Tax assessment; partnership. The Supreme Court holds that the proper assessment against the partnership suffices to extend the statute of limitations to collect the tax in a judicial proceeding from the general partners who are liable for the payment of the partnership's debts. United States v. Galletti et al.

Health Savings Account (HSA) - interaction with other health arrangements. This ruling addresses the interaction between Health Savings Accounts (HSAs), health flexible spending arrangements (health FSAs), and health reimbursement arrangements (HRAs).

Credit card annual fees. This ruling holds that credit card annual fees are not interest for federal income tax purposes. Moreover, the ruling holds that credit card annual fees are includible in the gross income by the card issuer when they become due and payable by cardholders under the terms of the credit card agreements.

This notice explains how the changes to section 1(h) of the Code made by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) apply to capital gain dividends paid (or accounted for as if paid) by regulated investment companies (RICs) and real estate investment trusts (REITs) in taxable years that end on or after May 6, 2003.

Changes in method of accounting for transfers to trusts under section 461(f). This document provides procedures for taxpayers to change their method of accounting for deducting under section 461(f) of the Code amounts transferred to trusts in transactions described in Notice 2003-77, 2003-49 I.R.B. 1182.

This document provides automatic consent procedures for taxpayers to change their method of accounting to a method that complies with Rev. Rul. 2004-52, in this Bulletin, or to the Ratable Inclusion Method for Credit Card Annual Fees described in this revenue procedure. Rev. Proc. 2002-9 modified and amplified.

This procedure describes conditions under which the Commissioner will allow a taxpayer to treat its income from credit card late fees as interest income on a pool of credit card loans. This document also provides automatic consent procedures for a taxpayer to change its method of accounting for credit card late fee income to a method that treats these fees as interest that creates or increases the amount of OID on a pool of credit card loans to which the fees relate. Rev. Proc. 2002-9 modified and amplified.

Joint ventures. This ruling illustrates the tax consequences for a section 501(c)(3) organization that enters into a joint venture with a for-profit organization as an insubstantial part of its activities.

A list is provided of organizations now classified as private foundations.

Indian tribal government. This ruling provides clarification with regard to an Indian tribal government's ability to qualify as an eligible shareholder under section 1361 of the Code. Specifically, the ruling explains that a federally recognized Indian tribal government does not qualify as a permissible S corporation shareholder under section 1361(b)(1)(B) because it is not treated as an individual subject to individual income taxes under section 1 of the Code. The ruling also explains that a federally recognized Indian Tribe cannot qualify as a permissible S corporation shareholder under section 1361(c)(6) because it is neither a section 501(c)(3) organization, nor a section 401(a) qualified plan, profit-sharing, or stock bonus plan organization.

This procedure provides guidance to regulated investment companies (RICs) who must comply with the asset diversification rules of section 851(b)(3) of the Code. The procedure describes conditions under which a RIC may look through a repurchase agreement (repo) to government securities serving as the underlying collateral to treat itself as the owner of the government securities for purposes of these rules. The procedure is effective for repos held by a RIC on or after August 15, 2001.

This procedure provides a method of accounting under which taxpayers using an accrual method of accounting may defer including all or part of certain advance payments in gross income until the year after the year the payment is received. Rev. Proc. 71-21 modified and superseded and Rev. Proc. 2002-9 modified and amplified.

This announcement provides background information relating to Rev. Proc. 2004-34 in this Bulletin. Rev. Proc. 2004-34 provides a method of accounting under which taxpayers using an accrual method of accounting may defer including all or part of certain advance payments in gross income until the year after the year the payment is received.

In the situations described below, may an individual make contributions to a Health Savings Account (HSA) under section 223 of the Internal Revenue Code if the individual is covered by a high deductible health plan (HDHP) and also covered by a health flexible spending arrangement (health FSA) or a health reimbursement arrangement (HRA)?

Situation 1. An individual is covered by an HDHP (as defined under section 223(c)(2)(A)). The HDHP has an 80/20 percent coinsurance feature above the deductible. The individual is also covered by a health FSA under a section 125 cafeteria plan and an HRA that meets the requirements of Notice 2002-45, 2002-2 C.B. 93. The health FSA and HRA pay or reimburse all section 213(d) medical expenses that are not covered by the HDHP (such as co-payments, coinsurance, expenses not covered due to the deductible and other medical expenses not covered by the HDHP). The health FSA and HRA coordinate the payment of benefits under the ordering rules of Notice 2002-45. The individual is not entitled to benefits under Medicare and may not be claimed as a dependent on another person’s tax return.

Situation 2. Same facts as Situation 1, except that the health FSA and HRA are limited-purpose arrangements that pay or reimburse, pursuant to the written plan document, only vision and dental expenses (whether or not the minimum annual deductible of the HDHP has been satisfied). In addition, the health FSA and HRA pay or reimburse preventive care benefits as described in Notice 2004-23, 2004-15 I.R.B. 725.

Situation 3. Same facts as Situation 1, except that the individual is not covered by a health FSA. Under the employer’s HRA, the individual elects, before the beginning of the HRA coverage period, to forgo the payment or reimbursement of medical expenses incurred during that coverage period. The decision to forgo the payment or reimbursement of medical expenses does not apply to permitted insurance, permitted coverage and preventive care (“excepted medical expenses”). See section 223(c)(1)(B) and Notice 2004-23. Medical expenses incurred during the suspended HRA coverage period (other than the excepted medical expenses if otherwise allowed to be paid or reimbursed by an HRA), cannot be paid or reimbursed by the HRA currently or later (i.e., after the HRA suspension ends). However, the employer decides to continue to make employer contributions to the HRA during the suspension period and thus the maximum available amount under the HRA is not affected by the suspension but is available for the payment or reimbursement of the excepted medical expenses incurred during the suspension period as well as medical expenses incurred in later HRA coverage periods.

Situation 4. Same facts as Situation 1, except that the health FSA and HRA are post-deductible arrangements that only pay or reimburse medical expenses (including the individual’s 20 percent coinsurance responsibility for expenses above the deductible) after the minimum annual deductible of the HDHP has been satisfied.

Situation 5. Same facts as Situation 1, except that the individual is not covered by a health FSA. The employer’s HRA is a retirement HRA that only reimburses those medical expenses incurred after the individual retires.

Section 223(a) allows a deduction for contributions to an HSA for an “eligible individual” for any month during the taxable year. Section 223(c)(1)(A) provides that an “eligible individual” means, with respect to any month, any individual who is covered under an HDHP on the first day of such month and is not, while covered under an HDHP, “covered under any health plan which is not a high deductible health plan, and which provides coverage for any benefit which is covered under the high deductible health plan.”

Section 223(b) provides a limit on amounts that can be contributed to an HSA. The maximum annual contribution limit for an eligible individual with self-only coverage is the amount required by section 223(b)(2)(A). The maximum annual contribution limit for an eligible individual with family coverage is the amount required by section 223(b)(2)(B).

Section 223(c)(2)(A) defines an HDHP as a health plan that satisfies certain requirements with respect to minimum annual deductibles and maximum annual out-of-pocket expenses. Generally, if substantially all of the coverage in a health plan that is intended to be an HDHP is provided through a health FSA or HRA, the health plan is not an HDHP.

In addition to coverage under an HDHP, section 223(c)(1)(B) provides that an eligible individual may have specifically enumerated coverage that is disregarded for purposes of the deductible. Coverage that may be disregarded includes “permitted insurance” and other specified coverage (“permitted coverage”). “Permitted insurance” is coverage under which substantially all of the coverage provided relates to liabilities incurred under workers’ compensation laws, tort liabilities, liabilities relating to ownership or use of property, insurance for a specified disease or illness, and insurance that pays a fixed amount per day (or other period) of hospitalization. “Permitted coverage” (whether through insurance or otherwise) is coverage for accidents, disability, dental care, vision care or long-term care. Section 223(c)(2)(C) also provides a safe harbor for the absence of a preventive care deductible. See Notice 2004-23.

The legislative history of section 223 explains these provisions by stating that “eligible individuals for HSAs are individuals who are covered by a high deductible health plan and no other health plan that is not a high deductible health plan.” The legislative history also explains that, “[a]n individual with other coverage in addition to a high deductible health plan is still eligible for an HSA if such other coverage is certain permitted insurance or permitted coverage.” H.R. Conf. Rep. No. 391, 108^th Cong., 1st Sess. 841 (2003).

Section 125(a) states that no amount will be included in the gross income of a participant in a cafeteria plan solely because, under the plan, the participant may choose among the benefits of the plan. Section 125(d) defines a cafeteria plan as a written plan under which participants may choose among two or more benefits consisting of cash and qualified benefits.

Section 125(f) defines qualified benefits as any benefit not included in the gross income of the employee by reason of an express provision in the Code. Qualified benefits include employer-provided accident and health coverage under section 106, including health FSAs.

Notice 2002-45, 2002-2 C.B. 93, describes the tax treatment of HRAs. The notice explains that an HRA that receives tax-favored treatment is an arrangement that is paid for solely by the employer and not pursuant to a salary reduction election under section 125, reimburses the employee for medical care expenses incurred by the employee and by the employee’s spouse and dependents, and provides reimbursement up to a maximum dollar amount with any unused portion of that amount at the end of the coverage period carried forward to subsequent coverage periods.

Notice 2002-45, Part IV, states that if an employer provides an HRA in conjunction with another accident or health plan and that other plan is provided pursuant to a salary reduction election under a cafeteria plan, then all the facts and circumstances are considered in determining whether the salary reduction is attributable to the HRA. An accident or health plan funded pursuant to salary reduction is not an HRA and is subject to the rules under section 125.

Under section 223, an eligible individual cannot be covered by a health plan that is not an HDHP unless that health plan provides permitted insurance, permitted coverage or preventive care. A health FSA and an HRA are health plans and constitute other coverage under section 223(c)(1)(A)(ii). Consequently, an individual who is covered by an HDHP and a health FSA or HRA that pays or reimburses section 213(d) medical expenses is generally not an eligible individual for the purpose of making contributions to an HSA. See Rev. Rul. 2004-38, 2004-15 I.R.B. 717, which holds that an individual who is covered by an HDHP that does not provide prescription drug coverage and a separate prescription drug plan or rider that provides benefits before the minimum annual deductible of the HDHP has been satisfied is not an eligible individual for HSA purposes.

However, an individual is an eligible individual for the purpose of making contributions to an HSA for periods the individual is covered under the following arrangements:

Limited-Purpose Health FSA or HRA. A limited-purpose health FSA that pays or reimburses benefits for “permitted coverage” (but not through insurance or for long-term care services) and a limited-purpose HRA that pays or reimburses benefits for “permitted insurance” (for a specific disease or illness or that provides a fixed amount per day (or other period) of hospitalization) or “permitted coverage” (but not for long-term care services). In addition, the limited-purpose health FSA or HRA may pay or reimburse preventive care benefits. The individual is an eligible individual for the purpose of making contributions to an HSA because these benefits may be provided whether or not the HDHP deductible has been satisfied.

Suspended HRA. A suspended HRA, pursuant to an election made before the beginning of the HRA coverage period, that does not pay or reimburse, at any time, any medical expense incurred during the suspension period except preventive care, permitted insurance and permitted coverage (if otherwise allowed to be paid or reimbursed by the HRA). The individual is an eligible individual for the purpose of making contributions to an HSA. When the suspension period ends, the individual is no longer an eligible individual because the individual is again entitled to receive payment or reimbursement of section 213(d) medical expenses from the HRA. An individual who does not forgo the payment or reimbursement of medical expenses incurred during an HRA coverage period, is not an eligible individual for HSA purposes during that HRA coverage period.

If an HSA is funded through salary reduction under a cafeteria plan during the suspension period, the terms of the salary reduction election must indicate that the salary reduction is used only to pay for the HSA offered in conjunction with the HRA and not to pay for the HRA itself. Thus, the mere fact that an individual participates in an HSA funded pursuant to a salary reduction election does not necessarily result in attributing the salary reduction to the HRA.

