[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2003 Edition]
[From the U.S. Government Printing Office]



[[Page i]]



                    26


          Parts 2 to 29

                         Revised as of April 1, 2003

Internal Revenue





          Containing a codification of documents of general 
          applicability and future effect
          As of April 1, 2003
          With Ancillaries
          Published by
          Office of the Federal Register
          National Archives and Records
          Administration

A Special Edition of the Federal Register



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                     U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003



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                            Table of Contents



                                                                    Page
  Explanation.................................................       v

  Title 26:
          Chapter I--Internal Revenue Service, Department of 
          the Treasury (Continued)                                   3
  Finding Aids:
      Table of CFR Titles and Chapters........................     737
      Alphabetical List of Agencies Appearing in the CFR......     755
      Table of OMB Control Numbers............................     765
      List of CFR Sections Affected...........................     783



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                     ----------------------------

                     Cite this Code:  CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus,  26 CFR 2.1 refers 
                       to title 26, part 2, 
                       section 1.

                     ----------------------------

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                               EXPLANATION

    The Code of Federal Regulations is a codification of the general and 
permanent rules published in the Federal Register by the Executive 
departments and agencies of the Federal Government. The Code is divided 
into 50 titles which represent broad areas subject to Federal 
regulation. Each title is divided into chapters which usually bear the 
name of the issuing agency. Each chapter is further subdivided into 
parts covering specific regulatory areas.
    Each volume of the Code is revised at least once each calendar year 
and issued on a quarterly basis approximately as follows:

Title 1 through Title 16.................................as of January 1
Title 17 through Title 27..................................as of April 1
Title 28 through Title 41...................................as of July 1
Title 42 through Title 50................................as of October 1

    The appropriate revision date is printed on the cover of each 
volume.

LEGAL STATUS

    The contents of the Federal Register are required to be judicially 
noticed (44 U.S.C. 1507). The Code of Federal Regulations is prima facie 
evidence of the text of the original documents (44 U.S.C. 1510).

HOW TO USE THE CODE OF FEDERAL REGULATIONS

    The Code of Federal Regulations is kept up to date by the individual 
issues of the Federal Register. These two publications must be used 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2003), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
dates and effective dates are usually not the same and care must be 
exercised by the user in determining the actual effective date. In 
instances where the effective date is beyond the cut-off date for the 
Code a note has been inserted to reflect the future effective date. In 
those instances where a regulation published in the Federal Register 
states a date certain for expiration, an appropriate note will be 
inserted following the text.

OMB CONTROL NUMBERS

    The Paperwork Reduction Act of 1980 (Pub. L. 96-511) requires 
Federal agencies to display an OMB control number with their information 
collection request.

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Many agencies have begun publishing numerous OMB control numbers as 
amendments to existing regulations in the CFR. These OMB numbers are 
placed as close as possible to the applicable recordkeeping or reporting 
requirements.

OBSOLETE PROVISIONS

    Provisions that become obsolete before the revision date stated on 
the cover of each volume are not carried. Code users may find the text 
of provisions in effect on a given date in the past by using the 
appropriate numerical list of sections affected. For the period before 
January 1, 2001, consult either the List of CFR Sections Affected, 1949-
1963, 1964-1972, 1973-1985, or 1986-2000, published in 11 separate 
volumes. For the period beginning January 1, 2001, a ``List of CFR 
Sections Affected'' is published at the end of each CFR volume.

CFR INDEXES AND TABULAR GUIDES

    A subject index to the Code of Federal Regulations is contained in a 
separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Statutory 
Authorities and Agency Rules (Table I). A list of CFR titles, chapters, 
and parts and an alphabetical list of agencies publishing in the CFR are 
also included in this volume.
    An index to the text of ``Title 3--The President'' is carried within 
that volume.
    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

    There are no restrictions on the republication of material appearing 
in the Code of Federal Regulations.

INQUIRIES

    For a legal interpretation or explanation of any regulation in this 
volume, contact the issuing agency. The issuing agency's name appears at 
the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-741-6000 
or write to the Director, Office of the Federal Register, National 
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info@fedreg.nara.gov.

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ELECTRONIC SERVICES

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CFR Sections Affected), The United States Government Manual, the Federal 
Register, Public Laws, Public Papers, Weekly Compilation of Presidential 
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free). E-mail, gpoaccess@gpo.gov.

[[Page vii]]

    The Office of the Federal Register also offers a free service on the 
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                              Raymond A. Mosley,
                                    Director,
                          Office of the Federal Register.

April 1, 2003.



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                               THIS TITLE

    Title 26--Internal Revenue is composed of twenty volumes. The 
contents of these volumes represent all current regulations issued by 
the Internal Revenue Service, Department of the Treasury, as of April 1, 
2003. The first thirteen volumes comprise part 1 (Subchapter A--Income 
Tax) and are arranged by sections as follows: Secs. 1.0-1-1.60; 
Secs. 1.61-1.169; Secs. 1.170-1.300; Secs. 1.301-1.400; Secs. 1.401-
1.440; Secs. 1.441-1.500; Secs. 1.501-1.640; Secs. 1.641-1.850; 
Secs. 1.851-1.907; Secs. 1.908-1.1000; Secs. 1.1001-1.1400; 
Secs. 1.1401-1.1503-2A; and Sec. 1.1551-1 to end. The fourteenth volume 
containing parts 2-29, includes the remainder of subchapter A and all of 
Subchapter B--Estate and Gift Taxes. The last six volumes contain parts 
30-39 (Subchapter C--Employment Taxes and Collection of Income Tax at 
Source); parts 40-49; parts 50-299 (Subchapter D--Miscellaneous Excise 
Taxes); parts 300-499 (Subchapter F--Procedure and Administration); 
parts 500-599 (Subchapter G--Regulations under Tax Conventions); and 
part 600 to end (Subchapter H--Internal Revenue Practice).

    The OMB control numbers for Title 26 appear in Sec. 602.101 of this 
chapter. For the convenience of the user, Sec. 602.101 appears in the 
Finding Aids section of the volumes containing parts 1 to 599.

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                       TITLE 26--INTERNAL REVENUE




                   (This book contains parts 2 to 29)

  --------------------------------------------------------------------
                                                                    Part

chapter i--Internal Revenue Service, Department of the 
  Treasury (Continued)......................................           2

[[Page 3]]



    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)




  --------------------------------------------------------------------

                  SUBCHAPTER A--INCOME TAX (CONTINUED)
Part                                                                Page
2               Maritime construction reserve fund..........           5
3               Capital construction fund...................          21
4               Temporary income tax regulations under 
                    section 954 of the Internal Revenue Code          41
5               Temporary income tax regulations under the 
                    Revenue Act of 1978.....................          74
5c              Temporary income tax regulations under the 
                    Economic Recovery Tax Act of 1981.......          79
5e              Temporary income tax regulations, travel 
                    expenses of Members of Congress.........          98
5f              Temporary income tax regulations under the 
                    Tax Equity and Fiscal Responsibility Act 
                    of 1982.................................         101
6a              Temporary regulations under Title II of the 
                    Omnibus Reconciliation Act of 1980......         117
7               Temporary income tax regulations under the 
                    Tax Reform Act of 1976..................         141
8               Temporary income tax regulations under 
                    section 3 of the Act of October 26, 1974 
                    (Pub. L. 93-483)........................         159
9               Temporary income tax regulations under the 
                    Tax Reduction Act of 1975...............         160
11              Temporary income tax regulations under the 
                    Employee Retirement Income Security Act 
                    of 1974.................................         161
12              Temporary income tax regulations under the 
                    Revenue Act of 1971.....................         182
13              Temporary income tax regulations under the 
                    Tax Reform Act of 1969..................         192
14a             Temporary income tax regulations relating to 
                    incentive stock options.................         197
15              Temporary income tax regulations relating to 
                    exploration expenditures in the case of 
                    mining..................................         204
15a             Temporary income tax regulations under the 
                    Installment Sales Revision Act..........         209
16              Temporary regulations under the Revenue Act 
                    of 1962.................................         228

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16A             Temporary income tax regulations relating to 
                    the partial exclusion for certain 
                    conservation cost-sharing payments......         229
17              Temporary income tax regulations under 26 
                    U.S.C. 103(c)...........................         237
18              Temporary income tax regulations under the 
                    Subchapter S Revision Act of 1982.......         238
19              Temporary regulations under the Revenue Act 
                    of 1964.................................         239
                   SUBCHAPTER B--ESTATE AND GIFT TAXES
20              Estate tax; estates of decedents dying after 
                    August 16, 1954.........................         242
22              Temporary estate tax regulations under the 
                    Economic Recovery Tax Act of 1981.......         514
25              Gift tax; gifts made after December 31, 1954         515
26              Generation-skipping transfer tax regulations 
                    under the Tax Reform Act of 1986........         690
28-29           [Reserved]


Supplementary Publications: Internal Revenue Service Looseleaf 
  Regulations System.

  Additional supplementary publications are issued covering individual 
parts of the Alcohol, Tobacco and Firearms Regulations, and Regulations 
Under Tax Convention.

[[Page 5]]



                  SUBCHAPTER A--INCOME TAX (CONTINUED)





PART 2--MARITIME CONSTRUCTION RESERVE FUND--Table of Contents




Sec.
2.1  Statutory provisions; sections 511 and 905, Merchant Marine Act, 
          1936, and related statutes.
2.1-1  Definitions.
2.1-2  Scope of section 511 of the Act and the regulations in this part.
2.1-3  Requirements as to vessel operations.
2.1-4  Application to establish fund.
2.1-5  Tentative authorization to establish fund.
2.1-6  Establishment of fund.
2.1-7  Circumstances permitting reimbursement from a construction 
          reserve fund.
2.1-8  Investment of funds in securities.
2.1-9  Valuation of securities in fund.
2.1-10  Withdrawals from fund.
2.1-11  Time deposits.
2.1-12  Election as to nonrecognition of gain.
2.1-13  Deposit of proceeds of sales or indemnities.
2.1-14  Deposit of earnings and receipts.
2.1-15  Time for making deposits.
2.1-16  Tax liability as to earnings deposited.
2.1-17  Basis of new vessel.
2.1-18  Allocation of gain for tax purposes.
2.1-19  Requirements as to new vessels.
2.1-20  Obligation of deposits.
2.1-21  Period for construction of certain vessels.
2.1-22  Time extensions for expenditure or obligation.
2.1-23  Noncompliance with requirements.
2.1-24  Extent of tax liability.
2.1-25  Assessment and collection of deficiencies.
2.1-26  Reports by taxpayers.
2.1-27  Controlled corporation.
2.1-28  Administrative jurisdiction.

    Authority: Sec. 511(b), 49 Stat. 1985, as amended, sec. 7805, 68A 
Stat. 917; 26 U.S.C. 7805, 46 U.S.C. 1161(b).

    Source: T.D. 6820, 30 FR 6030, Apr. 29, 1965, unless otherwise 
noted.

    Editorial Note: The regulations contained in this part have been 
recodified in 46 CFR part 287.



Sec. 2.1  Statutory provisions; sections 511 and 905, Merchant Marine Act, 1936, and related statutes.

    Sec. 511. [Merchant Marine Act, 1936] (a) When used in this section 
the term new vessel means any vessel (1) documented or agreed with the 
Commission to be documented under the laws of the United States; (2) 
constructed in the United States after December 31, 1939, or the 
construction of which has been financed under titles V or VII of this 
Act, as amended, or the construction of which has been aided by a 
mortgage insured under title XI of this Act as amended; and (3) either 
(A) of such type, size, and speed as the Commission shall determine to 
be suitable for use on the high seas or Great Lakes in carrying out the 
purposes of this Act, but not of less than 2,000 gross tons or of less 
speed than twelve knots, unless the Commission shall determine and 
certify in each case that a vessel of a specified lesser tonnage or 
speed is desirable for use by the United States in case of war or 
national emergency, or (B) constructed to replace a vessel or vessels 
requisitioned or purchased by the United States.
    (b) For the purpose of promoting the construction, reconstruction, 
reconditioning, or acquisition of vessels, or for other purposes 
authorized in this section, necessary to carrying out the policy set 
forth in title I of this Act, any citizen of the United States who is 
operating a vessel or vessels in the foreign or domestic commerce of the 
United States or in the fisheries or owns in whole or in part a vessel 
or vessels being so operated, or who, at the time of purchase or 
requisition of the vessel by the Government, was operating a vessel or 
vessels so engaged or owned in whole or in part a vessel or vessels 
being so operated or had acquired or was having constructed a vessel or 
vessels for the purpose of operation in such commerce or in the 
fisheries, may establish a construction reserve fund, for the 
construction, reconstruction, reconditioning, or acquisition of new 
vessels, or for other purposes authorized in this section, to be 
composed of deposits of proceeds from sales of vessels, indemnities on 
account of losses of vessels, earnings from the operation of vessels 
documented under the laws of the United States and from services 
incident thereto, and receipts, in the form of interest or otherwise, 
with respect to amounts previously deposited. Such construction reserve 
fund shall be established, maintained, expended, and used in accordance 
with the provisions of this section and rules or regulations to be 
prescribed jointly by the Commission and the Secretary of the Treasury.
    (c) In the case of the sale or actual or constructive total loss of 
a vessel, if the taxpayer deposits an amount equal to the net proceeds 
of the sale or to the net indemnity with respect to the loss in a 
construction reserve fund established under subsection (b), then--
    (1) If the taxpayer so elects in his income-tax return for the 
taxable year in which the gain was realized, or

[[Page 6]]

    (2) In case a vessel is purchased or requisitioned by the United 
States, or is lost, in any taxable year beginning after December 31, 
1939, and the taxpayer receives payment for the vessel so purchased or 
requisitioned, or receives from the United States indemnity on account 
of such loss, subsequent to the end of such taxable year, if the 
taxpayer so elects prior to the expiration of sixty days after the 
receipt of the payment or indemnity, and in accordance with a form of 
election to be prescribed by the Commissioner of Internal Revenue with 
the approval of the Secretary of the Treasury,

no gain shall be recognized to the taxpayer in respect of such sale or 
indemnification in the computation of net income for the purposes of 
Federal income or excess-profits taxes. If an election is made under 
subdivision (2) and if computation or recomputation in accordance with 
this subsection is otherwise allowable but is prevented, on the date of 
making such election or within six months thereafter, by any statute of 
limitation, such computation or recomputation nevertheless shall be made 
notwithstanding such statute if a claim therefor is filed within six 
months after the date of making such election.
    For the purposes of this subsection no amount shall be considered as 
deposited in a construction reserve fund unless it is deposited within 
sixty days after it is received by the taxpayer.
    As used in this subsection the term net proceeds and the term net 
indemnity mean the sum of (1) the adjusted basis of the vessel and (2) 
the amount of gain which would be recognized to the taxpayer without 
regard to this subsection.
    (d) The basis for determining gain or loss and for depreciation, for 
the purposes of Federal income or excess profits taxes, of any new 
vessel constructed, reconstructed, reconditioned, or acquired by the 
taxpayer, or with respect to which purchase-money indebtedness is 
liquidated as provided in subsection (g), in whole or in part out of the 
construction reserve fund shall be reduced by that portion of the 
deposits in the fund expended in the construction, reconstruction, 
reconditioning, acquisition, or liquidation of purchase-money 
indebtedness of the new vessel which represents gain not recognized for 
tax purposes under subsection (c).
    (e) For the purposes of this section, (1) if the net proceeds of a 
sale or the net indemnity in respect of a loss are deposited in more 
than one deposit, the amount consisting of the gain shall be considered 
as first deposited; (2) amounts expended, obligated, or otherwise 
withdrawn shall be applied against the amounts deposited in the fund in 
the order of deposit; and (3) if any deposit consists in part of gain 
not recognized under subsection (c), any expenditure, obligation, or 
withdrawal applied against such deposit shall be considered to consist 
of gain in the proportion that the part of the deposit consisting of 
gain bears to the total amount of the deposit.
    (f) With respect to any taxable year, amounts on deposit on the last 
day of such year in a construction reserve fund in accordance with this 
section and with respect to which all the requirements of subsection (g) 
have been satisfied, to the extent that such requirements are applicable 
as of the last day of said taxable year, shall not constitute an 
accumulation of earnings or profits within the meaning of section 102 of 
the Internal Revenue Code [Part I (section 531 and following), 
Subchapter A, Chapter 1 of the Internal Revenue Code of 1954].
    (g) The provisions of subsections (c) and (f) shall apply to any 
deposit in the construction reserve fund only to the extent that such 
deposit is expended or obligated for expenditure, in accordance with 
rules and regulations to be prescribed jointly by the Commission and the 
Secretary of the Treasury--
    (1) Under a contract for the construction or acquisition of a new 
vessel or vessels (or in the discretion of the Commission, for a part 
interest therein), or, with the approval of the Commission, for the 
reconstruction or reconditioning of a new vessel or vessels, entered 
into within (i) two years from the date of deposit or the date of any 
extension thereof which may be granted by the Commission pursuant to the 
provisions of section 511(h), in the case of deposits made prior to the 
date [July 17, 1952] on which these amendatory provisions become 
effective, or (ii) three years from the date of such deposit in the case 
of a deposit made after such effective date, only if under such rules 
and regulations--
    (A) Within such period not less than 12\1/2\ per centum of the 
construction or contract price of the vessel or vessels is paid or 
irrevocably committed on account thereof and the plans and 
specifications therefor are approved by the Commission to the extent by 
it deemed necessary; and
    (B) In case of a vessel or vessels not constructed under the 
provisions of this title or not purchased from the Commission, (i) said 
construction is completed, within six months from the date of the 
construction contract, to the extent of not less than 5 per centum 
thereof (or in case the contract covers more than one vessel, the 
construction of the first vessel so contracted for is so completed to 
the extent of not less than 5 per centum) as estimated by the Commission 
and certified by it to the Secretary of the Treasury, and (ii) all 
construction under such contract is completed with reasonable dispatch 
thereafter;
    (2) For the liquidation of existing or subsequently incurred 
purchase-money indebtedness to persons other than a parent company of, 
or a company affiliated or associated

[[Page 7]]

with, the mortgagor on a new vessel or vessels within (i) two years from 
the date of deposit or the date of any extension thereof which may be 
granted by the Commission pursuant to the provisions of section 511(h), 
in the case of deposits made prior to the date [July 17, 1952] on which 
these amendatory provisions become effective, or (ii) three years from 
the date of such deposit in the case of a deposit made after such 
effective date.
    (h) The Commission is authorized under rules and regulations to be 
prescribed jointly by the Secretary of the Treasury and the Commission 
to grant extensions of the period within which the deposits shall be 
expended or obligated or within which construction shall have progressed 
to the extent of 5 per centum of completion as provided herein, but such 
extension shall not be for an aggregate additional period in excess of 
two years with respect to the expenditure or obligation of such deposits 
or more than one year with respect to the progress of such construction: 
Provided, That until January 1, 1965, in addition to the extensions 
hereinbefore permitted, further extensions may be granted ending not 
later than December 31, 1965.
    (i) Any such deposited gain or portion thereof which is not so 
expended or obligated within the period provided, or which is otherwise 
withdrawn before the expiration of such period, or with respect to which 
the construction has not progressed to the extent of 5 per centum of 
completion within the period provided, or with respect to which the 
Commission finds and certifies to the Secretary of the Treasury that, 
for causes within the control of the taxpayer, the entire construction 
is not completed with reasonable dispatch, if otherwise taxable income 
under the law applicable to the taxable year in which such gain was 
realized, shall be included in the gross income for such taxable year, 
except for the purpose of the declared value excess-profits tax and the 
capital stock tax. If any such deposited gain or portion thereof with 
respect to a deposit made in any taxable year ending on or before June 
30, 1945, is so included in gross income for such taxable year, there 
shall (in addition to any other deficiency) be assessed, collected, and 
paid in the same manner as if it were a deficiency, an amount equal to 
1.1 per centum of the amount of gain so included, such amount being in 
lieu of any adjustment with respect to the declared value excess-profits 
tax for such taxable year.
    (j) Notwithstanding any other provision of law, any deficiency in 
tax for any taxable year resulting from the inclusion of any amount in 
gross income as provided by subsection (i), and the amount to be treated 
as a deficiency under such subsection in lieu of any adjustment with 
respect to the declared value excess-profits tax, may be assessed or a 
proceeding in court for the collection thereof may be begun without 
assessment, at any time: Provided, however, That interest on any such 
deficiency or amount to be treated as a deficiency shall not begin until 
the date the deposited gain or portion thereof in question is required 
under subsection (i) to be included in gross income.
    (k) This section shall be applicable to a taxpayer only in respect 
of sales or indemnifications for losses occurring within a taxable year 
beginning after December 31, 1939, and only in respect of earnings 
derived during a taxable year beginning after December 31, 1939.
    (l) For the purposes of this section a vessel shall be considered as 
constructed or acquired by the taxpayer if constructed or acquired by a 
corporation at a time when the taxpayer owns at least 95 per centum of 
the total number of shares of each class of stock of the corporation.
    (m) The terms used in this section shall have the same meaning as in 
chapter 1 of the Internal Revenue Code.
    (n) The terms contract for the construction and construction 
contract, as used in this section, shall include, in the case of a 
taxpayer who constructs a new vessel in a shipyard owned by such 
taxpayer, an agreement between such taxpayer and the Commission with 
respect to such construction and containing provisions deemed necessary 
or advisable by the Commission to carry out the purposes and policy of 
this section.
    (o) The terms reconstruction and reconditioning, as used in this 
section, shall include the reconstruction, reconditioning, or 
modernization of a vessel for exclusive use on the Great Lakes, 
including the St. Lawrence River and Gulf, if the Commission determines 
that the objectives of this Act will be promoted by such reconstruction, 
reconditioning, or modernization, and, notwithstanding any other 
provisions of law, such vessel shall be deemed to be a ``new vessel'' 
within the meaning of this section for such reconstruction, 
reconditioning, or modernization.

[Sec. 511 as added by Act of October 10, 1940 (Pub. L. 840, 76th Cong., 
54 Stat. 1106), as amended by Act of June 17, 1943 (Pub. L. 78, 78th 
Cong., 57 Stat. 157); Act of Dec. 23, 1944 (Pub. L. 552, 78th Cong., 58 
Stat. 920); secs. 9-14, Act of July 17, 1952 (Pub. L. 586, 82d Cong., 66 
Stat. 762); Act of Sept. 12, 1964 (Pub. L. 88-595, 78 Stat. 943)]

    Sec. 905. [Merchant Marine Act, 1936.] When used in this Act--
    (a) The words foreign commerce or foreign trade mean commerce or 
trade between the United States, its Territories or possessions,

[[Page 8]]

or the District of Columbia, and a foreign country.

                                * * * * *

    (c) The words citizen of the United States include a corporation, 
partnership, or association only if it is a citizen of the United States 
within the meaning of section 2 of the Shipping Act, 1916, as amended 
(U.S.C., title 46, sec. 802), and with respect to a corporation under 
title VI of this Act, all directors of the corporation are citizens of 
the United States, and, in the case of a corporation, partnership, or 
association operating a vessel on the Great Lakes, or on bays, sounds, 
rivers, harbors, or inland lakes of the United States the amount of 
interest required to be owned by a citizen of the United States shall be 
not less than 75 per centum.

                                * * * * *

    (e) The terms United States Maritime Commission and Commission shall 
mean the Secretary of Commerce, the Maritime Administrator, or the * * * 
[Maritime Subsidy Board] as the context may require * * *.

[Sec. 905 (a), (c), and (e) (49 Stat. 2016), amended by sec. 39 (a) and 
(b), Act of June 23, 1938 (Pub. L. 705, 75th Cong., 52 Stat. 964); Act 
of July 17, 1952 (Pub. L. 586, 82d Cong., 66 Stat. 765); sec. 4, Act of 
Sept. 21, 1959 (Pub. L. 86-327, 73 Stat. 597)]

    Sec. 2. [Shipping Act, 1916.] (a) That within the meaning of this 
Act no corporation, partnership, or association shall be deemed a 
citizen of the United States unless the controlling interest therein is 
owned by citizens of the United States, and, in the case of a 
corporation, unless its president or other chief executive officer and 
the chairman of its board of directors are citizens of the United States 
and unless no more of its directors than a minority of the number 
necessary to constitute a quorum are noncitizens and the corporation 
itself is organized under the laws of the United States or of a State, 
Territory, District, or possession thereof, but in the case of a 
corporation, association, or partnership operating any vessel in the 
coastwise trade the amount of interest required to be owned by citizens 
of the United States shall be 75 per centum.
    (b) The controlling interest in a corporation shall not be deemed to 
be owned by citizens of the United States (a) if the title to a majority 
of the stock thereof is not vested in such citizens free from any trust 
or fiduciary obligation in favor of any person not a citizen of the 
United States; or (b) if the majority of the voting power in such 
corporation is not vested in citizens of the United States; or (c) if 
through any contract or understanding it is so arranged that the 
majority of the voting power may be exercised, directly or indirectly, 
in behalf of any person who is not a citizen of the United States; or 
(d) if by any other means whatsoever control of the corporation is 
conferred upon or permitted to be exercised by any person who is not a 
citizen of the United States.
    (c) Seventy-five per centum of the interest in a corporation shall 
not be deemed to be owned by citizens of the United States (a) if the 
title to 75 per centum of its stock is not vested in such citizens free 
from any trust or fiduciary obligation in favor of any person not a 
citizen of the United States; or (b) if 75 per centum of the voting 
power in such corporation is not vested in citizens of the United 
States; or (c) if, through any contract or understanding it is so 
arranged that more than 25 per centum of the voting power in such 
corporation may be exercised, directly or indirectly, in behalf of any 
person who is not a citizen of the United States; or (d) if by any other 
means whatsoever control of any interest in the corporation in excess of 
25 per centum is conferred upon or permitted to be exercised by any 
person who is not a citizen of the United States.
    (d) The provisions of this Act shall apply to receivers and trustees 
of all persons to whom the Act applies, and to the successors or 
assignees of such persons.

[Sec. 2 (39 Stat. 729) as amended by Act of July 15, 1918 (Pub. L. 198, 
65th Cong., 40 Stat. 900); sec. 38, Merchant Marine Act, 1920 (41 Stat. 
1008); sec. 3, Act of Sept. 21, 1959 (Pub. L. 86-327, 73 Stat. 597)]



Sec. 2.1-1  Definitions.

    (a) As used in the regulations in this part, except as otherwise 
expressly provided--
    (1) Act means the Merchant Marine Act, 1936, as amended (46 U.S.C. 
27).
    (2) Section means one of the sections of the regulations in this 
part.
    (3) Administration means the Maritime Administration of the 
Department of Commerce as created by Reorganization Plan No. 21 of 1950 
(46 U.S.C. 1111 note).
    (4) Citizen means a person who, if an individual, was born or 
naturalized as a citizen of the United States or, if other than an 
individual, meets the requirements of section 905(c) of the Act and 
section 2 of the Shipping Act, 1916, as amended (46 U.S.C. 802).
    (5) Taxpayer means a citizen who has established or seeks to 
establish a construction reserve fund under the provisions of section 
511 of the Act and the regulations in this part, and may include a 
partnership.

[[Page 9]]

    (6) Corporation includes associations, joint-stock companies and 
insurance companies.
    (7) Stock includes the shares in an association, joint-stock 
company, or insurance company.
    (8) Affiliate or associate means a person directly or indirectly 
controlling, controlled by, or under common control with, another 
person.
    (9) Control, as used in subparagraph (8) of this paragraph, means 
the possession of the power to direct in any manner the management and 
policies of a person, and the terms ``controlling'' and ``controlled'' 
shall have the meanings correlative to the foregoing.
    (10) Person means an individual, a corporation, a partnership, an 
association, an estate, a trust, or a company.
    (11) Partnership includes a syndicate, group, pool, joint venture, 
or other unincorporated organization.
    (12) Construction, if so determined by the Administration, shall 
include reconstruction and reconditioning.
    (13) Reconstruction and reconditioning shall include the 
reconstruction, reconditioning, or modernization of a vessel for 
exclusive use on the Great Lakes, including the Saint Lawrence River and 
Gulf, if the Administration determines that the objectives of the Act 
will be promoted by such reconstruction, reconditioning, or 
modernization, and, notwithstanding any other provisions of law, such 
vessel shall be deemed to be a ``new vessel'' within the meaning of 
section 511 of the Act for such reconstruction, reconditioning, or 
modernization.
    (14) Purchase-money indebtedness means any indebtedness, or evidence 
thereof, created as the result of the purchase of a vessel by the 
taxpayer.
    (15) Contract, contract for the construction, and construction 
contract shall include, if so determined by the Administration, a 
contract for reconstruction or reconditioning and shall include, in the 
case of a taxpayer who constructs a new vessel in a shipyard owned by 
such taxpayer, an agreement, between such taxpayer and the 
Administration with respect to such construction, and containing 
provisions deemed necessary or advisable by the Administration to carry 
out the purposes and policy of section 511 of the Act.
    (b) Insofar as the computation and collection of taxes are 
concerned, other terms used in the regulations in this part, except as 
otherwise provided, have the same meaning as in the Internal Revenue 
Code and the regulations thereunder.



Sec. 2.1-2  Scope of section 511 of the Act and the regulations in this part.

    (a) Applicability of regulations. (1) The regulations prescribed in 
this part--
    (i) Apply to gain realized from the sale or loss of vessels, 
earnings from the operation of vessels, and interest (or otherwise) with 
respect to amounts previously deposited in the construction reserve 
fund, for a taxable year beginning after December 31, 1964, and
    (ii) Apply to the expenditure, obligation, or withdrawal, during a 
taxable year beginning after December 31, 1964, of any deposits of gain, 
earnings, and interest (or otherwise) of the character referred to in 
subdivision (i) of this subparagraph without regard to the taxable year 
in which the deposits were made.
    (2) As to gain, earnings, or interest (or otherwise) described in 
subparagraph (1)(i) of this paragraph and as to an expenditure, 
obligation, or withdrawal described in subparagraph (1)(ii) of this 
paragraph, the regulations in this part supersede Treasury Decision 
5330, as amended (26 CFR (1939) Part 32).
    (b) Nonrecognition and accumulation. Section 511 of the Act 
provides, under conditions specified, for the nonrecognition, for income 
and excess-profits tax purposes, of the gain realized from the sale or 
indemnification for loss of certain vessels including certain vessels in 
the course of construction, or shares therein. It also permits the 
accumulation of the proceeds of such sales or indemnification and of 
certain earnings without liability under Part I (section 531 and 
following), Subchapter G, Chapter I of the Internal Revenue Code of 
1954, and the regulations thereunder (Secs. 1.531-1 through 1.537-3 of 
this chapter (Income Tax Regulations)).
    (c) Availability of benefits. The benefits of section 511 of the Act 
are available to any citizen as defined in paragraph (a)(4) of Sec. 2.1-
1, who, during any

[[Page 10]]

taxable year owns, in whole or in part, a vessel or vessels within the 
scope of Sec. 2.1-3. A citizen operating such a vessel or vessels owned 
by any other person or persons can derive no benefit from the provisions 
relating to the nonrecognition of gain from the sale or loss of such 
vessel or vessels so owned, but may establish a construction reserve 
fund in which he may deposit earnings from the operation of such vessel 
or vessels.
    (d) Applicability of section 511. Section 511 of the Act applies 
only with respect to sales or losses of vessels within the scope of 
Sec. 2.1-3 or in respect of earnings derived from the operation of such 
vessels. A loss to be within section 511 of the Act must be an actual or 
constructive total loss. Whether there is a total loss, actual or 
constructive, will be determined by the Administration.



Sec. 2.1-3  Requirements as to vessel operations.

    Section 511 of the Act applies with respect to vessels operated in 
the foreign or domestic commerce of the United States or in the 
fisheries of the United States and vessels acquired or being constructed 
for the purpose of such operation. The foreign commerce of the United 
States includes commerce or trade between the United States (including 
the District of Columbia), the territories and possessions which are 
embraced within the coastwise laws, and a foreign country or other 
territories and possessions of the United States. The domestic commerce 
of the United States includes commerce or trade between ports of the 
United States and its territories and possessions, embraced within the 
coastwise laws and on inland rivers. The fisheries include the fisheries 
of the United States and its territories and possessions. Section 511 of 
the Act does not apply to vessels operated in the foreign commerce or 
fisheries of any country other than the United States.



Sec. 2.1-4  Application to establish fund.

    Any person claiming to be entitled to the benefits of section 511 of 
the Act may make application, in writing, to the Administration for 
permission to establish a construction reserve fund. The application 
shall be in such form and substance as the Administration may prescribe 
and shall designate, among other things, the depository or depositories 
with which the taxpayer proposes to establish the said fund. The 
original application shall be executed and verified by the taxpayer, or 
if the taxpayer is a corporation, by one of its principal officers, in 
triplicate, and shall be accompanied by eight conformed copies when 
filed with the Administration.



Sec. 2.1-5  Tentative authorization to establish fund.

    Where the time between the receipt by the Administration of the 
application for permission to establish a construction reserve fund and 
the date prior to which an amount received from the sale or loss of a 
vessel must be deposited to come within the scope of section 511 of the 
Act is insufficient to permit a determination of the eligibility of the 
applicant, the Administration may tentatively authorize the 
establishment of a construction reserve fund and the deposit of such 
amount therein. Such tentative authorization shall be subject to 
rescission by the Administration if subsequently it is determined that 
the applicant is not entitled to the benefits of section 511 of the Act, 
or has not complied with the statutory requirements. For example, a 
tentative authorization will be rescinded if the Administration 
ascertains that the applicant is not a citizen. Upon such determination, 
the fund shall be closed and all amounts on deposit therein shall be 
withdrawn.



Sec. 2.1-6  Establishment of fund.

    (a) Authorization by the Administration. If the application is 
approved by the Administration, the Administration will adopt Orders 
authorizing the establishment of a construction reserve fund with the 
depository or depositories designated by the taxpayer and approved by 
the Administration. The Orders will provide for joint control by the 
Administration and the taxpayer over such fund, will set forth the 
conditions governing the establishment and maintenance of the fund and 
the making of deposits therein and withdrawals

[[Page 11]]

therefrom, and will designate the representatives authorized to execute 
instruments of withdrawal on behalf of the Administration.
    (b) Resolution or agreement of the taxpayer. A certified copy of the 
Orders of the Administration will be furnished the taxpayer. If the 
taxpayer is a corporation, it shall promptly adopt, through its board of 
directors, a resolution satisfactory in form and substance to the 
Administration, authorizing the establishment and maintenance of the 
fund in conformity with the action of the Administration. If the 
taxpayer is not a corporation, it shall promptly execute an agreement 
with the depository satisfactory in form and substance to the 
Administration to conform to the action of the Administration as set 
forth in the Orders. Certified copies of the Orders of the 
Administration and of the resolution of the taxpayer (if it is a 
corporation) will be furnished to the depository by the Administration 
and the taxpayer, respectively, for its guidance in maintaining the fund 
and honoring instruments of withdrawal. The taxpayer, if a corporation, 
shall also furnish the Administration with a certified copy of its 
resolution, or if not a corporation, a duplicate original of its 
agreement with the depository.
    (c) Constructive action not recognized. Constructive deposits, 
substitutions or withdrawals will not be recognized by the 
Administration in the establishment and maintenance of the fund.
    (d) Failure to make deposits as basis for termination of fund. In 
the event no deposit is made into the fund for more than five years, any 
amounts remaining in the fund shall be removed from the fund at the 
discretion of the Administration and, if so removed, the fund shall be 
terminated. In the event of such termination, see Sec. 2.1-23 for 
recognition of gain.



Sec. 2.1-7  Circumstances permitting reimbursement from a construction reserve fund.

    (a) Payments prior to establishment of fund. If, prior to the 
establishment of a construction reserve fund under the regulations in 
this part, a taxpayer has made necessary payments under a contract which 
satisfies the provisions of the regulations in this part and section 511 
of the Act for the construction or acquisition of a new vessel, such 
taxpayer may, if subsequently authorized to establish a construction 
reserve fund under the regulations in this part, draw against such fund 
as reimbursement for the amount, if any, of other funds which, with the 
approval or ratification of the Administration, the taxpayer used for 
making such necessary payments prior to the establishment of the fund.
    (b) Payments subsequent to establishment of fund. If, subsequent to 
the establishment of a construction reserve fund under the regulations 
in this part, the taxpayer has made necessary payments under a contract 
which satisfies the provisions of the regulations in this part and 
section 511 of the Act for the construction or acquisition of a new 
vessel, such taxpayer may draw against such fund as reimbursement for 
the amount, if any, of other funds which, with the approval or 
ratification of the Administration, the taxpayer had used for the 
purpose of making such necessary payments.



Sec. 2.1-8  Investment of funds in securities.

    (a) Obligations of or guaranteed by the United States. Interest-
bearing direct obligations of the United States, or obligations fully 
guaranteed as to principal and interest by the United States, may be 
deposited in the construction reserve fund in lieu of cash, may be 
purchased with cash on deposit in the fund, or may be substituted for 
securities or commitment to finance in the fund, subject to the 
provisions of paragraph (b) of this section.
    (b) Other securities. In cases where the taxpayer desires to deposit 
any securities in the fund in lieu of cash other than those of or 
guarantees by the United States or to purchase such other securities 
with cash on deposit in the fund, or to substitute such other securities 
for securities or commitment to finance in the fund, the taxpayer shall 
make written application to the Administration and shall not consummate 
the transaction until the written consent of the Administration shall 
have been received. The application shall describe the securities fully. 
Every approval by the Administration

[[Page 12]]

of such application shall be conditioned upon agreement by the taxpayer 
forthwith to dispose of such securities upon subsequent request by the 
Administration. Immediately upon the purchase of any securities for 
deposit in the fund, the taxpayer shall advise the Administration, 
giving the date of purchase, a description of the securities, and the 
price paid therefor (net, brokerage and other charges, and gross). 
Ordinarily, the Administration will not approve the deposit in the fund 
in lieu of cash, or the purchase with cash on deposit in the fund or the 
substitution for securities in the fund of securities not actively 
traded in on exchanges registered under the Securities Exchange Act of 
1934 (15 U.S.C. ch. 2B), or securities which are not legal for 
investment of trust funds. Whenever the Administration approves the 
substitution of other securities for securities in the fund, such 
substitution shall be effected only upon or after the deposit of the 
substituted securities into the fund.
    (c) Cash. Cash may be substituted for amounts which are on deposit 
in the fund in any other form.
    (d) Devalued securities. In the event the Administration determines 
that the market value at any date of any securities in the fund has 
decreased to a figure which is less than 90 percent of the market value 
at the time of deposit into the fund, then within 60 days after the 
taxpayer receives notice of such determination the taxpayer shall 
(except as otherwise provided in this paragraph) deposit into the fund 
cash or securities in an amount equal to the difference between the 
current market value of the devalued securities and the market value of 
such securities at the time of their original deposit. However if any 
securities in the fund are valued at the time of their deposit at less 
than the market value of such securities at the time of their deposit 
the taxpayer shall be required to deposit only an amount equal to that 
portion of the difference between the current market value of the 
devalued securities and the market value of such securities at the time 
of their original deposit which bears the same ratio to such total 
difference as the amount at which the securities were valued at the time 
of their deposit bears to the market value at the time of such deposit.



Sec. 2.1-9  Valuation of securities in fund.

    (a) Equivalent values. In cases where securities are deposited in 
the fund in lieu of cash, or are purchased with cash on deposit in the 
fund, or are substituted for securities in the fund, the value of such 
securities must not be less than the amount of cash in lieu of which 
they are so deposited or with which they are so purchased, or the value 
at the time of deposit of the securities for which they were so 
substituted. If the securities on deposit in the fund are replaced by 
cash from the general funds of the taxpayer, the amount of cash to be 
deposited in the fund in lieu thereof shall be not less than the amount 
at which such securities were valued at the time of their deposit in the 
fund.
    (b) Determination of value. (1) For the purpose of determining the 
amount in the fund, the value of securities shall be their ``market 
value'' (which shall be the basis for determining value, unless 
otherwise agreed to by the administration) and shall be determined in 
the following manner:
    (i) In instances where no actual purchase is involved, such as the 
initial deposit of securities in the fund in lieu of cash, the last 
sales price thereof on the principal exchange on the day the deposit was 
made shall be deemed to be the ``market value'' thereof, or, if no such 
sales were made, the ``market value'' thereof will be determined by the 
Administration on such basis as it may deem to be fair and reasonable in 
each case.
    (ii) In instances where the purchase of securities with cash on 
deposit in the fund is involved, ``market value'' shall be the gross 
price paid (adjusted for accrued interest): Provided, That if such 
securities are purchased otherwise than upon a registered exchange the 
price shall be within the range of transactions on the exchange on the 
date of such purchase, or, if there were no such transactions, then the 
``market value'' thereof will be determined by the Administration on 
such basis as it may deem to be fair and reasonable in each case.

[[Page 13]]

    (2) Purchase-money obligations secured by mortgages on vessels sold 
or irrevocable commitments to finance the construction or acquisition of 
new vessels which are deposited in the construction reserve fund as 
provided in Sec. 2.1-13 ordinarily will be considered as equivalent to 
their face value.



Sec. 2.1-10  Withdrawals from fund.

    (a) Withdrawals for obligations or liquidation. (1) Checks, drafts, 
or other instruments of withdrawal to meet obligations under a contract 
for the construction or acquisition of a new vessel or vessels or for 
the liquidation of existing or subsequently incurred purchase-money 
indebtedness, after having been executed by the taxpayer, shall be 
forwarded to the Administration in Washington, DC, with appropriate 
explanation of the purpose of the proposed withdrawal, including 
properly certified invoices or other supporting papers. Such instruments 
of withdrawal, if payable to the Administration, will be deposited by 
the Administration for collection, and the proceeds thereof, upon 
collection, will be credited to the appropriate contract with the 
Administration; but if drawn to the order of payees other than the 
Administration, after countersignature on behalf of the Administration, 
will ordinarily be forwarded to the payees.
    (2) An amount obligated under a contract for the construction or 
acquisition of a new vessel or vessels or for the liquidation of 
existing or subsequently incurred purchase-money indebtedness, whether 
the obligor has the entire or a partial interest therein within the 
scope of section 511 of the Act, may not, so long as the contract or 
indebtedness continues in full force and effect, be withdrawn except to 
meet payments due or to become due under such contract or for such 
liquidation.
    (b) Other withdrawals. Checks, drafts, or other instruments of 
withdrawal executed by the taxpayer for purposes other than to meet 
obligations under a contract for the construction or acquisition of a 
new vessel or vessels or for the liquidation of existing or subsequently 
incurred purchase-money indebtedness, whether the taxpayer has the 
entire or a partial interest therein, shall be drawn by the taxpayer to 
its own order and forwarded to the Administration in Washington, DC, 
with appropriate explanation of the purpose of the proposed withdrawal. 
Such withdrawals may occur by reason of a determination by the 
Administration that the taxpayer is not entitled to the benefits of 
section 511 of the Act (see Sec. 2.1-5), or that a particular deposit 
has been improperly made (see Sec. 2.1-13), or by reason of the election 
of the taxpayer to make such withdrawals. Upon receipt of such checks, 
drafts, or other instruments of withdrawal, the Administration will give 
notice thereof to the Commissioner of Internal Revenue. The Commissioner 
will advise the Administration of the receipt of the notice and the date 
it was received. The Administration shall not countersign such checks, 
drafts, or other instruments of withdrawal or transmit them to the 
taxpayer until the expiration of 30 days from the date of receipt of the 
notice by the Commissioner, unless the Commissioner or such official of 
the Internal Revenue Service as he may designate for the purpose 
consents in writing to earlier countersignature by the Administration 
and transmittal to the taxpayer. Upon the expiration of such 30-day 
period, or prior thereto if the aforesaid consent of the Commissioner 
has been obtained, the Administration will countersign the check, draft, 
or other instrument of withdrawal and forward it to the taxpayer.
    (c) Inapplicability to certain transactions. The provisions of this 
section shall not be applicable to transactions deemed to be withdrawals 
by reason of the sale of securities held in the fund for an amount less 
than the market value thereof at the time of their deposit (see 
Sec. 2.1-23), nor to the cancellation of an irrevocable commitment 
deposited in the fund, upon proof satisfactory to the Administration 
that the terms of such commitment have been fully satisfied.



Sec. 2.1-11  Time deposits.

    Deposits in the construction reserve fund not invested in securities 
may be placed in time deposits when, in the judgment of the taxpayer, it 
is desirable and feasible so to do. The taxpayer

[[Page 14]]

shall promptly advise the Administration of any time deposit 
arrangements made with the depository. The Administration reserves the 
right at any time to require the termination or modification of any such 
arrangements. With prior approval of the Administration a time deposit 
may be made in a depository other than the one with which the 
construction reserve fund is established.



Sec. 2.1-12  Election as to nonrecognition of gain.

    (a) Election requirements. As a prerequisite to the nonrecognition 
of gain on the sale or loss of a vessel (or of a part interest therein) 
for Federal income tax purposes, the taxpayer, after establishing a 
construction reserve fund, must make an election with respect to such 
vessel or interest in the manner set forth in this paragraph.
    (1) In general. Except as provided in subparagraph (2) of this 
paragraph, the election must be made in the taxpayer's Federal income 
tax return (or, in the case of a partnership, in the partnership return 
of income) for the taxable year in which the gain with respect to the 
sale or loss of the vessel is realized. The election as to the 
nonrecognition of gain shall be shown by a statement to that effect, 
submitted as a part of, and attached to, the return. The statement, 
which need not be on any prescribed form, shall set forth a computation 
of the amount of the realized gain, the identity of the vessel, the 
nature and extent of the taxpayer's interest therein, whether such 
vessel was sold or lost and the date of sale or loss, the full sale 
price or full amount of indemnity, and the amount and date of each 
payment thereof, the basis for tax purposes and any other data affecting 
the determination of the realized gain.
    (2) Certain Government payments. In case a vessel is purchased or 
requisitioned by the United States, or is lost, in any taxable year and 
the taxpayer receives payment for the vessel so purchased or 
requisitioned, or receives from the United States indemnity on account 
of such loss, subsequent to the end of such taxable year, the taxpayer 
shall make his election by filing notice thereof with the Commissioner 
of Internal Revenue, Washington, DC, 20224, prior to the expiration of 
60 days after receipt of the payment or indemnity. The taxpayer shall 
file a copy of the notice with the Secretary, Federal Maritime Board, 
Washington, DC, 20573. The form of the notice of election shall be 
prepared by the taxpayer and shall be substantially as follows:

  Election Relative to Nonrecognition of Gain Under Section 511(c)(2), 
                        Merchant Marine Act, 1936

    Pursuant to the provisions of section 511(c)(2) of the Merchant 
Marine Act, 1936, as amended, notice is hereby given that the 
undersigned taxpayer elects that gain in respect of the sale to the 
United States, or indemnification received from the United States on 
account of the loss, of the vessel named below or share therein shall 
not be recognized. The circumstances involved in the computation of such 
gain are as follows:

Name and other identification of vessel_________________________________
Nature and extent of the taxpayer's interest in the vessel______________
Nature of disposition, i.e., sale or loss_______________________________
Date of disposition_____________________________________________________
Full sale price or full amount of indemnity received by taxpayer________
Amount and date of each payment of sale price or indemnity received by 
taxpayer________________________________________________________________
Amount and date of each previous deposit of such payments in 
construction reserve fund_______________________________________________
________________________________________________________________________
Identification of each check or other instrument by which payment made 
to taxpayer_____________________________________________________________
________________________________________________________________________
Tax basis of taxpayer's interest in vessel______________________________
Any other data affecting the determination of the realized gain_________
Amount of gain (submit computation)_____________________________________
________________________________________________________________________
                                                      (Name of taxpayer)
By______________________________________________________________________
________________________________________________________________________
                                                     (Date of execution)
    (b) [Reserved]



Sec. 2.1-13  Deposit of proceeds of sales or indemnities.

    (a) Manner of deposit. The deposit required by section 511 of the 
Act must be made in a construction reserve fund established with a 
depository or depositories approved by the Administration and subject to 
the joint control of the Administration and the taxpayer. It is not 
necessary to establish a separate fund with respect to each vessel or 
share in a vessel sold or lost.

[[Page 15]]

    (b) Amount of deposit. With respect to any vessel sold or lost, or a 
share therein, the deposit must be in an amount equal to the ``net 
proceeds'' of the sale, or the ``net indemnity'' for the loss. By ``net 
proceeds'' and ``net indemnity'' is meant (1) the depositor's interest 
in the adjusted basis of the vessel plus (2) the amount of gain which 
would be recognized for tax purposes in the absence of section 511 of 
the Act. In determining ``net proceeds'', the amount necessarily paid or 
incurred for brokers' commissions is to be deducted from the gross 
amount of the sales price. In the event the taxpayer is an affiliate or 
associate of the buyer, the amount of the sales price shall not exceed 
the fair market value of the vessel or vessels sold as determined by the 
Administration. In such case the taxpayer shall furnish evidence 
sufficient, in the opinion of the Administration, to establish that the 
sales price is not in excess of the fair market value. In determining 
``net indemnity'', the amount necessarily paid or incurred purely for 
collection, or rate of exchange discounts on the payment, of the 
indemnity is to be deducted from the gross amount of collectible 
indemnity. In case of the sale or loss of several vessels or share 
therein, a deposit of the ``net proceeds'' or ``net indemnity'' with 
respect to one or more of the vessels or shares is permissible. Where 
several vessels or shares are sold for a lump sum, the ``net proceeds'' 
allocated to each vessel or share shall be determined in accordance with 
any reasonable rule satisfactory to the Commissioner of Internal 
Revenue. The taxpayer must deposit the full amount of each payment 
(including cash, notes, or other evidences of indebtedness) as a single 
deposit in the construction reserve fund. A payment divided between two 
or more depositories will be regarded as a single deposit. Amounts 
received by the taxpayer prior to the date of consummation of the sale 
of the vessel shall be considered as having been received by the 
taxpayer at the time the sale is consummated.
    (c) Purchase-money obligations. Where the proceeds from the sale of 
a vessel include purchase-money obligations, such obligations together 
with the entire collateral therefor, or, in the case of deposit of the 
proceeds of a share in the vessel, a proportionate part of the 
obligations and collateral as determined by the Administration, shall be 
deposited, with the remainder of the proceeds, in the construction 
reserve fund as a part of the ``net proceeds''. The depository shall 
receive payment of all amounts due on such purchase-money obligations 
and such amounts shall be placed in the fund in substitution for the 
portion of the obligations paid. All installments of purchase-money 
obligations shall be paid directly into the fund by the obligor. In the 
event any such installment is not so deposited, the Administration, at 
any time after the due date, may require the taxpayer to deposit an 
amount equal to such installment. If the taxpayer so desires, he may 
deposit in the construction reserve fund cash or approved securities in 
an amount equal to the face value of any purchase-money obligations in 
lieu of depositing such obligations.
    (d) Vessel subject to mortgage at time of sale or loss. Where a 
vessel is subject to a mortgage or other encumbrance at the time of its 
sale or loss and the taxpayer actually receives only an amount 
representing the equity therein or a share in such equity corresponding 
to his share in the vessel, he shall deposit in the construction reserve 
fund such amount and concurrently therewith other funds in an amount 
equal to the difference between the amount received and the ``net 
proceeds'' or ``net indemnity''. Such other funds may be in the form of 
cash, or, subject to the approval of the Administration, (1) interest-
bearing securities, or (2) an irrevocable and unconditional commitment 
to finance the construction or acquisition of a new vessel in whole or 
in part by an obligor approved by the Administration in an amount equal 
to the amount by which the ``net proceeds'' exceed the cash or 
securities deposited in the fund.
    (e) Unauthorized deposits. A deposit which is not provided for by 
section 511 of the Act shall, without unreasonable delay, be withdrawn 
from the fund and tax liability will be determined as though such 
deposit had not been made. (See Secs. 2.1-10 and 2.1-24.)

[[Page 16]]



Sec. 2.1-14  Deposit of earnings and receipts.

    (a) Earnings. A citizen may deposit all or any part of earnings 
derived from the operation, within the scope of Sec. 2.1-3, of a vessel 
or vessels owned either by himself or any other person, if such earnings 
are intended for construction or acquisition of new vessels. Such 
earnings may include payments received by an owner, as compensation for 
use of his vessel, from other persons by whom it is so operated. 
Earnings from other sources may not be deposited. The earnings from 
operation of vessels which are eligible for deposit are the net earnings 
determined without regard to any deduction for depreciation, 
obsolescence, or amortization with respect to such vessels.
    (b) Receipts. Receipts from deposited funds, in the form of interest 
or otherwise, may be deposited.



Sec. 2.1-15  Time for making deposits.

    (a) Proceeds of sale or indemnification. Deposits of amounts 
representing proceeds of the sale or indemnification for loss of a 
vessel or share therein must be made within 60 days after receipt by the 
taxpayer.
    (b) Earnings and receipts. Earnings and receipts for the taxable 
year may be deposited at any time. (See Sec. 2.1-14.)



Sec. 2.1-16  Tax liability as to earnings deposited.

    Deposit in the construction reserve fund of earnings from the 
operation of a vessel or vessels, or receipts, in the form of interest 
or otherwise, with respect to amounts previously deposited does not 
exempt the taxpayer from tax liability with respect thereto nor postpone 
the time such earnings or receipts are includible in gross income. 
Earnings and receipts deposited in a construction reserve fund 
established in accordance with the provisions of section 511 of the Act 
and the regulations in this part will be deemed to have been accumulated 
for the reasonable needs of the business within the meaning of Part 1 
(section 531 and following), Subchapter G, Chapter I of the Internal 
Revenue Code of 1954, so long as the requirements of section 511 of the 
Act and the regulations in this part are satisfied relative to the use 
of the fund in the construction, reconstruction, reconditioning, or 
acquisition of new vessels, or for the liquidation of purchase-money 
indebtedness on such vessels. For incurrence of tax liability due to 
noncompliance with the requirements of section 511 of the Act and the 
regulations in this part with respect to deposits in the construction 
reserve fund, see the provisions of Sec. 2.1-23.



Sec. 2.1-17  Basis of new vessel.

    The basis for determining gain or loss and for depreciation for the 
purpose of the Federal income tax with respect to a new vessel 
constructed, reconstructed, reconditioned, or acquired by the taxpayer, 
or with respect to which purchase-money indebtedness is liquidated as 
provided in section 511(g) of the Act, with funds deposited in the 
construction reserve fund, is reduced by the amount of the unrecognized 
gain represented in the funds allocated under the provisions of the 
regulations in this part to the cost of such vessel. (See Sec. 2.1-18.)



Sec. 2.1-18  Allocation of gain for tax purposes.

    (a) General rules of allocation. As provided in Sec. 2.1-17, if 
amounts on deposit in a construction reserve fund are expended, 
obligated, or withdrawn for construction, reconstruction, 
reconditioning, or acquisition of new vessels, or for the liquidation of 
purchase-money indebtedness of such vessels, the portion thereof which 
represents gain shall be applied in reduction of the basis of such new 
vessels. The rules set forth below in this paragraph shall apply in 
allocating the unrecognized gain to the amounts so expended, obligated, 
or withdrawn:
    (1) If the ``net proceeds'' of a sale or ``net indemnity'' in 
respect of a loss are deposited in more than one deposit, the portion 
thereof representing unrecognized gain shall be considered as having 
been deposited first.
    (2) Amounts expended, obligated, or withdrawn from the construction 
reserve fund shall be applied against amounts deposited in the order of 
deposit.
    (3) If any deposit consists in part of gain not recognized under 
section 511(c)

[[Page 17]]

of the Act, then any expenditure, obligation, or withdrawal applied 
against such deposit shall be considered to consist of gain in the same 
proportion that the part of the deposit which constitutes gain bears to 
the total amount of the deposit.
    (b) Date of obligation. The date funds are obligated under a 
contract for the construction, reconstruction, reconditioning, or 
acquisition of new vessels, or for the liquidation of purchase-money 
indebtedness on such vessels, rather than the date of payment from the 
fund, will determine the order of application against the deposits in 
the fund. When a contract for the construction, reconstruction, 
reconditioning, or acquisition of new vessels, or for the liquidation of 
purchase-money indebtedness on such vessels is entered into, amounts on 
deposit in the construction reserve fund will be deemed to be obligated 
to the extent of the amount of the taxpayer's liability under the 
contract. Deposits will be deemed to be so obligated in the order of 
deposit, each new contract obligating the earliest deposit not 
previously expended, obligated, or withdrawn. If the liability under the 
contract exceeds the amount in the construction reserve fund, the 
contract will be deemed to obligate, to the extent of that part of such 
excess not otherwise satisfied, the earliest deposit or deposits 
thereafter made.
    (c) Illustration. The foregoing rules are illustrated in the 
following example:

    Example. (1) A taxpayer who makes his returns on the calendar year 
basis sells a vessel in 1963 for $1,000,000, realizing a gain of 
$400,000. Payment of $100,000 is received in March 1963 when the 
contract is signed, and the balance of $900,000 is received in June 1963 
on delivery of the vessel. The $1,000,000 is deposited in a construction 
reserve fund in July 1963. In December 1963, the taxpayer also deposits 
$150,000, representing earnings of that year. In 1964, he sells another 
vessel for $1,000,000, realizing a gain of $250,000. The sale price of 
$1,000,000 is received on delivery of the vessel in February 1964, and 
deposited in the construction reserve fund in March 1964. In September 
1964, the taxpayer purchases for cash out of the construction reserve 
fund a new vessel for $1,750,000. To the cost of this vessel must be 
allocated the 1963 deposits of $1,150,000 and $600,000 of the March 1964 
deposit. This leaves in the fund $400,000 of the March 1964 deposit. The 
amount of the unrecognized gain to be applied against the basis of the 
new vessel is $550,000, computed as follows: Gain of $400,000 
represented in the 1963 deposits, plus the same proportion of the 
$250,000 gain represented in the March 1964 deposit ($1,000,000) which 
the amount ($600,000) allocated to the vessel is of the amount of the 
deposit, i.e., $400,000 plus 600,000/1,000,000 of $250,000 or $150,000, 
a total of $550,000. This reduces the basis of the new vessel to 
$1,200,000 ($l,750,000 less $550,000).
    (2) In 1965, the taxpayer sells a third vessel for $3,000,000, 
realizing a gain of $900,000. The $3,000,000 is received and deposited 
in the construction reserve fund in June 1965, making a total in the 
fund of $3,400,000. In December 1965, the taxpayer contracts for the 
construction of a second new vessel to cost a maximum of $3,200,000, 
thereby obligating that amount of the fund, and in June 1966, receives 
permission to withdraw the unobligated balance amounting to $200,000. To 
the cost of the second new vessel must be allocated the $400,000 balance 
of the March 1964 deposit and $2,800,000 of the June 1965 deposit. The 
unrecognized gain to be applied against the basis of such new vessel is 
that proportion of the gain represented in each deposit which the 
portion of the deposit allocated to the vessel bears to the amount of 
such deposit, i.e., 400,000/1,000,000 of $250,000, or $100,000 plus 
2,800,000/3,000,000 of $900,000, or $840,000 making a total of $940,000. 
The $200,000 withdrawal is applied against the June 1965 deposit and the 
portion thereof which represents gain will be recognized as income for 
1965, the year in which realized. The computation of the recognized gain 
is as follows: 200,000/3,000,000 of $900,000, or $60,000.



Sec. 2.1-19  Requirements as to new vessels.

    (a) Requirements. For the purposes of section 511 of the Act and the 
regulations in this part, the new vessel must be--
    (1) Documented under the laws of the United States when it is 
acquired by the taxpayer, or the taxpayer must agree that when acquired 
it will be documented under the laws of the United States;
    (2)(i) Constructed in the United States after December 31, 1939, or 
(ii) its construction has been financed under Title V or Title VII of 
the Act, or (iii) its construction has been aided by a mortgage insured 
under Title XI of the Act; and
    (3) Either (i) of such type, size, and speed as the Administration 
determines to be suitable for use on the high seas or Great Lakes in 
carrying out the

[[Page 18]]

purposes of the Act, but of not less than 2,000 gross tons or of less 
speed than 12 knots, except that a particular vessel may be of lesser 
tonnage or speed if the Administration determines and certifies that the 
particular vessel is desirable for use by the United States in case of 
war or national emergency, or (ii) constructed to replace a vessel or 
vessels requisitioned or purchased by the United States, in which event 
it must be of such type, size, and speed as to constitute a suitable 
replacement for the vessel requisitioned or purchased, but if a vessel 
already built is acquired to replace a vessel or vessels requisitioned 
or purchased by the United States, such vessel must meet the 
requirements set forth in subdivision (i) of this subparagraph. 
Ordinarily, under subdivision (i) of this subparagraph, a vessel 
constructed more than five years before the date on which deposits in a 
construction reserve fund are to be expended or obligated for 
acquisition of such vessel will not be considered suitable for use in 
carrying out the purpose of the Act, except that the five-year age 
limitation provided above in this sentence shall not apply to a vessel 
to be reconstructed before being placed in operation by the taxpayer.
    (b) Time of construction. A vessel will be deemed to be constructed 
after December 31, 1939, only if construction was commenced after that 
date. Subject to the provisions of this section, a new vessel may be 
newly built for the taxpayer, or may be acquired after it is built.
    (c) Replacement of vessels. It is not necessary that vessels shall 
be replaced vessel for vessel. The new vessels may be more or less in 
number than the replaced vessels, provided the other requirements of 
this section are met.



Sec. 2.1-20  Obligation of deposits.

    (a) Time for obligation. Within three years from the date of any 
deposit in a construction reserve fund, unless extension is granted as 
provided in Sec. 2.1-22, such deposit must be obligated under a contract 
for the construction or acquisition of a new vessel or vessels (or in 
the discretion of the Administration for a share therein), with not less 
than 12\1/2\ percent of the construction or contract price of the entire 
vessel or vessels actually paid or irrevocably committed on account 
thereof or must be expended or obligated for the liquidation of existing 
or subsequently incurred purchase-money indebtedness to persons other 
than a parent company of, or a company affiliated or associated with, 
the mortgagor on a new vessel or vessels. Amounts on deposit in a 
construction reserve fund will be deemed to be obligated for expenditure 
when a binding contract of construction or acquisition has been entered 
into or when purchase-money indebtedness has been incurred and, if 
obligated under a contract of construction or acquisition, will be 
deemed to be irrevocably committed when due and payable in accordance 
with the terms of the contract of construction or acquisition.
    (b) Requirements for obligations. Unless otherwise authorized by the 
Administration, contracts for the construction of new vessels must be 
for a fixed price, or provide for a base price that may be adjusted for 
changes in labor and material costs not exceeding 15 percent of the base 
price. The fixed or base price, as the case may be, shall be fair and 
reasonable as determined by the Maritime Administration. Any financial 
or other interests between the taxpayer and the contractor shall be 
disclosed to the Administration by the taxpayer. Plans and 
specifications for the new vessel or vessels must be approved by the 
Administration to the extent it deems necessary. A deposit in a 
construction reserve fund may be expended or obligated for expenditure 
for procurement under an acquisition or construction contract of a part 
interest in a new vessel or vessels only after obtaining the written 
consent of the Administration. The granting of such consent shall be 
entirely in the discretion of the Administration and it may impose such 
conditions with respect thereto as it may deem necessary or advisable 
for the purpose of carrying out the provisions of section 511 of the 
Act. Applications for such consent shall be executed in triplicate, and, 
together with eight conformed copies thereof, filed with the 
Administration.

[[Page 19]]



Sec. 2.1-21  Period for construction of certain vessels.

    A new vessel constructed otherwise than under the provisions of 
Title V of the Act, and not purchased from the Administration must, 
within six months from the date of the construction contract, or within 
the period of any extension, be completed to the extent of not less than 
5 percent as estimated by the Administration and certified by it to the 
Secretary of the Treasury. In case of a contract covering more than one 
vessel it will be sufficient if one of the vessels is 5 percent 
completed within the six months' period from the date of the contract or 
within the period of any extension, and so certified. All construction 
must be completed with reasonable dispatch as determined by the 
Administration. If, for causes within the control of the taxpayer, the 
entire construction is not completed with reasonable dispatch, the 
Administration will so certify to the Secretary of the Treasury. For the 
effect of such certification, see Sec. 2.1-23.



Sec. 2.1-22  Time extensions for expenditure or obligation.

    (a) Extensions. The Administration, upon application and a showing 
of proper circumstances, (1) may allow an extension of time within which 
deposits shall be expended or obligated, not to exceed one year, and 
upon a second application received before the expiration of the first 
extension, may allow an additional extension not to exceed one year, and 
(2) may allow an extension or extensions of time within which five 
percent of the construction shall have been completed as provided in 
Sec. 2.1-21 not to exceed one year in the aggregate, and (3) may allow 
any other extensions that may be provided by amendment to the Act.
    (b) Application required. A taxpayer seeking an extension of time 
shall make application therefor, and transmit it with an appropriate 
statement of the circumstances, including the reasons justifying the 
requested extension or extensions, and appropriate documents in 
substantiation of the statement, to the Administration. The 
Administration will notify the Commissioner of Internal Revenue of any 
extension granted. In case an application for extension is denied, the 
taxpayer will be liable for delay as though no application had been 
made.



Sec. 2.1-23  Noncompliance with requirements.

    (a) Noncompliance. The amount of the gain which is that portion of 
the construction reserve fund otherwise constituting taxable income 
under the law applicable to the taxable year in which such gain was 
realized shall be included in the taxpayer's gross income for such 
taxable year for income or excess-profits tax purposes, if--
    (1) A portion of such fund is withdrawn for purposes other than--
    (i) The construction, reconstruction, reconditioning, or acquisition 
of a new vessel; or
    (ii) The liquidation of existing or subsequently incurred purchase-
money indebtedness to persons other than a parent company of, or a 
company affiliated or associated with, the mortgagor on a new vessel or 
vessels; or
    (2) The taxpayer fails to comply with the requirements of section 
511 of the Act or the regulations in this part relating to the 
utilization of construction reserve funds in the construction, 
reconstruction, reconditioning, or acquisition of a new vessel, or the 
liquidation of purchase-money indebtedness on such a vessel.

If securities on deposit in a construction reserve fund are sold and the 
amount placed in the fund in lieu thereof is less than the value of the 
securities at the time of their deposit, the difference between such 
value and the amount placed in the fund in lieu of the securities will 
be deemed to have been withdrawn. With respect to the substitution of 
new financing in the case of an irrevocable commitment, see paragraph 
(d) of Sec. 2.1-13.
    (b) Amount recognized. In the event of noncompliance with the 
prescribed conditions relative to any contract for construction, 
reconstruction, reconditioning, or acquisition of new vessels, or for 
the liquidation of purchase-money indebtedness on such vessels, 
recognition will extend to the entire amount of the gain represented in 
that portion of the construction reserve fund obligated under such 
contract.

[[Page 20]]

Thus, if the Administration determines and certifies to the Secretary of 
the Treasury that for causes within the control of the taxpayer 
construction under a contract is not completed with reasonable dispatch, 
the entire amount of the gain represented in the portion of the 
construction reserve fund obligated under the contract will be 
recognized even though all other conditions have been satisfied. In case 
of noncompliance with the requirements of section 511 of the Act or the 
regulations in this part, see the provisions of Sec. 2.1-18 as to the 
allocation of gain.
    (c) Unreasonable accumulation. Noncompliance with the provisions of 
section 511 of the Act or the regulations in this part relative to the 
utilization of the deposited amounts may also, inasmuch as the provision 
of section 511(f) of the Act is then inapplicable, warrant an 
examination to ascertain whether such amounts constitute an unreasonable 
accumulation of earnings and profits within the meaning of Part I 
(section 531 and following), Subchapter G, Chapter I of the Internal 
Revenue Code of 1954, or corresponding provisions of prior law. If 
amounts are deposited and the fund maintained in good faith for the 
purpose of construction, reconstruction, reconditioning, and acquisition 
of new vessels, or for the liquidation of purchase-money indebtedness on 
such vessels, such amounts will be deemed to have been accumulated for 
the reasonable needs of the business.



Sec. 2.1-24  Extent of tax liability.

    (a) Declared value excess-profits tax. Gain which is includible in 
gross income under Sec. 2.1-23 shall be included in gross income for all 
income and excess-profits tax purposes, but not for the purposes of the 
declared value excess-profits tax and the capital stock tax as provided 
in section 511(i) of the Act. In lieu of any adjustment with respect to 
such declared value excess-profits tax, there is imposed for any taxable 
year ending on or before June 30, 1945, in which the gain is realized an 
additional tax of 1.1 percent of the amount of the gain. No additional 
capital stock tax liability is incurred.
    (b) Improper deposits. In the case of deposits in the construction 
reserve fund of amounts derived from sources other than those specified 
in section 511 of the Act, or in the case of failure to deposit an 
amount equal to the ``net proceeds'' or ``net indemnity'' within the 
period prescribed in section 511(c) of the Act and Sec. 2.1-15, the 
taxpayer obtains no suspension or postponement of any tax liability and 
the tax is collectible without regard to the provisions of section 
511(c) of the Act.
    (c) Time for filing claim subsequent to election under section 
511(c)(2). If an election is made under section 511(c)(2) of the Act and 
paragraph (a)(2) of Sec. 2.1-12, and if computation or recomputation in 
accordance therewith is otherwise allowable but is prevented, on the 
date of filing of notice of such election, or within six months 
thereafter, by any statute of limitation; such computation or 
recomputation nevertheless shall be made notwithstanding such statute if 
a claim therefor is filed within six months after the date of making 
such election. If as the result of such computation or recomputation an 
overpayment is disclosed a claim for refund should be made in accordance 
with Sec. 301.6402-3 within such six months' period. For other rules 
applicable to the filing of claims for credit or refund of an 
overpayment of tax, see Sec. 301.6402-2 of this chapter (Regulations on 
Procedure and Administration), relating to claims for credit or refund.

[T.D. 6820, 30 FR 6030, Apr. 29, 1965, as amended by T.D. 7410, 41 FR 
11020, Mar. 16, 1976]



Sec. 2.1-25  Assessment and collection of deficiencies.

    Any additional tax, including the 1.1 percent amount imposed by 
section 511(i) of the Act, due on account of withdrawal from a 
construction reserve fund, or failure to comply with section 511 of the 
Act or the regulations in this part, is collectible as a deficiency. 
Interest upon such deficiency will run from the date the withdrawal or 
noncompliance occurs. The amount of any deficiency, including interest 
and additions to the tax, determined as a result of such withdrawal or 
noncompliance, may be assessed, or a proceeding in court for the 
collection thereof may be begun without assessment, at any time and 
without regard to any period of limitations or any other provisions of

[[Page 21]]

law or rule of law, including the doctrine of res judicata.



Sec. 2.1-26  Reports by taxpayers.

    (a) Information required. With each income tax return filed for a 
taxable year during any part of which a construction reserve fund is in 
existence the taxpayer shall submit a statement setting forth a detailed 
analysis of such fund. The statement, which need not be on any 
prescribed form, shall include the following information with respect to 
the construction reserve fund:
    (1) The actual balance in the fund at the beginning and end of the 
taxable year;
    (2) The date, amount, and source of each deposit during the taxable 
year;
    (3) If any deposit referred to in subparagraph (2) of this paragraph 
consists of proceeds from the sale, or indemnification of loss, of a 
vessel or share thereof, the amounts of the unrecognized gain;
    (4) The date, amount, and purpose of each expenditure or withdrawal 
from the fund; and
    (5) The date and amount of each contract, under which deposited 
funds are deemed to be obligated during the taxable year, for the 
construction, reconstruction, reconditioning, or acquisition of new 
vessels, or for the liquidation of purchase-money indebtedness on such 
vessels, and the identification of such vessels.
    (b) Records required. Taxpayers shall keep such records and make 
such additional reports as the Commissioner of Internal Revenue or the 
Administration may require.



Sec. 2.1-27  Controlled corporation.

    For the purpose of section 511 of the Act and the regulations in 
this part a new vessel is considered as constructed, reconstructed, 
reconditioned, or acquired by the taxpayer if constructed, 
reconstructed, reconditioned, or acquired by a corporation at a time 
when the taxpayer owns not less than 95 percent of the total number of 
shares of each class of stock of the corporation.



Sec. 2.1-28  Administrative jurisdiction.

    Sections 2.1-3 to 2.1-11, inclusive, Secs. 2.1-13 to 2.1-15, 
inclusive, and Secs. 2.1-19 to 2.1-22, inclusive, deal primarily with 
matters under the jurisdiction of the Administration. Sections 2.1-12, 
2.1-16 to 2.1-18, inclusive, and Secs. 2.1-23 to 2.1-27, inclusive, deal 
primarily with matters under the jurisdiction of the Commissioner of 
Internal Revenue. Generally, matters relating to the establishment, 
maintenance, expenditure, and use of construction reserve funds and the 
construction, reconstruction, reconditioning, or acquisition of new 
vessels are under the jurisdiction of the Administration; and matters 
relating to the determination, assessment, and collection of taxes are 
under the jurisdiction of the Commissioner of Internal Revenue. 
Correspondence should be addressed to the particular authority having 
jurisdiction in the matter.



PART 3--CAPITAL CONSTRUCTION FUND--Table of Contents




Sec.
3.0  Statutory provisions; section 607, Merchant Marine Act, 1936, as 
          amended.
3.1  Scope of section 607 of the Act and the regulations in this part.
3.2  Ceiling on deposits.
3.3  Nontaxability of deposits.
3.4  Establishment of accounts.
3.5  Qualified withdrawals.
3.6  Tax treatment of qualified withdrawals.
3.7  Tax treatment of nonqualified withdrawals.
3.8  Certain corporate reorganizations and changes in partnerships, and 
          certain transfers on death. [Reserved]
3.9  Consolidated returns. [Reserved]
3.10  Transitional rules for existing funds.
3.11  Definitions.

    Authority: Sec. 21(a) of the Merchant Marine Act of 1970 (84 Stat. 
1026); sec. 7805 of the Internal Revenue Code of 1954 (68A Stat. 917; 26 
U.S.C. 7805).

    Source: T.D. 7398, 41 FR 5812, Feb. 10, 1976, unless otherwise 
noted.



Sec. 3.0  Statutory provisions; section 607, Merchant Marine Act, 1936, as amended.

    Sec. 607 (a) Agreement Rules.
    Any citizen of the United States owning or leasing one or more 
eligible vessels (as defined in subsection (k)(1)) may enter into an 
agreement with the Secretary of Commerce under, and as provided in, this 
section to establish a capital construction fund (hereinafter in this 
section referred to as the ``fund'') with respect to any or all of such

[[Page 22]]

vessels. Any agreement entered into under this section shall be for the 
purpose of providing replacement vessels, additional vessels, or 
reconstructed vessels, built in the United States and documented under 
the laws of the United States for operation in the United States, 
foreign, Great Lakes, or noncontiguous domestic trade or in the 
fisheries of the United States and shall provide for the deposit in the 
fund of the amounts agreed upon as necessary or appropriate to provide 
for qualified withdrawals under subsection (f). The deposits in the 
fund, and all withdrawals from the fund, whether qualified or 
nonqualified, shall be subject to such conditions and requirements as 
the Secretary of Commerce may by regulations prescribe or are set forth 
in such agreement; except that the Secretary of Commerce may not require 
any person to deposit in the fund for any taxable year more than 50 
percent of that portion of such person's taxable income for such year 
(computed in the manner provided in subsection (b)(1)(A)) which is 
attributable to the operation of the agreement vessels.
    (b) Ceiling on Deposits.
    (1) The amount deposited under subsection (a) in the fund for any 
taxable year shall not exceed the sum of:
    (A) That portion of the taxable income of the owner or lessee for 
such year (computed as provided in chapter 1 of the Internal Revenue 
Code of 1954 but without regard to the carryback of any net operating 
loss or net capital loss and without regard to this section) which is 
attributable to the operation of the agreement vessels in the foreign or 
domestic commerce of the United States or in the fisheries of the United 
States,
    (B) The amount allowable as a deduction under section 167 of the 
Internal Revenue Code of 1954 for such year with respect to the 
agreement vessels,
    (C) If the transaction is not taken into account for purposes of 
subparagraph (A), the net proceeds (as defined in joint regulations) 
from (i) the sale or other disposition of any agreement vessel, or (ii) 
insurance or indemnity attributable to any agreement vessel, and
    (D) The receipts from the investment or reinvestment of amounts held 
in such fund.
    (2) In the case of a lessee, the maximum amount which may be 
deposited with respect to an agreement vessel by reason of paragraph 
(1)(B) for any period shall be reduced by any amount which, under an 
agreement entered into under this section, the owner is required or 
permitted to deposit for such period with respect to such vessel by 
reason of paragraph (1)(B).
    (3) For purposes of paragraph (1), the term ``agreement vessel'' 
includes barges and containers which are part of the complement of such 
vessel and which are provided for in the agreement.
    (c) Requirements as to Investments.
    Amounts in any fund established under this section shall be kept in 
the depository or depositories specified in the agreement and shall be 
subject to such trustee and other fiduciary requirements as may be 
specified by the Secretary of Commerce. They may be invested only in 
interest-bearing securities approved by the Secretary of Commerce; 
except that, if the Secretary of Commerce consents thereto, an agreed 
percentage (not in excess of 60 percent) of the assets of the fund may 
be invested in the stock of domestic corporations. Such stock must be 
currently fully listed and registered on an exchange registered with the 
Securities and Exchange Commission as a national securities exchange, 
and must be stock which would be acquired by prudent men of discretion 
and intelligence in such matters who are seeking a reasonable income and 
the preservation of their capital. If at any time the fair market value 
of the stock in the fund is more than the agreed percentage of the 
assets in the fund, any subsequent investment of amounts deposited in 
the fund, and any subsequent withdrawal from the fund, shall be made in 
such a way as to tend to restore the fund to a situation in which the 
fair market value of the stock does not exceed such agreed percentage. 
For purposes of this subsection, if the common stock of a corporation 
meets the requirements of this subsection and if the preferred stock of 
such corporation would meet such requirements but for the fact that it 
cannot be listed and registered as required because it is nonvoting 
stock, such preferred stock shall be treated as meeting the requirements 
of this subsection.
    (d) Nontaxability for Deposits.
    (1) For purposes of the Internal Revenue Code of 1954--
    (A) Taxable income (determined without regard to this section) for 
the taxable year shall be reduced by an amount equal to the amount 
deposited for the taxable year out of amounts referred to in subsection 
(b)(1)(A),
    (B) Gain from a transaction referred to in subsection (b)(1)(C) 
shall not be taken into account if an amount equal to the net proceeds 
(as defined in joint regulations) from such transaction is deposited in 
the fund,
    (C) The earnings (including gains and losses) from the investment 
and reinvestment of amounts held in the fund shall not be taken into 
account,
    (D) The earnings and profits of any corporation (within the meaning 
of section 316 of such Code) shall be determined without regard to this 
section, and
    (E) In applying the tax imposed by section 531 of such Code 
(relating to the accumulated earnings tax), amounts while held in the 
fund shall not be taken into account.
    (2) Paragraph (1) shall apply with respect to any amount only if 
such amount is deposited in the fund pursuant to the agreement

[[Page 23]]

and not later than the time provided in joint regulations.
    (e) Establishment of Accounts.
    For purposes of this section--
    (1) Within the fund established pursuant to this section three 
accounts shall be maintained:
    (A) The capital account,
    (B) The capital gain account, and
    (C) The ordinary income account.
    (2) The capital account shall consist of--
    (A) Amounts referred to in subsection (b)(1)(B),
    (B) Amounts referred to in subsection (b)(1)(C) other than that 
portion thereof which represents gain not taken into account by reason 
of subsection (d)(1)(B),
    (C) 85 percent of any dividend received by the fund with respect to 
which the person maintaining the fund would (but for subsection 
(d)(1)(C)) be allowed a deduction under section 243 of the Internal 
Revenue Code of 1954, and
    (D) Interest income exempt from taxation under section 103 of such 
Code.
    (3) The capital gain account shall consist of--
    (A) Amounts representing capital gains on assets held for more than 
6 months and referred to in subsection (b)(1)(C) or (b)(1)(D), reduced 
by--
    (B) Amounts representing capital losses on assets held in the fund 
for more than 6 months.
    (4) The ordinary income account shall consist of--
    (A) Amounts referred to in subsection (b)(1)(A),
    (B)(i) Amounts representing capital gains on assets held for 6 
months or less and referred to in subsection (b)(1)(C) or (b)(1)(D), 
reduced by--
    (ii) Amounts representing capital losses on assets held in the fund 
for 6 months or less,
    (C) Interest (not including any tax-exempt interest referred to in 
paragraph (2)(D)) and other ordinary income (not including any dividend 
referred to in subparagraph (E)) received on assets held in the fund,
    (D) Ordinary income from a transaction described in subsection 
(b)(1)(C), and
    (E) 15 percent of any dividend referred to in paragraph (2)(C).
    (5) Except on termination of a fund, capital losses referred to in 
paragraph (3)(B) or in paragraph (4)(B)(ii) shall be allowed only as an 
offset to gains referred to in paragraph (3)(A) or (4)(B)(i), 
respectively.
    (f) Purposes of Qualified Withdrawals.
    (1) A qualified withdrawal from the fund is one made in accordance 
with the terms of the agreement but only if it is for:
    (A) The acquisition, construction, or reconstruction of a qualified 
vessel,
    (B) The acquisition, construction, or reconstruction of barges and 
containers which are part of the complement of a qualified vessel, or
    (C) The payment of the principal on indebtedness incurred in 
connection with the acquisition, construction, or reconstruction of a 
qualified vessel or a barge or container which is part of the complement 
of a qualified vessel.

Except to the extent provided in regulations prescribed by the Secretary 
of Commerce, subparagraph (B), and so much of subparagraph (C) as 
relates only to barges and containers, shall apply only with respect to 
barges and containers constructed in the United States.
    (2) Under joint regulations, if the Secretary of Commerce determines 
that any substantial obligation under any agreement is not being 
fulfilled, he may, after notice and opportunity for hearing to the 
person maintaining the fund, treat the entire fund or any portion 
thereof as an amount withdrawn from the fund in a nonqualified 
withdrawal.
    (g) Tax Treatment of Qualified Withdrawals.
    (1) Any qualified withdrawal from a fund shall be treated--
    (A) First as made out of the capital account,
    (B) Second as made out of the capital gain account, and
    (C) Third as made out of the ordinary income account.
    (2) If any portion of a qualified withdrawal for a vessel, barge, or 
container is made out of the ordinary income account, the basis of such 
vessel, barge, or container shall be reduced by an amount equal to such 
portion.
    (3) If any portion of a qualified withdrawal for a vessel, barge, or 
container is made out of the capital gain account, the basis of such 
vessel, barge, or container shall be reduced by an amount equal to--
    (A) Five-eighths of such portion, in the case of a corporation 
(other than an electing small business corporation, as defined in 
section 1371 of the Internal Revenue Code of 1954), or
    (B) One-half of such portion, in the case of any other person.
    (4) If any portion of a qualified withdrawal to pay the principal on 
any indebtedness is made out of the ordinary income account or the 
capital gain account, then an amount equal to the aggregate reduction 
which would be required by paragraphs (2) and (3) if this were a 
qualified withdrawal for a purpose described in such paragraphs shall be 
applied, in the order provided in joint regulations, to reduce the basis 
of vessels, barges, and containers owned by the person maintaining the 
fund. Any amount of a withdrawal remaining after the application of the 
preceding sentence shall be treated as a nonqualified withdrawal.

[[Page 24]]

    (5) If any property the basis of which was reduced under paragraph 
(2), (3), or (4) is disposed of, any gain realized on such disposition, 
to the extent it does not exceed the aggregate reduction in the basis of 
such property under such paragraphs, shall be treated as an amount 
referred to in subsection (h)(3)(A) which was withdrawn on the date of 
such disposition. Subject to such conditions and requirements as may be 
provided in joint regulations, the preceding sentence shall not apply to 
a disposition where there is a redeposit in an amount determined under 
joint regulations which will, insofar as practicable, restore the fund 
to the position it was in before the withdrawal.
    (h) Tax Treatment of Nonqualified Withdrawals.
    (1) Except as provided in subsection (i), any withdrawal from a fund 
which is not a qualified withdrawal shall be treated as a nonqualified 
withdrawal.
    (2) Any nonqualified withdrawal from a fund shall be treated--
    (A) First as made out of the ordinary income account,
    (B) Second as made out of the capital gain account, and
    (C) Third as made out of the capital account.

For purposes of this section, items withdrawn from any account shall be 
treated as withdrawn on a first-in-first-out basis; except that (i) any 
nonqualified withdrawal for research, development, and design expenses 
incident to new and advanced ship design, machinery and equipment, and 
(ii) any amount treated as a nonqualified withdrawal under the second 
sentence of subsection (g)(4), shall be treated as withdrawn on a last-
in-first-out basis.
    (3) For purposes of the Internal Revenue Code of 1954--
    (A) Any amount referred to in paragraph (2)(A) shall be included in 
income as an item of ordinary income for the taxable year in which the 
withdrawal is made.
    (B) Any amount referred to in paragraph (2)(B) shall be included in 
income for the taxable year in which the withdrawal is made as an item 
of gain realized during such year from the disposition of an asset held 
for more than 6 months, and
    (C) For the period on or before the last date prescribed for payment 
of tax for the taxable year in which this withdrawal is made--
    (i) No interest shall be payable under section 6601 of such Code and 
no addition to the tax shall be payable under section 6651 of such Code,
    (ii) Interest on the amount of the additional tax attributable to 
any item referred to in subparagraph (A) or (B) shall be paid at the 
applicable rate (as defined in paragraph (4)) from the last date 
prescribed for payment of the tax for the taxable year for which such 
item was deposited in the fund, and
    (iii) No interest shall be payable on amounts referred to in clauses 
(i) and (ii) of paragraph (2) or in the case of any nonqualified 
withdrawal arising from the application of the recapture provision of 
section 606(5) of the Merchant Marine Act of 1936 as in effect on 
December 31, 1969.
    (4) For purposes of paragraph (3)(C)(ii), the applicable rate of 
interest for any nonqualified withdrawal--
    (A) Made in a taxable year beginning in 1970 or 1971 is 8 percent, 
or
    (B) Made in a taxable year beginning after 1971, shall be determined 
and published jointly by the Secretary of the Treasury and the Secretary 
of Commerce and shall bear a relationship to 8 percent which the 
Secretaries determine under joint regulations to be comparable to the 
relationship which the money rates and investment yields for the 
calendar year immediately preceding the beginning of the taxable year 
bear to the money rates and investment yields for the calendar year 
1970.
    (i) Certain Corporate Reorganizations and Changes in Partnerships.
    Under joint regulations--
    (1) A transfer of a fund from one person to another person in a 
transaction to which section 381 of the Internal Revenue Code of 1954 
applies may be treated as if such transaction did not constitute a 
nonqualified withdrawal, and
    (2) A similar rule shall be applied in the case of a continuation of 
a partnership (within the meaning of subchapter K of such Code).
    (j) Treatment of Existing Funds.
    (1) Any person who was maintaining a fund or funds (hereinafter in 
this subsection referred to as ``old fund'') under this section (as in 
effect before the enactment of this subsection) may elect to continue 
such old fund but--
    (A) May not hold moneys in the old fund beyond the expiration date 
provided in the agreement under which such old fund is maintained 
(determined without regard to any extension or renewal entered into 
after April 14, 1970),
    (B) May not simultaneously maintain such old fund and a new fund 
established under this section, and
    (C) If he enters into an agreement under this section to establish a 
new fund, may agree to the extension of such agreement to some or all of 
the amounts in the old fund.
    (2) In the case of any extension of an agreement pursuant to 
paragraph (1)(C), each item in the old fund to be transferred shall be 
transferred in a nontaxable transaction to the appropriate account in 
the new fund established under this section. For purposes of subsection 
(h)(3)(C), the date of the deposit of any item so transferred shall be 
July 1,

[[Page 25]]

1971, or the date of the deposit in the old fund, whichever is the 
later.
    (k) Definitions.
    For purposes of this section--
    (1) The term ``eligible vessel'' means any vessel--
    (A) Constructed in the United States and, if reconstructed, 
reconstructed in the United States,
    (B) Documented under the laws of the United States, and
    (C) Operated in the foreign or domestic commerce of the United 
States or in the fisheries of the United States.

Any vessel which (i) was constructed outside of the United States but 
documented under the laws of the United States on April 15, 1970, or 
(ii) constructed outside the United States for use in the United States 
foreign trade pursuant to a contract entered into before April 15, 1970, 
shall be treated as satisfying the requirements of subparagraph (A) of 
this paragraph and the requirements of subparagraph (A) of paragraph 
(2).
    (2) The term ``qualified vessel'' means any vessel--
    (A) Constructed in the United States and, if reconstructed, 
reconstructed in the United States,
    (B) Documented under the laws of the United States, and
    (C) Which the person maintaining the fund agrees with the Secretary 
of Commerce will be operated in the United States foreign, Great Lakes, 
or noncontiguous domestic trade or in the fisheries of the United 
States.
    (3) The term ``agreement vessel'' means any eligible vessel or 
qualified vessel which is subject to an agreement entered into under 
this section.
    (4) The term ``United States,'' when used in a geographical sense, 
means the continental United States including Alaska, Hawaii, and Puerto 
Rico.
    (5) The term ``United States foreign trade'' includes (but is not 
limited to) those areas in domestic trade in which a vessel built with 
construction-differential subsidy is permitted to operate under the 
first sentence of section 506 of this Act.
    (6) The term ``joint regulations'' means regulations prescribed 
under subsection (1).
    (7) The term ``vessel'' includes cargo handling equipment which the 
Secretary of Commerce determines is intended for use primarily on the 
vessel. The term ``vessel'' also includes an ocean-going towing vessel 
or an ocean-going barge or comparable towing vessel or barge operated on 
the Great Lakes.
    (8) The term ``noncontiguous trade'' means (i) trade between the 
contiguous forty-eight States on the one hand and Alaska, Hawaii, Puerto 
Rico, and the insular territories and possessions of the United States 
on the other hand, and (ii) trade from any point in Alaska, Hawaii, 
Puerto Rico, and such territories and possessions to any other point in 
Alaska, Hawaii, Puerto Rico, and such territories and possessions.
    (l) Records; Reports; Changes in Regulations.
    Each person maintaining a fund under this section shall keep such 
records and shall make such reports as the Secretary of Commerce or the 
Secretary of the Treasury shall require. The Secretary of the Treasury 
and the Secretary of Commerce shall jointly prescribe all rules and 
regulations, not inconsistent with the foregoing provisions of this 
section, as may be necessary or appropriate to the determination of tax 
liability under this section. If, after an agreement has been entered 
into under this section, a change is made either in the joint 
regulations or in the regulations prescribed by the Secretary of 
Commerce under this section which could have a substantial effect on the 
rights or obligations of any person maintaining a fund under this 
section, such person may terminate such agreement.



Sec. 3.1  Scope of section 607 of the Act and the regulations in this part.

    (a) In general. The regulations prescribed in this part provide 
rules for determining the income tax liability of any person a party to 
an agreement with the Secretary of Commerce establishing a capital 
construction fund (for purposes of this part referred to as the 
``fund'') authorized by section 607 of the Merchant Marine Act, 1936, as 
amended (for purposes of this part referred to as the ``Act''). With 
respect to such parties, section 607 of the Act in general provides for 
the nontaxability of certain deposits of money or other property into 
the fund out of earnings or gains realized from the operation of vessels 
covered in an agreement, gains realized from the sale or other 
disposition of agreement vessels or proceeds from insurance for 
indemnification for loss of agreement vessels, earnings from the 
investment or reinvestment of amounts held in a fund, and gains with 
respect to amounts or deposits in the fund. Transitional rules are also 
provided for the treatment of ``old funds'' existing on or before the 
effective date of the Merchant Marine Act of 1970 (see Sec. 3.10).
    (b) Cross references. For rules relating to eligibility for a fund, 
deposits, and withdrawals and other aspects, see the regulations 
prescribed by the Secretary of Commerce in titles 46 (Merchant Marine) 
and 50 (Fisheries) of the Code of Federal Regulations.

[[Page 26]]

    (c) Code. For purposes of this part, the term ``Code'' means the 
Internal Revenue Code of 1954, as amended.



Sec. 3.2  Ceiling on deposits.

    (a) In general--(1) Total ceiling. Section 607(b) of the Act 
provides a ceiling on the amount which may be deposited by a party for a 
taxable year pursuant to an agreement. The amount which a party may 
deposit into a fund may not exceed the sum of the following subceilings:
    (i) The lower of (a) the taxable income (if any) of the party for 
such year (computed as provided in Chapter I of the Code but without 
regard to the carryback of any net operating loss or net capital loss 
and without regard to section 607 of the Act) or (b) taxable income (if 
any) of such party for such year attributable under paragraph (b) of 
this section to the operation of agreement vessels (as defined in 
paragraph (f) of this section) in the foreign or domestic commerce of 
the United States or in the fisheries of the United States (see section 
607(b)(1)(A) of the Act).
    (ii) Amounts allowable as a deduction under section 167 of the Code 
for such year with respect to the agreement vessels (see section 
607(b)(1)(B) of the Act),
    (iii) The net proceeds (if not included in subdivision (i) of this 
paragraph) from (a) the sale or other disposition of any agreement 
vessels or (b) insurance or indemnity attributable to any agreement 
vessels (see section 607(b)(1)(C) of the Act and paragraph (c) of this 
section), and
    (iv) Earnings and gains from the investment or reinvestment of 
amounts held in such fund (see section 607(b)(1)(D) of the Act and 
paragraphs (d) and (g) of this section).
    (2) Overdeposits. (i) If for any taxable year an amount is deposited 
into the fund under a subceiling computed under subparagraph (1) of this 
paragraph which is in excess of the amount of such subceiling for such 
year, then at the party's option such excess (or any portion thereof) 
may--
    (a) Be treated as a deposit into the fund for that taxable year 
under another available subceiling, or
    (b) Be treated as not having been deposited for the taxable year and 
thus, at the party's option, may be disposed of either by it being--
    (1) Treated as a deposit into the fund under any subceiling 
available in the first subsequent taxable year in which a subceiling is 
available, in which case such amount shall be deemed to have been 
deposited on the first day of such subsequent taxable year, or
    (2) Repaid to the party from the fund.
    (ii)(a) When a correction is made for an overdeposit, proper 
adjustment shall be made with respect to all items for all taxable years 
affected by the overdeposit, such as, for example, amounts in each 
account described in Sec. 3.4, treatment of nonqualified withdrawals, 
the consequences of qualified withdrawals and the treatment of losses 
realized or treated as realized by the fund. Thus, for example, if the 
party chooses to have the fund repay to him the amount of an 
overdeposit, amounts in each account, basis of assets, and any affected 
item will be determined as though no deposit and repayment had been 
made. Accordingly, in such a case, if there are insufficient amounts in 
an account to cover a repayment of an overdeposit (as determined before 
correcting the overdeposit), and the party had applied the proceeds of a 
qualified withdrawal from such account towards the purchase of a 
qualified vessel (within the meaning of Sec. 3.11(a)(2)), then such 
account and the basis of the vessel shall be adjusted as of the time 
such withdrawal was made and proceeds were applied, and repayment shall 
be made from such account as adjusted. If a party chooses to treat the 
amount of an overdeposit as a deposit under a subceiling for a 
subsequent year, similar adjustments to affected items shall be made. If 
the amount of a withdrawal would have exceeded the amount in the fund 
(determined after adjusting all affected amounts by reason of correcting 
the overdeposit), the withdrawal to the extent of such excess shall be 
treated as a repayment made at the time the withdrawal was made.
    (b) If the accounts (as defined in Sec. 3.4) that were increased by 
reason of excessive deposits contain sufficient amounts at the time the 
overdeposit is

[[Page 27]]

discovered to repay the party, the party may, at his option, demand 
repayment of such excessive deposits from such accounts in lieu of 
making the adjustments required by (a) of this subdivision (ii).
    (iii) During the period beginning with the day after the date an 
overdeposit was actually made and ending with the date it was disposed 
of in accordance with subdivision (i)(b) of this subparagraph, there 
shall be included in the party's gross income for each taxable year the 
earnings attributed to any amount of overdeposit on hand during such a 
year. The earnings attributable to any amount of overdeposit on hand 
during a taxable year shall be an amount equal to the product of--
    (a) The average daily earnings for each one dollar in the fund (as 
determined in subdivision (iv) of this subparagraph),
    (b) The amount of overdeposit (as determined in subdivision (vi) of 
this subparagraph), and
    (c) The number of days during the taxable year the overdeposit 
existed.
    (iv) For purposes of subdivision (iii) (a) of this subparagraph, the 
average daily earnings for each dollar in the fund shall be determined 
by dividing the total earnings of the fund for the taxable year by the 
sum of the products of--
    (a) Any amount on hand during the taxable year (determined under 
subdivision (v) of this subparagraph), and
    (b) The number of days during the taxable year such amount was on 
hand in the fund.
    (v) For purposes of this subparagraph--
    (a) An amount on hand in the fund or an overdeposit shall not be 
treated as on hand on the day deposited but shall be treated as on hand 
on the day withdrawn, and
    (b) The fair market value of such amounts on hand for purposes of 
this subparagraph shall be determined as provided in Sec. 20.2031-2 of 
the Estate Tax Regulations of this chapter but without applying the 
blockage and other special rules contained in paragraph (e) thereof.
    (vi) For purposes of subdivision (iii) (b) of this subparagraph, the 
amount of overdeposit on hand at any time is an amount equal to--
    (a) The amount deposited into the fund under a subceiling computed 
under subparagraph (1) of this paragraph which is in excess of the 
amount of such subceiling, less
    (b) The sum of--
    (1) Amounts described in (a) of this subdivision (vi) treated as a 
deposit under another subceiling for the taxable year pursuant to 
subdivision (i) of this subparagraph,
    (2) Amounts described in (a) of this subdivision (vi) disposed of 
(or treated as disposed of) in accordance with subdivision (i) or (ii) 
of this subparagraph prior to such time.
    (vii) To the extent earnings attributed under subdivision (iii) of 
this subparagraph represent a deposit for any taxable year in excess of 
the subceiling described in subparagraph (1)(iv) of this paragraph for 
receipts from the investment or reinvestment of amounts held in the 
fund, such attributed earnings shall be subject to the rules of this 
subparagraph for overdeposits.
    (3) Underdeposit caused by audit adjustment. [Reserved]
    (4) Requirements for deficiency deposits. [Reserved]
    (b) Taxable income attributable to the operation of an agreement 
vessel--(1) In general. For purposes of this section, taxable income 
attributable to the operation of an agreement vessel means the amount, 
if any, by which the gross income of a party for the taxable year from 
the operation of an agreement vessel (as defined in paragraph (f) of 
this section) exceeds the allowable deductions allocable to such 
operation (as determined under subparagraph (3) of this paragraph). The 
term ``taxable income attributable to the operation of the agreement 
vessels'' means the sum of the amounts described in the preceding 
sentence separately computed with respect to each agreement vessel (or 
share therein) or, at the party's option, computed in the aggregate.
    (2) Gross income. (i) Gross income from the operation of agreement 
vessels means the sum of the revenues which are derived during the 
taxable year from the following:
    (a) Revenues derived from the transportation of passengers, freight, 
or

[[Page 28]]

mail in such vessels, including amounts from contracts for the charter 
of such vessels to others, from operating differential subsidies, from 
collections in accordance with pooling agreements and from insurance or 
indemnity net proceeds relating to the loss of income attributable to 
such agreement vessels.
    (b) Revenues derived from the operation of agreement vessels 
relating to commercial fishing activities, including the transportation 
of fish, support activities for fishing vessels, charters for commercial 
fishing, and insurance or indemnity net proceeds relating to the loss of 
income attributable to such agreement vessels.
    (c) Revenues from the rental, lease, or use by others of terminal 
facilities, revenues from cargo handling operations and tug and lighter 
operations, and revenues from other services or operations which are 
incidental and directly related to the operation of an agreement vessel. 
Thus, for example, agency fees, commissions, and brokerage fees derived 
by the party at his place of business for effecting transactions for 
services incidental and directly related to shipping for the accounts of 
other persons are includible in gross income from the operation of 
agreement vessels where the transaction is of a kind customarily 
consummated by the party for his own account at such place of business.
    (d) Dividends, interest, and gains derived from assets set aside and 
reasonably retained to meet regularly occurring obligations relating to 
the shipping or fishing business directly connected with the agreement 
vessel which obligations cannot at all times be met from the current 
revenues of the business because of layups or repairs, special surveys, 
fluctuations in the business, and reasonably foreseeable strikes 
(whether or not a strike actually occurs), and security amounts retained 
by reason of participation in conferences, pooling agreements, or 
similar agreements.
    (ii) The items of gross income described in subdivision (i) (c) and 
(d) of this subparagraph shall be considered to be derived from the 
operations of a particular agreement vessel in the same proportion that 
the sum of the items of gross income described in subdivision (i) (a) 
and (b) of this subparagraph which are derived from the operations of 
such agreement vessel bears to the party's total gross income for the 
taxable year from operations described in subdivision (i) (a) and (b) of 
this subparagraph.
    (iii) In the case of a party who uses his own or leased agreement 
vessels to transport his own products, the gross income attributable to 
such vessel operations is an amount determined to be an arm's length 
charge for such transportation. The arm's length charge shall be 
determined by applying the principles of section 482 of the Code and the 
regulations thereunder as if the party transporting the product and the 
owner of the product were not the same person but were controlled 
taxpayers within the meaning of Sec. 1.482-1(a)(4) of the Income Tax 
Regulations of this chapter. Gross income attributable to the operation 
of agreement vessels does not include amounts for which the party is 
allowed a deduction for percentage depletion under sections 611 and 613 
of the Code.
    (3) Deductions. From the gross income attributable to the operation 
of an agreement vessel or vessels as determined under subparagraph (2) 
of this paragraph, there shall be deducted, in accordance with the 
principles of Sec. 1.861-8 of the Income Tax Regulations of this 
chapter, the expenses, losses, and other deductions definitely related 
and therefore allocated and apportioned thereto and a ratable part of 
any expenses, losses, or other deductions which are not definitely 
related to any gross income of the party. Thus, for example, if a party 
has gross income attributable to the operation of an agreement vessel 
and other gross income and has a particular deduction definitely related 
to both types of gross income, such deduction must be apportioned 
between the two types of gross income on a reasonable basis in 
determining the taxable income attributable to the operation of the 
agreement vessel.
    (4) Net operating and capital loss deductions. The taxable income of 
a party attributable to the operation of agreement vessels shall be 
computed without regard to the carryback of any net

[[Page 29]]

operating loss deduction allowed by section 172 of the Code, the 
carryback of any net capital loss deduction allowed by sections 165(f) 
of the Code, or any reduction in taxable income allowed by section 607 
of the Act.
    (5) Method of accounting. Taxable income must be computed under the 
method of accounting which the party uses for Federal income tax 
purposes. Such method may include a method of reporting whereby items of 
revenue and expense properly allocable to voyages in progress at the end 
of any accounting period are eliminated from the computation of taxable 
income for such accounting period and taken into account in the 
accounting period in which the voyage is completed.
    (c) Net proceeds from transactions with respect to agreement 
vessels. [Reserved]
    (d) Earnings and gains from the investment or reinvestment of 
amounts held in a fund--(1) In general. (i) Earnings and gains received 
or accrued by a party from the investment or reinvestment of assets in a 
fund is the total amount of any interest or dividends received or 
accrued, and gains realized, by the party with respect to assets 
deposited in, or purchased with amounts deposited in, such fund. Such 
earnings and gains are therefore required to be included in the gross 
income of the party unless such amount, or a portion thereof, is not 
taken into account under section 607(d)(1)(C) of the Act and 
Sec. 3.3(b)(2)(ii) by reason of a deposit or deemed deposit into the 
fund. For rules relating to receipts from the sale or other disposition 
of nonmoney deposits into the fund, see paragraph (g) of this section.
    (ii) Earnings received or accrued by a party from investment or 
reinvestment of assets in a fund include the ratable monthly portion of 
original issue discount included in gross income pursuant to section 
1232(a)(3) of the Code. Such ratable monthly portion shall be deemed to 
be deposited into the ordinary income account of the fund, but an actual 
deposit representing such ratable monthly portion shall not be made. For 
basis of bond or other evidence of indebtedness issued at a discount, 
see Sec. 3.3(b)(2)(ii)(b).
    (2) Gain realized. (i) The gain realized with respect to assets in 
the fund is the excess of the amount realized (as defined in section 
1001(b) of the Code and the regulations thereunder) by the fund on the 
sale or other disposition of a fund asset over its adjusted basis (as 
defined in section 1011 of the Code) to the fund. For the adjusted basis 
of nonmoney deposits, see paragraph (g) of this section.
    (ii) Property purchased by the fund (including property considered 
under paragraph (g)(1)(iii) of this section as purchased by the fund) 
which is withdrawn from the fund in a qualified withdrawal (as defined 
in Sec. 3.5) is treated as a disposition to which subdivision (i) of 
this subparagraph applies. For purposes of determining the amount by 
which the balance within a particular account will be reduced in the 
manner provided in Sec. 3.6(b) (relating to order of application of 
qualified withdrawals against accounts) and for purposes of determining 
the reduction in basis of a vessel, barge, or container (or share 
therein) pursuant to Sec. 3.6(c), the value of the property is its fair 
market value on the day of the qualified withdrawal.
    (3) Holding period. Except as provided in paragraph (g) of this 
section, the holding period of fund assets shall be determined under 
section 1223 of the Code.
    (e) Leased vessels. In the case of a party who is a lessee of an 
agreement vessel, the maximum amount which such lessee may deposit with 
respect to any agreement vessel by reason of section 607(b)(1)(B) of the 
Act and paragraph (a)(1)(ii) of this section (relating to depreciation 
allowable) for any period shall be reduced by the amount (if any) which, 
under an agreement entered into under section 607 of the Act, the owner 
is required or permitted to deposit for such period with respect to such 
vessel by reason of section 607(b)(1)(B) of the Act and paragraph 
(a)(1)(ii) of this section. The amount of depreciation depositable by 
the lessee under this paragraph is the amount of depreciation deductible 
by the lessor on its income tax return, reduced by the amount described 
in the preceding sentence or the amount set forth in the agreement, 
whichever is lower.
    (f) Definition of agreement vessel. For purposes of this section, 
the term ``agreement vessel'' (as defined in

[[Page 30]]

Sec. 3.11(a)(3) and 46 CFR 390.6) includes barges and containers which 
are the complement of an agreement vessel and which are provided for in 
the agreement, agreement vessels which have been contracted for or are 
in the process of construction, and any shares in an agreement vessel. 
Solely for purposes of this section, a party is considered to have a 
``share'' in an agreement vessel if he has a right to use the vessel to 
generate income from its use whether or not the party would be 
considered as having a proprietary interest in the vessel for purposes 
of State or Federal law. Thus, a partner may enter into an agreement 
with respect to his share of the vessel owned by the partnership and he 
may make deposits of his distributive share of the sum of the four 
subceilings described in paragraph (a)(1) of this section. 
Notwithstanding the provisions of subchapter K of the Code (relating to 
the taxation of partners and partnerships), the Internal Revenue Service 
will recognize, solely for the purposes of applying this part, an 
agreement by an owner of a share in an agreement vessel even though the 
``share'' arrangement is a partnership for purposes of the Code.
    (g) Special rules for nonmoney deposits and withdrawals--(1) In 
general. (i) Deposits may be made in the form of money or property of 
the type permitted to be deposited under the agreement. (For rules 
relating to the types of property which may be deposited into the fund, 
see 46 CFR Sec. 390.7(d), and 50 CFR part 259.) For purposes of this 
paragraph, the term ``property'' does not include money.
    (ii) Whether or not the election provided for in subparagraph (2) of 
this paragraph is made--
    (a) The amount of any property deposit, and the fund's basis for 
property deposited in the fund, is the fair market value of the property 
at the time deposited, and
    (b) The fund's holding period for the property begins on the day 
after the deposit is made.
    (iii) Unless such an election is made, deposits of property into a 
fund are considered to be a sale at fair market value of the property, a 
deposit of cash equal to such fair market value, and a purchase by the 
fund of such property for cash. Thus, in the absence of the election, 
the difference between the fair market value of such property deposited 
and its adjusted basis shall be taken into account as gain or loss for 
purposes of computing the party's income tax liability for the year of 
deposit.
    (iv) For fund's basis and holding period of assets purchased by the 
fund, see paragraph (d) (2) and (3) of this section.
    (2) Election not to treat deposits of property other than money as a 
sale or exchange at the time of deposit. A party may elect to treat a 
deposit of property as if no sale or other taxable event had occurred on 
the date of deposit. If such election is made, in the taxable year the 
fund disposes of the property, the party shall recognize as gain or loss 
the amount he would have recognized on the day the property was 
deposited into the fund had the election not been made. The party's 
holding period with respect to such property shall not include the 
period of time such property was held by the fund. The election shall be 
made by a statement to that effect, attached to the party's Federal 
income tax return for the taxable year to which the deposit relates, or, 
if such return is filed before such deposit is made, attached to the 
party's return for the taxable year during which the deposit is actually 
made.
    (3) Effect of qualified withdrawal of property deposited pursuant to 
election. If property deposited into a fund, with respect to which an 
election under subparagraph (2) of this paragraph is made, is withdrawn 
from the fund in a qualified withdrawal (as defined in Sec. 3.5) such 
withdrawal is treated as a disposition of such property resulting in 
recognition by the party of gain or loss (if any) as provided in 
subparagraph (2) of this paragraph with respect to nonfund property. In 
addition, such withdrawal is treated as a disposition of such property 
by the fund resulting in recognition of gain or loss by the party with 
respect to fund property to the extent the fair market value of the 
property on the date of withdrawal is greater or less (as the case may 
be) than the adjusted basis of the property to the fund on such date. 
For purposes of determining the amount by which

[[Page 31]]

the balance within a particular account will be reduced in the manner 
provided in Sec. 3.6(b) (relating to order of application of qualified 
withdrawals against accounts) and for purposes of determining the 
reduction in basis of a vessel, barge, or container (or share therein) 
pursuant to Sec. 3.6(c), the value of the property is its fair market 
value on the day of the qualified withdrawal. For rules relating to the 
effect of a qualified withdrawal of property purchased by the fund 
(including deposited property considered under subparagraph (1)(iii) of 
this paragraph as purchased by the fund), see paragraph (d)(2)(ii) of 
this section.
    (4) Effect of nonqualified withdrawal of property deposited pursuant 
to election. If property deposited into a fund with respect to which an 
election under subparagraph (2) of this paragraph is made, is withdrawn 
from the fund in a nonqualified withdrawal (as defined in Sec. 3.7(b)), 
no gain or loss is to be recognized by the party with respect to fund 
property or nonfund property but an amount equal to the adjusted basis 
of the property to the fund is to be treated as a nonqualified 
withdrawal. Thus, such amount is to be applied against the various 
accounts in the manner provided in Sec. 3.7(c), such amount is to be 
taken into account in computing the party's taxable income as provided 
in Sec. 3.7(d), and such amount is to be subject to interest to the 
extent provided for in Sec. 3.7(e). In the case of withdrawals to which 
this subparagraph applies, the adjusted basis of the property in the 
hands of the party is the adjusted basis on the date of deposit, 
increased or decreased by the adjustments made to such property while 
held in the fund, and in determining the period for which the party has 
held the property there shall be included, in addition to the period the 
fund held the property, the period for which the party held the property 
before the date of deposit of the property into the fund. For rules 
relating to the basis and holding period of property purchased by the 
fund (including deposited property considered under subparagraph (1)(ii) 
of this paragraph as purchased by the fund) and withdrawn in a 
nonqualified withdrawal see Sec. 3.7(f).
    (5) Examples. The provisions of this paragraph are illustrated by 
the following examples:

    Example (1). X Corporation, which uses the calendar year as its 
taxable year, maintains a fund described in Sec. 3.1. X's taxable income 
(determined without regard to section 607 of the Act) is $100,000, of 
which $80,000 is taxable income attributable to the operation of 
agreement vessels (as determined under paragraph (b)(1) of this 
section). Under the agreement, X is required to deposit into the fund 
all earnings and gains received from the investment or reinvestment of 
amounts held in the fund, an amount equal to the net proceeds from 
transactions referred to in Sec. 3.2(c), and an amount equal to 50 
percent of its earnings attributable to the operation of agreement 
vessels provided that such 50 percent does not exceed X's taxable income 
from all sources for the year of deposit. The agreement permits X to 
make voluntary deposits of amounts equal to 100 percent of its earnings 
attributable to the operation of agreement vessels, subject to the 
limitation with respect to taxable income from all sources. The 
agreement also provides that deposits attributable to such earnings may 
be in the form of cash or other property. On March 15, 1973, X deposits, 
with respect to its 1972 earnings attributable to the operation of 
agreement vessels, stock with a fair market value at the time of deposit 
of $80,000 and an adjusted basis to X of $10,000. Such deposit 
represents agreement vessel income of $80,000. At the time of deposit, 
such stock had been held by X for a period exceeding 6 months. X does 
not elect under subparagraph (2) of this paragraph to defer recognition 
of the gain. Accordingly, under subparagraph (1)(iii) of this paragraph, 
the deposit is treated as a deposit of $80,000 and X realizes a long-
term capital gain of $70,000 on March 15, 1973.
    Example (2). The facts are the same as in example (1), except that X 
elects in accordance with subparagraph (2) of this paragraph not to 
treat the deposit as a sale or exchange. On July 1, 1974, the fund sells 
the stock for $85,000. The basis to the fund of the stock is $80,000 
(see subparagraph (1)(ii) (a) of this paragraph). With respect to 
nonfund property, X recognizes $70,000 of long-term capital gain on the 
sale includible in its gross income for 1974. With respect to fund 
property, X realizes $5,000 of long-term capital gain (the difference 
between the amount received by the fund on the sale of the stock, 
$85,000, and the basis to the fund of the stock, $80,000), an amount 
equal to which is required to be deposited into the fund with respect to 
1974, as a gain from the investment or reinvestment of amounts held in 
the

[[Page 32]]

fund. Since the fund held the stock for a period exceeding 6 months, the 
$5,000 is allocated to the fund's capital gain account under 
Sec. 3.4(c).
    Example (3). The facts are the same as in example (2), except that 
the fund sells the stock on July 1, 1974, for $75,000. As the basis to 
the fund of the stock is $80,000, with respect to fund property, X 
realizes a long-term capital loss on the sale (the difference between 
the amount received by the fund on the sale of the stock, $75,000, and 
the basis to the fund of the stock, $80,000), of $5,000, an amount equal 
to which is required to be charged against the fund's capital gain 
account under Sec. 3.4(e). Under subparagraph (2) of this paragraph, X 
recognizes $70,000 of long-term capital gain with respect to nonfund 
property on the sale which is includible in its gross income for 1974.
    Example (4). The facts are the same as in example (2), except that 
on July 1, 1974, X makes a qualified withdrawal (as defined in 
Sec. 3.5(a)) of the stock and uses it to pay indebtedness pursuant to 
Sec. 3.5(b). On the disposition by X considered to occur under 
subparagraph (3) of this paragraph on the qualified withdrawal, X 
recognizes $70,000 of long-term capital gain with respect to nonfund 
property, which is includible in its gross income for 1974, and a long-
term capital gain of $5,000 with respect to fund property, an amount 
equal to which is allocated to the fund's capital gain account under 
Sec. 3.4(c). The fund is treated as having a qualified withdrawal of an 
amount equal to the fair market value of the stock on the day of 
withdrawal, $85,000 (see subparagraph (3) of this paragraph). In 
addition, $85,000 is applied against the various accounts in the order 
provided in Sec. 3.6(b). The basis of the vessel with respect to which 
the indebtedness was incurred is to be reduced as provided in 
Sec. 3.6(c).
    Example (5). The facts are the same as in example (2), except that X 
withdraws the stock from the fund in a nonqualified withdrawal (as 
defined in Sec. 3.7(b)). Under subparagraph (4) of this paragraph, X 
recognizes no gain or loss with respect to fund or nonfund property on 
such withdrawal. An amount equal to the basis of the stock to the fund 
($80,000) is applied against the various accounts in the order provided 
in Sec. 3.7(c), and is taken into account in computing X's taxable 
income for 1974 as provided in Sec. 3.7(d). In addition, X must pay 
interest on the withdrawal as provided in Sec. 3.7(e). The basis to X of 
the stock is $10,000 notwithstanding the fact that the fair market value 
of such stock was $85,000 on the day of withdrawal (see subparagraph (4) 
of this paragraph).



