These regulations modify § 1.956–1T(b)(4) so that the rule can also apply when a foreign corporation controlled by a CFC is funded other than through capital contributions or debt. In addition, these temporary regulations add an example involving the funding of one CFC by another CFC that controls it to illustrate the application of the anti-avoidance rule when a principal purpose for funding the first CFC is to avoid the application of section 956 with respect to the funding CFC, even though there would be a section 956 inclusion with respect to the CFC that received the funding. This example illustrates that the CFCs’ tax attributes associated with a section 956 inclusion (such as total earnings and profits, previously taxed earnings and profits, and foreign tax credit pools) are taken into account in determining whether a principal purpose of a funding was to avoid the application of section 956 with respect to the funding CFC. In addition, this example makes clear that if a CFC is considered to indirectly hold United States property pursuant to § 1.956–1T(b)(4), then the CFC that actually holds the United States property will not also be considered to hold the property for purposes of section 956. See Example 3 in § 1.956–1T(b)(4)(iv).

These regulations also modify Example 1 and Example 2 of § 1.956–1T(b)(4) to more closely reflect the language of new § 1.956–1T(b)(4)(iv). The Department of the Treasury (Treasury Department) and the IRS do not view these modifications as a substantive change.

Moreover, § 1.956–1T(b)(4) applies if “one of the principal purposes” for the transaction is to avoid the application of section 956 with respect to the CFC. These temporary regulations apply when “a principal purpose” for the transaction is to avoid the application of section 956 with respect to the CFC. The Treasury Department and the IRS do not view this modification as a substantive change, since both formulations appropriately reflect that there may be more than one principal purpose for a transaction. Accordingly, § 1.956–1T(b)(4) may be applied if a principal purpose of a transaction is to avoid the application of section 956, even if there also were other principal purposes for the transaction.

Finally, the Treasury Department and the IRS have concluded that § 1.956–1T(b)(4) should apply without requiring the IRS to exercise its discretion, and, therefore, have modified the rule to be self-executing. This modification, as well as the modification to what constitutes a funding, is consistent with a previous change to a similar rule in § 1.304–4(b). See TD 9477, 74 FR 69021 (Dec. 30, 2009).

Existing § 1.956–1T(b)(4) applies only to transactions that involve foreign corporations that are controlled by a CFC. The Treasury Department and the IRS understand that taxpayers may be using partnerships to structure transactions that are similar to the types of transactions addressed by § 1.956–1T(b)(4). For example, with a principal purpose of avoiding the application of section 956, a CFC may contribute cash to a partnership in exchange for an interest in the partnership, which in turn lends the cash to a United States shareholder of the CFC. In such a case, a taxpayer may take the position that the CFC is not treated as indirectly holding the entire obligation of the United States shareholder but instead is treated as holding the obligation only to the extent of the CFC’s interest in the partnership under § 1.956–2(a)(3).

These types of partnership transactions raise concerns similar to those that are currently addressed by § 1.956–1T(b)(4). Accordingly, these temporary regulations expand § 1.956–1T(b)(4) to include transactions involving partnerships that are controlled by the CFC. These temporary regulations also contain a coordination rule in § 1.956–1T(b)(4)(iii), which provides that the new partnership rule in § 1.956–1T(b)(4)(i)(C) applies only to the extent that the amount of United States property that a CFC would be treated as holding under the rule exceeds the amount that it would be treated as holding under § 1.956–2(a)(3).

The Treasury Department and the IRS also understand that CFCs are engaging in transactions in which a CFC lends funds to a foreign partnership, which then distributes the proceeds from the borrowing to a U.S. partner who is related to the CFC and whose obligation would be United States property if it were held (or treated as held) by the CFC. Alternatively, the CFC could guarantee a loan to a foreign partnership, which then could distribute the loan proceeds to a related U.S. partner. Taxpayers take the position that section 956 does not apply to these transactions even though the CFC’s earnings are effectively repatriated to a related U.S. partner.

In response to these transactions, the temporary regulations add § 1.956–1T(b)(5) to address certain cases in which a CFC funds a foreign partnership (or guarantees a borrowing by a foreign partnership) and the foreign partnership makes a distribution to a U.S. partner that is related to the CFC. For purposes of section 956, § 1.956–1T(b)(5) treats the partnership obligation as an obligation of the distributee partner to the extent of the lesser of the amount of the distribution that would not have been made but for the funding of the partnership or the amount of the foreign partnership obligation. For example, if a related United States shareholder of a CFC has an interest in a foreign partnership, the CFC lends $100 to the partnership, and the partnership distributes $100 to the United States shareholder in a distribution that would not have been made but for the loan from the CFC, then the entire $100 partnership obligation held by the CFC will be treated as an obligation of the United States shareholder that qualifies as United States property. Section 1.956–1T(b)(5) generally has the same purpose and effect as proposed § 1.956–4(c)(3) contained in the notice of proposed rulemaking on this subject in the Proposed Rules section of this issue of the Internal Revenue Bulletin (REG–155164–09) and will be removed upon the finalization of proposed § 1.956–4(c)(3).

3. Active Rents and Royalties Exception to FPHCI

Although rents and royalties generally are included in FPHCI under section 954(c)(1)(A), rents and royalties derived in the active conduct of a trade or business and received from a person that is not a related person are excluded from FPHCI under the active rents and royalties exception in section 954(c)(2)(A) and § 1.954–2(b)(6). The section 954 regulations provide the exclusive rules for determining whether rents and royalties are derived in the active conduct of a trade or business for purposes of section 954(c)(2)(A). Specifically, § 1.954–2(c) provides four alternative ways for rents to be derived in the active conduct of a trade or business, and § 1.954–2(d) provides two alternative ways for royalties to be derived in the active conduct of a trade or business. One way for a CFC to derive rents and royalties in the active conduct of a trade or business is to satisfy an “active development” test, which, among other things, requires the CFC to be “regularly engaged” either in the “manufacture or production of, or in the acquisition and addition of substantial value to,” certain property (§ 1.954–2(c)(1)(i), applicable to rents); or in the “development, creation or production of, or in the acquisition of and addition of substantial value to,” certain property (§ 1.954–2(d)(1)(i), applicable to royalties) (collectively, active development tests). Although certain of the alternative ways (specifically, the active management and marketing tests) in which a CFC can satisfy the active rents and royalties exception require that the relevant activities be performed by the CFC’s own officers or staff of employees (§ 1.954–2(c)(1)(ii), (iv), and (d)(1)(ii)), the active development tests do not expressly contain this requirement. But see § 1.954–2(d)(3) Example 5 (indicating that royalties received by a CFC that financed independent persons in development activities were not considered derived in the active conduct of a trade or business for purposes of section 954(c)(2)(A)).

In addition to the active development tests, another way for a CFC to derive rents and royalties in the active conduct of a trade or business is to satisfy an “active marketing” test, which, among other things, requires the CFC to operate in a foreign country an organization that is regularly engaged in the business of marketing, or marketing and servicing, the leased or licensed property, and that is “substantial” in relation to the amount of rents or royalties derived from the leased or licensed property. See § 1.954–2(c)(1)(iv) and (d)(1)(ii). Pursuant to a safe harbor in the regulations, an organization is “substantial” if the active leasing or licensing expenses equal or exceed 25 percent of the adjusted leasing or licensing profits. See § 1.954–2(c)(2)(ii) and (d)(2)(ii). The regulations generally define active leasing expenses and active licensing expenses to mean, subject to certain exceptions, deductions that are properly allocable to rental or royalty income and that would be allowable under section 162 if the CFC were a domestic corporation. See § 1.954–2(c)(2)(iii) and (d)(2)(iii).

In general, the active rents and royalties exception is intended to distinguish between a CFC that passively receives investment income and a CFC that derives income from the active conduct of a trade or business. See S. Rep. No. 87–1881, 87th Cong., 2d Sess., at 83 (1962). Accordingly, the policy underlying the active rents and royalties exception requires that the CFC itself actively conduct the business that generates the rents or royalties. The Treasury Department and the IRS have determined that, consistent with this policy, the CFC must perform the relevant activities (that is, activities related to the manufacturing, production, development, or creation of, or, in the case of an acquisition, the addition of substantial value to, the property at issue) through its own officers or staff of employees in order to satisfy the active development tests. Thus, § 1.954–2T(c)(1)(i) and (d)(1)(i) expressly provide that the CFC lessor or licensor must perform the required functions through its own officers or staff of employees.

The Treasury Department and the IRS also have concluded that the policy of the active rents and royalties exception allows the relevant activities undertaken by a CFC through its officers or staff of employees to be performed in more than one foreign country. Thus, § 1.954–2T(c)(1)(iv) and (d)(1)(ii) provide that (i) a CFC’s officers or staff of employees may be located in one or more foreign countries; and (ii) an organization that meets the requirements of the active marketing test can be maintained and operated by the officers or staff of employees either in a single foreign country or in multiple foreign countries collectively. Similarly, § 1.954–2T(c)(2)(ii) and (d)(2)(ii) indicate that an organization can be in a single foreign country or in multiple foreign countries collectively for purposes of determining the substantiality of the foreign organization.

In applying the active development tests and active marketing tests, questions have arisen as to the treatment of cost sharing arrangements under which a person other than the CFC actually conducts relevant activities. Consistent with the policy underlying the active rents and royalties exception that requires the CFC itself to conduct the relevant activities, § 1.954–2T(c)(2)(viii) and (d)(2)(v) clarify that CST Payments and PCT Payments (as defined in § 1.482–7(b)(1)) made by a CFC will not cause the CFC’s officers and employees to be treated as undertaking the activities of the controlled participant to which the payments are made. This clarification applies for purposes of the active development tests and the active marketing tests, including for purposes of determining whether an organization that engages in marketing is substantial. Similarly, § 1.954–2T(c)(2)(iii)(E) and (d)(2)(iii)(E) provide that deductions for CST Payments and PCT Payments are excluded from the definition of active leasing expenses and active licensing expenses, respectively. Thus, CST Payments and PCT Payments are not active leasing expenses or active licensing expenses for purposes of determining whether an organization is “substantial” under the safe harbor test.

The rules in § 1.956–1T(b)(4) described in Part 1 of this preamble apply to taxable years of CFCs ending on or after September 1, 2015, and to taxable years of United States shareholders in which or with which such taxable years end, with respect to property acquired, including property treated as acquired as the result of a deemed exchange of property pursuant to section 1001, on or after September 1, 2015. The rule in § 1.956–1T(b)(5) described in Part 2 of this preamble applies to taxable years of CFCs ending on or after September 1, 2015, and to taxable years of United States shareholders in which or with which such taxable years end, in the case of distributions made on or after September 1, 2015. The rules regarding the active development test in § 1.954–2T(c)(1)(i) and (d)(1)(i) described in Part 3 of this preamble apply to rents or royalties, as applicable, received or accrued during taxable years of CFCs ending on or after September 1, 2015, and to taxable years of United States shareholders in which or with which such taxable years end, but only with respect to property manufactured, produced, developed, or created, or, in the case of acquired property, property to which substantial value has been added, on or after September 1, 2015. The rules regarding the active marketing test in § 1.954–2T(c)(1)(iv), (c)(2)(ii), (d)(1)(ii), and (d)(2)(ii) described in Part 3 of this preamble, as well as the rules regarding cost-sharing arrangements in § 1.954–2T(c)(2)(iii)(E), (c)(2)(viii), (d)(2)(iii)(E), and (d)(2)(v) also described in Part 3 of this preamble, apply to rents or royalties, as applicable, received or accrued during taxable years of CFCs ending on or after September 1, 2015, and to taxable years of United States shareholders in which or with which such taxable years end, to the extent that such rents or royalties are received or accrued on or after September 1, 2015. No inference is intended as to the application of the provisions amended by these temporary regulations under current law. The IRS may, where appropriate, challenge transactions, including those described in these temporary regulations and this preamble, under currently applicable Code or regulatory provisions or judicial doctrines.

* * * * *

(c) * * *

(1) * * *

(i) [Reserved]. For further guidance, see § 1.954–2T(c)(1)(i).

* * * * *

(iv) [Reserved]. For further guidance, see § 1.954–2T(c)(1)(iv).

(2) * * *

(ii) [Reserved]. For further guidance, see § 1.954–2T(c)(2)(ii).

(iii) * * *

(E) [Reserved]. For further guidance, see § 1.954–2T(c)(2)(iii)(E).

* * * * *

(viii) [Reserved]. For further guidance, see § 1.954–2T(c)(2)(viii).

* * * * *

(d) * * *

(1) * * *

(i) [Reserved]. For further guidance, see § 1.954–2T(d)(1)(i).

(ii) [Reserved]. For further guidance, see § 1.954–2T(d)(1)(ii).

(2) * * *

(ii) [Reserved]. For further guidance, see § 1.954–2T(d)(2)(ii).

(iii) * * *

(E) [Reserved]. For further guidance, see § 1.954–2T(d)(2)(iii)(E).

* * * * *

(v) [Reserved]. For further guidance, see § 1.954–2T(d)(2)(v).

* * * * *

(j) [Reserved]. For further guidance, see § 1.954–2T(j).

Par. 3. Section 1.954–2T is added to read as follows:

(a)(1) through (c)(1) introductory text [Reserved]. For further guidance, see § 1.954–2(a)(1) through (c)(1) introductory text.

(i) Property that the lessor, through its own officers or staff of employees, has manufactured or produced, or property that the lessor has acquired and, through its own officers or staff of employees, added substantial value to, but only if the lessor, through its officers or staff of employees, is regularly engaged in the manufacture or production of, or in the acquisition and addition of substantial value to, property of such kind;

(c)(1)(ii) and (iii) [Reserved]. For further guidance, see § 1.954–2(c)(1)(ii) and (c)(1)(iii).

(iv) Property that is leased as a result of the performance of marketing functions by such lessor through its own officers or staff of employees located in a foreign country or countries, if the lessor, through its officers or staff of employees, maintains and operates an organization either in such country or in such countries (collectively), as applicable, that is regularly engaged in the business of marketing, or of marketing and servicing, the leased property and that is substantial in relation to the amount of rents derived from the leasing of such property.

(c)(2)(i) [Reserved]. For further guidance, see § 1.954–2(c)(2)(i).

(ii) Substantiality of foreign organization. For purposes of paragraph (c)(1)(iv) of this section, whether an organization either in a foreign country or in foreign countries (collectively) is substantial in relation to the amount of rents is determined based on all the facts and circumstances. However, such an organization will be considered substantial in relation to the amount of rents if active leasing expenses, as defined in paragraph (c)(2)(iii) of this section, equal or exceed 25 percent of the adjusted leasing profit, as defined in paragraph (c)(2)(iv) of this section. In addition, for purposes of aircraft or vessels leased in foreign commerce, an organization will be considered substantial if active leasing expenses, as defined in paragraph (c)(2)(iii) of this section, equal or exceed 10 percent of the adjusted leasing profit, as defined in paragraph (c)(2)(iv) of this section. For purposes of paragraphs (c)(1)(iv) and (c)(2) of this section and § 1.956–2(b)(1)(vi), the term aircraft or vessels includes component parts, such as engines that are leased separately from an aircraft or vessel.

(c)(2)(iii) introductory text through (c)(2)(iii)(D) [Reserved]. For further guidance, see § 1.954–2(c)(2)(iii) through (c)(2)(iii)(D).

(E) Deductions for CST Payments or PCT Payments (as defined in § 1.482–7(b)).

(c)(2)(iv) through (c)(2)(vii) [Reserved]. For further guidance, see § 1.954–2(c)(2)(iv) through (c)(2)(vii).

(viii) Cost sharing arrangements (CSAs). For purposes of paragraphs (c)(1)(i) and (iv) of this section, CST Payments or PCT Payments (as defined in § 1.482–7(b)(1)) made by the lessor to another controlled participant (as defined in § 1.482–7(j)(1)(i)) pursuant to a CSA (as defined in § 1.482–7(a)) do not cause the activities undertaken by that other controlled participant to be considered to be undertaken by the lessor’s own officers or staff of employees.

(c)(3) and (d)(1) introductory text [Reserved]. For further guidance, see § 1.954–2(c)(3) and (d)(1) introductory text.

(i) Property that the licensor, through its own officers or staff of employees, has developed, created, or produced, or property that the licensor has acquired and, through its own officers or staff of employees, added substantial value to, but only so long as the licensor, through its officers or staff of employees, is regularly engaged in the development, creation, or production of, or in the acquisition and addition of substantial value to, property of such kind; or

(ii) Property that is licensed as a result of the performance of marketing functions by such licensor through its own officers or staff of employees located in a foreign country or countries, if the licensor, through its officers or staff of employees, maintains and operates an organization either in such foreign country or in such foreign countries (collectively), as applicable, that is regularly engaged in the business of marketing, or of marketing and servicing, the licensed property and that is substantial in relation to the amount of royalties derived from the licensing of such property.

(d)(2)(i) [Reserved]. For further guidance, see § 1.954–2(d)(2)(i).

(ii) Substantiality of foreign organization. For purposes of paragraph (d)(1)(ii) of this section, whether an organization either in a foreign country or in foreign countries (collectively) is substantial in relation to the amount of royalties is determined based on all of the facts and circumstances. However, such an organization will be considered substantial in relation to the amount of royalties if active licensing expenses, as defined in paragraph (d)(2)(iii) of this section, equal or exceed 25 percent of the adjusted licensing profit, as defined in paragraph (d)(2)(iv) of this section.

(d)(2)(iii) introductory text through (d)(2)(iii)(D) [Reserved]. For further guidance, see § 1.954–2(d)(2)(iii) introductory text through (d)(2)(iii)(D).

(E) Deductions for CST Payments or PCT Payments (as defined in § 1.482–7(b)).

(d)(2)(iv) [Reserved]. For further guidance, see § 1.954–2(d)(2)(iv).

(v) Cost sharing arrangements (CSAs). For purposes of paragraphs (d)(1)(i) and (ii) of this section, CST Payments or PCT Payments (as defined in § 1.482–7(b)(1)) made by the licensor to another controlled participant (as defined in § 1.482–7(j)(1)(i)) pursuant to a CSA (as defined in § 1.482–7(a)) do not cause the activities undertaken by that other controlled participant to be considered to be undertaken by the licensor’s own officers or staff of employees.

(d)(3) through (i) [Reserved]. For further guidance, see § 1.954–2(d)(3) through (i).

(j) Effective/applicability date. Paragraphs (c)(1)(i) and (d)(1)(i) of this section apply to rents or royalties, as applicable, received or accrued during taxable years of controlled foreign corporations ending on or after September 1, 2015, and to taxable years of United States shareholders in which or with which such taxable years end, but only with respect to property manufactured, produced, developed, or created, or in the case of acquired property, property to which substantial value has been added, on or after September 1, 2015. Paragraphs (c)(1)(iv), (c)(2)(ii), (c)(2)(iii)(E), (c)(2)(viii), (d)(1)(ii), (d)(2)(ii), (d)(2)(iii)(E), and (d)(2)(v) of this section apply to rents or royalties, as applicable, received or accrued during taxable years of controlled foreign corporations ending on or after September 1, 2015, and to taxable years of United States shareholders in which or with which such taxable years end, to the extent that such rents or royalties are received or accrued on or after September 1, 2015. See § 1.954–2(c)(1)(i), (c)(1)(iv), (c)(2)(ii), (c)(2)(iii), (d)(1)(i), (d)(1)(ii), (d)(2)(ii), and (d)(2)(iii), as contained in 26 CFR part 1 revised as of April 1, 2015, for rules applicable to rents or royalties, as applicable, received or accrued before September 1, 2015.

(k) Expiration date. The applicability of paragraphs (c)(1)(i), (c)(1)(iv), (c)(2)(ii), (c)(2)(iii)(E), (c)(2)(viii), (d)(1)(i), (d)(1)(ii), (d)(2)(ii), (d)(2)(iii)(E), and (d)(2)(v) of this section expires on or before Friday August 31, 2018.

Par. 4. Section 1.956–1 is amended by:

a. Adding paragraphs (b)(4), (b)(5), (f), and (g)(1) through (3).

b. Redesignating paragraph (e)(6)(vii) as paragraph (g)(4) and revising it.

The additions and revisions read as follows:

* * * * *

(b) * * *

(4) [Reserved]. For further guidance, see § 1.956–1T(b)(4).

(5) [Reserved]. For further guidance, see § 1.956–1T(b)(5).

* * * * *

(f) [Reserved]. For further guidance, see § 1.956–1T(f).

(g) introductory text through (g)(3) [Reserved]. For further guidance, see § 1.956–1T(g) introductory text through (g)(3).

(4) Paragraph (e)(6) of this section applies to property acquired in exchanges occurring on or after June 24, 2011. For transactions that occur prior to June 24, 2011, see § 1.956–1T(e)(6) as contained in 26 CFR Part 1 revised as of April 1, 2011.

Par. 5. Section 1.956–1T is amended by revising paragraph (b)(4), and adding paragraphs (b)(5), (e)(6), (g), and (h) to read as follows:

* * * * *

(b) * * *

(4) Certain indirectly held United States property—(i) General rule. For purposes of section 956, United States property held indirectly by a controlled foreign corporation includes—

(A) United States property held on behalf of the controlled foreign corporation by a trustee or a nominee;

(B) United States property acquired by any other foreign corporation that is controlled by the controlled foreign corporation if a principal purpose of creating, organizing, or funding by any means (including through capital contributions or debt) the other foreign corporation is to avoid the application of section 956 with respect to the controlled foreign corporation; and

(C) Property acquired by a partnership that is controlled by the controlled foreign corporation if the property would be United States property if held directly by the controlled foreign corporation, and a principal purpose of creating, organizing, or funding by any means (including through capital contributions or debt) the partnership is to avoid the application of section 956 with respect to the controlled foreign corporation.

(ii) Control. For purposes of paragraphs (b)(4)(i)(B) and (C) of this section, a controlled foreign corporation controls a foreign corporation or partnership if the controlled foreign corporation and the other foreign corporation or partnership are related within the meaning of section 267(b) or section 707(b). For this purpose, in determining whether two corporations are members of the same controlled group under, a person is considered to own stock owned directly by such person, stock owned for the purposes of section 1563(e)(1), and stock owned with the application of section 267(c).

(iii) Coordination rule. Paragraph (b)(4)(i)(C) of this section applies only to the extent that the amount of United States property that is treated as held indirectly by a controlled foreign corporation under that paragraph exceeds the amount of United States property that is treated as held by the controlled foreign corporation under § 1.956–2(a)(3).

(iv) Examples. The following examples illustrate the rules of this paragraph (b)(4). In each example, unless otherwise provided, P is a domestic corporation that wholly owns two controlled foreign corporations, FS1 and FS2.

Example 1. (i) Facts. FS1 sells inventory to FS2 in exchange for trade receivables due in 60 days. Avoiding the application of section 956 with respect to FS1 was not a principal purpose of establishing the trade receivables. FS2 has no earnings and profits and FS1 has substantial accumulated earnings and profits. FS2 makes a loan to P equal to the amount it owes FS1 under the trade receivables. FS2 pays the trade receivables according to their terms.

(ii) Result. FS1 will not be considered to indirectly hold United States property under this paragraph (b)(4) because the funding of FS2 through the sale of inventory in exchange for the establishment of trade receivables was not undertaken with a principal purpose of avoiding the application of section 956 with respect to FS1.

Example 2. (i) Facts. The facts are the same as in Example 1, except that, with a principal purpose of avoiding the application of section 956 with respect to FS1, FS1 and FS2 agree to defer FS2’s payment obligation, and FS2 does not timely pay the receivables.

(ii) Result. FS1 is considered to hold indirectly United States property under this paragraph (b)(4), because there was a funding of FS2, a principal purpose of which was to avoid the application of section 956 with respect to FS1.

Example 3. (i) Facts. FS1 has $100x of post-1986 undistributed earnings and profits and $100 post-1986 foreign income taxes, but does not have any cash. FS2 has earnings and profits of at least $100x, no post-1986 foreign income taxes, and substantial cash. Neither FS1 nor FS2 has earnings and profits described in section 959(c)(1) or section 959(c)(2). FS2 loans $100x to FS1. FS1 then loans $100x to P. An income inclusion by P of $100x under sections 951(a)(1)(B) and 956 with respect to FS1 would result in foreign income taxes deemed paid by P under section 960. A principal purpose of funding FS1 through the loan from FS2 is to avoid the application of section 956 with respect to FS2.

(ii) Result. Under paragraph (b)(4)(i)(B) of this section, FS2 is considered to indirectly hold the $100x obligation of P that is held by FS1. As a result, P has an income inclusion of $100x under sections 951(a)(1)(B) and 956 with respect to FS2, and the foreign income taxes deemed paid by P under section 960 is $0. P does not have an income inclusion under sections 951(a)(1)(B) and 956 with respect to FS1 related to the $100x loan from FS1 to P.

Example 4. (i) Facts. FS1 has substantial earnings and profits. P and FS1 are the only partners in a foreign partnership, FPRS. FS1 contributes $600x cash to FPRS in exchange for a 60% interest in the partnership, and P contributes real estate located outside the United States ($400x value) to FPRS in exchange for a 40% interest in the partnership. There are no special allocations in the FPRS partnership agreement. FPRS lends $100x to P. Under § 1.956–2(a)(3), FS1 is treated as holding United States property of $60x (60% x $100x) as a result of the FPRS loan to P. A principal purpose of creating, organizing, or funding FPRS is to avoid the application of section 956 with respect to FS1.

(ii) Result. Before taking into account paragraph (b)(4)(iii) of this section, because FS1 controls FPRS and a principal purpose of creating, organizing, or funding FPRS was to avoid the application of section 956 with respect to FS1, FS1 is considered under paragraph (b)(4)(i)(C) of this section to indirectly hold the $100x obligation of P that would be United States property if held directly by FS1. However, under paragraph (b)(4)(iii) of this section, FS1 is treated as holding United States property under paragraph (b)(4)(i)(C) only to the extent the amount held indirectly under paragraph (b)(4)(i)(C) of this section exceeds the amount of United States property that FS1 is treated as holding under § 1.956–2(a)(3). The amount of United States property that FS1 is treated as indirectly holding under paragraph (b)(4)(i)(C) of this section ($100x) exceeds the amount determined under § 1.956–2(a)(3) ($60x) by $40x. Thus, FS1 is considered to hold United States property within the meaning of section 956(c) in the amount of $100x ($60x under § 1.956–2(a)(3) and $40x under paragraphs (b)(4)(i)(C) and (b)(4)(iii) of this section).

(5) Certain foreign partnership distributions funded by CFCs—(i) General rule. For purposes of section 956, an obligation of a foreign partnership that is held (or that would be treated as held under § 1.956–2(c) if the obligation were an obligation of a United States person) by a controlled foreign corporation is treated as a separate obligation of a partner in the partnership when—

(A) The foreign partnership distributes an amount of money or property to the partner;

(B) The foreign partnership would not have made the distribution but for a funding of the partnership through the obligation; and

(C) The partner is related to the controlled foreign corporation within the meaning of section 954(d)(3).

(ii) Amount of obligation. Notwithstanding § 1.956–1(e), the amount that is treated as an obligation of the distributee partner pursuant to paragraph (b)(5)(i) of this section is equal to the lesser of the amount of the partnership distribution that would not have been made but for the funding of the partnership or the amount (as determined under § 1.956–1(e)) of the obligation of the foreign partnership that is held (or that would be treated as held under § 1.956–2(c) if the obligation were an obligation of a United States person) by the controlled foreign corporation.

(iii) Example. (A) Facts. P, a domestic corporation, wholly owns FS, a controlled foreign corporation. P owns a 70% interest in FPRS, a foreign partnership. A domestic corporation that is unrelated to P and FS owns the remaining 30% interest in FPRS. FPRS borrows $100x from FS, and distributes $80x to P. FPRS would not have made the distribution to P but for the funding by FS.

(B) Result. Under paragraph (b)(5)(i) of this section, a portion of the obligation of FPRS that FS holds is treated as an obligation of P, which constitutes United States property, because FPRS made a distribution to P that FPRS would not have made but for the funding of FPRS through the obligation held by FS. Under paragraph (b)(5)(ii) of this section, the amount that is treated as an obligation of P is the lesser of the amount of the distribution, $80x, or the amount of the entire obligation of FPRS held by FS, $100x. For purposes of section 956, therefore, on the date the loan to FPRS is made, FS is considered to hold United States property of $80x.

* * * * *

(e)(6) [Reserved]. For further guidance, see § 1.956–1(e)(6).

* * * * *

(g) Effective/applicability date. (1) Paragraph (b)(4) of this section applies to taxable years of controlled foreign corporations ending on or after September 1, 2015, and to taxable years of United States shareholders in which or with which such taxable years end, with respect to property acquired on or after September 1, 2015. See paragraph (b)(4) of § 1.956–1T, as contained in 26 CFR part 1 revised as of April 1, 2015, for the rules applicable to taxable years of controlled foreign corporations ending before September 1, 2015, and property acquired before September 1, 2015. For purposes of this paragraph (g)(1), a deemed exchange of property pursuant to section 1001 on or after September 1, 2015, constitutes an acquisition of the property on or after that date.

(2) Paragraph (b)(5) of this section applies to taxable years of controlled foreign corporations ending on or after September 1, 2015, and to taxable years of United States shareholders in which or with which such taxable years end, in the case of distributions made on or after September 1, 2015.

(3) [Reserved].

(4) [Reserved]. For further guidance, see § 1.956–1(g)(4).

(h) Expiration date. The applicability of paragraphs (b)(4) and (b)(5) of this section expires on or before August 31, 2018.

John Dalrymple, Deputy Commissioner for Services and Enforcement.

Approved: July 30, 2015.

Mark J. Mazur, Assistant Secretary of the Treasury (Tax Policy).

The Treasury Department and the IRS received numerous comments regarding the 2013 proposed regulations. Most comments agreed that the approach taken in the 2013 proposed regulations, in particular the use of a test based on delta, was a fair and practical way to apply section 871(m) to financial instruments linked to one or more U.S. equity securities. Commenters, however, identified a number of issues with the 2013 proposed regulations. Many of the comments suggested modifications and clarifications to the 2013 proposed regulations before they are issued as final regulations. Those comments are summarized in Part II of this preamble. Part II also explains the changes made to the final regulations in response to those comments.

Several of the issues identified by commenters required more significant changes or additions to the 2013 proposed regulations. To allow taxpayers adequate opportunity to consider and comment on these changes, the Treasury Department and the IRS are issuing portions of the regulations as temporary and proposed regulations. Those provisions, and the relevant comments, are summarized in Part III of this preamble.

The 2013 proposed regulations provide that a dividend equivalent is treated as a dividend from sources within the United States for purposes of sections 871(a), 881, 892, 894, and 4948(a), and chapters 3 and 4 of subtitle A of the Code. This rule follows section 871(m)(1) but adds the reference to section 894 to clarify (as provided in § 1.894–1(c)(2)) that a dividend equivalent is treated as a dividend for purposes of any provision regarding dividends in an income tax treaty. The final regulations retain the general sourcing provision. See § 1.871–15(b).

The 2013 proposed regulations define a dividend equivalent as (1) any substitute dividend that references a U.S. source dividend made pursuant to a securities lending or sale-repurchase transaction, (2) any payment that references a U.S. source dividend made pursuant to a specified NPC, (3) any payment that references a U.S. source dividend made pursuant to a specified ELI, or (4) any other substantially similar payment. A payment references a U.S. source dividend if the payment is directly or indirectly contingent upon a U.S. source dividend or determined by reference to such a dividend. While the transactions described in (1) and (2) are transactions described in sections 871(m)(2)(A) and (B), respectively, the 2013 proposed regulations extend section 871(m) to the transactions described in (3) and (4) under the regulatory authority granted in section 871(m)(2)(C), which includes as a dividend equivalent “any other payment determined by the Secretary to be substantially similar to a payment described in subparagraph (A) or (B)” of section 871(m)(2). The final regulations retain this four-part definition of a dividend equivalent. See § 1.871–15(c)(1). The final regulations also provide certain exceptions to the term “dividend equivalent,” which are described in section II.D of this preamble.

Section 871(m)(3)(A) provides a temporary definition of the term “specified notional principal contract.” This definition is effective for payments made on or after September 14, 2010, and on or before March 18, 2012. Section 871(m)(3)(B) provides that, for payments made after March 18, 2012, a specified NPC includes “any notional principal contract unless the Secretary determines that such contract is of a type which does not have the potential for tax avoidance.” The 2013 final regulations extend the applicability of the temporary statutory definition in section 871(m)(3)(A) (the four-part definition provided in paragraphs (3)(A)(i) through (iv)) to payments made before January 1, 2016. These final regulations amend the 2013 final regulations to extend the application of the temporary statutory definition adopted in the 2013 final regulations to payments made before January 1, 2017.

Pursuant to the grant of authority in section 871(m)(2)(C), the 2013 proposed regulations provide that certain payments made pursuant to a specified ELI are substantially similar to a dividend equivalent payment. Section 1.871–15(c)(1)(iii) of the 2013 proposed regulations defines a dividend equivalent to include any payment that references the payment of a dividend from an underlying security on a specified ELI. Section 1.871–15(a)(3) of the 2013 proposed regulations defines an ELI (whether or not specified) as any financial transaction (other than a securities lending or sale-repurchase transaction or an NPC) that references the value of one or more underlying securities. Forward contracts, futures contracts, options, debt instruments convertible into underlying securities, and debt instruments that have payments linked to underlying securities are common examples of an ELI.

The 2012 proposed regulations used a multi-factor test to determine whether an NPC or ELI is a specified contract subject to withholding under section 871(m). The 2013 proposed regulations replace the multi-factor test with a single-factor test that employs a “delta” threshold to determine whether a transaction is a section 871(m) transaction. Delta refers to the ratio of a change in the fair market value of a contract to a small change in the fair market value of the property referenced by the contract. Delta is widely used by participants in the derivatives markets to measure and manage risk. Under the test in the 2013 proposed regulations, any NPC or ELI that had a delta of 0.70 or greater when the long party acquired the transaction would be a section 871(m) transaction subject to withholding.

The Treasury Department and the IRS proposed a delta-based standard after concluding that it would provide a comparatively simple, administrable, and objective framework that would also minimize potential avoidance of U.S. withholding tax. A financial instrument that provides an economic return that is substantially similar to the return on the underlying stock should be taxed in the same manner as the underlying stock for the purpose of section 871(m). The Treasury Department and the IRS concluded that the delta test was the best way to identify these instruments.

The Treasury Department and the IRS received many comments regarding the delta test. Commenters generally agreed that the delta test was both a fair and comprehensive way to implement section 871(m), but provided comments on several aspects of the test. The major concerns noted in the comments relate to: (1) the use of 0.70 as the delta threshold; (2) the time for testing delta; (3) the ability of parties to the transaction to obtain and track the necessary delta information; and (4) the difficulty of determining an initial delta with respect to certain complex equity derivatives (in contrast with simple contracts, as defined in Part II.C.4 of this preamble).

Comments on the 2013 proposed regulations recommended raising the delta threshold, with suggestions ranging from a delta of 0.80 to 0.95. The majority of comments preferred a delta threshold of 0.90 or greater. Comments maintained that a higher delta would more accurately capture transactions that are economically equivalent to stock ownership and likely to be used for tax-avoidance. One comment noted that a 0.80 delta standard, although not prescribed in regulatory guidance, is used by some practitioners as a yardstick to judge economic equivalence in other tax contexts.

The Treasury Department and the IRS agree that the 0.70 delta in the 2013 proposed regulations could apply to contracts with economic characteristics that do not sufficiently resemble the underlying security to be within the scope of section 871(m). On the other hand, a delta threshold that is 0.90 (or higher) would exclude many instruments that are surrogates for the underlying security, such as deep-in-the-money options. The final regulations adopt a delta threshold of 0.80, which strikes a balance between the potential over-inclusiveness of the 0.70 delta threshold and the likelihood that a 0.90 (or higher) threshold would exclude transactions with economic returns that closely resemble an underlying security.

Several comments noted that a delta ratio is intended to measure the sensitivity of the value of a contract to comparatively small changes in the market value of the referenced property and suggested that the regulations incorporate this qualification in the definition of delta. The final regulations accept this suggestion and clarify the definition of delta by specifying that delta is calculated with respect to a small change in the fair market value of the property referenced by the contract. Typically, a small change is a change of less than 1 percent.

Many comments stated that the requirement to test delta each time a contract is acquired would be extremely difficult to administer, especially for ELIs that trade frequently. Multiple testing events create the possibility that identical instruments acquired at different times would have different tax characteristics, which withholding systems are generally not designed to handle. To ease compliance, comments suggested that delta be tested only when a contract is issued. For derivatives that are listed and cleared through central clearinghouses, another comment suggested that the delta test would be more administrable if taxpayers were permitted to simplify their calculations. For example, delta could be calculated using the fair market value of an ELI determined as of the market close on the trading day prior to the date the ELI is acquired, even though this approach would result in a less accurate calculation. Other comments suggested that, in determining the delta of an option, only the stock price at the time the option is entered into should be considered.

The Treasury Department and the IRS are persuaded that the difficulties of testing delta each time an NPC or ELI is acquired outweigh the benefit of the increased accuracy of that approach. Accordingly, the final regulations provide that the delta of an ELI or NPC is determined only when the instrument is issued; it is not re-tested when the instrument is purchased or otherwise acquired in the secondary market. Consequently, only an NPC or ELI that has a delta of 0.80 or greater at the time it is issued is a specified NPC or specified ELI.

For purposes of § 1.871–15, an instrument is treated as “issued” when it is entered into, purchased, or otherwise acquired at its inception or original issuance, which includes an issuance that results from a deemed exchange pursuant to section 1001. The requirement to test delta only at the time an instrument is issued also extends to the rules for determining the amount of each dividend equivalent (as discussed in section F.1 of this preamble).