Post-Deductible Health FSA or HRA. A post-deductible health FSA or HRA that does not pay or reimburse any medical expense incurred before the minimum annual deductible under section 223(c)(2)(A)(i) is satisfied. The individual is an eligible individual for the purpose of making contributions to the HSA. The deductible for the HRA or health FSA (“other coverage”) need not be the same as the deductible for the HDHP, but in no event may the HDHP or other coverage provide benefits before the minimum annual deductible under section 223(c)(2)(A)(i) is satisfied. Where the HDHP and the other coverage do not have identical deductibles, contributions to the HSA are limited to the lower of the deductibles. In addition, although the deductibles of the HDHP and the other coverage may be satisfied independently by separate expenses, no benefits may be paid before the minimum annual deductible under section 223(c)(2)(A)(i) has been satisfied.

Retirement HRA. A retirement HRA that pays or reimburses only those medical expenses incurred after retirement (and no expenses incurred before retirement). In this case, the individual is an eligible individual for the purpose of making contributions to the HSA before retirement but loses eligibility for coverage periods when the retirement HRA may pay or reimburse section 213(d) medical expenses. Thus, after retirement, the individual is no longer an eligible individual for the purpose of the HSA.

In the arrangements described, the individual does not fail to be an eligible individual under section 223 and may contribute to an HSA. In addition, combinations of these arrangements which are consistent with these requirements would not disqualify an individual from being an eligible individual. For example, if an employer offers a combined post-deductible health FSA and a limited-purpose health FSA, this would not disqualify an otherwise eligible individual from contributing to an HSA.

An individual may not be reimbursed for the same medical expense by more than one plan or arrangement. However, if the individual has available an HSA, a health FSA and an HRA that pay or reimburse the same medical expense, the health FSA or the HRA may pay or reimburse the medical expense, subject to the ordering rules in Notice 2002-45, Part V, so long as the individual certifies to the employer that the expense has not been reimbursed and that the individual will not seek reimbursement under any other plan or arrangement covering that expense (including the HSA).

In Situation 1, the individual is covered by an HDHP and by a health FSA and HRA that pay or reimburse medical expenses incurred before the minimum annual deductible under section 223(c)(2)(A)(i) has been satisfied. The health FSA and HRA pay or reimburse medical expenses that are not limited to the exceptions for permitted insurance, permitted coverage or preventive care. As a result, the individual is not an eligible individual for the purpose of making contributions to an HSA. This result is the same if the individual is covered by a health FSA or HRA sponsored by the employer of the individual’s spouse. See, Rev. Rul. 2004-38.

In Situation 2, the individual is covered by an HDHP and by a health FSA and HRA that pay or reimburse medical expenses incurred before the minimum annual deductible under section 223(c)(2)(A)(i) has been satisfied. However, the medical expenses paid or reimbursed by the health FSA and HRA include only vision and dental benefits (which are permitted coverage) and preventive care. All of these benefits may be covered as a separate health plan, as a separate or optional rider, or as part of the HDHP and whether or not the minimum annual deductible under section 223(c)(2)(A)(i) has been satisfied. The individual is an eligible individual for the purpose of making contributions to an HSA.

In Situation 3, the individual elects to forgo the payment or reimbursement of medical expenses incurred during an HRA coverage period. The suspension of payments and reimbursements by the HRA does not apply to permitted insurance, permitted coverage and preventive care (if otherwise allowed to be paid or reimbursed by the HRA). The individual is an eligible individual for the purpose of making contributions to an HSA until the suspension period ends and the individual is again entitled to receive, from the HRA, payments or reimbursements of section 213(d) medical expenses incurred after the suspension period.

In Situation 4, the health FSA and HRA pay or reimburse medical expenses (including the 20 percent coinsurance not otherwise covered by the HDHP) only after the HDHP’s minimum annual deductible has been satisfied. The individual is an eligible individual for the purpose of making contributions to an HSA.

In Situation 5, the HRA is a retirement HRA that only pays or reimburses medical expenses incurred after the individual retires. The individual is an eligible individual for the purpose of making contributions to an HSA before retirement because the HRA will pay or reimburse only medical expenses incurred after retirement.

The principal author of this notice is Shoshanna Tanner of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For further information regarding this notice, contact Ms. Tanner at (202) 622-6080 (not a toll-free call).

(1) Are credit card annual fees interest for federal income tax purposes?

(2) When are credit card annual fees includible in gross income by the card issuer?

X, a taxpayer that uses an overall accrual method of accounting for federal income tax purposes, issues credit cards. Each card allows the cardholder to access a revolving line of credit to make purchases of goods and services and, if otherwise provided for under the applicable cardholder agreement, to obtain cash advances.

Credit card issuers, including X, charge certain cardholders an annual fee. These credit card issuers make various benefits and services available to their cardholders during the year, regardless of whether the cardholder actually utilizes them. Further, although they provide these benefits and services to cardholders, no part of the annual fee that is charged to any cardholder is for a specific benefit or service provided by a credit card issuer to that cardholder.

Each cardholder’s credit card agreement sets forth the applicable terms and conditions under which X may charge that cardholder an annual fee. X charges some cardholders a nonrefundable annual fee. X charges other cardholders an annual fee that is refundable on a pro rata basis if the cardholder closes the account during the period covered by the fee.

Under the applicable cardholder agreement, no annual fee becomes due and payable until X posts an annual fee charge to the cardholder’s credit card account. X reflects this posting in the cardholder’s credit card statement. X generally posts the full amount of the annual fee in a single charge unless the terms of the agreement require X to post the annual fee charge in installments.

For federal income tax purposes, interest is an amount that is paid in compensation for the use or forbearance of money. Deputy v. DuPont, 308 U.S. 488 (1940), 1940-1 C.B. 118; Old Colony Railroad Co. v. Commissioner, 284 U.S. 552 (1932), 1932-1 C.B. 274. Neither the label used for the fee nor a taxpayer’s treatment of the fee for financial or regulatory reporting purposes is determinative of the proper federal income tax characterization of that fee. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542-43 (1979), 1979-1 C.B. 167, 174-75; Rev. Rul. 72-315, 1972-1 C.B. 49.

The annual fee that credit card issuers, including X, charge any cardholder is not for any specific benefit provided by the credit card issuer to that cardholder. Rather, it is charged for all of the benefits and services that are available to the cardholder under the applicable cardholder agreement. Because cardholders pay annual fees to credit card issuers, including X, in return for all of the benefits and services available under the applicable credit card agreement, annual fees are not compensation for the use or forbearance of money. Thus, X’s annual fee income is not interest income for federal income tax purposes.

Under § 451(a) of the Internal Revenue Code, the amount of any item of gross income is includible in gross income for the taxable year in which it is received by the taxpayer, unless that amount is to be properly accounted for in a different period under the method of accounting used by the taxpayer in computing taxable income.

Under § 1.451-1(a) of the Income Tax Regulations, income is includible in gross income by a taxpayer that uses an accrual method of accounting when all events have occurred that fix the taxpayer’s right to receive that income and the amount of that income can be determined with reasonable accuracy. See also § 1.446-1(c)(1)(ii)(A). Generally, all the events that fix the right to receive income occur when either the required performance takes place, payment is due, or payment is made, whichever occurs first (the all events test). See Rev. Rul. 2003-10, 2003-1 C.B. 288; Rev. Rul. 80-308, 1980-2 C.B. 162.

X is required to include these annual fees in gross income under § 1.451-1(a) when the fee income becomes due and payable under its agreements, because X’s right to the income is fixed at that point and the amount of the income can be determined with reasonable accuracy. Thus, the all events test is satisfied when X posts an annual fee charge to a cardholder’s credit card account even if X later is required to refund a portion of a previously posted refundable annual fee charge because the cardholder closes the account during the period covered by that fee.

Notwithstanding the holding of this revenue ruling, Rev. Proc. 2004-32, 2004-22 I.R.B. , dated June 1, 2004, this Bulletin, allows card issuers to account for annual fee income using the Ratable Inclusion Method for Credit Card Annual Fees, which is described in section 4 of that revenue procedure. Rev. Proc. 2004-32 also provides automatic consent for a taxpayer described in this revenue ruling to change its method of accounting for annual fee income.

(1) Credit card annual fees are not interest for federal income tax purposes.

(2) Credit card annual fees are includible in gross income by the card issuer when they become due and payable by cardholders under the terms of the credit card agreements.

The principal authors of this revenue ruling are Rebecca E. Asta, Alexa Dubert, and Tina Jannotta of the Office of Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact the principal authors at (202) 622-3930 (not a toll-free call).

1. Whether, under the facts described below, an organization continues to qualify for exemption from federal income tax as an organization described in § 501(c)(3) of the Internal Revenue Code when it contributes a portion of its assets to and conducts a portion of its activities through a limited liability company (LLC) formed with a for-profit corporation.

2. Whether, under the same facts, the organization is subject to unrelated business income tax under § 511 on its distributive share of the LLC’s income.

M is a university that has been recognized as exempt from federal income tax under § 501(a) as an organization described in § 501(c)(3). As a part of its educational programs, M offers summer seminars to enhance the skill level of elementary and secondary school teachers.

To expand the reach of its teacher training seminars, M forms a domestic LLC, L, with O, a company that specializes in conducting interactive video training programs. L’s Articles of Organization and Operating Agreement (“governing documents”) provide that the sole purpose of L is to offer teacher training seminars at off-campus locations using interactive video technology. M and O each hold a 50 percent ownership interest in L, which is proportionate to the value of their respective capital contributions to L. The governing documents provide that all returns of capital, allocations and distributions shall be made in proportion to the members’ respective ownership interests.

The governing documents provide that L will be managed by a governing board comprised of three directors chosen by M and three directors chosen by O. Under the governing documents, L will arrange and conduct all aspects of the video teacher training seminars, including advertising, enrolling participants, arranging for the necessary facilities, distributing the course materials and broadcasting the seminars to various locations. L’s teacher training seminars will cover the same content covered in the seminars M conducts on M’s campus. However, school teachers will participate through an interactive video link at various locations rather than in person. The governing documents grant M the exclusive right to approve the curriculum, training materials, and instructors, and to determine the standards for successful completion of the seminars. The governing documents grant O the exclusive right to select the locations where participants can receive a video link to the seminars and to approve other personnel (such as camera operators) necessary to conduct the video teacher training seminars. All other actions require the mutual consent of M and O.

The governing documents require that the terms of all contracts and transactions entered into by L with M, O and any other parties be at arm’s length and that all contract and transaction prices be at fair market value determined by reference to the prices for comparable goods or services. The governing documents limit L’s activities to conducting the teacher training seminars and also require that L not engage in any activities that would jeopardize M’s exemption under § 501(c)(3). L does in fact operate in accordance with the governing documents in all respects.

M’s participation in L will be an insubstantial part of M’s activities within the meaning of § 501(c)(3) and § 1.501(c)(3)-1(c)(1) of the Income Tax Regulations.

Because L does not elect under § 301.7701-3(c) of the Procedure and Administration Regulations to be classified as an association, L is classified as a partnership for federal tax purposes pursuant to § 301.7701-3(b).

L is a partnership for federal tax purposes. Therefore, L’s activities are attributed to M for purposes of determining both whether M operates exclusively for educational purposes and therefore continues to qualify for exemption under § 501(c)(3) and whether M has engaged in an unrelated trade or business and therefore may be subject to the unrelated business income tax on its distributive share of L’s income.

The activities M is treated as conducting through L are not a substantial part of M’s activities within the meaning of § 501(c)(3) and § 1.501(c)(3)-1(c)(1). Therefore, based on all the facts and circumstances, M’s participation in L, taken alone, will not affect M’s continued qualification for exemption as an organization described in § 501(c)(3).

Although M continues to qualify as an exempt organization described in § 501(c)(3), M may be subject to unrelated business income tax under § 511 if L conducts a trade or business that is not substantially related to the exercise or performance of M’s exempt purposes or functions.

The facts establish that M’s activities conducted through L constitute a trade or business that is substantially related to the exercise and performance of M’s exempt purposes and functions. Even though L arranges and conducts all aspects of the teacher training seminars, M alone approves the curriculum, training materials and instructors, and determines the standards for successfully completing the seminars. All contracts and transactions entered into by L are at arm’s length and for fair market value, M’s and O’s ownership interests in L are proportional to their respective capital contributions, and all returns of capital, allocations and distributions by L are proportional to M’s and O’s ownership interests. The fact that O selects the locations and approves the other personnel necessary to conduct the seminars does not affect whether the seminars are substantially related to M’s educational purposes. Moreover, the teacher training seminars L conducts using interactive video technology cover the same content as the seminars M conducts on M’s campus. Finally, L’s activities have expanded the reach of M’s teacher training seminars, for example, to individuals who otherwise could not be accommodated at, or conveniently travel to, M’s campus. Therefore, the manner in which L conducts the teacher training seminars contributes importantly to the accomplishment of M’s educational purposes, and the activities of L are substantially related to M’s educational purposes. Section 1.513-1(d)(2). Accordingly, based on all the facts and circumstances, M is not subject to unrelated business income tax under § 511 on its distributive share of L’s income.

