Internet that are submitted timely to the
IRS. All comments will be available for
public inspection and copying.
A public hearing has been scheduled
at 10 a.m. on Wednesday, May 7, 1997,
in the Auditorium, Internal Revenue Ser-
vice, 1111 Constitution Avenue NW,
Washington DC. Because of access re-
strictions, visitors will not be admitted
beyond the Internal Revenue Building
lobby more than 15 minutes before the
hearing starts.
The rules of 26 CFR 601.601(a)(3)
apply to the hearing.
Persons that wish to present oral
comments at the hearing must request to
speak by Wednesday, April 16, 1997,
and submit an outline of the topics to be
discussed and the time to be devoted to
each topic by Wednesday, April 16,
1997.
A period of 10 minutes will be allot-
ted 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 Phoebe Bennett of the Office of
the Assistant Chief Counsel (Corporate),
IRS. However, other personnel from the
IRS and Treasury Department partici-
pated in their development.
Proposed Amendments to the Regula-
tions
Accordingly, 26 CFR part 1 is pro-
posed 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. Section 1.368–1 is amended
by:
1. Revising the third sentence of
paragraph (b).
2. Adding two sentences between the
fourth and fifth sentences of paragraph
(b).
3. Adding paragraph (e).
The revisions and additions read as
follows:
§ 1.368–1 Purpose and scope of excep-
tion of reorganization exchanges.
* * * * *
(b) * * * Requisite to a reorganiza-
tion under the Code are a continuity of
the business enterprise under the modi-
fied corporate form, and (except as
provided in section 368(a)(1)(D)) a con-
tinuity of shareholder interest. * * * The
continuity of shareholder interest re-
quirement is described in paragraph (e)
of this section. The third and fifth
sentences of this paragraph apply to
transactions occurring after these regula-
tions are published as final regulations
in theFederal Register, except that
they shall not apply to any transactions
occurring pursuant to a written agree-
ment which is (subject to customary
conditions) binding on or before these
regulations are published as final regula-
tions in theFederal Register. * * *
* * * * *
(e)Continuity of shareholder inter-
est—(1)General rule.The purpose of
the continuity of shareholder interest
requirement is to prevent transactions
that resemble sales from qualifying for
nonrecognition of gain or loss available
to corporate reorganizations. Continuity
of shareholder interest requires that the
acquiring corporation furnish consider-
ation representing a proprietary interest
in the affairs of the acquiring corpora-
tion and that such consideration repre-
sents a substantial part of the value of
the stock or properties transferred. In
determining whether the acquiring cor-
poration has furnished such consider-
ation, all facts and circumstances must
be considered, including any plan or
arrangement for the acquiring corpora-
tion or its successor corporation (or a
person related to the acquiring corpora-
tion or its successor corporation within
the meaning of section 707(b)(1) or
section 267(b) (without regard to section
267(e))) to redeem or acquire the con-
sideration provided in the reorganiza-
tion. Thus, for example, if based on all
the facts and circumstances the acquir-
ing corporation has furnished solely
cash, the continuity of shareholder inter-
est requirement is not satisfied.
(2)Triangular reorganizations.For
purposes of this paragraph (e), in the
case of a triangular reorganization de-
scribed in § 1.358–6(b), the continuity
of shareholder interest requirement will
be applied with reference to the stock of
the corporation which is in control of
the acquiring corporation (in a forward
triangular merger) or in control of the
merged corporation (in a reverse trian-
gular merger).
541997–7 I.R.B.

(3)Examples.The following ex-
amples illustrate the application of this
paragraph (e):
Example 1.A owns all of the stock of T. T
merges into P. In the merger, A receives stock of P
having a fair market value of $50x and cash of
$50x. Immediately after the merger, and pursuant
to a preexisting binding contract negotiated by A,
A sells all of the stock of P received by A in the
merger to B, a party not related to P. The
transaction satisfies the continuity of shareholder
interest requirement because A received stock of P
representing a substantial part of the value of the
total consideration transferred in the acquisition.
