* * * * *

(b)* * *

(3) Product classes. Except as provided in paragraphs (b)(4) and (5) of this section, or as provided by the Commissioner in published guidance of general applicability, property within a product class consists of depreciable tangible personal property that is described in a 6-digit product class within Sectors 31, 32, and 33 (pertaining to manufacturing industries) of the North American Industry Classification System (NAICS), set forth in Executive Office of the President, Office of Management and Budget, North American Industry Classification System, United States, 2002 (NAICS Manual), as periodically updated. Copies of the NAICS Manual may be obtained from the National Technical Information Service, an agency of the U.S. Department of Commerce, and may be accessed on the internet. Sectors 31 through 33 of the NAICS Manual contain listings of specialized industries for the manufacture of described products and equipment. For this purpose, any 6-digit NAICS product class with a last digit of 9 (a miscellaneous category) is not a product class for purposes of this section. If a property is listed in more than one product class, the property is treated as listed in any one of those product classes. A property’s 6-digit product class is referred to as the property’s NAICS code.

(4) Modifications of NAICS product classes. The product classes of the NAICS Manual may be updated or otherwise modified from time to time as the manual is updated, effective on or after the date of the modification. The NAICS Manual generally is modified every five years, in years ending in a 2 or 7 (such as 2002, 2007, and 2012). The applicability date of the modified NAICS Manual is announced in the Federal Register and generally is January 1 of the year the NAICS Manual is modified. Taxpayers may rely on these modifications as they become effective in structuring exchanges under this section. Taxpayers may rely on the previous NAICS Manual for transfers of property made by a taxpayer during the one-year period following the effective date of the modification. For transfers of property made by a taxpayer on or after January 1, 1997, and on or before January 1, 2003, the NAICS Manual of 1997 may be used for determining product classes of the exchanged property.

(5) Administrative procedures for revising general asset classes and product classes. The Commissioner may, through published guidance of general applicability, supplement, modify, clarify, or update the guidance relating to the classification of properties provided in this paragraph (b). (See §601.601(d)(2) of this chapter.) For example, the Commissioner may determine not to follow (in whole or in part) a general asset class for purposes of identifying property of like class, may determine not to follow (in whole or in part) any modification of product classes published in the NAICS Manual, or may determine that other properties not listed within the same or in any product class or general asset class nevertheless are of a like class. The Commissioner also may determine that two items of property that are listed in separate product classes or in product classes with a last digit of 9 are of a like class, or that an item of property that has a NAICS code is of a like class to an item of property that does not have a NAICS code.

(6) No inference outside of section 1031. The rules provided in this section concerning the use of general asset classes or product classes are limited to exchanges under section 1031. No inference is intended with respect to the classification of property for other purposes, such as depreciation.

(7) Examples. * * *

* * * * *

Example 3. Taxpayer E transfers a grader to F in exchange for a scraper. Neither property is within any of the general asset classes. However, both properties are within the same product class (NAICS code 333120). The grader and scraper are of a like class and deemed to be of a like kind for purposes of section 1031.

Example 4. Taxpayer G transfers a personal computer (asset class 00.12), an airplane (asset class 00.21) and a sanding machine (NAICS code 333210), to H in exchange for a printer (asset class 00.12), a heavy general purpose truck (asset class 00.242) and a lathe (NAICS code 333210). The personal computer and the printer are of a like class because they are within the same general asset class. The sanding machine and the lathe are of a like class because they are within the same product class (although neither property is within any of the general asset classes). The airplane and the heavy general purpose truck are neither within the same general asset class nor within the same product class, and are not of a like kind.

(8) Transition rule. Properties within the same product classes based on the 4-digit codes contained in Division D of the Executive Office of the President, Office of Management and Budget, Standard Industrial Classification Manual (1987), will be treated as property of a like class for transfers of property made by taxpayers on or before May 19, 2005.

* * * * *

(d) Effective date. Except as otherwise provided in this paragraph (d), this section applies to exchanges occurring on or after April 11, 1991. Paragraphs (b)(3) through (b)(6), Example 3 and Example 4 of paragraph (b)(7), and paragraph (b)(8) of this section apply to transfers of property made by taxpayers on or after August 12, 2004. However, taxpayers may apply paragraphs (b)(3) through (b)(6), and Example 3 and Example 4 of paragraph (b)(7) of this section to transfers of property made by taxpayers on or after January 1, 1997, in taxable years for which the period of limitation for filing a claim for refund or credit under section 6511 has not expired.

Section 475(a) requires dealers in securities to mark their securities to market. Sections 475(e) and (f) allow dealers in commodities and traders in securities or commodities to elect similar treatment for their securities or commodities. If the security or commodity is inventory, it must be included in inventory at its fair market value, and if it is not inventory and is held at the end of the taxable year, gain or loss is recognized as if the security or commodity had been sold for its fair market value on the last business day of the taxable year.

Although the term “fair market value” has a long-standing and well-established meaning within the tax law, it is sometimes difficult to determine the fair market value of certain securities and commodities, particularly those that have no comparable sales. This has impeded the efficient administration of the mark-to-market system under section 475. Consequently, with a view to improving the administrability of the valuation requirements of section 475, the Treasury Department and the IRS issued the ANPRM, which set forth some principles upon which a safe harbor for valuation could be constructed. Using these principles, and incorporating a number of comments received from the public, these proposed regulations set forth a safe harbor for valuing securities and commodities under section 475.

The safe harbor generally permits eligible taxpayers to elect to have the values that are reported for eligible positions on certain financial statements treated as the fair market values reported for those eligible positions for purposes of section 475, if certain conditions are met. The safe harbor is based upon the principle that if the mark-to-market method used for financial reporting is sufficiently consistent with the mark-to-market method required by section 475, then the values used for financial reporting should be acceptable values for purposes of section 475, even if those values are not fair market values under general tax principles. To ensure minimal divergence from fair market value under tax principles, these proposed regulations impose certain restrictions on the financial accounting methods and financial statements that are eligible for the safe harbor and also require certain adjustments to the values of the eligible positions on those financial statements that may be used under the safe harbor.

The safe harbor requires that financial statement values be adjusted to comply with the requirements of section 482 or section 482 principles when applicable. For example, section 482 principles may require the revision of estimates of future cash flows used in valuing certain financial instruments to reflect the appropriate arm’s length pricing of inter-branch transactions as of their origination date. In addition, these proposed regulations do not alter the treatment of interest expense. See sections 861 and 882 and regulations thereunder.

The safe harbor is available to any taxpayer subject to the mark-to-mark regime under section 475, whether the taxpayer is a dealer in securities under section 475(a), a dealer in commodities under section 475(e), or a trader in either securities or commodities under section 475(f). The Commissioner will issue a revenue procedure that lists the types of securities and commodities that are subject to the safe harbor. It is anticipated that the revenue procedure will apply to every security position and every commodity position subject to mark-to-market under section 475. Comments are requested as to whether any types of securities or commodities should be excluded from the safe harbor.

It is important to note, however, that the valuation methodology under the safe harbor applies only for positions that are properly marked under section 475. The safe harbor only addresses valuation and does not expand or contract the scope of application of section 475. For example, if a security is not marked under section 475 because it has been identified as held for investment, then under the safe harbor it may not be marked for federal income tax purposes even though it is properly marked on the financial statement in accordance with U.S. Generally Accepted Accounting Principles (U.S. GAAP). Similarly, if a security is not marked on the applicable financial statement because it is a hedge but section 475(a) applies because the security was not identified as a hedge, then the security must still be marked under section 475.

To qualify for the safe harbor, a financial accounting method must satisfy certain basic requirements. First, it must mark eligible positions to market through valuations made as of the last business day of each taxable year. Second, it must recognize into income on the income statement any gain or loss from marking eligible positions to market. Third, it must recognize into income on the income statement any gain or loss on disposition of an eligible position as if a year-end mark occurred immediately before the disposition. Fourth, it must arrive at fair value in accordance with U.S. GAAP.

In addition to the basic requirements, the safe harbor also imposes certain limitations that ensure minimal divergence from fair market value. Under the first limitation, which applies only to securities and commodities dealers, except for eligible positions that are traded on a qualified board or exchange (as defined in section 1256(g)(7)), the financial accounting method must not result in values at or near the bid or ask values, even if the use of bid or ask values is permissible in accordance with U.S. GAAP. This limitation is based upon the business model for derivative contracts held by dealers in those derivatives, the model underlying most of the public comments received in response to the ANPRM.

According to the comments, dealers seek to capture and profit from bid-ask spreads by entering into positions that, in the aggregate, offset each other. The bid-ask spread contains the dealer’s profit and compensates the dealer for all risks and expenses. The origination of such a balanced portfolio may, therefore, be seen as creating a synthetic annuity, with a value that is largely immune from market-related changes in the values of the component securities. For these eligible positions, such as interest rate swap contracts, use of bid or ask values approximates realization accounting and, therefore, fails to cause recognition of the present value of the synthetic annuity in the taxable year that the annuity is created. Consequently, the valuation method described in §1.471-4(a)(1) generally fails to satisfy the limitation set forth in paragraph (d)(3)(i) of these proposed regulations.

The Treasury Department and the IRS request comments on whether dealers in commodities and traders in either securities or commodities operate under different business models and on how the rules set forth in these proposed regulations should be modified, if at all, to accommodate those business models.

Under the second limitation, if the method of valuation consists of determining the present value of projected cash flows from an eligible position or positions, then the method must not take into account any cash flows of income or expense that are attributable to a period or time before the valuation date. This limitation ensures that items of income or expense will not be accounted for twice, first through current realization and then again in the mark.

Under the third limitation, no cost or risk is accounted for more than once, either directly or indirectly. For example, a financial accounting method that allows a special adjustment for credit risk generally satisfies this limitation. It would not satisfy this limitation, however, if it computed the present value of projected cash flows using a discount rate that takes into account any amount of credit risk that is also taken into account by the special adjustment. Thus, if a dealer in securities enters into an interest rate swap contract with a counterparty with a AA/aa rating, taking credit enhancement and netting agreements into account, then the dealer cannot take a special adjustment to the value of the contract for all of the risk between a counterparty with a risk-free rating and the actual counterparty if the dealer determines the present value of projected cash flows from the contract using a mid-market swap curve based upon the LIBOR AA rate. The Treasury Department and the IRS understand, however, that there may be degrees of credit quality within an established rating level, such as AA/aa, and that valuation methodologies used currently may reflect these nuances in credit quality. Accordingly, a credit adjustment reflecting these nuances may satisfy this limitation.

The election to use the safe harbor is made by filing a statement with the taxpayer’s timely filed Federal income tax return for the taxable year for which the election is first effective. The statement must declare that the taxpayer makes the safe harbor election for all of its eligible positions. In addition to any other information that the Commissioner may require, the statement must describe the taxpayer’s applicable financial statement for the first taxable year for which the election is effective and must state that the taxpayer agrees to timely provide upon the request of the Commissioner all information, records, and schedules required by the safe harbor. The election continues to be in effect for all subsequent taxable years unless it is revoked.