1. M continues to qualify for exemption under § 501(c)(3) when it contributes a portion of its assets to and conducts a portion of its activities through L.

2. M is not subject to unrelated business income tax under § 511 on its distributive share of L’s income.

The principal author of this revenue ruling is Virginia G. Richardson of Exempt Organizations, Tax Exempt and Government Entities Division. For further information regarding this revenue ruling, contact Virginia G. Richardson at (202) 283-8938 (not a toll-free call).

Is a federally recognized Indian tribal government, as described in § 7701(a)(40)(A) of the Internal Revenue Code, an eligible S corporation shareholder under § 1361?

X is a federally recognized Indian tribal government (Indian tribal government) and a shareholder in Corporation, a domestic entity, formed in accordance with the laws of State. Corporation wants to make an election to be an S corporation.

Section 1361(a) provides that for purposes of this title, the term “S corporation” means, with respect to any taxable year, a small business corporation for which an election under § 1362(a) is in effect for the year.

Section 1361(b)(1) provides that for purposes of this subchapter, the term “small business corporation” means a domestic corporation which is not an ineligible corporation and which does not (A) have more than 75 shareholders, (B) have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(6)) who is not an individual, (C) have a nonresident alien as a shareholder, and (D) have more than one class of stock.

Section 1361(c)(6) provides that for purposes of subsection (b)(1)(B), an organization which is (A) described in §§ 401(a) or 501(c)(3), and (B) exempt from taxation under § 501(a), may be a shareholder in an S corporation.

Section 401(a) provides the definition of a qualified pension, profit-sharing, and stock bonus plans that qualifies under § 1361(b) as an eligible S corporation shareholder.

Section 501(a) provides that an organization described in subsection (c) or (d) or § 401(a) shall be exempt from taxation under this subtitle unless that exemption is denied under § 502 or § 503.

Section 501(c)(3) describes corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literacy, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in section (h)), and which does not participate in, or intervene in (including the publishing or distribution of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

Section 7701(a)(40)(A) states that the term “Indian tribal government” refers to the governing body of any tribe, band, community, village, or group of Indians, or (if applicable) Alaska Natives, which is determined by the Secretary of the Treasury, after consultation with the Secretary of the Interior, to exercise governmental functions.

Section 7871(a) and § 305.7871-1 of the Income Tax Regulations provide that Indian tribal governments will be treated as states for certain enumerated federal tax purposes.

Section 7871(d) states that, for purposes of § 7871(a), a subdivision of an Indian tribal government shall be treated as a political subdivision of a state if (and only if) the Secretary of the Treasury determines (after consultation with the Secretary of the Interior) that the subdivision has been delegated the right to exercise one or more of the substantial governmental functions of the Indian tribal government.

Rev. Proc. 2002-64, 2002-2 C.B. 717, provides the most recent list of federally recognized tribal governments. In the situation described in this ruling, X is a federally recognized Indian tribal government.

Generally, federal income tax statutes do not tax Indian tribes. See Rev. Rul. 67-284, 1967-2 C.B. 55. An Indian tribe is not subject to federal income tax as an individual under § 1 or as a corporation under § 11. However, colleges and universities formed by Indian tribes are subject to § 511(a)(2)(B) (relating to the taxation of colleges and universities which are agencies or instrumentalities of governments or their political subdivisions) pursuant to § 7871(a)(5). Indian tribes also are subject to certain excise taxes.

Rev. Rul. 60-384, 1960-2 C.B. 172, provides circumstances under which a governmental agency is prohibited from qualifying as a § 501(c)(3) organization. A state or municipality itself will not qualify as an organization described in § 501(c)(3) since its purposes are clearly not exclusively those described in § 501(c)(3). Where a particular branch or department under whose jurisdiction the activity in question is being coordinated is an integral part of a state or municipal government, the provisions of § 501(c)(3) would also not be applicable.

Based on the above law and published guidance, X, an Indian tribal government, is not subject to federal income tax as an individual under § 1. Because an Indian tribal government is not subject to tax as an individual for § 1 purposes, it is not considered an individual under § 1361(b)(1)(B).

In addition, X, an Indian tribal government, does not qualify under the § 1362(c)(6) exception for certain exempt organizations described in § 501(c)(3) or § 401(a). X is not a § 401(a) organization because it is not a qualified pension, profit-sharing, or stock bonus plan. Furthermore, X is not a § 501(c)(3) organization because it is a government and its purposes are not exclusively those described in § 501(c)(3). Consequently, X is not an eligible S corporation shareholder, and Corporation cannot make an election to be an S corporation.

A federally recognized Indian tribal government is not an eligible S corporation shareholder for purposes of § 1361.

The principal author of this revenue ruling is Laura C. Nash of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Ms. Nash at (202) 622-3050 (not a toll-free call).

This notice provides guidance to regulated investment companies (“RICs”), real estate investment trusts (“REITs”), and their shareholders in applying § 1(h) of the Internal Revenue Code to capital gain dividends of RICs and REITs. The notice explains how the changes to § 1(h) made by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “JGTRRA”), Pub. L. No. 108-27, 117 Stat. 752, apply to RIC and REIT capital gain dividends paid (or accounted for as if paid) in taxable years that end on or after May 6, 2003.

For individuals, estates, and trusts, § 1(h) imposes differing rates of tax on various transactions depending on the types of transactions giving rise to net capital gains. For transactions taken into account during taxable years ending before May 6, 2003, a taxpayer’s long-term capital gains and losses generally are separated into three tax-rate groups: a 20-percent group, a 25-percent group, and a 28-percent group. See Notice 97-59, 1997-2 C.B. 309. For certain taxpayers, transactions in the 20-percent group may be taxed at a 10-percent rate, or at an 8-percent rate if the gain is qualified 5-year gain under § 1(h)(9) (as in effect before the enactment of the JGTRRA).

For transactions taken into account during taxable years ending on or after May 6, 2003, and beginning before January 1, 2009, the JGTRRA reduced the 20-percent rate to 15 percent, reduced the 10-percent rate to 5 percent (0 percent for taxable years beginning after 2007), and repealed the rules dealing with qualified 5-year gain. For a taxable year that includes May 6, 2003, the reduction in rates and the repeal of the rules dealing with qualified 5-year gain apply to gain or loss properly taken into account for the portion of the taxable year on or after May 6, 2003. Because this effective date generally occurs sometime during a taxpayer’s taxable year, the amount of capital gain that benefits from the reduced 15-percent (or 5-percent) rate is generally the lesser of the net capital gain for the entire taxable year or the net capital gain determined using only gain and loss properly taken into account for the portion of the taxable year on or after May 6, 2003. JGTRRA § 301(c)(1)-(2) (“the JGTRRA transition rule”). In applying the JGTRRA transition rule with respect to a pass-through entity, the determination of when gains and losses are properly taken into account is made at the entity level. Id. § 301(c)(4). See the last paragraph of Section 3 of this notice for the application of this rule.

The Secretary has authority to issue regulations concerning the application of § 1(h) to sales and exchanges by (and of interests in) pass-through entities, including RICs and REITs. § 1(h)(9).

To the extent that a RIC or a REIT has net capital gain for a taxable year, it may designate as capital gain dividends the dividends that it pays during the year, the dividends that § 855 or 858 deems it to pay during the year, or deficiency dividends under § 860 that it pays for that year. In general, a capital gain dividend is treated by the shareholders that receive it as a gain from the sale or exchange of a capital asset held for more than one year.

Notice 97-64, 1997-2 C.B. 323, describes regulations that will be issued under § 1(h) concerning the application of § 1(h) to capital gain dividends of RICs and REITs, effective for taxable years ending on or after May 7, 1997. As described in Notice 97-64, the regulations will allow a RIC or REIT to make additional designations of capital gain dividends to reflect the differing tax-rate groups under § 1(h) and will provide limitations on the amounts that can be designated in the differing tax-rate groups. In calculating those limitations, the regulations will provide for a deferral adjustment or bifurcation adjustment in certain situations. In addition, the regulations will provide special rules for distributions of § 1202 gain.

Moreover, when those regulations are issued, they will reflect changes to § 1(h) since the publication of Notice 97-64. (For example, the Tax and Trade Relief Extension Act of 1998, Pub. L. No. 105-277, 112 Stat. 2681-886, ended the relevance of holding a capital asset for more than 18 months.)

This Notice 2004-39 describes how the reduction in rates made by the JGTRRA and the JGTRRA transition rule (for taxable years that include May 6, 2003), apply to capital gain dividends of RICs and REITs. Future guidance may be issued to clarify certain of the rules originally described in Notice 97-64 and to make other modifications to take into account industry experience with the rules. That guidance generally will apply on a prospective basis.

For taxable years ending on or after May 6, 2003, the rules described in Notice 97-64 continue to apply to capital gain dividends of RICs and REITs, with appropriate modifications to take into account the changes that have been made to § 1(h) since that notice was published. Thus, if a RIC or REIT designates a dividend as a capital gain dividend, the RIC or REIT may make an additional designation of the dividend as a 15%-rate gain distribution, subject to the limitations described in section 5 of Notice 97-64, including the limitation that the additional designation of a class of capital gain dividend not exceed the maximum distributable amount in that class.

In general, a RIC or REIT determines the maximum distributable amounts that may be designated in each class of capital gains dividends by performing the computation required by § 1(h) as if the RIC or REIT were an individual whose ordinary income is subject to a marginal tax rate of at least 28 percent. The maximum distributable gain in each class of capital gain dividends is equal to the amount that, in the computation under § 1(h), is multiplied by the corresponding rate gain percentage. The computation under § 1(h), however, is modified in the following ways:

The JGTRRA transition rule applies at both the RIC/REIT level and at the shareholder level. That is, the rule applies at the RIC/REIT level to taxable years of the RIC or REIT that contain May 6, 2003, to govern how capital gain dividends may be designated, and it applies to taxable years of RIC/REIT shareholders that contain May 6, 2003, to govern the application of § 1(h) to the shareholder for that taxable year. Thus, if a RIC or REIT pays a capital gain dividend during 2004 that it properly designates as a 20%-rate gain distribution and the dividend is received by a fiscal year trust in a year of the trust that includes May 6, 2003, the dividend is treated by the trust as gain that is properly taken into account for the portion of the taxable year before May 6, 2003. On the other hand, if that same capital gain dividend is received during 2004 by an individual shareholder, or a trust, whose taxable year is the calendar year, the dividend is subject to tax at a rate no higher than 15 percent, because the JGTRRA transition rule applies only to shareholder taxable years that include May 6, 2003.

In taxable years beginning on or after May 6, 2003, some taxpayers may receive a RIC or REIT distribution amount that is designated as a 20%-rate gain distribution and that includes a portion constituting 5-year gain. As a result of the repeal of the separate rules for 5-year gains, the 5-year gain portion of that 20%-rate gain distribution is not subject to the prior-law 8-percent rate for 5-year gain. These taxpayers, however, will not be disadvantaged by the rate changes. The 5-year gain portion will be treated the same as any other 20%-rate gain distribution that is received in a taxable year beginning on or after May 6, 2003, and therefore will be taxed at a rate no higher than 15 percent (5 percent for certain taxpayers). Any taxpayer that would have been eligible in a taxable year to pay tax at the 8-percent rate for some or all 5-year gain had the prior rates remained in effect will be eligible under the new rules to pay tax on that amount of 5-year gain at the 5-percent rate.

(1) Example 1. RIC X’s taxable year ends on April 30. X has only the following capital gains and losses for the periods indicated, all of which are from sales of stock held for less than five years:

X does not make a deferral adjustment because X does not have a post-October net capital loss or net long-term capital loss for its taxable year ending April 30, 2004. X must make a bifurcation adjustment, however, because it has a pre-November net capital gain, it has a taxable year ending in April, and it does not make a deferral adjustment. Because X must apply both the bifurcation adjustment and the JGTRRA transition rule, for the pre-November and post-October portions of this taxable year X must make separate determinations of the maximum amounts that may be designated as 20%-rate gain and 15%-rate gain. The sum of these amounts determines the various maximum amounts that can be designated in the different classes of gain for the entire year.

