On March 12, 2002, the IRS and Treasury published T.D. 8984, 2002-1 C.B. 668 [67 FR 11034]), which included temporary regulations under sections 337(d) and 1502 that limit the deductibility of loss recognized by a consolidated group on the disposition of stock of a subsidiary and that require certain basis reductions on the deconsolidation of stock of a subsidiary. Those regulations are intended to prevent a corporation from avoiding the recognition of gain on the disposition of assets through the use of the consolidated return regulations.

Section 1.337(d)-2T disallows loss recognized by a member of a consolidated group with respect to the disposition of stock of a subsidiary to the extent that such loss is attributable to the recognition of built-in gain on the disposition of an asset. For this purpose, built-in gain is gain recognized on the disposition of an asset to the extent attributable, directly or indirectly, in whole or in part, to any excess of value over basis that is reflected, before the disposition of the asset, in the basis of the share, directly or indirectly, in whole or in part, after applying section 1503(e) and other applicable provisions of the Internal Revenue Code and regulations.

On March 14, 2003, the IRS and Treasury published T.D. 9048, 2003-1 C.B. 645 [68 FR 12287]), which included temporary regulations generally intended to prevent consolidated groups from obtaining more than one tax benefit from a single economic loss. In particular, §1.1502-35T(f) of those temporary regulations prescribes rules that are intended to prevent groups from obtaining more than one tax benefit from a single economic loss when a group member claims a worthless stock deduction with respect to stock of a subsidiary. In such cases, the regulation requires an apportionment of the group’s consolidated net operating loss (CNOL) to the subsidiary under the principles of §1.1502-21T(b), and then treats the apportioned losses as expired.

On August 15, 1994, the IRS and Treasury Department published T.D. 8560, 1994-2 C.B. 200 [59 FR 41666]) adding paragraph (c) to §1.1502-80. Section 1.1502-80(c) provides that, for consolidated return years beginning on or after January 1, 1995, stock of a member is not treated as worthless under section 165 before the stock is treated as disposed of under the principles of §1.1502-19(c)(1)(iii). Under §1.1502-19(c)(1)(iii), stock of a subsidiary is treated as disposed of, by reason of worthlessness, at the time substantially all of the subsidiary’s assets are treated as disposed of, abandoned, or destroyed for federal income tax purposes, at the time of certain discharges of indebtedness of the subsidiary, or at the time a member takes into account certain deductions and losses with respect to indebtedness of the subsidiary. Section 1.1502-80(c) was promulgated to more fully implement the single entity treatment of consolidated groups. It also had the effects of preventing certain inappropriate disallowances of loss that occurred when §1.1502-20 governed the allowance of stock losses and of alleviating concerns regarding protecting the attributes of bankrupt subsidiaries.

Taxpayers have raised several questions regarding the interpretation and application of §§1.337(d)-2T, 1.1502-35T(f), and 1.1502-80(c). The following paragraphs describe these questions and the manner in which they are addressed in these temporary regulations.

The amendments set forth in these temporary regulations are applicable to tax years beginning after March 18, 2004. However, taxpayers may apply these temporary regulations to certain prior periods.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. These temporary regulations are necessary to provide taxpayers with immediate guidance regarding allowable loss and basis reductions in connection with dispositions and deconsolidations of subsidiary stock. These temporary regulations clarify existing rules and simplify their application in order to ease taxpayer compliance. Accordingly, good cause is found for dispensing with notice and public procedure pursuant to 5 U.S.C. 553(b)(B) and with a delayed effective date pursuant to 5 U.S.C. 553(d)(1) and (3). For the applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), refer to the Special Analyses section of the preamble to the cross-reference notice of proposed rulemaking published in the Bulletin. Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