A taxpayer cannot revoke the election without the consent of the Commissioner. The Commissioner, however, can revoke the election if the taxpayer fails to comply with any of the recordkeeping and production requirements and cannot show reasonable cause for the failure, the taxpayer ceases to use an eligible method, the taxpayer ceases to have an applicable financial statement, as described below, or the taxpayer holds a de minimis quantity of eligible positions that are subject to the safe harbor. No revocation is necessary if the taxpayer ceases to qualify as an eligible taxpayer, or section 475 does not otherwise apply, because the safe harbor may only be used to determine values and cannot be used unless section 475 applies. Once revoked by either the Commissioner or the taxpayer, neither the taxpayer nor any of its successors may make the election for any taxable year that begins before the date that is six years after the first day of the earliest taxable year affected by the revocation without the consent of the Commissioner.

Not all financial statements qualify under the safe harbor. Consequently, these proposed regulations set forth a system that enables a taxpayer to determine which one of its financial statements, if any, may be used when applying the safe harbor.

Three categories of financial statements qualify under the safe harbor and are set forth in order of priority, from highest to lowest. In the first and highest category are those financial statements that must be filed with the Securities and Exchange Commission (SEC), such as the 10-K and the Annual Statement to Shareholders. In the second category are those financial statements that must be provided to the Federal government or any of its agencies other than the IRS. In this category are statements filed by foreign-controlled financial institutions engaged in trade or business within the United States who report their mark-to-market results to the Federal Reserve or the Office of the Comptroller of the Currency. In the third category are certified audited financial statements that are provided to creditors to make lending decisions, that are provided to equity holders to evaluate their investment, or that are provided for other substantial non-tax purposes and are reasonably anticipated to be directly relied on for the purposes for which the statements were created. For a financial statement described in any of the three categories above to qualify as an applicable financial statement, it must be prepared in accordance with U.S. GAAP. If a taxpayer has two statements in the same category, each of which would qualify under the safe harbor, then the statement that results in the highest aggregate valuation of eligible positions is the only financial statement that may qualify for the safe harbor.

Statements filed with the SEC provide a high degree of confidence that the values used on those statements reflect reasonable approximations of fair value. Consequently, there are no additional business use requirements for those statements. For the second category (statements filed with other agencies of the Federal government) and the third category of statements (the other certified audited financial statements), this degree of confidence is ensured by requiring some substantial non-tax use in the taxpayer’s business. This determination of use must take into account whether the taxpayer’s reliance on the values exposes the taxpayer to material adverse consequences if the values are incorrect. Accordingly, the safe harbor requires that the values for eligible positions contained in these financial statements be used by the taxpayer in most of the significant management functions of all or substantially all of its business. This use includes activities such as senior management review of business-unit profitability, market risk measurement or management, credit risk measurement or management, internal allocation of capital, and compensation of personnel but does not include either tax accounting or reporting the results of operations to other persons. Significance of use is tested by examining all the facts and circumstances in light of the stated purpose of the business use requirement.

The IRS and Treasury understand that some dealers maintain internal books of account, not prepared in accordance with U.S. GAAP, for separate segments of their business and that these internal books of account may include a charge to each operating segment of an internal “cost of carry” calculated in the manner of interest (and the derivatives dealer book may be treated as a separate business segment for that purpose). The purpose of this cost-of-carry charge is to assess profitability or to reflect the cost of capital in maintaining the positions held in that business segment. The amounts so charged do not reduce the fair value of eligible positions on a balance sheet prepared in accordance with U.S. GAAP. The maintenance of these segmented accounts, which may apply an accounting approach that does not qualify as an eligible accounting method, does not prevent some other financial statement prepared in accordance with U.S. GAAP from qualifying as the taxpayer’s applicable financial statement.

The safe harbor can be administrable only if the IRS can readily verify that the values used on financial statements are also appropriately used on the Federal income tax return. Consequently, recordkeeping and record production are critical to the safe harbor. These proposed regulations provide specific requirements for the types of records that must be maintained and provided to enable ready verification. In general, electing taxpayers must clearly show: (1) that the same value used for financial reporting was used on the Federal income tax return; (2) that no eligible position subject to section 475 is excluded from the application of the safe harbor; and (3) that only eligible positions subject to section 475 are carried over to the Federal income tax return under the safe harbor. These proposed regulations outline what records must be retained and produced, including certain forms and schedules filed with the Federal income tax return, such as the Schedule M-1, “Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More,” Schedule M-3, “Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More,” and Form 1120F, “U.S. Income Tax Return of a Foreign Corporation.” These proposed regulations also provide that the Commissioner may enter into an advance agreement with a taxpayer on how records are to be maintained and how long the records are to be retained. All of the necessary records must be retained as long as their contents may become material in the administration of any internal revenue law.

To encourage rapid examinations of the Federal income tax returns of electing taxpayers, these proposed regulations require that all necessary records be produced within 30 days after the Commissioner requests them. If the required records are not provided as required, the regulations permit the Commissioner to use his discretion to: (1) extend the 30-day period; (2) excuse minor or inadvertent failures to provide the requested records; (3) require use of values that clearly reflect income but which are different from those used on the applicable financial statement; or (4) revoke the election (as described under “Election and Revocation” above) if a taxpayer does not demonstrate reasonable cause for the failure to maintain and produce the required records.

This section lists the major captions in §§1.475(a)-3, 1.475(a)-4, 1.475(b)-1, 1.475(b)-2, 1.475(b)-4, 1.475(c)-1, 1.475(c)-2, 1.475(d)-1 and 1.475(e)-1.

* * * * *

(a) Overview.

(1) Purpose.

(2) Summary of paragraphs.

(b) Safe harbor.

(1) General rule.

(2) Scope of the safe harbor.

(c) Eligible taxpayer.

(d) Eligible method.

(1) Sufficient consistency.

(2) General requirements.

(i) Frequency.

(ii) Recognition at the mark.

(iii) Recognition on disposition.

(iv) Fair value standard.

(3) Limitations.

(i) Bid-ask method.

(ii) Valuations based on present values of projected cash flows.

(iii) Accounting for costs and risks.

(4) Examples.

(e) Compliance with other rules.

(f) Election.

(1) Making the election.

(2) Duration of the election.

(3) Revocation.

(i) By the taxpayer.

(ii) By the Commissioner.

(4) Re-election.

(g) Eligible positions.

(h) Applicable financial statement.

(1) Definition.

(2) Primary financial statement.

(i) Statement required to be filed with Securities and Exchange Commission.

(ii) Statement filed with a Federal agency other than the IRS.

(iii) Certified audited financial statement.

(3) Example.

(4) Financial statements of equal priority.

(5) Consolidated groups.

(6) Supplement or amendment to a financial statement.

(7) Certified audited financial statement.

(i) [Reserved.]

(j) Significant business use.

(1) In general.

(2) Financial statement value.

(3) Management of a business as a dealer or trader.

(4) Significant use.

(k) Retention and production of records.

(1) In general.

(2) Specific requirements.

(i) Reconciliation.

(A) In general.

(B) Values on books and records with supporting schedules.

(C) Consolidation schedules.

(ii) Instructions provided by the Commissioner.

(3) Time for producing records.

(4) Retention period for records.

(5) Agreements with the Commissioner.

(l) [Reserved.]

(m) Use of different values.

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Par. 3. Section 1.475(a)-4 is added to read as follows:

(a) Overview—(1) Purpose. This section sets forth a safe harbor that under certain circumstances permits taxpayers to make an election pursuant to which the values of positions reported on certain financial statements are the fair market values of those positions for purposes of section 475. This safe harbor is based on the principle that, if a mark-to-market method used for financial reporting is sufficiently consistent with the requirements of section 475 and if the financial statement employing that method has certain indicia of reliability, then the values used on that financial statement should be appropriate values for purposes of section 475. If other provisions of the Code or regulations require adjustments to fair market value, use of the safe harbor does not obviate the need for those adjustments. See paragraph (e) of this section.

(2) Summary of paragraphs. Paragraph (b) of this section sets forth the safe harbor. To determine who may use the safe harbor, paragraph (c) of this section defines the term “eligible taxpayer” for purposes of the safe harbor. Paragraph (d) of this section sets forth the basic requirements for determining whether the method used for financial reporting is sufficiently consistent with the requirements of section 475. Paragraph (e) of this section describes adjustments to the financial statement values that may be required for purposes of applying section 475. Paragraph (f) of this section describes how to make the safe harbor election and the conditions under which the election may be revoked. Paragraph (g) of this section provides that the Commissioner will issue a revenue procedure that lists the types of securities and commodities that may qualify as “eligible positions” for purposes of the safe harbor. Using rules for determining priorities among financial statements, paragraph (h) of this section defines the term “applicable financial statement” and so describes the financial statement, if any, whose values may be used in the safe harbor. In some cases, as required by paragraph (j) of this section, the safe harbor is available only if the taxpayer’s operations make significant business use of financial statement values. Paragraph (k) of this section sets forth requirements for record retention and record production. Paragraph (m) of this section provides that the Commissioner may use fair market values that clearly reflect income, but which differ from values used on the applicable financial statement, if a taxpayer fails to comply with the recordkeeping and record production requirements of paragraph (k) of this section.

(b) Safe harbor—(1) General rule. Subject to any adjustment required by paragraph (e) of this section, if an eligible taxpayer uses an eligible method for the valuation of an eligible position on its applicable financial statement and the eligible taxpayer is subject to the election described in paragraph (f) of this section, the value that the eligible taxpayer assigns to that eligible position in its applicable financial statement is the fair market value of the eligible position for purposes of section 475, even if that value is not the fair market value of the position for any other purpose of the internal revenue laws. Notwithstanding the rule set forth in this paragraph, the Commissioner may, in certain circumstances, use fair market values that clearly reflect income but which are different than the values used on the applicable financial statement. See paragraph (m) of this section.

(2) Scope of the safe harbor. The safe harbor may be used only to determine values for eligible positions that are properly marked to market under section 475. It does not determine whether any positions may or may not be subject to mark-to-market accounting under section 475.

(c) Eligible taxpayer. An eligible taxpayer is a dealer in securities as defined in section 475(c)(1) and §1.475(c)-1, a dealer in commodities as defined in section 475(e), or a trader in securities or commodities as defined in section 475(f).

(d) Eligible Method—(1) Sufficient consistency. An eligible method is a mark-to-market method that is sufficiently consistent with the requirements of a mark-to-market method under section 475. To be sufficiently consistent, the eligible method must satisfy all of the requirements of paragraph (d)(2) and paragraph (d)(3) of this section.

(2) General requirements. The method—

(i) Frequency. Must require a valuation of the eligible position no less frequently than annually, including a valuation as of the last business day of the taxable year;

(ii) Recognition at the mark. Must recognize into income on the income statement for each taxable year mark-to-market gain or loss based upon the valuation or valuations described in paragraph (d)(2)(i) of this section;

(iii) Recognition on disposition. Must require, on disposition of the eligible position, recognition into income (on the income statement for the taxable year of disposition) as if a year-end mark occurred immediately before such disposition; and

(iv) Fair value standard. Must require use of a valuation standard that arrives at fair value in accordance with U.S. Generally Accepted Accounting Principles (U.S. GAAP) as established by the Financial Accounting Standards Board.

(3) Limitations—(i) Bid-ask method. Except for eligible positions that are traded on a qualified board or exchange, as defined in section 1256(g)(7), the valuation standard used for the applicable financial statement of an eligible taxpayer must not permit values at or near the bid or ask value. Consequently, the valuation method described in §1.471-4(a)(1) generally fails to satisfy this paragraph (d)(3)(i). The restriction in this paragraph (d)(3)(i) is satisfied if a resulting value is closer to the mid-market value than it is to the bid or ask value.