Sec. 3.3  Nontaxability of deposits.

    (a) In general. Section 607(d) of the Act sets forth the rules 
concerning the income tax effects of deposits made with respect to 
ceilings described in section 607(b) and Sec. 3.2. The specific 
treatment of deposits with respect to each of the subceilings is set 
forth in paragraph (b) of this section.
    (b) Treatment of deposits--(1) Earnings of agreement vessels. 
Section 607(d)(1)(A) of the Act provides that taxable income of the 
party (determined without regard to section 607 of the Act) shall be 
reduced by an amount equal to the amount deposited for the taxable year 
out of amounts referred to in section 607(b)(1)(A) of the Act and 
Sec. 3.2(a)(1)(i). For computation of the foreign tax credit, see 
paragraph (i) of this section.
    (2) Net proceeds from agreement vessels and fund earnings. (i)(a) 
Section 607(d)(1)(B) provides that gain from a transaction referred to 
in section 607(b)(1)(C) of the Act and Sec. 3.2(a)(1)(iii) (relating to 
ceilings on deposits of net proceeds from the sale or other disposition 
of agreement vessels) is not to be taken into account for purposes of 
the Code if an amount equal to the net proceeds from transactions 
referred to in such sections is deposited in the fund. Such gain is to 
be excluded from gross income of the party for the taxable year to which 
such deposit relates. Thus, the gain will not be taken into account in 
applying section 1231 of the Code for the year to which the deposit 
relates.
    (b) [Reserved]
    (ii)(a) Section 607(d)(1)(C) of the Act provides that the earnings 
(including gains and losses) from the investment and reinvestment of 
amounts held in the fund and referred to in section 607(b)(1)(D) of the 
Act and Sec. 3.2(a)(1)(iv) shall not be taken into account for purposes 
of the Code if an amount equal to such earnings is deposited into the 
fund. Such earnings are to be excluded from the gross income of the 
party for the taxable year to which such deposit relates.
    (b) However, for purposes of the basis adjustment under section 
1232(a)(3)(E) of the Code, the ratable monthly portion of original issue 
discount included in gross income shall be determined without regard to 
section 607(d)(1)(C) of the Act.
    (iii) In determining the tax liability of a party to whom 
subparagraph (1) of

[[Page 33]]

this paragraph applies, taxable income, determined after application of 
subparagraph (1) of this paragraph, is in effect reduced by the portion 
of deposits which represent gain or earnings respectively referred to in 
subdivision (i) or (ii) of this subparagraph. The excess, if any, of 
such portion over taxable income determined after application of 
subparagraph (1) of this paragraph is taken into account in computing 
the net operating loss (under section 172 of the Code) for the taxable 
year to which such deposits relate.
    (3) Time for making deposits. (i) This section applies with respect 
to an amount only if such amount is deposited in the fund pursuant to 
the agreement and not later than the time provided in subdivision (ii), 
(iii), or (iv) of this subparagraph for the making of such deposit or 
the date the Secretary of Commerce provides, whichever is earlier.
    (ii) Except as provided in subdivision (iii) or (iv) of this 
subparagraph, a deposit may be made not later than the last day 
prescribed by law (including extensions thereof) for filing the party's 
Federal income tax return for the taxable year to which such deposit 
relates.
    (iii) If the party is a subsidized operator under an operating-
differential subsidy contract, and does not receive on or before the 
59th day preceding such last day, payment of all or part of the accrued 
operating-differential subsidy payable for the taxable year, the party 
may deposit an amount equivalent to the unpaid accrued operating-
differential subsidy on or before the 60th day after receipt of payment 
of the accrued operating-differential subsidy.
    (iv) A deposit pursuant to Sec. 3.2(a)(3)(i) (relating to 
underdeposits caused by audit adjustments) must be made on or before the 
date prescribed for such a deposit in Sec. 3.2(a)(4).
    (4) Date of deposits. (i) Except as otherwise provided in 
subdivisions (ii) and (iii) of this subparagraph (with respect to 
taxable years beginning after December 31, 1969, and prior to January 1, 
1972), in Sec. 3.2(a)(2)(i), or in Sec. 3.10(b), deposits made in a fund 
within the time specified in subparagraph (3) of this paragraph are 
deemed to have been made on the date of actual deposit.
    (ii)(a) For taxable years beginning after December 31, 1969, and 
prior to January 1, 1971, where an application for a fund is filed by a 
taxpayer prior to January 1, 1972, and an agreement is executed and 
entered into by the taxpayer prior to March l, 1972,
    (b) For taxable years beginning after December 31, 1970, and prior 
to January 1, 1972, where an application for a fund is filed by a 
taxpayer prior to January 1, 1973, and an agreement is executed and 
entered into by the taxpayer prior to March l, 1973, and
    (c) For taxable years beginning after December 31, 1971, and prior 
to January 1, 1975, where an agreement is executed and entered into by 
the taxpayer on or prior to the due date, with extensions, for the 
filing of his Federal income tax return for such taxable year,

deposits in a fund which are made within 60 days after the date of 
execution of the agreement, or on or before the due date, with 
extensions thereof, for the filing of his Federal income tax return for 
such taxable year or years, whichever date shall be later, shall be 
deemed to have been made on the date of the actual deposit or as of the 
close of business of the last regular business day of each such taxable 
year or years to which such deposits relate, whichever day is earlier.
    (iii) Notwithstanding subdivision (ii) of this subparagraph, for 
taxable years beginning after December 31, 1970, and ending prior to 
January 1, 1972, deposits made later than the last date permitted under 
subdivision (ii) but on or before January 9, 1973, in a fund pursuant to 
an agreement with the Secretary of Commerce, acting by and through the 
Administrator of the National Oceanic and Atmospheric Administration, 
shall be deemed to have been made on the date of the actual deposit or 
as of the close of business of the last regular business day of such 
taxable year, whichever is earlier.
    (c) Determination of earnings and profits. [Reserved]
    (d) Accumulated earnings tax. As provided in section 607(d)(1)(E) of 
the Act amounts, while held in the fund, are

[[Page 34]]

not to be taken into account in computing the ``accumulated taxable 
income'' of the party within the meaning of section 531 of the Code. 
Amounts while held in the fund are considered held for the purpose of 
acquiring, constructing, or reconstructing a qualified vessel or barges 
and containers which are part of the complement of a qualified vessel or 
the payment of the principal on indebtedness incurred in connection with 
any such acquisition, construction, or reconstruction. Thus, for 
example, if the reasonable needs of the business (within the meaning of 
section 537 of the Code) justify a greater amount of accumulation for 
providing replacement vessels than can be satisfied out of the fund, 
such greater amount accumulated outside of the fund shall be considered 
to be accumulated for the reasonable needs of the business. For a 
further example, although amounts in the fund are not taken into account 
in applying the tax imposed by section 531 of the Code, to the extent 
there are amounts in a fund to provide for replacing a vessel, amounts 
accumulated outside of the fund to replace the same vessel are not 
considered to be accumulated for the reasonable needs of the business.
    (e) Nonapplicability of section 1231. If an amount equivalent to 
gain from a transaction referred to in section 607(b)(1)(C) of the Act 
and Sec. 3.2(c) (1) and (5) is deposited into the fund and, therefore, 
such gain is not taken into account in computing gross income under the 
provisions of paragraph (b)(2) of this section, then such gain will not 
be taken into account for purposes of the computations under section 
1231 of the Code.
    (f) Deposits of capital gains. In respect of capital gains which are 
not included in the gross income of the party by virtue of a deposit to 
which section 607(d) of the Act and this section apply, the following 
provisions of the Code do not apply: the minimum tax for tax preferences 
imposed by section 56 of the Code; the alternative tax imposed by 
section 1201 of the Code on the excess of the party's net long-term 
capital gain over his net short-term capital loss; and, in the case of a 
taxpayer other than a corporation, the deduction provided by section 
1202 of the Code of 50% of the amount of such excess. However, section 
56 may apply upon a nonqualified withdrawal with respect to amounts 
treated under Sec. 3.7(d)(2) as being made out of the capital gain 
account.
    (g) Deposits of dividends. The deductions provided by section 243 of 
the Code (relating to the deductions for dividends from a domestic 
corporation received by a corporation) shall not apply in respect of 
dividends (earned on assets held in the fund) which are deposited into a 
fund, and which, by virtue of such deposits and the provisions of 
section 607(d) of the Act and this section, are not included in the 
gross income of the party.
    (h) Presumption of validity of deposit. All amounts deposited in the 
fund shall be presumed to have been deposited pursuant to an agreement 
unless, after an examination of the facts upon the request of the 
Commissioner of Internal Revenue or his delegate, the Secretary of 
Commerce determines otherwise. The Commissioner or his delegate will 
request such a determination where there is a substantial question as to 
whether a deposit is made in accordance with an agreement.
    (i) Special rules for application of the foreign tax credit--(1) In 
general. For purposes of computing the limitation under section 904 of 
the Code on the amount of the credit provided by section 901 of the Code 
(relating to the foreign tax credit), the party's taxable income from 
any source without the United States and the party's entire taxable 
income are to be determined after application of section 607(d) of the 
Act. Thus, amounts deposited for the taxable year with respect to 
amounts referred to in section 607(b)(1)(A) of the Act and 
Sec. 3.2(a)(1)(i) (relating to taxable income attributable to the 
operation of agreement vessels) shall be treated as a deduction in 
arriving at the party's taxable income from sources without the United 
States (subject to the apportionment rules and subparagraph (2) of this 
paragraph) and the party's entire taxable income for the taxable year. 
Amounts deposited with respect to gain described in section 607(d)(1)(B) 
of the Act and Sec. 3.2(c) (relating to net proceeds from the sale or 
other disposition of an

[[Page 35]]

agreement vessel and net proceeds from insurance or indemnity) and 
amounts deposited with respect to earnings described in section 
607(d)(1)(C) of the Act and paragraph (b)(2)(ii) (relating to earnings 
from the investment and reinvestment of amounts held in a fund) of this 
section are not taken into account for purposes of the Code and hence 
are not included in the party's taxable income from sources without the 
United States or in the party's entire taxable income for purposes of 
this paragraph.
    (2) Apportionment of taxable income attributable to agreement 
vessels. For purposes of computing the overall limitation under section 
904(a)(2) of the Code the amount of the deposit made with respect to 
taxable income attributable to agreement vessels pursuant to 
Sec. 3.2(a)(1)(i) which is allocable to sources without the United 
States is the total amount of such deposit multiplied by a fraction the 
numerator of which is the gross income from sources without the United 
States from the operation of agreement vessels and the denominator of 
which is the total gross income from the operation of agreement vessels 
computed as provided in Sec. 3.2(b)(2). For purposes of this paragraph, 
gross income from sources without the United States attributable to the 
operation of agreement vessels is to be determined under sections 861 
through 863 of the Code and under the taxpayer's usual method of 
accounting provided such method is reasonable and in keeping with sound 
accounting practice. Any computation under the per-country limitation of 
section 904(a)(1) shall be made in the manner consistent with the 
provisions of the preceding sentences of this subparagraph.



Sec. 3.4  Establishment of accounts.

    (a) In general. Section 607(e)(1) of the Act requires that three 
bookkeeping or memorandum accounts are to be established and maintained 
within the fund: the capital account, the capital gain account, and the 
ordinary income account. Deposits of the amounts under the subceilings 
in section 607(b) of the Act and Sec. 3.2 are allocated among the 
accounts under section 607(e) of the Act and this section.
    (b) Capital account. The capital account shall consist of:
    (1) Amounts referred to in section 607(b)(1)(B) of the Act and 
Sec. 3.2(a)(1)(ii) (relating to deposits for depreciation),
    (2) Amounts referred to in section 607(b)(1)(C) of the Act and 
Sec. 3.2(a)(1)(iii) (relating to deposits of net proceeds from the sale 
or other disposition of agreement vessels) other than that portion 
thereof which represents gain not taken into account for purposes of 
computing gross income by reason of section 607(d)(1)(B) of the Act and 
Sec. 3.3(b)(2) (relating to nontaxability of gain from the sale or other 
disposition of an agreement vessel),
    (3) Amounts representing 85 percent of any dividend received by the 
fund with respect to which the party would, but for section 607(d)(1)(C) 
of the Act and Sec. 3.3(b)(2)(ii) (relating to nontaxability of deposits 
of earnings from investment and reinvestment of amounts held in a fund), 
be allowed a deduction under section 243 of the Code, and
    (4) Amounts received by the fund representing interest income which 
is exempt from taxation under section 103 of the Code.
    (c) Capital gain account. The capital gain account shall consist of 
amounts which represent the excess of (1) deposits of long-term capital 
gains on property referred to in section 607(b)(1) (C) and (D) of the 
Act and Sec. 3.2(a)(1) (iii) and (iv) (relating respectively to certain 
agreement vessels and fund assets), over (2) amounts representing losses 
from the sale or exchange of assets held in the fund for more than 6 
months (for purposes of this section referred to as ``long-term capital 
losses''). For purposes of this paragraph and paragraph (d)(2) of this 
section, an agreement vessel disposed of at a gain shall be treated as a 
capital asset to the extent that gain thereon is not treated as ordinary 
income, including gain which is ordinary income under section 607(g)(5) 
of the Act (relating to treatment of gain on disposition of a vessel 
with a reduced basis) and Sec. 3.6(e) or under section 1245 of the Code 
(relating to gain from disposition of certain depreciable property). For 
provisions relating to the treatment of short-term capital gains on 
certain

[[Page 36]]

transactions involving agreement vessels or realized by the fund, see 
paragraph (d) of this section. For rules relating to the treatment of 
capital losses on assets held in the fund, see paragraph (e) of this 
section.
    (d) Ordinary income account. The ordinary income account shall 
consist of:
    (1) Amounts referred to in section 607(b)(1)(A) of the Act and 
Sec. 3.2(a)(1)(i) (relating to taxable income attributable to the 
operation of an agreement vessel),
    (2) Amounts representing (i) deposits of gains from the sale or 
exchange of capital assets held for 6 months or less (for purposes of 
this section referred to as ``short-term capital gains'') referred to in 
section 607(b)(1) (C) or (D) of the Act and Sec. 3.2(a)(1) (iii) and 
(iv) (relating respectively to certain agreement vessels and fund 
assets), reduced by (ii) amounts representing losses from the sale or 
exchange of capital assets held in the fund for 6 months or less (for 
purposes of this section referred to as ``short-term capital losses''). 
For rules relating to the treatment of certain agreement vessels as 
capital assets, see paragraph (c) of this section,
    (3) Amounts representing interest (not including any tax-exempt 
interest referred to in section 607(e)(2)(D) of the Act and paragraph 
(b)(4) of this section) and other ordinary income received on assets 
held in the fund (not including any dividend referred to in section 
607(e)(2)(C) of the Act and subparagraph (5) of this paragraph),
    (4) Amounts representing ordinary income from a transaction 
(involving certain net proceeds with respect to an agreement vessel) 
described in section 607(b)(1)(C) of the Act and Sec. 3.2(a)(1)(iii), 
including gain which is ordinary income under section 607(g)(5) of the 
Act and Sec. 3.6(e) (relating to treatment of gain on the disposition of 
a vessel with a reduced basis) or under section 1245 of the Code 
(relating to gain from disposition of certain depreciable property), and
    (5) Fifteen percent of any dividend referred to in section 
607(e)(2)(C) of the Act and paragraph (b)(3) of this section received on 
any assets held in the fund.
    (e) Limitation on deduction for capital losses on assets held in a 
fund. Except on termination of a fund, long-term (and short-term) 
capital losses on assets held in the fund shall be allowed only as an 
offset to long-term (and short-term) capital gains on assets held in the 
fund, but only if such gains are deposited into the fund, and shall not 
be allowed as an offset to any capital gains on assets not held in the 
fund. The net long-term capital loss of the fund for the taxable year 
shall reduce the earliest long-term capital gains in the capital gain 
account at the beginning of the taxable year and the net short-term 
capital loss for the taxable year shall reduce the earliest short-term 
capital gains remaining in the ordinary income account at the beginning 
of the taxable year. Any such losses that are in excess of the capital 
gains in the respective accounts shall reduce capital gains deposited 
into the respective accounts in subsequent years (without regard to 
section 1212, relating to capital loss carrybacks and carryovers). On 
termination of a fund, any net long-term capital loss in the capital 
gain account and any net short-term capital loss remaining in the 
ordinary income account is to be taken into account for purposes of 
computing the party's taxable income for the year of termination as a 
long-term or short-term (as the case may be) capital loss recognized in 
the year the fund is terminated. With respect to the determination of 
the basis to a fund of assets held in such fund, see Sec. 3.2(g).

[T.D. 7398, 41 FR 5812, Feb. 10, 1976, as amended by T.D. 7831, 47 FR 
39675, Sept. 9, 1982]



Sec. 3.5  Qualified withdrawals.

    (a) In general. (1) A qualified withdrawal is one made from the fund 
during the taxable year which is in accordance with section 607(f)(1) of 
the Act, the agreement, and with regulations prescribed by the Secretary 
of Commerce and which is for the acquisition, construction, or 
reconstruction of a qualified vessel (as defined in Sec. 3.11(a)(2)) or 
barges and containers which are part of the complement of a qualified 
vessel (or shares in such vessels, barges, and containers), or for the 
payment of the principal of indebtedness incurred in connection with the 
acquisition, construction, or reconstruction of such qualified vessel 
(or a

[[Page 37]]

barge or container which is part of the complement of a qualified 
vessel).
    (2) For purposes of this section the term share is used to reflect 
an interest in a vessel and means a proprietary interest in a vessel 
such as, for example, that which results from joint ownership. 
Accordingly, a share within the meaning of Sec. 3.2(f) (relating to the 
definition of ``agreement vessel'' for the purpose of making deposits) 
will not necessarily be sufficient to be treated as a share within the 
meaning of this section.
    (3) For purposes of this section, the term acquisition means any of 
the following:
    (i) Any acquisition, but only to the extent the basis of the 
property acquired in the hands of the transferee is its cost. Thus, for 
example, if a party transfers a vessel and $1 million in an exchange for 
another vessel which qualifies for nonrecognition of gain or loss under 
section 1031 (a) of the Code (relating to like-kind exchange), there is 
an acquisition to the extent of $1 million.
    (ii) With respect to a lessee's interest in a vessel, expenditures 
which result in increasing the amounts with respect to which a deduction 
for depreciation (or amortization in lieu thereof) is allowable.
    (b) Payments on indebtedness. Payments on indebtedness may 
constitute qualified withdrawals only if the party shows to the 
satisfaction of the Secretary of Commerce a direct connection between 
incurring the indebtedness and the acquisition, construction, or 
reconstruction of a qualified vessel or its complement of barges and 
containers whether or not the indebtedness is secured by the vessel or 
its complement of barges and containers. The fact that an indebtedness 
is secured by an interest in a qualified vessel, barge, or container is 
insufficient by itself to demonstrate the necessary connection.
    (c) Payments to related persons. Notwithstanding paragraph (a) of 
this section, payments from a fund to a person owned or controlled 
directly or indirectly by the same interests as the party within the 
meaning of section 482 of the Code and the regulations thereunder are 
not to be treated as qualified withdrawals unless the party demonstrates 
to the satisfaction of the Secretary of Commerce that no part of such 
payment constitutes a dividend, a return of capital, or a contribution 
to capital under the Code.
    (d) Treatment of fund upon failure to fulfill obligations. Section 
607(f)(2) of the Act provides that if the Secretary of Commerce 
determines that any substantial obligation under the agreement is not 
being fulfilled, he may, after notice and opportunity for hearing to the 
party, treat the entire fund, or any portion thereof, as having been 
withdrawn as a nonqualified withdrawal. In determining whether a party 
has breached a substantial obligation under the agreement, the Secretary 
will consider among other things, (1) the effect of the party's action 
or omission upon his ability to carry out the purposes of the fund and 
for which qualified withdrawals are permitted under section 607(f)(1) of 
the Act, and (2) whether the party has made material misrepresentations 
in connection with the agreement or has failed to disclose material 
information. For the income tax treatment of nonqualified withdrawals, 
see Sec. 3.7.



Sec. 3.6  Tax treatment of qualified withdrawals.

    (a) In general. Section 607(g) of the Act and this section provide 
rules for the income tax treatment of qualified withdrawals including 
the income tax treatment on the disposition of assets acquired with fund 
amounts.
    (b) Order of application of qualified withdrawals against accounts. 
A qualified withdrawal from a fund shall be treated as being made: 
First, out of the capital account; second, out of the capital gain 
account; and third, out of the ordinary income account. Such withdrawals 
will reduce the balance within a particular account on a first-in-first-
out basis, the earliest qualified withdrawals reducing the items within 
an account in the order in which they were actually deposited or deemed 
deposited in accordance with this part. The date funds are actually 
withdrawn from the fund determines the time at which withdrawals are 
considered to be made.
    (c) Reduction of basis. (1) If any portion of a qualified withdrawal 
for the

[[Page 38]]

acquisition, construction, or reconstruction of a vessel, barge, or 
container (or share therein) is made out of the ordinary income account, 
the basis of such vessel, barge, or container (or share therein) shall 
be reduced by an amount equal to such portion.
    (2) If any portion of a qualified withdrawal for the acquisition, 
construction, or reconstruction of a vessel, barge, or container (or 
share therein) is made out of the capital gain account, the basis of 
such vessel, barge, or container (or share therein) shall be reduced by 
an amount equal to--
    (i) Five-eighths of such portion, in the case of a corporation 
(other than an electing small business corporation, as defined in 
section 1371 of the Code), or
    (ii) One-half of such portion, in the case of any other person.
    (3) If any portion of a qualified withdrawal to pay the principal of 
an indebtedness is made out of the ordinary income account or the 
capital gain account, then the basis of the vessel, barge, or container 
(or share therein) with respect to which such indebtedness was incurred 
is reduced in the manner provided by subparagraphs (1) and (2) of this 
paragraph. If the aggregate amount of such withdrawal from the ordinary 
income account and capital gain account would cause a basis reduction in 
excess of the party's basis in such vessel, barge, or container (or 
share therein), the excess is applied against the basis of other 
vessels, barges, or containers (or shares therein) owned by the party at 
the time of withdrawal in the following order: (i) vessels, barges, or 
containers (or shares therein) which were the subject of qualified 
withdrawals in the order in which they were acquired, constructed, or 
reconstructed; (ii) agreement vessels (as defined in section 607(k)(3) 
of the Act and Sec. 3.11(a)(3)) and barges and containers which are part 
of the complement of an agreement vessel (or shares therein) which were 
not the subject of qualified withdrawals, in the order in which such 
vessels, barges, or containers (or shares therein) were acquired by the 
party; and (iii) other vessels, barges, and containers (or shares 
therein), in the order in which they were acquired by the party. Any 
amount of a withdrawal remaining after the application of this 
subparagraph is to be treated as a nonqualified withdrawal. If the 
indebtedness was incurred to acquire two or more vessels, barges, or 
containers (or shares therein), then the basis reduction in such 
vessels, barges, or containers (or shares therein) is to be made pro 
rata in proportion to the adjusted basis of such vessels, barges, or 
containers (or shares therein) computed, however, without regard to this 
section and adjustments under section 1016(a) (2) and (3) of the Code 
for depreciation or amortization.
    (d) Basis for depreciation. For purposes of determining the 
allowance for depreciation under section 167 of the Code in respect of 
any property which has been acquired, constructed, or reconstructed from 
qualified withdrawals, the adjusted basis for determining gain on such 
property is determined after applying paragraph (c) of this section. In 
the case of reductions in the basis of any property resulting from the 
application of paragraph (c)(3) of this section, the party may adopt a 
method of accounting whereby (1) payments shall reduce the basis of the 
property on the day such payments are actually made, or (2) payments 
made at any time during the first half of the party's taxable year shall 
reduce the basis of the property on the first day of the taxable year, 
and payments made at any time during the second half of the party's 
taxable year shall reduce the basis of the property on the first day of 
the succeeding taxable year. For requirements respecting the change of 
methods of accounting, see Sec. 1.446-1(e)(3) of the Income Tax 
Regulations of this chapter.
    (e) Ordinary income treatment of gain from disposition of property 
acquired with qualified withdrawals. [Reserved]



Sec. 3.7  Tax treatment of nonqualified withdrawals.

    (a) In general. Section 607(h) of the Act provides rules for the tax 
treatment of nonqualified withdrawals, including rules for adjustments 
to the various accounts of the fund, the inclusion of amounts in income, 
and the payment of interest with respect to such amounts.

[[Page 39]]

    (b) Nonqualified withdrawals defined. Except as provided in section 
607 of the Act and Sec. 3.8 (relating to certain corporate 
reorganizations, changes in partnerships, and transfers by reason of 
death), any withdrawal from a fund which is not a qualified withdrawal 
shall be treated as a nonqualified withdrawal which is subject to tax in 
accordance with section 607(h) of the Act and the provisions of this 
section. Examples of nonqualified withdrawals are amounts remaining in a 
fund upon termination of the fund, and withdrawals which are treated as 
nonqualified withdrawals under section 607(f)(2) of the Act and 
Sec. 3.5(d) (relating to failure by a party to fulfill substantial 
obligation under agreement) or under the second sentence of section 
607(g)(4) of the Act and Sec. 3.6(c)(3) (relating to payments against 
indebtedness in excess of basis).
    (c) Order of application of nonqualified withdrawals against 
deposits. A nonqualified withdrawal from a fund shall be treated as 
being made: first, out of the ordinary income account; second, out of 
the capital gain account; and third, out of the capital account. Such 
withdrawals will reduce the balance within a particular account on a 
first-in-first-out basis, the earliest nonqualified withdrawals reducing 
the items within an account in the order in which they were actually 
deposited or deemed deposited in accordance with this part. Nonqualified 
withdrawals for research, development, and design expenses incident to 
new and advanced ship design, machinery, and equipment, and any amount 
treated as a nonqualified withdrawal under the second sentence of 
section 607(g)(4) of the Act and Sec. 3.6(c)(3), shall be applied 
against the deposits within a particular account on a last-in-first-out 
basis. The date funds are actually withdrawn from the fund determines 
the time at which withdrawals are considered to be made. For special 
rules concerning the withdrawal of contingent deposits of net proceeds 
from the installment sale of an agreement vessel, see Sec. 3.2(c)(6).
    (d) Inclusion in income. (1) Any portion of a nonqualified 
withdrawal which, under paragraph (c) of this section, is treated as 
being made out of the ordinary income account is to be included in gross 
income as an item of ordinary income for the taxable year in which the 
withdrawal is made.
    (2) Any portion of a nonqualified withdrawal which, under paragraph 
(c) of this section, is treated as being made out of the capital gain 
account is to be included in income as an item of long-term capital gain 
recognized during the taxable year in which the withdrawal is made.
    (3) For effect upon a party's taxable income of capital losses 
remaining in a fund upon the termination of a fund (which, under 
paragraph (b) of this section, is treated as a nonqualified withdrawal 
of amounts remaining in the fund), see Sec. 3.4(e).
    (e) Interest. (1) For the period on or before the last date 
prescribed by law, including extensions thereof, for filing the party's 
Federal income tax return for the taxable year during which a 
nonqualified withdrawal is made, no interest shall be payable under 
section 6601 of the Code in respect of the tax on any item which is 
included in gross income under paragraph (d) of this section, and no 
addition to such tax for such period shall be payable under section 6651 
of the Code. In lieu of the interest and additions to tax under such 
sections, simple interest on the amount of the tax attributable to any 
item included in gross income under paragraph (d) of this section is to 
be paid at the rate of interest determined for the year of withdrawal 
under subparagraph (2) of this paragraph. Such interest is to be charged 
for the period from the last date prescribed for payment of tax for the 
taxable year for which such item was deposited in the fund to the last 
date for payment of tax for the taxable year in which the withdrawal is 
made. Both dates are to be determined without regard to any extensions 
of time for payment. Interest determined under this paragraph which is 
paid within the taxable year shall be allowed as a deduction for such 
year under section 163 of the Code. However, such interest is to be 
treated as part of the party's tax for the year of withdrawal for 
purposes of collection and in determining any interest or additions to 
tax for the year of withdrawal under section 6601 or 6651, respectively, 
of the Code.

[[Page 40]]

    (2) For purposes of section 607(h)(3)(C)(ii) of the Act, and for 
purposes of certain dispositions of vessels constructed, reconstructed, 
or acquired with qualified withdrawals described in Sec. 3.6(e), the 
applicable rate of interest for any nonqualified withdrawal--
    (i) Made in a taxable year beginning in 1970 and 1971 is 8 percent.
    (ii) Made in a taxable year beginning after 1971, the rate for such 
year as determined and published jointly by the Secretary of the 
Treasury or his delegate and the Secretary of Commerce. Such rate shall 
bear a relationship to 8 percent which the Secretaries determine to be 
comparable to the relationship which the money rates and investment 
yields for the calendar year immediately preceding the beginning of the 
taxable year bear to the money rates and investment yields for the 
calendar year 1970. The determination of the applicable rate for any 
such taxable year will be computed by multiplying 8 percent by the ratio 
which (a) the average yield on 5-year Treasury securities for the 
calendar year immediately preceding the beginning of such taxable year, 
bears to (b) the average yield on 5-year Treasury securities for the 
calendar year 1970. The applicable rate so determined shall be computed 
to the nearest one-hundredth of 1 percent. If such a determination and 
publication is made, the latest published percentage shall apply for any 
taxable year beginning in the calendar year with respect to which 
publication is made.
    (3) No interest shall be payable in respect of taxes on amounts 
referred to in section 607(h)(2) (i) and (ii) of the Act (relating to 
withdrawals for research and development and payments against 
indebtedness in excess of basis) or in the case of any nonqualified 
withdrawal arising from the application of the recapture provision of 
section 606(5) of the Merchant Marine Act, 1936, as in effect on 
December 31, 1969.
    (f) Basis and holding period in the case of property purchased by 
the fund or considered purchased by the fund. In the case of a 
nonqualified withdrawal of property other than money which was purchased 
by the fund (including deposited property considered under 
Sec. 3.2(g)(1)(ii) as purchased by the fund), the adjusted basis of the 
property in the hands of the party is its adjusted basis to the fund on 
the day of the withdrawal. In determining the period for which the 
taxpayer has held the property withdrawn in a nonqualified withdrawal, 
there shall be included only the period beginning with the date on which 
the withdrawal occurred. For basis and holding period in the case of 
nonqualified withdrawals of property other than money deposited into the 
fund, see Sec. 3.2(g)(4).



Sec. 3.8  Certain corporate reorganizations and changes in partnerships, and certain transfers on death. [Reserved]



Sec. 3.9  Consolidated returns. [Reserved]



Sec. 3.10  Transitional rules for existing funds.

    (a) In general. Section 607(j) of the Act provides that any person 
who was maintaining a fund or funds under section 607 of the Merchant 
Marine Act, 1936, prior to its amendment by the Merchant Marine Act of 
1970 (for purposes of this part referred to as ``old fund'') may 
continue to maintain such old fund in the same manner as under prior law 
subject to the limitations contained in section 607(j) of the Act. Thus, 
a party may not simultaneously maintain such old fund and a new fund 
established under the Act.
    (b) Extension of agreement to new fund. If a person enters into an 
agreement under the Act to establish a new fund, he may agree to the 
extension of such agreement to some or all of the amounts in the old 
fund and transfer the amounts in the old fund to which the agreement is 
to apply from the old fund to the new fund. If an agreement to establish 
a new fund is extended to amounts from an old fund, each item in the old 
fund to which such agreement applies shall be considered to be 
transferred to the appropriate account in the manner provided for in 
Sec. 3.8(d) in the new fund in a nontaxable transaction which is in 
accordance with the provisions of the agreement under which such old 
fund was maintained. For purposes of determining the amount of interest 
under section 607(h)(3)(C) of the Act and Sec. 3.7(e), the

[[Page 41]]

date of deposit of any item so transferred shall be deemed to be July 1, 
1971, or the date of the deposit in the old fund, whichever is the 
later.



Sec. 3.11  Definitions.

    (a) As used in the regulations in this part and as defined in 
section 607(k) of the Act--
    (1) The term eligible vessel means any vessel--
    (i) Constructed in the United States, and if reconstructed, 
reconstructed in the United States,
    (ii) Documented under the laws of the United States, and
    (iii) Operated in the foreign or domestic commerce of the United 
States or in the fisheries of the United States. Any vessel which was 
constructed outside of the United States but documented under the laws 
of the United States on April 15, 1970, or constructed outside the 
United States for use in the U.S. foreign trade pursuant to a contract 
entered into before April 15, 1970, shall be treated as satisfying the 
requirements of subdivision (i) of this subparagraph and the 
requirements of subparagraph (2)(i) of this section.
    (2) The term qualified vessel means any vessel--
    (i) Constructed in the United States and, if reconstructed, 
reconstructed in the United States,
    (ii) Documented under the laws of the United States, and
    (iii) Which the person maintaining the fund agrees with the 
Secretary of Commerce will be operated in the U.S. foreign, Great Lakes, 
or noncontiguous domestic trade or in the fisheries of the United 
States.
    (3) The term agreement vessel means any eligible vessel or qualified 
vessel which is subject to an agreement entered into under section 607 
of the Act.
    (4) The term vessel includes cargo handling equipment which the 
Secretary of Commerce determines is intended for use primarily on the 
vessel. The term ``vessel'' also includes an ocean-going towing vessel 
or an ocean-going barge or comparable towing vessel or barge operated in 
the Great Lakes.
    (b) Insofar as the computation and collection of taxes are 
concerned, other terms used in the regulations in this part, except as 
otherwise provided in the Act or this part, have the same meaning as in 
the Code and the regulations thereunder.



PART 4--TEMPORARY INCOME TAX REGULATIONS UNDER SECTION 954 OF THE INTERNAL REVENUE CODE--Table of Contents




Sec.
4.954-0  Introduction.
4.954-1  Foreign base company income; taxable years beginning after 
          December 31, 1986.
4.954-2  Foreign personal holding company income; taxable years 
          beginning after December 31, 1986.

    Authority: 26 U.S.C. 7805.
    Section 4.954-0 also issued under 26 U.S.C. 954 (b) and (c).
    Section 4.954-1 also issued under 26 U.S.C. 954 (b) and (c).
    Section 4.954-2 also issued under 26 U.S.C. 954 (b) and (c).



Sec. 4.954-0  Introduction.

    (a) Effective date. (1) The provisions of Secs. 4.954-1 and 4.954-2 
apply to taxable years of a controlled foreign corporation beginning 
after December 31, 1986. Consequently, any gain or loss (including 
foreign currency gain or loss as defined in section 988(b)) recognized 
during such taxable years of a controlled foreign corporation is subject 
to these provisions. For further guidance, see Sec. 1.954-0(a) of this 
chapter.
    (2) The provisions of Secs. 1.954A-1 and 1.954A-2 apply to taxable 
years of a controlled foreign corporation beginning before January 1, 
1987. All references therein to sections of the Code are to the Internal 
Revenue Code of 1954 prior to the amendments made by the Tax Reform Act 
of 1986.
    (b) Outline of regulation provisions for sections 954(b)(3), 
954(b)(4), 954(b)(5) and 954(c) for taxable years of a controlled 
foreign corporation beginning after December 31, 1986.

    (I) Sec. 4.954-0 Introduction.
    (a) Effective dates.
    (b) Outline.
    (II) Sec. 4.954-1 Foreign base company income.
    (a) In general.
    (1) Purpose and scope.
    (2) Definition of gross foreign base company income.

[[Page 42]]

    (3) Definition of adjusted gross foreign base company income.
    (4) Definition of net foreign base company income.
    (5) Definition of adjusted net foreign base company income.
    (6) Insurance income definitions.
    (7) Additional items of adjusted net foreign base company income or 
adjusted net insurance income by reason of section 952(c).
    (8) Illustration.
    (b) Computation of adjusted gross foreign base company income and 
adjusted gross insurance income.
    (1) De minimus rule and full inclusion rule.
    (i) In general.
    (ii) Five percent de minimus test.
    (iii) Seventy percent full inclusion test.
    (2) Character of items of adjusted gross foreign base company 
income.
    (3) Coordination with section 952(c).
    (4) Anti-abuse rule.
    (i) In general.
    (ii) Presumption.
    (iii) Definition of related person.
    (iv) Illustration.
    (5) Illustration.
    (c) Computation of net foreign base company income.
    (d) Computation of adjusted net foreign base company income or 
adjusted net insurance income.
    (1) Application of high tax exception.
    (2) Effective rate at which taxes are imposed.
    (3) Taxes paid or accrued with respect to an item of income.
    (i) Income other than foreign personal holding company income.
    (ii) Foreign personal holding company income.
    (4) Definition of an item of income.
    (i) Income other than foreign personal holding company income.
    (ii) Foreign personal holding company income.
    (A) In general.
    (B) Consistency rule.
    (5) Procedure.
    (6) Illustrations.
    (e) Character of an item of income.
    (1) Substance of the transaction.
    (2) Separable character.
    (3) Predominant character.
    (4) Coordination of categories of gross foreign base company income 
or gross insurance income.
    (III) Sec. 4.954-2 Foreign Personal Holding Company Income.
    (a) Computation of foreign personal holding company income.
    (1) In general.
    (2) Coordination of overlapping definitions.
    (3) Changes in use or purpose with which property is held.
    (i) In general.
    (ii) Illustrations.
    (4) Definitions.
    (i) Interest.
    (ii) Inventory and similar property.
    (iii) Regular dealer.
    (iv) Dealer property.
    (v) Debt instrument.
    (b) Dividends, etc.
    (1) In general.
    (2) Exclusion of certain export financing.
    (i) In general.
    (ii) Conduct of a banking business.
    (iii) Illustration.
    (3) Exclusion of dividends and interest from related persons.
    (i) Excluded dividends and interest.
    (ii) Interest paid out of adjusted foreign base company income or 
insurance income.
    (iii) Dividends paid out of prior years' earnings.
    (iv) Fifty percent substantial assets test.
    (v) Value of assets.
    (vi) Location of tangible property used in a trade or business.
    (A) In general.
    (B) Exception.
    (vii) Location of intangible property used in a trade or business.
    (A) In general.
    (B) Property located in part in the payor's country of incorporation 
and in part in other countries.
    (viii) Location of property held for sale to customers.
    (A) In general.
    (B) Inventory located in part in the payor's country of 
incorporation and in part in other countries.
    (ix) Location of debt instruments.
    (x) Treatment of certain stock interests.
    (xi) Determination of period during which property is used in a 
trade or business.
    (xii) Treatment of banks and insurance companies [Reserved]
    (4) Exclusion of rents and royalties derived from related persons.
    (i) In general.
    (ii) Rents or royalties paid out of adjusted foreign base company 
income or insurance income.
    (5) Exclusion of rents and royalties derived in the active conduct 
of a trade or business.
    (6) Treatment of tax exempt interest.
    (c) Excluded rents.
    (1) Trade or business cases.
    (2) Special rules.
    (i) Adding substantial value.
    (ii) Substantiality of foreign organization.
    (iii) Definition of active leasing expense.
    (iv) Adjusted leasing profits.
    (3) Illustrations.
    (d) Excluded royalties.
    (1) Trade or business cases.
    (2) Special rules.
    (i) Adding substantial value.
    (ii) Substantiality of foreign organization.
    (iii) Definition of active licensing expense.
    (iv) Definition of adjusted licensing profit.

[[Page 43]]

    (3) Illustrations.
    (e) Certain property transactions.
    (1) In general.
    (i) Inclusion of FPHC income.
    (ii) Dual character property.
    (2) Property that gives rise to certain income.
    (i) In general.
    (ii) Exception.
    (3) Property that does not give rise to income.
    (4) Classification of gain or loss from the disposition of a debt 
instrument or on a deferred payment sale.
    (i) Gain.
    (ii) Loss.
    (5) Classification of options and other rights to acquire or 
transfer property.
    (6) Classification of certain interests in pass-through entities.
    [Reserved]
    (f) Commodities transactions.
    (1) In general.
    (2) Definitions.
    (i) Commodity.
    (ii) Commodities transaction.
    (3) Definition of the term ``qualified active sales''.
    (i) In general.
    (ii) Sale of commodities.
    (iii) Active conduct of a commodities business.
    (iv) Definition of the term ``substantially all.''
    (4) Definition of the term ``qualified hedging transaction''.
    (g) Foreign currency gain.
    (1) In general.
    (2) Exceptions.
    (i) Qualified business units using the dollar approximate separate 
transactions method.
    (ii) Tracing to exclude foreign currency gain or loss from qualified 
business and hedging transactions.
    (iii) Election out of tracing.
    (3) Definition of the term ``qualified business transaction''.
    (i) In general.
    (ii) Specific section 988 transactions attributable to the sale of 
goods or services.
    (A) Acquisition of debt instruments.
    (B) Becoming the obligor under debt instruments.
    (C) Accrual of any item of gross income.
    (D) Accrual of any item of expense.
    (E) Entering into forward contracts, futures contracts, options, and 
similar instruments.
    (F) Disposition of nonfunctional currency.
    (4) Definition of the term ``qualified hedging transaction''.
    (i) In general.
    (ii) Change in purpose of hedging transaction.
    (5) Election out of tracing.
    (i) In general.
    (ii) Exception.
    (iii) Procedure.
    (A) In general.
    (B) Time and manner.
    (C) Termination.
    (h) Income equivalent to interest.
    (1) In general.
    (2) Illustrations.
    (3) Income equivalent to interest from factoring.
    (i) General rule.
    (ii) Exceptions.
    (iii) Factored receivable.
    (iv) Illustrations.
    (4) Determination of sales income.
    (5) Receivables arising from performance of services.

[T.D. 8216, 53 FR 27491, July 21, 1988. Redesignated and amended by T.D. 
8618, 60 FR 46530, Sept. 7, 1995]



Sec. 4.954-1  Foreign base company income; taxable years beginning after December 31, 1986.

    (a) In general--(1) Purpose and scope. Section 954 (b) through (g) 
and Secs. 1.954-1T and 1.954-2T provide rules for computing the foreign 
base company income of a controlled foreign corporation. Foreign base 
company income is included in the subpart F income of a controlled 
foreign corporation under the rules of section 952 and the regulations 
thereunder. Subpart F income is included in the gross income of a United 
States shareholder of a controlled foreign corporation under the rules 
of section 951 and the regulations thereunder, and thus is subject to 
current taxation under section 1 or 11 of the Code. The determination of 
whether a foreign corporation is a controlled foreign corporation, the 
subpart F income of which is included currently in the gross income of 
its United States shareholders, is made under the rules of section 957 
and the regulations thereunder.
    (2) Gross foreign base company income. For taxable years of a 
controlled foreign corporation beginning after December 31, 1986, the 
gross foreign base company income of a controlled foreign corporation 
consists of the following categories of gross income:
    (i) Its foreign personal holding company income, as defined in 
section 954(c) and Sec. 1.954-2T,
    (ii) Its foreign base company sales income, as defined in section 
954(d) and the regulations thereunder,

[[Page 44]]

    (iii) Its foreign base company services income, as defined in 
section 954(e) and the regulations thereunder,
    (iv) Its foreign base company shipping income, as defined in section 
954(f) and the regulations thereunder, and
    (v) Its foreign base company oil related income, as defined in 
section 954(g) and the regulations thereunder.
    (3) Adjusted gross foreign base company income. The term ``adjusted 
gross foreign base company income'' means the gross foreign base company 
income of a controlled foreign corporation as adjusted by the de minimis 
and full inclusion rules of paragraph (b) of this section.
    (4) Net foreign base company income. The term ``net foreign base 
company income'' means the adjusted gross foreign base company income of 
a controlled foreign corporation reduced so as to take account of 
deductions properly allocable to such income under the rules of section 
954(b)(5) and paragraph (c) of this section. In computing net foreign 
base company income, foreign personal holding company income is reduced 
(but not below zero) by related person interest expense before 
allocating and apportioning other expenses in accordance with the rules 
of paragraph (c) of this section and Sec. 1.904(d)-5(c)(2).
    (5) Adjusted net foreign base company income. The term ``adjusted 
net foreign base company income'' means the net foreign base company 
income of a controlled foreign corporation reduced by any items of net 
foreign base company income for which the high tax exception of 
paragraph (d) of this section is elected. The term ``foreign base 
company income'' as used in the Code and elsewhere in the regulations 
generally means adjusted net foreign base company income.
    (6) Insurance income definitions. The term ``gross insurance 
income'' includes any item of gross income taken into account in 
determining insurance income under section 953 and the regulations 
thereunder. The term ``adjusted gross insurance income'' means gross 
insurance income as adjusted by the de minimis and full inclusion rules 
of paragraph (b) of this section. The term ``net insurance income'' 
means adjusted gross insurance income reduced under section 953 and the 
regulations thereunder so as to take into account deductions properly 
allocable or apportionable to such income. The term ``adjusted net 
insurance income'' means net insurance income reduced by any items of 
net insurance income for which the high tax exception of paragraph (d) 
of this section is elected.
    (7) Additional items of adjusted net foreign base company income or 
adjusted net insurance income by reason of section 952(c). Earnings and 
profits of the controlled foreign corporation that are recharacterized 
as foreign base company income or insurance income under section 952(c) 
are items of adjusted net foreign base company income or adjusted net 
insurance income. Thus, they are not included in the gross foreign base 
company income or gross insurance income of the controlled foreign 
corporation in computing adjusted gross foreign base company income or 
adjusted gross insurance income (for purposes of applying the de minimis 
and full inclusion tests of paragraph (b) of this section).
    (8) Illustration. The order of computation is illustrated by the 
following example. Computations in this paragraph (a)(8) and in 
paragraph (b)(5) of this section involving the operation of section 
952(c) are included for purposes of illustration only and do not provide 
substantive rules concerning the operation of that section.

    Example. (i) Gross income. CFC, a controlled foreign corporation, 
has gross income of $1000 for the current taxable year. Of that $1000 of 
income, $100 is interest income that is included in the definition of 
foreign personal holding company income under section 954(c)(1)(A) and 
Sec. 1.954-2T(b)(1)(ii), is not income from a trade or service 
receivable described in section 864(d)(1) or (6), and is not excluded 
from foreign personal holding company income under any provision of 
section 954(c) and Sec. 1.954-2T. Another $50 is foreign base company 
sales income under section 954(d) and the regulations thereunder. The 
remaining $850 of gross income is not included in the definition of 
foreign base company income or insurance income under sections 954(c), 
(d), (e), (f), (g), or 953 and the regulations thereunder, and is 
foreign source general limitation income described in section 
904(d)(1)(I) and the regulations thereunder.
    (ii) Expenses. CFC has expenses for the current taxable year of 
$500. Of that $500, $8 is

[[Page 45]]

from interest paid to a related person and is allocable to foreign 
personal holding company income along with $2 of other expense. Another 
$20 of expense is allocable to foreign base company sales. The remaining 
$470 of expense is allocable to income other than foreign base company 
income or insurance income.
    (iii) Earnings and deficits. CFC has earnings and profits for the 
current taxable year of $500. In the prior taxable year, CFC had losses 
with respect to income other than gross foreign base company income or 
gross insurance income. By reason of the limitation provided under 
section 952(c)(1)(A) and the regulations thereunder, those losses 
reduced the subpart F income (consisting entirely of foreign source 
general limitation income) of CFC by $600 for the prior taxable year.
    (iv) Taxes. Foreign tax of $30 is considered imposed on the interest 
income under the rules of section 954(b)(4) and paragraph (d) of this 
section. Foreign tax of $14 is considered imposed on the foreign base 
company sales income under the rules of section 954(b)(4) and paragraph 
(d) of this section. Foreign tax of $177 is considered imposed on the 
remaining foreign source general limitation income under the rules of 
section 954(b)(4) and paragraph (d) of this section. For the taxable 
year of the foreign corporation, the maximum U.S. rate of taxation under 
section 11 is 34 percent.
    (v) Conclusion. Based on these facts, if CFC elects to exclude all 
items of income subject to a high foreign tax under section 954(b)(4) 
and paragraph (d), it will have $500 of subpart F income as defined in 
section 952(a) (consisting entirely of foreign source general limitation 
income) determined as follows. The following steps do not illustrate the 
computation of the subpart F income of a controlled foreign corporation 
that has income from a trade or service receivable treated as interest 
under section 864(d)(1) or interest described in section 864(d)(6).

                     Step 1--Determine gross income:

(1) Gross income...................................................$1000

Step 2--Determine gross foreign base company income and gross insurance 
                                 income:

(2) Interest income included in foreign personal holding company income 
under section 954 (c)................................................100
(3) Foreign base company sales income under section 954(d)............50
(4) Total gross foreign base company income gross insurance income as 
defined in sections 954(c), (d), (e), (f) and (g) and 953 and the 
regulations thereunder (line (3) plus line (4))......................150

    Step 3--Determine adjusted gross foreign base company income and 
                    adjusted gross insurance income:

(5) Five percent of gross income (.05 x line (1)).....................50
(6) Seventy percent of gross income (.70 x line (1)).................700
(7) Adjusted gross foreign base company income and adjusted gross 
insurance income after the application of the de minimis test of 
paragraph (b) (line (4), or zero if line (4) is less than the lesser of 
line (5) or $1,000,000)..............................................150
(8) Adjusted gross foreign base company income and adjusted gross 
insurance income after the application of the full inclusion test of 
paragraph (b) (line (4), or line (1) if line (4) is greater than line 
(6)).................................................................150

            Step 4--Compute net foreign base company income:

(9) Related person interest expense and other expense allocable and 
apportionable to foreign personal holding company income..............10
(10) Deductions allocable and apportionable to foreign base company 
sales income..........................................................20
(11) Foreign personal holding company income after allocating deductions 
under section 954(b)(5) and paragraph (c) of this section (the lesser of 
line (2) or line (7), reduced (but not below zero) by line (9)).......90
(12) Foreign base company sales income after allocating deductions under 
section 954(b)(5) and paragraph (c) of this section (the lesser of line 
(3) or line (7), reduced (but not below zero) by line (10))...........30
(13) Total net foreign base company income after allocating deductions 
under section 954(b)(5) and paragraph (c) (line (11) plus line (12)) 
                                                                     120

                  Step 5--Compute net insurance income:

(14) Net insurance income under section 953 and the regulations 
thereunder.............................................................0

        Step 6--Compute adjusted net foreign base company income:

(15) Foreign tax imposed on foreign personal holding company income (as 
determined under paragraph (d)).......................................30
(16) Foreign tax imposed on foreign base company sales income (as 
determined under paragraph (d)).......................................14
(17) Ninety percent of the maximum U.S. corporate tax rate..........30.6
(18) Effective rate of foreign tax imposed on foreign personal holding

[[Page 46]]

company income (interest) under section 954(b)(4) and paragraph (d) 
(line (15) divided by line (11))......................................33
(19) Effective rate of foreign tax imposed on $40 of foreign base 
company sales income under section 954(b)(4) and paragraph (d) (line 
(16) divided by line (12))............................................47
(20) Foreign personal holding company income subject to a high foreign 
tax under section 954(b)(4) and paragraph (d) (zero, or line (11) if 
line (18) is greater than line (17))..................................90
(21) Foreign base company sales income subject to a high foreign tax 
under section 954(b)(4) and paragraph (d) (zero, or line (12) if line 
(19) is greater than line (17)).......................................30
(22) Adjusted net foreign base company income after applying section 
954(b)(4) and paragraph (d) (line (13), reduced by the sum of line (20) 
and line (21)).........................................................0

             Step 7--Compute adjusted net insurance income:

(23) Adjusted net insurance income.....................................0

 Step 8--Additions to or reduction of adjusted net foreign base company 
                   income by reason of section 952(c):

(24) Earnings and profits for the current year.......................500
(25) The excess in earnings and profits over subpart F income subject to 
being recharacterized as adjusted net foreign base company income under 
section 952(c)(2) (excess of line (24) over the sum of lines (22) and 
(23); if there is a deficit, then the limitation of section 952(c)(1) 
may apply for the current year)......................................500
(26) Amount of reduction in subpart F income for prior taxable years by 
reason of the limitation of section 952(c)(1) and the regulations 
thereunder...........................................................600
(27) Subpart F income as defined in section 952(a), assuming section 
952(a) (3), (4), or (5) does not apply (the sum of line (22), line (23), 
and the lesser of line (25) or line (26))............................500

    (b) Computation of adjusted gross foreign base company income and 
adjusted gross insurance income--(1) De minimis rule, etc.--(i) In 
general. If the de minimis rule of paragraph (b)(1)(ii) of this section 
applies, then adjusted gross foreign base company income and adjusted 
gross insurance income are each equal to zero. If the full inclusion 
rule of paragraph (b)(1)(iii) of this section applies, then adjusted 
gross foreign base company income consists of all items of gross income 
of the controlled foreign corporation other than gross insurance income, 
and adjusted gross insurance income consists of all items of gross 
insurance income. Otherwise, the adjusted gross foreign base company 
income of a controlled foreign corporation consists of the gross foreign 
base company income of the controlled foreign corporation, and the 
adjusted gross insurance income of a controlled foreign corporation 
consists of the gross insurance income of the controlled foreign 
corporation.
    (ii) Five percent de minimis test--(A) In general. The de minimis 
rule of this paragraph (b)(1)(ii) applies if the sum of the gross 
foreign base company income and the gross insurance income of a 
controlled foreign corporation is less than the lesser of--
    (1) 5 percent of gross income, or
    (2) $1,000,000.

Controlled foreign corporations having a functional currency other than 
the U.S. dollar shall translate the $1,000,000 threshold using the 
exchange rate provided under section 989(b)(3) and the regulations 
thereunder for amounts included in income under section 951(a).
    (B) Coordination with section 864(d). Gross foreign base company 
income or gross insurance income of a controlled foreign corporation 
always includes items of income from trade or service receivables 
described in section 864(d)(1) or (6), even if the de minimis rule of 
this paragraph (b)(1)(ii) is otherwise applicable. In that case, 
adjusted gross foreign base company income consists only of the items of 
income from trade or service receivables described in section 864(d)(1) 
or (6) that are included in gross foreign base company income, and 
adjusted gross insurance income consists only of the items of income 
from trade or service receivables described in section 864(d)(1) or (6) 
that are included in gross insurance income.
    (iii) Seventy percent full inclusion test. The full inclusion rule 
of this paragraph (b)(1)(iii) applies if the sum of the foreign base 
company income and the gross insurance income for the taxable year 
exceeds 70 percent of gross income.

[[Page 47]]

    (2) Character of items of gross income included in adjusted gross 
foreign base company income. The items of gross income included in the 
adjusted gross foreign base company income of a controlled foreign 
corporation retain their character as foreign personal holding company 
income, foreign base company sales income, foreign base company services 
income, foreign base company shipping income, or foreign base company 
oil related income. Items of gross income included in adjusted gross 
income because the full inclusion test of paragraph (b)(1)(iii) of this 
section is met are termed ``full inclusion foreign base company 
income,'' and constitute a separate category of adjusted gross foreign 
base company income for purposes of allocating and apportioning 
deductions under paragraph (c) of this section.
    (3) Coordination with section 952(c). Items of gross foreign base 
company income or gross insurance income that are excluded from adjusted 
foreign base company income or adjusted gross insurance income because 
the de minimis test of paragraph (b)(1)(ii) of this section is met are 
potentially subject to recharacterization as adjusted net foreign base 
company income or adjusted net insurance income (or other categories of 
income included in the computation of subpart F income under section 952 
and the regulations thereunder) for the taxable year under the rules of 
section 952(c). Items of full inclusion foreign base company income that 
are included in adjusted gross foreign base company income because the 
full inclusion test of paragraph (b)(1)(iii) of this section is met, and 
are included in subpart F income under section 952 and the regulations 
thereunder, do not reduce amounts that, under section 952(c), are 
subject to recharacterization in later years on account of deficits in 
prior years.
    (4) Anti-abuse rule--(i) In general. For purposes of applying the de 
minimis and full inclusion tests of paragraph (b)(1) of this section, 
the income of two or more controlled foreign corporations shall be 
aggregated and treated as the income of a single corporation if one 
principal purpose for separately organizing, acquiring, or maintaining 
such multiple corporations is to avoid the application of the de minimis 
or full inclusion requirements of paragraph (b)(1) of this section. For 
purposes of this paragraph (b), a principal purpose need not be the 
purpose of first importance.
    (ii) Presumption. Two or more controlled foreign corporations are 
presumed to have been organized, acquired or maintained to avoid the 
effect of the de minimis and full inclusion requirements of paragraph 
(b)(1) of this section if the corporations are related persons as 
defined in subdivision (iii) of this paragraph (b)(4) and the 
corporations are described in subdivision (A), (B), or (C). This 
presumption may be rebutted by proof to the contrary.
    (A) The activities now carried on by the controlled foreign 
corporations, or the assets used in those activities, are substantially 
the same activities that were carried on, or assets that were previously 
held by a single controlled foreign corporation, and the United States 
shareholders of the controlled foreign corporations or related persons 
(as determined under subdivision (iii) of this paragraph (b)(4)) are 
substantially the same as the United States shareholders of the one 
controlled foreign corporation in that prior taxable year. A presumption 
made in connection with the requirements of this subdivision (A) of 
paragraph (b)(4)(ii) may be rebutted by proof that the activities 
carried on by each controlled foreign corporation would constitute a 
separate branch under the principles of Sec. 1.367(a)-6T(g) if carried 
on directly by a United States person.
    (B) The controlled foreign corporations carry on a business, 
financial operation, or venture as partners directly or indirectly in a 
partnership (as defined in section 7701(a)(2) and Sec. 301.7701-3) that 
is a related person (as defined in subdivision (iii) of this paragraph 
(b)(4)) with respect to each such controlled foreign corporation.
    (C) The activities carried on by the controlled foreign corporations 
would constitute a single branch operation under Sec. 1.367(a)-6T(g)(2) 
if carried on directly by the United States person.
    (iii) Related persons. For purposes of this paragraph (b), two or 
more persons are related persons if they are in a relationship described 
in section 267(b).

[[Page 48]]

In determining for purposes of this paragraph (b) whether two or more 
corporations are members of the same controlled group under section 
267(b)(3), a person is considered to own stock owned directly by such 
person, stock owned with the application of section 1563(e)(1), and 
stock owned with the application of section 267(c). In determining for 
purposes of this paragraph (b) whether a corporation is related to a 
partnership under section 267(b)(10), a person is considered to own the 
partnership interest owned directly by such person and the partnership 
interest owned with the application of section 267(e)(3).
    (iv) Illustration. The following example illustrates the application 
of this paragraph (b)(4).

    Example. USP is the sole United States shareholder of three 
controlled foreign corporations: CFC1, CFC2 and CFC3. The three 
controlled foreign corporations all have the same taxable year. The 
three controlled foreign corporations are partners in FP, a foreign 
entity classified as a partnership under section 7701(a)(2) and 
Sec. 301.7701-3 of the regulations. For their current taxable years, 
each of the controlled foreign corporations derives all of its income 
other than foreign base company income from activities conducted through 
FP, and its foreign base company income from activities conducted both 
jointly through FP and separately without FP. Based on the facts in the 
table below, for their current taxable years, the foreign base company 
income derived by each controlled foreign corporation, including income 
derived from FP, is less than five percent of the gross income of each 
controlled foreign corporation and is less than $1,000,000:

------------------------------------------------------------------------
                                        CFC1        CFC2         CFC3
------------------------------------------------------------------------
Gross income.......................  $4,000,000  $8,000,000  $12,000,000
Five percent of gross income.......     200,000     400,000      600,000
Foreign base company income........     199,000     398,000      597,000
------------------------------------------------------------------------

    Thus, without the application of the anti-abuse rule of this 
subparagraph (5), each controlled foreign corporation would be treated 
as having no foreign base company income after the application of the de 
minimis rule of section 954(b)(3)(A) and Sec. 1.954-1T(b)(1).
    However, under these facts the requirements of subdivision (i) of 
this paragraph (b)(4) are presumed to be met. The sum of the foreign 
base company income of the controlled foreign corporations is 
$1,194,000. Thus, the amount of adjusted gross foreign base company 
income will not be less than the amount of gross foreign base company 
income by reason of the de minimis rule of section 954(b)(3)(A) and this 
paragraph (b).

    (5) Illustration. The following example illustrates computations 
required by sections 952 and 954 and this Sec. 1.954-1T if the full 
inclusion test of paragraph (b)(1)(iii) is met (see paragraph (a)(8) for 
an example illustrating computations required if the de minimis test of 
paragraph (b)(1)(ii) is met):

    Example. (i) Gross Income. CFC, a controlled foreign corporation, 
has gross income of $1,000 for the current taxable year. Of that $1,000 
of income, $720 is interest income that is included in the definition of 
foreign personal holding company income under section 954(c)(1)(A) and 
Sec. 1.954-2T(b)(ii), is not income from trade or service receivables 
described in section 864(d) (1) or (6), and is not excluded from foreign 
personal holding company income under any provisions of section 954(c) 
and Sec. 1.954-2T. The remaining $280 is services income that is not 
included in the definition of foreign base company income or insurance 
income under sections 954(c), (d), (e), (f), (g) or 953 and the 
regulations thereunder, and is foreign source general limitation income 
for purposes of section 904(d)(1)(I).
    (ii) Expenses. CFC has expenses for the current taxable year of 
$650. Of that $650, $350 is from interest paid to related persons that 
is allocable to foreign personal holding company income along with $50 
of other expense. The remaining $250 of expense is allocable to services 
income other than foreign base company income or insurance income.
    (iii) Earnings and deficits. CFC has earnings and profits for the 
current taxable year of $350. In the prior taxable year, CFC had losses 
with respect to income other than foreign base company income or 
insurance income. By reason of the limitation provided under section 
952(c)(1)(A) and the regulations thereunder, those losses reduced the 
subpart F income of CFC (consisting entirely of foreign source general 
limitation income) by $600 for the prior taxable year.
    (iv) Taxes. A foreign tax of $120 is considered imposed on the $720 
of interest income under the rules of section 954(b)(4) and paragraph 
(d) of this section, and a foreign tax of $2 is considered imposed on 
the services income under the rules of section 954(b)(4) and paragraph 
(d) of this section. For the taxable year of the foreign corporation, 
the maximum U.S. rate of taxation under section 11 is 34 percent.
    (v) Conclusion. Based on these facts, if CFC elects to exclude all 
items of income subject to a high foreign tax under section 954(b)(4) 
and paragraph (d), it will have $350 of subpart F income as defined in 
section 952(a) determined as follows:

[[Page 49]]

                     Step 1--Determine gross income:

(1) Gross income...................................................$1000

 Step 2--Compute gross foreign base company income and gross insurance 
                                 income:

(2) Gross foreign base company income and insurance income as defined in 
sections 954(c), (d), (e), (f), (g) and 953 and the regulations 
thereunder (interest income).........................................720

       Step 3--Compute adjusted gross foreign base company income:

(3) Seventy percent of gross income (.70 x line (1)).................700
(4) Adjusted gross foreign base company income or insurance income after 
the application of the full inclusion rule of this paragraph (b)(1) 
(line (2), or line (1) if line (2) is greater than line (3))........1000
(5) Full inclusion foreign base company income under paragraph 
(a)(2)(vi) (line (4) minus line (2)).................................280

            Step 4--Compute net foreign base company income:

(6) Related person interest expense and other deductions allocable and 
apportionable to foreign personal holding company income under section 
954(b)(5) and paragraph (c)..........................................400
(7) Deductions allocable and apportionable to full inclusion foreign 
base company income under section 954(b)(5) and paragraph (c)........250
(8) Foreign personal holding company income after allocating deductions 
under section 954(b)(5) and paragraph (c) of this section (line (2) 
reduced (but not below zero) by line (6))............................320
(9) Full inclusion foreign base company income after allocating 
deductions under section 954(b)(5) paragraph (c) of this section (line 
(5) reduced (but not below zero) by line (7)).........................30
(10) Total gross foreign base company income after allocating deductions 
under section 954(b)(5) and paragraph (c) (line (8) plus line (9))...350

                  Step 5--Compute net insurance income:

(11) Net insurance income under section 953 and the regulations 
thereunder.............................................................0

        Step 6--Compute adjusted net foreign base company income:

(12) Foreign tax imposed on foreign personal holding company income 
(interest)...........................................................120
(13) Foreign tax imposed on full inclusion foreign base company income 
                                                                       2
(14) Ninety percent of the maximum U.S. corporate tax rate..........30.6
(15) Effective rate of foreign tax imposed on $320 of foreign personal 
holding company income under section 954(b)(4) and paragraph (d) (line 
(12) divided by line (8)).............................................38
(16) Effective rate of foreign tax imposed of $30 of full inclusion 
foreign base company income under section 954(b)(4) and paragraph (d) 
(line (13) divided by line (9))........................................7
(17) Foreign personal holding company income subject to a high foreign 
tax under section 954(b)(4) and paragraph (d) (zero, or line (8) if line 
(15) is greater than line (14))......................................320
(18) Full inclusion foreign base company income subject to a high 
foreign tax under section 954(b)(4) and paragraph (d) (zero, or line (9) 
if line (16) is greater than line (14))................................0
(19) Adjusted net foreign base company income after applying section 
954(b)(4) and paragraph (d) (line (10), reduced by the sum of line (17) 
and line (18))........................................................30

             Step 7--Compute adjusted net insurance income:

(20) Adjusted net insurance income.....................................0

 Step 8--Additions to or reduction of adjusted net foreign base company 
                   income by reason of section 952(c):

(21) Earnings and profits for the current year.......................350
(22) The excess in earnings and profits over subpart F income, which is 
subject to being recharacterized as adjusted net foreign base company 
income under section 952(c)(2) (excess of line (21) over the sum of line 
(19) and line (20)); if there is a deficit, then the limitation of 
952(c)(1) may apply for the current year.............................320
(23) Amount of reduction in subpart F income for prior taxable years by 
reason of the limitation of section 952(c)(1) and the regulations 
thereunder...........................................................600
(24) Subpart F income as defined in section 952(a), assuming section 
952(a) (3), (4), or (5) does not apply (the sum of line (19) and line 
(20) plus the lesser of line (22) or line (23))......................350
(25) Amount of prior years' deficit remaining to be recharacterized as 
subpart F income in later years

[[Page 50]]

under section 952(c) (excess of line (23) over line (22))............280
    (c) Computation of net foreign base company income. The net foreign 
base company income of a controlled foreign corporation is computed by 
reducing (but not below zero) the amount of gross income in each of the 
categories of adjusted gross foreign base company income described in 
paragraph (b)(2) of this section, so as to take into account deductions 
allocable and apportionable to such income. For purposes of section 954 
and this section, expenses must be allocated and apportioned consistent 
with the allocation and apportionment of expenses for purposes of 
section 904(d). For purposes of this Sec. 1.954-1T, an item of net 
foreign base company income must be categorized according to the 
category of adjusted gross foreign base company income from which it is 
derived. Thus, an item of net foreign base company income must be 
categorized as a net item of--
    (1) Foreign personal holding company income,
    (2) Foreign base company sales income,
    (3) Foreign base company services income,
    (4) Foreign base company shipping income,
    (5) Foreign base company oil related income, or
    (6) Full inclusion foreign base company income.
    (d) Computation of adjusted net foreign base company income or 
adjusted net insurance income--(1) Application of high tax exception. 
Adjusted net foreign base company income (or adjusted net insurance 
income) equals the net foreign base company income (or net insurance 
income) of a controlled foreign corporation, reduced by any item of such 
income (other than foreign base company oil related income as defined in 
section 954(g)) subject to the high tax exception provided by section 
954(b)(4) and this paragraph (d). An item of income is subject to the 
high tax exception only if--
    (i) It is established that the income was subject to creditable 
income taxes imposed by a foreign country or countries at an effective 
rate that is greater than 90 percent of the maximum rate of tax 
specified in section 11 or 15 for the taxable year of the controlled 
foreign corporation; and
    (ii) An election is made under section 954(b)(4) and paragraph 
(d)(5) of this section to exclude the income from the computation of 
subpart F income.

See paragraph (d)(4) of this section for the definition of the term 
``item of income.'' For rules concerning the treatment for foreign tax 
credit purposes of amounts excluded from subpart F under section 
954(b)(4), see Sec. 904-1.4(c)(1).
    (2) Effective rate at which taxes are imposed. For purposes of this 
paragraph (d), the effective rate at which taxes are imposed on an item 
of income is--
    (i) The amount of income taxes paid or accrued (or deemed paid or 
accrued) with respect to the item of income, determined under paragraph 
(d)(3) of this section, divided by
    (ii) The item of net foreign base company income or net insurance 
income, determined under paragraph (d)(4) of this section (including the 
appropriate amount of income taxes referred to in subdivision (i) of 
this paragraph (d)(2), immediately above).
    (3) Taxes paid or accrued with respect to an item of income--(i) 
Income other than passive foreign personal holding company income. The 
amount of income taxes paid or accrued with respect to an item of income 
(other than an item of foreign personal holding company income that is 
passive income) for purposes of section 954(b)(4) and this paragraph (d) 
is the amount of foreign income taxes that would be deemed paid under 
section 960 with respect to that item if that item were included in the 
gross income of a U.S. shareholder under section 951(a)(1)(A). For this 
purpose, the amounts that would be deemed paid under section 960 shall 
be determined separately with respect to each controlled foreign 
corporation and without regard to the limitation applicable under 
section 904(a).
    (ii) Passive foreign personal holding company income. The amount of 
income taxes paid or accrued with respect to an item of foreign personal 
holding company income that is passive income for purposes of section 
954(b)(4) and this paragraph (d) is the amount of foreign income taxes 
paid or accrued or deemed paid by the foreign corporation

[[Page 51]]

that would be taken into account for purposes of applying the provisions 
of Sec. 1.904-4(c) with respect to that item of income.
    (4) Item of income--(i) Income other than passive foreign personal 
holding company income. The high tax exception applies (when elected) to 
all income that constitutes a single item under this paragraph (d)(4). A 
single item of net foreign base company income or net insurance income 
is an amount of net foreign base company income (other than foreign 
personal holding company income that is passive income) or net insurance 
income that:
    (A) Falls within a single category of net foreign base company 
income, as defined in paragraph (c) of this section, or net insurance 
income, and
    (B) Also falls within a single separate limitation category for 
purposes of sections 904(d) and 960 and the regulations thereunder.
    (ii) Passive foreign personal holding company income--(A) In 
general. For purposes of this paragraph (d) a single item of net foreign 
personal holding company income that is passive income is an amount of 
such income that falls within a single group of passive income under the 
grouping rules of Sec. 1.904-4(c) (3), (4), and (5).
    (B) Consistency rule. An election to exclude income from subpart F 
must be consistently made with respect to all items of passive foreign 
personal holding company income eligible to be excluded. Thus, high-
taxed passive foreign personal holding company income of a controlled 
foreign corporation must be excluded in its entirety, or remain subject 
to subpart F.
    (5) Procedure. The election provided by this paragraph (d) must be 
made--
    (i) By controlling United States shareholders, as defined in 
Sec. 1.964-1(c)(5), by attaching a statement to such effect with their 
original or amended income tax returns, and including any additional 
information required by subsequent administrative pronouncements, or
    (ii) In such other manner as may be prescribed in subsequent 
administrative pronouncements.

An election made under the procedure provided by this paragraph (d)(5) 
is binding on all United States shareholders of the controlled foreign 
corporation.
    (6) Illustrations. The rules of this paragraph (d) are illustrated 
by the following examples.

    Example 1. (i) Items of income. During its 1987 taxable year, 
controlled foreign corporation CFC receives from outside its country of 
operation portfolio dividend income of $100 and interest income of $100 
(consisting of a gross payment of $150 reduced by a third-country 
withholding tax of $50). For purposes of illustration, assume that the 
CFC incurs no expenses. None of the income is taxed in CFC's country of 
operation. The dividend income was not subject to their-country 
withholding taxes. The interest income was subject to withholding taxes 
equal to $50, and is therefore high withholding tax interest for 
purposes of section 960 (pursuant to the operation of section 904). The 
dividend income is passive income for purposes of section 960. 
Accordingly, pursuant to paragraph (d)(4) of this section, CFC has two 
items of income: (1) $100 of FPHC/passive income (the dividends) and (2) 
$100 of FPHC/high withholding tax income (the interest). The election 
under paragraph (d)(5) of this section to exclude high-taxed income from 
the operation of subpart F is potentially applicable to each such item 
in its entirety.
    (ii) Effective rates of tax. No foreign tax would be deemed paid 
under section 960 with respect to item (1). Therefore, the effective 
rate of foreign tax is 0, and the item may not be excluded from subpart 
F under the rules of this paragraph (d). Foreign tax of $50 would be 
deemed paid under section 960 with respect to item (2). Therefore, the 
effective rate of foreign tax is 33 percent ($50 of creditable taxes 
paid, divided by $150, consisting of the item of net foreign base 
company income ($100) plus creditable taxes paid thereon ($50). The 
highest rate of tax specified in section 11 for the 1987 taxable year is 
34 percent. Accordingly, item (2) may be excluded from subpart F 
pursuant to an election under paragraph (d)(5) of this section, since it 
is subject to foreign tax at an effective rate that is greater than 30.6 
percent (90 percent of 34 percent). However, it remains high withholding 
tax interest when included.
    Example 2. The facts are the same as in Example 1, except that CFC's 
country of operation imposes a tax of $50 with respect to CFC's dividend 
income. The interest income is still high withholding tax interest. The 
dividend income is still passive income (without regard to the possible 
applicability of the high tax exception of section 904(d)(2)). 
Accordingly, CFC has two items of income for purposes of this paragraph 
(d): (1) $100 of FPHC/high withholding tax interest income, and (2) $50 
of FPHC/passive income (net of the $50 foreign tax). Both items are 
taxed at

[[Page 52]]

an effective rate greater than 31.6 percent. Item 1: Foreign tax ($50) 
divided by sum ($150) of income item ($100) plus creditable tax thereon 
($50) equals 33 percent. Item 2: Foreign tax ($50) divided by sum ($100) 
of income item ($50) plus creditable tax thereon ($50) equals 50 
percent. Accordingly, an election may be made under paragraph (d)(5) of 
this section to exclude either, both, or neither of items 1 and 2 from 
subpart F.
    Example 3. The facts are the same as in Example 1, except that the 
$100 of portfolio dividend income is subject to a third-country 
withholding tax of $50, and the $150 of interest income is from sources 
within CFC's country of operation, is subject to a $10 income tax 
therein, and is not subject to a withholding tax. Although the interest 
income and the dividend income are both passive income, under paragraph 
(d)(4)(ii)(A) of this section they constitute separate items of income 
pursuant to the application of the grouping rules of Sec. 1.904-4(c). 
Accordingly, CFC has two items of income for purposes of this paragraph 
(d): (1) $50 (net of tax) of FPHC/non-country of operation/greater than 
15 percent withholding tax income; and (2) $140 (net of $10 tax) of 
FPHC/country of operation income. Item 1 is taxed at an effective rate 
greater than 30.6 percent, but Item 2 is not. Item 1: Foreign tax ($50) 
divided by sum ($100) of income item ($50) plus creditable tax thereon 
($50) equals 50 percent. Item 2: Foreign tax ($10) divided by sum ($150) 
of income item ($140) plus creditable tax thereon ($10) equals 6.67 
percent. Therefore, an election may be made under paragraph (d)(5) of 
this section to exclude Item 1 but not Item 2 from subpart F.
    Example 4. The facts are the same as in Example 3, except that the 
$150 of interest income is subject to an income tax of $50 in CFC's 
country of operation. Accordingly, CFC has two items of income, as in 
Example 4, but both items are taxed at an effective rate greater than 
30.6 percent. Item 1: Foreign tax ($50) divided by sum ($100) of income 
item ($50) plus creditable tax thereon ($50) equals 50 percent. Item 2: 
Foreign tax ($50) divided by sum ($150) if income item ($100) plus 
creditable tax thereon ($50) equals 33 percent. Pursuant to the 
consistency rule of paragraph (d)(4)(ii)(B) of this section, CFC's 
shareholders must consistently elect or not elect to exclude from 
subpart F all items of FPHC income that are eligible to be excluded. 
Therefore, an election may be made to exclude both Item 1 and Item 2 
from subpart F, or neither may be excluded.

    (e) Character of an item of income--(1) Substance of the 
transaction. For purposes of section 954 and the regulations thereunder, 
items of income shall be characterized in accordance with the substance 
of the transaction, and not in accordance with the designation applied 
by the parties to the transaction. For example, an amount received as 
``rent'' which actually constitutes income from the sale of property, 
royalties, or income from services shall not be characterized as 
``rent'' but shall be characterized as income from the sale of property, 
royalties or income from services, respectively. Local law shall not be 
controlling in characterizing an item of income.
    (2) Separable character. To the extent one of the definitional 
provisions of section 953 or 954 describes a portion of the income or 
gain derived from a transaction, that portion of income or gain is so 
characterized. Thus, a single transaction may give rise to income in 
more than one category of foreign base company income described in 
paragraph (a)(2) of this section. For example, if a controlled foreign 
corporation, in its business of purchasing and selling personal 
property, receives interest (including imputed interest and market 
discount) on an account receivable arising from a sale, a portion of the 
income derived from the transaction by the controlled foreign 
corporation will be interest, and another portion will be gain (or loss) 
from the sale of personal property. If the sale is denominated in a 
currency other than a functional currency as defined in section 985 and 
the regulations thereunder, the controlled foreign corporation may have 
additional income in the form of foreign currency gain as defined in 
section 988.
    (3) Predominant character. The portion of income derived from a 
transaction that meets the definition of foreign personal holding 
company income is always separately determinable, and thus must always 
be segregated from other income and separately classified under 
paragraph (2) of this paragraph (e). However, the portion of income 
derived from a transaction that would meet a particular definitional 
provision under section 954 or 953 and the regulations thereunder (other 
than the definition of foreign personal holding company income) in 
unusual circumstances may be indeterminable. If such portion is 
indeterminable, it must be classified in accordance with the predominant 
character of the transaction. For example, if a controlled

[[Page 53]]

foreign corporation engineers, fabricates, and installs a fixed offshore 
drilling platform as part of an integrated transaction, and the portion 
of income that relates to services is not accounted for separately from 
the portion that relates to sales, and is otherwise indeterminable, then 
the classification of income from the transaction shall be made in 
accordance with the predominant character of the particular integrated 
arrangement.
    (4) Coordination of categories of gross foreign base company income 
or gross insurance income. The definitions of gross foreign base company 
income and gross insurance income are limited by the following rules (to 
be applied in numerical order):
    (i) If an item of income is included in subpart F income under 
section 952(a)(1) and the regulations thereunder as insurance income, it 
is by definition excluded from any other category of subpart F income.
    (ii) If an item of income is included in the foreign base company 
oil related income of a controlled foreign corporation, it is by 
definition excluded from any other category of foreign base company 
income, other than as provided in subdivision (i) of this paragraph 
(e)(4).
    (iii) If an item of income is included in the foreign base company 
shipping income of a controlled foreign corporation, it is by definition 
excluded from any other category of foreign base company income, other 
than as provided in subdivisions (i) and (ii) of this paragraph (e)(4).
    (iv) If an item of income is included in foreign personal holding 
company income of a controlled foreign corporation, it is by definition 
not included in any other category of foreign base company income, other 
than as provided in subdivisions (i), (ii), and (iii) of this paragraph 
(e)(4).

An item of income shall not be excluded from the definition of a 
category of gross foreign base company income or gross insurance income 
under this paragraph (e)(4) by reason of being included in the general 
definition of another category of gross foreign base company income or 
gross insurance income, if the item of income is excluded from that 
other category by a more specific provision of section 953 or 954 and 
the regulations thereunder. For example, income derived from a commodity 
transaction that is excluded from foreign personal holding company 
income under Sec. 1.954-2T(f) as income from qualified active sales may 
be included in gross foreign base company income if it also meets the 
definition of foreign base company sales income. See Sec. 1.954-2T(a)(2) 
for the coordination of overlapping categories within the definition of 
foreign personal holding company income.

[T.D. 8216, 53 FR 27492, July 21, 1988. Redesignated and amended by T.D. 
8618, 60 FR 46530, Sept. 7, 1995]



Sec. 4.954-2  Foreign personal holding company income; taxable years beginning after December 31, 1986.

    (a) Computation of foreign personal holding company income--(1) In 
general. Foreign personal holding company income consists of the 
following categories of income:
    (i) Dividends, interest, rents, royalties, and annuities as defined 
in paragraph (b) of this section;
    (ii) Gain from certain property transactions as defined in paragraph 
(e) of this section;
    (iii) Gain from commodities transactions as defined in paragraph (f) 
of this section;
    (iv) Foreign currency gain as defined in paragraph (g) of this 
section; and
    (v) Income equivalent to interest as defined in paragraph (h) of 
this section.

Paragraph (a)(3) of this section provides rules for determining the use 
or purpose for which property is held, if a change in use or purpose 
would affect the computation of foreign personal holding company income 
under paragraphs (e), (f), and (g) of this section. Paragraphs (c) and 
(d) of this section provide rules for determining certain rents and 
royalties that are excluded from foreign personal holding company income 
under paragraph (b) of this section.
    (2) Coordination of overlapping definitions. If a particular portion 
of income from a transaction in substance falls within more than one of 
the definitional rules of section 954(c) and this section, its character 
is determined under the rules of subdivision (i)

[[Page 54]]

through (iii) of this paragraph (a)(2). The character of loss from a 
transaction must be similarly determined under the rules of this 
paragraph (a)(2).
    (i) If a portion of the income from a transaction falls within the 
definition of income equivalent to interest under paragraph (h) of this 
section and the definition of gain from certain property transactions 
under paragraph (e) of this section, gain from a commodities transaction 
under paragraph (f) of this section (whether or not derived from a 
qualified hedging transaction or qualified active sales), or foreign 
currency gain under paragraph (g) of this section (whether or not 
derived from a qualified business transaction or a qualified hedging 
transaction), that portion of income is treated as income equivalent to 
interest for purposes of section 954(c) and this section.
    (ii) If a portion of the income from a transaction falls within the 
definition of foreign currency gain under paragraph (g) of this section 
(whether or not derived from a qualified business transaction or a 
qualified hedging transaction) and the definition of gain from certain 
property transactions under paragraph (e) of this section, or gain from 
a commodities transaction under paragraph (f) of this section (whether 
or not derived from a qualified hedging transaction or qualified active 
sales), that portion of income is treated as foreign currency gain for 
purposes of section 954(c) and this section.
    (iii) If a portion of the income from a transaction falls within the 
definition of gain from a commodities transaction under paragraph (f) of 
this section (whether or not derived from a qualified hedging 
transaction or qualified active sales) and the definition of gain from 
certain property transactions under paragraph (e) of this section, that 
portion of income is treated as gain from a commodities transaction for 
purposes of section 954(c) and this section.
    (3) Changes in the use or purpose with which property is held--(i) 
In general. Under paragraphs (e), (f), and (g) of this section, 
transactions in certain property give rise to gain or loss included in 
the computation of foreign personal holding company income if the 
controlled foreign corporation holds that property for a particular use 
or purpose. For purposes of this section, in determining the purpose or 
use for which property is held, the period shortly before disposition is 
the most significant period. However, if a controlled foreign 
corporation held property with a purpose that would have caused its 
disposition to give rise to gain or loss included in the computation of 
foreign personal holding company income under this section, and prior to 
disposition the controlled foreign corporation changed the purpose or 
use for which it held the property to one that would cause its 
disposition to give rise to gain or loss excluded from the computation 
of foreign personal holding company income, then the later purpose or 
use shall be ignored unless it was continuously present for a 
predominant portion of the period during which the controlled foreign 
corporation held the property. Under paragraph (g)(4)(iii) of this 
section, a currency hedging transaction may be treated as two or more 
separate hedging transactions, such that each portion is separately 
considered in applying this paragraph (a)(3).
    (ii) Illustrations. The following examples illustrate the 
application of this paragraph (a)(3).

    Example 1. At the beginning of taxable year 1, CFC, a controlled 
foreign corporation, purchases a building for investment. During taxable 
years 1 and 2, CFC derives rents from this building that are included in 
the computation of foreign personal holding company income under 
paragraph (b)(1)(iii) of this section. At the beginning of taxable year 
3, CFC changes the use of the building by terminating all leases, and 
using it in an active trade or business. At the beginning of taxable 
year 4, CFC sells the building at a gain. For purposes of paragraph (e) 
of this section (gains from the sale or exchange of certain property) 
the building is considered to be property that gives rise to rents, as 
described in paragraph (e)(2). Because there was a change of use at the 
beginning of year 3 that would cause the disposition of the building to 
give rise to gain or loss excluded from the computation of foreign 
personal holding company income, the characterization of the gain 
derived at the beginning of year 4 is determined according to the 
property's use during the predominant portion of the period from 
purchase to date of sale. Therefore, gain from the sale of that building 
is included in the computation of foreign

[[Page 55]]

personal holding company income under paragraph (e) of this section.
    Example 2. For taxable years 1, 2, and 3, CFC, a controlled foreign 
corporation, is engaged in the active conduct of a commodity business as 
a handler of gold, as defined in paragraph (f)(3)(iii), and 
substantially all of its business is as an active handler of gold, as 
defined in paragraph (f)(3)(iv). At the beginning of taxable year 1, CFC 
purchases 1000 ounces of gold for investment. At the beginning of 
taxable year 3, CFC begins holding that gold in physical form for sale 
to customers. During taxable year 3, CFC sells the entire 1000 ounces of 
gold in transactions described in paragraph (f)(3)(ii) at a gain. For 
purposes of paragraph (f), CFC is considered to hold the gold for 
investment, and not in its capacity as an active handler of gold. Thus, 
under paragraph (f)(3)(i), the gold is not considered to be sold in the 
active trade or business of the CFC as a handler of gold, and gain from 
the sale is included in the computation of foreign personal holding 
company income under paragraph (f) of this section.
    Example 3. CFC, a controlled foreign corporation, is a regular 
dealer in unimproved land. The functional currency (as defined in 
section 985 and the regulations thereunder) of CFC is country X 
currency. On day 1 of its current taxable year, CFC enters into an 
agreement with A to pay $100 for certain real property to be held by CFC 
for investment. On day 10, under its method of accounting, CFC accrues 
the value of $100 in country X currency, but payment will not be made 
until the first day of the next taxable year (day 366). On day 190, CFC 
determines to hold the property for sale to customers in a transaction 
that would be a qualified business transaction under paragraph (g)(3) of 
this section. For purposes of this section, the land is considered to be 
held for investment, and the foreign currency gain attributable to that 
transaction is included in the computation of foreign personal holding 
company income under paragraph (g) of this section.
    Example 4. CFC, a controlled foreign corporation, is a regular 
dealer in widgets. The functional currency (as defined in section 985 
and the regulations thereunder) of CFC is country X currency. On day 1 
of its current taxable year, CFC sells widgets held in inventory to A 
for delivery on day 60. The sales price is denominated in U.S. dollars, 
and payment is to be made by A on the same day the widgets are to be 
delivered to A. The remaining facts and circumstances are such that this 
sale would meet the definition of a qualified business transaction under 
paragraph (g)(4), the foreign currency gain from which would be excluded 
from the computation of foreign personal holding company income under 
paragraph (g). On day 1, CFC sells U.S. dollars forward for delivery in 
60 days in a transaction that would be a qualified hedging transaction 
under paragraph (g)(5). On day 25 the sale of widgets to A is cancelled 
in a transaction that does not result in CFC realizing any foreign 
currency gain or loss with respect to the sale of widgets. However, CFC 
holds the dollar forward contract to maturity. Because the forward 
contract does not hedge a qualified business transaction during the 
period shortly before its maturity, it is not to be considered a 
qualified hedging transaction under paragraph (g), and any foreign 
currency gain or loss recognized therefrom is included in the 
computation of foreign personal holding company income under paragraph 
(g). However, if CFC identifies the portion of the foreign currency gain 
or loss derived from the forward contract that is attributable to days 1 
through 25, and the portion that is attributable to days 25 through 60, 
the forward contract may be considered two separate transactions in 
accordance with the rules provided by paragraph (g)(4)(ii) of this 
section. Thus, the forward sale may be separately considered a qualified 
hedging transaction for day 1 through day 25, and the foreign currency 
gain or loss attributable to day 1 through day 25 may be excluded from 
the computation of foreign personal holding company income under 
paragraph (g) of this section.
    Example 5. CFC, a controlled foreign corporation, has country X 
currency as its functional currency under section 985 and the 
regulations thereunder. On day 1 of the current taxable year, CFC, 
speculating on exchange rates, sells dollars forward for delivery in 120 
days. On day 65, CFC sells widgets held in inventory at a price 
denominated in dollars to be paid on day 120 in a transaction that is a 
qualified business transaction. CFC had not made any other dollar sales 
between day 1 and day 65 and does not anticipate making any other dollar 
sales during the taxable year. On day 65, CFC accrues the value of $100 
in country X currency. On day 120, CFC receives $100 payment for the 
widgets and recognizes foreign currency loss pursuant to that 
transaction. On day 120 CFC also delivers dollars in connection with the 
forward sale, and recognizes foreign currency gain pursuant to the 
delivery. Under this paragraph (a)(3) the currency transaction is 
considered to have been entered into for speculation, and any currency 
gain recognized by CFC on the forward sale of dollars must be included 
in the computation of foreign personal holding company income under 
paragraph (g). However, if CFC identifies the portion of the forward 
sale, and the foreign currency gain or therefrom, that is attributable 
to day 1 through day 64, and the portion that is attributable to day 65 
through day 120, the forward sale may be considered two separate 
transactions in accordance with the rules provided by paragraph

[[Page 56]]

(g)(4)(ii) of this section. Thus, the transaction for day 65 through day 
120 may be considered a separate transaction that is a qualified hedging 
transaction, and the foreign currency gain attributable to day 65 
through day 120 may be excluded from the computation of foreign personal 
holding company income under this paragraph (g) if all the other 
requirements for treatment as a qualified hedging transaction under 
paragraph (g) are met.

    (4) Definitions. The following definitions apply for purposes of 
computing foreign personal holding company income under this section.
    (i) Interest. The term ``interest'' includes amounts that are 
treated as ordinary income, original issue discount or interest income 
(including original issue discount and interest on a tax-exempt 
obligation) by reason of sections 482, 483, 864(d), 1273, 1274, 1276, 
1281, 1286, 1288, 7872 and the regulations thereunder, or as interest or 
original issue discount income by reason of any other provision of law. 
For special rules concerning interest exempt from U.S. tax pursuant to 
section 103, see paragraph (b)(6) of this section.
    (ii) Inventory and similar property. The term ``inventory and 
similar property'' (or ``inventory or similar property'') means property 
that is stock in trade of the controlled foreign corporation or other 
property of a kind which would properly be included in the inventory of 
the controlled corporation if on hand at the close of the taxable year 
(were the controlled foreign corporation a domestic corporation), or 
property held by the controlled foreign corporation primarily for sale 
to customers in the ordinary course of its trade or business. Rights to 
property held in bona fide hedging transactions that reduce the risk of 
price changes in the cost of ``inventory and similar property'' are 
included in the definition of that term if they are an integral part of 
the system by which a controlled foreign corporation purchases such 
property, and they are so identified by the close of the fifth day after 
the day on which the hedging transaction is entered into.
    (iii) Regular dealer. The term ``regular dealer'' means a merchant 
with an established place of business that--
    (A) Regularly and actively engages as a merchant in purchasing 
property and selling it to customers in the ordinary course of business 
with a view to the gains and profits that may be derived therefrom, or
    (B) Makes a market in derivative financial products of property 
(such as forward contracts to buy or sell property, option contracts to 
buy or sell property, interest rate and currency swap contracts or other 
national principal contracts) by regularly and actively offering to 
enter into positions in such products to the public in the ordinary 
course of business.

Purchasing and selling property through a regulated exchange or 
established off-exchange market (for example, engaging in futures 
transactions) is not actively engaging as a merchant for purposes of 
this section.
    (iv) Dealer property. Property held by a controlled foreign 
corporation is ``dealer property'' if--
    (A) The controlled foreign corporation is a regular dealer in 
property of such kind, and
    (B) The property is held by the controlled foreign corporation in 
its capacity as a dealer.

Property which is held by the controlled foreign corporation for 
investment or speculation is not such property.
    (v) Debt instrument. The term ``debt instrument'' includes bonds, 
debentures, notes, certificates, accounts receivable, and other 
evidences of indebtedness.
    (b) Dividends, etc.--(1) In general. Foreign personal holding 
company includes:
    (i) Dividends, except certain dividends from related persons as 
described in paragraph (b)(3) of this section and distributions of 
previously taxed income under section 959(b) and the regulations 
thereunder;
    (ii) Interest, except export financing interest as defined in 
paragraph (b)(2) of this section and certain interest received from 
related persons as described in paragraph (b)(3) of this section;
    (iii) Rents and royalties, except certain rents and royalties 
received from related persons as described in (b)(4) of this section and 
rents and royalties derived in the active conduct of a trade or business 
as defined in paragraph (b)(5); and

[[Page 57]]

    (iv) Annuities.
    (2) Exclusion of certain export financing--(i) In general. Pursuant 
to section 954(c)(2)(B), foreign personal holding company income 
computed under section 954(c)(1)(A) and this paragraph (b) does not 
include interest that is export financing interest. For purposes of 
section 954(c)(2)(B) and this section, the term ``export financing 
interest'' means interest that is derived in the conduct of a banking 
business and is export financing interest as defined in section 
904(d)(2)(G) and the regulations thereunder. Pursuant to section 
864(d)(5)(A)(iii), it does not include income from related party 
factoring that is treated as interest under section 864(d)(1) or 
interest described in section 864(d)(6).
    (ii) Conduct of a banking business. For purposes of this section, 
export financing interest as defined in section 904(d)(2)(G) and the 
regulations thereunder is considered derived in the conduct of a banking 
business if, in connection with the financing from which the interest is 
derived, the corporation, through its own officers or staff of 
employees, engages in all the activities in which banks customarily 
engage in issuing and servicing a loan.
    (iii) Illustration. The following example illustrates the 
application of this provision:

    Example. DS, a domestic corporation, manufactures property in the 
United States. In addition to selling inventory (property described in 
section 1221(1)), DS occasionally sells depreciable equipment it 
manufactures for use in its trade or business, which is property 
described in section 1221(2). Less than 50 percent of the fair market 
value, determined in accordance with section 904(d)(2)(G) and the 
regulations thereunder, of each item of inventory or equipment sold by 
DS is attributable to products imported into the United States. CFC, a 
controlled foreign corporation related (as defined in section 954(d)) to 
DS, provides loans for the purchase of property from DS, if the property 
is purchased exclusively for use of consumption outside the United 
States.
    If, in issuing and servicing loans made with respect to purchases 
from DS of depreciable equipment used in its trade or business, which is 
property described in section 1221(2) in the hands of DS, CFC engages in 
all the activities in which banks customarily engage in issuing and 
servicing loans, the interest accrued from these loans would be export 
financing interest meeting the requirements of paragraph (b)(2) of this 
section, which would not be included in foreign personal holding company 
income under section 954(c) and paragraph (b)(1)(ii) of this section. 
However, interest from the loans made with respect to purchases from DS 
of property which is inventory in the hands of DS cannot be export 
financing interest because it is treated as income from a trade or 
service receivable under section 864(d)(6) and the regulations 
thereunder, and thus is included in foreign personal holding company 
income under paragraph (b)(1)(ii) of this section. See Sec. 1.864-8T(d) 
for rules concerning certain income from trade and service receivables 
qualifying under the same country exception of section 864(d)(7).

    (3) Exclusion of dividends and interest from related persons--(i) 
Excluded dividends and interest. Foreign personal holding company income 
does not include dividends and interest if--
    (A) The payor is a corporation that is a related person as defined 
in section 954(a)(3),
    (B) The payor is created or organized (``incorporated'') under the 
laws of the same foreign country as the controlled foreign corporation, 
and
    (C) A substantial part of the payor's assets are used in a trade or 
business in the payor's country of incorporation as determined under 
subdivision (iv) of this paragraph (b)(3).