* * * * *

(c) * * *

(2) General rule. Loss is not disallowed under paragraph (a)(1) of this section and basis is not reduced under paragraph (b)(1) of this section to the extent the taxpayer establishes that the loss or basis is not attributable to the recognition of built-in gain, net of directly related expenses, on the disposition of an asset (including stock and securities). Loss or basis may be attributable to the recognition of built-in gain on the disposition of an asset by a prior group. For purposes of this section, gain recognized on the disposition of an asset is built-in gain to the extent attributable, directly or indirectly, in whole or in part, to any excess of value over basis that is reflected, before the disposition of the asset, in the basis of the share, directly or indirectly, in whole or in part, after applying section 1503(e) and other applicable provisions of the Internal Revenue Code and regulations. Federal income taxes may be directly related to built-in gain recognized on the disposition of an asset only to the extent of the excess (if any) of the group’s income tax liability actually imposed under Subtitle A of the Internal Revenue Code for the taxable year of the disposition of the asset over the group’s income tax liability for the taxable year redetermined by not taking into account the built-in gain recognized on the disposition of the asset. For this purpose, the group’s income tax liability actually imposed and its redetermined income tax liability are determined without taking into account the foreign tax credit under section 27(a) of the Internal Revenue Code. This paragraph (c)(2) applies to dispositions and deconsolidations on or after March 18, 2004. Taxpayers, however, may choose to apply this paragraph (c)(2) to dispositions and deconsolidations on or after March 7, 2002; otherwise, paragraph (c)(2) of §1.337(d)-2T as contained in 26 CFR part 1 edition revised as of April 1, 2003, shall apply.

* * * * *

(4) * * *

Example. Loss offsetting built-in gain in a prior group. (i) P buys all the stock of T for $50 in Year 1, and T becomes a member of the P group. T has 2 assets. Asset 1 has a basis of $50 and a value of $0, and asset 2 has a basis of $0 and a value of $50. T sells asset 2 during Year 3 for $50 and recognizes a $50 gain. Under the investment adjustment system, P’s basis in the T stock increased to $100 as a result of the recognition of gain. In Year 5, all of the stock of P is acquired by the P1 group, and the former members of the P group become members of the P1 group. T then sells asset 1 for $0, and recognizes a $50 loss. Under the investment adjustment system, P’s basis in the T stock decreases to $50 as a result of the loss. T’s assets decline in value from $50 to $40. P then sells all the stock of T for $40 and recognizes a $10 loss.

(ii) P’s basis in the T stock reflects both T’s unrecognized gain and unrecognized loss with respect to its assets. The gain T recognizes on the disposition of asset 2 is built-in gain with respect to both the P and P1 groups for purposes of paragraph (c)(2) of this section. In addition, the loss T recognizes on the disposition of asset 1 is built-in loss with respect to the P and P1 groups for purposes of paragraph (c)(2) of this section. T’s recognition of the built-in loss while a member of the P1 group offsets the effect on T’s stock basis of T’s recognition of the built-in gain while a member of the P group. Thus, P’s $10 loss on the sale of the T stock is not attributable to the recognition of built-in gain, and the loss is therefore not disallowed under paragraph (c)(2) of this section.

(iii) The result would be the same if, instead of having a $50 built-in loss in asset 1 when it becomes a member of the P group, T has a $50 net operating loss carryover and the carryover is used by the P group.

* * * * *

Par. 3. Section 1.1502-35T is amended by revising paragraph (f)(1) to read as follows:

* * *

(f) Worthlessness not followed by separate return years—(1) General rule. Notwithstanding any other provision in the regulations under section 1502, if a member of a group (the claiming group) treats stock of a subsidiary as worthless under section 165 (taking into account the provisions of §1.1502-80(c)) and, on the day following the last day of the claiming group’s taxable year in which the worthless stock deduction is claimed, the subsidiary (or its successor, determined without regard to paragraphs (d)(5)(iii) and (iv) of this section) is a member of a group that includes any corporation that, during that taxable year, was a member of the claiming group (other than a lower-tier subsidiary of the subsidiary) or is a successor (determined without regard to paragraphs (d)(5)(iii) and (iv) of this section) of such a member, then all losses treated as attributable to the subsidiary under the principles of §1.1502-21T(b)(2)(iv) shall be treated as expired as of the day following the last day of the claiming group’s taxable year in which the worthless stock deduction is claimed. In addition, notwithstanding any other provision in the regulations under section 1502, if a member recognizes a loss with respect to subsidiary stock and on the following day the subsidiary is not a member of the group and does not have a separate return year, then all losses treated as attributable to the subsidiary under the principles of §1.1502-21T(b)(2)(iv) shall be treated as expired as of the day following the last day of the group’s taxable year in which the stock loss is claimed. For purposes of this paragraph (f), the determination of the losses attributable to the subsidiary shall be made after computing the taxable income of the group for the taxable year in which the group treats the stock of the subsidiary as worthless or the subsidiary liquidates and after computing the taxable income for any taxable year to which such losses may be carried back. The loss treated as expired under this paragraph (f) shall not be treated as a noncapital, nondeductible expense under §1.1502-32(b)(2)(iii). This paragraph (f) applies to worthlessness determinations and liquidations that occur after March 18, 2004, and before March 12, 2006. However, the group may apply this paragraph (f) to worthlessness determinations and liquidations that occur on or after March 7, 2002, and before March 18, 2004; otherwise, paragraph (f) of §1.1502-35T as contained in 26 CFR part 1 edition revised as of April 1, 2003, shall apply to such determinations of worthlessness and liquidations.

* * * * *

Par. 4. Section 1.1502-80 is amended by adding a sentence to the end of paragraph (c) to read as follows:

* * * * *

(c) * * * For further guidance, see §1.1502-80T(c).

Par. 5. Section 1.1502-80T is added to read as follows:

(a) and (b) [Reserved]. For further guidance, see §1.1502-80(a) and (b).

(c) Deferral of section 165. Stock of a member is not treated as worthless under section 165 before the stock is treated as disposed of under the principles of §1.1502-19(c)(1)(iii). If stock of a member would otherwise be treated as worthless under the principles of section 165, then, notwithstanding the previous sentence, such stock may be treated as worthless under section 165 immediately prior to the time such member ceases to be a member of the group. See §§1.1502-11(c) and 1.1502-35T for additional rules relating to stock loss. This paragraph (c) applies to taxable years beginning after March 18, 2004, and before March 18, 2007. Taxpayers, however, may apply this paragraph (c) to taxable years beginning on or after January 1, 1995, and before March 18, 2004; otherwise, paragraph (c) of §1.1502-80 as contained in 26 CFR part 1 edition revised as of April 1, 2003, shall apply to taxable years beginning on or after January 1, 1995, and on or before March 18, 2004.

(d) through (f) [Reserved]. For further guidance, see §1.1502-80(d) through (f).

Approved March 9, 2004.

On September 4, 2003, the IRS and Treasury Department published in the Federal Register a notice of proposed rulemaking (REG-132760-03, 2003-43 I.R.B. 933 [68 FR 52542]) and temporary regulations (T.D. 9089, 2003-43 I.R.B. 906 [68 FR 52487]) under section 1502 of the Internal Revenue Code. The temporary regulations added §1.1502-28T, which provides guidance regarding the determination of the attributes that are available for reduction when a member of a consolidated group realizes discharge of indebtedness income that is excluded from gross income (excluded COD income) and the method for reducing those attributes. Section 1.1502-28T reflects a consolidated approach that is intended to make available for reduction attributes that are available to the debtor member. The regulations contain a rule governing the order in which attributes are reduced and a look-through rule that provides that when the basis of stock of a member (the lower-tier member) that is owned by another member is reduced, the lower-tier member must reduce its attributes as if it had realized excluded COD income in the amount of the basis reduction.

On December 11, 2003, the IRS and Treasury Department published in the Federal Register a notice of proposed rulemaking (REG-153319-03, 2003-52 I.R.B. 1256 [68 FR 69062]) and temporary regulations (T.D. 9098, 2003-52 I.R.B. 1248 [68 FR 69024]) under section 1502 amending §1.1502-28T. Those regulations clarify that certain attributes that arise (or are treated as arising) in a separate return year are subject to reduction when no SRLY limitation applies to the use of such attributes.