(ii) Valuations based on present values of projected cash flows. If the method of valuation consists of projecting cash flows from an eligible position or positions and determining the present value of those cash flows, the method must not take into account any cash flows (income or expense) attributable to a period or time prior to the valuation date. In addition, adjustment of the gain or loss recognized on the mark may be required with respect to payments on notional principal contracts that will occur after the valuation date to the extent that portions of the payments have been recognized for tax purposes prior to the valuation date and appropriate adjustment has not been made for purposes of determining financial statement value.

(iii) Accounting for costs and risks—(A) General rule. In a determination of fair value, appropriate costs and risks may be taken into account, but no cost or risk may be accounted for more than once, either directly or indirectly. If appropriate, the costs and risks that may be accounted for, include, but are not limited to, credit risk (appropriately adjusted for any credit enhancement), future administrative costs, and model risk. In the case of credit risk, an adjustment is implicit in computing the present value of cash flows using a discount rate greater than a risk-free rate. Accordingly, a determination of whether any further downward adjustment to value for credit risk is warranted, or whether an upward adjustment is required, must take that implicit adjustment into consideration.

(4) Examples. The following examples illustrate this paragraph (d).

Example 1. (i) A, a calendar year taxpayer, is a dealer in securities within the meaning of section 475(c)(1). A generally maintains a balanced portfolio of interest rate swaps and other interest rate derivatives, capturing bid-ask spreads and keeping its market exposure within desired limits (using, if necessary, additional derivatives for this purpose). A uses a mark-to-market method on a statement that it is required to file with the United States Securities and Exchange Commission (Securities and Exchange Commission or SEC) and that satisfies paragraph (d)(2) of this section with respect to both the contracts with customers and the additional derivatives. None of the derivatives is traded on a qualified board or exchange, as defined in section 1256(g)(7). When determining the amount of any gain or loss realized on a sale, exchange, or termination of a position, A makes a proper adjustment for amounts taken into account respecting payments or receipts. All of A’s counterparties on the derivatives have credit quality ratings of AA/aa, according to standard credit ratings obtained from private credit rating agencies.

(ii) Under A’s valuation method, as of each valuation date A determines a mid-market probability distribution of future cash flows under the derivatives and computes the present values of these cash flows. In computing these present values, A uses an industry standard yield curve that is appropriate for obligations by persons with credit quality ratings of AA/aa. In addition, based on information including its own knowledge about the counterparties, A adjusts some of these present values either upward or downward to reflect A’s reasonable judgment about the extent to which the true credit status of each counterparty’s obligation, taking credit enhancements into account, differs from AA/aa.

(iii) A’s methodology does not violate the requirement in paragraph (d)(3)(iii) of this section that the same cost or risk not be taken into account, directly or indirectly, more than once.

Example 2. (i) The facts are the same as in Example 1, except that A uses risk-free rates to discount the payments to be received under the derivatives. Based on information, including its own knowledge about the counterparties, A adjusts these present values to reflect A’s reasonable judgment about the extent to which the true credit status of each counterparty’s obligation, taking credit enhancements into account, differs from a risk-free obligation.

(ii) A’s methodology does not violate the requirement in paragraph (d)(3)(iii) of this section that the same cost or risk not be taken into account, directly or indirectly, more than once.

Example 3. (i) The facts are the same as in Example 1, except that, after computing present values using the discount rates that are appropriate for obligors with credit quality ratings of AA/aa, A, based on information including its own knowledge about the counterparties, adjusts some of these present values either upward or downward to reflect A’s reasonable judgment about the extent to which the true credit status of each counterparty’s obligation, taking credit enhancements into account, differs from AAA/aaa.

(ii) A’s methodology violates the requirement in paragraph (d)(3)(iii) of this section that the same cost or risk not be taken into account, directly or indirectly, more than once. By using a AA/aa discount rate, A’s method takes into account the difference between risk-free obligations and AA/aa obligations. This difference includes the difference between a rating of AAA/aaa and one of AA/aa. By adjusting values for the difference between a rating of AAA/aaa and one of AA/aa, A takes into account risks that it had already accounted for through the discount rates that it used. The same result would occur if A judged some of its counterparties’ obligations to be of AAA/aaa quality but A failed to adjust the values of those obligations to reflect the difference between a rating of AAA/aaa and one of AA/aa.

Example 4. (i) The facts are the same as in Example 1, except that A determines the mid-market value for each derivative and then subtracts the corresponding part of the bid-ask spread.

(ii) A’s methodology violates the rule in paragraph (d)(3)(i) of this section that forbids valuing the derivatives at or near the bid or ask value.

Example 5. (i) The facts are the same as in Example 1, and, in addition, A’s adjustments for all risks and costs, including credit risk, future administrative costs, and model risk, consistently cause the adjusted value to be at or near the bid value or ask value.

(ii) A’s methodology violates the rule in paragraph (d)(3)(i) of this section that forbids valuing the derivatives at or near the bid or ask value.

(e) Compliance with other rules. Notwithstanding any other provisions of this section, the fair market values for purposes of the safe harbor must be consistent with section 482 or rules that adopt section 482 principles, when applicable. Thus applicable financial statement values must be adjusted as necessary for purposes of the safe harbor. For example, if a notional principal contract is subject to section 482 or section 482 principles, the values of future cash flows taken into account in determining the value of the contract for purposes of section 475 must be consistent with section 482.

(f) Election—(1) Making the election. Unless the Commissioner prescribes otherwise, an eligible taxpayer elects under this section by filing with the Commissioner a statement declaring that the taxpayer makes the safe harbor election in this section for all its eligible positions. In addition to any other information that the Commissioner may require, the statement must describe the taxpayer’s applicable financial statement for the first taxable year for which the election is effective and must state that the taxpayer agrees to timely provide upon the request of the Commissioner all information, records, and schedules required by paragraph (k) of this section. The statement must be attached to a timely filed Federal income tax return (including extensions) for the taxable year for which the election is first effective.

(2) Duration of the election. Once made, the election continues in effect for all subsequent taxable years unless revoked.

(3) Revocation—(i) By the taxpayer. An eligible taxpayer that is subject to an election under this section may revoke it only with the consent of the Commissioner.

(ii) By the Commissioner. The Commissioner, after consideration of all relevant facts and circumstances, may revoke an election under this section, effective beginning with the first open year for which the election is effective or with any subsequent year, if—

(A) The taxpayer fails to comply with paragraph (k) of this section (concerning record retention and production) and the taxpayer does not show reasonable cause for this failure;

(B) The taxpayer ceases to have an applicable financial statement or ceases to use an eligible method; or

(C) For any other reason, no more than a de minimis number of eligible positions, or no more than a de minimis fraction of the taxpayer’s eligible positions, are covered by the safe harbor in paragraph (b) of this section.

(4) Re-election. If an election is revoked, either by the Commissioner or by the taxpayer, the taxpayer (or any successor of the taxpayer) may not make the election for any taxable year that begins before the date that is six years after the first day of the earliest taxable year affected by the revocation without the consent of the Commissioner.

(g) Eligible positions. Eligible positions mean those types or classes of securities or commodities that are marked to market under section 475 and are described by the Commissioner as eligible positions for purposes of this safe harbor in a revenue procedure or other published guidance.

(h) Applicable financial statement—(1) Definition. An eligible taxpayer’s applicable financial statement for a taxable year is the taxpayer’s primary financial statement for that year if the statement is described in paragraph (h)(2)(i) of this section (concerning statements required to be filed with the SEC) or if the statement is both described in either paragraph (h)(2)(ii) or (iii) of this section and also meets the requirements of paragraph (j) of this section (concerning significant business use). Otherwise, or if the taxpayer does not have a primary financial statement for the taxable year, the taxpayer does not have an applicable financial statement for the taxable year.

(2) Primary financial statement. For any taxable year, an eligible taxpayer’s primary financial statement is the financial statement, if any, described in one or more of paragraphs (h)(2)(i) through (iii) of this section. If more than one financial statement of the taxpayer for the year is so described, the primary financial statement is the one first described in paragraphs (h)(2)(i) through (iii) of this section. A taxpayer has only one primary financial statement for any year.

(i) Statement required to be filed with the Securities and Exchange Commission. A financial statement that is prepared in accordance with U.S. GAAP and that is required to be filed with the SEC, such as the 10-K or the Annual Statement to Shareholders.

(ii) Statement filed with a Federal agency other than the IRS. A financial statement that is prepared in accordance with U.S. GAAP and that is required to be provided to the Federal government or any of its agencies other than the IRS.

(iii) Certified audited financial statement. A certified audited financial statement that is prepared in accordance with U.S. GAAP; that is given to creditors for purposes of making lending decisions, given to equity holders for purposes of evaluating their investment in the eligible taxpayer, or provided for other substantial non-tax purposes; and that the taxpayer reasonably anticipates will be directly relied on for the purposes for which it was created.

(3) Example. A prepares a financial statement, FS1, that is required to be filed with a Federal government agency other than the SEC or the IRS, and is thus described in paragraph (h)(2)(ii) of this section. A also prepares a second financial statement, FS2, that is a certified audited financial statement that is given to creditors and that A reasonably anticipates will be relied on for purposes of making lending decisions, and that is thus described in paragraph (h)(2)(iii) of this section. Because FS1, which is described in paragraph (h)(2)(ii) of this section, is described before FS2, which is described in paragraph (h)(2)(iii) of this section, FS1 is A’s primary financial statement.

(4) Financial statements of equal priority. If two or more financial statements are of equal priority, after applying the rules of paragraph (h)(2) of this section, then the statement that results in the highest aggregate valuation of eligible positions being marked to market under section 475 is the primary financial statement.

(5) Consolidated groups. If the taxpayer is a member of an affiliated group that files a consolidated return, the primary financial statement of the taxpayer is the primary financial statement of the common parent (within the meaning of section 1504(a)(1)) of the consolidated group.

(6) Supplement or amendment to a financial statement. For purposes of paragraph (b)(1) of this section and this paragraph (h), a financial statement includes any supplement or amendment to the financial statement.

(7) Certified audited financial statement. For purposes of this paragraph (h), a financial statement is a certified audited financial statement if it is certified by an independent certified public accountant from a Registered Public Accounting firm, as defined in section 2(a)(12) of the Sarbanes-Oxley Act of 2002, Public Law 107-204, 116 Stat. 746 (July 30, 2002), 15 U.S.C. §7201(a)(12), and rules promulgated under that Act, and is—

(i) Certified to be fairly presented (a “clean” opinion);

(ii) Certified to be fairly presented subject to a concern about a contingency, other than a contingency relating to the value of eligible positions (a qualified “subject to” opinion); or

(iii) Certified to be fairly presented except for a method of accounting with which the Certified Public Accountant disagrees and which is not a method used to determine the value of an eligible position held by an eligible taxpayer (a qualified “except for” opinion).

(i) [Reserved].

(j) Significant business use—(1) In general. A financial statement is described in this paragraph (j) if—

(i) The financial statement contains values for eligible positions;

(ii) The eligible taxpayer makes significant use of financial statement values in most of the significant management functions of its business; and

(iii) That use is related to the management of all or substantially all of the eligible taxpayer’s business.

(2) Financial statement value. For purposes of this paragraph (j), the term financial statement value means—

(i) A value that is taken from the financial statement; or

(ii) A value that is produced by a process that is in all respects identical to the process that produces the values that appear on the financial statement but that is not taken from the statement because either—

(A) The value was determined as of a date for which the financial statement does not value eligible positions; or

(B) The value is used in the management of the business before the financial statement has been prepared.