Except as otherwise provided under this paragraph (b)(3), the principles 
of section 367(a) and regulations thereunder shall apply in determining 
whether the payor has a trade or business in its country of 
incorporation, and whether its assets are used in that trade or 
business.
    (ii) Interest paid out of adjusted foreign base company income or 
insurance income. Interest may not be excluded from the foreign personal 
holding company income of the recipient under this paragraph (b)(3) to 
the extent that the deduction for the interest is allocated under 
Sec. 1.954-1T(c) to the payor's adjusted gross foreign base company 
income (as defined in Sec. 1.954-1T(a)(3)), adjusted gross insurance 
income (as defined in Sec. 1.954-1T(a)(6)), or other categories of 
income included in the computation of subpart F income under section 
952(a), for purposes of computing the payor's net foreign base company 
income (as defined in Sec. 1.954-

[[Page 58]]

1T(a)(4), net insurance income (as defined in Sec. 1.954-1T(a)(6)), or 
income described in sections 952(a) (3), (4), and (5).
    (iii) Dividends paid out of prior years' earnings. Dividends are 
excluded from foreign personal holding company income under this 
paragraph (b)(3) only to the extent they are paid out of earnings and 
profits which were earned or accumulated during a period in which the 
requirements of subdivision (i) of this paragraph (b)(3) were satisfied 
or, to the extent earned or accumulated during a taxable year of the 
related foreign corporation ending on or before December 31, 1962, 
during a period in which the payor was a related corporation as to be 
controlled foreign corporation and the other requirements of subdivision 
(i) of this paragraph (b)(3) are substantially satisfied.
    (iv) Fifty percent substantial assets test. A substantial part of 
the assets of the payor will be considered used in a trade or business 
located in its country of incorporation only if, for each quarter during 
such taxable year, the average value (as of the beginning and end of the 
quarter) of its assets which are used in the trade or business and are 
located in such country constitutes over 50 percent of the average value 
(as of the beginning and end of the quarter) of all the assets of the 
payor (including assets not used in a trade or business). For such 
purposes the value of assets shall be determined under subdivision (v) 
of this paragraph (b)(3), and the location of assets used in a trade or 
business of the payor shall be determined under subdivisions (vi) 
through (xi) of this paragraph (b)(3).
    (v) Value of assets. For purposes of determining whether a 
substantial part of the assets of the payor are used in a trade or 
business in its country of incorporation, the value of assets shall be 
their actual value (not reduced by liabilities), which, in the absence 
of affirmative evidence to the contrary, shall be deemed to be their 
adjusted basis.
    (vi) Location of tangible property used in a trade or business--(A) 
In general. Tangible property (other than inventory and similar 
property) used in a trade or business is considered located in the 
country in which it is physically located.
    (B) Exception. If tangible personal property used in a trade or 
business is intended for use in the payor's country of incorporation, 
but is temporarily located elsewhere, it will be considered located 
within payor's country of incorporation if the reason for its location 
elsewhere is for inspection or repair, and it is not currently in 
service in a country other than the payor's country of incorporation and 
is not to be placed in service in a country other than the payor's 
country of incorporation following the inspection or repair.
    (vii) Location of intangible property used in a trade or business--
(A) In general. The location of intangible property (other than 
inventory or similar property and debt instruments) used in a trade or 
business is determined based on the site of the activities conducted by 
the payor during the current year in connection with using or exploiting 
that property. An item of intangible property is located in the payor's 
country of incorporation during each quarter of the current taxable year 
if the activities connected with its use or exploitation are conducted 
during the entire current taxable year by the payor in its country of 
incorporation. For this purpose, the determination of the country in 
which services are performed shall be made under the principles of 
section 954(e) and Sec. 1.954-4(c).
    (B) Property located in part in the payor's country of incorporation 
and in part in other countries. If the activities connected with the use 
or exploitation of an item of intangible property are conducted during 
the current taxable year by the payor in the payor's country of 
incorporation and in other countries, then a percentage of the 
intangible (measured by the average value of the item as of the 
beginning and end of the quarter) is considered located in the payor's 
country of incorporation during each quarter. That percentage equals the 
ratio that the expenses of the payor incurred during the entire taxable 
year by reason of such activities that are conducted in the payor's 
country of incorporation bear to the expenses of the payor incurred 
during the entire taxable year by reason of all

[[Page 59]]

such activities worldwide. Expenses incurred in connection with the use 
or exploitation of an item of intangible property are included in the 
computation provided by this paragraph (b)(3) if they are deductible 
under section 162 or includible in inventory costs or the costs of goods 
sold (were the payor a domestic corporation).
    (viii) Location of property held for sale to customers--(A) In 
general. Inventory or similar property is considered located in the 
payor's country of incorporation during each quarter of the taxable year 
if the activities of the payor in connection with the production and 
sale, or purchase and release, of such property and conducted in the 
payor's country of incorporation during the entire taxable year. If the 
payor conducts such activities through an independent contractor, then 
the location of such activities shall be the place in which they are 
conducted by the independent contractor.
    (B) Inventory located in part in the payor's country of 
incorporation and in part in other countries. If the activities 
connected with the production and sales, or purchase and resale, of 
inventory or similar property are conducted by the payor in the payor's 
country of incorporation and other countries, then a percentage of the 
inventory or similar property (measured by the average value of the item 
as of the beginning and end of the quarter) is considered located in the 
payor's country of incorporation each quarter. That percentage equals 
the ratio that the costs of the payor incurred during the entire taxable 
year by reason of such activities that are conducted in the payor's 
country of incorporation bear to all such costs incurred by reason of 
such activities worldwide. A cost incurred in connection with the 
production and sale or purchase and resale of inventory or similar 
property is included in this computation if it--
    (1) Must be included in inventory costs or otherwise capitalized 
with respect to inventory or similar property under section 61, 263A, 
471, or 472 and the regulations thereunder (whichever would be 
applicable were the payor a domestic corporation), or
    (2) Would be deductible under section 162 (were the payor a domestic 
corporation) and is definitely related to gross income derived from such 
property (but not to all classes of gross income derived by the payor) 
under the principles of Sec. 1.861-8.
    (ix) Location of debt instruments. For purposes of this paragraph 
(b)(3), debt instruments are considered to be used in a trade or 
business only if they arise from the sale of inventory or similar 
property by the payor or from the rendition of services by the payor in 
the ordinary course of a trade or business of the payor, but only until 
such time as interest is required to be charged under section 482 and 
the regulations thereunder. Debt instruments that arise from the sale of 
inventory or similar property are treated as having the same location, 
proportionately, as inventory or similar property that is held during 
the same calendar quarter. Debt instruments arising from the rendition 
of services in the ordinary course of a trade or business are considered 
located on a proportionate basis in the countries in which the services 
to which they relate are performed.
    (x) Treatment of certain stock interests. For the purpose of 
determining the value of assets used in a trade or business in the 
country of incorporation, stock directly or indirectly owned by the 
payor within the meaning of section 958(a) in a controlled foreign 
corporation (``lower-tier corporation''), which is incorporated in the 
same country as the payor, shall be considered located in the country of 
incorporation and used in a trade or business of the payor in proportion 
to the value of the assets of the lower-tier corporation that are used 
in a trade or business in the country of incorporation. The location of 
assets used in a trade or business of the lower-tier corporation shall 
be determined under the rules of this paragraph (b)(3).
    (xi) Determination of period during which property is used in a 
trade or business. Property purchased or produced for use in a trade or 
business shall not be considered used in a trade or business until it is 
placed in service, and shall cease to be considered used in a trade or 
business when it is retired from service. The dates during which 
depreciable property is determined to

[[Page 60]]

be in use must be consistent with the determination of depreciation 
under sections 167 and 168 and the regulations thereunder.
    (xii) Treatment of banks and insurance companies. [Reserved.]
    (4) Exclusion of rents and royalties derived from related persons--
(i) In general. Foreign personal holding company income does not include 
rents or royalties if--
    (A) The payor is a corporation that is a related person as defined 
in section 954(d)(3), and
    (B) The rents or royalties are for the use of, or the privilege of 
using, property within the country under the laws of which the recipient 
of the payments is created or organized.

If the property is used both within and without the country under the 
laws of which the controlled foreign corporation is created or 
organized, the part of the rent or royalty attributable to the use of, 
or the privilege of using, the property outside such country of 
incorporation is, unless otherwise provided, foreign personal holding 
company income under this paragraph (b).
    (ii) Rents or royalties paid out of adjusted foreign base company 
income or insurance income. Rents or royalties may not be excluded from 
the foreign personal holding company income of the recipient under this 
paragraph (b)(4) to the extent that deductions for the payments are 
allocated under section 954(b)(5) and Sec. 1.954-1T(a)(4) to the payor's 
adjusted gross foreign base company income (as defined in Sec. 1.954-
1T(a)(3)), adjusted gross insurance income (as defined in Sec. 1.954-
1T(a)(6), or other categories of income included in the computation of 
subpart F income under section 952(a), for purposes of computing the 
payor's net foreign base company income (as defined in Sec. 1.954-
1T(a)(4)), net insurance income (as defined in Sec. 1.954-1T(a)(6)), or 
income described in section 952(a) (3), (4), or (5).
    (5) Exclusion of rents and royalties derived in the active conduct 
of a trade or business. Foreign personal holding company income shall 
not include rents or royalties which are derived in the active conduct 
of a trade or business and which are received from a person other than a 
related person within the meaning of section 954(d)(3). Whether or not 
rents or royalties are derived in the active conduct of a trade or 
business is to be determined from the facts and circumstances of each 
case; but see paragraph (c) or (d) of this section for specific cases in 
which rents or royalties will be considered for purposes of this 
paragraph to be derived in the active conduct of a trade or business. 
The frequency with which a foreign corporation enters into transactions 
from which rents or royalties are derived will not of itself establish 
the fact that such rents or royalties are derived in the active conduct 
of a trade or business.
    (6) Treatment of tax exempt interest. Foreign personal holding 
company income includes all interest income, including interest that is 
exempt from U.S. tax pursuant to section 103 (``tax-exempt interest''). 
However, that net foreign base company income of a controlled foreign 
corporation that is attributable to such tax-exempt interest shall be 
treated as tax-exempt interest in the hands of the U.S. shareholders of 
the foreign corporation. Accordingly, any net foreign base company 
income that is included in the subpart F income of a U.S. shareholder 
and that is attributable to such tax-exempt interest shall remain exempt 
from the regular income tax, but potentially subject to the alternative 
minimum tax, in the hands of the U.S. shareholder.
    (c) Excluded rents--(1) Trade or business cases. Rents will be 
considered for purposes of paragraph (b)(5) of this section to be 
derived in the active conduct of a trade or business if such rents are 
derived by the controlled foreign corporation (``lessor'') from leasing-
-
    (i) Property which the lessor has manufactured or produced, or has 
acquired and added substantial value to, but only if the lessor is 
regularly engaged in the manufacture or production of, or in the 
acquisition and addition of substantial value to, property of such kind,
    (ii) Real property with respect to which the lessor, through its own 
officers or staff of employees, regularly performs active and 
substantial management and operational functions while the property is 
leased,
    (iii) Personal property ordinarily used by the lessor in the active 
conduct

[[Page 61]]

of a trade or business, leased during a temporary period when the 
property would, but for such leasing, be idle, or
    (iv) Property which is leased as a result of the performance of 
marketing functions by such lessor if the lessor, through its own 
officers or staff of employees located in a foreign country, maintains 
and operates an organization in such country which is regularly engaged 
in the business of marketing, or of marketing and servicing, the leased 
property and which is substantial in relation to the amount of rents 
derived from the leasing of such property.
    (2) Special rules--(i) Adding substantial value. For purposes of 
paragraph (c)(1)(i) of this section, the performance of marketing 
functions will not be considered to add substantial value to property.
    (ii) Substantiality of foreign organization. An organization in a 
foreign country will be considered substantial in relation to the amount 
of rents, for purposes of paragraph (c)(1)(iv) of this section, if 
active leasing expenses, as defined in paragraph (c)(2)(iii), equal or 
exceed 25 percent of the adjusted leasing profit, as defined in 
paragraph (c)(2)(iv) of this section.
    (iii) Active leasing expenses The term ``active leasing expenses'' 
means the deductions incurred by an organization of the lessor in a 
foreign country which are properly allocable to rental income and which 
would be allowable under section 162 to the lessor (were the lessor a 
domestic corporation) other than--
    (A) Deductions for compensation for personal services rendered by 
shareholders of, or related persons with respect to, the lessor,
    (B) Deductions for rents paid or accrued,
    (C) Deductions which, although generally allowable under section 
162, would be specifically allowable to the lessor (were the lessor a 
domestic corporation) under sections other than section 162 (such as 
sections 167 and 168), and
    (D) Deductions for payments made to independent contractors with 
respect to the leased property.
    (iv) Adjusted leasing profit. The term ``adjusted leasing profit'' 
means the gross income of the lessor from rents, reduced by the sum of--
    (A) The rents paid or incurred by the controlled foreign corporation 
with respect to such gross rental income,
    (B) The amounts which would be allowable to such lessor (were the 
lessor a domestic corporation) as deductions under section 167 or 168 
with respect to such rental income, and
    (C) The amounts paid to independent contractors with respect to such 
rental income.
    (3) Illustrations. The application of this paragraph (c) is 
illustrated by the following examples.

    Example 1. Controlled foreign corporation A is regularly engaged in 
the production of office machines which it sells or leases to others and 
services. Under paragraph (c)(1)(i) of this section, the rental income 
of A Corporation from the leases is derived in the active conduct of a 
trade or business for purposes of section 954(c)(2)(A).
    Example 2. Controlled foreign corporation D purchases motor vehicles 
which it leases to others. In the conduct of its short-term leasing of 
such vehicles in foreign country X, Corporation D owns a large number of 
motor vehicles in country X which it services and repairs, leases motor 
vehicles to customers on an hourly, daily, or weekly basis, maintains 
offices and service facilities in country X from which to lease and 
service such vehicles, and maintains therein a sizable staff of its own 
administrative, sales, and service personnel. Corporation D also leases 
in country X on a long-term basis, generally for a term of one year, 
motor vehicles which it owns. Under the terms of the long-term leases, 
Corporation D is required to repair and service, during the term of the 
lease, the leased motor vehicles without cost to the lessee. By the 
maintenance in country X of office, sales, and service facilities and 
its complete staff of administrative, sales, and service personnel, 
Corporation D maintains and operates an organization therein which is 
regularly engaged in the business of marketing and servicing the motor 
vehicles which are leased. The deductions incurred by such organization 
satisfy the 25-percent test of paragraph (c)(2)(ii) of this section; 
thus, such organization is substantial in relation to the rents 
Corporation D receives from leasing the motor vehicles. Therefore, under 
paragraph (c)(1)(iv) of this section, such rents are derived in the 
active conduct of a trade or business for purposes of section 
954(c)(2)(A).
    Example 3. [Reserved]
    Example 4. Controlled foreign corporation E owns a complex of 
apartment buildings

[[Page 62]]

which it has acquired by purchase. Corporation E engages a real estate 
management firm to lease the apartments, manage the buildings and pay 
over the net rents to the owner. The rental income of E Corporation from 
such leases is not derived in the active conduct of a trade or business 
for purposes of section 954(c)(2)(A).
    Example 5. Controlled foreign corporation F acquired by purchase a 
twenty-story office building in a foreign country, three floors of which 
it occupies and the rest of which it leases. Corporation F acts as 
rental agent for the leasing of offices in the building and employs a 
substantial staff to perform other management and maintenance functions. 
Under paragraph (c)(1)(ii) of this section, the rents received by 
Corporation F from such leasing operations are derived in the active 
conduct of a trade or business for purposes of section 954(c)(2)(A).
    Example 6. Controlled foreign corporation G owns equipment which it 
ordinarily uses to perform contracts in foreign countries to drill oil 
wells. For occasional brief and irregular periods it is unable to obtain 
contracts requiring immediate performance sufficient to employ all such 
equipment. During such a period it sometimes leases such idle equipment 
temporarily. After the expiration of such temporary leasing of the 
property, Corporation G continues the use of such equipment in the 
performance of its own drilling contracts. Under paragraph (c)(1)(iii) 
of this section, rents G receives from such leasing of idle equipment 
are derived in the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).

    (d) Excluded royalties--(1) Trade or business cases. Royalties will 
be considered for purposes of paragarph (b)(5) of this section to be 
derived in the active conduct of a trade or business if such royalties 
are derived by the controlled foreign corporation (``licensor'') from 
licensing--
    (i) Property which the licensor has developed, created, or produced, 
or has acquired and added substantial value to, but only so long as the 
licensor is regularly engaged in the development, creation, or 
production of, or in the acquisition of and addition of substantial 
value to, property of such kind, or
    (ii) Property which is licensed as a result of the performance of 
marketing functions by such licensor and the licensor, through its own 
staff of employees located in a foreign country, maintains and operates 
an organization in such country which is regularly engaged in the 
business of marketing, or of marketing and servicing, the licensed 
property and which is substantial in relation to the amount of royalties 
derived from the licensing of such property.
    (2) Special rules--(i) Adding substantial value. For purposes of 
paragraph (d)(1)(i), the performance of marketing functions will not be 
considered to add substantial value to property.
    (ii) Substantiality of foreign organization. An organization in a 
foreign country will be considered substantial in relation to the amount 
of royalties, for purposes of paragraph (d)(1)(ii) of this section, if 
the active licensing expenses, as defined in paragraph (d)(2)(iii) of 
this section, equal or exceed 25 percent of the adjusted licensing 
profit, as defined in paragraph (d)(2)(iv) of this section.
    (iii) Active licensing expenses. The term ``active licensing 
expenses'' means the deductions incurred by an organization of the 
licensor which are properly allocable to royalty income and which would 
be allowable under section 162 to the licensor (were the licensor a 
domestic corporation) other than--
    (A) Deductions for compensation for personal services rendered by 
shareholders of, or related persons with respect to, the licensor,
    (B) Deductions for royalties paid or incurred,
    (C) Deductions which, although generally allowable under section 
162, would be specifically allowable to the licensor (were the 
controlled foreign corporation a domestic corporation) under sections 
other than section 162 (such as section 167), and
    (D) Deductions for payments made to independent contractors with 
respect to the licensed property.
    (iv) Adjusted licensing profit. The term ``adjusted licensing 
profit'' means the gross income of the licensor from royalties, reduced 
by the sum of--
    (A) The royalties paid or incurred by the controlled foreign 
corporation with respect to such gross royalty income,
    (B) The amounts which would be allowable to such licensor as 
deductions under section 167 (were the licensor a domestic corporation) 
with respect to such royalty income, and

[[Page 63]]

    (C) The amounts paid to independent contractors with respect to such 
royalty income.
    (3) Illustrations. The application of this paragraph (d) is 
illustrated by the following examples.

    Example 1. Controlled foreign corporation A, through its own staff 
of employees, owns and operates a research facility in foreign country 
X. At the research facility employees of Corporation A who are full time 
scientists, engineers, and technicians regularly perform experiments, 
tests, and other technical activities, which ultimately result in the 
issuance of patents that it sells or licenses. Under paragraph (d)(1)(i) 
of this section, royalties received by Corporation A for the privilege 
of using patented rights which it develops as a result of such research 
activity are derived in the active conduct of a trade or business for 
purposes of section 954(c)(2)(A).
    Example 2. Assume that Corporation A in example 1, in addition to 
receiving royalties for the use of patents which it develops, receives 
royalties for the use of patents which it acquires by purchase and 
licenses to others without adding any value thereto. Corporation A 
generally consummates royalty agreements on such purchased patents as 
the result of inquiries received by it from prospective licensees when 
the fact becomes known in the business community, as a result of the 
filing of a patent, advertisements in trade journals, announcements, and 
contacts by employees of Corporation A, that Corporation A has acquired 
rights under a patent and is interested in licensing its rights. 
Corporation A does not, however, maintain and operate an organization in 
a foreign country which is regularly engaged in the business of 
marketing the purchased patents. The royalties received by Corporation A 
for the use of the purchased patents are not derived in the active 
conduct of a trade or business for purposes of section 954(c)(2)(A).
    Example 3. Controlled foreign corporation B receives royalties for 
the use of patents which it acquires by purchase. The primary business 
of Corporation B, operated on a regular basis, consists of licensing 
patents which it has purchased ``raw'' from inventors and, through the 
efforts of a substantial staff of employees consisting of scientists, 
engineers, and technicians, made susceptible to commercial application. 
For example, Corporation B, after purchasing patent rights covering a 
chemical process, designs specialized production equipment required for 
the commercial adaptation of the process and, by so doing, substantially 
increases the value of the patent. Under paragraph (d)(1)(i) of this 
section, royalties received by Corporation B from the use of such patent 
are derived in the active conduct of a trade or business for purposes of 
section 954(c)(2)(A).
    Example 4. Controlled foreign corporation D finances independent 
persons in the development of patented items in return for an ownership 
interest in such items from which it derives a percentage of royalty 
income, if any, subsequently derived from the use by others of the 
protected right. Corporation D also attempts to increase its royalty 
income from such patents by contacting prospective licensees and 
rendering to licensees advice which is intended to promote the use of 
the patented property. Corporation D does not, however, maintain and 
operate an organization in a foreign country which is regularly engaged 
in the business of marketing the patents. Royalties received by 
Corporation D for the use of such patents are not derived in the active 
conduct of a trade or business for purposes of section 954(c)(2)(A).

    (e) Certain property transactions--(1) In general--(i) Inclusion in 
FPHC income. Foreign personal holding company income includes the excess 
of gains over losses from the sale or exchange of--
    (A) Property which gives rise to dividends, interest, rents, 
royalties or annuities as described in paragraph (e)(2) of this section, 
and
    (B) Property which does not give rise to income, as described in 
paragraph (e)(3) of this section.

If losses from the sale or exchange of such property exceed gains, the 
net loss is not within the definition of foreign personal holding 
company income under this paragraph (e), and may not be allocated to, or 
otherwise reduce, other foreign personal holding company income under 
section 954(b)(5) and Sec. 1.954-1T(c). Gain or loss from a transaction 
that is treated as capital gain or loss under section 988(a)(1)(B) is 
not foreign currency gain or loss as defined in paragraph (g), but is 
gain or loss from the sale or exchange of property which is included in 
the computation of foreign personal holding company income under this 
paragraph (e)(1). Paragraphs (e) (4) and (5) of this section provide 
specific rules for determining whether gain or loss from dispositions of 
debt instruments and dispositions of options or similar property must be 
included in the computation of foreign personal holding company income 
under this paragraph (e)(1). A loss that is deferred or that otherwise 
may not be taken into account under any provision of the Code may not be 
taken

[[Page 64]]

into account for purposes of determining foreign personal holding 
company income under any provision of this paragraph (e).
    (ii) Dual character property. Property may only in part constitute 
property that gives rise to certain income as described in paragraph 
(e)(2) of this section or property that does not give rise to any income 
as described in paragraph (e)(3) of this section. In such cases, the 
property must be treated as two separate properties for purposes of this 
paragraph (e). Accordingly, the sale or exchange of such dual character 
property will give rise to gain or loss that in part must be included in 
the computation of foreign personal holding company income under this 
paragraph (e), and in part is excluded from such computation. Gain or 
loss from the disposition of dual character property must be bifurcated 
for purposes of this paragraph (e)(1)(i) pursuant to the method that 
most reasonably reflects the relative uses of the property. Reasonable 
methods may include comparisons in terms of gross income generated or 
the physical division of the property. In the case of real property, the 
physical division of the property will in most cases be the most 
reasonable method available. For example, if a controlled foreign 
corporation owns an office building, uses 60 percent of the building in 
its business, and rents out the other 40 percent, then 40 percent of the 
gain recognized on the disposition of the property would reasonably be 
treated as gain which is included in the computation of foreign personal 
holding company income under this paragraph (e)(1). This paragraph 
(e)(1)(ii) addresses the contemporaneous use of property for dual 
purposes; for rules concerning changes in the use of property affecting 
its classification for purposes of this paragraph (e), see paragraph 
(a)(3) of this section.
    (2) Property that gives rise to certain income--(i) In general. 
Property the sale or exchange of which gives rise to foreign personal 
holding company income under this paragraph (e)(2) includes property 
that gives rise to dividends, interest, rents, royalties and annuities 
described in paragraph (b) of this section, except for rents and 
royalties derived from unrelated persons in the active conduct of a 
trade or business under paragraph (b)(5) of this section. The property 
described by this paragraph (e)(2) includes property which gives rise to 
export financing interest described in paragraph (b)(2) of this section 
and property which gives rise to income from related persons described 
in paragraphs (b)(3) and (b)(4) of this section.
    (ii) Exception. Property described in this paragraph (e)(2) does not 
include--
    (A) Dealer property (as defined in paragraph (a)(4)(iv) of this 
section), and
    (B) Inventory and similar property (as defined in paragraph 
(a)(4)(ii) of this section) other than securities.
    (3) Property that does not give rise to income. The term ``property 
that does not give rise to income'' for purposes of this section 
includes all rights and interests in property (whether or not a capital 
asset) except--
    (i) Property that gives rise to dividends, interest, rents, 
royalties and annuities described in paragraph (e)(2) of this section 
and property that gives rise to rents and royalties derived in the 
active conduct of a trade or business under paragraph (b)(5) of this 
section;
    (ii) Dealer property (as defined in paragraph (a)(4)(iv) of this 
section);
    (iii) Inventory and similar property (as defined in paragraph 
(a)(4)(ii)) other than securities;
    (iv) Property (other than real property) used in the controlled 
foreign corporation's trade or business that is of a character which 
would be subject to the allowance for depreciation under section 167 or 
168 and the regulations thereunder (including tangible property 
described in Sec. 1.167(a)-2 and intangibles described in Sec. 1.167(a)-
3);
    (v) Real property that does not give rise to rental or similar 
income, to the extent used in the controlled foreign corporation's trade 
or business; and
    (vi) Intangible property as defined in section 936(h)(3)(B) and 
goodwill that is not subject to the allowance for depreciation under 
section 167 and the regulations thereunder to the extent used in the 
controlled foreign corporation's trade or business and disposed of in 
connection with the sale of a trade or

[[Page 65]]

business of the controlled foreign corporation.
    (4) Classification of gain or loss from the disposition of a debt 
instrument or on a deferred payment sale--(i) Gain. Gain from the sale, 
exchange, or retirement of a debt instrument is included in the 
computation of foreign personal holding company income under this 
paragraph (e) unless--
    (A) It is treated as interest income (as defined in paragraph 
(a)(4)(i) of this section); or
    (B) It is treated as income equivalent to interest under paragraph 
(h) of this section.
    (ii) Loss. Loss from the sale, exchange, or retirement of a debt 
instrument is included in the computation of foreign personal holding 
company income under this paragraph (e) unless--
    (A) It is directly allocated to interest income (as defined in 
paragraph (a)(4)(i) of this section) or income equivalent to interest 
(as defined in paragraph (h) of this section) under any provision of the 
Code or regulations thereunder;
    (B) It is required to be apportioned in the same manner as interest 
expense under section 864(e) or any other provision of the Code or 
regulations thereunder; or
    (C) The debt instrument was taken in consideration for the sale or 
exchange of property (or the provision of services) by the controlled 
foreign corporation and gain or loss from that sale or exchange (or 
income from the provision of services) is not includible in foreign base 
company income under this section.
    (5) Classification of options and other rights to acquire or 
transfer property. Subject to the exceptions provided in paragraphs 
(e)(3) (ii) and (iii) of this section (relating to certain dealer 
property and inventory property), rights to acquire or transfer 
property, including property that gives rise to income, are classified 
as property that does not give rise to income under paragraph (e)(3) of 
this section. These rights include options, warrants, futures contracts, 
options on a futures contract, forward contracts, and options on an 
index relating to stocks, securities or interest rates.
    (6) Classification of certain interests in pass through entities. 
[Reserved]
    (f) Commodities transactions--(1) In general. Except as otherwise 
provided in this paragraph (f), foreign personal holding company income 
includes the excess of gains over losses from commodities transactions. 
If losses from commodities transactions exceed gains, the net loss is 
not within the definition of foreign personal holding company income 
under this paragraph (f), and may not be allocated to, or otherwise 
reduce, foreign personal holding company income under section 954(b)(5) 
and Sec. 1.954-1T(a)(4). The terms ``commodity'' and ``commodities 
transactions'' are defined in paragraph (f)(2) of this section. Gains 
and losses from qualified active sales and qualified hedging 
transactions are excluded from the computation of foreign personal 
holding company income under this paragraph (f). The term ``qualified 
active sales'' is defined in paragraph (f)(3). The term ``qualified 
hedging transaction'' is defined in paragraph (f)(4) of this section. An 
election is provided under paragraph (g)(5) of this section to include 
all gains and losses from section 1256 foreign currency transactions, 
which would otherwise be commodities transactions, in the computation of 
foreign personal holding company income under paragraph (g) instead of 
this paragraph (f). A loss that is deferred or that otherwise may not be 
taken into account under any provision of the Code may not be taken into 
account for purposes of determining foreign personal holding company 
income under any provision of this paragraph (f).
    (2) Definitions--(i) Commodity. For purposes of this section, the 
term ``commodity'' means:
    (A) Tangible personal property of a kind which is actively traded or 
with respect to which contractual interests are actively traded, and
    (B) Nonfunctional currency (as defined under section 988 and the 
regulations thereunder).

[[Page 66]]

    (ii) Commodities transaction. A commodities transaction means the 
purchase or sale of a commodity for immediate (spot) delivery, or 
deferred (forward) delivery, or the right to purchase, sell, receive, or 
transfer a commodity, or any other right or obligation with respect to a 
commodity, accomplished through a cash or off-exchange market, an 
interbank market, an organized exchange or board of trade, an over-the-
counter market, or in a transaction effected between private parties 
outside of any market. Commodities transactions include, but are not 
limited to:
    (A) A futures or forward contract in a commodity,
    (B) A leverage contract in a commodity purchased from leverage 
transaction merchants,
    (C) An exchange of futures for physical transaction,
    (D) A transaction in which the income or loss to the parties is 
measured by reference to the price of a commodity, a pool of 
commodities, or an index of commodities,
    (E) The purchase or sale of an option or other right to acquire or 
transfer a commodity, a futures contract in a commodity, or an index of 
commodities, and
    (F) The delivery of one commodity in exchange for the delivery of 
another commodity, the same commodity at another time, cash, or 
nonfunctional currency.
    (3) Definition of the term ``qualified active sales''--(i) In 
general. The term ``qualified active sales'' means the sale of 
commodities in the active conduct of a commodity business as a producer, 
processor, merchant, or handler of commodities if substantially all of 
the controlled foreign corporation's business is as an active producer, 
processor, merchant, or handler of commodities of like kind. The sale of 
commodities held by a controlled foreign corporation other than in its 
capacity as an active producer, processor, merchant or handler of 
commodities of like kind is not a qualified active sale.
    (ii) Sale of commodities. The term ``sale of commodities'' means any 
transaction in which the controlled foreign corporation intends to 
deliver to a purchaser a commodity held by the controlled foreign 
corporation in physical form.
    (iii) Active conduct of a commodities business. For purposes of this 
paragraph, a controlled foreign corporation is engaged in the active 
conduct of a commodities business as a producer, processor, merchant, or 
handler of commodities only if--
    (A) It holds commodities as inventory or similar property (as 
defined in paragraph (a)(4)(ii)); and
    (B) It incurs substantial expenses in the ordinary course of a 
commodities business from engaging in one of the following activities 
directly, and not through an independent contractor:
    (1) Substantial activities in the production of commodities, 
including planting, tending or harvesting crops, raising or slaughtering 
livestock, or extracting minerals.
    (2) Substantial processing activities prior to the sale of 
commodities including concentrating, refining, mixing, crushing, 
aerating, or milling; or
    (3) Significant activities relating to the physical movement, 
handling and storage of commodities including preparation of contracts 
and invoices; arranging freight, insurance and credit; arranging for 
receipt, transfer or negotiation of shipping documents; arranging 
storage or warehousing, and dealing with quality claims; owning and 
operating facilities for storage or warehousing or owning or chartering 
vessels or vehicles for the transportation of commodities.

For purposes of this paragraph (f), a corporation is not engaged in a 
commodities business as a producer, processor, merchant, or handler of 
commodities if its business is primarily financial. In general, the 
business of a controlled foreign corporation is financial if it 
primarily engages in commodities transactions for investment or 
speculation, or if it primarily provides products or services to 
customers for investment or speculation.
    (iv) Substantially all. Substantially all of the controlled foreign 
corporation's business is as an active producer, processor, merchant, or 
handler of commodities if the activities described in paragraph 
(f)(3)(iii) give rise to 85 percent of the taxable income of the 
controlled foreign corporation (computed

[[Page 67]]

as though the corporation were a domestic corporation). For this 
purpose, gains or losses from qualified hedging transactions, as defined 
in paragraph (f)(4), are considered derived from the qualified active 
sales to which they relate or are expected to relate.
    (4) Definition of the term ``qualified hedging transaction.'' The 
term ``qualified hedging transaction'' means a bona fide hedging 
transaction that:
    (i) Is reasonably necessary to the conduct of business as a 
producer, processor, merchant or handler of a commodity in the manner in 
which such business is customarily and usually conducted by others;
    (ii) Is entered into primarily to reduce the risk of price change 
(but not the risk of currency fluctuations) with respect to commodities 
sold or to be sold in qualified active sales described in paragraph 
(f)(3) of this paragraph; and
    (iii) Is clearly identified on the controlled foreign corporation's 
records before the close of the fifth day after the day during which the 
hedging transaction is entered into and at a time when there is a 
reasonable risk of loss; however, if the controlled foreign corporation 
does not at such time specifically and properly identify the qualified 
active sales (or category of such sales) to which a hedging transaction 
relates, the district director in his sole discretion may determine 
which hedging transactions (if any) are related to qualified active 
sales.
    (g) Foreign currency gain--(1) In general. Except as provided in 
paragraph (g)(2), foreign personal holding company income includes the 
excess of foreign currency gains over losses (as defined in section 
988(b)) attributable to any section 988 transactions. If foreign 
currency losses exceed gains, the net loss is not within the definition 
of foreign personal holding company income under this paragraph (g), and 
may not be allocated to, or otherwise reduce, foreign personal holding 
company income under section 954(b)(5) and Sec. 1.954-1T(a)(4). To the 
extent the gain or loss from a transaction is treated as interest income 
or expense under sections 988(a)(2) or 988(d) and the regulations 
thereunder, it is not included in the computation of foreign personal 
holding company income under this paragraph (g). (For other rules 
concerning income described in more than one category of foreign 
personal holding company income, see Sec. 1.954-2(a)(2).) A loss that is 
deferred or that otherwise may not be taken into account under any 
provision of the Code may not be taken into account for purposes of 
determining foreign personal holding company income under any provision 
of this paragraph (g).
    (2) Exceptions--(i) Qualified business units using the dollar 
approximate separate transactions method. Any DASTM gain or loss 
computed under Sec. 1.985-3(d) must be allocated under the rules of 
Sec. 1.985-3 (e)(2)(iv) or (e)(3).
    (ii) Tracing to exclude foreign currency gain or loss from qualified 
business and hedging transactions. A foreign currency gain or loss is 
excluded from the computation of foreign personal holding company income 
under this paragraph (g) if it is clearly identified on the records of 
the controlled foreign corporation as being derived from a qualified 
business transaction or a qualified hedging transaction. The term 
``qualified business transaction'' is defined in paragraph (g)(3) of 
this section. The term ``qualified hedging transaction'' is defined 
paragraph (g)(4) of this section. However, currency gain or loss of a 
qualified business unit included in the computation of currency gain or 
loss under subdivision (i) of this paragraph (g)(2) may not be excluded 
from foreign personal holding company income under the tracing rule of 
this paragraph (g)(2)(ii). Furthermore, the tracing rule of this 
paragraph (g)(2)(ii) will not apply if a controlled foreign corporation 
makes the election provided by paragraph (g)(2)(iii) of this section.
    (iii) Election out of tracing. A controlled foreign corporation may 
elect a method of accounting under which all foreign currency gains or 
losses attributable to section 988 transactions are included in foreign 
personal holding company income. The scope and requirements for this 
election are provided in paragraph (g)(5) of this section. This election 
does not apply to foreign currency gains or losses of a qualified 
business unit included in the

[[Page 68]]

computation of gain or loss under paragraph (g)(2)(i) of this section.
    (3) Definition of the term ``qualified business transaction''--(i) 
In general. The term ``qualified business transaction'' means a 
transaction (other than a ``qualified hedging transaction'' as described 
in paragraph (g)(4) of this section) that:
    (A) Does not have investment or speculation as a significant 
purpose;
    (B) Is not attributable to property or an activity of the kind that 
gives rise to subpart F income (other than foreign currency gain under 
this paragraph (g)), or could reasonably be expected to give rise to 
subpart F income (including upon disposition); for example, the 
transaction may not be attributable to stock or debt of another 
corporation (including related corporations organized and operating in 
the same country), or property likely to give rise to foreign base 
company sales or services income; and
    (C) Is attributable to business transactions described in 
subdivision (ii) of this paragraph (g)(3).

A qualified business transaction includes the disposition of a debt 
instrument that constitutes inventory property under paragraph 
(a)(4)(ii) or dealer property under paragraph (a)(4)(iv) of this 
section. The provisions of this paragraph (g)(3) do not apply to the 
foreign currency gain or loss of a qualified business unit (as 
determined under Sec. 1.985-3T(d)(2)) included in the computation of 
gain or loss under paragraph (g)(2)(i) of this section. The provisions 
of this paragraph (g)(3) do, however, apply to other currency 
transactions of a qualified business unit that elects (or is deemed to 
elect) the U.S. dollar as its functional currency under section 
985(b)(3) and Sec. 1.985-2T. Qualified business transactions and the 
amount of foreign currency gain or loss derived therefrom must be 
clearly identified on its records by the controlled foreign corporation. 
If the controlled foreign corporation is unable to specifically identify 
the qualified business transactions and the foreign currency gain or 
loss derived therefrom, the district director in his sole discretion may 
determine which transactions of the corporation giving rise to the 
foreign currency gains or losses are attributable to qualified business 
transactions.
    (ii) Specific business transactions. A transaction of a controlled 
foreign corporation must meet the requirements of any of subdivisions 
(A) through (F) of this paragraph (g)(3)(ii) to be a qualified business 
transaction under this paragraph (g)(3).
    (A) Acquisition of debt instruments. If the transaction is the 
acquisition of a debt instrument described in section 988(c)(1)(B)(i) 
and the regulations thereunder, the debt must be derived from--
    (1) The sale of inventory and similar property to customers by the 
controlled foreign corporation in the ordinary course of regular 
business operations, or
    (2) The rendition of services by the corporation in the ordinary 
course of regular business operations.

For purposes of this paragraph (g)(3)(ii)(A), a debt instrument will not 
be considered derived in the ordinary course of regular business 
operations unless the instrument matures, and is reasonably expected to 
be satisfied, within the period for which interest need not be charged 
under section 482 and the regulations thereunder.
    (B) Becoming the obligor under debt instruments. If the transaction 
is becoming the obligor under a debt instrument described in section 
988(c)(1)(B)(i) and the regulations thereunder, the debt must be 
incurred for:
    (1) Payment of expenses that are includible by the controlled 
foreign corporation in the cost of goods sold under Sec. 1.61-3 for 
property held primarily for sale to customers in the ordinary course of 
regular business operations, are inventoriable costs under section 471 
and the regulations thereunder, or are allocable or apportionable under 
the rules of Sec. 1.861-8 to gross income derived from inventory and 
similar property,
    (2) Payment of expenses that are allocable or apportionable under 
the rules of Sec. 1.861-8 to gross income derived from services provided 
by the controlled foreign corporation in the ordinary course of regular 
business operations,

[[Page 69]]

    (3) Acquisition of an asset that does not give rise to subpart F 
income during the current taxable year (other than by application of 
section 952(c)) and is not reasonably expected to give rise to subpart F 
income in subsequent taxable years, or
    (4) Acquisition of dealer property as defined in paragraph 
(a)(4)(iv) of this section.

The identification requirements of subdivision (i) of this paragraph 
(g)(3) will not be met with respect to a borrowing if the controlled 
foreign corporation fails to clearly identify the debt and the expenses 
(or categories of expenses) to which it relates before the close of the 
fifth day after the day on which the expenses are incurred.
    (C) Accrual of any item of gross income. If the transaction is the 
accrual (or otherwise taking into account) of any item of gross income 
or receipts as described in section 988(c)(1)(B)(ii) and the regulations 
thereunder, the item of gross income or receipts must be derived from:
    (1) The sale of inventory and similar property in the ordinary 
course of regular business operations, or
    (2) The provision of services by the controlled foreign corporation 
to customers in the ordinary course of regular business operations.
    (D) Accrual of any item of expense. If the transaction is the 
accrual (or otherwise taking into account) of any item of expense as 
described in section 988(c)(1)(B)(ii) and the regulations thereunder, 
the item of expense must be:
    (1) An expense that is includible by the controlled foreign 
corporation in the cost of goods sold under Sec. 1.61-3 for property 
held primarily for sale to customers in the ordinary course of regular 
business operations, is an inventoriable cost under section 471 and the 
regulations thereunder, or is allocable or apportionable under the rules 
of Sec. 1.861-8 to gross income derived from inventory and similar 
property, or
    (2) An expense that is allocable or apportionable under the rules of 
Sec. 1.861-8 to gross income derived from services provided by the 
controlled foreign corporation in the ordinary course of regular 
business operations.
    (E) Entering into forward contracts, futures contracts, options and 
similar instruments. If the transaction is entering into any forward 
contract, futures contract, option or similar financial instrument and 
if such contract or instrument is not marked to market at the close of 
the taxable year under section 1256, as described in section 
988(c)(1)(B)(iii) and the regulations thereunder, then the contract or 
instrument must be property held as dealer property as defined in 
paragraph (a)(4)(ii) of this section.
    (F) Disposition of nonfunctional currency. If the transaction is the 
disposition of nonfunctional currency, as described in section 
988(c)(1)(C) and the regulations thereunder, then the transaction must 
be for a purpose described in paragraph (g)(3)(ii)(B), for the payment 
of taxes not attributable to subpart F income, or must be the 
disposition of property held as dealer property as defined in paragraph 
(a)(4)(iv) of this section.
    (G) Transactions in business assets. The acquisition or disposition 
of an asset that is used or held for use in the active conduct of a 
trade or business.
    (4) Definition of the term ``qualified hedging transaction''--(i) In 
general. The term ``qualified hedging transaction'' means a bona fide 
hedging transaction meeting all the requirements of subdivisions (A) 
through (D) of this paragraph (g)(4)(i):
    (A) The transaction must be reasonably necessary to the conduct of 
regular business operations in the manner in which such business 
operations are customarily and usually conducted by others.
    (B) The transaction must be entered into primarily to reduce the 
risk of currency fluctuations with respect to property or services sold 
or to be sold or expenses incurred or to be incurred in transactions 
that are qualified business transactions under paragraph (g)(3) of this 
section.
    (C) The hedging transaction and the property or expense (or category 
of property or expense) to which it relates must be clearly identified 
on the records of the controlled foreign corporation before the close of 
the fifth day after the day during which the hedging transaction is 
entered into and

[[Page 70]]

at a time during which there is a reasonable risk of currency loss.
    (D) The amount of foreign currency gain or loss that is attributable 
to a specific hedging transaction must be clearly identifiable on the 
records of the controlled foreign corporation or its controlling 
shareholder (as defined in Sec. 1.964-1(c)(5)).

The provisions of this paragraph (g)(4) do not apply to transactions of 
a qualified business unit included in the computation of gain or loss 
under paragraph (g)(2)(i). The provisions of this paragraph (g)(4) do 
apply, however, to other currency transactions of a qualified business 
unit that elects (or is deemed to elect) the U.S. dollar as its 
functional currency under section 985(b)(3) and Sec. 1.985-3T. If the 
controlled foreign corporation does not specifically identify the 
qualified business transactions (or category of qualified business 
transactions) to which a hedging transaction relates or is unable to 
specifically identify the amount of foreign currency gain or loss 
derived from the hedging transactions, the district director in his sole 
discretion may make the identifications required of the controlled 
foreign corporation and determine which hedging transactions (if any) 
are related to qualified business transactions, and the amount of 
foreign currency gain or loss attributable to the qualified hedging 
transactions.
    (ii) Change in purpose of hedging transaction. If a hedging 
transaction is entered into for one purpose, and the purpose for that 
transaction subsequently changes, the transaction may be treated as two 
separate hedging transactions for purposes of this paragraph (g)(4). In 
such a case, the portion of the transaction that relates to a qualified 
business transaction is considered a qualified hedging transaction if it 
separately meets all the other requirements of this paragraph (g)(4) for 
treatment as a qualified hedging transaction. For purposes of paragraph 
(g)(4)(i)(C), the foreign corporation must identify on its records the 
portion of the transaction that relates to a qualified business 
transaction by the close of the fifth day after the day on which the 
hedge becomes so related (i.e., either the day on which the hedge is 
first entered into or on the day on which it first relates to a 
qualified business transaction due to a change in its purpose). The 
foreign corporation must identify on its records the portion of the 
transaction that does not relate to a qualified business transaction by 
the close of the fifth day after the day on which the purpose for the 
hedging transaction changes.
    (5) Election out of tracing--(i) In general. A controlled foreign 
corporation may elect to account for currency gains and losses under 
section 988 and gains and losses from section 1256 currency contracts by 
including in the computation of foreign personal holding company income 
under this paragraph (g) all foreign currency gains or losses 
attributable to section 988 transactions, and all gains or losses from 
section 1256 foreign currency contracts. Separate elections for section 
1256 foreign currency contracts and section 988 transactions are not 
permitted. If a controlled foreign corporation makes the election 
described in this paragraph (g)(5)(i), the election is effective for all 
related persons as defined in section 954(d)(3) and the regulations 
thereunder.
    (ii) Exception. The election provided by this paragraph (g)(5) does 
not apply to foreign currency gain or loss of a qualified business unit 
determined under Sec. 1.985-3T(d)(2). It does, however, apply to other 
foreign currency gains or losses of a qualified business unit that 
elects (or is deemed to elect) the U.S. dollar as its functional 
currency.
    (iii) Procedure--(A) In general. The election provided by this 
paragraph (g)(5) shall be made in the manner prescribed in this 
paragraph and in subsequent administrative pronouncements.
    (B) Time and manner. The controlled foreign corporation may make the 
election by filing a statement with its original or amended information 
return for the taxable year for which the election is made. The 
controlling United States shareholders, as defined in Sec. 1.964-
1(c)(5), may make the election on behalf of the controlled foreign 
corporation and related corporations by filing a statement to such 
effect with their original or amended income tax returns for the taxable 
year during

[[Page 71]]

which the taxable year of the controlled foreign corporation for which 
the election is made ends. The election is effective for the taxable 
year of the controlled foreign corporation for which the election is 
made, for the taxable years of all related controlled foreign 
corporations ending within such taxable year, and for all subsequent 
years of such corporations. The statement shall include the following 
information:
    (1) The name, address, taxpayer identification number, and taxable 
year of each United States shareholder;
    (2) The name, address, and taxable year of each controlled foreign 
corporation for which the election is effective; and
    (3) Any additional information to be required by the Secretary by 
administrative pronouncement.

Each United States shareholder or controlled foreign corporation filing 
the election must provide copies of the election to all controlled 
foreign corporations for which the election is effective, and all United 
States shareholders of such corporations. However, failure to provide 
such copies will not void (or cause to be voidable) an election under 
this paragraph (g)(5).
    (C) Termination. The election provided by this paragraph (g)(5) may 
be terminated only with the consent of the Commissioner: Attn.: CC:INTL.
    (h) Income equivalent to interest--(1) In general. Foreign personal 
holding company income includes income that is equivalent to interest. 
Income equivalent to interest includes, but is not limited to, income 
derived from the following categories of transactions:
    (i) An investment, or series of integrated transactions which 
include an investment, in which the payments, net payments, cash flows, 
or return predominantly reflect the time value of money, and
    (ii) Transactions in which the payments or a predominant portion 
thereof are in substance for the use or forebearance of money, but are 
not generally treated as interest.

However, amounts treated as interest under section 954(c)(1)(A) and 
paragraph (b) of this section are not income equivalent to interest 
under this paragraph (h). Income from the sale of property will not be 
treated as income equivalent to interest for purposes of this paragraph 
(h), subject to the rule of paragraph (h)(4) of this section, unless the 
sale is part of an integrated transaction that gives rise to interest or 
income equivalent to interest. See sections 482, 483 and 1274 for the 
extent to which such income may be characterized as interest income 
subject to paragraph (b) of this section. Income equivalent to interest 
for purposes of this paragraph (h) includes all income attributable to a 
transfer of securities subject to section 1058. Income equivalent to 
interest also includes a portion of certain deferred payments received 
for the purpose of services, in accordance with the provisions of 
paragraph (h)(5) of this section. Income equivalent to interest does not 
include income attributable to notional principal contracts such as 
interest rate swaps, currency swaps, interest rate floor agreements, or 
similar contracts except to the extent that such contracts are part of 
an integrated transaction that gives rise to income equivalent to 
interest. Income derived from notional contracts by a person acting in 
its capacity as a regular dealer in such contracts will be presumed not 
to be integrated with an investment.
    (2) Illustrations. The following examples illustrate the application 
of this paragraph (h):

    Example 1. CFC, a controlled foreign corporation, promises that A, 
an unrelated person, may borrow up to $500 in principal for one year 
beginning at any time during the next three months at an interest rate 
of 10 percent. In exchange, A pays CFC a commitment fee of $2.00. 
Pursuant to this loan commitment, CFC lends $80 to A. As a result, the 
entire $2.00 fee is included in the computation of foreign personal 
holding company income under this paragraph (h)(1)(ii).
    Example 2. (i) At the beginning of its current taxable year, CFC, a 
controlled foreign corporation, purchases at face value a one-year debt 
instrument issued by A having a $100 principal amount and bearing a 
floating rate of interest set at the London Interbank Offered Rate 
(``LIBOR'') plus one percentage point. Contemporaneously, CFC borrows 
$100 from B for one year at a fixed interest rate of 10 percent, using 
the debt instrument as security.
    (ii) During its current taxable year, CFC accrues $11 of interest 
from A on the bond. That interest is foreign personal holding company 
income under section 954(c)(1) and

[[Page 72]]

Sec. 1.954-2T(b), and thus is not income equivalent to interest. During 
its current taxable year, CFC incurs $10 of interest expense with 
respect to the borrowing from B. That expense is allocated and 
apportioned to, and reduces, foreign base company income or insurance 
income to the extent provided in sections 954(b)(5), 863(e), and 864(e) 
and the regulations thereunder.
    Example 3. (i) At the beginning of its 1988 taxable year, CFC, a 
controlled foreign corporation, purchases at face value a one-year debt 
instrument issued by A having a $100 principal amount and bearing a 
floating rate of interest set at the London Interbank Offered Rate 
(``LIBOR'') plus one percentage point payable on the last day of CFC's 
current taxable year. CFC subsequently determines that it would prefer 
receiving interest at a fixed rate, and, on January 1, 1989, enters into 
an agreement with B, an unrelated person, whereby B promises to pay CFC 
on the last day of CFC's 1989 taxable year an amount equal to 10 percent 
on a notional principal amount of $100. In exchange, CFC promises to pay 
B on the last day of CFC's 1989 taxable year an amount equal to LIBOR 
plus one percentage point on the notional principal amount.
    (ii) CFC receives a total of $10 from B, and pays $9 to B. CFC also 
receives $9 from A. The $9 paid to B is directly allocated to, or is 
otherwise an adjustment to, the $10 received from B. The transactions 
are considered an intergrated transaction giving rise to $9 of interest 
income (paid by A) and, under paragraph (h)(1)(i), $1 of income 
equivalent to interest (paid by B).
    Example 4. The facts are the same as in Example 3, except that CFC 
does not hold any debt obligations. Since the transaction with B is not 
integrated with an investment giving rise to interest or income 
equivalent to interest, the net $1 of income realized by CFC does not 
constitute income equivalent to interest.
    Example 5. (i) CFC, a controlled foreign corporation, enters into an 
agreement with A whereby CFC purchases commodity X from A at a price of 
$100, and A contemporaneously repurchases commodity X from CFC for 
payment and delivery in 3 months at a price of $104 set by the forward 
market.
    (ii) The transaction is in substance a loan from CFC to A secured by 
commodity X. Thus, CFC accrues $4 of gross income which is included in 
foreign personal holding company income as interest under section 
954(c)(1)(A) and paragraph (b) of this section.
    Example 6. (i) CFC purchases commodity Y on the spot market for $100 
and contemporaneously, sells commodity Y forward for delivery and 
payment in 3 months at a price of $104 set by the forward market.
    (ii) The $100 paid on the spot purchase of commodity Y offsets any 
market risk on the forward sale so that the $4 of income to be derived 
predominantly reflects time value of money. Thus, under paragraph 
(h)(1)(i), the spot purchase of commodity Y and the offsetting forward 
sale will be treated as an integrated transaction giving rise to $4 of 
income equivalent to interest.

    (3) Income equivalent to interest from factoring--(i) General rule. 
Income equivalent to interest includes factoring income. Except as 
provided in paragraph (h)(3)(ii) of this section, the term ``factoring 
income'' includes any income (including any discount income or service 
fee, but excluding any stated interest) derived from the acquisition and 
collection or disposition of a factored receivable. The rules of this 
paragraph (h)(3) apply only with respect to the tax treatment of 
factoring income derived from the acquisition and collection or 
disposition of a factored receivable and shall not affect the 
characterization of an expense or loss of either the person whose goods 
or services gave rise to a factored receivable or the obligor under a 
receivable. The amount of income equivalent to interest realized with 
respect to a factored receivable is the difference (if a positive 
number) between the amount paid for the receivable by the foreign 
corporation and the amount that it collects on the receivable (or 
realizes upon its sale of the receivable).
    (ii) Exceptions. Factoring income shall not include--
    (A) Income treated as interest under section 864(d)(1) or (6) and 
the regulations thereunder (relating to income derived from trade or 
service receivables of related persons), even if such income is not 
treated as described in section 864(d)(1) by reason of the same-country 
exception of section 864(d)(7);
    (B) Income derived from a factored receivable if payment for the 
acquisition of the receivable is made on or after the date on which 
stated interest begins to accrue, but only if the rate of stated 
interest equals or exceeds 120 percent of the Federal short term rate 
(as defined under section 1274) (or the equivalent rate for a currency 
other than the dollar) as of the date on which the receivable is 
acquired by the foreign corporation; or
    (C) Income derived from a factored receivable if payment for the 
acquisition of the receivable by the foreign

[[Page 73]]

corporation is made only on or after the anticipated date of payment of 
all principal by the obligor (or the anticipated weighted average date 
of payment of a pool of purchased receivables).
    (iii) Factored receivable. For purposes of this paragraph (h)(3), 
the term ``factored receivable'' includes any account receivable or 
other evidence of indebtedness, whether or not issued at a discount and 
whether or not bearing stated interest, arising out of the disposition 
of property or the performance of services by any person, if such 
account receivable or evidence of indebtedness is acquired by a person 
other than the person who disposed of the property or provided the 
services that gave rise to the account receivable or evidence of 
indebtedness. For purposes of this paragraph (h)(3), it is immaterial 
whether the person providing the property or services agrees to transfer 
the receivable at the time of sale (as by accepting a third-party charge 
or credit card) or at a later time.
    (iv) Illustrations. The following examples illustrate the 
application of this paragraph (h)(3).

    Example 1. DP, a domestic corporation, owns all of the outstanding 
stock of FS, a controlled foreign corporation. FS acquires accounts 
receivable arising from the sale of property by unrelated corporation X. 
The receivables have a face amount of $100, and after 30 days bear 
stated interest equal to at least 120 percent of the applicable short 
term Federal rate (determined as of the date the receivable is 
acquired). FS purchases the receivables from X for $95 on Day 1 and 
collects $100 from the obligor under the receivable on Day 40. Income 
(other than stated interest) derived by FS from the factored receivables 
is factoring income within the meaning or paragraph (h)(3)(i) of this 
section and, therefore, is income equivalent to interest.
    Example 2. The facts are the same as in example 1, except that FS 
does not pay X for the receivables until Day 30. Income derived by FS 
from the factored receivables is not factoring income by reason of 
paragraph (h)(3)(ii)(B) of this section.
    Example 3. The facts are the same as in example 2, except that it is 
anticipated that all principal will be paid by the obligor of the 
receivables by Day 30. Income derived by FS from this ``maturity 
factoring'' of the receivables is not factoring income by reason of 
paragraph (h)(3)(ii)(C) of this section, and therefore does not give 
rise to income equivalent to interest.
    Example 4. The facts are the same as in example 1, except that, 
rather than collecting $100 from the obligor under the factored 
receivable on Day 40, FS sells the receivable to controlled foreign 
corporation Y on Day 15 for $97. Both the income derived by FS on the 
factored receivable and the income derived by Y (other than stated 
interest) on the receivable are factoring income within the meaning of 
paragraph (h)(3)(i) of this section, and therefore, constitute income 
equivalent to interest.
    Example 5. The facts are the same as in example 4, except that FS 
sells the factored receivable to Y for $99 on Day 45, at which time 
interest is accruing on the unpaid balance of $100. FS has $4 of net 
factoring income that is income equivalent to interest. Because interest 
was accruing at the time Y acquired the receivable at a rate equal to at 
least 120 percent of the applicable short term Federal rate, income 
derived by Y from the factored receivable is not factoring income by 
reason of pargraph (h)(3)(ii)(B).
    Example 6. DP, a domestic corporation engaged in an integrated 
credit card business, owns all of the outstanding stock of FS, a 
controlled foreign corporation. On Day 1 individual A uses a credit card 
issued by DP to purchase shoes priced at $100 from X, a foreign 
corporation unrelated to DP, FS, or A. By prearrangement with DP, on Day 
7, X transfers the receivable arising from A's purchase to FS in 
exchange for $95. FS collects $100 from A on Day 45. Income derived by 
FS on the factored receivable is factoring income within the meaning of 
paragraph (h)(3)(i) of this section and, therefore, is income equivalent 
to interest.

    (4) Determination of sales income. Income equivalent to interest for 
purposes of this paragraph (h) does not include income from the sale of 
property unless the sale is part of an integrated transaction that gives 
rise to interest or income equivalent to interest. Income derived by a 
controlled foreign corporation will be treated as arising from the sale 
of property only if the corporation in substance carries out sales 
activities. Accordingly, an arrangement that is designed to lend the 
form of a sales transaction to a transaction that in substance 
constitutes and advance of funds will be disregarded. For example, if a 
controlled foreign corporation acquires property on 30-day payment terms 
from one person and sells that property to another person on 90 day 
payment terms and at prearranged prices and terms such that

[[Page 74]]

the foreign corporation bears no substantial economic risk with respect 
to the purchase and sale other than the risk of non-payment, the foreign 
corporation has not in substance derived income from the sale of 
property.
    (5) Receivables arising from performance of services. If payment for 
services performed by a controlled foreign corporation is not made until 
more than 120 days after the date on which such services are performed, 
then the income derived by the foreign corporation constitutes income 
equivalent to interest to the extent that interest income would be 
imputed under the principles of section 483 or the original issue 
discount provisions (section 1271 et seq.), if--
    (A) Such provisions applied to contracts for the performance of 
services,
    (B) The time period referred to in sections 483(c)(1) and 
1274(c)(1)(B) were 120 days rather than six months, and
    (C) The time period referred to in section 483(c)(1)(A) were 120 
days rather than one year.

[T.D. 8216, 53 FR 27498, July 21, 1988; 53 FR 29801, Aug. 8, 1988, as 
amended by T.D. 8556, 59 FR 37672, July 25, 1994. Redesignated and 
amended by T.D. 8618, 60 FR 46530, Sept. 7, 1995]



PART 5--TEMPORARY INCOME TAX REGULATIONS UNDER THE REVENUE ACT OF 1978--Table of Contents




Sec.
5.856-1  Extensions of the grace period for foreclosure property by a 
          real estate investment trust.
5.1502-45  Limitation on losses to amount at risk.
5.1561-1  Taxable years of component members of controlled group of 
          corporations that include December 31, 1978.
5.6411-1  Tentative refund under claim of right adjustment.

    Authority: 26 U.S.C. 7805.



Sec. 5.856-1  Extensions of the grace period for foreclosure property by a real estate investment trust.

    (a) In general. Under section 856(e), a real estate investment trust 
(``REIT'') may elect to treat as foreclosure property certain real 
property (including interests in real property), and any personal 
property incident to such real property, that the REIT acquires after 
December 31, 1973. In general, the REIT must acquire the property as the 
result of having bid in the property at foreclosure, or having otherwise 
reduced the property to ownership or possession by agreement or process 
of law, after there was default (or default was imminent) on a lease of 
such property (where the REIT was the lessor) or on an indebtedness owed 
to the REIT which such property secured. Property that a REIT elects to 
treat as foreclosure property ceases to be foreclosure property with 
respect to such REIT at the end of a grace period. The grace period ends 
on the date which is 2 years after the date on which the REIT acquired 
the property, unless the REIT has been granted an extension or 
extensions of the grace period. If the grace period is extended, the 
property ceases to be foreclosure property on the day immediately 
following the last day of the grace period, as extended.
    (b) Rules for extensions of the grace period. In general, 
Sec. 1.856-6(g) prescribes rules regarding extensions of the grace 
period. However, in order to reflect the amendment of section 856(e)(3) 
of the Code by section 363(c) of the Revenue Act of 1978, the following 
rules also apply:
    (1) In the case of extensions granted after November 6, 1978, with 
respect to extension periods beginning after December 31, 1977, the 
district director may grant one or more extensions of the grace period 
for the property, subject to the limitation that no extension shall 
extend the grace period beyond the date which is 6 years after the date 
the REIT acquired the property. In any other case, an extension shall be 
for a period of not more than 1 year, and not more than two extensions 
can be granted with respect to the property.
    (2) In the case of an extension period beginning after December 31, 
1977, a request for an extension filed on or before March 28, 1980, will 
be considered to be timely if the limitation on the number and length of 
extensions in section 856(e)(3), as in effect before the amendment made 
by section 363(c) of the Revenue Act of 1978, would have barred the 
extension.

[T.D. 7767, 46 FR 11284, Feb. 6, 1981]

[[Page 75]]



Sec. 5.1502-45  Limitation on losses to amount at risk.

    (a) In general--(1) Scope. This section applies to a loss of any 
subsidiary if the common parent's stock meets the stock ownership 
requirement described in section 465(a)(1)(C).
    (2) Limitation on use of losses. Except as provided in paragraph 
(a)(4) of this section, a loss from an activity of a subsidiary during a 
consolidated return year is includible in the computation of 
consolidated taxable income (or consolidated net operating loss) and 
consolidated capital gain net income (or consolidated net capital loss) 
only to the extent the loss does not exceed the amount that the parent 
is at risk in the activity at the close of that subsidiary's taxable 
year. In addition, the sum of a subsidiary's losses from all its 
activities is includible only to the extent that the parent is at risk 
in the subsidiary at the close of that year. Any excess may not be taken 
into account for the consolidated return year but will be treated as a 
deduction allocable to that activity of the subsidiary in the first 
succeeding taxable year.
    (3) Amount parent is at risk in subsidiary's activity. The amount 
the parent is at risk in an activity of a subsidiary is the lesser of 
(i) the amount the parent is at risk in the subsidiary or (ii) the 
amount the subsidiary is at risk in the activity. These amounts are 
determined under paragraph (b) of this section and the principles of 
section 465. See section 465 and the regulations thereunder and the 
examples in paragraph (e) of this section.
    (4) Excluded activities. The limitation on the use of losses in 
paragraph (a)(2) of this section does not apply to a loss attributable 
to an activity described in section 465(c)(3)(D).
    (5) Substance over form. Any transaction or arrangement between 
members (or between a member and a person that is not a member) which 
does not cause the parent to be economically at risk in an activity of a 
subsidiary will be treated in accordance with the substance of the 
transaction or arrangement notwithstanding any other provision of this 
section.
    (b) Rules for determining amount at risk--(1) Excluded amounts. The 
amount a parent is at risk in an activity of a subsidiary at the close 
of the subsidiary's taxable year does not include any amount which would 
not be taken into account under section 465 were the subsidiary not a 
separate corporation. Thus, for example, if the amount a parent is at 
risk in the activity of a subsidiary is attributable to nonrecourse 
financing, the amount at risk is not more than the fair market value of 
the property (other than the subsidiary's stock or debt or assets) 
pledged as security.
    (2) Guarantees. If a parent guarantees a loan by a person other than 
a member to a subsidiary, the loan increases the amount the parent is at 
risk in the activity of the subsidiary.
    (c) Application of section 465. This section applies in a manner 
consistent with the provisions of section 465. Thus, for example, the 
recapture of losses provided in section 465(e) applies if the amount the 
parent is at risk in the activity of a subsidiary is reduced below zero.
    (d) Other consolidated return provisions unaffected. This section 
limits only the extent to which losses of a subsidiary may be used in a 
consolidated return year. This section does not apply for other 
purposes, such as Secs. 1.1502-32 and 1.1502-19, relating to investment 
in stock of a subsidiary and excess loss accounts, repectively. Thus, a 
loss which reduces a subsidiary's earnings and profits in a consolidated 
return year, but is disallowed as a deduction for the year by reason of 
this section, may nonetheless result in a negative adjustment to the 
basis of an owning member's stock in the subsidiary or create (or 
increase) an excess loss account.
    (e) Examples. The provisions of this section may be illustrated by 
the examples in this paragraph (e). In each example, the stock ownership 
requirement of section 465(a)(1)(C) is met for the stock of the parent 
(P), and each affiliated group files a consolidated return on a calendar 
year basis and comprises only the members described.

    Example (1). In 1979, P forms S with a contribution of $200 in 
exchange for all of S's stock. During the year, S borrows $400 from a 
commercial lender and P guarantees $100 of the loan. S uses $500 of its 
funds to acquire a motion picture film. S incurs a loss of $120

[[Page 76]]

for the year with respect to the film. At the close of 1979, the amount 
P is at risk in S's activity is $300. If S has no gain or loss in 1980, 
and there are no contributions from or distributions to P, at the close 
of 1980 P's amount at risk in S's activity will be $180.
    Example. (2). P forms S-1 with a capital contribution of $1 on 
January 1, 1980. On February 1, 1980. S-1 borrows $100 with full 
recourse and contributes all $101 to its newly formed subsidiary S-2. S-
2 uses the proceeds to explore for natural oil and gas resources. S-2 
incurs neither gain nor loss from its explorations during the taxable 
year. As of December 31, 1980, P is at risk in the exploration activity 
of S-2 only to the extent of $1.

    (f) Effective date. This section applies to consolidated return 
years ending on or after December 31, 1979.

[T.D. 7685, 45 FR 16484, Mar. 14, 1980]



Sec. 5.1561-1  Taxable years of component members of controlled group of corporations that include December 31, 1978.

    (a) In general. This section prescribes a regulation for applying 
sections 301 (a) and (b) (19), and 106, of the Revenue Act of 1978 (the 
Act) in the case of certain taxable years of component members of a 
controlled group of corporations (as defined in section 1563 of the 
Internal Revenue Code). The section applies only to taxable years that 
include December 31, 1978, and only if the taxable year of at least one 
component member ends in 1979.
    (b) Background. Section 301(a) of the Act amends section 11 of the 
Code (relating to tax imposed on corporations) to provide for taxable 
income brackets that are subject to tax at rates less than the maximum 
rate of 46 percent. Section 301(b)(19) of the Act amends section 1561(a) 
of the Code (relating to limitations on certain multiple tax benefits in 
the case of certain controlled corporations) to limit the component 
members of a controlled group to an aggregate amount in each bracket 
which does not exceed the maximum amount in such bracket to which a 
corporation which is not a component member of a controlled group is 
entitled. Section 106 of the Act amends section 21 of the Code (relating 
to effect of changes in rate of tax) to provide that the amendments made 
by section 301 of the Act shall be treated as a change in a rate of tax. 
Since the amendments made by section 301 of the Act are effective for 
taxable years beginning after December 31, 1978, under the amendment to 
section 21 the effective date of the change in rate of tax is January 1, 
1979.
    (c) No apportionment plan in effect. If no apportionment plan (see 
Sec. 1.1561-3 of the Income Tax Regulations) is in effect with respect 
to December 31, 1978, the single $50,000 surtax exemption available 
before January 1, 1979, and the single bracket amounts available after 
December 31, 1978, shall be equally divided among the component members 
of the controlled group on December 31, 1978. In the case of a 
controlled group which includes component members that join in the 
filing of a consolidated return and other component members that do not 
join in the filing of such a return, each component member of the group 
(including each component member that joins in filing the consolidated 
return) shall be treated as a separate corporation for purposes of 
equally apportioning the $50,000 surtax exemption in effect before 
January 1, 1979, and the bracket amounts in effect after December 31, 
1978. In such a case, the surtax exemption and bracket amounts of the 
corporations filing the consolidated return shall be the sum of the 
amount apportioned to each component member that joins in filing the 
consolidated return.
    (d) Apportionment plan. (1) If one or more component members of the 
controlled group have a calendar taxable year and if an apportionment 
plan is adopted under Sec. 1.1561-3 apportioning the entire $50,000 
surtax exemption available for 1978 to such calendar-year members, then 
the amount in each taxable income bracket available for fiscal-year 
members is zero. If only a part of the $50,000 surtax exemption is 
apportioned to calendar-year members, then a proportionate part of the 
$25,000 amount in each taxable income bracket is available for the 
fiscal-year members. For example, if $30,000 (\3/5\ of $50,000) is 
apportioned to calendar-year members, \2/5\ of the $25,000 amount in 
each bracket, or $10,000, as well as the remaining \2/5\ of the 1978 
surtax exemption, is available to the fiscal-year members.

[[Page 77]]

    (2) The amount in each taxable income bracket available to fiscal-
year members may be apportioned among such members in any manner the 
controlled group may select. For example, the available amount in the 
first bracket (subject to a 17-percent rate) may be allocated to one 
member, the amount in the second bracket (subject to a 20-percent rate) 
may be allocated to another member, and so on. Moreover, the available 
amount in each bracket may be divided among the members in any manner 
the group may select.
    (3) In computing 1978 tentative taxes under section 21, the total 
surtax exemption available to fiscal-year members for 1978 must be 
divided among such members in the same proportion as the sum of the 
available amount in each bracket is divided among them. Thus, if the sum 
of the available bracket amounts is $100,000 (i.e., $25,000 in each 
bracket), and if corporation X is apportioned 30 percent, or $30,000, of 
this amount (regardless of which brackets corporation X may select), 
then 30 percent of the surtax exemption available to the fiscal-year 
members for 1978 (i.e., 30 percent of $50,000, or $15,000) must be 
apportioned to corporation X.
    (e) Corporations affected. The provisions of section 1561 may reduce 
the surtax exemption or bracket amounts of any corporation which is a 
component member of a controlled group of corporations and which is 
subject to the tax imposed by section 11, or by any other provision of 
subtitle A of the Code if the tax under such other provisions is 
computed by reference to the tax imposed by section 11. Such other 
provisions include, for example, sections 511(a)(1), 594, 802, 831, 852, 
857, 882, 1201, and 1378.
    (f) Example. This section may be illustrated by the following 
example:

    Example. Corporations X, Y, and Z are component members of a 
controlled group of corporations on December 31, 1978. X has taxable 
income of $10,000 for the taxable year ending December 31, 1978. Y has 
taxable income of $60,000 for the taxable year ending June 30, 1979. Z 
has taxable income of $90,000 for the taxable year ending September 30, 
1979. The group files an apportionment plan under Sec. 1.1561-3 
apportioning $10,000 (i.e., \1/5\ of $50,000) to X, the calendar-year 
member. Therefore, \4/5\ of the amount in each bracket, or $20,000, is 
available to Y and Z, the fiscal-year members. Under the plan, Y is 
apportioned the entire amount in the first bracket and $10,000 of the 
amount in the second bracket. Z is apportioned $10,000 of the amount in 
the second bracket and the entire amount in the third and fourth 
brackets. Therefore, Y is apportioned $30,000, or \3/8\ of the total 
available amount in the four brackets, and Z is apportioned $50,000, or 
\5/8\ of the total available amount. The tax liabilities of Y and Z for 
their taxable years ending in 1979 are computed as follows: (Computation 
of X's tax liability for 1978, using a surtax exemption of $10,000, is 
not shown.)

                           1979 TENTATIVE TAX
                                                                       Y
                                                              ----------
Taxable income...............................................    $60,000
                                                              ==========
Tax on amount in first bracket: 17 percent of $20,000........      3,400
Tax on amount in second bracket: 20 percent of $10,000.......      2,000
Tax on remaining income: 46 percent of $30,000...............     13,800
                                                              ----------
1979 tentative tax...........................................     19,200
                                                              ==========
                                                                       Z
                                                              ----------
Taxable income...............................................     90,000
                                                              ==========
Tax on amount in second bracket: 20 percent of $10,000.......      2,000
Tax on amount in third bracket: 30 percent of $20,000........      6,000
Tax on amount in fourth bracket: 40 percent of $20,000.......      8,000
Tax on remaining income: 46 percent of $40,000...............     18,400
                                                              ----------
1979 tentative tax...........................................     34,400
                                                              ==========
 


                           1978 TENTATIVE TAX
                                                                       Y
                              ------------
Taxable income...............................................     60,000
                              ============

[[Page 78]]

 
Normal tax:
  20 percent of $7,500 (\3/8\ of $20,000)....................      1,500
  22 percent of $52,500......................................     11,550
                              ------------
                                                                  13,050
Surtax:
      Taxable income.........    $60,000
      Surtax exemption.......     15,000  (\3/8\ of $40,000)
                              -----------
                                 $45,000  x26 percent........     11,700
                                                              ----------
1978 tentative tax...........................................     24,750
                              ============
                                                                       Z
                              ------------
Taxable income...............................................     90,000
                              ============
Normal tax:
  20 percent of $12,500 (\5/8\ of $20,000)...................      2,500
  22 percent of $77,500......................................     17,050
                              ------------
                                                                  19,500
Surtax:
      Taxable income.........    $90,000
      Surtax exemption.......     25,000  (\5/8\ of $40,000)
                              -----------
                                 $65,000  x 26 percent.......     16,900
                                                              ----------
1978 tentative tax...........................................     36,450
                              ============
The 1978 and 1979 tentative taxes are apportioned as follows:
      Corporation Y:
      1978--184/365 of $24,750...............................     12,477
      1979--181/365 of $19,200...............................      9,521
                              ------------
    Total tax for taxable year...............................     21,998
                              ============
Corporation Z:
  1978--92/365 of $36,450....................................      9,187
  1979--273/365 of $34,400...................................     25,729
      Total tax for taxable year.............................     34,916
                              ============
 


[T.D. 7583, 44 FR 872, Jan. 4, 1979]



Sec. 5.6411-1  Tentative refund under claim of right adjustment.

    (a) Effective date. This section applies to applications for 
tentative refunds filed after November 5, 1978, under section 6411(d).
    (b) In general. Section 6411(d) allows taxpayers to apply for a 
tentative refund of amounts treated under section 1341(b)(1) as an 
overpayment of tax under a claim of right adjustment. This section 
contains rules for filing an application for this tentative refund. The 
computation of amounts treated as an overpayment must be made in 
accordance with section 1341 and the regulations under that section.
    (c) Method of applying for tentative refund--(1) In general. For a 
corporation, the application is made by filing Form 1139. For taxpayers 
other than corporations, the application is made by filing Form 1045. 
The application must be made by filing those forms even if the taxpayer 
is not applying for a tentative carryback adjustment under section 
6411(a). If the taxpayer files the form to apply for the section 6411(d) 
tentative refund only, it may disregard those lines on the form used to 
compute the section 6411(a) carryback adjustment. If the taxpayer has a 
carryback of a net operating loss, credit, or capital loss for the 
taxable year (determined without the deduction described in section 
1341(a)(2)) and applies for both the section 6411(a) tenative carryback 
adjustment and the section 6411(d) tentative refund, an ordering rule 
applies. The taxpayer must take into account any adjustments made in 
applying for the tentative carryback adjustment under section 6411(a) 
before determining the amount

[[Page 79]]

of the overpayment for which an application under section 6411(d) is 
being made. The taxpayer must attach to the form a separate schedule 
containing the information required under paragraph (d) of this section.
    (2) Applications made before February 7, 1980. Applications made 
before February 7, 1980 that are made under penalties of perjury will be 
considered meeting the requirements of this section if made by filing a 
separate statement whether or not it is attached to Form 1139 or 1045. 
This application, however, must contain the information required under 
paragraph (d) of this section (other than paragraph (d)(2)).
    (d) Information required--(1) In general. The application must 
contain (i) the taxpayer's name, address, and identification number and 
(ii) the information set forth in paragraph (d) (2) and (3) of this 
section, determined in accordance with section 1341 and the regulations 
under that section. For example, the decrease in tax under paragraph 
(d)(3)(iii) of this section is determined under Sec. 1.1341-1(d)(4).
    (2) Computation under section 1341(a)(4). The application must 
contain the following information related to the computation under 
section 1341(a)(4):
    (i) The amount of income restored by the taxpayer to another during 
the taxable year and the amount of the corresponding deduction described 
in section 1341(a)(2);
    (ii) The tax for the taxable year computed with the deduction 
described in section 1341(a)(2); and
    (iii) The tax for each prior taxable year (determined before 
adjustment under section 1341) to which any net operating loss described 
in section 1341(b)(4)(A) may be carried and the decrease in tax for each 
of those years that results from the carryback of that loss.
    (3) Computation under section 1341(a)(5). The application must 
contain the following information related to the computation under 
section 1341(a)(5):
    (i) The tax for the taxable year without the deduction described in 
section 1341(a)(2);
    (ii) The tax for each prior taxable year (determined before 
adjustment under section 1341) for which a decrease in tax is computed 
under section 1341(a)(5)(B);
    (iii) The decrease in tax for each prior taxable year computed under 
section 1341(a)(5)(B), including any decrease resulting from a net 
operating loss or capital loss described in section 1341(b)(4)(B); and
    (iv) The amount treated as an overpayment of tax under section 
1341(b)(1).
    (e) Time and place for filing. The application must be filed no 
earlier than the date of filing the return for the taxable year of 
restoration and no later than the date 12 months from the last day of 
that taxable year. The application must be filed with the Internal 
Revenue Service Center (or other office) where the taxpayer filed its 
return for the taxable year of restoration.
    (f) Not a claim for credit or refund. An application for tentative 
refund under section 6411(d) is not a claim for credit or refund. The 
principles of paragraph (b)(2) of Sec. 1.6411-1 apply in determining the 
effect of an application for a tentative refund. For example, the filing 
of an application for tentative refund under section 6411(d) is not a 
claim for credit or refund in determining whether a claim for credit or 
refund was timely filed.

[T.D. 7672, 45 FR 8295, Feb. 7, 1980; 45 FR 17138, Mar. 18, 1980]



PART 5c--TEMPORARY INCOME TAX REGULATIONS UNDER THE ECONOMIC RECOVERY TAX ACT OF 1981--Table of Contents




Sec.
5c.44F-1  Leases and qualified research expenses.
5c.103-1  Leases and capital expenditures.
5c.103-2  Leases and industrial development bonds.
5c.103-3  Leases and arbitrage.
5c.168(f)(8)-1  Special rules for leases.
5c.168(f)(8)-2  Election to characterize transaction as a section 
          168(f)(8) lease.
5c.168(f)(8)-3  Requirements for lessor.
5c.168(f)(8)-4  Minimum investment of lessor.
5c.168(f)(8)-5  Term of lease.
5c.168(f)(8)-6  Qualified leased property.
5c.168(f)(8)-7  Reporting of income, deductions and investment tax 
          credit; at risk rules.
5c.168(f)(8)-8  Loss of section 168(f)(8) protection; recapture.

[[Page 80]]

5c.168(f)(8)-9  Pass-through leases--transfer of only the investment tax 
          credit to a party other than the ultimate user of the 
          property. [Reserved]
5c.168(f)(8)-10  Leases between related parties. [Reserved]
5c.168(f)(8)-11  Consolidated returns. [Reserved]
5c.1305-1  Special income averaging rules for taxpayers otherwise 
          required to compute tax in accordance with Sec. 5c.1256-3.

    Authority: 26 U.S.C. 168(f)(8)(G) and 7805.

    Source: T.D. 7791, 46 FR 51907, Oct. 23, 1981, unless otherwise 
noted.



Sec. 5c.44F-1  Leases and qualified research expenses.

    For purposes of section 44F(b)(2)(A)(iii), the determination of 
whether any amount is paid or incurred to another person for the right 
to use personal property in the conduct of qualified research shall be 
made without regard to the characterization of the transaction as a 
lease under section 168(f)(8). See Sec. 5c.168(f)(8)-1(b).



Sec. 5c.103-1  Leases and capital expenditures.

    For purposes of section 103(b)(6)(D) and Sec. 1.103-10(b)(2)(iv)(b), 
the determination of whether property is leased and whether property is 
of a type that is ordinarily subject to a lease shall be made without 
regard to the characterization of the transaction as a lease under 
section 168(f)(8).



Sec. 5c.103-2  Leases and industrial development bonds.

    For purposes of section 103(b)(2), the determination of whether an 
obligation constitutes an industrial development bond shall be made 
without regard to the characterization of the transaction as a lease 
under section 168(f)(8).

[T.D. 7800, 46 FR 63257, Dec. 31, 1981]



Sec. 5c.103-3  Leases and arbitrage.

    In the case of a sale and leaseback transaction qualifying under 
section 168(f)(8), where the lessee's rental payments are substantially 
equal in timing and amount to the principal and interest payments on the 
lessor's note, the arbitrage provisions of section 103(c) and 
Secs. 1.103-13, 1.103-14, and 1.103-15 shall apply to any obligations of 
the lessee (or party related to the lessee) without regard to the 
section 168(f)(8) lease transaction.

[T.D. 7800, 46 FR 63257, Dec. 31, 1981]



Sec. 5c.168(f)(8)-1  Special rules for leases.

    (a) In general. Section 168(f)(8) of the Internal Revenue Code of 
1954 provides special rules for characterizing certain agreements as 
leases and characterizing the parties to the agreement as lessors and 
lessees for Federal tax law purposes. These rules apply only with 
respect to qualified leased property. If all the requirements of section 
168(f)(8) and Secs. 5c.168(f)(8)-2 through 5c.168(f)(8)-11 are met, then 
the agreement shall be treated as a lease, and the party characterized 
as the lessor shall be treated as the owner of the property. In such 
case, the lessor shall be deemed to have entered into the lease in the 
course of carrying on a trade or business and shall be allowed 
accelerated cost recovery system (ACRS) deductions under section 168 and 
the investment tax credit under section 38 with respect to the leased 
property.
    (b) Exception for qualified research expenditures. For purposes of 
section 44F(b)(2)(A)(iii), the determination of whether any amount is 
paid or incurred to another person for the right to use personal 
property in the conduct of qualified research shall be made without 
regard to the characterization of the transaction as a lease under 
section 168(f)(8). Thus, if a lessee would be considered the owner of 
the property without regard to section 168(f)(8), any amounts paid by 
the lessee under the lease shall not be considered amounts paid or 
incurred for the right to use the property.
    (c) Other factors disregarded. If an agreement meets the 
requirements of section 168(f)(8) and Secs. 5c.168(f)(8)-2 through 
5c.168(f)(8)-11, the following factors will not be taken into account in 
determining whether the transaction is a lease:
    (1) Whether the lessor or lessee must take the tax benefits into 
account in order to determine that a profit is made from the 
transaction;
    (2) The fact that the lessee is the nominal owner of the property 
for State or local law purposes (e.g., has legal title to the property) 
and retains the burdens, benefits, and incidents of

[[Page 81]]

ownership (such as payment of taxes and maintenance charges with respect 
to the property);
    (3) Whether or not a person other than the lessee may be able to use 
the property after the lease term;
    (4) The fact that the property may (or must) be bought or sold at 
the end of the lease term at a fixed or determinable price that is more 
or less than its fair market value at that time;
    (5) The fact that the lessee or related party has provided financing 
or has guaranteed financing for the transaction (other than for the 
lessor's minimum 10 percent investment); and
    (6) The fact that the obligation of any person is subject to any 
contingency or offset agreement. See, for example, the rent and debt 
service offset in Example (2) of paragraph (e).

An agreement that meets the requirements of section 168(f)(8) and 
Secs. 5c.168(f)(8)-2 through 5c.168(f)(8)-11 may be treated by the 
parties as a lease for Federal Tax law purposes only. Similarly, a sale 
by the lessee of the leased property to the lessor in a transaction 
where the property is leased back under an agreement that meets the 
requirements of section 168(f)(8) may be treated by the parties as a 
sale for Federal tax law purposes only. The agreements need not comply 
with State law requirements concerning transfer of title, recording, 
etc.
    (d) Ownership in one of the parties. Notwithstanding any other 
section, if neither the lessor nor the lessee would be the owner of the 
property without regard to section 168(f)(8), or, if any party with an 
economic interest in the property (other than the lessor or lessee or 
any subsequent transferee of their interests) claims ACRS deductions or 
any investment tax credit with respect to the leased property, an 
election under section 168(f)(8) with respect to such property shall be 
void as of the date of the execution of the lease agreement.
    (e) Examples. The application of section 168(f)(8) and 
Secs. 5c.168(f)(8)-2 through 5c.168(f)(8)-11 may be illustrated by the 
following examples:

    Example (1). X Corp. wishes to acquire a $1 million piece of 
equipment which is ``qualified leased property'' as defined in section 
168(f)(8)(D). The equipment has a 10-year economic life and falls within 
the 5-year ACRS class. Y Corp. is a person meeting the qualifications 
set forth in section 168(f)(8)(B)(i) and Sec. 5c.168(f)(8)-3 and wishes 
to be the owner of the property for Federal tax law purposes. Y 
therefore purchases the equipment from the manufacturer for $1 million, 
paying $200,000 in cash and borrowing $800,000 from a bank (payable over 
9 years and requiring nine equal annual payments of principal and 
interest of $168,000). Y then leases the equipment to X under an 
agreement providing for nine annual rental payments of $168,000, and the 
parties elect in accordance with the provisions of Sec. 5c.168(f)(8)-2 
to have the provisions of section 168(f)(8) apply. The timing and amount 
of the rental payments required to be made by X (the ``lessee-user'') 
under the lease will be exactly equal to the timing and amount of the 
principal and interest payments that Y (the ``lessor'') will be required 
to make to the bank under its purchase money note. Under these 
circumstances, Y is treated as the owner and lessor of the property for 
Federal tax law purposes; it therefore is entitled to the investment tax 
credit and the ACRS deductions with respect to the property. Y's basis 
in the property is $1 million. Y must report the rent as income and will 
be entitled to deduct the interest on the purchase money note. The 
aggregate payments required to be made by X under the lease are treated 
as rent in accordance with Sec. 5c.168(f)(8)-7 and are deductible as 
such.
    Example (2). The facts are the same as in example (1) except that X 
purchases the equipment for $1 million and wishes to transfer ownership 
of the property for Federal tax law purposes to Y under a sale and 
leaseback arrangement. Accordingly, X sells the property to Y for 
$200,000 in cash (which represents the agreed upon compensation for the 
tax benefits to be enjoyed by Y as lessor) plus a 9-year, $800,000 note 
calling for nine $168,000 annual payments of principal and interest. Y 
then leases the property back to X under an agreement providing for nine 
annual rental payments of $168,000. The parties elect in accordance with 
the provisions of Sec. 5c.168(f)(8)-2 to have the provisions of section 
168(f)(8) apply. The timing and amount of the rental payments required 
to be made by X (as the lessee-user) under the lease will be exactly 
equal to the timing and amount of the principal and interest payments 
that Y will be required to make to X under Y's purchase money note, so 
that the only cash transferred between X and Y is the $200,000 down 
payment. Y's obligation to make debt service payments on the note is 
contingent on X's obligation to make rental payments under the lease. 
Under these circumstances, Y is treated as the owner and lessor of the 
property for Federal tax law purposes; it therefore is entitled to the 
investment tax credit and ACRS deductions with respect to

[[Page 82]]

the property. Y's basis in the property is $1 million. Y must report the 
rent as income and will be entitled to deduct the interest on the 
purchase money note. No gain or loss will be recognized by X on the sale 
of the property since the sale price equals X's basis in the property. X 
must report as income the interest paid by Y on the note and will be 
entitled to a deduction for the rental payments it makes under the lease 
in accordance with Sec. 5c.168(f)(8)-7.
    Example (3). Assume that in both examples (1) and (2) X has an 
option to purchase the equipment at the end of the lease term for $1.00. 
The fact that the property may (or must) be bought or sold at the end of 
the lease term at a fixed or determinable price that is more or less 
than its fair market value is not taken into account in determining the 
status of the transactions as leases under section 168(f)(8).

[T.D. 7791, 46 FR 51907, Oct. 23, 1981, as amended by T.D. 7795, 46 FR 
56148, Nov. 13, 1981]



Sec. 5c.168(f)(8)-2  Election to characterize transaction as a section 168(f)(8) lease.

    (a) Election--(1) In general. The election to characterize a 
transaction as a lease qualifying under section 168(f)(8) shall be made 
within the time and manner as set forth in this section without regard 
to section 168(f)(4).
    (2) Lease agreement. For an agreement to be treated as a lease under 
section 168(f)(8) and this section, the lease agreement must be executed 
not later than 3 months after the property was first placed in service, 
as defined in Sec. 5c.168(f)(8)-6(b)(2)(i) (or prior to November 14, 
1981, if the property was first placed in service by the lessee after 
December 31, 1980, and before August 14, 1981). The agreement must be in 
writing and must state that all of the parties to the agreement agree to 
characterize it as a lease for purposes of Federal tax law and elect to 
have the provisions of section 168(f)(8) apply to the transaction. The 
agreement must also name the party who will be treated as the lessor and 
the party who will be treated as the lessee.
    (3) Information return concerning the election. (i) Except as 
provided in subdivision (ii), for each lease agreement, the lessor and 
lessee must jointly file Form 6793, Safe Harbor Lease Information 
Return, concerning their election under section 168(f)(8). The 
information return must be signed by both the lessor and the lessee and 
filed not later than the 30th day after the agreement is executed with 
the Commissioner of Internal Revenue, 1111 Constitution Avenue, N.W., 
Washington, D.C. 20224 (Attn: Form 6793). Unless the failure to file 
timely is shown to be due to reasonable cause, the failure to file the 
information return timely shall void the section 168(f)(8) election as 
of the date of the execution of the lease agreement. The information 
return shall include the following items:
    (A) The name, address, and taxpayer identifying number of the lessor 
and the lessee (and the common parent company if a consolidated return 
is filed);
    (B) The service center with which the income tax returns of the 
lessor and lessee are filed;
    (C) A description of each property with respect to which the 
election is made;
    (D) The date on which the lessee places the property in service 
(determined as defined in Sec. 5c.168(f)(8)-6(b)(2)(i)), the date on 
which the lease begins, and the term of the lease;
    (E) The recovery property class of the leased property under section 
168(c)(2) (for example, 5 years) and the ADR midpoint life of the leased 
property;
    (F) The terms of the payments between the parties to the lease 
transaction;
    (G) Whether the ACRS deductions and the investment tax credit are 
allowable to the same taxpayer;
    (H) The aggregate amount paid to outside parties to arrange or carry 
out the transaction, such as, for example, legal and investment banking 
fees;
    (I) For the lessor only: The unadjusted basis of the property as 
defined in section 168(d)(1);
    (J) For the lessor only: If the lessor is a partnership or a grantor 
trust, the name, address, and taxpayer identifying number of the 
partners or the beneficiaries, and the Service Center with which the 
income tax return of each partner or beneficiary is filed; and
    (K) Such other information as may be required by the return or its 
instructions.

The aggregate amount paid to outside parties which is described in 
paragraph

[[Page 83]]

(a)(3)(i)(H) of this section need not be disclosed unless it is 
reasonable to estimate that either the lessor or the lessee will lease 
property under section 168(f)(8) for the calendar year which has an 
aggregate adjusted basis to such person of more than $1,000,000. If 
either the lessor or the lessee reasonably expects to lease property 
with an aggregate basis of more than $1,000,000, then both parties must 
disclose their transaction costs.
    (ii) In the case of an agreement executed before January 1, 1982, 
only the lessor is required to file the information return described in 
paragraph (a)(3)(i) of this section and the return must be postmarked 
not later than January 31, 1982. Unless the failure to file timely is 
shown to be due to reasonable cause, or unless the lessee files the 
information return postmarked by January 31, 1982, the lessor's failure 
to file the information return timely shall be a disqualifying event as 
of February 1, 1982, which shall cause an agreement to cease to be 
treated as a lease under section 168(f)(8). For the Federal income tax 
consequences of a disqualifying event, see Sec. 5c.168(f)(8)-8.
    (iii) A copy of the information return described in paragraph (a)(3) 
(i) and (ii) shall be filed by each party with its timely filed Federal 
income tax return for its taxable year during which the lease term 
begins. However, for taxable years ending in 1981 with respect to lease 
agreements executed during calendar year 1981, such statement shall be 
filed by the later of (A) the due date (taking extensions into account) 
of the party's 1981 Federal income tax return, or (B) where the filing 
of an amended return is required, with the amended return within 3 
months following the execution of the lease agreement. For the 
requirement to file an amended return within 3 months and the 
consequences of the failure to so file, see Sec. 5c.168(f)(8)-
6(b)(2)(ii). A taxpayer that is required to file the information return 
with its Federal income tax return before an information return form is 
available shall file, in lieu of the required information return, a 
statement which contains the information set forth in subparagraphs (A) 
through (J) of pargraph (a)(3)(i). The failure by the lessor to file the 
information return (or, if applicable, the statement referred to in the 
preceding sentence) with its timely filed Federal income tax return 
shall be a disqualifying event which shall cause an agreement to cease 
to be treated as a lease under section 168(f)(8). For the Federal income 
tax consequences of a disqualifying event, see Sec. 5c.168(f)(8)-8.
    (4) Election is irrevocable. An agreement made pursuant to paragraph 
(a)(2) of this section shall be irrevocable as of the later of the date 
such agreement was executed or November 23, 1981.
    (5) Disposition by lessee. Except in the case of transactions 
described in subparagraph (6), of this paragraph, if the lessee (or any 
transferee of the lessee's interest) sells or assigns its interest in 
the lease or in the property, the agreement will cease to be 
characterized as a lease under section 168(f)(8) as of the time of the 
sale or assignment unless the transferee furnishes to the lessor within 
60 days following the transfer the transferee's written consent to take 
the property subject to the lease, and the transferee and lessor file a 
statement with their timely filed Federal income tax returns for the 
taxable year in which the transfer occurs containing the following 
information:
    (i) The name, address, and taxpayer identifying number of the lessor 
and the transferee;
    (ii) The district director's office with which the income tax 
returns of the lessor and transferee are filed;
    (iii) A description of the property; and
    (iv) Confirmation of the transferee's consent.

See Sec. 5c.168(f)(8)-8 for the Federal income tax consequence where an 
agreement ceases to be characterized as a lease under section 168(f)(8).
    (6) Disposition of lessee's interest in bankruptcy, etc., or similar 
proceeding. In the case of an agreement executed after May 31, 1982, 
where the lessee's interest in the lease or in the property is sold or 
assigned in a bankruptcy, liquidation, receivership, a court-supervised 
foreclosure, or in any similar proceeding for the relief or protection 
of insolvent debtors in Federal or State court, the agreement will 
continue to

[[Page 84]]

be characterized as a lease under section 168(f)(8) and the purchaser or 
assignee shall take the property subject to the lease if--
    (i) Prior to the consummation of the sale or assignment, the lessor 
gives written notice of its Federal income tax ownership to the judicial 
or administrative body having jurisdiction over the proceeding and to 
the debtor in possession of the interest or, if at such time a trustee, 
receiver or similar person has been appointed by the court, to the 
person appointed. The notice must contain a request that the court and 
the debtor or the person appointed provide a copy of the notice to the 
purchaser or assignee prior to the consummation of the sale or 
assignment. Within 60 days following the sale or assignment, the lessor 
must provide notice of its Federal income tax ownership and copies of 
the lease agreement, and, in the case of a sale and leaseback 
transaction, the lessor's purchase money obligation, to the purchaser or 
assignee;
    (ii) The lessor files a statement with its timely filed Federal 
income tax return for the taxable year in which the sale or assignment 
occurs containing the following information:
    (A) The name, address, and taxpayer identifying number of the lessor 
and the purchaser or assignee;
    (B) The district director's office with which the Federal income tax 
returns of the lessor and purchaser or assignee are filed;
    (C) A description of the property; and
    (iii) Prior to the consummation of the sale or assignment, all 
secured lenders of the lessee with interests in the property, which 
interests arose not later than the time the lessee first used the 
property under the lease (and which were perfected in accordance with 
applicable local law), specifically either exclude or release in writing 
the Federal income tax ownership of the property from their interests.

The purchaser or assignee of the interest with respect to which this 
paragraph applies shall file a statement with its timely filed Federal 
income tax return for the taxable year in which the sale or assignment 
occurs containing the information described in subdivision (ii) of this 
subparagraph. If the interest is subsequently transferred (other than in 
a bankruptcy, liquidation, receivership, court-supervised foreclosure, 
or similar proceeding) during the term of the lease, the agreement will 
continue to be characterized as a lease under section 168(f)(8) and the 
transferee will take the property subject to the lease if either (A) the 
lessor gives the transferee, prior to the transfer, a copy of the lease, 
written notice of its Federal income tax ownership, and, in the case of 
a sale and leaseback transaction, a copy of the lessor's purchase money 
obligation, and the lessor files a statement with its timely filed 
Federal income tax return as described in subdivision (ii) of this 
subparagraph, or (B) within 60 days following the transfer, the 
transferee agrees in writing to take the property subject to the lease 
and the lessor and transferee file a statement with their timely filed 
Federal income tax returns within the time and in the manner described 
in paragraph (a)(5) of this section. However, an agreement will not 
continue to be characterized as a lease under this subparagraph if, 
under another applicable provision, it would cease to be characterized 
as a lease. See Sec. 5c.168(f)(8)-8 for the Federal income tax 
consequences where an agreement ceased to be characterized as a lease 
under section 168(f)(8).
    (7) Consequences of taking the property subject to the lease 
agreement. For purposes of Secs. 5c.168(f)(8)-1 through 5c168(f)(8)-11, 
in a situation where a transferee of a lessee's interest acquires the 
property subject to the lease, the transferee shall be deemed to have 
acquired a leasehold interest in the property equal to the remaining 
lease term, any unpaid obligation of the lessor arising in connection 
with the sale of the property by the original lessee in a sale and 
leaseback transaction, and any option of the lessee to purchase the 
property. Any consideration paid by the transferee for the property 
shall be allocated to the lessor's obligation to the extent of the 
unpaid balance of the obligation. Any excess over the unpaid balance 
shall be

[[Page 85]]

allocated between the leasehold interest and the purchase option in 
proportion to their relative fair market values. As the new lessee, the 
transferee shall not be entitled to claim any ACRS deduction with 
respect to the property while the lease remains in effect and shall not 
be entitled to any investment tax credit with respect to the property. 
The transferee shall report interest income on the lessor's obligation, 
and shall be entitled to deduct the rent paid under the lease, in 
accordance with Sec. 5c.168(f)(8)-7. In addition, the transferee shall 
be entitled to amortize the portion of its cost allocable to the 
leasehold interest. Coversely, as long as the lease remains in effect, 
the lessor will continue to be recognized as the owner of the property 
for Federal income tax purposes, shall be required to report rents due 
under the lease, and shall be entitled to deduct interest on its 
obligation.
    (8) Election to treat certain leases under subparagraph (6) rules. 
The lessor under a section 168(f)(8) lease executed on or before May 31, 
1982, may elect to have the provisions of paragraph (a)(6) of this 
section apply in the case of a sale or assignment of the lessee's 
interest in the lease or in the property in a bankruptcy, receivership, 
liquidation, court-supervised foreclosure, or similar proceeding. The 
election of the lessor with respect to any leased property may be made 
at any time prior to the consummation of any sale or assignment of such 
property in a bankruptcy, etc., or similar proceeding, by complying with 
the provisions of subparagraph (6) of this paragraph.
    (b) Examples. The application of the provisions of this section may 
be illustrated by the following examples:

    Example (1). X Corp. maintains its books and records for Federal tax 
law purposes on a calendar year basis. On February 1, 1981, X acquires 
certain equipment for use in its business, and the equipment is deemed 
to be placed in service on that date within the meaning of 
Sec. 5c.163(f)(8)-6(b)(2)(i). On November 1, 1981, X sells the equipment 
to Y and leases it back under a lease in which the parties elect to have 
the provisions of section 168(f)(8) apply. The election is considered 
timely for purposes of making Y the owner of the property under section 
168(f)(8) since the lease agreement was executed before November 14, 
1981.
    Example (2). The facts are the same as in example (1) except that X 
Corp.'s taxable year ends on February 28, 1981. X claimed the investment 
tax credit and depreciation deductions with respect to the property in 
its return filed April 1, 1981. The lease will qualify for safe harbor 
treatment under section 168(f)(8) provided X, within 3 months after the 
lease agreement was executed, files an amended return pursuant to 
Sec. 5c.168(f)(8)-6(b)(2)(ii) for its taxable year ending February 28, 
1981, in which X foregoes its right to claim any investment tax credit 
or ACRS deductions with respect to the property subject to the lease.
    Example (3). X Corp. (as lessee) sells certain new equipment to Y 
Corp. (as lessor) and leases it back under a section 168(f)(8) lease. 
During the term of the lease X sells its interest in the property to T 
Corp. (other than in a bankruptcy or similar proceeding), and T does not 
give Y a written consent to take the property subject to the leased. The 
agreement ceases to be treated as a lease under section 168(f)(8) as of 
the date of the sale.
    Example (4). The facts are the same as in example (3) except that 
the sale of the property takes place while X is under the jurisdiction 
of a court in a bankruptcy proceeding. All lenders of X having perfected 
interests in the property that arose by the time the property was first 
used under the lease have specifically either excluded or released the 
ownership of the property for Federal income tax purposes from their 
interests. Within the required time periods, Y gives appropriate 
notification to the court, the bankruptcy trustee, and T that the 
property is subject to the lease and files the required statement with 
its Federal income tax return for the taxable year in which the sale 
occurs. The agreement continues to be treated as a lease under section 
168(f)(8). T will take the property subject to the lease. T must 
allocate the purchase price among the lessor's note, the leasehold 
interest, and the option (if any) to purchase the property.
    Example (5). The facts are the same as in example (4), except that 
one lender of X having a perfected and timely interest in the property 
does not specifically exclude or release the Federal income tax 
ownership of the property from its interest. The agreement will cease to 
be treated as a lease under section 168(f)(8) as of the date of the 
transfer to T. The result would be the same if Y failed to furnish any 
of the notices required by subdivision (i) of paragraph (a) and (6) or 
failed to file a statement as required by subdivision (ii) of paragraph 
(a)(6).
    Example (6). The facts are the same as in example (4). In addition, 
during the term of the lease T transfers the property to U Corp. and Y 
fails to furnish U with written notice that the property is subject to 
the lease prior to the sale and U refuses to agree to

[[Page 86]]

consent to the lease agreement. The agreement will cease to be treated 
as a lease under section 168(f)(8) as of the date of the transfer to U. 
The result would be the same if Y furnished U with timely written notice 
of its tax ownership but failed to file the required statement with its 
tax return for its taxable year in which the sale occurred.

[T.D. 7791, 46 FR 51907, Oct. 23, 1981, as amended by T.D. 7795, 46 FR 
56148, Nov. 13, 1981; T.D. 7800, 46 FR 63257, Dec. 31, 1981]



Sec. 5c.168(f)(8)-3  Requirements for lessor.

    (a) Qualified lessor. In order for an agreement to be treated as a 
lease under section 168(f)(8), the party characterized in the agreement 
as the lessor must be a qualified lessor. The term ``qualified lessor'' 
means--
    (1) A corporation which is neither an electing small business 
corporation under section 1371(b) nor a personal holding company under 
section 542(a), or
    (2) A partnership all of whose partners are corporations described 
in subparagraph (1), or
    (3) A grantor trust whose grantor and beneficiaries are all 
corporations described in paragraph (a)(1) or partnerships described in 
paragraph (a)(2).
    (b) Effect of disqualification of lessor. If at any time during the 
term of the agreement the lessor ceases to be a qualified lessor, the 
agreement will lose its characterization as a lease under section 
168(f)(8) as of the date of the event causing such disqualification. If 
any partner of a partnership described in paragraph (a)(2) ceases to be 
a corporation described in paragraph (a)(1), the partnership entity 
shall cease to be a qualified lessor. Similarly, if any beneficiary of a 
trust described in paragraph (a)(3) ceases to be a corporation described 
in paragraph (a)(1), the trust shall cease to be a qualified lessor. See 
Sec. 5c.168(f)(8)-8 for the Federal income tax consequences of such a 
disqualification.
    (c) One tax owner per property. Only one person may be a qualified 
lessor under section 168(f)(8) with respect to leased property. Thus, 
property that is subject to a lease under section 168(f)(8) may not be 
subleased under a lease for which a section 168(f)(8) election is made. 
In addition, if a lessor sells or assigns in a taxable transaction its 
interest in a section 168(f)(8) lease or in the underlying property, the 
lease shall cease to qualify under section 168(f)(8) and no other lease 
may be executed under section 168(f)(8) with respect to the property. 
The preceding sentence applies to a sale or assignment of its interest 
by a partner of a lessor that is a partnership described in paragraph 
(a)(2) of this section or by a beneficiary of a lessor that is a trust 
described in paragraph (a)(3) of this section. See Sec. 5c.168(f)(8)-8 
for the Federal income tax consequences where a lease ceases to qualify 
under section 168(f)(8). However, lease brokers, agents, etc., may, for 
example, prepare executory contracts with the lessee whereby the 
broker's assignee may execute a lease as lessor, and, if the 
requirements of section 168(f)(8) and Secs. 5c.168(f)(8)-1 through 
5c.168(f)(8)-11 are met, the lease will qualify under section 168(f)(8).
    (d) Examples. The application of paragraph (c) may be illustrated by 
the following examples:

    Example (1). X Corp. (as lessee) sells certain new equipment to Y 
Corp. (as lessor) and leases it back under a section 168(f)(8) lease. 
Within 3 months after the property was placed in service, Y assigns its 
interest in the lease to Z. Upon the transfer to Z, the lease will no 
longer qualify for treatment under section 168(f)(8). The property may 
not thereafter be the subject of a section 168(f)(8) lease.

    Example (2). X Corp., which wishes to acquire certain equipment for 
use in its business and to transfer ownership of the property for 
Federal income tax law purposes, purchases the equipment and enters into 
an executory contract with LB, a lease broker, under which X agrees to 
execute a section 168(f)(8) lease as lessee with a third party lessor. 
At a later date (but within the prescribed 3-month period), LB arranges 
for X and T Corp. (which wishes to secure Federal income tax law 
ownership) to execute a lease agreement in accordance with 
Sec. 5c.168(f)(8)-2. The lease will qualify for treatment under section 
168(f)(8).