Comments noted practical issues with obtaining delta information, particularly for exchange-traded positions where the dealer is not involved in determining pricing and the short party may not have the expertise to calculate delta. Comments suggested adopting an alternative test for identifying high-delta options based on their relative intrinsic value (amount by which the option is in-the-money) and relative extrinsic value (time value). This test would require the simpler calculation of determining the applicable strike price as a percentage of the current fair market value of the ELI and deeming ELIs at a certain percentage as passing or failing the delta threshold. Alternatively, comments suggested permitting the long party to rely on commonly available online tools to calculate delta for exchange-traded ELIs, provided that the taxpayer uses inputs that are within the range of commercially acceptable variation, uses a consistent methodology, and records its calculations contemporaneously. Comments also recommended relying on an anti-abuse rule for particularly complex derivatives for which delta information would be unavailable to any party other than the issuer, speculating that the increased cost and risk of complex transactions generally would outweigh any tax savings.

The Treasury Department and the IRS are concerned that these alternative tests or shorthand methods for determining delta may result in uncertainty for withholding agents and the IRS that could make it difficult to determine the status of potential section 871(m) transactions. Moreover, the changes to the final regulations to require that delta be tested only when a contract is first issued, accompanied by enhanced reporting rules (described in more detail later in this preamble), make these alternative tests unnecessary. Accordingly, the final regulations do not adopt these recommendations.

However, in order to simplify the delta calculation for contracts that reference multiple underlying securities, the final regulations provide that a short party may calculate delta using a single exchange-traded security in certain circumstances. More specifically, if a short party issues a contract that references a basket of 10 or more underlying securities and uses an exchange-traded security, such as an exchange-traded fund, that references substantially the same underlying securities to hedge the contract at the time it is issued, the short party may use the hedge security to determine the delta of the security it is issuing rather than determining the delta of each security referenced in the basket.

Although commenters generally agreed that the delta test was fair and practical for the majority of equity-linked derivatives, numerous comments explained that the delta test would be difficult or impossible to apply to certain more exotic equity derivatives. For example, contracts that have asymmetrical or binary payouts may reference a different number of shares of an underlying security at different payout points. Similarly, contracts that have path-dependent payouts may reference multiple underlying securities, with payouts that are interdependent on the performance of each underlying security. In each of these cases, comments noted that the delta is indeterminate because the number of shares of the underlying security that determine the payout of the derivative cannot be known at the time the contract is entered into.

The Treasury Department and the IRS agree that an alternative to the delta test is needed for contracts with indeterminate deltas. To address these contracts, the final regulations distinguish between simple contracts and complex contracts. Generally, a simple contract is a contract that references a single, fixed number of shares of one or more issuers to determine the payout. The number of shares must be known when the contract is issued. In addition, the contract must have a single maturity or exercise date on which all amounts (other than any upfront payment or any periodic payments) are required to be calculated with respect to the underlying security. The fact that a contract has more than one expiry, or a continuous expiry, does not preclude the contract from being a simple contract. Thus, an American-style option is a simple contract even though the option may be exercised by the holder at any time on or before the expiration of the option if amounts due under the contract are determined by reference to a single, fixed number of shares on the exercise date. Most NPCs and ELIs are expected to be simple contracts and remain subject to the delta test described above.

A complex contract is any contract that is not a simple contract. Contracts with indeterminate deltas are classified as complex contracts, which are subject to a new substantial equivalence test. That test is included in the temporary regulations, described in more detail in Part III of this preamble. The delta test in the final regulations therefore applies only to simple contracts.

Several comments requested that the final regulations exclude certain payments from the definition of “dividend equivalent” or exclude certain transactions from the definition of “section 871(m) transaction.” These comments generally noted that the payment or transaction at issue either is already taxed under another provision of the Code or does not provide the long party with an opportunity to avoid gross basis taxation on U.S. source dividends.

The 2013 proposed regulations provide that a payment referencing a distribution on an underlying security is not a dividend equivalent to the extent that the distribution would not be subject to tax pursuant to section 871 or section 881 if the long party owned the underlying security directly. The final regulations retain this provision. See § 1.871–15(c)(2)(i).

Under sections 305(b) and (c) and regulations authorized by section 305(c), a change to the conversion ratio or conversion price of a convertible debt instrument that is a convertible security for purposes of section 305 (a convertible security) may be treated as a distribution of property to which section 301 applies made to the holder of the convertible security. See § 1.305–7. To the extent such a distribution is treated under section 301(c)(1) as a dividend as defined in section 316 (a section 305 dividend), § 1.1441–2(d)(1) would require withholding on the section 305 dividend without regard to the fact that there is no payment at that time. Absent special rules, a section 305 dividend resulting from a change in conversion ratio or price of a convertible security that is a section 871(m) transaction could also be subject to withholding as a dividend equivalent.

The 2013 proposed regulations provide that a payment pursuant to a section 871(m) transaction is not a dividend equivalent to the extent that it is treated as a distribution taxable as a dividend pursuant to section 305. Comments noted that section 305 dividends and dividend equivalents under section 871(m) arise in different contexts and are determined differently. Moreover, section 305 dividends will reduce earnings and profits pursuant to section 312. Comments suggested that the regulations provide more detail to coordinate these two provisions, including guidance on how to reconcile withholding on the delta-based dividend equivalent in these regulations with withholding otherwise required on section 305 dividends.

After consideration of the comments, these final regulations clarify that a dividend equivalent with respect to a section 871(m) transaction is reduced by any amount treated in accordance with section 305(b) and (c) as a dividend with respect to the underlying security referenced by the section 871(m) transaction. For example, if a change in the conversion ratio of a convertible security that is a section 871(m) transaction is treated as a section 305 dividend made to the holder of the convertible security, a dividend equivalent is reduced by the amount of the section 305 dividend arising from such change.

Although a transaction (for example, a change in conversion ratio of a convertible security) may give rise to both a dividend equivalent and a section 305 dividend, dividend equivalents and section 305 dividends have different characteristics. These final regulations do not alter any of the rules applicable to section 305 dividends. As noted in Part II.M. of this preamble, however, the changes made elsewhere in these final regulations should make section 871(m) inapplicable to most convertible debt instruments, including those that are convertible securities subject to section 305(c).

The 2013 proposed regulations reserve on the question of whether a due bill gives rise to a dividend equivalent and request comments regarding whether a payment made by a seller of stock to the purchaser pursuant to an agreement to deliver a pending U.S. source dividend after the record date (for example, a due bill) should be treated as a substantially similar payment.

One comment noted that a due bill may give rise to payments that appear to satisfy the criteria for a dividend equivalent. That comment expressed concern regarding the impact this treatment might have on the capital markets because of the relative frequency of due bills, as well as the administrative complexity of treating these payments as dividend equivalents. Another comment asserted that a due bill is not the economic equivalent of a dividend. Both comments requested that the regulations either address due bills under the anti-abuse rule or exclude them from the term dividend equivalent.

The final regulations provide that a dividend equivalent does not include a payment made pursuant to a due bill that arises from the actions of a securities exchange that apply to all transactions in the stock and when the relevant exchange has set an ex-dividend date that occurs after the record date. This rule is expected to apply in situations in which a securities exchange sets an ex-dividend date after the record date to accommodate a special dividend.

The 2013 proposed regulations do not specifically exclude payments of compensation for personal services of a nonresident alien individual from being treated as a dividend equivalent. Comments suggested that compensation arrangements should be excluded from dividend equivalent treatment because compensation is already subject to an existing tax withholding framework, compensatory transactions arise in a different context from other derivatives and do not have the potential to avoid U.S. withholding tax, and compensation should be subject to tax where the services are performed.

The Treasury Department and the IRS have determined that section 871(m) should not apply to compensation that is generally subject to withholding or has a specific exception therefrom. Accordingly, the final regulations provide that a dividend equivalent does not include the portion of equity-based compensation for personal services of a nonresident alien individual that is wages subject to withholding under section 3402, excluded from the definition of wages under § 31.3401(a)(6)–1, or exempt from withholding under § 1.1441–4(b). For example, when a restricted stock unit is paid as compensation and tax is collected by the employer at the time of payment through withholding, the payment will not also be a dividend equivalent subject to withholding. If the restricted stock unit results in the receipt of stock, however, dividends subsequently paid on that stock would be subject to withholding under section 871.

In response to comments, § 1.871–15(j) of the 2013 proposed regulations provides an exception to the definition of a section 871(m) transaction when a taxpayer enters into a transaction as part of a plan pursuant to which one or more persons (including the taxpayer) are obligated to acquire more than 50 percent of the entity issuing the underlying securities.

Comments requested that the acquisition threshold in this exception be lowered from 50 percent to 10 or 20 percent. Comments noted that corporate acquisitions generally would not provide an opportunity for avoiding dividend withholding. Further, comments noted that the anti-abuse rule should be sufficient to address any abuse that could occur through such transactions. Comments acknowledged that when a target company pays a pre-closing dividend and the purchase price is reduced for the dividend, this may allow the purchaser to avoid a subsequent dividend. However, comments observed that this event should be viewed as a purchase price adjustment rather than a dividend equivalent.

The final regulations do not change the 50 percent threshold. Requiring that an acquisition (as part of a plan by one or more person) total more than 50 percent of a corporation is appropriate because it indicates that the primary intent of the acquirer is to obtain a controlling interest rather than just a substantial investment in the target company. In circumstances where a taxpayer enters into a transaction pursuant to which the taxpayer is obligated to acquire 50 percent or less of the entity issuing the underlying securities, and the transaction is a section 871(m) transaction, any party to the transaction that is a broker, dealer, or intermediary, a short party, or a withholding agent, must comply with any requirements in the final regulation to make appropriate determinations, and satisfy reporting and withholding obligations, as applicable.

Section 871(m)(5) provides that a “payment” includes any gross amount that references a U.S. source dividend and that is used to compute any net amount transferred to or from the taxpayer. The 2013 proposed regulations provide that a dividend equivalent includes any amount that references an actual or estimated payment of a U.S. source dividend, whether the reference is explicit or implicit. Thus, in addition to amounts equal to actual payments of dividends and estimated dividends, a dividend equivalent includes any other contractual term of a section 871(m) transaction that is calculated based on an actual or estimated dividend. For example, when a long party enters into an NPC that provides for payments based on the appreciation in the value of an underlying security but that does not explicitly entitle the long party to receive payments based on regular dividends (a price return swap), the 2013 proposed regulations treat the price return swap as a transaction that provides for the payment of a dividend equivalent because the anticipated dividend payments are presumed to be taken into account in determining other terms of the NPC, such as in the payments that the long party is required to make to the short party or in setting the price of the underlying securities referenced in the price return swap.

Comments objected to the provisions in the 2013 proposed regulations that include estimated and implicit dividends in the definition of a dividend equivalent. These comments noted that an estimated dividend is reflected as a price reduction or as an amount that the foreign investor does not have to pay rather than an amount the foreign investor affirmatively receives for holding the derivative, which suggests that there is no “payment” of a dividend equivalent to the foreign investor. Comments also noted that, while estimated dividends may be implicitly incorporated into the pricing of a derivative, the price is ultimately determined by supply and demand in the market and the expected dividend is not always explicitly used in computing the amount paid.

The Treasury Department and the IRS have concluded that the economic benefit of a dividend is present in transactions that implicitly incorporate estimated dividends to virtually the same extent as transactions that pay or adjust for actual dividends. Thus, the final regulations retain the rules in the 2013 proposed regulations that include estimated and implicit dividends as dividend equivalents. See § 1.871–15(i)(2). More specifically, the final regulations provide that any gross amount that references the payment of a dividend, whether actual or estimated, explicit or implicit, is treated as a dividend equivalent to the extent of the amount determined under the regulations. The final regulations change the time that withholding is required on a payment of a dividend equivalent, as discussed in Part II.N of this preamble.

Under the 2013 proposed regulations, the amount of a dividend equivalent for a specified NPC or specified ELI equals the per-share dividend amount with respect to the underlying security multiplied by the number of shares of the underlying security referenced in the contract (subject to adjustment), multiplied by the delta of the transaction with respect to the underlying security at the time when the amount of the dividend equivalent is determined. If a transaction provides for a payment based on an estimated or implicit estimated dividend, the actual dividend is used to calculate the amount of the dividend equivalent unless the short party identifies a reasonable estimated dividend amount in writing at the inception of the transaction. When a payment based on estimated dividends is supported by the required documentation, the per-share dividend amount used to compute the amount of a dividend equivalent is the lesser of the estimated dividend and the actual dividend.

Comments on the 2013 proposed regulations noted that recalculating the delta of a section 871(m) transaction each time the amount of a dividend equivalent is determined would add administrative complexity without necessarily improving accuracy. In the interest of simplicity, several comments recommended using the actual dividend amount rather than an amount adjusted for delta as the dividend equivalent amount. Other comments suggested using the delta at the time the transaction is issued or entered into for determining the dividend equivalent amount. For complex transactions for which the delta is indeterminate, comments suggested that withholding be based on the number of shares required by the short party to the transaction to hedge its initial position in the transaction.

The final regulations simplify the rules for determining the amount of a dividend equivalent in response to these comments. For a simple contract, the final regulations provide that the amount of the dividend equivalent for each underlying security equals the amount of the per-share dividend, multiplied by the number of shares referenced in the contract, multiplied by the applicable delta. In a change from the 2013 proposed regulations, the final regulations provide that this formula references the delta of the transaction at the time the simple contract is issued, rather than when the dividend is paid. For a complex contract, the amount of the dividend equivalent equals the amount of the per-share dividend multiplied by the number of shares that constitute the initial hedge of the complex contract (as that term is defined in § 1.871–15(a)(5) and discussed in Part III.A of this preamble).

Another simplifying rule applies to dividend equivalents paid with respect to baskets of more than 25 securities. If a section 871(m) transaction references a basket of more than 25 underlying securities, the short party is allowed to treat all of the dividends on the basket as paid on the last day of the calendar quarter.

For a specified NPC or specified ELI with a term of one year or less when acquired, the 2013 proposed regulations provide that the amount of a dividend equivalent is determined when the long party disposes of the section 871(m) transaction. Therefore, a long party that acquires an option with a term of one year or less that is a specified ELI would not incur a withholding tax if the option lapses.

One comment noted that the rule providing that there is no dividend equivalent for options that have a term of one year or less and lapse unexercised is inappropriate in the case of written put options because put writers realize their maximum profit when puts lapse. Comments further noted that the one-year rule could have uneconomic consequences for options close to expiration and for options that are slightly in-the-money or slightly out-of-the-money because the delta could fluctuate materially in response to small changes in the price of the underlying stock.

Based on the comments received, the final regulations eliminate the special rule for contracts with terms of one year or less. Any benefit from the rule is outweighed by the complexity of creating systems to track contracts that differ only in term. Eliminating the special rule for contracts of one year or less means that a dividend equivalent amount must be determined for any option, including a short-term option, that is a specified ELI.

The 2013 proposed regulations revise rules provided in the 2012 proposed regulations pertaining to an exception for transactions that reference certain equity indices. Under the 2013 proposed regulations, a qualified index is any index that (1) references 25 or more underlying securities, (2) references only long positions in underlying securities, (3) contains no underlying security that represents more than 10 percent of the index’s weighting, (4) rebalances based on objective rules at set intervals, (5) does not provide a dividend yield that is greater than 1.5 times the dividend yield of the S&P 500 Index, and (6) is referenced by futures or option contracts that trade on a national securities exchange or a domestic board of trade. In addition, the 2013 proposed regulations provide that a qualified index would become disqualified if a transaction references a qualified index and also references a short position in any component underlying security of the qualified index other than a short position with respect to the entire qualified index (such as a cap or a floor).

One comment recommended eliminating the exception for a qualified index. This comment noted that when a long party holds a total return swap referencing a basket of underlying securities, that swap is economically equivalent to multiple total return swaps that each reference a single underlying security. Similarly, when a long party holds a delta-one derivative that references an index, that derivative is economically equivalent to multiple delta-one derivatives each referencing a single component of the index; therefore, that long party is receiving the economic equivalent of all dividends paid with respect to each stock in the index. Thus, transactions that reference U.S. stock indices have no less potential for avoidance of gross basis withholding tax on dividends than transactions that reference single equities or that reference customized baskets of equities.

Another comment noted that the criteria in the 2013 proposed regulations provide a reasonable method for identifying legitimate indices that have not been designed to avoid withholding taxes. That comment noted that the rules would exclude most securities that are linked to an index and traded on U.S. stock exchanges from dividend taxation, while preventing customized indices from becoming a vehicle designed to evade U.S. dividend taxes.

The majority of comments, however, recommended that the scope of the index exception be expanded to include most of the indices that are represented by exchange traded funds. Several comments requested that the definition allow an index with fewer than 25 stocks to be a qualified index, noting that many sector indices have fewer than 25 names. Another comment suggested providing an exception to the requirement that an index be referenced by exchange-traded futures or options that would apply to indices that are sufficiently broad-based (for example, indices containing one hundred or more component securities). Comments also suggested eliminating the requirement that the stock of a single company cannot represent more than 10 percent of the index’s weighting because some indices include component securities that grow rapidly. Several comments also noted that many indices would fail to satisfy the requirement that a qualified index rebalance based on objective rules at set intervals because many popular indices, including the S&P 500 Index, rebalance using a combination of objective and subjective factors.

Comments further requested that the permitted dividend yield be increased to 2.5 times the current dividend yield of the S&P 500 Index. The comments noted that an index may not satisfy the requirement based on 1.5 times the current dividend yield of the S&P 500 Index if the stocks in the index depreciated significantly relative to the general U.S. stock market. In addition, other indices would not qualify because some market sectors routinely pay dividends at a rate that is more than 1.5 times the average rate in the U.S. market.

Other comments suggested additional categories of indices that should be treated as qualified indices. Specifically, one comment recommended that any index that was published by a recognized independent index publisher should be a qualified index if the index is offered for license to third parties on similar terms and multiple third party industry participants actually license the index. The comments proposed defining a recognized independent index publisher as an organization that publishes indices that are created, calculated, and compiled by a group of employees that have no duties other than those related to the publication of the indices.

The rule in the 2013 proposed regulations that prevents taxpayers from using short positions to decrease their long position with respect to one or more components of an index was also noted by comments as too restrictive. Comments suggested permitting taxpayers to decrease risk with respect to a small percentage of the value of the stocks in the index without disqualifying the index. One comment suggested that an index should remain a qualified index unless the short position is used to establish a net long position in a narrow set of underlying securities for purposes of evading withholding.

The 2013 proposed regulations also included a safe harbor for global indices with 10 percent or less U.S. stocks. Comments recommended expanding this safe harbor because U.S. equities in a global index can comprise more than half of the index’s weighting. The comments proposed increasing the threshold to allow U.S. stocks to represent 50 percent or more of the index. These comments also noted that global indices do not typically trade on U.S. securities or commodities exchanges and will not be qualified indices under the current provisions. Other comments suggested that the regulations except from withholding all global indices that are not created to avoid withholding tax, with a presumption that widely-used benchmark indices are not designed to avoid tax.

The Treasury Department and the IRS believe that the approach taken in the 2013 proposed regulations for identifying qualified indices appropriately balances the competing concerns. Accordingly, the final regulations generally retain the criteria of the 2013 proposed regulations with modifications to clarify the intent and improve the functionality of the qualified index rule. See § 1.871–15(l).

The final regulations add a paragraph stating that the purpose of the qualified index rule is to provide a safe harbor for transactions on passive indices that reference a diverse basket of securities and that are widely used by numerous market participants. The index exception is not intended to apply to any index that is customized or reflects a trading strategy, is unavailable to other investors, or targets special dividends. The final regulations further provide that an index will not be treated as a qualified index if treating the index as a qualified index would be contrary to this purpose.

To make the rules easier to administer, the final regulations modify the time for determining whether an index satisfies the qualified index criteria. Specifically, the final regulations provide that the determination of whether an index is a qualified index is made on the first business day of each calendar year, and that determination applies for all potential section 871(m) transactions issued during that calendar year.

In response to comments, a number of changes also were made to specific aspects of the qualified index definition. First, the final regulations delete the modifier “underlying” with respect to “securities,” thereby allowing an index to qualify with fewer than 25 component underlying securities provided that the index contains a total of at least 25 component securities (in other words, a component security may include a security that does not give rise to U.S. source dividends). The index, however, will not qualify if it references five or fewer component underlying securities that together represent more than 40 percent of the weighting of the component securities in the index. Second, the final regulations increase the 10 percent limit for the maximum weighting of a single underlying security to 15 percent. Third, in response to concerns regarding the requirement that a qualified index rebalance based on objective rules, the final regulations do not require that an index be modified or rebalanced at set dates or intervals, and provide flexibility for how the rules governing the constitution of an index are applied. Instead, under the final regulations, an index that is periodically rebalanced by a board or committee that is allowed to exercise judgment in interpreting the rules governing the composition of the index will not be disqualified if the index is otherwise a qualified index.

The final regulations continue to require that an index be referenced by futures or options listed on a national securities exchange or board of trade to be a qualified index, which is consistent with the intent to provide a safe harbor only for non-customized and widely-available indices. The final regulations do, however, permit an index that trades on certain foreign exchanges to be a qualified index, provided that the referenced component underlying securities, in aggregate, comprise less than 50 percent of the weighting of the component securities in the index and the index otherwise meets the definition of a qualified index.

Similarly, the Treasury Department and the IRS have concluded that the proposed rule permitting no more than 1.5 times the current dividend yield of the S&P 500 Index is appropriate and have retained it in the final regulations. To reduce the number of required calculations, however, the final regulations provide that the annual yields of the tested index and of the S&P 500 Index are determined based on their annual yields for the immediately preceding calendar year, rather than requiring comparison of the annual yields for the month immediately preceding the date that the potential section 871(m) transaction is issued.

The Treasury Department and the IRS agree that de minimis short positions, whether as part of the index or entered into separately, should not disqualify an index. Accordingly, the final regulations permit a qualified index to reference one or more short positions (in addition to any short positions with respect to the entire qualified index, such as caps or floors, which were already permitted by the 2013 proposed regulations) that represent five percent or less, in the aggregate, of the value of the long positions in underlying securities in the qualified index.

The 2013 proposed regulations treat multiple transactions as a single transaction for purposes of determining if the transactions are a section 871(m) transaction when a long party (or a related person) enters into two or more transactions that reference the same underlying security and the transactions were entered into in connection with each other. The 2013 proposed regulations apply only to combine transactions in which the taxpayer is the long party, and typically would not combine transactions when a taxpayer is the long party with respect to an underlying security in one transaction and the short party with respect to the same underlying security in another transaction. The 2013 proposed regulations provide that a broker-dealer must use “reasonable diligence” to determine whether a transaction is a section 871(m) transaction. Under the 2013 proposed regulations, a withholding agent was not required to withhold on a dividend equivalent paid pursuant to a transaction that is combined with one or more other transactions unless the withholding agent knew that the long party (or a related person) entered into the potential section 871(m) transactions in connection with each other.

The Treasury Department and the IRS requested comments regarding whether and how the rules for combining separate transactions should apply in other situations, such as when a taxpayer holds both long and short positions with respect to the same underlying security (for example, a call spread). Comments also were requested regarding whether and how the remaining transaction (or transactions) should be retested when a long party terminates one or more, but not all, of the transactions that make up a combined position.

Several comments recommended that the regulations not provide a specific combination rule and instead rely on an anti-abuse rule. One comment endorsed the proposed regulations as they applied to combinations of long calls and written puts (two options that can be used to closely approximate the economics of stock ownership) but recommended that transactions not be combined if the transactions replicate the same or similar risks with respect to additional shares (for example, two purchased calls on the same underlying securities).

Many comments observed that determining whether transactions were entered into “in connection with” each other would be difficult for a withholding agent and that the regulations should adopt a different standard or clarify the meaning of the phrase. Comments asked that the final regulations conform the standard for combined transactions to the narrower withholding standard that requires “actual knowledge.” Comments noted that the requirement in the 2013 proposed regulations for broker-dealers to use “reasonable diligence” to determine whether a transaction is a section 871(m) transaction could be interpreted to require broker-dealers to inquire whether transactions are entered into in connection with each other in order to determine whether they must be combined. These comments observed that this standard for combined transactions is impractical because broker-dealers are generally not in a position to discern the intent of their counterparties, even using “reasonable diligence.”

Several comments recommended that a combination rule permit netting of long and short positions. Commenters observed that many standard option strategies involve multiple options positions, often combining positive and negative delta options. As a result, an approach that does not combine these positions would fail to reflect the economics of the transactions. Commenters suggested that when a taxpayer modifies an existing combined position that includes both long and short positions, the combined position should continue to be tested based on the net deltas of the component positions rather than test the delta for each position separately. None of the comments, however, proposed an administrable test that could be used to reliably combine long and short positions and net the resulting deltas.

The final regulations retain the general rules from the 2013 proposed regulations that define when transactions are combined. In response to questions about whether the rules were intended to combine transactions that had similar economic exposure, the final regulations add a requirement that the potential section 871(m) transactions, when combined, replicate the economics of a transaction that would be a section 871(m) transaction if the transactions had been entered into as a single transaction. Thus, the purchase of two out-of-the-money call options would typically not be combined because each call option provides the taxpayer with exposure to appreciation, but not depreciation, on the referenced stock.

The Treasury Department and the IRS recognize the challenges that short parties could face in identifying transactions to be combined. The final regulations therefore provide brokers acting as short parties with two presumptions they can apply to determine their liability to withhold. First, a broker may presume that transactions are not entered into in connection with each other if the long party holds the transactions in separate accounts. Second, a broker may presume that transactions entered into two or more business days apart are not entered into in connection with each other. These presumptions are independent of each other. Thus, a broker acting as a short party is relieved of the obligation to withhold if either of the two presumptions is met. A broker cannot rely on the first presumption if it has actual knowledge that the long party created or used separate accounts to avoid section 871(m), however, and neither presumption applies if the broker has actual knowledge that transactions were entered into in connection with each other.

In addition, the final regulations provide that the Commissioner will presume that transactions that are properly reflected on separate trading books of the taxpayer are not entered into in connection with each other. The Commissioner will also presume that a long party did not enter into two or more transactions in connection with each other if the long party entered into the transactions two or more business days apart. These presumptions are rebuttable. The Commissioner may rebut the first presumption with facts and circumstances showing that separate trading books were created or used to avoid section 871(m), and may rebut either presumption with facts and circumstances showing that the transactions in question were entered into in connection with each other.

The Commissioner will also apply an affirmative presumption. The Commissioner will presume that transactions that are entered into fewer than two business days apart and reflected on the same trading book are entered into in connection with each other. In this case, the long party can rebut the presumption by presenting facts and circumstances showing that the transactions were not entered into in connection with each other. In applying the presumptions that are based on trades being separated by at least two business days, the regulations include a rule of convenience that generally allows parties to treat all of their transactions as entered into at 4:00 pm.

The presumptions are not available to the long party. A long party therefore must treat two or more transactions as combined transactions if the transactions satisfy the requirements to be a combined transaction. The long parties affected by this rule consist primarily of securities traders, who are in a position to know their securities positions and trading strategies and to monitor their compliance with section 871(m).

The Treasury Department and the IRS will continue to evaluate the possibility of expanding the combination rules to accommodate netting of long and short positions in light of future developments in transactional reporting and recordkeeping. Additional comments regarding combined transactions are welcome.

The 2013 proposed regulations treat a transaction that references an interest in an entity that is not a C corporation for Federal tax purposes as referencing the allocable portion of any underlying securities and potential section 871(m) contracts held directly or indirectly by that entity. The 2013 proposed regulations provide an exception for a transaction that references an interest in an entity that is not a C corporation if the underlying securities and potential section 871(m) transactions allocable to that interest represent, in the aggregate, 10 percent or less of the value of the interest in the referenced entity at the time the transaction is entered into. Comments recommended changing the threshold for applying the look-through rule from 10 percent to 50 percent unless the taxpayer controls the entity. Comments also noted that taxpayers would have difficulty determining the assets owned by referenced entities.

The final regulations revise the rules to provide that section 871(m) applies to derivatives that reference a partnership interest only when the partnership is either a dealer or trader in securities, has significant investments in securities, or holds an interest in a lower-tier partnership that engages in those activities. The final regulations define a security by cross-reference to section 475(c). When the rule in the final regulations applies, a potential section 871(m) transaction that references a partnership interest is treated as referencing the allocable share of underlying securities and the potential section 871(m) transactions in the partnership directly or indirectly allocable to that partnership interest. Even when a partnership is not covered by this rule, the anti-abuse rule in § 1.871–15(o) may still apply, or the transaction may be recharacterized under the substance-over-form doctrine or other common law doctrine.

The 2013 proposed regulations provide that the Commissioner may treat any payment made with respect to a transaction as a dividend equivalent if the taxpayer acquires the transaction with a principal purpose of avoiding the application of section 871(m). Comments generally agreed with the need for such a rule, and the final regulations retain this provision. See § 1.871–15(o).

In addition, the IRS may challenge the U.S. tax results claimed in connection with transactions that are designed to avoid the application of section 871(m) using all available statutory provisions and judicial doctrines (including the substance-over-form doctrine, the economic substance doctrine under section 7701(o), the step transaction doctrine, and tax ownership principles) as appropriate. For example, nothing in section 871(m) precludes the IRS from asserting that a contract labeled as an NPC or other equity derivative is in fact an ownership interest in an underlying security referenced in the contract.

The 2013 proposed regulations provide rules for reporting and withholding. The preamble to the 2013 proposed regulations explains that most equity-linked transactions involve a financial institution acting as a broker, dealer, or intermediary and that the financial institution would be in the best position to report the tax consequences of a potential section 871(m) transaction. Accordingly, § 1.871–15(o) of the 2013 proposed regulations provides that when a broker or dealer is a party to a potential section 871(m) transaction, the broker or dealer is required to determine whether the transaction is a section 871(m) transaction, and if so, the amounts of the dividend equivalents. If no broker or dealer is a party to a transaction or both parties are brokers or dealers, the short party is required to determine whether the transaction is a section 871(m) transaction and the amounts of the dividend equivalents. Determinations made by the broker, dealer, or short party are binding on the parties to the section 871(m) transaction unless a party to the transaction knows or has reason to know that the information is incorrect. Those determinations, however, are not binding on the IRS.

Comments expressed concern that the delta information necessary for an investor to determine whether a transaction is subject to section 871(m) may not be available on a timely basis, and requested that the regulations expand the categories of persons permitted to request information about the status and calculations associated with potential section 871(m) transactions. Comments recommended requiring the information to be provided on an issuer’s website at or prior to the time that the transaction is issued and updated regularly. Investors could then rely on such information between update intervals.

In response to these comments, the final regulations make several changes to the reporting obligations in the 2013 proposed regulations. The final regulations revise the period for providing requested information from 14 calendar days to 10 business days from the date of the request. In addition, the final regulations replace the list of persons entitled to request information in the 2013 proposed regulations with a simpler provision that entitles “any party to the transaction” to request information. The final regulations define “a party to the transaction” to include any agent acting on behalf of a long party or short party to a potential section 871(m) transaction, or any person acting as an intermediary with respect to a potential section 871(m) transaction. This simplification responds to the requests to expand the scope of persons entitled to request information. Several other changes that were requested, however, such as posting information electronically, were already permitted by the 2013 proposed regulations. Like the 2013 proposed regulations, the final regulations permit parties to a transaction to obtain information on potential section 871(m) transactions in a variety of ways, including through electronic publication (such as a website).

Comments also noted that a short party to a listed option will not be able to provide the long party with a written estimate of dividends at inception because the short party does not have a contractual relationship with the long party. These comments requested that the broker be required to provide the written estimates. As in the 2013 proposed regulations, the final regulations do not require any party to a transaction to provide written estimates of dividends. The final regulations have taken these comments into account, however, by increasing a taxpayer’s ability to obtain information from other parties to the transaction. The final regulations accomplish this by expanding the definition of a “party to the transaction” to include a broker and by clarifying that either a dealer or a middleman is a “broker.” Therefore, if written estimates of dividends are prepared when a transaction is issued, the long party should be able to obtain the information from another party to the transaction, whether the short party or a broker.

The 2013 proposed regulations generally cross-reference the recordkeeping rules in § 1.6001–1 for how a taxpayer establishes whether a transaction is a section 871(m) transaction and whether a payment is a dividend equivalent. For clarity and to ensure that the IRS will have access to sufficient information to audit taxpayers and withholding agents that are parties to section 871(m) transactions, the final regulations provide more detailed recordkeeping rules. The final regulations provide that any person required to retain records must keep sufficient information to establish whether a transaction is a section 871(m) transaction and the amount of a dividend equivalent. To satisfy this requirement, a taxpayer must retain documentation and work papers supporting a delta calculation or substantial equivalence calculation (including the number of shares of the initial hedge) and written estimated dividends (if any). The records and documentation must be created substantially contemporaneously with the time the potential section 871(m) transaction is issued.

Section 871(h)(1) generally provides that U.S. source portfolio interest received by a nonresident alien individual is not subject to the 30-percent U.S. tax imposed under section 871(a)(1). Section 871(h)(4)(A)(i), however, excludes certain contingent interest payments from the definition of portfolio interest. Section 871(h)(4)(A)(ii) grants the Secretary authority to impose tax on contingent interest other than the payments described in section 871(h)(4)(A)(i) when necessary or appropriate to prevent the avoidance of federal income tax.

Comments on the 2012 proposed regulations recommended narrowing the definition of a specified notional principal contract to clarify that the term does not include contingent or convertible debt. These comments suggested that section 871(m) should not override the portfolio interest exception. Section 871(h)(4)(A)(ii) expressly provides authority to the Secretary to treat interest as contingent interest if necessary or appropriate to prevent the avoidance of federal income tax. Consistent with this grant of authority, the 2013 proposed regulations provide that contingent interest will not qualify for the portfolio interest exemption to the extent that the contingent interest payment is a dividend equivalent. The final regulations retain this exception to the portfolio interest exemption. There is no reason that an equity derivative that otherwise would be a specified NPC or a specified ELI should receive different treatment because it is embedded in a debt instrument. A debt instrument that provides for a contingent interest payment determined by reference to a U.S. source dividend payment that would otherwise be a section 871(m) transaction is a transaction that has the potential for tax avoidance, and it is appropriate for section 871(m) to apply. The effect of this rule, however, is expected to be minimal because the delta of the embedded derivative in a contingent debt or convertible debt instrument is tested only at the time it is issued.

Numerous comments requested that convertible debt instruments be excluded from the definition of an ELI. Comments suggested that certain characteristics typical of convertible debt would discourage foreign investors from using these instruments to avoid U.S. withholding tax. Comments pointed, for example, to high transaction costs and certain discontinuities between the economic performance of the convertible debt and that of the underlying stock, such as the downside protection and creditors’ rights afforded by convertible debt. Comments noted that convertible bonds are important capital markets instruments used by U.S. corporations to raise capital at lower rates. Comments also speculated that treating such bonds as specified ELIs could adversely impact capital markets by decreasing demand, reducing liquidity, and increasing costs.

The final regulations do not provide an exception from section 871(m) for convertible debt. When the stock price significantly exceeds the conversion price, convertible debt becomes a surrogate for the stock into which the debt can be converted. Accordingly, a convertible debt obligation is a specified ELI if the delta of the embedded option at the time the convertible debt is originally issued is 0.80 or higher. Moreover, the fact that convertible debt ordinarily has been issued with a delta on the embedded option of less than 0.80 is expected to significantly reduce the effect of these regulations on the convertible debt market. In response to uncertainty expressed by some market participants, the final regulations clarify that the delta of the convertible feature is tested separately from the delta of the debt instrument in making section 871(m) calculations.

Section 1.1441–2(d)(5) of the 2013 proposed regulations provides that a withholding agent is not obligated to withhold on a dividend equivalent until the later of: (1) when the amount of the dividend equivalent is determined and (2) when any of the following occurs: (a) money or other property is paid pursuant to a section 871(m) transaction, (b) the withholding agent has custody or control of money or other property, or (c) there is an upfront payment or a prepayment of the purchase price.

Comments emphasized the burden of withholding on dividend equivalents absent actual payments, and noted that, in the absence of actual payment, continuous monitoring and withholding on each specified ELI over time is impractical. Certain comments suggested that a foreign broker only be required to withhold on dividend equivalents from ELIs when there is a final payment or a sale.

Comments also maintained that upfront payments should not be viewed as payments subject to withholding because such proceeds are received in exchange for issuing the instrument, are used by the issuer to purchase related hedging positions, and are not intended to be reserves for satisfying tax owed by the counterparty.

Some comments expressed concern regarding the practical difficulties in withholding from funds that the broker-dealer holds as collateral. Comments noted that the broker-dealer may not be legally entitled to use cash or property in one account to satisfy a withholding obligation in another account. In addition, foreign counterparties may hold different accounts through different affiliates of a broker-dealer. Comments indicated that it would be impractical to determine the existence of affiliate accounts and apply set-off rules on that basis.

After consideration of these comments, the Treasury Department and the IRS have concluded that the withholding agent’s obligations should not arise until an actual payment is made or there is a final settlement of a transaction. Accordingly, the final regulations provide that a withholding agent is not obligated to withhold on a dividend equivalent until the later of when a payment is made with respect to a section 871(m) transaction or when the amount of a dividend equivalent is determined. A payment with respect to a section 871(m) transaction will generally occur when the long party receives or makes a payment, when there is a final settlement of the section 871(m) transaction, or when the long party sells or otherwise disposes of the section 871(m) transaction. For options and other contracts that typically require an upfront payment, the final regulations do not treat the premium or other upfront payment as a payment for withholding purposes. Thus, withholding on these section 871(m) transactions is not required until there is a final settlement (including, in the case of an option, a lapse) or the long party sells or otherwise disposes of the transaction. Consequently, if an option that is a section 871(m) transaction lapses, the short party is nonetheless required to withhold on any dividend equivalent associated with the option. Parties may need to modify contractual arrangements to ensure that there are sufficient funds available to satisfy withholding obligations.

As noted in Part II of this preamble, many commenters stated that the delta test was workable for most equity derivatives but would be difficult or impossible to apply to more exotic equity derivatives. In particular, a contract that provides for payments based on a number of shares of stock that varies at different points, or that provides for a payment that does not vary with the price of the shares (often called “digital” options), have an indeterminate delta because the number of shares of the underlying security that determine the payout of the derivative cannot be known at the time the contract is entered into. Path-dependent contracts were also mentioned as problematic for the delta computation.