For the pre-November period, the JGTRRA transition rule applies because the period includes May 6, 2003. Thus, X determines a net capital gain amount using only gain and loss properly taken into account for the portion of the taxable year that is on or after May 6, 2003 (and, because the determination is for the pre-November period, on or before October 31, 2003). The amount so determined is $0. X’s net capital gain for the entire pre-November period is $100x. Thus, for the pre-November period, X’s maximum designation of 20%-rate gain is $100x and its maximum designation of 15%- rate gain is $0. (X also has a net short-term gain of $10x in the pre-November period, which results in a dividend that is not specially designated and is treated by shareholders as ordinary income.)

For the post-October period, the JGTRRA transition rule does not apply because that period does not include May 6, 2003. Because X has $110x of net capital gain for that period, X’s maximum designation of 15%-rate gain is $110x.

For the taxable year ending April 30, 2004, therefore, X may designate up to $210x of capital gain dividends, of which up to $110x may be designated as 15%-rate gain distributions and up to $100x may be designated as 20%-rate gain distributions.

(2) Example 2. RIC Y’s taxable year ends on April 30. Y has only the following capital gains and losses for the periods indicated, all of which are from sales of stock held for less than five years:

Y does not make a deferral adjustment because it does not have a post-October net capital loss or net long-term capital loss for its taxable year ending April 30, 2004. Y does not make a bifurcation adjustment because it does not have a net capital gain for the pre-November portion of its taxable year ending April 30, 2004. Because Y’s taxable year ending April 30, 2004, includes May 6, 2003, the JGTRRA transition rule applies in determining Y’s maximum designations of capital gain for that taxable year.

Y’s net capital gain for the entire year is $100x. Y’s net capital gain determined using only gain and loss properly taken into account for the portion of the taxable year on or after May 6, 2003, however, is $10x. For this taxable year, Y may designate up to $100x of capital gain dividends, of which up to $10x may be designated as 15%-rate gain distributions and up to $90x may be designated as 20%-rate gain distributions.

Assume that Y pays a capital gain dividend on December 1, 2004, and that, under § 855(a), Y treats the dividend as having been paid during its taxable year ending April 30, 2004, but that, under § 855(b), Y’s shareholders treat the dividend as having been received in their taxable years that contain December 1, 2004. Assume also that shareholder A of Y is an individual, estate, or trust whose taxable year is the calendar year and that, on December 1, 2004, A receives from Y a dividend of $10x, of which $1x is designated as a 15%-rate gain distribution and $9x is designated as a 20%-rate gain distribution. Because A’s 2004 taxable year does not include May 6, 2003, neither the JGTRRA transition rule nor JGTRRA § 301(c)(4) applies to A for that taxable year. Thus, the $10x capital gain dividend received by A in 2004 is subject to a tax rate no higher than 15 percent.

The principal author of this notice is Sonja Kotlica of the Office of Associate Chief Counsel (Financial Institutions & Products). For further information regarding this notice, contact Ms. Kotlica at (202) 622-3960 (not a toll-free call).

This revenue procedure describes conditions under which a taxpayer that has invested in a repurchase agreement (repo) may treat its position in the repo as a Government security for purposes of qualifying as a regulated investment company (RIC) under the asset diversification test of section 851(b)(3) of the Internal Revenue Code.

.01 A repo is a written agreement that provides for a “sale” and “repurchase” of a security or securities (the “underlying securities,” or the “collateral”. The purchaser agrees to purchase the underlying securities at a specific price and the seller, or “counterparty,” agrees to repurchase the same securities on a specific date for a specified price, plus an additional amount that reflects the time value of the purchaser’s investment from the date of purchase of the underlying securities to the date of their repurchase by the seller.

.02 RICs purchase securities in repo transactions as a convenient means to invest idle cash at competitive rates on a secured basis, generally for short periods of time. See Securities and Exchange Commission (SEC) Release No. IC-25058, 66 FR 36156, 36156-57 (July 11, 2001):

Id. at 36157 (footnote omitted).

.03 Section 851(b) provides that certain requirements must be satisfied for a domestic corporation to be taxed as a RIC under subchapter M, part I. Section 851(b)(3) imposes certain asset diversification requirements with respect to a RIC’s total assets that must be satisfied as of the close of each quarter of the RIC’s taxable year.

.04 Section 851(b)(3)(A) requires that at least 50 percent of the value of a corporation’s total assets be represented by cash and cash items (including receivables), Government securities, securities of other RICs, and other securities generally limited in respect of any one issuer to an amount not greater in value than 5 percent of the value of the total assets of the RIC and to not more than 10 percent of the outstanding voting securities of such issuer.

.05 Section 851(b)(3)(B) provides that not more than 25 percent of the RIC’s total assets may be invested in the securities (other than Government securities and the securities of other RICs) of any one issuer, or of two or more issuers that the RIC controls and that are determined, under regulations, to be engaged in the same or similar trades or businesses or related trades or businesses.

.06 Section 5(b)(1) of the Investment Company Act of 1940, 15 U.S.C. 80a-1 et seq. (1940 Act) defines a “diversified company” as a management company that has at least 75 percent of its assets invested in cash and cash items (including receivables), Government securities, securities of other investment companies, and other securities that, for the purpose of this calculation, are limited in respect of any one issuer to an amount not greater in value than 5 percent of the value of the total assets of the management company and to not more than 10 percent of the outstanding voting securities of the issuer. The remaining 25 percent of the management company’s assets may be invested in any manner.

.07 Effective August 15, 2001, the SEC adopted Rule 5b-3, which is intended to adapt the 1940 Act to the economic realities of repos and to reflect recent developments in bankruptcy law protecting parties to repos. SEC Release No. IC-25058. Subject to certain conditions, Rule 5b-3 permits a fund to “look through” the counterparty to the collateral in determining whether the fund is in compliance with the investment criteria for diversified funds set forth in section 5(b)(1) of the 1940 Act and with certain other securities laws.

.08 The following definition is set forth in Rule 5b-3:

Rule 5b-3(c)(1).

.09 The “Collateralized Fully” definition plays a critical role in the application of the 1940 Act diversification rules to repos:

Rule 5b-3(a).

The effect of this rule is that, for purposes of the definition of a diversified investment company in section 5 of the1940 Act, if a repo is Collateralized Fully, a fund may (but need not) treat an investment in the repo as an investment in the underlying security or securities.

.10 Section 851(c)(5) provides that, for purposes of section 851(b)(3), all terms not specifically defined in section 851(c) shall have the same meaning as when used in the 1940 Act, as amended. The term “Government security” is not specifically defined in section 851(c).

.11 Section 2(a)(16) of the 1940 Act defines the term “Government security” for purposes of the 1940 Act without specific reference to funds investing in repos for which Government securities serve as collateral.

.12 The RIC diversification rules of subchapter M are substantially similar in structure and purpose to those of section 5(b)(1) of the 1940 Act. Both sets of rules impose numerical limitations on the percentages and types of assets that may be held by an investment company. Both sets of rules are intended to protect the investor from the risks of loss and of illiquidity inherent in the concentration of assets in the securities of a single or a small number of issuers. See H.R. Rep. No. 2020, 86^th Cong., 2^d Sess. 820-26. In view of the commonality of structure and purpose of both sets of rules and in view of the need for RICS simultaneously to comply with both, the RIC diversification provisions of the Code and those of the1940 Act should be interpreted consistently.

This revenue procedure applies to repos that, within the meaning of Rule 5b-3(c)(1), are Collateralized Fully with securities that qualify as Government securities for purposes of section 851(b)(3).

If a taxpayer has invested in a repo to which this revenue procedure applies, the taxpayer may treat its position in that repo as a Government security for purposes of section 851(b)(3) even if the taxpayer is not treated as the owner of the underlying securities for federal tax purposes.

This revenue procedure is effective for repos held by a RIC on or after August 15, 2001.

The principal author of this revenue procedure is Susan Thompson Baker of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue procedure, contact her at (202) 622-3940 (not a toll-free call).

This revenue procedure provides procedures for taxpayers to change their method of accounting for deducting under § 461(f) of the Internal Revenue Code amounts transferred to trusts in transactions described in Notice 2003-77, 2003-49 I.R.B. 1182.

.01 On November 19, 2003, the Internal Revenue Service and Treasury Department filed with the Federal Register proposed and temporary regulations under § 461(f). T.D. 9095, 2003-49 I.R.B. 1175 [68 F.R. 65634]; REG-136890-02, 2003-49 I.R.B. 1191 [68 F.R 65645]. These regulations clarify that the transfer of a taxpayer’s note or promise to provide property or services in the future is not a transfer for the satisfaction of a contested liability under § 461(f). The regulations also provide that a transfer of a taxpayer’s stock or the stock or note of a related party is not a transfer for the satisfaction of a contested liability under § 461(f). The regulations further provide that, in general, economic performance does not occur when a taxpayer transfers money or other property to a trust, escrow account, or court to provide for the satisfaction of a contested workers compensation, tort, or other payment liability. Rather, economic performance occurs when payment is made to the claimant.

.02 Notice 2003-77, 2003-49 I.R.B. 1182, identifies as “listed transactions” for purposes of § 1.6011-4(b)(2) of the Income Tax Regulations and §§ 301.6111-2(b)(2) and 301.6112-1(b)(2) of the Procedure and Administration Regulations, transactions in which taxpayers established trusts purported to qualify under § 461(f) that are the same as or substantially similar to the following transactions:

(1) Transactions in which a taxpayer transfers money or other property in taxable years beginning after December 31, 1953, and ending after August 16, 1954, and retains certain powers over the money or other property transferred;

(2) Transactions in which a taxpayer transfers any indebtedness of the taxpayer or any promise by the taxpayer to provide services or property in the future in taxable years beginning after December 31, 1953, and ending after August 16, 1954;

(3) Transactions in which a taxpayer using an accrual method of accounting transfers money or other property after July 18, 1984, to provide for the satisfaction of a workers compensation or tort liability (unless the trust is the person to which the liability is owed, or payment to the trust discharges the taxpayer’s liability to the claimant);

(4) Transactions in which a taxpayer using an accrual method of accounting transfers money or other property in taxable years beginning after December 31, 1991, to provide for the satisfaction of a liability for which payment is economic performance under § 1.461-4(g) (unless the trust is the person to which the liability is owed, or payment to the trust discharges the taxpayer’s liability to the claimant), other than a liability for workers compensation or tort; and

(5) Transactions in which a taxpayer transfers stock issued by the taxpayer, or indebtedness or stock issued by a party related to the taxpayer (as defined in § 267(b)), on or after November 19, 2003.

.03 Section 1.6011-4(a) provides that every taxpayer that has participated (as described in § 1.6011-4(c)(3)) in a reportable transaction and that is required to file a tax return must attach a disclosure statement to its return. A reportable transaction includes any transaction that is the same as or substantially similar to one of the types of transactions that the IRS has determined to be a tax avoidance transaction and identified by published guidance as a listed transaction. Section 1.6011-4(b)(2). Generally, a listed transaction is not treated as a reportable transaction if the transaction affected the taxpayer’s Federal income tax liability as reported on any tax return filed on or before February 28, 2000. Section 1.6011-4T(b)(2) as published in T.D. 8877, 2000-1 C.B. 747, in 65 Fed. Reg. 11205. See also § 1.6011-4(h).

.04 Sections 446(e) and 1.446-1(e) provide that, except as otherwise provided, a taxpayer must secure the consent of the Commissioner before changing a method of accounting for federal income tax purposes. Section 1.446-1(e)(3)(i) provides that, to obtain the Commissioner’s consent to an accounting method change, a taxpayer must file a Form 3115, Application for Change in Accounting Method, during the taxable year in which the taxpayer desires to make the proposed change. Section 1.446-1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the limitations, terms, and conditions deemed necessary to permit a taxpayer to obtain consent to change a method of accounting in accordance with § 446(e).