[T.D. 7791, 46 FR 51907, Oct. 23, 1981, as amended by T.D. 7795, 46 FR 
56149, Nov. 13, 1981]



Sec. 5c.168(f)(8)-4  Minimum investment of lessor.

    (a) Minimum investment. Under section 168(f)(8)(B)(ii), an agreement 
will

[[Page 87]]

not be characterized as a lease for purposes of section 168(f)(8) unless 
the qualified lessor has a minimum at risk investment which, at the time 
the property is placed in service under the lease and at all times 
during the term of the lease, is not less than 10 percent of the 
adjusted basis of the leased property. As the adjusted basis of the 
leased property is reduced by capital cost recovery deductions, the 
minimum investment required will also be reduced to 10 percent of the 
revised adjusted basis, until the adjusted basis has been completely 
recovered, at which time no minimum investment will be required. 
Financing provided by the lessee or a party related to the lessee, such 
as a recourse note given by the lessor to the lessee, will not be taken 
into account in determining the lessor's minimum investment.
    (b) At risk amount. The minimum investment which the lessor has at 
risk with respect to the leased property for purposes of paragraph (a) 
of this section includes only consideration paid and recourse 
indebtedness incurred by the lessor to purchase the property. The lessor 
must have sufficient net worth (without regard to the value of any 
leases which qualify under section 168(f)(8)) to satisfy any personal 
liability incurred. Any tax benefits which the lessor derives from the 
leased property shall not be taken into account to reduce the amount the 
lessor has at risk. An agreement between the lessor and the lessee 
requiring either or both parties to purchase or sell the qualified 
leased property at some price (whether or not fixed in the agreement) at 
the end of the lease term shall not affect the amount the lessor has at 
risk with respect to the property. However, an option held by the lessor 
to sell the property that is exercisable before the end of the period 
prescribed under section 168(c)(2) for the recovery property class of 
the leased property (taking into account any election by the lessor or 
lessee under section 168(b)(3)) shall reduce the amount the lessor is 
considered to have at risk by the amount of the option price at the time 
the option becomes exercisable.



Sec. 5c.168(f)(8)-5  Term of lease.

    (a) Term of lease--Basic rules. To qualify as a lease under section 
168(f)(8) and Sec. 5c.168 (f)(8)-1 (a), the lease agreement must provide 
for a term that does not exceed the maximum term described in paragraph 
(b) of this section; such term must also at least equal the minimum term 
described in paragraph (c).
    (b) Maximum term. For purposes of section 168(f)(8)(B)(iii) and this 
section, the term of the lease may not exceed the greater of--
    (1) 90 percent of the useful life of the property under section 167, 
or
    (2) 150 percent of the asset depreciation range (ADR) present class 
life (``midpoint'') of such property, applicable as of January 1, 1981 
(without regard to section 167(m)(4)), published in Rev. Proc. 77-10, 
1977-1 C. B. 548, and revisions thereto.

Solely for purposes of this paragraph (b), ``useful life'' means the 
period when the leased asset can reasonably be expected to be 
eonomically useful in anyone's trade or business; such term does not 
mean the period during which the lessor expects to lease the property. 
Any option to extend the term of the lease, whether or not at fair 
market value rent, must be included in the term of the lease for 
purposes of this paragraph. If several different pieces of property are 
the subject of a single lease, the maximum allowable term for such lease 
will be measured with respect to the property with the shortest life. In 
no case, however, will the lease term qualify under this section if such 
term with respect to any piece of property is less than the minimum term 
described in paragraph (c).
    (c) Minimum term. For purposes of this section, the term of the 
lease must at least equal the period prescribed under section 168(c)(2) 
for the recovery property class of the leased property. For example, if 
a piece of leased equipment is in the 5-year recovery property class, 
the lease agreement must have a minimum term of 5 years. In general, the 
determination of whether property is 3-year recovery property, 5-year 
recovery property, etc., in the hands of the lessor will be based on the 
characterization of the property in the hands of the owner as determined 
without regard to the section 168(f)(8) lease. Thus,

[[Page 88]]

for example, property which is public utility property or RRB 
replacement property absent the section 168(f)(8) lease will be 
characterized as such in the hands of the lessor for purposes of section 
168(f)(8). However, with respect to RRB replacement property, the 
transitional rule of section 168(f)(3) shall be inapplicable to the 
lessor. In addition, any election under section 168(b)(3) by the lessor 
with respect to the class of recovery property to which the qualified 
leased property is assigned shall apply to the leased property in 
determining the term of the lease. A lease term that does not exceed the 
term required to satisfy the minimum lease term of this paragraph will 
be deemed to comply with the maximum lease term described in paragraph 
(b) if such minimum lease term exceeds such maximum lease term.
    (d) Examples. The application of this section may be illustrated by 
the following examples:

    Example (1). X Corp. (as lessee) and Y Corp. (as lessor) enter into 
a lease which they elect to be treated under section 168(f)(8) with 
respect to a chemical manufacturing facility that will also generate 
steam for use in the production of electricity. The assets comprising 
the chemical plant are described in ADR guideline class 28.0 (midpoint 
life of 9.5 years), and the assets comprising the steam plant are 
described in ADR class 00.4 (midpoint life of 22 years). To satisfy the 
maximum lease term requirement of section 168(f)(8)(B)(iii)(II) and 
Sec. 5c.168 (f)(8)-5(b), the lease term may not exceed 14.25 years (150 
percent of the 9.5 year midpoint life of the chemical plant).
    Example (2). The facts are the same as in example (1) except that 
the chemical plant and the steam plant are the subject of separate 
leases. For purposes of section 168(f)(8)(B)(iii)(II) and 
Sec. 5c.168(f)(8)-5 (b), the maximum term of the lease with respect to 
the chemical plant is 14.25 years (150 percent of 9.5 years) and the 
maximum term of the lease with respect to the steam plant is 33 years 
(150 percent of 22 years).

[T.D. 7791, 46 FR 51907, Oct. 23, 1981; 50 FR 13020, Apr. 2, 1985]



Sec. 5c.168(f)(8)-6  Qualified leased property.

    (a) Basic rules--(1) In general. An agreement shall be treated as a 
section 168(f)(8) lease only if the property which is leased is 
qualified leased property. Qualified leased property is recovery 
property as defined in section 168(c) and is either--
    (i) Except as provided in subparagraph (2), new section 38 property 
of the lessor which is leased no later than 3 months after the date the 
property was placed in service (or prior to November 14, 1981, if the 
property was placed in service after December 31, 1980, and before 
August 14, 1981) and which, if acquired by the lessee, would have been 
new section 38 property of the lessee, or
    (ii) Property which is a qualified mass commuting vehicle (as 
defined in section 103(b)(9)) and which is financed in whole or in part 
by proceeds from an issue of obligations the interest on which is 
excludable from income under section 103(a).
    (2) Sale and leaseback arrangement. (i) Where the leased property is 
purchased, directly or indirectly, by the lessor from the lessee (or a 
party related to the lessee), the property will not be qualified leased 
property unless the property was (or would have been) new section 38 
property of the lessee and was purchased and leased no later than 3 
months after the date the property was placed in service by the lessee 
(or prior to November 14, 1981, if the property was placed in service by 
the lessee after December 31, 1980 and before August 14, 1981) and with 
respect to which the lessor's adjusted basis does not exceed the 
adjusted basis of the lessee (or a party related to the lessee) at the 
time of the lease. If the lessor's adjusted basis in the property 
exceeds the seller's adjusted basis with respect to the property at the 
beginning of the lease, the property will not be qualified leased 
property.
    (ii) For purposes of this paragraph (a)(2) and paragraph (b)(3)(ii) 
of this section, transactional costs with respect to a sale and 
leaseback arrangement that are not currently deductible shall be 
allocated to the lease agreement (and not included in the lessor's 
adjusted basis with respect to the property) and amortized over the term 
of the lease. These costs include legal and investment banking fees and 
printing costs.
    (iii) The application of this paragraph (a)(2) may be illustrated by 
the following examples:


[[Page 89]]


    Example (1). X, an airline, contracts to have an airplane 
constructed for a fixed price of $10 million. Prior to completion of 
construction of the airplane, the value of the airplane increases to $11 
million. X buys the airplane at the contract price of $10 million and, 
before it is placed in service, sells the airplane at its fair market 
value of $11 million to Y and then leases it back. The lease will not 
qualify for safe harbor protection under section 168(f)(8) because the 
lessor's adjusted basis in the airplane exceeds the lessee's adjusted 
basis. This result obtains even though the airplane qualifies as new 
section 38 property of X airline.
    Example (2). Assume the same facts as in example (1) except that, 
prior to completion of the construction of the airplane, X assigns its 
contract to Y for $1 million, and Y thereafter buys the airplane at the 
contract price of $10 million. The acquisition by Y is treated as an 
indirect purchase from the lessee. Because Y's adjusted basis in the 
airplane would exceed the lessee's adjusted basis, the lease will not 
qualify under section 168(f)(8).

    (b) Special rules--(1) New section 38 property. (i) New section 38 
property is section 38 property described in subsection (b) of section 
48 and the regulations thereunder other than a qualified rehabilitated 
building (within the meaning of section 48(g)(1)). Qualified leased 
property must be new section 38 property at the beginning of the lease 
and must continue to be section 38 property in the hands of the lessor 
and the lessee throughout the lease term. The fact that the lessee used 
the property within the 3-month period prior to the lease will not 
disqualify the property as new section 38 property of the lessee.
    (ii) The application of this paragraph (b)(1) may be illustrated by 
the following examples:

    Example (1). N is a hospital exempt from Federal income tax and 
wishes to purchase certain equipment for use in furtherance of its 
exempt functions (i.e., other than for use in an unrelated trade or 
business). O, a qualified lessor as defined in Sec. 5c.168(f)(8)-3(a), 
acquires the property and leases it to N. Since the equipment would not 
be new section 38 property of N if N had acquired it by virtue of 
section 48(a)(4) (relating to exception from definition of section 38 
property for certain property used by certain tax-exempt organizations), 
the equipment is not qualified leased property and the lease does not 
qualify under section 168(f)(8). Whether O is considered the owner of 
the property for Federal tax law purposes will be determined without 
regard to the provisions of section 168(f)(8).
    Example (2). P Corp. is constructing progress expenditure property 
as defined in section 46(d)(2) for R Corp. Progress expenditure property 
is property which it is reasonable to believe will be section 38 
property in the hands of the taxpayer when it is placed in service. 
Before the date that the property is placed in service (as defined in 
Sec. 5c.168(f)(8)-6(b)(2)(i)), the property is not new section 38 
property. Accordingly, progress expenditure property cannot be qualified 
leased property.
    Example (3). R Corp., a foreign railroad, acquires new rolling stock 
and enters into a sale and leaseback transaction with B Corp., a 
domestic corporation. R uses the rolling stock within and without the 
United States, but predominantly outside the United States within the 
meaning of section 48(a)(2)(A). Section 48(a)(2)(B)(ii) is inapplicable 
to R because R is neither a domestic railroad corporation nor a United 
States person; therefore, the rolling stock cannot be section 38 
property to R. The property is not qualified leased property.

    (2) Placed in service. (i) Property shall be considered as placed in 
service at the time the property is placed in a condition or state of 
readiness and availability for a specifically assigned function. If an 
entire facility is leased under one lease, property which is part of the 
facility will not be considered placed in service under this rule until 
the entire facility is placed in service. If the lessee claims any 
investment tax credit or ACRS deductions with respect to any component 
which is part of an entire facility that is subsequently leased, the 
lessee must file an amended return within the time prescribed in 
paragraph (b)(2)(ii) of this section in which it foregoes its claim to 
the investment tax credit and ACRS deductions. If such amended return 
may not be filed because the time for filing a claim for refund with 
respect to any component under section 6511 has expired, each component 
of the facility will be considered as placed in service at the time the 
individual component is placed in a condition or state of readiness and 
availability for a specifically assigned function and not when the 
entire facility is placed in service.
    (ii) For purposes other than determining whether property is 
qualified leased property, property subject to a lease under section 
168(f)(8) will be deemed to have been placed in service not earlier than 
the date such property is used under the lease. If the lessee

[[Page 90]]

claims any investment tax credit or ACRS deductions with respect to 
property placed in service under a lease, the lessee must file an 
amended return within 3 months following the execution of the lease 
agreement in which the lessee foregoes its claim to the investment tax 
credit and ACRS deductions with respect to the leased property or the 
election under section 168(f)(8) will be void.
    (iii) The application of this paragraph (b)(2) may be illustrated by 
the following examples:

    Example (1). X Corp. acquires equipment on December 31, 1982, and 
places the equipment in service. X's taxable year ends December 31. On 
March 20, 1983, X sells the equipment to Y Corp. and leases it back in a 
transaction that qualifies under section 168(f)(8). The property is 
considered to be new section 38 property to X under paragraph (b)(1). X 
is not allowed any investment tax credit or ACRS deductions with respect 
to the property in 1982 because the property is not considered to have 
been placed in service for purposes other than determining whether it is 
qualified leased property until it is used under the lease under 
subdivision (ii) of this subparagraph (2). If X has claimed credits or 
deductions on its 1982 return, it must file an amended return for 1982 
within 3 months following the execution of the lease agreement or the 
election will be void.
    Example (2). In March 1985, K Corp. completes reconditioning of a 
machine, which it constructed and placed in service in 1982 and which 
has an adjusted basis in 1985 of $10,000. The cost of reconditioning 
amounts to an additional $20,000. K would be entitled to a basis of 
$20,000 in computing its qualified investment in new section 38 property 
for 1985. In May 1985, K enters into a sale and leaseback transaction 
with L Corp. with respect to the reconditioned parts of the machine that 
are new section 38 property to K. K and L elect to have section 
168(f)(8) apply. Assuming that the adjusted basis of the leased property 
is the same to L as it is to K, the property qualifies as qualified 
leased property under section 168(f)(8)(D)(ii) and L is considered the 
tax owner of the property. Since, for purposes other than determining 
whether property is qualified leased property, the property is deemed 
originally placed in service not earlier than the date the property is 
used under the lease, the property is new section 38 property to L and L 
may claim the investment tax credit (and ACRS deductions) with respect 
to the leased property.

    (3) Qualified mass commuting vehicle. (i) A qualified mass commuting 
vehicle as defined in section 103(b)(9) will constitute qualified leased 
property for purposes of section 168(f)(8)(D)(iii) and this section 
provided all of the following requirements are met:
    (A) At least part (as, for example, 5 percent) of the financing for 
the purchase of such vehicle must be derived from proceeds of 
obligations the interest on which is excludable from income under 
section 103(a)(1) (whether or not such obligations are described in 
section 103(b)(4)(I));
    (B) The vehicle must be recovery property (i.e., it must have been 
first placed in service by the lessee after December 31, 1980); and
    (C) The vehicle must not have been previously leased under a section 
168(f)(8) lease by the lessee.

A qualified mass commuting vehicle that is qualified leased property may 
be leased under section 168(f)(8) at any time after December 31, 1980. 
The requirement of paragraph (b)(3)(i)(A) of this section may be 
satisfied where the vehicles leased under a section 168(f)(8) lease are 
refinanced with proceeds of an obligation the interest on which is 
excludable from income under section 103(a)(1).
    (ii) Where the leased property is purchased, directly or indirectly, 
by the lessor from the lessee (or a party related to the lessee), the 
property will not qualify under this subsection unless the lessor's 
adjusted basis in the property does not exceed the adjusted basis of the 
lessee (or related party) at the time of the execution of the lease. The 
adjusted basis of property to a lessee (or related party) shall be 
determined under Part II of Subchapter O of Chapter I of the Code for 
purposes of determining gain, except that the adjustment described in 
section 1016(a)(3) and Sec. 1.1016-4 need not be made for property 
acquired during calendar year 1981 and leased no later than March 1, 
1982.
    (iii) In a transaction characterized as a lease under section 
168(f)(8), the lessor's adjusted basis may not include that portion, if 
any, of the cost of the vehicle to the lessee (or related party) that is 
financed, directly or indirectly, with an Urban Mass Transportation

[[Page 91]]

Administration (UMTA) grant (excluding a grant under the interstate 
transfer provision of the Federal-Aid Highway Act (FAHA)), a FAHA grant, 
or any other Federal grant. Where a vehicle is included as part of an 
UMTA-funded project, 80 percent of the vehicle's cost will be deemed to 
be financed with an UMTA grant and 20 percent will be deemed to be 
financed from non-Federal sources without regard to whether the UMTA 
funds or the non-Federal funds are traceable to any particular vehicle 
included within the project. For purposes of this subparagraph and 
paragraph (b)(3)(ii) of this section, amounts originating from non-
Federal sources which are paid or incurred with respect to leased 
property by a State or political subdivision of the State (or political 
subdivision created by the joint authorization of two or more States) 
shall be taken into account in computing the lessee's adjusted basis in 
the leased property as if the lessee had paid or incurred such amounts.
    (iv) If a vehicle is purchased pending approval of an UMTA grant, 
the lessor's unadjusted basis in the vehicle may equal the lessee's 
unadjusted basis unreduced by any subsequently approved UMTA grant; 
however, if an UMTA grant is later approved and the vehicle is included 
as part of an UMTA-funded project, except as provided hereinafter in 
this subparagraph, the lease shall terminate with respect to an 
undivided 80 percent interest in the vehicle. For the Federal income tax 
consequences of the termination of a lease, see Sec. 5c.168(f)(8)-8. If 
such a subsequently approved UMTA grant is used to purchase additional 
qualified mass commuting vehicles, the portion of each vehicle deemed to 
be allocable to non-UMTA financing (i.e., 20 percent) may be leased 
under section 168(f)(8). If a vehicle is purchased pending approval of 
an UMTA grant and leased under section 168(f)(8), the lease will not be 
deemed to have terminated with respect to 80 percent of the vehicle when 
the UMTA grant is later approved if the total interest leased before the 
grant is approved did not exceed 20 percent of the lessee's adjusted 
basis in the vehicle (unadjusted basis prior to March 1, 1982) unreduced 
by any subsequently approved UMTA grant. For purposes of this 
subparagraph and paragraph (b)(3)(iii) of this section, the allocation 
principles applicable to UMTA grants shall apply in the case of FAHA 
grants except that 85 percent and 15 percent shall be substituted for 80 
percent and 20 percent, respectively. Similar allocation rules shall 
also apply to other Federal grants used to finance the acquisition of 
qualified mass commuting vehicles.
    (v)(A) Notwithstanding the provisions of Sec. 5c.168(f)(8)-
2(a)(3)(iii), the lessee in a transaction to which this paragraph (b)(3) 
applies is not required to file an information return or a statement 
concerning its election under section 168(f)(8).
    (B) Notwithstanding the provisions of Sec. 5c.168(f)(8)-2(a)(5), if 
the transfer of a qualified mass commuting vehicle is not otherwise a 
disqualifying event, the transferee is not required to file the 
statement mentioned therein.
    (C) The fact that a qualified mass commuting vehicle is not section 
38 property because it is used by an exempt entity will not disqualify 
the lease under Sec. 5c.168(f)(8)-8(b)(4); however, a disqualifying 
event will occur, and the agreement will cease to be characterized as a 
lease under section 168(f)(8), with respect to a vehicle which (1) 
ceases to be a qualified mass commuting vehicle or (2) would cease to be 
section 38 property if used by a taxable entity as, for example, a 
vehicle used predominantly outside the United States. For the Federal 
income tax consequences of a disqualifying event, see Sec. 5c.168(f)(8)-
8.
    (vi) The lessor of a qualified vehicle will not be allowed an 
investment tax credit with respect to it under section 38.
    (vii) The application of this paragraph (b)(3) may be illustrated by 
the following examples:

    Example (1). On July 1, 1981, a unit of city X, X Transit Authority 
(XTA), purchases 100 buses after receiving an UMTA grant for 80 percent 
of their purchase price. Fifteen percent of the purchase price is 
financed with a combination of State and local governmental grants and 5 
percent is financed with proceeds from an issue of tax-exempt 
obligations described in section 103(b)(4)(I). Because UMTA financed an 
80 percent interest

[[Page 92]]

in the 100 buses, XTA may lease under section 168(f)(8) only a 20 
percent interest in each bus. If XTA were to lease 100 percent of 20 
buses, only 20 percent of such buses would be deemed to be leased under 
a safe harbor lease.
    Example (2). The facts are the same as in example (1) except that 
UMTA has not yet approved XTA's application in 1981. Pending the UMTA 
approval, XTA purchases and places in service 20 buses in July 1981. The 
20 buses are financed with tax-exempt obligations described in section 
103(b)(4)(I). On December 15, 1981, XTA sells a 100 percent interest in 
these 20 buses to Corporation M and leases them back under a lease in 
which the parties elect to have the provisions of section 168(f)(8) 
apply. M is a calendar-year taxpayer and claims an ACRS deduction with 
respect to the buses on its return for taxable year 1981. On July 1, 
1982, UMTA approves XTA's grant application, thus enabling XTA to 
purchase an additional 80 buses. Because 80 percent of the original 20 
buses are deemed to have been financed by UMTA beginning on July 1, 
1982, the safe harbor lease terminates with respect to an undivided 80 
percent interest in the 20 buses. If XTA would be considered the owner 
of the buses without regard to section 168(f)(8), the termination will 
result in a deemed sale of an undivided 80 percent interest in the 20 
buses by M to XTA. The amount realized by M on the sale will include a 
proportionate part of the outstanding amount of M's debt plus the sum of 
any other consideration received by M. M will realize gain or loss, 
depending upon its basis, with applicable section 1245 recapture. 
However, XTA may lease the 20 percent interest in the 80 new buses it 
purchased in 1982 which is deemed to have been financed with non-Federal 
funds.
    Example (3). The facts are the same as in example (2) except that 
the grant approved by UMTA is used to purchase and renovate a bus garage 
facility. Eighty percent of the original 20 buses are deemed to have 
been financed by UMTA beginning on July 1, 1982. The lease would still 
terminate with respect to an undivided 80 percent interest in the 
vehicles. XTA cannot lease the garage facility under 168(f)(8) because 
it does not constitute a qualified mass commuting vehicle.
    Example (4). The facts are the same as in example (2) except that on 
December 15, 1981, XTA sells and leases back only a 20 percent interest 
in the 20 buses acquired in July 1981. When the UMTA grant is later 
approved, the lease will not terminate with respect to any portion of 
the 20 buses. In addition, XTA may lease the 20 percent interest in the 
80 new buses purchased in 1982 and deemed to have been financed with 
non-Federal funds.
    Example (5). On August 1, 1982, UMTA approves a grant for a major 5-
year capital expenditure program to improve city Y's rapid rail transit 
system. None of the funds relating to this UMTA-funded project, provided 
either by UMTA or by city Y, will be used to purchase qualified mass 
commuting vehicles. Instead, a number of rapid rail cars and buses will 
be purchased entirely with funds provided with a combination of grants 
by the State and city governments and of proceeds from an issue of tax-
exempt obligations described in section 103(a). Because none of the 
rapid rail cars and buses are included as part of the UMTA-funded 
project, no part of them is deemed to be financed by UMTA. If at least 5 
percent of the cost of the qualified mass commuting vehicles is provided 
by tax exempt obligations under section 103(a), the vehicles will be 
qualified leased property in their entirety.
    Example (6). City Z has a mass transit agency (ZTA) which purchases 
on July 1, 1982, 10 buses for which it pays $1,000,000, 95 percent of 
which is derived from grants from city Z and 5 percent from tax exempt 
obligations described in section 103(a). The buses have a useful life 
within the meaning of Sec. 1.167(a)-1(b) of 10 years and their salvage 
value is zero. On July 1, 1983, ZTA sells these buses to corporation P 
and leases them back in a transaction which the parties elect to have 
treated as a lease under section 168(f)(8). At the time of the sale and 
leaseback, ZTA's adjusted basis in the 10 buses under section 1016(a)(3) 
and Sec. 1.1016-4 is $900,000 ($1,000,000 cost less $100,000 of 
depreciation sustained, computed on a stright-line basis). Before the 
transaction will qualify under section 168(f)(8) and Sec. 5c.168(f)(8)-
6(b)(3)(ii), P's adjusted basis in the vehicles may not exceed ZTA's 
basis, or $900,000. Assuming that the transaction qualifies under 
section 168(f)(8) and that corporation P is a calendar year taxpayer, P 
may claim ACRS deductions for 1982 of $135,000 (15 percent of $900,000).
    Example (7). The facts are the same as in example (6) except that 
the sale and leaseback transaction is closed on December 31, 1982. P's 
adjusted basis in the vehicles may not exceed ZTA's basis, or $950,000 
($1,000,000 cost less $50,000 of depreciation sustained, computed on a 
straight-line basis).
    Example (8). The facts are the same as in example (6) except that 
ZTA purchases the buses on June 1, 1981, and enters into the sale and 
leaseback transaction with corporation P on December 31, 1981. Under 
Sec. 5c.168(f)(8)-6(b)(3)(ii), no adjustment is made to ZTA's basis in 
the buses for depreciation sustained. Therefore, P's basis in the buses 
may equal ZTA's cost of $1,000,000.
    Example (9). On July 1, 1981, a unit of city W, W Transit Authority 
(WTA), purchases 100 buses with local grants derived entirely from a 
city W sales tax. The buses do not constitute qualified leased property 
under Sec. 5c.168(f)(8)-6(b)(3) because no part of the financing for 
their purchase was derived from the proceeds of tax exempt obligations.

[[Page 93]]

    Example (10). The facts are the same as in example (9) except that 
on November 1, 1981, WTA borrows 5 percent of the cost of the buses and 
pledges them as security. The interest on WTA's obligation is excludable 
from income under section 103(a)(1). On December 31, 1981, WTA sells to 
T Corp. all 100 buses and leases them back. Under Sec. 5c.168(f)(8)-
6(b)(3)(i), each bus is deemed to be financed with the proceeds of tax 
exempt obligations. Therefore, if the vehicles otherwise meet the 
definition of qualified leased property, all the vehicles will be 
qualified leased property under this section.

    (4) Foreign lessees. In addition to the other provisions of this 
section, property which is leased under a section 168(f)(8) lease to a 
foreign person shall not be qualified leased property unless the gross 
income attributable to the property from all sources (determined without 
regard to section 872(a) or 882(b)) is effectively connected with a 
trade or business within the United States, and the taxable income, if 
any, attributable to the property is subject to tax under section 
871(b)(1) or 882(a)(1). For this purpose, if income attributable to the 
property is not included in gross income of a foreign lessee, and is 
exempt from taxation, under sections 872 or 833, or if the income is 
otherwise exempt from taxation under any income tax convention to which 
the United States is a party, then the property shall not be qualified 
leased property.
    (5) Other rules. (i) Qualified leased property may include undivided 
interests in property or property regardless of whether or not it is 
considered separate property under State or local law. If property 
subject to a section 168(f)(8) lease is later determined not to be 
qualified leased property, disqualification of the lease under section 
168(f)(8) will apply only as to that property.
    (ii) The application of this paragraph (b)(5) may be illustrated by 
the following examples:

    Example (1). On July 1, 1981, X Corp. contracts to have a 
manufacturing facility constructed for use in its business. Construction 
of the facility is completed on July 1, 1982, and the facility is deemed 
to be placed in service as of that date under Sec. 5c.168(f)(8)-
6(b)(2)(i). The facility is comprised of a mixture of new section 38 
property and buildings that do not qualify as section 38 property. On 
August 1, 1982, X sells the new section 38 property in the facility to Y 
and leases it back under an agreement in which the parties elect to be 
treated as a lease described in section 168(f)(8). Assuming that the 
other requirements of this paragraph are met, the new section 38 
property contained in the facility will be qualified leased property. If 
it is later determined that property subject to the section 168(f)(8) 
lease is not new section 38 property (and thus not qualified leased 
property), the safe harbor protection will be lost only as to that 
property.
    Example (2). X Corp. acquires a certain piece of equipment (which is 
new section 38 property) for use in its business. Within 3 months, X 
sells a 70 percent undivided interest in the property to lessor A and a 
10 percent undivided interest in the property to lessor B and leases 
both portions back under separate section 168(f)(8) leases. The 
investment tax credit and ACRS deductions associated with the property 
will be divided among X, lessor A, and lessor B, on a basis of 20 
percent, 70 percent, and 10 percent, respectively.

[T.D. 7791, 46 FR 51907, Oct. 23, 1981, as amended by T.D. 7795, 46 FR 
56150, Nov. 13, 1981; T.D. 7800, 46 FR 63258, Dec. 31, 1981]



Sec. 5c.168(f)(8)-7  Reporting of income, deductions and investment tax credit; at risk rules.

    (a) In general. The fact that the lessor's payments of interest and 
principal and the lessee's rental payments under the lease are not equal 
in amount will not prevent the lease from qualifying under section 
168(f)(8). However, see paragraph (b) for special requirements in sale 
and leaseback transactions. In determining the parties' income, 
deductions, and investment tax credit under the lease, the rules in 
paragraphs (c) through (g) of this section shall apply regardless of the 
overall method of accounting otherwise used by the parties.
    (b) Requirements for sale and leaseback transaction. If the property 
leased is financed by the lessee (or a related party of the leasee) in a 
sale and leaseback transaction, the lease will not qualify under section 
168(f)(8) unless--
    (1) The term of the lessor's purchase money obligation is 
coterminous with the term of the lease, and
    (2) The lessor's obligation bears a reasonable rate of interest. For 
this purpose, a rate of interest shall be presumed to be reasonable if, 
on the date the agreement is executed, it is within 3 percentage points 
of (i) the rate in effect under section 6621, the prime rate in effect 
at any local commercial bank,

[[Page 94]]

or the most recent applicable rate determined by the Secretary under 
Sec. 1.385-6 (e)(2)(i), or (ii) an arm's-length rate as defined in 
Sec. 1.482-2, or (iii) any rate between any two of the rates described 
by subdivisions (i) and (ii) of this paragraph(b)(2).
    (c) Interest deductions and income--(1) Deductibility from income. 
In determining the amount of interest that a lessor may deduct in a 
taxable year with respect to its purchase money obligation given to the 
lessee or to a third party creditor, the lessor may not claim a 
deduction that would be--
    (i) Greater than a deduction that would be allowed to an accrual 
basis taxpayer under a level-payment mortgage, amortized over a period 
equal to the term of the lessor's obligation, or
    (ii) Less than a deduction that would be allowed to an accrual basis 
taxpayer under a straight line amortization of the principal over the 
term of the lessor's obligation.

In cases in which the property is not financed by the lessee or a party 
related to the lessee, the computation of the interest deduction may 
take into account fluctuations in the interest rate which are dependent 
on adjustments in the prime rate or events outside the control of the 
lessor and the third party creditor.
    (2) Includibility in income. The lessee shall include interest on 
the lessor's purchase money obligation in income at the same time and in 
the same amount as the lessor's interest deductions, as determined under 
paragraph (c)(1).
    (d) Rental income and deductions--(1) Deductibility from income. The 
amount of the lessee's rent deduction under a section 168(f)(8) lease 
with respect to any taxable year shall be a pro rata portion of the 
aggregate amount required to be paid by the lessee to the lessor under 
the terms of the lease agreement. If the lessee is required to purchase 
the leased property at the end of the lease term, of if the lessor has 
an option to sell the property to the lessee, rent shall not include the 
lesser of--
    (i) The amount of the lessee's purchase obligation, whether fixed by 
the terms of the lease agreement or conditioned on the exercise of the 
lessor's option to sell the property to the lessee, or
    (ii) The fair market value of the property at the end of the lease 
term determined at the beginning of the lease term.

For this purpose, fair market value shall be determined without taking 
into account any increase or decrease for inflation or deflation during 
the lease term. Rent deductions may be adjusted pursuant to the terms of 
the lease agreement to account for fluctuations which are dependent on 
events outside the control of the lessor and lessee, such as a change in 
the interest rate charged by a third party creditor of the lessor on the 
debt incurred to finance the purchase of the leased property.
    (2) Includibility in income. The lessor shall include rent in income 
as follows:
    (i) In the case of prepayments of rent, the earlier of when such 
rent is paid by the lessee or accrued under the lease, and
    (ii) In the case of other rent, at the same time and in the same 
amount as the lessee's rent deductions, as determined under paragraph 
(d)(1).
    (e) ACRS deductions. The deductions that the lessor is allowed under 
section 168(a) with respect to property subject to a section 168(f)(8) 
lease shall be determined without regard to the limitation in section 
168(f)(10)(B)(iii). The recovery class of qualified leased property in 
the hands of the lessor shall be determined by the character of the 
property in the hands of the owner of the property without regard to 
section 168(f)(8). Any elections under section 168(b)(3) by the lessor 
with respect to the class of recovery property to which the qualified 
leased property is assigned shall apply to the leased property. However, 
with respect to RRB replacement property, the transitional rule of 
section 168(f)(3) shall be inapplicable to the lessor.
    (f) At risk requirements. The amount of the investment credit and 
ACRS deductions that a lessor shall be allowed with respect to the 
leased property shall be limited to the extent the at risk rules under 
the investment tax credit provisions and section 465 apply to the lessee 
or to the lessor. In determining the amount the lessee would be

[[Page 95]]

at risk, the at risk rules will be applied as if the lessee had not 
elected to have section 168(f)(8) apply. Thus, for example, if, without 
regard to section 168(f)(8), an individual lessee would be treated as 
the owner of the leased property for Federal tax law purposes, the 
lessor under a section 168(f)(8) lease would be allowed ACRS deductions 
or investment tax credits with respect to the property only to the 
extent that the lessee may have claimed them had the parties not elected 
treatment under section 168(f)(8). In addition, the ACRS deductions and 
investment tax credits that a lessor is allowed with respect to the 
property are further limited to the extent that the at risk rules apply 
to the lessor as owner of the property under the section 168(f)(8) 
lease. If the lessor and the lessee are subject to the at risk rules, 
the lessor is allowed only the lesser of the ACRS deductions and 
investment tax credits allowable to the lessor and the lessee.
    (g) Limitation on section 48(d) amount. If in a sale and leaseback 
transaction the lessor elects pursuant to section 48(d) to treat the 
lessee (which is the user of the property) as having acquired the 
property for purposes of claiming the investment tax credit, the lessee 
shall be treated as acquiring the property for an amount equal to the 
basis of the property to the lessor (and not for an amount equal to its 
fair market value). The investment tax credit allowable to the lessee is 
further limited to the extent the at risk rules apply to either the 
lessor or to the lessee. See paragraph (f) of this section.
    (h) Examples. The application of the provisions of this section may 
be illustrated by the following examples.

    Example (1). Y, a qualified lessor, acquires a piece of equipment 
which is qualified leased property for $1 million and leases it to X 
under a lease which the parties properly elect to have characterized as 
a lease described in section 168(f)(8). The equipment has a 10-year 
economic life and falls within the 5-year ACRS class. Under the terms of 
the lease, X, the lessee-user, is obligated to pay Y nine annual 
payments of $10,000 and, at the end of the lease term, Y has the option 
to sell the property to X for $2,160,000. Under Sec. 5c.168(f)(8)-7(d), 
the aggregate payments required to be made by X under the lease are 
$2,250,000 ($90,000 rent plus $2,160,000 option price) and are treated 
as rent to Y (less a reasonable estimate for the residual value of the 
property) and taxable as such. Assuming a reasonable estimate of the 
residual value is zero, the full $2,250,000 will be treated as rent, and 
under Sec. 5c.168(f)(8)-7(d), such amount is deductible by X and 
includible in Y's income ratably over the term of the lease, i.e., at a 
rate of $250,000 per year ($2,250,000 divided by 9).
    Example (2). The facts are the same as in example (1) except that 
under the terms of the lease X is obligated to make rental payments of 
$100,000 for each of the first 5 years of the lease and $300,000 for 
each of the 4 remaining years under the lease. Further, X has an option 
to purchase the equipment for $1.00 at the end of the lease term. 
Pursuant to Sec. 5c.168(f)(8)-7(d), X's aggregate rental payments are 
deductible by X and are includible in Y's income ratably over the term 
of the lease. Thus, the annual rental payments are deemed to be $188,000 
per year ($1,700,000 divided by 9).

[T.D. 7791, 46 FR 51907, Oct. 23, 1981, as amended by T.D. 7795, 46 FR 
56150, Nov. 13, 1981]



Sec. 5c.168(f)(8)-8  Loss of section 168(f)(8) protection; recapture.

    (a) In general. Upon the occurrence of an event that causes an 
agreement to cease to be characterized as a lease under section 
168(f)(8), the characterization of the lessor and lessee shall be 
determined without regard to section 168(f)(8).
    (b) Events which cause an agreement to cease to be characterized as 
a lease. A disqualifying event shall cause an agreement to cease to be 
treated as a lease under section 168(f)(8) as of the date of the 
disqualifying event. A disqualifying event shall include the following:
    (1) The lessor sells or assigns its interest in the lease or in the 
qualified leased property in a taxable transaction.
    (2) The failure by the lessor to file a copy of the information 
return (or applicable statement) with its income tax return as required 
in Sec. 5c.168(f) (8)-2 (a)(3)(iii).
    (3) The lessee (or any transferee of the lessee's interest) sells or 
assigns its interest in the lease or in the qualified leased property in 
a transaction not described in Sec. 5c.168(f)(8)-2(a)(6) and the 
transferee fails to execute, within the prescribed time, the consent 
described in Sec. 5c.168(f)(8)-2(a)(5), or either the lessor or the 
transferee fail to file statements with their income tax returns as 
required by that paragraph.

[[Page 96]]

    (4) The property ceases to be section 38 property as defined in 
Sec. 1.48-1 in the hands of the lessor or lessee, for example, due to 
its conversion to personal use or to use predominantly outside the 
United States, or to use by a lessee exempt from Federal income 
taxation.
    (5) The lessor ceases to be a qualified lessor by becoming an 
electing small business corporation or a personal holding company 
(within the meaning of section 542(a)).
    (6) The minimum investment of the lessor becomes less than 10 
percent of the adjusted basis of the qualified leased property as 
described in section 168(f)(8)(B)(ii) and Sec. 5c.168(f)(8)-4.
    (7) The lease terminates.
    (8) The property becomes subject to more than one lease for which an 
election is made under section 168(f)(8).
    (9) Retirements and casualties. [Reserved]
    (10) The property is transferred in a bankruptcy or similar 
proceeding and the lessor fails either to furnish the appropriate 
notification or to file a statement with its income tax return as 
required by Sec. 5c.168(f)(8)-2(a)(6).
    (11) The property is transferred in a bankruptcy or similar 
proceeding and not all lenders with perfected and timely interests in 
the property specifically exclude or release the Federal income tax 
ownership of the property as required under Sec. 5c.168(f)(8)-
2(a)(6)(iii.)
    (12) The property is transferred subsequent to a bankruptcy or 
similar proceeding and the lessor fails to furnish notice to the 
transferee prior to the transfer or fails to file a statement with its 
income tax return, and either the lessor fails to secure the 
transferee's consent or the lessor or the transferee fail to file 
statements with their returns.
    (13) The property is leased under the provisions of section 
168(f)(8)(D)(iii) and Sec. 5c.168(f)(8)-6(b)(3) and ceases to be a 
qualified mass commuting vehicle.
    (14) The failure by the lessor to file the required information 
return described in Sec. 5c.168(f)(8)-2 (a)(3)(ii) by January 31, 1982, 
unless the lessee files such return by January 31, 1982.
    (c) Recapture. The required amount of recapture of the investment 
tax credit and of accelerated cost recovery deductions after a 
disqualifying event shall be determined under sections 47 and 1245, 
respectively.
    (d) Consequences of loss of safe harbor protection. The tax 
consequences of a disqualifying event depend upon the characterization 
of the parties without regard to section 168(f)(8). If the lessee would 
be the owner of the property without regard to section 168(f)(8), the 
disqualifying event will be deemed to be a sale of the qualified leased 
property by the lessor to the lessee. The amount realized by the lessor 
on the sale will include the outstanding amount (if any) of the lessor's 
debt on the property plus the sum of any other consideration received by 
the lessor. A disposition that results from a disqualifying event shall 
not be treated as an installment sale under section 453.
    (e) Examples. The application of the provisions of this section may 
be illustrated by the following examples:

    Example (1). M Corp. and N Corp. enter into a sale and leaseback 
transaction in which the leaseback agreement is characterized as a lease 
under section 168(f)(8) and M is treated as the lessor. In the second 
year of the lease, M becomes an electing small business corporation 
under subchapter S. The agreement ceases to be treated as a lease under 
section 168(f)(8) as of the date of the subchapter S election. Without 
respect to section 168(f)(8), N would be considered the owner of the 
property. The disqualification of M will be treated as a sale of the 
qualified leased property from M to N for the amount of the purchase 
money debt on the property then outstanding. M will realize gain or 
loss, depending upon its basis, with applicable investment tax credit 
and section 1245 recapture. N will acquire the property with a basis 
equal to the amount of the outstanding obligation. The property will not 
be used section 38 property to N under Sec. 1.48-3(a)(2).
    Example (2). Q Corp. (as lessor) and P Corp. (as lessee) enter into 
a lease that is characterized as a lease under section 168(f)(8). The 
lease has a 6-year term. P has no option to renew the lease or to 
purchase the property. At the end of 6 years, if P would be considered 
the owner of the property without regard to section 168(f)(8), upon the 
termination of the lease the property will be deemed to be sold by Q to 
P for the amount of the purchase money debt outstanding with respect to 
the property.

[T.D. 7791, 46 FR 51907, Oct. 23, 1981, as amended by T.D. 7795, 46 FR 
56150, Nov. 13, 1981; T.D. 7800, 46 FR 63259, Dec. 31, 1981]

[[Page 97]]



Sec. 5c.168(f)(8)-9  Pass-through leases--transfer of only the investment tax credit to a party other than the ultimate user of the property. [Reserved]



Sec. 5c.168(f)(8)-10  Leases between related parties. [Reserved]



Sec. 5c.168(f)(8)-11  Consolidated returns. [Reserved]



Sec. 5c.1305-1  Special income averaging rules for taxpayers otherwise required to compute tax in accordance with Sec. 5c.1256-3.

    (a) In general. If an eligible individual (as defined in section 
1303 and the regulations thereunder) is described in the first sentence 
of Sec. 5c.1256-3(a), chooses the benefits of income averaging and 
otherwise complies with the special rules under section 1304 and the 
regulations thereunder, and has averagable income (as defined in section 
1302 and the regulations thereunder) in excess of $3,000, then the 
individual shall compute the tax under section 1301 as provided in this 
section. The computation under this section shall be in lieu of the 
computation under Sec. 5c.1256-3.
    (b) Computation of tax. The individual shall compute the tax under 
section 1301 as follows:

Step (1). Compute tax under section 1301 and the regulations thereunder 
on all taxable income, including gains or losses on regulated futures 
contracts subject to section 1256(a) and the regulations thereunder, 
using rates applicable to the taxpayer for the taxable year which 
includes June 23, 1981.
Step (2). Compute tax under section 1301 and the regulations thereunder 
on all taxable income, including gains or losses on regulated futures 
contracts subject to section 1256(a) and the regulations thereunder, 
using rates applicable to the taxpayer for taxable years beginning in 
1982.
Step (3). Compute the percentage of adjusted gross income attributable 
to all sources except regulated futures contracts subject to section 
1256(a) and the regulations thereunder.
Step (4). Compute the percentage of adjusted gross income attributable 
to regulated futures contracts subject to section 1256(a) and the 
regulations thereunder. Both the percentage in Step (3) and the 
percentage in Step (4) are to be rounded to the nearest percent. The sum 
of both percentages must equal 100 percent.
Step (5). Multiply the result of Step (1) with the result of Step (3).
Step (6). Multiply the result of Step (2) with the result of Step (4).
Step (7). Add the result of Step (5) and the result of Step (6). This is 
the tax for the individual under section 1301 for the taxable year which 
includes June 23, 1981.

    (c) Option to defer tax. If an individual computes the tax under 
section 1301 as provided in paragraph (a) of this section, the 
individual may also opt to pay part or all of the deferrrable tax under 
income averaging (as defined in paragraph (d) of this section) for the 
taxable year which includes June 23, 1981, in 2 or more, but not more 
than 5, equal installments in accordance with this section. Such 
individual may not opt to pay part or all of the deferrable tax in 
installments under Sec. 5c.1256-3. An individual opting to defer payment 
must attach a statement to Form 6781 indicating the computation of 
deferrable tax under income averaging, the number of installments in 
which the individual opts to pay the deferrable tax under income 
averaging, and the amount of each such payment.
    (d) Deferrable tax under income averaging. The deferrable tax under 
income averaging is the excess of--
    (1) The tax for the taxable year which includes June 23, 1981, 
computed pursuant to paragraph (b) of this section, over
    (2) The tax for the taxable year which includes June 23, 1981, 
computed pursuant to paragraph (b) of this section, except that pre-
transitional year gain or loss (as described in Sec. 5c.1256-2(g)) is 
omitted for purposes of recomputing the percentage in Step (4). As 
computed under this subparagraph (2), the sum of the percentage in Step 
(3) and Step (4) will not equal 100 percent.
    (e) Rules of application. The provisions of Sec. 5c.1256-3 (c), (f), 
(g), (h), (i), and (j) shall apply in computing the tax and in 
determining the deferrable tax under income averaging under this 
section.
    (f) Examples. The application of this section may be illustrated by 
the following examples:

    Example (1). Individual A is a single, calendar year taxpayer with 
no dependents. A reported the following amounts for the following years 
on line 34 of Form 1040:


[[Page 98]]



    1977--$80,000
    1978--$90,000
    1979--$100,000
    1980--$110,000

A reports the following amounts for the following lines on Form 1040 for 
1981:

    line 7--$120,000
    line 12--$600,000
    line 32b--$19,000
    line 33--$1,000

    The amount on line 12 is computed as follows: $937,500 of gain is 
attributable to regulated futures contracts subject to section 1256(a). 
Of that total, 40 percent is short term capital gain ($375,000) and 60 
percent is long term capital gain ($562,500). Of the long term capital 
gain, 40 percent is taxable ($225,000). Therefore, A reports $600,000 on 
line 12 ($375,000+$225,000).
    The result of Step (1) is $464,013.41. The result of Step (2) is 
$337,051.52. The result of Step (3) is 17 percent. The result of Step 
(4) is 83 percent. The result of Step (5) is $78,882.28. The result of 
Step (6) is $279,752.76. The result of Step (7) is $358,635.04. This is 
A's tax for 1981 under section 1301.
    Example (2). The facts are the same as in Example (1), except that 
$703,125 of the $937,500 gain attributable to regulated futures 
contracts is pre-transitional year gain or loss (as described in 
Sec. 5c.1256-2(g)). A's tax for 1981 under section 1301 is $358,635.04. 
A may opt to pay in installments a maximum of $221,004.68 of the tax due 
in 1981. If A opts to defer the maximum amount and pay in 5 equal 
installments, A must pay for 1981 a tax of $181,831.30. Each of the 4 
succeeding installments is $44,200.94 plus interest computed in 
accordance with Sec. 5c.1256-3(g)(3).

(Secs. 1305 and 7805 of the Internal Revenue Code of 1954 (78 Stat. 110, 
26 U.S.C. 1305; 68A Stat. 917, 26 U.S.C. 7805); secs. 508(c) and 509 of 
the Economic Recovery Tax Act of 1981 (95 Stat. 333-335))

[T.D. 7826, 47 FR 38692, Sept. 2, 1982]



PART 5e--TEMPORARY INCOME TAX REGULATIONS, TRAVEL EXPENSES OF MEMBERS OF CONGRESS--Table of Contents




    Authority: Secs. 280A(f)(4)(B) and 7805 of the Internal Revenue Code 
of 1954 (95 Stat. 1641, 26 U.S.C. 7805; 68A Stat. 917, 26 U.S.C. 7805).



Sec. 5e.274-8  Travel expenses of Members of Congress.

    (a) In general. Members of Congress (including any Delegate and 
Resident Commissioner) who are away from home within the meaning of 
section 162 (a), in the Washington, DC area, may elect in accordance 
with paragraph (f) of this section to deduct an amount described in 
paragraph (c) of this section as living expenses, without 
substantiation. A Member who elects under this section may not deduct 
any amount for the living expenses described in paragraph (b). A Member 
who does not make an election under this section must substantiate his 
expenses for living in Washington, DC in accordance with section 274 and 
Sec. 1.274-5.
    (b) Living expenses covered. The amount allowed to be deducted 
without substantiation, pursuant to this section, for costs incurred for 
living in the Washington, DC area represents amounts expended for meals, 
lodging, and other incidental expenses. Meals include the actual cost of 
the food and expenses incident to the preparation and serving thereof. 
Lodging includes amounts paid for rent, care of premises, utilities, 
insurance and depreciation of household furnishings owned by the Member. 
In the case of a Member who lives in a residence owned by him in the 
Washington, DC area, the cost of lodging also includes depreciation on 
such residence. Other incidental expenses include laundry, cleaning, and 
local transportation. Local transportation includes travel within a 50 
mile radius of Washington, DC, whether by private automobile, taxicab or 
other transportation for hire. Interest and taxes on personal property 
will not be considered expenses to be included within this paragraph.
    (c)(1) Amounts allowed without substantiation. The amount that may 
be deducted pursuant to section 162 and these regulations is an amount 
equal to the product of the number of Congressional days in the taxable 
year, multiplied by the designated amount. The designated amount is--
    (i) In the case of a Member who deducts interest and taxes 
attributable to the ownership of a personal residence in the Washington, 
DC area, two-thirds of the maximum amount of actual subsistence for 
Washington, DC payable pursuant to 5 U.S.C. 5702(c), or
    (ii) In the case of a Member not described in paragraph (c)(1)(i), 
the maximum amount of actual subsistence for

[[Page 99]]

Washington, DC payable pursuant to 5 U.S.C. 5702(c).

A Member who incurs interest and taxes on his residence in the 
Washington, DC area may forego the deduction of such amounts and use the 
designated amount prescribed by paragraph (c)(1)(ii).
    (2) If a Member, who lives in a residence owned by him in the 
Washington, DC area, chooses to deduct amounts prescribed in paragraph 
(c)(1) of this section, the Member must treat as an adjustment to the 
basis of such residence an amount equal to 20 percent of the maximum 
amount of actual subsistence multiplied by the number of Congressional 
days. Such adjustments will be considered a proper adjustment for 
exhaustion, wear, and tear under this subtitle.
    (d) Congressional days. The number of Congressional days with 
respect to a Member is the number of days in the taxable year less the 
number of days in periods in which the Member's Congressional chamber 
was not in session for 5 consecutive days or more (including Saturday 
and Sunday). The number of days with respect to a Member is determined 
without regard to whether or not the Member was in the Washington, DC 
area on such days.

[[Page 100]]

[GRAPHIC] [TIFF OMITTED] TC16OC91.000

    (e) Other deductible amounts. This section does not preclude the 
deduction of otherwise allowable expenses for travel fares (other than 
local travel in the Washington, DC), long distance telephone and 
telegraph, and travel expenses incurred other than in the Washington, DC 
area. However, such

[[Page 101]]

expenses are subject to the substantiation requirements of section 274.
    (f) Election. To elect to deduct the amounts prescribed by this 
section, a Member must attach to his return for the taxable year a 
statement indicating, (1) that the deduction for travel expenses while 
living in the Washington, DC area are computed pursuant to Sec. 5e.274-
8, and (2) whether a separate deduction is being taken for interest and 
taxes paid or incurred with respect to the personal residence of the 
Member if in the Washington, DC area.
    (g) Effective date. This section is effective for taxable year 
beginning after December 31, 1980.
    (h) Examples. The following examples are based on a calendar from a 
Final Edition of the Calendar of the United States, House of 
Representatives and History of Legislation. The marked days indicate 
days the House of Representatives was in session.

    Example 1 In determining the number of Congressional days for 198X 
for which the designated amount may be computed, the number of days in 
such year is reduced by 125 days determined as follows:

------------------------------------------------------------------------
                                                                   Days
------------------------------------------------------------------------
Feb. 14-18.....................................................        5
Apr. 3-14......................................................       12
May 23-27......................................................        5
July 3-20......................................................       18
Aug. 2-17......................................................       16
Aug. 29-Sept. 2................................................        5
Oct. 3-Nov. 11.................................................       40
Nov. 22-Nov. 30................................................        9
Dec. 17-Dec. 31................................................       15
                                                                --------
    Total......................................................      125
------------------------------------------------------------------------


Thus for 198X (a leap year) a typical Member of the House of 
Representatives will have 241 (366-125) Congressional days.
    Example 2 On August 1, Z a calendar year taxpayer is elected to the 
Congress to fill the unexpired term of Member Y. In determining the 
number of Congressional days, Z may only consider the number of days 
during the year for which he was a Member of Congress. For Z the number 
of Congressional days is 68.
    Example 3 Member X, a calendar year taxpayer, owns his own home in 
Washington, DC, where he lives with his family. While in Washington, DC, 
Member X is away from home within the meaning of section 162(a). X 
maintains no records attributable to his expenses in Washington, DC X 
has been a Member of Congress for the entire year. The maximum amount of 
subsistence for Washington, DC for 198X is $75. X may deduct for 198X 
$18,075 (241 daysx$75) attributable to expenses while away from home in 
Washington, DC. Even if X maintained records as to living expenses in 
Washington, DC, X may choose to deduct $18,075 as the total amount 
attributable to living expenses in Washington, DC. If X deducts $18,075 
X may not deduct any interest and taxes under section 163 or 164 
attributable to the residence in Washington, DC.
    Example 4 Member C, a calendar year taxpayer owns his own home in 
Washington, DC, where he lives with his family. While in Washington, DC. 
Member C is away from home within the meaning of section 162(a). C can 
establish that he paid $12,000 as interest on a mortgage and $3,000 in 
local real estate taxes. C has been a Member of Congress for the entire 
year. C may choose to deduct $12,050 (241 daysx[\2/3\x$75]) attributable 
to expenses in Washington, DC. Further, C may deduct under sections 163 
and 164 $12,000 of interest and $3,000 of taxes respectively.
    Example 5 Assume the same facts as in Example (4). In addition, on 
March 15, 16, and 17, Member C travels to New York City to deliver a 
speech for which he receives an honorarium which he includes in income. 
C receives no additional amounts for travel reimbursement. While in New 
York City C incurs $350 for 3 nights lodging at a hotel and $150 for 
meals. In addition to the amounts deductible pursuant to this section, C 
may deduct the $500 as a travel expenses. Such deduction is subject to 
the substantiation rules of section 274.
    Example 6 Assume the same facts as example (5). Member C receives, 
in addition to the honorarium, $600 reimbursement for travel expenses. C 
must include the $600 in income and may deduct the travel expenses he 
incurred.

[T.D. 7802, 47 FR 2987, Jan. 21, 1982; 47 FR 4680, Feb. 2, 1982]



PART 5f--TEMPORARY INCOME TAX REGULATIONS UNDER THE TAX EQUITY AND FISCAL RESPONSIBILITY ACT OF 1982--Table of Contents




Sec.
5f.103-1  Obligations issued after December 31, 1982, required to be in 
          registered form.
5f.103-2  Public approval of industrial development bonds.
5f.103-3  Information reporting requirements for certain bonds.
5f.163-1  Denial of interest deduction on certain obligations issued 
          after December 31, 1982, unless issued in registered form.
5f.168(f)(8)-1  Questions and answers concerning transitional rules and 
          related matters regarding certain safe harbor leases.


[[Page 102]]


    Authority: 26 U.S.C. 7805. Secs. 5f.103-1 and 5f.163-1 also issued 
under 26 U.S.C. 103(j), 26 U.S.C. 163(f), and 96 Stat. 595.



Sec. 5f.103-1  Obligations issued after December 31, 1982, required to be in registered form.

    (a) Registration; general rule. Interest on a registration-required 
obligation (as defined in paragraph (b) of this section) shall not be 
exempt from tax notwithstanding section 103 (a) or any other provision 
of law, exclusive of any treaty obligation of the United States, unless 
the obligation is issued in registered form (as defined in paragraph (c) 
of this section).
    (b) Registration-required obligation. For purposes of this section, 
the term ``registration-required obligation'' means any obligation 
except any one of the following:
    (1) An obligation not of a type offered to the public. The 
determination as to whether an obligation is not of a type offered to 
the public shall be based on whether similar obligations are in fact 
publicly offered or traded.
    (2) An obligation that has a maturity at the date of issue of not 
more than 1 year.
    (3) An obligation issued before January 1, 1983. An obligation first 
issued before January 1, 1983, shall not be considered to have been 
issued on or after that date merely as a result of the existence of a 
right on the part of the holder of such obligation to convert the 
obligation from registered form into bearer form, or as a result of the 
exercise of such a right.
    (4) An obligation described in Sec. 5f.163-1 (c) (relating to 
certain obligations issued to foreign persons).
    (c) Registered form--(1) General rule. An obligation issued after 
January 20, 1987, pursuant to a binding contract entered into after 
January 20, 1987, is in registered form if--
    (i) The obligation is registered as to both principal and any stated 
interest with the issuer (or its agent) and transfer of the obligation 
may be effected only by surrender of the old instrument and either the 
reissuance by the issuer of the old instrument to the new holder or the 
issuance by the issuer of a new instrument to the new holder,
    (ii) The right to the principal of, and stated interest on, the 
obligation may be transferred only through a book entry system 
maintained by the issuer (or its agent) (as described in paragraph 
(c)(2) of this section), or
    (iii) The obligation is registered as to both principal and any 
stated interest with the issuer (or its agent) and may be transferred 
through both of the methods described in subdivisions (i) and (ii).
    (2) Special rule for registration of a book entry obligation. An 
obligation shall be considered transferable through a book entry system 
if the ownership of an interest in the obligation is required to be 
reflected in a book entry, whether or not physical securities are 
issued. A book entry is a record of ownership that identifies the owner 
of an interest in the obligation.
    (d) Effective date. The provisions of this section shall apply to 
obligations issued after December 31, 1982, unless issued on an exercise 
of a warrant for the conversion of a convertible obligation if such 
warrant or obligation was offered or sold outside the United States 
without registration under the Securities Act of 1933 and was issued 
before August 10, 1982.
    (e) Special rules. The following special rules apply to obligations 
issued after January 20, 1987, pursuant to a binding contract entered 
into after January 20, 1987.
    (1) An obligation that is not in registered form under paragraph (c) 
of this section is considered to be in bearer form.
    (2) An obligation is not considered to be in registered form as of a 
particular time if it can be transferred at that time or at any time 
until its maturity by any means not described in paragraph (c) of this 
section.
    (3) An obligation that as of a particular time is not considered to 
be in registered form by virtue of subparagraph (2) of this paragraph 
(e) and that, during a period beginning with a later time and ending 
with the maturity of the obligation, can be transferred only by a means 
described in paragraph (c) of this section, is considered to be in 
registered form at all times during such period.
    (f) Examples. The application of this section may be illustrated by 
the following examples:


[[Page 103]]


    Example (1). Municipality X publicly offers its general debt 
obligations to United States persons. The obligations have a maturity at 
issue exceeding 1 year. The obligations are registration-required 
obligations under Sec. 5f.103-1(b). When individual A buys an 
obligation, X issues an obligation in A's name evidencing A's ownership 
of the principal and interest under the obligation. A can transfer the 
obligation only by surrendering the obligation to X and by X issuing a 
new instrument to the new holder. The obligation is issued in registered 
form.
    Example (2). Municipality Y issues a single obligation on January 4, 
1983 to Bank M provided that (i) Bank M will not at any time transfer 
any interest in the obligation to any person unless the transfer is 
recorded on Municipality Y's records (except by means of a transfer 
permitted in (ii) of this example) and (ii) interests in the obligation 
that are sold by Bank M (and any persons who acquire interests from M) 
will be reflected in book entries. C, an individual, buys an interest in 
Y's obligation from Bank M. Bank M receives the interest or principal 
payments with respect to C's interest in the obligation as agent for C. 
Bank M records interests in the Municipality Y obligation as agent of 
Municipality Y. Any transfer of C's interest must be reflected in a book 
entry in accordance with Bank M's agreement with Municipality Y. Since 
C's interest can only be transferred through a book entry system 
maintained by the issuer (or its agent), the obligation is considered 
issued in registered form. Interest received by C is excludable from 
gross income under section 103(a).
    Example (3). Municipality Z wishes to sell its debt obligations 
having a maturity in excess of 1 year. The obligations are sold to Banks 
N, O, and P, all of which are located in Municipality Z. By their terms 
the obligations are freely transferable, although each of the banks has 
stated that it acquired the obligations for purposes of investment and 
not for resale. Obligations similar to the obligations sold by 
Municipality Z are traded in the market for municipal securities. The 
obligations issued by Municipality Z are of a type offered to the public 
and are therefore registration-required under Sec. 5f.103-1 (b).
    Example (4). Corporation A issues an obligation that is registered 
with the corporation as to both principal and any stated interest. 
Transfer may be effected by the surrender of the old instrument and 
either the reissuance by the issuer of the old instrument to the new 
holder or the issuance by the issuer of a new instrument to the new 
holder. The obligation can be converted into a form in which the right 
to the principal of, or stated interest on, the obligation may be 
effected by physical transfer of the obligation. Under Sec. 5f.103-1 (c) 
and (e), the obligation is not considered to be in registered form and 
is considered to be in bearer form.
    Example (5). Corporation B issues its obligations in a public 
offering in bearer definitive form. Beginning at X months after the 
issuance of the obligations, a purchaser (either the original purchaser 
or a purchaser in the secondary market) may deliver the definitive bond 
in bearer form to the issuer in exchange for a registration receipt 
evidencing a book entry record of the ownership of the obligation. The 
issuer maintains the book entry system. The purchaser identified in the 
book entry as the owner of record has the right to receive a definitive 
bearer obligation at any time. Under Sec. 5f.103-1 (c) and (e), the 
obligation is not considered to be issued in registered form and is 
considered to be issued in bearer form. All purchasers of the obligation 
are considered to hold an obligation in bearer form.
    Example (6). Corporation C issues obligations in bearer form. A 
foreign person purchases a definitive bearer obligation and then sells 
it to a United States person. At the time of the sale, the United States 
person delivers the bearer obligation to Corporation C and receives an 
obligation that is identical except that the obligation is registered as 
to both principal and any stated interest with the issuer or its agent 
and may be transferred at all times until its maturity only through a 
means described in Sec. 5f.103-1(c). Under Sec. 5f.103-1(e), the 
obligation is considered to be in registered form from the time it is 
delivered to Corporation C until its maturity.

    (g) Cross-references. See section 103A(j)(1) for the registration 
requirement of certain mortgage subsidy bonds issued after December 31, 
1981, and Sec. 6a.103A-1(a)(5) for the definition of registered form for 
such obligations issued after December 31, 1981, and on or before 
December 31, 1982. See also section 103(h) (requiring registration of 
certain energy bonds issued on or after October 18, 1979).

[T.D. 7852, 47 FR 51361, Nov. 15, 1982, as amended by T.D. 8111, 51 FR 
15463, Dec. 19, 1986]



Sec. 5f.103-2  Public approval of industrial development bonds.

    (a) General rule. An industrial development bond (within the meaning 
of Sec. 1.103-7(b)(1) issued after December 31, 1982, shall be treated 
as an obligation not described in section 103(a) unless it is issued as 
part of an issue which satisfies the public approval requirement of 
section 103(k) and paragraph (c) of

[[Page 104]]

this section or is described in the exceptions set forth in paragraph 
(b) of this section.
    (b) Exceptions--(1) No extension of maturity. Paragraph (a) of this 
section does not apply to a refunding obligation if--
    (i) It refunds an obligation which was approved under section 103(k) 
and this section (or which is treated as approved pursuant to paragraph 
(f) of this section), and
    (ii) It has a maturity date which is not later than the maturity 
date of the obligation to be refunded.
    (2) Refunding of pre-July 1, 1982, obligation. Paragraph (a) of this 
section does not apply to an obligation issued solely to refund an 
obligation which--
    (i) Was issued before July 1, 1982, and
    (ii) Has a term which does not exceed 3 years.

The term of an obligation is determined without regard to whether it is 
a refunding obligation. With respect to the refunding of an issue also 
containing obligations with terms which exceed 3 years, paragraph (b)(2) 
applies only if the refunding issue proceeds are used solely to refund 
obligations with terms not exceeding 3 years and to pay reasonable 
incidental costs of the refunding (e.g., legal and accounting fees, 
printing costs, and rating fees) attributable thereto. Paragraph (b)(2) 
applies only to issues issued after December 31, 1982, the proceeds of 
which are used to refund issues issued prior to July 1, 1982. Thus, 
subsequent refundings of such refunding issues must satisfy the public 
approval requirement of section 103(k) and paragraph (c) of this 
section.
    (c) Public approval requirement--(1) In general. An issue is 
publicly approved if prior to the date of issue the governmental unit(s) 
described in subparagraphs (2) and (3) this paragraph (c) approve the 
issue, in the manner described in paragraph (d) of this section. See 
paragraph (f) for rules pertaining to determining the scope of an 
approval and paragraph (g)(1) for the definition of ``governmental 
unit''.
    (2) Issuer approval. The governmental unit (i) which will issue the 
obligations or (ii) on behalf of which the issue is to be issued must 
approve the issue (``issuer approval''). If the issuer is not a 
governmental unit, the governmental unit on behalf of which the issuer 
acts shall be determined in a manner consistent with determinations 
under Sec. 1.103-1, and such unit must approve the issue. However, in 
the case of an issuer which issues obligations on behalf of more than 
one governmental unit (e.g., an authority which acts for two counties), 
any one of such units may give the issuer approval required by this 
paragraph (c)(2).
    (3) Host approval. Each governmental unit the geographic 
jurisdiction (as defined in paragraph (g)(4)) of which contains the site 
of a facility to be financed by the issue must approve the issue (``host 
approval''). However, if the entire site of a facility to be financed by 
the issue is within the geographic jurisdiction of more than one 
governmental unit within a State (counting the State as a governmental 
unit within such State), then any one of such units may provide host 
approval for the issue with respect to that facility. For purposes of 
this paragraph (c)(3), if property to be financed by the issue is 
located within two or more governmental units but not entirely within 
either of such units, each portion of the property which is located 
entirely within the smallest respective governmental units may be 
treated as a separate facility. The issuer approval (as described in 
paragraph (c)(2)) may be treated as a host approval if the governmental 
unit giving the issuer approval is also a governmental unit described in 
this paragraph (c)(3). See paragraph (e)(2) with respect to host 
approval by a governmental unit with no applicable elected 
representative.
    (d) Method of public approval. For purposes of this section, an 
issue is approved by a governmental unit only if--
    (1) An applicable elected representative (as defined in paragraph 
(e)) of such unit approves the issue following a public hearing (as 
defined in paragraph (g)(2)) held in a location which, under the facts 
and circumstances, is convenient for residents of the unit, and for 
which there was reasonable public notice (as defined in paragraph 
(g)(3)), or
    (2) A referendum of the voters of the unit (as defined in paragraph 
(g)(5)) approves the issue.

[[Page 105]]


An approval may satisfy the requirements of this section without regard 
to the authority under State or local law for the acts constituting such 
approval. The location of hearing will be presumed convenient for 
residents of the unit if it is located in the approving governmental 
unit's capital or seat of government. If more than one governmental unit 
is required to provide a public hearing, such hearings may be combined 
as long as the combined hearing is a joint undertaking that provides all 
of the residents of the participating governmental units (i.e., those 
relying on such hearing as an element of public approval) a reasonable 
opportunity to be heard. The location of any combined hearing is 
presumed to provide a reasonable opportunity to be heard provided it is 
no farther than 100 miles from the seat of government of each 
participating governmental unit beyond whose geographic jurisdiction the 
hearing is conducted.
    (e) Applicable elected representative--(1) In general. The 
applicable elected representative of a governmental unit means--
    (i) Its elected legislative body,
    (ii) Its chief elected executive officer,
    (iii) In the case of a State, the chief elected legal officer of the 
State's executive branch of government, or
    (iv) Any official elected by the voters of the unit and designated 
for purposes of this section by the unit's chief elected executive 
officer or by State or local law to approve issues for the unit.

For purposes of subdivisions (ii), (iii), and (iv) of this paragraph 
(e)(1), an official shall be considered elected by the voters of the 
unit only if he is popularly elected at-large by the voters of the 
governmental unit. If an official popularly elected at-large by the 
voters of a governmental unit is appointed or selected pursuant to State 
or local law to be the chief executive officer of the unit, such 
official is deemed to be an elected chief executive officer for purposes 
of this section but for no longer than his tenure as an official elected 
at-large. In the case of a bicameral legislature which is popularly 
elected, both chambers together constitute an applicable elected 
representative, but neither chamber does independently, unless so 
designated under paragraph (e)(1)(iv). If multiple elected legislative 
bodies of a governmental unit have independent legislative authority, 
however, the body with the more specific authority relating to the issue 
is the only legislative body described in paragraph (e)(1)(i) of this 
section. See paragraph (h), Example (7) of this section.
    (2) Governmental unit with no applicable elected representative. (i) 
The applicable elected representatives of a governmental unit with no 
representative (but for this paragraph (e)(2) and section 
103(k)(2)(E)(ii)) are deemed to be those of the next higher governmental 
unit (with an applicable elected representative) from which the 
governmental unit derives its authority. For purposes of this 
subparagraph (2), a governmental unit derives its authority from another 
unit which--
    (A) Enacts a specific law (e.g., a provision in a State 
constitution, charter or statute) by or under which the governmental 
unit is created,
    (B) Otherwise empowers or approves the creation of the governmental 
unit, or
    (C) Appoints members to the governing body of the governmental unit.

In the case of a governmental unit with no applicable elected 
representative (but for this paragraph (e)(2)), any unit described in 
subdivision (A), (B), or (C) or this paragraph (e)(2)(i) may be treated 
as the next higher unit, without regard to the relative status of all of 
such units under State law.
    (ii) In the case of a host approval (as required under paragraph 
(c)(3) of this section), a unit may be treated as the next higher unit, 
only if--
    (A) The facility is located within its geographic jurisdiction, and
    (B) Eligible individuals, if any, residing at the site of the 
facility are entitled to vote for the applicable elected representative 
of that unit (as determined under this paragraph (e)).
    (3) On behalf of issuers. In the case of an issuer which is not a 
governmental unit but which issues bonds on behalf of a governmental 
unit, the applicable elected representative is any applicable elected 
representative of the unit on behalf of which the bonds are issued. If 
the unit on behalf of which the bonds are issued has no applicable 
elected representative (but for paragraph (e)(2)

[[Page 106]]

of this section), the applicable elected representative of the 
governmental unit is determined in the manner described in paragraph 
(e)(2).
    (f) Scope of approval--(1) In general. Public approval is required 
by section 103(k) and this section for issues of industrial development 
bonds, except as otherwise provided in paragraphs (a) and (b) of this 
section. An issue is treated as approved if the governmental units 
(described in paragraph (c) of this section in relation to the issue) 
have approved either--
    (i) The issue (by approving each facility to be financed), not more 
than one year before the date of issue, or
    (ii) A plan of financing for each facility financed by the issue 
pursuant to which the issue in question is timely issued (as required in 
paragraph (f)(3) of this section).

In either case, the scope of the approval is determined by the 
information, as specified in paragraph (f)(2), contained in the notice 
of hearing (when required) and the approval.
    (2) Information required. A facility is within the scope of an 
approval if the notice of hearing (when required) and the approval 
contain--
    (i) A general, functional description of the type and use of the 
facility to be financed (e.g., ``a 10,000 square foot machine shop and 
hardware manufacturing plant'', ``400-room airport hotel building'', 
``dock facility for supertankers'', ``convention center auditorium and 
sports arena with 25,000 seating capacity'', ``air and water pollution 
control facilities for oil refinery''),
    (ii) The maximum aggregate face amount of obligations to be issued 
with respect to the facility,
    (iii) The initial owner, operator, or manager of the facility,
    (iv) The prospective location of the facility by its street address 
or, if none, by a general description designed to inform readers of its 
specific location.

An approval is valid for purposes of this section with respect to any 
issue used to provide publicly approved facilities, notwithstanding 
insubstantial deviations with respect to the maximum aggregate face 
amount of the bonds issued under the approval for the facility, the name 
of its initial owner, manager, or operator, or the type or location of 
the facility from that described in the approval. An approval or notice 
of public hearing will not be considered to be adequate if any of the 
items in subdivisions (i) through (iv) of this subparagraph (2), with 
respect to the facility to be financed, are unknown on the date of the 
approval or the date of the public notice.
    (3) Timely issuance pursuant to a plan of financing. An issue is 
timely issued pursuant to a plan of financing for a facility if--
    (i) The issue is issued no later than 3 years after the first issue 
pursuant to the plan, and
    (ii) The first such issue in whole or in part issued pursuant to the 
plan was issued no later than 1 year after the date of approval.
    (4) Facility--definition. For purposes of this paragraph (f), the 
term ``facility'' includes a tract or adjoining tracts of land, the 
improvements thereon and any personal property used in connection with 
such real property. Separate tracts of land (including improvements and 
connected personal property) may be treated as one facility only if they 
are used in an integrated operation.
    (g) Definitions. For purposes of this section--
    (1) Governmental unit. Governmental unit has the same meaning as in 
Sec. 1.103-1. Thus, a governmental unit is a State, territory, a 
possession of the United States, the District of Columbia, or any 
political subdivision thereof. The term ``political subdivision'' 
denotes any division of any State or local governmental unit which is a 
municipal corporation or which has been delegated the right to exercise 
part of the sovereign power of the unit.
    (2) Public hearing. Public hearing means a forum providing a 
reasonable opportunity for interested individuals to express their 
views, both orally and in writing, on the proposed issue of bonds and 
the location and nature of a proposed facility to be financed. In 
general, a governmental unit may select its own procedure for the 
hearing, provided that interested individuals have a reasonable 
opportunity to express their views. Thus, it may impose reasonable 
requirements on persons

[[Page 107]]

who wish to participate in the hearing, such as a requirement that 
persons desiring to speak at the hearing so request in writing at least 
24 hours before the hearing or that they limit their oral remarks to 10 
minutes. For purposes of this public hearing requirement, it is not 
necessary, for example, that the applicable elected representative who 
will approve the bonds be present at the hearing, that a report on the 
hearing be submitted to that official, or that State administrative 
procedural requirements for public hearings in general be observed. 
However, compliance with such State procedural requirements (except 
those at variance with a specific requirement set forth in this section) 
will generally assure that the hearing satisfies the requirements of 
this section. The hearing may be conducted by any individual appointed 
or employed to perform such function by the governmental unit or its 
agencies, or by the issuer (if on behalf of issuer). Thus, for example, 
for bonds to be issued by an authority that acts on behalf of a county, 
the hearing may be conducted by the authority, the county, or an 
appointee or employee of either.
    (3) Reasonable public notice. Reasonable public notice means 
published notice which is reasonably designed to inform residents of the 
affected governmental units, including residents of the issuing unit and 
the governmental unit where a facility is to be located, of the proposed 
issue. The notice must state the time and place for the hearing and 
contain the information contained in paragraph (f)(2) of this section. 
Notice is presumed reasonable if published no fewer than 14 days before 
the hearing. Except in the locality of the facility, publication is 
presumed to be reasonably designed to inform residents of the approving 
governmental unit if given in the same manner and same locations as 
required of the approving governmental unit for any other purposes for 
which applicable State or local law specifies a notice of public hearing 
requirement (including laws relating to notice of public meetings of the 
governmental unit). Notice is presumed reasonably designed to inform 
affected residents in the locality of the facility only if published in 
one or more newspapers of general circulation available to residents of 
that locality or if announced by radio or television broadcast to those 
residents.
    (4) Geographic jurisdiction. Geographic jurisdiction is the area 
encompassed by the boundaries prescribed by State or local law for a 
governmental unit or, if there are no such boundaries, the area in which 
a unit may exercise such sovereign powers that make that unit a 
governmental unit for purposes of Sec. 1.103-1 and this section.
    (5) Voter referendum. A voter referendum is a vote by the voters of 
the affected governmental unit conducted in the manner and at such a 
time as voter referenda on matters relating to governmental spending or 
bond issuances by the governmental unit under applicable State and local 
law.
    (h) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example (1). State X proposes to issue an industrial development 
bond, the proceeds of which are to finance a facility located entirely 
within the geographic jurisdiction of City Y (which is located in State 
X). Under the provisions of paragraph (c), only State X must approve the 
issue because State X is the issuer and the facility is to be located 
entirely within the State's geographic jurisdiction. Its applicable 
elected representative must approve the issue after the public notice 
and public hearing requirements are satisfied.
    Example (2). (i) Industrial Development Authority X proposes to 
issue an industrial development bond, the proceeds of which are to 
finance a facility located entirely within the geographic jurisdiction 
of City Y (which is located in State Z). Authority X acts on behalf of 
State Z. Under the provisions of paragraph (c), only State Z must 
approve the issue because State Z is the governmental unit on behalf of 
which Authority X, the issuer, is acting and the facility is to be 
located entirely within its geographic jurisdiction.
    (ii) State Z has a governor, an elected bicameral legislature and an 
appointed attorney general who is the chief legal officer of State Z. 
Under the laws of State Z, the attorney general must approve any issue 
of industrial development bonds. The approval by the attorney general is 
not a sufficient approval under this section, since the attorney general 
is not an applicable elected representative within the meaning of this 
section. Under the provisions of paragraphs (d) and (e), either the 
governor, both chambers of the legislature or any popularly elected

[[Page 108]]

official of the State who is designated for this purpose by the governor 
or by State law must approve the issue after the public notice and 
public hearing requirements are satisfied.
    Example (3). (i) County Y, a county in State X, proposes to issue an 
industrial development bond, the proceeds of which are to finance a 
facility located entirely within its jurisdiction. Under the provisions 
of paragraph (c), only County Y must approve the issue because County Y 
is the issuer and the facility is to be located entirely within the 
geographic jurisdiction of County Y.
    (ii) County Y has no elected officials or legislature. County Y 
derives its authority from State X which is the next higher governmental 
unit with an applicable elected representative. The laws of State X 
designate the attorney general, who is an official of State X elected 
at-large, as the official who must approve any issue of industrial 
development bonds for the State. Under this section, State X's attorney 
general is an applicable elected representative who may approve the 
issue after the public notice and public hearing requirements are 
satisfied.
    Example (4). (i) City X, a city located in County Y and State Z, 
proposes to issue an industrial development bond, the proceeds of which 
are to finance a facility located entirely within the geographic 
jurisdiction of City X. Under the provisions of paragraph (c), only City 
X must approve the issue because it is the issuer and the facility is to 
be located entirely within the geographic jurisdiction of City X.
    (ii) Mayor A, the chief elected executive officer of City X, has 
designated, for purposes of this section, Deputy Mayor B, an official of 
City X elected at-large, to approve industrial development bond issues 
for the city. Under the provisions of paragraph (e), Deputy Mayor B may 
approve the issue, since he is an applicable elected representative, 
after the public notice and public hearing requirements are satisfied.
    Example (5). (i) County M proposes to issue an industrial 
development bond to finance a project located partly within the 
geographic jurisdiction of County M and partly within the geographic 
jurisdiction of County N. Both counties are located in State X. The part 
of the project in County N is also located partly within the geographic 
jurisdiction of City O and partly within the geographic jurisdiction of 
City P. Under the provisions of paragraph (c)(2), County M must give 
issuer approval. Additionally, under the provisions of paragraph (c)(3), 
either State X, County N, or both Cities O and P, must give host 
approval.
    (ii) Counties M and N will approve the issue, but neither has any 
officials who are elected at-large by the voters of the respective 
governmental units. Both governmental units derive their authority from 
State X which is the next higher governmental unit with an applicable 
elected representative. Under the provisions of paragraph (e), an 
applicable elected representative of State X must approve the issue for 
Counties M and N after the public notice and public hearing requirements 
are satisfied.
    Example (6). (i) County M proposes to issue an industrial 
development bond to finance two facilities. One facility is located 
entirely within the geographic jurisdiction of County M and the second 
facility is located partly within the geographic jurisdiction of County 
M and partly within the geographic jurisdiction of County N. The second 
facility is also located within the geographic jurisdictions of Cities O 
and P, which cities are located within the geographic jurisdiction of 
County N. Under the provisions of paragraph (c)(2), County M must give 
issuer approval. Additionally, under the provisions of paragraph (c)(3), 
either State X, County N, or both Cities O and P, must give host 
approval.
    (ii) Counties M and N will approve the issue. Each has a chief 
elected executive officer. Under the provisions of paragraphs (d) and 
(e), the chief elected executive officer of each county may approve the 
issue, after the public notice and public hearing requirements are 
satisfied.
    Example (7). (i) State X proposes to issue an industrial development 
bond to finance a facility located partly within the geographic 
jurisdiction of State X and partly within the geographic jurisdiction of 
State Y. That portion of the facility located in State Y is located 
entirely within the geographic jurisdiction of City Z. State X must give 
issuer approval. Additionally, either State Y or City Z must give host 
approval as that part of the facility to be located outside State X will 
be entirely within the geographic jurisdiction of each unit.
    (ii) Under the provisions of paragraphs (d) and (e), the governor of 
State X may approve the issue, after the public notice and public 
hearing requirements are satisfied. City Z (assuming that it give host 
approval for the bond) has a city council and a school board, both of 
which are elected legislative bodies with independent jurisdiction. The 
authority of the school board is limited under State law to matters 
directly concerning the provision of public education. Under paragraph 
(e), the school board is not an applicable elected representative of 
City Z but the city council is an applicable elected representative of 
City Z. The city council may approve the issue after the public hearing 
and public notice requirements are satisfied.
    Example (8). (i) Public Housing Authority M, a governmental unit, 
proposes to issue an

[[Page 109]]

industrial development bond to finance several housing projects with 
known sites located entirely within its geographic jurisdiction. M's 
geographic jurisdiction is coextensive with the combined geographic 
jurisdictions of Counties N and O. The projects are separately owned and 
managed. They are not adjacent to each other. The projects also are 
located in County N. Under the provisions of paragraph (c), M must give 
issuer approval.
    (ii) M, which has no elected officials or legislature, was created 
by both Counties N and O pursuant to a special statute of State Q 
permitting such a joint undertaking. Both Counties N and O have an 
applicable elected representative. Under the provisions of paragraph 
(e)(2), either County N, County O, or State Q is deemed to be the next 
higher governmental unit with an applicable elected representative, and 
an applicable elected representative from any of these units may give 
the issuer approval for Authority M. Therefore, either the applicable 
representative of County N, County O, or State Q can give the issuer 
approval for Authority M.
    (iii) For purposes of the host approval, the issuer approval by M 
will satisfy the host approval requirement only if the applicable 
elected representative of County N or State Q gives issuer approval for 
M. Under the provisions of paragraph (e)(2), the host approval 
requirement is satisfied only if qualified persons residing at the site 
of the facility are entitled to vote for the applicable elected 
representative who gave the approval (i.e., the representative of State 
Q or County N). However, if the applicable elected representative of O 
gave issuer approval for Authority M, a separate host approval would be 
required because the residents of the sites where the projects are 
located (i.e., County N) could not note for the applicable elected 
representative of County O.
    (iv) Public Housing Authority M conducts a public hearing concerning 
prospective housing projects following notice thereof published in a 
newspaper of general circulation in County N. Additionally, M provides 
notice to the residents of O (which are also within M's jurisdiction) in 
the manner required for notice of public hearing for other purposes 
under State Q law. Following the public hearing, the chief elected 
executive officer of County N approves for Authority M prospective 
issues for the project. M issues two $7 million issues, one for each 
project. One issue is issued six months after the date of approval; the 
second issue is issued thirteen months thereafter. On these facts, only 
the first issue satisfied the public approval requirement of this 
section.

[T.D. 7892, 48 FR 21117, May 11, 1983]



Sec. 5f.103-3  Information reporting requirements for certain bonds.

    (a) General rule. Under section 103(l), any private purpose bond 
issued after December 31, 1982 (including any obligation issued 
thereafter to refund private purpose bonds issued before December 31, 
1982) shall be treated as an obligation not described in section 103(a) 
unless the information reporting requirement (as described in paragraph 
(c) of this section) is substantially satisfied with respect to the 
issue of which the bond is a part. For rules concerning bonds issued 
after December 31, 1986, see Sec. 1.149(e)-1 of this chapter.
    (b) Private purpose bonds. For purposes of this section, the term 
``private purpose bond'' means--
    (1) Any industrial development bond (as defined in section 103(b)(2) 
and Sec. 1.103-7(b)(1)), or
    (2) Any obligation which is issued as part of an issue all or a 
major portion of the proceeds of which are to be used directly or 
indirectly--
    (i) To finance loans to individuals for educational or related 
expenses (hereinafter referred to as a ``student loan bond''), or
    (ii) By an organization described in section 501(c)(3) which is 
exempt from taxation by reason of section 501(a) (hereinafter referred 
to as ``private exempt entity bond'').

The meaning of the terms ``major portion'' and ``directly or 
indirectly'' shall be the same as under Sec. 1.103-7. Student loan bonds 
include, but are not limited to, qualified scholarship funding bonds (as 
defined in section 103(e)).
    (c) Information required. An obligation satisfies the requirements 
of section 103(l) and this section only if it is issued as part of an 
issue with respect to which the issuer, based on information and 
reasonable expectations determined as of the date of issue, submits on 
Form 8038 the information required therein, including--
    (1) The name, address, and employer identification number of the 
issuer,
    (2) The date of issue (as defined in paragraph (g)(1)),
    (3) The face amount of the issue,
    (4) The total purchase price of the issue,

[[Page 110]]

    (5) The amount allocated to a reasonably required reserve or 
replacement fund,
    (6) The amount of lendable proceeds (as defined in paragraph (g)(4) 
of this section),
    (7) The stated interest rate of each maturity (as defined in 
paragraph (g)(2) of this section) or, if the interest rate is variable, 
a description of the method under which the interest rate is computed,
    (8) The term (as defined in paragraph (g)(3)) of each maturity,
    (9) A general description of the property to be financed by the 
issue (including property financed by an obligation that will be 
refunded with the issue proceeds) which includes--
    (i) The type of bond issued, that is, a student loan bond, a private 
exempt entity bond, or an industrial development bond and in the case of 
an industrial development bond described in section 103(b)(4), the 
subparagraph of section 103(b)(4) that describes the property, e.g., for 
a football stadium, that the property is described in section 
103(b)(4)(B),
    (ii) The recovery classes (as defined in section 168(c)(2)), if 
applicable, of the various items of financed property and the 
approximate amount of lendable proceeds attributable thereto,
    (iii) The approximate amount of lendable proceeds attributable to 
land or other property not described in subdivision (ii),
    (iv) In the case of obligations described in section 103(b)(6) or 
private exempt entity bonds, the four-digit Standard Industrial 
Classification Code of the facilities financed,
    (10) If section 103(k) (relating to public approval requirement for 
industrial development bonds) applies to such issue, the name(s) of the 
approving governmental unit(s) and of the applicable elected 
representative(s) (as defined in section 103(k)(2)(E) and Sec. 5f.103-
2(e)) or a description of the voter referendum that approved the issue 
for such unit(s), and
    (11) The name, address, and employer identification number of--
    (i) Each initial principal user (as defined in paragraph (g)(5) of 
this section) of any facilities provided with the proceeds of the issue,
    (ii) The common parent, if any, of any affiliated group of 
corporations (as defined in section 1504(a) but determined without 
regard to the exceptions of section 1504(b)) of which such initial 
principal user is a member, and
    (iii) Any person (not included under paragraph (c)(11)(i)) that is 
treated as a principal user under section 103(b)(6)(L), but only if the 
issue is treated as a separate issue under section 103(b)(6)(K).

The information to be supplied must be determined based on information 
and reasonable expectations as of the date of issue. Therefore, such 
statement need not be amended to report information learned subsequent 
to the date of issue. However, if the statement is filed after the date 
of issue it may reflect such information and the reasonable expectations 
of the issuer as of that date.
    (d) Additional information. An issuer may supply the following 
information--
    (1) The average maturity of the issue (as defined in section 
103(b)(14)), and
    (2) The average reasonably expected economic life (as defined in 
section 103(b)(14)) of the facility which is financed with the issue.
    (e) Time for filing. The statement required by section 103(l) and 
this section shall be filed not later than the 15th day of the 2nd 
calendar month after the close of the calendar quarter in which the 
obligation is issued. It may be filed at any time before such date but 
must be complete based on facts and reasonable expectations as of the 
date of issue. The Secretary may grant an extension of time for filing 
the statement required under section 103(l) and this section if there is 
reasonable cause for the failure to file such statement in a timely 
fashion.
    (f) Place for filing. Form 8038 is to be mailed to the Internal 
Revenue Service Center, Philadelphia, Pennsylvania 19255.
    (g) Definitions. For purposes of this section--
    (1) The term date of issue means the date on which the issuer 
physically exchanges the first of the obligations which are part of the 
issue for the underwriter's (or other purchaser's) funds. In the event 
that amounts are

[[Page 111]]

periodically advanced with respect to an issue, the date of issue is 
when the first of such obligations under the issue is created and the 
funds are advanced.
    (2) The term maturity means those obligations of the issue having 
both the same maturity date and the same stated interest rate.
    (3) The term term of an issue means the duration of the period 
beginning on the date of issue and ending on the latest maturity date of 
any obligation of the issue without regard to optional redemption dates.
    (4) The term lendable proceeds means the amount of the original 
proceeds, net of amounts allocated to a reasonably required reserve or 
replacement fund. See generally Sec. 1.103-13(b) and Sec. 1.103-14(d) 
for further definitions.
    (5) The term initial principal user means each person who as of the 
date of issue is obligated to use the facility to such an extent that 
under section 103(b)(6) such person would be treated as a principal 
user. With respect to organizations described in section 501(c)(3), 
however, such determination is made without regard to whether such 
organization is treated as an exempt organization under section 
103(b)(3) and Sec. 1.103-7(b)(2).

[T.D. 7892, 48 FR 21120, May 11, 1983, as amended by T.D. 8129, 52 FR 
7411, Mar. 11, 1987; T.D. 8425, 57 FR 36003, Aug. 12, 1992]



Sec. 5f.163-1  Denial of interest deduction on certain obligations issued after December 31, 1982, unless issued in registered form.

    (a) Denial of deduction generally. Interest paid or accrued on a 
registration-required obligation (as defined in paragraph (b) of this 
section) shall not be allowed as a deduction under section 163 or any 
other provision of law unless such obligation is issued in registered 
form (as defined in Sec. 5f.103-1(c)).
    (b) Registration-required obligation. For purposes of this section, 
the term ``registration-required obligation'' means any obligation 
except any one of the following:
    (1) An obligation issued by a natural person.
    (2) An obligation not of a type offered to the public. The 
determination as to whether an obligation is not of a type offered to 
the public shall be based on whether similar obligations are in fact 
publicly offered or traded.
    (3) An obligation that has a maturity at the date of issue of not 
more than 1 year.
    (4) An obligation issued before January 1, 1983. An obligation first 
issued before January 1, 1983, shall not be considered to have been 
issued on or after such date merely as a result of the existence of a 
right on the part of the holder of such obligation to convert such 
obligation from registered form into bearer form, or as a result of the 
exercise of such a right.
    (5) An obligation described in subparagraph (1) of paragraph (c) 
(relating to certain obligations issued to foreign persons).
    (c) [Reserved]
    (d) Effective date. The provisions of this section shall apply to 
obligations issued after December 31, 1982, unless issued on an exercise 
of a warrant for the conversion of a convertible obligation if such 
warrant or obligation was offered or sold outside the United States 
without registration under the Securities Act of 1933 and was issued 
before August 10, 1982.
    (e) Obligations first issued after December 31, 1982, where the 
right exists for the holder to convert such obligation from registered 
form into bearer form. [Reserved]
    (f) Examples. The application of this section may be illustrated by 
the following examples:

    Example (1). All of the shares of Corporation X are owned by two 
individuals, A and B. X desires to sell all of its assets to Corporation 
Y, all of the shares of which are owned by individual C. Following the 
sale, Corporation X will be completely liquidated. As partial 
consideration for the Corporation X assets, Corporation Y delivers a 
promissory note to X, secured by a security interest and mortgage on the 
acquired assets. The note given by Y to X is not of a type offered to 
the public.
    Example (2). Corporation Z has a credit agreement with Bank M 
pursuant to which Corporation Z may borrow amounts not exceeding $10X 
upon delivery of Z's note to Bank M. The note Z delivers to M is not of 
a type offered to the public.
    Example (3). Individuals D and E operate a retail business through 
partnership DE. D wishes to loan partnership DE $5X. DE's note 
evidencing the loan from D is not of a type offered to the public.

[[Page 112]]

    Example (4). Individual F owns one-third of the shares of 
Corporation W. F makes a cash advance to W. W's note evidencing F's cash 
advance is not of a type offered to the public.
    Example (5). Closely-held Corporation R places its convertible 
debentures with 30 individuals who are United States persons. The 
offering is not required to be registered under the Securities Act of 
1933. Similar debentures are publicly offfered and traded. The 
obligations are not considered of a type not offered to the public.
    Example (6). In 1980, Corporation V issued its bonds due in 1986 
through an offering registered with the Securities and Exchange 
Commission. Although the bonds were initially issued in registered form, 
the terms of the bonds permit a holder, at his option, to convert a bond 
into bearer form at any time prior to maturity. Similarly, a person who 
holds a bond in bearer form may, at any time, have the bond converted 
into registered form.
    (i) Assume G bought one of Corporation V's bonds upon the original 
issuance in 1980. In 1983, G requests that V convert the bond into 
bearer form. Except for the change from registered to bearer form, the 
terms of the bond are unchanged. The bond held by G is not considered 
issued after December 31, 1982, under Sec. 5f.163-1(b)(4).
    (ii) Assume H buys one of Corporation V's bonds in the secondary 
market in 1983. The bond H receives is in registered form, but H 
requests that V convert the obligation into bearer form. There is no 
other change in the terms of the instrument. The bond held by H is not 
considered issued after December 31, 1982, under Sec. 5f.163-1(b)(4).
    (iii) Assume the same facts as in (ii) except that in 1984 I 
purchases H's V Corporation bond, which is in bearer form. I requests V 
to convert the bond into registered form. There is no other change in 
the terms of the instrument. In 1985, I requests V to convert the bond 
back into bearer form. Again, there is no other change in the terms of 
the instrument. The bond purchased by I is not considered issued after 
December 31, 1982, under Sec. 5f.163-1(b)(4).
    Example (7). Corporation U wishes to make a public offering of its 
debentures to United States persons. U issues a master note to Bank N. 
The terms of the note require that any person who acquires an interest 
in the note must have such interest reflected in a book entry. Bank N 
offers for sale interests in the Corporation U note. Ownership interests 
in the note are reflected on the books of Bank N. Corporation U's 
debenture is considered issued in registered form.
    Example (8). Issuer S wishes to make a public offering of its debt 
obligations to United States persons. The obligations will have a 
maturity in excess of one year. On November 1, 1982, the closing on the 
debt offering occurs. At the closing, the net cash proceeds of the 
offering are delivered to S, and S delivers a master note to the 
underwriter of the offering. On January 2, 1983, S delivers the debt 
obligations to the purchasers in definitive form and the master note is 
cancelled. The obligations are not registration-required because they 
are considered issued before January 1, 1983.
    Example (9). In July 1983, Corporation T sells an issue of debt 
obligations maturing in 1985 to the public in the United States. Three 
of the obligations of the issue are issued to J in bearer form. The 
balance of the obligations of the issue are issued in registered form. 
The terms of the registered and bearer obligations are identical. The 
obligations issued to J are of a type offered to the public and are 
registration-required obligations. Since the three obligations are 
issued in bearer form, T is subject to the tax imposed under section 
4701 with respect to the three bearer obligations. In addition, interest 
paid or accrued on the three bearer obligations is not deductible by T. 
Moreover, since the issuance of the three bearer obligations is subject 
to tax under section 4701, J is not prohibited from deducting losses on 
the obligations under section 165(j) or from treating gain on the 
obligations as capital gain under section 1232(d). The balance of the 
obligations in the issue do not give rise to liability for the tax under 
section 4701, and the deductibility of interest on such obligations is 
not affected by section 163(f).
    Example (10). Broker K acquires a bond issued in 1980 by the United 
States Treasury through the Bureau of Public Debt. Broker K sells 
interests in the bond to the public after December 31, 1982. A purchaser 
may acquire an interest in any interest payment falling due under the 
bond or an interest in the principal of the bond. The bond is held by 
Custodian L for the benefit of the persons acquiring these interests. On 
receipt of interest and principal payments under the bond, Custodian L 
transfers the amount received to the person whose ownership interest 
corresponds to the bond component giving rise to the payment. Under 
section 1232B, each bond component is treated as an obligation issued 
with original issue discount equal to the excess of the stated 
redemption price at maturity over the purchase price of the bond 
component. The interests sold by K are obligations of a type offered to 
the public. Further, the interests are, in accordance with section 
1232B, considered issued after December 31, 1982. Accordingly, the 
interests are registration-required obligations under Sec. 5f.163-1(b).

[T.D. 7852, 47 FR 51362, Nov. 15, 1982, as amended by T.D. 7965, 49 FR 
33235, Aug. 22, 1984]

[[Page 113]]



Sec. 5f.168(f)(8)-1  Questions and answers concerning transitional rules and related matters regarding certain safe harbor leases.

    The following questions and answers concern the transitional rules 
and related matters regarding certain safe harbor leases under section 
208(d) of the Tax Equity and Fiscal Responsibility Act of 1982 (Pub. L. 
97-248) (``TEFRA''):

    Q-1: If a lessee, prior to the period beginning after December 31, 
1980, and ending before July 2, 1982 (the ``window period''), enters 
into a binding contract to acquire property and the property is 
delivered to the lessee during the window period, is the property 
eligible for the transitional rule provided in section 208(d)(3) of 
TEFRA which applies the safe harbor leasing rules of section 168(f)(8) 
of the Internal Revenue Code of 1954 as in effect before the enactment 
of TEFRA?
    A-1: Yes, assuming all other requirements of the TEFRA transitional 
rules are met. Section 208(d)(3)(A) (i) and (ii) of TEFRA provide 
alternative tests under which an item of property may constitute 
``transitional safe harbor lease property'' for purposes of the 
transitional rules under the modifications to the safe harbor lease 
provisions of section 168(f)(8). The tests are:
    (i) The lease entered into a binding contract to acquire the 
property;
    (ii) The lessee entered into a binding contract to construct the 
property;
    (iii) The property was acquired by the lessee; or
    (iv) Construction of the property was commenced by or for the 
lessee.