Example 2. A owns 80 percent of the stock of
T and none of the stock of P, which is widely
held. T merges into P. In the merger, A receives
stock of P. In addition, A obtains registration rights
pursuant to an agreement with P to register the P
stock and sells such stock shortly after the acquisi-
tion in the open market. The transaction satisfies
the continuity of shareholder interest requirement.
Example 3.A owns 80 percent of the stock of
T and none of the stock of P. T merges into P. In
the merger, A receives stock of P. In addition, A
arranges with an independent investment banker to
hedge the risk of loss on the P stock received in
the merger. Neither P nor a party related to P
enters directly or indirectly into the hedging
transaction. The transaction satisfies the continuity
of shareholder interest requirement.
Example 4.A owns 80 percent of the stock of
T and none of the stock of P. T merges into P. In
the merger, A receives stock of P but with an
agreement that it will be redeemed shortly by P.
Pursuant to the agreement, shortly after the merger
P redeems all of the stock of P received by A in
the merger for cash. Under all of the facts and
circumstances, the cash is treated as furnished by
P in the merger, so that the merger does not
satisfy the continuity of shareholder interest re-
quirement. The result is the same if S, P’s wholly
owned subsidiary, buys all of the stock of P
received by A in the merger for cash. The result is
also the same if pursuant to a plan between P, its
investment banker, and A, P’s investment banker
buys all of the stock of P received by A in the
merger for cash and, shortly thereafter, P redeems
the stock held by the investment banker for cash.
(4)Effective date.Paragraph (e) ap-
plies to transactions occurring after
these regulations are published as final
regulations in theFederal Register,
except that it shall not apply to any
transactions occurring pursuant to a
written agreement which is (subject to
customary conditions) binding on or
before these regulations are published as
final regulations in theFederal Regis-
ter.
Par. 3. In § 1.368–2, paragraph (a) is
amended by removing the second sen-
tence and adding two new sentences in
its place to read as follows:
§ 1.368–2 Definition of terms.
(a) * * * The term does not embrace
the mere purchase by one corporation of
the properties of another corporation.
The preceding sentence applies to trans-
actions occurring after these regulations
are published as final regulations in the
Federal Register, except that it shall
not apply to any transactions occurring
pursuant to a written agreement which is
(subject to customary conditions) bind-
ing on or before these regulations are
published as final regulations in the
Federal Register. * * *
* * * * *
Margaret Milner Richardson,
Commissioner of Internal Revenue.
(Filed by the Office of the Federal Register on
December 20, 1996, 8:45 a.m., and published in
the issue of the Federal Register for December 23,
1996, 61 F.R. 67512)
Foundations Status of Certain
Organizations
Announcement 97–12
The following organizations have
failed to establish or have been unable
to maintain their status as public chari-
ties or as operating foundations. Accord-
ingly, grantors and contributors may not,
after this date, rely on previous rulings
or designations in the Cumulative List
of Organizations (Publication 78), or on
the presumption arising from the filing
of notices under section 508(b) of the
Code. This listing doesnotindicate that
the organizations have lost their status
as organizations described in section
501(c)(3), eligible to receive deductible
contributions.