(3) Management of a business as a dealer or trader. For purposes of this paragraph (j), the term management of a business as a dealer or trader refers to the financial and commercial oversight of the business. Oversight includes, but is not limited to, senior management review of business-unit profitability, market risk measurement or management, credit risk measurement or management, internal allocation of capital, and compensation of personnel. Management of a business as a dealer or trader does not include either tax accounting or reporting the results of operations to other persons.

(4) Significant use. If an eligible taxpayer uses financial statement values for some significant management functions and uses values that are not financial statement values for other significant management functions, then the determination of whether the taxpayer has made significant use of the financial statement values is made on the basis of all the facts and circumstances. This determination must particularly take into account whether the taxpayer’s reliance on the financial statement values exposes the taxpayer to material adverse economic consequences if the values are incorrect.

(k) Retention and production of records—(1) In general. In addition to all records that section 6001 otherwise requires to be retained, an eligible taxpayer subject to the election provided by this section must keep, and timely provide to the Commissioner upon request, records and books of account that are sufficient to establish that the values used for eligible positions for purposes of section 475 are the values used in the applicable financial statement. This obligation extends to all books and records that are required to be maintained for any period for financial or regulatory reporting purposes, even if these books or records may not otherwise be specifically covered by section 6001. All records described in this paragraph (k) must be maintained for the period described in paragraph (k)(4) of this section, even if a lesser period of retention applies for financial statement or regulatory purposes.

(2) Specific requirements—(i) Reconciliation. Unless the Commissioner otherwise provides—

(A) In general. An eligible taxpayer must provide reconciliation schedules between the applicable financial statement for the taxable year and Federal income tax return for that year. The required reconciliation schedules include all supporting schedules, exhibits, computer programs and any other information used in producing the values and schedules, documentation of rules and procedures governing determination of the values. The required schedules also include a detailed explanation of any adjustments necessitated by imperfect overlap between the eligible positions that the taxpayer marks to market under section 475 and the eligible positions for which the applicable financial statement uses an eligible method. A corporate taxpayer subject to this paragraph (k) must reconcile the net income amount reported on its applicable financial statement to the amount reported on the applicable forms and schedules on its Federal income tax return (such as the Schedule M-1, “Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More”; Schedule M-3, “Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More”; and Form 1120F, “U.S. Income Tax Return of a Foreign Corporation”) in the time and manner provided by the Commissioner. Eligible taxpayers that are not otherwise required to file a Schedule M-1 or Schedule M-3 must reconcile net income using substitute schedules similar to Schedule M-1 and Schedule M-3, and these substitute schedules must be attached to the return.

(B) Values on books and records with supporting schedules. The books and records must state the value used for each eligible position separately from the value used for any other eligible position. However, an eligible taxpayer may make adjustments to values on a pooled basis, if the taxpayer demonstrates that it can compute gain or loss attributable to the sale or other disposition of an individual eligible position.

(C) Consolidation schedules. The taxpayer must provide a schedule showing consolidation and de-consolidation that is used in preparing the applicable financial statement, along with exhibits and subordinate schedules. This schedule must provide information that addresses the differences for consolidation between the applicable financial statement and the Federal income tax return.

(ii) Instructions provided by the Commissioner. The Commissioner may provide an alternative time or manner in which an eligible taxpayer subject to this paragraph (k) must establish that the same values used for eligible positions on the applicable financial statement are also the values used for purposes of section 475 on the Federal income tax return.

(3) Time for producing records. All documents described in this paragraph (k) must be produced within 30 days of a request by the Commissioner, unless the Commissioner grants a written extension. Generally, the Commissioner will exercise his discretion to excuse a minor or inadvertent failure to provide requested documents if the taxpayer shows reasonable cause for the failure, has made a good faith effort to comply with the requirement to produce records, and promptly remedies the failure. For failures to maintain, or timely produce, records, see paragraph (m) of this section (allowing the Commissioner, but not the taxpayer, to use fair market values which clearly reflect income, but which are different from those values used on the applicable financial statement, for eligible positions that otherwise might be subject to the safe harbor) and paragraph (f)(3)(ii) of this section (allowing the Commissioner to revoke the election).

(4) Retention period for records. All materials required by this paragraph (k) and section 6001 must be retained as long as their contents may become material in the administration of any internal revenue law.

(5) Agreements with the Commissioner. The Commissioner and an eligible taxpayer may enter into a written agreement that establishes, for purposes of this paragraph (k), which records must be maintained, how they must be maintained, and for how long they must be maintained.

(l) [Reserved].

(m) Use of different values. If the taxpayer fails to satisfy paragraph (k) of this section (concerning record retention and record production) with respect to the records that relate to certain eligible positions for a taxable year, the Commissioner may, for those eligible positions for that year, use fair market values under section 475 that are different from those values reported for those positions on the applicable financial statement and are values the Commissioner determines to be appropriate to clearly reflect income. See paragraph (f)(3)(ii) of this section concerning revocation of the election by the Commissioner, when a taxpayer does not produce required records and fails to demonstrate reasonable cause for such failure.

Par. 4. Section 1.475(e)-1 is amended by redesignating paragraphs (d) through (j) as paragraphs (e) through (k), respectively and adding a new paragraph (d) to read as follows:

* * * * *

(d) Effective date. Section 1.475(a)-4 (concerning a safe harbor to use applicable financial statement values for purposes of section 475) applies to taxable years ending on or after the date on which the Treasury decision promulgating these regulations is published in the FEDERAL REGISTER.

* * * * *

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.

Section 83 generally applies to a transfer of property by one person to another in connection with the performance of services. The courts have held that a partnership capital interest is property for this purpose. See Schulman v. Commissioner, 93 T.C. 623 (1989) (section 83 governs the issuance of an option to acquire a partnership interest as compensation for services provided as an employee); Kenroy, Inc. v. Commissioner, T.C. Memo 1984-232. Therefore, the proposed regulations provide that a partnership interest is property within the meaning of section 83, and that the transfer of a partnership interest in connection with the performance of services is subject to section 83.

The proposed regulations apply section 83 to all partnership interests, without distinguishing between partnership capital interests and partnership profits interests. Although the application of section 83 to partnership profits interests has been the subject of controversy, see, e.g., Campbell v. Commissioner, T.C. Memo 1990-162, aff’d in part and rev’d in part, 943 F.2d 815 (8^th Cir. 1991), n. 7; St. John v. U.S., 84-1 USTC 9158 (C.D. Ill. 1983), the Treasury Department and the IRS do not believe that there is a substantial basis for distinguishing among partnership interests for purposes of section 83. All partnership interests constitute personal property under state law and give the holder the right to share in future earnings from partnership capital and labor. Moreover, some commentators have suggested that the same tax rules should apply to both partnership profits interests and partnership capital interests. These commentators have suggested that taxpayers may exploit any differences in the tax treatment of partnership profits interests and partnership capital interests. The Treasury Department and the IRS agree with these comments. Therefore, all of the rules in these proposed regulations and the accompanying proposed revenue procedure (described below) apply equally to partnership capital interests and partnership profits interests. However, a right to receive allocations and distributions from a partnership that is described in section 707(a)(2)(A) is not a partnership interest. In section 707(a)(2)(A), Congress directed that such an arrangement should be characterized according to its substance, that is, as a disguised payment of compensation to the service provider. See S. Rep. No. 98-169, 98 Cong. 2d Sess., at 226 (1984).

Section 83(b) allows a person who receives substantially nonvested property in connection with the performance of services to elect to include in gross income the difference between: (A) the fair market value of the property at the time of transfer (determined without regard to a restriction other than a restriction which by its terms will never lapse); and (B) the amount paid for such property. Under section 83(b)(2), the election under section 83(b) must be made within 30 days of the date of the transfer of the property to the service provider.

Consistent with the principles of section 83, the proposed regulations provide that, if a partnership interest is transferred in connection with the performance of services, and if an election under section 83(b) is not made, then the holder of the partnership interest is not treated as a partner until the interest becomes substantially vested. If a section 83(b) election is made with respect to such an interest, the service provider will be treated as a partner for purposes of Subtitle A of the Code. These rules are similar to the current rules pertaining to substantially nonvested stock in a subchapter S corporation. See §1.1361-1(b)(3) (upon an election under section 83(b), the service provider becomes a shareholder for purposes of subchapter S).

These principles differ from Rev. Proc. 2001-43. Under that revenue procedure, if a partnership profits interest is transferred in connection with the performance of services, then the holder of the partnership interest may be treated as a partner even if no section 83(b) election is made, provided that certain conditions are met.

Certain changes to the regulations under both subchapter K and section 83 are needed to coordinate the principles of subchapter K with the principles of section 83. Among the changes that are proposed in these regulations are: (1) conforming the subchapter K rules to the section 83 timing rules; (2) revising the section 704(b) regulations to take into account the fact that allocations with respect to an unvested interest may be forfeited; and (3) providing that a partnership generally recognizes no gain or loss on the transfer of an interest in the partnership in connection with the performance of services for that partnership. In addition, Rev. Procs. 93-27, 1993-2 C.B. 343, and 2001-43, 2001-2 C.B. 191, which generally provide for nonrecognition by both the partnership and the service provider on the transfer of a profits interest in the partnership for services performed for that partnership, must be modified to be consistent with these proposed regulations. Accordingly, in conjunction with these proposed regulations, the IRS is issuing Notice 2005-43, 2005-24 I.R.B. . That notice contains a proposed revenue procedure that, when finalized, will obsolete Rev. Procs. 93-27 and 2001-43. The Treasury Department and the IRS intend for these proposed regulations and the proposed revenue procedure to become effective at the same time. The proposed amendments to the regulations under section 83 and subchapter K, as well as the notice, are described in further detail below.

The proposed revenue procedure and certain parts of the proposed regulations (as described below) only apply to a transfer by a partnership of an interest in that partnership in connection with the performance of services for that partnership (compensatory partnership interests). The Treasury Department and the IRS request comments on the income tax consequences of transactions involving related persons, such as, for example, the transfer of an interest in a lower-tier partnership in exchange for services provided to the upper-tier partnership.

Except as otherwise provided in §1.83-6(a)(3), if property is transferred in connection with the performance of services, then the service recipient’s deduction, if any, is allowed only for the taxable year of that person in which or with which ends the taxable year of the service provider in which the amount is included as compensation. See section 83(h). In contrast, under section 706(a) and §1.707-1(c), guaranteed payments described in section 707(c) are included in the partner’s income in the partner’s taxable year within or with which ends the partnership’s taxable year in which the partnership deducted the payments. Under §1.721-1(b)(2) of the current regulations, an interest in partnership capital issued by the partnership as compensation for services rendered to the partnership is treated as a guaranteed payment under section 707(c). Some commentators suggested that the proposed regulations should resolve the potential conflict between the timing rules of section 83 and the timing rules of section 707(c).

Under the proposed regulations, partnership interests issued to partners for services rendered to the partnership are treated as guaranteed payments. Also, the proposed regulations provide that the section 83 timing rules override the timing rules of section 706(a) and §1.707-1(c) to the extent they are inconsistent. Accordingly, if a partnership transfers property to a partner in connection with the performance of services, the timing and the amount of the related income inclusion and deduction is determined by section 83 and the regulations thereunder.