The IRS and Treasury Department have received comments regarding certain technical issues that arise under the regulations. The temporary regulations included in this document address certain issues related to the application of section 1245 and the matching rule of §1.1502-13, and certain issues related to the inclusion of excess loss accounts in cases in which excluded COD income is not fully applied to reduce attributes. The IRS and Treasury Department anticipate that there may be further changes to the regulations but believe that immediate guidance on these issues is desirable. The following sections describe these issues and the manner in which they are addressed in these temporary regulations.

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. These temporary regulations are necessary to provide taxpayers with immediate guidance regarding the application of section 108 when a member of a consolidated group realizes discharge of indebtedness income that is excluded from gross income and the consequences of such application. Accordingly, good cause is found for dispensing with notice and public procedure pursuant to 5 U.S.C. 553(b)(B) and with a delayed applicability date pursuant to 5 U.S.C. 553(d)(3). For applicability of the Regulatory Flexibility Act, please refer to the cross-reference notice of proposed rulemaking published elsewhere in this issue of the Bulletin. Pursuant to section 7805(f) of the Internal Revenue Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805. * * *

Section 1.1502-13T also issued under 26 U.S.C. 1502. * * *

Par. 2. Paragraph (g)(3)(ii)(B) of §1.1502-13 is revised to read as follows:

Temporary regulations in this issue of the Bulletin amend the Income Tax Regulations (26 CFR part 1) relating to section 337(d) and section 1502. The text of those regulations also serves as the text of these proposed regulations. The preamble to the temporary regulations explains the amendments.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that these regulations will primarily affect affiliated groups of corporations, which tend to be larger businesses. Therefore a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and the Treasury Department request comments on the clarity of the proposed regulations and how they may be made easier to understand. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested by any person who timely submits comments. If a public hearing is scheduled, notice of the date, time and place for the hearing will be published in the Federal Register.

Paragraph 1. The authority citation for part 1 continues to read as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.337(d)-2(c)(2) is added to read as follows:

On September 4, 2003, the IRS and Treasury Department published in the Federal Register a notice of proposed rulemaking (REG-132760-03, 2003-43 I.R.B. 933 [68 FR 52542]) and temporary regulations (T.D. 9089, 2003-43 I.R.B. 906 [68 FR 52487]) under section 1502 of the Internal Revenue Code. The temporary regulations added §1.1502-28T, which provides guidance regarding the determination of the attributes that are available for reduction when a member of a consolidated group realizes discharge of indebtedness income that is excluded from gross income (excluded COD income) and the method for reducing those attributes.

The text of the temporary regulations published in this issue of the Bulletin amend the Income Tax Regulations (26 CFR part 1) relating to section 1502. The temporary regulations address certain issues related to the application of section 1245 and the matching rule of §1.1502-13, and the inclusion of excess loss accounts in cases in which excluded COD is not fully applied to reduce attributes. The text of those regulations also serves as the text of these proposed regulations with respect to those issues. The preamble to the temporary regulations explains those amendments.

These regulations also propose amendments to §§1.1502-28T and 1.1502-11 to address certain issues that have been raised regarding the computation of gain or loss on the disposition of member stock and regarding the computation of the portion of an excess loss account that must be taken into account when excluded COD income is not fully applied to reduce attributes. In particular, if the stock of the subsidiary that realizes excluded COD income is sold, the reduction of other members’ attributes will cause an increase in the basis of the stock of the subsidiary, thus reducing the gain (or increasing the loss) on the stock sale that might otherwise have been offset by attributes and possibly making more attributes available for reduction. If the stock of a subsidiary other than one that realizes excluded COD income is sold, the reduction of such subsidiary’s attributes in respect of the excluded COD income will cause a decrease in the basis of the sold subsidiary stock, thus increasing the gain (or reducing the loss) on the stock sale, possibly resulting in the absorption of more attributes and making fewer attributes available for reduction.