Former Public Charities. The follow-
ing organizations (which have been
treated as organizations that are not
private foundations described in section
509(a) of the Code) are now classified
as private foundations:
ACDASCO, Chicago IL
Advertising Professionals of Des Moines
Scholarship Foundation, Des Moines,
IA
American Dream Corporation, Des
Moines, IA
American Variety Arts Foundation,
Detroit, MI
Americas Choice Community, Clarinda,
IA
Am Housing, Inc., Omaha, NE
Association of Active Emergency Med
Tech of Clay, Vermillion, SD
Association of Disabled Americans Inc.,
Poplar Bluff, MO
Batavia Riverwalk Committee Inc.,
Wheaton, IL
Belle Fourche Historical Preservation
Inc., Belle Fourche, SD
Black Health Care Coalition, Kansas
City, MO
Blue Springs School of Economics Inc.,
Blue Springs, MO
Bonnie Lynn Acres Inc., Milwaukee, WI
Canyon Ferry Limnological Institute
Inc., Helena, MT
Cardiff Giant Theater Company,
Chicago, IL
Cates Goodfellow Housing, St. Louis,
MO
Cat Tables Inc., Lebanon, MO
Change, Pontiac, IL
Children, Inc., Woodward, IA
Chippewa Valley Volunteer Center Inc.,
Eau Claire, WI
Christian Ministries of St. Louis Inc,
Clayton, MO
Christian Mission of Pignon-Pella, Pella,
IA
Clayton Historical Society, Clayton, MO
Coast to Coast Theatre Company LTD,
Waukegan, IL
Community Support Systems Inc.,
Omaha, NE
Cozad Youth Center Inc., Cozad, NE
Crisis Intervention Shelter Service,
Sturgis, SD
Eagles Rest Ministries, Bloomington,
MN
Edina Public Schools French Immerson
Parent Organization, Edina, MN
Financial Information & Service Center
Inc., Green Bay, Green Bay, WI
Fresh Start Center Inc., Greenfield, WI
Friends of the Sugar River Inc.,
Belleville, WI
Fountain House-Milwaukee Inc.,
Milwaukee, WI
Fox Cities Marathon Inc., Appleton, WI
Gifts From the Heart Milwaukee Inc.,
Milwaukee, WI
Gopher Golf Booster Club Inc.,
Minneapolis, MN
Homer Civic Association, Winona, MN
Ken Petty Ministries, Benton, IL
Lake City Athletic Boosters Club Inc.,
Lake City, MN
Lambda Justice Center, Minneapolis,
MN
Latino Sports Association of Wisconsin
Inc., Milwaukee, WI
Learning Bridges Research Organization
Inc., Clayton, MO
Lewis University Project Upward,
Romeoville, IL
Lukas Foss Cultural Centre Inc.,
Milwaukee, WI
M-2 W-2 of Wisconsin Inc., Nashotah,
WI
Main Entrance Inc., Little Falls, MN
Mankato West Booster Club, North
Mankato, MN
Masterworks of Minneapolis Inc.,
Minneapolis, MN
551997–7 I.R.B.

Merrit Youth Hockey Association,
Duluth, MN
Methodist Manor of Waukegan Inc.,
Waukesha, WI
Midwest Hip Hop Movement, Chicago,
IL
Minnesota Big Dads, Stillwater, MN
Minnesota Charitable Accounts Inc., St.
Paul, MN
Minnesota Czechoslovak Center,
Minneapolis, MN
Minnesota Leadership Foundation,
Minneapolis, MN
Minnesota Living Center Inc., St. Paul,
MN
Minnesotans for Light Rail Transit
(MNLRT), Brooklyn Park, MN
Minnesota Sharp Tailed Grouse Society
Inc., Duluth, MN
Mt. Zion Child Development Center,
Milwaukee, WI
Naperville Youth Football League,
Naperville, IL
National Coalition of Black Amer Men
Inc., Milwaukee, WI
Nels Sorensen Memorial, Minneapolis,
MN
New Jerusalem Ministries Inc. Green
Bay, WI
North Star Focal Point Center for
Adolescents, Minneapolis, MN
Northstar Stair Community Land Trust,
St. Paul, MN
Opera 101 Theatre Company, St. Paul,
MN
Over and Back, Northfield, MN
Ozark Mountain Center for
Environmental Education, Alton, MO
Park Rapids Activities Foundation Inc.,
Park Rapids, MN
Phillips Tender Loving Care,
Minneapolis, MN
Prevail-Psychiatric Reform Thru
Education Visionary Action, Madison,
WI
Princeton Alumni Association, Inc.,
Princeton, MO
Project Fresh Start, Chicago, IL
Property Management Resource Center,
Chicago, IL
Quality Behavioral Care, Chicago, IL
Racine County Clubhouse, Inc., Racine,
WI
Remedial Education Adolescents
Disadvantaged Foundation Inc., Baton
Rouge, LA
River Falls Educational Foundation Inc.,
River Falls, WI
River Forest Boosters Association,
Chicago, IL
River Valley Child Center Inc., Spring
Green, WI
Running Water Historical Society,
Yankton, SD
Save Our School Inc., Streator, IL
Service Personnel Support Group,
Rochester, MN
Shepherds Foundation Inc., Union
Grove, WI
Shoreview Historical Society,
Shoreview, MN
Sian Ka An Biosphere Foundation,
Minneapolis, MN
Silk for Life Project Inc., Milwaukee,
WI
Sind Medical Association of North
America Inc., Milwaukee, WI
Society of Noise Reductionist Inc., St.