.05 Rev. Proc. 97-27, 1997-1 C.B. 680, (as modified and amplified by Rev. Proc. 2002-19, 2002-1 C.B. 696, as amplified and clarified by Rev. Proc. 2002-54, 2002-2 C.B. 432), provides procedures for obtaining the consent of the Commissioner to change a method of accounting for federal income tax purposes. In general, under these procedures a taxpayer must file a Form 3115 during the year of change and may not request or make a retroactive change in method of accounting unless specifically authorized by the Commissioner. Rev. Proc. 97-27, sections 5.01, 2.04. In addition, under these procedures a taxpayer generally takes into account a positive § 481(a) adjustment resulting from the change in method of accounting ratably over four taxable years and receives audit protection for taxable years prior to the year of change. Rev. Proc. 97-27, sections 5.02(3)(a), 9.01. However, section 8.01 of Rev. Proc. 97-27 states that the Service reserves the right to decline to process a Form 3115 “in situations in which it would not be in the best interest of sound tax administration to permit the requested change. In this regard, the Service will consider whether the change in method of accounting would clearly and directly frustrate compliance efforts of the Service in administering the income tax laws.”

.06 Rev. Rul. 90-38, 1990-1 C.B. 57, provides that, if a taxpayer uses an erroneous method of accounting for two or more consecutive taxable years, the taxpayer has adopted a method of accounting. The ruling further provides that a taxpayer may not, without the Commissioner’s consent, retroactively change from an erroneous to a permissible method of accounting by filing an amended return.

.07 A change from deducting an asserted liability in the taxable year of transfer of money or other property to a trust described in Notice 2003-77 to deducting the liability in the taxable year of payment to the claimant is a change in method of accounting. The Service has determined that it is not in the best interest of sound tax administration to permit a prospective change in method of accounting for such deductions in transactions that are required to be disclosed as listed transactions under § 1.6011-4. In addition, in the interest of sound tax administration, the Service has determined that the terms and conditions set forth in Rev. Proc. 97-27 should be modified for changes in methods of accounting for such deductions in transactions that are not required to be disclosed as listed transactions under § 1.6011-4.

This revenue procedure applies to taxpayers that desire to change a method of accounting for transactions described in section 2.02 of this revenue procedure.

.01 Change in method of accounting for transactions described in Notice 2003-77 that are required to be disclosed as listed transactions under § 1.6011-4. The Service will not process applications for changes in method of accounting filed for transactions within the scope of this revenue procedure that are required to be disclosed under § 1.6011-4. Taxpayers may change their method of accounting for these transactions by filing an amended return in accordance with section 4.04 of this revenue procedure.

.02 Change in method of accounting for transactions described in Notice 2003-77 that are not required to be disclosed as listed transactions under § 1.6011-4. Taxpayers that desire to change a method of accounting for transactions within the scope of this revenue procedure that are not required to be disclosed under § 1.6011-4 may change their method of accounting for these transactions by filing an amended return in accordance with section 4.04 of this revenue procedure or may request a change in method of accounting in accordance with the advance consent procedures of Rev. Proc. 97-27 with the following modifications:

(1) In lieu of the four year spread period for positive § 481(a) adjustments provided in section 5.02(3)(a) of Rev. Proc. 97-27, the taxpayer must take into account the entire amount of a positive § 481(a) adjustment in the taxable year of change; and

(2) The taxpayer must describe each transaction, explain in the Form 3115 why the transaction is not required to be disclosed under § 1.6011-4, and state the amount of § 481(a) adjustment for that transaction.

.03 Change in method of accounting by taxpayers that have engaged in multiple transactions described in Notice 2003-77, some of which are required to be disclosed as listed transactions under § 1.6011-4. A taxpayer changing its method of accounting for multiple transactions within the scope of this revenue procedure, some of which are required to be disclosed under § 1.6011-4 and some of which are not required to be disclosed under § 1.6011-4:

(1) May change its method of accounting for transactions that are not required to be disclosed under § 1.6011-4 in accordance with section 4.02 of this revenue procedure, but must take into account in computing the § 481(a) adjustment only amounts attributable to those transactions; and

(2) Must file amended returns in accordance with sections 4.01 and 4.04 of this revenue procedure to change its method of accounting for all transactions required to be disclosed under § 1.6011-4 prior to filing the Form 3115 for transactions not required to be disclosed.

.04 Change in method of accounting by filing amended return.

(1) In accordance with § 1.446-1(e)(3)(ii) and Rev. Rul. 90-38, consent is hereby granted for any taxpayer that has engaged in a transaction within the scope of this revenue procedure to file amended returns to retroactively change an impermissible method of accounting for amounts transferred to trusts purported to qualify under § 461(f) to a method that complies with § 461(f) and the regulations thereunder. This consent is granted only if the taxpayer files such amended returns for the first taxable year in which the taxpayer used the impermissible method of accounting for these transactions (or if the period of limitations has expired for such taxable year, for the first taxable year for which the period of limitations has not expired) and for each subsequent taxable year in which the taxpayer’s use of the impermissible method of accounting for these transactions reduced the taxpayer’s taxable income. If the period of limitations has expired for the first taxable year in which a taxpayer used the impermissible method of accounting for these transactions and the taxpayer files amended returns pursuant to this consent, the amended return for the first taxable year for which the period of limitations has not expired must include the entire amount of the § 481(a) adjustment attributable to the change in accounting method.

(2) A taxpayer that complies with section 4.04(1) of this revenue procedure also may file amended returns for any taxable years in which the taxpayer’s use of the impermissible method of accounting for these transactions increased its taxable income.

(3) Taxpayers filing amended returns under this revenue procedure must write “FILED UNDER REVENUE PROCEDURE 2004-31” at the top of the amended return. Taxpayers also must comply with the requirements of § 1.6011-4 including, but not limited to, attaching to the amended return any disclosure statements that may be required in accordance with § 1.6011-4(a) and (e).

This revenue procedure is effective on May 6, 2004.

The principal author of this revenue procedure is Norma Rotunno of the Office of the Associate Chief Counsel (Income Tax & Accounting). For further information regarding this notice, contact Ms. Rotunno at (202) 622-7900 (not a toll-free number).

This revenue procedure allows credit card issuers described in Rev. Rul. 2004-52, 2004-22 I.R.B. , dated June 1, 2004, this Bulletin, to account for annual fee income using the Ratable Inclusion Method for Credit Card Annual Fees, which is set forth in section 4 of this revenue procedure. The procedure also provides automatic consent procedures for a credit card issuer within the scope of this revenue procedure to change its method of accounting for annual fee income.

.01 Rev. Rul. 2004-52 describes certain taxpayers that issue credit cards. Each card allows the cardholder to access a revolving line of credit to make purchases of goods and services and, if otherwise provided by the applicable cardholder agreement, to obtain cash advances. These taxpayers may charge cardholders a credit card annual fee. Rev. Rul. 2004-52 holds that credit card annual fees are not interest for federal income tax purposes and that they are includible in income when the all events test under § 451 of the Internal Revenue Code is satisfied. Under the facts of Rev. Rul. 2004-52, the all events test is satisfied when the credit card annual fee becomes due and payable under the taxpayer’s cardholder agreements.

.02 Any change in a taxpayer’s treatment of income from credit card annual fees, including a change to conform the taxpayer’s method to either Rev. Rul. 2004-52 or to the Ratable Inclusion Method for Credit Card Annual Fees, which is permitted by section 4 of this revenue procedure, is a change in method of accounting to which the provisions of §§ 446 and 481 apply.

.03 Under § 446(e) and § 1.446-1(e)(2)(i) of the Income Tax Regulations, a taxpayer generally must secure the consent of the Commissioner before changing a method of accounting for federal income tax purposes. Section 1.446-1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the terms and conditions necessary to obtain consent to change a method of accounting. Rev. Proc. 2002-9, 2002-1 C.B. 327 (as modified and clarified by Announcement 2002-17, 2002-1 C.B. 561, modified and amplified by Rev. Proc. 2002-19, 2002-1 C.B. 696, and amplified, clarified, and modified by Rev. Proc. 2002-54, 2002-2 C.B. 432), provides procedures by which a taxpayer may obtain automatic consent to change to the methods of accounting described in the Appendix of Rev. Proc. 2002-9. Section 5.03 of Rev. Proc. 2002-9 provides that, unless otherwise provided, a taxpayer making a change in method of accounting under the revenue procedure must take into account a § 481(a) adjustment in the manner provided in section 5.04 of Rev. Proc. 2002-9.

This revenue procedure applies to a taxpayer that uses an overall accrual method of accounting for federal income tax purposes and that issues credit cards to, and receives annual fees from, cardholders under agreements that allow each cardholder to use a credit card to access a revolving line of credit to make purchases of goods and services and, if so authorized, to obtain cash advances.

.01 Permission to use the Ratable Inclusion Method for Credit Card Annual Fees. The Commissioner in an exercise of his discretion under § 446 permits taxpayers within the scope of this revenue procedure to account for their income from credit card annual fees using the Ratable Inclusion Method for Credit Card Annual Fees, which is described in this section 4.

.02 Description of method. Under the Ratable Inclusion Method for Credit Card Annual Fees, a credit card annual fee is recognized in income ratably over the period covered by the fee.

.03 Special rules. A taxpayer’s use of the Ratable Inclusion Method for Credit Card Annual Fees does not clearly reflect its credit card annual fee income (and thus the Commissioner does not permit its use) unless the taxpayer also complies with the rules in section 4.03(1) and 4.03(2) of this revenue procedure.

(1) Closed accounts. If a credit card is cancelled or if a cardholder account is otherwise closed during a taxable year, any remaining unrecognized portion of the credit card annual fee that is allocable to the account must be recognized in income in that year, unless the remaining portion is refunded.

(2) Fees billed in installments. If a credit card annual fee is due and payable in installments, each installment must be recognized ratably over the period to which the installment relates.

.04 Aggregation of fees. Taxpayers may account for income from credit card annual fees in an aggregate manner. A taxpayer that accounts for annual fees in an aggregate manner must establish that its recognition of credit card annual fee income satisfies the rules in sections 4.02 and 4.03 of this revenue procedure.

A taxpayer within the scope of this revenue procedure that wants to change its method of accounting for income from credit card annual fees, either to a method that satisfies the all events test in accordance with Rev. Rul. 2004-52 or to the Ratable Inclusion Method for Credit Card Annual Fees that is described in section 4 of this revenue procedure, must follow the provisions of Rev. Proc. 2002-9 (or its successor), with the following modifications:

.01 The scope limitations in section 4.02 of Rev. Proc. 2002-9 do not apply to a taxpayer that wants to make the change for either its first or second taxable year ending on or after December 31, 2003; and

.02 The taxpayer must prepare and file a Form 3115 in accordance with section 6 of Rev. Proc. 2002-9 and must enter the designated number for the automatic change in method in Line 1a of Form 3115.

(1) The designated number for the automatic accounting method change to include credit card annual fees in income as required by Rev. Rul. 2004-52 is “80”.

(2) The designated number for the automatic accounting method change to the Ratable Inclusion Method for Credit Card Annual Fees is “81”.

If a taxpayer within the scope of this revenue procedure currently uses the method described in section 4 of this revenue procedure, the method of accounting for the taxpayer’s credit card annual fees will not be raised as an issue by the Service in a taxable year that ends before December 31, 2003. Also, if a taxpayer currently uses the method described in section 4 of this revenue procedure, and its use of that method is an issue under consideration (within the meaning of section 3.09 of Rev. Proc. 2002-9) in examination, before an appeals office, or before the U.S. Tax Court for any taxable year that ends before December 31, 2003, that issue will not be further pursued by the Service.

Rev. Proc. 2002-9 is modified and amplified to include this automatic change in the APPENDIX.

This revenue procedure is effective for taxable years ending on or after December 31, 2003.

The principal authors of this revenue procedure are Rebecca E. Asta, Alexa Dubert and Tina Jannotta of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue procedure, contact the principal authors at (202) 622-3930 (not a toll-free call).

This revenue procedure describes conditions under which the Commissioner will allow a taxpayer to treat its income from credit card late fees as interest income on a pool of credit card loans. This revenue procedure also provides the exclusive procedure by which a taxpayer within the scope of this revenue procedure may obtain the Commissioner’s consent to change its method of accounting for income from credit card late fees to a method that treats these fees as interest that creates or increases the amount of original issue discount (OID) on the pool of credit card loans to which the fees relate.

.01 Certain taxpayers issue credit cards that allow a cardholder to access a revolving line of credit to purchase goods and services. Some of these taxpayers may also issue credit cards that allow a cardholder to obtain cash advances.