Indeterminate delta may, for example, occur in contracts commonly known as structured notes. Structured notes are financial instruments that combine aspects of debt with aspects of derivatives, such as equity options. As an example, in return for an upfront payment of a set amount, a structured note might provide the long party with leveraged upside return, meaning that the long party is entitled to receive a fixed percentage (for example, 200 percent) of any appreciation in the value of a referenced stock up to a capped amount (for example, 125 percent of the issue price) in addition to return of the upfront payment, while being exposed to 100 percent of any depreciation in the value of the referenced stock, with any such depreciation reducing the amount of the upfront payment that is returned to the long party. In such a structured note, the holder would have two times the “upside” up to the cap but only one times exposure to the “downside.” The issuer of this kind of structured note cannot readily determine a delta for the note because it references a different number of shares at different payoff amounts. In other words, because delta is the ratio of the change in the fair market value of a contract to a small change in the fair market value of the property referenced by the contract, the value of the referenced property must be known to calculate delta. In the case of the structured note described in this paragraph, the number of shares of stock (and hence the value of the property) referenced by the contract will be different depending on whether the stock appreciates, and in such case whether the cap is reached, or whether the stock depreciates.

As explained in Part II.C.4 of this preamble, a contract with an indeterminate delta is not a simple contract, and therefore falls into the residual category as a complex contract. Because the delta test cannot accurately be applied to a complex contract, commenters had various suggestions for how to determine whether such a contract should be a section 871(m) transaction. One comment suggested that the delta should be calculated using the highest possible number of shares that could be referenced by the derivative at maturity. This comment further suggested that the regulations include a delta-specific anti-abuse rule to prevent issuers from manipulating the number of referenced shares to artificially reduce delta. Other comments suggested that the regulations should disaggregate a transaction into a series of components and then separately apply the delta test to each component. When multiple derivatives are embedded in a single instrument, a comment recommended that multiple pieces be aggregated into separate components (for example, aggregating all embedded calls and separately aggregating all embedded puts) using an ordering rule that would maximize the likelihood that the delta threshold would be met.

A majority of comments requested that some version of a “proportionality” test be applied to complex contracts or to contracts where the basic delta test is susceptible of manipulation. A proportionality test measures the likelihood that a contract’s performance will track the performance of the referenced equity. That is, a proportionality test measures the same variability or economic equivalence that the delta test seeks to measure without needing to know the number of shares that the contract references at the outset. Like the delta test, a proportionality test is based on the principle that when the value of an NPC or ELI closely tracks the value of an underlying security, it is appropriate to treat the NPC or ELI as a surrogate for the underlying security.

To test whether a complex contract is a section 871(m) transaction, the temporary regulations adopt the “substantial equivalence” test. The substantial equivalence test is a version of a proportionality test that was advocated by many commenters, and it uses information easily accessible to most issuers of complex contracts. Generally, the substantial equivalence test measures the change in value of a complex contract when the price of the underlying security referenced by that contract is hypothetically increased by one standard deviation or decreased by one standard deviation (each, a “testing price”) and compares that change to the change in value of the shares of the underlying security that would be held to hedge the complex contract at the time the contract is issued (the “initial hedge”) at each testing price. The smaller the proportionate difference between the change in value of the complex contract and the change in value of its initial hedge at multiple testing prices, the more equivalence there is between the contract and the referenced underlying security. When this difference is equal to or less than the difference for a simple contract benchmark with a delta of 0.80 and its initial hedge, the complex contract is treated as substantially equivalent to the underlying security.

The Treasury Department and the IRS are aware that there may be NPCs or ELIs that even the substantial equivalence test may not adequately address. The temporary regulations provide that when the steps of the substantial equivalence test cannot be applied to a particular complex contract, a taxpayer must use the principles of the substantial equivalence test to reasonably determine whether the complex contract is a section 871(m) transaction with respect to each underlying security.

The Treasury Department and the IRS request comments regarding the substantial equivalence test described in the temporary regulations. In particular, comments are requested on whether the two testing points required for most transactions in the temporary regulations are adequate to ensure that the substantial equivalence test captures the appropriate types of transactions, and the administrability of the test and its application to complex contracts that reference multiple securities, including path-dependent instruments.

Section 871(m)(1) generally treats a dividend equivalent as a dividend from sources within the United States without regard to the residence of the person paying the dividend equivalent. As a result, section 871(m) may apply to payments made by a foreign payor to a foreign payee. See Staff of J. Comm. on Taxation, Technical Explanation of the Revenue Provisions Contained in Senate Amendment 3310, the “Hiring Incentives to Restore Employment Act,” JCX–4–10, at 79 (Feb. 23, 2010) (explaining that section 871(m) may apply to a chain of dividend equivalents, including payments made by a foreign person pursuant to transactions described in Notice 97–66); see also Notice 97–66, 1997–2 C.B. 328, at § 5, Examples 3 and 4 (illustrating that a foreign person making a substitute dividend payment to another foreign person must withhold U.S. tax). Because Congress was concerned that this rule may result in over-withholding in some instances, Congress granted the Secretary authority in section 871(m)(6) to reduce tax on a chain of dividend equivalents, but only to the extent that the taxpayer can establish that tax has been paid with respect to another dividend equivalent in the chain, or is not otherwise due, or as the Secretary determines is appropriate to address the role of financial intermediaries in such chain. For purposes of section 871(m)(6), a dividend is treated as a dividend equivalent.

The 2013 proposed regulations address the role of financial intermediaries in a chain of dividend equivalents with a rule that provides that payments made to a “qualified dealer” are not treated as dividend equivalents if made pursuant to a transaction that is entered into by the qualified dealer in its capacity as a dealer in securities and the dealer is the long party. For purposes of this rule, a qualified dealer is any dealer that is subject to regulatory supervision by a governmental authority in the jurisdiction in which it was created or organized and that certifies to the short party that it is receiving the payment in its capacity as a dealer. The 2013 proposed regulations require the qualified dealer to certify as to its dealer status to a short party on a transaction-by-transaction basis, and do not apply to dividends paid to a qualified dealer.

Comments requested that the qualified dealer exception in the 2013 proposed regulations be expanded, noting that it would be impractical for dealers to certify that each transaction was entered into in a dealer capacity (and not as a proprietary trade) and that the rule did not accommodate transactions entered into as a hedge of another transaction. Some comments suggested that the regulations exclude transactions entered into in the ordinary course of the dealer’s business for hedging purposes. Other comments recommended expanding the exception to include affiliates of qualified dealers that issue certain potential section 871(m) transactions. Comments further recommended that an affiliate in these circumstances should not be required to certify that it is acting in its capacity as a dealer. Several comments requested that, in addition to expanding the definition of qualified dealer, the final regulations provide rules similar to the proposed regulatory framework described in Notice 2010–46 (discussed in more detail in section III.B.4 of this preamble).

The comments received on both the 2012 proposed regulations and the 2013 proposed regulations consistently expressed the desire for a comprehensive withholding and documentation regime tailored to derivatives dealers. Rather than create a new regime for section 871(m) transactions, the Treasury Department and the IRS determined that the most comprehensive and efficient way to respond to the requests in the comments is to expand the existing qualified intermediary (QI) regime to accommodate taxpayers acting as financial intermediaries on section 871(m) transactions. Generally, a QI is an eligible person that enters into a QI agreement with the IRS and that acts as a QI under such agreement. See Rev. Proc. 2014–39, 2014–29 I.R.B. 150. A QI agreement typically requires the QI to assume certain documentation and withholding responsibilities in exchange for simplified information reporting for its foreign account holders and the ability to not disclose proprietary account holder information to a withholding agent that may be a competitor. A QI may either assume primary withholding responsibilities or may provide withholding information to a withholding agent from which it receives a payment.

QIs that hold stocks and bonds for customers often receive payments subject to withholding on behalf of their foreign account holders as custodians rather than as beneficial owners. In contrast, a broker that enters into derivative contracts as a principal typically receives dividends and dividend equivalents as part of a chain of transactions in which the broker is a counterparty to both long and short positions.

The Treasury Department and the IRS intend to implement the particular requirements of withholding and reporting on dividend equivalents received and paid by brokers by amending the QI agreement to include new provisions that will permit an eligible QI to act as a qualified derivatives dealer (QDD). A QI that acts as a QDD will not be subject to withholding on dividends or payments that may be dividend equivalents made with respect to potential section 871(m) transactions that the QDD receives while acting in its capacity as a dealer.

In order to act as a QDD, a QI must meet four requirements. First, the QDD must furnish to withholding agents a QI withholding certificate affirming that the recipient is acting as a QDD for dividends and dividend equivalent payments associated with the withholding certificate. Second, the QDD must agree to assume primary withholding and reporting responsibilities on all payments associated with the withholding certificate that the QDD receives and makes as a dealer, and to determine whether payments it makes are dividend equivalents. Third, a QDD must agree to remain liable for tax on any dividends and dividend equivalents it receives unless the QDD is obligated to make an offsetting dividend equivalent payment as the short party on the same underlying security. Finally, a QDD must comply with any compliance review procedures that are applicable to a QI acting as a QDD, as specified in the QI agreement.

The class of persons eligible to act as a QDD is narrower than the class of persons that are eligible to enter into a QI agreement. A QI will be allowed to act as a QDD if it is either (1) a securities dealer that is regulated as a dealer in the jurisdiction in which it was organized or operates, or (2) a bank that is regulated as a bank in the jurisdiction in which it was organized or operates (or a wholly-owned foreign affiliate of such a bank). To act as a QDD, a QI that is not a securities dealer also must issue potential section 871(m) transactions to customers and receive dividends or dividend equivalent payments incident to hedges of potential section 871(m) transactions that it issues. The latter category of QDDs is intended to allow banks and bank affiliates that issue equity-linked instruments on an occasional basis to still act as QDDs.

Shortly after section 871(m) was enacted, the Treasury Department and the IRS published Notice 2010–46, 2010–24 I.R.B. 757. Notice 2010–46 addresses potential overwithholding in the context of securities lending and sale repurchase agreements. Notice 2010–46 provides a two-part solution to the problem of overwithholding on a chain of dividends and dividend equivalents. First, it provides an exception from withholding for payments to a qualified securities lender (QSL). Second, it provides a proposed framework to credit forward prior withholding on a chain of substitute dividends paid pursuant to a chain of securities loans or stock repurchase agreements. The QSL regime requires a person that agrees to act as a QSL to comply with certain withholding and documentation requirements. Notice 2010–46 and any QI agreement imposing QSL requirements will remain effective until final regulations implementing the QDD rules are published.

As stated above, Notice 2010–46 provided a proposed framework to credit forward prior withholding on a chain of substitute dividends paid pursuant to a chain of securities loans or stock repurchase agreements. The Treasury Department and the IRS will continue to consider whether a credit forward system for prior withholding would be appropriate in the context of a chain of dividend equivalents on NPCs or ELIs. While administrating the credit forward system described in Notice 2010–46, however, the IRS has had difficulty verifying that prior withholding in a chain of securities loans had in fact occurred in order to justify the crediting of prior withholding to a subsequent payment. The temporary regulations, therefore, reserve on the issue of a general credit forward system, and the Treasury Department and the IRS request comments on the need for such a system and how it could be implemented.

All existing QI agreements expire on December 31, 2016. Prior to January 1, 2017, the Treasury Department and the IRS intend to publish an updated QI agreement and rules addressing the requirements for QDD status. Procedures for entering into a QI agreement that permits a QI to act as a QDD are expected to be set out in this agreement. QDD status will be effective no sooner than January 1, 2017. Until these temporary regulations are finalized and appropriate provisions are incorporated into a new QI agreement, the provisions for QSLs and the credit-forward rules under Notice 2010–46 will continue to apply for dividend equivalents that are substitute dividend payments made pursuant to a securities lending or a sale-repurchase transaction.

Once fully implemented, the new QDD status under the QI regime will replace and expand the QSL regime described in Notice 2010–46. To continue to be eligible for the exception from withholding, entities that have been treated as QSLs will be required to enter into a QI agreement to satisfy and comply with the requirements for QDD treatment provided in the temporary regulations and in the updated QI Agreement. When these temporary regulations are finalized, the Treasury Department and the IRS expect the final regulations to supplant the proposed regulatory framework described in Notice 2010–46.

The 2013 proposed regulations do not specifically address whether payments made on life insurance or annuity contracts are dividend equivalents when the payments are directly or indirectly contingent upon or determined by reference to the payment of a dividend from sources within the United States. Comments noted that treating annuity contract payments as dividend equivalents could conflict with section 72, which provides that the holder of an annuity contract is taxed only when an amount is received from the annuity. Comments further noted that when a foreign person receives payments or withdrawals from an annuity contract issued by a domestic insurance company, the payment is FDAP subject to 30% withholding to the extent such payment or withdrawal constitutes gross income as determined in accordance with section 72. Similarly, withdrawals of income from a life insurance contract issued by a domestic insurance company are generally U.S. source FDAP subject to withholding. Commenters argued that the existing rules that apply to life insurance and annuity contracts obviate the need for withholding under section 871(m).

The Treasury Department and the IRS agree that the taxation of life insurance and annuity contracts issued by domestic insurance companies is adequately addressed under current law. Therefore, the temporary regulations provide that there is no dividend equivalent associated with a payment that a foreign person receives pursuant to the terms of an annuity, endowment, or life insurance contract issued by a domestic insurance company (including the foreign or U.S. possession branch of the domestic insurance company).

The Treasury Department and the IRS are considering how section 871(m) should apply to annuity, endowment, and life insurance contracts that reference U.S. equities and that are issued by foreign life insurance companies. Until further guidance is issued, the temporary regulations provide that these contracts do not include a dividend equivalent when issued by a foreign corporation that is predominately engaged in an insurance business and that would be subject to tax under subchapter L if it were a domestic corporation. Similarly, the temporary regulations do not treat any portion of a payment received by a foreign life insurance company as a dividend equivalent when the payment is made according to the terms of an insurance contract, such as reinsurance, by a foreign corporation meeting the same requirements. The Treasury Department and the IRS are also evaluating how section 871(m) should apply to reinsurance contracts. Taxpayers are encouraged to send comments on how section 871(m) should apply to foreign life insurance companies and the contracts they issue.

The final and temporary regulations are generally effective on September 18, 2015. To ensure that brokers have adequate time to develop the systems needed to implement the regulations, however, the final and temporary regulations generally apply to transactions issued on or after January 1, 2017. In addition, with respect to transactions issued on or after January 1, 2016, and before January 1, 2017, that are section 871(m) transactions, the regulations also apply to any payment of a dividend equivalent made on or after January 1, 2018. The regulations do not change the applicability date of § 1.871–15(d)(1)(i) for specified NPCs described in that section.

The chapter 4 regulations provide a coordinating effective date for the treatment of dividend equivalents as withholdable payments for purposes of chapter 4 withholding. Section 1.1471–2(b)(2)(i)(A)(2) provides that grandfathered obligations under chapter 4 include any obligation that gives rise to a withholdable payment solely because the obligation gives rise to a dividend equivalent pursuant to section 871(m) and the regulations thereunder. This grandfather rule applies only to obligations that are executed on or before the date that is six months after the date on which obligations of its type are first treated as giving rise to dividend equivalents.

* * * * *

(h) Portfolio interest not to include certain contingent interest—(1) Dividend equivalents. Contingent interest does not qualify as portfolio interest to the extent that the interest is a dividend equivalent within the meaning of section 871(m).

(2) Amount of dividend equivalent that is not portfolio interest. The amount that does not qualify as portfolio interest because it is a dividend equivalent equals the amount of the dividend equivalent determined pursuant to § 1.871–15(j). Unless otherwise excluded pursuant to section 871(h), any other interest paid on an obligation that is not a dividend equivalent may qualify as portfolio interest.

* * * * *

(j) * * *

(4) Effective/applicability date. The rules of paragraph (h) of this section apply beginning September 18, 2015.

Par. 3. Section 1.871–15 is amended by:

1. Redesignating paragraphs (d)(1)(i) as (d)(1)(i)(A), (d)(1) introductory text as (d)(1)(i), (d)(1)(ii) as (d)(1)(i)(B), (d)(1)(iii) as (d)(1)(i)(C), and (d)(1)(iv) as (d)(1)(i)(D).

2. Removing “2016” from newly redesignated paragraph (d)(1)(i) and adding “2017” in its place.

3. Removing “Specified NPCs before January 1, 2016” from newly redesignated paragraph (d)(1)(i) and adding “In general” in its place.

4. Adding new paragraphs (d)(1) introductory text, (d)(1)(ii) and (d)(2).

5. Redesignating paragraph (o) as paragraph (r)(2) and:

a. Revising the heading for newly redesignated paragraph (r)(2),

b. Removing the language “This” in paragraph (r)(2) and adding “Paragraph (d)(1)(i) of this” in its place, and

c. Adding new paragraphs (r)(1), (r)(3), (r)(4), and (q).

7. Adding new paragraphs (a) through (c), and (e) through (p).

The additions and revisions read as follows:

(a) Definitions. For purposes of this section, the following terms have the meanings described in this paragraph (a).

(1) Broker. A broker is a broker within the meaning provided in section 6045(c).

(2) Dealer. A dealer is a dealer in securities within the meaning of section 475(c)(1).

(3) Dividend. A dividend is a dividend as described in section 316.

(4) Equity-linked instrument. An equity-linked instrument (ELI) is a financial transaction, other than a securities lending or sale-repurchase transaction or an NPC, that references the value of one or more underlying securities. For example, a futures contract, forward contract, option, debt instrument, or other contractual arrangement that references the value of one or more underlying securities is an ELI.

(5) Initial hedge. An initial hedge is the number of underlying security shares that a short party would need to fully hedge an NPC or ELI (whether the NPC or ELI is a complex contract or a simple contract benchmark (within the meaning of paragraph (h)(2) of this section), as appropriate) with respect to an underlying security at the time the NPC or ELI is issued, even if the short party does not in fact fully hedge the NPC or ELI.

(6) Issue. An NPC or ELI is treated as issued at inception, original issuance, or at the time of an issuance as a result of a deemed exchange pursuant to section 1001.

(7) Notional principal contract. A notional principal contract (NPC) is a notional principal contract as defined in § 1.446–3(c).

(8) Option. An option includes an option embedded in any debt instrument, forward contract, NPC, or other potential section 871(m) transaction.

(9) Parties to the transaction—(i) Long party. A long party is the party to a potential section 871(m) transaction with respect to an underlying security that would be entitled to receive a payment of a dividend equivalent (within the meaning of paragraph (i) of this section) described in paragraph (c) of this section.

(ii) Short party. A short party is the party to a potential section 871(m) transaction with respect to an underlying security that would be obligated to make a payment of a dividend equivalent (within the meaning of paragraph (i) of this section) described in paragraph (c) of this section.

(iii) Party to the transaction. A party to the transaction is any person that is a long party or a short party to a potential section 871(m) transaction, any agent acting on behalf of the long party or short party, or any person acting as an intermediary with respect to the potential section 871(m) transaction.

(iv) Party to the transaction that is both a long party and a short party—(A) In general. If a potential section 871(m) transaction references more than one underlying security, the long party and short party are determined separately with respect to each underlying security. A party to a potential section 871(m) transaction is both a long party and a short party when the party is entitled to a payment that references a dividend payment on an underlying security and the same party is obligated to make a payment that references a dividend payment on another underlying security pursuant to the potential section 871(m) transaction.

(B) Example. The following example illustrates the definitions in paragraph (a)(9) of this section:

Example. (i) Stock X and Stock Y are underlying securities. A and B enter into an NPC that entitles A to receive payments from B based on any appreciation in the value of Stock X and dividends paid on Stock X during the term of the contract and obligates A to make payments to B based on any depreciation in the value of Stock X during the term of the contract. In return, the NPC entitles B to receive payments from A based on any appreciation in the value of Stock Y and dividends paid on Stock Y during the term of the contract and obligates B to make payments to A based on any depreciation in the value of Stock Y during the term of the contract.

(ii) A is the long party with respect to Stock X, and the short party with respect to Stock Y. B is the long party with respect to Stock Y, and the short party with respect to Stock X.

(10) Payment. A payment has the meaning provided in paragraph (i) of this section.

(11) Reference. To reference means to be contingent upon or determined by reference to, directly or indirectly, whether in whole or in part.

(12) Section 871(m) transaction and potential section 871(m) transaction. A section 871(m) transaction is any securities lending or sale-repurchase transaction, specified NPC, or specified ELI. A potential section 871(m) transaction is any securities lending or sale-repurchase transaction, NPC, or ELI that references one or more underlying securities.

(13) Securities lending or sale-repurchase transaction. A securities lending or sale-repurchase transaction is any securities lending transaction, sale-repurchase transaction, or substantially similar transaction that references an underlying security. Securities lending transaction and sale-repurchase transaction have the same meaning as provided in § 1.861–3(a)(6).

(14) Simple contracts and complex contracts—(i) Simple contract. A simple contract is an NPC or ELI for which, with respect to each underlying security,

(A) All amounts to be paid or received on maturity, exercise, or any other payment determination date are calculated by reference to a single, fixed number of shares (as determined in paragraph (j)(3) of this section) of the underlying security, provided that the number of shares can be ascertained when the contract is issued, and

(B) The contract has a single maturity or exercise date with respect to which all amounts (other than any upfront payment or any periodic payments) are required to be calculated with respect to the underlying security. A contract has a single exercise date even though it may be exercised by the holder at any time on or before the stated expiration of the contract. An NPC or ELI that includes a term that discontinuously increases or decreases the amount paid or received (such as a digital option), or that accelerates or extends the maturity is not a simple contract. A simple contract that is an NPC is a simple NPC. A simple contract that is an ELI is a simple ELI.

(ii) Complex contract—(A) In general. A complex contract is any NPC or ELI that is not a simple contract. A complex contract that is an NPC is a complex NPC. A complex contract that is an ELI is a complex ELI.

(B) Example. An ELI entitles the long party to a return equal to 200 percent of the appreciation on 100 shares of Stock X, and obligates the long party to pay an amount equal to the actual depreciation on 100 shares of Stock X. Because the ELI does not provide the long party with an amount that is calculated by reference to a single, fixed number of shares of Stock X on the maturity date that can be ascertained at issuance, it is not a simple ELI. More specifically, upon maturity the ELI will either entitle the long party to receive a payment that is, in substance, measured by reference to 200 shares of stock or obligate the long party to make a payment measured by reference to 100 shares of stock. The ELI is a complex ELI because it is not a simple ELI.

(15) Underlying security. An underlying security is any interest in an entity if a payment with respect to that interest could give rise to a U.S. source dividend pursuant to § 1.861–3, where applicable taking into account paragraph (m) of this section. Except as provided in paragraph (l) of this section, if a potential section 871(m) transaction references an interest in more than one entity described in the preceding sentence or different interests in the same entity, each referenced interest is a separate underlying security for purposes of applying the rules of this section.

(b) Source of a dividend equivalent. A dividend equivalent is treated as a dividend from sources within the United States for purposes of sections 871(a), 881, 892, 894, and 4948(a), and chapters 3 and 4 of subtitle A of the Internal Revenue Code.

(c) Dividend equivalent—(1) In general. Except as provided in paragraph (2), dividend equivalent means—

(i) Any payment that references the payment of a dividend from an underlying security pursuant to a securities lending or sale-repurchase transaction;

(ii) Any payment that references the payment of a dividend from an underlying security pursuant to a specified NPC described in paragraph (d) of this section;

(iii) Any payment that references the payment of a dividend from an underlying security pursuant to a specified ELI described in paragraph (e) of this section; and

(iv) Any other substantially similar payment as described in paragraph (f) of this section.

(2) Exceptions—(i) Not a dividend. A payment that references a distribution with respect to an underlying security is not a dividend equivalent to the extent that the distribution would not be subject to tax pursuant to section 871 or section 881 if the long party owned the underlying security. For example, if an NPC references stock in a regulated investment company that pays a dividend that includes a capital gains dividend described in section 852(b)(3)(C) that would not be subject to tax under section 871 or section 881 if paid directly to the long party, then an NPC payment is not a dividend equivalent to the extent that it is determined by reference to the capital gains dividend.

(ii) Section 305 coordination. A dividend equivalent with respect to a section 871(m) transaction is reduced by any amount treated in accordance with section 305(b) and (c) as a dividend with respect to the underlying security referenced by the section 871(m) transaction.

(iii) Due bills. A dividend equivalent does not include a payment made pursuant to a due bill arising from the actions of a securities exchange that apply to all transactions in the stock with respect to the dividend. For purposes of this section, a stock will be considered to trade with a due bill only when the relevant securities exchange has set an ex-dividend date with respect to a dividend that occurs after the record date.

(iv) Certain payments pursuant to annuity, endowment, and life insurance contracts. [Reserved]. For further guidance, see § 1.871–15T(c)(2)(iv).

(v) Certain payments pursuant to employee compensation arrangements. A dividend equivalent does not include the portion of equity-based compensation for personal services of a nonresident alien individual that is—

(A) Wages subject to withholding under section 3402 and the regulations under that section;

(B) Excluded from the definition of wages under § 31.3401(a)(6)–1; or

(C) Exempt from withholding under § 1.1441–4(b).

(d) Specified NPCs—(1) Specified NPCs entered into before January 1, 2017—(i) * * *

(ii) Specified NPC status as of January 1, 2017. An NPC that is treated as a specified NPC pursuant to paragraph (d)(1)(i) of this section will remain a specified NPC on or after January 1, 2017.

(2) Specified NPCs on or after January 1, 2017—(i) Simple NPCs. A simple NPC that has a delta of 0.8 or greater with respect to an underlying security when the NPC is issued is a specified NPC.

(ii) Complex NPCs. A complex NPC that meets the substantial equivalence test described in paragraph (h) of this section with respect to an underlying security when the NPC is issued is a specified NPC.

(e) Specified ELIs—(1) Simple ELIs. A simple ELI that has a delta of 0.8 or greater with respect to an underlying security when the ELI is issued is a specified ELI.

(2) Complex ELIs. A complex ELI that meets the substantial equivalence test described in paragraph (h) of this section with respect to an underlying security when the ELI is issued is a specified ELI.

(f) Other substantially similar payments. For purposes of this section, any payment made in satisfaction of a tax liability of the long party with respect to a dividend equivalent by a withholding agent is a dividend equivalent received by the long party. The amount of that dividend equivalent constitutes additional income to the payee to the extent provided in § 1.1441–3(f)(1).

(g) Delta—(1) In general. Delta is the ratio of the change in the fair market value of an NPC or ELI to a small change in the fair market value of the number of shares of the underlying security (as determined under paragraph (j)(3) of this section) referenced by the NPC or ELI. If an NPC or ELI contains more than one reference to a single underlying security, all references to that underlying security are taken into account in determining the delta with respect to that underlying security. If an NPC or ELI references more than one underlying security or other property, the delta with respect to each underlying security must be determined without taking into account any other underlying security or property. The delta of an equity derivative that is embedded in a debt instrument or other derivative is determined without taking into account changes in the market value of the debt instrument or other derivative that are not directly related to the equity element of the instrument. Thus, for example, the delta of an option embedded in a convertible note is determined without regard to the debt component of the convertible note. For purposes of this section, delta must be determined in a commercially reasonable manner. If a taxpayer calculates delta for non-tax business purposes, that delta ordinarily is the delta used for purposes of this section.

(2) Time for determining delta. For purposes of applying the rules of this section, the delta of a potential section 871(m) transaction is determined only when the potential section 871(m) transaction is issued (as defined in paragraph (a)(6) of this section).

(3) Simplified delta calculation for certain simple contracts that reference multiple underlying securities. If an NPC or ELI references 10 or more underlying securities and the short party uses an exchange-traded security (for example, an exchange-traded fund) that references substantially all of the underlying securities (the hedge security) to hedge the NPC or ELI at the time it is issued, the delta of the NPC or ELI may be calculated by determining the ratio of the change in the fair market value of the simple contract to a small change in the fair market value of the hedge security. A delta determined under this paragraph (g)(3) must be used as the delta for each underlying security for purposes of calculating the amount of a dividend equivalent as provided in paragraph (j)(1)(ii) of this section.

(4) Examples. The following examples illustrate the rules of this paragraph (g). For purposes of these examples, Stock X and Stock Y are common stock of domestic corporations X and Y. LP is the long party to the transaction.

Example 1. Delta calculation for an NPC. The terms of an NPC require LP to pay the short party an amount equal to all of the depreciation in the value of 100 shares of Stock X and an interest-rate based return. In return, the NPC requires the short party to pay LP an amount equal to all of the appreciation in the value of 100 shares of Stock X and any dividends paid by X on those shares. The value of the NPC will change by $1 for each $0.01 change in the price of a share of Stock X. When LP entered into the NPC, Stock X had a fair market value of $50 per share. The NPC therefore has a delta of 1.0 ($1.00 / ($0.01 x 100)).

Example 2. Delta calculation for an option. LP purchases a call option that references 100 shares of Stock Y. At the time LP purchases the call option, the value of the option is expected to change by $0.30 for a $0.01 change in the price of a share of Stock Y. When LP purchases the option, Stock Y has a fair market value of $100 per share. The call option has a delta of 0.3 ($0.30 / ($0.01 x 100)).

(h) Substantial Equivalence. [Reserved]. For further guidance, see § 1.871–15T(h).

(i) Payment of a dividend equivalent—(1) Payments determined on gross basis. For purposes of this section, a payment includes any gross amount that references the payment of a dividend and that is used in computing any net amount transferred to or from the long party even if the long party makes a net payment to the short party or no amount is paid because the net amount is zero.

(2) Actual and estimated dividends—(i) In general. A payment includes any amount that references an actual or estimated payment of dividends, whether the reference is explicit or implicit. If a potential section 871(m) transaction provides for a payment based on an estimated dividend that adjusts to account for the amount of an actual dividend paid, the payment is treated as referencing the actual dividend amount and not an estimated dividend amount.

(ii) Implicit dividends. A payment includes an actual or estimated dividend payment that is implicitly taken into account in computing one or more of the terms of a potential section 871(m) transaction, including interest rate, notional amount, purchase price, premium, upfront payment, strike price, or any other amount paid or received pursuant to the potential section 871(m) transaction.

(iii) Actual dividend presumption. A short party to a section 871(m) transaction is treated as paying a per-share dividend amount equal to the actual dividend amount unless the short party to the section 871(m) transaction identifies a reasonable estimated dividend amount in writing at the time the transaction is issued. For this purpose, a reasonable estimated dividend amount stated in an offering document or the documents governing the terms at the time the transaction is issued will establish the estimated dividend amount. To qualify as an estimated dividend amount, the written estimated dividend amount must separately state the amount estimated for each anticipated dividend or state a formula that allows each dividend to be determined. If an underlying security is not expected to pay a dividend, a reasonable estimate of the dividend amount may be zero.

(iv) Additions to estimated payments. If a section 871(m) transaction provides for any payment in addition to an estimated dividend and that additional payment is determined by reference to a dividend (for example, a special dividend), both the estimated dividend and the additional payment are used to determine the per-share dividend amount.

(3) Dividends for certain baskets—(i) In general. If a section 871(m) transaction references long positions in more than 25 underlying securities, the short party may treat the dividends with respect to the referenced underlying securities as paid at the end of the applicable calendar quarter to compute the per-share dividend amount.

(ii) Publicly available dividend yield. For purposes of paragraph (i)(3)(i) of this section, if a section 871(m) transaction references the same underlying securities as a security (for example, stock in an exchange-traded fund) or index for which there is a publicly available quarterly dividend yield, the publicly available dividend yield may be used to determine the per-share dividend amount for the section 871(m) transaction with any adjustment for special dividends.

(iii) Dividend yield for a section 871(m) transaction using the simplified delta calculation. When the delta of a section 871(m) transaction is determined under paragraph (g)(3) of this section, the per-share dividend amount for that section 871(m) transaction must be determined using the dividend yield for the exchange-traded security that fully hedges the section 871(m) transaction.

(4) Examples. The following examples illustrate the rules of this paragraph (i). For purposes of these examples, Stock X is common stock of Corporation X, a domestic corporation, that historically pays quarterly dividends on Stock X. The parties anticipate that Corporation X will continue to pay quarterly dividends.

Example 1. Forward contract to purchase domestic stock. (i) When Stock X is trading at $50 per share, Foreign Investor enters into a forward contract to purchase 100 shares of Stock X in one year. Reasonable estimates of the quarterly dividend are specified in the transaction documents. The price in the forward contract is determined by multiplying the number of shares referenced in the contract by the current price of the shares and an interest rate, and subtracting the value of any dividends expected to be paid during the term of the contract. Assuming that the forward contract is priced using an interest rate of 4 percent and total estimated dividends with a future value of $1 per share during the term of the forward contract, the purchase price set in the forward contract is $5,100 (100 shares x $50 per share x 1.04 – ($1 x 100)).

(ii) Subject to paragraph (i)(2)(iv) of this section, the estimate dividend amounts are the per share dividend amounts because the estimate is reasonable and specified in accordance with paragraph (i)(2)(iii) of this section. The estimate dividend amounts are dividend equivalents for purposes of this section.

Example 2. Price return only swap contract. (i) Foreign Investor enters into a price return swap contract that entitles Foreign Investor to receive payments based on the appreciation in the value of 100 shares of Stock X and requires Foreign Investor to pay an amount based on LIBOR plus any depreciation in the value of Stock X. The swap contract neither explicitly entitles Foreign Investor to payments based on dividends paid on Stock X during the term of the contract nor references an estimated dividend amount. The LIBOR rate in the swap contract, however, is reduced to reflect expected annual dividends on Stock X.

(ii) Because the LIBOR leg of the swap contract is reduced to reflect estimated dividends and the estimated dividend amounts are not specified, Foreign Investor is treated as receiving the actual dividend amounts in accordance with paragraph (i)(2) of this section. The actual per-share dividend amounts are dividend equivalents for purposes of this section.

(j) Amount of dividend equivalent—(1) Calculation of the amount of a dividend equivalent—(i) Securities lending or sale-repurchase transactions. For a securities lending or sale-repurchase transaction, the amount of the dividend equivalent for each underlying security equals the amount of the actual per-share dividend paid on the underlying security multiplied by the number of shares of the underlying security.

(ii) Simple contracts. For a simple contract that is a section 871(m) transaction, the amount of the dividend equivalent for each underlying security equals:

(A) The per-share dividend amount (as determined under either paragraph (i)(2) or (i)(3) of this section) with respect to the underlying security multiplied by;

(B) The number of shares of the underlying security multiplied by;

(C) The delta of the section 871(m) transaction with respect to the underlying security.

(iii) Complex contracts. For a complex contract that is a section 871(m) transaction, the amount of the dividend equivalent for each underlying security equals:

(A) The per-share dividend amount (as determined under paragraph (i)(2) or (i)(3) of this section) with respect to the underlying security multiplied by;

(B) The initial hedge for the underlying security.

(iv) Other substantially similar payments. In addition to any amount determined pursuant to paragraph (j)(1)(i), (ii), or (iii), the amount of a dividend equivalent includes the amount of any payment described in paragraph (f) of this section.

(2) Time for determining the amount of a dividend equivalent. The amount of a dividend equivalent is determined on the earlier of the date that is the record date of the dividend and the day prior to the ex-dividend date with respect to the dividend. For example, if a specified NPC provides for a payment at settlement that takes into account an earlier dividend payment, the amount of the dividend equivalent is determined on the earlier of the record date or the day prior to the ex-dividend date for that dividend.

(3) Number of shares. The number of shares of an underlying security generally is the number of shares of the underlying security stated in the contract. If the transaction modifies that number by a factor or fraction or otherwise alters the amount of any payment, the number of shares is adjusted to take into account the factor, fraction, or other modification. For example, in a transaction in which the long party receives or makes payments based on 200 percent of the appreciation or depreciation (as applicable) of 100 shares of stock, the number of shares of the underlying security is 200 shares of the stock.

(k) Limitation on the treatment of certain corporate acquisitions as section 871(m) transactions. A potential section 871(m) transaction is not a section 871(m) transaction with respect to an underlying security if the transaction obligates the long party to acquire ownership of the underlying security as part of a plan pursuant to which one or more persons (including the long party) are obligated to acquire underlying securities representing more than 50 percent of the value of the entity issuing the underlying securities.

(l) Rules relating to indices—(1) Purpose. The purpose of this section is to provide a safe harbor for potential section 871(m) transactions that reference certain passive indices that are based on a diverse basket of publicly-traded securities and that are widely used by numerous market participants. Notwithstanding any other provision in this paragraph (l), an index is not a qualified index if treating the index as a qualified index would be contrary to the purpose described in this paragraph.

(2) Qualified index not treated as an underlying security. For purposes of this section, a qualified index is treated as a single security that is not an underlying security. The determination of whether an index referenced in a potential section 871(m) transaction is a qualified index is made at the time the transaction is issued based on whether the index is a qualified index on the first business day of the calendar year in which the transaction is issued.

(3) Qualified index. A qualified index means an index that—

(i) References 25 or more component securities (whether or not the security is an underlying security);

(ii) Except as provided in paragraph (l)(6)(ii) of this section, references only long positions in component securities;

(iii) References no component underlying security that represents more than 15 percent of the weighting of the component securities in the index;

(iv) References no five or fewer component underlying securities that together represent more than 40 percent of the weighting of the component securities in the index;

(v) Is modified or rebalanced only according to publicly stated, predefined criteria, which may require interpretation by the index provider or a board or committee responsible for maintaining the index;

(vi) Did not provide an annual dividend yield in the immediately preceding calendar year from component underlying securities that is greater than 1.5 times the annual dividend yield of the S&P 500 Index as reported for the immediately preceding calendar year; and

(vii) Is traded through futures contracts or option contracts (regardless of whether the contracts provide price only or total return exposure to the index or provide for dividend reinvestment in the index) on—

(A) A national securities exchange that is registered with the Securities and Exchange Commission or a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission; or

(B) A foreign exchange or board of trade that is a qualified board or exchange as determined by the Secretary pursuant to section 1256(g)(7)(C) or that has a staff no action letter from the CFTC permitting direct access from the United States that is effective on the applicable testing date, provided that the referenced component underlying securities, in the aggregate, comprise less than 50 percent of the weighting of the component securities in the index.

(4) Safe harbor for certain indices that reference assets other than underlying securities. Notwithstanding paragraph (l)(3) of this section, an index is a qualified index if the referenced component underlying securities in the aggregate comprise 10 percent or less of the weighting of the component securities in the index.