In addition, the amount of the excess loss account in the stock of a subsidiary that is required to be taken into account can only be determined after the computation of tax for the year of the discharge and the reduction of attributes. Pursuant to §1.1502-28T(b)(6)(ii), however, that excess loss account must be included on the group’s tax return for the taxable year that includes the date on which the subsidiary realizes the excluded COD income. If that excess loss account were offset by losses that could be reduced in respect of the excluded COD income, the inclusion of that amount could result in fewer attributes available for reduction. The availability of fewer attributes for reduction might increase the excluded COD income that was not applied to reduce attributes and, therefore, the amount of the excess loss account in the subsidiary’s stock required to be taken into account.

These regulations provide guidance regarding the timing of stock basis adjustments, the calculation of stock gain or loss (including the amount of an excess loss account required to be taken into account), and the reduction of attributes when a member (P) disposes of stock of a subsidiary (S) during a year in which a member realizes excluded COD income. In particular, these regulations propose the steps used to compute the group’s consolidated taxable income and to effect the reduction of attributes. In order to avoid circular calculations, these proposed regulations adopt an approach that limits the reduction of attributes in certain cases in which a disposition of subsidiary stock occurs during a year in which one or more members realize excluded COD income.

This methodology applies not only when there is an actual disposition of subsidiary stock, but also when there is a deemed disposition, including a disposition that results by reason of the application of §1.1502-19(c)(1)(iii)(B) when excluded COD income is not fully applied to reduce attributes. However, in order to know whether there has been a disposition of stock by reason of the application of §1.1502-19(c)(1)(iii)(B), the group must have computed its consolidated taxable income (or loss) and applied the rules of sections 108 and 1017 and §1.1502-28T. Therefore, as discussed below, a number of the steps proposed will have a slightly different application when there is such a deemed disposition of subsidiary stock rather than an actual disposition of subsidiary stock. The following paragraphs outline the proposed steps.

First, the extent to which S’s deductions and losses for the tax year of the disposition (and its deductions and losses carried over from prior years) may offset income and gain is computed pursuant to the current rules of §1.1502-11(b)(2) and (3). Those rules require a tentative computation of the group’s taxable income, without regard to the stock gain or loss. In the case of a disposition of subsidiary stock that results from the application of §1.1502-19(c)(1)(iii)(B) (which will only be apparent after the application of the sixth step described below), the application of §1.1502-11(b)(2) and (3) will not result in the imposition of a limitation on the use of S’s deductions and losses.

Second, §§1.1502-32 and 1.1502-32T are tentatively applied to adjust the basis of the S stock to reflect the amount of S’s unlimited deductions and losses that are absorbed in the tentative computation of taxable income (or loss) for the year of the disposition (and any prior years to which the deductions or losses may be carried) that is made pursuant to §1.1502-11(b)(2). The basis of the S stock is not adjusted to reflect the realization of excluded COD income and the reduction of attributes in respect thereof.

Third, in the case of a disposition of S stock that does not result from excluded COD income not being fully applied to reduce attributes, P’s income, gain, or loss from the disposition of S stock is computed using the basis of such stock computed in the preceding step.

Fourth, taxable income (or loss) for the year of disposition (and any prior years to which the deductions or losses may be carried) is tentatively computed. For this purpose, in the case of a disposition of S stock that does not result from excluded COD income not being fully applied to reduce attributes, the tentative computations of taxable income (or loss) take into account P’s income, gain, or loss from the disposition of S stock computed in the preceding step. Any excess loss account that is taken into account as a result of excluded COD income not being fully applied to reduce attributes is not included in this tentative computation of taxable income (or loss).

Fifth, the excluded COD income is tentatively applied to reduce attributes pursuant to the rules of sections 108 and 1017 and §1.1502-28T. Only those attributes that remain after the tentative computations of taxable income (or loss) in the fourth step are subject to reduction.