These tests are stated in the alternative, and, accordingly, property 
may be eligible for pre-TEFRA safe harbor leasing if any one of the 
tests is satisfied. Thus, if a lessee acquired property during the 
window period, the property may be eligible for pre-TEFRA safe harbor 
leasing even though a binding contract to acquire the property was 
executed before the window period. Similarly, if construction of 
property commences during the window period, the property may be 
eligible for pre-TEFRA safe harbor leasing even though a binding 
contract to construct the property was executed before the window 
period.
    Q-2: How do the transitional rules apply to components of an 
integrated manufacturing, production, or extraction process, none of 
which would be considered ``placed in service'' until all of the 
components are placed in service?
    A-2: (i) The transitional rules regarding acquisition, binding 
contracts, and commencement of construction are applied to each separate 
item of property which is part of a manufacturing, production, or 
extraction process. What constitutes a separate item will be determined 
on a case-by-case basis, taking into account all relevant factors. In 
general, a discrete component capable of performing a function which is 
separate from or in addition to the function of other components to 
which it may be related is a separate item of property; but an item that 
is integrated into a component which performs a function separate from 
other components to which it is related is not itself a separate item of 
property. For example, a bolt or a nut that is used to construct a 
machine does not constitute a separate item of property. On the other 
hand, the transitional rules will not be applied to an entire facility 
as a whole, as was the case under the investment tax credit transition 
rule of section 50 in Hawaiian Independent Refinery, Inc. v. United 
States, 49 AFTR 2d 675 (Ct. Cl. Tr. Judge 1982), where the taxpayer was 
held to have constructed a property which consisted of an entire 
refinery complex. Thus, for example, for purposes of these transitional 
rules, an oil or gas well, storage tanks, and pipeline located on a 
lease would not be considered a single item of property. Although each 
item is related to the production of oil or gas, each is discrete and 
each is capable of performing a separate function from the other. In 
addition, in the case of an integrated manufacturing, production, or 
extraction process, commencement of construction of one item of property 
within the process would not be considered construction of any other 
item of property that is part of the process.
    (ii) If property qualifies as transitional safe harbor lease 
property, all direct and indirect costs allocable to the property 
(except for those described in Sec. 5c.168(f)(8)-6(a)(2)(ii)) and 
required to be capitalized for Federal income tax purposes will also 
qualify as transitional safe harbor lease property to the extent such 
costs are incurred on or before the date on which the property is leased 
under section 168(f)(8).
    (iii) The adjusted basis to the lessor of property leased on or 
prior to December 1, 1982, under a transitional safe harbor lease shall 
be deemed to include all direct and indirect costs (including 
installation costs) described in subdivision (ii) allocable to such 
property that were incurred before it was leased despite the fact that 
such costs were not included in the lessor's adjusted basis of such 
property under the terms of the lease agreement, provided that the 
parties to such agreement reasonably believed that they had leased the 
whole of such property. Such costs will be treated as having been 
included in the lessor's adjusted basis of such safe harbor lease 
property on the date the lease agreement was executed without regard to 
any provisions in the lease agreement that limits the dollar amount of 
the permissible adjustment of the lessor's adjusted basis to such 
property. To qualify for inclusion of

[[Page 114]]

such direct and indirect costs within the basis of such property, the 
parties to such agreement must file an amended Form 6793, the Safe 
Harbor Lease Information Return, no later than April 21, 1983, which 
reflects the parties' intent to include installation and other such 
costs within the basis of such property. For purposes of this 
subdivision, a transitional safe harbor lease is a lease either which 
was executed after July 1, 1982, and on or prior to December 1, 1982, or 
which includes some transitional safe harbor lease property, as defined 
in TEFRA section 208(d)(3), that was placed in service after July 1, 
1982, and on or prior to December 1, 1982.
    Q-3: What test will be applied in determining whether an item of 
property is constructed or acquired by the lessee?
    A-3: Except as expressly provided in section 208(d)(3) (D) or (E) of 
TEFRA, the determination of whether and when any such events occurred 
with respect to an item of property will generally be made in accordance 
with the principles and precedents prior to TEFRA under the investment 
tax credit and depreciation allowance transitional provisions. See 
Secs. 1.48-2(b)(6) and 1.167(c)-1(a)(2), which provide definitions of 
the term ``acquired'', and Secs. 1.48-2(b)(1) and 1.167(c)-1(a)(1), 
which provide definitions of the term ``constructed by''. Also see Rev. 
Rul. 80-312, 1980-2 C.B. 21, which discusses the factors to be 
considered in determining when a taxpayer has control over a project 
being constructed.
    In general, for purposes of TEFRA section 208(d)(3), construction of 
an item of property is considered to have commenced when physical work 
of a significant nature has begun with respect to the property. Thus, 
construction does not begin when parts or components which enter into 
construction are acquired. If property is assembled from purchased parts 
or components, the commencement of construction occurs when actual 
assembly of the property begins. If a taxpayer manufactures a major part 
or component of an item of property for itself, construction will be 
considered to have begun when the manufacturing of that part or 
component commences. However, construction of an item of property will 
not be considered as begun if physical work by the taxpayer relates to 
minor parts or components. Clearing and grading of land will be 
considered in determining when construction begins on an item of 
property only if they are directly associated with the construction of 
the property.
    Q-4: Under section 168(f)(8)(J), the at-risk rules are liberalized 
for closely held lessors that engage in safe harbor leasing. These rules 
apply ``in the case of property placed in service after the date of 
enactment of this subparagraph,'' namely, after September 3, 1982.
    Do the liberalized at-risk rules apply in the case where otherwise 
qualified property is placed in service by a lessee in August of 1982 
but is leased by a corporate lessor subject to the at-risk rules after 
September 3, 1982?
    A-4: The liberalized at-risk rule in section 168 (f)(8)(J) is 
applicable in this case because, in determining whether property is 
placed in service before or after the date of enactment of section 
168(f)(8)(J), the relevant date is the date the property is placed in 
service by the lessor. Additionally, a closely held corporate lessor, 
which is not a personal service corporation, may lease transitional safe 
harbor lease property placed in service after September 3, 1982, under 
the liberalized at-risk rule.
    Q-5: Is it necessary for property placed in service by a lessee in 
December of 1982 to be leased before January 1, 1983, in order to 
qualify under the general transitional rule of section 208(d)(3)(A) of 
TEFRA, which requires that the property be placed in service before 
January 1, 1983?
    A-5: The legislative intent of this transitional rule was to provide 
a 3-month period after property is placed in service by a lessee in 
which a safe harbor lease could be entered into. Cf. section 209(c) of 
TEFRA (3-month window applies to true leases entered into after 1983). 
The legislative intent further was to permit property to qualify as 
transitional safe harbor lease property if it was placed in service by 
the end of 1982 by a lessee. Accordingly, transitional safe harbor lease 
property placed in service in 1982 by a lessee may be leased in a safe 
harbor lease transaction within 3 months after it is placed in service 
by the lessee without losing its status as transitional safe harbor 
lease property.
    However, for all other purposes of the Code other than section 
168(f)(8)(D)(i), section 168(f)(8)(D)(viii)(II) will apply and the 
property will be treated as originally placed in service not earlier 
than the date that the property is used under the lease. Thus, for 
example, if transitional safe harbor lease property is placed in service 
in December of 1982 and leased under section 168(f)(8) in January of 
1983, the property will not lose its status as transitional safe harbor 
lease property, but the basis adjustment rules of section 48(g) will 
apply with respect to the property.
    Q-6: Will a contract to acquire property be considered ``binding'' 
for purposes of section 208(d)(3)(A)(i) of TEFRA if the contract 
contains no liquidated damages clause?
    A-6: Generally, an irrevocable contract which contains no provision 
for liquidated damages in the event of breach or cancellation would be 
considered binding. Morover, in determining the amount of the lessee's 
potential liability, the fair market value of the property will not be 
taken into account. For example, if a lessee entered into an irrevocable 
contract to purchase an asset for $100 and the contract contained no 
provision for liquidated damages, the contract would be

[[Page 115]]

considered binding notwithstanding the fact that the property at all 
times after July 1, 1982, had a value of $99 and under local law the 
seller could only recover the difference in the event the lessee failed 
to perform. On the other hand, if the contract by its terms provided for 
liquidated damages of less than 5 percent of the purchase price which is 
in lieu of any damages allowable by law, in the event of breach or 
cancellation, the contract would not be considered binding.
    Q-7: How does the 50-percent limitation on lessors in section 
168(i)(1) and the 45-percent limitation on lessees in section 
168(f)(8)(D)(ii) apply to corporations which are part of an affiliated 
group filing consolidated returns?
    A-7: Both the 50-percent limitation on lessors and the 45-percent 
limitation on lessees will be applied on a consolidated basis for 
corporations filing consolidated returns.
    Q-8: Section 168(f)(8)(J) liberalized the at-risk rules for safe 
harbor leasing and provides that in cases where the safe harbor lessee 
would be considered the owner of the property without regard to the safe 
harbor lease, the lessor is considered to be at risk with respect to the 
property in an amount equal to the amount the lessee is considered at 
risk with respect to such property as determined under section 465.
    Will a corporate lessor that would ordinarily be subject to the at-
risk rules under section 465 be exempt from such rules under section 
168(f)(8)(J) in a situation where acquisition of the leased property is 
financed with nonrecourse debt by a lessee that is not subject to the 
at-risk rules?
    A-8: Yes. The liberalized at-risk rules of section 168(f)(8)(J) will 
apply in cases where the lessee's ACRS deductions and investment tax 
credit with respect to the property would not have been limited under 
the at-risk rules had the parties not elected treatment under section 
168(f)(8).
    Q-9: Section 168(f)(8)(J)(ii) excepts certain service corporations 
from the liberalized at-risk rules of section 168(f)(8)(J)(i). Does the 
exception in subdivision (ii) also extend to subsidiaries of such 
service corporations that file consolidated returns?
    A-9: Yes. The liberalized at-risk rules of section 168(f)(8)(J)(i) 
will not apply to any subsidiary filing a consolidated return with a 
service organization described in section 168(f)(8)(J)(ii).
    Q-10: Will property lose its status as transitional safe harbor 
lease property under section 208(d)(3) of TEFRA solely by reason of the 
fact that the person who is a party to a binding contract to acquire the 
property assigns his rights in the contract to another person?
    A-10: When a person who is a party to a binding contract transfers 
his rights in the contract (or the property covered by the contract) to 
another person and the transferor (or a corporation which is a member of 
the same affiliated group as the transferor) will use the property under 
a lease for a period not less than 50 percent of the appropriate 
recovery period for the leased property under section 168(c), then to 
the extent of the transferred rights, this other person will succeed to 
the position of the transferor with respect to the binding contract and 
the property. Accordingly, under these circumstances, property will not 
lose its status as transitional safe harbor lease property.
    In addition, property will not be disqualified as transitional safe 
harbor lease property solely by reason of a transfer by a person of his 
rights in a contract (or the property covered by the contract) in a 
transaction in which the basis of the property in the hands of the 
transferee is determined by reference to its basis in the hands of the 
transferor (e.g., transfers governed by sections 332, 351, 361, 721, and 
731). Thus, for example, if a corporation entered into a binding 
contract for the construction or acquisition of property prior to July 
1, 1982, and after such date assigned the contract to a corporation 
within the same affiliated group which files consolidated returns, the 
assignee will be entitled to treat the property acquired pursuant to the 
contract as transitional safe harbor lease property, assuming the 
property would have so qualified in the hands of the transferor. 
Similarly, if a joint venture or partnership between two corporations 
entered into a binding contract or commenced construction of property 
before July 2, 1982, but dissolved and distributed its assets to the 
partners or joint venturers after July 2, 1982, the joint venturers or 
partners may treat the assets as transitional safe harbor lease 
property, assuming the property would have so qualified had the joint 
venture or partnership remained in existence.
    Q-11: During 1982, Corporation Y placed in service section 38 
property with a total cost of $100X. On August 15, 1982, Corporation Y 
placed in service the last component of an entire facility within the 
meaning of Sec. 5c.168(f)(8)-6(b)(2). The facility had a total cost 
basis of $40X, of which $30X was transitional safe harbor lease property 
within the meaning of section 208(d)(3) of TEFRA and $10X was not 
transitional safe harbor lease property. On November 1, 1982, 
Corporation Y sold and leased back under a section 168(f)(8) lease the 
$30X of transitional safe harbor lease property in the facility.
    Will the entire facility rule in Sec. 5c.168(f)(8)-6(b)(2) apply in 
this situation where the taxpayer has not leased all of the section 38 
property in the facility?
    A-11: No. The placed in service date, for purposes of the rule 
requiring that property be leased within 3 months after such property 
was placed in service by the lessee, would be determined under the 
entire facility rule in Sec. 5c.168(f)(8)-6(b)(2) only if Corporation Y 
had leased all the qualified leased property in the facility. Since 
Corporation Y leased only the $30X of transitional section

[[Page 116]]

38 property, of the facility and did not lease the $10X of 
nontransitional property, Corporation Y may not rely on the entire 
facility rule of Sec. 5c.168(f)(8)-6(b)(2) for purposes of determining 
the placed in service date for the property under the section 168(f)(8) 
lease.
    Q-12: Assume the same facts as in Q-11, except that Corporation Y 
had also placed in service by August 15, 1982, $30X of miscellaneous 
machinery and equipment all of which was transitional safe harbor lease 
property within the meaning of section 208(d)(3) of TEFRA. On November 
1, 1982, in addition to the $30X of transitional property in the 
facility, Corporation Y also sold and leased back under a separate 
section 168(f)(8) lease the $30X of miscellaneous machinery and 
equipment.
    Will the entire facility rule in Sec. 5c.168(f)(8)-6(b)(2) apply in 
this situation to the $30X of transitional property in the facility?
    A-12: Yes. Since Corporation Y leased $30X of transitional machinery 
and equipment and the $30X of the facility which consisted of 
transitional property, Corporation Y can lease none of the 
nontransitional property in the facility because, by reason of the 45-
percent cap on lessees contained in section 168(f)(8)(D) (ii) and (iii) 
and (I), it is not qualified leased property for purposes of section 
168(f)(8). Thus, on the facts, Corporation Y has leased all the 
qualified leased property in the facility.
    Q-13: Corporation X constructed a manufacturing complex consisting 
of three integrated operational components, each with a different ADR 
present class life midpoint, which together constitute an ``entire 
facility'' within the meaning of Sec. 5c.168(f)(8)-6(b)(2). The last 
components of the facility were placed in service on August 15, 1982. On 
October 1, 1982, Corporation X sold to Corporation Z and leased back 
under section 168(f)(8) all the qualified leased property of the 
facility.
    For purposes of the rule requiring that property be leased within 3 
months after such property was placed in service by the lessee, will the 
leased components of the entire facility be considered placed in service 
by the lessee on August 15, 1982, the date the last components were 
placed in service, if the components are leased at one time pursuant to 
documents consisting of three section 168(f)(8) leases with different 
terms to reflect the different ADR midpoint lives of the qualified 
leased property in the facility?
    A-13: Yes. If the entire facility rule in Sec. 5c.168(f)(8)-6(b)(2) 
applies, the facility components which were placed in service prior to 
August 15, 1982, will be treated as placed in service by the lessee on 
August 15, 1982, for purposes of the 3-month rule. This rule will apply 
if all the qualified leased property of the facility is leased at one 
time. The documentation may be in the form of multiple, simultaneously 
executed agreements or maybe in the form of an agreement comprised of 
one or more parts or schedules. Each of the multiple agreements, or each 
of the parts or schedules of an agreement, may have different lease 
terms for property with different ADR midpoint lives, so long as each 
such agreement or part of schedule individually would be treated as a 
lease under section 168(f)(8), taking into account the entire facility 
rule, with lease terms commencing on the same date. A single transaction 
effected by multiple agreements or by an agreement with one or more 
parts or schedules will meet the maximum lease term requirement of 
Sec. 5c.168(f)(8)-5(b) so long as each agreement or each part or 
schedule of an agreement meets the maximum lease term requirement.
    Q-14: Under Sec. 5c.168(f)(8)-6(b)(2), the special rule for 
facilities applies only if the entire facility is leased under a section 
168(f)(8) lease.
    Will a transaction not qualify under section 168(f)(8) if the 
parties, acting in good faith, omit an insubstantial portion of the 
qualified lease property from the lease?
    A-14: No. The facility rule of Sec. 5c.168(f)(8)-6(b)(2) will apply 
if the parties, acting in good faith, substantially comply with its 
terms.
    Q-15: When will construction of an aircraft be considered to have 
been begun after June 25, 1981, and before February 20, 1982, for 
purposes of TEFRA section 208(d)(3)(D)?
    A-15: Construction of an aircraft will be considered to have been 
begun after June 25, 1981, and before February 20, 1982, if during such 
period any of the following events occurred:
    (i) Construction or reconstruction of a subassembly designated for 
the aircraft was commenced;
    (ii) Construction of a lot increment of subassemblies (one or more 
of which was designated for the aircraft) was commenced; or
    (iii) The stub wing join occurred.
    Q-16: Does the definition of assets used in the manufacture or 
production of steel for purposes of TEFRA section 208(d)(2)(F) include 
all assets used in this function (such as electrical and steam 
generators and distribution equipment, coke oven by-product equipment) 
although not necessarily includible in the former ADR guideline class 
for primary steel mill products?
    A-16: Yes, all assets that are used, in their primary function, as 
an integral part of the steel manufacturing or production process are 
included. Cf. Sec. 1.48-1(d)(4). However, the steel manufacturing or 
production process does not include processing beyond the production of 
primary ferrous metals (as defined by the ADR Class for Manufacture of 
Primary Ferrous Metals).
    Q-17: Where a qualified mass commuting vehicle meets the 
requirements for both the TEFRA section 208(d)(2) transitional rule and 
the TEFRA section 208(d)(5) special rule for mass commuting vehicles, 
which provision will control?
    A-17: The general transitional rule of TEFRA section 208(d)(2) will 
apply. Thus,

[[Page 117]]

pursuant to TEFRA section 208(d)(2)(B), the provisions of section 
168(f)(8)(J), but not the provisions of section 168(i)(1), will apply 
only to such property. If the general transitional rule does not apply 
to a specific mass commuting vehicle, the provision of section 168(i)(1) 
applies to the lessor who leases such vehicle.
    Q-18: Does the definition of a qualified mass commuting vehicle 
include component parts of a qualified mass commuting vehicle--such as 
an undercarriage of a subway car or the costs of rehabilitation or 
reconstruction of a mass commuting vehicle (or component part thereof)?
    A-18: Yes.

[T.D. 7850, 47 FR 50853, Nov. 10, 1982, as amended by T.D. 7879, 48 FR 
11942, Mar. 22, 1983]



PART 6a--TEMPORARY REGULATIONS UNDER TITLE II OF THE OMNIBUS RECONCILIATION ACT OF 1980--Table of Contents




Sec.
6a.103A-1  Interest on mortgage subsidy bonds.
6a.103A-2  Qualified mortgage bond.
6a.103A-3  Qualified veterans' mortgage bonds.
6a.6652(g)-1  Failure to make return or furnish statement required under 
          section 6039C.

    Authority: 26 U.S.C. 7805.
    Sections 6a.103A-2(k), (l), and (m) also issued under 26 U.S.C. 
103A(j) (3), (4), and (5).



Sec. 6a.103A-1  Interest on mortgage subsidy bonds.

    (a) In general--(1) Mortgage subsidy bond. A mortgage subsidy bond 
shall be treated as an obligation not described in section 103 (a)(1) or 
(a)(2). Thus, the interest on a mortgage subsidy bond is includable in 
gross income and subject to Federal income taxation.
    (2) Exceptions. Any qualified mortgage bond and any qualified 
veterans' mortgage bond shall not be treated as a mortgage subsidy bond. 
See Sec. 6a.103A-2 with respect to requirements of qualified mortgage 
bonds and Sec. 6a.103A-3 with respect to requirements of qualified 
veterans' mortgage bonds.
    (3) Additional requirement. In addition to the requirements of 
Sec. 6a.103A-2, Sec. 6a.103A-3, and this section, qualified mortgage 
bonds and qualified veterans' mortgage bonds shall be subject to the 
requirements of section 103(c) and the regulations thereunder.
    (4) Advance refunding. On or after December 5, 1980, no tax-exempt 
obligation may be issued for the advance refunding of a mortgage subsidy 
bond (determined without regard to section 103A(b)(2) or Sec. 6a.103A-
1(a)(2)). An obligation issued for the refunding of a mortgage subsidy 
bond will be considered to be an advance refunding obligation if it is 
issued more than 180 days before the prior issue is discharged.
    (5) Registration. Any obligation that is part of a qualified 
mortgage bond issue or qualified veterans' mortgage bond issue and which 
is issued after December 31, 1981, must be in registered form. The term 
``in registered form'' has the same meaning as in Sec. 1.6049-2(d). 
Thus, in general, an obligation is issued in registered form if it is 
registered as to both principal and interest and if its transfer must be 
effected by the surrender of the old instrument to the issuer and by 
either the reissuance of the old instrument to a new holder or the 
issuance of a new instrument to a new holder.
    (b) Definitions. For purposes of Secs. 6a.103A-2, 6a.103A-3, and 
this section the following definitions apply:
    (1) Mortgage subsidy bond. (i) The term ``mortgage subsidy bond'' 
means any obligation which is issued as part of an issue a significant 
portion of the proceeds of which is to be used directly or indirectly to 
provide mortgages on owner-occupied residences.
    (ii) For purposes of subdivision (i), a significant portion of the 
proceeds of an issue is used to provide mortgages if 5 percent or more 
of the proceeds are so used.
    (2) Mortgage. The term ``mortgage'' includes deeds of trust, 
conditional sales contracts, pledges, agreements to hold title in 
escrow, and any other form of owner financing.
    (3) Bond. The term ``bond'' means any obligation. The term 
``obligation'' means any evidence of indebtedness.
    (4) State. (i) The term ``State'' includes a possession of the 
United States and the District of Columbia.
    (ii) For purposes of subdivision (i), obligations issued by or on 
behalf of any State or local governmental unit by constituted 
authorities impowered

[[Page 118]]

to issue such obligations are the obligations of such governmental unit. 
See Sec. 1.103-1(b).
    (5) Proceeds. The term ``proceeds'' includes original proceeds and 
investment proceeds. The terms ``original proceeds'' and ``investment 
proceeds'' shall have the same meaning as in Sec. 1.103-13(b)(2). Unless 
otherwise provided in Sec. 6a.103A-2 or this section, however, amounts 
earned from the investment of proceeds which are derived from qualified 
mortgage bonds in nonmortgage investments may not be commingled for the 
purposes of accounting for expenditures with other non-bond amounts, and 
such proceeds are investment proceeds even though not treated as 
investment proceeds for purposes of section 103(c). Repayments of 
principal on mortgages shall be treated as proceeds of an issue. Amounts 
(such as State appropriations or surplus funds) which are provided by 
the issuer or a private lender in conjunction with a qualified mortgage 
bond or a qualified veterans' mortgage bond shall not be treated as 
proceeds of a mortgage subsidy bond under this section. However, fees 
which are paid by a participating financial institution pursuant to an 
agreement with the issuer whereby such institution receives the right to 
originate or service mortgages and which are retained by an issuer are 
treated as original proceeds of the issue. Amounts provided by the 
issuer or a private lender may be treated as proceeds of an issue for 
purposes of section 103(c).
    (6) Single-family and owner-occupied residences. Except for purposes 
of Sec. 6a.103A-2 (g) and (h)(2)(ii), the terms ``single-family'' and 
``owner-occupied,'' when used with respect to residences, include two-, 
three-, and four-family residences--
    (i) One unit of which is occupied by the owner of the units, and
    (ii) Which were first occupied as a residence at least 5 years 
before the mortgage is executed.

[T.D. 7780, 46 FR 34314, July 1, 1981; 46 FR 37890, July 23, 1981, as 
amended by T.D. 7794, 46 FR 55514, Nov. 10, 1981]



Sec. 6a.103A-2  Qualified mortgage bond.

    (a) In general--(1) Qualified mortgage bond. A qualified mortgage 
bond shall not be treated as a mortgage subsidy bond, and the interest 
on a qualified mortgage bond will be exempt from Federal income 
taxation.
    (2) Termination date. No obligation issued after December 31, 1987, 
shall be treated as part of a qualified mortgage bond issue.
    (b) Definitions and special rules. For purposes of this section and 
Sec. 6a.103A-1, the following definitions apply:
    (1) Qualified mortgage bond. The term ``qualified mortgage bond'' 
means one or more obligations issued by a State or any political 
subdivision thereof (hereinafter referred to as ``governmental unit'') 
as part of an issue--
    (i) All of the original proceeds of which, net of the costs of 
issuing the obligations and proceeds invested in a reasonably required 
reserve fund (such net amount hereinafter in this section referred to as 
``lendable proceeds''), are to be used to finance owner-occupied 
residences, and
    (ii) Which meets each of the requirements of Sec. 6a.103A-1 and this 
section.

A qualified mortgage bond does not include any bond that is an 
industrial development bond under section 103(b).
    (2) Constitutional home rule city. The term ``constitutional home 
rule city'' means, with respect to any calendar year, any political 
subdivision of a State which, under a State constitution which was 
adopted in 1970 and effective on July 1, 1971, had home rule powers on 
the 1st day of the calendar year.
    (3) Targeted area residence. The term ``targeted area residence'' 
means a residence in an area which is either--
    (i) A qualified census tract, or
    (ii) An area of chronic economic distress.
    (4) Qualified census tract. (i) The term ``qualified census tract'' 
means a census tract in which 70 percent or more of the families have an 
income which is 80 percent or less of the State-wide median family 
income.
    (ii) The determination under subdivision (i) shall be made on the 
basis of the most recent decennial census for which data are available. 
With respect to any particular bond issue, such determination may be 
based upon the decennial census data available 3 months prior to the 
date of issuance and shall

[[Page 119]]

not be affected by official changes to such data during or after such 3-
month period.
    (iii) The term ``census tract'' means a census tract as defined by 
the Secretary of Commerce.
    (5) Areas of chronic economic distress. (i) The term ``area of 
chronic economic distress'' means an area designated by a State as 
meeting the standards established by that State for purposes of this 
subparagraph and approved by the Secretary and by the Secretary of 
Housing and Urban Development in accordance with the criteria set forth 
in (iii) of this subparagraph. A State may withdraw such designation at 
any time, with reasonable cause. Such withdrawal shall be effective upon 
notification by the State to the Assistant Secretary for Housing/Federal 
Housing Commissioner of the Department of Housing and Urban Development. 
Such withdrawal shall not affect the tax-exempt status of any 
outstanding issue of obligations.
    (ii) For purposes of making a designation under this subparagraph, 
withdrawing a designation, or making any other submission, ``State'' 
means the governor of a State, or a State official commissioned by the 
governor or by State statute for such purposes.
    (iii) The following criteria will be used in evaluating a proposed 
designation of an area of chronic economic distress:
    (A) The condition of the housing stock, including the age of the 
housing and the number of abandoned and substandard residential units. 
Data pertinent to this criterion include the number and percentage of 
housing units that were constructed prior to 1940, the average age of 
the housing stock, the number and percentage of abandoned housing units, 
and the number and percentage of substandard residential units.
    (B) The need of area residents for owner financing under a qualified 
mortgage bond issue as indicated by low per capita income, a high 
percentage of families in poverty, a high number of welfare recipients, 
and high unemployment rates. Data pertinent to this criterion include 
the per capita income of the population in the area, the number and 
percentage of families eligible to receive food stamps from a program 
pursuant to 7 U.S.C. 2011, the number and percentage of families 
eligible to receive payments under the Aid to Families with Dependent 
Children program, and the unemployment rate.
    (C) The potential for use of owner financing under a qualified 
mortgage bond issue to improve housing conditions in the area. Data 
pertinent to this criterion include the number and percentage of owner-
occupied homes that are substandard, the number and percentage of 
families that are low- or moderate-income renters, and the number and 
percentage of substandard units in the area that will be improved 
through the use of owner financing provided by the proceeds of a 
qualified mortgage bond issue.
    (D) The existence of a housing assistance plan which provides a 
displacement program and a public improvements and services program 
(similar to the Housing Assistance Plan (HAP) required by the Department 
of Housing and Urban Development under the Community Development Block 
Grant program (42 U.S.C. 5301 et seq.)).

This determination shall be based upon the most recent data availabe. 
The certification described in subdivision (iv)(C) shall satisfy the 
criteria set forth in subdivisions (C) and (D). A certification 
described in (iv)(D) shall satisfy the criteria set forth in 
subdivisions (A) and (B): Provided, That the majority of the households 
in the proposed area have incomes less than 80 percent of the median 
income for the standard metropolitan statistical area (SMSA) in which 
the proposed area is located or, if the proposed area is not within a 
SMSA, less than 80 percent of the median income for the State.
    (iv) A proposal by the State that an area be approved as an area of 
chronic economic distress shall contain the following information:
    (A) A description of the proposed area by its geographical limits.
    (B) Maps of the State and of areas within the State that are 
qualified census tracts and existing or proposed areas of chronic 
economic distress.

[[Page 120]]

    (C) Where applicable, a certification of the local Area Manager of 
the Department of Housing and Urban Development in which the proposed 
area is located that the proposed area is a Neighborhood Strategy Area 
(NSA) under 24 CFR 570.301(c) promulgated pursuant to the Community 
Development Block Grant program or an area comparable to a NSA which has 
been reviewed and approved by the Area Manager as meeting the standards 
for an NSA.
    (D) Where applicable, a certification from the HUD Area Manager with 
jurisdiction over the proposed area that the proposed area is within a 
geographic area which has been declared eligible for grants under the 
Urban Development Action Grant Program, Pursuant to 24 CFR 570.452, by 
the Secretary of Housing and Urban Development.
    (E) Statistical and descriptive information pertinent to the 
criteria enumerated in subdivision (iii) of this subparagraph, and a 
succinct statement of how the information furnished satisfies those 
criteria. Such statistical information shall be based upon the most 
recent data available.
    (F) If the State so desires, a written request for a conference 
prior to any adverse decision on the proposed designation.
    (G) A certification by the Governor or designated official that the 
proposed designation conforms to these regulations.
    (v) The proposed designation and the information furnished with it 
as required by subdivision (iv) of this subparagraph shall be submitted 
in triplicate to the Assistant Secretary for Housing/Federal Housing 
Commissioner of the Department of Housing and Urban Development 
(Attention: Office of State Agency and Bond Financed Programs, Rm. 6138, 
451 7th Street, SW., Washington, D.C. 20410).
    (vi) Only those areas of chronic economic distress that have been 
previously designated by the State and approved in accordance with this 
subparagraph at least 3 months prior to the date of issuance need to be 
taken into account for any particular bond issue. Residences located in 
areas designated as areas of chronic economic distress approved in 
accordance with this subparagraph within such 3-month period or after 
the date of issue, however, may be treated as targeted area residences. 
However, for purposes of paragraph (h)(2), relating to the specified 
portion of proceeds to be placed in targeted areas, and paragraph 
(i)(3)(ii)(A), relating to the 1\1/2\ year temporary period, only areas 
approved as areas of chronic economic distress in accordance with this 
subparagraph at the time of issue may be taken into consideration.
    (6) Standard metropolitan statistical area. A standard metropolitan 
statistical area (``SMSA'') is an area in and around a city of 50,000 
inhabitants or more (or equivalent area) and defined by the Secretary of 
Commerce as an SMSA.
    (7) Statistical area. The term ``statistical area'' means--
    (i) An SMSA,
    (ii) Any county (or portion thereof) which is not within an SMSA, or
    (iii) If there is insufficient recent statistical information with 
respect to a county (or portion thereof) described in subdivision (ii) 
of this subparagraph, such other area as may be designated by the 
Commissioner, upon proper application, as a substitute for such county 
(or portion thereof).

For purposes of subdivisions (ii) and (iii) of this subparagraph, in 
Alaska, the entire State, and in Louisiana, a parish, shall be treated 
in a manner similar to a county.
    (8) Acquisition cost. (i) The term ``acquisition cost'' means the 
cost of acquiring a residence from the seller as a completed residential 
unit. Acquisition cost includes the following:
    (A) All amounts paid, either in cash or in kind, by the purchaser 
(or a related party or for the benefit of the purchaser) to the seller 
(or a related party or for the benefit of the seller) as consideration 
for the residence.
    (B) If a residence is incomplete, the reasonable cost of completing 
the residence whether or not the cost of completing construction is to 
be financed with bond proceeds. For example, where a mortgagor purchases 
a building which is so incomplete that occupancy of the building is not 
permitted under local law, the acquisition cost

[[Page 121]]

includes the cost of completing the building so that occupancy of the 
building is permitted.
    (C) Where a residence is purchased subject to a ground rent, the 
capitalized value of the ground rent. Such value shall be calculated 
using a discount rate equal to the yield on the issue (as defined in 
Sec. 6a.103A-2(i)(2)(vi)).
    (ii) The term ``acquisition cost'' does not include the following:
    (A) The usual and reasonable settlement or financing costs. 
Settlement costs include titling and transfer costs, title insurance, 
survey fees, or other similar costs. Financing costs include credit 
reference fees, legal fees, appraisal expenses, ``points'' which are 
paid by the buyer (but not the seller, even though borne by the 
mortgagor through a higher purchase price) or other costs of financing 
the residence. However, such amounts will be excluded in determining 
acquisition cost only to the extent that the amounts do not exceed the 
usual and reasonable costs which would be paid by the buyer where 
financing is not provided through a qualified mortgage bond issue. For 
example, if the purchaser agrees to pay to the seller more than a pro 
rata share of property taxes, such excess shall be treated as part of 
the acquisition cost of a residence.
    (B) The value of services performed by the mortgagor or members of 
the mortgagor's family in completing the residence. For purposes of the 
preceding sentence, the family of an individual shall include only the 
individual's brothers and sisters (whether by the whole or half blood), 
spouse, ancestors, and lineal descendants. For example, where the 
mortgagor builds a home alone or with the help of family members, the 
acquisition cost includes the cost of materials provided and work 
performed by subcontractors (whether or not related to the mortgagor) 
but does not include the imputed cost of any labor actually performed by 
the mortgagor or a member of the mortgagor's family in constructing the 
residence. Similarly, where the mortgagor purchases an incomplete 
residence the acquisition cost includes the cost of material and labor 
paid by the mortgagor to complete the residence but does not include the 
imputed value of the mortgagor's labor or the labor of the mortgagor's 
family in completing the residence.
    (C) The cost of land which has been owned by the mortgagor for at 
least 2 years prior to the date on which construction of the residence 
begins.
    (iii) The following examples illustrate the provisions of 
subparagraph (8):

    Example (1). A contracts with B, a builder of single-family 
residences, for the purchase of a residence. Under the terms of the 
contract, B will deliver a residential unit to A that contains an 
uncompleted recreation room and an unfinished third floor and which 
lacks a garage. Normally, a completed recreation room, a finished third 
floor and a garage are provided as part of the residence built by B. The 
contract price for the residence is $58,000. At the same time, A 
contracts with C, an affiliate of B, to complete the recreation room and 
third floor and to construct the garage for a contract price of $10,000. 
C will perform this work after A receives title to the unit from B. 
Under Sec. 6a.103A-2(b)(8)(i)(A), the acquisition cost of A's completed 
residential unit is $68,000, which represents the contract price of the 
residence plus the cost of completion of the recreation room and third 
floor and construction of the garage.
    Example (2). E owns a single-family residence which E has listed for 
sale. D contracts to purchase E's residence, and the contract provides 
for a selling price of $30,000. D also agrees to pay an unsecured debt 
in the amount of $5,000, which E owes to X, a local bank. D further 
agrees to purchase from E the refrigerator, stove, washer, and dryer 
located in E's residence for $500. Such amount is equal to the fair 
market value of such personalty. D also agrees to purchase the light 
fixtures, curtain rods, and wall-to-wall carpeting for a fair market 
value price of $700. Under Sec. 6a.103A-2(b)(8)(i)(A), the acquisition 
cost of D's completed residential unit is $35,700. Such amount includes 
the $5,000 unsecured debt paid off by D. The $500 paid for the 
refrigerator, stove, washer, and dryer are not included because such 
items are not included within the definition of a residence under 
Sec. 6a.103A-2(d)(4). Such definition does include, however, the light 
fixtures, curtain rods, and wall-to-wall carpeting purchased by D.
    Example (3). F contracts with G to purchase G's home for $40,000. 
After purchasing the residence, F pays a party unrelated to G $3,000 for 
painting, minor repairs, and refinishing the floors. Under Sec. 6a.103A-
2(b)(8)(i)(A), the acquisition cost of the residence is $40,000. Such 
fix-up expenses are not treated as part of the acquisition costs. If G 
had incurred such fix-up expenses, however,

[[Page 122]]

F may not reduce his acquisition cost of the residence by such amounts.

    (9) Qualified home improvement loan. (i) The term ``qualified home 
improvement loan'' means the financing (whether or not secured by a 
mortgage), in an amount which does not exceed $15,000 with respect to 
any residence, of alterations, repairs, and improvements on, or in 
connection with, an existing single-family, owner-occupied residence by 
the owner thereof, but only if such items substantially protect or 
improve the basic livability or energy efficiency of the residence.
    (ii) Alterations, repairs, or improvements that satisfy the 
requirement of subdivision (i) of this subparagraph include the 
renovation of plumbing or electric systems, the installation of improved 
heating or air conditioning systems, the addition of living space, or 
the renovation of a kitchen area. Items that will not be considered to 
substantially protect or improve the basic livability of the residence 
include swimming pools, tennis courts, saunas, or other recreational or 
entertainment facilities.
    (iii) If--
    (A) Two or more qualified home improvement loans are provided for 
the same residence, whether or not by the same lender, and
    (B) Any person who had a present ownership interest in such 
residence at the time the previous qualified home improvement loan or 
loans were made has a present ownership interest in the residence at the 
time the subsequent qualified home improvement loan is made,

Then the allowable amount of the subsequent qualified home improvement 
loan shall be reduced by the amount, at origination, of any previous 
qualified home improvement loan, so that the sum of such loans does not 
exceed $15,000.
    (iv) The following example illustrates the provisions of 
subparagraph (9):

    Example. A and B jointly own a residence located in Town M. They 
obtain a qualified home improvement loan for $10,000 from Town M. A 
acquires B's interest in the residence. A applies to State X for a 
qualified home improvement loan. The maximum amount of a qualified home 
improvement loan which may be made by State X is $5,000, the amount that 
when added to the $10,000 previous loan from Town M does not exceed 
$15,000.
    (10) Qualified rehabilitation loans. (i) The term ``qualified 
rehabilitation loan'' means any owner financing provided in connection 
with--
    (A) A qualified rehabilitation, or
    (B) The acquisition of a residence with respect to which there has 
been a qualified rehabilitation,

But only if the mortgagor to whom such financing is provided is the 
first resident of the residence after completion of the rehabilitation. 
Where there are two or more mortgagors of a rehabilitation loan, the 
first residency requirement is met if any of the mortgagors meets the 
first residency requirement.
    (ii) The term ``qualified rehabilitation'' means any rehabilitation 
of a residence if--
    (A) There is a period of at least 20 years between the date on which 
the building was first used and the date on which physical work on such 
rehabilitation begins,
    (B) 75 percent or more of the existing external walls of such 
building are retained in place as external walls in the rehabilitation 
process, and
    (C) The expenditures for such rehabilitation are 25 percent or more 
of the mortgagor's adjusted basis in the residence (including the land 
on which the residence is located).
    (iii) For purposes of (A) and (B), the rules applicable to the 
investment tax credit for qualified rehabilitated buildings under 
section 48(g)(1) (A)(iii) and (B) shall apply. However, unlike section 
48(g)(1)(B), once a building meets the 20-year test, more than one 
rehabilitation of that building within a 20-year period may qualify as a 
qualified rehabilitation.
    (iv) The adjusted basis to the mortgagor is the mortgagor's adjusted 
basis for purposes of determining gain or loss on the sale or exchange 
of a capital asset (as defined in section 1221). The mortgagor's 
adjusted basis shall be determined as of the date of completion of the 
rehabilitation, or, if later, the date the mortgagor acquires the 
residence, i.e., the date on which the mortgagor includes in basis any 
amounts

[[Page 123]]

expended for rehabilitation that are expended for capital assets.
    (v) The amounts expended by the mortgagor for rehabilitation include 
all amounts expended for rehabilitation regardless of whether the 
amounts expended were financed from the proceeds of the loan or from 
other sources, and regardless of whether the expenditure is a capital 
expenditure, so long as the expenditure is made during the 
rehabilitation of the residence and is reasonably related to the 
rehabilitation of the residence. The value of services performed by the 
mortgagor or members of the mortgagor's family (as used in Sec. 6a.103A-
2(b)(8)(ii)(B)) in rehabilitating the residence will not be included in 
determining the rehabilitation expenditures for purposes of the 25-
percent test.
    (vi) Where a mortgagor purchases a residence that has been 
substantially rehabilitated, the 25-percent test is determined by 
comparing the total expenditures made by the seller for the 
rehabilitation of the residence with the acquisition cost of the 
residence to the mortgagor. The total expenditures made by the seller 
for rehabilitation do not include the cost of acquiring the building or 
land but do include all amounts directly expended by the seller in 
rehabilitating the building (excluding overhead and other indirect 
charges).
    (c) Good faith compliance efforts--(1) Mortgage eligibility 
requirements. An issue of qualified mortgage bonds which fails to meet 
one or more of the requirements of paragraphs (d), (e), (f), and (j) of 
this section shall be treated as meeting such requirements if each of 
the following provisions is met.
    (i) The issuer in good faith attempted to meet all such requirements 
before the mortgages were executed. Good faith requires that the trust 
indenture, participation agreements with loan originators, and other 
relevant instruments contain restrictions that permit the financing of 
mortgages only in accordance with such requirements. In addition, the 
issuer must establish reasonable procedures to ensure compliance with 
such requirements. Such procedures include reasonable investigations by 
the issuer or its agent to determine that the mortgages satisfy such 
requirements.
    (ii) Ninety-five percent or more of the lendable proceeds (as 
defined in Sec. 6a.103A-2(b)(1)) that were devoted to owner financing 
were devoted to residences with respect to which, at the time the 
mortgages were executed or assumed, all such requirements were met. In 
determining whether the proceeds are devoted to owner financing which 
meets such requirements, the issuer may rely on an affidavit of the 
mortgagor that the property is located within the issuer's jurisdiction 
and an affidavit of the mortgagor and the seller that the requirements 
of Sec. 6a.103A-2(f) are met. The issuer may also rely on his own or his 
agent's examination of copies of income tax returns which were filed 
with the Internal Revenue Service and which are provided by the 
mortgagor or obtained by the issuer or loan originator in accordance 
with the procedures set forth in Sec. 301.6103(c)-1 which indicate that, 
during the preceding 3 years, the mortgagor did not claim deductions for 
taxes or interest on indebtness with respect to real property 
constituting his principal residence, in addition to an affidavit of the 
mortgagor that the requirements of Sec. 6a.103A-2(e) are met. The 
mortgagor may also provide the issuer or his agent with an affidavit 
that the mortgagor was not required to file such return in accordance 
with section 6012 during one or all of the preceding 3 years. Where a 
particular mortgage fails to meet more than one of these requirements, 
the amount of the mortgage will be taken into account only once in 
determining whether the 95-percent requirement is met. However, all of 
the defects in the mortgage must be corrected pursuant to paragraph 
(c)(1)(iii) of this section.
    (iii) Any failure to meet such requirements is corrected within a 
reasonable period after such failure is discovered. For example, where a 
mortgage fails to meet one or more of such requirements those failures 
can be corrected by calling the nonqualifying mortgage or by replacing 
the nonqualifying mortgage with a qualifying mortgage.
    (iv) Examples. The following examples illustrate the application of 
paragraph (c)(1) of this section:


[[Page 124]]


    Example (1). State X issues obligations to be used to provide 
mortgages for owner-occupied residences. X contracts with bank M to 
originate and service the mortgages. The trust indenture and 
participation agreement require that the mortgages meet the mortgage 
eligibility requirements referred to in paragraph (c)(1). In addition, 
pursuant to procedures established by X, M obtains a signed affidavit 
from each applicant that the applicant intends to occupy the property as 
his or her principal residence within 60 days after the final closing 
and thereafter to maintain the property as his or her principal 
residence. Further, M obtains from each applicant copies certified by 
the Internal Revenue Service of the applicant's Federal tax returns for 
the preceding 3 years and examines each statement to determine whether 
the applicant has claimed a deduction for taxes on real property which 
was the applicant's principal residence pursuant to section 164(a)(1) or 
a deduction pursuant to section 163 for interest paid on a mortgage 
secured by real property which was the applicant's principal residence. 
Also in accordance with X's procedures, M obtains from each applicant a 
signed affidavit as to facts that are sufficient for M to determine 
whether the residence is located within X's jurisdiction and affidavits 
from the seller and the buyer that the purchase price and the new 
mortgage requirements have been met, and neither M nor X knows or has 
reason to believe that such affidavits are false. The mortgage 
instrument provides that the mortgage may not be assumed by another 
person unless X determines that the principal residence, 3-year, and 
purchase price requirements are met at the time of the assumption. These 
facts are sufficient evidence of the good faith of the issuer and meet 
the requirements of paragraph (c)(1)(i). Further, if 95 percent of the 
lendable proceeds are devoted to owner financing which according to 
these procedures meet the requirements of paragraphs (d), (e), (f), and 
(i), then the issue meets the requirements of paragraph (c)(1)(ii).
    Example (2). State Y issues obligations to be used to provide 
mortgages for owner-occupied residences. Y contracts with bank N to 
originate and service the mortgages. The trust indenture and 
participation agreement require that the mortgagor certify compliance 
with the requirements referred to in paragraph (c)(1). By itself, this 
certification is not sufficient evidence of the good faith of the issuer 
to meet the requirements referred to in paragraph (c)(1).
    Example (3). The facts are the same as in Example 1, except that M 
discovers through a verification procedure required by X that, at the 
time of closing, A fraudulently executed the residencey affidavit. 
Instead of occupying the property as a principal residence, A leased the 
property to B for one year. A did not use the property as his residence 
during the lease term. Thus, at the time that A's mortgage was executed 
the residence failed to meet the requirements of paragraph (d) of this 
section.


More than 95 percent of the lendable proceeds of the issue were devoted 
to residences which met all the requirements referred to in paragraph 
(c)(1) at the time the mortgages were executed. Furthermore, pursuant to 
a provision in the mortgage instrument M called the loan. Any failures 
with respect to other mortgages are corrected by M. Based on these 
facts, the issue meets the requirements of subparagraph (c)(1).
    Example (4). The facts are the same as in Example (1), except that 
the issuer requires copies of the applicant's signed tax returns that 
were filed with the Internal Revenue Service for the preceding 3 years 
but does not require that such returns be certified. If 95 percent of 
the lendable proceeds are devoted to owner financing which according to 
these procedures meet the requirements of paragraphs (d), (e), (f), and 
(i), then the issue meets the requirements of paragraph (c)(1)(ii).

    (2) Nonmortgage eligibility requirements. An issue of qualified 
mortgage bonds which fails to meet one or more of the requirements of 
paragraphs (g), (h), and (i) of this section and Sec. 6a.103A-1(a)(5) 
shall be treated as meeting such requirements if each of the following 
provisions is met.
    (i) The issuer in good faith attempted to meet all such 
requirements. This good faith requirement will be met if all reasonable 
steps are taken by the issuer to ensure that the issue complies with 
these requirements.
    (ii) Any failure to meet such requirements is due to inadvertent 
error, e.g., mathematical error, after taking reasonable steps to comply 
with such requirements.
    (iii) The following examples illustrate the application of this 
subparagraph (2):

    Example (1). City X issues obligations to finance owner-occupied 
residences. However, despite taking all reasonable steps to determine 
accurately the size of the market share limitation, as provided in 
paragraph (g)(3), the limit is exceeded because the amount of the 
mortgages originated in the area during the past 3 years is incorrectly 
computed as a result of mathematical error. Such facts are sufficient 
evidence of the good faith of the issuer to meet the requirements of 
paragraph (c)(2).

[[Page 125]]

    Example (2). City Y issues $25 million of bonds to finance single-
family, owner-occupied homes. Attorney A gives an opinion that the bonds 
satisfy the arbitrage requirements of Sec. 6a.103A-2(i) and 
Sec. 6a.103A-1(a)(3). In fact, however, the legal conclusion reached by 
A is erroneous, and the bonds do not meet the requirements of 
Sec. 6a.103A-2(i). The issue does not meet the requirements of 
subparagraph (c)(2) because the erroneous opinion does not constitute 
inadvertent error.

    (d) Residence requirements--(1) In general. An issue meets the 
requirements of this paragraph only if all of the residences for which 
owner financing is provided under the issue meet the requirements of 
this paragraph. A residence meets the requirements of this paragraph 
only if--
    (i) It is a single-family residence (as defined in Sec. 6a.103A-
1(b)(6)) which, at the time the mortgage is executed or assumed, can 
reasonably be expected by the issuer to become the principal residence 
of the mortgagor within a reasonable time after the financing is 
provided; and
    (ii) It is located within the jurisdiction of the authority issuing 
the obligation.
    (2) Affidavit. The requirements of subparagraph (1)(i) of this 
paragraph may normally be met if the mortgagor executes an affidavit of 
his intent to use the residence as his principal residence within a 
reasonable time (e.g., 60 days) after the financing is provided.
    (3) Principal residence. Whether a residence is used as a principal 
residence depends upon all the facts and circumstances of each case, 
including the good faith of the mortgagor. A residence which is 
primarily intended to be used in a trade or business shall not satisfy 
the requirements of this paragraph. For purposes of the preceding 
sentence, any use of a residence which does not qualify for a deduction 
allowable for certain expenses incurred in connection with the business 
use of a home under section 280A shall not be considered as a use in a 
trade or business. Except for certain owner-occupied residences 
described in paragraph (b)(6) of Sec. 6a.103A-1, a residence more than 
15 percent of the total area of which is reasonably expected to be used 
primarily in a trade or business does not satisfy the requirements of 
this subparagraph. Further, a residence used as an investment property 
or a recreational home does not satisfy the requirements of this 
subparagraph.
    (4) Residence. (i) The term ``residence'' includes stock held by a 
tenant-stockholder in a cooperative housing corporation (as those terms 
are defined in section 216(b) (1) and (2)). It does not include property 
such as an appliance, a piece of furniture, a radio, etc., which, under 
applicable local law, is not a fixture. The term also includes factory-
made housing which is permanently fixed to real property. The 
determination of whether factory-made housing is permanently fixed to 
real property shall be made on the basis of the facts and circumstances 
of each particular case.
    (ii) Land. Land appurtenant to a residence shall be considered as 
part of the residence only if such land reasonably maintains the basic 
livability of the residence and does not provide, other than 
incidentally, a source of income to the mortgagor.
    (5) Examples. The following examples illustrate the application of 
this paragraph (d):

    Example (1). A contracts to purchase a new residence from B. Since B 
is unable to move from the residence until 1 month after the scheduled 
closing date, A agrees to lease the residence to B for 1 month at a rent 
equal to the fair rental value. A applies for a mortgage to be provided 
from the proceeds of a qualified mortgage bond. In light of all the 
facts and circumstances in the case, the fact that A temporarily leases 
the residence to B does not prevent the residence from being considered 
as property that can reasonably be expected to be used as A's principal 
residence within a reasonable period of time after financing is 
provided.
    Example (2). C contracts to purchase a new residence located on 2 
acres of land in city X. City X has a zoning regulation which prevents 
the subdividing of any lot in that part of the city for use as a private 
residence into parcels of less than 2 acres. In light of all the facts 
and circumstances in the case, the fact that the residence is located on 
2 acres of land appurtenant to the residence does not prevent the entire 
property from being considered as property to be used by C as a 
residence.
    Example (3). D contracts to purchase a new residence located on 40 
acres of land that D intends to farm. Any financing provided for the 
purchase of that portion of the property intended to be farmed will not 
be considered

[[Page 126]]

as financing provided for an owner-occupied residence.

    (e) 3-year requirement--(1) In general. An issue meets the 
requirements of this paragraph only if each of the mortgagors to whom 
owner financing is provided under the issue meets the requirements of 
this paragraph. A mortgagor meets the requirements of this paragraph 
only if the mortgagor had no present ownership interest in a principal 
residence at any time during the 3-year period prior to the date on 
which the mortgage is executed. For purposes of the preceding sentence, 
the mortgagor's interest in the residence with respect to which the 
financing is being provided shall not be taken into account.
    (2) Exceptions. Subparagraph (1) shall not apply with respect to--
    (i) Any financing provided with respect to a targeted area residence 
(as defined in Sec. 6a.103A-2(b)(3)),
    (ii) Any qualified home improvement loan (as defined in Sec. 6a103A-
2(b)(9)), and
    (iii) Any qualified rehabilitation loan (as defined in Sec. 6a.103A-
2(b)(10)).
    (3) Multiple mortgagors. In the event that there is more than one 
mortgagor with respect to a particular residence, each of such 
mortgagors must meet the 3-year requirement. A person who is liable 
under a note secured by the mortgage but who does not have a present 
ownership interest in a residence subject to the mortgage need not meet 
the 3-year requirement. For example, where a parent of a home purchaser 
cosigns the note for a child but the parent takes no interest in the 
residence, it is not necessary that the parent meet the 3-year 
requirement since the parent is not a mortgagor of the residence.
    (4) Included interests. Examples of interests which constitute 
present ownership interests are the following:
    (i) A fee simple interest;
    (ii) A joint tenancy, a tenancy in common, or tenancy by the 
entirety;
    (iii) The interest of a tenant-shareholder in a cooperative;
    (iv) A life estate;
    (v) A land contract (i.e., a contract pursuant to which possession 
and the benefits and burdens of ownership are transferred although legal 
title is not transferred until some later time); and
    (vi) An interest held in trust for the mortgagor (whether or not 
created by the mortgagor) that would constitute a present ownership 
interest if held directly by the mortgagor.
    (5) Excluded interests. Examples of interests which do not 
constitute present ownership interests are the following:
    (i) A remainder interest;
    (ii) A lease with or without an option to purchase;
    (iii) A mere expectancy to inherit an interest in a principal 
residence;
    (iv) The interest that a purchaser of a residence acquires on the 
execution of a purchase contract; and
    (v) An interest in other than a principal residence during the 
previous 3 years.
    (f) Purchase price requirements--(1) In general. An issue meets the 
requirements of this paragraph only if the acquisition cost (as defined 
in Sec. 6a.103A-2(b)(8)) of each residence, other than a targeted area 
residence, for which owner financing is provided does not exceed 90 
percent of the average area purchase price applicable to such residence. 
In the case of a targeted area residence (as defined in Sec. 6a.103A-
2(b)(3)), the acquistion cost may not exceed 110 percent of the average 
area purchase price applicable to such residence.
    (2) Exception. Paragraph (1) shall not apply with respect to any 
qualified home improvement loan (as defined in Sec. 6a.103A-2(b)(9)).
    (3) Average area purchase price. The term ``average area purchase 
price'' means, with respect to any residence, the average purchase price 
of all single-family residences in the statistical area (as defined in 
Sec. 6a.103A-2(b)(7)) in which the residence being financed is located 
for the most recent 12-month period for which sufficient statistical 
information is available. The determination whether a particular 
residence meets the purchase price requirement shall be made as of the 
date on which the commitment to provide the financing is made or, if 
earlier, the date of purchase of the residence.
    (4) Special rules. (i) In the case of a qualified rehabilitation 
loan, the requirements of this paragraph are met if the mortgagor's 
adjusted basis in the

[[Page 127]]

property as of the completion of the rehabilitation (including the cost 
of the rehabilitation) meets the requirements of paragraph (f)(1). For 
this purpose, a rehabilitated residence is to be treated as a residence 
which has been previously occupied.
    (ii) The determination of average area purchase price shall be made 
separately with respect to--
    (A) Residences which have not been previously occupied;
    (B) Residences which have been previously occupied; and
    (C) One-family, two-family, three-family, and four-family 
residences.
    (5) Safe harbor limitation. (i) For purposes of meeting the 
requirements of this paragraph, an issuer may rely upon average area 
purchase price limitations published by the Treasury Department for the 
statistical area in which a residence is located. These safe harbor 
limitations will be effective for the period stated at the time of 
publication. An issuer may use a limitation different from such safe 
harbor limitation for any statistical area (as defined in Sec. 6a.103A-
2(b)(7)) for which the issuer has more accurate and comprehensive data.
    (ii) The following example illustrates the application of 
subparagraph (5)(i):

    Example. The average area purchase price safe harbor limitation for 
new single-family residences published by the Treasury Department for 
the second half of 1981 for the jurisdiction of governmental unit X is 
$41,500. However, on July 1, 1981, X determines that its average area 
purchase price for new single-family residences is actually $43,000. 
Such determination is based on a comprehensive survey of residential 
housing sales in the jurisdiction over the previous calendar year. The 
data accumulated are based on records maintained by the county clerk's 
office in X's jurisdiction, which enables X to compute average area 
purchase prices separately for new and used residences and for one-, 
two-, three-, and four-family residences. X cannot reasonably update 
such data more often than once a year. X may use average area purchase 
prices computed from these data for mortgages made from July 1, 1981, 
through June 30, 1982, rather than the safe harbor published by the 
Treasury Department.

    (g) Limitation on aggregate amount of qualified mortgage bonds 
issued during any calendar year--(1) In general. An issue meets the 
requirements of this section only if the aggregate amount of bonds 
issued pursuant thereto, when added to the sum of (i) the aggregate 
amount of qualified mortgage bonds previously issued by the issuing 
authority during the calendar year and (ii) the amount of qualified 
mortgage bonds which the issuing authority previously elected not to 
issue under section 25(c)(2)(A)(ii) and the regulations thereunder 
during the calendar year, does not exceed the applicable limit (``market 
limitation'') for such authority for such calendar year.
    (2) State housing finance agency. Except as provided in paragraph 
(g)(4) of this section, the market limitation for any State housing 
finance agency for any calendar year shall be 50 percent of the State 
ceiling for such year. For purposes of the preceding sentence, if any 
State has more than one housing finance agency all such agencies shall 
be treated as a single agency.
    (3) Other issuers. Except as provided in paragraph (g)(4), the 
market limitation for any issuing authority (other than a State housing 
finance agency) for any calendar year is an amount equal to that 
authority's proportionate share of 50 percent of the State ceiling 
amount for such calendar year. The proportionate share is an amount 
which bears the same ratio to 50 percent of the State ceiling for such 
year as--
    (i) The average annual aggregate principal amount of mortgages 
executed during the immediately preceding 3 calendar years for single-
family, owner-occupied residences located within the jurisdiction of 
such issuing authority, bears to
    (ii) An average determined in the same way for the entire State.
    (4) Constitutional home rule city. (i) In determining the market 
limitation for any constitutional home rule city (as defined in 
paragraph (b)(2) of this section), subparagraph (3) shall be applied by 
substituting ``100 percent'' for ``50 percent.''
    (ii) In a State with one or more constitutional home rule cities, in 
computing the market limitation for issuers other than constitutional 
home rule cities, the State ceiling amount for any calendar year shall 
be reduced by the aggregate market limitation for

[[Page 128]]

such year for all constitutional home rule cities in the State.
    (5) Overlapping jurisdictions. (i) For purposes of subparagraph (3) 
of this paragraph, if an area is within the jurisdiction of two or more 
governmental units, such area shall be treated as only within the 
jurisdiction of the unit having jurisdiction over the smallest 
geographical area. However, the governmental unit with jurisdiction over 
the smallest geographical area may enter into a written agreement to 
allocate all or a designated portion of such overlapping area to the 
governmental unit having jurisdiction over the next smallest 
geographical area.
    (ii) Where two governmental units have authority to issue mortgage 
subsidy bonds and both governmental units have jurisdiction over the 
identical geographical area, the aggregate principal amount of mortgages 
on residences located within that area shall be allocated to the 
governmental unit having broader sovereign powers.
    (6) State ceiling. (i) Except as provided in paragraph (g)(6)(v), 
the State ceiling applicable to any State for any calendar year shall be 
the greater of--
    (A) 9 percent of the average annual aggregate principal amount of 
mortgages executed during the immediately preceding 3 calendar years for 
single-family, owner-occupied residences located within the jurisdiction 
of such State, or
    (B) $200,000,000.

Only single-family owner-occupied residences (without regard to the 
definition of such term under Sec. 6a.103A-1(b)(6)) may be used in 
determining the market limitation regardless of whether or not 
residences with up to four family units are to be financed by the 
program. First and second mortgages or mortgages used to refinance an 
existing mortgage shall be used in making such determination. Liens, 
special assessments, and similar encumbrances may not be taken into 
consideration.
    (ii) For mortgages on residences with more than one family unit, the 
full amount of the mortgage shall be applied toward the market 
limitation and not merely that portion allocable to the owner-occupied 
unit.
    (iii) For purposes of determining the State ceiling amount 
applicable to any State for any calendar year an issuer may rely upon 
the State ceiling amount published by the Treasury Department for such 
calendar year. An issuer may rely on a different State ceiling amount 
than such safe-harbor limitation where the issuer has made a more 
accurate and comprehensive determination of such amount.
    (iv) The following example illustrates the application of 
subparagraphs (3) and (6) of this paragraph (g):

    Example. Pursuant to the allocation rule provided in subparagraph 
(3), City Y determines that its maximum market limitation in 1981 is 
$15,000,000. This determination is based on records maintained by the 
county clerk's office from which data for the preceding 3 years have 
been accumulated by City Y as to the number of sales of single-family 
homes in City Y's jurisdiction, the purchase price in each such sales 
transaction, the number of such sales that were financed by mortgages 
and the volume of second mortgages and refinancing on previously 
purchased owner-occupied single-family residences. This information, 
combined with estimates made by City Y of the average mortgage-loan-to-
purchase-price ratio and the ratio of sales of single-family, owner-
occupied residences to all sales of single-family residences from a 
representative sample of sales transactions, enables Y to estimate the 
preceding 3 years' annual aggregate mortgage volume by using the 
following formula:
[GRAPHIC] [TIFF OMITTED] TC16OC91.001

where
v=The preceding 3 years' average annual aggregate volume of mortgages on 
single-family, owner-occupied residences in City Y,
ui=Number of sales of single-family residences,
wi=Average purchase price of all sales,
xi=Percent of all sales transactions that were financed with 
mortgages,
yi=Estimated average mortgage-loan-to-purchase-price ratio,
zi=Estimated percent of sales that were owner-occupied 
residences,
ai=Total volume of second mortgages and refinancing on 
previously purchased owner-occupied, single-family residences,
i=The annual period of calculation, and
t=The current year.


City Y determines its applicable limit for 1981 based on the following 
formula:

L=0.5 (v/s) r, where
L=Market limitation for City Y for the current year,

[[Page 129]]

s=The preceding 3 years' average annual aggregate volume of mortgages on 
single-family, owner-occupied residences in State X, and
r=Ceiling for State X (i.e., r=the greater of .09s or $200,000,000).

City Y may use the Treasury estimate of s which will be published with 
the mortgage volume safe harbor limitation. City Y may rely on its 
determination of its market limitation for obligations issued during 
1981.

    (v) Reduction in State ceiling. If for any calendar year an issuer 
of mortgage credit certificates, as defined in section 25 and the 
regulations thereunder, fails to meet the requirements of section 25 
(d)(2) and the regulations thereunder, relating to the limit on the 
aggregate amount of mortgage credit certificates that may be issued, the 
applicable State ceiling under paragraph (g)(6)(i) of this section for 
the State in which the program operates will be reduced by 1.25 times 
the correction amount (as defined in section 25 (f)(2) and the 
regulations thereunder) with respect to that failure for the calendar 
year following the calendar year in which the Commissioner determines 
the correction amount with respect to that failure.
    (7) Excess obligations. Where an issue of obligations when added to 
the aggregate amount of bonds issued by the same issuing authority in 
the same calendar year exceeds the market limitation determined in 
accordance with this paragraph (g), no portion of the issue will be 
treated as a qualified mortgage bond issue, and interest on such 
obligations shall be subject to Federal income taxation. However, 
previously issued qualified mortgage bond issues which met the market 
limitation at the time of their issuance will not cease to be qualified 
mortgage bond issues even though a subsequent issue causes the aggregate 
amount of obligations to exceed such limitation for a calendar year.
    (8) Transitional rule obligations. In applying this paragraph (g) to 
any calendar year, there shall not be taken into account any bond which, 
by reason of section 1104 of the Mortgage Subsidy Bond Tax Act of 1980 
(94 Stat. 2670) (relating to transitional rules), receives the same tax 
treatment as bonds issued on or before April 24, 1979.
    (9) Procedure for providing a different allocation. (i) A State may, 
by law enacted after December 5, 1980, provide a different formula for 
allocating the State ceiling amount among the governmental units in such 
State (other than constitutional home rule jurisdictions) having 
authority to issue qualified mortgage bonds.
    (ii) The governor of any State may proclaim a different formula than 
provided in subparagraphs (g)(2) and (g)(3) for allocating the State 
ceiling amount among the governmental units in such State having 
authority to issue qualified mortgage bonds. The authority of the 
governor to proclaim a different formula shall not apply after the 
earlier of--
    (A) The 1st day of the 1st calendar year beginning after the 1st 
calendar year after 1980 during which the legislature of the State met 
in regular session, or
    (B) The effective date of any State legislation dealing with such 
ceiling enacted after December 5, 1980.

If, on or before either date, the governor of any State exercises the 
authority to provide a different allocation, such allocation shall be 
effective until the date specified in (B).
    (iii) Unless otherwise provided in a State constitutional amendment 
or by law changing the home rule provisions adopted in the manner 
provided by the State constitution, the allocation of that portion of 
the State ceiling which is allocated to any constitutional home rule 
city may not be changed by the governor or State legislature unless such 
city agrees to such different allocation.
    (iv) Where a State elects to make a different allocation in 
accordance with subdivision (i) or (ii) of this subparagraph, the 
determination as to whether a particular bond issue meets the 
requirements of paragraph (g) of this section will be based upon the 
allocation in effect at the time such bonds were issued. Moreover, the 
authority to provide for a different allocation may not be used directly 
or indirectly to increase the State ceiling amount.
    (v) An issuing authority located in a State with one or more 
constitutional home rule cities may use an alternative method to those 
provided in

[[Page 130]]

subparagraphs (2), (3), and (4) for determining such issuing authority's 
market limitation if, prior to issuing any obligations for the calendar 
year, it demonstrates to the satisfaction of the Commissioner that--
    (A) The use of the methods provided in subparagraph (2), (3), or (4) 
would impose an unreasonable hardship on the issuing authority, and
    (B) Such alternative method is reasonable.
    (h) Portion of loans required to be placed in targeted areas--(1) In 
general. An issue meets the requirements of this paragraph only if--
    (i) The portion of the lendable proceeds (as defined in 
Sec. 6a.103A-2(b)(1)) of the issue specified in subparagraph (2) is made 
available for owner financing of targeted area residences (as defined in 
Sec. 6a.103A-2(b)(3)) for at least 1 year after the date on which owner 
financing is first made available with respect to targeted area 
residences, and
    (ii) The issuer attempts with reasonable diligence to place such 
proceeds in qualified mortgages.

Proceeds are considered first made available with respect to targeted 
area residences on the date on which any financing of mortgages with the 
lendable proceeds of an issue first becomes available. Reasonable 
diligence requires that the issuer and the loan originators use 
reasonable efforts in trying to place mortgages in targeted areas, such 
as by advertising that mortgage funds are available for targeted areas. 
Reasonable diligence is not shown by merely providing in the governing 
instruments that the required amount be set aside for targeted areas.
    (2) Specified portion. The specified portion of lendable proceeds of 
an issue required to be made available in targeted areas is the lesser 
of--
    (i) 20 percent of the lendable proceeds, or
    (ii) 40 percent of the average annual aggregate principal amount of 
mortgages executed during the immediately preceding 3 calendar years for 
single-family, owner-occupied residences in targeted areas within the 
jurisdiction of the issuing authority.
    (3) Safe harbor. For purposes of computing the required portion of 
proceeds specified in subparagraph (2)(ii) of this paragraph, where such 
provision is applicable, an issuer may rely upon the amount produced by 
the following formula:
[GRAPHIC] [TIFF OMITTED] TC16OC91.002

where
P=Required portion to be made available in targeted areas,
X=Average annual aggregate principal amount of mortgages executed during 
the immediately preceding 3 calendar years for single-family, owner-
occupied residences within the State in which the issuing jurisdiction 
is located,
Y=The total population within the State, based on the most recent 
decennial census for which data are available, and
Z=The total population in the targeted areas located within the issuer's 
jurisdiction, based on the most recent decennial census for which data 
are available.


The issuing jurisdiction may use the Treasury Department estimate of X 
which will be published with the mortgage volume safe harbor limitation.
    (4) Minimum amount. (i) The specified portion required to be made 
available in targeted areas is a minimum amount. More than the minimum 
amount may be (but need not be) made available in targeted areas.
    (ii) With respect to any proceeds not required to be made available 
in targeted areas, the requirements of this paragraph do not abrogate 
the requirement of the arbitrage rules that due diligence be used in 
placing lendable proceeds into mortgages.
    (i) Arbitrage and investment gain--(1) In general. An issue meets 
the requirements of this paragraph only if such issue meets the 
requirements of subparagraphs (2), (3), and (4) of this paragraph. For 
purposes of these requirements, all determinations of yield, effective 
interest rates, and amounts required to be paid or credited to 
mortgagors under paragraph (i)(4)(i) of this section shall be made on an 
actuarial basis taking into account the present value of money. The 
requirements of section 103A(i) and this paragraph are applicable in 
addition to the requirements of section 103(c) and Secs. 1.103-13, 
1.103-14, and 1.103-15.
    (2) Effective rate of mortgage interest not to exceed bond yield by 
more than 1 percentage point--(i) Maximum yield. An

[[Page 131]]

issue of qualified mortgage bonds shall be treated as meeting the 
requirements of this subparagraph only if the excess of--
    (A) The effective rate of interest on the mortgages financed by the 
issue, over
    (B) The yield on the issue,

is not greater over the term of the issue than 1 percentage point.
    (ii) Effective rate of interest. (A) In determining the effective 
rate of interest on any mortgage for purposes of this subparagraph, 
there shall be taken into account all fees, charges, and other amounts 
borne by the mortgagor which are attributable to the mortgage or to the 
bond issue. Such amounts include points, commitment fees, origination 
fees, servicing fees, and prepayment penalties paid by the mortgagor.
    (B) Items that shall be treated as borne by the mortgagor and shall 
be taken into account in calculating the effective rate of interest also 
include--
    (1) All points, commitment fees, origination fees, or similar 
charges borne by the seller of the property;
    (2) The excess of any amounts received from any person other than 
the mortgagor by any person in connection with the acquisition of the 
mortgagor's interest in the property over the usual and reasonable costs 
incurred by a person acquiring like property where owner financing is 
not provided through the use of qualified mortgage bonds.
    (C) The following items shall not be treated as borne by the 
mortgagor and shall not be taken into account in calculating the 
effective rate of interest:
    (1) Any expected rebate of arbitrage profit (as required by 
Sec. 6a.103A-2(i)(4)).
    (2) Any application fee, survey fee, credit report fee, insurance 
fee or similar settlement or financing cost to the extent such amount 
does not exceed amounts charged in such area in cases where owner 
financing is not provided through the use of qualified mortgage bonds. 
For example, amounts paid for FHA, VA, or similar private mortgage 
insurance on an individual's mortgage need not be taken into account so 
long as such amounts do not exceed the amounts charged in the area with 
respect to a similar mortgage that is not financial with qualified 
mortgage bonds. Premiums charged for pool mortgage insurance will be 
considered amounts in excess of the usual and reasonable amounts charged 
for insurance in cases where owner financing is not provided through the 
use of qualified mortgage bonds.
    (D)(1) Where amounts other than those derived from the proceeds of a 
mortgage subsidy bond are used to finance single-family residences such 
amounts will not be treated as the proceeds of a qualified mortgage bond 
issue and will not be subject to the limitations set forth in 
subparagraphs (2), (3), and (4) of this paragraph (i). Such amounts may, 
however, be treated as proceeds for purposes of the requirements of 
section 103(c) and the regulations thereunder. Thus, the portion of the 
mortgage pool financed by the proceeds of a qualified mortgage bond 
issue will be subject to the limitations of subparagraphs (2), (3), and 
(4) of this paragraph (i), while the portion not provided with bond 
proceeds will not be subject to such limitations. The interest rate, 
points, origination fees, servicing fees, and other amounts charged with 
respect to that portion of a mortgage loan financed with non-bond 
amounts may not exceed the reasonable and customary amount which would 
be charged where financing is not provided through a qualified mortgage 
bond issue. Where the charge does exceed such reasonable and customary 
amount, any excess will be taken into account in computing the effective 
interest rate on the portion of the loan provided with the proceeds of 
the qualified mortgage bond issue. Furthermore, where such fees and 
other charges are less than the reasonable and customary charges, the 
issuer may not allocate that portion of the charges on the loan amounts 
made with bond proceeds which is equal to such differential to loan 
amounts made with non-bond proceeds.
    (2) If any mortgage is allocated to two or more sources of funds, 
the receipt of amounts which are described in paragraph (i)(2)(ii) (A) 
and (B) of this section, repayments of principal, or payments of 
interest on such mortgage must be allocated to each source of funds.

[[Page 132]]

    (E) The effective rate of interest on any mortgage shall be 
determined in a manner consistent with actuarial methods and shall take 
into account the discounted value of all amounts from the time received 
to an amount equal to the ``purchase price'' of the mortgage. Such 
discount rate is the effective rate of interest on the mortgages. The 
``purchase price'' of a mortgage means the net amount loaned to the 
mortgagor. For example, if a mortgage loan is in the amount of $30,000 
and the mortgagor is charged one point ($300) as an origination fee 
which amount is deducted from loan proceeds available to the mortgagor, 
the purchase price is $29,700. If interest on an issue is paid 
semiannually, all regular monthly mortgage payments and prepayments of 
principal may be treated as being received at the end of each semiannual 
debt service period.
    (1) If interest on an issue is paid semiannually, all regular 
monthly mortgage payments may be treated as being received at the end of 
each semiannual debt service period.
    (2) Prepayments of principal shall be treated as being received on 
the last day of the month in which the issuer reasonably expects to 
receive such prepayments.
    (F) The rate shall be determined on a composite basis for all 
mortgages financed by the issue.
    (iii) Example. The following example illustrate the provisions of 
subparagraph (2)(ii) of this paragraph:

    Example. Purchaser A contracts with seller B, who is represented by 
real estate agent C, for the purchase of B's residence for $65,000. A 
applies to County X for a mortgage provided by the proceeds of a 
qualified mortgage bond. County X requires that agent C provide it with 
a principal residence affidavit as well as verify the purchase price of 
the residence and the location of the purchasers previous residences. 
Due to the increased administrative burden imposed on agent C by County 
X, C charges B a real estate commission of 8 percent ($5,200), rather 
than 6 percent ($3,900). The normal real estate commission is 6 percent. 
Since the 8 percent commission charged by C and paid by B is in excess 
of the usual and reasonable real estate commission where owner financing 
is not provided through the use of qualified mortgage bonds, 2 percent 
($1,300) shall be treated as borne by A and taken into account in 
calculating the effective rate of interest on the mortgage.

    (iv) Prepayment assumption In determining the affective rate of 
interest on mortgages, it shall be assumed that the mortagage prepayment 
rate for mortgages made out of both original proceeds and mortgages that 
the issuer expects with reasonable certainty to be made out of 
prepayments of principal will be equal to 100 percent of the rate set 
forth in the most recent mortgage maturity experience table for 
mortgages having the same term insured under section 203 of the National 
Housing Act and published by the Federal Housing Administration in 
``Survivorship and Decrement Tables for HUD/FHA Home MORTGAGE Insurance 
Program'' for the region, or, if available, the State in which the 
residence is located. For purposes of applying these tables, either the 
original balance method or the declining balance method of calculating 
mortgage loan prepayments may be used. For proceeds used to finance 
qualified home improvement loans or shorter term qualified 
rehabilitation loans for which there are no comparable FHA mortgage 
maturity experience tables, the assumption used by the issuer as to the 
rate of prepayment shall be based upon the reasonable expectations of 
the issuer, as reflected, where applicable, by the issuer's prior 
experience with such loans.
    (v) Net losses. The projected net losses on the mortgage pool (after 
foreclosure and payment of insurance proceeds), based on the most recent 
default experience for the area in which the residences are located, 
shall be taken into consideration in calculating the effective rate of 
interest on the mortgages. However, where mortgages provided under an 
issue are insured with FHA, VA, or private mortgage insurance, in 
conjunction with pool mortgage insurance, the expected net losses will 
be presumed to be zero. In the event that the actual losses on the 
mortgage pool exceed the projected net losses which were taken into 
consideration in calculating the effective rate of interest on the 
mortgages, investment proceeds earned from nonmortgage assets may be 
used to recover the excess losses and

[[Page 133]]

need not be paid or credited to the mortgagors under Sec. 6a.103A-
2(i)(4).
    (vi) Yield on the issue. (A) The yield on an issue of qualified 
mortgage bonds shall be calculated on the basis of--
    (1) The issue price, and
    (2) An expected maturity for the bonds which is consistent with the 
prepayment assumption required under subparagraph (2)(iv) of this 
paragraph.

The expected maturity will be considered consistent with such prepayment 
assumption if all prepayments are assumed to be used to call bonds 
proportionately (i.e., a ``strip'' call). The preceding sentence shall 
not apply to prepayments of mortgages provided from original proceeds to 
the extent such prepayments are used to provide mortgages.
    (B) For purposes of (1) of this subdivision (vi), the term ``issue 
price'' shall have the same meaning as in section 1232(b)(2). Thus, in 
general, such term means the initial offering price to the public, not 
including bond houses and brokers, or similar persons or organizations 
acting in the capacity of underwriters or wholesalers, at which price a 
substantial amount of such obligations were sold or, if privately 
placed, the price paid by the first buyer of such obligations or the 
acquisition cost of the first buyer.
    (3) Nonmortgage investments--(i) Maximum investment. Except as 
provided in subdivision (ii) of this subparagraph, an issue meets the 
requirements of this subparagraph only if--
    (A) At no time during any bond year does the aggregate amount 
invested in nonmortgage investments, e.g., reasonably required reserve 
funds, with a yield materially higher than the yield on the issue exceed 
150 percent of the debt service on the issue for the current bond year, 
and
    (B) Such aggregate amount invested in nonmortgage assets with a 
yield materially higher than the yield on the issue is promptly and 
appropriately reduced as mortgages are repaid.

The amount subject to the maximum investment rule in subdivision (i)(A) 
of this subparagraph includes the original bond proceeds, investment 
proceeds and repayments of principal on the mortgages. For purposes of 
subdivision (B), the amount described in subdivision (A) shall be 
considered promptly and appropriately reduced if beginning in the first 
bond year after the expiration of the temporary period for original 
proceeds described in subdivision (ii)(A) of this subparagraph, such 
amount is reduced within 30 days of the beginning of each bond year by 
an amount equal to the difference between the average scheduled monthly 
mortgage receipts for the bond year (excluding any receipts that were 
scheduled with respect to mortgages that were discharged in the 
preceding bond year) and the average scheduled monthly mortgage receipts 
for the preceding bond year.
    (ii) Temporary periods. Subparagraph (3)(i) of this paragraph shall 
not apply to--
    (A) Proceeds (including prepayments of principal designated to be 
used to acquire additional mortgages) of the issue invested for an 
initial temporary period not to exceed 1 year (1\1/2\ years for proceeds 
required to be set aside for placing mortgages in targeted areas) until 
such proceeds are needed for mortgages, and
    (B) Repayments of principal and interest on mortgages that are 
contributed to a bona fide debt service fund (as defined in Sec. 1.103-
13(b)(12)) and invested for a 13-month temporary period as provided in 
Sec. 1.103-14(b)(10).
    (iii) Debt service defined. For purposes of subparagraph (3)(i)(A) 
of this paragraph, the debt service on the issue for any bond year is 
the scheduled amount of interest and amortization of principal payable 
for such year with respect to such issue. There shall not be taken into 
account amounts scheduled with respect to any bond which has been 
retired before the beginning of the bond year.
    (iv) Nonmortgage investments. A nonmortgage investment is any 
investment other than an investment in a qualified mortgage. For 
example, a mortgage-secured certificate or obligation is a nonmortgage 
investment. Investment earnings from participation fees (described in 
Sec. 6a.103A-1(b)(5)) are treated as investment proceeds on nonmortgage 
investments unless such fees are used to pay debt service or to finance 
owner occupied residences.

[[Page 134]]

    (v) Bonds issued after June 30, 1993. Section 1.148-2(f)(2)(iv) 
applies to bonds issued after June 30, 1993, in lieu of this paragraph 
(i)(3).
    (4) Arbitrage and investment gains to be used to reduce costs of 
owner financing--(i) Rebate requirement. An issue shall be treated as 
meeting the requirements of this subparagraph only if an amount equal to 
the sum of:
    (A) The excess of--
    (1) The net amount earned on all nonmortgage investments pursuant to 
subparagraph (3)(i) and (ii) of this paragraph (other than investments 
attributable to an excess described in this subdivision (A)) over
    (2) The amount which would have been earned if the investments were 
invested at a rate equal to the yield on the issue, plus
    (B) Any income attributable to the excess described in subdivision 
(A),--

shall be paid or credited to the mortgagors as rapidly as practicable. 
Such amount may be disproportionately distributed to the mortgagors if 
the larger portion of such amount is distributed to lower income 
mortgagors. The determination of the excess described in subdivision (A) 
shall take into account any reinvestment of nonmortgage investment 
receipts and any gain or loss realized on the disposition of nonmortgage 
investments. In addition, where nonmortgage investments are retained by 
the issuer after retirement of an issue, any unrealized gains or losses 
as of the date of retirement of such issue must be taken into account, 
in calculating the amount to be rebated to the mortgagors. The amount 
described in subdivision (A)(2) is the amount that would have been 
earned if the investments in nonmortgage obligations were invested at a 
rate equal to the yield on the issue calculated in the same manner as 
provided in Sec. 6a.103A-2(i)(2)(vi) and by using the same compounding 
method. For purposes of subdivision (B), any income attributable to the 
excess described in subdivision (A) shall be taken into account whether 
or not such income exceeds the yield on the bonds.
    (ii) Computation period. Whether earnings are amounts described in 
subdivision (i) (A) or (B) of this subparagraph shall be determined by 
making computations on an annual basis. For example, if at the end of 
the first year the earnings on nonmortgage investments exceed the amount 
that could have been earned if such investments were invested at the 
bond yield, the amount of earnings equal to such difference constitutes 
an excess described in subdivision (i)(A) of this subparagraph. In the 
following year, investment proceeds earned on such excess must be taken 
into account, whether or not such earnings exceed the yield on the 
bonds, and may not be treated as ``negative arbitrage''.
    (iii) Paid or credited. For purposes of subdivision (i) of this 
subparagraph, amounts are paid or credited to mortgagors as rapidly as 
practicable if such amounts are paid or credited to such mortgagors at 
the time the mortgagor discharges the mortgage, for example, through 
prepayment of the entire principal amount or through making the last 
regular payment on the mortgage. The amount paid or credited to the 
mortgagors must have a present value at least equal to the present value 
of the amount described in subdivision (i) of this subparagraph, using 
the yield on the bonds as the discount rate. In the case of prepayments, 
the cumulative amount required to be rebated under subparagraph (4)(i) 
of this paragraph may be determined as of a date before the actual 
prepayment but not more than 1 year earlier than the date of prepayment. 
Except as provided in subparagraph (2)(v) or subparagraph (4)(iv) of 
this paragraph, such amount may not be subject to the claim of any 
party, e.g., a bondholder, and may not be paid over to any party other 
than the mortgagor or the United States.
    (iv) Reduction where issuer does not use full 1 percentage point. 
(A) The amount required to be paid or credited to mortgagors under 
subparagraph (4)(i) of this paragraph shall be reduced by the amount 
which (if it were treated as an interest payment made by mortgagors) 
would result in the excess referred to in subparagraph (2)(i) of this 
paragraph being equal to 1 percentage point. Such amount shall be fixed 
and determined as of the yield determination date. This fixed dollar 
amount may be received by the issuer at any time but may not be adjusted 
for the time of

[[Page 135]]

payment. Such fixed dollar amount shall be equal to the difference 
between the purchase price of mortgages financed by the proceeds of the 
issue and the present value of expected payments of principal and 
interest on such mortgages, using a discount rate equal to the bond 
yield plus 1 percentage point.
    (B) The following example illustrates the provisions of subparagraph 
(4)(iv)(A) of this paragraph:

    Example. In 1981, County X issues obligations to provide mortgages 
for owner-occupied residences. The yield paid on the obligations is 10 
percent, and the effective rate of interest on the mortgages provided by 
the proceeds of such obligations is 9.75 percent. X maintains a 
reasonably required reserve fund which is invested at 15 percent and 
intends to recover that additional amount computed in the manner 
described in subparagraph (4)(iv) which could have been earned from 
investment of the proceeds in mortgages with an effective interest rate 
of 11 percent from the arbitrage earned from the reserve fund 
nonmortgage assets. X plans to recover such amount from the arbitrage 
over a period of 3 years; thus, X will not recover such amount until 
1984. X may not adjust the amount to be received to account for the time 
when such amount will be received.

    (v) Election to pay United States. Subparagraph (4)(i) of this 
paragraph shall be satisfied with respect to any issue if the issuer 
elects in writing before issuing the obligations to pay over to the 
United States--
    (A) Not less frequently than once each 5 years after the date of 
issue, an amount equal to 90 percent of the aggregate amount described 
in subdivision (i) earned during such period (and not theretofore paid 
to the United States), and
    (B) Not later than 30 days after the redemption of the last 
obligation, 100 percent of such aggregate amount not theretofore paid to 
the United States.
    (j) New mortgages--(1) In general. An issue meets the requirements 
of this paragraph only if no part of the proceeds of such issue is to be 
used to acquire or replace an existing mortgage. All of the lendable 
proceeds must be used to provide mortgage loans to persons who did not 
have a mortgage (whether or not paid off) on the residence securing the 
mortgage note at any time prior to the execution of the mortgage.
    (2) Exceptions. For purposes of this paragraph, the replacement of--
    (i) Construction period loans,
    (ii) Bridge loans or similar temporary initial financing, and
    (iii) In the case of a qualified rehabilitation, an existing 
mortgage,

shall not be treated as the acquisition or replacement of an existing 
mortgage. Generally, temporary initial financing is any financing which 
has a term of 24 months or less.
    (3) Assumptions. An issue meets the requirement of this paragraph 
only if a mortgage with respect to which owner financing has been 
provided under such issue may be assumed only if the requirements of 
paragraphs (d), (e), and (f) of this section are met with respect to 
such assumption. The determination of whether these requirements are met 
is based upon the facts as they exist at the time of the assumption as 
if the loan were being made for the first time. For example, the 
purchase price requirement is to be determined by reference to the 
average area purchase price at the time of the assumption and not when 
the mortgage was originally placed. If the bond documents and relevant 
mortgage instruments provide that a mortgage may be assumed only if the 
issuer has determined that the conditions stated in this subparagraph 
are satisfied, the good faith and 95-percent requirements of paragraph 
(c)(1) (i) and (ii) of this section will be considered satisfied with 
respect to the requirements of this subparagraph at the time the 
mortgages were executed. However, any failure to meet the requirements 
of this subparagraph at the time a mortgage is assumed is subject to the 
remedy requirement in paragraph (c)(1)(iii) of this section.
    (4) Examples. The following examples illustrate the application of 
this paragraph (j):

    Example (1). In June 1981 mortgagor A obtained a mortgage from a 
private lending institution in order to construct a house on land which 
A purchased without a mortgage in May 1981. In January 1982 A applies to 
obtain permanent financing on the residence from a program sponsored by 
State housing finance agency Y. Such program is funded with the proceeds 
of qualified mortgage bonds. If A meets the other requirements of this 
section, A qualifies for such permanent financing since the replacing of 
construction

[[Page 136]]

financing is not treated as the acquisition or replacement of an 
existing mortgage.
    Example (2). In June 1981 mortgagor B purchased a new residence in a 
targeted area but was unable to sell his former residence. Therefore, B 
obtained temporary financing for his new residence until his former 
residence was sold. In October 1981 B applies to County Z to obtain 
financing from a program funded with proceeds of qualified mortgage 
bonds. Such financing is needed by B to replace the temporary financing 
for his new residence. If B meets the other requirements of this 
section, the mortgage qualifies for such permanent financing since the 
permanent financing replaces temporary initial financing.
    Example (3). In 1979 mortgagor C purchased a residence but was 
unable to obtain financing from a program sponsored by County W because 
such program prohibited loans from the program which were in excess of 
80 percent of the fair market value of the property. Therefore, in 1979 
C obtained financing from a private lending institution with the 
intention of refinancing when he accumulated sufficient equity in the 
property. In 1981 C has accumulated sufficient equity in the property so 
as to comply with the requirements of the program. C applies to County W 
to refinance under the program, which is funded with the proceeds of 
qualified mortgage bonds. Even if C met the other requirements of this 
section, the mortgage would fail to meet the requirement of paragraph 
(j) since such a mortgage would replace an existing mortgage.
    Example (4). In 1969 mortgagor D purchased a residence and obtained 
financing from a private lending institution. In 1981 D applies to 
County U for a loan for the rehabilitation of the property and for the 
refinancing of the existing mortgage. The program is funded with 
qualified mortgage bonds. If D meets the other requirements of this 
section the mortgage qualifies for such permanent financing since the 
replacement of the mortgage is not treated as the replacement or 
acquisition of an existing mortgage.
    Example (5). In 1950 mortgagor E purchased a residence, obtaining a 
mortgage from a private lending institution to finance the purchase 
price. In 1980 E completed repaying the mortgage. In 1981 E applies for 
a loan from a program sponsored by State housing finance agency X and 
funded with the proceeds of qualified mortgage bonds. The mortgage does 
not meet the requirements of paragraph (j) since E had a previous 
mortgage on his residence, even though such mortgage was previously 
released.

    (k) Information reporting requirement. See Sec. 1.103A-2(k) for 
rules relating to section 103A(j)(3).
    (l) Policy statement. See Sec. 1.103A-2(l) for rules relating to 
section 103A(j)(5).
    (m) State certification. See Sec. 1.103A-2(m) for rules relating to 
section 103A(j)(4).

(98 Stat. 901 (26 U.S.C. 103A(j) (3) and (4)); 68A Stat. 917 (26 U.S.C. 
7805))

[T.D. 7780, 46 FR 34314, July 1, 1981, as amended by T.D. 7794, 46 FR 
55514, Nov. 10, 1981; T.D. 7817, 47 FR 22361, May 24, 1982; T.D. 7819, 
47 FR 24701, June 8, 1982; T.D. 7821, 47 FR 28094, June 29, 1982; T.D. 
7995, 49 FR 48293, Dec. 12, 1984; T.D. 8023, 50 FR 19355, May 8, 1985; 
T.D. 8049, 50 FR 35547, Sept. 3, 1985; T.D. 8476, 58 FR 33553, June 18, 
1993]



Sec. 6a.103A-3  Qualified veterans' mortgage bonds.

    (a) In general. A qualified veterans' mortgage bond shall not be 
treated as a mortgage subsidy bond, and the interest shall be exempt 
from Federal income taxation.
    (b) Qualified veterans' mortgage bond. (1) With respect to 
obligations issued prior to July 19, 1984, the term ``qualified 
veterans' mortgage bond'' means any issue of obligations--
    (i) Which meets the requirements of Sec. 6a.103A-1, Sec. 6a.103A-
2(j) (1) and (2), and this section;
    (ii) Substantially all of the proceeds of which are to be used to 
provide financing for single-family, owner-occupied residences (which 
meet the requirements of Sec. 6a.103A-1(b)(6) and Sec. 6a.103A-2(d)) for 
veterans; and
    (iii) Payment of the principal and interest on which is secured by a 
pledge of the full faith and credit of the issuing State.

A qualified veterans' mortgage bond does not include any bond that is an 
industrial development bond under section 103(b).
    (2) With respect to obligations issued after July 18, 1984, the term 
``qualified veterans' mortgage bond'' means any issue of obligations--
    (i) Which meets the requirements of Sec. 6.103A-1, Sec. 6a.103A-2(d) 
(relating to residence requirements), (j) (1) and (2) (relating to new 
mortgage requirement), and (k) (relating to information reporting 
requirement), and this section;
    (ii) Substantially all of the proceeds of which are to be used to 
provide financing for qualified veterans; and
    (iii) Payment of the principal and interest on which is secured by a 
pledge

[[Page 137]]

of the full faith and credit of the issuing State.

A qualified veterans' mortgage bond does not include any bond that is an 
industrial development bond under section 103(b).
    (c) Qualified veteran. (1) An issue meets the requirements of this 
paragraph only if each of the mortgagors to whom owner financing is 
provided is a qualified veteran.
    (2) With respect to obligations issued prior to July 19, 1984, the 
term ``qualified veteran'' means any veteran.
    (3) With respect to obligations issued after July 18, 1984, the term 
``qualified veteran'' means any veteran who--
    (i) Served on active duty at some time before January 1, 1977, and
    (ii) Applied for financing before the later of--
    (A) The date 30 years after the date on which such veteran left 
active service, or
    (B) January 1, 1985.
    (4) The term ``veteran'' shall have the same meaning as in 38 U.S.C. 
101(2), that is, a person who served in the active military, naval, or 
air service, and who was discharged or released therefrom under 
conditions other than dishonorable.
    (d) Husband and wife. For purposes of this section, if a residence 
is to be owned by a husband and wife as joint tenants, as tenants by the 
entirety, or as community property, and if one spouse is a veteran, then 
both spouses shall be treated as satisfying the requirements of 
paragraph (c) of this section.
    (e) Substantially all. For purposes of this section, the term 
``substantially all'' shall have the same meaning as in Sec. 1.103-8.
    (f) Qualified home improvement loan. The term ``qualified home 
improvement loan'' means the financing (whether or not secured by a 
mortgage) of alterations, repairs, and improvements on, or in connection 
with, an existing single-family, owner-occupied residence by a veteran 
who is the owner thereof. The alterations, repairs, and improvements, 
however, must substantially protect or improve the basic livability or 
energy efficiency of the property, such as the renovation of plumbing or 
electric systems, the installation of improved heating or air 
conditioning systems, the addition of living space, or the renovation of 
a kitchen area. Items that will not be considered to substantially 
protect or improve the basic livability of the property include swimming 
pools, tennis courts, saunas, or other recreational or entertainment 
facilities.
    (g) Volume limitation--(1) In general. In the case of obligations 
issued after June 22, 1984, an issue meets the requirements of this 
paragraph only if the aggregate amount of obligations issued pursuant 
thereto, when added to the aggregate amount of qualified veterans' 
mortgage bonds previously issued by the State during the calendar year, 
does not exceed the State veterans limit for such calendar year. In 
determining the aggregate amount of qualified veterans' mortgage bonds 
issued in calendar year 1984, obligations issued prior to June 23, 1984, 
shall not be taken into account.
    (2) State veterans limit. (i) The State veterans limit for any State 
is the amount equal to--
    (A) The aggregate amount of qualified veterans' mortgage bonds 
issued by the State during the period beginning on January 1, 1979, and 
ending on June 22, 1984 (not including the amount of any qualified 
veterans' mortgage bonds actually issued during the calendar year, or 
the applicable portion of 1984, in such period for which the amount of 
such bonds was the lowest), divided by
    (B) The number (not to exceed 5) of calendar years after 1978 and 
before 1985 during which the State issued qualified veterans' mortgage 
bonds.

In determining the number of calendar years after 1978 and before 1985 
during which the State issued qualified veterans' mortgage bonds, any 
qualified veterans' mortgage bonds issued after June 22, 1984, shall not 
be taken into account. A State that did not issue qualified veterans' 
mortgage bonds during the period beginning on January 1, 1979, and 
ending on June 22, 1984, may not issue qualified veterans' mortgage 
bonds after June 22, 1984.
    (ii) In the case of any obligation which has a term of 1 year or 
less and which was issued to provide financing for property taxes, the 
amount taken

[[Page 138]]

into account under this paragraph with respect to such obligation shall 
be \1/15\ of its principal amount.
    (3) Examples. The following examples illustrate the provisions of 
this paragraph:

    Example (1). State R issued the following issues of qualified 
veterans' mortgage bonds: a $200 million issue on March 31, 1979, a $150 
million issue on May 1, 1980, a $75 million issue on September 1, 1981, 
a $200 million issue on June 5, 1982, a $125 million issue on March 1, 
1983, a $60 million issue on April 1, 1984, and a $100 million issue on 
September 1, 1984. R issued no other issues of qualified veterans' 
mortgage bonds during the period beginning January 1, 1979, and ending 
on December 31, 1984. The aggregate amount of qualified veterans' 
mortgage bonds issued during the period January 1, 1984, through June 
22, 1984 ($60 million), is not taken into account in determining R's 
State veterans limit because that is the lowest aggregate amount of 
qualified veterans' mortgage bonds issued during the calendar year or 
the applicable portion of 1984, in the period beginning on January 1, 
1979, and ending on June 22, 1984. Thus, R's State veterans limit is 
$150 million ($750 million (which is the sum of $200 million, $150 
million, $75 million, $200 million, and $125 million) divided by 5). The 
September 1, 1984, issue is not included in determinig the State 
veterans limit because that issue was issued after June 22, 1984. The 
September 1, 1984, issue of qualified veterans' mortgage bonds meets the 
requirements of Sec. 6a. 103A-3 (g) since the aggregate amount of 
qualified veterans' mortgage bonds issued in calendar year 1984 (not 
including obligations issued prior to June 23, 1984), does not exceed 
the State veterans limit.
    Example (2). State S issued a $100 million issue of qualified 
veterans' mortgage bonds on March 31, 1984. S issued no other issues of 
qualified veterans' mortgage bonds during the period beginning on 
January 1, 1979, and ending on June 22, 1984. The aggregate amount of 
qualified veterans' mortgage bonds issued in the calendar year, or the 
applicable portion of 1984, in the period January 1, 1979, through June 
22, 1984, for which the amount of bonds was the lowest is zero. Thus, 
the State veterans limit for S is $100 million (($100 million minus $0) 
divided by 1).

    (h) Good faith compliance efforts--(1) Mortgage eligibility 
requirements. An issue of qualified veterans' mortgage bonds issued 
after July 18, 1984, which fails to meet the requirements of section 
103A(o)(1), Sec. 6a.103A-2(d) relating to residence requirements), and 
Sec. 6a.103A-2(j) (1) and (2) (relating to new mortgage requirements) 
shall be treated as meeting such requirements if each of the following 
provisions is complied with:
    (i) The issuer in good faith attempted to meet all such requirements 
before the mortgages were executed. Good faith requires that the trust 
indenture, participation agreements with loan originators, and other 
relevant instruments contain restrictions that permit the financing of 
residences only in accordance with such requirements. In addition, the 
issuer must establish reasonable procedures to ensure compliance with 
such requirements. Such procedures include reasonable investigations by 
the issuer to satisfy such requirements.
    (ii) Ninety-five percent or more of the lendable proceeds (as 
defined in Sec. 6a.103A-2(b)(1)) that were devoted to owner-financing 
were devoted to residences with respect to which, at the time the 
mortgages were executed, all such requirements were met. In determining 
whether a person is a qualified veteran the issuer may rely on copies of 
the mortgagor's certificate of discharge indicating that the mortgagor 
served on active duty at some time before January 1, 1977, and stating 
the date on which the mortgagor left active service provided that 
neither the issuer nor its agent knows or has reason to believe that 
such affidavit is false. Where a particular mortgage fails to meet more 
than one of these requirements, the amount of the mortgage will be taken 
into account only once in determining whether the 95-percent requirement 
is met. However, all of the defects in the mortgage must be corrected 
pursuant to subdivision (iii).
    (iii) Any failure to meet such requirements is corrected within a 
reasonable period after such failure is discovered. For example, 
failures can be corrected by calling the nonqualifying mortgage or by 
replacing the nonqualifying mortgage with a qualifying mortgage.
    (2) Nonmortgage eligibility requirements. An issue of qualified 
veterans' mortgage bonds issued after July 18, 1984, which fails to meet 
the requirements of paragraph (g) of this section

[[Page 139]]

shall be treated as meeting such requirements if each of the 
requirements of Sec. 6a.103A-2(c)(2) (i) and (ii) is met.

(98 Stat. 901(26 U.S.C. 103A(j) (3) and (4)); 68A Stat. 917 ( 26 U.S.C. 
7805))

[T.D. 7780, 46 FR 34314, July 1, 1981; 46 FR 37890, July 23, 1981, as 
amended by T.D. 7995, 49 FR 48297, Dec. 12, 1984]



Sec. 6a.6652(g)-1  Failure to make return or furnish statement required under section 6039C.

    (a) Amount imposed. In the case of each failure to meet the 
requirements of--
    (1) Section 6039C, relating to information returns with respect to 
United States real property interests, or
    (2) Section 6039C(b)(3), relating to statements to be provided to 
substantial investors in United States real property interests,

on or before the date prescribed therefor (determined with regard to any 
extension of time for filing), the person failing to meet such 
requirement shall pay $25 for each day during which such failure 
continues.
    (b) Limitation--(1) Domestic corporations and nominees. The maximum 
penalty which may be imposed under paragraph (a) of this section on a 
domestic corporation or nominee for failure to meet the requirements of 
section 6039C(a) for any calendar year is $25,000.
    (2) Partnerships, trusts, estates and foreign corporations. The 
maximum penalty which may be imposed on a partnership, trust, estate or 
foreign corporation for failure to meet the requirements of section 
6039C(b) for any calendar year is $25,000.
    (3) Foreign persons holding U.S. real property interests and 
nominees. The maximum penalty which may be imposed on a foreign person 
holding a U.S. real property interest or on a nominee holding a U.S. 
real property interest for a foreign person for failure to meet the 
requirements of section 6039C(c) for any calendar year is the lesser of 
$25,000 or 5 percent of the aggregate of the fair market value of the 
U.S. real property interests owned by such person at any time during 
such calendar year.
    (c) Definitions--(1) Fair market value. The term ``fair market 
value'' as used in this section is defined in Sec. 6a.897-1 (in the 
Federal Register 47 FR 41541, Sept. 21, 1982).
    (2) Failure. The term ``failure to meet the requirements of section 
6039C'' includes the failure to file a return for any calendar year on 
the date prescribed therefor (determined with regard to any extension of 
time for such filing), or the omission on a return of one or more items 
of information required by section 6039C and the regulations thereunder 
to be provided on the return. It also includes the failure to furnish a 
statement required by section 6039C(b)(3). The failure to furnish a 
return required under section 6039C(b)(1) and the failure to furnish a 
statement to a substantial investor as required by section 6039C(b)(3), 
are separate failures for purposes of paragraph (a) of this section. 
Also, each failure to provide a statement to each substantial investor 
is a separate failure for purposes of paragraph (a). Thus, if an entity 
has 100 substantial investors as defined in section 6039C and fails to 
furnish any of the required statements to substantial investors, there 
are 100 separate failures to furnish the required statement.
    (3) Aggregate of the fair market value of the United States real 
property interests. The ``aggregate of the fair market value of the U.S. 
real property interests'' is the total of the fair market values of each 
U.S. real property interest owned at any time during the calendar year. 
Fair market value is determined as of December 31 of such year for 
property held at the end of the year and on the date of disposition for 
property disposed of during the year.
    (d) Attribution of ownership. For purposes of calculating the 
penalty limitation under Sec. 6a.6652(g)-1(b)(3) with respect to failure 
to meet the requirements of section 6039C(c), U.S. real property 
interests held by a partnership, trust, or estate shall be treated as 
owned proportionately by its partners or beneficiaries.
    (e) Exceptions--(1) Provision of security. If a person otherwise 
required by section 6039C to file a return for a calendar year or 
furnish a statement to a substantial investor complies with the 
requirements of Sec. 6a.6039C-5 relating to furnishing security in lieu 
of filing

[[Page 140]]

such return, or is exempt, by virtue of Sec. 6a.6039C-5(f), from filing 
a return for such year with respect to its U.S. real property interests 
held, no penalty will be imposed under paragraph (a) of this section for 
failure to file such return or furnish such statement.
    (2) Showing of reasonable cause. No amount shall be imposed under 
paragraph (a) of this section for a failure described in such paragraph 
if it is established to the satisfaction of the Director of the Internal 
Revenue Service Center, 11601 Roosevelt Boulevard, Philadelphia, 
Pennsylvania 19155 or in the case of returns concerning the Virgin 
Islands, the Commissioner of the Bureau of Internal Revenue, Tax 
Division, Charlotte Amalie, St. Thomas, V.I. 00801, that such failure is 
due to reasonable cause and not to willful neglect. An affirmative 
showing of reasonable cause must be made in the form of a written 
statement, made under the penalties of perjury, containing a declaration 
by the person failing to make a return or furnish a statement under 
section 6039C setting forth all the facts alleged as reasonable cause. 
Whether reasonable cause is shown may depend upon the subsection of 
section 6039C under which the failure occurs. However, the fact that 
stock of a foreign corporation, or any other interest in any entity to 
which this section applies, is registered in bearer form does not 
constitute reasonable cause under this paragraph (e)(2) of this section 
for failure to comply with the requirements of section 6039C(b). Also, 
the fact that disclosure of ownership would contravene a secrecy law of 
any country does not constitute reasonable cause for failure to comply 
with the requirements of section 6039C(b). Where a return has been filed 
and there is an omission of one or more items of information required by 
section 6039C and the regulations thereunder, one of the facts to be 
considered in determining whether such failure is due to reasonable 
cause is the materiality of the item omitted.
    (3) Spouse or parent already filed with respect to same property. If 
an individual files a return with respect to all U.S. real property 
interests held by such individual in accordance with Sec. 6a.6039C-4(b), 
no penalty shall be imposed under this section on such individual's 
spouse or minor child for failure to file a return under Sec. 6a.6039C-4 
with respect to the same property.
    (f) Manner of payment. The amount imposed under paragraph (a) of 
this section on any person shall be paid in the same manner as tax upon 
the issuance of a notice and demand therefor.
    (g) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example (1). Domestic corporation X is required under section 6039C 
(a) to make a return for calendar year 1982. X does not file such return 
on or before May 15, 1983 as required under Sec. 6a.6039C-1(c). The 
failure to file the return for calendar year 1982 continues throughout 
calendar years 1983, 1984, 1985, and 1986. The failure to file is not 
due to reasonable cause and no security has been furnished in lieu of 
filing. The maximum penalty which can be imposed on X for failure to 
file the 1982 return is $25,000, determined as follows:

------------------------------------------------------------------------
                                                              Cumulative
                                                   Penalty   penalty for
                                                   incurred   failure to
                                                   in given   file 1982
                                                     year       return
------------------------------------------------------------------------
Total penalty incurred in 1983 ($25 per day x        $5,750       $5,750
 230 days)......................................
Total penalty incurred in 1984 (a leap year):         9,150       14,900
 ($25 per day x 366 days).......................
Total penalty incurred in 1985 ($25 per day x         9,125       24,025
 365 days)......................................
Total penalty incurred in 1986 (lesser of $25           975       25,000
 per day x 365 days or $975 (remaining penalty
 which may be imposed)).........................
------------------------------------------------------------------------

    Example (2). The facts are the same as in example (1) except that X 
also fails to file a return under section 6039C (a) for calendar year 
1983. The failure to file its return for calendar year 1983 continues 
throughout calendar years 1984, 1985, 1986 and 1987. The total penalty 
which may be imposed on X for failure to file its return for calendar 
year 1983 is $25,000. The amount of penalty which can be imposed on X in 
calendar years 1984, 1985, 1986 and 1987 is determined as follows:

------------------------------------------------------------------------
                                                                  Total
                                             Penalty   Penalty   penalty
                                            for 1982  for 1983     for
                                             failure   failure    given
                                                                  year
------------------------------------------------------------------------
Penalty incurred in 1984 (a leap year):
  For failure to file 1982 return ($25 per    $9,150  ........  ........
   day x 366 days)........................

[[Page 141]]

 
  For failure to file 1983 return ($25 per  ........    $5,750  ........
   day x 230 days)........................
                                                               ---------
    Total.................................  ........  ........   $14,900
                                                               =========
Penalty incurred in 1985:
  For failure to file 1982 return ($25 per     9,125  ........  ........
   day x 365 days)........................
  For failure to file 1983 return ($25 per  ........     9,125  ........
   day x 365 days)........................
                                                               ---------
    Total.................................  ........  ........    18,250
                                                               =========
Penalty incurred in 1986:
  For failure to file 1982 return (lesser        975  ........  ........
   of $25 per day x 365 days or $975
   (remaining penalty which may be
   imposed))..............................
  For failure to file 1983 return ($25 per  ........     9,125  ........
   day x 365 days)........................
                                                               ---------
    Total.................................  ........  ........    10,100
                                                               =========
Penalty incurred in 1987: For failure to                 1,000  ........
 file 1983 return (lesser of $25 per day x
 365 days or $1,000 (remaining penalty
 which may be imposed))...................
                                                               ---------
    Total.................................  ........  ........     1,000
------------------------------------------------------------------------

    Example (3). Foreign corporation Y is required under section 
6039C(b)(1) to make a return for calendar year 1982. In addition, Y is 
required under section 6039C(b)(3) to furnish statements to each 
substantial investor in U.S. real property interests. Y has 10 such 
substantial investors. Y does not file such return on or before May 15, 
1983 as required under Sec. 6a.6039C-1(c), nor does it furnish the 
required statements on or before January 31, 1983 as required under 
Sec. 6a.6039C-3(h). The failure to file the return for calendar year 
1982 and to furnish the required statements for 1982 continues 
throughout calendar years 1984 and 1985. The failure to meet the 
requirements of section 6039C(b) are not due to reasonable cause and no 
security has been furnished in lieu of filing. The total penalty which 
can be imposed on Y for failure to file the return and statements 
required under section 6039C(b) for calendar year 1982 is $25,000. The 
amount of penalty incurred by Y in calendar year 1983 for failure to 
file the return and statements for calendar year 1982 is $25,000, 
determined as follows:

Penalty incurred in 1982:
  For failure to file return ($25 per dayx230 days)...........    $5,750
  For each failure to furnish a statement required by section     19,250
   6039C(b)(3) ($25 per dayx10 statementsxthe 334 days from
   February 1, 1983 to December 31, 1983 ($83,500) but not
   more than $19,250 (which when added to $5,750 would total
   $25,000))..................................................
                                                               ---------
    Total.....................................................    25,000
 


Since Y has incurred the maximum penalty for failure to file its return 
and statements required for 1982 by the end of calendar year 1983, no 
further penalty for these failures is imposed.
    Example (4). Under section 6039C(c) foreign person Y is required to 
make a return for calendar year 1982. Y does not file such return on May 
15, 1983 and the failure is not due to reasonable cause. No security has 
been furnished in lieu of filing. All properties owned by Y in 1982 are 
U.S. real property interests. Y purchased property M in January 1982 
when its fair market value was $10,000. In March, Y purchased property N 
when its fair market value was $15,000. In November, Y sold property M 
for $20,000. The fair market value of property N on December 31, 1982, 
was $20,000. The total of the fair market values of M and N (M as of the 
date of its sale and N as of December 31, 1982) is $40,000. The maximum 
penalty which may be imposed on Y for failure to meet the requirements 
of section 6093C(c) for any calendar year is the lesser of $25,000 or 5 
percent of the aggregate of the fair market values of the U.S. real 
property interests owned by Y at any time during such calendar year. 
Since $2,000 (5 percent of $40,000) is less than $5,750 ($25 times 230 
days, the number of days in calendar year 1983 for which the failure 
continues), the maximum penalty which may be imposed on Y in 1983 is 
$2,000. Since the maximum penalty for the failure to file the 1982 
return is incurred in 1983, no amount may be imposed for Y's continuing 
failure to file the return for calendar year 1982 during calendar years 
after 1983.

    (h) Effective date. This section shall apply to 1980 and subsequent 
calendar years. The calendar year 1980 shall be treated as beginning on 
June 19, 1980 and ending on December 31, 1980.

[T.D. 7866, 48 FR 648, Jan. 6, 1983]



PART 7--TEMPORARY INCOME TAX REGULATIONS UNDER THE TAX REFORM ACT OF 1976--Table of Contents




Sec.
7.48-1  Election to have investment credit for movie and television 
          films determined in accordance with previous litigation.
7.48-2  Election of forty-percent method of determining investment 
          credit for movie

[[Page 142]]

          and television films placed in service in a taxable year 
          beginning before January 1, 1975.
7.48-3  Election to apply the amendments made by sections 804 (a) and 
          (b) of the Tax Reform Act of 1976 to property described in 
          section 50(a) of the Code.
7.57(d)-1  Election with respect to straight line recovery of 
          intangibles.
7.105-1  Questions and answers relating to exclusions of certain 
          disability income payments.
7.105-2  Substantial gainful activity.
7.465-1  Amounts at risk with respect to activities begun prior to 
          effective date; in general.
7.465-2  Determination of amount at risk.
7.465-3  Allocation of loss for different taxable years.
7.465-4  Insufficient records.
7.465-5  Examples.
7.704-1  Partner's distributive share.
7.936-1  Qualified possession source investment income.
7.999-1  Computation of the international boycott factor.
7.6039A-1  Information regarding carryover basis property acquired from 
          a decedent.
7.6041-1  Return of information as to payments of winnings from bingo, 
          keno, and slot machines.

    Authority: 26 U.S.C. 7805, unless otherwise stated.



Sec. 7.48-1  Election to have investment credit for movie and television films determined in accordance with previous litigation.