(5) Weighting of component securities. For purposes of this paragraph (l), the weighting of a component security of an index is the percentage of the index’s value represented, or accounted for, by the component security.

(6) Transactions that reference a qualified index and one or more component securities or indices—(i) In general. When a potential section 871(m) transaction references a qualified index and one or more component securities or other indices, the qualified index remains a qualified index only if the potential section 871(m) transaction does not reference a short position in any referenced component security of the qualified index, other than a short position with respect to the entire qualified index (for example, a cap or floor) or a de minimis short position described in paragraph (l)(6)(ii) of this section. If, in connection with a potential section 871(m) transaction that references a qualified index, a taxpayer (or a related person within the meaning of section 267(b) or section 707(b)) enters into one or more transactions that reduce exposure to any referenced component security of the index, other than transactions that reduce exposure to the entire index, then the potential section 871(m) transaction is not treated as referencing a qualified index.

(ii) Safe harbor for de minimis short positions. Notwithstanding paragraphs (l)(3)(ii) and (l)(6)(i) of this section, an index may be a qualified index if the short position (whether part of the index or entered into separately by the taxpayer or related person within the meaning of section 267(b) or section 707(b)) reduces exposure to referenced component securities of a qualified index (excluding any short positions with respect to the entire qualified index) by five percent or less of the value of the long positions in component securities in the qualified index.

(7) Transactions that indirectly reference a qualified index. If a potential section 871(m) transaction references a security (for example, stock in an exchange-traded fund) that tracks a qualified index, the potential section 871(m) transaction will be treated as referencing a qualified index.

(m) Rules relating to derivatives that reference partnerships—(1) In general. When a potential section 871(m) transaction references a partnership interest, the assets of the partnership will be treated as referenced by the potential section 871(m) transaction only if the partnership carries on a trade or business of dealing or trading in securities, holds significant investments in securities (either of which is a covered partnership), or directly or indirectly holds an interest in a lower-tier partnership that is a covered partnership. For purposes of this section, if a covered partnership directly or indirectly holds assets that are underlying securities or potential section 871(m) transactions, any potential section 871(m) transaction that references an interest in the covered partnership is treated as referencing the shares of the underlying securities, including underlying securities of potential section 871(m) transactions, directly or indirectly allocable to that partnership interest. For purposes of this paragraph (m), a security is defined in section 475(c).

(2) Significant investments in securities—(i) In general. For purposes of this paragraph (m), a partnership holds significant investments in securities if either—

(A) 25 percent or more of the value of the partnership’s assets consist of underlying securities or potential section 871(m) transactions; or

(B) The value of the underlying securities or potential section 871(m) transactions equals or exceeds $25 million.

(ii) Determining the value of the partnership’s assets. For purposes of this paragraph (m)(2), the value of a partnership’s assets is determined at the time the potential 871(m) transaction referencing that partnership interest is issued based on the value of the assets held by the partnership on the last day of the partnership’s prior taxable year unless the long party or the short party has actual knowledge that a subsequent transaction has caused the partnership to cross either of the thresholds described in paragraph (m)(2)(i). The value of a partnership’s assets is equal to their fair market value, except that the value of any NPC, futures contract, forward contract, option, and any similar financial instrument held by the partnership is deemed to be the value of the notional securities referenced by the transaction.

(n) Combined transactions—(1) In general. For purposes of determining whether a potential section 871(m) transaction is a section 871(m) transaction, two or more potential section 871(m) transactions are treated as a single transaction with respect to an underlying security when—

(i) A person (or a related person within the meaning of section 267(b) or section 707(b)) is the long party with respect to the underlying security for each potential section 871(m) transaction;

(ii) The potential section 871(m) transactions reference the same underlying security;

(iii) The potential section 871(m) transactions, when combined, replicate the economics of a transaction that would be a section 871(m) transaction if the transactions had been entered into as a single transaction; and

(iv) The potential section 871(m) transactions are entered into in connection with each other (regardless of whether the transactions are entered into simultaneously or with the same counterparty).

(2) Section 871(m) transactions. If a potential section 871(m) transaction is a section 871(m) transaction, either by itself or as a result of a combination with one or more other potential section 871(m) transactions, it does not cease to be a section 871(m) transaction as a result of applying paragraph (n) of this section or disposing of one or more of the potential section 871(m) transaction with which it is combined.

(3) Short party presumptions regarding combined transactions—(i) Transactions in separate accounts. A short party that is a broker may presume that transactions are not entered into in connection with each other for purposes of paragraph (n)(1) of this section if a long party holds or reflects the transactions in separate accounts maintained by the short party, unless the short party has actual knowledge that the transactions held or reflected in separate accounts by the long party were entered into in connection with each other or that separate accounts were created or used to avoid section 871(m).

(ii) Transactions separated by at least two business days. A short party that is a broker may presume that transactions entered into two or more business days apart are not entered into in connection with each other for purposes of paragraph (n)(1) of this section unless the short party has actual knowledge that the transactions were entered into in connection with each other.

(4) Presumptions Commissioner will apply to long party—(i) Transactions in separate trading books. The Commissioner will presume that a long party did not enter into two or more transactions in connection with each other for purposes of paragraph (n)(1) of this section if the long party properly reflected those transactions on separate trading books. The Commissioner may rebut this presumption with facts and circumstances showing that transactions reflected on separate trading books were entered into in connection with each other or that separate trading books were created or used to avoid section 871(m).

(ii) Transactions separated by at least two days. The Commissioner will presume that a long party did not enter into two or more transactions in connection with each other for purposes of paragraph (n)(1) of this section if the long party entered into the transactions two or more business days apart. The Commissioner may rebut this presumption with facts and circumstances showing that the transactions entered into two or more business days apart were entered into in connection with each other.

(iii) Transactions separated by less than two days and reflected in the same trading book. The Commissioner will presume that transactions that are entered into less than two business days apart and reflected on the same trading book are entered into in connection with each other. A long party can rebut this presumption with facts and circumstances showing that the transactions were not entered into in connection with each other.

(5) Rules of application—(i) Two business days rule. For the purpose of determining the number of business days between transactions, the short party may, and the Commissioner will, assume that all transactions are entered into at 4:00 pm on the date the transaction becomes effective in the jurisdiction of the long party.

(ii) No long party presumptions. Notwithstanding the presumptions described in paragraphs (n)(3) and (n)(4) of this section, the long party must treat two or more transactions as combined transactions if the transactions are described in paragraph (n)(1) of section.

(6) Ordering rule for transactions entered into in connection with each other. If a long party enters into more than two potential section 871(m) transactions that could be combined under this paragraph (n), a short party is required to apply paragraph (n)(1) of this section by combining transactions in a manner that results in the most transactions with a delta of 0.8 or higher with respect to the referenced underlying security. Thus, for example, if a taxpayer has sold one at-the-money put and purchased two at-the-money calls, each with respect to 100 shares of the same underlying security, the put and one call are combined. Similarly, a purchased call on 100 shares and a sold put on 200 shares of the same underlying security can be combined for 100 shares with 100 shares of the put remaining separate. The two calls are not combined because they do not provide the long party with economic exposure to depreciation in the underlying security. Similarly, if a long party enters into more than two potential section 871(m) transactions that could be combined under this paragraph (n), but have not been combined by a short party, the long party is required to apply paragraph (n)(1) of this section by combining transactions in a manner that results in the most transactions with a delta of 0.8 or higher with respect to the referenced underlying security.

(7) More than one underlying security referenced. If potential section 871(m) transactions reference more than one underlying security, paragraph (n)(1) of this section applies separately with respect to each underlying security.

(o) Anti-abuse rule. If a taxpayer (directly or through the use of a related person within the meaning of section 267(b) or section 707(b)) acquires (whether by entering into, purchasing, accepting by transfer, by exchange, or by conversion, or otherwise acquiring) or disposes of (whether by sale, offset, exercise, termination, expiration, maturity, or other means) a transaction or transactions with a principal purpose of avoiding the application of this section, the Commissioner may treat any payment (as described in paragraph (i) of this section) made with respect to that transaction or transactions as a dividend equivalent to the extent necessary to prevent the avoidance of this section. Therefore, notwithstanding any other provision of this section, the Commissioner may, for example, adjust the delta of a transaction, change the number of shares, adjust an estimated dividend amount, change the maturity, adjust the timing of payments, treat a transaction that references a partnership interest as referencing the assets of the partnership, combine, separate, or disregard transactions, indices, or components of indices to reflect the substance of the transaction or transactions, or otherwise depart from the rules of this section as necessary to determine whether the transaction includes a dividend equivalent or the amount or timing of a dividend equivalent. A purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately). When a withholding agent knows that the taxpayer acquired or disposed of a transaction or transactions with a principal purpose of avoiding the application of this section and the Commissioner treats a payment made with respect to any transaction as a dividend equivalent, the withholding agent may be liable for any tax pursuant to section 1461.

(p) Information required to be reported regarding a potential section 871(m) transaction—(1) In general. If a broker or dealer is a party to a potential section 871(m) transaction with a counterparty or customer that is not a broker or dealer, the broker or dealer is required to determine whether the potential section 871(m) transaction is a section 871(m) transaction. If both parties to a potential section 871(m) transaction are brokers or dealers, or neither party to a potential section 871(m) transaction is a broker or dealer, the short party must determine whether the potential section 871(m) transaction is a section 871(m) transaction. The party to the transaction that is required to determine whether a transaction is a section 871(m) transaction must also determine and report to the counterparty or customer the timing and amount of any dividend equivalent (as described in paragraphs (i) and (j) of this section). Except as otherwise provided in paragraph (n)(3) of this section, the party required to make the determinations described in this paragraph is required to exercise reasonable diligence to determine whether a transaction is a section 871(m) transaction, the amount of any dividend equivalents, and any other information necessary to apply the rules of this section. The information must be provided in the manner prescribed in paragraphs (p)(2) and (p)(3) of this section. The determinations required by paragraph (p) of this section are binding on the parties to the potential section 871(m) transaction and on any person who is a withholding agent with respect to the potential section 871(m) transaction unless the person knows or has reason to know that the information received is incorrect. The determinations are not binding on the Commissioner.

(2) Reporting requirements. For rules regarding the reporting requirements of withholding agents with respect to dividend equivalents described in this section, see §§ 1.1461–1(b) and (c) and 1.1474–1(c) and (d).

(3) Additional information available to a party to a potential section 871(m) transaction—(i) In general. Upon request by any person described in paragraph (p)(3)(ii) of this section, the party required to report information pursuant to paragraph (p)(1) of this section must provide the requester with information regarding the amount of each dividend equivalent, the delta of the potential section 871(m) transaction, the amount of any tax withheld and deposited, the estimated dividend amount if specified in accordance with paragraph (i)(2)(iii) of this section, the identity of any transactions combined pursuant to paragraph (n) of this section, and any other information necessary to apply the rules of this section. The information requested must be provided within a reasonable time, not to exceed 10 business days, and communicated in one or more of the following ways:

(A) By telephone, and confirmed in writing;

(B) By written statement sent by first class mail to the address provided by the requesting party;

(C) By electronic publication available to all persons entitled to request information; or

(D) By any other method agreed to by the parties, and confirmed in writing.

(ii) Persons entitled to request information. Any party to the transaction described in paragraph (a)(9) of this section may request the information specified in paragraph (p) of this section with respect to a potential section 871(m) transaction from the party required by paragraph (p)(3)(i) of this section to provide the information.

(iii) Reliance on information received. A person described in paragraph (p)(1) or (p)(3)(ii) of this section that receives information described in paragraph (p)(1) or (p)(3)(i) of this section may rely on that information to provide information to any other person unless the recipient knows or has reason to know that the information received is incorrect. When the recipient knows or has reason to know that the information received is incorrect, the recipient must make a reasonable effort to determine and provide the information described in paragraph (p)(1) or (p)(3)(i) of this section to any person described in paragraph (p)(1) or (p)(3)(ii) of this section that requests information from the recipient.

(4) Recordkeeping rules—(i) In general. For rules regarding recordkeeping requirements sufficient to establish whether a transaction is a section 871(m) transaction and whether a payment is a dividend equivalent and the amount of gross income treated as a dividend equivalent, see § 1.6001–1.

(ii) Records sufficient to establish whether a transaction is a section 871(m) transaction and any dividend equivalent amount. Any person required to retain records must keep sufficient information to establish whether a transaction is a section 871(m) transaction and the amount of a dividend equivalent (if any), including documentation and work papers supporting the delta calculation or the substantial equivalence test (including the number of shares of the initial hedge), as applicable, and written estimated dividends (if any). The records and documentation must be created substantially contemporaneously. A record will be considered to have been created substantially contemporaneously if it was created within 10 business days of the date the potential section 871(m) transaction is issued.

(q) Dividend and dividend equivalent payments to a qualified derivatives dealer. [Reserved]. For further guidance, see § 1.871–15T(q).

(r) Effective/applicability date—(1) In general. This section applies to payments made on or after September 18, 1015 except as provided in paragraphs (r)(2), (3), and (4) of this section.

(2) Effective/applicability date for paragraph (d)(1)(i). * * *

(3) Effective/applicability date for paragraphs (d)(2) and (e). Paragraphs (d)(2) and (e) apply to any payment made on or after January 1, 2017, with respect to any transaction issued on or after January 1, 2017, and to any payment made on or after January 1, 2018, with respect to any transaction issued on or after January 1, 2016, and before January 1, 2017.

(4) Effective/applicability date for paragraphs (c)(2)(iv), (h), and (q). [Reserved]. For further guidance, see § 1.871–15T(r)(4).

Par. 4. Section 1.871–15T is added to read as follows:

(a) through (b) [Reserved]. For further guidance, see § 1.871–15(a) through (b).

(c) [Reserved]. For further guidance, see § 1.871–15(c)(1) through (c)(2)(iii).

(iv) Payments made pursuant to annuity, endowment, and life insurance contracts—(A) Insurance contracts issued by domestic insurance companies. A payment made pursuant to a contract that is an annuity, endowment, or life insurance contract issued by a domestic corporation (including its foreign or U.S. possession branch) that is a life insurance company described in section 816(a) does not include a dividend equivalent if the payment is subject to tax under section 871(a) or section 881.

(B) Insurance contracts issued by foreign insurance companies. A payment does not include a dividend equivalent if it is made pursuant to a contract that is an annuity, endowment, or life insurance contract issued by a foreign corporation that is predominantly engaged in an insurance business and that would be subject to tax under subchapter L if it were a domestic corporation.

(C) Insurance contracts held by foreign insurance companies. A payment made pursuant to a policy of insurance (including a policy of reinsurance) does not include a dividend equivalent if it is made to a foreign corporation that is predominantly engaged in an insurance business and that would be subject to tax under subchapter L if it were a domestic corporation.

(v) [Reserved]. For further guidance, see § 1.871–15(c)(2)(v).

(d) through (g) [Reserved]. For further guidance, see § 1.871–15(d) through (g).

(h) Substantial equivalence test—(1) In general. The substantial equivalence test described in this paragraph (h) applies to determine whether a complex contract is a section 871(m) transaction. The substantial equivalence test assesses whether a complex contract substantially replicates the economic performance of the underlying security by comparing, at various testing prices for the underlying security, the differences between the expected changes in value of that complex contract and its initial hedge with the differences between the expected changes in value of a simple contract benchmark (as described in paragraph (h)(2) of this section) and its initial hedge. If the complex contract contains more than one reference to a single underlying security, all references to that underlying security are taken into account for purposes of applying the substantial equivalence test with respect to that underlying security. With respect to an equity derivative that is embedded in a debt instrument or other derivative, the substantial equivalence test is applied to the complex contract without taking into account changes in the market value of the debt instrument or other derivative that are not directly related to the equity element of the instrument. The complex contract is a section 871(m) transaction with respect to an underlying security if, for that underlying security, the expected change in value of the complex contract and its initial hedge is equal to or less than the expected change in value of the simple contract benchmark and its initial hedge when the substantial equivalence test described in this paragraph (h) is calculated at the time the complex contract is issued. To the extent that the steps of the substantial equivalence test set out in this paragraph (h) cannot be applied to a particular complex contract, a taxpayer must use the principles of the substantial equivalence test to reasonably determine whether the complex contract is a section 871(m) transaction with respect to each underlying security. For purposes of this section, the test must be applied and the inputs must be determined in a commercially reasonable manner. If a taxpayer calculates any relevant input for non-tax business purposes, that input ordinarily is the input used for purposes of this section.

(2) Simple contract benchmark. The simple contract benchmark is a closely comparable simple contract that, at the time the complex contract is issued, has a delta of 0.8, references the applicable underlying security referenced by the complex contract, and has the same maturity as the complex contract with respect to the applicable underlying security. Depending on the complex contract, the simple contract benchmark might be, for example, a call option, a put option, or a collar.

(3) Substantial equivalence. A complex contract is a section 871(m) transaction with respect to an underlying security if the complex contract calculation described in paragraph (h)(4) of this section results in an amount that is equal to or less than the amount of the benchmark calculation described in paragraph (h)(5) of this section.

(4) Complex contract calculation—(i) In general. The complex contract calculation for each underlying security referenced by a potential section 871(m) transaction that is a complex contract is computed by:

(A) Determining the change in value (as described in paragraph (h)(4)(ii) of this section) of the complex contract with respect to the underlying security at each testing price (as described in paragraph (h)(4)(iii) of this section);

(B) Determining the change in value of the initial hedge for the complex contract at each testing price;

(C) Determining the absolute value of the difference between the change in value of the complex contract determined in paragraph (h)(4)(i)(A) of this section and the change in value of the initial hedge determined in paragraph (h)(4)(i)(B) of this section at each testing price;

(D) Determining the probability (as described in paragraph (h)(4)(iv) of this section) associated with each testing price;

(E) Multiplying the absolute value for each testing price determined in paragraph (h)(4)(i)(C) of this section by the corresponding probability for that testing price determined in paragraph (h)(4)(i)(D) of this section;

(F) Adding the product of each calculation determined in paragraph (h)(4)(i)(E) of this section; and

(G) Dividing the sum determined in paragraph (h)(4)(i)(F) of this section by the initial hedge for the complex contract.

(ii) Determining the change in value. The change in value of a complex contract is the difference between the value of the complex contract with respect to the underlying security at the time the complex contract is issued and the value of the complex contract with respect to the underlying security if the price of the underlying security were equal to the testing price at the time the complex contract is issued. The change in value of the initial hedge of a complex contract with respect to the underlying security is the difference between the value of the initial hedge at the time the complex contract is issued and the value of the initial hedge if the price of the underlying security were equal to the testing price at the time the complex contract is issued.

(iii) Testing price. The testing prices must include the prices of the underlying security if the price of the underlying security at the time the complex contract is issued were alternatively increased by one standard deviation and decreased by one standard deviation, each of which is a separate testing price. In circumstances where using only two testing prices is reasonably likely to provide an inaccurate measure of substantial equivalence, a taxpayer must use additional testing prices as necessary to determine whether a complex contract satisfies the substantial equivalence test. If additional testing prices are used for the substantial equivalence test, the probabilities as described in paragraph (h)(4)(iv) of this section must be adjusted accordingly.

(iv) Probability. For purposes of paragraphs (h)(4)(i)(D) and (E) of this section, the probability of an increase by one standard deviation is the measure of the likelihood that the price of the underlying security will increase by any amount from its price at the time the complex contract is issued. For purposes of paragraphs (h)(4)(i)(D) and (E) of this section, the probability of a decrease by one standard deviation is the measure of the likelihood that the price of the underlying security will decrease by any amount from its price at the time the complex contract is issued.

(5) Benchmark calculation. The benchmark calculation with respect to each underlying security referenced by the potential section 871(m) transaction is determined by using the computation methodology described in paragraph (h)(4) of this section with respect to a simple contract benchmark for the underlying security.

(6) Substantial equivalence calculation for certain complex contracts that reference multiple underlying securities. If a complex contract references 10 or more underlying securities and the short party uses an exchange-traded security (for example, an exchange-traded fund) that references substantially all of the underlying securities (the hedge security) to hedge the complex contract at the time it is issued, the substantial equivalence calculations for the complex contract may be calculated by treating the hedge security as the underlying security. When the hedge security is used for the substantial equivalence calculation pursuant to this paragraph (h)(6), the initial hedge is the number of shares of the hedge security for purposes of calculating the amount of a dividend equivalent as provided in paragraph (j)(1)(iii) of this section.

(7) Example. The following example illustrates the rules of paragraph (h) of this section. For purposes of this example, Stock X is common stock of domestic corporation X. FI is the financial institution that structures the transaction described in the example, and is the short party to the transaction. Investor is a nonresident alien individual.

Example. Complex contract that is not substantially equivalent. (i) FI issues an investment contract (the Contract) that has a stated maturity of one year, and Investor purchases the Contract from FI at issuance for $10,000. At maturity, the Contract entitles Investor to a return of $10,000 (i) plus 200 percent of any appreciation in Stock X above $100 per share, capped at $110, on 100 shares or (ii) minus 100 percent of any depreciation in Stock X below $90 on 100 shares. At the time FI issues the Contract, the price of Stock X is $100 per share. Thus, for example, Investor will receive $11,000 if the price of Stock X is $105 per share at maturity of the Contract, but Investor will receive $9,000 if the price of Stock X is $80 per share when the Contract matures. At issuance, FI acquires 64 shares of Stock X to fully hedge the Contract issued to Investor.

(ii) The Contract references an underlying security and is not an NPC, so it is classified as an ELI under paragraph (a)(4) of this section. At issuance, the Contract does not provide for an amount paid at maturity that is calculated by reference to a single, fixed number of shares of Stock X. When the Contract matures, the amount paid is effectively calculated based on either 200 shares of Stock X (if the price of Stock X has appreciated up to $110) or 100 shares of Stock X (if the price of Stock X has declined below $90). Consequently, the Contract is a complex contract described in paragraph (a)(14) of this section.

(iii) Because it is a complex ELI, FI applies the substantial equivalence test described in paragraph (h) of this section to determine whether the Contract is a specified ELI. FI determines that the price of Stock X would be $120 if the price of Stock X were increased by one standard deviation, and $79 if the price of Stock X were decreased by one standard deviation. Based on these results, FI next determines the change in value of the Contract to be $2,000 at the testing price that represents an increase by one standard deviation ($12,000 testing price minus $10,000 issue price) and a negative $1,100 at the testing price that represents a decrease by one standard deviation ($10,000 issue price minus $8,900 testing price). FI performs the same calculations for the 64 shares of Stock X that constitute the initial hedge, determining that the change in value of the initial hedge is $1,280 at the testing price that represents an increase by one standard deviation ($6,400 at issuance compared to $7,680 at the testing price) and negative $1,344 at the testing price that represents a decrease by one standard deviation ($6,400 at issuance compared to $5,056 at the testing price).

(iv) FI then determines the absolute value of the difference between the change in value of the initial hedge and the Contract at the testing price that represents an increase by one standard deviation and a decrease by one standard deviation. Increased by one standard deviation, the absolute value of the difference is $720 ($2,000 – $1,280); decreased by one standard deviation, the absolute value of the difference is $244 (negative $1,100 minus negative $1,344). FI determines that there is a 52% chance that the price of Stock X will have increased in value when the Contract matures and a 48% chance that the price of Stock X will have decreased in value at that time. FI multiplies the absolute value of the difference between the change in value of the initial hedge and the Contract at the testing price that represents an increase by one standard deviation by 52%, which equals $374.40. FI multiplies the absolute value of the difference between the change in value of the initial hedge and the Contract at the testing price that represents a decrease by one standard deviation by 48%, which equals $117.12. FI adds these two numbers and divides by the number of shares that constitute the initial hedge to determine that the complex contract calculation is 7.68 ((374.40 plus 117.12) divided by 64).

(v) FI then performs the same calculation with respect to the simple contract benchmark, which is a one-year call option that references one share of Stock X, settles on the same date as the Contract, and has a delta of 0.8. The one-year call option has a strike price of $79 and has a cost (the purchase premium) of $22. The initial hedge for the one-year call option is 0.8 shares of Stock X.

(vi) FI first determines that the change in value of the simple contract benchmark is $19.05 if the testing price is increased by one standard deviation ($22.00 at issuance to $41.05 at the testing price) and negative $20.95 if the testing price is decreased by one standard deviation ($22.00 at issuance to $1.05 at the testing price). Second, FI determines that the change in value of the initial hedge is $16.00 at the testing price that represents an increase by one standard deviation ($80 at issuance to $96 at the testing price) and negative $16.80 at the testing price that represents a decrease by one standard deviation ($80.00 at issuance to $63.20 at the testing price).

(vii) FI determines the absolute value of the difference between the change in value of the initial hedge and the one-year call option at the testing price that represents an increase by one standard deviation is $3.05 ($16.00 minus $19.05). FI next determines the absolute value of the difference between the change in value of the initial hedge and the option at the testing price that represents a decrease by one standard deviation is $4.15 (negative $16.80 minus negative $20.95). FI multiplies the absolute value of the difference between the change in value of the initial hedge and the option at the testing price that represents an increase by one standard deviation by 52%, which equals $1.586. FI multiplies the absolute value of the difference between the change in value of the initial hedge and the option at the testing price that represents a decrease by one standard deviation by 48%, which equals $1.992. FI adds these two numbers and divides by the number of shares that constitute the initial hedge to determine that the benchmark calculation is 4.473 ((1.586 plus 1.992) divided by .8).

(viii) FI concludes that the Contract is not a section 871(m) transaction because the complex contract calculation of 7.68 exceeds the benchmark calculation of 4.473.

(i) through (p) [Reserved]. For further guidance, see § 1.871–15(i) through (p).

(q) Dividend and dividend equivalent payments to a qualified derivatives dealer—(1) In general. Except as otherwise provided in this paragraph (q), a qualified derivatives dealer described in § 1.1441–1(e)(6) that receives a dividend or the payment of a dividend equivalent (within the meaning of paragraph (i) of this section) in its dealer capacity will not be liable for tax under section 871 or section 881 provided that the qualified derivatives dealer complies with its obligations under the qualified intermediary agreement described in §§ 1.1441–1(e)(5) and 1.1441–1(e)(6). If a qualified derivatives dealer receives a dividend or dividend equivalent payment on or determined by reference to an underlying security and the offsetting dividend equivalent payment the qualified derivatives dealer is contractually obligated to make on the same underlying security is less than the dividend and dividend equivalent amount received (including when the qualified derivatives dealer is not contractually obligated to make an offsetting dividend equivalent payment), the qualified derivatives dealer is liable for tax under section 871 or section 881 for the difference. For purposes of this paragraph (q), a dividend or dividend equivalent is not treated as received by a qualified derivatives dealer acting in its dealer capacity if the dividend or dividend equivalent is received by the qualified derivatives dealer acting as a proprietary trader. Transactions properly reflected in a qualified derivatives dealer’s dealer book are presumed to be held by a dealer in its dealer capacity for purposes of this paragraph (q).

(2) Examples. The following examples illustrate the rules of this paragraph (q):

Example 1. Forward contract entered into by a foreign dealer. (i) Facts. FB is a foreign bank that is a qualified intermediary that acts as a qualified derivatives dealer. On April 1, Year 1, FB enters into a cash settled forward contract initiated by a foreign customer (Customer) that entitles Customer to receive from FB all of the appreciation and dividends on 100 shares of Stock X, and obligates Customer to pay FB any depreciation on 100 shares of Stock X, at the end of three years. FB hedges the forward contract by entering into a total return swap contract with a domestic broker (U.S. Broker) and maintains the swap contract as a hedge for the duration of the forward contract. The swap contract entitles FB to receive an amount equal to all of the dividends on 100 shares of Stock X and obligates FB to pay an amount referenced to a floating interest rate each quarter, and also entitles FB to receive from or pay to U.S. Broker, as the case may be, the difference between the value of 100 shares of Stock X at the inception of the swap and the value of 100 shares of Stock X at the end of 3 years. FB provides valid documentation to U.S. Broker that FB will receive payments under the swap contract in its capacity as a qualified derivatives dealer, and FB contemporaneously enters both the swap contract with U.S. Broker and the forward contract with Customer on its dealer books. Stock X pays a quarterly dividend of $0.25 per share.

(ii) Application of rules. FB is a long party on a delta one contract (the total return swap) and a short party on a delta one contract (the forward contract with Customer). U.S. Broker is not obligated to withhold on the dividend equivalent payments to FB on the swap contract that are referenced to Stock X dividends, however, because U.S. Broker has received valid documentation that it may rely upon to treat the payment as made to FB acting as a qualified derivatives dealer. Similarly, FB is not obligated to pay tax on the payments it receives from U.S. Broker referenced to Stock X dividends because at the time it received the payments FB was contractually obligated to make fully offsetting dividend equivalent payments as the short party with respect to 100 shares of Stock X to Customer. FB is required to withhold on dividend equivalent payments to Customer on the forward contract in accordance with § 1.1441–2(e)(8).

Example 2. At-the-money option contract entered into by a foreign dealer. (i) Facts. The facts are the same as Example 1, but customer purchases from FB an at-the-money call option on 100 shares of Stock X with a term of one year. The call option has a delta of 0.5 and FB hedges the call option by purchasing 50 shares of Stock X, which are held in an account with U.S. Broker, who also acts as paying agent.

(ii) Application of rules. FB is a long party on 50 shares of Stock X and a short party on an option. Because the option has a delta of less than 0.8 on the date it was issued, it is not a section 871(m) transaction. U.S. Broker is not obligated to withhold on the Stock X dividends paid to FB because U.S. Broker has received valid documentation that it may rely upon to treat the dividends as paid to FB acting as a qualified derivatives dealer. FB is liable for tax under section 871 or section 881 on the Stock X dividends it receives from U.S. Broker, however, because at the time it received the dividends FB was not contractually obligated to make an offsetting dividend equivalent payment to Customer. FB is not required to make an offsetting dividend equivalent payment to Customer because the option has a delta of 0.5; therefore, it is not a section 871(m) transaction.

Example 3. In-the-money option contract entered into by a foreign dealer. (i) Facts. The facts are the same as Example 2, but Customer purchases from FB an in-the-money call option on 100 shares of Stock X with a term of one year. The call option has a delta of 0.8 and FB hedges the call option by purchasing 80 shares of Stock X, which are held in an account with U.S. Broker, who also acts as paying agent. The price of Stock X declines substantially and the option lapses unexercised.

(ii) Application of rules. FB is a long party on 80 shares of Stock X and a short party on an option. Because the option has a delta of 0.8 on the date it was issued, it is a section 871(m) transaction. U.S. Broker is not obligated to withhold on the Stock X dividends paid to FB because U.S. Broker has received valid documentation that it may rely upon to treat the dividends as paid to FB acting as a qualified derivatives dealer. Similarly, FB is not obligated to pay tax on the Stock X dividends it receives from U.S. Broker to the extent that FB is contractually obligated to make offsetting dividend equivalent payments as the short party to Customer. FB is required to withhold on dividend equivalent payments to Customer on the option contract in accordance with § 1.1441–2(e)(8). FB is also liable for tax under section 871 or section 881 on Stock X dividends, if any, that exceed the dividend equivalent payment to Customer.

(r)(1) through (3) [Reserved]. For further guidance, see § 1.871–15(r)(1) through (3).

(4) Effective/applicability date. This section applies to payments made on or after January 1, 2017.

(s) Expiration date. This section expires September 17, 2018.

Par. 5. Section 1.1441–1 is amended by:

1. Redesignating paragraph (b)(4)(xxi) as (b)(4)(xxiv).

2. Adding paragraphs (b)(4)(xxi) through (xxiii).

3. Adding new paragraphs (e)(3)(ii)(F) and (6).

4. Adding new paragraph (f)(4).

The additions read as follows:

* * * * *

(b) * * *

(4) * * *

(xxi) Amounts paid with respect to a notional principal contract described in § 1.871–15(a)(7), an equity-linked instrument described in § 1.871–15(a)(4), or a securities lending or sale-repurchase transaction described in § 1.871–15(a)(13) are exempt from withholding under section 1441(a) as dividend equivalents under section 871(m) if the transaction is not a section 871(m) transaction within the meaning of § 1.871–15(a)(12), if the transaction is subject to the exception described in § 1.871–15(k), or if the payment is not a dividend equivalent pursuant to § 1.871–15(c)(2). However, the amounts may be subject to withholding under section 1441(a) if they are subject to tax under any section other than section 871(m). For purposes of this withholding exemption, it is not necessary for the payee to provide documentation establishing that a notional principal contract or equity-linked instrument has a delta (as described in § 1.871–15(g)) that is less than 0.80 or does not have substantial equivalence (as defined in § 1.871–15(h)) with the underlying security. For purposes of the withholding exemption regarding corporate acquisitions described in § 1.871–15(k), the exemption only applies if the long party furnishes, under penalties of perjury, a written statement to the withholding agent certifying that it satisfies the requirements of § 1.871–15(k).

(xxii) Certain payments to qualified derivatives dealers (as described in paragraph (e)(6) of this section). For purposes of this withholding exemption, the qualified derivatives dealer must furnish to the withholding agent the documentation described in paragraph (e)(3)(ii) of this section. A withholding agent that makes a payment of a dividend or a divided equivalent to a qualified intermediary that is acting as a qualified derivatives dealer is not required to withhold on the payment if the withholding agent can reliably associate the payment with a valid qualified intermediary withholding certificate as described in paragraph (e)(3)(ii) of this section, including the certification described in paragraph (e)(3)(ii)(E).

(xxiii) Amounts paid with respect to a potential section 871(m) transaction that is only a section 871(m) transaction as a result of applying § 1.871–15(n) to treat certain transactions as combined transactions, if the withholding agent is able to rely on one or more of the presumptions provided in § 1.871–15(n)(3)(i) or (ii) (applying those paragraphs whether or not the withholding agent is a short party by substituting “withholding agent” for “short party”), and the withholding agent does not otherwise have actual knowledge that the long party (or a related person within the meaning of section 267(b) or section 707(b)) entered into the potential section 871(m) transaction in connection with any other potential section 871(m) transactions. The ability of one or more withholding agents to rely on the presumptions provided in section 1.871–15(n)(3) does not affect the withholding tax obligations or liability of any party to the transaction that cannot rely on the presumptions. Notwithstanding the withholding exemption provided to the withholding agent in this paragraph (b)(4)(xxii), the long party may still be liable for tax on dividend equivalent amounts with respect to such combined transactions under section 871(m).

* * * * *

(e)(3)(ii)(E) [Reserved]. For further guidance, see § 1.1441–1T(e)(3)(ii)(F).

* * * * *

(6) Qualified derivatives dealers. [Reserved]. For further guidance, see § 1.1441–1T(e)(6).

(f) * * *

(4) Effective/applicability date. Paragraphs (b)(4)(xxi) through (b)(4)(xxiii) of this section, and paragraphs (e)(3)(ii)(E) and (e)(6) of this section apply to payments made on or after September 18, 2015.

Par. 6. Section 1.1441–1T is amended by:

1. Redesignating paragraph (e)(3)(ii)(E) as paragraph (e)(3)(ii)(F).

2. Adding new paragraphs (e)(3)(ii)(E) and (e)(6).

3. Revising paragraph (e)(5)(i).

4. Amending paragraph (f)(3) by removing “This section” and adding in its place “Except for paragraphs (e)(3)(ii)(E) and (e)(6), this section” and adding a third sentence.

5. Amending paragraph (g) by removing “The applicability” and adding in its place “Except for paragraphs (e)(3)(ii)(E) and (e)(6), the applicability” and adding a third sentence.

The additions and revisions read as follows:

* * * * *

(e) * * *

(3) * * *

(ii) * * *

(E) In the case of dividends or dividend equivalents received by a qualified intermediary acting as a qualified derivatives dealer, a certification that the qualified intermediary meets the requirements to act as a qualified derivatives dealer as further described in paragraph (e)(6) of this section and that the qualified derivatives dealer assumes primary withholding and reporting responsibilities under chapters 3, 4, and 61, and section 3406 with respect to any dividend equivalent payments;

* * * * *

(5) Qualified intermediaries—(i) In general. A qualified intermediary, as defined in paragraph (e)(5)(ii) of this section, may furnish a qualified intermediary withholding certificate to a withholding agent. The withholding certificate provides certifications on behalf of other persons for the purpose of claiming and verifying reduced rates of withholding under section 1441 or 1442 and for the purpose of reporting and withholding under other provisions of the Internal Revenue Code, such as the provisions under chapter 61 and section 3406 (and the regulations under those provisions). Furnishing such a certificate is in lieu of transmitting to a withholding agent withholding certificates or other appropriate documentation for the persons for whom the qualified intermediary receives the payment, including interest holders in a qualified intermediary that is fiscally transparent under the regulations under section 894. Although the qualified intermediary is required to obtain withholding certificates or other appropriate documentation from beneficial owners, payees, or interest holders pursuant to its agreement with the IRS, it is generally not required to attach such documentation to the intermediary withholding certificate. Notwithstanding the preceding sentence, a qualified intermediary must provide a withholding agent with the Forms W–9, or disclose the names, addresses, and taxpayer identifying numbers, if known, of those U.S. non-exempt recipients for whom the qualified intermediary receives reportable amounts (within the meaning of paragraph (e)(3)(vi) of this section) to the extent required in the qualified intermediary’s agreement with the IRS. When a qualified intermediary is acting as a qualified derivatives dealer, the withholding certificate entitles a withholding agent to make payments of dividend equivalents and dividends to the qualified derivatives dealer free of withholding. Paragraph (e)(6) of this section contains detailed rules prescribing the circumstances in which a qualified intermediary can act as a qualified derivatives dealer. A person may claim qualified intermediary status before an agreement is executed with the IRS if it has applied for such status and the IRS authorizes such status on an interim basis under such procedures as the IRS may prescribe.