Paul, MN
South Dakota Concrete Promotion
Association, Spearfish, SD
Space West Ridge Community
Development Center, Chicago, IL
Therapeutic Recreators for Recovery,
Algonquin, IL
United for Progress Outreach
Organization, Chicago, IL
U.S.S. Springfield Commissioning
Committee, Springfield, IL
Whiteside County AIDS Network,
Morrison, IL
Women at the Court House,
Minneapolis, MN
Womens Board, Chicago, IL
XI Lambda Educational Foundation,
Chicago, IL
Youth Enjoying Sobriety, Peoria, IL
If an organization listed above sub-
mits information that warrants the re-
newal of its classification as a public
charity or as a private operating founda-
tion, the Internal Revenue Service will
issue a ruling or determination letter
with the revised classification as to
foundation status. Grantors and contribu-
tors may thereafter rely upon such rul-
ing or determination letter as provided
in section 1.509(a)–7 of the Income Tax
Regulations. It is not the practice of the
Service to announce such revised classi-
fication of foundation status in the Inter-
nal Revenue Bulletin.
561997–7 I.R.B.

Announcement of the Disbarment, Suspension, or Consent to Voluntary
Suspension of Attorneys, Certified Public Accountants, Enrolled Agents, and
Enrolled Actuaries From Practice Before the Internal Revenue Service
Under Section 330, Title 31 of the
United States Code, the Secretary of the
Treasury, after due notice and opportu-
nity for hearing, is authorized to sus-
pend or disbar from practice before the
Internal Revenue Service any person
who has violated the rules and regula-
tions governing the recognition of attor-
neys, certified public accountants, en-
rolled agents or enrolled actuaries to
practice before the Internal Revenue
Service.
Attorneys, certified public accoun-
tants, enrolled agents, and enrolled actu-
aries are prohibited in any Internal Rev-
enue Service matter from directly or
indirectly employing, accepting assis-
tance from, being employed by or shar-
ing fees with, any practitioner disbarred
or under suspension from practice be-
fore the Internal Revenue Service.
To enable attorneys, certified public
accountants, enrolled agents, and en-
rolled actuaries to identify such dis-
barred or suspended practitioners, the
Director of Practice will announce in the
Internal Revenue Bulletin the names and
addresses of practitioners who have
been suspended from such practice, their
designation as attorney, certified public
accountant, enrolled agent, or enrolled
actuary, and date of disbarment or pe-
riod of suspension. This announcement
will appear in the weekly Bulletin for
five successive weeks or as long as it is
practicable for each attorney, certified
public accountant, enrolled agent, or
enrolled actuary so suspended or dis-
barred and will be consolidated and
published in the Cumulative Bulletin.
After due notice and opportunity for
hearing before an administrative law
judge, the following individuals have
been disbarred from further practice be-
fore the Internal Revenue Service:
NameAddressDesignationEffective Date
Noske, Joan MarieBismarck, NDCPASeptember 7, 1996
Dalrymple, John K.Troy, MICPASeptember 26, 1996
57

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 de-
scribe the effect:
Amplifieddescribes a situation where
no change is being made in a prior
published position, but the prior position
is being extended to apply to a variation
of the fact situation set forth therein.
Thus, if an earlier ruling held that a
principle applied to A, and the new
ruling holds that the same principle also
applies to B, the earlier ruling is ampli-
fied. (Compare withmodified, below).