Sixth, §§1.1502-32 and 1.1502-32T are applied to adjust the basis of the S stock to reflect the amount of S’s unlimited deductions and losses that are absorbed in the tentative computation of taxable income (or loss) for the year of the disposition (and any prior years to which the deductions or losses may be carried) made pursuant to the fourth step, and the excluded COD income that is applied to reduce attributes and the attributes reduced in respect of the excluded COD income pursuant to the fifth step.

Seventh, the group’s actual gain or loss on the disposition of S stock is computed using the basis of such stock computed in the preceding step. At this point, whether and to what extent an excess loss account in the stock of a subsidiary that realizes excluded COD income must be taken into account is computed. In many cases, taking into account the basis consequences of the excluded COD income prior to computing the amount of an excess loss account required to be taken into account may be favorable to taxpayers because those consequences might decrease or even eliminate an excess loss account and, therefore, reduce the amount of excess loss account required to be taken into account. The IRS and Treasury Department are aware that taking into account the basis effects of the excluded COD income of all members of the group may increase the excess loss account in the subsidiary stock. This result may occur in a case in which the excluded COD income of one subsidiary (the first subsidiary) is not fully applied to reduce attributes and the excluded COD income of another subsidiary (the second subsidiary) is applied to reduce attributes in the first subsidiary’s chain. The IRS and Treasury Department nevertheless believe that this result is not inappropriate as the reduction of an attribute in the first subsidiary’s chain in respect of excluded COD income of the second subsidiary may avoid taking into account an excess loss account in the second subsidiary’s stock.

Eighth, the taxable income (or loss) for the year of the disposition (and any prior years to which the deductions or losses may be carried) is computed. These amounts are calculated by applying the limitation on the use of S’s deductions and losses to offset income computed pursuant to the first step, and by including the gain or loss recognized on the disposition of S stock computed pursuant to the preceding step. However, attributes that were tentatively used to offset income in the tentative computation of taxable income (or loss) in the fourth step and attributes that were tentatively reduced in the fifth step cannot offset any excess loss account taken into account as a result of excluded COD income not being fully applied to reduce attributes. This limitation gives effect to the requirement that the excess loss account be taken into account and avoids circular calculations. If an excess loss account that is taken into account as a result of excluded income could be offset by attributes that could be reduced in respect of the excluded COD income, the use of attributes to offset the excess loss account could result in fewer attributes available for reduction and a greater amount of excluded COD income that was not applied to reduce attributes, which, in turn, would increase the amount of the excess loss account required to be taken into account. Ultimately, the inclusion of the excess loss account and the realization of excluded COD income could have no effect on the overall tax liability of the group, thereby rendering meaningless the requirement to take into account the excess loss account.

Ninth, the excluded COD income is actually applied to reduce attributes pursuant to the rules of sections 108 and 1017 and §1.1502-28T. Only those attributes remaining after the actual computations of taxable income (or loss) pursuant to the eighth step are subject to reduction in the ninth step. In certain cases, however, the reduction of attributes will be limited to prevent circular calculations. The proposed regulations include two rules in this regard.

The first rule provides that when S or a subsidiary of S realizes excluded COD income, the aggregate amount of excluded COD income that is applied to reduce attributes attributable to members other than S and any lower-tier corporation of S cannot exceed the aggregate amount of excluded COD income that is applied to reduce attributes attributable to members other than S and any lower-tier corporation of S pursuant to the fifth step (tentative reduction of attributes). Without this limitation, the amount of excluded COD income applied to reduce attributes could exceed the amount of excluded COD income applied to reduce attributes in the fifth step, which would result in a greater positive adjustment (or a lesser negative adjustment) to the basis of the S stock compared to that made in the sixth step, and reduce the gain (or increase the loss) recognized on the disposition of the S stock, which might increase the attributes available for reduction and the amount of excluded COD income applied to reduce attributes.