* * * * *

(6) Qualified derivatives dealers—(i) In general. To act as a qualified derivatives dealer under a qualified intermediary agreement, a qualified intermediary must be an eligible entity as described in paragraph (e)(6)(ii) of this section and, in accordance with the qualified intermediary agreement, must—

(A) Furnish to a withholding agent a qualified intermediary withholding certificate (described in paragraph (e)(3)(ii) of this section) that indicates that the qualified intermediary is a qualified derivatives dealer with respect to the applicable dividends and dividend equivalent payments;

(B) Agree to assume the primary withholding and reporting responsibilities, including the documentation provisions under chapters 3, 4, and 61, and section 3406, the regulations under those provisions, and other withholding provisions of the Internal Revenue Code, on all dividends and dividend equivalents that it receives and makes in its dealer capacity. For this purpose, a qualified derivatives dealer is required to obtain a withholding certificate or other appropriate documentation from each counterparty to whom the qualified derivatives dealer pays a dividend equivalent. The qualified derivatives dealer is also required to determine whether a payment it makes to a counterparty is, in whole or in part, a dividend equivalent;

(C) Agree to remain liable for tax under section 871 and section 881 on any dividend or payment of a dividend equivalent (within the meaning of § 1.871–15(i)) it receives in its dealer capacity to the extent that the offsetting dividend equivalent payment on an underlying security the qualified derivatives dealer is contractually obligated to make is less than the dividend and dividend equivalent amount the qualified derivatives dealers received on or with respect to the same underlying security (including when the qualified derivatives dealer is not contractually obligated to make an offsetting dividend equivalent payment); and

(D) Comply with the compliance review procedures applicable to a qualified intermediary that acts as a qualified derivatives dealer under a qualified intermediary agreement, which will specify the time and manner in which a qualified derivatives dealer must:

(1) Certify to the IRS that it has complied with the obligations to act as a qualified derivatives dealer (including its performance of a periodic review applicable to a qualified derivatives dealer);

(2) Report to the IRS the dividend equivalent payments that it made and the dividends and dividend equivalent amounts received in determining offsetting payments (as described in § 1.871–15(q)(1)); and

(3) Respond to inquiries from the IRS about obligations it has assumed as a qualified derivatives dealer in a timely manner.

(ii) Definition of eligible entity. An eligible entity is a qualified intermediary that is—

(A) A dealer in securities subject to regulatory supervision as a dealer by a governmental authority in the jurisdiction in which it was organized or operates; or

(B) A bank subject to regulatory supervision as a bank by a governmental authority in the jurisdiction in which it was organized or operates or an entity that is wholly-owned by a bank subject to regulatory supervision as a bank by a governmental authority in the jurisdiction in which it was organized or operates and that—

(1) Issues potential section 871(m) transactions to customers; and

(2) Receives dividends with respect to stock or dividend equivalent payments pursuant to potential section 871(m) transactions that hedge potential section 871(m) transactions that it issued.

(iii) Crediting prior withholding to a subsequent dividend equivalent payment. [Reserved].

* * * * *

(f)(3) * * * Paragraphs (e)(3)(ii)(E) and (e)(6) apply beginning September 18, 2015.

(g) * * * Paragraphs (e)(3)(ii)(E) and (e)(6) of this section expire September 17, 2018.

Par. 7. Section 1.1441–2 is amended by adding paragraph (e)(8) and adding a sentence to the end of paragraph (f) to read as follows:

* * * * *

(e) * * *

(8) Payments of dividend equivalents—(i) In general. A payment of a dividend equivalent is not considered to be made until the later of when—

(A) The amount of a dividend equivalent is determined as provided in § 1.871–15(j)(2), and

(B) A payment occurs with respect to the section 871(m) transaction.

(ii) Payment. For purposes of paragraph (e)(8) of this section, a payment occurs with respect to a section 871(m) transaction when—

(A) Money or other property is paid to or by the long party;

(B) In the case of a section 871(m) transaction described in § 1.871–15(i)(3), a payment is treated as being made at the end of the applicable calendar quarter; or

(C) The long party sells, exchanges, transfers, or otherwise disposes of the section 871(m) transaction (including by settlement, offset, termination, expiration, lapse, or maturity).

(iii) Premiums and other upfront payments. When a long party pays a premium or other upfront payment to the short party at the time a section 871(m) transaction is issued, the premium or other upfront payment is not treated as a payment for purposes of paragraph (e)(8)(ii)(A) of this section.

* * * * *

(f) * * * Paragraph (e)(8) of this section applies to payments made on or after September 18, 2015.

Par. 8. Section 1.1441–3 is amended by:

1. Adding a second sentence to paragraph (h)(1).

2. Redesignating paragraph (h)(2) as (h)(3) and revising newly redesignated paragraph (h)(3).

3. Adding new paragraph (h)(2).

The additions and revisions read as follows:

* * * * *

(h)* * *

(1) * * * Withholding is required on the amount of the dividend equivalent calculated under § 1.871–15(j).

(2) Reliance by withholding agent on reasonable determinations. For purposes of determining whether a payment is a dividend equivalent and the timing and amount of a dividend equivalent under section 871(m), a withholding agent may rely on the information received from the party to the transaction that is required (as provided in § 1.871–15(p)) to make those determinations, unless the withholding agent knows or has reason to know that the information is incorrect. When a withholding agent fails to withhold the required amount because the party described in § 1.871–15(p) fails to reasonably determine or timely provide information regarding whether a transaction is a section 871(m) transaction, the timing and amount of any dividend equivalent, or any other information required to be provided pursuant to § 1.871–15(p), and the withholding agent relied, absent actual knowledge to the contrary, on that party’s determination or did not timely receive required information, then the failure to withhold is imputed to the party required to make the determinations described in § 1.871–15(p). In that case, the IRS may collect any underwithheld amount from the party to the transaction that was required to make the determinations described in § 1.871–15(p) or timely provide the information and subject that party to applicable interest and penalties as if the party were a withholding agent with respect to the payment of the dividend equivalent made pursuant to the section 871(m) transaction.

(3) Effective/applicability date. Except for the first sentence of paragraph (h)(1), this paragraph (h) applies to payments made on or after September 18, 2015. The first sentence of paragraph (h)(1) of this section, applies to payments made on or after January 23, 2012.

* * * * *

Par. 9. Section 1.1441–7 is amended by:

1. Adding Example 7 to paragraph (a)(3).

2. Adding a second sentence to paragraph (a)(4).

The additions read as follows:

(a) * * *

(3) * * *

Example 7. CO is a domestic clearing organization. CO serves as a central counterparty clearing and settlement service provider for derivatives exchanges in the United States. CB is a broker organized in Country X, a foreign country, and a clearing member of CO. CB is a nonqualified intermediary, as defined in § 1.1441–1(c)(14). FC is a foreign corporation that has an investment account with CB. FC instructs CB to purchase a call option that is a specified ELI (as described in § 1.871–15(e)). CB effects the trade for FC on the exchange. The exchange matches FC’s order with an order for a written call option with the same terms. The exchange then sends the matched trade to CO, which clears the trade. CB and the clearing member representing the call option seller settle the trade with CO. Upon receiving the matched trade, the option contracts are novated and CO becomes the counterparty to CB and the counterparty to the clearing member representing the call option seller. To the extent that there is a dividend equivalent with respect to the call option, both CO and CB are withholding agents as described in paragraph (a)(1) of this section.

(4) * * * Example 7 of paragraph (a)(3) of this section applies to payments made on or after September 18, 2015.

* * * * *

Par. 10. Section 1.1461–1 is amended by:

1. Redesignating paragraphs (c)(2)(i)(N) as (c)(2)(i)(O) and (c)(2)(i)(M) as (c)(2)(i)(N).

2. Adding paragraph (c)(2)(i)(M).

3. Redesignating paragraph (c)(2)(ii)(K) as (c)(2)(ii)(L) and redesignating paragraph (c)(2)(ii)(J) as (c)(2)(ii)(K)

4. Adding paragraph (c)(2)(ii)(J).

5. Adding a second sentence to paragraph (c)(2)(iii).

The additions read as follows:

* * * * *

(c) * * *

(2) * * *

(i) * * *

(M) Any dividend or any payment that references the payment of a dividend from an underlying security pursuant to a securities lending or sale-repurchase transaction paid to a qualified derivatives dealer even when the withholding agent is not required to withhold on the payment pursuant to § 1.1441–1(b)(4)(xxi), (xxii), or (xxiii);

* * * * *

(ii) * * *

(J) Except as provided in § 1.1461–1(c)(2)(i)(M), any payment to a qualified derivatives dealer when the withholding agent is not required to withhold on the payment pursuant to § 1.1441–1(b)(4)(xxi), (xxii), or (xxiii);

* * * * *

* * * Paragraphs (c)(2)(i)(M) and (c)(2)(ii)(J) of this section apply beginning September 18, 2015.

Par. 11. Section 1.1473–1 is amended by:

1. Adding new paragraph (a)(4)(viii).

2. Adding a sentence to the end of paragraph (f).

The additions read as follows:

(a) * * *

(4) * * *

(viii) Certain dividend equivalents. Amounts paid with respect to a notional principal contract described in § 1.871–15(a)(7), an equity-linked instrument described in § 1.871–15(a)(4), or a securities lending or sale-repurchase transaction described in § 1.871–15(a)(13) that are exempt from withholding under section 1441(a) as dividend equivalents under section 871(m) if the transaction is not a section 871(m) transaction within the meaning of § 1.871–15(a)(12), if the transaction is subject to the exception described in § 1.871–15(k), or to the extent the payment is not a dividend equivalent pursuant to § 1.871–15(c)(2).

* * * * *

(f) * * * Paragraph (a)(4)(viii) of this section applies to payments made on or after September 18, 2015.

John Dalrymple Deputy Commissioner for Services and Enforcement.

Approved: July 20, 2015

Mark J. Mazur Assistant Secretary of the Treasury (Tax Policy).

This Treasury decision contains final regulations (the Final Regulations) that amend 26 CFR part 1 under sections 367 and 368 of the Internal Revenue Code (Code). These Final Regulations provide guidance relating to the qualification of transactions as F reorganizations and the treatment of outbound F reorganizations.

In general, upon the exchange of property, gain or loss must be recognized if the new property differs materially, in kind or extent, from the old property. See § 1.1001–1(a); § 1.368–1(b). The purpose of the reorganization provisions of the Code is to except from the general rule of section 1001 certain specifically described exchanges that are required by business exigencies and effect only a readjustment of continuing interests in property under modified corporate forms. See § 1.368–1(b). These exchanges, described in sections 354, 356, and 361, must be made in pursuance of a plan of reorganization. See § 1.368–1(c).

Section 368(a)(1) describes several types of transactions that constitute reorganizations. One of these, described in section 368(a)(1)(F), is “a mere change in identity, form, or place of organization of one corporation, however effected” (a Mere Change). One court has described the F reorganization as follows:

Berghash v. Commissioner, 43 T.C. 743, 752 (1965) (citation and footnotes omitted), aff’d, 361 F.2d 257 (2d Cir. 1966).

Although the statutory description of an F reorganization is short, and courts have described F reorganizations as simple, questions have arisen regarding the requirements of F reorganizations. In particular, when a corporation changes its identity, form, or place of incorporation, questions have arisen as to what other changes (if any) may occur, either before, during, or after the Mere Change, without affecting the status of the Mere Change (that is, what other changes are compatible with the Mere Change). These questions can become more pronounced if the transaction intended to qualify as an F reorganization is composed of a series of steps occurring over a period of days or weeks. Moreover, changes in identity, form, or place of organization are often undertaken to facilitate other changes that are difficult to effect in the corporation’s current form or place of organization.

On January 16, 1990, the Treasury Department and the IRS published temporary regulations (TD 8280) in the Federal Register (55 FR 1406) under sections 367(a), (b), and (e). A notice of proposed rulemaking (INTL–704–87) cross-referencing these temporary regulations was published the same day under RIN 1545–AL35 in the Federal Register (55 FR 1472) (1990 Proposed Regulations). No public hearing was requested or held. Prior to the publication of the 1990 Proposed Regulations, the Treasury Department and the IRS had issued two notices and a revenue ruling providing that, in an outbound F reorganization, the transferor corporation’s taxable year closes, and clarifying that, in such F reorganizations, there is an actual or constructive transfer of assets and an exchange of stock. See Notice 88–50, 1988–1 CB 535; Notice 87–29, 1987–1 CB 474; Rev. Rul. 87–27, 1987–1 CB 134. The 1990 Proposed Regulations, in relevant part, proposed the rules described in Notice 88–50, Notice 87–29, and Rev. Rul. 87–27. No comments were received on this aspect of the 1990 Proposed Regulations. While this aspect of the 1990 Proposed Regulations has not yet been finalized, final regulations (TD 8834) regarding the primary subject of the 1990 Proposed Regulations—guidance under sections 367(e)(1) and 367(e)(2) regarding outbound distributions under sections 355 and 332—have since been issued. See, for example, TD 8834, 64 FR 43072 (Aug. 9, 1999). A new RIN (RIN 1545–BM78, REG–117141–15) has been issued under which the portion of the 1990 Proposed Regulations relating to outbound F reorganizations will be finalized.

On August 12, 2004, the Treasury Department and the IRS published a notice of proposed rulemaking (REG–106889–04) (2004 Proposed Regulations) in the Federal Register (69 FR 49836) regarding the requirements for F reorganizations. The 2004 Proposed Regulations are discussed in more detail in section 3. of this Background section of this preamble. In the preamble to the 2004 Proposed Regulations, the Treasury Department and the IRS requested comments from the public. One written comment was received with respect to the 2004 Proposed Regulations. No public hearing was requested or held.

On February 25, 2005, the Treasury Department and the IRS published final regulations (TD 9182) (2005 Regulations) in the Federal Register (70 FR 9219) adopting a portion of the 2004 Proposed Regulations. The 2005 Regulations provide that the continuity of interest and continuity of business enterprise requirements applicable to reorganizations in general do not apply to reorganizations under section 368(a)(1)(E) or section 368(a)(1)(F). The preamble to the 2005 Regulations stated that the Treasury Department and the IRS would continue to study the other issues addressed in the 2004 Proposed Regulations and would welcome further comments from the public. One written comment was received with regard to the 2005 Regulations.

A corporation that continues to inhabit its corporate shell can change in many respects. Although these changes may have federal income tax consequences, they do not result in the corporation being treated for federal income tax purposes as a new corporation or as transferring its assets. Nor do these changes cause the corporation’s taxable year to close. Unlike a partnership that might terminate for federal income tax purposes upon the transfer of a given percentage of the partnership interests, a corporation that continues to inhabit a single corporate shell continues to exist for federal tax purposes, independent of the identity of its shareholders or the composition of its assets.

The underlying premise of the 2004 Proposed Regulations was that, if a corporate enterprise changes its corporate shell while adhering to four proposed requirements for a Mere Change, the resulting corporation should be treated as the functional equivalent of the transferor corporation.

As noted in section 1. of this Background, questions have arisen as to whether other changes are compatible with a Mere Change. In addressing these questions, the 2004 Proposed Regulations embraced the principles derived from the language of section 368(a)(1)(F), the historic practice of the IRS and courts in applying that statutory definition, and functional differences between F reorganizations and other types of reorganizations.

Like other types of reorganizations, an F reorganization generally involves, in form, two corporations, one (a Transferor Corporation) that transfers (or is deemed to transfer) assets to the other (a Resulting Corporation). However, the statute describes an F reorganization as being with respect to “one corporation” and provides for treatment that differs from that accorded other types of reorganizations in which assets are transferred from one corporation to another (Asset Reorganizations). As noted in the preamble to the 2004 Proposed Regulations, “an F reorganization is treated for most purposes of the Code as if the reorganized corporation were the same entity as the corporation in existence before the reorganization.” Thus, the tax treatment accorded an F reorganization is more consistent with that of a single continuing corporation in that (1) the taxable year of the Transferor Corporation does not close and includes the operations of the Resulting Corporation for the remainder of the year, and (2) the Resulting Corporation’s losses may be carried back to taxable years of the Transferor Corporation.

Because an F reorganization must involve “one corporation,” and continuation of the taxable year and loss carrybacks from the Resulting Corporation to the Transferor Corporation are allowed, the statute cannot accommodate transactions in which the Resulting Corporation has preexisting activities or tax attributes. See H. Rep. Conf. Rep’t. 97–760, 97th Cong., 2d Sess., at pp. 540–41 (1982). Accordingly, the 2004 Proposed Regulations did not allow for more than de minimis activities or very limited assets or tax attributes in the Resulting Corporation from sources other than the Transferor Corporation. This is one of the principal distinctions between F reorganizations and Asset Reorganizations. The proposed rule was consistent with the historical interpretation of the statute in this regard.

Similarly, the requirement that there be “one corporation” means that the status of the Resulting Corporation as the successor to the Transferor Corporation must be unambiguous. Accordingly, and consistent with the historical interpretation of the statute, the 2004 Proposed Regulations required that, for a transaction to qualify as a Mere Change, the Transferor Corporation be liquidated for tax purposes.

In Helvering v. Southwest Consolidated Corp., 315 U.S. 194 (1942), the Supreme Court noted that “a transaction which shifts the ownership of the proprietary interest in a corporation is hardly a ‘mere change in identity, form, or place of incorporation’ within the meaning of [the F reorganization provision].” The 2004 Proposed Regulations also adopted this principle by providing that an F reorganization could not be used as a vehicle to introduce new owners into the corporate enterprise.

Based on these principles, the 2004 Proposed Regulations would have imposed four requirements for an F reorganization, with limited exceptions. First, all the stock of the Resulting Corporation, including stock issued before the transfer, would have had to be issued in respect of stock of the Transferor Corporation. Second, a change in the ownership of the corporation in the transaction would not have been allowed, except a change that had no effect other than that of a redemption of less than all the shares of the corporation. Third, the Transferor Corporation would have had to completely liquidate in the transaction. Fourth, the Resulting Corporation would not have been allowed to hold any property or possess any tax attributes (including those specified in section 381(c)) immediately before the transfer.

As discussed in the preamble to the 2004 Proposed Regulations, the first two requirements reflected the Supreme Court’s holding in Helvering v. Southwest Consolidated Corp., supra, that a transaction cannot be a Mere Change if it shifts the ownership of the proprietary interests in a corporation. These requirements would have prevented a transaction involving the introduction of a new shareholder or new equity capital into the corporation from qualifying as an F reorganization. Notwithstanding these requirements, the first requirement would have allowed the Resulting Corporation to issue a nominal amount of stock not in respect of stock of the Transferor Corporation to facilitate the organization of the Resulting Corporation.

Under the second requirement (no change in ownership), redemptions of less than all the shares of the corporation would have been allowed. The law was not completely clear as to the effect of redemptions on the qualification of a transaction as an F reorganization. Some authorities supported the proposition that changes in ownership resulting from redemptions were compatible with an F reorganization. See Reef Corp. v. U.S., 368 F.2d 125 (5th Cir. 1966) (holding that a redemption of 48 percent of the stock of a corporation that occurred during a change in place of incorporation did not cause the transaction to fail to qualify as an F reorganization, because the redemption was functionally separate from the F reorganization even if coincident in time); § 1.301–1(l) (relating in part to the treatment of a distribution with respect to stock that is in substance separate from a reincorporation); Rev. Rul. 66–284, 1966–2 CB 115 (concluding that a transaction could qualify as an F reorganization even though there was less than a one percent change in a corporation’s shareholders as a result of stock held by dissenting shareholders being redeemed in the transaction); cf. Casco Products Corp. v. Commissioner, 49 T.C. 32 (1967) (reaching a comparable result without finding an F reorganization where a nine percent shareholder was redeemed in the transaction).

The third requirement and the fourth requirement implemented the statutory requirement that an F reorganization involve only one corporation. Although the third requirement was that the Transferor Corporation completely liquidate in the transaction, a legal dissolution was not required. This accommodation allowed the value of the Transferor Corporation’s charter to be preserved. Further, the Proposed Regulations would have allowed the Transferor Corporation to retain a nominal amount of assets to preserve its legal existence.

The fourth requirement would have precluded the Resulting Corporation from holding any property or having any tax attributes immediately before the transfer. Nevertheless, the Proposed Regulations would have allowed the Resulting Corporation to hold or to have held a nominal amount of assets to facilitate its organization or preserve its existence, and to have tax attributes related to these assets. In addition, the Proposed Regulations provided that the fourth requirement would not be violated if, before the transfer, the Resulting Corporation held the proceeds of borrowings undertaken in connection with the transaction.

The Treasury Department and the IRS concluded that the words “however effected” in the statutory definition of F reorganization reflect a Congressional intent to treat as an F reorganization a series of transactions that together result in a Mere Change. The 2004 Proposed Regulations reflected this view by providing that a series of related transactions that together result in a Mere Change may qualify as an F reorganization. This view is consistent with the IRS’s historical interpretation of the statute.

The Treasury Department and the IRS also recognized that an F reorganization may be a step in a larger transaction that effects more than a Mere Change. For example, in Situation 1 of Rev. Rul. 96–29, 1996–1 CB 50, the IRS ruled that a reincorporation qualified as an F reorganization even though it was a step in a transaction in which the reincorporated entity issued common stock in a public offering and redeemed preferred stock having a value of 40 percent of the aggregate value of its outstanding stock immediately prior to the offering. In Situation 2 of the same ruling, the IRS ruled that a reincorporation of a corporation in another state qualified as an F reorganization even though it was a step in a transaction in which the reincorporated entity acquired the business of another entity.

Consistent with Rev. Rul. 96–29, the 2004 Proposed Regulations provided that events occurring before or after a transaction or series of transactions that otherwise constitutes a Mere Change and related thereto would not cause the Mere Change to fail to qualify as an F reorganization (the Related Events Rule). The 2004 Proposed Regulations further provided that the qualification of the Mere Change as an F reorganization would not alter the treatment of the other events.

The Related Events Rule would have operated in tandem with the proposal, which was made a final rule in the 2005 Regulations, that the continuity of interest and continuity of business enterprise requirements of § 1.368–1(d) and (e) that are generally applicable to reorganizations under section 368 do not apply to F reorganizations. These rules, together, would have focused the F reorganization analysis on the discrete step or series of steps (to use the words of many observers, those steps occurring “in a bubble”) that may satisfy the four requirements for a Mere Change, even if these steps constitute part of a larger series of steps. In other words, these rules rejected the application of step transaction principles to integrate all the steps of the overall plan or agreement to accomplish the larger transaction and thereby potentially prevent the transaction from qualifying as an F reorganization. See Rev. Rul. 75–456, 1975–2 CB 128 (F reorganization of the acquiring corporation in a stock reorganization under section 368(a)(1)(B) did not prevent that provision’s “solely for voting stock” requirement from being satisfied); see also Rev. Rul. 79–250, 1979–2 CB 156 (F reorganization of issuing corporation immediately after forward triangular merger did not prevent the transaction from satisfying requirements of section 368(a)(2)(D)).

Overall, the 2004 Proposed Regulations would have found certain changes occurring in connection with a change in identity, form, or place of organization to be compatible with the Mere Change requirement. Some changes could have been effected simultaneously with the transaction or series of transactions otherwise qualifying as an F reorganization because these changes would not have violated any of the four proposed requirements for a Mere Change. Thus, for example, a corporation could have bought, sold, or exchanged property, borrowed money, or repaid debt because the 2004 Proposed Regulations would not have required an identity of assets between the Transferor Corporation and the Resulting Corporation. Other changes could not have been effected simultaneously with the potential F reorganization, but could have occurred before or after the F reorganization “in a bubble,” for example, the issuance of new equity capital or the transfer of shares to new shareholders.

Prior to the issuance of the 2004 Proposed Regulations, much commentary had focused on whether distributions of money or other property in F reorganizations were distributions to which section 356 applied, or whether sections 301 and 302, and related provisions, governed the treatment of these distributions. The Treasury Department and the IRS believed it appropriate to treat these distributions as transactions separate from the F reorganization, even if they occurred immediately before or immediately after the F reorganization, after some of the transactions making up the F reorganization and before other transactions making up the F reorganization, or as part of the same plan as the F reorganization. See, for example, § 1.301–1(l). Accordingly, the 2004 Proposed Regulations provided that, if a shareholder received money or other property (including in exchange for its shares) from the Transferor Corporation or the Resulting Corporation in a transaction that constituted an F reorganization, the money or other property would be treated as distributed by the Transferor Corporation immediately before the transaction, and that section 356 would not apply.

After consideration of the comments received with respect to the 2004 Proposed Regulations and the 2005 Regulations, the Treasury Department and the IRS are publishing, in this Treasury decision, additional Final Regulations regarding F reorganizations. The Final Regulations generally adopt the provisions of the 2004 Proposed Regulations not previously adopted in the 2005 Regulations, with changes discussed in the remainder of this preamble, and several clarifying, non-substantive changes. The Final Regulations also include rules regarding outbound F reorganizations by adopting, without substantive change, the provisions of the 1990 Proposed Regulations relating to section 367(a) and making conforming revisions to other regulations.

Like the 2004 Proposed Regulations, the Final Regulations are based on the premise that it is appropriate to treat the Resulting Corporation in an F reorganization as the functional equivalent of the Transferor Corporation and to give its corporate enterprise roughly the same freedom of action as would be accorded a corporation that remains within its original corporate shell. The Final Regulations provide that a transaction that involves an actual or deemed transfer of property by a Transferor Corporation to a Resulting Corporation is a Mere Change that qualifies as an F reorganization if six requirements are satisfied (with certain exceptions). The Final Regulations provide that a transaction or a series of related transactions to be tested against the six requirements (a Potential F Reorganization) begins when the Transferor Corporation begins transferring (or is deemed to begin transferring) its assets to the Resulting Corporation, and ends when the Transferor Corporation has distributed (or is deemed to have distributed) the consideration it receives from the Resulting Corporation to its shareholders and has completely liquidated for federal income tax purposes. The concept of a Potential F Reorganization was added to the Final Regulations to aid in determining which steps in a multi-step transaction should be considered when applying the six requirements to a potential mere change (that is, which steps are “in the bubble”).

In the context of determining whether a Potential F Reorganization qualifies as a Mere Change, deemed asset transfers include, but are not limited to, those transfers treated as occurring as a result of an entity classification election under paragraph § 301.7701–3(c)(1)(i), as well as transfers resulting from the application of step transaction principles. One example of such a transfer would be the deemed asset transfer by the Transferor Corporation to the Resulting Corporation resulting from a so-called “liquidation- reincorporation” transaction. See, for example, Davant v. Commissioner, 366 F.2d 874 (5th Cir. 1966); § 1.331–1(c) (liquidation-reincorporation may be a tax-free reorganization). Another example of such a deemed asset transfer would include the deemed transfer of the Transferor Corporation’s assets to the Resulting Corporation in a so-called “drop-and-check” transaction in which a newly formed Resulting Corporation acquires the stock of a Transferor Corporation from its shareholders and, as part of the plan, the Transferor Corporation liquidates into the Resulting Corporation. See, for example, steps (d) and (c) of Rev. Rul. 2015–10, 2015–21 IRB 973; Rev. Rul. 2004–83, 2004–2 CB 157; Rev. Rul. 67–274, 1967–2 CB 141.

Four of the six requirements are generally adopted from the 2004 Proposed Regulations, and the fifth and sixth requirements address comments received with respect to the Proposed Regulations regarding “overlap transactions” (for example, transactions involving the Transferor Corporation’s transfer of its assets to a potential successor corporation other than the Resulting Corporation in a transaction that could also qualify for nonrecognition treatment under a different provision of the Code). Viewed together, these six requirements ensure that an F reorganization involves only one continuing corporation and is neither an acquisitive transaction nor a divisive transaction. Thus, an F reorganization does not include a transaction that involves a shift in ownership of the enterprise, an introduction of assets in exchange for equity (other than that raised by the Transferor Corporation prior to the F reorganization), or a division of assets or tax attributes of a Transferor Corporation between or among the Resulting Corporation and other acquiring corporations. An F reorganization also does not include a transaction that leads to multiple potential acquiring corporations having competing claims to the Transferor Corporation’s tax attributes under section 381.

Certain exceptions, similar to those of the 2004 Proposed Regulations, apply to these six requirements. Three of these exceptions allow de minimis departures from the six requirements for purposes unrelated to federal income taxation.

As in the 2004 Proposed Regulations, the first and the second requirements of the Final Regulations reflect the Supreme Court’s holding in Helvering v. Southwest Consolidated Corp, supra, that a transaction that shifts the ownership of the proprietary interests in a corporation cannot qualify as a Mere Change. Thus, the Final Regulations provide that a transaction that involves the introduction of a new shareholder or new equity capital into the corporation “in the bubble” does not qualify as an F reorganization.

Consistent with the 2004 Proposed Regulations, the first requirement in the Final Regulations is that immediately after the Potential F Reorganization, all the stock of the Resulting Corporation must have been distributed (or deemed distributed) in exchange for stock of the Transferor Corporation in the Potential F Reorganization. The 2004 Proposed Regulations focused on the issuance of the stock of the Resulting Corporation in respect of stock of the Transferor Corporation. The Treasury and the IRS believe, however, that a focus on the distribution of the stock of the Resulting Corporation better matches the transactions that occur (or are deemed to occur) in reorganizations.

Also consistent with the 2004 Proposed Regulations, the second requirement is that, subject to certain exceptions, the same person or persons own all the stock of the Transferor Corporation at the beginning of the Potential F Reorganization and all of the stock of the Resulting Corporation at the end of the Potential F Reorganization, in identical proportions.

Notwithstanding these requirements and also consistent with the Proposed Regulations, the Final Regulations allow the Resulting Corporation to issue a de minimis amount of stock not in respect of stock of the Transferor Corporation, to facilitate the organization or maintenance of the Resulting Corporation. This rule is designed to allow, for example, reincorporation in a jurisdiction that requires minimum capitalization, two or more shareholders, or ownership of shares by directors. It is also intended to allow a transfer of assets to certain pre-existing entities, for reasons explained further in section 2.B. of this Explanation of Revisions.

In addition, the Final Regulations allow changes of ownership that result from either (i) a holder of stock in the Transferor Corporation exchanging that stock for stock of equivalent value in the Resulting Corporation having terms different from those of the stock in the Transferor Corporation or (ii) receiving a distribution of money or other property from either the Transferor Corporation or the Resulting Corporation, whether or not in redemption of stock of the Transferor Corporation or the Resulting Corporation. In other words, the corporation involved in a Mere Change may also recapitalize, redeem its stock, or make distributions to its shareholders, without causing the Potential F Reorganization to fail to qualify as an F reorganization. These exceptions reflect the determination of the Treasury Department and the IRS that allowing certain transactions to occur contemporaneously with an F reorganization is appropriate so long as one corporation could effect the transaction without undergoing an F reorganization. These exceptions also reflect the case law, discussed in section 3.A. of the Background, holding that certain transactions qualify as F reorganizations even if some shares are redeemed in the transaction, and rulings by the IRS that a recapitalization may happen at the same time as an F reorganization. See, for example, Rev. Rul. 2003–19, 2003–1 CB 468, and Rev. Rul. 2003–48, 2003–1 CB 863 (both providing that certain demutualization transactions may involve both E Reorganizations and F reorganizations).

As in the 2004 Proposed Regulations, the third requirement (limiting the assets and attributes of the Resulting Corporation immediately before the transaction) and the fourth requirement (requiring the liquidation of the Transferor Corporation) under the Final Regulations reflect the statutory mandate that an F reorganization involve only one corporation. Although the Final Regulations generally require the Resulting Corporation not to hold any property or have any tax attributes immediately before the Potential F Reorganization, as in the 2004 Proposed Regulations, the Resulting Corporation is allowed to hold a de minimis amount of assets to facilitate its organization or preserve its existence (and to have tax attributes related to these assets), and the Resulting Corporation is allowed to hold proceeds of borrowings undertaken in connection with the Potential F Reorganization.

A commenter responding to the 2004 Proposed Regulations stated that the Final Regulations should allow the Resulting Corporation to hold, in addition to the proceeds of borrowings, cash proceeds of stock issuances before the Mere Change. The Treasury Department and the IRS do not believe that the Resulting Corporation should be allowed to issue more than a de minimis amount of stock before a transaction constituting a Mere Change because that would allow a substantial investment of new capital and/or new shareholders, or an acquisition of assets from more than one corporation. This rule does not, however, preclude the Transferor Corporation from issuing new stock before a Potential F Reorganization constituting an F reorganization. Nor does it preclude the Resulting Corporation from issuing new stock after the Potential F Reorganization.

Under the fourth requirement in the Final Regulations, the Transferor Corporation must completely liquidate in the Potential F Reorganization for federal income tax purposes. Nevertheless, as in the 2004 Proposed Regulations, the Transferor Corporation is not required to legally dissolve and is allowed to retain a de minimis amount of assets for the sole purpose of preserving its legal existence.

The fifth requirement under the Final Regulations is that immediately after the Potential F Reorganization, no corporation other than the Resulting Corporation may hold property that was held by the Transferor Corporation immediately before the Potential F Reorganization, if such other corporation would, as a result, succeed to and take into account the items of the transferor corporation described in section 381(c). Thus, a transaction that divides the property or tax attributes of a Transferor Corporation between or among acquiring corporations, or that leads to potential competing claims to such tax attributes, will not qualify as a Mere Change.

The sixth requirement under the Final Regulations is that immediately after the Potential F Reorganization, the Resulting Corporation may not hold property acquired from a corporation other than the Transferor Corporation if the Resulting Corporation would, as a result, succeed to and take into account the items of such other corporation described in section 381(c). Thus, a transaction that involves simultaneous acquisitions of property and tax attributes from multiple transferor corporations (such as the transaction described in Rev. Rul. 58–422, 1958–2 CB 145) will not qualify as a Mere Change.

These requirements address a comment received with respect to the second requirement of the 2004 Proposed Regulations that there not be a change in the ownership of the corporation in the transaction, except a change that has no effect other than a redemption of less than all the shares of the corporation. The comment stated that allowing a corporation to distribute property in redemption of less than all of its shares could result in satisfying both the requirements for an F reorganization with respect to one transferee corporation and the requirements of another nonrecognition provision with respect to a different transferee corporation. The result would be uncertainty as to which corporation should succeed to the Transferor Corporation’s tax attributes.

For example, assume that corporation P owns all of the stock of corporation T, and T operates two separate businesses, Business 1 (worth $297) and Business 2 (worth $3). Further assume that T merges into newly formed corporation R, and that, pursuant to the merger agreement, P receives Business 1 and all of R’s stock in exchange for surrendering all of the T stock, and R receives Business 2. Under the 2004 Proposed Regulations, the transaction could have qualified as an F reorganization, with T as the Transferor Corporation and R as the Resulting Corporation, because the only change in ownership is a redemption of less than all of the T shares. However, because T transfers 99 percent of its historic business assets (Business 1) to P in exchange for all of T’s stock, the transaction might also qualify as a complete liquidation under sections 332 and 337 or an upstream reorganization under section 368(a)(1)(C) of T into P. This overlap – with two potential acquiring corporations – would present unintended complexities. For example, as discussed above, there would be uncertainty as to which corporation should succeed to T’s tax attributes.

Accordingly, notwithstanding the overall flexibility provided with respect to transactions occurring contemporaneously with a Mere Change, the Final Regulations provide that a Mere Change cannot accommodate transactions that occur at the same time as the Potential F Reorganization if those other transactions could result in a corporation other than the Resulting Corporation acquiring the tax attributes of the Transferor Corporation.

The same commenter requested clarification of the treatment of combinations of several corporations into a single, newly-created corporation. Consistent with the statutory language of section 368(a)(1)(F), the Treasury Department and the IRS believe that a Mere Change involves only one Transferor Corporation and one Resulting Corporation. Thus, the Final Regulations provide that only one Transferor Corporation can transfer property to the Resulting Corporation in the Potential F Reorganization. If more than one corporation transfers assets to the Resulting Corporation in a Potential F Reorganization, none of the transfers would constitute an F reorganization.

In some cases, business or legal considerations may require extra steps to complete a transaction that is intended to qualify as a Mere Change. As discussed in section 3.B.i. of the Background, the Treasury Department and the IRS concluded that the words “however effected” in the statutory definition of F reorganization reflect a Congressional intent to treat a series of transactions that together result in a Mere Change as an F reorganization, even if the transfer (or deemed transfer) of property from the Transferor Corporation to the Resulting Corporation occurs indirectly. The Final Regulations confirm this conclusion by providing that a Potential F Reorganization consisting of a series of related transactions that together result in a Mere Change may qualify as an F reorganization, whether or not certain steps in the series, viewed in isolation, might, for example, be treated as a redemption under section 304(a), as a complete liquidation under section 331 or section 332, or as a transfer of property under section 351. For example, the first step in an F reorganization of a corporation owned by individual shareholders could be a dissolution of the Transferor Corporation, so long as this step is followed by a transfer of all the assets of the Transferor Corporation to a Resulting Corporation. However, see § 1.368–2(k) for completed reorganizations that will not be recharacterized as a Mere Change as a result of one or more subsequent transfers of assets or stock, such as where a Transferor Corporation transfers all of its assets to its parent corporation in liquidation, followed by the parent corporation’s retransfer of those assets to a new corporation. See also Rev. Rul. 69–617, 1969–2 CB 57 (an upstream merger followed by a contribution of all the target assets to a new subsidiary corporation is a reorganization under sections 368(a)(1)(A) and 368(a)(2)(C)).

As discussed in section 3.B.ii. of the Background, the Treasury Department and the IRS recognized that an F reorganization may be a step, or a series of steps, before, within, or after other transactions that effect more than a Mere Change, even if the Resulting Corporation has only a transitory existence following the Mere Change. In some cases an F reorganization sets the stage for later transactions by alleviating non-tax impediments to a transfer of assets. In other cases, prior transactions may tailor the assets and shareholders of the Transferor Corporation before the commencement of the F reorganization. Although an F reorganization may facilitate another transaction that is part of the same plan, the Treasury Department and the IRS have concluded that step transaction principles generally should not recharacterize F reorganizations because F reorganizations involve only one corporation and do not resemble sales of assets. From a federal income tax perspective, F reorganizations are generally neutral, involving no change in ownership or assets, no end to the taxable year, and inheritance of the tax attributes described in section 381(c) without a limitation on the carryback of losses. See, for example, Rev. Rul. 96–29 (discussed in section 3.B.ii. of the Background); § 1.381(b)–1(a)(2).