    (a) Generally. Under section 804(c)(3) of the Tax Reform Act of 1976 
(Pub. L. 94-455, 90 Stat. 1595), any taxpayer who filed an action in any 
court of competent jurisdiction before January 1, 1976, for a 
determination of such taxpayer's rights to investment credit under 
section 38 of the Internal Revenue Code of 1954 with respect to any film 
placed in service in any taxable year beginning before January 1, 1975, 
may elect to have investment credit on all films placed in service in 
taxable years beginning before January 1, 1975, (except those subject to 
an election under section 804(e)(2) of the Act), determined as though 
section 804 of the Act (except section 804(c)(3) of the Act) had not 
been enacted.
    (b) Manner of making the election. The election allowed by section 
804(c)(3) of the Act may be made by a notification in the form of a 
letter signed by the taxpayer or an authorized representative of the 
taxpayer stating:
    (1) The taxpayer's name, address, and identification number;
    (2) The taxable years in which the films were placed in service with 
respect to which the election shall apply; and
    (3) The court in which the litigation was commenced and information 
adequate to identify the particular litigation, for example, the names 
of the litigants, the date the suit was commenced, and the court case or 
docket number of the litigation.

The letter should be sent to the Deputy Commissioner of Internal 
Revenue, Attention: CC:RL:Br2, Room 4617, 1111 Constitution Avenue, 
N.W., Washington, DC 20224.
    (c) Time for making the election. The election under section 
804(c)(3) of the Act must be made not later than January 3, 1977. If 
mailed, the cover containing the notification of such election must be 
postmarked not later than January 3, 1977.
    (d) Revocation of election. An election under section 804(c)(3) of 
the Act, once made, shall be irrevocable.

[T.D. 7449, 41 FR 56629, Dec. 29, 1976]



Sec. 7.48-2  Election of forty-percent method of determining investment credit for movie and television films placed in service in a taxable year beginning 
          before January 1, 1975.

    (a) General rule. Under section 804(c)(2) of the Tax Reform Act of 
1976 (90 Stat. 1595), taxpayers who placed movie or television films 
(here- inafter referred to as films and tapes) in service during taxable 
years beginning before January 1, 1975, may elect to have their 
investment credit on all such films and tapes determined under section 
46(c) of the Code using an amount equal to 40 percent of aggregate 
production costs in lieu of the basis of such property. If the election 
is made, 100 percent is the applicable percentage used in determining 
qualified investment under section 46(c) of the Code regardless of 
actual useful life. The election can be made only with respect to 
qualified films and tapes that are new section 38 property and the 
investment credit is allowed only to the extent that a taxpayer has an 
ownership interest in the film or tape. No investment credit is allowed 
under section 804(c)(2)

[[Page 143]]

of the Act on any film or tape that is not section 38 property or that 
was produced and shown exclusively outside of the United States. Thus, 
no election may be made under this section with respect to a film or 
tape which is suspension period property to which section 48(h) applies 
or to a film or tape which is termination period property to which 
section 49(a) applies. Any investment credit taken on any film or tape 
subject to the election is not subject to recapture because of an early 
disposition or because a film or tape otherwise ceases to be section 38 
property under section 47(a) of the Code. Thus, there will be no 
recapture because a film or tape is used outside the United States under 
section 48(a)(2) of the Code or section 804(c)(1)(C) of the Act, or 
because of any disposition under section 47(a)(7)(B) of the Code.
    (b) Time and manner of making an election--(1) Time for making the 
election. The election under section 804(c)(2) of the Act must be made 
not later than April 25, 1977.
    (2) Manner of making the election. An election under this section 
must be made by filing amended income tax returns for each taxable year 
beginning before January 1, 1975, in which films and tapes subject to 
the election were placed in service, together with a statement signed by 
the taxpayer containing the information described below. The amended 
returns and the statement must be filed with the district director 
having audit jurisdiction over the last return filed to which the 
election relates. Each amended return shall contain a schedule listing 
by name all films and tapes placed in service during the year to which 
the amended return relates and setting forth all computations necessary 
to determine the aggregate production costs of each such film or tape 
listed and the ownership interest of the taxpayer in each film or tape 
listed. In the case of a taxpayer which is a partner, shareholder of an 
electing small business corporation, or beneficiary of a trust or 
estate, such computations must be adequate to determine the ownership 
interest of the partnership, electing small business corporation, or 
trust or estate in each such film or tape, (a taxpayer which is a 
partner, shareholder, or beneficiary may satisfy the requirements of the 
preceding sentence by attaching to his amended return a copy of an 
amended return, if one is filed, of the partnership, electing small 
business corporation, or trust or estate which sets forth computations 
necessary to determine the ownership interest of the entity in each such 
film or tape.) No amended return need be filed for a taxable year if 
application of the election to films and tapes placed in service during 
that year would not affect tax liability for any taxable year.
    The statement shall contain the following information:
    (i) The taxpayer's name and taxpayer identification number (under 
section 6109 of the Code).
    (ii) A statement that the taxpayer is making the election under 
section 804(c)(2) of the Act.
    (iii) A statement that the taxpayer agrees that the period for 
assessment and collection under section 6501 of the Code will remain 
open until December 31, 1978, solely with respect to adjustments of tax 
liability attributable to investment credit allowed on films and tapes 
placed in service in each year covered by the election. Unless the 
district director notifies the taxpayer within 7 days of receipt of the 
statement that such extension is denied, it will be presumed that the 
district director consents to such extension. Of course, the period 
covered by this statement may be extended beyond December 31, 1978 by 
mutual agreement. This statement does not shorten the regular statutory 
period for any year or take precedence over a previous or subsequent 
agreement with the Internal Revenue Service extending the statutory 
period for any year.
    (iv) A list of the addresses used by the taxpayer on each return 
filed during each taxable year subject to the election.
    (v) A statement that the taxpayer consents to join in judicial 
proceedings to determine the investment credit allowable and entitlement 
to investment credit on any film or tape subject to the election, which 
meets all of the requirements set forth in paragraph (b)(3) of this 
section.
    (vi) A statement as to whether an election has been made by the 
taxpayer

[[Page 144]]

under section 804(e)(2) of the Act for films and tapes which are 
property described in section 50(a) of the Code which were placed in 
service in taxable years beginning before January 1, 1975.
    (vii) A list by name of all films or tapes placed in service during 
the years to which the election relates.
    (viii) With respect to each film or tape listed in paragraph 
(b)(2)(vii) of this section, a list of all producers, distributors, and 
persons with a participation interest (with addresses where available).
    (ix) In the case of an election made by a partner, shareholder of an 
electing small business corporation (as defined in section 1371(b) of 
the Code), or beneficiary, a statement indicating the name, taxpayer 
identification number, and address for tax return purposes of the 
respective partnership, electing small business corporation, or trust or 
estate.
    (3) Consent to join in judicial proceedings. No election may be made 
by any taxpayer unless the statement made under paragraph (b)(2)(v) of 
this section provides that the taxpayer shall:
    (i) Treat the determination of the investment credit allowable on 
each film or tape subject to an election as a separate cause of action;
    (ii) Make all reasonable efforts necessary to join in or intervene 
in any judicial proceeding in any court for determining the person 
entitled to, and the amount of, the investment credit allowable with 
respect to any film or tape covered by the election after receiving 
notice from the Commissioner of Internal Revenue or his delegate 
indicating that a conflicting claim to the investment credit for such 
film or tape is being asserted in such court by another person; and
    (iii) Consent to revocation of the election by the Commissioner of 
Internal Revenue or his delegate with respect to all films and tapes 
placed in service in taxable years for which the election applies, if 
the taxpayer fails to make all reasonable efforts necessary to join in 
or intervene in any judicial proceeding under paragraph (b)(3)(ii) of 
this section.
    (4) Who makes the election. The election must be made separately by 
each person who has an ownership interest. However, where a film or tape 
is owned by a partnership, electing small business corporation (as 
defined in section 1371(b) of the Code), or trust or estate, the 
election must be made separately by each partner, shareholder or 
beneficiary. The election is not to be made by a partnership or electing 
small business corporation, and is to be made by a trust or estate only 
if the trust or estate in determining its tax liability would be allowed 
investment credit on a film or tape subject to the election. The 
election of any partner, shareholder, beneficiary or trust or estate 
shall be effective regardless of whether any related partner, 
shareholder, beneficiary, or trust or estate makes the election.
    (5) Additional time to perfect election. A taxpayer that by April 
25, 1977, files a statement containing the information described in 
paragraph (b)(2) (i) through (v) of this section shall be deemed to have 
made a timely election under paragraph (b)(2) of this section if by July 
5, 1977, the taxpayer has complied with all of the requirements of 
paragraph (b)(2) of this section. If a taxpayer demonstrates to the 
satisfaction of the district director that it is unable to meet the July 
5, 1977, date even though it has made a good faith effort to do so, the 
district director may at his discretion extend that date to no later 
than October 4, 1977, for that taxpayer. Requests for extensions of the 
July 5, 1977, date should be addressed to the district director with 
whom the statement was filed.
    (c) Revocation of election--(1) Revocation by taxpayer. (i) Except 
as provided in paragraph (c)(1)(ii) of this section, an election made 
under section 804(c)(2) of the Act may not be revoked by a taxpayer 
unless consent to revoke the election is obtained from the Commissioner 
of Internal Revenue or his delegate. Application for consent to revoke 
the election will be accepted only if permanent regulations are issued 
which contain rules which may not reasonably have been anticipated by 
taxpayers at the time the election was made. Any permanent regulations 
will provide a reasonable period of time within which taxpayers will be 
permitted to apply for consent to revoke

[[Page 145]]

the election and will allow revocation (where revocation is not barred 
by the limitations on credit or refund inspection 6511 of the Code) in 
the event of a determination by the Commissioner of Internal Revenue or 
his delegate that such permanent regulations contain provisions that may 
not reasonably have been anticipated by taxpayers at the time of making 
such election.
    (ii) An election properly made under section 804(e)(2) of the Act, 
to have sections 48(k) and 47 (a)(7) of the Code apply to films and 
tapes which are property described in section 50(a) of the Code and 
which were placed in service in taxable years beginning before January 
1, 1975, shall automatically revoke any election under section 804(c)(2) 
of the Act with respect to such films and tapes. Such revocation does 
not require the consent of the Commissioner of Internal Revenue or his 
delegate.
    (2) Revocation by Commissioner. The Commissioner of Internal Revenue 
or his delegate shall revoke an election made under section 804(c)(2) of 
the Act if a taxpayer fails to make all reasonable efforts necessary to 
join in or intervene, in a judicial proceeding for determination of the 
person entitled to, and the amount of, the investment credit allowable 
with respect to any film or tape covered by the election after receiving 
notice from the Commissioner or his delegate which indicates that a 
conflicting claim to the investment credit for such film or tape is 
being asserted in court by another person.
    (d) Furnishing of supplementary information required. If these 
regulations are revised to require the furnishing of information in 
addition to that which was furnished with the amended returns and 
statement of election filed pursuant to paragraph (b) (2) and (3) of 
this section, the taxpayer must furnish such additional information in a 
statement addressed to the district director with whom the amended 
return and statement of election were filed.


((68A Stat. 917; 26 U.S.C. 7804); sec. 804(c)(2) (C) and (D) of the Tax 
Reform Act of 1976 (90 Stat. 1595))

[T.D. 7474, 42 FR 17123, Mar. 31, 1977; T.D. 7480, 42 FR 19479, Apr. 14, 
1977]



Sec. 7.48-3  Election to apply the amendments made by sections 804 (a) and (b) of the Tax Reform Act of 1976 to property described in section 50(a) of the Code.

    (a) General rule. Under section 804(e)(2) of the Tax Reform Act of 
1976 (90 Stat. 1596), taxpayers may elect to apply the amendments made 
by section 804 (a) and (b) of the Act to movie and television films that 
are property described in section 50(a) of the Code and that were placed 
in service in taxable years beginning before January 1, 1975.
    (b) Time for and manner of making election--(1) Time for making 
election. The election under section 804(e)(2) the Act must be made not 
later than October 4, 1977.
    (2) Manner of making election. The election under section 804(e)(2) 
shall be made by applying the same rules applicable under section 
804(c)(2) as described in Sec. 7.48-2(b) (2), (3), and (4) except that 
Sec. 7.48-2(b)(2)(ii) shall be read to require a statement that the 
taxpayer is making an election under section 804(e)(2) of the Act, and 
Sec. 7.48-2(b)(2)(vi) shall not apply. An election properly made under 
section 804(e)(2) of the Act may not be revoked after October 4, 1977.

(Sec. 804(e)(2), Tax Reform Act of 1976 (90 Stat. 1596))

[T.D. 7509, 42 FR 47828, Sept. 22, 1977]



Sec. 7.57(d)-1  Election with respect to straight line recovery of intangibles.

    (a) Purpose. This section prescribes rules for making the election 
permitted under section 57(d)(2), as added by the Tax Reform Act of 
1976. Under this election taxpayers may use cost depletion to compute 
straight line recovery of intangibles.
    (b) Election. The election under section 57(d) is subject to the 
following rules:
    (1) The election is made within the time prescribed by law 
(including extensions thereof) for filing the return for the taxable 
year in which the intangible drilling costs are paid or incurred or, if 
later, by July 25, 1978.
    (2) The election is made separately for each well. Thus, a taxpayer 
may make the election for only some of his or her wells.

[[Page 146]]

    (3) The election is made by using, for the well or wells to which 
the election applies, cost depletion to compute straight line recovery 
of intangibles for purposes of determining the amount of the preference 
under section 57(a)(11).
    (4) The election may be made whether or not the taxpayer uses cost 
depletion in computing taxable income.
    (5) The election is made by a partnership rather than by each 
partner.
    (c) Computation of cost depletion. For purposes of computing 
straight line recovery of intangibles through cost depletion, both 
depletable and depreciable intangible drilling and development costs for 
the taxable year are taken into account. They are treated as if 
capitalized, added to basis, and recovered under Sec. 1.611-2(a). Costs 
paid or incurred in other taxable years are not taken into account.

(Secs. 57(d) and 7805 of the Internal Revenue Code of 1954 (90 Stat. 
1551; 68A Stat. 917; 26 U.S.C. 57(d), 7805))

[T.D. 7541, 43 FR 17816, Apr. 26, 1978; 43 FR 18993, May 3, 1978]



Sec. 7.105-1  Questions and answers relating to exclusions of certain disability income payments.

    The following questions and answers relate to the exclusion of 
certain disability income payments under section 105(d) of the Internal 
Revenue Code of 1954, as amended by sections 505 (a) and (c) of the Tax 
Reform Act of 1976 (90 Stat. 1566):

    Q-1: What effect on the sick pay exclusion does the new law have?
    A-1: The ``sick pay'' provisions of prior law (which allowed a 
limited exclusion from gross income of sick pay received before 
mandatory retirement age by active employees temporarily absent from 
work because of sickness or injury, as well as by disability retirees) 
have been replaced by provisions of the new law (which provide for a 
limited exclusion of disability payments but restrict its application to 
individuals retired on disability who meet certain requirements as to 
permanent and total disability, age, etc.) (Q-4). As a result of the 
more restrictive provisions of the new law, many taxpayers who qualified 
for the exclusion in previous taxable years will not be eligible to 
claim the disability payments exclusion beginning with the effective 
date of the new law.
    Q-2: What is the effective date of the new law relating to 
disability exclusion?
    A-2: The disability income exclusion and related annuity provisions 
of the Tax Reform Act of 1976 are effective for taxable years beginning 
on or after January 1, 1977. In addition, the Tax Reduction and 
Simplification Act of 1977 allows certain taxpayers to begin excluding 
pension or annuity costs in taxable years beginning in 1976. In the case 
of a retiree who uses the cash receipts and disbursements method of 
accounting, the new law applies to payments received on or after the 
effective date even if the payment is for a period before the effective 
date. Thus, a payment for December 1976 that is received in January 1977 
by a calendar-year, cash-basis taxpayer is controlled by the new law.
    Q-3: What are disability payments?
    A-3: In general, disability payments are amounts constituting wages 
or payments in lieu of wages made under provisions of a plan providing 
for the payment of such amounts to an employee for a period during which 
the employee is absent from work on account of permanent and total 
disability. Amounts paid to such an employee after mandatory retirement 
age is attained are not wages or payments in lieu of wages for purposes 
of the disability income exclusion.
    Q-4: Who is eligible to exclude disability payments?
    A-4: A taxpayer who receives disability payments in lieu of wages 
under a plan providing for the payment of such amounts may qualify for 
the exclusion provided all of the following requirements are met:
    (1) The taxpayer has not reached age 65 (see Q-9) before the end of 
the taxable year;
    (2) The taxpayer has not reached mandatory retirement age (see Q-8) 
before the beginning of the taxable year;
    (3) The taxpayer retired on disability (see Q-10) (or if retired 
prior to January 1, 1977 and did not retire on disability, would have 
been eligible to retire on disability at the time of such retirement);
    (4) The taxpayer was permanently and totally disabled (see Q-11) 
when the taxpayer retired (or if the taxpayer retired before January 1, 
1977, was permanently and totally disabled on January 1, 1976, or 
January 1, 1977); and
    (5) The taxpayer has not made an irrevocable election not to claim 
the disability income exclusion (see Q-17 through Q-19).
    Q-5: What limitations are placed on the amounts excludable?
    A-5: The amount of disability income that is excludable:
    (a) Cannot exceed the amount of the disability income payments 
received for any pay period;
    (b) Cannot exceed a maximum weekly rate of $100 per taxpayer. Thus, 
the maximum disability income exclusion allowable on a joint return (see 
Q-7) in the usual case where one spouse receives disability payments, 
generally, would be $5,200, and if both spouses

[[Page 147]]

received disability payments the maximum exclusion, generally, would be 
$10,400 ($5,200 for each spouse);
    (c) Cannot exceed, in the case of a disability income payment for a 
period of less than a week, a prorated portion of the amount otherwise 
excludable for that week (see Q-6); and
    (d) Cannot exceed, for the entire taxable year, the total amount 
otherwise excludable for such taxable year reduced, dollar for dollar, 
by the amount by which the taxpayer's adjusted gross income (determined 
without regard to the disability income exclusion) exceeds $15,000. 
Where a disability income exclusion is claimed by either or both spouses 
on a joint return, the taxpayer's adjusted gross income means the total 
adjusted gross income of both spouses combined (determined without 
regard to the disability income exclusion) (see also Q-7).
    Q-6: On what occasion is a taxpayer likely to receive part-week 
disability payments? How do you prorate such payments?
    A-6: Such part-week payments may be received when one of the 
following events occurs after the first day of the taxpayer's normal 
workweek: (a) the disability retirement commences: (b) the taxpayer 
reaches mandatory retirement age in a taxable year prior to the taxable 
year in which such taxpayer attains age 65; or (c) the taxpayer dies. To 
prorate a part-week disability income payment for purposes of the 
exclusion, the taxpayer must:
    (1) Determine the ``daily exclusion,'' which is the lesser of--
    (a) The taxpayer's daily rate of disability pay, or
    (b) $100 divided by the number of days in the taxpayer's normal 
workweek.
    (2) Multiply the daily exclusion by the number of days for which the 
part-week payment was made.

Thus, for a taxpayer whose normal workweek was Monday through Friday and 
whose retirement on permanent and total disability began on Wednesday, 
the first disability income payment would include a payment for a part-
week consisting of three days. Assuming that the daily exclusion 
determined in (1), above, is $20, the taxpayer's exclusion for the first 
week would be $60 ($20x3).
    Q-7: What filing restrictions apply to a married taxpayer who claims 
a disability income exclusion?
    A-7: A taxpayer married at the close of the taxable year who lived 
with his or her spouse at any time during such taxable year must file a 
joint return in order to claim the disability income exclusion. However, 
a taxpayer married at the close of the taxable year who lived apart from 
his or her spouse for the entire taxable year may claim the exclusion on 
either a joint or separate return.
    Q-8: What is ``mandatory retirement age''?
    A-8: Generally, mandatory retirement age is the age at which the 
taxpayer would have been required to retire under the employer's 
retirement program, had the taxpayer not become disabled.
    Q-9: Does a taxpayer reach age 65 on the day before his or her 65th 
birthday for purposes of the disability income exclusion, as is the case 
for purposes of the exemption for age and the credit for the elderly?
    A-9: No. For purposes of the disability income exclusion, a taxpayer 
reaches age 65 on the day of his or her 65th birthday anniversary. Thus, 
a taxpayer whose 65th birthday occurs on January 1, 1978, is not 
considered to reach age 65 during 1977, for purposes of the disability 
income exclusion.
    Q-10: What does ``retired on disability'' mean?
    A-10: Generally, it means that an employee has ceased active 
employment in all respects because of a disability and has retired under 
a disability provision of a plan for employees. However, an employee who 
has actually ceased active employment in all respects because of a 
disability may be treated as ``retired on disability'' even though the 
employee has not yet gone through formal ``retirement'' procedures, as 
for example, where an employer carries the disabled employee in a non-
retired status under the disability provisions of the plan solely for 
the purpose of continuing such employee's eligibility for certain 
employer-provided fringe benefits. In addition, such an employee may be 
treated as ``retired on disability'' even though the initial period 
immediately following his or her ceasing of employment on account of a 
disability must first be used against accumulated ``sick leave'' or 
``annual leave'' prior to the employee being formally placed in 
disability retirement status.
    Q-11: What is permanent and total disability?
    A-11: It is the inability to engage in any substantial gainful 
activity by reason of any medically determinable physical or mental 
impairment that:
    (a) Can be expected to result in death;
    (b) Has lasted for a continuous period of not less than 12 months; 
or
    (c) Can be expected to last for a continuous period of not less than 
12 months. The substantial gainful activity referred to is not limited 
to the activity, or a comparable activity, in which the individual 
customarily engaged prior to such individual's retirement on disability.
    See Sec. 7.105-2 for additional information relating to substantial 
gainful activity.
    Q-12: If a taxpayer retired on disability but it is not clear until 
the following taxable year that the disability as of the date of such 
retirement was permanent and total (so that the employee did not exclude 
any amount as disability income in the earlier taxable year), may the 
taxpayer file an amended return to claim the disability income exclusion 
for the taxable year in which

[[Page 148]]

such taxpayer retired on disability which was permanent and total?
    A-12: Yes.
    Q-13: What proof must a taxpayer furnish to establish the existence 
of permanent and total disability?
    A-13: If retired on disability before January 1, 1977: A certificate 
from a qualified physician attesting that--
    (a) The taxpayer was permanently and totally disabled on January 1, 
1976 or January 1, 1977; or
    (b) The records of the Veterans Administration show that the 
taxpayer was permanently and totally disabled as defined in 38 CFR 3.340 
or 3.342 on January 1, 1976 or January 1, 1977.
    If retired on disability during 1977 or thereafter: A certificate 
from a qualified physician attesting that--
    (a) The taxpayer was permanently and totally disabled on the date he 
or she retired; or
    (b) The records of the Veterans Administration show that the 
taxpayer was permanently and totally disabled as defined in 38 CFR 3.340 
or 3.342 on the date he or she retired.
    In either case, the taxpayer must attach the certificate or a copy 
of the certificate to his or her income tax return. The certificate 
shall give the physician's name and address. No certificate from any 
employer is required with regard to the determination of permanent and 
total disability.
    Q-14: For what period does a taxpayer eligible (see Q-4) for the 
disability income exclusion (without regard to the $15,000 income 
phaseout explained in Q-5) continue to be eligible for such exclusion?
    A-14: Unless the taxpayer earlier makes the irrevocable election not 
to claim the disability income exclusion described in Q-17 through Q-19, 
such taxpayer continues to be eligible until the earlier of:
    (a) The beginning of the taxable year in which the taxpayer reaches 
age 65; and
    (b) The day on which the taxpayer reaches mandatory retirement age.
    Q-15: May a taxpayer while eligible (see Q-4) for the disability 
income exclusion under the new law, exclude any applicable pension or 
annuity costs?
    A-15: No. This is true even though while eligible for the disability 
income exclusion, such taxpayer is unable to exclude any amount of the 
disability income payments because of the $15,000 income phaseout (see 
Q-5).
    Q-16: When will a taxpayer who is eligible (see Q-4) to exclude 
disability income payments (without regard to the $15,000 phaseout 
explained in Q-5) under the new law be able to exclude any applicable 
pension or annuity costs?
    A-16: In general, such a taxpayer will begin to exclude any of his 
or her pension or annuity costs under applicable rules of the Code 
beginning on the first day of the taxable year in which he or she 
attains age 65 or, if mandatory retirement age is attained in an earlier 
taxable year, beginning on the day the taxpayer attains mandatory 
retirement age.
    Q-17: May a taxpayer who is eligible (see Q-4) to exclude disability 
income payments (without regard to the $15,000 phaseout explained in Q-
5) under the new law begin to exclude applicable pension or annuity 
costs in an earlier taxable year?
    A-17: Yes, but such a taxpayer must make the election described in 
Q-18 and Q-19 in which case the taxpayer would no longer be eligible for 
the disability income exclusion.
    Q-18: What is an election not to claim the disability income 
exclusion?
    A-18: It is an irrevocable election for the taxable year for which 
the election is made, and each taxable year thereafter. If such an 
election is made the taxpayer will begin to recover tax-free, out of the 
payments, his or her annuity costs as provided under the applicable 
provision of the Code.
    Q-19: How does a taxpayer who is eligible to exclude disability 
income payments (without regard to the $15,000 phaseout explained in Q-
5) under the new law make this election?
    A-19: The election is made by means of a statement attached to the 
taxpayer's income tax return (or amended return) for the taxable year in 
which the taxpayer wishes to have the applicable annuity rule apply. The 
statement shall set forth the taxpayers qualifications to make the 
election (i.e., that the taxpayer is eligible (see Q-4) to exclude 
disability income payments (without regard to the $15,000 income 
phaseout explained in Q-5)) and that such taxpayer irrevocably elects 
not to claim the benefit of excluding disability income payments under 
section 105(d), as amended, for such taxable year and each taxable year 
thereafter. The election cannot be made for any taxable year beginning 
before January 1, 1976.
    Q-20: Did the changes made by the Tax Reduction and Simplification 
Act provide any relief to taxpayers eligible for the sick pay exclusion 
in taxable years beginning in 1976?
    A-20: Yes. As originally enacted, the more restrictive provisions of 
the disability income exclusion applied to taxable years beginning in 
1976. The Tax Reduction and Simplification Act postponed the effective 
date of these provisions for 1 year. Thus, taxpayers may claim the sick 
pay exclusion in taxable years beginning in 1976.

(Secs. 105(d) and 7805 of the Internal Revenue Code of 1954 (90 Stat. 
1566; 68A Stat. 917; 26 U.S.C. 105(d); 7805))

[T.D. 7450, 41 FR 56630, Dec. 29, 1976, as amended at 42 FR 2954, Jan. 
14, 1977; T.D. 7544, 43 FR 19655, May 8, 1978]

[[Page 149]]



Sec. 7.105-2  Substantial gainful activity.

    (a) Purpose. This section defines substantial gainful activity for 
purposes of section 105(d) and Sec. 7.105-1, prescribes rules for 
determining whether a taxpayer has the ability to engage in substantial 
gainful activity, and provides examples of the application of the 
definition and rules in specific factual situations.
    (b) Definition. Substantial gainful activity is the performance of 
significant duties over a reasonable period of time in work for 
remuneration or profit (or in work of a type generally performed for 
remuneration or profit).
    (c) General rules. (1) Full-time work under competitive 
circumstances generally indicates ability to engage in substantial 
gainful activity.
    (2) Work performed in self-care or the taxpayer's own household 
tasks, and nonremunerative work performed in connection with hobbies, 
institutional therapy or training, school attendance, clubs, social 
programs, and similar activities is not substantial gainful activity. 
However, the nature of the work performed may be evidence of ability to 
engage in substantial gainful activity.
    (3) The fact that a taxpayer is unemployed for any length of time is 
not, of itself, conclusive evidence of inability to engage in 
substantial gainful activity.
    (4) Regular performance of duties by a taxpayer in a full-time, 
competitive work situation at a rate of pay at or above the minimum wage 
will conclusively establish the taxpayer's ability to engage in 
substantial gainful activity. For purposes of paragraphs (c)(4) and 
(c)(5) of this section, the minimum wage is the minimum wage prescribed 
by section 6(a)(1) of the Fair Labor Standards Act of 1938, as amended, 
29 U.S.C. 206(a)(1).
    (5) Regular performance of duties by a taxpayer in a part-time, 
competitive work situation at a rate of pay at or above the minimum wage 
will conclusively establish the taxpayer's ability to engage in 
substantial gainful activity, if the duties are performed at the 
employer's convenience.
    (6) In situations other than those described in paragraphs (c)(4) 
and (c)(5) of this section, other factors, such as the nature of the 
duties performed, may establish a taxpayer's ability to engage in 
substantial gainful activity.
    (d) Examples. The following examples illustrate the application of 
the definition in paragraph (b) of this section and the rules in 
paragraph (c) of this section in specific factual situations. In 
examples 1 through 5, the facts establish that the taxpayers are able to 
engage in substantial gainful activity and, therefore, are not entitled 
to claim the disability income exclusion of section 105(d). In examples 
6 through 9, the facts do not, of themselves, establish the taxpayers' 
ability or inability to engage in substantial gainful activity. In these 
situations, all the facts and circumstances must be examined to 
determine whether the taxpayers are able to engage in substantial 
gainful activity.

    Example (1). Before retirement on disability, taxpayer worked for a 
hotel as night desk clerk. After retirement, the taxpayer is hired by 
another hotel as night desk clerk at a rate of pay exceeding the minimum 
wage. Since the taxpayer regularly performs duties in a full-time 
competitive work situation at a rate of pay at or above the minimum 
wage, he or she is able to engage in substantial gainful activity.
    Example (2). A taxpayer who retired on disability from employment as 
a sales clerk is employed as a full-time babysitter at a rate of pay 
equal to the minimum wage. Since the taxpayer regularly performs duties 
in a full-time, competitive work situation at a rate of pay at or above 
the minimum wage, he or she is able to engage in substantial gainful 
activity.
    Example (3). A taxpayer retired on disability from employment as a 
teacher because of terminal cancer. The taxpayer's physician recommended 
continuing employment for therapeutic reasons and taxpayer accepted 
employment as a part-time teacher at a rate of pay in excess of the 
minimum wage. The part-time teaching work is done at the employer's 
convenience. Even though the taxpayer's illness is terminal, the 
employment was recommended for therapeutic reasons, and the work is 
part-time, the fact that the work is done at the employer's convenience 
demonstrates that the taxpayer is able to engage in substantial gainful 
activity.
    Example (4). A taxpayer who retired on disability, is employed full-
time in a competitive work situation that is less demanding than his or 
her former position. The rate of pay exceeds the minimum wage but is 
about half of the taxpayer's rate of pay in the

[[Page 150]]

former position. It is immaterial that the new work activity is less 
demanding or less gainful than the work in which the taxpayer was 
engaged before his or her retirement on disability. Since the taxpayer 
regularly performs duties in a full-time, competitive work situation at 
a rate of pay at or above the minimum wage, he or she is able to engage 
in substantial gainful activity.
    Example (5). A taxpayer who retired on disability from employment as 
a bookkeeper drives trucks for a charitable organization at the 
taxpayer's convenience. The taxpayer receives no compensation, but 
duties of this nature generally are performed for remuneration or 
profit. Some weeks the taxpayer works 10 hours, some weeks 40 hours, and 
over the year the taxpayer works an average of 20 hours per week. Even 
though the taxpayer receives no compensation, works part-time, and at 
his or her convenience, the nature of the duties performed and the 
average number of hours worked per week conclusively establish the 
taxpayer's ability to engage in substantial gainful activity.
    Example (6). A taxpayer who retired on disability was instructed by 
a doctor that uninterrupted bedrest was vital to the treatment of his or 
her disability. However, because of financial need, the taxpayer secured 
new employment in a sedentary job. After attempting the new employment 
for approximately two months, the taxpayer was physically unable to 
continue the employment. The fact that the taxpayer attempted to work 
and did, in fact, work for two months, does not, of itself, conclusively 
establish the taxpayer's ability to engage in substantial gainful 
activity.
    Example (7). A taxpayer who retired on disability accepted 
employment with a former employer on a trial basis. The purpose of the 
employment was to determine whether the taxpayer was employable. The 
trial period continued for an extended period of time and the taxpayer 
was paid at a rate equal to the minimum wage. However, because of the 
taxpayer's disability only light duties of a nonproductive make-work 
nature were assigned. Unless the activity is both substantial and 
gainful, the taxpayer is not engaged in substantial gainful activity. 
The activity was gainful because the taxpayer was paid at a rate at or 
above the minimum wage. However, the activity was not substantial 
because the duties were of a nonproductive, make-work nature. 
Accordingly, these facts do not, of themselves, establish the taxpayer's 
ability to engage in substantial gainful activity.
    Example (8). A taxpayer who retired on disability from employment as 
a bookkeeper lives with a relative who manages several motel units. The 
taxpayer assisted the relative for one or two hours a day by performing 
duties such as washing dishes, answering phones, registering guests, and 
bookkeeping. The taxpayer can select the times during the day when he or 
she feels most fit to perform the tasks undertaken. Work of this nature, 
performed off and on during the day at the taxpayer's convenience, is 
not activity of a ``substantial and gainful'' nature even if the 
individual is paid for the work. The performance of these duties does 
not, of itself, show that the taxpayer is able to engage in substantial 
gainful activity.
    Example (9). A taxpayer who retired on disability because of a 
physical or mental impairment accepts sheltered employment in a 
protected environment under an institutional program. Sheltered 
employment is offered in sheltered workshops, hospitals and similar 
institutions, homebound programs, and Veterans Administration 
domiciliaries. Typically, earnings are lower in sheltered employment 
than in commercial employment. Consequently, impaired workers normally 
do not seek sheltered employment if other employment is available. The 
acceptance of sheltered employment by an impaired taxpayer does not 
necessarily establish his or her ability to engage in substantial 
gainful activity.

(Secs. 105(d) and 7805 of the Internal Revenue Code of 1954 (90 Stat. 
1566; 68A Stat. 917; 26 U.S.C. 105(d); 7805))

[T.D. 7544, 43 FR 19656, May 8, 1978]



Sec. 7.465-1  Amounts at risk with respect to activities begun prior to effective date; in general.

    Section 465 provides that a taxpayer (other than a corporation which 
is not a subchapter S corporation or a personal holding company) engaged 
in certain activities may not deduct losses from such activity to the 
extent the losses exceed the amount the taxpayer is at risk with respect 
to the activity. For the types of activities to which section 465 
applies and for determining what constitutes a separate activity, see 
section 465(c). Section 465 generally applies to losses attributable to 
amounts paid or incurred in taxable years beginning after December 31, 
1975. For the purposes of applying the at risk limitation to activities 
begun before the effective date of the provision (and which were not 
excepted from application of the provision), it is necessary to 
determine the amount at risk as of the first day of the first taxable 
year beginning after December 31, 1975. The amount at risk in an 
activity as of the first day of the first taxable year of the taxpayer 
beginning after December

[[Page 151]]

31, 1975, (for the purposes of Sec. 7.465-1 through 7.465-5 such first 
day shall be referred to as the effective date) shall be determined 
according to the rules provided in Secs. 7.465-2 through 7.465-5.

[T.D. 7504, 42 FR 42197, Aug. 22, 1977]



Sec. 7.465-2  Determination of amount at risk.

    (a) Initial amount. The amount a taxpayer is at risk on the 
effective date with respect to an activity to which section 465 applies 
shall be determined in accordance with this section. The initial amount 
the taxpayer is at risk in the activity shall be the taxpayer's initial 
basis in the activity as modified by disregarding amounts described in 
section 465(b) (3) or (4) (relating generally to amounts protected 
against loss or borrowed from related persons).
    (b) Succeeding adjustments. For each taxable year ending before the 
effective date, the initial amount at risk shall be increased and 
decreased by the items which increased and decreased the taxpayer's 
basis in the activity in that year as modified by disregarding the 
amounts described in section 465(b) (3) or (4).
    (c) Application of losses and withdrawals. (1) Losses described in 
section 465(d) which are incurred in taxable years beginning prior to 
January 1, 1976 and deducted in such taxable years, will be treated as 
reducing first that portion of the taxpayer's basis which is 
attributable to amounts not at risk. On the other hand, withdrawals made 
in taxable years beginning before January 1, 1976, will be treated as 
reducing the amount which the taxpayer is at risk.
    (2) Therefore, if in a taxable year beginning prior to January 1, 
1976 there is a loss described in section 465(d), it shall reduce the 
amount at risk only to the extent it exceeds the amount of the 
taxpayer's basis which is not at risk. For the purposes of this 
paragraph the taxpayer's basis which is not at risk is that portion of 
the taxpayer's basis in the activity (as of the close of the taxable 
year and prior to reduction for the loss) which is attributable to 
amounts described in section 465(b) (3) or (4).
    (d) Amount at risk shall not be less than zero. If, after 
determining the amount described in paragraph (a), (b), and (c) of this 
section, the amount at risk (but for this paragraph) would be less than 
zero, the amount at risk on the effective date shall be zero.

[T.D. 7504, 42 FR 42197, Aug. 22, 1977]



Sec. 7.465-3  Allocation of loss for different taxable years.

    If the taxable year of the entity conducting the activity differs 
from that of the taxpayer, the loss attributable to the activity for the 
first taxable year of the entity ending after the beginning of the first 
taxable year of the taxpayer beginning after December 31, 1975, shall be 
allocated in the following manner. That portion of the loss from the 
activity for such taxable year of the entity which bears the same ratio 
as the number of days in such taxable year before January 1, 1976, 
divided by the total number of days in the taxable year, shall be 
attributable to taxable years of the taxpayer beginning before January 
1, 1976. Consequently, that portion shall be treated in accordance with 
Sec. 7.465-2.

[T.D. 7504, 42 FR 42198, Aug. 22, 1977]



Sec. 7.465-4  Insufficient records.

    If sufficient records do not exist to accurately determine under 
Sec. 7.465-2 the amount which a taxpayer is at risk on the effective 
date, the amount at risk shall be the taxpayer's basis in the activity 
reduced (but not below zero) by the taxpayer's share of amounts 
described in section 465(b) (3) or (4) with respect to the activity on 
the day before the effective date.

[T.D. 7504, 42 FR 42198, Aug. 22, 1977]



Sec. 7.465-5  Examples.

    The provisions of Sec. 7.465-1 and Sec. 7.465-2 may be illustrated 
by the following examples:

    Example (1). J and K, as equal partners, form partnership JK on 
January 1, 1975. Partnership JK is engaged solely in an activity 
described in section 465(c)(1). On January 1, 1975, each partner 
contributes $10,000 in cash from personal assets to JK. On July 1, 1975, 
JK borrows $40,000 (of which J's share is $20,000) from a bank under a 
nonrecourse financing arrangement secured only by the new equipment (for 
use in the activity) purchased with the $40,000. On September 1, 1975, 
JK reduces the amount due on the loan to $36,000 (of which J's share is 
$18,000). On October 1, 1975, JK distributes $3,000 to each

[[Page 152]]

partner. For taxable year 1975, JK has no income or loss. Although J's 
basis in the activity is $25,000 ($10,000+$18,000--$3,000) J's amount at 
risk on the effective date is $7,000 determined as follows:

Initial amount at risk........................................   $10,000
Plus: Items which increased basis other than amounts described         0
 in sec. 465(b) (3) or (4)....................................
                                                               ---------
    Total.....................................................    10,000
Less: Distribution............................................     3,000
                                                               =========
J's amount at risk on effective date..........................     7,000
 

    Example (2). Assume the same facts as in Example (1) except that JK 
has a loss (as described in section 465(d) for 1975 of which J's share 
is $12,000. Although J's basis in the activity is $13,000 
($10,000+$18,000--($3,000+$12,000)) J's amount at risk on the effective 
date is $7,000 determined as follows:

Initial amount at risk........................................   $10,000
Plus: Items which increased basis other than amounts described         0
 in sec. 465(b) (3) or (4)....................................
                                                               ---------
    Total.....................................................    10,000
                                                               =========
Less: Distribution............................................     3,000
Portion of loss ($12,000) in excess of portion of basis not at         0
 risk ($18,000)...............................................
                                                               ---------
    Total.....................................................     3,000
                                                               =========
J's amount at risk on effective date..........................     7,000
 

    Example (3). Assume the same facts as in Example (1) except that JK 
has a loss (as described in section 465(d) for 1975, and J's share is 
$23,000. J's basis in the activity is $2,000 ($10,000+$18,000--
($3,000+$23,000)). The amount at risk on the effective date is 
determined as follows:

Initial amount at risk........................................   $10,000
Plus: Items which increased basis other than amounts described         0
 in sec. 465(b) (3) or (4)....................................
                                                               ---------
    Total.....................................................    10,000
                                                               =========
Less: Distribution............................................     3,000
Portion of loss ($23,000) in excess of portion of basis not at     5,000
 risk ($18,000)...............................................
                                                               ---------
    Total.....................................................     8,000
                                                               =========
J's amount at risk on the effective date......................     2,000
 


[T.D. 7504, 42 FR 42198, Aug. 22, 1977]



Sec. 7.704-1  Partner's distributive share.

    (a)-(c) [Reserved]
    (d) Limitation on allowance of losses. (1)-(2) [Reserved]
    (3)(i) Section 213(e) of the Tax Reform Act of 1976 amended section 
704(d) of the Internal Revenue Code relating to the deductions by 
partners of losses incurred by a partnership. A partner is entitled to 
deduct the share of partnership loss to the extent of the adjusted basis 
of the partner's interest in the partnership. As amended, section 704(d) 
provides, in general, that the adjusted basis of a partner's interest in 
the partnership for the purpose of deducting partnership losses shall 
not include any portion of a partnership liability for which the partner 
has no personal liability. This restriction, however, does not apply to 
any activity to the extent that section 465 of the Code applies nor to 
any partnership whose principal activity is investing in real property, 
other than mineral property. Section 465 does not apply to corporations 
other than a subchapter S corporation or a personal holding company.
    (ii) The restrictions in the amendment to section 704(d) will not 
apply to any corporate partner with respect to liabilities incurred in 
an activity described in section 465(c)(1). In all other respects the 
restrictions in the amendment will apply to all corporate partners 
unless the partnership's principal activity is investment in real 
property, other than mineral property.

[T.D. 7445, 41 FR 55344, Dec. 20, 1976]



Sec. 7.936-1  Qualified possession source investment income.

    For purposes of this section, interest earned after September 30, 
1976 (less applicable deductions), by a domestic corporation, engaged in 
the active conduct of a trade or business in Puerto Rico, which elects 
the application of section 936 with respect to deposits with certain 
Puerto Rican financial institutions will be treated as qualified 
possession source investment income within the meaning of section 
936(d)(2) if (1) the interest qualifies for exemption from Puerto Rican 
income tax under regulations issued by the Secretary of the Treasury of 
Puerto Rico, as in effect on September 28, 1976, under the authority of 
section 2(j) of the Puerto Rico Industrial Incentive Act of 1963, as 
amended, (2) the interest is from sources within Puerto Rico (within the 
meaning of section 936(d)(2)(A)), and (3) the funds with respect to 
which the interest is earned are derived from the active conduct of a 
trade or business in Puerto Rico or from investment of funds so derived.

[T.D. 7452, 41 FR 56794, Dec. 30, 1976]

[[Page 153]]



Sec. 7.999-1  Computation of the international boycott factor.

    (a) In general. Sections 908(a), 952(a)(3), and 995(b)(1)(F) provide 
that certain benefits of the foreign tax credit, deferral of earnings of 
foreign corporations, and DISC are denied if a person or a member of a 
controlled group (within the meaning of section 993(a)(3)) that includes 
that person participates in or cooperates with an international boycott 
(within the meaning of section 999(b)(3)). The loss of tax benefits may 
be determined by multiplying the otherwise allowable tax benefits by the 
``international boycott factor.'' Section 999(c)(1) provides that the 
international boycott factor is to be determined under regulations 
prescribed by the Secretary. The method of computing the international 
boycott factor is set forth in paragraph (c) of this section. A special 
rule for computing the international boycott factor of a person that is 
a member of two or more controlled groups is set forth in paragraph (d). 
Transitional rules for making adjustments to the international boycott 
factor for years affected by the effective dates are set forth in 
paragraph (e). The definitions of the terms used in this section are set 
forth in paragraph (b).
    (b) Definitions. For purposes of this section:
    (1) Boycotting country. In respect of a particular international 
boycott, the term ``boycotting country'' means any country described in 
section 999(a)(1) (A) or (B) that requires participation in or 
cooperation with that particular international boycott.
    (2) Participation in or cooperation with an international boycott. 
For the definition of the term ``participation in or cooperation with an 
international boycott'', see section 999(b)(3) and Parts H through M of 
the Treasury Department's International Boycott Guidelines.
    (3) Operations in or related to a boycotting country. For the 
definitions of the terms ``operations'', ``operations in a boycotting 
country'', ``operations related to a boycotting country'', and 
``operations with the government, a company, or a national of a 
boycotting country'', see Part B of the Treasury Department's 
International Boycott Guidelines.
    (4) Clearly demonstrating clearly separate and identifiable 
operations. For the rules for ``clearly demonstrating clearly separate 
and identifiable operations'', see Part D of the Treasury Department's 
International Boycott Guidelines.
    (5) Purchase made from a country. The terms ``purchase made from a 
boycotting country'' and ``purchases made from any country other than 
the United States'' mean, in respect of any particular country, the 
gross amount paid in connection with the purchase of, the use of, or the 
right to use:
    (i) Tangible personal property (including money) from a stock of 
goods located in that country,
    (ii) Intangible property (other than securities) in that country,
    (iii) Securities by a dealer to a beneficial owner that is a 
resident of that country (but only if the dealer knows or has reason to 
know the country of residence of the beneficial owner),
    (iv) Real property located in that country, or
    (v) Services performed in, and the end product of services performed 
in, that country (other than payroll paid to a person that is an officer 
or employee of the payor).
    (6) Sales made to a country. The terms ``sales made to a boycotting 
country'' and ``sales made to any country other than the United States'' 
mean, in respect of any particular country, the gross receipts from the 
sale, exchange, other disposition, or use of:
    (i) Tangible personal property (including money) for direct use, 
consumption, or disposition in that country,
    (ii) Services performed in that country,
    (iii) The end product of services (wherever performed) for direct 
use, consumption, or disposition in that country,
    (iv) Intangible property (other than securities) in that country,
    (v) Securities by a dealer to a beneficial owner that is a resident 
of that country (but only if the dealer knows or has reason to know the 
country of residence of the beneficial owner), or

[[Page 154]]

    (vi) Real property located in that country.

To determine the country of direct use, consumption, or disposition of 
tangible personal property and the end product of services, see 
paragraph (b)(10) of this section.
    (7) Sales made from a country. The terms ``sales made from a 
boycotting country'' and ``sales made from any country other than the 
United States'' mean, in respect of a particular country, the gross 
receipts from the sale, exchange, other disposition, or use of:
    (i) Tangible personal property (including money) from a stock of 
goods located in that country,
    (ii) Intangible property (other than securities) in that country, or
    (iii) Services performed in, and the end product of services 
performed in, that country.

However, gross receipts from any such sale, exchange, other disposition, 
or use by a person that are included in the numerator of that person's 
international boycott factor by reason of paragraph (b)(6) of this 
section shall not again be included in the numerator by reason of this 
subparagraph.
    (8) Payroll paid or accrued for services performed in a country. The 
terms ``payroll paid or accrued for services performed in a boycotting 
country'' and ``payroll paid or accrued for services performed in any 
country other than the United States'' mean, in respect of a particular 
country, the total amount paid or accrued as compensation to officers 
and employees, including wages, salaries, commissions, and bonuses, for 
services performed in that country.
    (9) Services performed partly within and partly without a country--
(i) In general. Except as provided in paragraph (b)(9)(ii) of this 
section, for purposes of allocating to a particular country:
    (A) The gross amount paid in connection with the purchase or use of,
    (B) The gross receipts from the sale, exchange, other disposition or 
use of, and
    (C) The payroll paid or accrued for services performed, or the end 
product of services performed, partly within and partly without that 
country, the amount paid, received, or accrued to be allocated to that 
country, unless the facts and circumstances of a particular case warrant 
a different amount, will be that amount that bears the same relation to 
the total amount paid, received, or accrued as the number of days of 
performance of the services within that country bears to the total 
number of days of performance of services for which the total amount is 
paid, received, or accrued.
    (ii) Transportation, telegraph, and cable services. Transportation, 
telegraph, and cable services performed partly within one country and 
partly within another country are allocated between the two countries as 
follows:
    (A) In the case of a purchase of such services performed from 
Country A to Country B, fifty percent of the gross amount paid is deemed 
to be a purchase made from Country A and the remaining fifty percent is 
deemed to be a purchase made from Country B.
    (B) In the case of a sale of such services performed from Country A 
to Country B, fifty percent of the gross receipts is deemed to be a sale 
made from Country R and the remaining fifty percent is deemed to be a 
sale made to Country B.
    (10) Country of use, consumption, or disposition. As a general rule, 
the country of use, consumption, or disposition of tangible personal 
property (including money) and the end product of services (wherever 
performed) is deemed to be the country of destination of the tangible 
personal property or the end product of the services. (Thus, if legal 
services are performed in one country and an opinion is given for use by 
a client in a second country, the end product of the legal services is 
used, consumed, or disposed of in the second country.) The occurrence in 
a country of a temporary interruption in the shipment of the tangible 
personal property or the delivery of the end product of services shall 
not constitute such country the country of destination. However, if at 
the time of the transaction the person providing the tangible personal 
property or the end product of services knew, or should have known from 
the facts and circumstances surrounding the transaction, that the 
tangible personal property or the end product of services probably would 
not be used, consumed,

[[Page 155]]

or disposed of in the country of destination, that person must determine 
the country of ultimate use, consumption or disposition of the tangible 
personal property or the end product of services. Notwithstanding the 
preceding provisions of this subparagraph, a person that sells, 
exchanges, otherwise disposes of, or makes available for use, tangible 
personal property to any person all of whose business except for an 
insubstantial part consists of selling from inventory to retail 
customers at retail outlets all within one country may assume at the 
time of such sale to such person that the tangible personal property 
will be used, consumed, or disposed of within such country.
    (11) Controlled group taxable year. The term ``controlled group 
taxable year'' means the taxable year of the controlled group's common 
parent corporation. In the event that no common parent corporation 
exists, the members of the group shall elect the taxable year of one of 
the members of the controlled group to serve as the controlled group 
taxable year. The taxable year election is a binding election to be 
changed only with the approval of the Secretary of his delegate. The 
election is to be made in accordance with the procedures set forth in 
the instructions to Form 5713, the International Boycott Report.
    (c) Computation of international boycott factor--(1) In general. The 
method of computing the international boycott factor of a person that is 
not a member of a controlled group is set forth in paragraph (c)(2) of 
this section. The method of computing the international boycott factor 
of a person that is a member of a controlled group is set forth in 
paragraph (c)(3) of this section. For purposes of paragraphs (c) (2) and 
(3), purchases and sales made by, and payroll paid or accrued by, a 
partnership are deemed to be made or paid or accrued by a partner in 
that proportion that the partner's distributive share bears to the 
purchases and sales made by, and the payroll paid or accrued by, the 
partnership. Also for purposes of paragraphs (c) (2) and (3), purchases 
and sales made by, and payroll paid or accrued by, a trust referred to 
in section 671 are deemed to be made both by the trust (for purposes of 
determining the trust's international boycott factor), and by a person 
treated under section 671 as the owner of the trust (but only in that 
proportion that the portion of the trust that such person is considered 
as owning under sections 671 through 679 bears to the purchases and 
sales made by, and the payroll paid and accrued by, the trust).
    (2) International boycott factor of a person that is not a member of 
a controlled group. The international boycott factor to be applied by a 
person that is not a member of a controlled group (within the meaning of 
section 993(a)(3)) is a fraction.
    (i) The numerator of the fraction is the sum of the--
    (A) Purchases made from all boycotting countries associated in 
carrying out a particular international boycott.
    (B) Sales made to or from all boycotting countries associated in 
carrying out a particular international boycott, and
    (C) Payroll paid or accrued for services performed in all boycotting 
countries associated in carrying out a particular international boycott 
by that person during that person's taxable year, minus the amount of 
such purchases, sales, and payroll that is clearly demonstrated to be 
attributable to clearly separate and identifiable operations in 
connection with which there was no participation in or cooperation with 
that international boycott.
    (ii) The denominator of the fraction is the sum of the--
    (A) Purchases made from any country other than the United States,
    (B) Sales made to or from any country other than the United States, 
and
    (C) Payroll paid or accrued for services performed in any country 
other than the United States by that person during that person's taxable 
year.
    (3) International boycott factor of a person that is a member of a 
controlled group. The international boycott factor to be applied by a 
person that is a member of a controlled group (within the meaning of 
section 993(a)(3)) shall be computed in the manner described in 
paragraph (c)(2) of this section, except that there shall be taken into 
account the purchases and sales made by, and the payroll paid or accrued 
by,

[[Page 156]]

each member of the controlled group during each member's own taxable 
year that ends with or within the controlled group taxable year that 
ends with or within that person's taxable year.
    (d) Computation of the international boycott factor of a person that 
is a member of two or more controlled groups. The international boycott 
factor to be applied under sections 908(a), 952(a)(3), and 995(b)(1)(F) 
by a person that is a member of two or more controlled groups shall be 
determined in the manner described in paragraph (c)(3), except that the 
purchases, sales, and payroll included in the number and denominator 
shall include the purchases, sales, and payroll of that person and of 
all other members of the two or more controlled groups of which that 
person is a member.
    (e) Transitional rules--(1) Pre-November 3, 1976 boycotting 
operations. The international boycott factor to be applied under 
sections 908(a), 952(a)(3), and 995(b)(1)(F) by a person that is not a 
member of a controlled group, for that person's taxable year that 
includes November 3, 1976, or a person that is a member of a controlled 
group, for the controlled group taxable year that includes November 3, 
1976, shall be computed in the manner described in paragraphs (c)(2) and 
(c)(3), respectively, of this section. However, that the following 
adjustments shall be made:
    (i) There shall be excluded from the numerators described in 
paragraphs (c)(2)(i) and (c)(3)(i) of this section purchases, sales, and 
payroll clearly demonstrated to be attributable to clearly separate and 
identifiable operations--
    (A) That were completed on or before November 3, 1976, or
    (B) In respect of which it is demonstrated that the agreements 
constituting participation in or cooperation with the international 
boycott were renounced, the renunciations were communicated on or before 
November 3, 1976, to the governments or persons with which the 
agreements were made and the agreements have not been reaffirmed after 
November 3, 1976, and
    (ii) The international boycott factor resulting after the numerator 
has been modified in accordance with paragraph (e)(1)(i) of this section 
shall be further modified by multiplying it by a fraction. The numerator 
of that fraction shall be the number of days in that person's taxable 
year (or, if applicable, in that person's controlled group taxable year) 
remaining after November 3, 1976, and the denominator shall be 366.

The principles of this subparagraph are illustrated in the following 
example:

    Example. Corporation A, a calendar year taxpayer, is not a member of 
a controlled group. During the 1976 calendar year, Corporation DA had 
three operations in a boycotting country under three separate contracts, 
each of which contained agreements constituting participation in or 
cooperation with an international boycott. Each contract was entered 
into on or after September 2, 1976. Operation (1) was completed on 
November 1, 1976. The sales made to a boycotting country in connection 
with Operation (1) amounted to $10. Operation (2) was not completed 
during the taxable year, but on November 1, 1976, Corporation A 
communicated a renunciation of the boycott agreement covering that 
operation to the government of the boycotting country. The sales made to 
a boycotting country in connection with Operation (2) amounted to $40. 
Operation (3) was not completed during the taxable year, nor was any 
renunciation of the boycott agreement made. The sales made to a 
boycotting country in connection with Operation (3) amounted to $25. 
Corporation A had no purchases made from, sales made from, or payroll 
paid or accrued for services performed in, a boycotting country. 
Corporation A had $500 of purchases made from, sales made from, sales 
made to, and payroll paid or accrued for services performed in, 
countries other than the United States. Company A's boycott factor for 
1976, computed under paragraph (c)(2) of this section (before the 
application of this subparagraph) would be:
[GRAPHIC] [TIFF OMITTED] TC16OC91.003

    However, the $10 is eliminated from the numerator by reason of 
paragraph (e)(1)(i)(A) of this section, and the $40 is eliminated from 
the numerator by reason of paragraph (e)(1)(i)(B) of this section. Thus, 
before the application of paragraph (e)(1)(ii) of this section, 
Corporation A's international boycott factor is $25/$500. After the 
application of paragraph (e)(1)(ii), Corporation A's international 
boycott factor is:
[GRAPHIC] [TIFF OMITTED] TC16OC91.004

    (2) Pre-December 31, 1977 boycotting operations. The international 
boycott factor to be applied under sections 908(a), 952(a)(3), and 
995(b)(1)(F) by a person that is not a member of a controlled

[[Page 157]]

group, for that person's taxable year that includes December 31, 1977, 
or by a person that is a member of a controlled group, for the 
controlled group taxable year that includes December 31, 1977, shall be 
computed in the manner described in paragraphs (c)(2) and (c)(3), 
respectively, of this section. However, the following adjustments shall 
be made:
    (i) There shall be excluded from the numerators described in 
paragraphs (c)(2)(i) and (c)(3)(i) of this section purchases, sales, and 
payroll clearly demonstrated to be attributable to clearly separate and 
identifiable operations that were carried out in accordance with the 
terms of binding contracts entered into before September 2, 1976, and--
    (A) That were completed on or before December 31, 1977, or
    (B) In respect of which it is demonstrated that the agreements 
constituting participation in or cooperation with the international 
boycott were renounced, the renunciations were communicated on or before 
December 31, 1977, to the governments or persons with which the 
agreements were made, and the agreements were not reaffirmed after 
December 31, 1977, and
    (ii) In the case of clearly separate and identifiable operations 
that are carried out in accordance with the terms of binding contracts 
entered into before September 2, 1976, but that do not meet the 
requirements of paragraph (e)(2)(i) of this section, the numerators 
described in paragraphs (c)(2)(i) and (c)(3)(i) of this section shall be 
adjusted by multiplying the purchases, sales, and payroll clearly 
demonstrated to be attributable to those operations by a fraction, the 
numerator of which is the number of days in such person's taxable year 
(or, if applicable, in such person's controlled group taxable year) 
remaining after December 31, 1977, and the denominator of which is 365.

The principles of this subparagraph are illustrated in the following 
example:

    Example. Corporation A is not a member of a controlled group and 
reports on the basis of a July 1-June 30 fiscal year. During the 1977-
1978 fiscal year, Corporation A had 2 operations carried out pursuant to 
the terms of separate contracts, each of which had a clause that 
constituted participation in or cooperation with an international 
boycott. Neither operation was completed during the fiscal year, nor 
were either of the boycotting clauses renounced. Operation (1) was 
carried out in accordance with the terms of a contract entered into on 
November 15, 1976. Operation (2) was carried out in accordance with the 
terms of a binding contract entered into before September 2, 1976. 
Corporation A had sales made to a boycotting country in connection with 
Operation (1) in the amount of $50, and in connection with Operation (2) 
in the amount of $100. Corporation A had sales made to countries other 
than the United States in the amount of $500. Corporation A had no 
purchases made from, sales made from, or payroll paid or accrued for 
services performed in, any country other than the United States. In the 
absence of this subparagraph, Corporation A's international boycott 
factor would be
[GRAPHIC] [TIFF OMITTED] TC16OC91.005


However, by reason of the application of this subparagraph, Corporation 
A's international boycott factor is reduced to
[GRAPHIC] [TIFF OMITTED] TC16OC91.006

    (3) Incomplete controlled group taxable year. If, at the end of the 
taxable year of a person that is a member of a controlled group, the 
controlled group taxable year that includes November 3, 1976 has not 
ended, or the taxable year of one or more members of the controlled 
group that includes November 3, 1976 has not ended, then the 
international boycott factor to be applied under sections 908(a), 
952(a)(3) and 995(b)(1)(F) by such person for the taxable year shall be 
computed in the manner described in paragraph (c)(3) of this section. 
However, the numerator and the denominator in that paragraph shall 
include only the purchases, sales, and payroll of those members of the 
controlled group whose taxable years ending after November 3, 1976 have 
ended as the end of the taxable year of such person.
    (f) Effective date. This section applies to participation in or 
cooperation with an international boycott after November 3, 1976. In the 
case of operations which constitute participation in or cooperation with 
an international boycott and which are carried out in accordance with 
the terms of a binding contract entered into before September

[[Page 158]]

2, 1976, this section applies to such participation or cooperation after 
December 31, 1977.

[T.D. 7467, 42 FR 11833, Mar. 1, 1977]



Sec. 7.6039A-1  Information regarding carryover basis property acquired from a decedent.

    (a) Information for Internal Revenue Service. In the case of a 
decedent who dies after December 31, 1976, the executor (as defined in 
section 2203) shall furnish to the Internal Revenue Service the 
following information, as applicable--
    (1) If an estate tax return is required to be filed under section 
6018 of the Internal Revenue Code of 1954, as amended, and if the return 
form contains questions relating to carryover basis property, the 
executor must answer those questions.
    (2) If no estate tax return is required to be filed under section 
6018 of the Internal Revenue Code of 1954, as amended, or if a return is 
required to be filed but the return form used does not contain questions 
relating to carryover basis property, the executor must file the form 
prescribed by the Commissioner. This form may be attached to the estate 
tax return or the decedent's final individual income tax return. If this 
form is not attached to the estate tax return or the decedent's final 
individual income tax return, it must be filed with the Internal Revenue 
Service office where the decedent's final income tax return would be 
filed if one were required within 9 months after the date of the 
decedent's death or by December 31, 1978, whichever is later.
    (b) Information to be furnished to beneficiaries. Any executor 
required under paragraph (a) of this section to furnish information to 
the Internal Revenue Service relating to carryover basis property must 
furnish in writing to the distributee of each piece of carryover basis 
property--
    (1) A description of the property,
    (2) The adjusted basis of the property as computed under section 
1023 (a), (c), and (d),
    (3) The amount of the increase in the basis of the property 
determined under section 1023(h),
    (4) The value of the property for Federal estate tax purposes, and
    (5) A notice that the beneficiary should keep this information as 
part of permanent records.
    (c) Time for furnishing information to beneficiaries. The 
information which an executor is required to furnish to the 
beneficiaries under this paragraph must be furnished on or before the 
latest of--
    (1) The date the property is distributed to the beneficiary,
    (2)(i) In the case of an executor who is required to file an estate 
tax return, 6 months after the due date (including extensions) of such 
return,
    (ii) In the case of an executor who is not required to file an 
estate tax return, 15 months from the date of death of the decedent, or
    (3) December 31, 1978.
    (d) Subsequent adjustments to carryover basis. In the event 
subsequent adjustments are made which relate to the carryover basis of 
any piece of property included in a decedent's gross estate, whether by 
reason of an adjustment resulting from an examination of the estate tax 
return or otherwise, any executor required under paragraph (a) of this 
section to furnish information to the Internal Revenue Service shall, 
within 3 months of a determination, as defined in section 1313 (a), of 
such adjustments, provide to the recipient of each item of carryover 
basis property the information set forth in paragraph (b) of this 
section recomputed as required by such adjustments.
    (e) Effective date. This section is effective in respect of 
decedents dying after December 31, 1976.

(Secs. 7805 and 6039A of the Internal Revenue Code of 1954 (68A Stat. 
917, 90 Stat. 1878; 26 U.S.C. 7805, 6039A))

[T.D. 7540, 43 FR 16735, Apr. 20, 1978, as amended by T.D. 7559, 43 FR 
36244, Aug. 16, 1978]



Sec. 7.6041-1  Return of information as to payments of winnings from bingo, keno, and slot machines.

    (a) In general. On or after May 1, 1977, every person engaged in a 
trade or business and making a payment in the course of such trade or 
business of winnings (including winnings which are exempt from 
withholding under section 3402(q)(5)) of $1,200 or more from a bingo 
game or slot machine play or of

[[Page 159]]

$1,500 or more from a keno game shall make an information return with 
respect to such payment.
    (b) Special rules. For purposes of paragraph (a) of this section, in 
determining whether such winnings equal or exceed the $1,200 or $1,500 
amount--
    (1) In the case of a bingo game or slot machine play, the amount of 
winnings shall not be reduced by the amount wagered;
    (2) In the case of a keno game, the amount of winnings from one game 
shall be reduced by the amount wagered in that one game;
    (3) Winnings shall include the fair market value of a payment in any 
medium other than cash;
    (4) All winnings by the winner from one bingo or keno game shall be 
aggregated; and
    (5) Winnings and losses from any other wagering transaction by the 
winner shall not be taken into account.
    (c) Prescribed form. The return required by paragraph (a) of this 
section shall be made on Form W-2G and shall be filed with the Internal 
Revenue Service Center serving the district in which is located the 
principal place of business of the person making the return on or before 
February 28 of the calendar year following the calendar year in which 
the payment of winnings is made. Each Form W-2G shall contain the 
following:
    (1) Name, address, and employer identification number of the person 
making the payment;
    (2) Name, address, and social security number of the winner;
    (3) General description of two types of identification (e.g., 
``driver's license'', ``social security card'', or ``voter registration 
card'') furnished to the maker of the payment for verification of the 
winner's name, address, and social security number;
    (4) Date and amount of the payment; and
    (5) Type of wagering transaction.

In addition, in the case of a bingo or keno game, Form W-2G shall show 
any number, color, or other designation assigned to the game with 
respect to which the payment is made. In the case of a slot machine 
play, Form W-2G shall show the identification number of the slot 
machine.

[T.D. 7457, 42 FR 1471, Jan. 7, 1977, as amended by T.D. 7492, 42 FR 
33286, June 30, 1977]



PART 8--TEMPORARY INCOME TAX REGULATIONS UNDER SECTION 3 OF THE ACT OF OCTOBER 26, 1974 (PUB. L. 93-483)--Table of Contents




    Authority: Secs. 2055(e)(3) and 7805 of the Internal Revenue Code of 
1954 (68A Stat. 917; 26 U.S.C. 7805).



Sec. 8.1  Charitable remainder trusts.

    (a) Certain wills and trusts in existence on September 21, 1974. In 
the case of a will executed before September 21, 1974, or a trust 
created (within the meaning of applicable local law) after July 31, 
1969, and before September 21, 1974, which is amended pursuant to 
section 2055(e)(3) and Sec. 24.1 of this chapter (Temporary Estate Tax 
Regulations), a charitable remainder trust resulting from such amendment 
will be treated as a charitable remainder trust from the date it would 
be deemed created under Sec. 1.664-1(a) (4) and (5) of this chapter 
(Income Tax Regulations), whether or not such date is after September 
20, 1974.
    (b) Certain transfers to trusts created before August 1, 1969. 
Property transferred to a trust created (within the meaning of 
applicable local law) before August 1, 1969, whose governing instrument 
provides that an organization described in section 170(c) receives an 
irrevocable remainder interest in such trust shall be deemed transferred 
to a trust created on the date of such transfer, provided that the 
transfer occurs after July 31, 1969 and prior to October 18, 1971, and 
pursuant to an amendment provided in Sec. 24.1 of this chapter 
(Temporary Estate Tax Regulations), the transferred property and any 
undistributed income therefrom is severed and placed in a separate trust 
as of the date of the amendment.

[T.D. 7393, 40 FR 58853, Dec. 19, 1975]

[[Page 160]]



PART 9--TEMPORARY INCOME TAX REGULATIONS UNDER THE TAX REDUCTION ACT OF 1975--Table of Contents




Sec.
9.1  Investment credit--public utility property elections.
9.2  [Reserved]
9.3  Temporary TRASOP requirements for 1-percent additional investment 
          credit.



Sec. 9.1  Investment credit--public utility property elections.

    (a) Applicability of prior election under section 46(f)--(1) In 
general. Except as provided in paragraph (a)(2) of this section, an 
election made before March 10, 1972 (hereinafter referred to as a 1972 
election) under section 46(f) (redesignated from section 46(e) by the 
Tax Reduction Act of 1975) applies to the credit allowable for a taxable 
year with respect to public utility property described in section 
46(f)(5) by reason of sections 301 and 302 of the Tax Reduction Act of 
1975.
    (2) 1972 immediate flow-through election. A 1972 election under 
section 46(f)(3) (hereinafter referred to as an election for immediate 
flow-through) does not apply to the additional credit allowed under 
section 38 with respect to limited property (public utility property 
described in section 46(c)(3)(B) to which section 167(1)(2)(C) applies, 
other than nonregulated communication property of the type described in 
the last sentence of section 46(c)(3)(B) by reason of the Tax Reduction 
Act of 1975. However, a 1972 election for immediate flow-through does 
apply to the additional credit allowed for a taxable year with respect 
to property described in section 46(f)(5)(B). See paragraph (b) of this 
section for a new election under section 46(f)(3) with regard to the 
additional credit with respect to limited property allowed by reason of 
the Tax Reduction Act of 1975. See paragraph (a)(3) of this section for 
determination of additional credit. For purposes of this section the 
phrase ``determined as if the Tax Reduction Act had not been enacted'' 
means the following amendments shall be disregarded in determining 
credit allowable or allowed:
    (i) The increase in the amount of credit from 7 percent to 10 or 11 
percent under section 46(a)(1) (A), (B), and (D),
    (ii) The increase in the amount of qualified investment from 4/7 to 
7/7 under section 46(a)(1)(C) and (c)(3)(A),
    (iii) The increase in the dollar limitation from $50,000 to $100,000 
on used property under section 48(c)(2), and
    (iv) The increase in the limitation based on tax under section 
46(a)(6) for certain public utilities.

In determining the amount of credit attributable to limited property 
possible disallowance under section 46(f) shall be disregarded.
    (3) Additional credit allowed--(i) Credit earned in taxable year. 
The amount of additional credit allowed for credit earned for limited 
property for taxable year is an amount equal to the excess of--
    (A) The credit allowed by section 38 for the taxable year 
(determined without regard to section 46(b)) multiplied by a fraction, 
the numerator of which is the amount of credit earned for limited 
property for the taxable year and the denominator of which is the amount 
of credit earned for all section 38 property for the taxable year, over
    (B) The amount of normal credit allowed for limited property for the 
taxable year (determined without regard to section 46(b)). The amount of 
normal credit allowed for limited property is the amount of credit that 
would be allowed for the taxable year determined as if the Tax Reduction 
Act had not been enacted multiplied by a fraction, the numerator of 
which is the amount of credit earned for limited property for the 
taxable year determined as if the Tax Reduction Act had not been enacted 
and the denominator of which is the credit earned for all section 38 
property for the taxable year determined as if the Tax Reduction Act had 
not been enacted.
    (ii) Carryover or carryback to taxable year. The amount of 
additional credit allowed for limited property attributable to a 
carryover or a carryback of any unused credit to any taxable year in an 
amount equal to the excess of--
    (A) The amount of credit allowed by section 38 for the taxable year 
by reason of section 46(b) multiplied by the fraction contained in 
paragraph (a)(3)(i)(A) of this section for the unused credit year, over

[[Page 161]]

    (B) The amount of unused normal credit allowed for limited property 
for the taxable year. The amount of unused normal credit allowed for 
limited property is the amount of unused credit that would be allowed 
for the taxable year under section 38 by reason of section 46(b), taking 
into account the amount of unused credit that would be allowed for any 
preceding year, determined as if the Tax Reduction Act had not been 
enacted, multiplied by the fraction contained in paragraph (a)(3)(i)(B) 
of this section for the unused credit year.
    (b) New election--(1) In general. A taxpayer who made a 1972 
election for immedite flow-through under section 46(f)(3) with respect 
to limited property may elect to apply section 46(f)(3) to the 
additional credit allowed by the Tax Reduction Act of 1975 with respect 
to such property, or, if eligible, may make the election in paragraph 
(b)(2) of this section to apply section 46(f)(2) to such additional 
credit. The election to apply section 46(f) (2) or (3) must be made 
before June 28, 1975, in the manner provided in paragraph (c) of this 
section. If the taxpayer does not make a new election, section 46(f)(1) 
shall apply to additional credit for limited property. However, if the 
taxpayer made a 1972 election under section 46(f)(2) with respect to 
property to which section 46(f)(3) does not apply, then section 46(f)(2) 
shall apply to such additional credit notwithstanding any prohibition in 
section 46(f)(3) to the contrary.
    (2) Special section 46(f)(2) election. A taxpayer who:
    (i) Made a 1972 election under section 46(f)(3),
    (ii) Did not make an election to apply section 46(f)(2) with respect 
to property to which section 46(f)(3) does not apply, and
    (iii) Did not acquire property to which section 46(f)(1) applied in 
any taxable year ending before January 1, 1975, may elect to apply 
section 46(f)(2) to the additional credit allowed by the Tax Reduction 
Act of 1975 with respect to limited property notwithstanding any 
prohibition in section 46(f)(3) to the contrary.
    (c) Method of making election. A taxpayer may make an election 
described in paragraph (b) of this section by filing a statement before 
June 28, 1975, with the district director or director of the internal 
revenue service center with whom the taxpayer ordinarily files its 
income tax return. For rules with respect to taxpayers filing 
consolidated returns, see Sec. 1.1502-77(a) of part 1 of this chapter. 
The statement shall contain the following information: (1) The name, 
address, and taxpayer identification number of the taxpayer, and (2) the 
election which the taxpayer is making under paragraph (b) of this 
section. If a taxpayer is electing flow-through under section 46(f)(3), 
the statement shall also contain a written recitation that the election 
is made at the taxpayer's own option and without regard to any 
requirement imposed by an agency described in section 46(c)(3)(B) having 
jurisdiction over the taxpayer. The recitation shall be verified by a 
written declaration that it is made under the penalties of perjury.

(Secs. 46(f) and 7805 of the Internal Revenue Code of 1954 (85 Stat. 
503, 68A Stat. 917; 26 U.S.C. 46, 7805))

[T.D. 7360, 40 FR 25472, June 16, 1975]



Sec. 9.2  [Reserved]



Sec. 9.3  Temporary TRASOP requirements for 1-percent additional investment credit.

    The provisions listed in Sec. 1.46-8 (a)(4) (i)--(ix) (Income Tax 
Regulations) are deemed effective only as temporary regulations under 
this section.

(Sec. 301(d)(2)(C) and (10) of the Tax Reduction Act of 1975 and sec. 
7805 of the Internal Revenue Code of 1954 (89 Stat. 38, 68A Stat. 917 
(26 U.S.C. 7805)))

[T.D. 7589, 44 FR 4145, Jan. 16, 1979; 44 FR 6715, Feb. 2, 1979]



PART 11--TEMPORARY INCOME TAX REGULATIONS UNDER THE EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974--Table of Contents




Sec.
11.401(a)-11  Qualified joint and survivor annuities.
11.401(a)-19  Nonforfeitability in case of certain withdrawals.
11.401(b)-1  Certain retroactive changes in plan.

[[Page 162]]

11.401(d)(1)-1  Nonbank trustees of trusts benefiting owner-employees.
11.402(e)(4)(A)-1  Lump sum distributions in the case of an employee who 
          has separated from service.
11.402(e)(4)(B)-1  Election to treat an amount as a lump sum 
          distribution.
11.404(a)(6)-1  Time when contributions to ``H.R. 10'' plans considered 
          made.
11.408(a)(2)-1  Trustee of individual retirement accounts.
11.410-1  Election by church to have participation, vesting, funding, 
          etc., provisions apply.
11.410(b)-1  Minimum coverage requirements.
11.412(c)-7  Election to treat certain retroactive plan amendments as 
          made on the first day of the plan year.
11.412(c)-11  Election with respect to bonds.
11.412(c)-12  Extension of time to make contributions to satisfy 
          requirements of section 412.
11.415(c)(4)-1  Special elections for section 403(b) annuity contracts 
          purchased by educational institutions, hospitals and home 
          health service agencies.

    Authority: Sec. 7805 of the Internal Revenue Code of 1954 (68A Stat. 
917; 26 U.S.C. 7805), unless otherwise noted.



Sec. 11.401(a)-11  Qualified joint and survivor annuities.

    (a) In general--(1) General rule. A trust, which is a part of a plan 
providing for the payment of benefits in any form of a life annuity 
(i.e., an annuity requiring survival of the participant or his spouse as 
a condition for payment), shall not constitute a qualified trust under 
section 401(a)(11) and this section unless such plan provides that these 
benefits must be paid in a form having the effect of a qualified joint 
and survivor annuity. Therefore, any benefits which may be paid in any 
form of a life annuity must be paid in a form having the effect of a 
qualified joint and survivor annuity unless the participant makes the 
election, described in paragraph (c) of this section, not to receive 
benefits in this form. A plan will not fail to meet the requirements of 
section 401(a)(11) and this section merely because it provides that the 
spouse of a deceased participant may elect to have benefits paid in a 
form other than a qualified joint and survivor annuity. Section 
401(a)(11) and this section shall apply only in the case of a plan to 
which section 411 (relating to minimum vesting standards) applies 
without regard to section 411(e)(2). Without regard to the election 
provided under paragraph (d)(3) of this section, unless an election has 
been made under paragraph (c) of this section, a plan to which this 
section applies must provide that a survivor annuity shall be payable on 
the death of an active participant after normal retirement age.
    (2) Illustration. The provisions of this paragraph may be 
illustrated by the following example:

    Example. The X Corporation Defined Contribution Plan was established 
in 1960. As in effect on January 1, 1974, the plan provided that, upon 
his retirement, a participant could elect to receive the balance of his 
individual account in the form of (1) a lump-sum cash payment, (2) a 
lump-sum distribution consisting of X Corporation stock, (3) five equal 
annual cash payments, (4) a life annuity, or (5) a combination of 
options (1) through (4). The plan also provided that, if a participant 
did not elect another form of distribution, the balance of his 
individual account would be distributed to him in the form of a lump-sum 
cash payment upon his retirement. Assume that section 401(a)(11) and 
this section first become applicable to the plan as of its plan year 
beginning January 1, 1976, with respect to persons who were active 
participants in the plan on such date (see paragraph (h) of this 
section). Unless the X Corporation Defined Contribution Plan either 
discontinues the life annuity payment option or is amended to provide 
that the balance of a participant's individual account will be paid to 
him in a form having the effect of a qualified joint and survivor 
annuity unless the participant elects another form of benefit payment, 
the trust established under the plan will fail to qualify under section 
401(a).

    (b) Definitions. As used in this section--
    (1) Qualified joint and survivor annuity. The term ``qualified joint 
and survivor annuity'' means an annuity for the life of the participant 
with a survivor annuity for the life of his spouse which is neither (i) 
less than one-half of, nor (ii) greater than, the amount of the annuity 
payable during the joint lives of the participant and his spouse. A 
qualified joint and survivor annuity must be at least the actuarial 
equivalent of the normal form of annuity or any optional form of benefit 
offered under the plan. Equivalence may be determined, on the basis of 
consistently applied reasonable actuarial factors,

[[Page 163]]

for each participant or for all participants or reasonable groupings of 
participants, if such determination does not result in discrimination in 
favor of employees who are officers, shareholders, or highly 
compensated. An annuity is not a qualified joint and survivor annuity if 
payments to the spouse of a deceased participant are terminated because 
of such spouse's remarriage.
    (2) Annuity starting date. The term ``annuity starting date'' means 
the first day of the first period with respect to which an amount is 
received as an annuity, whether by reason of retirement or by reason of 
disability.
    (3) Earliest retirement age. The term ``earliest retirement age'' 
means the earliest date on which, under the plan, the participant could 
elect to receive retirement benefits, including any benefit the 
participant is entitled to receive on account of disability.
    (c) Election not to take joint and survivor annuity form--(1) In 
general. A plan shall not be treated as satisfying the requirements of 
this section unless each participant has the right to elect in writing 
not to take a joint and survivor annuity during a reasonable period 
before the annuity starting date. However, if a plan provides that a 
qualified joint and survivor annuity is the only form of benefit payable 
under the plan, no election need be provided.
    (2) Information to be provided to the participant. (i) The plan 
administrator must furnish to the participant a written notification, in 
nontechnical terms, of the availability of the election provided by this 
paragraph, within a reasonable amount of time after the first day of the 
election period. This notification shall also inform the participant of 
the availability of the information specified in subdivision (ii) of 
this subparagraph.
    (ii) The plan administrator must furnish to the participant a 
written explanation in nontechnical language of the terms and conditions 
of the joint and survivor annuity and the financial effect upon the 
participant's annuity (in terms of dollars per annuity payment) of 
making an election under this paragraph. This explanation must be 
provided to the participant within a reasonable amount of time from the 
date of the participant's request during the election period.
    (3) Form of election. The election shall be in writing and clearly 
indicate that the participant is electing to receive his benefits under 
the plan in a form other than that of a joint and survivor annuity.
    (4) Election is revocable. This election may be revoked in writing 
during the election period. After an election is revoked another 
election under this paragraph may be made during the election period.
    (d) Plans providing for early retirement--(1) Period during which 
qualified joint and survivor annuity not required. Notwithstanding the 
provisions of paragraph (a) of this section, in the case of a plan which 
provides for the payment of benefits before the normal retirement age 
(as defined in section 411(a)(8)), the plan is not required to provide 
for the payment of annuity benefits in a form having the effect of a 
qualified joint and survivor annuity during the period beginning on the 
date on which the employee enters into the plan as a participant and 
ending on the later of--
    (i) The date the employee reaches the earliest retirement age under 
the plan (as defined in paragraph (b)(3) of this section), or
    (ii) The first day of the 120th month beginning before the date on 
which the employee reaches normal retirement age.
    (2) Period during which qualified joint and survivor annuity 
required. (i) If a participant terminates employment and begins to 
receive retirement benefits during the period described in subparagraph 
(1) of this paragraph, he and his spouse must receive, after the 
termination of such period (or after the date such period would have 
terminated if the participant had survived), benefits having the effect 
of a qualified joint and survivor annuity, unless the participant has 
made an election under paragraph (c) of this section.
    (ii) If a participant terminates employment and begins to receive 
retirement benefits after the period described in subparagraph (1) of 
this paragraph, he and his spouse must receive benefits having the 
effect of a qualified joint and survivor annuity,

[[Page 164]]

unless the participant has made an election under paragraph (c) of this 
section.
    (iii) The provisions of this subparagraph may be illustrated by the 
following example:

    Example. A plan which provides a benefit in the form of a life 
annuity also provides that a participant may retire before the normal 
retirement age of 65 and receive a benefit, if he has completed 30 years 
of service. A, an employee, became a participant at the age of 18. A 
retires and begins to receive retirement benefits at the age of 48. 
Unless A otherwise elects, the plan must provide a qualified joint and 
survivor annuity to A and his spouse after A reaches age 55 (the later 
of the earliest retirement age (age 48) or 10 years before normal 
retirement age (age 55)) or after the date A would have reached age 55, 
if he had survived. The survivor annuity paid to the spouse must satisfy 
the requirements of paragraph (b)(1) of this section. The plan may, but 
is not required to, provide the survivor annuity before age 55 if the 
participant dies between age 48 and age 55.

    (3) Election of survivor annuity--(i) In general. (A) A plan 
described in subparagraph (1) of this paragraph does not meet the 
requirements of paragraph (a) of this section unless, under the plan, a 
participant may elect, during a reasonable period, a survivor annuity to 
be payable on his death during the period beginning on the date on which 
the period described in subparagraph (1) of this paragraph ends and 
ending on the date on which he reaches normal retirement age if he 
continues his employment during that period. Breaks in service during 
that period will neither invalidate a previous election or revocation 
nor prevent an election from being made or revoked during the election 
period.
    (B) If a plan provides that a survivor annuity is the only form of 
benefit payable under the plan, no election need be provided.
    (ii) Example. The provisions of subdivision (i) of this subparagraph 
may be illustrated by the following example:

    Example. A plan which provides a life annuity also provides that a 
participant may retire before the normal retirement age of 65 and 
receive a benefit, if he has completed 30 years of service. Under this 
plan, an employee who became a participant at the age of 18 will be 
eligible to receive retirement benefits at the age of 48. This plan must 
allow a participant who continues his employment to elect a survivor 
annuity, described in subdivision (v) of this subparagraph, to be 
payable on the death of the participant if death occurs after age 55 
(the later of the date the participant reaches the earliest retirement 
age (age 48) or 10 years before normal retirement age (age 55)) but 
before the date the participant reaches normal retirement age (age 65).

    (iii) Information to be provided by plan administrator. (A) The plan 
administrator must furnish to the participant a written notification in 
nontechnical terms of the availability of the election provided by this 
subparagraph, within a reasonable amount of time after the first day of 
the election period. This notification shall also inform the participant 
of the availability of the information specified in subdivision (iii)(B) 
of this subparagraph.
    (B) During the election period, the plan administrator must furnish 
to the participant, within a reasonable amount of time from the date of 
his request, a written explanation in nontechnical language of the terms 
and conditions of the survivor annuity and the financial effect upon the 
participant's annuity (in terms of dollars per annuity payment) of an 
election or of a revocation of an election under this subparagraph.
    (iv) Payments under the survivor annuity. In order to meet the 
requirements of this subparagraph, if an election is made, the payments 
under the survivor annuity must not be less than the payments which 
would have been made under the joint and survivor annuity to which the 
surviving spouse would have been entitled if the participant had made 
the election described in this subparagraph immediately prior to his 
retirement and if his retirement had occurred on the day before his 
death and within the period during which an election can be made. For 
example, if a participant is entitled to a single life annuity of $100 
per month or a reduced amount under a qualified joint and survivor 
annuity of $80 per month, regardless of when he makes a valid election 
under subparagraph (2) of this paragraph, his spouse is entitled to a 
payment of at least $40, but not more than $80 per month, under the 
survivor annuity.

[[Page 165]]

    (v) Form of election. The election shall be in writing and clearly 
indicate that the participant is electing the joint and survivor annuity 
form.
    (vi) Election is revocable. An election under this subparagraph may 
be revoked in writing during the election period. After an election has 
been revoked, another election under this subparagraph may be made 
during the election period. See paragraph (c) of this section, relating 
to the right to elect not to take the joint and survivor annuity form.
    (e) Marriage requirements. (1) A plan shall be treated as satisfying 
the requirements of this section even though it requires the participant 
and his spouse to have been married to each other on the annuity 
starting date.
    (2) A plan shall be treated as satisfying the requirements of this 
section even though it provides that the spouse of the participant is 
not entitled to receive a survivor annuity (whether or not the election 
described in paragraph (d)(3) of this section has been made) unless the 
participant and his spouse have been married to each other throughout 
the 1-year period ending on the date of such participant's death.
    (f) Effect of participant's death on an election or revocation of an 
election under paragraph (c) or (d)(3). A plan shall not be treated as 
not satisfying the requirements of this section merely because the plan 
contains a provision that any election made under paragraph (c) or 
(d)(3) of this section and any revocation of any such election does not 
become effective or ceases to be effective if the participant dies 
within a period, not in excess of 2 years, beginning on the date of such 
election or revocation. A plan containing a provision described in the 
preceding sentence shall not satisfy the requirements of this section 
unless it also provides that any such election and any revocation of any 
such election will be given effect in any case in which--
    (1) The participant dies from accidental causes,
    (2) A failure to give effect to the election or revocation would 
deprive the participant's survivor of a survivor annuity, and
    (3) Such election or revocation is made before such accident 
occurred.
    (g) Costs of providing joint and survivor annuity form. A plan may 
take into account in any equitable manner consistent with generally 
accepted actuarial principles applied on a consistent basis any 
increased costs resulting from providing joint and survivor annuity 
benefits.
    (h) Application and effective date. (1) Section 401(a)(11) and this 
section shall apply to a plan only with respect to plan years to which 
section 411 (relating to minimum vesting standards) is applicable to the 
plan.
    (2) Section 401(a)(11) and this section shall apply if--
    (i) The participant's annuity starting date falls within a plan year 
beginning after December 31, 1975, and
    (ii) The participant was an active participant in the plan on or 
after the first day of the first plan year beginning after December 31, 
1975.

For purposes of this paragraph, the term ``active participant'' means a 
participant for whom benefits are being accrued under the plan on his 
behalf, the employer is obligated to contribute to or under the plan on 
his behalf, or the employer would have been obligated to contribute to 
or under the plan on his behalf if any contributions were made to or 
under the plan.

(Sec. 401(a)(11) of the Internal Revenue Code of 1954, 88 Stat. 935 (26 
U.S.C. 401(a)(11)))

[T.D. 7379, 40 FR 45810, Oct. 3, 1975; 40 FR 49326, Oct. 22, 1975]



Sec. 11.401(a)-19  Nonforfeitability in case of certain withdrawals.

    (a) Application of section. Section 401(a)(19) and this section 
apply to a plan to which section 411(a) applies. (See section 411(e) and 
Sec. 11.411(a)-2 for applicability of section 411.)
    (b) Prohibited forfeitures--(1) General rule. A plan to which this 
section applies is not a qualified plan (and a trust forming a part of 
such plan is not a qualified trust) if, under such plan, any part of a 
participant's accrued benefit derived from employer contributions is 
forfeitable solely because a benefit derived from the participant's 
contributions under the plan is voluntarily withdrawn by him after he 
has become a 50 percent vested participant.

[[Page 166]]

    (2) 50 percent vested participant. For purposes of paragraph (b)(1) 
of this section, a participant is a 50 percent vested participant when 
he has a nonforfeitable right (within the meaning of section 411 and the 
regulations thereunder) to at least 50 percent of his accrued benefit 
derived from employer contributions.
    (3) Certain forfeitures. Paragraph (b)(1) of this section does not 
apply in the case of a forfeiture permitted by section 411(a)(3)(D)(iii) 
and Sec. 11.411(a)-4(b)(5)(i) (relating to forfeitures of certain 
benefits accrued before September 2, 1974).

[T.D. 7387, 40 FR 51421, Nov. 5, 1975]



Sec. 11.401(b)-1  Certain retroactive changes in plan.

    (a) General rule. (1) Under section 401(b), a stock bonus, pension, 
profit-sharing or annuity plan or bond purchase plan which does not 
satisfy the requirements of section 401(a) on any day solely as a result 
of a disqualifying provision (as defined in paragraph (b) of this 
section) shall be considered to have satisfied such requirements on such 
day if there is adopted during the remedial amendment period (as 
determined under paragraphs (c) and (d) of this section) with respect to 
such disqualifying provision an amendment which causes the plan to 
satisfy all such requirements of section 401(a), 403(a) or 405(a) for 
the whole of the remedial amendment period (including extension 
thereof).
    (2) This section shall not apply to any disqualifying provision if 
the remedial amendment period (as determined under paragraphs (c) and 
(d)(1) of this section determined without regard to paragraph (d)(2) of 
this section) with respect to such disqualifying provision ends prior to 
September 2, 1974.
    (b) Disqualifying provisions. For purposes of this section, with 
respect to a plan described in paragraph (a) of this section the term 
``disqualifying provision'' means any provision of--
    (1) A plan as adopted,
    (2) A plan amendment, or
    (3) The Employee Income Security Act of 1974 (Pub. L. 93-406, 88 
Stat. 829),

which causes such plan to fail to satisfy the requirements of section 
401(a), 403(a), or 405(a).
    (c) Remedial amendment period. (1) The remedial amendment period 
with respect to a disqualifying provision begins on the effective date 
of the disqualifying provision. For purposes of this section, the 
effective date of a disqualifying provision is--
    (i) In the case of a disqualifying provision in a plan as adopted, 
the date the plan is put into effect,
    (ii) In the case of a plan amendment, the date the plan amendment is 
adopted or put into effect (whichever is earlier), or
    (iii) In the case of a statutory provision described in paragraph 
(b)(3) of this section, the effective date of such provision.
    (2) Unless extended as provided by paragraph (d) of this section, 
the remedial amendment period ends with the time prescribed by law 
(including extensions) for filing the return of the employer for the 
employer's taxable year in which falls--
    (i) With respect to a disqualifying provision in a plan as adopted, 
or a plan amendment, the later of the date on which such provision was 
adopted or put into effect.
    (ii) With respect to a statutory provision described in paragraph 
(b)(3) of this section, the effective date of such provision.
    (d) Extension for determination letters--(1) In general. If, before 
the end of the remedial amendment period (determined without regard to 
this paragraph) with respect to a disqualifying provision, the employer 
or plan administrator files a request pursuant to Sec. 601.210(o) of 
this chapter (Statement of Procedural Rules) for a determination letter 
with respect to the initial qualifications of the plan or the effect of 
such disqualifying provision on the qualified status of the plan (or a 
trust which is part of a plan) under section 401(a), 403(a), or 405(a), 
then except as provided in subparagraph (3) of this paragraph, such 
remedial amendment period may be extended for a period not to exceed 150 
days, beginning on the day after the last day of the employers taxable 
year in which falls the dates described in subdivisions (i) and (ii) of 
paragraph (c)(2) of this section. The 150-day period does not include 
any day on which there is pending before the

[[Page 167]]

Internal Revenue Service a request for a determination letter described 
in this subparagraph. For this purpose, such a request is considered to 
be pending before the Internal Revenue Service from the date it is filed 
with the Internal Revenue Service to the date on which notice of the 
final determination with respect to the request is issued by the 
Internal Revenue Service, the request is withdrawn, or the request is 
otherwise finally disposed of by the Internal Revenue Service.
    (2) Special rules. Except as provided in subparagraph (3) of this 
paragraph, the period provided by subparagraph (1) of this paragraph 
shall not end prior to the later of December 31, 1975, or the expiration 
of 30 days after--
    (i) The date on which a notice of final determination with respect 
to a request described in that subparagraph is issued by the Internal 
Revenue Service, or, where applicable,
    (ii) The date on which a judgment pursuant to section 7476 (relating 
to declaratory judgments) by the United States Tax Court in a case or 
controversy involving such determination becomes final.
    (3) Overall limitation. The period provided by subparagraph (1) of 
this paragraph shall not expire later than the last day (determined 
under section 6501) for assessment of any tax imposed by the Internal 
Revenue Code with respect to the taxable year of the employer 
immediately preceding the first day of such period.

(Sec. 401(b), Internal Revenue Code of 1954, 88 Stat. 943 (26 U.S.C. 
401(b)))

[T.D. 7377, 40 FR 44544, Sept. 29, 1975]



Sec. 11.401(d)(1)-1  Nonbank trustees of trusts benefiting owner-employees.

    (a) Effective dates--(1) General rule. For a plan not in existence 
on January 1, 1974, this section shall apply to the first plan year 
commencing after September 2, 1974, and all subsequent plan years.
    (2) Existing plans. For a plan in existence on January 1, 1974, this 
section shall apply to the first plan year commencing after December 31, 
1975, and all subsequent plan years.
    (b) In general. For plan years to which this section applies, the 
trustee of a trust described in Sec. 1.401-12(c)(1)(i) may 
(notwithstanding Sec. 1.401-12(c)) be a person other than a bank (within 
the meaning of section 401(d)(1)) if he demonstrates to the satisfaction 
of the Commissioner that the manner in which he will administer trusts 
will be consistent with the requirements of section 401. Such 
demonstration must be made by a written application to the Commissioner 
of Internal Revenue, Attention: E:EP, Internal Revenue Service, 
Washington, DC 20224. Such application must meet the requirements set 
forth in paragraphs (c) to (g) of this section.
    (c) Fiduciary ability. The applicant must demonstrate in detail his 
ability to act within the accepted rules of fiduciary conduct. Such 
demonstration must include the following elements of proof:
    (1) Continuity. (i) The applicant must assure the uninterrupted 
performance of its fiduciary duties notwithstanding the death or change 
of its owners. Thus, for example, there must be sufficient diversity in 
the ownership of the applicant to ensure that the death or change of its 
owners will not interrupt the conduct of its business. Therefore, the 
applicant cannot be an individual.
    (ii) Sufficient diversity in the ownership of an incorporated 
applicant means that individuals each of whom owns more than 20 percent 
of the voting stock in the applicant own, in the aggregate, no more than 
50 percent of such stock.
    (iii) Sufficient diversity in the ownership of an applicant which is 
a partnership means that--
    (A) Individuals each of whom owns more than 20 percent of the 
profits interest in the partnership own, in the aggregate, no more than 
50 percent of such profits interest, and
    (B) Individuals each of whom owns more than 20 percent of the 
capital interest in the partnership own, in the aggregate, no more than 
50 percent of such capital interest.
    (iv) For purposes of this subparagraph, the ownership of stock and 
of capital and profits interests shall be determined in accordance with 
the rules for constructive ownership of stock provided in section 
1563(e) and (f)(2). For this purpose, the rules for

[[Page 168]]

constructive ownership of stock provided in section 1563(e) and (f)(2). 
For this purpose, the rules for constructive ownership of stock provided 
in section 1563(e) and (f)(2) shall apply to a capital or profits 
interest in a partnership as if it were a stock interest.
    (2) Established location. The applicant must have an established 
place of business in the United States where he is accessible during 
every business day.
    (3) Fiduciary experience. The applicant must have fiduciary 
experience or expertise sufficient to ensure that he will be able to 
perform his fiduciary duties. Evidence of fiduciary experience must 
include proof that a significant part of the business of the applicant 
consists of exercising fiduciary powers similar to those he will 
exercise if his application is approved. Evidence of fiduciary expertise 
must include proof that the applicant employs personnel experienced in 
the administration of fiduciary powers similar to those he will exercise 
if his application is approved.
    (4) Fiduciary responsibility. The applicant must assure compliance 
with the rules of fiduciary conduct set out in paragraph (f) of this 
section.
    (5) Financial responsibility. The applicant must exhibit a high 
degree of solvency commensurate with the obligations imposed by this 
section. Among the factors to be taken into account are the applicant's 
net worth, his liquidity, and his ability to pay his debts as they come 
due.
    (d) Capacity to account. The applicant must demonstrate in detail 
his experience and competence with respect to accounting for the 
interests of a large number of individuals (including calculating and 
allocating income earned and paying out distributions to payees). 
Examples of accounting for the interests of a large number of 
individuals include accounting for the interests of a large number of 
shareholders in a regulated investment company and accounting for the 
interests of a large number of variable annuity contract holders.
    (e) Fitness to handle funds--(1) In general. The applicant must 
demonstrate in detail his experience and competence with respect to 
other activities normally associated with the handling of retirement 
funds.
    (2) Examples. Examples of activities normally associated with the 
handling of retirement funds include:
    (i) To receive, issue receipts for, and safely keep securities;
    (ii) To collect income;
    (iii) To execute such ownership certificates, to keep such records, 
make such returns, and render such statements as are required for 
Federal tax purposes;
    (iv) To give proper notification regarding all collections;
    (v) To collect matured or called principal and properly report all 
such collections;
    (vi) To exchange temporary for definitive securities;
    (vii) To give proper notification of calls, subscription rights, 
defaults in principal or interest, and the formation of protective 
committees;
    (viii) To buy, sell, receive, or deliver securities on specific 
directions.
    (f) Rules of fiduciary conduct--(1) Administration of fiduciary 
powers. The applicant must demonstrate that under applicable regulatory 
requirements, corporate or other governing instruments, or its 
established operating procedures:
    (i)(A) The owners or directors of the applicant will be responsible 
for the proper exercise of fiduciary powers by the applicant. Thus, all 
matters pertinent thereto, including the determination of policies, the 
investment and disposition of property held in a fiduciary capacity, and 
the direction and review of the actions of all employees utilized by the 
applicant in the exercise of his fiduciary powers, will be the 
responsibility of the owners or directors. In discharging this 
responsibility, the owners or directors may assign to designated 
employees, by action duly recorded, the administration of such of the 
applicant's fiduciary powers as may be proper to assign.
    (B) A written record will be made of the acceptance and of the 
relinquishment or closing out of all fiduciary accounts, and of the 
assets held for each account.
    (C) At least once during each period of 12 months all the assets 
held in or for each fiduciary account where the applicant has investment 
responsibilities will be reviewed to determine the

[[Page 169]]

advisability of retaining or disposing of such assets.
    (ii) All employees taking part in the performance of the applicant's 
fiduciary duties will be adequately bonded. Nothing in this subdivision 
shall require any person to be bonded in contravention of section 412(d) 
of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 
1112(d)).
    (iii) The applicant will designate, employ, or retain legal counsel 
who will be readily available to pass upon fiduciary matters and to 
advise the applicant.
    (iv) In order to segregate the performance of his fiduciary duties 
from other business activities, the applicant will maintain a separate 
trust division under the immediate supervision of an individual 
designated for that purpose. The trust division may utilize the 
personnel and facilities of other divisions of the applicant, and other 
divisions of the applicant may utilize the personnel and facilities of 
the trust division, as long as the separate identity of the trust 
division is preserved.
    (2) Adequacy of net worth. (i) Not less frequently than once during 
each calendar year the applicant will determine the value of the assets 
held by him in trust. Such assets will be valued at their current value, 
except that the assets of an employee benefit plan to which section 
103(b)(3)(A) of the Employee Retirement Income Security Act of 1974 (29 
U.S.C. 1023(b)(3)(A)) applies will be considered to have the value 
stated in the most recent annual report of the plan.
    (ii) No fiduciary account will be accepted by the applicant unless 
his net worth (determined as of the end of the most recent taxable year) 
exceeds the greater of--
    (A) $100,000, or
    (B) Four percent of the value of all of the assets held by the 
applicant in trust (determined as of the most recent valuation date).
    (iii) The applicant will take whatever lawful steps are necessary 
(including the relinquishment of fiduciary accounts) to ensure that his 
net worth (determined as of the close of each taxable year) exceeds the 
greater of--
    (A) $50,000, or
    (B) Two percent of the value of all of the assets held by the 
applicant in trust (determined as of the most recent valuation date).
    (3) Audits. (i) The applicant will at least once during each period 
of 12 months cause detailed audits of the fiduciary books and records to 
be made by an independent qualified public accountant, and at such time 
will ascertain whether the fiduciary accounts have been administered in 
accordance with law, this section, and sound fiduciary principles. Such 
audits shall be conducted in accordance with generally accepted auditing 
standards, and shall involve such tests of the fiduciary books and 
records of the applicant as are considered necessary by the independent 
qualified public accountant.
    (ii) In the case of an applicant who is regulated, supervised, and 
subject to periodic examination by a State or Federal agency, such 
applicant may adopt an adequate continuous audit system in lieu of the 
periodic audits required by paragraph (f)(3)(i) of this section.
    (iii) A report of the audits and examinations required under this 
subparagraph, together with the action taken thereon, will be noted in 
the fiduciary records of the applicant.
    (4) Funds awaiting investment or distribution. Funds held in a 
fiduciary capacity by the applicant awaiting investment or distribution 
will not be held uninvested or undistributed any longer than is 
reasonable for the proper management of the account.
    (5) Custody of investments. (i) Except for investments pooled in a 
common investment fund in accordance with the provisions of paragraph 
(f)(6) of this section, the investments of each account will not be 
commingled with any other property.
    (ii) Fiduciary assets requiring safekeeping will be deposited in an 
adequate vault. A permanent record will be kept of fiduciary assets 
deposited in or withdrawn from the vault.
    (6) Common investment funds. Where not in contravention of local law 
the assets of an account may be pooled in a common investment fund (as 
defined in paragraph (f)(8)(iii) of this section) which must be 
administered as follows:

[[Page 170]]

    (i) Each common investment fund must be established and maintained 
in accordance with a written agreement, containing appropriate 
provisions as to the manner in which the fund is to be operated, 
including provisions relating to the investment powers and a general 
statement of the investment policy of the applicant with respect to the 
fund; the allocation of income, profits and losses; the terms and 
conditions governing the admission or withdrawal of participations in 
the fund; the auditing of accounts of the applicant with respect to the 
fund; the basis and method of valuing assets in the fund, setting forth 
specific criteria for each type of asset; the minimum frequency for 
valuation of assets of the fund; the period following each such 
valuation date during which the valuation may be made (which period in 
usual circumstances may not exceed 10 business days); the basis upon 
which the fund may be terminated; and such other matters as may be 
necessary to define clearly the rights of participants in the fund. A 
copy of the agreement must be available at the principal office of the 
applicant for inspection during all business hours, and upon request a 
copy of the agreement must be furnished to any interested person.
    (ii) All participations in the common investment fund must be on the 
basis of a proportionate interest in all of the assets.
    (iii) Not less frequently than once during each period of 3 months 
applicant must determine the value of the assets in the fund as of the 
date set for the valuation of assets. No participation may be admitted 
to or withdrawn from the fund except (A) on the basis of such valuation 
and (B) as of such valuation date. No participation may be admitted to 
or withdrawn from the fund unless a written request for or notice of 
intention of taking such action has been entered on or before the 
valuation date in the fiduciary records of the applicant. No request or 
notice may be canceled or countermanded after the valuation date.
    (iv)(A) The applicant must at least once during each period of 12 
months cause an adequate audit to be made of the common investment fund 
by a qualified public accountant.
    (B) The applicant must at least once during each period of 12 months 
prepare a financial report of the fund which, based upon the above 
audit, must contain a list of investments in the fund showing the cost 
and current market value of each investment; a statement for the period 
since the previous report showing purchases, with cost; sales, with 
profit or loss and any other investment changes; income and 
disbursements; and an appropriate notation as to any investments in 
default.
    (C) The applicant must transmit and certify the accuracy of the 
financial report to the administrator of each plan participating in the 
common investment fund within 120 days after the end of the plan year.
    (v) When participations are withdrawn from a common investment fund, 
distributions may be made in cash or ratably in kind, or partly in cash 
and partly in kind, provided that all distributions as of any one 
valuation date must be made on the same basis.
    (vi) If for any reason an investment is withdrawn in kind from a 
common investment fund for the benefit of all participants in the fund 
at the time of such withdrawal and such investment is not distributed 
ratably in kind, it must be segregated and administered or realized upon 
for the benefit ratably of all participants in the common investment 
fund at the time of withdrawal.
    (7) Books and records. (i) The applicant must keep his fiduciary 
records separate and distinct from other records. All fiduciary records 
must be so kept and retained for as long as the contents thereof may 
become material in the administration of any internal revenue law. The 
fiduciary records must contain full information relative to each 
account.
    (ii) The applicant must keep an adequate record of all pending 
litigation to which he is a party in connection with the exercise of 
fiduciary powers.
    (8) Definitions. For purposes of this paragraph and paragraph (c)(5) 
of this section--
    (i) The term ``account'' or ``fiduciary account'' means a trust 
described in

[[Page 171]]

section 401(a) (including a custodial account described in section 
401(f)), a custodial account described in section 403(b)(7), or an 
individual retirement account described in section 408(a) (including a 
custodial account described in section 408(h)).
    (ii) The term ``administrator'' means an administrator as defined in 
section 3(16)(A) of the Employee Retirement Income Security Act of 1974, 
29 U.S.C. 1002(16)(A).
    (iii) The term ``common investment fund'' means a trust which 
satisfied the following requirements:
    (A) The trust consists of all or part of the assets of several 
accounts which have been established with the applicant, and
    (B) The trust is described in section 401(a) and exempt from tax 
under section 501(a), or is a common investment fund described in 
Sec. 1.408-2(b)(5) (as published with notice of proposed rulemaking in 
the Federal Register on February 21, 1975, at 40 FR 7661), or both.
    (iv) The term ``employee benefit plan'' means an employee benefit 
plan as defined in section 3(2) of the Employee Retirement Income 
Security Act of 1974, 29 U.S.C. 1002(2).
    (v) The term ``fiduciary records'' means all matters which are 
written, transcribed, recorded, received or otherwise come into the 
possession of the applicant and are necessary to preserve information 
concerning the acts and events relevant to the fiduciary activities of 
the applicant.
    (vi) The term ``qualified public accountant'' means a qualified 
public accountant as defined in section 103(a)(3)(D) of the Employee 
Retirement Income Security Act of 1974, 29 U.S.C. 1023(a)(3)(D).
    (vii) The term ``net worth'' means the amount of the applicant's 
assets less the amount of his liabilities, as determined in accordance 
with generally accepted accounting principles.
    (g) Special rules--(1) Passive trustee. (i) An applicant who 
undertakes to act only as a passive trustee may be relieved of one or 
more of the requirements of this section upon clear and convincing proof 
that such requirements are not germane, under all the facts and 
circumstances, to the manner in which he will administer any trust. A 
trustee is a passive trustee only if under the written trust instrument 
he has no discretion to direct the investment of the trust funds or any 
other aspect of the business administration of the trust, but is merely 
authorized to acquire and hold particular investments specified by the 
trust instrument. Thus, for example, in the case of an applicant who 
undertakes merely to acquire and hold the stock of a single regulated 
investment company, the requirements of paragraphs (f)(1)(i)(C), 
(1)(iv), and (6) of this section shall not apply and no negative 
inference shall be drawn from the applicant's failure to demonstrate his 
experience or competence with respect to the activities described in 
paragraph (e)(2)(v) to (viii) of this section.
    (ii) The determination letter issued to an applicant who is approved 
by reason of this subparagraph shall state that the applicant is 
authorized to act only as a passive trustee.
    (2) Federal or State regulation. Evidence that an applicant is 
subject to Federal or State regulation with respect to one or more 
relevant factors shall be given weight in proportion to the extent that 
such regulatory standards are consonant with the requirements of section 
401.
    (3) Savings account. (i) An applicant will be approved to act as 
trustee under this subparagraph if the following requirements are 
satisfied:
    (A) The applicant is a credit union, industrial loan company, 
savings and loan association, or other financial institution designated 
by the Commissioner;
    (B) The investment of the trust assets will be solely in deposits in 
the applicant;
    (C) Deposits in the applicant are insured (up to the dollar limit 
prescribed by applicable law) by an agency or instrumentality of the 
United States or a State.
    (ii) Any applicant who satisfies the requirements of this 
subparagraph is hereby approved, and (notwithstanding paragraph (b) of 
this section) is not required to submit a written application. This 
approval takes effect on the first day after December 22, 1976, on which

[[Page 172]]

the applicant satisfies the requirements of this subparagraph, and 
continues in effect for so long as the applicant continues to satisfy 
those requirements.
    (4) Notification of Commissioner. The applicant must notify the 
Commissioner in writing of any change which affects the continuing 
accuracy of any representation made in the application required by this 
section, whether the change occurs before or after the applicant 
receives a determination letter. Such notification must be addressed to 
Commissioner of Internal Revenue, Attention: E:EP, Internal Revenue 
Service, Washington, DC 20224.
    (5) Substitution of trustee. No applicant shall be approved unless 
he undertakes to act as trustee only under trust instruments which 
contain a provision to the effect that the employer is to substitute 
another trustee upon notification by the Commissioner that such 
substitution is required because the applicant has failed to comply with 
the requirements of this section or is not keeping such records, or 
making such returns, or rendering such statements as are required by 
forms or regulations.
    (6) Revocation. Approval of the application required by this section 
may be revoked for any good and sufficient reason.