The second rule provides that when a member other than S or a subsidiary of S realizes excluded COD income, the aggregate amount of excluded COD income that is applied to reduce attributes (other than credits) attributable to S and any lower-tier corporation of S cannot exceed the aggregate amount of excluded COD income that is applied to reduce attributes (other than credits) attributable to S and any lower-tier corporation of S in the fifth step. Without this limitation, the amount of excluded COD income applied to reduce the attributes (other than credits) attributable to S or a subsidiary of S could exceed the amount of excluded COD income applied to reduce the attributes (other than credits) attributable to S or a subsidiary of S in the fifth step, which would result in a lesser positive adjustment (or a greater negative adjustment) to the basis of the S stock compared to that made in the sixth step, and increase the gain (or decrease the loss) recognized on the disposition of the S stock, which might decrease the attributes of S’s shareholder available for reduction, increase the reduction of S’s attributes, and result in a lesser positive adjustment (or a greater negative adjustment) to the basis of the S stock.

The IRS and Treasury Department are aware that the foregoing methodology does not prevent circular calculations in all cases, specifically certain cases in which there is a disposition of the stock of more than one subsidiary. The IRS and Treasury Department request comments regarding whether rules preventing circular calculations in these other cases are necessary. If such rules are necessary, the IRS and Treasury Department request comments regarding the approach that those rules should adopt.

Given the difficulty of the problem addressed by these regulations, the IRS and Treasury Department request comments regarding these rules prior to making them effective. Therefore, the rules described above are proposed. Before these rules are adopted as temporary or final regulations, taxpayers may rely on the rules proposed in these regulations.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. Further, it is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that these regulations will primarily affect affiliated groups of corporations that have elected to file consolidated returns, which tend to be larger businesses. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in the Federal Register.

Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read, in part as follows:

Authority: 26 U.S.C. 7805. * * *

Section 1.1502-28 also issued under 26 U.S.C. 1502. * * *

Par. 2. Section 1.1502-11 is amended by:

1. Revising paragraph (b)(1).

2. Redesignating paragraph (c) as paragraph (d).

3. Adding new paragraph (c).

The revision and addition read as follows:

In many APA cases, the taxpayer’s application is preceded by a pre-file conference with the APA staff in which the taxpayer can solicit the informal views of the APA Program. Pre-file conferences can occur on an anonymous basis, although a taxpayer must disclose its identity when it applies for an APA. Taxpayers must file the appropriate user fee on or before the due date of the tax return for the first taxable year that the taxpayer proposes to be covered by the APA. Many taxpayers file a user fee first and then follow up with a full application later. The procedures for pre-file conferences, user fees, and applications can be found in Rev. Proc. 96-53.

The APA application can be a relatively modest document for a small business taxpayer. Notice 98-65 describes the special APA procedures for small businesses. For most taxpayers, however, the APA application is a substantial document filling several binders. The APA Program makes every effort to reach agreement on the basis of the information provided in the taxpayer’s application.

The application is assigned to an APA team leader who is responsible for the case. The APA team leader’s first responsibility is to organize the APA team. This involves contacting the appropriate LMSB International Territory Manager to secure the assignment of an international examiner to the APA case and the LMSB Counsel’s office to secure a field counsel lawyer. In a bilateral case, the U.S. Competent Authority will assign a U.S. Competent Authority analyst to the team. In a large APA case, the international examiner may invite his or her manager and other LMSB personnel familiar with the taxpayer to join the team. When the APA may affect taxable years in Appeals, the appropriate appellate conferee will be invited to join the team. In all cases, the team leader contacts the Manager, LMSB International Technical Advisors, to determine whether to include a technical advisor on the team. The IRS APA team will generally include a technical advisor if the APA request concerns cost-sharing, intangibles or services. The APA team leader then distributes copies of the APA application to all team members and sets up an opening conference with the taxpayer. The APA office strives to hold this opening conference within 45 days of the assignment of the case to a team leader. At the opening conference, the APA team leader proposes a case plan designed to complete the recommended U.S. negotiating position for a bilateral APA within 9 months from the date the full application was filed and to complete a unilateral APA within 12 months from the application date. In 2003, the median for completing negotiating positions was 15.2 months (average 15.3), and the median for completing unilateral APAs was 9.2 months (average 20.0).