Clarifiedis used in those instances
where the language in a prior ruling is
being made clear because the language
has caused, or may cause, some confu-
sion. It is not used where a position in a
prior ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously
published ruling and points out an es-
sential 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 pub-
lished position. (Compare withamplified
andclarified, above).
Obsoleteddescribes a previously pub-
lished ruling that is not considered de-
terminative with respect to future trans-
actions. This term is most commonly
used in a ruling that lists previously
published rulings that are obsoleted be-
cause of changes in law or regulations.
A ruling may also be obsoleted because
the substance has been included in regu-
lations subsequently adopted.
Revokeddescribes situations where
the position in the previously published
ruling is not correct and the correct
position is being stated in the new
ruling.
Supersededdescribes a situation
where the new ruling does nothing more
than restate the substance and situation
of a previously published ruling (or
rulings). Thus, the term is used to
republish under the 1986 Code and
regulations the same position published
under the 1939 Code and regulations.
The term is also used when it is desired
to republish in a single ruling a series of
situations, names, etc., that were previ-
ously published over a period of time in
separate rulings. If the new ruling does
more than restate the substance of a
prior ruling, a combination of terms is
used. For example,modifiedandsuper-
sededdescribes a situation where the
substance of a previously published rul-
ing 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 published ruling is first
modified and then, as modified, is su-
perseded.
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 ruling has been supplemented
several times, a new ruling may be
published that includes the list in the
original ruling and the additions, and
supersedes all prior rulings in the series.
Suspendedis used in rare situations to
show that the previous published rulings
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 following abbreviations in current use and
formerly used will appear in material published in
the Bulletin.
A—Individual.
Acq.—Acquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank.
B.T.A.—Board of Tax Appeals.
C.—Individual.
C.B.—Cumulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Cooperative.
Ct.D.—Court Decision.
CY—County.
D—Decedent.
DC—Dummy Corporation.
DE—Donee.
Del. Order—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Employer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduciary.
FC—Foreign Country.
FICA—Federal Insurance Contribution Act.
FISC—Foreign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Federal Unemployment Tax Act.
FX—Foreign Corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grantee.
GP—General Partner.
GR—Grantor.
IC—Insurance Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited Partner.
LR—Lessor.
M—Minor.
Nonacq.—Nonacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Personal Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Partnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Real Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsidiary.
S.P.R.—Statements of Procedural Rules.
Stat.—Statutes at Large.