.02 The terms and conditions that govern the cardholder’s use of the credit card are provided in a credit card agreement. Under many credit card agreements, the cardholder is charged a fee when the cardholder is delinquent with respect to a payment due (late fee).

.03 For federal income tax purposes, interest is an amount that is paid in compensation for the use or forbearance of money. Deputy v. DuPont, 308 U.S. 488 (1940), 1940-1 C.B. 118; Old Colony Railroad Co. v. Commissioner, 284 U.S. 552 (1932), 1932-1 C.B. 274. Whether a fee is an interest charge for federal income tax purposes is determined by reference to all of the relevant facts and circumstances surrounding the imposition of the charge. Neither the label used for the charge (for example, a “finance charge”) nor a taxpayer’s treatment of the item for financial or regulatory reporting purposes is determinative of the proper federal income tax characterization of the fee. See Rev. Rul. 72-315, 1972-1 C.B. 49; see also Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542-43 (1979), 1979-1 C.B. 167.

.04 Rev. Rul. 74-187, 1974-1 C.B. 48, holds that late fees on utility bills are interest absent evidence that the late payment charge assessed by the public utility is for a specific service performed in connection with the customer’s account. Even if a charge is a one-time charge or is imposed as a flat sum in addition to a stated periodic interest rate, that charge may still be interest for federal income tax purposes. See Rev. Rul. 77-417, 1977-2 C.B. 60, and Rev. Rul. 72-2, 1972-1 C.B. 19.

.05 Under § 1273(a)(1) of the Internal Revenue Code, OID is the excess of the stated redemption price at maturity (SRPM) of a debt instrument over the issue price of that instrument. Under § 1273(a)(2), the SRPM of a debt instrument is the amount fixed by the last modification of the purchase agreement and includes interest and other amounts payable at that time, other than qualified stated interest (QSI). Under § 1.1273-1(b) of the Income Tax Regulations, the SRPM is the sum of all payments provided by the debt instrument other than QSI. Under § 1.1273-1(c), QSI is stated interest that is unconditionally payable in cash or property (other than debt instruments of the issuer) or that will be constructively received under § 451 at least annually at a single fixed rate.

.06 Section 1004 of the Taxpayer Relief Act of 1997, which is effective for taxable years beginning after August 5, 1997, extended the rules of § 1272(a)(6) to any pool of debt instruments the yield on which may be affected by reason of prepayments. See H.R. Conf. Rep. No. 220, 105^th Cong., 1^st Sess. 522 (1997). Section 1272(a)(6) provides rules for determining the daily portions of OID if principal is subject to acceleration.

.07 Any change in the taxpayer’s treatment of income from credit card late fees that affects when those fees are recognized in income is a change in method of accounting to which the provisions of §§ 446 and 481 apply. Under § 1.446-1(e)(2)(i), a taxpayer generally must secure the consent of the Commissioner before changing a method of accounting for federal income tax purposes. Section 1.446-1(e)(3)(ii) authorizes the Commissioner to prescribe administrative procedures setting forth the terms and conditions necessary to obtain consent to change a method of accounting.

.08 Rev. Proc. 2002-9, 2002-1 C.B. 327 (as modified and clarified by Announcement 2002-17, 2002-1 C.B. 561, modified and amplified by Rev. Proc. 2002-19, 2002-1 C.B. 696, and amplified, clarified, and modified by Rev. Proc. 2002-54, 2002-2 C.B. 432), provides procedures by which taxpayers may obtain automatic consent to change to the methods of accounting described in the Appendix of Rev. Proc. 2002-9. Section 5.03 of Rev. Proc. 2002-9 provides that, unless otherwise provided, a taxpayer making a change in method of accounting under the revenue procedure must take into account a section 481(a) adjustment in the manner provided in section 5.04 of Rev. Proc. 2002-9.

This revenue procedure applies to a taxpayer if—

.01 The taxpayer issues credit cards allowing cardholders to access a revolving line of credit established by the taxpayer; and

.02 None of the cardholders’ credit card transactions with the taxpayer is treated by the taxpayer for federal income tax purposes as creating either debt that is given in consideration for the sale or exchange of property (within the meaning of §1274) or debt that is deferred payment for property (within the meaning of § 483).

.01 Subject to subsection .02 of this section 4, if a taxpayer is within the scope of this revenue procedure, the Commissioner will not challenge either the taxpayer’s treatment of credit card late fees as interest or the taxpayer’s treatment of this interest as being part of SRPM and thus as creating or increasing OID on a pool of credit card loans to which these fees relate.

.02 Subsection .01 of section 4 of this revenue procedure applies only if the taxpayer follows all of the requirements of section 5 of this revenue procedure and, if the taxpayer is changing its method of accounting, all of the requirements of section 6 of this revenue procedure.

A taxpayer must be able to demonstrate the following:

.01 The amount of any credit card late fee charged to each cardholder by the taxpayer is separately stated on the cardholder’s account when the late fee is imposed; and

.02 Under the applicable credit card agreement governing each cardholder’s use of the credit card, no amount identified as a credit card late fee is charged for property or for specific services performed by the taxpayer for the benefit of the cardholder.

If a taxpayer within the scope of this revenue procedure wants to change its method of accounting for income from credit card late fees and if, under the method to which the taxpayer is changing, these fees are treated as interest that creates or increases the amount of OID on a pool of credit card loans to which these fees relate, the taxpayer must follow the provisions of Rev. Proc. 2002-9 (or its successor), with the following modifications:

.01 The scope limitations in section 4.02 of Rev. Proc. 2002-9 do not apply to a taxpayer that wants to make the change for either its first or second taxable year ending on or after December 31, 2003; and

.02 The taxpayer must prepare and file a Form 3115 in accordance with section 6 of Rev. Proc. 2002-9 and enter the designated number (“82”) for this automatic change in method in Line 1a of Form 3115.

.01 If a taxpayer within the scope of this revenue procedure currently uses a method of accounting that treats credit card late fees as interest that creates or increases the amount of OID on a pool of credit card loans to which these fees relate, the issue of whether the taxpayer is properly treating its credit card late fees as OID on a pool of credit card loans will not be raised by the Commissioner in a taxable year that ends before December 31, 2003.

.02 If a taxpayer within the scope of this revenue procedure currently uses a method of accounting that treats credit card late fees as interest that creates or increases the amount of OID on a pool of credit card loans to which these fees relate and its use of that method is an issue under consideration (within the meaning of section 3.09 of Rev. Proc. 2002-9) in examination, before an appeals office, or before the U.S. Tax Court for any taxable year that ends before December 31, 2003, that issue will not be further pursued by the Service.

.03 Neither the audit protection provided in connection with a change in a taxpayer’s method of accounting for credit card late fees that is properly made under section 6 of this revenue procedure, nor the audit protection provided under sections 7.01 and 7.02 of this revenue procedure, is a determination by the Commissioner that the taxpayer is properly accounting for any OID income on that pool of credit card loans. Thus, for example, the Service is not precluded from pursuing the issue of whether a taxpayer is properly accounting for its OID income (including any OID attributable to late fees) on its pool of credit card loans in accordance with § 1272(a)(6).

Rev. Proc. 2002-9 is modified and amplified to include this automatic change in the APPENDIX.

This revenue procedure is effective for taxable years ending on or after December 31, 2003.

The principal authors of this revenue procedure are Rebecca E. Asta, Alexa Dubert and Tina Jannotta of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue procedure, contact the principal authors at (202) 622-3930 (not a toll-free call).

This revenue procedure allows taxpayers a limited deferral beyond the taxable year of receipt for certain advance payments. Qualifying taxpayers generally may defer to the next succeeding taxable year the inclusion in gross income for federal income tax purposes of advance payments (as defined in section 4 of this revenue procedure) to the extent the advance payments are not recognized in revenues (or, in certain cases, are not earned) in the taxable year of receipt. Except as provided in section 5.02(2) of this revenue procedure for certain short taxable years, this revenue procedure does not permit deferral to a taxable year later than the next succeeding taxable year. This revenue procedure neither restricts a taxpayer’s ability to use the methods provided in § 1.451-5 of the Income Tax Regulations regarding advance payments for goods nor limits the period of deferral available under § 1.451-5.

This revenue procedure also provides the exclusive administrative procedures under which a taxpayer within the scope of this revenue procedure may obtain consent to change to a method of accounting provided in section 5 of this revenue procedure.

.01 In general, § 451 of the Internal Revenue Code provides that the amount of any item of gross income is included in gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period. Section 1.451-1(a) provides that, under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. All the events that fix the right to receive income generally occur when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest. See Rev. Rul. 84-31, 1984-1 C.B. 127.

.02 Section 1.451-5 generally allows accrual method taxpayers to defer the inclusion in gross income for federal income tax purposes of advance payments for goods until the taxable year in which they are properly accruable under the taxpayer’s method of accounting for federal income tax purposes if that method results in the advance payments being included in gross income no later than when the advance payments are recognized in revenues under the taxpayer’s method of accounting for financial reporting purposes.

.03 Rev. Proc. 71-21, 1971-2 C.B. 549, was published to implement an administrative decision of the Commissioner in the exercise of his discretion under § 446 to allow accrual method taxpayers in certain specified and limited circumstances to defer the inclusion in gross income for federal income tax purposes of payments received (or amounts due and payable) in one taxable year for services to be performed by the end of the next succeeding taxable year. Rev. Proc. 71-21 was designed to reconcile the federal income tax and financial accounting treatment of payments received for services to be performed by the end of the next succeeding taxable year without permitting extended deferral of the inclusion of those payments in gross income for federal income tax purposes.

.04 Considerable controversy exists about the scope of Rev. Proc. 71-21. In particular, advance payments for non-services (and often, for combinations of services and non-services) do not qualify for deferral under Rev. Proc. 71-21, and taxpayers and the Internal Revenue Service frequently disagree about whether advance payments are, in fact, for “services.” In addition to the issue of defining “services” for purposes of Rev. Proc. 71-21, questions also arise about whether advance payments received under a series of agreements, or under a renewable agreement, are within the scope of Rev. Proc. 71-21. In the interest of reducing the controversy surrounding these issues, the Service has determined that it is appropriate to expand the scope of Rev. Proc. 71-21 to include advance payments for certain non-services and combinations of services and non-services. Additionally, the Service has determined that it is appropriate to expand the scope of Rev. Proc. 71-21 to include advance payments received in connection with an agreement or series of agreements with a term or terms extending beyond the end of the next succeeding taxable year. The Service has determined, however, that for taxpayers deferring recognition of income under this revenue procedure it is appropriate to retain the limited one-year deferral of Rev. Proc. 71-21 (except as provided in section 5.02(2) of this revenue procedure for certain short taxable years).

This revenue procedure applies to taxpayers using or changing to an overall accrual method of accounting that receive advance payments as defined in section 4 of this revenue procedure.

The following definitions apply solely for purposes of this revenue procedure —

.01 Advance Payment. Except as provided in section 4.02 of this revenue procedure, a payment received by a taxpayer is an “advance payment” if —

.02 Exclusions From Advance Payment. The term “advance payment” does not include —

.03 Intellectual Property. The term “intellectual property” includes copyrights, patents, trademarks, service marks, trade names, and similar intangible property rights (such as franchise rights and arena naming rights).

.04 Received. Income is “received” by the taxpayer if it is actually or constructively received, or if it is due and payable to the taxpayer.

.05 Next Succeeding Taxable Year. The term “next succeeding taxable year” means the taxable year immediately following the taxable year in which the advance payment is received by the taxpayer.

.06 Applicable Financial Statement. The taxpayer’s applicable financial statement is the taxpayer’s financial statement listed in paragraphs (1) through (3) of this section 4.06 that has the highest priority (including within paragraph (2)). A taxpayer that does not have a financial statement described in paragraphs (1) through (3) of this section 4.06 does not have an applicable financial statement for purposes of this revenue procedure. The financial statements are, in descending priority —

.01 Full Inclusion Method. A taxpayer within the scope of this revenue procedure that includes the full amount of advance payments in gross income for federal income tax purposes in the taxable year of receipt is using a proper method of accounting under § 1.451-1, regardless of whether the taxpayer recognizes the full amount of advance payments in revenues for that taxable year for financial reporting purposes and regardless of whether the taxpayer earns the full amount of advance payments in that taxable year.

.02 Deferral Method.