(Sec. 401(d)(1) and Internal Revenue Code of 1954 (88 Stat. 939 26 
U.S.C. 401))

[T.D. 7383, 40 FR 48509, Oct. 16, 1975 as amended by T.D. 7448, 41 FR 
55510, Dec. 21, 1976]



Sec. 11.402(e)(4)(A)-1  Lump sum distributions in the case of an employee who has separated from service.

    (a) Balance to the credit of an employee. Section 402(e)(4)(A) 
provides that in order for a distribution or payment from a qualified 
plan to be a lump sum distribution, the distribution or payment must 
represent the employee's balance under the plan. The employee's balance 
does not include any amount which is forfeited under the plan (even 
though the amount may be reinstated) as of the close of the taxable year 
of the recipient within which the distribution is made. In addition, in 
the case of an employee who has separated from service, the employee's 
balance does not include an amount which is subject to forfeiture not 
later than the close of the plan year within which the employee incurs a 
one-year break in service (within the meaning of section 411) if--
    (1) By reason of the break in service, the amount is actually 
forfeited at or prior to the close of that plan year, and
    (2) The break in service occurs within 25 months after the 
employee's separation from service. In the case of a plan which uses the 
elapsed time method of crediting service, the break in service may occur 
within 25 months of the employee's severance from service. See 
Department of Labor regulations relating to the elapsed time method for 
the date an employee severs from service.

An employee may assume that an amount subject to forfeiture will be 
treated as forfeited by the date prescribed in paragraphs (a) (1) and 
(2) of this section if, under the plan, forfeiture will occur not later 
than that date. Therefore, he may assume that a distribution is a lump 
sum distribution at the time it is made, if the other requirements for 
lump sum distributions are satisfied. However, if the amount is not 
forfeited by that date, the amount will be taken into account in 
determining the balance to the credit of the employee. Accordingly, the 
distribution will not be a lump sum distribution because it did not 
include the employee's entire balance under the plan.
    (b) Rollover contribution. As described in paragraph (a) of this 
section, an employee may assume that a distribution is a lump sum 
distribution even though part of the balance of his account has not been 
forfeited at the time the distribution is made. He may then roll the 
distribution over as a contribution to an individual retirement 
arrangement pursuant to section 402(a)(5) or 403(a)(4). It may be 
subsequently determined that the distribution was not a lump sum 
distribution because an amount subject to forfeiture was not in fact 
forfeited within the time required in paragraph (a) of this section. In 
that case, the contribution will be an excess contribution to the 
individual retirement arrangement, deemed made in the first taxable year 
of the employee in which it can be determined that an amount subject to 
forfeiture will not be forfeited.

[[Page 173]]

    (c) Effective date. This section is effective for distributions made 
in taxable years of recipients beginning after December 31, 1973.

[T.D. 7488, 42 FR 27882, June 1, 1977]



Sec. 11.402(e)(4)(B)-1  Election to treat an amount as a lump sum distribution.

    (a) In general. For purposes of sections 402, 403, and this section, 
an amount which is described in section 402(e)(4)(A) and which is not an 
annuity contract may be treated as a lump sum distribution under section 
402(e)(4)(A) only if the taxpayer elects for the taxable year to have 
all such amounts received during such year so treated. Not more than one 
election may be made under this section with respect to an employee 
after such employee has attained age 59\1/2\.
    (b) Taxpayers eligible to make the election. Individuals, estates, 
and trusts are the only taxpayers eligible to make the election provided 
by this section. In the case of a lump sum distribution made with 
respect to an employee to 2 or more trusts, the election provided by 
this section shall be made by the employee or by the personal 
representative of a deceased employee.
    (c) Procedure for making election--(1) Time and scope of election. 
An election under this section shall be made for each taxable year to 
which such election is to apply. The election shall be made before the 
expiration of the period (including extension thereof) prescribed in 
section 6511 for making a claim for credit or refund of the assessed tax 
imposed by Chapter I of Subtitle A of the Code for such taxable year.
    (2) Manner of making election. An election by the taxpayer with 
respect to a taxable year shall be made by filing Form 4972 as a part of 
the taxpayer's income tax return or amended return for the taxable year.
    (3) Revocation of election. An election made pursuant to this 
section may be revoked within the time prescribed in subparagraph (1) of 
this paragraph for making an election, only if there is filed, within 
such time, an amended income tax return for such taxable year, which 
includes a statement revoking the election and is accompanied by payment 
of any tax attributable to the revocation. If an election for a taxable 
year is revoked, another election may be made for that taxable year 
under subparagraphs (1) and (2) of this paragraph.

(Sec. 402(e)(4)(B) of the Internal Revenue Code of 1954 (88 Stat. 989, 
26 U.S.C. 402(e)(4)(B)))

[T.D. 7339, 40 FR 1016, Jan. 6, 1975]



Sec. 11.404(a)(6)-1  Time when contributions to ``H.R. 10'' plans considered made.

    (a) In general. Section 404(a)(6), as amended by section 1013(c)(2) 
of the Employee Retirement Income Security Act of 1974, provides that 
for purposes of paragraphs (1), (2), and (3) of section 404(a), a 
taxpayer shall be deemed to have made a payment on the last day of the 
preceding taxable year if the payment is on account of such taxable year 
and is made not later than the time prescribed by law for filing the 
return for such taxable year (including extensions thereof). Under 
section 1017(b) of the Employee Retirement Income Security Act of 1974 
(prior to its amendment by the Tax Reduction Act of 1975), in the case 
of a plan which was in existence on January 1, 1974, the foregoing 
provision generally applies for contributions on account of taxable 
years of an employer ending with or within plan years beginning after 
December 31, 1975. In the case of a plan not in existence on January 1, 
1974, the foregoing provision generally applies for contributions on 
account of taxable years of an employer ending with or within plan years 
beginning after September 2, 1974. See Sec. 11.410(a)-2(c) for time a 
plan is considered in existence. See also Sec. 11.410(a)-2(d), which 
provides that a plan in existence on January 1, 1974 may elect to have 
certain provisions, including the amendment to section 404(a)(6) 
contained in section 1013 of the Employee Retirement Income Security Act 
of 1974, apply to a plan year beginning after September 2, 1974, and 
before the otherwise applicable effective date contained in that 
section.
    (b) ``H.R. 10'' plans may elect new provision. Under section 402 of 
the Tax Reduction Act of 1975 (89 Stat. 47), in the case of a plan which 
was in existence on January 1, 1974, and which provides contributions or 
benefits for employees

[[Page 174]]

some or all of whom are employees within the meaning of section 
401(c)(1) of the Code and Sec. 1.401-10(b), the provision described in 
paragraph (a) of this section shall apply for taxable years of an 
employer ending with or within plan years beginning after December 31, 
1974, but only if the employer (within the meaning of section 401(c)(4) 
of the Code and Sec. 1.401-10(e)) elects to have such provisions apply 
as provided in paragraph (c) of this section.
    (c) Manner of election. The election described in paragraph (b) of 
this section shall be considered to be made if the employer (as 
described in paragraph (b) of this section)--
    (1) Makes a contribution which relates to his preceding taxable year 
within the time prescribed in paragraph (a) of this section to a plan 
described in paragraph (b) of this section, and
    (2) Claims a deduction for such contribution on his tax return for 
such year (or, in the case of a contribution by a partnership on behalf 
of a partner, the contribution is shown on Schedule K of the partnership 
tax return for such year); no formal statement is necessary. In the case 
of an employer whose income tax return for the year on account of which 
the payment is made is required to be filed (determined without regard 
to extensions of time) on or before April 15, 1976, and who made a 
payment within the time prescribed in paragraph (a) of this section, the 
election also may be made by filing an amended return or claim for 
refund with respect to such year on or before September 30, 1976.
    (d) Election is irrevocable. Any election made under paragraph (c) 
of this section, once made, shall be irrevocable.
    (e) Examples. The rules of this section are illustrated by the 
following examples.

    Example (1). On October 15, 1976, the ABC Partnership made a 
contribution to the ABC Profit Sharing Plan and Trust on behalf of 
partners and common-law employees with respect to the plan year ending 
December 31, 1975. The ABC Profit Sharing Trust was exempt under section 
501 (a) throughout 1975. The contribution for both partners and 
employees was reflected on the partnership return for the calendar year 
1975 which was filed on October 10, 1976; proper extensions of the due 
date of the partnership return had been received, extending the due date 
to October 15, 1976. The election is valid since all requirements of 
this section have been met.
    Example (2). The XYZ Partnership made a plan contribution on April 
10, 1976, with respect to the plan year ending December 31, 1975, but 
the amount contributed for 1975 was not reflected in the partnership 
return filed for the calendar year 1975 on April 15, 1976. However, the 
XYZ Partnership filed an amended partnership return for the year 1975 on 
September 30, 1976, claiming a deduction for the employee-related 
contribution and setting forth on Schedule K the contribution relating 
to partners. The election is valid, since the contribution on account of 
1975 was made within the time required, and was shown on the amended tax 
return of the employer for 1975 filed within the time prescribed in 
paragraph (c)(2) of this section.
    Example (3). Mr. Smith, a sole proprietor whose taxable year is the 
calendar year, made a contribution to the Smith Profit Sharing Plan and 
Trust on April 15, 1976, for the plan year which began December 1, 1974, 
and ended November 30, 1975. The plan was in existence on January 1, 
1974. Since the contribution was made within the time prescribed by this 
section and was on account of a taxable year of the employer ending 
within a plan year which began after December 31, 1974, the contribution 
may be deducted on Mr. Smith's return for 1975, even though the 
contribution was for a plan year beginning before December 31, 1974.
    Example (4). The DEF Partnership, reporting its income on the basis 
of a fiscal year ending June 30, made a contribution to its ``H.R. 10'' 
plan which was in existence on January 1, 1974, and whose plan year was 
the calendar year. The contribution was made on September 30, 1975, and 
was on account of the taxable year of the partnership ending June 30, 
1975. The contribution was properly reflected in the partnership return 
for the fiscal year ending June 30, 1975. The partnership's election to 
have section 404(a)(6), as amended, apply to its fiscal year ending June 
30, 1975, is valid since that year ended with or within a plan year 
beginning after December 31, 1974.

[T.D. 7402, 41 FR 5633, Feb. 9, 1976]



Sec. 11.408(a)(2)-1  Trustee of individual retirement accounts.

    A person may demonstrate to the satisfaction of the Commissioner 
that the manner in which he will administer the trust will be consistent 
with the requirements of section 408 only upon the filing of a written 
application to the

[[Page 175]]

Commissioner of Internal Revenue, Attention: E:EP, Internal Revenue 
Service, Washington, D.C. 20224. Such application must meet the 
applicable requirements of the regulations under section 401(d)(1) 
relating to nonbank trustees of pension and profit-sharing trusts 
benefiting owner-employees.

(Sec. 408(a)(2) of the Internal Revenue Code of 1954 (88 Stat. 959, 26 
U.S.C. 408(a)(2)))

[T.D. 7390, 40 FR 53580, Nov. 19, 1975]



Sec. 11.410-1  Election by church to have participation, vesting, funding, etc., provisions apply.

    (a) In general. If a church or convention or association of churches 
which maintains any church plan, as defined in section 414(e), makes an 
election under this section, certain provisions of the Code and Title I 
of the Employee Retirement Income Security Act of 1974 (the ``Act'') 
shall apply to such church plan as if such plan were not a church plan. 
The provisions of the Code referred to are section 410 (relating to 
minimum participation standards), section 411 (relating to minimum 
vesting standards), section 412 (relating to minimum funding standards), 
section 4975 (relating to prohibited transactions), and paragraphs (11), 
(12), (13), (14), (15), and (19) of section 401(a) (relating to joint 
and survivor annuities, mergers and consolidations, assignment or 
alienation of benefits, time of benefit commencement, certain social 
security increases, and withdrawals of employee contributions, 
respectively).
    (b) Election is irrevocable. An election under this section with 
respect to any church plan shall be binding with respect to such plan 
and, once made, shall be irrevocable.
    (c) Procedure for making election--(1) Time of election. An election 
under this section may be made for plan years for which the provisions 
of section 410(d) of the Code apply to the church plan. By reason of 
section 1017(b) of the Act section 410(d) does not apply to a plan in 
existence on January 1, 1974, for plan years beginning before December 
31, 1975. Section 1017(d) of the Act permits a plan administrator to 
elect to have certain provisions of the Code (including section 410(d)) 
apply to a plan before the otherwise applicable effective dates of such 
provisions. See Sec. 420.0-1 of the regulations in this chapter 
(Temporary Regulations on Procedure and Administration under the 
Employee Retirement Income Security Act of 1974). Therefore, an election 
under section 410(d) of the Code may be made for a plan year beginning 
before December 31, 1975, only if an election has been made under 
section 1017(d) of the Act with respect to that plan year.
    (2) By whom election is to be made. The election provided by this 
section may be made only by the plan administrator of the church plan.
    (3) Manner of making election. The plan administrator may elect to 
have the provisions of the Code described in paragraph (a) of this 
section apply to the church plan as if it were not a church plan by 
attaching the statement described in subparagraph (5) of this paragraph 
to either (i) the annual return required under section 6058(a) (or an 
amended return) with respect to the plan which is filed for the first 
plan year for which the election is effective or (ii) a written request 
for a determination letter relating to the qualification of the plan 
under section 401(a), 403(a), or 405(a) of the Code and, if trusteed, 
the exempt status under section 501(a) of the Code of a trust 
constituting a part of the plan.
    (4) Conditional election. If an election is made with a written 
request for a determination letter, the election may be conditioned upon 
issuance of a favorable determination letter and will become irrevocable 
upon issuance of such letter.
    (5) Statement. The statement described in subparagraph (3) of this 
paragraph shall indicate (i) that the election is made under section 
410(d) of the Code and (ii) the first plan year for which it is 
effective.

(Sec. 410(d), Internal Revenue Code, 1954 (88 Stat. 901; 26 U.S.C. 
410(d)))

[T.D. 7363, 40 FR 27217, June 27, 1975]



Sec. 11.410(b)-1  Minimum coverage requirements.

    (a)-(c) [Reserved]
    (d) Special rules. (1) [Reserved]
    (2) Discrimination. The determination as to whether a plan 
discriminates in favor of employees who are officers, shareholders, or 
highly compensated, is

[[Page 176]]

made on the basis of the facts and circumstances of each case, allowing 
a reasonable difference between the percentage of such employees 
benefited by the plan to all employees benefited by the plan and the 
percentage of all such employees of the employer to all employees of the 
employer. A showing that a specified percentage of employees covered by 
a plan are not officers, shareholders, or highly compensated, without a 
showing that the difference (if any) between such percentage and the 
percentage of all employees who are not officers, shareholders, or 
highly compensated is reasonable, is not sufficient to establish that 
the plan does not discriminate in favor of employees who are officers, 
shareholders, or highly compensated.

(Sec. 410, Internal Revenue Code of 1954 (88 Stat. 898; 26 U.S.C. 410))

[T.D. 7380, 40 FR 45816, Oct. 3, 1975, as amended by T.D. 7508, 42 FR 
47197, Sept. 20, 1977]



Sec. 11.412(c)-7  Election to treat certain retroactive plan amendments as made on the first day of the plan year.

    (a) General rule. Under section 412(c)(8), a plan administrator may 
elect to have any amendment which is adopted after the close of the plan 
year to which it applies deemed to have been made on the first day of 
such plan year if the amendment--
    (1) Is adopted no later than 2 and one-half months after the close 
of such plan year (or, in the case of a multiemployer plan, no later 
than 2 years after the close of such plan year),
    (2) Does not reduce the accrued benefit of any participant 
determined as of the beginning of such plan year, and
    (3) Does not reduce the accrued benefit of any participant 
determined as of the time of adoption of the amendment, or, if it does 
so reduce such accrued benefit, it is shown that the plan administrator 
filed a notice with the Secretary of Labor notifying him of the 
amendment, and--
    (i) The Secretary of Labor approved the amendment, or
    (ii) The Secretary of Labor failed to disapprove the amendment 
within 90 days after the date on which the notice was filed.
    (b) Time and manner of making election. (1) The election under 
section 412(c)(8) shall be made by the plan administrator by a statement 
of election described in subparagraph (3) of this paragraph, attached to 
the annual return relating to minimum funding standards required to be 
filed under section 6058 with respect to the plan year to which the 
election relates.
    (2) In the event that an amendment to which paragraph (a) of this 
section applies is adopted after the filing of the annual return 
required under section 6058, the plan administrator may make the 
election under section 412(c)(8) by attaching a statement of election, 
described in paragraph (b)(3) of this section, to a copy of such annual 
return, and filing such copy no later than the time allowed for the 
filing of such returns under section 6058. (In the case of multiemployer 
plans, such copy may be filed within a 24 month period beginning with 
the date prescribed for the filing of such returns.)
    (3) The statement of election filed by or on behalf of the plan 
administrator shall--
    (i) State the date of the close of the first plan year to which the 
amendment applies and the date on which the amendment was adopted;
    (ii) Contain a statement that the amendment does not reduce the 
accrued benefit of any participant determined as of the beginning of the 
plan year preceding the plan year in which the amendment is adopted; and
    (iii) Contain either--
    (A) A statement that the amendment does not reduce the accrued 
benefit of any participant determined as of the time of adoption of such 
amendment, or
    (B) A copy of the notice filed with the Secretary of Labor under 
section 412(c)(8) and a statement that either the Secretary of Labor has 
approved the amendment or he has failed to act within 90 days after 
notification of the amendment.

[T.D. 7338, 39 FR 44751, Dec. 27, 1974]



Sec. 11.412(c)-11  Election with respect to bonds.

    (a) In general. Section 412(c)(2)(B) provides that, at the election 
of the administrator of a plan which includes a

[[Page 177]]

trust qualified under section 401(a) or of a plan which satisfies the 
requirements of section 403(a) or section 405(a), the value of a bond or 
other evidence of indebtedness which is held by the plan and which is 
not in default as to principal or interest may be determined on an 
amortized basis running from initial cost at purchase to the amount 
payable at maturity (or, in the case of a bond which is callable prior 
to maturity, the earliest call date). So long as this election is in 
effect, the value of any such evidence of indebtedness shall, for 
purposes of section 412, be determined on such an amortized basis rather 
than on a method taking into account fair market value as described in 
section 412(c)(2)(A).
    (b) Manner of making election. The election to value evidences of 
indebtedness in accordance with paragraph (a) of this section shall be 
made by a statement to that effect attached to and filed as a part of 
the annual return of the plan required under section 6058 of the Code.
    (c) Effect of election. The election provided by section 
412(c)(2)(B), once made, will affect the valuation of all evidences of 
indebtedness, not in default as to principal or interest, which are held 
by the plan for the plan year for which the election is made and any 
evidences of indebtedness which are subsequently acquired by the plan. 
The value of any evidence of indebtedness which is in default as of the 
valuation date for the plan year must be determined on the basis of any 
reasonable actuarial method of valuation which takes into account fair 
market value in accordance with section 412(c)(2)(A) and must continue 
to be so valued until the indebtedness is no longer in default.
    (d) Consent to revoke required--(1) In general. An election made in 
accordance with paragraph (a) of this section may be revoked only if 
consent to revoke the election is obtained from the Secretary or his 
delegate.
    (2) Manner of obtaining permission for revocation. [Reserved]

(Secs. 302(c)(2)(B), 412(c)(2)(B) of the Internal Revenue Code of 1954 
(88 Stat. 871, 914))

[T.D. 7335, 39 FR 44009, Dec. 20, 1974]



Sec. 11.412(c)-12  Extension of time to make contributions to satisfy requirements of section 412.

    (a) In general. Section 412(c)(10) of the Internal Revenue Code of 
1954 provides that for purposes of section 412 a contribution for a plan 
year made after the end of such plan year but not later than two and 
one-half months after the last day of such plan year shall be deemed to 
have been made on such last day. Section 412(c) (10) further provides 
that the two and one-half month period may be extended for not more than 
six months under regulations.
    (b) Six month extension of two and one-half month period. (1) For 
purposes of section 412 a contribution for a plan year to which section 
412 applies that is made not more than eight and one-half months after 
the end of such plan year shall be deemed to have been made on the last 
day of such year.
    (2) The rules of this section relating to the time a contribution to 
a plan is deemed made for purposes of the minimum funding standard under 
section 412 are independent from the rules contained in section 404(a) 
(6) relating to the time a contribution to a plan is deemed made for 
purposes of claiming a deduction for such contribution under section 
404.

(Sec. 412(c)(10), Internal Revenue Code of 1954 (88 Stat. 917; 26 U.S.C. 
412(c)(10)))

[T.D. 7439, 41 FR 46597, Oct. 22, 1976]



Sec. 11.415(c)(4)-1  Special elections for section 403(b) annuity contracts purchased by educational institutions, hospitals and home health service agencies.

    (a) Limitations applicable to contributions for section 403(b) 
annuity contracts--(1) In general. An annuity contract described in 
section 403(b) which is treated as a defined contribution plan (as 
defined in section 414(i)) is subject to the rules regarding the amount 
of annual additions (as defined in section 415(c)(2)) that may be made 
to a participant's account in a defined contribution plan for any 
limitation year (as defined in subparagraph (2) of this paragraph) under 
section 415(c)(1) and Revenue Ruling 75-481, 1975-2 C.B. 188. An annual 
addition to the account of an individual under a section 403(b)

[[Page 178]]

annuity contract in excess of such limitation for a limitation year is 
includible in the gross income of the individual for the taxable year 
with or within which such limitation year ends and reduces the exclusion 
allowance under section 403(b)(2) for such taxable year to the extent of 
the excess. Such annuity contracts are, of course, also subject to the 
limitation imposed by section 403(b)(2) with respect to the amount that 
may be contributed by the employer for the purchase of an annuity 
contract described in section 403(b) and be excluded from the gross 
income of the employee on whose behalf such annuity contract is 
purchased. In general, the excludable contribution for such an annuity 
contract for a particular taxable year is the lesser of the exclusion 
allowance computed under section 403(b)(2) for such taxable year or the 
limitation imposed by section 415(c)(1) for the limitation year ending 
with or within such taxable year. For purposes of the limitation imposed 
by section 415(c)(1), the amount contributed toward the purchase of an 
annuity contract described in section 403(b) is treated as allocated to 
the employee's account as of the last day of the limitation year ending 
with or within the taxable year during which such contribution is made.
    (2) Limitation year. For purposes of this section--
    (i) Except as provided in subdivision (ii) of this subparagraph, the 
limitation year applicable to an individual on whose behalf an annuity 
contract described in section 403(b) has been purchased by an employer 
shall be the calendar year unless such individual elects to change the 
limitation year to another 12-month period and attaches a statement to 
his income tax return filed for the taxable year in which such change is 
made.
    (ii) The limitation year applicable to an individual described in 
subdivision (i) of this subparagraph who is in control (within the 
meaning of section 414 (b) or (c) as modified by section 415(h)) of any 
employer shall be the same as the limitation year of such employer.
    (3) Special elections. Under section 415(c)(4), special elections 
are permitted with respect to section 403(b) annuity contracts 
(including custodial accounts treated as section 403(b) annuity 
contracts under section 403(b)(7)) purchased by educational institutions 
(as defined in section 151(e)(4) and the regulations thereunder), home 
health service agencies (as defined in subparagraph (4) of this 
paragraph) and hospitals. In lieu of the limitation described in section 
415(c)(1)(B) otherwise applicable to the annual addition (as defined in 
section 415(c)(2)) that may be made to the account of a participant in a 
qualified defined contribution plan for a particular limitation year, an 
individual for whom an annuity contract described in this subparagraph 
is purchased may elect, in accordance with the provisions of paragraph 
(b) of this section, to have substituted for such limitation the amounts 
described in subparagraph (5)(i) or (5)(ii) of this paragraph. In lieu 
of the exclusion allowance determined under section 403(b)(2) and the 
regulations thereunder otherwise applicable for the taxable year with or 
within which the limitation year ends to an individual on whose behalf 
an annuity contract described in this subparagraph is purchased, such an 
individual may elect, in accordance with the provisions of paragraph (b) 
of this section, to have substituted for such exclusion allowance the 
amount described in subparagraph (5)(iii) of this paragraph.
    (4) Definition. For purposes of this section, a home health service 
agency is an organization described in section 501(c)(3) which is exempt 
from taxation under section 501(a) and which has been determined by the 
Secretary of Health, Education, and Welfare to be a home health agency 
under section 1395(x)(o) of Title 42 of the United States Code.
    (5) Elections. (i) For the limitation year that ends with or within 
the taxable year in which an individual separates from the service of 
his employer (and only for such limitation year), the ``(A) election 
limitation'' shall be the exclusion allowance computed under section 
403(b)(2)(A) and the regulations thereunder (without regard to section 
415) for the taxable year in which such separation occurs taking into 
account such individual's years of service (as defined in section 
403(b)(4) and the regulations thereunder) for the employer and 
contributions described in section

[[Page 179]]

403(b)(2)(A)(ii) and the regulations thereunder during the period of 
years (not exceeding 10) ending on the date of separation. For purposes 
of the preceding sentence, all service for the employer performed within 
such period must be taken into account. However, the ``(A) election 
limitation'' shall not exceed the amount described in section 
415(c)(1)(A) (as adjusted under section 415(d)(1)(B)) applicable to such 
individual for such limitation year.
    (ii) For any limitation year, the ``(B) election limitation'' shall 
be equal to the least of the following amounts--
    (A) $4,000, plus 25 percent of the individual's includable 
compensation (as defined in section 403(b)(3) and the regulations 
thereunder) for the taxable year with or within which the limitation 
year ends,
    (B) The amount of the exclusion allowance determined under section 
403(b)(2)(A) and the regulations thereunder for the taxable year with or 
within which such limitation year ends, or
    (C) $15,000.
    (iii) For any taxable year, the ``(C) election limitation'' shall 
equal the lesser of the amount described in section 415(c)(1)(A) (as 
adjusted under section 415(d)(1)(B)) or the amount described in section 
415(c)(1)(B) applicable to the individual for the limitation year ending 
with or within such taxable year. For purposes of the preceding 
sentence, compensation described in section 415(c)(1)(B) taken into 
account for a particular limitation year does not include amounts 
contributed toward the purchase of an annuity contract described in 
section 403(b) during such limitation year (whether or not includable in 
the gross income of the individual on whose behalf such contribution is 
made).
    (b) Special rules for elections and salary reduction agreements for 
years before final regulations are published--(1) Election. (i) For a 
limitation year which ends before or with or within the taxable year in 
which applicable final regulations under section 415 are first published 
in the Federal Register, an individual may wish to take advantage of the 
alternative limitations described in section 415(c)(4). One way of doing 
this is to attach a statement of intention to his individual tax return 
for the taxable year. The statement should provide that the individual 
intends to elect one of those alternative limitations. It should also 
specify which alternative he intends to elect. No form is prescribed for 
the statement of intention, but it must include the individual's name, 
address and Social Security number. If the individual is not required to 
file an income tax return for the taxable year to which the statement of 
intention is to apply, the statement of intention may still be filed at 
the Internal Revenue Service Center where that individual would file the 
return if he were required to file. It should be filed by the time he 
would have filed his return. The Internal Revenue Service will treat the 
statement of intention as an actual election for all taxable years 
through the taxable year in which applicable final regulations under 
section 415 are first published in the Federal Register for all 
purposes, except that it will not be irrevocable. If, pursuant to this 
subdivision, an individual takes advantage of an alternative limitation 
for a taxable year, then, except as provided in paragraph (b)(1)(iii) of 
this section, the individual may not take advantage of any other 
alternative limitation pursuant to this subdivision for any taxable 
year. If an individual does not file a statement of intention, he will 
still be able to take advantage of the alternative limitations for these 
taxable years. He will be able to do this if he determines his income 
tax liability for the taxable year in a way which is consistent with one 
of the alternative limitations.
    (ii) The actual election for all taxable years through the taxable 
year in which applicable final regulations under section 415 are first 
published in the Federal Register will be made by filing the election 
with the Internal Revenue Service at the time and in the manner to be 
described by final regulations under section 415.
    (iii) When an individual makes the actual election for any taxable 
year through the taxable year in which applicable final regulations 
under section 415 are published in the Federal Register, he may choose 
any of the alternative limitations, even if his choice is

[[Page 180]]

inconsistent with the alternative limitation which he used in 
determining his income tax liability for that taxable year. He may also 
choose not to elect any of the alternative limitations, even if he used 
one of them in determining his income tax liability for that taxable 
year. However, if his choice is different from the choice which he used 
in determining his income tax liability for the taxable year, there may 
be an adjustment in his tax for that year. For purposes of section 6654 
(relating to failure of an individual to pay estimated tax), a 
difference in tax for such a year resulting from a difference in these 
choices will not be treated as an underpayment. This rule applies to the 
extent the difference in tax is due to the actual election of one of the 
alternative limitations or to a final decision not to use one of the 
alternative limitations for the taxable year.
    (2) Salary reduction agreements for 1976 and 1977. (i) An individual 
who is employed by an organization described in paragraph (a)(3) may 
make a salary reduction agreement for his taxable year beginning in 1976 
or 1977 at any time before the end of the 1976 or 1977 taxable year, 
respectively, without the agreement's being considered a new agreement 
within the meaning of Sec. 1.403(b)-1(b)(3)(i). The agreement for 1976 
may be made on or before June 15, 1977, if that date is later than the 
end of the individual's 1976 taxable year. The agreement for 1977 may be 
made on or before April 17, 1978, if that date is later than the end of 
the individual's 1977 taxable year.
    (ii) This subparagraph applies only if the individual actually 
elects one of the alternative limitations under section 415(c)(4) for 
1976 or 1977 (as the case may be).
    (iii) The salary reduction agreement for 1976 may be made effective 
with respect to any amount earned during the taxpayer's most recent one-
year period of service (as described in Sec. 1.403(b)-1(f)) ending not 
later than the end of the 1976 taxable year, notwithstanding 
Sec. 1.403(b)-1(b)(3)(i). Similarly, the salary reduction agreement for 
1977 may be made effective with respect to such period of service ending 
not later than the end of the 1977 taxable year.
    (iv) If the salary reduction agreement for 1976 is entered into at 
any time after December 31, 1976, or if the salary reduction agreement 
for 1977 is entered into at any time after December 31, 1977, an amended 
Form W-2 must be filed on behalf of the individual.
    (3) Election is irrevocable. The election described in paragraph 
(a)(3) of this section, once made in accordance with the provisions of 
subparagraph (1) of this paragraph, shall be irrevocable with respect to 
the limitation years or taxable years to which such election relates.
    (4) Limitations. With respect to any limitation or taxable year, an 
election by an individual pursuant to subparagraph (1) of this paragraph 
to have any subdivision of paragraph (a)(5) of this section apply to 
contributions made on his behalf by his employer with respect to any 
section 403(b) annuity contract will preclude an election to have any 
other subdivision of paragraph (a)(5) apply for any future limitation or 
taxable year with respect to any section 403(b) annuity contract 
contributions made by any employer of such individual. With respect to 
any limitation year, an election by an individual to have paragraph 
(a)(5)(i) of this section apply to contributions made on his behalf by 
his employer with respect to any section 403(b) annuity contract will 
preclude an election to have any subdivision of paragraph (a)(5) apply 
for any future limitation or taxable year with respect to any section 
403(b) annuity contract contributions made by any employer of such 
individual.
    (5) Aggregation rules--(i) Annuity contracts described in section 
403(b). For purposes of applying the limitations of this section for a 
particular limitation or taxable year, all contributions toward the 
purchase of annuity contracts described in section 403(b) made on behalf 
of an individual by his employer and any related employer (as defined in 
subdivision (ii) of this subparagraph) must be aggregated without regard 
to:
    (A) Whether such individual makes any election pursuant to 
subparagraph (1) of this paragraph for such year; and
    (B) Whether such individual files a statement of intention pursuant 
to subparagraph (1) of this paragraph, for

[[Page 181]]

such year. In addition, any other aggregation required by Revenue Ruling 
75-481, 1975-2 C.B. 188, must be made to the extent applicable.
    (ii) Definition. For purposes of this section, with respect to a 
particular employer, a related employer is any other employer which is a 
member of a controlled group of corporations (as defined in section 
414(b), and the regulations thereunder and as modified by section 
415(h)) or a group of trades or business (whether or not incorporated) 
under common control (as defined in section 414(c) and the regulations 
thereunder and as modified by section 415(h)) in which such particular 
employer is a member.
    (c) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example (1). Doctor M is an employee of H Hospital (an organization 
described in section 501(c)(3) and exempt from taxation under section 
501(a)) for the entire 1976 calendar year. M is not in control of H 
within the meaning of section 414 (b) or (c), as modified by section 
415(h). M uses the calendar year as the taxable year and M uses the 
calendar year as the limitation year. M has includible compensation (as 
defined in section 403(b)(3) and the regulations thereunder) and 
compensation (as defined in section 415(c)(3)) for taxable year 1976 of 
$30,000, and M has 4 years of service (as defined in Sec. 1.403(b)-1(f)) 
with H as of December 31, 1976. During M's prior service with H, H had 
contributed a total of $12,000 on M's behalf for annuity contracts 
described in section 403(b), which amount was excludable from M's gross 
income for such prior years. Thus, for the limitation year ending with 
or within taxable year 1976, M's exclusion allowance determined under 
section 403(b)(2)(A) is $12,000 ((.20x$30,000x4) -$12,000). The 
limitation imposed by section 415(c)(1) that is applicable to M for 
limitation year 1976 is the lesser of $26,825 (the amount described in 
section 415(c)(1)(A) adjusted under section 415(d)(1)(B) for limitation 
year 1976) or $7,500 (the amount described in section 415(c)(1)(B)). 
Absent the special elections provided in section 415(c)(4), $7,500 would 
be the maximum contribution H could make for annuity contracts described 
in section 403(b) on M's behalf for limitation year 1976 without 
increasing M's gross income for taxable year 1976. However, because H is 
an organization described in section 415(c)(4), M may make a special 
election with respect to amounts contributed by H on M's behalf for 
section 403(b) annuity contracts for 1976. Assume that M does not 
separate from the service of H during 1976 and that, therefore, the 
``(A) election limitation'' described in section 415(c)(4)(A) is not 
available to M. If M elects the ``(B) election limitation'' for 1976, H 
could contribute $11,500 on M's behalf for annuity contracts described 
in section 403(b) for that year (the least of $11,500 (the amount 
described in section 415(c)(4) (B)(i)); $12,000 (the amount described in 
section 415(c)(4)(B)(ii)), and $15,000 (the amount described in section 
415(c)(4)(B)(iii))). If M elects the ``(C) election limitation'' for 
1976, H could only contribute up to $7,500 (the lower of the amounts 
described in section 415(c)(1) (A) or (B)) for section 403(b) annuity 
contracts on M's behalf for 1976 without increasing M's gross income for 
that year.
    Example (2). Assume the same facts as in example (1) except that H 
had contributed a total of $18,000 on M's behalf for annuity contracts 
in prior years, which amount was excludable from M's gross income for 
such prior years. Accordingly, for 1976, M's exclusion allowance 
determined under section 403(b)(2)(A) is $6,000 ((.20x$30,000x4) -
$18,000). The limitation imposed by section 415(c)(1) applicable to M 
for 1976 is $7,500 (the lesser of the amount described in section 
415(c)(1) (A) or (B)). Absent the special elections provided in section 
415(c)(4), $6,000 would be the maximum amount H could contribute for 
annuity contracts described in section 403(b) on M's behalf for 1976 
without increasing M's gross income for that year. However, if M elects 
the ``(C) election limitation'' for 1976, H may contribute up to $7,500 
without increasing M's gross income for that year.
    Example (3). G, a teacher, is an employee of E, an educational 
institution described in section 151(e)(4). G uses the calendar year as 
the taxable year and G uses the 12-month consecutive period beginning 
July 1 as the limitation year. G has includible compensation (as defined 
in section 403(b)(3) and the regulations thereunder) for taxable year 
1976 of $12,000 and G has compensation (as defined in section 415(c)(3)) 
for the limitation year ending with or within taxable year 1976 of 
$12,000. G has 20 years of service (as defined in Sec. 1.403(b)-1(f)) as 
of May 30, 1976, the date G separates from the service of E. During G's 
service with E before taxable year 1976, E had contributed $34,000 
toward the purchase of a section 403(b) annuity contract on G's behalf, 
which amount was excludable from G's gross income for such prior years. 
Of this amount, $19,000 was so contributed and excluded during the 10 
year period ending on May 30, 1976. For the taxable year 1976, G's 
exclusion allowance determined under section 403(b)(2)(A) is $14,000 
((.20x$12,000x20) -$34,000). Absent the special elections described in 
section 415(c)(4), $3,000 (the lesser of G's exclusion allowance for 
taxable year 1976 or the section 415(c)(1) limitation applicable to G 
for the limitation year ending with or within such taxable year) would 
be

[[Page 182]]

the maximum excludable contribution E could make for section 403(b) 
annuity contracts on G's behalf for the limitation year ending with or 
within taxable year 1976. However, because E is an organization 
described in section 415(c)(4), G may make a special election with 
respect to amounts contributed on G's behalf by E for section 403(b) 
annuity contracts for the limitation year ending with or within taxable 
year 1976. Because G has separated from the service of E during such 
taxable year, G may elect the ``(A) election limitation'' as well as the 
``(B) election limitation'' or the ``(C) election limitation''. If G 
elects the ``(A) election limitation'' for the limitation year ending 
with or within taxable year 1976, E could contribute up to $5,000 
((.20x$12,000x10) -$19,000) on G's behalf for section 403(b) annuity 
contracts for such limitation year without increasing G's gross income 
for the taxable year with or within which such limitation year ends. If 
G elects the ``(B) election limitation'' for such limitation year, E 
could contribute $7,000 (the least of $7,000 (the amount described in 
section 415(c)(4)(B)(i)); $14,000 (the amount described in section 
415(c)(4)(B)(ii)); and $15,000 (the amount described in section 
415(c)(4)(B)(iii))). If G elects the ``(C) election limitation'' for 
taxable year 1976, E could contribute $3,000 (the lesser of the amounts 
described in section 415(c)(1) (A) or (B)).

    (d) Plan year. For purposes of section 415 and this section, an 
annuity contract described in section 403(b) shall be deemed to have a 
plan year coinciding with the taxable year of the individual on whose 
behalf the contract has been purchased unless that individual 
demonstrates that a different 12-month period should be considered to be 
the plan year.

    (e) Effective date. The provisions of this section are applicable 
for taxable years beginning in and for limitation years ending with or 
within taxable years beginning in 1976.

(Sec. 415(c)(4)(D) of the Internal Revenue Code of 1954 (88 Stat. 983; 
26 U.S.C. 415(c)(4)(D)))

[T.D. 7442, 41 FR 52296, Nov. 29, 1976, as amended by T.D. 7531, 43 FR 
1065, Jan. 6, 1978]



PART 12--TEMPORARY INCOME TAX REGULATIONS UNDER THE REVENUE ACT OF 1971--Table of Contents




Sec.
12.3  Investment credit, public utility property elections.
12.4  Election of Class Life Asset Depreciation Range System (ADR).
12.7  Election to be treated as a DISC.
12.8  Elections with respect to net leases of real property.
12.9  Election to postpone determination with respect to the presumption 
          described in section 183(d).

    Authority: 26 U.S.C. 167, 263, and 7805.



Sec. 12.3  Investment credit, public utility property elections.

    (a) Elections--(1) In general. Under section 46(e), three elections 
may be made on or before March 9, 1972, with respect to section 46(e) 
property (as defined in subparagraph (3) of this paragraph). An election 
made under the provisions of section 46(e) shall be irrevocable.
    (2) Applicability of elections. (i) Any election under section 46(e) 
shall be made with respect to all of the taxpayer's property eligible 
for the election whether or not the taxpayer is regulated by more than 
one regulatory body.
    (ii)(a) Paragraph (1) of section 46(e) shall apply to all of the 
taxpayer's section 46(e) property in the absence of an election under 
paragraph (2) or (3) of section 46(e). If an election is made under 
paragraph (2) of section 46(e), paragraph (1) of such section shall not 
apply to any of the taxpayer's section 46(e) property.
    (b) An election made under the last sentence of section 46(e)(1) 
shall apply to that portion of the taxpayer's section 46(e) property to 
which paragraph (1) of section 46(e) applies and which is short supply 
property within the meaning of Sec. 1.46-5(b)(2) of this chapter (Income 
Tax Regulations) as set forth in a notice of proposed rule making 
published in 37 FR 3526 on February 17, 1971.
    (iii) If a taxpayer makes an election under paragraph (2) of section 
46(e), and makes no election under paragraph (3) of such section, the 
election under paragraph (2) of section 46(e) shall apply to all of its 
section 46(e) property.
    (iv) If a taxpayer makes an election under paragraph (3) of section 
46(e), such election shall apply to all of the taxpayer's section 46(e) 
property to which section 167(l)(2)(C) applies. Paragraph (1) or (2) of 
section 46(e) (as the case may be) shall apply to that portion of the 
taxpayer's section 46(e)

[[Page 183]]

property which is not property to which section 167(l)(2)(C) applies. 
Thus, for example, if a taxpayer makes an election under paragraph (2) 
of section 46(e), and also makes an election under paragraph (3) of 
section 46(e), paragraph (3) shall apply to all of the taxpayer's 
section 46(e) property to which section 167(l)(2)(C) applies and 
paragraph (2) shall apply to the remainder of the taxpayer's section 
46(e) property.
    (3) Section 46(e) property. ``Section 46(e) property'' is section 38 
property which is both property described in section 50 and is--
    (i) Public utility property within the meaning of section 
46(c)(3)(B) (other than nonregulated communication property of the type 
described in the last sentence of section 46(c)(3)(B)), or
    (ii) Property used predominantly in the trade or business of the 
furnishing or sale of (a) steam through a local distribution system or 
(b) the transportation of gas or steam by pipeline, if the rates for 
such furnishing or sale are established or approved by a governmental 
unit, agency, instrumentality, or commission described in section 
46(c)(3)(B).
    (b) Method of making elections. A taxpayer may make the elections 
described in section 46(e) by filing a statement, on or before March 9, 
1972, with the district director or director of the internal revenue 
service center with whom the taxpayer ordinarily files its income tax 
return. For rules in the case of taxpayers filing consolidated returns, 
see Sec. 1.1502-77(a) of this chapter (Income Tax Regulations). Such 
statement shall contain the following information:
    (1) The name, address, and taxpayer identification number of the 
taxpayer,
    (2) The paragraph (or paragraphs) of section 46(e) under which the 
taxpayer is making the election,
    (3) If an election is made under the last sentence of section 
46(e)(1), the name and address of all regulatory bodies which have 
jurisdiction over the taxpayer with respect to the section 46(e) 
property covered by such election and a statement setting forth the type 
of the public utility activity described in section 46(e)(5)(B) in which 
the taxpayer engages, and
    (4) If an election is made under paragraph (3) of section 46(e), a 
statement indicating whether an election has been made by the taxpayer 
under section 167(l)(4)(A).

[T.D. 7161, 37 FR 3511, Feb. 17, 1972]



Sec. 12.4  Election of Class Life Asset Depreciation Range System (ADR).

    (a) Elections filed before February 1, 1972. No election or tax 
return shall be filed which does not conform to section 109 of the 
Revenue Act of 1971 (Pub. L. 92-178, 85 Stat. 508). If a taxpayer has 
before February 1, 1972 filed an election and a tax return in accordance 
with Sec. 1.167(a)-11 of this chapter (relating to depreciation 
allowances using the Asset Depreciation Range System published in the 
Federal Register for June 23, 1971), such election will be treated as an 
election under the Class Life Asset Depreciation Range System (ADR) as 
contained in section 109 of the Revenue Act of 1971 and the proposed 
amendments to Sec. 1.167(a)-11 of this chapter published in the Federal 
Register for January 27, 1972, provided that the election conforms with 
the provisions of the Class Life Asset Depreciation Range System (ADR) 
contained in section 109 of the Revenue Act of 1971 and the amendments 
to the regulations as finally adopted. Such an election and the 
determination of tax liability on the tax return are subject to the 
terms and conditions of section 109 of the Revenue Act of 1971 and the 
final regulations prescribing the Class Life Asset Depreciation Range 
System (ADR). (For revocation of an election, see paragraph (c) of this 
section.) An election and tax return filed before February 1, 1972, 
which does not conform with the final regulations prescribing the Class 
Life Asset Depreciation Range System (ADR) is an invalid election unless 
corrected by an amended tax return and election filed no later than the 
time permitted by paragraph (c) of this section. If a valid election 
under Sec. 1.167(a)-11 of this chapter is not filed for a taxable year, 
the taxpayer is required to file or amend his tax return and determine 
tax liability for the taxable year without regard to Sec. 1.167(a)-11 of 
this chapter.
    (b) Elections filed after January 31, 1972. No election or tax 
return shall be

[[Page 184]]

filed which does not conform with section 109 of the Revenue Act of 
1971. An election and tax return filed under Sec. 1.167(a)-11 of this 
chapter after January 31, 1972, and before the final amendments to the 
regulations are published in the Federal Register, should be filed in 
accordance with section 109 of the Revenue Act of 1971 and the proposed 
amendments to Sec. 1.167(a)-11 of this chapter relating to the Class 
Life Asset Depreciation Range System (ADR). Such election and the 
determination of tax liability on the tax return are subject to the 
terms and conditions of section 109 of the Revenue Act of 1971 and the 
final regulations prescribing the Class Life Asset Depreciation Range 
System (ADR). An election and tax return filed after January 31, 1972, 
which does not conform with the final regulations prescribing the Class 
Life Asset Depreciation Range System (ADR), is not a valid election 
unless corrected by an amended tax return and election filed no later 
than the time permitted by paragraph (c) of this section. (For 
revocation of election, see paragraph (c) of this section.) If a valid 
election under Sec. 1.167(a)-11 of this chapter is not filed for a 
taxable year the taxpayer is required to file or amend his tax return 
and determine tax liability for the taxable year without regard to 
Sec. 1.167(a)-11 of this chapter.
    (c) Special rule for election and revocation. Notwithstanding the 
rules of Sec. 1.167(a)-11 of this chapter, a taxpayer is permitted to 
make, amend or revoke an election under Sec. 1.167(a)-11 of this chapter 
at any time before the latest of (1) the time the taxpayer files his 
first return for the taxable year of election, (2) 120 days after the 
final regulations prescribing the Class Life Asset Depreciation Range 
System (ADR) are published in the Federal Register, or (3) the time 
prescribed by law (including extensions thereof) for filing the return 
for the taxable year of election. The notification of amendment or 
revocation of an election shall be made by filing an amended tax return 
with the Internal Revenue Service Center with which the election was 
filed. The election should be filed in the manner specified in the Class 
Life Asset Depreciation Range System (ADR) regulations as finally 
prescribed.
    (d) Examples. The principles of this section may be illustrated by 
the following examples:

    Example (1). Taxpayer A filed an election under Sec. 1.167(a)-11 
before February 1, 1972. A elected to use the modified half-year 
convention by treating all assets as placed in service on the first day 
of the second quarter of the taxable year, excluded section 1250 
property (as defined in section 1250(c)) and property used predominantly 
outside the United States from the election, and included ``subsidiary 
assets'' (as defined in Sec. 1.167(a)-11(b)(5)(vii) of the proposed 
amendments to the regulations) in the election. A's election does not 
conform with the regulations under Sec. 1.167(a)-11 as proposed to be 
amended. A should file an amended return and election within 120 days 
after the publication of the final Class Life Asset Depreciation Range 
System (ADR) regulations under Sec. 1.167(a)-11. Such amended return and 
election must conform to the final amendments to the regulations. In the 
amended election, A must adopt one of the conventions permitted by the 
final amendments. Assuming the proposed amendments are finally adopted, 
A may exclude his subsidiary assets from the election provided the 
conditions of paragraph (b)(5)(vii) of Sec. 1.167(a)-11 of the 
regulations, as proposed to be amended, are met, and A must include 
property used predominantly outside the United States in the election 
unless paragraph (b)(5)(iii), (v), or (vi) of Sec. 1.167(a)-11, as 
proposed to be amended, permit the exclusion of the property. Generally, 
A must include section 1250 property in the election unless paragraph 
(b)(5)(vi) of Sec. 1.167(a)-11, as proposed to be amended, permits the 
exclusion of the property.
    Example (2). Taxpayer B filed an election to compute depreciation 
under Sec. 1.167(a)-11 before February 1, 1972. B elected to use the 
half-year convention and has no assets used predominantly outside the 
United States. B excluded section 1250 property from the election and 
included his subsidiary assets in the election. Assume that the 
provisions of paragraph (b)(5)(vi) of Sec. 1.167(a)-11, as proposed to 
be amended, apply and permit the exclusion of section 1250 property and 
that B does not elect to exclude subsidiary assets pursuant to paragraph 
(b)(5)(vii), as proposed to be amended. B has no assets which were 
excluded from the election under paragraph (b)(5)(v) of Sec. 1.167(a)-
11, as proposed to be amended. The election which was filed before 
February 1, 1972, will be treated as a valid election under the Class 
Life Asset Depreciation Range System (ADR) as contained in the final 
amendments to the regulations, if it conforms with those amendments. B 
need not file an amended election provided his

[[Page 185]]

election conforms to the final regulations under Sec. 1.167(a)-11. 
However, B may file an amended election within 120 days after the final 
regulations under Sec. 1.167(a)-11 are published in the Federal Register 
in order to include section 1250 property, or to exclude subsidiary 
assets, or to make other changes, or to revoke the election.

[T.D. 7159, 37 FR 1469, Jan. 29, 1972]



Sec. 12.7  Election to be treated as a DISC.

    (a) Manner and time of election--(1) Manner--(i) In general. A 
corporation can elect to be treated as a DISC under section 992(b) for a 
taxable year beginning after December 31, 1971. Except as provided in 
subdivision (ii) of this subparagraph, the election is made by the 
corporation filing Form 4876 with the service center with which it would 
file its income tax return if it were subject for such taxable year to 
all the taxes imposed by subtitle A of the Internal Revenue Code of 
1954, and a copy of the completed Form 4876 with the Commissioner of 
Internal Revenue (attention: ACTS:A:AO), Washington, D.C. 20224. The 
form shall be signed by any person authorized to sign a corporation 
return under section 6062, and shall contain the information required by 
such form. Except as provided in paragraphs (b)(3) and (c) of this 
section, such election to be treated as a DISC shall be valid only if 
the consent of every person who is a shareholder of the corporation as 
of the beginning of the first taxable year for which such election is 
effective is on or attached to such Form 4876 when filed with the 
service center.
    (ii) Transitional rule for corporations electing during 1972. If the 
first taxable year for which an election by a corporation to be treated 
as a DISC is a taxable year beginning after December 31, 1971, and on or 
before December 31, 1972, such election may be made either in the manner 
prescribed in subdivision (i) of this subparagraph or by filing, at the 
place prescribed in subdivision (i) of this subparagraph, a statement 
captioned ``Election to be Treated as a DISC''. Such statement of 
election shall be valid only if the consent of each shareholder is filed 
with the service center in the form, and at the time, prescribed in 
paragraph (b) of this section. Such statement shall be signed by any 
person authorized to sign a corporation return under section 6062 and 
shall include the name, address, and employer identification number (if 
known) of the corporation, the beginning date of the first taxable year 
for which the election is effective, the number of shares of stock of 
the corporation issued and outstanding as of the earlier of the 
beginning of the first taxable year for which the election is effective 
or the time the statement is filed, the number of shares held by each 
shareholder as of the earlier of such dates, and the date and place of 
incorporation. As a condition of the election being effective, a 
corporation which elects to become a DISC by filing a statement in 
accordance with this subdivision must furnish (to the service center 
with which the statement was filed) such additional information as is 
required by Form 4876 by March 31, 1973.
    (2) Time of making election--(i) In general. In the case of a 
corporation making an election to be treated as a DISC for its first 
taxable year, such election shall be made within 90 days after the 
beginning of such taxable year. In the case of a corporation which makes 
an election to be treated as a DISC for any taxable year beginning after 
March 31, 1972 (other than the first taxable year of such corporation), 
the election shall be made during the 90-day period immediately 
preceding the first day of such taxable year.
    (ii) Transitional rules for certain corporations electing during 
1972. In the case of a corporation which makes an election to be treated 
as a DISC for a taxable year beginning after December 31, 1971, and on 
or before March 31, 1972 (other than its first taxable year), the 
election shall be made within 90 days after the beginning of such 
taxable year.
    (b) Consent by shareholders--(1) In general--(i) Time and manner of 
consent. Under paragraph (a)(1)(i) of this section, subject to certain 
exceptions, the election to be treated as a DISC is not valid unless 
each person who is a shareholder as of the beginning of the first 
taxable year for which the election is effective signs either the 
statement of consent on Form 4876 or a separate statement of consent 
attached to such

[[Page 186]]

form. A shareholder's consent is binding on such shareholder and all 
transferees of his shares and may not be withdrawn after a valid 
election is made by the corporation. In the case of a corporation which 
files an election to become a DISC for a taxable year beginning after 
December 31, 1972, if a person who is a shareholder as of the beginning 
of the first taxable year for which the election is effective does not 
consent by signing the statement of consent set forth on Form 4876, such 
election shall be valid (except in the case of an extension of the time 
for filing granted under the provisions of subparagraph (3) of this 
paragraph or paragraph (c) of this section) only if the consent of such 
shareholder is attached to the Form 4876 upon which such election is 
made.
    (ii) Form of consent. A consent other than the statement of consent 
set forth on Form 4876 shall be in the form of a statement which is 
signed by the shareholder and which sets forth (a) the name and address 
of the corporation and of the shareholder and (b) the number of shares 
held by each such shareholder as of the time the consent is made and (if 
the consent is made after the beginning of the corporation's taxable 
year for which the election is effective) as of the beginning of such 
year. If the consent is made by a recipient of transferred shares 
pursuant to paragraph (c) of this section, the statement of consent 
shall also set forth the name and address of the person who held such 
shares as of the beginning of such taxable year and the number of such 
shares. Consent shall be made in the following form: ``I (insert name of 
shareholder), a shareholder of (insert name of corporation seeking to 
make the election) consent to the election of (insert name of 
corporation seeking to make the election) to be treated as a DISC under 
section 992(b) of the Internal Revenue Code. The consent so made by me 
is irrevocable and is binding upon all transferees of my shares in 
(insert name of corporation seeking to make the election).'' The 
consents of all shareholders may be incorporated in one statement.
    (iii) Who may consent. Where stock of the corporation is owned by a 
husband and wife as community property (or the income from such stock is 
community property), or is owned by tenants in common, joint tenants, or 
tenants by the entirety, each person having a community interest in such 
stock or the income therefrom and each tenant in common, joint tenant, 
and tenant by the entirety must consent to the election. The consent of 
a minor shall be made by his legal guardian or by his natural guardian 
if no legal guardian has been appointed. The consent of an estate shall 
be made by the executor or administrator thereof. The consent of a trust 
shall be made by the trustee thereof. The consent of an estate or trust 
having more than one executor, administrator, or trustee may be made by 
any executor, administrator, or trustee authorized to make a return of 
such estate or trust pursuant to section 6012(b)(5). The consent of a 
corporation or partnership shall be made by an officer or partner 
authorized pursuant to section 6062 or 6063, as the case may be, to sign 
the return of such corporation or partnership. In the case of a foreign 
person, the consent may be signed by any individual (whether or not a 
U.S. person) who would be authorized under sections 6061 through 6063 to 
sign the return of such foreign person if he were a U.S. person.
    (2) Transitional rule for corporations electing during 1972. In the 
case of a corporation which files an election to be treated as a DISC 
for a taxable year beginning after December 31, 1971, and on or before 
December 31, 1972, such election shall be valid only if the consent of 
each person who is a shareholder as of the beginning of the first 
taxable year for which such election is effective is filed with the 
service center with which the election was filed within 90 days after 
the first day of such taxable year or within the time granted for an 
extension of time for filing such consent. The form of such consent 
shall be the same as that prescribed in subparagraph (1) of this 
paragraph. Such consent shall be attached to the statement of election 
or shall be filed separately (with such service center) with a copy of 
the statement of election. An extension of time for filing a consent may 
be granted in the manner, and subject to the conditions, described in 
subparagraph (3) of this paragraph.

[[Page 187]]

    (3) Extension of time to consent. An election which is timely filed 
and would be valid except for the failure to attach the consent of any 
shareholder to the Form 4876 upon which the election was made or to 
comply with the 90-day requirement in subparagraph (2) of this paragraph 
or paragraph (c)(1) of this section, as the case may be, will not be 
invalid for such reason if it is shown to the satisfaction of the 
service center that there was a reasonable cause for the failure to file 
such consent, and if such shareholder files a proper consent to the 
election within such extended period of time as may be granted by the 
Internal Revenue Service. In the case of a late filing of a consent, a 
copy of the Form 4876 or statement of election shall be attached to such 
consent and shall be filed with the same service center as the election. 
The form of such consent shall be the same as that set forth in 
paragraph (b)(1)(ii) of this section. In no event can any consent be 
made pursuant to this paragraph on or after the last day of the first 
taxable year for which a corporation elects to be treated as a DISC.
    (c) Consent by holder of transferred shares--(1) In general. If a 
shareholder of a corporation transfers--
    (i) Prior to the first day of the first taxable year for which such 
corporation elects to be treated as a DISC, some or all of the shares 
held by him without having consented to such election, or
    (ii) On or before the 90th day after the first day of the first 
taxable year for which such corporation elects to be treated as a DISC, 
some or all of the shares held by him as of the first day of such year 
(or if later, held by him as of the time such shares are issued), 
without having consented to such election, then consent may be made by 
any recipient of such shares on or before the 90th day after the first 
day of such first taxable year. If such recipient fails to file his 
consent on or before such 90th day, an extension of time for filing such 
consent may be granted in the manner, and subject to the conditions, 
described in paragraph (b)(3) of this section. In addition, if the 
transfer occurs more than 90 days after the first day of such taxable 
year, an extension of time for filing such consent may be granted to 
such recipient only if it is determined under paragraph (b)(3) of this 
section that an extension of time would have been granted the transferor 
for the filing of such consent if the transfer had not occurred. A 
consent which is not attached to the original Form 4876 or statement of 
election (as the case may be) shall be filed with the same service 
center as the original Form 4876 or statement of election and shall have 
attached a copy of such original form or statement of election. The form 
of such consent shall be the same as that set forth in paragraph 
(b)(1)(ii) of this section. For the purposes of this paragraph, a 
transfer of shares includes any sale, exchange, or other disposition, 
including a transfer by gift or at death.
    (2) Requirement for the filing of an amended form 4876 or statement 
of election. In any case in which a consent to a corporation's election 
to be treated as a DISC is made pursuant to subparagraph (1) of this 
paragraph, such corporation must file an amended form 4876 or statement 
of election (as the case may be) reflecting all changes in ownership of 
shares. Such form must be filed with the same service center with which 
the original form 4876 or statement of election was filed by such 
corporation.
    (d) Effect of election--(1) Effect on corporation. A valid election 
to be treated as a DISC remains in effect (without regard to whether the 
electing corporation qualifies as a DISC for a particular year) until 
terminated by any of the methods provided in paragraph (e) of this 
section. While such election is in effect, the electing corporation is 
subject to sections 991 through 997 and other provisions of the code 
applicable to DISC's for any taxable year for which it qualifies as a 
DISC (or is treated as qualifying as a DISC pursuant to section 
992(a)(2)). Such corporation is also subject to such provisions for any 
taxable year for which it is treated as a former DISC as a result of 
qualifying or being treated as a DISC for any taxable year for which 
such election was in effect.
    (2) Effect on shareholders. A valid election by a corporation to be 
treated as a DISC subjects the shareholders of such corporation to the 
provisions of

[[Page 188]]

section 995 (relating to the taxation of the shareholders of a DISC or 
former DISC) and to all other provisions of the code relating to the 
shareholders of a DISC or former DISC. Such provisions of the code apply 
to any person who is a shareholder of a DISC or former DISC whether or 
not such person was a shareholder at the time the corporation elected to 
become a DISC.
    (e) Termination of election--(1) In general. An election to be 
treated as a DISC is terminated only as provided in subparagraph (2) or 
(3) of this paragraph.
    (2) Revocation of election--(i) Manner of revocation. An election by 
a corporation to be treated as a DISC may be revoked by the corporation 
for any taxable year of the corporation after the first taxable year for 
which the election is effective. Such revocation shall be made by the 
corporation filing a statement that the corporation revokes its election 
under section 992(b) to be treated as a DISC. Such statement shall 
indicate the corporation's name, address, employer identification 
number, and the first taxable year of the corporation for which the 
revocation is to be effective. The statement shall be signed by any 
person authorized to sign a corporation return under section 6062. Such 
revocation shall be filed with the service center with which the 
corporation filed its election, except that, if it filed an annual 
information return under section 6011(e)(2), the revocation shall be 
filed with the service center with which it filed its last such return.
    (ii) Years for which revocation is effective. If a corporation files 
a statement revoking its election to be treated as a DISC during the 
first 90 days of a taxable year (other than the first taxable year for 
which such election is effective), such revocation will be effective for 
such taxable year and all taxable years thereafter. If the corporation 
files a statement revoking its election to be treated as a DISC after 
the first 90 days of a taxable year, the revocation will be effective 
for all taxable years following such taxable year.
    (3) Continued failure to be a DISC. If a corporation which has 
elected to be treated as a DISC does not qualify as a DISC (and is not 
treated as a DISC pursuant to section 992(a)(2)) for each of any 5 
consecutive taxable years, such election terminates and will not be 
effective for any taxable year after such 5th taxable year. Such 
termination will be effective automatically, without notice to such 
corporation or to the Internal Revenue Service. If, during any 5-year 
period for which an election is effective, the corporation should 
qualify as a DISC (or be treated as a DISC pursuant to section 
992(a)(2)) for a taxable year, a new 5-year period shall automatically 
start at the beginning of the following taxable year.
    (4) Election after termination. If a corporation has made a valid 
election to be treated as a DISC and such election terminates in either 
manner described in subparagraph (2) or (3) of this paragraph, such 
corporation is eligible to reelect to be treated as a DISC at any time 
by following the procedures described in paragraphs (a) through (c) of 
this section. If a corporation terminates its election and subsequently 
reelects to be treated as a DISC, the corporation and its shareholders 
continue to be subject to sections 995 and 996 with respect to the 
period during which its first election was in effect. Thus, for example, 
distributions upon disqualification includible in the gross incomes of 
shareholders of a corporation pursuant to section 995(b)(2) continue to 
be so includible for taxable years for which a second election of such 
corporation is in effect without regard to the second election.

[T.D. 7237, 37 FR 28626, Dec. 28, 1972]



Sec. 12.8  Elections with respect to net leases of real property.

    (a) In general. The elections described in this section are 
available for determining whether real property held by the taxpayer is 
subject to a net lease for purposes of section 57 (relating to items of 
tax preference for purposes of the minimum tax for tax preferences) or 
163(d) (relating to limitation on interest on investment indebtedness). 
Under sections 57(c)(1)(A) and 163(d)(4)(A)(i), property will be 
considered to be subject to a net lease for a taxable year where the sum 
of the deductions of the lessor with respect to the property for the 
taxable year allowable solely by reason of section 162

[[Page 189]]

(other than rents and reimbursed amounts with respect to the property) 
is less than 15 percent of the gross income from rents produced by the 
property (hereinafter referred to as the ``expense test''). Under 
sections 57(c)(2) and 163(d)(7)(A), where a parcel of real property of 
the taxpayer is leased under two or more leases, the taxpayer may elect 
to apply the expense test set forth in sections 57(c)(1)(A) and 
163(d)(4)(A)(i) by treating all leased portions of such property as 
subject to a single lease. Under sections 57(c)(3) and 163(d)(7)(B), at 
the election of the taxpayer, the expense test set forth in sections 
57(c)(1)(A) and 163(d)(4)(A)(i) shall not apply with respect to real 
property of the taxpayer which has been in use for more than 5 years.
    (b) Election with respect to multiple leases of single parcel of 
real property. If a parcel of real property of the taxpayer is leased 
under two or more leases, the expense test referred to in paragraph (a) 
of this section shall, at the election of the taxpayer, be applied by 
treating all leased portions of such property as subject to a single 
lease. For purposes of this paragraph, the term ``parcel of real 
property'' includes adjacent properties each of which is subject to 
lease.
    (c) Election with respect to real property in use for more than 5 
years. At the election of the taxpayer, the expense test referred to in 
paragraph (a) of this section shall not apply with respect to real 
property of the taxpayer which has been in use for more than 5 years. 
For this purpose, real property is in use only during the period that 
such property is both owned and used for commercial purposes by the 
taxpayer. If an improvement to the property was made during the time 
such property was owned by the taxpayer, and if, as a result of such 
improvement, the adjusted basis of such property was increased by 50 
percent or more, use of such property for commercial purposes shall be 
deemed to have commenced for purposes of this paragraph as of the date 
such improvement was completed. An election under this paragraph shall 
apply to all real property of the taxpayer which has been in use for 
more than 5 years.
    (d) Procedure for making election--(1) Time and scope of election. 
An election under paragraph (b) or (c) of this section shall be made for 
each taxable year to which such election is to apply. The election must 
be made before the later of (i) the time prescribed by law for filing 
the taxpayer's return for the taxable year for which the election is 
made (determined with regard to any extension of time) or (ii) August 
31, 1973, but the election may not be made after the expiration of the 
time prescribed by law for the filing of a claim for credit or refund of 
tax with respect to the taxable year for which the election is to apply.
    (2) Manner of making election. Except as provided in the following 
sentence, an election by the taxpayer with respect to a taxable year 
shall be made by a statement containing the information described in 
paragraph (d)(3) of this section which is--
    (i) Attached to the taxpayer's return or amended return for such 
taxable year,
    (ii) Attached to a timely filed claim by the taxpayer for credit or 
refund of tax for such taxable year, or
    (iii) Filed by the taxpayer with the director of the Internal 
Revenue Service Center where the return for such taxable year was filed.

In the case of a taxable year ending before July 1, 1973, no formal 
statement of election is necessary if the taxpayer's return took into 
account an election under paragraph (b) or (c) of this section; the 
taxpayer will be considered to have made an election in accordance with 
the manner in which leases with respect to parcels of real property 
described in paragraph (b) of this section, or leases of property which 
has been in use for more than 5 years as described in paragraph (c) of 
this section, are treated in the return.
    (3) Statement. The statement described in paragraph (d)(2) of this 
section shall contain the following information:
    (i) The name, address, and taxpayer identification number of the 
taxpayer;
    (ii) The taxable year to which the election is to apply if the 
statement is not attached to the return or a claim for credit or refund;

[[Page 190]]

    (iii) A description of any leases which are to be treated as a 
single lease; and
    (iv) A description of any real property in use for more than 5 years 
to which the expense test is not to apply.
    (4) Revocation of election. An election made pursuant to this 
paragraph may be revoked within the time prescribed in paragraph (d)(1) 
of this section for making an election and may not be revoked 
thereafter. Any such revocation shall be made in the manner prescribed 
by paragraph (d)(2) of this section for the making of an election.
    (e) Election by members of partnership. Under section 703(b) (as 
amended by section 304(c) of the Revenue Act of 1971), any election 
under section 57(c) or 163(d)(7) with respect to property held by a 
partnership shall be made by each partner separately, rather than by the 
partnership. If an election made by a taxpayer under paragraph (b) of 
this section applies in whole or in part to property held by a 
partnership, the taxpayer shall, in applying the expense test referred 
to in paragraph (a) of this section, take into account his distributive 
share of the deductions of the partnership with respect to the property 
for the taxable year allowable solely by reason of section 162 (other 
than rents and reimbursed amounts with respect to the property) and also 
his distributive share of the partnership's rental income from such 
property for the taxable year.

[T.D. 7271, 38 FR 9296, Apr. 13, 1973]



Sec. 12.9  Election to postpone determination with respect to the presumption described in section 183(d).

    (a) In general. An individual, electing small business corporation, 
trust or estate may elect in accordance with the rules set forth in this 
section to postpone a determination whether the presumption described in 
section 183(d) applies with respect to any activity in which the 
taxpayer engages until after the close of the fourth taxable year (sixth 
taxable year, in the case of an activity described in Sec. 1.183-
1(c)(3)) following the taxable year in which the taxpayer first engages 
in such activity. The election must be made in accordance with the 
applicable requirements of paragraphs (b), (c) and (d) of this section. 
Except as otherwise provided in paragraphs (c) and (e) of this section, 
an election made pursuant to this section shall be binding for the first 
taxable year in which the taxpayer first engages in the activity and for 
all subsequent taxable years in the five (or seven) year period referred 
to in the first sentence of this paragraph. For purposes of this 
section, a taxpayer shall be treated as not having engaged in an 
activity during any taxable year beginning before January 1, 1970.
    (b) Period to which an election applies. An individual, trust, 
estate, or small business corporation may make the election. The five 
year presumption period (seven year presumption period in the case of an 
activity described in Sec. 1.183-1(c)(3)) to which the election shall 
apply shall be the five (or seven) consecutive taxable years of such 
taxpayer beginning with the taxable year in which such taxpayer first 
engages in the activity. For purposes of this section, a taxpayer who 
engages in an activity as a partner, engages in it in each of his 
taxable years with or within which ends a partnership year during which 
the activity was carried on by the partnership.
    (c) Time for making an election. A taxpayer who is an individual, 
trust, estate or small business corporation may make the election 
provided in Sec. 183(e) by filing the statement and consents required by 
paragraph (d) of this section within--
    (1) 3 years after the due date of such taxpayer's return (determined 
without extensions) for the taxable year in which such taxpayer first 
engages in the activity, but not later than
    (2) 60 days after such taxpayer receives a written notice (if any) 
from a district director that the district director proposes to disallow 
deductions attributable to an activity not engaged in for profit under 
section 183.

The provisions of paragraph (c)(2) of this section shall in no event be 
construed to extend the period described in (c)(1) of this section for 
making such election. Notwithstanding the time periods prescribed in 
paragraph (c) (1) and (2) of this section, if no election has been made 
before a suit or proceeding described in section 7422(a) is maintained 
or a petition is filed in the Tax

[[Page 191]]

Court for a redetermination of a deficiency for any taxable year within 
the presumption period to which the election would apply, no election 
may be made except with the consent of the Commissioner which will not 
be given unless no appreciable delay in the suit or proceeding will be 
caused.
    (d) Manner of making election. (1) The election shall be made by the 
individual, trust, estate, or electing small business corporation, as 
the case may be, engaged in the activity, by filing a statement which 
sets forth the following information--
    (i) The name, address, and taxpayer identification number of such 
taxpayer, and, if applicable, of the partnership in which he engages in 
the activity,
    (ii) A declaration stating that the taxpayer elects to postpone a 
determination as to whether the presumption described in section 183(d) 
applies until after the close of the taxpayer's fourth taxable year 
(sixth taxable year, in the case of an activity described in Sec. 1.183-
1(c)(3)) following the taxable year in which the taxpayer first engaged 
in such activity and identifying that first such taxable year, and,
    (iii) A description of each activity (as defined in Sec. 1.183-
1(d)(1)) with respect to which the election is being made.
    (2) For an election to be effective, there must be attached to the 
statement properly executed consents, in the form prescribed by the 
Commissioner, extending the period prescribed by section 6501 for the 
assessment of any tax to a date which is not earlier than 18 months 
after the due date of the return (determined without extensions) for the 
final year in the presumption period to which the election applies, as 
follows:
    (i) Consents for each of the taxpayer's taxable years in the 
presumption period to which the election applies,
    (ii) If the election is made by an electing small business 
corporation, a consent of each person who is a shareholder during any 
taxable year to which the election applies, for each of such 
shareholder's taxable years with or within which end each of the 
corporation's taxable years in the presumption period,
    (iii) If a taxpayer referred to in paragraph (d)(2)(i) of this 
section or shareholder referred to in paragraph (d)(2)(ii) of this 
section is married at the time of the election, in the case of his 
present spouse, a consent for each of such spouse's taxable years which 
correspond to the taxable years (other than prior years of the 
shareholder during no part of which he was a shareholder) for which 
consents are required by paragraph (d)(2) (i) or (ii) of this section as 
the case may be.

Such consents shall not be construed to shorten the period described in 
section 6501 for any taxable year within the presumption period to which 
the election applies.
    (3) The statement, with the required consents attached, shall be 
filed--
    (i) With the service center at which the taxpayer making the 
election is required to file his return, or
    (ii) If the taxpayer is notified by a district director that, 
pursuant to section 183 he is proposing to disallow deductions with 
respect to an activity not engaged in for profit, with such district 
director.
    (e) Subsequent invalidations. If, after a timely election has been 
made, but still within the presumption period, a suit or proceeding (as 
described in section 7422(a)) is maintained by the electing taxpayer, a 
shareholder referred to in paragraph (d)(2)(ii) of this section, or 
spouse referred to in paragraph (d)(2)(iii) of this section for any 
taxable year for which a consent is required by this section and the 
taxpayer, shareholder, or spouse has not been issued a notice of 
deficiency (as described in section 6212(a)) with respect to such 
taxable year, such election shall not be effective to postpone the 
determination whether the presumption applies, for such taxable year, 
but the consents extending the statute of limitations filed with the 
election shall not thereby be invalidated. The immediately preceding 
sentence shall not apply to a suit or proceeding maintained by the 
spouse of an electing taxpayer for a taxable year for which such spouse 
has filed a separate return, or a suit or proceeding maintained by a 
shareholder for a taxable year in which he was not such a shareholder. 
An election by an individual taxpayer or electing small

[[Page 192]]

business corporation, shall be subsequently invalidated for all years in 
the presumption period to which it had applied if--
    (1) The electing taxpayer or shareholder taxpayer files a joint 
return for one of the first three (five, in the case of an activity 
described in Sec. 1.183-1(c) (3)) taxable years in such presumption 
period, and
    (2) The spouse with whom he files such joint return has not 
previously executed a consent described in paragraph (d)(2)(iii) of this 
section, and
    (3) Within one year after the filing of such joint return (or, if 
later, 90 days after March 14, 1974), such spouse has not filed a 
consent described in paragraph (d)(2) of this section.

An election by an electing small business corporation shall be 
invalidated for all years in the presumption period to which it applies 
if a person who was not a shareholder on the date of election becomes a 
shareholder during the first three (or five) years of the presumption 
period to which the election applies and does not, within 90 days after 
the date on which he becomes a shareholder (or, if later, 90 days after 
March 14, 1974), file a consent required by paragraph (d)(2) of this 
section. Invalidation of the election by operation of this paragraph 
will in no case affect the validity of the consents filed with such 
election.
    (f) Extension of time for filing election in hardship cases. The 
Commissioner may upon application by a taxpayer, consent to an extension 
of time prescribed in this section for making an election if he finds 
that such an extension would be justified by hardship incurred by reason 
of the time at which this section is published. The burden will be on 
the taxpayer to establish that under the relevant facts the Commissioner 
should so consent.

[T.D. 7308, 39 FR 9947, Mar. 15, 1974]



PART 13--TEMPORARY INCOME TAX REGULATIONS UNDER THE TAX REFORM ACT OF 1969--Table of Contents




Sec.
13.0-13.3  [Reserved]
13.4  Arbitrage bonds; temporary rules.
13.5-13.9  [Reserved]
13.10  Distribution of money in lieu of fractional shares.
13.11  Revocation of election to report income on the installment basis.

    Authority: 26 U.S.C. 7805.



Secs. 13.0-13.3  [Reserved]



Sec. 13.4  Arbitrage bonds; temporary rules.

    (a) In general--(1) Arbitrage bonds. Section 103(d)(1) provides that 
any arbitrage bond (as such term is defined in section 103(d)(2)) shall 
be treated as an obligation not described in section 103(a)(1). Thus, 
the interest on an obligation which would have been excluded from gross 
income pursuant to the provisions of section 103(a)(1) will be included 
in gross income and subject to Federal income taxation if such 
obligation is an arbitrage bond. Under section 103(d)(2), an obligation 
is an arbitrage bond if it is issued by a governmental unit as part of 
an issue of obligations (for purposes of this section referred to as 
``governmental obligations'') all or a major portion of the proceeds of 
which are (i) reasonably expected to be used directly or indirectly to 
acquire certain obligations or securities (for purposes of this section 
referred to as ``acquired obligations'') which may reasonably be 
expected, at the time of issuance of such governmental obligations, to 
produce a yield over the term of the issue of such governmental 
obligations which is materially higher (taking into account any discount 
or premium) than the yield on such issue, or (ii) reasonably expected to 
be used to replace funds which were used directly or indirectly to 
acquire such acquired obligations. For rules as to industrial 
development bonds, see section 103(c).
    (2) Definitions. (i) For purposes of this section, the term 
``governmental unit'' means a State, the District of Columbia, a 
Territory, or a possession of the United States, or any political 
subdivision of any of the foregoing.
    (ii) For purposes of this section, the term ``securities'' has the 
same meaning as in section 165(g)(2) (A) and (B).
    (3) Materially higher. For purposes of this section, the yield 
produced by acquired obligations is not ``materially higher'' than the 
yield produced by an issue of governmental obligations if it

[[Page 193]]

is reasonably expected, at the time of issue of such governmental 
obligations, that the adjusted yield (computed in accordance with 
subparagraphs (4) and (5) of this paragraph) to be produced by the 
acquired obligations will not exceed the adjusted yield (computed in 
accordance with subparagraphs (4) and (5) of this paragraph) to be 
produced by the issue of governmental obligations by more than one-
eighth of 1 percentage point. In the case of an issue of governmental 
obligations issued on or before July 1, 1972, the percentage specified 
in the preceding sentence shall be one-half of 1 percentage point.
    (4) Yield. (i) For purposes of this section, ``yield'' shall be 
computed using the ``interest cost per annum'' method in accordance with 
subdivision (ii) or (iii) of this subparagraph (as the case may be) or 
any other method satisfactory to the Commissioner which is consistent 
with generally accepted principles of computing yield. In the case of 
acquired obligations, the yield to be produced by such obligations shall 
be computed as if all acquired obligations comprised a single issue of 
obligations. Thus, for example, if the governmental unit acquires two 
blocks of Federal obligations, with different interest rates and 
maturity periods for each block, the yield on such acquired obligations 
shall be computed as if one issue of obligations with different interest 
rates and maturity periods had been acquired. The maturity period of 
each acquired obligation shall be the period that the governmental unit 
reasonably expects to hold such obligation.
    (ii) If all the governmental or acquired obligations of an issue 
have a single interest rate (expressed in dollars per $1,000 of face 
amount of bonds), yield shall be computed using the following 4 steps:
    (a) Step (1). Compute the total number of bond years for the issue 
by multiplying the number of bonds (treating each $1,000 of face value 
as one bond for purposes of this computation) of each maturity by the 
length of the maturity period (expressed in years and fractions thereof) 
and then adding together the amounts determined for each maturity 
period.
    (b) Step (2). Compute the total interest payable on the issue by 
multiplying the total number of bond years (as computed in step (1)) by 
the amount payable, expressed in dollars, as interest on each $1,000 of 
bonds for 1 year.
    (c) Step (3). Compute the net interest in dollars for the issue by 
adding the amount, in dollars, of any discount to, or by subtracting the 
amount, in dollars, of any premium from, the total interest payable on 
the issue.
    (d) Step (4). Compute yield by dividing the net interest by the 
product obtained by multiplying the total number of bond years for the 
issue by 10.
    (iii) If governmental or acquired obligations of an issue have 
different interest rates (expressed in dollars per $1,000 of face amount 
of bonds), yield shall be computed using the following 4 steps:
    (a) Step (1). Compute the total number of bond years for each group 
of bonds bearing the same interest rate (treating each $1,000 of face 
value as one bond for purposes of this computation) in the manner 
described in step 1 of subdivision (ii) of this subparagraph.
    (b) Step (2). Compute the total interest payable on the issue by 
multiplying the total number of bond years for each group of bonds 
bearing the same interest rate (as computed in step (1)) by the amount 
payable, expressed in dollars, as interest on each $1,000 of bonds for 1 
year, and then adding together the amounts determined for each group.
    (c) Step (3). Compute net interest in the manner described in step 
(3) of subdivision (ii) of this subparagraph.
    (d) Step (4). Compute the yield produced by the issue in the manner 
described in step (4) of subdivision (ii) of this subparagraph.
    (iv) For purposes of this section, the same method of computing 
yield shall be used to compute the yield to be produced by an issue of 
governmental obligations and to compute the yield to be produced by 
acquired obligations acquired with the proceeds of such issue of 
governmental obligations.
    (v) The following example illustrates the provisions of this 
subparagraph:

    Example. Assume an issue of $200,000 ($1,000 per bond) with a stated 
interest (expressed in dollars per bond) of $50 on bonds maturing in 1, 
2, or 3 years, a stated interest of $60 on bonds maturing in 4, 5, 6, or 
7 years and a stated interest of $70 on bonds maturing in 8, 9, or 10 
years. Assume also that a price of $101 has been bid for the issue. The 
yield on

[[Page 194]]

the issue is determined in accordance with the table below:

----------------------------------------------------------------------------------------------------------------
                                                                           Total
                                                                            bond
                                      Amount    Rate   Years to   Bond    years at   x   Interest   =   Interest
                                                       maturity   years   interest         rate           cost
                                                                            rate
----------------------------------------------------------------------------------------------------------------
                                      $10,000    $50          1
                                        5,000     50          2
                                       25,000     50          3
                                                                --------
                                                                                95                        $4,750
                                       10,000     60          4      40
                                       10,000     60          5      50
                                       30,000     60          6     180
                                       50,000     60          7     350
                                                                --------
                                                                               620                        37,200
                                       20,000     70          8     160
                                       25,000     70          9     225
                                       15,000     70         10     150
                                    ------------------------------------
                                                                               535             70         37,450
                                                                        -----------                   ----------
Totals.............................   200,000                                1,250                        79,400
                                    ----------                          ===========                   ==========
Less premium.........................................................................................      2,000
                                    -----------
Net interest cost....................................................................................     77,400
Divide by: Product of total bond years (1,250), multiplied by 10.....................................     12,500
                                    -----------
Yield (Percent)......................................................................................      6,192
----------------------------------------------------------------------------------------------------------------

    (5) Adjusted yield. (i) For purposes of this section, ``adjusted 
yield'' shall be computed in accordance with subparagraph (4) of this 
paragraph, except that in the case of--
    (a) Acquired obligations, an amount equal to the sum of the 
administrative costs reasonably expected to be incurred in purchasing, 
carrying, and selling or redeeming such obligations shall be treated as 
a premium on the purchase price of such acquired obligations.
    (b) An issue of governmental obligations, an amount equal to the sum 
of the reasonably expected administrative costs of issuing, carrying, 
and repaying such issue of obligations shall be treated as a discount on 
the selling price of such issue of governmental obligations.
    (ii) The provisions of subdivision (i) of this subparagraph may be 
illustrated by the following examples:

    Example (1). State Z issues $15 million of obligations all of which 
will mature in 10 years. The obligations are sold at $1,000 each (par) 
to yield 6 percent interest. The adjusted yield produced by such issue 
of obligations will be determined as follows, assuming the following 
administrative expenses of issuing, carrying, and repaying such issue of 
obligations are reasonably expected:

Issuing costs:
  Printing........................................   $12,500
  Financial advisors..............................    25,000
  Counsel fees....................................    12,500
    Total...................................................     $50,000
Carrying costs, paying agent and trustees fees..............      10,000
Repaying costs, paying agent................................       3,000
                                                   -----------
    Total administrative costs..............................      63,000
                                                   -----------
Bond years (15,000x10 years)................................     150,000
Interest cost per $1,000 bond per year......................          60
                                                   -----------
    Total interest cost.....................................   9,000,000
  Discount or premium.......................................           0
  Plus adjustments..........................................      63,000
                                                   -----------
  Net interest cost.........................................   9,063,000
  Divide by product of bond years (150,000) multiplied by 10   1,500,000
                                                   -----------
  Adjusted yield............................................      6.042%
 

    Example (2). State Z uses the net proceeds of the issue of 
obligations described in Example (1) to acquire $14,922,000 of student's 
notes at par of $1,000 each under a student loan program. The students' 
notes will all mature in 10 years, and all have a stated interest of 
7\1/2\ percent. Expenses of the program including printing of forms 
($5,000), financial advisors' fees ($11,000), counsel fees ($12,000), 
trustees' fees ($5,000), fees for the collecting agents and various 
banks which administer the loans ($100,000), advertising expenses 
($10,000), credit reference checks

[[Page 195]]

($20,000), and general office overhead ($5,000). Of the expenses listed 
in the preceding sentence, only those indicated on the following table 
constitute adjustments to yield in order to determine the adjusted yield 
to be produced by the students' notes:

Purchasing costs:
  Printing forms..................................    $5,000
  Financial advisors..............................    11,000
  Counsel fees....................................    12,000
                                                   ----------
    Total...................................................     $28,000
Carrying costs, trustees fees...............................       5,000
                                                   -----------
    Total administrative costs..............................      33,000
                                                   -----------
Bond years (14,922x10 years)................................     149,220
Interest receivable per $1,000 note per year................          75
                                                   -----------
    Total interest receivable...............................  11,191,500
  Discount or premium.......................................           0
  Minus adjustments.........................................      33,000
                                                   -----------
  Net interest receivable...................................  11,158,500
  Divide by product of bond years (149,220) multiplied by 10   1,492,200
                                                   -----------
  Adjusted yield............................................      7.478%
 

    (b) Rule with respect to certain governmental programs--(1) General 
rule. Subject to the limitations of subparagraph (3) of this paragraph, 
any obligations which are part of an issue of governmental obligations 
the proceeds of which are reasonably expected to be used to finance 
certain governmental programs (described in subparagraph (2) of this 
paragraph) are not arbitrage obligations.
    (2) Governmental programs. A governmental program is described in 
this subparagraph if--
    (i) The program involves the acquisition of acquired purpose 
obligations to carry out the purposes of such program (which 
obligations, for purposes of this paragraph, are referred to as 
``acquired program obligations'');
    (ii) At least 90 percent of all such acquired program obligations, 
by amount of cost outstanding, are evidences of loans to a substantial 
number of persons representing the general public, loans to exempt 
persons within the meaning of section 103(c)(3), or loans to provide 
housing and related facilities, or any combination of the foregoing;
    (iii) At least 90 percent of all of the amounts received by the 
governmental unit with respect to acquired program obligations shall be 
used for one or more of the following purposes: To pay the principal or 
interest or otherwise to service the debt on governmental obligations 
relating to the governmental program; to reimburse the governmental 
unit, or to pay, for administrative costs of issuing such governmental 
obligations; to reimburse the governmental unit, or to pay, for 
administrative and other costs and anticipated future losses directly 
related to the program financed by such governmental obligations; to 
make additional loans for the same general purposes specified in such 
programs; or to redeem and retire governmental obligations at the next 
earliest possible date of redemption; and
    (iv) Requires that any person (or any related person, as defined in 
section 103(c)(6)(C)) from whom the governmental unit may, under the 
program, acquire acquired program obligations shall not, pursuant to an 
arrangement, formal or informal, purchase the governmental obligations 
in an acquired program obligations to be acquired from such person by 
the governmental unit.
    (3) Limitation. The provisions of subparagraph (1) of this paragraph 
shall apply only if it is reasonably expected that--
    (i) A major portion of the proceeds of such issue of governmental 
obligations, including proceeds represented by repayments of principal 
and interest received by the governmental unit with respect to acquired 
program obligations, shall not be invested for more than a temporary 
period (within the meaning of section 103(d)(4)(A)), in acquired 
obligations (other than acquired program obligations) which produce a 
materially higher yield than the yield produced over the term of the 
issue by such governmental obligations, and
    (ii)(a) The adjusted yield (computed in accordance with paragraphs 
(a) (4) and (5) of this section) to be produced by acquired program 
obligations shall not exceed the adjusted yield (computed in accordance 
with paragraphs (a) (4) and (5) of this section) to be produced by such 
issue of governmental obligations by more than 1\1/2\ percentage points, 
or
    (b) Where the difference in the adjusted yields described in 
subdivision (ii)(a) of this subparagraph is expected to exceed 1\1/2\ 
percentage points, the amounts to be obtained as a result of the 
difference in such adjusted yields

[[Page 196]]

shall not exceed the amount necessary to pay expenses (including losses 
resulting from bad debts) reasonably expected to be incurred as a direct 
result of administering the program to be financed with the proceeds of 
such issue of governmental obligations, to the extent that such amounts 
are not payable with funds appropriated from other sources.
    (4) Examples. The following examples illustrate governmental 
programs described in subparagraph (2) of this paragraph:

    Example (1). State A issues obligations the proceeds of which are to 
be used to purchase certain home mortgage notes from commercial banks. 
The purpose of the governmental program is to encourage the construction 
of low income residential housing by creating a secondary market for 
mortgage notes and thereby increasing the availability of mortgage money 
for low income housing. The legislation provides that the adjusted yield 
produced by the mortgage notes to be acquired will not exceed the 
adjusted yield produced by such issue of obligations by more than 1\1/2\ 
percentage points. Amounts received as interest and principal payments 
on the mortgage notes are to be used for one or more of the following 
purposes: (1) To service the debt on the governmental obligations, (2) 
to retire such obligations at their earliest possible date of 
redemption, (3) to purchase additional mortgage notes. The governmental 
program is one which is described in subparagraph (2) of this paragraph 
and the governmental obligations are not arbitrage bonds.
    Example (2). State B issues obligations the proceeds of which are to 
be used to make loans directly to students and to purchase from 
commercial banks promissory notes made by students as the result of 
loans made to them by such banks. The legislation authorizing the 
student loan program provides that the purpose of the program is to 
enable financially disadvantaged students to continue their studies. The 
legislation also provides that purchases will be made from banks only 
where such banks agree that an amount at least equal to the purchase 
price will be devoted to new or additional student loans. It is 
reasonably expected that the difference in adjusted yields between the 
issue of governmental obligations by State B and the students' notes 
will be 1\3/4\ percentage points. It is also reasonably expected that 
the amount necessary to pay the expenses (other than expenses taken into 
account in computing adjusted yield) enumerated in subparagraph 
(3)(ii)(b) of this paragraph, directly incurred as a result of 
administering State B's student loan program, such as, for example, 
losses resulting from bad debts, insurance costs, bookkeeping expenses, 
advertising expenses, credit reference checks, appraisals, title 
searches, general office overhead, service fees for collecting agents 
and various banks which administer the loans, and salaries of employees 
not paid from other sources, will not require a difference in adjusted 
yields in excess of 1\1/2\ percentage points. The governmental program 
is one which is described in subparagraph (2) of this paragraph. Since, 
however, the difference in adjusted yields produced by the students' 
notes and the issue of State B obligations is reasonably expected to 
exceed 1\1/2\ percentage points, and since State B cannot show that 1\3/
4\ percentage points is necessary to cover such expenses, the provisions 
of subparagraph (1) of this paragraph shall not apply to the issue of 
State B obligations. If, however, State B reasonably expected that 1\3/
4\ percentage points would be necessary to cover such expenses, the 
provisions of subparagraph (1) of this paragraph would apply and the 
governmental obligations would not be arbitrage bonds.
    Example (3). Authority C issues obligations the proceeds of which 
are to be used to purchase land to be sold to veterans. The governmental 
unit will receive purchase-money mortgage notes secured by mortgages on 
the land from the veterans in return for such land. The purpose of the 
program is to enable veterans to acquire land at reduced cost. The 
adjusted yield produced by the mortgage notes is not reasonably expected 
to exceed the adjusted yield produced by the issue of obligations issued 
by Authority C by more than 1\1/2\ percentage points. Amounts received 
as interest and principal payments on the mortgage notes are to be used 
for one or more of the following purposes: (1) To pay the administrative 
costs directly related to the program, (2) to service the debt on the 
governmental obligations, (3) to retire such governmental obligations at 
their earliest possible call date, (4) to purchase additional land to be 
sold to veterans. The governmental program is one which is described in 
subparagraph (2) of this paragraph and the governmental obligations are 
not arbitrage bonds.

    (c) Effective date. The provisions of this section will apply with 
respect to obligations issued after October 9, 1969, and before final 
regulations are promulgated.

[T.D. 7072, 35 FR 17406, Nov. 13, 1970; 35 FR 18524, Dec. 5, 1970, as 
amended by T.D. 7174, 37 FR 10932, June 1, 1972; T.D. 7273, 38 FR 10927, 
May 3, 1973]

[[Page 197]]



Secs. 13.5-13.9  [Reserved]



Sec. 13.10  Distribution of money in lieu of fractional shares.

    (a) In general. (1) Under the general rule of section 305, as 
amended by section 421(a) of the Tax Reform Act of 1969, gross income 
does not include the amount of any distribution of the stock (or rights 
to acquire the stock) of a corporation made by such corporation to its 
shareholders with respect to its stock. Under an exception to the 
general rule, a distribution by a corporation of its stock or rights to 
acquire its stock is treated as a distribution of property to which 
section 301 applies if the distribution (or a series of distributions of 
which such distribution is one) has the result of (i) the receipt of 
money or other property by some shareholders, and (ii) an increase in 
the proportionate interests of other shareholders in the assets or 
earnings and profits of the corporation. Also, the Secretary or his 
delegate is directed to prescribe regulations under which a redemption 
which is treated as a distribution to which section 301 applies, or any 
other transaction having a similar effect on the interest of any 
shareholder, shall be treated as a distribution with respect to any 
shareholder whose proportionate interest in the assets or earnings and 
profits of the corporation is increased by such redemption or 
transaction.
    (2) The general rule, and not the exception, applies in the case 
where cash is distributed in lieu of fractional shares to which the 
shareholders would otherwise be entitled, provided the purpose in 
distributing the cash is to save the distributing corporation the 
trouble, expense, and inconvenience of issuing and transferring 
fractional shares (or scrip representing fractional shares), or issuing 
full shares representing the sum of fractional shares, and not to give 
any particular group of shareholders an increased interest in the assets 
or earnings and profits of the corporation.
    (b) Illustration. The application of paragraph (a) of this section 
may be illustrated by the following example:

    Example. Corporation X is a large corporation whose stock is widely 
held by the public, no one shareholder owning more than 10 percent of 
the outstanding stock. The stock is listed on a recognized exchange and 
is currently selling at less than $75 per share. During the year the 
corporation pays a 3-percent stock dividend. Cash is paid to each 
shareholder in lieu of a fractional share to which he would otherwise be 
entitled. The distribution of cash in lieu of fractional shares is not 
intended to give any particular group of shareholders an increased 
interest in the assets or earnings and profits of the corporation, but 
is intended to save the corporation the trouble, expense, and 
inconvenience of issuing and transferring scrip representing fractional 
shares. The general rule, and not the exception, applies in this 
situation.

(Sec. 305(c), 83 Stat. 614; 26 U.S.C. 305(c))

[T.D. 7039, 35 FR 7012, May 2, 1970]



Sec. 13.11  Revocation of election to report income on the installment basis.

    (a) In general. Under section 453(c)(4) taxpayers who are dealers in 
personal property and who elected installment-basis income reporting, 
subject to the provisions of section 453(c)(1) (relating to change from 
accrual to installment basis), may revoke their previously made 
election.
    (b) Time and manner of revoking election. The revocation by a 
taxpayer may be made by filing an amended return on an appropriate form 
or forms, such as Form 1040X for an individual taxpayer, for the year of 
change (the first year for which income was computed using the 
installment basis) and for each subsequent year for which a return was 
filed using the installment basis. The taxpayer should indicate on such 
amended returns that he is revoking an election to report income on the 
installment basis. Such revocation must be made within 3 years from the 
last date prescribed for the filing of the return for the year of change 
including any extension of time granted the taxpayer. In reporting 
income on the amended returns described in this section, the taxpayer 
shall use the accrual method of accounting.

[T.D. 7044, 35 FR 8823, June 6, 1970]



PART 14a--TEMPORARY INCOME TAX REGULATIONS RELATING TO INCENTIVE STOCK OPTIONS--Table of Contents




    Authority: 26 U.S.C. 7805.

[[Page 198]]



Sec. 14a.422A-1  Questions and answers relating to incentive stock option transitional rules.

    The following questions and answers relate to the application of 
incentive stock option (ISO) treatment to certain previously granted 
stock options, pursuant to section 422A of the Internal Revenue Code of 
1954, as added by section 251 of the Economic Recovery Tax Act of 1981 
(95 Stat. 172) (ERTA):

     General Description of Section 422A and Its Transitional Rules

    Q-1: What is the significance of new section 422A of the Code 
entitled ``Incentive Stock Options?''
    A-1: Prior to the enactment of section 422a, the tax treatment of 
employee stock options generally was governed by section 83 of the Code 
and the regulations thereunder. Under those rules, the value of a stock 
option constituted ordinary income to the employee when granted only if 
the option itself had a readily ascertainable fair market value at that 
time. If the option did not have a readily ascertainable value when 
granted, it did not constitute ordinary income at that time. Instead, 
when the option was exercised, the difference between the value of the 
stock at exercise and the option price constituted ordinary income to 
the employee. An employer who granted a stock option generally was 
allowed a business expense deduction equal to the amount includible in 
the employee's income in its corresponding taxable year.
Section 422A provides for incentive stock options (ISO's). Under this 
new provision there will be no tax consequences when an ISO is either 
granted or exercised, and the employee generally will be taxed at 
capital gains rates when and if the stock received on exercise of the 
option is sold. Similarly, no business expense deduction will be allowed 
to the employer with respect to an ISO.
    Q-2: What requirements must be met for ISO treatment under section 
422A?
    A-2: (a) Section 422A provides that the employee, in order to 
receive ISO treatment, must not dispose of the stock within two years 
after the option is granted, and must hold the stock itself for at least 
one year. If all requirements other than these holding period rules are 
met, tax is deferred until disposition of the stock, but gain (in an 
amount equal to the lesser of (1) the fair market value of the stock on 
the date of exercise minus the option price or (2) the amount realized 
on disposition minus the option price) is treated as ordinary income and 
the employer is allowed a deduction at that time.
    (b) In addition, for the entire time from the date of granting the 
option until three months before the date of exercise (expanded to 12 
months if employment ceased due to permanent and total disability), the 
option holder must be an employee either of the company granting the 
option, a parent or subsidiary of that corporation, or a corporation (or 
parent or subsidiary of that corporation) which has assumed the option 
of another corporation as a result of a corporate reorganization, 
liquidation, etc. This requirement and the holding period requirement 
are waived in the case of the death of the employee.
    (c) For an option to qualify as an ISO, the following conditions 
must be met:
    (1) The option must be granted under a plan specifying the aggregate 
number of shares of stock which may be issued and the employees or class 
of employees eligible to receive the options. This plan must be approved 
by the stockholders of the granting corporation within 12 months before 
or after the plan is adopted.
    (2) The option must be granted within ten years from the date the 
plan is adopted or the date the plan is approved by the stockholders, 
whichever is earlier.
    (3) The option must by its terms be exercisable only within ten 
years of the date it is granted.
    (4) The option price must equal or exceed the fair market value of 
the stock at the time the option is granted. This requirement will be 
deemed satisfied if there has been a good faith attempt to value the 
stock accurately, even if the option price is less than the stock value.
    (5) The option by its terms must be nontransferable other than at 
death and must be exercisable during the employee's lifetime only by the 
employee.
    (6) The employee must not, at the time the option is granted, own 
stock representing more than ten percent of the voting power of all 
classes of stock of the employer corporation or its parent or 
subsidiary. However, the stock ownership limitation will not apply if 
the option price is at least 110 percent of the fair market value (at 
the time the option is granted) of the stock subject to the option and 
the option by its terms is not exercisable more than five years from the 
date it is granted.
    (7) The option by its terms is not exercisable while there is 
outstanding any ISO which was granted to the employee at an earlier 
time. For this purpose, an option which has not been exercised in full 
is outstanding until the expiration of the period which under its 
initial terms it could have been exercised. Thus, the cancellation of an 
earlier option will not enable a subsequent option to be exercised any 
sooner.
    (8) In the case of options granted after 1980 the terms of the plan 
must limit the amount of aggregate fair market value of the stock 
(determined at the time of the grant of the

[[Page 199]]

option) for which any employee may be granted ISO's in any calendar year 
to not more than $100,000 plus a carryover amount. The carryover amount 
for an employee from any year after 1980 is one-half of the amount by 
which $100,000 exceeds the value at time of grant of the stock for which 
ISO's were granted in such prior year. Amounts may be carried over three 
years. Options granted in any year use up the $100,000 current year 
limitation first and then the carryover from the earliest year.
    (d) Section 422A also provides that:
    (1) Stock acquired on exercise of an ISO may be paid for with stock 
of the corporation granting the option.
    (2) The difference between the option price and the fair market 
value of the stock at the exercise of an ISO is not an item of tax 
preference.
    (3) The employee may have the right to receive additional 
compensation (in cash or property) at the time of exercise of the ISO so 
long as the additional amount is subject to inclusion in income under 
the provisions of sections 61 and 83 of the Code.
    (4) An ISO will not be disqualified because of the inclusion of any 
condition not inconsistent with the qualification requirements.
    Q-3: What are the transitional rules relating to ISO treatment under 
section 422A?
    A-3: ERTA Sec. 251(c) provides the transitional rules relating to 
ISO treatment. That section initially limits the applicability of 
section 422A to options originally granted on or after January 1, 1976.
In the case of an option granted during the years 1976 through 1980, 
section 422A will apply only if (1) the option was exercised on or after 
January 1, 1981, or was outstanding on that date, and (2) the employer 
elects (in such manner as the Treasury Department provides) to have the 
option treated as an ISO (see A-4). (See A-12 for necessary section 422A 
qualification requirements.) The aggregate fair market value (determined 
at time of grant) of stock for which an employee may be granted ISO's 
prior to 1981 may not exceed $50,000 per calendar year and $200,000 in 
the aggregate for the five-year period 1976-1980.
In the case of an option granted on or after January 1, 1976, and 
outstanding on August 13, 1981, paragraph (1) of section 425(h) of the 
Code shall not apply to either any change in the option terms (or the 
terms of the plan under which the option was granted) or the obtaining 
of shareholder approval, to permit such option to qualify as an ISO, 
provided such change and/or shareholder approval occurs on or before 
August 13, 1982. (Section 425(h) of the Code requires that if an option 
is changed, so that it is modified, extended, or renewed, the option 
shall be treated as newly granted as of the date of such change.)