T—Target Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Transferee.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpayer.
TR—Trust.
TT—Trustee.
U.S.C.—United States Code.
X—Corporation.
Y—Corporation.
Z—Corporation.
58

Numerical Finding List
1
Bulletin 1997–1 through 1997–6
Announcements:
97–1, 1997–2 I.R.B.63
97–2, 1997–2 I.R.B.63
97–3, 1997–2 I.R.B.63
97–4, 1997–3 I.R.B.14
97–5, 1997–3 I.R.B.15
97–6, 1997–4 I.R.B.11
97–7, 1997–4 I.R.B.12
97–8, 1997–4 I.R.B.12
97–9, 1997–5 I.R.B.27
97–11, 1997–6 I.R.B.19
Notices:
97–1, 1997–2 I.R.B.22
97–2, 1997–2 I.R.B.22
97–3, 1997–1 I.R.B.8
97–4, 1997–2 I.R.B.24
97–5, 1997–2 I.R.B.25
97–6, 1997–2 I.R.B.26
97–7, 1997–1 I.R.B.8
97–8, 1997–4 I.R.B.7
97–9, 1997–2 I.R.B.35
97–10, 1997–2 I.R.B.41
97–11, 1997–2 I.R.B.50
97–12, 1997–3 I.R.B.11
97–13, 1997–6 I.R.B.13
Proposed Regulations:
REG–209672–93, 1997–615
REG–209762–95, 1997–3 I.R.B.12
REG–209828–96, 1997–615
REG–209834–96, 1997–4 I.R.B.9
REG–247678–96, 1997–617
Revenue Procedures:
97–1, 1997–1 I.R.B.11
97–2, 1997–1 I.R.B.64
97–3, 1997–1 I.R.B.84
97–4, 1997–1 I.R.B.96
97–5, 1997–1 I.R.B.132
97–6, 1997–1 I.R.B.153
97–7, 1997–1 I.R.B.185
97–8, 1997–1 I.R.B.187
97–9, 1997–2 I.R.B.56
97–10, 1997–2 I.R.B.59
97–11, 1997–6 I.R.B.13
97–12, 1997–4 I.R.B.7
97–13, 1997–5 I.R.B.18
97–14, 1997–5 I.R.B.20
97–15, 1997–5 I.R.B.21
97–17, 1997–5 I.R.B.25
Revenue Rulings:
97–1, 1997–2 I.R.B.10
97–2, 1997–2 I.R.B.7
97–3, 1997–2 I.R.B.5
97–4, 1997–3 I.R.B.6
97–5, 1997–4 I.R.B.5
97–6, 1997–4 I.R.B.4
97–7, 1997–5 I.R.B.14
Treasury Decisions:
8688, 1997–3 I.R.B.7
8689, 1997–3 I.R.B.9
8690, 1997–5 I.R.B.5
8691, 1997–5 I.R.B.16
8692, 1997–3 I.R.B.4
8693, 1997–6 I.R.B.9
8694, 1997–6 I.R.B.11
Treasury Decisions—Continued
8695, 1997–4 I.R.B.5
8696, 1997–6 I.R.B.4
8697, 1997–2 I.R.B.11
8699, 1997–6 I.R.B.4
1
A cumulative list of all Revenue Rulings,
Revenue Procedures, Treasury Decisions, etc.,
published in Internal Revenue Bulletins 1996–27
through 1996–53 will be found in Internal
Revenue Bulletin 1997–1, dated January 6, 1997.
59

Finding List of Current Action on
Previously Published Items
1
Bulletin 1997–1 through 1997–6
*Denotes entry since last publication
Revenue Procedures:
66–3
Modified by
97–11, 1997–6 I.R.B.13
87–21
Modified by
97–11, 1997–6 I.R.B/13
92–20
Modified by
97–1, 1997–1 I.R.B.11
92–20
Modified by
97–10, 1997–2 I.R.B.59
92–90
Superseded by
97–1, 1997–1 I.R.B.11
94–52
Revoked by
97–11, 1997–6 I.R.B.13
96–1
Superseded by
97–1, 1997–1 I.R.B.11
96–2
Superseded by
97–2, 1997–1 I.R.B.64
96–3
Superseded by
97–3, 1997–1 I.R.B.84
96–4
Superseded by
97–4, 1997–1 I.R.B.96
96–5
Superseded by
97–5, 1997–1 I.R.B.132
96–6
Superseded by
97–6, 1997–1 I.R.B.153
96–7
Superseded by
97–7, 1997–1 I.R.B.185
96–8
Superseded by
97–8, 1997–1 I.R.B.187
Revenue Rulings:
70–480
Revoked by
97–6, 1997–4 I.R.B.4
92–19
Supplemented in part by
97–2, 1997–2 I.R.B.7
96–12
Superseded by
97–3, 1997–1 I.R.B.84
Revenue Rulings—Continued
96–13
Modified by
97–1, 1997–1 I.R.B.11
96–22
Superseded by
97–3, 1997–1 I.R.B.84
96–34
Superseded by
97–3, 1997–1 I.R.B.84
96–39
Superseded by
97–3, 1997–1 I.R.B.84
96–43
Superseded by
97–3, 1997–1 I.R.B.84
96–56
Superseded by
97–3, 1997–1 I.R.B.84
1
A cumulative finding list for previously published
items mentioned in Internal Revenue Bulletins
1996–27 through 1996–53 will be found in Inter-
nal Revenue Bulletin 1997–1, dated January 6,
1997.
60

NOTES
61