.03 Examples. In each example below, the taxpayer uses an accrual method of accounting for federal income tax purposes and files its returns on a calendar year basis. Except as stated otherwise, the taxpayer in each example has an applicable financial statement as defined in section 4.06 of this revenue procedure.

Example 1. On November 1, 2004, A, in the business of giving dancing lessons, receives an advance payment for a 1-year contract commencing on that date and providing for up to 48 individual, 1-hour lessons. A provides eight lessons in 2004 and another 35 lessons in 2005. In its applicable financial statement, A recognizes of the payment in revenues for 2004, and of the payment in revenues for 2005. A uses the Deferral Method. For federal income tax purposes, A must include of the payment in gross income for 2004, and the remaining of the payment in gross income for 2005.

Example 2. Assume the same facts as in Example 1, except that the advance payment is received for a 2-year contract under which up to 96 lessons are provided. A provides eight lessons in 2004, 48 lessons in 2005, and 40 lessons in 2006. In its applicable financial statement, A recognizes of the payment in revenues for 2004, of the payment in revenues for 2005, and of the payment in gross revenues for 2006. For federal income tax purposes, A must include of the payment in gross income for 2004, and the remaining of the payment in gross income for 2005.

Example 3. On June 1, 2004, B, a landscape architecture firm, receives an advance payment for goods and services that, under the terms of the agreement, must be provided by December 2005. On December 31, 2004, B estimates that of the work under the agreement has been completed. In its applicable financial statement, B recognizes of the payment in revenues for 2004 and of the payment in revenues for 2005. B uses the Deferral Method. For federal income tax purposes, B must include of the payment in gross income for 2004, and the remaining of the payment in gross income for 2005, regardless of whether B completes the job in 2005.

Example 4. On July 1, 2004, C, in the business of selling and repairing television sets, receives an advance payment for a 2-year contract under which C agrees to repair or replace, or authorizes a representative to repair or replace, certain parts in the customer’s television set if those parts fail to function properly. In its applicable financial statement, C recognizes of the payment in revenues for 2004, of the payment in revenues for 2005, and of the payment in revenues for 2006. C uses the Deferral Method. For federal income tax purposes, C must include of the payment in gross income for 2004 and the remaining of the payment in gross income for 2005.

Example 5. On December 2, 2004, D, in the business of selling and repairing television sets, sells for $200 a television set with a 90-day warranty on parts and labor (for which D, rather than the manufacturer, is the obligor). D regularly sells televisions sets without the warranty for $188. In its applicable financial statement, D allocates $188 of the sales price to the television set and $12 to the 90-day warranty, recognizes of the amount allocable to the warranty ($4) in revenues for 2004, and recognizes the remaining of the amount allocable to the warranty ($8) in revenues for 2005. D uses the Deferral Method. For federal income tax purposes, D must include the $4 allocable to the warranty in gross income for 2004 and the remaining $8 allocable to the warranty in gross income for 2005.

Example 6. E, in the business of photographic processing, receives advance payments for mailers and certificates that oblige E to process photographic film, prints, or other photographic materials returned in the mailer or with the certificate. E tracks each of the mailers and certificates with unique identifying numbers. On July 20, 2004, E receives payments for 2 mailers. One of the mailers is submitted and processed on September 1, 2004, and the other is submitted and processed on February 1, 2006. In its applicable financial statement, E recognizes the payment for the September 1, 2004, processing in revenues for 2004 and the payment for the February 1, 2006, processing in revenues for 2006. E uses the Deferral Method. For federal income tax purposes, E must include the payment for the September 1, 2004, processing in gross income for 2004 and the payment for the February 1, 2006, processing in gross income for 2005.

Example 7. F, a hair styling salon, receives advance payments for gift cards that may later be redeemed at the salon for hair styling services or hair care products at the face value of the gift card. The gift cards look like standard credit cards, and each gift card has a magnetic strip that, in connection with F’s computer system, identifies the available balance. The gift cards may not be redeemed for cash, and have no expiration date. In its applicable financial statement, F recognizes advance payments for gift cards in revenues when redeemed. F is not able to determine the extent to which advance payments are recognized in revenues in its applicable financial statement for the taxable year of receipt and therefore does not meet the requirement of section 5.02(1)(b)(i) of this revenue procedure. Further, F does not determine under a basis described in section 5.02(3)(b) of this revenue procedure the extent to which payments are earned for the taxable year of receipt . Therefore, F may not use the Deferral Method for these advance payments.

Example 8. Assume the same facts as in Example 7, except that the gift cards have an expiration date 12 months from the date of sale, F does not accept expired gift cards, and F recognizes unredeemed gift cards in revenues in its applicable financial statement for the taxable year in which the cards expire. Because F tracks the sale date and the expiration date of the gift cards for purposes of its applicable financial statement, F is able to determine the extent to which advance payments are recognized in revenues for the taxable year of receipt. Therefore, F meets the requirement of section 5.02(1)(b)(i) of this revenue procedure and may use the Deferral Method for these advance payments.

Example 9. G, a video arcade operator, receives payments in 2004 for game tokens that are used by customers to play the video games offered by G. The tokens cannot be redeemed for cash. The tokens are imprinted with the name of the video arcade, but they are not individually marked for identification. For purposes of its applicable financial statement, G completed a study that determined that for payments received for tokens in the current year, x percent of tokens are expected to be used in the current year, y percent of tokens are expected to be used in the next year, and z percent of tokens are expected to never be used. Based on the study, in its applicable financial statement G recognizes in revenues for 2004 x percent (tokens expected to be used in 2004) and z percent (tokens expected never to be used) of the payments received in 2004 for tokens; G recognizes in revenues for 2005 the remaining y percent of the payments received in 2004 for tokens. G uses the Deferral Method. Using the study, G determines the extent to which advance payments are recognized in revenues in its applicable financial statement for the taxable year of receipt and therefore meets the requirement of section 5.02(1)(b)(i) of this revenue procedure. Under section 5.02(3)(a) of this revenue procedure, G must include advance payments in gross income in accordance with its applicable financial statement in the taxable year of receipt, provided that any portion of the payment not included in income in the taxable year of receipt is included in gross income for the next succeeding taxable year. Thus, for federal income tax purposes, G must include x percent and z percent of the advance payments in gross income for 2004, and y percent of the advance payments in gross income for 2005.

Example 10. Assume the same facts as in Example 9, except that G does not have an applicable financial statement (as defined in section 4.06 of this revenue procedure). G completed a study on a statistical basis, based on adequate data available to G, and concluded that for payments received in the current year, x percent of tokens are expected to be used in the current year, y percent of tokens are expected to be used in the next year, and the remaining z percent of tokens are expected to never be used. Based on the study, G treats as earned for 2004 x percent (for tokens expected to be used in that year) as well as z percent (for tokens that are expected to never be used). G uses the Deferral Method. Using the study, G determines the extent to which advance payments are earned in the taxable year of receipt and therefore meets the requirement of section 5.02(1)(b)(ii) of this revenue procedure. Because G does not have an applicable financial statement, G may determine the extent to which a payment is earned in the taxable year of receipt on a statistical basis under section 5.02(3)(b)(i) of this revenue procedure, provided that any portion that is not included in the taxable year of receipt is included in the next succeeding taxable year. Thus, for federal income tax purposes, G must include x percent and z percent of the advance payments in gross income for 2004, and y percent of the advance payments in gross income for 2005.

Example 11. H is in the business of compiling and providing business information for a particular industry in an online format accessible over the internet. On September 1, 2004, H receives an advance payment from a subscriber for 1 year of access to its online database, beginning on that date. In its applicable financial statement, H recognizes of the payment in revenues for 2004 and the remaining in revenues for 2005. H uses the Deferral Method. For federal income tax purposes, H must include of the payment in gross income for 2004 and the remaining of the payment in gross income for 2005.

Example 12. On December 1, 2004, I, in the business of operating a chain of “shopping club” retail stores, receives advance payments for membership fees. Upon payment of the fee, a member is allowed access for a 1-year period to I’s stores, which offer discounted merchandise and services. In its applicable financial statement, I recognizes of the payment in revenues for 2004 and of the payment in revenues for 2005. I uses the Deferral Method. For federal income tax purposes, I must include of the payment in gross income for 2004, and the remaining of the payment in gross income for 2005.

Example 13. In 2004, J, in the business of operating tours, receives payments from customers for a 10-day cruise that will take place in April 2005. Under the agreement, J charters a cruise ship, hires a crew and a tour guide, and arranges for entertainment and shore trips for the customers. In its applicable financial statement, J recognizes the payments in revenues for 2005. J uses the Deferral Method. For federal income tax purposes, J must include the payments in gross income for 2005.

Example 14. On November 1, 2004, K, a travel agent, receives payment from a customer for an airline flight that will take place in April 2005. K purchases and delivers the airline ticket to the customer on November 14, 2004. K retains a portion of the customer’s payment (the excess of the customer’s payment over the cost of the airline ticket) as its commission. Because K is not required to provide any services after the ticket is delivered to the customer, K earns its commission when the airline ticket is delivered. The customer may cancel the flight and receive a refund from K only to the extent the airline itself provides refunds. K does not have an applicable financial statement (as defined in section 4.06 of this revenue procedure), but, in its unaudited financial statements, K recognizes its commission in revenues for 2005. The commission is not an advance payment as defined in section 4.01 of this revenue procedure because the payment is not earned by K, in whole or in part, in a subsequent taxable year. Thus, K may not use the Deferral Method for this payment.

Example 15. L, a professional sports franchise, is a member of a sports league that enters into contracts with television networks for the right to broadcast games to be played between teams in the league. The money received by the sports league under the contracts is divided equally among the member teams. The league entered into a 3-year broadcasting contract beginning October 1, 2004. L receives three equal installment payments on October 1 of each contract year, beginning in 2004. In its applicable financial statement, L recognizes of the first installment payment in revenues for 2004 and in revenues for 2005; L recognizes of the second installment in revenues for 2005 and in revenues for 2006; L recognizes of the third installment in revenues for 2006 and in revenues for 2007. L uses the Deferral Method. Under section 4 of this revenue procedure, each installment payment constitutes an “advance payment.” For federal income tax purposes, L must include of the first installment payment in gross income for 2004 and in gross income for 2005; of the second installment in gross income for 2005 and in gross income for 2006; and of the third installment in gross income for 2006 and in gross income for 2007.

Example 16. M is in the business of negotiating, placing, and servicing insurance coverage and administering claims for insurance companies. On December 1, 2004, M enters into a contract with an insurance company to provide property and casualty claims administration services for a 4-year period beginning January 1, 2005. Pursuant to the contract, the insurance company makes four equal annual payments to M; each payment relates to a year of service and is made during the month prior to the service year (for example, M is paid on December 1, 2004, for the service year beginning January 1, 2005). In its applicable financial statement, M recognizes the first payment in revenues for 2005; the second payment in revenues for 2006; the third payment in revenues for 2007; and the fourth payment in revenues for 2008. M uses the Deferral Method. Under section 4 of this revenue procedure, each annual payment constitutes an “advance payment.” For federal income tax purposes, M must include the first payment in gross income for 2005; the second payment in gross income for 2006; the third payment in gross income for 2007; and the fourth payment in gross income for 2008.

Example 17. N is a cable internet service provider that enters into contracts with subscribers to provide internet services for a monthly fee (paid prior to the service month). For those subscribers who do not own a compatible modem, N provides a rental cable modem for an additional monthly charge (also paid prior to the service month). Pursuant to the contract, N will replace or repair the cable modem if it proves defective during the contract period. In December 2004, N receives payments from subscribers for January 2005 internet service and cable modem use. In its applicable financial statement, N recognizes the entire amount of these payments in revenues for 2005. N uses the Deferral Method. Because a subscriber’s use of a cable modem is ancillary to the provision of internet services by N, and because the cable modem warranty is ancillary to the use of the cable modem, the payments are advance payments within the meaning of section 4.01(3)(i) of this revenue procedure. Further, because the deferral period for each item is the same in N’s applicable financial statement, N is not required to allocate the advance payments (see section 5.02(4)(b) of this revenue procedure). For federal income tax purposes, N must include the advance payments in gross income for 2005.