In drafting these regulations, the Treasury Department and the IRS considered alternative approaches for resolving the timing inconsistency between section 83 and section 707(c). One alternative approach considered was to provide that the transfer of property in connection with the performance of services is not treated as a guaranteed payment within the meaning of section 707(c). This approach was not adopted in the proposed regulations due to, among other things, concern that such a characterization of these transfers could have unintended consequences on the application of provisions of the Code outside of subchapter K that refer to guaranteed payments. The Treasury Department and the IRS request comments on alternative approaches for resolving the timing inconsistency between section 83 and section 707(c).

The proposed regulations provide guidance regarding the allocation of the partnership’s deduction for the transfer of property in connection with the performance of services. Some commentators suggested that the proposed regulations require that the partnership’s deduction be allocated among the partners in accordance with their interests in the partnership prior to the transfer.

Section 706(d)(1) provides generally that, if, during any taxable year of a partnership, there is a change in any partner’s interest in the partnership, each partner’s distributive share of any item of income, gain, loss, deduction, or credit of the partnership for such taxable year shall be determined by the use of any method prescribed by regulations which takes into account the varying interests of the partners in the partnership during the taxable year. Regulations have not yet been issued describing the rules for taking into account the varying interests of the partners in the partnership during a taxable year. Section 1.706-1(c)(2)(ii) provides that, in the case of a sale, exchange, or liquidation of a partner’s entire interest in a partnership, the partner’s share of partnership items for the taxable year may be determined by either: (1) closing the partnership’s books as of the date of the transfer (closing of the books method); or (2) allocating to the departing partner that partner’s pro rata part of partnership items that the partner would have included in the partner’s taxable income had the partner remained a partner until the end of the partnership taxable year (proration method). The Treasury Department and the IRS believe that section 706(d)(1) adequately ensures that partnership deductions that are attributable to the portion of the partnership’s taxable year prior to a new partner’s entry into the partnership are allocated to the historic partners.

Section 706(d)(2), however, places additional limits on how partnerships may allocate these deductions. Under section 706(d)(2)(B), payments for services by a partnership using the cash receipts and disbursements method of accounting are allocable cash basis items. Under section 706(d)(2)(A), if during any taxable year of a partnership there is a change in any partner’s interest in the partnership, then (except to the extent provided in regulations) each partner’s distributive share of any allocable cash basis item must be determined under the proration method. To allow partnerships to allocate deductions with respect to property transferred in connection with the performance of services under a closing of the books method, the proposed regulations provide that section 706(d)(2)(A) does not apply to such a transfer.

 

Under the proposed regulations, the service provider’s capital account is increased by the amount the service provider takes into income under section 83 as a result of receiving the interest, plus any amounts paid for the interest. Some commentators suggested that the amount included in the service provider’s income under section 83, plus the amount paid for the interest, may differ from the amount of capital that the partnership has agreed to assign to the service provider. These commentators contend that the substantial economic effect safe harbor in the section 704(b) regulations should be amended to allow partnerships to reallocate capital between the historic partners and the service provider to accord with the economic agreement of the parties.

The reallocation of partnership capital in these circumstances is not consistent with the policies underlying the substantial economic effect safe harbor and the capital account maintenance rules. The purpose of the substantial economic effect safe harbor is to ensure that, to the extent that there is an economic benefit or burden associated with a partnership allocation, the partner to whom the allocation is made receives the economic benefit or bears the economic burden. Under section 83, the economic benefit of receiving a partnership interest in connection with the performance of services is the amount that is included in the compensation income of the service provider, plus the amount paid for the interest. This is the amount by which the service partner’s capital account should be increased.

As explained in section 6 below, a proposed revenue procedure issued concurrently with these proposed regulations would allow a partnership, its partners, and the service provider to elect to treat the fair market value of a partnership interest as equal to the liquidation value of that interest. If such an election is made, the capital account of a service provider receiving a partnership interest in connection with the performance of services is increased by the liquidation value of the partnership interest received.

If an election under section 83(b) has been made with respect to a substantially nonvested interest, the holder of the nonvested interest may be allocated partnership items that may later be forfeited. For this reason, allocations of partnership items while the interest is substantially nonvested cannot have economic effect. Under the proposed regulations, such allocations will be treated as being in accordance with the partners’ interests in the partnership if: (a) the partnership agreement requires that the partnership make forfeiture allocations if the interest for which the section 83(b) election is made is later forfeited; and (b) all material allocations and capital account adjustments under the partnership agreement not pertaining to substantially nonvested partnership interests for which a section 83(b) election has been made are recognized under section 704(b). This safe harbor does not apply if, at the time of the section 83(b) election, there is a plan that a substantially nonvested interest will be forfeited. All of the facts and circumstances (including the tax status of the holder of the substantially nonvested interest) will be considered in determining whether there is a plan that the interest will be forfeited. In such a case, the partners’ distributive shares of partnership items shall be determined in accordance with the partners’ interests in the partnership under §1.704-1(b)(3).

Generally, forfeiture allocations are allocations to the service provider of partnership gross income and gain or gross deduction and loss (to the extent such items are available) that offset prior distributions and allocations of partnership items with respect to the forfeited partnership interest. These rules are designed to ensure that any partnership income (or loss) that was allocated to the service provider prior to the forfeiture is offset by allocations on the forfeiture of the interest. Also, to carry out the prohibition under section 83(b)(1) on deductions with respect to amounts included in income under section 83(b), these rules generally cause a forfeiting partner to be allocated partnership income to offset any distributions to the partner that reduced the partner’s basis in the partnership below the amount included in income under section 83(b).

Forfeiture allocations may be made out of the partnership’s items for the entire taxable year. In determining the gross income of the partnership in the taxable year of the forfeiture, the rules of §1.83-6(c) apply. As a result, the partnership generally will have gross income in the taxable year of the forfeiture equal to the amount of the allowable deduction to the service recipient partnership upon the transfer of the interest as a result of the making of the section 83(b) election, regardless of the fair market value of the partnership’s assets at the time of forfeiture.

In certain circumstances, the partnership will not have enough income and gain to fully offset prior allocations of loss to the forfeiting service provider. The proposed revenue procedure includes a rule that requires the recapture of losses taken by the service provider prior to the forfeiture of the interest to the extent that those losses are not recaptured through forfeiture allocations of income and gain to the service provider. This rule does not provide the other partners in the partnership with the opportunity to increase their shares of partnership loss (or reduce their shares of partnership income) for the year of the forfeiture by the amount of loss that was previously allocated to the forfeiting service provider.

In other circumstances, the partnership will not have enough deductions and loss to fully offset prior allocations of income to the forfeiting service provider. It appears that, in such a case, section 83(b)(1) may prohibit the service provider from claiming a loss with respect to partnership income that was previously allocated to the service provider. However, a forfeiting partner is entitled to a loss for any basis in a partnership that is attributable to contributions of money or property to the partnership (including amounts paid for the interest) remaining after the forfeiture allocations have been made. See §1.83-2(a).

Comments are requested as to whether the regulations should require or allow partnerships to create notional tax items to make forfeiture allocations where the partnership does not have enough actual tax items to make such allocations. Comments are also requested as to whether section 83(b)(1) should be read to allow a forfeiting service provider to claim a loss with respect to partnership income that was previously allocated to the service provider and not offset by forfeiture allocations of loss and deduction and, if so, whether it is appropriate to require the other partners in the partnership to recognize income in the year of the forfeiture equal to the amount of the loss claimed by the service provider. In particular, comments are requested as to whether section 83 or another section of the Code provides authority for such a rule.

Commentators requested guidance regarding the valuation of partnership interests transferred in connection with the performance of services. Section 83 generally provides that the recipient of property transferred in connection with the performance of services recognizes income equal to the fair market value of the property, disregarding lapse restrictions. See Schulman v. Commissioner, 93 T.C. 623 (1989). However, some authorities have concluded that, under the particular facts and circumstances of the case, a partnership profits interest had only a speculative value or that the fair market value of a partnership interest should be determined by reference to the liquidation value of that interest. See §1.704-1(e)(1)(v); Campbell v. Commissioner, 943 F.2d 815 (8^th Cir. 1991); St. John v. U.S., 1984-1 USTC 9158 (C.D. 111. 1983). But see Diamond v. Commissioner, 492 F.2d 286 (7^th Cir. 1974) (holding under pre-section 83 law that the receipt of a profits interest with a determinable value at the time of receipt resulted in immediate taxation); Campbell v. Commissioner, T.C. Memo 1990-162, aff’d in part and rev’d in part, 943 F.2d 815 (8^th Cir. 1991).

The Treasury Department and the IRS have determined that, provided certain requirements are satisfied, it is appropriate to allow partnerships and service providers to value partnership interests based on liquidation value. This approach ensures consistency in the treatment of partnership profits interests and partnership capital interests, and accords with other regulations issued under subchapter K, such as the regulations under section 704(b).

In accordance with these proposed regulations, the revenue procedure proposed in Notice 2005-43, 2005-24 I.R.B. , will, when finalized, provide additional rules that partnerships, partners, and persons providing services to the partnership in exchange for interests in that partnership would be required to follow when electing under §1.83-3(l) of these proposed regulations to treat the fair market value of those interests as being equal to the liquidation value of those interests. For this purpose, the liquidation value of a partnership interest is the amount of cash that the holder of that interest would receive with respect to the interest if, immediately after the transfer of the interest, the partnership sold all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership’s operations) for cash equal to the fair market value of those assets, and then liquidated.

There is a dispute among commentators as to whether a partnership should recognize gain or loss on the transfer of a compensatory partnership interest. Some commentators believe that, on the transfer of such an interest, the partnership should be treated as satisfying its compensation obligation with a fractional interest in each asset of the partnership. Under this deemed sale of assets theory, the partnership would recognize gain or loss equal to the excess of the fair market value of each partial asset deemed transferred to the service provider over the partnership’s adjusted basis in that partial asset. Other commentators believe that a partnership should not recognize gain or loss on the transfer of a compensatory partnership interest. They argue, among other things, that the transfer of such an interest is not properly treated as a realization event for the partnership because no property owned by the partnership has changed hands. They also argue that taxing a partnership on the transfer of such an interest would result in inappropriate gain acceleration, would be difficult to administer, and would cause economically similar transactions to be taxed differently.

Generally, when appreciated property is used to pay an obligation, gain on the property is recognized. The Treasury Department and the IRS are still analyzing whether an exception to this general rule is appropriate on the transfer of an interest in the capital or profits of a partnership to satisfy certain partnership obligations (such as the obligations to pay interest or rent). However, the Treasury Department and the IRS believe that partnerships should not be required to recognize gain on the transfer of a compensatory partnership interest. Such a rule is more consistent with the policies underlying section 721 — to defer recognition of gain and loss when persons join together to conduct a business — than would be a rule requiring the partnership to recognize gain on the transfer of these types of interests. Therefore, the proposed regulations provide that partnerships are not taxed on the transfer or substantial vesting of a compensatory partnership interest. Under §1.704-1(b)(4)(i) (reverse section 704(c) principles), the historic partners generally will be required to recognize any income or loss attributable to the partnership’s assets as those assets are sold, depreciated, or amortized.