The Final Regulations adopt the Related Events Rule of the 2004 Proposed Regulations, which provided that related events preceding or following the Potential F Reorganization that constitutes a Mere Change generally would not cause that Potential F Reorganization to fail to qualify as an F reorganization. Notwithstanding the Related Events Rule, in the cross-border context, related events preceding or following an F reorganization may be relevant to the tax consequences under certain international provisions that apply to F reorganizations. For example, such events may be relevant for purposes of applying certain rules under section 7874 and for purposes of determining whether stock of the Resulting Corporation should be treated as stock of a controlled foreign corporation for purposes of section 367(b). See, for example, section 2.03(b)(iv), Example 2 in Notice 2014–52, 2014–52 IRB 712; Rev. Rul. 83–23, 1983–1 CB 82.

The Final Regulations also adopt the provision of the 2004 Proposed Regulations that the qualification of a Potential F Reorganization as an F reorganization would not alter the treatment of other related transactions. For example, if an F reorganization is part of a plan that includes a subsequent merger involving the Resulting Corporation, the qualification of a Potential F Reorganization as an F reorganization will not alter the tax consequences of the subsequent merger.

A comment to the Proposed Regulations stated that, in some cases, an asset transfer that would constitute a step in an F reorganization is also a necessary step for characterizing a larger transaction as a nonrecognition transaction that would not constitute an F reorganization. For example, assume that corporation P acquires all of the stock of unrelated corporation T in exchange for consideration consisting of $50 cash and P voting stock with $50 value (without making an election under section 338), and, immediately thereafter and as part of the same plan, T is merged into corporation S, a newly-formed corporation wholly owned by P. Viewed in isolation, the merger of T into S appears to constitute a Mere Change. Provided the requirements for Asset Reorganization treatment are otherwise satisfied, however, the step transaction doctrine is applied to integrate the steps and treat the transaction as a statutory merger of T into S in which S acquires T’s assets in exchange for $50 cash, $50 of P voting stock and assumption of T’s liabilities, and T distributes the cash and P stock to its shareholders. This merger qualifies as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(D), and P’s momentary ownership of T stock is disregarded. See Situation 2 of Rev. Rul. 2001–46, 2001–2 CB 321 (same). The stock of S is not treated as issued for the assets of T; the historic shareholders of T are replaced by P as the shareholder of the resulting corporation (S); and the transaction is not a Mere Change.

To clarify this and similar situations, the Treasury Department and the IRS have determined that, if the Potential F Reorganization or a step thereof involving a transfer of property from the Transferor Corporation to the Resulting Corporation is also a reorganization or part of a reorganization in which a corporation in control (within the meaning of section 368(c)) of the Resulting Corporation is a party to the reorganization (within the meaning of section 368(b)), the Potential F Reorganization is not a Mere Change and does not qualify as an F reorganization. This rule will apply to transactions qualifying as reorganizations (i) under section 368(a)(1)(C) by reason of the parenthetical language therein, (ii) under section 368(a)(1)(A) by reason of section 368(a)(2)(D), and (iii) under sections 368(a)(1)(A) or (C) by reason of section 368(a)(2)(C).

The IRS has long taken the position that, if a Transferor Corporation’s transfer of property qualifies as a step in both an F reorganization and another type of reorganization in which the Resulting Corporation is the acquiring corporation, the transaction qualifies for the benefits accorded to an F reorganization. See, for example, Rev. Rul. 57–276, 1957–1 CB 126 (section 381(b) applies such that the parts of the Transferor Corporation’s taxable year before and after an F reorganization constitute a single taxable year of the Acquiring Corporation, notwithstanding that the transaction also qualifies as another type of reorganization under section 368(a)(1)); Rev. Rul. 79–289, 1979–2 CB 145 (section 357(c) does not apply to an F reorganization even if the transaction also qualifies as another type of reorganization to which section 357(c) applies); § 1.381(b)–1(a)(2) (providing for rules applicable to F reorganizations, regardless of whether such reorganizations also qualify as another type of reorganization).

To avoid confusion in the application of the reorganization provisions, the Treasury Department and the IRS have decided that, except as provided earlier in this section 5. of the Explanation of Revisions, if a Potential F Reorganization qualifies as a reorganization under section 368(a)(1)(F) and would also qualify as a reorganization under section 368(a)(1)(A), 368(a)(1)(C), or 368(a)(1)(D), then for all federal income tax purposes the Potential F Reorganization qualifies only as a reorganization under section 368(a)(1)(F). This rule does not apply to a reorganization within the meaning of sections 368(a)(1)(E) (see Rev. Rul. 2003–19, 2003–1 CB 468, and Rev. Rul. 2003–48, 2003–1 CB 863 (providing that certain demutualization transactions may involve both E Reorganizations and F reorganizations)) or 368(a)(1)(G) (see section 368(a)(3)(C)).

As described in section 3.D. of the Background, the 2004 Proposed Regulations provided that, if a shareholder received money or other property (including in exchange for its shares) from the Transferor Corporation or the Resulting Corporation in a transaction that constituted an F reorganization, the money or other property would be treated as distributed by the Transferor Corporation immediately before the transaction, not as additional consideration under section 356(a). The preamble to the 2004 Proposed Regulations indicated that this treatment would also be appropriate for distributions of money or other property in E reorganizations.

Although the Treasury Department and the IRS considered whether a distribution occurring during a Potential F Reorganization should prevent it from qualifying as an F reorganization, the Treasury Department and the IRS determined to allow flexibility for such distributions. Nevertheless, unlike other types of reorganizations, which generally involve substantial changes in economic position, F reorganizations are mere changes in form. Accordingly, the Treasury Department and the IRS have concluded that any concurrent distribution should be treated as a transaction separate from the F reorganization. See § 1.301–1(l); see also Bazley v. Commissioner, 331 U.S. 737 (1947) (distribution in the context of a purported E reorganization treated as a dividend).

An F reorganization is a Mere Change involving only one continuing corporation and is neither an acquisitive transaction nor a divisive transaction. From a federal income tax perspective, F reorganizations generally are neutral, involving no change in ownership or assets, no end to the taxable year, and inheritance of the tax attributes described in section 381(c). A distribution that occurs at the same time as a Mere Change is, in substance, a distribution from one continuing corporation and is functionally separate from the Mere Change. The Treasury Department and the IRS believe that a distribution from one continuing corporation should not be treated the same as an exchange of money or other property for stock of a target corporation in an acquisitive reorganization. Instead, the distribution should be treated as a separate transaction occurring at the same time. Although the 2004 Proposed Regulations would have treated a distribution as occurring immediately before the transaction qualifying as an F reorganization, the Treasury Department and the IRS believe it is sufficient to treat the distribution as a separate transaction that occurs at the same time as the F reorganization.

As explained in this preamble, the first requirement of the Final Regulations is that all of the stock of the Resulting Corporation be distributed in exchange for stock of the Transferor Corporation. Certain entities may be treated as corporations for federal tax purposes even though they do not have owners that could be treated as shareholders for federal tax purposes to whom the profits of the corporation would inure (for example, some charitable organizations described in section 501(c)(3)). Nevertheless, these entities may be able to engage in corporate reorganizations. Thus, no inference should be drawn from the use of the terms “stock” or “shareholders” in these Final Regulations with respect to the ability of such entities to engage in reorganizations under section 368(a)(1)(F).

The Treasury Department and the IRS are studying how to assign (or reassign) employer identification numbers (EINs) to taxpayers following an F reorganization, including in cases in which the Transferor Corporation remains in existence as a disregarded entity, and comments on this issue are welcome.

* * * * *

(d) * * *

(4) through (5) [Reserved]. For further guidance, see § 1.367(a)–1T(d)(4) through (5).

(e) Close of taxable year in certain section 368(a)(1)(F) reorganizations. If a domestic corporation is the transferor corporation in a reorganization described in section 368(a)(1)(F) after March 30, 1987, in which the acquiring corporation is a foreign corporation, then the taxable year of the transferor corporation shall end with the close of the date of the transfer and the taxable year of the acquiring corporation shall end with the close of the date on which the transferor’s taxable year would have ended but for the occurrence of the transfer. With regard to the consequences of the closing of the taxable year, see section 381 and the regulations thereunder.

(f) Exchanges under sections 354(a) and 361(a) in certain section 368(a)(1)(F) reorganizations—(1) Rule. In every reorganization under section 368(a)(1)(F), where the transferor corporation is a domestic corporation, and the acquiring corporation is a foreign corporation, there is considered to exist—

(i) A transfer of assets by the transferor corporation to the acquiring corporation under section 361(a) in exchange for stock (or stock and securities) of the acquiring corporation and the assumption by the acquiring corporation of the transferor corporation’s liabilities;

(ii) A distribution of the stock (or stock and securities) of the acquiring corporation by the transferor corporation to the shareholders (or shareholders and security holders) of the transferor corporation; and

(iii) An exchange by the transferor corporation’s shareholders (or shareholders and security holders) of their stock (or stock and securities) of the transferor corporation for stock (or stock and securities) of the acquiring corporation under section 354(a).

(2) Rule applies regardless of whether a continuance under applicable law. For purposes of paragraph (f)(1) of this section, it shall be immaterial that the applicable foreign or domestic law treats the acquiring corporation as a continuance of the transferor corporation.

(g)(1) through (3) [Reserved]. For further guidance, see § 1.367(a)–1T(g)(1) through (3).

(4) * * * The rules in paragraph (e) of this section apply to transactions occurring on or after March 31, 1987. The rules in paragraph (f) of this section apply to transactions occurring on or after January 1, 1985.

Par. 4. Section 1.367(a)–1T is amended by revising paragraphs (e) and (f) to read as follows:

* * * * *

(e) [Reserved]. For further guidance, see § 1.367(a)–1(e).

(f) [Reserved]. For further guidance, see § 1.367(a)–1(f).

* * * * *

Par. 5. Section 1.368–2 is amended by adding paragraph (m) to read as follows:

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(m) Qualification as a reorganization under section 368(a)(1)(F)—(1) Mere change. To qualify as a reorganization under section 368(a)(1)(F), a transaction must result in a mere change in identity, form, or place of organization of one corporation, however effected (a mere change). A mere change can consist of a transaction that involves an actual or deemed transfer of property from one corporation (a transferor corporation) to one other corporation (a resulting corporation). Such a transaction is a mere change and qualifies as a reorganization under section 368(a)(1)(F) only if all the requirements set forth in paragraphs (m)(1)(i) through (vi) of this section are satisfied. For purposes of this paragraph (m), a transaction or a series of related transactions that can be tested against the requirements set forth in paragraphs (m)(1)(i) through (vi) of this section (a potential F reorganization) begins when the transferor corporation begins transferring (or is deemed to begin transferring) its assets, directly or indirectly, to the resulting corporation, and it ends when the transferor corporation has distributed (or is deemed to have distributed) to its shareholders the consideration it receives (or is deemed to receive) from the resulting corporation and has completely liquidated for federal income tax purposes. For purposes of this paragraph (m), deemed transfers include, for example, those provided in § 301.7701–3(g)(1)(iv) of this chapter (when an entity disregarded as separate from its owner elects under paragraph § 301.7701–3(c)(1)(i) of this chapter to be classified as an association, the owner of the entity is deemed to transfer all of the assets and liabilities of the entity to the association in exchange for stock of the association). Deemed transfers also include those resulting from the application of step transaction principles. For example, step transaction principles may disregard a transitory holding of property by an individual after a liquidation of the transferor corporation and before a subsequent transfer of the transferor corporation’s property to the resulting corporation. Step transaction principles may also treat a contribution of all the stock of the transferor corporation to the resulting corporation, followed by a liquidation (or deemed liquidation) of the transferor corporation, as a deemed transfer of the transferor corporation’s property to the resulting corporation, followed by a distribution of stock of the resulting corporation in complete liquidation of the transferor corporation.

(i) Resulting corporation stock distributed in exchange for transferor corporation stock. Immediately after the potential F reorganization, all the stock of the resulting corporation, including any stock of the resulting corporation issued before the potential F reorganization, must have been distributed (or deemed distributed) in exchange for stock of the transferor corporation in the potential F reorganization. However, for purposes of this paragraph (m)(1)(i) and paragraph (m)(1)(ii) of this section, a de minimis amount of stock issued by the resulting corporation other than in respect of stock of the transferor corporation to facilitate the organization of the resulting corporation or maintain its legal existence is disregarded.

(ii) Identity of stock ownership. The same person or persons must own all of the stock of the transferor corporation, determined immediately before the potential F reorganization, and of the resulting corporation, determined immediately after the potential F reorganization, in identical proportions. However, this requirement is not violated if one or more holders of stock in the transferor corporation exchange stock in the transferor corporation for stock of equivalent value in the resulting corporation, but having different terms from those of the stock in the transferor corporation, or receive a distribution of money or other property from either the transferor corporation or the resulting corporation, whether or not in exchange for stock in the transferor corporation or the resulting corporation.

(iii) Prior assets or attributes of resulting corporation. The resulting corporation may not hold any property or have any tax attributes (including those specified in section 381(c)) immediately before the potential F reorganization. However, this requirement is not violated if the resulting corporation holds or has held a de minimis amount of assets to facilitate its organization or maintain its legal existence, and has tax attributes related to holding those assets, or holds the proceeds of borrowings undertaken in connection with the potential F reorganization.

(iv) Liquidation of transferor corporation. The transferor corporation must completely liquidate, for federal income tax purposes, in the potential F reorganization. However, the transferor corporation is not required to dissolve under applicable law and may retain a de minimis amount of assets for the sole purpose of preserving its legal existence.

(v) Resulting corporation is the only acquiring corporation. Immediately after the potential F reorganization, no corporation other than the resulting corporation may hold property that was held by the transferor corporation immediately before the potential F reorganization, if such other corporation would, as a result, succeed to and take into account the items of the transferor corporation described in section 381(c).

(vi) Transferor corporation is the only acquired corporation. Immediately after the potential F reorganization, the resulting corporation may not hold property acquired from a corporation other than the transferor corporation if the resulting corporation would, as a result, succeed to and take into account the items of such other corporation described in section 381(c).

(2) Non-application of continuity of interest and continuity of business enterprise requirements. A continuity of the business enterprise and a continuity of interest are not required for a potential F reorganization to qualify as a reorganization under section 368(a)(1)(F). See § 1.368–1(b).

(3) Related transactions—(i) Series of transactions. A potential F reorganization consisting of a series of related transactions that together result in a mere change of one corporation may qualify as a reorganization under section 368(a)(1)(F), whether or not certain steps in the series, viewed in isolation, could be subject to other Code provisions, such as sections 304(a), 331, 332, or 351. However, see paragraph (k) of this section for transactions that qualify as reorganizations under section 368(a) and will not be recharacterized as a mere change as a result of one or more subsequent transfers of assets or stock.

(ii) Mere change within a larger transaction. A potential F reorganization that qualifies as a reorganization under section 368(a)(1)(F) may occur before, within, or after other transactions that effect more than a mere change, even if the resulting corporation has only transitory existence. Related events that precede or follow the potential F reorganization generally will not cause that potential F reorganization to fail to qualify as a reorganization under section 368(a)(1)(F). Qualification of a potential F reorganization as a reorganization under section 368(a)(1)(F) will not alter the character of other transactions for federal income tax purposes, and step transaction principles may be applied to other transactions without regard to whether certain steps qualify as a reorganization or part of a reorganization under section 368(a)(1)(F).

(iii) Distributions treated as separate transactions. As provided in paragraph (m)(1)(ii) of this section, a potential F reorganization may qualify as a mere change even though a holder of stock in the transferor corporation receives a distribution of money or other property from either the transferor corporation or the resulting corporation. If a shareholder receives money or other property (including in exchange for its shares) from the transferor corporation or the resulting corporation in a potential F reorganization that qualifies as a reorganization under section 368(a)(1)(F), then the receipt of money or other property (including any exchanged for shares) is treated as an unrelated, separate transaction from the reorganization, whether or not connected in a formal sense. See § 1.301–1(l).

(iv) Transactions also qualifying under other provisions of section 368(a)(1). In certain cases, a potential F reorganization would (but for this paragraph (m)(3)(iv)) qualify both as a reorganization under section 368(a)(1)(F) and as a reorganization or part of a reorganization under another provision of section 368(a)(1). The following rules determine which of these overlapping qualifications applies.

(A) If the potential F reorganization or a step thereof qualifies as a reorganization or part of a reorganization under another provision of section 368(a)(1), and if a corporation in control (within the meaning of section 368(c)) of the resulting corporation is a party to such other reorganization (within the meaning of section 368(b)), the potential F reorganization will not qualify as a reorganization under section 368(a)(1)(F).

(B) Except as provided in paragraph (m)(3)(iv)(A) of this section, if, but for this paragraph (m)(3)(iv)(B), the potential F reorganization would qualify as a reorganization under both section 368(a)(1)(F) and one or more of sections 368(a)(1)(A), 368(a)(1)(C), or 368(a)(1)(D), then for all federal income tax purposes the potential F reorganization will qualify as a reorganization only under section 368(a)(1)(F).

(4) Examples. The following examples illustrate the application of this paragraph (m). Unless the facts otherwise indicate, A, B, and C are domestic individuals; P, S, T, X, Y, and Z (and similar designations) are domestic corporations; each transaction is entered into for a valid business purpose; all persons and transactions are unrelated; and all other relevant facts are set forth in the examples.

Example 1. Cash contribution and redemption – no mere change. C owns all of the stock of X, a State A corporation. The net value of X’s assets and liabilities is $1,000,000. Y, a State B corporation, seeks to acquire the assets of X for cash. To effect the acquisition, Y and X enter into an agreement under which Y will contribute $1,000,000 to Z, a newly formed corporation of which Y is the sole shareholder, in exchange for Z stock and X will merge into Z. In the merger, C surrenders all of the X stock and receives the $1,000,000 Y contributed to Z. C receives no Z stock in the transaction. After the merger, Y holds all of the Z stock, and Z holds all of the assets and liabilities previously held by X. Z stock is not distributed to the shareholders of X in exchange for their stock in X as required by paragraph (m)(1)(i) of this section, and the transaction results in a change in the ownership of X that does not result from an exchange or distribution described in paragraph (m)(1)(ii) of this section. Therefore, the merger of X into Z is not a mere change of X and does not qualify as a reorganization under section 368(a)(1)(F).

Example 2. Cash redemption – mere change. A owns 75%, and B owns 25%, of the stock of X, a State A corporation. The management of X determines that it would be in the best interest of X to reorganize under the laws of State B. Accordingly, X forms Y, a State B corporation, and X and Y enter into an agreement under which X will merge into Y. A does not wish to own stock in Y. In the merger, A surrenders A’s X stock and receives cash, and B surrenders all of B’s X stock and receives all the stock of Y. The change in ownership caused by A’s surrender of X stock results from a distribution and exchange described in paragraph (m)(1)(ii) of this section. Therefore, the merger of X into Y is a mere change of X and qualifies as a reorganization under section 368(a)(1)(F). Under paragraph (m)(3)(iii) of this section, A’s surrender of X stock for cash is treated as a transaction, separate from the reorganization, to which section 302(a) applies.

Example 3. Pre-transaction de minimis stock issuance – mere change – other provisions of section 368(a)(1). P owns all of the stock of S, a Country A corporation. The management of P determines that it would be in the best interest of S to change its place of incorporation to Country B. Under Country B law, a corporation must have at least two shareholders to enjoy limited liability. P is advised by its Country B advisors that the new corporation should issue 1% of its stock to a shareholder that is not P’s nominee to assure satisfaction of the two-shareholder requirement. As part of an integrated plan, C, an officer of S, organizes Y, a Country B corporation with 1,000 shares of common stock authorized, and contributes cash to Y in exchange for ten of the common shares. S then merges into Y under the laws of Country A and Country B. Pursuant to the plan of merger, P surrenders its shares of S stock and receives 990 shares of Y common stock. The ten shares of Y stock issued to C not in respect of the S stock are de minimis and are used to facilitate the organization of Y within the meaning of paragraph (m)(1)(i) of this section. Therefore, the issuance of this stock to a new shareholder does not prevent the merger of S into Y from qualifying as a mere change of S. Accordingly, the merger is a reorganization under section 368(a)(1)(F). Without regard to the merger’s qualification under section 368(a)(1)(F), the merger would also qualify as a reorganization under both section 368(a)(1)(A) and section 368(a)(1)(D). Under paragraph (m)(3)(iv)(B) of this section, if a potential F reorganization qualifies as a reorganization under section 368(a)(1)(F), and would also qualify under one or more of sections 368(a)(1)(A) or 368(a)(1)(D), the potential F reorganization qualifies only as a reorganization under 368(a)(1)(F), and neither section 368(a)(1)(A) nor section 368(a)(1)(D) will apply.

Example 4. Pre-transaction assets, attributes – no mere change. A owns all of the stock of P, and P owns all of the stock of S, which is engaged in a manufacturing business. P has owned the stock of S for many years. P owns no assets other than the stock of S. A decides to eliminate the holding company structure by merging P into S. Because it operates a manufacturing business, the potential resulting corporation, S, holds property and has tax attributes immediately before the potential F reorganization. Therefore, under paragraph (m)(1)(iii) of this section, the merger of P into S is not a mere change of P and does not qualify as a reorganization under section 368(a)(1)(F). The same result would occur under paragraph (m)(1)(iii) of this section if, instead of P merging into S, S merged into P, because P, the potential resulting corporation, holds property (the stock of S) and has tax attributes immediately before the potential F reorganization.

Example 5. Series of related transactions – mere change. P owns all of the stock of S1, a State A corporation. The management of P determines that it would be in the best interest of S1 to change its place of incorporation to State B. Accordingly, under an integrated plan, P forms S2, a new State B corporation; P contributes the S1 stock to S2; and S1 merges into S2 under the laws of State A and State B. Under paragraph (m)(3)(i) of this section, a series of transactions that together result in a mere change of one corporation may qualify as a reorganization under section 368(a)(1)(F). The contribution of S1 stock to S2 and the merger of S1 into S2 together constitute a mere change of S1. Therefore, the potential F reorganization qualifies as a reorganization under section 368(a)(1)(F). Without regard to its qualification under section 368(a)(1)(F), the potential F reorganization would also qualify as a reorganization under both section 368(a)(1)(A) and section 368(a)(1)(D). Under paragraph (m)(3)(iv)(B) of this section, if a potential F reorganization qualifies as a reorganization under section 368(a)(1)(F) and would also qualify under one or more of sections 368(a)(1)(A) or 368(a)(1)(D), it qualifies only as a reorganization under 368(a)(1)(F), and neither section 368(a)(1)(A) nor section 368(a)(1)(D) will apply. The result would be the same with respect to qualification under section 368(a)(1)(F) if, instead of merging into S2, S1 completely liquidates or is deemed to liquidate by reason of a conversion into an entity disregarded as separate from its owner under § 301.7701–3(g)(1)(iii) of this chapter.

Example 6. Post-transaction stock sale – mere change. P owns all of the stock of S1, a State A corporation. The management of P determines that it would be in the best interest of S1 to change its place of incorporation to State B. Accordingly, P forms S2, a new State B corporation. S1 then merges into S2 under the laws of State A and State B. Immediately thereafter, and as part of the same plan, P sells all of its stock in S2 to an unrelated party. Without regard to P’s sale of S2 stock, the merger of S1 into S2 is a potential F reorganization that qualifies as a mere change of S1 within the meaning of paragraph (m)(1) of this section. Under paragraph (m)(3)(ii) of this section, related events that occur before or after a potential F reorganization that qualifies as a mere change generally do not cause that potential F reorganization to fail to qualify as a reorganization under section 368(a)(1)(F). Therefore, P’s sale of the S2 stock is disregarded in determining whether the merger of S1 into S2 is a mere change of S1. Accordingly, the merger of S1 into S2 qualifies as a reorganization under section 368(a)(1)(F). The result would be the same if, instead of the S2 stock being sold by P, S2 merges into a previously unrelated corporation and terminates its separate existence.

Example 7. Post-transaction redemption – mere change. A owns all of the stock of T. P owns all of the stock of S. Each of T, P, and S is a State A corporation engaged in a manufacturing business. The following transactions occur pursuant to a single plan. First, T merges into S with A receiving solely stock in P. Second, P changes its state of incorporation to State B by merging into newly incorporated New P under the laws of State A and State B. Third, New P redeems all the New P stock issued to A in respect of A’s P stock (initially issued to A in respect of A’s T stock) for cash. Without regard to the other steps, the merger of P into New P is a potential F reorganization that qualifies as a reorganization under section 368(a)(1)(F). Under paragraph (m)(3)(ii) of this section, related events that occur before or after a potential F reorganization that qualifies as a mere change generally do not prevent that potential F reorganization from qualifying as a reorganization under section 368(a)(1)(F). Therefore, the merger of P into New P qualifies as a reorganization under section 368(a)(1)(F). Under paragraph (m)(3)(ii) of this section, the qualification of the merger of P into New P as a reorganization under section 368(a)(1)(F) does not alter the tax treatment of the merger of T into S. Because the P shares received by A in respect of the T shares (exchanged for New P shares in the mere change of P into New P) are redeemed for cash pursuant to the plan, the merger of T into S does not satisfy the continuity of interest requirement of § 1.368–1(e) and therefore does not qualify as a reorganization under section 368(a).

Example 8. Series of related transactions – mere change. P owns all of the stock of S, a State A corporation. The management of P determines that it would be in the best interest of S to change its form from a State A corporation to a State A limited partnership but to continue to be treated as a corporation for federal tax purposes. Accordingly, P contributes 1% of the S stock to newly formed LLC, a limited liability company, in exchange for all of the membership interests in LLC. P is the sole member of LLC. Under § 301.7701–3 of this chapter, LLC is disregarded as an entity separate from its owner, P. Then, under a State A statute, S converts to a State A limited partnership. In the conversion, P’s interest as a 99% shareholder of S is converted into a 99% limited partner interest, and LLC’s interest as a 1% shareholder of S is converted into a 1% general partner interest. S also elects, under § 301.7701–3(c) of this chapter, to be classified as a corporation for federal income tax purposes, effective on the same day as the conversion. Under paragraph (m)(3)(i) of this section, the conversion of S from a State A corporation to a State A limited partnership, together with the election to treat S as a corporation for federal tax purposes, results in a mere change of S and qualifies as a reorganization under section 368(a)(1)(F).

Example 9. Other acquiring corporation – no mere change. P owns 80%, and A owns 20%, of the stock of S. A and the management of P determine that it would be in the best interest of S to completely liquidate while A continues to operate part of the business of S in corporate form. Accordingly, S distributes 80% of its assets to P and 20% of its assets to A; S dissolves; and A contributes the assets it receives from S to newly incorporated New S in exchange for all of the stock of New S. S’s distribution of 80% of its property to P as part of the complete liquidation of S meets the requirements of section 332. Thus, section 381(a)(1) applies to P’s acquisition of 80% of the property held by S immediately before the transaction. Under paragraph (m)(1)(v) of this section, the potential F reorganization in which 20% of the property held by S immediately before the transaction is transferred to New S cannot be a mere change of S, because section 381(a) applies to P’s acquisition of property held by S immediately before the potential F reorganization. Accordingly, sections 331 and 336 apply to A’s acquisition of property from S and S’s distribution of property to A, and section 351 applies to A’s contribution of that property to New S.

Example 10. Other acquiring corporation – no mere change. P owns all of the stock of S1. The management of P determines that it would be in the best interest of S1 to merge S1 into P. Accordingly, pursuant to a state merger statute, S1 merges into P. Immediately afterward and as part of the same plan, P contributes 50% of the former assets of S1 to newly incorporated S2 in exchange for all of the stock of S2. The transaction does not qualify as a complete liquidation of S1 under section 332 (because of the reincorporation of some of S1’s assets) but does qualify as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(C) and paragraph (k) of this section. Under paragraph (m)(1)(v) of this section, the potential F reorganization in which some of the former assets of S1 are transferred (in form) first to P, and then to S2, is not a mere change of S1, because section 381(a) applies to P’s acquisition of property held by S1 immediately before the potential F reorganization. Furthermore, under paragraph (m)(3)(iv)(A) of this section, P, the corporation in control of S2 within the meaning of section 368(c), is a party to the reorganization within the meaning of section 368(b). Thus, the indirect transfer of property from S1 to S2 does not qualify under section 368(a)(1)(F).

Example 11. Other acquiring corporation – mere change. P owns all of the stock of S1. S1’s only asset is all of the equity interest in LLC2, a domestic limited liability company. Under § 301.7701–3 of this chapter, LLC2 is disregarded as an entity separate from its owner, S1. Pursuant to an integrated plan to undergo a reorganization under 368(a)(1)(F), S1 and LLC2 undergo the following two state law conversions. First, under state law LLC2 converts into S2, a corporation. Second, under state law S1 converts into LLC1, a domestic limited liability company. Under § 301.7701–3 of this chapter, LLC1 is disregarded as an entity separate from its owner, P. As a result of the two conversions, S1 is deemed to transfer its assets to S2 in exchange for all of the stock in S2 and then distribute the S2 stock to P in complete liquidation of S1. The two conversions, viewed as a potential F reorganization, constitute a mere change of S1, and that potential F reorganization qualifies as a reorganization under section 368(a)(1)(F). The result would be the same if, instead of converting into S2 pursuant to state law, LLC2 elected under § 301.7701–3(c) to change its classification for federal tax purposes and be treated as an association taxable as a corporation, provided the effective date of the election (and its resulting deemed transactions) occurs before the conversion of S1.

Example 12. Other acquiring corporation – no mere change. The facts are the same facts as in Example 11, except that S1 converts into LLC1 prior to the conversion of LLC2 into S2. As a result of these conversions, S1 is deemed to distribute all of its assets to P in exchange for all of P’s S1 stock, and P is deemed to transfer all of those assets to S2 in exchange for all of the stock in S2. The transaction does not qualify as a complete liquidation of S1 under section 332 (because of the reincorporation of S1’s assets), but does qualify as a reorganization under section 368(a)(1)(C) by reason of section 368(a)(2)(C) and paragraph (k) of this section. Under paragraph (m)(1)(v) of this section, the potential F reorganization in which the former assets of S1 are deemed transferred, first by S1 to P, and then by P to S2, is not a mere change of S1 because section 381(a) applies to P’s acquisition of property held by S1 immediately before the potential F reorganization. Furthermore, the corporation in control of S2, within the meaning of section 368(c), is a party to the reorganization within the meaning of section 368(b). Thus, the indirect transfer of property from S1 to S2 does not qualify under section 368(a)(1)(F).

Example 13. Series of related transactions – no mere change. X owns all of the stock of T. P acquires all of the stock of T in exchange for consideration consisting of $50 cash and P voting stock with $50 value. No election is made under section 338. Immediately thereafter and as part of the same plan, P forms S as a wholly-owned subsidiary, and T is merged into S. Viewed in isolation as a potential F reorganization, the merger of T into S appears to constitute a mere change of T. However, the acquisition of the T stock by P and the merger of T into S, viewed together, qualify as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(D). The step transaction doctrine is applied treat the transaction as a statutory merger of T into S in exchange for $50 cash and $50 of P’s voting stock (and S’s assumption of T’s liabilities), P’s momentary ownership of T stock is disregarded. Under paragraph (m)(3)(iv)(A) of this section, P, the corporation in control of S, is a party to the reorganization within the meaning of section 368(b). Thus, the transfer of property from T to S does not qualify under section 368(a)(1)(F).

Example 14. Multiple transferor corporations – no mere change. P owns all the stock of S1 and S2. The management of P determines it would be in the best interest of S1 and S2 to operate as a single corporation. P forms S3 and, under applicable corporate law,S1 and S2 simultaneously merge into S3. Immediately after the merger, P owns all the stock of S3. Each of the mergers can be tested as a potential F reorganization. However, immediately after the simultaneous mergers. the resulting corporation, S3, holds property acquired from a corporation other than the transferor corporation, and section 381(a) would apply to the acquisition of such property. Therefore, under paragraph (m)(1)(vi) of this section, neither potential F reorganization is a mere change, and neither merger into S3 qualifies as a reorganization under section 386(a)(1)(F). The result would be different if the mergers were not simultaneous. If S1 completed its merger into S3 before S2 began its merger into S3, the merger of S1 into S3 would qualify as a reorganization under section 368(a)(1)(F), but the merger of S2 into S3 would not so qualify (although it would qualify as a reorganization under sections 368(a)(1)(A) and 368(a)(1)(D)).

(5) Effective/Applicability Date. This paragraph (m) applies to transactions occurring on or after September 21, 2015.

On March 18, 2010, the Hiring Incentives to Restore Employment Act of 2010, Pub. L. 111–147 (H.R. 2847), added chapter 4 to Subtitle A of the Internal Revenue Code (sections 1471–1474 (commonly known as “FATCA”)). Chapter 4 generally requires withholding agents to withhold 30 percent on certain payments to a foreign financial institution (FFI) unless the FFI has entered into an agreement (FFI agreement) to obtain status as a participating FFI and to, among other things, report certain information with respect to U.S. accounts. On January 17, 2013, Treasury and the IRS published final regulations under chapter 4 (T.D. 9610, 78 Fed. Reg. 5873). On February 20, 2014, Treasury and the IRS published temporary regulations under chapter 4 (T.D. 9657, 79 Fed. Reg. 12,812) that clarify and modify certain provisions of the final regulations (the temporary and final regulations, together, the chapter 4 regulations).

The amounts subject to withholding under chapter 4 are “withholdable payments.” Under § 1.1473–1(a), the term “withholdable payment” generally means any payment of U.S. source fixed or determinable annual or periodical (FDAP) income, and for sales or other dispositions occurring after December 31, 2016, any gross proceeds from the sale or other disposition of any property of a type that can produce interest or dividends that are U.S. source FDAP income. Withholding on withholdable payments of U.S. source FDAP income generally began on July 1, 2014. The transitional rule that provides for gross proceeds withholding after December 31, 2016, allows FFIs and withholding agents to implement FATCA in stages to minimize burdens consistent with ensuring that the information reporting objectives of FATCA are met and maintained.

Several transitional rules exist with respect to withholding under chapter 4 on withholdable payments of U.S. source FDAP income.

Under a transitional rule in § 1.1473–1(a)(4)(vi), a payment made on or before December 31, 2016, with respect to an “offshore obligation” is not treated as a withholdable payment if the payment is made by a person that is not acting as an intermediary (including a qualified securities lender and excluding any insurance broker with respect to premiums), withholding foreign partnership, or withholding foreign trust with respect to the payment.

Under § 1.1471–2(b), a withholdable payment does not include a payment made under a “grandfathered obligation.” A grandfathered obligation includes any obligation, as defined in § 1.1471–2(b)(2)(ii), outstanding on July 1, 2014. Under § 1.1471–2(b)(2)(i)(A)(3), a grandfathered obligation also includes an agreement requiring a secured party to make a payment with respect to collateral posted to secure a grandfathered obligation. If collateral secures both grandfathered and non-grandfathered obligations, the collateral posted to secure the grandfathered obligations must be determined by allocating, pro rata by value, the collateral to all outstanding obligations secured by the collateral (the pro rata rule).

Furthermore, under a transitional rule in § 1.1473–1(a)(4)(vii), a payment made on or before December 31, 2016, by a secured party, or to a secured party other than a nonparticipating FFI, with respect to collateral securing one or more transactions under a collateral arrangement is not treated as a withholdable payment, provided that only a commercially reasonable amount of collateral is held by the secured party (or by a third party for the benefit of the secured party) as part of the collateral arrangement.

Chapter 4 provides that, in order for an FFI to obtain the status of a participating FFI, it must agree to all the requirements of being a participating FFI, including withholding on passthru payments made to recalcitrant account holders and nonparticipating FFIs. See section 1471(b)(1)(D)(i). A passthru payment is defined in the regulations to mean a withholdable payment and any foreign passthru payment. The chapter 4 regulations reserve on the definition of the term “foreign passthru payment.” See § 1.1471–5(h)(2). A transitional rule in § 1.1471–4(b)(4) provides that a participating FFI is not required to withhold tax on a foreign passthru payment made to a recalcitrant account holder or a nonparticipating FFI before the later of January 1, 2017, or the date of publication in the Federal Register of final regulations defining foreign passthru payment.

In order for an FFI that is a member of an expanded affiliated group (EAG) to obtain the status of a participating FFI or registered deemed-compliant FFI, § 1.1471–4(a)(4) requires that each FFI that is a member of the EAG have the chapter 4 status of a participating FFI, deemed-compliant FFI, or exempt beneficial owner. The final regulations include two transitional rules to provide limited relief to FFIs with branches or affiliates that are located in jurisdictions whose laws prohibit such branches or affiliates from complying with an FFI agreement. These transitional rules are intended to provide jurisdictions additional time to enter into an IGA with the United States or to modify their domestic laws to allow FFIs not covered by an IGA to be able to comply with the terms of the FFI agreement.

Under the transitional rule for a “limited branch,” an FFI that otherwise satisfies the requirements for participating FFI status can become a participating FFI, notwithstanding that one or more branches cannot satisfy the requirements of a participating FFI, provided that all noncompliant branches satisfy the conditions for limited branch status and the FFI meets the other requirements described in § 1.1471–4(e)(2)(i). Under the transitional rule for a “limited FFI,” an FFI can become either a participating FFI or a registered deemed-compliant FFI, notwithstanding that one or more other FFIs in its EAG cannot comply with all of the requirements of a participating FFI, provided that any such noncompliant FFIs meet the definition of a “limited FFI” under § 1.1471–4(e)(3). Under §§ 1.1471–4(e)(2)(v) and (3)(iv), limited branch and limited FFI statuses will be unavailable after December 31, 2015.

Under section 1471, a withholding agent is not generally required to withhold on payments to an FFI that is deemed to comply with the requirements of section 1471(b) (a deemed-compliant FFI). The chapter 4 regulations provide that a registered deemed-compliant FFI includes an FFI that satisfies the requirements of § 1.1471–5(f)(1)(i)(F)(1) or (2) to qualify as either a sponsored investment entity or a sponsored controlled foreign corporation (a sponsored registered deemed-compliant FFI). A sponsoring entity of a sponsored registered deemed-compliant FFI must agree to perform, on behalf of the FFI, all due diligence, withholding, reporting, and other requirements that the FFI would have been required to perform if it were a participating FFI. A sponsoring entity must register with the IRS as a sponsoring entity and must also register the sponsored registered deemed-compliant FFI by the later of January 1, 2016, or the date that the FFI identifies itself as qualifying as a registered deemed-compliant FFI under § 1.1471–5(f)(1)(i)(F)(1) or (2). The chapter 4 regulations include a transitional due diligence rule providing that for payments prior to January 1, 2016, a withholding agent may rely on a withholding certificate provided by a sponsored registered deemed-compliant FFI that includes only the global intermediary identification number (GIIN) of the FFI’s sponsoring entity. See § 1.1471–3(e)(3)(iv)(B) (cross-referenced in § 1.1471–3(d)(4)(i)) for additional due diligence requirements that apply in such cases.