               Election Procedure and Selection of Options

    Q-4: What is the procedure for electing ISO treatment for options 
granted during the years 1976 through 1980 and outstanding on January 1, 
1981?
    A-4: Note: The following procedure preempts the election procedure 
set forth in Temporary Regulation Sec. 301.9100-4T(d) of this chapter 
(TD 7793, 46 FR 54538 (November 3, 1981)). If, prior to December 21, 
1981, a corporation has filed an election statement that conforms to the 
requirements of Sec. 301.9100-4T(d) of this chapter, such an election 
statement will be considered to have been properly filed. An election 
statement filed prior to December 21, 1981, that does not meet the 
requirements of either Sec. 301.9100-4T(d) of this chapter or this A-4, 
will not be considered to have been properly filed. In any event, a 
corporation may re-file the election statement, conforming it to the 
requirements of this A-4, and such re-filing will then constitute the 
only election (see A-9, regarding timely rescissions, for a possible 
reason a corporation may want to re-file).
A corporation may file only one election statement and that statement 
must include all options that are to receive ISO treatment. Thus a 
corporation that makes an election with respect to certain options 
granted before 1981 may not make any subsequent election with respect to 
other options granted before 1981. An election shall be made by 
attaching a statement to the employer's income tax return (or amended 
return) for the first taxable year during which either an option subject 
to the election or an option qualifying under the rules of section 422A 
is exercised. An election shall be made no later than the due date 
(including extensions) of the income tax return for such year, except 
that if the due date occurs before August 14, 1982, the employer will be 
permitted to make the election at any time prior to August 14, 1982, on 
a statement attached to an amended return. In any event, no election 
will be permitted after the due date (taking extensions into account) of 
the income tax return for the taxable year including December 31, 1982.
The statement must--
    (a) Contain the name, address, and taxpayer identification number of 
the corporation.
    (b) Identify the election as an election under section 251(c)(1)(B) 
of the Economic Recovery Tax Act of 1981.
    (c) Specify, by employee, the options to which the election applies. 
For each option so elected, the filing must state the option's date of 
original grant (and, if applicable, date of most recent modification) 
and total exercise price (i.e., the total number of shares subject to 
the option multiplied by the price per share).

[[Page 200]]

All options that are subject to the election must meet the section 422A 
qualification requirements (see A-2(c)) at the time the election 
statement is filed. The only exception to this rule is the requirement, 
when necessary, of securing shareholder approval (see A-32 and A-34).
    Q-5: In electing ISO treatment for options granted during the years 
1976 through 1980 and outstanding on January 1, 1981, may a corporation 
select only those options that it wants to receive ISO treatment?
    A-5: Yes. However the original grant dates--or later grant dates for 
options with section 425(h) amendments (see A-9)--of the options 
selected for ISO treatment will determine the new sequencing order for 
purposes of the ISO sequential exercise restriction (see A-2(c)(7)). For 
example consider the case of options granted in 1977, 1978, and 1979, 
and assume that in 1980 the 1978 option was modified to add a term 
beneficial to the employee (a modification which under 425(h) would be 
treated as the granting of a new option). If the 1977, 1978 (as 
modified), and 1979 options are now elected as ISO's, the sequencing 
order is as follows: the 1977 option must be exercised first, the 1979 
option second, and the 1978 option (as modified) third. See also A-9 and 
A-38.
    Q-6: In electing ISO treatment for options granted during the years 
1976 through 1980 and outstanding on January 1, 1981, may a corporation 
select options on an option-by-option basis and/or an employee-by-
employee basis?
    A-6: Yes. Subject to the $50,000 per year and $200,000 aggregate 
limits (see A-3), a corporation may select for ISO treatment any or all 
options granted to any or all employees, subject only to plan 
requirements as to who must be benefited under a plan, as among 
different classes of employees.
    Q-7: In electing ISO treatment for options granted during the years 
1976 through 1980 and outstanding on January 1, 1981, may a corporation 
select only a portion of the elected option to receive such treatment?
    A-7: Yes. Subject to the $50,000 per year and $200,000 aggregate 
limits (see A-3), a corporation may select for ISO treatment any portion 
of any option. If the option is not exercised prior to January 21, 1982, 
the option must be amended so that the ISO portion is clearly 
identified. When such a ``split'' option is exercised, separate stock 
certificates must be issued (or reissued)--one for the ISO stock and one 
for the non-ISO stock. See also A-15 and A-18.

      Eligibility Requirements and Issues Involving Pre-enactment 
            Modifications, Dollar Limitations, and Dual Plans

    Q-8: Is an option originally granted prior to January 1, 1976, and 
amended on or after January 1, 1976, eligible for ISO treatment?
    A-8: No. For purposes of ISO eligibility, the controlling date is 
the date of original grant. A modification, extension, or renewal on or 
after January 1, 1976, of any option originally granted before that 
date, will not make such option eligible for ISO treatment, regardless 
of whether or not the option, as so modified, extended, or renewed, 
would be treated as newly granted within the meaning of section 425(h).
    Q-9: If an option granted on or after January 1, 1976, was amended 
between its date of grant and August 13, 1981, will such an amendment 
affect the option's eligibility for ISO treatment?
    A-9: An amendment to an otherwise eligible option (or plan) prior to 
August 13, 1981, will be subject to the rules of section 425(h). If, 
pursuant to section 425(h), the amendment is a modification, extension, 
or renewal of the option, such amendment shall be considered as the 
granting of a new option. In order for such an option to be eligible for 
ISO treatment, the option (and plan) must comply with the section 422A 
qualification requirements (see A-2(c)). The option will be deemed to 
have been granted on the date it was amended. Thus, the option price 
cannot be less than the fair market value of the stock on that date. If 
the corporation wishes to retain the original grant price (and grant 
date) of the option, the corporation may do so by rescinding the 
amendment that was either a modification, extension, or renewal pursuant 
to section 425(h), so long as such rescission occurs prior to the 
earliest of the exercise of the option, the election of ISO treatment, 
and August 14, 1982. To be effective, such rescission must apply to the 
entire option. For example, in the case of a $100,000 option granted in 
1978 and amended in 1980, the corporation could not rescind the 
modification as to only half of the option, and then elect for ISO 
treatment both $50,000 of the option granted in 1978 and $50,000 of the 
option as amended in 1980.
    Q-10: An option granted during 1978 was amended during 1980 to add 
the following features: An alternative stock appreciation right, the 
right to exercise the option with previously-acquired corporate stock, 
and the right to receive a cash bonus upon the exercise of the option. 
At the same time, the exercise period of the option was extended from 
five to ten years and the post-employment exercise period was extended 
from 3 to 18 months. If the option is to be elected as an ISO, which of 
the above amendments is either a modification, extension, or renewal 
within the meaning of section 425(h) so that the option will be treated 
as newly granted on the date it was amended?
    A-10: Any one of the above amendments will cause the option, 
pursuant to section 425(h), to be treated as newly granted on the date 
it was amended.
    Q-11: An option granted during 1978 was amended during 1980 to add 
the right to exercise the option with previously acquired corporate 
stock. During 1981, the corporation properly elected ISO treatment for 
the amended option

[[Page 201]]

and, pursuant to section 425(h), adjusted the option price upward so 
that it equaled the fair market value of the stock subject to the option 
as of the date of the 1980 amendment. During 1982, the employee intends 
to exercise the option and will pay cash. Under these circumstances, is 
the employee entitled to exercise the option at the 1978 option price?
    A-11: No. The option price, as amended in 1980, is the option price. 
The application of section 425(h) to option amendments is not affected 
by whether or not the employee actually benefits from such amendments 
(but see A-9 regarding timely rescissions).
    Q-12: Is an option granted on or after January 1, 1976, and 
exercised on or after January 1, 1981, eligible for ISO treatment, if, 
at the time of exercise, the option (or plan) did not meet all of the 
qualification requirements of section 422A and the transitional rules 
(see A-2(c) and A-3, respectively)?
    A-12: No. Except in cases described in A-13 through A-15, and A-34, 
in order for an option to be eligible for ISO treatment it must, at the 
time of exercise, conform to all of the qualification requirements of 
section 422A and the transition rules. It is not possible to amend an 
exercised option retroactively, in order to correct non-conforming or 
missing terms, or to rescind an improper exercise.
    Q-13: Is an option granted on or after January 1, 1976, and 
exercised on or after January 1, 1981, eligible for ISO treatment if, at 
the time of exercise, the terms of the option did not contain the ISO 
sequential exercise restriction (see A-2(c)(7))?
    A-13: If the option was exercised prior to January 21, 1982, without 
containing the ISO sequential exercise restriction, such option may 
still be eligible for ISO treatment. The absence of the restriction will 
not disqualify an option if the employee in fact had no prior 
outstanding ISO's at the time the option in question was exercised. If 
the option was exercised on or after January 21, 1982, the absence of 
the ISO sequential exercise restriction will not disqualify an option if 
the employee in fact had no prior outstanding ISO's at the time the 
option in question was granted. In order to identify prior outstanding 
ISO's, it will be necessary to take into account all options either 
elected or qualifying for ISO treatment (see A-5, A-9, and A-38).
    Q-14: Is an option granted and exercised during 1981 eligible for 
ISO treatment if, at the time of exercise, the terms of the plan 
pursuant to which the option was granted did not contain the $100,000 
per year limit on ISO grants (see A-2(c)(8))?
    A-14: If the option was exercised prior to January 21, 1982, the 
absence from the plan of the $100,000 per year limit will not disqualify 
the option. ISO treatment will only be available, however, for exercised 
amounts that do not exceed the $100,000 limit. Those amounts in excess 
of the limit will be treated as non-ISO's. If it is necessary to 
``split'' an exercised option because the $100,000 limit has been 
exceeded, separate stock certificates must be issued (or reissued) no 
later than January 21, 1982, one for the ISO stock and one for the non-
ISO stock. If the option was not exercised prior to January 21, 1982, 
the rules of A-18 will apply.
    Q-15: Is an option granted during the years 1976 through 1980, and 
exercised during 1981, eligible for ISO treatment if, at the time of 
exercise, the option, either alone or in conjunction with similarly 
granted options, exceeded the $50,000 per year limit (or the $200,000 
aggregate limit) on ISO grants (see A-3)?
    A-15: If the option was exercised prior to January 21, 1982, the 
fact that the aggregate fair market value of the stock exceeded the 
$50,000 per year limit (or the $200,000 aggregate limit) will not 
prevent the election of up to $50,000 of the option as an ISO (subject 
to the $200,000 aggregate limit). Those amounts in excess of the 
applicable dollar limits cannot be elected as ISO's. If it is necessary 
to ``split'' an exercised option because the applicable dollar limits 
have been exceeded, separate stock certificates must be issued (or 
reissued) no later than January 21, 1982, one for the ISO stock and one 
for the non-ISO stock (see also A-7). If the option was not exercised 
prior to January 21, 1982, the rules of A-18 will apply.
    Q-16: Do the $100,000 per year limit (see A-2(c)(8)), and the 
$50,000 per year and $200,000 aggregate limits (see A-3) apply to all 
options granted to an employee or only to elected and qualifying ISO's?
    A-16: All three limits apply only to elected and qualifying ISO's.
    Q-17: Do the $100,000 per year limit (see A-2(c)(8)), and the 
$50,000 per year and $200,000 aggregate limits (see A-3) apply to the 
fair market value of the stock granted, or to the option price of the 
options granted?
    A-17: The dollar limits apply to the fair market value of the stock 
granted. Thus, an employee who is also a 10 percent shareholder would be 
permitted to receive an ISO grant to purchase $100,000 worth of stock at 
an option price of $110,000 (see A-2(c)(6)).
    Q-18: How do the $100,000 per year limit (see A-2(c)(8)), and the 
$50,000 per year and $200,000 aggregate limits (see A-3) apply to an 
option granted on or after January 1, 1976, and not exercised prior to 
January 21, 1982?
    A-18: Such an option will not qualify for ISO treatment if, at the 
time it is exercised, the option amount is in excess of the applicable 
dollar limit. In order for such an option to qualify for ISO treatment, 
it must be ``split'' into an ISO and a non-ISO portion so that the ISO 
portion of the option does not exceed the applicable dollar limit. This 
option ``split'' must be accomplished prior to the exercise of the 
original option and the ISO portion of the option must be clearly

[[Page 202]]

identified. Any ``split'' option that was required, by its original 
terms, to be exercised in full, will still be required to be exercised 
in full after it is ``split.'' Upon the exercise of a ``split'' option, 
separate stock certificates must be issued--one for the ISO stock and 
one for the non-ISO stock. Additionally, if the option was granted on or 
after January 1, 1981, the terms of the plan pursuant to which the 
option was granted must be amended to add the $100,000 per year limit--
before the option is exercised.
    Q-19: How does the $50,000 per year limit (see A-3) apply to the 
case of an employee who was granted $100,000 of options in 1979, and who 
proposes to exercise these options $50,000 in 1982 and $50,000 in 1983?
    A-19: Only $50,000 (valued as of the date of grant) of the stock for 
which options were granted in 1979 will be eligible for ISO treatment. 
The $50,000 per year limit relates only to the year of grant, not to the 
year of vesting (as in the case of installment options) or exercise. 
Additionally, no carryover provision applies to the $50,000 per year 
limit. Thus, even if the employee had not been granted any options in 
prior years, the result described above would not change.
    Q-20: Is it permissible for a corporation to grant ISO's and non-
ISO's under the same plan, or must such options be granted pursuant to 
separate plans?
    A-20: Both ISO's and non-ISO's may be granted pursuant to one plan 
so long as such plan, by its terms, meets all of the ISO qualification 
requirements (see A-2 (c)). Additionally, each option granted pursuant 
to such a ``dual'' plan must be clearly identified as to its status, 
i.e., ISO or non-ISO.
    Q-21: May a single option agreement, issued pursuant to a plan, 
grant both ISO's and non-ISO's, or must such option agreements grant 
either only ISO's or only non-ISO's?
    A-21: Both ISO's and non-ISO's may be granted pursuant to a single 
option agreement, so long as each option is clearly identified as to its 
status, i.e., ISO or non-ISO, and none of the options are subject to a 
``tandem'' exercise arrangement (see A-39).
    Q-22: When either amending an existing plan or creating a new plan 
that is to grant ISO's, is it necessary under the ISO qualification 
requirements (see A-2(c)) to specify only the aggregate number of total 
shares issuable under the plan, or must the aggregate numbers of ISO's 
and non-ISO's be specified?
    A-22: Only the aggregate number of total shares issuable under the 
plan must be specified.
    Q-23: Must either an option, or the plan pursuant to which the 
option is granted, contain a specific provision restricting the exercise 
of any ISO to within 3 months of termination of the employee's 
employment (see A-2(b))?
    A-23: No. An otherwise eligible option will receive ISO treatment if 
it is, in fact, exercised within 3 months of termination of the 
employee's employment (except in cases of disability or death). 
Moreover, an option term that permits exercise beyond 3 months after 
termination of employment, will not disqualify an option from receiving 
ISO treatment.
    Q-24: In order for an option to be eligible for ISO treatment, the 
option price must equal or exceed the fair market value of the stock 
subject to the option when the option is granted. This requirement will 
be deemed to have been satisfied if, at the time of grant, there was a 
good faith attempt to accurately value the stock--even if such valuation 
should subsequently prove to be in error (see A-2(c)(4)). Do similar 
good faith rules apply to the $100,000 per year and 50 percent carryover 
limits (see A-2(c)(8)), and the $50,000 per year and $200,000 aggregate 
limits (see A-3) relating to the value of ISO options granted per 
employee?
    A-24: Yes.

                   Required Option and Plan Amendments

    Q-25: What types of amendments, under the transitional rule 
governing changes in the terms of options and plans (see A-3), will not 
invoke the application of section 425(h)?
    A-25: The transitional rule waives the applicability of section 
425(h) only with respect to amendments which are necessary in order to 
permit an option or plan to meet the minimum qualification requirements 
of section 422A (see A-2(c)). Amendments to add or delete permissible 
terms (such as the right to use previously acquired corporate stock to 
exercise the option) do not fall within the waiver of section 425(h).
    Q-26: Is an option granted after August 13, 1981, under a plan (or 
option terms) which fails to meet the qualification requirements of 
section 422A (see A-2(c)), eligible for ISO treatment?
    A-26: No. However, prior to being exercised, such an option (or its 
plan) may be amended to meet the qualification requirements of section 
422A and thus become eligible for ISO treatment. All such amendments, 
where an option is granted after August 13, 1981, will be subject to the 
rules of section 425(h) (see A-3). Thus, for example, if an option is 
granted on September 1, 1981, it may qualify as an ISO only if it is 
amended, and the option price is at least equal to the fair market value 
of the stock as of the amendment date.
    Q-27: May the terms of an outstanding option that was granted on or 
after January 1, 1981, and that automatically qualified for ISO 
treatment, be selectively amended so as to disqualify the option from 
receiving ISO treatment? May the option be cancelled?
    A-27: Yes. However, despite either the cancellation of the option or 
any disqualifying amendment to the option (or the plan pursuant to which 
the option was granted), the original option will, for purposes of the 
ISO sequential exercise restriction, be treated as an outstanding ISO 
until such option, by its

[[Page 203]]

original terms, expires by reason of lapse of time (see A-2(c)(7)).
    Q-28: May a non-ISO plan be amended so as to qualify only 
prospectively granted options for ISO treatment?
    A-28: Yes. Amendments to a non-ISO plan, so as to meet the section 
422A qualification requirements (see A-2(c)), will only apply to 
previously granted and outstanding options when such amendments, by 
their terms, are clearly intended to have retroactive effect.
    Q-29: If a corporation grants new ISO's in exchange for the 
cancellation of outstanding non-ISO's, will such an exchange violate 
either the 422A qualification requirements (see A-2(c)) or the 
transition rules (see A-3)?
    A-29: No, so long as such an exchange does not constitute a 
``tandem'' exercise arrangement (see A-39).

                       Shareholder Approval Issues

    Q-30: If a plan received shareholder approval within 12 months 
before or after the date such plan was originally adopted and it is 
being amended to conform to the qualification requirements of section 
422A (see A-2(c)), will new shareholder approval be required?
    A-30: For purposes of the section 422A qualification requirements, 
new shareholder approval will be required only if the original plan did 
not specify the aggregate number of issuable shares or identify the 
eligible employees (or class of employees).
    Q-31: Does the amendment of a plan to add the $100,000 per year and 
50 percent carryover limits (see A-2(c)(8)), relating to options granted 
on or after January 1, 1981, require new shareholder approval?
    A-31: No.
    Q-32: If a plan never received shareholder approval, or did not 
receive such approval within 12 months before or after the plan was 
adopted, will such plan conform to the qualification requirements of 
section 422A (see A-2(c)) if shareholder approval is obtained prior to 
August 14, 1982?
    A-32: Yes, but only if an option granted pursuant to the plan was 
outstanding on August 13, 1981 (see A-3). If no option granted pursuant 
to the plan was outstanding on August 13, 1981, such plan must be re-
adopted by the granting corporation and, if necessary, amended to meet 
the section 422A qualification requirements. Shareholder approval must 
be obtained within 12 months before or after the date the plan is re-
adopted. Consequently, any option granted after August 13, 1981, and 
before the date the plan is re-adopted, will be treated as newly granted 
on the date of re-adoption of the plan.
    Q-33: If an option was granted pursuant to no plan at all and the 
option was outstanding on August 13, 1981, may a plan now be instituted 
and shareholder approval obtained, as part of the amendments permitted 
under the transitional rules (see A-3)?
    A-33: Yes.
    Q-34: Assuming that shareholder approval is required with respect to 
certain amendments made to conform an option outstanding on August 13, 
1981 (or its plan), to the qualification requirements of section 422A 
(see A-2(c)), may such option be exercised prior to securing shareholder 
approval and still be eligible for ISO treatment?
    A-34: Yes, so long as shareholder approval is secured within the 
one-year period specified by the transitional rules (see A-3).

                       Sequential Exercise Issues

    Q-35: Will the existence (or exercise) of prior stock options which 
are neither elected nor qualified to receive ISO treatment, ever prevent 
the exercise of an ISO under the 422A sequential exercise restriction 
(see A-2)?
    A-35: No. However, if an option that is either elected or qualified 
to receive ISO treatment, contains sequencing restrictions that refer to 
options other than ISO's, the option will continue to be burdened by 
such restrictions. The deletion of such non-ISO sequencing restrictions 
from the option is not an amendment necessary in order to qualify an 
option for ISO treatment as permitted by the transitional rules (see A-
3). Consequently, section 425(h) would be applicable to such an 
amendment.
    Q-36: Under the sequencing rules applicable to section 422 qualified 
stock options, an option was permitted to be exercised out of sequence 
so long as it was issued at a higher price than prior outstanding 
options (section 422(c)(6)). Will a similar exception to the sequencing 
restriction be applicable to ISO's?
    A-36: No. Section 422A does not contain such an exception to the 
sequencing restriction.
    Q-37: How does the section 422A sequential exercise restriction (see 
A-2(c)(7)) apply to an ISO granted in one year that, by its terms, can 
only be exercised in installments over a period of years?
    A-37: Such an installment ISO is the grant of a single option. The 
section 422A sequential exercise restriction would restrict the exercise 
of any later-granted ISO until either the exercise or expiration of all 
installments of this earlier-granted ISO.
    Q-38: Assume that an option granted and exercised during January of 
1982 automatically qualifies, by its terms, for ISO treatment. During 
February of 1982, the same employee exercised a second option, one that 
had been granted during 1978. Prior to the exercise of the 1978 option, 
it was amended under the transitional rules (see A-3) so that it would 
conform to the section 422A qualification requirements (see A-2(c)). If 
the 1978 option is properly elected to receive ISO treatment (see A-4), 
will such an election adversely affect the 1982 option's status as an 
ISO?
    A-38: Yes. The election of the 1978 option to receive ISO treatment 
will automatically disqualify the 1982 option. If the 1982 option

[[Page 204]]

is to qualify as an ISO, it cannot be exercised prior to the exercise or 
expiration of all ISO's previously granted and outstanding on the 1982 
option's date of grant (see A-2(c)(7)). When the 1982 option was granted 
during January of 1982, the 1978 option was already granted and 
outstanding for purposes of the section 422A sequential exercise 
restriction.

           Receipt of Property or Cash Upon Exercise of an ISO

    Q-39: Section 422A provides that ISO treatment will be available 
even though the employee has the right to receive cash or other property 
at the time of the exercise of the option, so long as such property is 
subject to inclusion in income under section 83 (see A-2(d)(3)). To what 
extent does section 422A permit the use of tandem options and stock 
appreciation rights (SARs) in connection with ISO's?
    A-39: A tandem stock option, wherein two options are issued together 
and the exercise of one affects the right to exercise the other, is not 
permitted because such a tandem option arrangement may be used to evade 
the section 422A qualification requirements (see A-2(c)).
A tandem ISO-SAR, wherein an ISO and an SAR are granted together and the 
exercise of one affects the right to exercise the other, is permitted so 
long as the SAR, by its terms, meets the following requirements:
    (a) The SAR will expire no later than the expiration of the 
underlying ISO.
    (b) The SAR may be for no more than 100% of the spread, i.e., the 
difference between the exercise price of the underlying option and the 
market price of the stock subject to the underlying option at the time 
the SAR is exercised.
    (c) The SAR is transferable only when the underlying ISO is 
transferable, and under the same conditions.
    (d) The SAR may be exercised only when the underlying ISO is 
eligible to be exercised.
    (e) The SAR may be exercised only when there is a positive spread, 
i.e., when the market price of the stock subject to the option exceeds 
the exercise price of the option.
If all of the above requirements are met, for purposes of the 422A 
sequential exercise restriction (see A-2(c)(7)), a tandem ISO-SAR will 
be considered exercised in full when either the underlying ISO or the 
SAR is exercised. Additionally, SAR's may be paid in either cash or 
property, or a combination thereof, so long as the section 83 income 
inclusion rule applies to any property so transferred.

[T.D. 7799, 46 FR 61840, Dec. 21, 1981, as amended by T.D. 8435, 57 FR 
43896, Sept. 23, 1992]



PART 15--TEMPORARY INCOME TAX REGULATIONS RELATING TO EXPLORATION EXPENDITURES IN THE CASE OF MINING--Table of Contents




Sec.
15.0-1  Scope of regulations in this part.
15.1-1  Elections to deduct.
15.1-2  Revocation of election to deduct.
15.1-3  Elections as to method of recapture.
15.1-4  Special rules.

    Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805.

    Source: T.D. 6907, 31 FR 16776, Dec. 31, 1966, unless otherwise 
noted.



Sec. 15.0-1  Scope of regulations in this part.

    The regulations in this part relate to expenditures of the type 
described in section 615(a) or in section 617(a)(1) paid or incurred 
after September 12, 1966. The regulations in this part do not apply to 
the income tax treatment of mining exploration expenditures paid or 
incurred before September 13, 1966, and no election made pursuant to the 
provisions of the regulations in this part shall have any effect on the 
income tax treatment of exploration expenditures paid or incurred before 
such date. See Sec. 15.1-4 for rules relating to treatment of 
exploration expenditures paid or incurred during taxable years beginning 
before September 13, 1966, and ending after September 12, 1966.



Sec. 15.1-1  Elections to deduct.

    (a) Manner of making election--(1) Election to deduct under section 
617(a). The election to deduct exploration expenditures as expenses 
under section 617(a) may be made by deducting such expenditures in the 
taxpayer's income tax return for the first taxable year ending after 
September 12, 1966, for which the taxpayer desires to deduct exploration 
expenditures which are paid or incurred by him during such taxable year 
and after September 12, 1966. This election may be exercised by 
deducting such expenditures either in the taxpayer's return for such 
taxable year or in an amended return filed before the expiration of the 
period for filing a claim for credit or refund of income tax for such 
taxable year. Where

[[Page 205]]

the election is made in an amended return for a taxable year prior to 
the most recent year for which the taxpayer has filed a return, the 
taxpayer shall file amended income tax returns, reflecting any increase 
or decrease in tax attributable to the election, for all taxable years 
affected by the election. See section 617(a)(2)(C) for provisions 
relating to the tolling of the statute of limitations for the assessment 
of any deficiency for any taxable year, to the extent the deficiency is 
attributable to an election under section 617(a). In applying the 
election to the years affected there shall be taken into account the 
effect that any adjustments resulting from the election shall have on 
other items affected thereby, such as the deduction for charitable 
contributions, the foreign tax credit, net operating loss and other 
deductions or credits the amount of which is limited by the taxpayer's 
taxable income, and the effect that adjustments of any such items have 
on other taxable years. Amended returns filed for taxable years 
subsequent to the taxable year for which the election under section 
617(a) is made by amended return shall apply the recapture provisions of 
subsections (b)(1)(B), (c), and (d) of section 617.
    (2) Election to deduct under section 615--(i) General rule. The 
election to deduct exploration expenditures under section 615 shall be 
made in a statement filed with the district director, or director of the 
regional service center, with whom the taxpayer's income tax return is 
required to be filed. If the election is made within the time period 
prescribed for filing an income tax return (including extensions 
thereof) for the first taxable year ending after September 12, 1966, 
during which the taxpayer pays or incurs expenditures which are within 
the scope of section 615 and which are paid or incurred by him after 
September 12, 1966, this statement shall be attached to the taxpayer's 
income tax return for such taxable year. If the election is made after 
the time prescribed for filing such return but before the expiration of 
the period (described in paragraph (d)(1) of this section) for making 
the election under section 615(e), the statement must be signed by the 
taxpayer or his authorized representative. The statement shall be filed 
even though the taxpayer charges to capital account all such 
expenditures paid or incurred by him during such taxable year after such 
date. The statement shall clearly indicate that the taxpayer elects to 
have section 615 apply to all amounts deducted by him with respect to 
mining exploration expenditures paid or incurred after September 12, 
1966. If the taxpayer desires, he may file this statement by attaching 
it to his return for a taxable year prior to the first taxable year 
ending after September 12, 1966, in which he pays or incurs mining 
exploration expenditures. Except as provided, in subdivision (ii) of 
this subparagraph, if the taxpayer does not file such a statement within 
the period prescribed by section 615(e) and paragraph (d)(1) of this 
section, any amounts deducted by him with respect to exploration 
expenditures paid or incurred by him after September 12, 1966, will be 
deemed to have been deducted pursuant to an election under section 
617(a).
    (ii) Exception. The last sentence of subdivision (i) of this 
subparagraph shall not apply if all mining exploration expenditures 
which are paid or incurred by the taxpayer after September 12, 1966, and 
which are deducted by him in his income tax return for the first taxable 
year ending after September 12, 1966, during which he pays or incurs 
such expenditures are outside the scope of section 617(a). For example, 
assume that, in his return for his first taxable year ending after 
September 12, 1966, a taxpayer deducts mining exploration expenditures 
paid or incurred after September 12, 1966, and does not attach to his 
return the statement described in subdivision (i) of this subparagraph. 
However, all of the exploration expenditures paid or incurred by the 
taxpayer after September 12, 1966, and before the end of the taxable 
year were paid or incurred with respect to minerals located neither in 
the United States nor on the Outer Continental Shelf. The taxpayer will 
be deemed to have made an election under section 615(e) by deducting all 
or part of those expenditures as expenses in his income tax return.

[[Page 206]]

    (b) Information to be furnished. A taxpayer who makes or has made an 
election under either section 615(e) or section 617(a) to deduct 
expenditures paid or incurred after September 12, 1966, shall indicate 
clearly on his income tax return for each taxable year for which he 
deducts any such expenditures the amount of the deduction claimed under 
section 615 (a) or (b) or section 617(a) with respect to each property 
or area of interest. Such property or area of interest shall be 
identified by a description sufficiently adequate to permit application 
of the recapture rules of section 617 (b), (c), and (d) and the rules of 
section 615(g) (relating to effect of transfer of mineral property).
    (c) Effect of election. A taxpayer who has made an election under 
section 615(e) may never make an election under section 617(a) unless, 
within the period set forth in section 615(e) and paragraph (b)(1) of 
Sec. 15.1-2, he revokes his election under section 615(e). A taxpayer 
who has made an election under section 617(a) may never make an election 
under section 615(e) unless, within the period set forth in section 
615(e) and paragraph (b)(1) of Sec. 15.1-2, he revokes his election 
under section 617(a). A taxpayer who has made, and has not revoked, an 
election under section 617(a) may not, in his return for the taxable 
year for which the election is made or for any subsequent taxable year, 
charge to capital account any expenditures which are within the scope of 
section 617(a), and he must deduct all such expenditures as expenses. 
Except as provided in paragraph (a)(2) of Sec. 1.615-2 of this chapter 
(Income Tax Regulations), a taxpayer who makes an election under 615(e) 
may not change his treatment of exploration expenditures deducted, 
deferred, or capitalized pursuant to such election unless he revokes the 
election made under section 615(e).
    (d) Time for making election--(1) Election under section 615(e). A 
taxpayer may not make an election under section 615(e) after the 
expiration of the 3-year period beginning with the date prescribed by 
section 6072 or other provision of law for filing the taxpayer's income 
tax return for the first taxable year ending after September 12, 1966, 
in which the taxpayer pays or incurs expenditures to which section 
615(a) would apply if an election were made under section 615(e). This 
3-year period shall be determined without regard to any extension of 
time for filing the taxpayer's income tax return. An election under 
section 615(e) may not be made after the expiration of the 3-year period 
even though the taxpayer charged to capital account, or erroneously 
deducted as development expenditures under section 616, all mine 
exploration expenditures paid or incurred by him after September 12, 
1966, and before the end of his first taxable year ending after 
September 12, 1966, in which he paid or incurred such expenditures.
    (2) Election under section 617(a). The election under section 617(a) 
may be made at any time before the expiration of the period prescribed 
for filing a claim for credit or refund of the tax imposed by chapter 1 
for the first taxable year for which the taxpayer desires to deduct 
exploration expenditures under section 617.
    (3) Timely mailing treated as timely filing. Section 7502 (relating 
to timely mailing treated as timely filing) shall apply in determining 
the date when an election under either section 615(e) or section 617(a) 
is made.



Sec. 15.1-2  Revocation of election to deduct.

    (a) Manner of revoking election. A taxpayer may revoke an election 
made by him under section 615(e) or section 617(a) by filing with the 
internal revenue officer with whom the taxpayer's income tax return is 
required to be filed, within the periods set forth in paragraph (b) of 
this section, a statement, signed by the taxpayer or his authorized 
representative, which sets forth that the taxpayer is revoking the 
election previously made by him with respect to the deduction of mining 
exploration expenditures paid or incurred after September 12, 1966, and 
states with whom the document making the election was filed. A taxpayer 
revoking such an election shall file amended income tax returns, 
reflecting any increase or decrease in tax attributable to the 
revocation of election, for all taxable years affected by the revocation 
of election. See section 617(a)(2)(C)

[[Page 207]]

for provisions relating to the tolling of the statute of limitations for 
the assessment of any deficiency for any taxable year, to the extent the 
deficiency is attributable to an election or revocation of election 
under section 617(a). In applying the revocation of an election to the 
years affected there shall be taken into account the effect that any 
adjustments resulting from the revocation of election shall have on 
other items affected thereby, such as the deduction for charitable 
contributions, the foreign tax credit, net operating loss, and other 
deductions or credits the amount of which is limited by the taxpayer's 
taxable income, and the effect that adjustments of any such items have 
on other taxable years.
    (b) Time for revoking election--(1) Election under section 615(e). 
An election under section 615(e) may be revoked at any time before the 
expiration of the 3-year period described in paragraph (d)(1) of 
Sec. 15.1-1. Such an election may not be revoked after the expiration of 
the 3-year period.
    (2) Election under section 617(a). An election under section 617(a) 
may be revoked before the expiration of the last day of the third month 
following the month in which the final regulations issued under the 
authority of section 617 are published in the Federal Register. After 
the expiration of this period, a taxpayer who has made an election under 
section 617(a) may not revoke that election unless he obtains the 
consent of the Secretary or his delegate in the manner to be set forth 
in the final regulations under section 617.
    (c) Additional information to be furnished by a transferor of 
mineral property. If, before revoking his election, the taxpayer has 
transferred any mineral property with respect to which he deducted 
exploration expenditures paid or incurred after September 12, 1966, to 
another person in a transaction as a result of which the basis of such 
property in the hands of the transferee is determined by reference to 
the basis in the hands of the transferor, the statement submitted 
pursuant to paragraph (a) of this section shall state that such property 
has been so transferred and shall identify the transferee, the property 
transferred, and the date of the transfer.



Sec. 15.1-3  Elections as to method of recapture.

    (a) In general. If the taxpayer so elects with respect to all mines 
with respect to which deductions have been allowed under section 617(a) 
and which reach the producing stage during a taxable year, he shall 
include in gross income for the taxable year an amount equal to the 
adjusted exploration expenditures with respect to such mines (determined 
under section 617(f)(1)). The amount so included in income shall be 
treated for purposes of Subtitle A of the Internal Revenue Code as 
expenditures which are paid or incurred on the respective dates on which 
the mines reach the producing stage and which are properly chargeable to 
capital account. If the taxpayer does not make this election for a 
taxable year during which any mine with respect to which deductions have 
been allowed under section 617(a) reaches the producing stage, the 
deduction for depletion under section 611 with respect to the property 
(whether determined under Sec. 1.611-2 of this chapter (Income Tax 
Regulations) or under section 613) shall be disallowed until the amount 
of depletion which would be allowable but for section 617(b)(1)(B) 
equals the amount of the adjusted exploration expenditures with respect 
to the mine. The fact that a taxpayer does not make the election 
described in the first sentence of this paragraph for a taxable year 
during which mines with respect to which deductions have been allowed 
under section 617(a) reach the producing stage shall not preclude the 
taxpayer from making the election with respect to other mines which 
reach the producing stage during a subsequent taxable year. However, an 
election may not be made for any taxable year with respect to any mines 
which reached the producing stage during a preceding taxable year.
    (b) Manner of making elections. A taxpayer will be considered to 
have made an election in accordance with the manner in which the 
adjusted exploration expenditures with respect to the mines reaching the 
producing stage during a taxable year are treated in his return for such 
taxable year.
    (c) Time for making election. The election described in paragraph 
(a) of this

[[Page 208]]

section may be made, or changed by filing an amended return, not later 
than the time prescribed by law for filing the return (including 
extensions thereof) for the taxable year.



Sec. 15.1-4  Special rules.

    (a) Taxable years beginning before September 13, 1966, and ending 
after September 12, 1966--(1) General rule. An election made under 
section 615(e) or section 617(a) applies only to expenditures paid or 
incurred after September 12, 1966. The income tax treatment of 
exploration expenditures paid or incurred before September 13, 1966, 
will be determined in accordance with the provisions of section 615 
prior to its amendment by the Act of September 12, 1966 (Pub. L. 89-570, 
80 Stat. 759). If a taxpayer makes an election under section 615(e) in 
his income tax return for a taxable year beginning before September 13, 
1966, and ending after September 12, 1966, amounts deducted under 
section 615 with respect to expenditures paid or incurred during such 
taxable year but before September 13, 1966, will be taken into account 
in determining whether the $100,000 limitation set forth in section 
615(a) is reached during 1966. Similarly, a taxpayer making an election 
under section 615(e) shall take into account expenditures deducted under 
section 615 for periods prior to September 13, 1966, in determining when 
the $400,000 overall limitation set forth in section 615(c) is reached. 
The fact that a taxpayer deducts under section 615 expenditures paid or 
incurred prior to September 13, 1966, shall not affect his right to make 
an election under section 617(a) to deduct under section 617 
expenditures paid or incurred after September 12, 1966.
    (2) Allocation in case of inadequate records. If a taxpayer pays or 
incurs exploration expenditures during a taxable year beginning before 
September 13, 1966, and ending after September 12, 1966, but his records 
as to any mine or property are inadequate to permit a determination of 
the amount paid or incurred during the portion of the year ending after 
September 12, 1966, and the amount paid or incurred on or before such 
date, the exploration expenditures as to which the records are 
inadequate paid or incurred with respect to the mine or property during 
the taxable year shall be allocated to each part year (that is, the part 
occurring before September 13, 1966, and the part occurring after 
September 12, 1966) in the ratio which the number of days in such part 
year bears the number of days in the entire taxable year. For example, 
if the records of a calendar year taxpayer for 1966 are inadequate to 
permit a determination of the amount of exploration expenditures paid or 
incurred with respect to a certain mine or property after September 12, 
1966, and the amount paid or incurred before September 13, 1966, \255/
365\ of the total exploration expenditures paid or incurred by the 
taxpayer with respect to the mine or property during 1966 shall be 
allocated to the period beginning January 1, 1966, and ending September 
12, 1966, and \110/365\ of the total exploration expenditures paid or 
incurred with respect to the mine or property during 1966 shall be 
allocated to the period beginning September 13, 1966, and ending 
December 31, 1966.
    (3) Partnership elections. With respect to exploration expenditures 
paid or incurred by a partnership before September 13, 1966, the option 
to deduct under section 615(a) and the election to defer under section 
615(b) shall be made by the partnership, rather than by the individual 
partners. All elections under sections 615(e), 617(a), or 617(b) as to 
the tax treatment of a partner's distributive share of exploration 
expenditures paid or incurred by any partnership of which he is a member 
shall be made by the individual partner, rather than by the partnership.
    (b) Effect of transfer of mineral property. The binding effect of a 
taxpayer's election under section 615(e) shall not be affected by his 
receiving property with respect to which deductions have been allowed 
under section 617(a). The binding effect of a taxpayer's election under 
section 617(a) shall not be affected by his receiving property with 
respect to which deductions have been allowed under section 615 pursuant 
to an election made under section 615(e). However, see section 615(g)(2) 
for rules under which amounts deducted under section 615 by a transferor 
may be subject to recapture in the hands of a

[[Page 209]]

transferee who has made an election under section 617(a).



PART 15a--TEMPORARY INCOME TAX REGULATIONS UNDER THE INSTALLMENT SALES REVISION ACT--Table of Contents




Sec.
15a.453-0  Taxable years affected.
15a.453-1  Installment method reporting for sales of real property and 
          casual sales of personal property.
15a.453-2  Installment obligations received as liquidating distribution. 
          [Reserved]

    Authority: 26 U.S.C. 453(i) and 7805.



Sec. 15a.453-0  Taxable years affected.

    (a) In general. Except as otherwise provided, the provisions of 
Sec. 15a.453-1 (a) through (e) generally apply to installment method 
reporting for sales of real property and casual sales of personal 
property occurring after October 19, 1980. See 26 CFR Sec. 1.453-1 (rev. 
as of April 1, 1980) for the provisions relating to installment method 
reporting for sales of real property and casual sales before October 20, 
1980 (except as provided in paragraph (b) of this section) and for 
provisions relating to installment sales by dealers in personal property 
occurring before October 20, 1980.
    (b) Certain limitations. The provisions of prior law (section 453(b) 
of the Internal Revenue Code of 1954, in effect as of October 18, 1980) 
which required that the buyer receive no more than 30 percent of the 
selling price in the taxable year of the installment sale and that at 
least two payments be received shall not apply to reporting for casual 
installment sales of personal property and installment sales of real 
property occurring in a taxable year ending after October 19, 1980.

[T.D. 7768, 46 FR 10709, Feb. 4, 1981; 46 FR 43036, Aug. 26, 1981]



Sec. 15a.453-1  Installment method reporting for sales of real property and casual sales of personal property.

    (a) In general. Unless the taxpayer otherwise elects in the manner 
prescribed in paragraph (d)(3) of this section, income from a sale of 
real property or a casual sale of personal property, where any payment 
is to be received in a taxable year after the year of sale, is to be 
reported on the installment method.
    (b) Installment sale defined--(1) In general. The term ``installment 
sale'' means a disposition of property (except as provided in paragraph 
(b)(4) of this section) where at least one payment is to be received 
after the close of the taxable year in which the disposition occurs. The 
term ``installment sale'' includes dispositions from which payment is to 
be received in a lump sum in a taxable year subsequent to the year of 
sale. For purposes of this paragraph, the taxable year in which payments 
are to be received is to be determined without regard to section 453(e) 
(relating to related party sales), section (f)(3) (relating to the 
definition of a ``payment'') and section (g) (relating to sales of 
depreciable property to a spouse or 80-percent-owned entity).
    (2) Installment method defined--(i) In general. Under the 
installment method, the amount of any payment which is income to the 
taxpayer is that portion of the installment payment received in that 
year which the gross profit realized or to be realized bears to the 
total contract price (the ``gross profit ratio''). See paragraph (c) of 
this section for rules describing installment method reporting of 
contingent payment sales.
    (ii) Selling price defined. The term ``selling price'' means the 
gross selling price without reduction to reflect any existing mortgage 
or other encumbrance on the property (whether assumed or taken subject 
to by the buyer) and, for installment sales in taxable years ending 
after October 19, 1980, without reduction to reflect any selling 
expenses. Neither interest, whether stated or unstated, nor original 
issue discount is considered to be a part of the selling price. See 
paragraph (c) of this section for rules describing installment method 
reporting of contingent payment sales.
    (iii) Contract price defined. The term ``contract price'' means the 
total contract price equal to selling price reduced by that portion of 
any qualifying indebtedness (as defined in paragraph (b)(2)(iv) of this 
section), assumed or taken subject to by the buyer, which does not 
exceed the seller's basis in the property (adjusted, for installment

[[Page 210]]

sales in taxable years ending after October 19, 1980, to reflect 
commissions and other selling expenses as provided in paragraph 
(b)(2)(v) of this section). See paragraph (c) of this section for rules 
describing installment method reporting of contingent payment sales.
    (iv) Qualifying indebtedness. The term ``qualifying indebtedness'' 
means a mortgage or other indebtedness encumbering the property and 
indebtedness, not secured by the property but incurred or assumed by the 
purchaser incident to the purchaser's acquisition, holding, or operation 
in the ordinary course of business or investment, of the property. The 
term ``qualifying indebtedness'' does not include an obligation of the 
taxpayer incurred incident to the disposition of the property (e.g., 
legal fees relating to the taxpayer's sale of the property) or an 
obligation functionally unrelated to the acquisition, holding, or 
operating of the property (e.g., the taxpayer's medical bill). Any 
obligation created subsequent to the taxpayer's acquisition of the 
property and incurred or assumed by the taxpayer or placed as an 
encumbrance on the property in contemplation of disposition of the 
property is not qualifying indebtedness if the arrangement results in 
accelerating recovery of the taxpayer's basis in the installment sale.
    (v) Gross profit defined. The term ``gross profit'' means the 
selling price less the adjusted basis as defined in section 1011 and the 
regulations thereunder. For sales in taxable years ending after October 
19, 1980, in the case of sales of real property by a person other than a 
dealer and casual sales of personal property, commissions and other 
selling expenses shall be added to basis for purposes of determining the 
proportion of payments which is gross profit attributable to the 
disposition. Such additions to basis will not be deemed to affect the 
taxpayer's holding period in the transferred property.
    (3) Payment--(i) In general. Except as provided in paragraph (e) of 
this section (relating to purchaser evidences of indebtedness payable on 
demand or readily tradable), the term ``payment'' does not include the 
receipt of evidences of indebtedness of the person acquiring the 
property (``installment obligation''), whether or not payment of such 
indebtedness is guaranteed by a third party (including a government 
agency). For special rules regarding the receipt of an evidence of 
indebtedness of a transferee of a qualified intermediary, see 
Secs. 1.1031(b)-2(b) and 1.1031(k)-1(j)(2)(iii) of this chapter. A 
standby letter of credit (as defined in paragraph (b)(3)(iii) of this 
section) shall be treated as a third party guarantee. Payments include 
amounts actually or constructively received in the taxable year under an 
installment obligation. For a special rule regarding a transfer of 
property to a qualified intermediary followed by the sale of such 
property by the qualified intermediary, see Sec. 1.1031(k)-1(j)(2)(ii) 
of this chapter. Receipt of an evidence of indebtedness which is secured 
directly or indirectly by cash or a cash equivalent, such as a bank 
certificate of deposit or a treasury note, will be treated as the 
receipt of payment. For a special rule regarding a transfer of property 
in exchange for an obligation that is secured by cash or a cash 
equivalent held in a qualified escrow account or a qualified trust, see 
Sec. 1.1031(k)-1(j)(2)(i) of this chapter. Payment may be received in 
cash or other property, including foreign currency, marketable 
securities, and evidences or indebtedness which are payable on demand or 
readily tradable. However, for special rules relating to the receipt of 
certain property with respect to which gain is not recognized, see 
paragraph (f) of this section (relating to transactions described in 
sections 351, 356(a) and 1031). Except as provided in Sec. 15a.453-2 of 
these regulations (relating to distributions of installment obligations 
in corporate liquidations described in section 337), payment includes 
receipt of an evidence of indebtedness of a person other than the person 
acquiring the property from the taxpayer. For purposes of determining 
the amount of payment received in the taxable year, the amount of 
qualifying indebtedness (as defined in paragraph (b)(2)(iv) of this 
section) assumed or taken subject to by the person acquiring the 
property shall be included only to the extent that it exceeds the basis 
of the property (determined after adjustment to reflect selling 
expenses). For purposes

[[Page 211]]

of the preceding sentence, an arrangement under which the taxpayer's 
liability on qualifying indebtedness is eliminated incident to the 
disposition (e.g., a novation) shall be treated as an assumption of the 
qualifying indebtedness. If the taxpayer sells property to a creditor of 
the taxpayer and indebtedness of the taxpayer is cancelled in 
consideration of the sale, such cancellation shall be treated as 
payment. To the extent that cancellation is not in consideration of the 
sale, see Secs. 1.61-12(b)(1) and 1.1001-2(a)(2) relating to discharges 
of indebtedness. If the taxpayer sells property which is encumbered by a 
mortgage or other indebtedness on which the taxpayer is not personally 
liable, and the person acquiring the property is the obligee, the 
taxpayer shall be treated as having received payment in the amount of 
such indebtedness.
    (ii) Wrap-around mortgage. This paragraph (b)(3)(ii) shall apply 
generally to any installment sale after March 4, 1981 unless the 
installment sale was completed before June 1, 1981 pursuant to a written 
obligation binding on the seller that was executed on or before March 4, 
1981. A ``wrap-around mortgage'' means an agreement in which the buyer 
initially does not assume and purportedly does not take subject to part 
or all of the mortgage or other indebtedness encumbering the property 
(``wrapped indebtedness'') and, instead, the buyer issues to the seller 
an installment obligation the principal amount of which reflects such 
wrapped indebtedness. Ordinarily, the seller will use payments received 
on the installment obligation to service the wrapped indebtedness. The 
wrapped indebtedness shall be deemed to have been taken subject to even 
though title to the property has not passed in the year of sale and even 
though the seller remains liable for payments on the wrapped 
indebtedness. In the hands of the seller, the wrap-around installment 
obligation shall have a basis equal to the seller's basis in the 
property which was the subject of the installment sale, increased by the 
amount of gain recognized in the year of sale, and decreased by the 
amount of cash and the fair market value of other nonqualifying property 
received in the year of sale. For purposes of this paragraph (b)(3)(ii), 
the amount of any indebtedness assumed or taken subject to by the buyer 
(other than wrapped indebtedness) is to be treated as cash received by 
the seller in the year of sale. Therefore, except as otherwise required 
by section 483 or 1232, the gross profit ratio with respect to the wrap-
around installment obligation is a fraction, the numerator of which is 
the face value of the obligation less the taxpayer's basis in the 
obligation and the denominator of which is the face value of the 
obligation.
    (iii) Standby letter of credit. The term ``standby letter of 
credit'' means a non-negotiable, non-transferable (except together with 
the evidence of indebtedness which it secures) letter of credit, issued 
by a bank or other financial institution, which serves as a guarantee of 
the evidence of indebtedness which is secured by the letter of credit. 
Whether or not the letter of credit explicitly states it is non-
negotiable and nontransferable, it will be treated as non-negotiable and 
nontransferable if applicable local law so provides. The mere right of 
the secured party (under applicable local law) to transfer the proceeds 
of a letter of credit shall be disregarded in determining whether the 
instrument qualifies as a standby letter of credit. A letter of credit 
is not a standby letter of credit if it may be drawn upon in the absence 
of default in payment of the underlying evidence of indebtedness.
    (4) Exceptions. The term ``installment sale'' does not include, and 
the provisions of section 453 do not apply to, dispositions of personal 
property on the installment plan by a person who regularly sells or 
otherwise disposes of personal property on the installment plan, or to 
dispositions of personal property of a kind which is required to be 
included in the inventory of the taxpayer if on hand at the close of the 
taxable year. See section 453A and the regulations thereunder for rules 
relating to installment sales by dealers in personal property. A dealer 
in real property or a farmer who is not required under his method of 
accounting to maintain inventories may report the gain on the 
installment method under section 453.

[[Page 212]]

    (5) Examples. The following examples illustrate installment method 
reporting under this section:

    Example (1). In 1980, A, a calendar year taxpayer, sells Blackacre, 
an unencumbered capital asset in A's hands, to B for $100,000: $10,000 
down and the remainder payable in equal annual installments over the 
next 9 years, together with adequate stated interest. A's basis in 
Blackacre, exclusive of selling expenses, is $38,000. Selling expenses 
paid by A are $2,000. Therefore, the gross profit is $60,000 ($100,000 
selling price-$40,000 basis inclusive of selling expenses). The gross 
profit ratio is \3/5\ (gross profit of $60,000 divided by $100,000 
contract price). Accordingly, $6,000 \3/5\ of $10,000) of each $10,000 
payment received is gain attributable to the sale and $4,000 ($10,000-
$6,000) is recovery of basis. The interest received in addition to 
principal is ordinary income to A.
    Example (2). C sells Whiteacre to D for a selling price of $160,000. 
Whiteacre is encumbered by a longstanding mortgage in the principal 
amount of $60,000. D will assume or take subject to the $60,000 mortgage 
and pay the remaining $100,000 in 10 equal annual installments together 
with adequate stated interest. C's basis in Whiteacre is $90,000. There 
are no selling expenses. The contract price is $100,000, the $160,000 
selling price reduced by the mortgage of $60,000 assumed or taken 
subject to. Gross profit is $70,000 ($160,000 selling price less C's 
basis of $90,000). C's gross profit ratio is \7/10\ (gross profit of 
$70,000 divided by $100,000 contract price). Thus, $7,000 (\7/10\ of 
$10,000) of each $10,000 annual payment is gain attributable to the 
sale, and $3,000 ($10,000-$7,000) is recovery of basis.
    Example (3). The facts are the same as in example (2), except that 
C's basis in the land is $40,000. In the year of the sale C is deemed to 
have received payment of $20,000 ($60,000-$40,000, the amount by which 
the mortgage D assumed or took subject to exceeds C's basis). Since 
basis is fully recovered in the year of sale, the gross profit ratio is 
1 ($120,000/$120,000) and C will report 100% of the $20,000 deemed 
payment in the year of sale and each $10,000 annual payment as gain 
attributable to the sale.
    Example (4). E sells Blackacre, an unencumbered capital gain 
property in E's hands, to F on January 2, 1981. F makes a cash down 
payment of $500,000 and issues a note to E obliging F to pay an 
additional $500,000 on the fifth anniversary date. The note does not 
require a payment of interest. In determining selling price, section 483 
will apply to recharacterize as interest a portion of the $500,000 
future payment. Assume that under section 483 and the applicable 
regulations $193,045 is treated as total unstated interest, and the 
selling price is $806,955 ($1 million less unstated interest). Assuming 
E's basis (including selling expenses) in Blackacre is $200,000) gross 
profit is $606,955 ($806,955-$200,000) and the gross profit ratio is 
75.21547%. Accordingly, of the $500,000 cash down payment received by E 
in 1981, $376,077 (75.21547% of $500,000) is gain attributable to the 
sale and $123,923 is recovery of basis ($500,000-$376,077).
    Example (5). In 1982, G sells to H Blackacre, which is encumbered by 
a first mortgage with a principal amount of $500,000 and a second 
mortgage with a principal amount of $400,000, for a selling price of $2 
million. G's basis in Blackacre is $700,000. Under the agreement between 
G and H, passage of title is deferred and H does not assume and 
purportedly does not take subject to either mortgage in the year of 
sale. H pays G $200,000 in cash and issues a wrap-around mortgage note 
with a principal amount of $1,800,000 bearing adequate stated interest. 
H is deemed to have acquired Blackacre subject to the first and second 
mortgages (wrapped indebtedness) totalling $900,000. The contract price 
is $1,300,000 (selling price of $2 million less $700,000 mortgages 
within the seller's basis assumed or taken subject to). Gross profit is 
also $1,300,000 (selling price of $2 million less $700,000 basis). 
Accordingly in the year of sale, the gross profit ratio is 1 
($1,300,000/$1,300,000). Payment in the year of sale is $400,000 
($200,000 cash received plus $200,000 mortgage in excess of basis 
($900,000-$700,000)). Therefore, G recognizes $400,000 gain in the year 
of sale ($400,000x1). In the hands of G the wrap-around installment 
obligation has a basis of $900,000, equal to G's basis in Blackacre 
($700,000) increased by the gain recognized by G in the year of sale 
($400,000) reduced by the cash received by G in the year of sale 
($200,000). G's gross profit with respect to the note is $900,000 
($1,800,000 face amount less $900,000 basis in the note) and G's 
contract price with respect to the note is its face amount of 
$1,800,000. Therefore, the gross profit ratio with respect to the note 
is \1/2\ ($900,000/$1,800,000).
    Example (6). The facts are the same as example (5) except that under 
the terms of the agreement H assumes the $500,000 first mortgage on 
Blackacre. H does not assume and purportedly does not take subject to 
the $400,000 second mortgage on Blackacre. The wrap-around installment 
obligation issued by H to G has a face amount of $1,300,000. The tax 
results in the year of sale to G are the same as example (5) ($400,000 
payment received and gain recognized). In the hands of G, basis in the 
wrap-around installment obligation is $400,000 ($700,000 basis in 
Blackacre plus $400,000 gain recognized in the year of sale minus 
$700,000 ($200,000 cash received and $500,000 treated as cash received 
as a result of H's assumption of the first mortgage)). G's gross profit 
with respect to the note is $900,000 ($1,300,000 face amount of the 
wrap-

[[Page 213]]

around installment obligation less $400,000 basis in that note) and G's 
contract price with respect to the note is its face value of $1,300,000. 
Therefore, the gross profit ratio with respect to the note is \9/13\ 
($900,000/$1,300,000).
    Example (7). A sells the stock of X corporation to B for a $1 
million installment obligation payable in equal annual installments over 
the next 10 years with adequate stated interest. The installment 
obligation is secured by a standby letter of credit (within the meaning 
of paragraph (b)(3)(iii) of this section) issued by M bank. Under the 
agreement between B and M bank, B is required to maintain a compensating 
balance in an account B maintains with M bank and is required by the M 
bank to post additional collateral, which may include cash or a cash 
equivalent, with M bank. Under neither the standby letter of credit nor 
any other agreement or arrangement is A granted a direct lien upon or 
other security interest in such cash or cash equivalent collateral. 
Receipt of B's installment obligation secured by the standby letter of 
credit will not be treated as the receipt of payment by A.
    Example (8). The facts are the same as in example (7) except that 
the standby letter of credit is in the drawable sum of $600,000. To 
secure fully its $1 million note issued to A, B deposits in escrow 
$400,000 in cash and Treasury bills. Under the escrow agreement, upon 
default in payment of the note A may look directly to the escrowed 
collateral. Receipt of B's installment obligation will be treated as the 
receipt payment by A in the sum of $400,000.

    (c) Contingent payment sales--(1) In general. Unless the taxpayer 
otherwise elects in the manner prescribed in paragraph (d)(3) of this 
section, contingent payment sales are to be reported on the installment 
method. As used in this section, the term ``contingent payment sale'' 
means a sale or other disposition of property in which the aggregate 
selling price cannot be determined by the close of the taxable year in 
which such sale or other disposition occurs.

The term ``contingent payment sale'' does not include transactions with 
respect to which the installment obligation represents, under applicable 
principles of tax law, a retained interest in the property which is the 
subject of the transaction, an interest in a joint venture or a 
partnership, an equity interest in a corporation or similar 
transactions, regardless of the existence of a stated maximum selling 
price or a fixed payment term. See paragraph (c)(8) of this section, 
describing the extent to which the regulations under section 385 apply 
to the determination of whether an installment obligation represents an 
equity interest in a corporation.

This paragraph prescribes the rules to be applied in allocating the 
taxpayer's basis (including selling expenses except for selling expenses 
of dealers in real estate) to payments received and to be received in a 
contingent payment sale. The rules are designed appropriately to 
distinguish contingent payment sales for which a maximum selling price 
is determinable, sales for which a maximum selling price is not 
determinable but the time over which payments will be received is 
determinable, and sales for which neither a maximum selling price nor a 
definite payment term is determinable. In addition, rules are prescribed 
under which, in appropriate circumstances, the taxpayer will be 
permitted to recover basis under an income forecast computation.
    (2) Stated maximum selling price--(i) In general. (A) contingent 
payment sale will be treated as having a stated maximum selling price 
if, under the terms of the agreement, the maximum amount of sale 
proceeds that may be received by the taxpayer can be determined as of 
the end of the taxable year in which the sale or other disposition 
occurs. The stated maximum selling price shall be determined by assuming 
that all of the contingencies contemplated by the agreement are met or 
otherwise resolved in a manner that will maximize the selling price and 
accelerate payments to the earliest date or dates permitted under the 
agreement. Except as provided in paragraph (c)(2)(ii) and (7) of this 
section (relating to certain payment recomputations), the taxpayer's 
basis shall be allocated to payments received and to be received under a 
stated maximum selling price agreement by treating the stated maximum 
selling price as the selling price for purposes of paragraph (b) of this 
section. The stated maximum selling price, as initially determined, 
shall thereafter be treated as the selling price unless and until that 
maximum amount is reduced, whether pursuant to the terms of the original 
agreement,

[[Page 214]]

by subsequent amendment, by application of the payment 
recharacterization rule (discribed in paragraph (c)(2)(ii) of this 
section), or by a subsequent supervening event such as bankruptcy of the 
obligor. When the maximum amount is subsequently reduced, the gross 
profit ratio will be recomputed with respect to payments received in or 
after the taxable year in which an event requiring reduction occurs. If, 
however, application of the foregoing rules in a particular case would 
substantially and inappropriately accelerate or defer recovery of the 
taxpayer's basis, a special rule will apply. See paragraph (c)(7) of 
this section.
    (B) The following examples illustrate the provisions of paragraph 
(e)(2)(i) of this section. In each example, it is assumed that 
application of the rules illustrated will not substantially and 
inappropriately defer or accelerate recovery of the taxpayer's basis.

    Example (1). A sells all of the stock of X corporation to B for 
$100,000 payable at closing plus an amount equal to 5% of the net 
profits of X for each of the next nine years, the contingent payments to 
be made annually together with adequate stated interest. The agreement 
provides that the maximum amount A may receive, inclusive of the 
$100,000 down payment but exclusive of interest, shall be $2,000,000. 
A's basis in the stock of X inclusive of selling expenses, is $200,000. 
Selling price and contract price are considered to be $2,000,000. Gross 
profit is $1,800,000, and the gross profit ratio is 9/10 ($1,800,000/
$2,000,000). Accordingly, of the $100,000 received by A in the year of 
sale, $90,000 is reportable as gain attributable to the sale and $10,000 
is recovery of basis.
    Example (2). C owns Blackacre which is encumbered by a long-standing 
mortgage of $100,000. On January 15, 1981, C sells Blackacre to D under 
the following payment arrangement: $100,000 in cash on closing; nine 
equal annual installment payments of $100,000 commencing January 15, 
1982; and nine annual payments (the first to be made on March 30, 1982) 
equal to 5% of the gross annual rental receipts from Blackacre generated 
during the preceding calendar year. The agreement provides that each 
deferred payment shall be accompanied by a payment of interest 
calculated at the rate of 12% per annum and that the maximum amount 
payable to C under the agreement (exclusive of interest) shall be 
$2,100,000. The agreement also specifies that D will assume the long-
standing mortgage. C's basis (inclusive of selling expenses) in 
Blackacre is $300,000. Accordingly, selling price is $2,100,000 and 
contract price is $2,000,000 (selling price of $2,100,000 less the 
$100,000 mortgage). The gross profit ratio is 9/10 (gross profit of 
$1,800,000 divided by $2,000,000 contract price). Of the $100,000 cash 
payment received by C in 1981, $90,000 is gain attributable to the sale 
of Blackacre and $10,000 is recovery of basis.

    (ii) Certain interest recomputations. When interest is stated in the 
contingent price sale agreement at a rate equal to or greater than the 
applicable prescribed test rate referred to in Sec. 1.483-1(d)(1)(ii) 
and such stated interest is payable in addition to the amounts otherwise 
payable under the agreement, such stated interest is not considered a 
part of the selling price. In other circumstances (i.e., section 483 is 
applicable because no interest is stated or interest is stated below the 
applicable test rate, or interest is stated under a payment 
recharacterization provision of the sale agreement), the special rule 
set forth in this (ii) shall be applied in the initial computation and 
subsequent recomputations of selling price, contract price, and gross 
profit ratio. The special rule is referred to in this section as the 
``price-interest recomputation rule.'' As used in this section, the term 
``payment recharacterization'' refers to a contractual arrangement under 
which a computed amount otherwise payable as part of the selling price 
is denominated an interest payment. The amount of unstated interest 
determined under section 483 or (if section 483 is inapplicable in the 
particular case) the amount of interest determined under a payment 
recharacterization arrangement is collectively referred to in this 
section as ``internal interest'' amounts. The price-interest 
recomputation rule is applicable to any stated maximum selling price 
agreement which contemplates receipt of internal interest by the 
taxpayer. Under the rule, stated maximum selling price will be 
determined as of the end of the taxpayer's taxable year in which the 
sale or other disposition occurs, taking into account all events which 
have occurred and are subject to prompt subsequent calculation and 
verification and assuming that all amounts that may become payable under 
the agreement will be paid on the earliest date or dates permitted under 
the agreement. With respect to the year of sale, the amount (if

[[Page 215]]

any) of internal interest then shall be determined taking account of the 
respective components of that calculation. The maximum amount initially 
calculated, minus the internal interest so determined, is the initial 
stated maximum selling price under the price-interest recomputation 
rule. For each subsequent taxable year, stated maximum selling price 
(and thus selling price, contract price, and gross profit ratio) shall 
be recomputed, taking into account all events which have occurred and 
are subject to prompt subsequent calculation and verification and 
assuming that all amounts that may become payable under the agreement 
will be paid on the earliest date or dates permitted under the 
agreement. The redetermined gross profit ratio, adjusted to reflect 
payments received and gain recognized in prior taxable years, shall be 
applied to payments received in that taxable year.
    (iii) Examples. The following examples illustrate installment method 
reporting of a contingent payment sale under which there is a stated 
maximum selling price. In each example, it is assumed that application 
of the rules described will not substantially and inappropriately defer 
or accelerate recovery of the taxpayer's basis.

    Example (1). A owns all of the stock of X corporation with a basis 
to A of $20 million. On July 1, 1981, A sells the stock of X to B under 
an agreement calling for fifteen annual payments respectively equal to 
5% of the net profits of X earned in the immediately preceding fiscal 
year beginning with the fiscal year ending March 31, 1982. Each payment 
is to be made on the following June 15th, commencing June 15, 1982, 
together with adequate stated interest. The agreement specifies that the 
maximum amount (exclusive of interest) payable to A shall not exceed $60 
million. Since stated interest is payable as an addition to the selling 
price and the specified rate is not below the section 483 test rate, 
there is no internal interest under the agreement. The stated maximum 
selling price is $60 million. The gross profit ratio is \2/3\ (gross 
profit of $40 million divided by $60 million contract price). Thus, if 
on June 15, 1982, A receives a payment of $3 million (exclusive of 
interest) under the agreement, in that year A will report $2 million ($3 
million x \2/3\) as gain attributable to the sale, and $1 million as 
recovery of basis.
    Example (2). (i) The facts are the same as in example (1) except 
that the agreement does not call for the payment of any stated interest 
but does provide for an initial cash payment of $3 million on July 1, 
1981. The maximum amount payable, including the $3 million initial 
payment, remains $60 million. Since section 483 will apply to each 
payment received by A more than one year following the date of sale 
(section 483 is inapplicable to the contingent payment that will be 
received on June 15, 1982 since that date is within one year following 
the July 1, 1981 sale date), the agreement contemplates internal 
interest and the price-interest recomputation rule is applicable. Under 
the rule, an initial determination must be made for A's taxable year 
1981. On December 31, 1981, the last day of the taxable year, no events 
with regard to the first fiscal year have occurred which are subject to 
prompt subsequent calculation and verification because that fiscal year 
will end March 31, 1982. Under the price-interest recomputation rule, on 
December 31, 1981 A is required to assume that the maximum amount 
subsequently payable under the agreement ($57 million, equal to $60 
million less the $3 million initial cash payment received by A in 1981) 
will be paid on the earliest date permissible under the agreement, i.e., 
on June 15, 1982. Since no part of a payment received on that date would 
be treated as interest under section 483, the initial stated maximum 
selling price, applicable to A's 1981 tax calculations, is deemed to be 
$60 million. Thus, the 1981 gross profit ratio is \2/3\ and for the 
taxable year 1981 A will report $2 million as gain attributable to the 
sale.
    (ii) The net profits of X for its fiscal year ending March 31, 1982 
are $120 million. On June 15, 1982 A receives a payment from B equal to 
5% of that amount, or $6 million. On December 31, 1982, A knows that the 
maximum amount he may subsequently receive under the agreement is $51 
million, and A is required to assume that this amount will be paid to 
him on the earliest permissible date, June 15, 1983. Section 483 does 
not treat as interest any part of the $6 million received by A on June 
15, 1982, but section 483 will treat as unstated interest a computed 
part of the $51 million it is assumed A will receive on June 15, 1983. 
Assuming that under the tables in the regulations under section 483, it 
is determined that the principal component of a payment received more 
than 21 months but less than 27 months after the date of sale is 
considered to be .82270, $41,957,700 of the presumed $51 million payment 
will be treated as principal. The balance of $9,042,300 is interest. 
Accordingly, in A's 1982 tax calculations stated maximum selling price 
will be $50,957,700, which amount is equal to the stated maximum selling 
price that was determined in the 1981 tax calculations ($60 million) 
reduced by the section 483 interest component of the $6 million payment 
received by A in 1982 ($0) and further reduced by the section 483 
interest component of the $51 million presumed payment to be received

[[Page 216]]

by A on June 15, 1983 ($9,042,300). Similarly, in determining gross 
profit for 1982 tax calculations, the gross profit of $40 million 
determined in the 1981 tax calculations must be reduced by the same 
section 483 interest amounts, yielding a recomputed gross profit of 
$30,957,700 ($40,000,000-$9,042,300). Further, since prior to 1982 A 
received payment under the agreement (1981 payment of $3 million of 
which $2 million was profit), the appropriate amounts must be subtracted 
in the 1982 tax calculation. The total previously received selling price 
payment of $3 million is subtracted from the recomputed maximum selling 
price of $50,957,700, yielding an adjusted selling price of $47,957,700. 
The total previously recognized gain of $2 million is subtracted from 
the recomputed maximum gross profit of $30,957,700, yielding an adjusted 
gross profit of $28,957,700. The gross profit percentage applicable to 
1982 tax calculations thus is determined to be 60.38175%, equal to the 
quotient of dividing the adjusted gross profit of $28,957,700 by the 
adjusted selling price of $47,957,700. Accordingly, of the $6 million 
received by A in 1982, no part of which is unstated interest under 
section 483, A will report $3,622,905 (60.38175% of $6 million) as gain 
attributable to the sale and $2,377,095 ($6,000,000-$3,622,905) as 
recovery of basis.
    (iii) The net profits of X for its fiscal year ending March 31, 1983 
are $200 million. On June 15, 1983 A receives a payment from B equal to 
$10 million. On December 31, 1983, A knows that the maximum amount he 
may subsequently receive under the agreement is $41 million, and A is 
required to assume that this amount will be paid to him on the earliest 
permissible date, June 15, 1984. Assuming that under the tables in the 
regulations under section 483 it is determined that the principal 
component of a payment received more than 33 months but less than 39 
months after the date of sale is .74622, $30,595,020 of the presumed $41 
million ($51 million-$10 million) payment will be treated as principal 
and $10,404,980 is interest. Based upon the assumed factor for 21 months 
but less than 27 months (.82270) $8,227,000 of the $10 million payment 
is principal and $1,773,000 is interest. Accordingly, in A's 1983 tax 
calculations stated maximum selling price will be $47,822,020, which 
amount is equal to the stated maximum selling price determined in the 
1981 calculation ($60 million) reduced by the section 483 interest 
component of the $6 million 1982 payment ($0), the section 483 interest 
component of the 1983 payment ($1,773,000) and by the section 483 
interest component of the presumed $41 million payment to be received in 
1984 ($10,404,980). The recomputed gross profit is $27,822,020 ($40 
million-$10,404,980-$1,773,000). The previously reported payments must 
be deducted for the 1983 calculation. Selling price is reduced to 
$38,822,020 by subtracting the $3 million 1981 payment and the $6 
million 1982 payment ($47,822,020-$9 million) and gross profit is 
reduced to $22,199,115 by subtracting the 1981 profit of $2 million and 
the 1982 profit of $3,622,905 ($27,822,020-$5,622,905), yielding a gross 
profit percentage of 57.18176% ($22,199,115/$38,822,020). Accordingly, 
of the $10 million received in 1983, A will report $1,773,000 as 
interest under section 483, and of the remaining principal component of 
$8,227,000, $4,704,343 as gain attributable to the sale 
($8,227,000x57.18176%) and $3,522,657 ($8,227,000-$4,704,343) as 
recovery of basis.
    Example (3). The facts are the same as in example (2) except that X 
is a collapsible corporation as defined in section 341(b)(1) and no 
limitation or exception under section 341 (d), (e), or (f) is 
applicable. Under section 341(a), all of A's gain on the sale will be 
ordinary income. Accordingly, section 483 will not apply to treat as 
interest any part of the payments to be received by A under his 
agreement with B. See section 483(f)(3). Therefore, the price-interest 
recomputation rule is inapplicable and the tax results to A in each year 
in which payment is received will be determined in a manner consistent 
with example (1).
    Example (4). The facts are the same as in example (2) (maximum 
amount payable under the agreement $60 million) except that the 
agreement between A and B contains the following ``payment 
recharacterization'' provision:
    ``Any payment made more than one year after the (July 1, 1981) date 
of sale shall be composed of an interest element and a principal 
element, the interest element being computed on the principal element at 
an interest rate of 9% per annum computed from the date of sale to the 
date of payment.''


The results reached in example (2), with respect to the $3 million 
initial cash payment received by A in 1981 remain the same because, 
under the payment recharacterization formula, no amount received or 
assumed to be received prior to July 1, 1982 is treated as interest. The 
1982 tax computation method described in example (2) is equally 
applicable to the $6 million payment received in 1982. However, the 
adjusted gross profit ratio determined in this example (4) will differ 
from the ratio determined in example (2). The difference is attributable 
to the difference between a 9% stated interest rate calculation (in this 
example (4)) and the compound rate of unstated interest required under 
section 483 and used in calculating the results in example (2).
    Example (5). The facts are the same as in example (1). In 1992 X is 
adjudged a bankrupt and it is determined that, in and after 1992, B will 
not be required to make any further payments under the agreement, i.e., 
B's contingent payment obligation held by A now

[[Page 217]]

has become worthless. Assume that A previously received aggregate 
payments (exclusive of interest) of $45 million and out of those 
payments recovered $15 million of A's total $20 million basis. For 1992 
A will report a loss of $5 million attributable to the sale, taken at 
the time determined to be appropriate under the rules generally 
applicable to worthless debts.
    Example (6). (i) C owns all of the stock of Z corporation, a 
calendar year taxpayer. On July 1, 1981, C sells the stock of Z to D 
under an agreement calling for payment, each year for the next ten 
years, of an amount equal to 10% of the net profits of Z earned in the 
immediately preceding calendar year beginning with the year ending 
December 31, 1981. Each payment is to be made on the following April 
1st, commencing April 1, 1982. In addition, C is to receive a payment of 
$5 million on closing. The agreement specifies that the maximum amount 
payable to C, including the $5 million cash payment at closing, is $24 
million. The agreement does not call for the payment of any stated 
interest. Since section 483 will apply to each payment received by C 
more than one year following the date of sale (section 483 is 
inapplicable to the payment that will be received on April 1, 1982, 
since that date is within one year following the July 1, 1981 sale 
date), the agreement contemplates internal interest and the price 
interest recomputation rule is applicable. Under that rule, C must make 
an initial determination for his taxable year 1981.
    (ii) On December 31, 1981, the exact amount of Z's 1981 net profit 
is not known, since it normally takes a number of weeks to compile the 
relevant information. However, the events which will determine the 
amount of the payment C will receive on April 1, 1982 have already 
occurred, and the information (Z's 1981 financial statement) will be 
promptly calculated and verified and will be available prior to the time 
C's 1981 tax return is timely filed. On March 15, 1982, Z reports net 
income of $14 million, and on April 1, 1982 D pays C $1.4 million.
    (iii) Under the price-interest recomputation rule, C is required to 
determine the gross profit ratio for the 1981 $5 million payment on the 
basis of the events which occurred by the close of that taxable year and 
which are verifiable before the due date of the 1981 return. Because at 
the end of C's 1981 taxable year all events which will determine the 
amount of the April 1, 1982 payment have occurred and because the actual 
facts are known prior to the due date of C's return, C will take those 
facts into account when calculating the gross profit ratio. Thus, 
because C knows that the 1982 payment is $1.4 million, C knows that the 
remaining amount to be recovered under the contract is $17.6 million 
($24 million - ($5 million + $1.4 million)). For purposes of this 
paragraph C must assume that the entire $17.6 million will be paid on 
the earliest possible date, April 1, 1983. Because section 483 will 
apply to that payment, and assuming that under the tables in the 
regulations under section 483 the principal component of a payment 
received 21 months after the date of sale is considered to be .86384, 
$15,203,584 of the $17.6 million would be principal and $2,396,416 
($17,600,000 - $15,203,584) would be interest. Therefore, C must assume, 
for purposes of reporting the $5 million payment received in 1981, that 
the selling price is $21,603,584 calculated as follows:

Total selling price.....................................     $24,000,000
Interest component of the $17,600,000 payment which C         -2,396,416
 must assume will be made April 1, 1983.................
                                                         ---------------
  Adjusted selling price to be used when reporting the        21,603,584
   1981 payment.........................................
 

    (iv) Assume that on March 15, 1982, Z reports net income of $15 
million for 1982 and that on April 1, 1983 D pays C $1.5 million. 
Because section 483 will apply to that payment, and assuming that under 
the tables in the regulations under section 483 the principal component 
of a payment received 21 months after the date of sale is considered to 
be .86384, $1,295,760 of the $1,500,000 payment will be principal and 
$204,240 ($1,500,000 - $1,295,760) will be interest. Because C knows the 
amount of the 1983 payment when filing the 1982 tax return, C must 
assume that the remaining amount to be received under the contract, 
$16.1 million ($24 million - ($5 million + $1.4 million + $1.5 
million)), will be received as a lump sum on April 1, 1984. Because 
section 483 will again apply, and assuming that the principal component 
of a payment made 34 months after the date of the sale is .74622, 
$12,014,142 of the $16.1 million would be principal, and $4,085,858 
($16,100,000 - $12,014,142) would be interest. Therefore, C must assume, 
for purpose of reporting the $1.4 million payment made April 1, 1982, 
that the adjusted selling price (within the meaning of example (2)) is 
$14,709,902, calculated as follows:

Total selling price.....................................     $24,000,000
Interest component of the $1,500,000 payment made April         -204,240
 1, 1983................................................
Interest component of the $16,100,000 payment which C         -4,085,858
 must assume will be made April 1, 1984.................
Payment made in 1981....................................      -5,000,000
                                                         ---------------
  Adjusted selling price for calculations for reporting       14,709,902
   the 1982 payment.....................................
 


    (3) Fixed period--(i) In general. When a stated maximum selling 
price cannot be determined as of the close of the taxable year in which 
the sale or other disposition occurs, but the maximum period over which 
payments may be received under the contingent sale price agreement is 
fixed, the taxpayer's basis

[[Page 218]]

(inclusive of selling expenses) shall be allocated to the taxable years 
in which payment may be received under the agreement in equal annual 
increments. In making the allocation it is not relevant whether the 
buyer is required to pay adequate stated interest. However, if the terms 
of the agreement incorporate an arithmetic component that is not 
identical for all taxable years, basis shall be allocated among the 
taxable years to accord with that component unless, taking into account 
all of the payment terms of the agreement, it is inappropriate to 
presume that payments under the contract are likely to accord with the 
variable component. If in any taxable year no payment is received or the 
amount of payment received (exclusive of interest) is less than the 
basis allocated to that taxable year, no loss shall be allowed unless 
the taxable year is the final payment year under the agreement or unless 
it is otherwise determined in accordance with the rules generally 
applicable to worthless debts that the future payment obligation under 
the agreement has become worthless. When no loss is allowed, the 
unrecovered portion of basis allocated to the taxable year shall be 
carried forward to the next succeeding taxable year. If application of 
the foregoing rules to a particular case would substantially and 
inappropriately defer or accelerate recovery of the taxpayer's basis, a 
special rule will apply. See paragraph (c)(7) of this section.

    (ii) Examples. The following examples illustrate the rules for 
recovery of basis in a contingent payment sale in which stated maximum 
selling price cannot be determined but the period over which payments 
are to be received under the agreement is fixed. In each case, it is 
assumed that application of the described rules will not substantially 
and inappropriately defer or accelerate recovery of the taxpayer's 
basis.

    Example (1). A sells Blackacre to B for 10 percent of Blackacre's 
gross yield for each of the next 5 years. A's basis in Blackacre is $5 
million. Since the sales price is indefinite and the maximum selling 
price is not ascertainable from the terms of the contract, basis is 
recovered ratably over the period during which payment may be received 
under the contract. Thus, assuming A receives the payments (exclusive of 
interest) listed in the following table, A will report the following:

----------------------------------------------------------------------------------------------------------------
                                                                                                       Gain
                              Year                                    Payment          Basis       attributable
                                                                                     recovered      to the sale
----------------------------------------------------------------------------------------------------------------
1...............................................................      $1,300,000      $1,000,000        $300,000
2...............................................................       1,500,000       1,000,000         500,000
3...............................................................       1,400,000       1,000,000         400,000
4...............................................................       1,800,000       1,000,000         800,000
5...............................................................       2,100,000       1,000,000       1,100,000
----------------------------------------------------------------------------------------------------------------

    Example (2). The facts are the same as in example (1), except that 
the payment in year 1 is only $900,000. Since the installment payment is 
less than the amount of basis allocated to that year, the unrecovered 
basis, $100,000, is carried forward to year 2.

----------------------------------------------------------------------------------------------------------------
                                                                                                       Gain
                              Year                                    Payment          Basis       attributable
                                                                                     recovered      to the sale
----------------------------------------------------------------------------------------------------------------
1...............................................................        $900,000        $900,000  ..............
2...............................................................       1,500,000       1,100,000        $400,000
3...............................................................       1,400,000       1,000,000         400,000
4...............................................................       1,800,000       1,000,000         800,000
5...............................................................       2,100,000       1,000,000       1,100,000
----------------------------------------------------------------------------------------------------------------

    Example (3). C owns all of the stock of X corporation with a basis 
of $100,000 (inclusive of selling expenses). D purchases the X stock 
from C and agrees to make four payments computed in accordance with the 
following formula: 40% of the net profits of X in year 1, 30% in year 2, 
20% in year 3, and 10% in year 4. Accordingly, C's basis is allocated as 
follows: $40,000 to year 1, $30,000 to year 2, $20,000 to year 3, and 
$10,000 to year 4.
    Example (4). The facts are the same as in example (3), but the 
agreement also requires that D make fixed installment payments in 
accordance with the following schedule: no payment in year 1, $100,000 
in year 2, $200,000 in year 3, $300,000 in year 4, and $400,000 in year 
5. Thus, while it is reasonable to project that the contingent component 
of the payments will decrease each year, the fixed component of the 
payments will increase each year. Accordingly, C is required to allocate 
$20,000 of basis to each of the taxable years 1 through 5.

    (4) Neither stated maximum selling price nor fixed period. If the 
agreement neither specifies a maximum selling price nor limits payments 
to a fixed period, a question arises whether a sale realistically has 
occurred or whether, in economic effect, payments received under the 
agreement are in the nature of rent or royalty income. Arrangements of 
this sort will be closely scrutinized. If, taking into account all of 
the pertinent facts, including the nature of the property, the 
arrangement

[[Page 219]]

is determined to qualify as a sale, the taxpayer's basis (including 
selling expenses) shall be recovered in equal annual increments over a 
period of 15 years commencing with the date of sale. However, if in any 
taxable year no payment is received or the amount of payment received 
(exclusive of interest) is less than basis allocated to the year, no 
loss shall be allowed unless it is otherwise determined in accordance 
with the timing rules generally applicable to worthless debts that the 
future payment obligation under the agreement has become worthless; 
instead the excess basis shall be reallocated in level amounts over the 
balance of the 15 year term. Any basis not recovered at the end of the 
15th year shall be carried forward to the next succeeding year, and to 
the extent unrecovered thereafter shall be carried forward from year to 
year until all basis has been recovered or the future payment obligation 
is determined to be worthless. The general rule requiring initial level 
allocation of basis over 15 years shall not apply if the taxpayer can 
establish to the satisfaction of the Internal Revenue Service that 
application of the general rule would substantially and inappropriately 
defer recovery of the taxpayer's basis. See paragraph (c)(7) of this 
section. If the Service determines that initially allocating basis in 
level amounts over the first 15 years will substantially and 
inappropriately accelerate recovery of the taxpayer's basis in early 
years of that 15-year term, the Service may require that basis be 
reallocated within the 15-year term but the Service will not require 
that basis initially be allocated over more than 15 years. See paragraph 
(c)(7) of this section.
    (5) Foreign currency and other fungible payment units--(i) In 
general. An installment sale may call for payment in foreign currency. 
For federal income tax purposes, foreign currency is property. Because 
the value of foreign currency will vary over time in relation to the 
United States dollar, an installment sale requiring payment in foreign 
currency is a contingent payment sale. However, when the consideration 
payable under an installment sale agreement is specified in foreign 
currency, the taxpayer's basis (including selling expenses) shall be 
recovered in the same manner as basis would have been recovered had the 
agreement called for payment in United States dollars. This rule is 
equally applicable to any installment sale in which the agreement 
specifies that payment shall be made in identified, fungible units of 
property the value of which will or may vary over time in relation to 
the dollar (e.g., bushels of wheat or ounces of gold).
    (ii) Example. The following example illustrates the provisions of 
this subparagraph:

    Example. A sells Blackacre to B for 4 million Swiss francs payable 1 
million in year 2 and 3 million in year 3, together with adequate stated 
interest. A's basis (including selling expenses) in Blackacre is 
$100,000. Twenty five thousand dollars of A's basis (\1/4\ of total 
basis) is allocable to the year 2 payment of 1 million Swiss francs and 
$75,000 of A's basis is allocable to the year 3 payment of 3 million 
Swiss francs.

    (6) Income forecast method for basis recovery--(i) In general. The 
rules for ratable recovery of basis set forth in paragraph (c) (2) 
through (4) of this section focus on the payment terms of the contingent 
selling price agreement. Except to the extent contemplated by 
paragraph(c)(7) of this section (relating to a special rule to prevent 
substantial distortion of basis recovery), the nature and productivity 
of the property sold is not independently relevant to the basis to be 
recovered in any payment year. The special rule for an income forecast 
method of basis recovery set forth in paragraph (c)(6) of this section 
recognizes that there are cases in which failure to take account of the 
nature or productivity of the property sold may be expected to result in 
distortion of the taxpayer's income over time. Specifically, when the 
property sold is depreciable property of a type normally eligible for 
depreciation on the income forecast method, or is depletable property of 
a type normally eligible for cost depletion in which total future 
production must be estimated, and payments under the contingent selling 
price agreement are based upon receipts or units produced by or from the 
property, the taxpayer's basis may appropriately be recovered by using 
an income forecast method.

[[Page 220]]

    (ii) Availability of method. In lieu of applying the rules set forth 
in paragraph (c) (2) through (4) of this section, in an appropriate case 
the taxpayer may elect (on its tax return timely filed for the first 
year under the contingent payment agreement in which a payment is 
received) to recover basis using the income forecast method of basis 
recovery. No special form of election is prescribed. An appropriate case 
is one meeting the criteria set forth in paragraph (c)(6)(i) of this 
section in which the property sold is a mineral property, a motion 
picture film, a television film, or a taped television show. The 
Internal Revenue Service may from time to time specify other properties 
of a similar character which, in appropriate circumstances, will be 
eligible for recovery of basis on the income forecast method. In 
addition, a taxpayer may seek a ruling from the Service as to whether a 
specific property qualifies as property of a similar character eligible, 
in appropriate circumstances, for income forecast recovery of basis.
    (iii) Required calculations. The income forecast method requires 
application of a fraction, the numerator of which is the payment 
(exclusive of interest) received in the taxable year under a contingent 
payment agreement, and the denominator of which is the forecast or 
estimated total payments (exclusive of interest) to be received under 
the agreement. This fraction is multiplied by the taxpayer's basis in 
the property sold to determine the basis recovered with respect to the 
payment received in the taxable year. If in a subsequent year it is 
found that the income forecast was substantially overestimated or 
underestimated by reason of circumstances occurring in such subsequent 
year, an adjustment of the income forecast of such subsequent year shall 
be made. In such case, the formula for computing recovery of basis would 
be as follows: payment received in the taxable year (exclusive of 
interest) divided by the revised estimated total payments (exclusive of 
interest) then and thereafter to be made under the agreement (the 
current year's payment and total estimated future payments), multiplied 
by the taxpayer's unrecovered basis remaining as of the beginning of the 
taxable year. If the agreement contemplates internal interest (as 
defined in paragraph (c)(2)(ii) of this section), in making the initial 
income forecast computation and in making any required subsequent 
recomputation the amount of internal interest (which shall not be 
treated as payment under the agreement) shall be calculated by assuming 
that each future contingent selling price payment will be made in the 
amount and at the time forecast. The total forecast of estimated 
payments to be received under the agreement shall be based on the 
conditions known to exist at the end of the taxable year for which the 
return is filed. If a subsequent upward or downward revision of this 
estimate is required, the revision shall be made at the end of the 
subsequent taxable year based on additional information which became 
available after the last prior estimate. No loss shall be allowed unless 
the taxable year is the final payment year under the agreement or unless 
it is otherwise determined in accordance with the rules generally 
applicable to the time a debt becomes worthless that the future payment 
obligation under the agreement has become worthless.
    (iv) Examples. The following examples illustrate the income forecast 
method of basis recovery:

    Example (1). A sells a television film to B for 5% of annual gross 
receipts from the exploitation of the film. The film is an ordinary 
income asset in the hands of A. A reasonably forecasts that total 
payments to be received under the contingent selling price agreement 
will be $1,200,000, and that A will be paid $600,000 in year 1, $150,000 
in year 2, $300,000 in year 3, $100,000 in year 4, and $50,000 in year 
5. A reasonably anticipates no or only insignificant receipts 
thereafter. A's basis in the film is $100,000. Under the income forecast 
method, A's basis initially is allocated to the five taxable years of 
forecasted payment as follows:

------------------------------------------------------------------------
                  Year                      Percentage         Basis
------------------------------------------------------------------------
1.......................................           50.00         $50,000
2.......................................           12.50          12,500
3.......................................           25.00          25,000
4.......................................            8.33           8,333
5.......................................            4.17           4,167
------------------------------------------------------------------------


Payments are received and A reports the sale under the installment 
method as follows:

[[Page 221]]


----------------------------------------------------------------------------------------------------------------
                                                                      Payment          Basis
                              Year                                   received        recovered     Gain on sale
----------------------------------------------------------------------------------------------------------------
1...............................................................        $600,000         $50,000        $550,000
2...............................................................         150,000          12,500         137,500
3...............................................................         300,000          25,000         275,000
4...............................................................         100,000           8,333          91,667
5...............................................................          50,000           4,167          45,833
----------------------------------------------------------------------------------------------------------------

    Example (2). The facts are the same as in example (1), except that 
in year 2 A receives no payment. In year 3 A receives a payment of 
$300,000 and reasonably estimates that in subsequent years he will 
receive total additional payments of only $100,000. In year 2 A will be 
allowed no loss. At the beginning of year 3 A's unrecovered basis is 
$50,000. In year 3 A must recompute the applicable basis recovery 
fraction based upon facts known and forecast as at the end of year 3: 
year 3 payment of $300,000 divided by estimated current and future 
payments of $400,000, equaling 75%. Thus, in year 3 A recovers $37,500 
(75% of $50,000) of A's previously unrecovered basis.

    (7) Special rule to avoid substantial distortion--(i) In general. 
The normal basis recovery rules set forth in paragraph (c) (2) through 
(4) of this section may, with respect to a particular contingent payment 
sale, substantially and inappropriately defer or accelerate recovery of 
the taxpayer's basis.
    (ii) Substantial and inappropriate deferral. The taxpayer may use an 
alternative method of basis recovery if the taxpayer is able to 
demonstrate prior to the due date of the return including extensions for 
the taxable year in which the first payment is received, that 
application of the normal basis recovery rule will substantially and 
inappropriately defer recovery of basis. To demonstrate that application 
of the normal basis recovery rule will substantially and inappropriately 
defer recovery of basis, the taxpayer must show (A) that the alternative 
method is a reasonable method of ratably recovering basis and, (B) that, 
under that method, it is reasonable to conclude that over time the 
taxpayer likely will recover basis at a rate twice as fast as the rate 
at which basis would have been recovered under the otherwise applicable 
normal basis recovery rule. The taxpayer must receive a ruling from the 
Internal Revenue Service before using an alternative method of basis 
recovery described in paragraph (c)(7)(ii) of this section.

The request for a ruling shall be made in accordance with all applicable 
procedural rules set forth in the Statement of Procedural Rules (26 CFR 
part 601) and any applicable revenue procedures relating to submission 
of ruling requests. The request shall be submitted to the Commissioner 
of Internal Revenue, Attention: Assistant Commissioner (Technical), 
Washington, DC 20224. The taxpayer must file a request for a ruling 
prior to the due date for the return including extensions. In 
demonstrating that application of the normal basis recovery rule would 
substantially and inappropriately defer recovery of the taxpayer's 
basis, the taxpayer in appropriate circumstances may rely upon 
contemporaneous or immediate past relevant sales, profit, or other 
factual data that are subject to verification. The taxpayer ordinarily 
is not permitted to rely upon projections of future productivity, 
receipts, profits, or the like. However, in special circumstances a 
reasonable projection may be acceptable if the projection is based upon 
a specific event that already has occurred (e.g., corporate stock has 
been sold for future payments contingent on profits and an inadequately 
insured major plant facility of the corporation has been destroyed).
    (iii) Substantial and inappropriate acceleration. Notwithstanding 
the other provisions of this paragraph, the Internal Revenue Service may 
find that the normal basis recovery rule will substantially and 
inappropriately accelerate recovery of basis. In such a case, the 
Service may require an alternate method of basis recovery, unless the 
taxpayer is able to demonstrate either (A) that the method of basis 
recovery required by the Service is not a reasonable method of ratable 
recovery, or (B) that it is not reasonable to conclude that the taxpayer 
over time is likely to recover basis at a rate twice as fast under the 
normally applicable basis recovery rule as the rate at which basis would 
be recovered under the method proposed by the Service. In making such 
demonstrations the taxpayer may rely in appropriate circumstances upon 
contemporaneous or immediate past relevant sales, profit, or other 
factual data subject to verification. In special circumstances a 
reasonable projection

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may be acceptable, but only with the consent of the Service, if the 
projection is based upon a specific event that has already occurred.
    (iv) Subsequent recomputation. A contingent payment sale may 
initially and properly have been reported under the normally applicable 
basis recovery rule and, during the term of the agreement, circumstances 
may show that continued reporting on the original method will 
substantially and inappropriately defer or accelerate recovery of the 
unrecovered balance of the taxpayer's basis. In this event, the special 
rule provided in this paragraph is applicable.
    (v) Examples. The following examples illustrate the application of 
the special rule of this paragraph. In examples (1) and (2) it is 
assumed that rulings consistent with paragraph (c)(7)(ii) of this 
section have been requested.

    Example (1). A owns all of the stock of X corporation with a basis 
of $100,000. A sells the stock of X to B for a cash down payment of 
$1,800,000 and B's agreement to pay A an amount equal to 1% of the net 
profits of X in each of the next 10 years (together with adequate stated 
interest). The agreement further specifies that the maximum amount that 
may be paid to A (exclusive of interest) shall not exceed $10 million. A 
is able to demonstrate that current and recent profits of X have 
approximated $2 million annually, and that there is no reason to 
anticipate a major increase in the annual profits of X during the next 
10 years. One percent of $2 million annual profits is $20,000, a total 
of $200,000 over 10 years. Under the basis recovery rule normally 
applicable to a maximum contingent selling price agreement, in the year 
of sale A would recover $18,000 of A's total $100,000 basis, and would 
not recover more than a minor part of the balance until the final year 
under the agreement. On a $2 million selling price ($200,000 plus 
$1,800,000 down payment), A would recover $90,000 of A's total $100,000 
basis in the year of sale and 5% of each payment ($100,000/$2,000,000) 
received up to a maximum of $10,000 over the next ten years. Since the 
rate of basis recovery under the demonstrated method is more than twice 
the rate under the normal rule, A will be permitted to recover $90,000 
basis in the year of sale.
    Example (2). The facts are the same as in example (1) except that no 
maximum contingent selling price is stated in the agreement. Under the 
basis recovery rule normally applicable when no maximum amount is stated 
but the payment term is fixed, in the year of sale and in each 
subsequent year A would recover approximately $9,100 (1/11 of $100,000) 
of A's total basis. A will be permitted to recover $90,000 of A's total 
basis in the year of sale.
    Example (3). The facts are the same as in example (1) except that A 
sells the X stock to B on the following terms: 1% of the annual net 
profits of X in each of the next 10 years and a cash payment of 
$1,800,000 in the eleventh year, all payments to be made together with 
adequate stated interest. No maximum contingent selling price is stated. 
Under the normally applicable basis recovery rule, A would recover 1/11 
of A's total $100,000 basis in each of the 11 payment years under the 
agreement. On the facts (see example (1)), A cannot demonstrate that 
application of the normal rule would not substantially and 
inappropriately accelerate recovery of A's basis. Accordingly, A will be 
allowed to recover only $1,000 of A's total basis in each of the 10 
contingent payment years under the agreement, and will recover the 
$90,000 balance of A's basis in the final year in which the large fixed 
cash payment will be made.

    (8) Coordination with regulations under section 385. (i) In general. 
The regulations under section 385 do not apply to an instrument (as 
defined in Sec. 1.385-3(c)) providing for a contingent payment of 
principal (with or without stated interest) issued in connection with a 
sale or other disposition of property to a corporation if Sec. 1.385-6 
(relating to proportionality) does not apply to such instrument (or to a 
class of instruments which includes such instrument). Thus, such 
instrument will be treated as stock or indebtedness under applicable 
principles of law without reference to the regulations under section 
385.
    (ii) Examples. The following examples illustrate the application of 
this paragraph:

    Example (1). On January 1, 1982, corporation X buys a factory from 
Y, an independent creditor (within the meaning of Sec. 1.385-6(b)). In 
exchange for the factory, Y receives $200,000 in cash on January 1, 
1982. In addition, on January 1, 1984, Y will receive a payment in the 
range of $100,000 to $300,000, plus adequate stated interest, depending 
on the factory's output. Based on these facts, Sec. 1.385-6 does not 
apply to X's obligation to Y (see Sec. 1.385-6(a)(3)(ii)) and the 
regulations under section 385 doe not apply to X's obligation to Y.
    Example (2). The facts are the same as in example (1), except that 
the contingent payment due on January 1, 1984 will be in the range of 
$50,000 to $250,000. In addition, on

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January 1, 1982, Y receives a $50,000 noninterest-bearing note due 
absolutely and unconditionally on January 1, 1984. Based on these facts, 
the $50,000 note is treated as stock or indebtedness under the 
regulations under section 385.

    (d) Election not to report an installment sale on the installment 
method--(1) In general. An installment sale is to be reported on the 
installment method unless the taxpayer elects otherwise in accordance 
with the rules set forth in paragraph (d)(3) of this section.
    (2) Treatment of an installment sale when a taxpayer elects not to 
report on the installment method--(i) In general. A taxpayer who elects 
not to report an installment sale on the installment method must 
recognize gain on the sale in accordance with the taxpayer's method of 
accounting. The fair market value of an installment obligation shall be 
determined in accordance with paragraph (d)(2) (ii) and (iii) of this 
section. In making such determination, any provision of contract or 
local law restricting the transferability of the installment obligation 
shall be disregarded. Receipt of an installment obligation shall be 
treated as a receipt of property, in an amount equal to the fair market 
value of the installment obligation, whether or not such obligation is 
the equivalent of cash. An installment obligation is considered to be 
property and is subject to valuation, as provided in paragraph (d)(2) 
(ii) and (iii) of this section, without regard to whether the obligation 
is embodied in a note, an executory contract, or any other instrument, 
or is an oral promise enforceable under local law.
    (ii) Fixed amount obligations. (A) A fixed amount obligation means 
an installment obligation the amount payable under which is fixed. 
Solely for the purpose of determining whether the amount payable under 
an installment obligation is fixed, the provisions of section 483 and 
any ``payment recharacterization'' arrangement (as defined in paragraph 
(c)(2)(ii) of this section) shall be disregarded. If the fixed amount 
payable is stated in identified, fungible units of property the value of 
which will or may vary over time in relation to the United States dollar 
(e.g., foreign currency, ounces of gold, or bushels of wheat), such 
units shall be converted to United States dollars at the rate of 
exchange or dollar value on the date the installment sale is made. A 
taxpayer using the cash receipts and disbursements methods of accounting 
shall treat as an amount realized in the year of sale the fair market 
value of the installment obligation. In no event will the fair market 
value of the installment obligation be considered to be less than the 
fair market value of the property sold (minus any other consideration 
received by the taxpayer on the sale). A taxpayer using the accrual 
method of accounting shall treat as an amount realized in the year of 
sale the total amount payable under the installment obligation. For this 
purpose, neither interest (whether stated or unstated) nor original 
issue discount is considered to be part of the amount payable. If the 
amount payable is otherwise fixed, but because the time over which 
payments may be made is contingent, a portion of the fixed amount will 
or may be treated as internal interest (as defined in paragraph 
(c)(2)(ii) of this section), the amount payable shall be determined by 
applying the price interest recomputation rule (described in paragraph 
(c)(2)(ii) of this section). Under no circumstances will an installment 
sale for a fixed amount obligation be considered an ``open'' 
transaction. For purposes of this (ii), remote or incidential 
contingencies are not to be taken into account.
    (B) The following examples illustrate the provisions of paragraph 
(d)(2) of this section.

    Example (1). A, an accrual method taxpayer, owns all of the stock of 
X corporation with a basis of $20 million. On July 1, 1981, A sells the 
stock of X corporation to B for $60 million payable on June 15, 1992. 
The agreement also provides that against this fixed amount, B shall make 
annual prepayments (on June 15) equal to 5% of the net profits of X 
earned in the immediately preceding fiscal year beginning with the 
fiscal year ending March 31, 1982. Thus the first prepayment will be 
made on June 15, 1982. No stated interest is payable under the agreement 
and thus the unstated interest provisions of section 483 are applicable. 
Under section 483, no part of any payment made on June 15, 1982 (which 
is within one year following the July 1, 1981 sale date), will be 
treated as unstated interest. Under the price interest recomputation 
rule, it is presumed that the entire $60

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million fixed amount will be paid on June 15, 1982. Accordingly, if A 
elects not to report the transaction on the installment method, in 1981 
A must report $60 million as the amount realized on the sale and must 
report $40 million as gain on the sale in that year.
    Example (2). The facts are the same as in example (1) except that A 
uses the cash receipts and disbursements method of accounting. In 1981 A 
must report as an amount realized on the sale the fair market value of 
the installment obligation and must report as gain on the sale in 1981 
the excess of that amount realized over A's basis of $20 million. In no 
event will the fair market value of the installment obligation be 
considered to be less than the fair market value of the stock of X. In 
determining the fair market value of the installment obligation, any 
contractual or legal restrictions on the transferability of the 
installment obligation, and any remote or incidental contingencies 
otherwise affecting the amount payable or time of payments under the 
installment obligation, shall be disregarded.

    (iii) Contingent payment obligations. Any installment obligation 
which is not a fixed amount obligation (as defined in paragraph 
(d)(2)(ii) of this section) is a contingent payment obligation. If an 
installment obligation contains both a fixed amount component and a 
contingent payment component, the fixed amount component shall be 
treated under the rules of paragraph (d)(2)(ii) of this section and the 
contingent amount component shall be treated under the rules of this 
(iii). The fair market value of a contingent payment obligation shall be 
determined by disregarding any restrictions on transfer imposed by 
agreement or under local law. The fair market value of a contingent 
payment obligation may be ascertained from, and in no event shall be 
considered to be less than, the fair market value of the property sold 
(less the amount of any other consideration received in the sale). Only 
in those rare and extraordinary cases involving sales for a contingent 
payment obligation in which the fair market value of the obligation 
(determinable under the preceding sentences) cannot reasonably be 
ascertained will the taxpayer be entitled to assert that the transaction 
is ``open.'' Any such transaction will be carefully scrutinized to 
determine whether a sale in fact has taken place. A taxpayer using the 
cash receipts and disbursements method of accounting must report as an 
amount realized in the year of sale the fair market value of the 
contingent payment obligation. A taxpayer using the accrual method of 
accounting must report an amount realized in the year of sale determined 
in accordance with that method of accounting, but in no event less than 
the fair market value of the contingent payment obligation.
    (3) Time and manner for making election--(i) In general. An election 
under paragraph (d)(1) of this section must be made on or before the due 
date prescribed by law (including extensions) for filing the taxpayer's 
return for the taxable year in which the installment sale occurs. The 
election must be made in the manner prescribed by the appropriate forms 
for the taxpayer's return for the taxable year of the sale. A taxpayer 
who reports an amount realized equal to the selling price including the 
full face amount of any installment obligation on the tax return filed 
for the taxable year in which the installment sale occurs will be 
considered to have made an effective election under paragraph (d)(1) of 
this section. A cash method taxpayer receiving an obligation the fair 
market value of which is less than the face value must make the election 
in the manner prescribed by appropriate instructions for the return 
filed for the taxable year of the sale.
    (ii) Election made after the due date. Elections after the time 
specified in paragraph (d)(3)(i) of this section will be permitted only 
in those rare circumstances when the Internal Revenue Service concludes 
that the taxpayer had good cause for failing to make a timely election. 
A recharacterization of a transaction as a sale in a taxable year 
subsequent to the taxable year in which the transaction occurred (e.g., 
a transaction initially reported as a lease later is determined to have 
been an installment sale) will not justify a late election. No 
conditional elections will be permitted. For a special transitional rule 
relating to certain taxable years for which a return is filed prior to 
February 19, 1981, see paragraph (d)(5) of this section.
    (4) Revoking an election. Generally, an election made under 
paragraph (d)(1) is

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irrevocable. An election may be revoked only with the consent of the 
Internal Revenue Service. A revocation is retroactive. A revocation will 
not be permitted when one of its purposes is the avoidance of Federal 
income taxes, or when the taxable year in which any payment was received 
has closed. For a special transitional rule relating to certain taxable 
years for which a return is filed prior to February 19, 1981, see 
paragraph (d)(5) of this section.
    (5) Transitional rules. The following transitional rules shall apply 
with respect to any contingent payment sale made after October 19, 1980 
in a taxable year, ending after that date, for which the taxpayer has 
filed a federal income tax return prior to February 19, 1981. If in such 
tax return the taxpayer has treated the contingent payment sale under 
the installment method, consent of the Internal Revenue Service to a 
late election by the taxpayer not to report the transaction on the 
installment method will generally be granted if the request for election 
out of installment method treatment is filed by May 5, 1981. If in such 
tax return the taxpayer has elected not to report the contingent payment 
sale under the installment method, consent of the Service to revocation 
of the election by the taxpayer will generally be granted if the request 
for revocation is filed by May 5, 1981.
    (e) Purchaser evidences of indebtedness payable on demand or readily 
tradable--(1) Treatment as payment--(i) In general. A bond or other 
evidence of indebtedness (hereinafter in this section referred to as an 
obligation) issued by any person and payable on demand shall be treated 
as a payment in the year received, not as installment oblig