The rule providing for nonrecognition of gain or loss does not apply to the transfer or substantial vesting of an interest in an eligible entity, as defined in §301.7701-3(a) of the Procedure and Administration Regulations, that becomes a partnership under §301.7701-3(f)(2) as a result of the transfer or substantial vesting of the interest. See McDougal v. Commissioner, 62 T.C. 720 (1974) (holding that the service recipient recognized gain on the transfer of a one-half interest in appreciated property to the service provider, immediately prior to the contribution by the service recipient and the service provider of their respective interests in the property to a newly formed partnership).

The proposed regulations concerning noncompensatory partnership options published on January 22, 2003, contained special rules regarding the revaluations of partnership property while noncompensatory partnership options were outstanding. Specifically, the regulations proposed modifications to §1.704-1(b)(2)(iv)(f) and (h) to provide that any revaluation during the period in which there are outstanding noncompensatory options generally must take into account the fair market value, if any, of outstanding options. These proposed regulations do not contain similar provisions, because under recently proposed modifications to the regulations under §1.7041(b)(2)(iv), the obligation to issue a partnership interest in satisfaction of an option agreement is a liability that is taken into account in determining the fair market value of partnership assets as a result of a revaluation. See REG-106736-00, 2003-2 C.B. 60 [68 FR 37434] (June 24, 2003) (relating to the assumption of certain obligations by partnerships from partners).

The proposed regulations concerning noncompensatory partnership options published on January 22, 2003, contained a rule (§1.761-3) providing that the holder of a noncompensatory option is treated as a partner under certain circumstances. However, the Treasury Department and the IRS have concluded that these proposed regulations should not contain a similar rule for partnership options transferred in connection with the performance of services because of the possibility that constructive transfers of property, subject to section 83, may occur under circumstances other than those described in the proposed rules for treating the holder of a noncompensatory option as a partner. The Treasury Department and the IRS request comments on whether anti-abuse rules are necessary to prevent taxpayers from using the rules in these proposed regulations or the rules in Notice 2005-43 to inappropriately shift items of partnership income or loss between the service provider and the other partners.

Section 761(c) generally allows a partnership to modify its agreement at any time on or prior to the due date for the partnership’s return for the taxable year (without regard to extensions). Thus, for example, a partnership could, at the end of its taxable year, amend its partnership agreement to provide that a service provider was entitled to a substantially vested or nonvested interest in partnership profits and losses from the beginning of the partnership’s taxable year. It is expected that, if a substantially vested compensatory partnership interest is transferred to an employee or independent contractor (or an election under section 83(b) is made with respect to the transfer of a substantially nonvested compensatory partnership interest to an employee or independent contractor), the partnership will report the transfer on Form W-2, “Wage and Tax Statement,” or Form 1099-MISC, “Miscellaneous Income,” as appropriate. The Form W-2 or Form 1099-MISC would be issued to the service provider by the partnership by January 31 of the year following the calendar year in which the partnership interest is transferred, and the partnership would file such forms with the Social Security Administration or IRS, respectively, by February 28 (March 31 if filed electronically) of the year following the calendar year in which the partnership interest is transferred. The service provider would be required to report any income recognized on the transfer of the partnership interest on the service provider’s return for the taxable year (of the service provider) in which the transfer occurs.

It is unclear whether the retroactive commencement date of such an interest should be treated as the date of the transfer of the interest for purposes of section 83 and other provisions of the Code outside of subchapter K. If the retroactive effective date of the interest is treated as the transfer date for all purposes, a number of administrative concerns arise. For example, the partnership may not, by the January 31 deadline, have the information necessary to issue Form W-2 or Form 1099-MISC to the service provider. Also, the service provider may not, by the due date for filing the section 83(b) election, have the information necessary to file the election. The Treasury Department and the IRS request comments on the timing for section 83 purposes of retroactive transfers of partnership interests and on any actions that may be appropriate to address the associated administrative concerns.

As explained above, the proposed regulations treat the transfer of a partnership interest to a partner in connection with the performance of services as a guaranteed payment. To ensure that the service provider partner has the information necessary to include the transfer in income for the taxable year in which the transfer occurs (rather than the taxable year in which or with which ends the partnership taxable year in which the transfer occurs), the Treasury Department and the IRS are considering the possibility of amending the section 6041 regulations to provide that this type of guaranteed payment must be reported by the partnership on Form 1099-MISC, which is required to be issued to the service provider on or before January 31 of the year following the calendar year of such transfer. The Treasury Department and the IRS request comments on whether such a requirement is appropriate and administrable.

* * * * *

(e) Property. * * * Accordingly, property includes a partnership interest. The previous sentence is effective for transfers on or after the date final regulations are published in the Federal Register. * * *

* * * * *

(l) Special rules for the transfer of a partnership interest. (1) Subject to such additional conditions, rules, and procedures that the Commissioner may prescribe in regulations, revenue rulings, notices, or other guidance published in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), a partnership and all of its partners may elect a safe harbor under which the fair market value of a partnership interest that is transferred in connection with the performance of services is treated as being equal to the liquidation value of that interest for transfers on or after the date final regulations are published in the Federal Register if the following conditions are satisfied:

(i) The partnership must prepare a document, executed by a partner who has responsibility for Federal income tax reporting by the partnership, stating that the partnership is electing, on behalf of the partnership and each of its partners, to have the safe harbor apply irrevocably as of the stated effective date with respect to all partnership interests transferred in connection with the performance of services while the safe harbor election remains in effect and attach the document to the tax return for the partnership for the taxable year that includes the effective date of the election.

(ii) Except as provided in paragraph (l)(1)(iii) of this section, the partnership agreement must contain provisions that are legally binding on all of the partners stating that—

(A) The partnership is authorized and directed to elect the safe harbor; and

(B) The partnership and each of its partners (including any person to whom a partnership interest is transferred in connection with the performance of services) agrees to comply with all requirements of the safe harbor with respect to all partnership interests transferred in connection with the performance of services while the election remains effective.

(iii) If the partnership agreement does not contain the provisions described in paragraph (l)(1)(ii) of this section, or the provisions are not legally binding on all of the partners of the partnership, then each partner in a partnership that transfers a partnership interest in connection with the performance of services must execute a document containing provisions that are legally binding on that partner stating that—

(A) The partnership is authorized and directed to elect the safe harbor; and

(B) The partner agrees to comply with all requirements of the safe harbor with respect to all partnership interests transferred in connection with the performance of services while the election remains effective.

(2) The specified effective date of the safe harbor election may not be prior to the date that the safe harbor election is executed. The partnership must retain such records as may be necessary to indicate that an effective election has been made and remains in effect, including a copy of the partnership’s election statement under this paragraph (l), and, if applicable, the original of each document submitted to the partnership by a partner under this paragraph (l). If the partnership is unable to produce a record of a particular document, the election will be treated as not made, generally resulting in termination of the election. The safe harbor election also may be terminated by the partnership preparing a document, executed by a partner who has responsibility for Federal income tax reporting by the partnership, which states that the partnership, on behalf of the partnership and each of its partners, is revoking the safe harbor election on the stated effective date, and attaching the document to the tax return for the partnership for the taxable year that includes the effective date of the revocation.

Par. 3. Section 1.83-6 is amended by revising the first sentence of paragraph (b) to read as follows:

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(b) Recognition of gain or loss. Except as provided in section 721 and section 1032, at the time of a transfer of property in connection with the performance of services the transferor recognizes gain to the extent that the transferor receives an amount that exceeds the transferor’s basis in the property. * * *

* * * * *

Par. 4. Section 1.704-1 is amended as follows:

1. In paragraph (b)(0), an entry is added to the table for §1.704-1(b)(4)(xii).

2. In paragraph (b)(1)(ii)(a), a sentence is added at the end of the paragraph.

3. Paragraph (b)(2)(iv)(b)(1) is revised.

4. Paragraph (b)(2)(iv)(f)(5)(iii) is revised.

5. Paragraph (b)(4)(xii) is added.

6. Paragraph (b)(5) Example 29 is added.

The additions and revisions read as follows:

* * * * *

(b) * * *(0) * * *

* * * * *

Substantially nonvested interests………….………1.704-1(b)(4)(xii)

* * * * *

(1) * * *

(ii) * * * (a) * * * In addition, paragraph (b)(4)(xii) and paragraph (b)(5) Example 29 of this section apply to compensatory partnership interests (as defined in §1.721-1(b)(3)) that are transferred on or after the date final regulations are published in the Federal Register.

* * * * *

(2) * * *

(iv) * * *

(b) * * *

(1) the amount of money contributed by that partner to the partnership and, in the case of a compensatory partnership interest (as defined in §1.721-1(b)(3)) that is transferred on or after the date final regulations are published in the Federal Register, the amount included on or after that date in the partner’s compensation income under section 83(a), (b), or (d)(2).

* * * * *

(f) * * *

(5) * * *

(iii) In connection with the transfer or vesting of a compensatory partnership interest (as defined in §1.721-1(b)(3)) that is transferred on or after the date final regulations are published in the Federal Register, but only if the transfer or vesting results in the service provider recognizing income under section 83 (or would result in such recognition if the interest had a fair market value other than zero).

* * * * *

(4) * * *

(xii) Substantially nonvested interests—(a) In general. If a section 83(b) election has been made with respect to a substantially nonvested interest, the holder of the nonvested interest may be allocated partnership income, gain, loss, deduction, or credit (or items thereof) that will later be forfeited. For this reason, allocations of partnership items while the interest is substantially nonvested cannot have economic effect.

(b) Deemed Compliance with Partners’ Interests in the Partnership. If a section 83(b) election has been made with respect to a substantially nonvested interest, allocations of partnership items while the interest is substantially nonvested will be deemed to be in accordance with the partners’ interests in the partnership if—

(1) The partnership agreement requires that the partnership make forfeiture allocations if the interest for which the section 83(b) election is made is later forfeited; and

(2) All material allocations and capital account adjustments under the partnership agreement not pertaining to substantially nonvested partnership interests for which a section 83(b) election has been made are recognized under section 704(b).

(c) Forfeiture allocations. Forfeiture allocations are allocations to the service provider (consisting of a pro rata portion of each item) of gross income and gain or gross deduction and loss (to the extent such items are available) for the taxable year of the forfeiture in a positive or negative amount equal to—

(1) The excess (not less than zero) of the—

(i) Amount of distributions (including deemed distributions under section 752(b) and the adjusted tax basis of any property so distributed) to the partner with respect to the forfeited partnership interest (to the extent such distributions are not taxable under section 731); over

(ii) Amounts paid for the interest and the adjusted tax basis of property contributed by the partner (including deemed contributions under section 752(a)) to the partnership with respect to the forfeited partnership interest; minus

(2) The cumulative net income (or loss) allocated to the partner with respect to the forfeited partnership interest.

(d) Positive and negative amounts. For purposes of paragraph (b)(4)(xii)(c) of this section, items of income and gain are reflected as positive amounts, and items of deduction and loss are reflected as negative amounts.

(e) Exception. Paragraph (b)(4)(xii)(b) of this section shall not apply to allocations of partnership items made with respect to a substantially nonvested interest for which the holder has made a section 83(b) election if, at the time of the section 83(b) election, there is a plan that the interest will be forfeited. In such a case, the partners’ distributive shares of partnership items shall be determined in accordance with the partners’ interests in the partnership under paragraph (b)(3) of this section. In determining whether there is a plan that the interest will be forfeited, the Commissioner will consider all of the facts and circumstances (including the tax status of the holder of the forfeitable compensatory partnership interest).

(f) Cross references. Forfeiture allocations may be made out of the partnership’s items for the entire taxable year of the forfeiture. See §1.706-3(b) and paragraph (b)(5) Example 29 of this section.