Under section IV(B)(3)(c) of Annex II of the Model 1 IGA, if the sponsoring entity of a sponsored investment entity or sponsored controlled foreign corporation identifies any U.S. reportable accounts, the sponsoring entity must register the sponsored entity with the IRS on or before the later of December 31, 2015, and the date that is 90 days after such account is first identified. Under section IV(B)(3)(c) of Annex II of the Model 2 IGA, the sponsoring entity must register the sponsored entity prior to December 31, 2015.

Under section 1472, a withholding agent generally is required to withhold on payments to a nonfinancial foreign entity (NFFE) unless the NFFE provides the withholding agent with certain information identifying the NFFE’s substantial U.S. owners (or a certification that the NFFE does not have any such owners), and the withholding agent reports such information to the IRS. The final regulations except withholding agents from withholding or reporting under section 1472 with respect to payments beneficially owned by entities qualifying as excepted NFFEs. The temporary regulations issued under chapter 4 add direct reporting NFFEs as a class of excepted NFFEs. A direct reporting NFFE is an NFFE that elects to report information about its substantial U.S. owners directly to the IRS (rather than to its withholding agent) and that meets the requirements of § 1.1472–1(c)(3). A direct reporting NFFE must register with the IRS and obtain a GIIN.

A direct reporting NFFE may elect to be treated as a sponsored direct reporting NFFE if another entity, other than a nonparticipating FFI, agrees to act as its sponsoring entity for performing all of the due diligence, reporting, and other requirements that the NFFE would have been required to perform as a direct reporting NFFE. A sponsoring entity of a sponsored direct reporting NFFE must register with the IRS as a sponsoring entity and must register the NFFE. The temporary regulations include a transitional due diligence rule for payments prior to January 1, 2016, that allows a withholding agent to rely on a withholding certificate provided by a sponsored direct reporting NFFE that includes only the GIIN of the NFFE’s sponsoring entity. See § 1.1471–3(e)(3)(iv)(B) for additional due diligence requirements that apply in such cases.

Article 4(5) of the Model 1 IGA and Article 3(5) of the Model 2 IGA generally provide that, in order for an FFI resident in or organized under the laws of the partner jurisdiction to be compliant with the IGA and be treated as a participating FFI, deemed-compliant FFI, or exempt beneficial owner, as appropriate, all of the FFI’s related entities or branches must be FATCA-compliant. However, the Model 1 and Model 2 IGAs also provide that if a resident FFI has a related entity or branch that operates in a jurisdiction that prevents such entity or branch from complying with FATCA, or the FFI has a related entity or branch that is treated as a nonparticipating FFI solely due to the expiration of the transitional rule for limited FFIs and limited branches under the chapter 4 regulations, such FFI shall continue to be in compliance with the IGA and be treated as a participating FFI, deemed-compliant FFI, or exempt beneficial owner, as appropriate, if the conditions described in subparagraphs (a) through (c) of Article 4(5) of the Model 1 IGA or Article 3(5) of the Model 2 IGA are satisfied.

There are two versions of the Model 1 IGA. A Model 1A IGA provides for reciprocal information exchange between the United States and the partner jurisdiction. The obligation to exchange information generally begins after the IGA enters into force under Article 10(1) of the IGA and the competent authorities provide notification that each is satisfied that the other jurisdiction has in place the necessary safeguards to ensure that the information received will remain confidential and be used solely for tax purposes and the infrastructure necessary for an effective exchange relationship. See Articles 3(8) and 3(9) of the Model 1A IGA.

A Model 1B IGA provides for information to be exchanged only by the partner jurisdiction. Under a Model 1B IGA, the obligation for a partner jurisdiction to exchange information with the United States begins when the IGA enters into force under Article 10(1) or Article 12(1) (as applicable) of the IGA.

Once an IGA has entered into force and any relevant notifications described above for the Model 1A IGA have been provided, Article 2 of both versions of the Model 1 IGA requires the partner jurisdiction to obtain and exchange specified information with respect to each U.S. reportable account. Under Article 3(5) of the Model 1 IGA, the partner jurisdiction is obligated to obtain and exchange information within nine months after the end of the calendar year to which the information relates. In the case of information required to be obtained and exchanged with respect to 2014 pursuant to a Model 1 IGA that is in force, the 2014 information should be exchanged by the partner jurisdiction by September 30, 2015.

B is a housing authority established by Tribe C, a federally recognized Indian tribe. The Director and the Assistant Director of B are both members of Tribe C. During each of the 2011, 2012, and 2013 taxable years, the Director and the Assistant Director are each paid bonuses in the amount of $15x. In the 2014 taxable year, members of Tribe C’s Tribal Council authorize per capita distributions out of the tribe’s tribal Trust Account in the amount of $1x to every member of the tribe and an additional $2x in per capita distributions to every elder in the tribe. In addition, the members of Tribe C’s Tribal Council authorize distributions out of the tribal Trust Account to the Director and Assistant Director in the amount of $15x each, instead of paying bonuses to the Director and the Assistant Director. The distributions of $15x to the Director and the Assistant Director are mischaracterized compensation and, therefore, are included in their gross income under 26 U.S.C. § 61.

Tribe D is a federally recognized Indian tribe. A group of Tribe D members own Corporation E, an information technology company that provides call center services. Corporation E’s headquarters is located on land held in trust by the Secretary of the Interior for the benefit of Tribe D. Tribe D charges Corporation E rent at fair market value for its headquarters. However, the lease agreement with Tribe D includes a provision whereby Corporation E also deposits an amount approximating its net revenues into Tribe D’s tribal Trust Account, characterizing the revenue as additional rent. Subsequently, members of Tribe D’s Tribal Council authorize per capita distributions out of the tribal Trust Account in an aggregate amount equal to the purported “additional rent” to the group of Tribe D members who own Corporation E. The distributions of the mischaracterized business profits from the tribal Trust Account constitute gross income under 26 U.S.C. § 61 to the members receiving the distributions.

Tribe F is a federally recognized Indian tribe. Tribe F owns all of Corporation G, which owns and operates a casino located on land held in trust by the Secretary of the Interior for the benefit of Tribe F. All of Corporation G’s gaming revenues are subject to the Indian Gaming Regulatory Act. After paying out all prizes and all administrative expenses (excluding management fees), Corporation G distributes 50% of its net gaming revenues to Tribe F. Also, under a lease agreement with Tribe F, Corporation G deposits the remaining 50% of its net gaming revenues into Tribe F’s tribal Trust Account, characterizing the deposits as rent for use of the land for the casino. Subsequently, members of Tribe F’s Tribal Council authorize per capita distributions to every member of the tribe out of the net gaming revenues that are held in the tribal Trust Account. The distributions out of the tribal Trust Account are mischaracterized gaming revenues. Because per capita distributions of net gaming revenues are subject to federal income taxation, the distributions constitute gross income under 26 U.S.C. § 61 to the members of the tribe receiving the distributions.

Section 1302(e) of the Affordable Care Act provides for catastrophic health plans. These plans are minimum essential coverage and qualified health plans, may be offered only in the individual market, and may be enrolled in through an Exchange, but taxpayers may not claim the premium tax credit for this coverage. See § 36B(c)(3)(A).

For purposes of reporting by Exchanges under § 36B(f)(3) on coverage in a qualified health plan, the term qualified health plan has the same meaning as in § 1301(a) of the Affordable Care Act except that it does not include a catastrophic plan described in § 1302(e) of the Affordable Care Act. Section 1.36B–1(c). Accordingly, Exchanges do not report on catastrophic coverage. Section 1.36B–1(c), –5(a). The § 6055 regulations, however, provide that health insurance issuers need not report on coverage in a qualified health plan in the individual market enrolled in through an Exchange, because that information is generally reported by Exchanges under § 36B(f)(3). As a result, at present neither the Exchanges nor health insurance issuers have the responsibility for reporting minimum essential coverage under a catastrophic plan.

To ensure that there is reporting of catastrophic health plans enrolled in through an Exchange, the Treasury Department and the IRS intend to propose regulations under § 6055 requiring issuers of these plans to report the coverage on Form 1095–B. The Treasury Department and the IRS anticipate that the regulations will apply to coverage in 2016 and to returns and statements filed and furnished in 2017. Health insurance issuers may report on 2015 catastrophic coverage (on returns and statements filed and furnished in 2016) and are encouraged to do so. An issuer that reports on 2015 catastrophic coverage will not be subject to penalties for these returns.

The Treasury Department and the IRS anticipate publishing regulations under § 6055 to clarify that health insurance issuers and carriers reporting on insured group health plans may use the TTIN of the employer sponsoring the plan on the statement furnished to the taxpayer.

Proposed § 6055 regulations also will provide that statements reporting coverage under an expatriate health plan may be furnished in electronic format unless the recipient affirmatively refuses consent or requests a paper statement. Reporting entities may apply these rules for coverage under expatriate health plans that are issued or renewed on or after July 1, 2015, and may rely on Notice 2015–43, 2015–29 I.R.B. 73, which addresses the definition of “expatriate health plans” and provides transition relief.

The supplemental coverage rule in § 1.6055–1(d)(2) is intended to eliminate duplicate reporting of an individual’s minimum essential coverage under circumstances when there is reasonable certainty that the provider of the “primary” coverage will report. This rule has proven to be confusing. Accordingly, the Treasury Department and the IRS anticipate proposing regulations that would replace this rule with rules providing that (1) if an individual is covered by multiple minimum essential coverage plans or programs provided by the same provider, reporting is required for only one of them; and (2) reporting generally is not required for an individual’s minimum essential coverage for which an individual is eligible only if the individual is covered by other minimum essential coverage for which § 6055 reporting is required.

These rules would apply month by month and individual by individual. Thus, under the first rule (that is, the rule for reporting multiple minimum essential coverage plans or programs of the same provider), if for a month an individual is enrolled in a self-insured group health plan and also has a self-insured health reimbursement arrangement (HRA) from the same employer, the provider (the employer) is required to report only one type of coverage for that individual. If an employee is covered under both arrangements for some months of the year but retires or otherwise drops coverage under the non-HRA group health plan and is covered only under the HRA, the employer must report coverage under the HRA for the months after the employee retires or drops the non-HRA coverage. The employer must report the coverage in an arrangement of any individual who is covered by only one arrangement.

Under the second rule (that is, the rule for reporting minimum essential coverage for which an individual is eligible only if the individual is covered by other minimum essential coverage), reporting would not be required for Medicare or TRICARE supplements and Medicaid coverage providing benefits only to an individual enrolled in other coverage for which reporting is required, such as employer coverage or a qualified health plan. Reporting also would not be required under the second rule for an HRA that is available only to employees and other individuals who enroll in an employer’s insured group health plan for months that the individual is enrolled in the insured group health plan. It is anticipated that, for employer coverage, this rule will apply only if the two types of coverage are eligible employer-sponsored coverage of the same employer. For example, if an employee is enrolled in both his employer’s HRA and insured group health plan, the employer is not required to report the employee’s coverage under the HRA. However, if an employee is enrolled in an employer’s HRA and in a spouse’s non-HRA group health plan, the employee’s employer would be required to report for the HRA, and the employee’s spouse’s employer (or the health insurance issuer or carrier, if the plan is insured) would be required to report for the non-HRA group health plan coverage.

A reporting entity that fails to comply with the filing and statement furnishing requirements of § 6055 may be subject to penalties for failure to file a correct information return (§ 6721) or to furnish a correct payee statement (§ 6722). The preamble to the § 6055 regulations (T.D. 9660, 79 FR 13220) provides short-term relief from reporting penalties for 2015 coverage. Specifically, the IRS will not impose penalties under §§ 6721 and 6722 on reporting entities that can show that they have made good faith efforts to comply with the information reporting requirements. This relief applies to incorrect or incomplete information, including TINs or dates of birth, reported on a return or statement.

The preamble to the § 6055 regulations also notes the general rule that, under § 6724 and the related regulations, the §§ 6721 and 6722 penalties may be waived if a failure is due to reasonable cause, that is, the reporting entity demonstrates that it acted in a responsible manner and the failure is due to significant mitigating factors or events beyond the reporting entity’s control. Section 301.6724–1(e) provides specific procedures for soliciting TINs which, if followed, establish that a reporting entity that does not report a TIN has acted in a responsible manner.

Nonetheless, reporting entities have expressed concerns that § 6055 reporting has significant differences from other information reporting provisions that are not adequately addressed by the regulations under § 6724 for establishing reasonable cause. For example, reporting entities asserted that the requirements for TIN solicitation under § 301.6724–1(e) are not practical in the context of § 6055 reporting.

The Treasury Department and the IRS request comments on the application of the reasonable good cause rules under § 6724 to § 6055 reporting, and in particular the rules under § 301.6724–1(e) relating to TIN solicitation and reporting. Pending the issuance of additional guidance, reporting entities will not be subject to penalties for failure to report a TIN if they comply with the requirements of § 301.6724–1(e) with the following modifications: (1) the initial solicitation is made at an individual’s first enrollment or, if already enrolled on September 17, 2015, the next open season, (2) the second solicitation is made at a reasonable time thereafter, and (3) the third solicitation is made by December 31 of the year following the initial solicitation. Additionally, a reporting entity is not required to solicit a TIN from an individual whose coverage is terminated.

The governments of American Samoa, the Commonwealth of the Northern Mariana Islands, Guam, Puerto Rico, and the U.S. Virgin Islands provide Medicaid and CHIP coverage to their eligible residents. Because bona fide residents of U.S. possessions or territories are treated as having minimum essential coverage under § 5000A(f)(4), reporting of Medicaid and CHIP coverage for these taxpayers is not needed for administration of the individual shared responsibility requirement. Therefore, Medicaid and CHIP agencies in U.S. possessions or territories are not required to report that coverage under § 6055.

Section 5000A(f) does not identify the Basic Health Program as a government-sponsored program, but it closely resembles government-sponsored coverage such as Medicaid and CHIP. Accordingly, like Medicaid and CHIP, the state agency that administers the Basic Health Program is the entity that must report that coverage under § 6055.

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(c) * * *

(2) * * *

(iv) [The text of the proposed amendments to § 1.871–15(c)(2)(iv) is the same as the text of § 1.871–15T(c)(2)(iv) published elsewhere in this issue of the Internal Revenue Bulletin.]

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(h) [The text of the proposed amendments to § 1.871–15(h) is the same as the text of § 1.871–15T(h) published elsewhere in this issue of the Internal Revenue Bulletin.]

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(q) [The text of the proposed amendments to § 1.871–15(q) is the same as the text of § 1.871–15T(q) published elsewhere in this issue of the Internal Revenue Bulletin.]

Par. 3. Section 1.1441–1 is amended by revising paragraph (e)(3)(ii)(E) and paragraph (e)(6) to read as follows:

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(e) * * *

(3) * * *

(ii) * * *

(E) [The text of the proposed amendments to § 1.1441–1(e)(3)(ii)(E) is the same as the text of § 1.1441–1T(e)(3)(ii)(E) published elsewhere in this issue of the Internal Revenue Bulletin.]

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(5) [The text of the proposed amendments to § 1.1441–1(e)(5) is the same as the text of § 1.1441–1T(e)(5) published elsewhere in this issue of the Internal Revenue Bulletin.]

(6) [The text of the proposed amendments to § 1.1441–1(e)(6) is the same as the text of § 1.1441–1T(e)(6) published elsewhere in this issue of the Internal Revenue Bulletin.]

John Dalrymple Deputy Commissioner for Services and Enforcement.

Filed by the Office of the Federal Register on September 17, 2015, 8:45 a.m., and published in the issue of the Federal Register for September 18, 2015, 80 F.R. 56415)

The present CWA process requires that the acknowledgement provided to the donor contain information useful in preparing the donor’s tax return for the year of the contribution. To effectively substitute for the CWA, any donee reporting process would require not only that an information return be filed with the IRS, but also that a copy be provided to the donor for use in preparing the donor’s federal income tax return for the year of the contribution.

In order to better protect donor privacy, the Treasury Department and the IRS have concluded that the Form 990 series should not be used for donee reporting. Instead, before finalization of these proposed regulations, the IRS intends to develop a specific-use information return for donee reporting. Donees are not required to adopt donee reporting. Donees who opt to use donee reporting will be required to provide a copy of the information return to the donor at the address the donor provides for this purpose, and the information return will contain only the information related to that donor. The proposed regulations are reserved on the particular form that will be prescribed for this purpose.

Section 170(f)(8)(D) provides that a donee organization must include the information described in section 170(f)(8)(B) on its return for the donor to qualify for the donee reporting exception. Accordingly, the proposed regulations require that donees who opt to use donee reporting must report that information as well as the donor’s name, address, and taxpayer identification number. The donor’s taxpayer identification number is necessary in order to properly associate the donation information with the correct donor. Unlike a CWA, which is not sent to the IRS, the donee reporting information return will be sent to the IRS, which must have a means to store, maintain, and readily retrieve the return information for a specific taxpayer if and when substantiation is required in the course of an examination. The Treasury Department and the IRS request comments on the scope of the information necessary to verify substantiation of charitable contribution deductions under donee reporting.

The Treasury Department and the IRS are concerned about the potential risk for identity theft involved with donee reporting given that donees will be collecting donors’ taxpayer identification numbers and maintaining those numbers for some period of time. The Treasury Department and the IRS request comments on whether additional guidance is necessary regarding the procedures a donee should use in soliciting and maintaining a donor’s taxpayer identification number and address to mitigate the risk.

In order to minimize the burden on donees, the proposed regulations provide that donee reporting is not required, but may be done at the option of a donee organization. If a contribution is not reported using donee reporting, then the donor must obtain a CWA. The Treasury Department and the IRS request comments on these provisions and whether additional guidance is necessary to clarify the requirements for donors and donees if the donee chooses to use donee reporting for some or all of the contributions it receives. Also, because of the potential burden on donee organizations, the Treasury Department and the IRS request comments on how the donee reporting process might be better designed to minimize donee burden, and how it may interact with the requirement under section 6115 to provide donors information regarding quid pro quo contributions.

Section 170(f)(8) is premised on donors receiving timely substantiation of their donations of $250 or more. The CWA assists a donor preparing a return (as well as the IRS examining the return) in determining whether, and in what amount, a donor may claim a charitable contribution deduction. H.R. Rept. No. 103–111, at 783, 785 (1993), 1993–3 CB 167, 359, 361; Viralam v. Commissioner, 136 T.C. 151, 171 (2011); Addis v. Commissioner, 118 T.C. 528, 536 (2002), aff’d, 374 F.3d 881 (9th Cir. 2004); DiDonato v. Commissioner, T.C. Memo. 2011–153. It would be inconsistent with the purpose of section 170(f)(8) to allow an exception to the CWA requirement of section 170(f)(8)(A) based on information that might be reported by a donee on a return that is filed many years after the purported charitable contribution was made. Rather, any alternative method to using a CWA for substantiating charitable contributions through donee reporting must provide timely information to both the IRS and the donor in order to satisfy the purpose of section 170(f)(8).

Accordingly, the proposed regulations provide that any information return under section 170(f)(8)(D) must be filed by the donee no later than February 28th of the year following the year in which the contribution is made, and the donee organization must provide a copy of the information return to the donor by the same date. An information return that is not filed timely with the IRS, with a copy provided to the donor, will not qualify under section 170(f)(8)(D).

February 28th is the date when numerous other information returns concerning transactions with other persons must be filed. See, for example, § 1.6041–6 (information at source), § 1.6045–1(j) (returns of brokers), and § 1.6049–4(g) (returns regarding payment of interest). The requirement that a donee organization provide a copy of the information return to the donor no later than February 28th of the year following the year in which the contribution is made is intended to provide donors with timely information needed to claim appropriate charitable contribution deductions on their returns, as well as to ensure sound tax administration – objectives that will not be met if donee reporting is allowed to occur long after the contribution was made. In addition, for donors to be relieved of the obligation to obtain a CWA, the donee must file the donee reporting information return, and communicate that it has done so to the donor, before the due date for the donor’s return. The Treasury Department and the IRS request comments on the use of February 28th as the due date for filing a return and furnishing a copy to a donor.

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(f) * * *

(18) Donee organization reporting—(i) Prescribed form. [Reserved]

(ii) Content of return. A document will not qualify as a return for purposes of section 170(f)(8)(D) unless it contains all of the following information:

(A) The name and address of the donee;

(B) The name and address of the donor;

(C) The taxpayer identification number of the donor;

(D) The amount of cash and a description (but not necessarily the value) of any property other than cash contributed by the donor to the donee;

(E) Whether any goods and services were provided by the donee organization in consideration, in whole or in part, for the contribution by the donor; and

(F) A description and good faith estimate of the value of any goods and services provided by the donee organization or a statement that such goods and services consist solely of intangible religious benefits.

(iii) Time for filing return. Every donee organization filing a return described in section 170(f)(8)(D) shall file such return on or before February 28 of the year following the calendar year in which the contribution was made. If the return is not filed timely, the return does not qualify under section 170(f)(8)(D), and section 170(f)(8)(A) through (C) applies to the contribution.

(iv) Furnishing a copy to donor. Every donee organization filing a return described in section 170(f)(8)(D) shall furnish a copy of the return to the donor whose contribution is reported on such return on or before February 28 of the year following the calendar year in which the contribution was made. The copy of the return shall be provided to the donor at the address the donor provides for this purpose.

(v) Donee organization reporting at option of donee. Donee organization reporting is not required. Donee reporting is available solely at the option of a donee organization, and the requirements of section 170(f)(8)(A) through (C) apply to all contributions that are not reported using donee reporting.

(19) Effective/applicability date. Paragraphs (f)(1) through (17) of this section apply to contributions made on or after December 16, 1996. However, taxpayers may rely on the rules of paragraphs (f)(1) through (17) for contributions made on or after January 1, 1994. Paragraph (f)(18) of this section applies to contributions made on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.

John Dalrymple, Deputy Commissioner for Services and Enforcement.

Filed by the Office of the Federal Register on September 16, 2015, 8:45 a.m., and published in the issue of the Federal Register for September 17, 2015, 80 F.R. 55802)

Comments received in response to the request for comments in the preamble to the proposed regulations under section 954(i) recommended that the general rule under section 956 should treat an obligation of a foreign partnership held by a CFC as an obligation of a foreign person, rather than as an obligation of its partners, including any partners that are United States persons. Those comments noted that the inclusion of a domestic partnership in the definition of a United States person in section 7701 causes an obligation of a domestic partnership to be treated as an obligation of a United States person for purposes of section 956. Based on that observation, the comments asserted that section 956 implicitly treats both domestic and foreign partnerships as entities, rather than as aggregates of their partners, for purposes of determining whether an obligation of a partnership is United States property, such that an obligation of a foreign partnership with one or more partners that are United States persons should not be treated as an obligation of a United States person for purposes of section 956. The comments further stated that a general rule that treated an obligation of a foreign partnership as an obligation of a foreign person, rather than a United States person, would be consistent with the purposes of section 956.

The definition of United States person in section 7701(a)(30) includes a domestic partnership, such that an obligation of a domestic partnership generally is an obligation of a United States person for purposes of section 956. In contrast, section 7701 contains no corresponding definition of foreign person that includes a foreign partnership, nor any residual definition treating a person that is not a United States person as a foreign person. Moreover, section 956 does not address the status of an obligation of a foreign partnership as an obligation of a United States person or as United States property. Section 956(e), however, provides that the Secretary shall prescribe such regulations as may be necessary to carry out the purposes of section 956, including regulations to prevent the avoidance of section 956. Additionally, the Code and Regulations alternately treat partnerships either as aggregates of their partners or as entities, depending on the context and relevant policy considerations. For example, current law under section 956 employs both approaches with regard to domestic partnerships, applying an aggregate approach with respect to United States property held through a domestic partnership and an entity approach with respect to the obligations of a domestic partnership.

Section 956 is intended to prevent a United States shareholder of a CFC from inappropriately deferring U.S. taxation of CFC earnings and profits by “prevent[ing] the repatriation of income to the United States in a manner which does not subject it to U.S. taxation.” H.R. Rep. No. 87–1447, 87th Cong., 2d Sess., at 58 (1962). In the absence of section 956, a United States shareholder of a CFC could access the CFC’s funds (untaxed earnings and profits) in a variety of ways other than by the payment of an actual taxable dividend, such that there would be no reason for the United States shareholder to incur the dividend tax. Section 956 ensures that, to the extent CFC earnings are made available for use in the United States or for use by the United States shareholder, the United States shareholder of the CFC is subject to current U.S. taxation with respect to such amounts. Accordingly, under section 956, the investment by a CFC of its earnings and profits in United States property is “taxed to the [CFC’s] shareholders on the grounds that this is substantially the equivalent of a dividend.” S. Rep. No. 87–1881, 87th Cong., 2d Sess., at 88 (1962).

The Treasury Department and the IRS have determined that failing to treat an obligation of a foreign partnership as an obligation of its partners could allow deferral of U.S. taxation of CFC earnings and profits in a manner inconsistent with the purposes of section 956. When a United States shareholder can conduct operations through a foreign partnership using deferred CFC earnings, those earnings effectively have been made available to the United States shareholder. Additionally, because assets of a partnership generally are available to the partners without additional U.S. tax, a United States shareholder potentially could directly access deferred CFC earnings lent to a foreign partnership in which the United States shareholder is a partner without those earnings becoming subject to current U.S. tax by causing the partnership to make a distribution.

In light of these considerations, these proposed regulations treat an obligation of a foreign partnership as an obligation of its partners for purposes of section 956, subject to the exception described in Part 1.B of this preamble for obligations of foreign partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner. More specifically, proposed § 1.956–4(c)(1) generally treats an obligation of a foreign partnership as an obligation of the partners to the extent of each partner’s share of the obligation as determined in accordance with the partner’s interest in partnership profits. The Treasury Department and the IRS have considered various methods for determining a partner’s share of a partnership obligation, including the regulations under section 752 for determining a partner’s share of partnership liabilities, the partner’s liquidation value percentage (discussed in Part 3 of this preamble), and the partner’s interest in partnership profits. Using the partner’s interest in partnership profits to determine a partner’s share of a partnership obligation is consistent with the observation that, to the extent the proceeds of a partnership borrowing are used by the partnership to invest in profit-generating activities, partners in the partnership (including service partners with limited or no partnership capital) will benefit from the partnership obligation to the extent of their interests in the partnership profits. Taking this into account along with considerations of administrability, the Treasury Department and the IRS believe that it is appropriate to determine a partner’s share of a foreign partnership’s obligation in accordance with the partner’s interest in partnership profits. However, the Treasury Department and the IRS solicit comments on whether the liquidation value percentage method or another method would be a more appropriate basis for determining a partner’s share of a foreign partnership’s obligation.

The determination of a partner’s share of the obligation will be made as of the close of each quarter of the CFC’s taxable year in connection with the calculation of the amount of United States property held by the CFC for purposes of section 956(a)(1)(B). Thus, for example, if a partner in a foreign partnership is a United States shareholder of a CFC, an obligation of the partnership that is held by the CFC will be treated as United States property (subject to the exception described in Part 1.B of this preamble for obligations of foreign partnerships in which neither the lending CFC nor any person related to the lending CFC is a partner) to the extent of the United States shareholder partner’s share of the obligation as determined in accordance with the partner’s interest in partnership profits as of the close of each quarter of the CFC’s taxable year.

The general rule in proposed § 1.956–4(c)(1) also applies to determine the extent to which a CFC guarantees or otherwise supports an obligation of a related United States person when the related United States person is a partner in a foreign partnership that incurred the obligation that is the subject of the CFC’s credit enhancement. Likewise, if a CFC is a partner in a foreign partnership that owns property that would be United States property if held by the CFC, and the property is subject to a liability that would constitute a specific charge within the meaning of § 1.956–1(e)(1), the CFC’s share of the liability, as determined under proposed § 1.956–4(c)(1), would be treated as a specific charge that, under § 1.956–1(e)(1), could reduce the amount taken into account by the CFC in determining the amount of its share of the United States property, as determined under proposed § 1.956–4(b).

One commenter asserted that if a United States shareholder of a CFC is a partner in a foreign partnership and is treated as having an inclusion under section 956 when the CFC makes a loan to the partnership, as can occur under these proposed regulations, and that partner later receives an actual distribution from the partnership, the partner could have an inappropriate second inclusion when it is deemed to receive a distribution from the partnership upon the partnership’s repayment of the loan. The second inclusion in this fact pattern could arise under subchapter K to the extent the partner is required to reduce its basis in its partnership interest under section 733 on the actual distribution and again reduce its basis as a result of a deemed distribution under section 752(b) when its share of the loan is repaid. If the distributions exceed the partner’s basis in its partnership, including the increase to basis under section 752(a) when the partnership originally undertook the obligation, the partner could recognize gain under section 731. The commenter suggested that having inclusions under both section 956 and subchapter K in this fact pattern is inappropriate and that changes should be made to the subchapter K rules to prevent this result.

The Treasury Department and the IRS have determined that these proposed regulations and the existing rules under subchapter K and section 959 provide the appropriate result in the fact pattern described in the comment. The potential for gain under subchapter K in the fact pattern exists regardless of the application of section 956. The required inclusion under these proposed regulations to the extent a CFC is treated as holding an obligation of a United States person reflects policy considerations distinct from the policy considerations underlying the potential results under subchapter K. Moreover, in the fact pattern, the United States property held by the CFC in connection with its loan to the partnership generates previously taxed earnings and profits described in section 959(c)(1)(A) that, in general, are available for distribution by the CFC to its United States shareholder without further U.S. tax on the distributed amount. Accordingly, these proposed regulations do not include rules under subchapter K to address this comment.

The Treasury Department and the IRS have determined that certain obligations of foreign partnerships should not be treated as United States property. Under section 956(c)(2)(L), obligations of a domestic partnership are excluded from the definition of United States property if neither the CFC nor any related person (as defined in section 954(d)(3)) is a partner in the domestic partnership immediately after the acquisition by the CFC of any obligation of the partnership. The Treasury Department and the IRS have determined that the policy considerations underlying this rule are also relevant for comparable foreign partnerships. See H.R. Conf. Rep. No. 108–755, 108th Cong., 2d Sess., at 391 (2004); H.R. Rep. No. 108–548, 108th Cong., 2d Sess., at 198 (2004); S. Rep. No. 108–192, 108th Cong., 1st Sess., at 46 (2003). Accordingly, proposed § 1.956–4(c)(2) provides that an obligation of a foreign partnership is treated as an obligation of the foreign partnership (and not as an obligation of its partners) for purposes of determining whether a CFC holds United States property if neither the CFC nor any person related to the CFC (within the meaning of section 954(d)(3)) is a partner in the partneship.

The proposed regulations include a special rule that increases the amount of a foreign partnership obligation that is treated as United States property under the general rule when the following requirements are satisfied: (i) a CFC lends funds (or guarantees a loan) to a foreign partnership whose obligation is, in whole or in part, United States property with respect to the CFC pursuant to proposed § 1.956–4(c)(1); (ii) the partnership distributes the proceeds to a partner that is related to the CFC (within the meaning of section 954(d)(3)) and whose obligation would be United States property if held by the CFC; (iii) the foreign partnership would not have made the distribution but for a funding of the partnership through an obligation held (or treated as held) by the CFC; and (iv) the distribution exceeds the partner’s share of the partnership obligation as determined in accordance with the partner’s interest in partnership profits. When these requirements are satisfied, proposed § 1.956–4(c)(3) provides that the amount of the partnership obligation that is treated as an obligation of the distributee partner (and thus as United States property held by the CFC) is the lesser of the amount of the distribution that would not have been made but for the funding of the partnership and the amount of the partnership obligation. For example, assume a United States shareholder of a CFC that is related to the CFC within the meaning of section 954(d)(3) has a 60 percent interest in the profits of a foreign partnership and the CFC lends $100 to the partnership. If the partnership, in turn, distributes $100 to the United States shareholder in a distribution that would not have been made but for the funding by the CFC, the CFC will be treated as holding United States property in the amount of $100.

Section 1.956–1T(b)(5) of the temporary regulations published elsewhere in the Rules and Regulations section of this issue of the Internal Revenue Bulletin under section 956 also addresses the funded distribution fact pattern discussed above. That temporary rule also provides that the obligation of the foreign partnership is treated as an obligation of the distributee partner when similar conditions are satisfied. The Treasury Department and the IRS expect to withdraw § 1.956–1T(b)(5) as unnecessary when proposed § 1.956–4(c), including § 1.956–4(c)(3), is adopted as a final regulation.

Existing § 1.956–2(c)(1) provides that, subject to an exception, any obligation of a United States person with respect to which a CFC is a pledgor or guarantor is considered for purposes of section 956 to be United States property held by the CFC. In order to better align the regulations with the statutory text of section 956(d), these regulations propose to revise § 1.956–2(c)(1) to clarify that a CFC that is a pledgor or guarantor of an obligation of a United States person is treated as holding the obligation. Accordingly, under the proposed rule, the general exceptions to the definition of United States property would apply to the obligation treated as held by the CFC.

These proposed regulations provide that the pledge and guarantee rules under § 1.956–2(c) apply to a CFC that directly or indirectly guarantees an obligation of a foreign partnership that is treated as an obligation of a United States person under proposed § 1.956–4(c). Accordingly, if an obligation of a foreign partnership is treated as an obligation of a United States person pursuant to proposed § 1.956–4(c) and a CFC directly or indirectly guarantees the partnership obligation, the CFC will be treated as holding an obligation of the United States person.

These proposed regulations extend the pledge and guarantee rule in § 1.956–2(c)(1) to pledges and guarantees made by partnerships. Thus, proposed § 1.956–2(c)(1) provides that a partnership that guarantees an obligation of a United States person will be treated as holding the obligation for purposes of section 956. As a result, as discussed in Parts 2.D and 3 of this preamble, proposed § 1.956–4(b) will then treat the partners of the partnership that is the pledgor or guarantor as holding shares of that obligation. For example, if a partnership with one CFC partner guarantees an obligation of the CFC’s United States shareholder, the CFC will be treated as holding a share of the obligation under proposed §§ 1.956–1(e)(2), 1.956–2(c)(1), and 1.956–4(b).

Under current § 1.956–2(c)(2), a CFC is treated as a pledgor or guarantor of an obligation of a United States person if its assets serve at any time, even though indirectly, as security for the performance of the obligation. Consistent with this rule, a partnership should be considered a pledgor or guarantor of an obligation of a United States person if the partnership’s assets serve indirectly as security for the performance of the obligation, for example, because the partnership agrees to purchase the obligation at maturity if the United States person does not repay it. Thus, proposed § 1.956–2(c)(2) applies the indirect pledge or guarantee rule to domestic and foreign partnerships.

In the case of a partnership that is considered a pledgor or guarantor of an obligation under proposed § 1.956–2(c)(2), however, it would not be appropriate to separately apply § 1.956–2(c)(2) directly to a CFC partner in the partnership to treat the partner as a pledgor or guarantor (in addition to treating the partnership as a pledgor or guarantor) solely as a result of the partnership’s indirect pledge or guarantee. Therefore, proposed § 1.956–2(c)(2) provides that when a partnership is considered a pledgor or guarantor of an obligation, a CFC that is a partner in the partnership will not be treated as a pledgor or guarantor of the obligation solely as a result of its ownership of an interest in the partnership. Accordingly, the CFC will be treated under proposed § 1.956–4(b) as holding its share of the obligation to which the pledge or guarantee relates as described in Part 2.D of this preamble but will not also be treated as a separate indirect pledgor or guarantor of the obligation. As a result, the CFC will not be treated as holding more than its share of the obligation, as determined under proposed § 1.956–4(b).

As discussed in Part 1.A of this preamble, under proposed § 1.956–4(c) an obligation of a foreign partnership generally is treated as an obligation of the partners in the partnership. In addition, as discussed in Part 3 of this preamble, a partner in a partnership is treated as holding its attributable share of property held by the partnership. The application of these two rules and the proposed indirect pledge or guarantee rule could create uncertainty. For example, if a CFC and a related United States person were the only partners in a foreign partnership that borrowed from a person unrelated to the partners, an issue could arise as to whether the partnership assets attributed to the CFC under proposed § 1.956–4(b) are considered under proposed § 1.956–2(c)(2) to indirectly serve as security for the performance of the portion of the partnership obligation that is treated as an obligation of the United States person under proposed § 1.956–4(c).

A CFC that is a partner in a partnership should not be treated as a pledgor or guarantor of an obligation of the partnership merely because the CFC partner is treated under proposed § 1.956–4(b) as owning a portion of the partnership assets that support an obligation that is allocated under proposed § 1.956–4(c) to a partner that is a United States person. Accordingly, proposed § 1.956–4(d) provides that, for purposes of section 956 and proposed § 1.956–2(c)(2), if a CFC is a partner in a partnership, the attribution of the assets of the partnership to the CFC under proposed § 1.956–4(b) does not in and of itself give rise to an indirect pledge or an indirect guarantee of an obligation of the partnership that is allocated under proposed § 1.956–4(c) to a partner that is a United States person. This rule is consistent with the new rule under proposed § 1.956–2(c)(2) providing that a CFC that is a partner in a partnership will not be treated, solely as a result of its interest in the partnership, as a pledgor or guarantor of an obligation with respect to which the partnership is considered to be a pledgor or guarantor. However, as under current law, the determination of whether a CFC’s assets serve as security for the performance of an obligation for purposes of proposed § 1.956–2(c)(2) is based on all of the facts and circumstances. In appropriate circumstances, the existence of other factors, such as the use of proceeds from a partnership borrowing, the use of partnership assets as security for a partnership borrowing, or special allocations of partnership income or gain, may result in a CFC partner being considered a pledgor or guarantor of an obligation of the partnership pursuant to proposed § 1.956–2(c)(2) when taken into account in conjunction with the attribution of the assets of the partnership to the CFC.