Example 18. On January 1, 2005, O enters into, and receives advance payments pursuant to, a 5-year license agreement for its computer software. Under the contract, the licensee pays O both the first-year (2005) license fee and the fifth-year (2009) license fee upon commencement of the agreement. The fees for the second, third, and fourth years are payable on January 1 of each license year. In its applicable financial statement, O recognizes the fees in revenues for the respective license year. O uses the Deferral Method. For federal income tax purposes, O must include the first-year license fee in gross income for 2005, the second-year and the fifth-year license fee in gross income for 2006, the third-year license fee in gross income for 2007, and the fourth-year license fee in gross income for 2008.

Example 19. On July 1, 2004, P, in the business of selling and licensing computer software (off the shelf, fully customized, and semi-customized) and providing customer support, receives an advance payment for a 2-year “software maintenance contract” under which P will provide software updates if it develops an update within the contract period, as well as online and telephone customer support. In its applicable financial statement, P recognizes of the payment in revenues for 2004, in revenues for 2005, and the remaining in revenues for 2006, regardless of when P provides updates or customer support. P uses the Deferral Method. For federal income tax purposes, P must include of the payment in gross income for 2004 and in gross income for 2005.

Example 20. Assume the same facts as in Example 19, except that P changes its taxable period to a fiscal year ending March 31 so that P has a short taxable year beginning January 1, 2005, and ending March 31, 2005. In its applicable financial statement, P recognizes of the payment in revenues for the taxable year ending December 31, 2004; in revenues for the short taxable year ending March 31, 2005; in revenues for the taxable year ending March 31, 2006; and in revenues for the taxable year ending March 31, 2007. Because the taxable year ending March 31, 2005, is 92 days or less, section 5.02(2) of this revenue procedure applies. For federal income tax purposes, P must include of the payment in gross income for the taxable year ending December 31, 2004, in gross income for the short taxable year ending March 31, 2005, and the remaining in gross income for the taxable year ending March 31, 2006.

Example 21. Assume the same facts as in Example 19, except that P ceases to exist on December 1, 2004, in a transaction other than a transaction to which § 381(a) applies. For federal income tax purposes, P must include the entire advance payment in gross income for 2004.

Example 22. On July 1, 2004, Q, in the business of selling and licensing computer software (off the shelf, fully customized, and semi-customized) and providing customer support, receives an advance payment of $100 for a 2-year software license agreement that includes a 1-year “software maintenance contract” under which Q will provide software updates if it develops an update within the contract period, as well as online and telephone customer support. In its applicable financial statement, Q allocates $20 of the payment to the maintenance contract and $80 to the license agreement, based on objective criteria. With respect to the $20 allocable to the maintenance contract, Q recognizes ($10) in revenues for 2004 and the remaining ($10) in revenues for 2005 regardless of when Q provides updates or customer support. With respect to the $80 allocable to the license agreement, Q recognizes ($20) in revenues for 2004, ($40) in revenues for 2005, and the remaining ($20) in revenues for 2006. Q uses the Deferral Method. For federal income tax purposes, Q must include $30 in gross income for 2004 ($10 allocable to the maintenance contract and $20 allocable to the license agreement) and the remaining $70 in gross income for 2005.

.01 In General. Except as provided in section 6.02 of this revenue procedure, this revenue procedure is effective for taxable years ending on or after May 6, 2004.

.02 Automatic Change for 2003. For a change in accounting method under section 8.02 or 8.04(1) of this revenue procedure, this revenue procedure is effective for taxable years ending on or after December 31, 2003. See section 8.06 of this revenue procedure for applicable transition rules.

If a taxpayer uses the Deferral Method described in section 5.02 of this revenue procedure for advance payments (as defined in section 4 of this revenue procedure), the taxpayer’s use of the Deferral Method will not be raised as an issue by the Service in a taxable year that ends before May 6, 2004. But see sections 9 and 10 of Rev. Proc. 2002-9, 2002-1 C.B. 327 (as modified and clarified by Announcement 2002-17, 2002-1 C.B. 561, modified and amplified by Rev. Proc. 2002-19, 2002-1 C.B. 696, and amplified, clarified, and modified by Rev. Proc. 2002-54, 2002-2 C.B. 432); section 11 of Rev. Proc. 97-27, 1997-1 C.B. 680 (as modified and amplified by Rev. Proc. 2002-19, as amplified and clarified by Rev. Proc. 2002-54). If the taxpayer uses the Deferral Method described in section 5.02 of this revenue procedure, and the treatment of advance payments (as defined in section 4 of this revenue procedure) under the Deferral Method is an issue under consideration (within the meaning of section 3.09 of Rev. Proc. 2002-9) in examination, in appeals, or before the U.S. Tax Court in a taxable year that ends before May 6, 2004, that issue will not be further pursued by the Service.

.01 In General. A change in a taxpayer’s treatment of advance payments to either of the methods described in section 5 of this revenue procedure is a change in method of accounting to which the provisions of §§ 446 and 481, and the regulations thereunder, apply. A taxpayer may adopt any permissible method of accounting for advance payments for the first taxable year in which the taxpayer receives advance payments. A taxpayer that seeks to change its method of accounting for advance payments must use Form 3115, Application for Change in Accounting Method, and complete all applicable parts thereof. See § 1.446-1(e).

.02 Automatic Change. Except with respect to a change in method to which section 8.03 or 8.04(2) of this revenue procedure applies, a taxpayer within the scope of this revenue procedure that wants to change to one of the methods of accounting provided in section 5 of this revenue procedure must follow the automatic change in method of accounting provisions in Rev. Proc. 2002-9 (or its successor) with the following modifications —

.03 Advance Consent Change.

.04 Changes to an Overall Accrual Method and the Deferral Method.

.05 Previously Filed Forms 3115. If a taxpayer within the scope of this revenue procedure that qualifies to change its method automatically under section 8.02 or 8.04(1) of this revenue procedure filed a Form 3115 with the national office for a taxable year ending on or after December 31, 2003, and the Form 3115 is pending with the national office on May 6, 2004, the taxpayer must notify the national office in writing prior to July 6, 2004, if the taxpayer wants to withdraw its Form 3115 to make the change under section 8.02 or 8.04(1) of this revenue procedure. If the taxpayer notifies the national office within the time provided in this section 8.05, the taxpayer’s Form 3115, and any user fee that was submitted with the Form 3115, will be returned to the taxpayer. A taxpayer whose Form 3115 is returned under this section 8.05 may file a new Form 3115 under the provisions prescribed in section 8.02 or 8.04(1) of this revenue procedure. If the taxpayer does not notify the national office within the time provided in this section 8.05, the national office will continue to process the taxpayer’s Form 3115 in accordance with the administrative procedures under which it was originally filed, using existing authority (such as Rev. Proc. 71-21 or § 1.451-5, as applicable). With regard to changes under section 8.04(1) of this revenue procedure, this section 8.05 does not waive the generally applicable scope provisions and other requirements in section 5.01 of the Appendix of Rev. Proc. 2002-9.

.06 Automatic Change Transition Rule. A taxpayer within the scope of this revenue procedure that qualifies to change its method automatically under section 8.02 or 8.04(1) of this revenue procedure may change to the Full Inclusion Method, the Deferral Method, or an overall accrual method and the Deferral Method, as applicable, for taxable years ending on or after December 31, 2003. If a taxpayer has timely filed its federal income tax return for its first taxable year ending on or after December 31, 2003, and has not attached a Form 3115 to change its method of accounting for that taxable year to a method provided in this revenue procedure, the taxpayer, as provided in section 6.02(3)(b)(i) of Rev. Proc. 2002-9, is granted an automatic extension of 6 months from the due date of its federal income tax return for the year of change (excluding extensions) to obtain the automatic consent provided by this revenue procedure, provided the taxpayer attaches Form 3115 to an amended return for the year of change and otherwise complies with section 6.02(3)(b)(i) of Rev. Proc. 2002-9.

Rev. Proc. 71-21 is modified and superseded. Rev. Proc. 2002-9 is modified and amplified to include in section 5 of the Appendix the automatic change provided in section 8.04(1) of this revenue procedure, and to include in section 5A of the Appendix the automatic change provided in section 8.02 of this revenue procedure. The Deferral Method provided in this revenue procedure is available to qualifying taxpayers notwithstanding revenue rulings, revenue procedures, notices, or announcements published by the Service that may provide different rules for when advance payments must be included in gross income. See, e.g., Rev. Rul. 70-445, 1970-2 C.B. 101; Rev. Rul. 68-44, 1968-1 C.B. 191; Rev. Rul. 65-141, 1965-1 C.B. 210; and Rev. Rul. 60-85, 1960-1 C.B. 181.

The principal author of this revenue procedure is Edwin B. Cleverdon of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue procedure, contact Mr. Cleverdon at (202) 622-7900 (not a toll-free call).

The Internal Revenue Service has issued Rev. Proc. 2004-34, page of this Bulletin, which finalizes, with modifications, the revenue procedure proposed in Notice 2002-79, 2002-2 C.B. 964 (the proposed revenue procedure). The purpose of this announcement is to discuss some of the most significant issues raised in connection with finalizing the revenue procedure.

Notice 2002-79 proposed a revenue procedure to modify and supersede Rev. Proc. 71-21, 1971-2 C.B. 549. The proposed revenue procedure provided a limited deferral beyond the taxable year of receipt for certain advance payments for services, certain non-services, and combinations of services and certain non-services. Notice 2002-79 requested comments on the proposed revenue procedure and on the following specific issues:

The Service received comments on these and several other issues. The most significant comments, along with certain other changes to the proposed revenue procedure, are discussed below.

The principal author of this announcement is Edwin B. Cleverdon of the Office of Associate Chief Counsel (Income Tax & Accounting). For further information regarding this announcement, contact Edwin B. Cleverdon at (202) 622-7900 (not a toll-free call).

Under Title 31, Code of Federal Regulations, Part 10, an attorney, certified public accountant, enrolled agent, or enrolled actuary, in order to avoid institution or conclusion of a proceeding for his or her disbarment or suspension from practice before the Internal Revenue Service, may offer his or her consent to disbarment from such practice. The Director, Office of Professional Responsibility, in his discretion, may disbar an attorney, certified public accountant, enrolled agent, or enrolled actuary in accordance with the consent offered.

The following individuals have been placed under consent disbarment from practice before the Internal Revenue Service:

Under Title 31, Code of Federal Regulations, Part 10, an attorney, certified public accountant, enrolled agent, or enrolled actuary, in order to avoid institution or conclusion of a proceeding for his or her disbarment or suspension from practice before the Internal Revenue Service, may offer his or her consent to suspension from such practice. The Director, Office of Professional Responsibility, in his discretion, may suspend an attorney, certified public accountant, enrolled agent, or enrolled actuary in accordance with the consent offered.

The following individuals have been placed under consent suspension from practice before the Internal Revenue Service:

Under Title 31, Code of Federal Regulations, Part 10, the Director, Office of Professional Responsibility, is authorized to immediately suspend from practice before the Internal Revenue Service any practitioner who, within five years from the date the expedited proceeding is instituted (1) has had a license to practice as an attorney, certified public accountant, or actuary suspended or revoked for cause or (2) has been convicted of certain crimes.

The following individuals have been placed under suspension from practice before the Internal Revenue Service by virtue of the expedited proceeding provisions:

Under Title 31, Code of Federal Regulations, Part 10, in lieu of a proceeding being instituted or continued, an attorney, certified public accountant, enrolled agent, or enrolled actuary, may offer his or her consent to the issuance of a censure. Censure is a public reprimand.

The following individuals have consented to the issuance of a Censure:

The following organizations have failed to establish or have been unable to maintain their status as public charities or as operating foundations. Accordingly, grantors and contributors may not, after this date, rely on previous rulings or designations in the Cumulative List of Organizations (Publication 78), or on the presumption arising from the filing of notices under section 508(b) of the Code. This listing does not indicate that the organizations have lost their status as organizations described in section 501(c)(3), eligible to receive deductible contributions.

Former Public Charities. The following organizations (which have been treated as organizations that are not private foundations described in section 509(a) of the Code) are now classified as private foundations:

If an organization listed above submits information that warrants the renewal of its classification as a public charity or as a private operating foundation, the Internal Revenue Service will issue a ruling or determination letter with the revised classification as to foundation status. Grantors and contributors may thereafter rely upon such ruling or determination letter as provided in section 1.509(a)-7 of the Income Tax Regulations. It is not the practice of the Service to announce such revised classification of foundation status in the Internal Revenue Bulletin.