* * * * *

(5) * * *

Example 29. (i) In Year 1, A and B each contribute cash to LLC, a newly formed limited liability company classified as a partnership for Federal tax purposes, in exchange for equal units in LLC. Under LLC’s operating agreement, each unit is entitled to participate equally in the profits and losses of LLC. The operating agreement also provides that the partners’ capital accounts will be determined and maintained in accordance with paragraph (b)(2)(iv) of this section, that liquidation proceeds will be distributed in accordance with the partners’ positive capital account balances, and that any partner with a deficit balance in that partner’s capital account following the liquidation of the partner’s interest must restore that deficit to the partnership. At the beginning of Year 3, SP agrees to perform services for LLC. In connection with the performance of SP’s services and a payment of $10 by SP to LLC, LLC transfers a 10% interest in LLC to SP. SP’s interest in LLC is substantially nonvested (within the meaning of §1.83-3(b)). At the time of the transfer of the LLC interest to SP, LLC’s operating agreement is amended to provide that, if SP’s interest is forfeited, then SP is entitled to a return of SP’s $10 initial contribution, and SP’s distributive share of all partnership items (other than forfeiture allocations under §1.704-1(b)(4)(xii)) will be zero with respect to that interest for the taxable year of the partnership in which the interest was forfeited. The operating agreement is also amended to require that LLC make forfeiture allocations if SP’s interest is forfeited. Additionally, the operating agreement is amended to provide that no part of LLC’s compensation deduction is allocated to the service provider to whom the interest is transferred. SP makes an election under section 83(b) with respect to SP’s interest in LLC. Upon receipt, the fair market value of SP’s interest in LLC is $100. In each of Years 3, 4, 5, and 6, LLC has operating income of $100 (consisting of $200 of gross receipts and $100 of deductible expenses), and makes no distributions. SP forfeits SP’s interest in LLC at the beginning of Year 6. At the time of the transfer of the interest to SP, there is no plan that SP will forfeit the interest in LLC.

(ii) Because a section 83(b) election is made, SP recognizes compensation income in the year of the transfer of the LLC interest. Therefore, SP recognizes $90 of compensation income in the year of the transfer of the LLC interest (the excess of the fair market value of SP’s interest in LLC, $100, over the amount SP paid for the interest, $10). Under paragraph (b)(2)(iv)(b)(1) of this section, in Year 3, SP’s capital account is initially credited with $100, the amount paid for the interest ($10) plus the amount included in SP’s compensation income upon the transfer under section 83(b) ($90). Under §§1.83-6(b) and 1.721-1(b)(2), LLC does not recognize gain on the transfer of the interest to SP. LLC is entitled to a compensation deduction of $90 under section 83(h). Under the terms of the operating agreement, the deduction is allocated equally to A and B.

(iii) As a result of SP’s election under section 83(b), SP is treated as a partner starting from the date of the transfer of the LLC interest to SP in Year 3. Section 1.761-1(b). In each of years 3, 4 and 5, SP’s distributive share of partnership income is $10 (10% of $100), A’s distributive share of partnership income is $45 (45% of $100), and B’s distributive share of partnership income is $45 (45% of $100). In accordance with the operating agreement, SP’s capital account is increased (to $130) by the end of Year 5 by the amounts allocated to SP, and A’s and B’s capital accounts are increased by the amounts allocated to A and B. Because LLC satisfies the requirements of paragraph (b)(4)(xii) of this section, LLC’s allocations in years 3, 4 and 5 are deemed to be in accordance with the partners’ interests in the partnership.

(iv) As a result of the forfeiture of the LLC interest by SP in year 6, LLC is required to recognize income ($90) equal to the amount of the allowable deduction on the transfer of the LLC interest to SP under §1.83-6(c). LLC repays SP’s $10 capital contribution to SP, reducing SP’s capital account to $120. Under the terms of the operating agreement, because SP forfeited SP’s interest, SP’s distributive share of all partnership items (other than forfeiture allocations) is zero for Year 6. To reverse SP’s prior allocations of LLC income, LLC makes forfeiture allocations of $30 of deductions ($0 (the difference between the $10 distributed to SP and the $10 contributed to LLC by SP) minus $30 (the cumulative net LLC income allocated to SP) to SP in Year 6. Notwithstanding section 706(c) and (d), these allocations may be made out of LLC’s partnership items for the entire taxable year of the forfeiture. Thus, in Year 6, $30 of deductions are allocated to SP, and the remaining $220 of net operating income ($200 of gross receipts and $90 of income under §1.83-6(c) less $70 of remaining deductions) are allocated to A and B equally for tax purposes. In accordance with section 83(b)(1) (last sentence), SP does not receive a deduction or capital loss for the amount ($90) that was included in SP’s compensation income. Because LLC satisfies the requirements of paragraph (b)(4)(xii) of this section, LLC’s allocations in year 6 are deemed to be in accordance with the partners’ interests in the partnership.

* * * * *

Par. 5. Section 1.706-3 is added to read as follows.

(a) Allocations of certain deductions under section 83(h). The transfer of property subject to section 83 in connection with the performance of services is not an allocable cash basis item within the meaning of section 706(d)(2)(B).

(b) Forfeiture allocations. If an election under section 83(b) is made with respect to a partnership interest that is substantially nonvested (within the meaning of §1.83-3(b)), and that interest is later forfeited, the partnership must make forfeiture allocations to reverse prior allocations made with respect to the forfeited interest. See §1.704-1(b)(4)(xii). Although the person forfeiting the interest may not have been a partner for the entire taxable year, forfeiture allocations may be made out of the partnership’s items for the entire taxable year.

(c) Effective date. This section applies to transfers of property on or after the date final regulations are published in the Federal Register.

Par. 6. In §1.707-1, paragraph (c) is amended by revising the second sentence to read as follows:

* * * * *

(c) Guaranteed Payments. * * * However, except as otherwise provided in section 83 and the regulations thereunder, a partner must include such payments as ordinary income for that partner’s taxable year within or with which ends the partnership taxable year in which the partnership deducted such payments as paid or accrued under its method of accounting. * * *

* * * * *

Par. 7. In §1.721-1, paragraph (b) is revised to read as follows.

* * * * *

(b)(1) Except as otherwise provided in this section or §1.721-2, section 721 does not apply to the transfer of a partnership interest in connection with the performance of services or in satisfaction of an obligation. The transfer of a partnership interest to a person in connection with the performance of services constitutes a transfer of property to which section 83 and the regulations thereunder apply. To the extent that a partnership interest transferred in connection with the performance of services rendered by a decedent prior to the decedent’s death is transferred after the decedent’s death to the decedent’s successor in interest, the fair market value of such interest is an item of income in respect of a decedent under section 691.

(2) Except as provided in section 83(h) and 1.83-6(c), no gain or loss shall be recognized by a partnership upon—

(i) The transfer or substantial vesting of a compensatory partnership interest; or

(ii) The forfeiture of a compensatory partnership interest. See §1.704-1(b)(4)(xii) for rules regarding forfeiture allocations of partnership items that may be required in the taxable year of a forfeiture.

(3) For purposes of this section, a compensatory partnership interest is an interest in the transferring partnership that is transferred in connection with the performance of services for that partnership (either before or after the formation of the partnership), including an interest that is transferred on the exercise of a compensatory partnership option. A compensatory partnership option is an option to acquire an interest in the issuing partnership that is granted in connection with the performance of services for that partnership (either before or after the formation of the partnership).

(4) To the extent that a partnership interest is—

(i) Transferred to a partner in connection with the performance of services rendered to the partnership, it is a guaranteed payment for services under section 707(c);

(ii) Transferred in connection with the performance of services rendered to a partner, it is not deductible by the partnership, but is deductible only by such partner to the extent allowable under Chapter 1 of the Code.

(5) This paragraph (b) applies to interests that are transferred on or after the date final regulations are published in the Federal Register.

* * * * *

Par. 8. Section 1.761-1(b) is amended by adding two sentences to the end of the paragraph to read as follows.

* * * * *

(b) * * * If a partnership interest is transferred in connection with the performance of services, and that partnership interest is substantially nonvested (within the meaning of §1.83-3(b)), then the holder of the partnership interest is not treated as a partner solely by reason of holding the interest, unless the holder makes an election with respect to the interest under section 83(b). The previous sentence applies to partnership interests that are transferred on or after the date final regulations are published in the Federal Register. * * * * *

Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.

A U.S. person’s transfer of appreciated property (including stock) to a foreign corporation in connection with any exchange described in sections 332, 351, 354, 356, or 361 generally is treated under section 367(a)(1) as a taxable transaction, unless an exception applies. Congress enacted section 367(a) to prevent the avoidance of U.S. tax on transfers of appreciated property outside the United States in nonrecognition transfers involving foreign corporations. S.R. Rep. No. 169, Vol. 1, 98^th Cong. 2d Sess., at 360 (Apr. 2, 1984).

In the case of a U.S. person’s transfer of stock to a foreign corporation in an exchange described in section 367(a)(1), §1.367(a)-3 provides exceptions to the general gain recognition rule of section 367(a)(1), if certain conditions are satisfied including, in some instances, the filing of a gain recognition agreement (GRA). See §1.367(a)-3(b) (transfer of stock in a foreign corporation) and (c) (transfer of stock in a domestic corporation).

Section 367(b) addresses transactions covered by sections 332, 351, 354, 355, 356, and 361 in which there is no transfer of property described in section 367(a). Section 367(b) provides that a foreign corporation shall be considered to be a corporation for purposes of these subchapter C provisions, except to the extent provided in regulations. The status of a foreign corporation as a corporation for these purposes may allow various participants to the transaction to qualify for nonrecognition treatment.

One of the underlying policies of section 367(b) is the preservation of the potential application of section 1248. H. R. Rep. No. 94-658, 94^th Cong., 1^st Sess., at 242 (November 12, 1975). Section 1248 generally recharacterizes gain recognized by a U.S. person (a section 1248 shareholder) that owns 10 percent or more of the total combined voting power of a controlled foreign corporation, as defined in section 957, or, in certain instances, stock of a former controlled foreign corporation, upon the disposition of the stock of such corporation as dividend income to the extent of the earnings and profits that are attributable to such stock (section 1248 amount).

Consequently, §1.367(b)-4(b)(1) generally requires a section 1248 shareholder (or, in certain instances, a foreign corporation that has a section 1248 shareholder) to include in income its section 1248 amount as a result of certain section 367(b) transactions, including certain section 351 exchanges, if as a result of the transaction section 1248 shareholder status or controlled foreign corporation status is lost.

Section 304 was enacted to prevent withdrawals of corporate earnings by controlling shareholders in transactions that result in capital gains treatment. See H.R. Rep. No. 2014, 105^th Cong. 1st Sess., at 465 (June 24, 1997). Section 304(a)(1) generally provides that, for purposes of sections 302 and 303, if one or more persons are in control of each of two corporations and in return for property one of the corporations (the acquiring corporation) acquires stock in the other corporation (the issuing corporation) from the person (or persons) so in control, then such property shall be treated as a distribution in redemption of the acquiring corporation stock.