Under existing § 1.956–1(e)(2), the amount taken into account by a CFC in determining the amount of its United States property with respect to a pledge or guarantee described in § 1.956–2(c)(1) is the unpaid principal amount of the obligation with respect to which the CFC is a pledgor or guarantor. In connection with the proposed revision to § 1.956–2(c)(1), which treats a partnership as holding an obligation with respect to which it is a pledgor or guarantor (as discussed in Part 2.B of this preamble), these regulations propose to revise § 1.956–1(e)(2) to also apply in cases in which partnerships are pledgors or guarantors of an obligation.

Accordingly, under proposed § 1.956–1(e)(2), as under current law, each pledgor or guarantor is treated as holding the entire unpaid principal amount of the obligation to which its pledge or guarantee relates. As a result, in cases in which there are, with respect to a single obligation, multiple pledgors or guarantors that are CFCs or partnerships in which a CFC is a partner, the aggregate amount of United States property treated as held by CFCs may exceed the unpaid principal amount of the obligation. To the extent that the CFCs have sufficient earnings and profits, there could be multiple section 951 inclusions with respect to the same obligation that exceed, in the aggregate, the unpaid principal amount of the obligation.

The Treasury Department and the IRS are considering whether to exercise the authority granted under section 956(e) to prescribe regulations as may be necessary to carry out the purposes of section 956 to allocate the amount of the obligation among the relevant CFCs so as to eliminate the potential for multiple inclusions and, instead, limit the aggregate inclusions to the unpaid principal amount of the obligation. Comments are requested on whether the Treasury Department and the IRS should adopt such a limitation, and if such a limitation were adopted, on methods to implement the limitation. One approach to implementing such a limitation would be to allow a taxpayer to allocate the unpaid principal amount of the obligation among the guarantor CFCs and partnerships based on any consistently applied, reasonable method selected by the taxpayer that results in aggregate section 951 inclusions equal to the unpaid principal amount.

Alternatively, the Treasury Department and the IRS could seek to establish a generally applicable method for allocating the unpaid principal amount of the obligation among the various guarantors. Allocating the unpaid principal amount of the obligation among multiple CFCs and partnerships in accordance with their available credit capacities measured, for example, by the relative net values of their assets might be broadly consistent with a creditor’s analysis of the support for the obligation, but such an approach would give rise to administrability concerns. A more administrable option would be to require taxpayers to allocate the unpaid principal amount of the obligation based on the earnings and profits of the CFCs that are treated as holding the obligation (or portion thereof). Several allocation methods based on earnings and profits are possible, including methods that allocate the unpaid principal amount of the obligation: (i) to all of the CFCs in accordance with their applicable earnings; (ii) to all of the CFCs in accordance with their earnings and profits described in section 959(c)(3); or (iii) first to the CFCs with only earnings and profits described in section 959(c)(3) (in accordance with their section 959(c)(3) earnings and profits), and then to the remainder of the CFCs, based on applicable earnings. All of these approaches could result in aggregate section 951 inclusions (for the year) totaling less than the unpaid principal amount of the obligation (for example, where one or more CFCs has previously taxed earnings and profits that reduce its section 951 inclusion).

In considering the options, the Treasury Department and the IRS will consider whether it is appropriate to select a method that could result in aggregate section 951 inclusions for a year totaling less than the unpaid principal amount of the obligation, the extent to which a particular method creates planning opportunities inconsistent with the policies underlying sections 956 and 959, and how administrable and effective the method is over multiple years. In particular, the Treasury Department and the IRS are concerned that certain proration methods could create an incentive for taxpayers to include as additional pledgors or guarantors of an obligation CFCs with substantial amounts of previously taxed earnings and profits, solely to allocate substantial portions of the obligation to these CFCs and thereby minimize the current section 951 inclusions. There are also a number of complexities that could affect the application of a rule that limits multiple inclusions, including differences in taxable years among the relevant CFCs and fluctuations in the unpaid principal amount of the obligation as well as the earnings and profits of the CFCs. The Treasury Department and the IRS request that comments on potential allocation methods address the issues described in this paragraph.

Under current § 1.956–2(a)(3), if a CFC is a partner in a partnership that holds property that would be United States property if held directly by the CFC partner, the CFC partner is treated as holding an interest in the property based on its interest in the partnership. These proposed regulations provide rules on the determination of the amount that the CFC partner is treated as holding under this rule, which is redesignated in these proposed regulations as proposed § 1.956–4(b).

Under proposed § 1.956–4(b), a CFC partner will be treated as holding its share of partnership property determined in accordance with the CFC partner’s liquidation value percentage, taking into account any special allocation of income, or, where appropriate, gain from that property that is not disregarded or reallocated under section 704(b) or any other Code section, regulation, or judicial doctrine and that does not have a principal purpose of avoiding the purposes of section 956. See § 1.704–1(b)(1)(iii). This rule serves, in general, as a reasonable measure of a partner’s interest in property held by a partnership because it generally results in an allocation of specific items of property that corresponds with each partner’s economic interest in that property, including any income, or gain, that may be subject to special allocations.

These proposed regulations include examples illustrating the application of this proposed rule, including an example that illustrates a case in which it is appropriate to take into account a special allocation of gain because the property is anticipated to appreciate in value but generate relatively little income. Although proposed § 1.956–4(b) would apply only to property acquired on or after publication in the Federal Register of the Treasury decision adopting the rule as a final regulation, it generally would be reasonable to use the method set forth in proposed § 1.956–4(b) to determine a partner’s interest in property acquired prior to finalization.

Although the method provided by proposed § 1.956–4(b) generally should reflect a partner’s economic interest in partnership property, the Treasury Department and the IRS solicit comments on whether there may be situations in which the method would not reflect the partners’ economic interest in the partnership or its property, and, if so, whether there are alternative measures or rules to better address such circumstances. Furthermore, the Treasury Department and the IRS solicit comments on whether a single method should be used as the general rule for determining both a partner’s share of a partnership obligation (as determined under proposed § 1.956–4(c), discussed in Part 1.A of this preamble) and a partner’s share of partnership assets, and, if so, whether the appropriate measure would be a partner’s interest in partnership profits, a partner’s liquidation value percentage, or an alternative measure.

Section 956(c)(3) provides that United States property generally includes trade or service receivables acquired from a related United States person in a factoring transaction when the obligor with respect to the receivables is a United States person. Section 1.956–3T(b)(2) provides rules for determining whether a trade or service receivable has been indirectly acquired from a related United States person for purposes of section 956(c)(3). These provisions include a rule that applies to receivables held on a CFC’s behalf by a partnership in which the CFC owns (directly or indirectly) a beneficial interest. See § 1.956–3T(b)(2)(ii)(A). This rule is similar to the rule in both current § 1.956–2(a)(3) and proposed § 1.956–4(b). Section 1.956–3T(b)(2) also includes a rule that applies to receivables held on a CFC’s behalf by another foreign corporation controlled by the CFC if one of the principal purposes for creating, organizing, or funding such other foreign corporation (through capital contributions or debt) is to avoid the application of section 956. See § 1.956–3T(b)(2)(ii)(B). This rule is similar to a rule in § 1.956–1T(b)(4).

The Treasury Department and the IRS have determined that the rules in § 1.956–3T(b)(2)(ii) applicable to factoring transactions involving partnerships should be consistent with the rules provided in § 1.956–1T(b)(4) and proposed § 1.956–4(b), which generally apply when partnerships own property that would be United States property in the hands of a CFC partner. Accordingly, these proposed regulations propose to revise the rules governing factoring transactions so that rules similar to the rules in current § 1.956–1T(b)(4) and proposed § 1.956–4(b) apply to factoring transactions involving partnerships. These proposed regulations also propose to revise the rules governing factoring transactions to remove the reference to S corporations, which are treated as partnerships for purposes of subpart F, including section 956. See section 1373(a).

The Treasury Department and the IRS understand that issues have arisen as to the proper treatment under section 956 of obligations of entities that are disregarded as entities separate from their owner for federal tax purposes. Accordingly, these proposed regulations state explicitly in proposed § 1.956–2(a)(3) that, for purposes of section 956, an obligation of a disregarded entity is treated as an obligation of the owner of the disregarded entity. Thus, for example, an obligation of a disregarded entity that is owned by a domestic corporation is treated as an obligation of the domestic corporation for purposes of section 956. The rule in proposed § 1.956–2(a)(3) follows from the application of the entity classification rules of § 301.7701–3 and is therefore not a change from current law.

In addition, proposed § 1.956–4(e) confirms that, for purposes of section 956, an obligation of a domestic partnership is an obligation of a United States person, regardless of whether the partners in the partnership are United States persons. Under section 956(c)(1)(C), an obligation of a United States person generally is United States property for purposes of section 956 unless an exception in section 956(c)(2) applies to the obligation. For example, as noted in Part 1.B of this preamble, section 956(c)(2)(L) would apply to exclude an obligation of a domestic partnership held by a CFC from the definition of United States property if neither the CFC nor a person related to the CFC (within the meaning of section 954(d)(3)) were a partner in the partnership.

These proposed regulations are proposed to be effective for taxable years of CFCs ending on or after the date of publication in the Federal Register of the Treasury decision adopting these rules as final regulations, and taxable years of United States shareholders in which or with which such taxable years end. Most of these rules are proposed to apply to property acquired, or pledges or guarantees entered into, on or after September 1, 2015, including property considered acquired, or pledges or guarantees considered entered into, on or after September 1, 2015, as a result of a deemed exchange pursuant to section 1001. See proposed § 1.956–4(c) (dealing with obligations of foreign partnerships, described in Part 1 of this preamble); proposed §§ 1.956–2(c), 1.956–4(d), and 1.956–1(e)(2) (dealing with pledges or guarantees, including pledges or guarantees either by a partnership or with respect to obligations of a foreign partnership, described in Part 2 of this preamble); and proposed § 1.956–3 (dealing with trade or service receivables acquired from related United States persons, described in Part 4 of this preamble). Two rules, however, are proposed to apply to obligations held on or after the date of publication in the Federal Register of the Treasury decision adopting these rules as final regulations. See proposed §§ 1.956–2(a)(3) and 1.956–4(e) (dealing with obligations of disregarded entities and domestic partnerships, respectively, described in Part 5 of this preamble). Finally, proposed § 1.956–4(b) (dealing with partnership property indirectly held by a CFC, described in Part 3 of this preamble) is proposed to apply to property acquired on or after the date of publication in the Federal Register of the Treasury decision adopting these rules as final regulations. No inference is intended as to the application of the provisions proposed to be amended by these proposed regulations under current law, including in transactions involving obligations of foreign partnerships. The IRS may, where appropriate, challenge transactions under currently applicable Code or regulatory provisions or judicial doctrines.

* * * * *

(c) * * *

(1) * * *

(i) [The text of proposed amendments to § 1.954–2(c)(1)(i) is the same as the text of § 1.954–2T(c)(1)(i) published elsewhere in this issue of the Internal Revenue Bulletin].

* * * * *

(iv) [The text of proposed amendments to § 1.954–2(c)(1)(iv) is the same as the text of § 1.954–2T(c)(1)(iv) published elsewhere in this issue of the Internal Revenue Bulletin].

(2) * * *

(ii) [The text of proposed amendments to § 1.954–2(c)(2)(ii) is the same as the text of § 1.954–2T(c)(2)(ii) published elsewhere in this issue of the Internal Revenue Bulletin].

(iii) * * *

(E) [The text of proposed amendments to § 1.954–2(c)(2)(iii)(E) is the same as the text of § 1.954–2T(c)(2)(iii)(E) published elsewhere in this issue of the Internal Revenue Bulletin].

* * * * *

(viii) [The text of proposed amendments to § 1.954–2(c)(2)(viii) is the same as the text of § 1.954–2T(c)(2)(viii) published elsewhere in this issue of the Internal Revenue Bulletin].

* * * * *

(d) * * *

(1) * * *

(i) [The text of proposed amendments to § 1.954–2(d)(1)(i) is the same as the text of § 1.954–2T(d)(1)(i) published elsewhere in this issue of the Internal Revenue Bulletin].

(ii) [The text of proposed amendments to § 1.954–2(d)(1)(ii) is the same as the text of § 1.954–2T(d)(1)(ii) published elsewhere in this issue of the Internal Revenue Bulletin].

(2) * * *

(ii) [The text of proposed amendments to § 1.954–2(d)(2)(ii) is the same as the text of § 1.954–2T(d)(2)(ii) published elsewhere in this issue of the Internal Revenue Bulletin].

(iii) * * *

(E) [The text of proposed amendments to § 1.954–2(d)(2)(iii)(E) is the same as the text of § 1.954–2T(d)(2)(iii)(E) published elsewhere in this issue of the Internal Revenue Bulletin].

* * * * *

(v) [The text of proposed amendments to § 1.954–2(d)(2)(v) is the same as the text of § 1.954–2T(d)(2)(v) published elsewhere in this issue of the Internal Revenue Bulletin].

* * * * *

(j) [The text of proposed amendments to § 1.954–2(j) is the same as the text of § 1.954–2T(j) published elsewhere in this issue of the Internal Revenue Bulletin].

Par. 3. Section 1.956–1 is amended by revising paragraphs (b)(4) and (5), (e)(2), and (g), to read as follows:

* * * * *

(b) * * *

(4) [The text of proposed amendments to § 1.956–1(b)(4) is the same as the text of § 1.956–1T(b)(4) published elsewhere in this issue of the Internal Revenue Bulletin].

(5) [The text of proposed amendments to § 1.956–1(b)(5) is the same as the text of § 1.956–1T(b)(5) published elsewhere in this issue of the Internal Revenue Bulletin].

* * * * *

(e) * * *

(2) Rule for pledges and guarantees. For purposes of this section, the amount of an obligation treated as held (before application of § 1.956–4(b)) as a result of a pledge or guarantee described in § 1.956–2(c) is the unpaid principal amount of the obligation on the applicable determination date.

* * * * *

(g) through (g)(2) [The text of proposed amendments to § 1.956–1(g) through (g)(2) is the same as the text of § 1.956–1T(g) through (g)(2) published elsewhere in this issue of the Internal Revenue Bulletin].

(3) Paragraph (e)(2) of this section applies to taxable years of controlled foreign corporations ending on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation, and taxable years of United States shareholders in which or with which such taxable years end, with respect to pledges or guarantees entered into on or after September 1, 2015. For purposes of this paragraph (g)(3), a pledgor or guarantor is treated as entering into a pledge or guarantee when there is a significant modification, within the meaning of § 1.1001–3(e), of an obligation with respect to which it is a pledgor or guarantor on or after September 1, 2015.

* * * * *

Par. 4. Section 1.956–2 is amended by:

a. Revising paragraphs (a)(3) and (c)(1) and (2);

b. Adding Example 4 to paragraph (c)(3);

c. Adding reserved paragraph (g); and

d. Adding paragraph (h).

The revisions and additions read as follows:

(a) * * *

(3) Treatment of disregarded entities. For purposes of section 956, an obligation of a business entity (as defined in § 301.7701–2(a) of this chapter) that is disregarded as an entity separate from its owner for federal tax purposes under §§ 301.7701–1 through 301.7701–3 of this chapter is treated as an obligation of its owner.

* * * * *

(c) * * *(1) General rule. Except as provided in paragraph (c)(4) of this section, for purposes of section 956, any obligation of a United States person with respect to which a controlled foreign corporation or a partnership is a pledgor or guarantor will be considered to be held by the controlled foreign corporation or the partnership, as the case may be. See § 1.956–1(e)(2) for rules that determine the amount of the obligation treated as held by a pledgor or guarantor under this paragraph (c). For rules that treat an obligation of a foreign partnership as an obligation of the partners in the foreign partnership for purposes of section 956, see § 1.956–4(c).

(2) Indirect pledge or guarantee. If the assets of a controlled foreign corporation or a partnership serve at any time, even though indirectly, as security for the performance of an obligation of a United States person, then, for purposes of paragraph (c)(1) of this section, the controlled foreign corporation or partnership will be considered a pledgor or guarantor of that obligation. If a partnership is considered a pledgor or guarantor of an obligation, a controlled foreign corporation that is a partner in the partnership will not also be treated as a pledgor or guarantor of the obligation solely as a result of its ownership of an interest in the partnership. For purposes of this paragraph, a pledge of stock of a controlled foreign corporation representing at least 66 2/3 percent of the total combined voting power of all classes of voting stock of such corporation will be considered an indirect pledge of the assets of the controlled foreign corporation if the pledge is accompanied by one or more negative covenants or similar restrictions on the shareholder effectively limiting the corporation’s discretion to dispose of assets and/or incur liabilities other than in the ordinary course of business. See § 1.956–4(d) for guidance on the treatment of indirect pledges or guarantees of an obligation of a partnership attributed to its partners under § 1.956–4(c).

(3) * * *

* * * * *

Example 4. (i) Facts. USP, a domestic corporation, owns 70% of the stock of FS, a controlled foreign corporation, and a 90% interest in FPRS, a foreign partnership. X, an unrelated foreign person, owns 30% of the stock of FS. Y, an unrelated foreign person, owns a 10% interest in FPRS. There are no special allocations in the FPRS partnership agreement. FPRS borrows $100x from Z, an unrelated person. FS pledges its assets as security for FPRS’s performance of its obligation to repay the $100x loan. USP’s share of the $100x FPRS obligation, determined in accordance with its interest in partnership profits, is $90x. Under § 1.956–4(c), $90x of the FPRS obligation is treated as an obligation of USP for purposes of section 956.

(ii) Result. For purposes of section 956, under paragraph (c)(1) of this section, FS is considered to hold an obligation of USP in the amount of $90x, and thus is treated as holding United States property in the amount of $90x.

* * * * *

(h) Effective/applicability date. (1) Paragraph (a)(3) of this section applies to taxable years of controlled foreign corporations ending on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation, and taxable years of United States shareholders in which or with which such taxable years end, with respect to obligations held on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation.

(2) Paragraphs (c)(1), (c)(2), and Example 4 of paragraph (c)(3) of this section apply to taxable years of controlled foreign corporations ending on or after the date of publication in the Federal Register of the Treasury decision adopting these rules as final regulations, and taxable years of United States shareholders in which or with which such taxable years end, with respect to pledges and guarantees entered into on or after September 1, 2015. For purposes of this paragraph (h)(2), a pledgor or guarantor is treated as entering into a pledge or guarantee when there is a significant modification, within the meaning of § 1.1001–3(e), of an obligation with respect to which it is a pledgor or guarantor on or after September 1, 2015.

Par. 5. Section 1.956–3 is added to read as follows:

(a) through (b)(2)(i) [Reserved]. For further guidance, see § 1.956–3T(a) through (b)(2)(i).

(ii) Acquisition by nominee, pass-through entity, or related foreign corporation. A controlled foreign corporation is treated as holding a trade or service receivable that is held by a nominee on its behalf, or by a simple trust or other pass-through entity (other than a partnership) to the extent of its direct or indirect ownership or beneficial interest in such simple trust or other pass-through entity. See §§ 1.956–1T(b)(4) and 1.956–4(b) for rules that may treat a controlled foreign corporation as indirectly holding a trade or service receivable held by a foreign corporation or partnership. A controlled foreign corporation that is treated as holding a trade or service receivable held by another person (the direct holder) (or that would be treated as holding the receivable if the receivable were United States property or would be United States property if held directly by the controlled foreign corporation) is considered to have acquired the receivable from the person from whom the direct holder acquired the receivable. This paragraph (b)(2)(ii) does not limit the application of paragraph (b)(2)(iii) of this section. The following examples illustrate the application of this paragraph (b)(2)(ii):

Example 1. (i) Facts. A domestic corporation, P, wholly owns a controlled foreign corporation, FS, with substantial earnings and profits. FS contributes $200x of cash to a partnership, PRS, in exchange for an 80% partnership interest. An unrelated foreign person contributes real estate located in a foreign country with a fair market value of $50x to PRS for the remaining 20% partnership interest. There are no special allocations in the PRS partnership agreement. PRS uses the $200x of cash received from FS to purchase trade receivables from P. The obligors with respect to the trade receivables are United States persons that are not related to any partner in PRS. The liquidation value percentage, as determined under § 1.956–4(b), for FS with respect to PRS is 80%. A principal purpose of funding PRS (through FS’s cash contribution) is to avoid the application of section 956 with respect to FS.

(ii) Result. Under § 1.956–4(b)(1), FS is treated as holding 80% of the trade receivables acquired by PRS from P, with a basis equal to $160x (80% x $200x, PRS’s basis in the trade receivables). However, because FS controls PRS and a principal purpose of FS funding PRS was to avoid the application of section 956 with respect to FS, under § 1.956–1T(b)(4), if the trade receivables would be United States property if held directly by FS, FS additionally would be treated as holding the trade receivables to the extent that they exceed the amount of the receivables it holds under § 1.956–4(b), which is $40x ($200x – $160x). Accordingly, under this paragraph (b)(2)(ii), FS is treated as having acquired from P, a related United States person, the trade receivables that it is treated as holding with a basis equal to $200x ($160x + $40x). Thus, FS is treated as holding United States property with a basis of $200x under paragraph (a) of this section.

Example 2. (i) Facts. A domestic corporation, P, wholly owns a controlled foreign corporation, FS1, that has earnings and profits of at least $300x. FS1 organizes a foreign corporation, FS2, with a $200x cash contribution. FS2 uses the cash contribution to purchase trade receivables from P. The obligors with respect to the trade receivables are unrelated United States persons. A principal purpose of funding FS2 (through FS1’s cash contribution) is to avoid the application of section 956 with respect to FS1.

(ii) Result. Under § 1.956–1T(b)(4), if the trade receivables held by FS2 were United States property, FS1 would be treated as holding the trade receivables held by FS2 because FS1 controls FS2 and a principal purpose of FS1 funding FS2 was to avoid the application of section 956 with respect to FS1. Accordingly, under this paragraph (b)(2)(ii), FS1 is treated as having acquired from P, a related United States person, the trade receivables that it would be treated as holding with a basis equal to $200x. Thus, FS1 is treated as holding United States property with a basis of $200x under paragraph (a) of this section.

(b)(2)(iii) through (c) [Reserved]. For further guidance, see § 1.956–3T(b)(2)(iii) through (c).

(d) Effective/applicability date. Paragraph (b)(2)(ii) of this section applies to taxable years of controlled foreign corporations ending on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation, and taxable years of United States shareholders in which or with which such taxable years end, with respect to trade or service receivables acquired on or after September 1, 2015. For purposes of this paragraph (d), a significant modification, within the meaning of § 1.1001–3(e), of a trade or service receivable on or after September 1, 2015, constitutes an acquisition of the trade or service receivable on or after that date.

Par. 6. Section 1.956–4 is added to read as follows:

(a) Overview. This section provides rules concerning the application of section 956 to certain obligations of and property held by a partnership. Paragraph (b) of this section provides rules concerning United States property held indirectly by a controlled foreign corporation through a partnership. Paragraph (c) of this section provides rules that generally treat obligations of a foreign partnership as obligations of the partners in the foreign partnership, as well as a special rule that treats a partner that is a United States person as owing additional amounts of a partnership obligation in certain circumstances. Paragraph (d) of this section sets forth a rule concerning the application of the indirect pledge or guarantee rule to obligations of partnerships. Paragraph (e) of this section provides that obligations of a domestic partnership are obligations of a United States person. Paragraph (f) of this section provides effective and applicability dates. See §§ 1.956–1T(b)(4) and 1.956–2(c) for additional rules applicable to partnerships.

(b) Property held indirectly through a partnership—(1) General rule. For purposes of section 956, a partner in a partnership is treated as holding its attributable share of any property held by the partnership (including an obligation that the partnership is treated as holding as a result of the application of § 1.956–2(c)). A partner’s attributable share of partnership property is determined under the rules set forth in paragraph (b)(2) of this section. An upper-tier partnership’s attributable share of the property of a lower-tier partnership is treated as property of the upper-tier partnership for purposes of applying this paragraph (b)(1) to the partners of the upper-tier partnership. For purposes of section 956, a partner’s adjusted basis in the property of the partnership equals the partner’s attributable share of the partnership’s adjusted basis in the property (taking into account any adjustments to basis under section 743(b) (with respect to the partner) or section 734(b) or any similar adjustments to basis), as determined under the rules set forth in paragraph (b)(2) of this section. The rules in § 1.956–1(e)(2) apply to determine the amount of an obligation treated as held by a partnership as a result of the application of § 1.956–2(c). See § 1.956–1T(b)(4) for special rules that may treat a controlled foreign corporation as holding a greater amount of United States property held by a partnership than the amount determined under this section.

(2) Methodology—(i) Liquidation value percentage. Except as otherwise provided in paragraph (b)(2)(ii) of this section, for purposes of paragraph (b)(1) of this section, a partner’s attributable share of partnership property is determined in accordance with the partner’s liquidation value percentage. For purposes of this paragraph (b)(2)(i), the liquidation value of a partner’s interest in a partnership is the amount of cash the partner would receive with respect to the interest if, immediately after the occurrence of the most recent event described in § 1.704–1(b)(2)(iv)(f)(5) or § 1.704–1(b)(2)(iv)(s)(1) (a revaluation event), or, if there has been no revaluation event, immediately after the formation of the partnership, as the case may be, the partnership sold all of its assets for cash equal to the fair market value of such assets (taking into account section 7701(g)), satisfied all of its liabilities (other than those described in § 1.752–7), paid an unrelated third party to assume all of its § 1.752–7 liabilities in a fully taxable transaction, and then liquidated. A partner’s liquidation value percentage, which is determined upon the formation of a partnership and redetermined upon any revaluation event, irrespective of whether the capital accounts of the partners are adjusted under § 1.704–1(b)(2)(iv)(f), is the ratio (expressed as a percentage) of the liquidation value of the partner’s interest in the partnership divided by the aggregate liquidation value of all of the partners’ interests in the partnership.

(ii) Special allocations. For purposes of paragraph (b)(1) of this section, if a partnership agreement provides for the allocation of income (or, where appropriate, gain) from partnership property to a partner that differs from the partner’s liquidation value percentage in a particular taxable year (a special allocation), then the partner’s attributable share of that property is determined solely by reference to the partner’s special allocation with respect to the property, provided the special allocation does not have a principal purpose of avoiding the purposes of section 956.

(3) Examples. The following examples illustrate the rule of this paragraph (b):

Example 1. (i) Facts. USP, a domestic corporation, wholly owns FS, a controlled foreign corporation, which, in turn, owns an interest in FPRS, a foreign partnership. The remaining interest in FPRS is owned by an unrelated foreign person. FPRS holds non-depreciable property, with an adjusted basis of $100x, that would be United States property (“US property”) if held by FS directly. At the close of quarter 1 of year 1, the liquidation value percentage, as determined under paragraph (b)(2) of this section, for FS with respect to FPRS is 25%. There are no special allocations in the FPRS partnership agreement.

(ii) Result. Under paragraph (b)(1) of this section, for purposes of section 956, FS is treated as holding its attributable share of the property held by FPRS with an adjusted basis equal to its attributable share of FPRS’s adjusted basis in the property. Under paragraph (b)(2) of this section, FS’s attributable share of FPRS’s property is determined in accordance with FS’s liquidation value percentage, which is 25%. Thus, FS’s attributable share of property held by FPRS is 25%, and its attributable share of FPRS’s basis in the property is $25x. Accordingly, for purposes of determining the amount of US property held by FS as of the close of quarter 1 of year 1, FS is treated as holding US property with an adjusted basis of $25x.

Example 2. (i) Facts. The facts are the same as in Example 1, except that the FPRS partnership agreement, which satisfies the requirements of section 704(b), specially allocates 80% of the income with respect to US property to FS. The special allocation does not have a principal purpose of avoiding the purposes of section 956.

(ii) Result. Under paragraph (b)(1) of this section, for purposes of section 956, FS is treated as holding its attributable share of the property held by FPRS with an adjusted basis equal to its attributable share of FPRS’s adjusted basis in the property. In general, FS’s attributable share of FPRS property is determined in accordance with FS’s liquidation value percentage. However, under paragraph (b)(2)(ii) of this section, FS’s attributable share of US property is determined in accordance with its special allocation. FS’s special allocation percentage for US property is 80%, and thus FS’s attributable share of US property held by FPRS is 80% and its attributable share of FPRS’s basis in US property is $80x. Accordingly, for purposes of determining the amount of US property held by FS as of the close of quarter 1 of year 1, FS is treated as holding US property with an adjusted basis of $80x.

Example 3. (i) Facts. USP, a domestic corporation, wholly owns FS, a controlled foreign corporation, which, in turn, owns an interest in FPRS, a foreign partnership. USP owns the remaining interest in FPRS. FPRS holds property (the “FPRS property”) that would be United States property (“US property”) if held by FS directly. The FPRS property is anticipated to appreciate in value but generate relatively little income. The US property has an adjusted basis of $100x. The FPRS partnership agreement, which satisfies the requirements of section 704(b), specially allocates 80% of the income with respect to the FPRS property to USP and 80% of the gain with respect to the disposition of FPRS property to FS. The special allocation does not have a principal purpose of avoiding the purposes of section 956.

(ii) Result. Under paragraph (b)(2)(ii) of this section, the partners’ attributable shares of the FPRS property are determined in accordance with the special allocation of gain. Accordingly, for purposes of determining the amount of US property held by FS in each year that FPRS holds FPRS property, FS’s attributable share of the FPRS property is 80% and its attributable share of FPRS’s basis in US property is $80x. Thus, FS is treated as holding US property with an adjusted basis of $80x.

(c) Obligations of a foreign partnership—(1) In general. Except as provided in paragraphs (c)(2) and (3) of this section, for purposes of section 956, an obligation of a foreign partnership is treated as a separate obligation of each of the partners in the partnership to the extent of each partner’s share of the obligation. A partner’s share of the partnership’s obligation is determined in accordance with the partner’s interest in partnership profits. The partner’s interest in partnership profits is determined by taking into account all facts and circumstances relating to the economic arrangement of the partners. An upper-tier partnership’s share of an obligation of a lower-tier partnership is treated as an obligation of the upper-tier partnership for purposes of applying this paragraph (c)(1) to the partners of the upper-tier partnership.

(2) Exception for obligations of partnerships in which neither the lending controlled foreign corporation nor any person related to the lending controlled foreign corporation is a partner. For purposes of applying section 956 with respect to a controlled foreign corporation, an obligation of a foreign partnership is treated as an obligation of a foreign partnership, and not as an obligation of its partners, if neither the controlled foreign corporation nor any person related to the controlled foreign corporation within the meaning of section 954(d)(3) is a partner in the partnership. For purposes of section 956, an obligation treated as an obligation of a foreign partnership pursuant to this paragraph (c)(2) is not an obligation of a United States person.

(3) Special obligor rule in the case of certain partnership distributions. For purposes of determining a partner’s share of a foreign partnership’s obligation under section 956, if the foreign partnership distributes an amount of money or property to a partner that is related to a controlled foreign corporation within the meaning of section 954(d)(3) and whose obligation would be United States property if held (or if treated as held) by the controlled foreign corporation, and the foreign partnership would not have made the distribution but for a funding of the partnership through an obligation held (or treated as held) by a controlled foreign corporation, notwithstanding § 1.956–1(e), the partner’s share of the partnership obligation is the greater of—

(i) The partner’s share of the partnership obligation as determined under paragraph (c)(1) of this section; and

(ii) The lesser of the amount of the distribution that would not have been made but for the funding of the partnership and the amount of the obligation (as determined under § 1.956–1(e)).

(4) Examples. The following examples illustrate the rules of this paragraph (c):

Example 1. (i) Facts. USP, a domestic corporation, wholly owns FS, a controlled foreign corporation, and owns a 90% interest in the partnership profits of FPRS, a foreign partnership. X, a foreign person that is unrelated to USP or FS, owns a 10% interest in the partnership profits of FPRS. FPRS borrows $100x from FS. FS’s basis in the FPRS obligation is $100x.

(ii) Result. Under paragraph (c)(1) of this section, for purposes of section 956, the obligation of FPRS is treated as obligations of its partners (USP and X) to the extent of each partner’s interest in the partnership profits of FPRS. Because USP, a partner in FPRS, is related to FS within the meaning of section 954(d)(3), the exception in paragraph (c)(2) of this section does not apply. Based on its interest in FPRS’s profits, USP’s attributable share of the FPRS obligation is $90x. Accordingly, for purposes of section 956, $90x of the FPRS obligation held by FS is treated as an obligation of USP and is United States property within the meaning of section 956(c). Therefore, on the date the loan is made, FS is treated as holding United States property of $90x.

Example 2. (i) Facts. The facts are the same as in Example 1, except that USP owns 40% of the stock of FS and is not a related person (as defined in section 954(d)(3)) with respect to FS. Y, a United States person that is unrelated to USP or X, owns the remaining 60% of the stock of FS.

(ii) Result. Because neither FS nor any person related to FS within the meaning of section 954(d)(3) is a partner in FPRS, the exception in paragraph (c)(2) of this section applies to treat the FPRS obligation as an obligation of a foreign partnership and not an obligation of a United States person. Therefore, paragraph (c)(1) of this section does not apply, and FS is not treated as holding United States property.

Example 3. (i) Facts. USP, a domestic corporation, wholly owns FS, a controlled foreign corporation. USP has a 60% interest in the partnership profits of FPRS, a foreign partnership. FS has a 30% interest in the partnership profits of FPRS. USC, a domestic corporation that is unrelated to USP and FS, has a 10% interest in the partnership profits of FPRS. FPRS borrows $100x from an unrelated person. FS guarantees the FPRS obligation.

(ii) Result. Under paragraph (c)(1) of this section, for purposes of section 956, the obligation of FPRS is treated as obligations of its partners (USP, FS, and USC) to the extent of each partner’s interest in the partnership profits of FPRS. Because USP, a partner in FPRS, is related to FS within the meaning of section 954(d)(3), and because FS is a partner in FPRS, the exception in paragraph (c)(2) of this section does not apply. Based on their interests in partnership profits, USP’s attributable share of the FPRS obligation is $60x, and USC’s attributable share of the FPRS obligation is $10x. For purposes of section 956, $60x of the FPRS obligation is treated as an obligation of USP, and $10x of the FPRS obligation is treated as an obligation of USC. Under § 1.956–2(c)(1), FS is treated as holding the obligations of USP and USC that FS guaranteed. All of the exceptions to the definition of United States property contained in section 956 and § 1.956–2 apply to determine whether the obligations of USP and USC treated as held by FS constitute United States property. Accordingly, the obligation of USC is not United States property under section 956(c)(2)(F) and § 1.956–2(b)(1)(viii). The obligation of USP, however, is United States property within the meaning of section 956(c). Therefore, on the date the guarantee is made, FS is treated as holding United States property of $60x.

Example 4. (i) Facts. USP, a domestic corporation, wholly owns FS, a controlled foreign corporation. USP has a 70% interest in the partnership profits of FPRS, a foreign partnership. A domestic corporation that is unrelated to USP and FS has a 30% interest in the partnership profits of FPRS. FPRS borrows $100x from FS and makes a distribution of $80x to USP. FPRS would not have made the distribution to USP but for the funding of FPRS by FS.

(ii) Result. Because USP, a partner in FPRS, is related to FS within the meaning of section 954(d)(3), the exception in paragraph (c)(2) of this section does not apply. Moreover, an obligation of USP held by FS would be United States property. USP’s attributable share of the FPRS obligation as determined under paragraph (c)(1) of this section in accordance with USP’s interest in partnership profits is $70x. Under paragraph (c)(3) of this section, USP’s share of the FPRS obligation is the greater of (i) USP’s attributable share of the obligation, $70x, or (ii) the lesser of the amount of the distribution, $80x, or the amount of the obligation, $100x. For purposes of section 956, therefore, $80x of the FPRS obligation is treated as an obligation of USP and is United States property within the meaning of section 956(c). Thus, on the date the loan is made, FS is treated as holding United States property of $80x.

(d) Limitation on a partner’s indirect pledge or guarantee. For purposes of section 956 and § 1.956–2(c), a controlled foreign corporation that is a partner in a partnership is not considered a pledgor or guarantor of the portion of an obligation of the partnership attributed to its partners that are United States persons under paragraph (c) of this section solely as a result of the attribution of a portion of the partnership’s assets to the controlled foreign corporation under paragraph (b) of this section.

(e) Obligations of a domestic partnership. For purposes of section 956, an obligation of a domestic partnership is an obligation of a United States person. See section 956(c)(2)(L) for an exception from the treatment of such an obligation as United States property.

(f) Effective/applicability dates. (1) Paragraph (b) of this section applies to taxable years of controlled foreign corporations ending on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation, and taxable years of United States shareholders in which or with which such taxable years end, with respect to property acquired on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation. For purposes of this paragraph (f)(1), a deemed exchange of property pursuant to section 1001 on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation constitutes an acquisition of the property on or after that date.

(2) Paragraph (c) of this section applies to taxable years of controlled foreign corporations ending on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation, and taxable years of United States shareholders in which or with which such taxable years end, with respect to obligations acquired, or pledges or guarantees entered into, on or after September 1, 2015. For purposes of this paragraph (f)(2), a significant modification, within the meaning of § 1.1001–3(e), of an obligation on or after September 1, 2015, constitutes an acquisition of the obligation on or after that date. Furthermore, for purposes of this paragraph (f)(2), a pledgor or guarantor is treated as entering into a pledge or guarantee when there is a significant modification, within the meaning of § 1.1001–3(e), of an obligation with respect to which it is a pledgor or guarantor on or after September 1, 2015.

(3) Paragraph (d) of this section applies to taxable years of controlled foreign corporations ending on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation, and taxable years of United States shareholders in which or with which such taxable years end, with respect to pledges or guarantees entered into on or after September 1, 2015. For purposes of this paragraph (f)(3), a pledgor or guarantor is treated as entering into a pledge or guarantee when there is a significant modification, within the meaning of § 1.1001–3(e), of an obligation with respect to which it is a pledgor or guarantor on or after September 1, 2015.

(4) Paragraph (e) of this section applies to taxable years of controlled foreign corporations ending on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation, and to taxable years of United States shareholders in which or with which such taxable years end, with respect to obligations held on or after the date of publication in the Federal Register of the Treasury decision adopting this rule as a final regulation.

John Dalrymple, Deputy Commissioner for Services and Enforcement.