Prior to 1997, section 304(a)(1) provided that, to the extent of a distribution treated as a distribution to which section 301 applies, the issuing corporation stock would be treated as having been transferred by the person from whom acquired, and as having been received by the acquiring corporation as a contribution to the capital of the acquiring corporation. Section 304 was amended by section 1013 of the Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 788, 918) (August 5, 1997) to provide that, to the extent that a stock acquisition covered by section 304(a)(1) is treated as a distribution to which section 301 applies, the transferor and the acquiring corporation are treated as if (1) the transferor transferred the stock of the issuing corporation to the acquiring corporation in exchange for stock of the acquiring corporation in a transaction to which section 351(a) applies, and (2) the acquiring corporation then redeemed the stock it is treated as having issued. Because the acquiring corporation is treated as receiving the stock of the issuing corporation in a transaction to which section 351 applies, the transferor’s basis in the stock of the issuing corporation carries over to the acquiring corporation under section 362.

In the case of an acquisition to which section 304(a) applies, section 304(b)(2) generally provides that the determination of the amount that is a dividend (and the source thereof) is made as if the property were distributed first by the acquiring corporation to the extent of its earnings and profits, and then by the issuing corporation to the extent of its earnings and profits. In a transaction involving a foreign acquiring corporation, section 304(b)(5) may limit the amount of the earnings and profits of the foreign acquiring corporation that will be taken into account for purposes of section 304(b)(2)(A).

The application of section 367(a) and (b) to certain section 304(a)(1) transactions involving a foreign corporation has been addressed in various published guidance. See, e.g., Rev. Rul. 91-5, 1991-1 C.B. 114 (holding that section 367 applied to the deemed contribution to capital of target corporation stock under prior law because section 367(c)(2) resulted in the stock transfer constituting a section 351 exchange). Moreover, in the preamble to the proposed regulations regarding redemptions taxable as dividends (REG-150313-01, 2002-2 C.B. 777 [67 FR 64331] October 18, 2002), the IRS and Treasury indicated that certain international provisions may apply to section 304(a)(1) transfers, and provided as an example the application of section 367 and the regulations promulgated thereunder to a deemed section 351 exchange involving foreign corporations. The IRS and Treasury also stated that further guidance on the application of the international provisions to section 304(a)(1) transactions would be forthcoming.

The IRS and Treasury have determined that the policies underlying section 304 (prevention of withdrawals of corporate earnings through the use of transactions that result in capital gains treatment), section 367(a) (prevention of U.S. tax avoidance through transfers of appreciated property to foreign corporations), and section 367(b) (inter alia, preservation of the potential application of section 1248) are preserved if section 367(a) and (b) are not applied to a deemed section 351 exchange resulting from a section 304(a)(1) transaction. In addition, the IRS and Treasury believe that the interests of sound tax administration are served by not applying section 367(a) and (b) to a deemed section 351 exchange resulting from a section 304(a)(1) transaction. Consequently, these proposed regulations provide that section 367(a) and (b) will not apply to a deemed section 351 exchange resulting from a section 304(a)(1) transaction. These proposed regulations do not address section 351 transactions other than those exchanges treated as section 351 exchanges by reason of section 304(a)(1).

In a section 304(a)(1) transaction in which a U.S. person transfers the stock of an issuing corporation to a foreign acquiring corporation, without the application of section 367(a), the U.S. person will nevertheless recognize an amount of income that is at least equal to the inherent gain in the stock of the issuing corporation that is being transferred to the foreign acquiring corporation. This income recognition results from the construct of the transaction as a distribution in redemption of the acquiring corporation shares. The income recognized may be in the form of dividend income, gain on the disposition of stock, or both. Section 301(c)(1), (3). Thus, the policy underlying section 367(a), which is to prevent the avoidance of U.S. tax on transfers of appreciated property to a foreign corporation in certain nonrecognition transactions, is maintained through the operation of subchapter C principles even if section 367(a) is not applied to a section 304(a)(1) transaction. Moreover, as discussed below, the application of section 367(a) to a section 304(a)(1) transaction may, in certain instances where the U.S. transferor files a GRA, result in a total income inclusion that is greater than the fair market value of the stock being transferred. The IRS and Treasury believe that this result is inconsistent with the policies of section 367.

For instance, in order to avoid recognizing gain on a section 351 transfer of appreciated foreign stock to a foreign corporation under section 367(a)(1), a U.S. person may be required to enter into a GRA. See §1.367(a)-3(b)(1)(ii). As noted, when a U.S. person transfers stock of a wholly owned foreign corporation (the foreign issuing corporation) to a wholly owned foreign acquiring corporation in exchange for property, section 304(a)(1) treats the U.S. person as having received foreign acquiring corporation stock in a deemed section 351 exchange, and then as having that stock immediately redeemed by the foreign acquiring corporation. If the U.S. person were to enter into a GRA, the application of section 367(a) to such a transaction will likely result in the GRA remaining in existence after the deemed redemption of the foreign acquiring corporation’s stock. A U.S. person may, in fact, recognize income but, as a result of the GRA, not recognize any gain in the section 304(a)(1) transaction (e.g., the section 304(a)(1) transaction results in dividend income to the U.S. corporate transferor equal to the consideration paid by the foreign acquiring corporation). In such a case, because the U.S. person has not recognized the inherent gain in the transferee foreign corporation’s stock deemed to be received in the section 304(a)(1) transaction, the GRA will not be terminated. See §1.367(a)-8(h)(1) (requiring a transaction in which all realized gain (if any) is recognized currently to terminate a GRA). As a result, the U.S. transferor would remain subject to the GRA provisions contained in §1.367(a)-8. If the GRA subsequently were triggered pursuant to §1.367(a)-8(e) (e.g., if the foreign issuing corporation disposes of substantially all of its assets to an unrelated party during the 5-year GRA period), the U.S. transferor may be subject to a total income inclusion that is greater than the fair market value of the stock being transferred.

The application of section 367(a) to the transaction described above also results in administrative burdens for both the IRS and taxpayers. For instance, the conditions contained in §1.367(a)-3(b) and (c) require a determination of the value and class of stock either received by the U.S. person in the transaction or owned by the U.S. person immediately after the transfer. See, e.g., §1.367(a)-3(b)(1)(i) and (ii) and (c)(1)(i), (ii), and (iii). To the extent the transaction is described in section 304(a)(1), the foreign acquiring corporation does not actually issue any stock to the U.S. person. Therefore, in order to apply the above provisions, the IRS and taxpayers must make determinations based on the stock that is deemed to be issued by the foreign acquiring corporation.

For the reasons stated above, the IRS and Treasury have decided to exercise their regulatory authority under section 367(a) such that section 367(a) will not apply to deemed section 351 exchanges resulting from section 304(a)(1) transactions.

As discussed above in the preamble under heading B, §1.367(b)-4(b)(1) provides that, in the case of a section 351 exchange of stock of a foreign acquired corporation by a U.S. person that is a section 1248 shareholder of such corporation (or a controlled foreign corporation that has a section 1248 shareholder) to a foreign acquiring corporation, the section 1248 shareholder (or a controlled foreign corporation that has a section 1248 shareholder) must include in income its section 1248 amount, unless the requisite section 1248 shareholder status or controlled foreign corporation status is maintained immediately after the exchange. However, in a section 304(a)(1) transaction in which section 1248 shareholder status and controlled foreign corporation status is maintained immediately after the deemed section 351 exchange, such that there is no section 1248 inclusion, the transferor may be treated as receiving a dividend from the foreign acquired corporation pursuant to section 304(b)(2)(B). Thus, in a section 304(a)(1) transaction, some or all of the earnings that make up the section 1248 amount that section 367(b) seeks to preserve may be immediately included in income by the exchanging shareholder.

Additionally, application of §1.367(b)-4(b)(1) can, in some instances, create administrative burdens and be problematic. Section 1.367(b)-4(b)(1) requires a determination of the type and amount of stock received in the deemed section 351 exchange to determine whether the necessary section 1248 shareholder status and controlled foreign corporation status is maintained. Moreover, the application of §1.367(b)-4(b)(1) to a section 304(a)(1) transaction often can be problematic because the necessary section 1248 shareholder status and controlled foreign corporation status may be treated as satisfied in the construct of the deemed section 351 exchange even though such status is immediately lost as a result of the deemed redemption transaction. For instance, the necessary section 1248 shareholder status and controlled foreign corporation status may be satisfied immediately after the deemed section 351 exchange when a U.S. corporation transfers a controlled foreign corporation (the foreign issuing corporation) to a foreign acquiring corporation in a section 304(a)(1) transaction, by taking into consideration the deemed issued stock by the foreign acquiring corporation. However, if both the U.S. corporate transferor and the foreign acquiring corporation are wholly owned by the same foreign parent, the necessary section 1248 shareholder status and controlled foreign corporation status will not be satisfied immediately after the deemed redemption transaction.

For the reasons listed above, the IRS and Treasury have decided to exercise their regulatory authority under section 367(b) such that section 367(b) will not apply to deemed section 351 exchanges resulting from section 304(a)(1) transactions.

Section 304(b)(6) grants the Secretary authority to prescribe regulations that are appropriate in order to eliminate multiple inclusions of any item of income by reason of section 304(a) and to provide appropriate basis adjustments (including modifications to the application of sections 959 and 961) in section 304(a) transactions in which the acquiring or issuing corporation is a foreign corporation. The IRS and Treasury are considering whether to issue regulations under section 304(b)(6) to adjust (1) the acquiring corporation’s basis of the issuing corporation stock it acquires in the transaction, and (2) the transferor’s basis of the issuing corporation stock in situations in which the transferor continues to own issuing corporation stock immediately after the transaction, to the extent that the transferor is treated under section 304(b)(2)(B) as receiving a distribution from the earnings and profits of the issuing corporation. Comments are requested regarding how such adjustments should be made, particularly if different classes of issuing corporation stock are acquired or retained in the section 304(a)(1) transaction. Comments also are requested as to how, and to what extent, these types of adjustments should be made outside the context of section 304(b)(6) (e.g., in a section 304(a)(1) transaction in which both the acquiring corporation and issuing corporation are domestic corporations).

(a) In general. * * * However, if, pursuant to section 304(a)(1), a U.S. person is treated as transferring stock of a domestic or foreign corporation to a foreign corporation in exchange for stock of such foreign corporation in a transaction to which section 351(a) applies, such deemed section 351 exchange is not a transfer to a foreign corporation subject to section 367(a). * * *

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(e) Effective dates. (1) In general. The rules in paragraphs (a), (b) and (d) of this section generally apply to transfers occurring on or after July 20, 1998. However, the third sentence of paragraph (a) of this section shall apply to section 304(a)(1) transactions occurring on or after the date these regulations are published as final regulations in the Federal Register. * * *

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Par. 3. In §1.367(b)-4, a sentence is added to the end of paragraph (a) to read as follows:

(a) Scope. * * * However, if pursuant to section 304(a)(1), a foreign acquiring corporation is treated as acquiring the stock of a foreign acquired corporation in a transaction to which section 351(a) applies, such deemed section 351 exchange is not an acquisition subject to section 367(b).

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Par. 4. Section 1.367(b)-6 is amended by revising paragraph (a)(1) to read as follows:

(a) Effective date — (1) In general. Sections 1.367(b)-1 through 1.367(b)-5, and this section, generally apply to section 367(b) exchanges that occur on or after February 23, 2000. However, the last sentence of paragraph (a) in §1.367(b)-4 shall apply to section 304(a)(1) transactions occurring on or after the date these regulations are published as final regulations in the Federal Register.

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Cono R. Namorato,
Acting Deputy Commissioner for
Services and Enforcement.