The APA team must satisfy itself that the relevant facts submitted by the taxpayer are complete and accurate. This due diligence aspect of the APA is vital to the process. It is because of this due diligence that the IRS can reach advance agreements with taxpayers in the highly factual setting of transfer pricing. Due diligence can proceed in a number of ways. Typically, the taxpayer and the APA team will agree to dates for future meetings during the opening conference. In advance of the opening conference, the APA team leader will submit a list of questions to the taxpayer for discussion. The opening conference may result in a second set of questions. These questions are developed by the APA team and provided to the taxpayer through the APA team leader. It is important to note that this due diligence is not an audit and is focused on the transfer pricing issues associated with the transactions in the taxpayer’s application, or such other transactions that the taxpayer and the IRS may agree to add.

A significant part of the analytical work associated with an APA is done typically by the APA or IRS field economist assigned to the case. The analysis may result in the need for additional information. Once the IRS APA team has completed its due diligence and analysis, it begins negotiations with the taxpayer over the various aspects of the APA including the selection of comparable transactions, asset intensity and other adjustments, the TPM, which transactions to cover, the appropriate critical assumptions, the APA term, and other key issues. The APA team leader will discuss particularly difficult issues with his or her managers, but generally the APA team leader is empowered to negotiate the APA.

This phase differs for bilateral and unilateral cases. In a bilateral case, the discussions proceed in two parts and involve two IRS offices — the APA Program and the U.S. Competent Authority. In the first part, the APA team will attempt to reach a consensus with the taxpayer regarding the recommended position that the U.S. Competent Authority should take in negotiations with its treaty partner. This recommended U.S. negotiating position is a paper drafted by the APA team leader and signed by the APA Director that provides the APA Program’s view of the best TPM for the covered transaction, taking into account IRC § 482 and the regulations thereunder, the relevant tax treaty, and the U.S. Competent Authority’s experience with the treaty partner.

The experience of the APA office and the U.S. Competent Authority is that APA negotiations are likely to proceed more rapidly with a foreign competent authority if the U.S. negotiating position is fully supported by the taxpayer. Consequently, the APA Office works together with the taxpayer in developing the recommended U.S. negotiating position. On occasion, the APA team will agree to disagree with a taxpayer. In these cases, the APA office will send a recommended U.S. negotiating position to the U.S. Competent Authority that includes elements with which the taxpayer does not agree. This disagreement is noted in the paper. The APA team leader also solicits the views of the field members of the APA team, and, in the vast majority of APA cases, the international examiner, LMSB field counsel, and other IRS field team members concur in the position prepared by the APA team leader.

Once the APA Program completes the recommended U.S. negotiating position, the APA process shifts from the APA Program to the U.S. Competent Authority. The U.S. Competent Authority analyst assigned to the APA takes the recommended U.S. negotiating position and prepares the final U.S. negotiating position, which is then transmitted to the foreign competent authority. The negotiations with the foreign competent authority are conducted by the U.S. Competent Authority analyst, most often in face-to-face negotiating sessions conducted periodically throughout the year. At the request of the U.S. Competent Authority analyst, the APA team leader may continue to assist the negotiations.

In unilateral APA cases, the discussions proceed solely between the APA Program and the taxpayer. In a unilateral case, the taxpayer and the APA Program must reach agreement to conclude an APA. Like the bilateral cases, the APA team leader almost always will achieve a consensus with the IRS field personnel assigned to the APA team regarding the final APA. The APA Program has a procedure in which the IRS field personnel are solicited formally for their concurrence in the final APA. This concurrence, or any items in disagreement, is noted in a cover memorandum prepared by the APA team leader that accompanies the final APA sent forward for review and execution.

Once the IRS and the taxpayer reach agreement, the drafting of the final APA generally takes little time because the APA Program has developed standard language that is incorporated into every APA. The current version of this language is found in Attachment A. APAs are reviewed by the Branch Chief and the APA Director. In addition, the team leader prepares a summary memorandum for the Associate Chief Counsel (International) (ACC(I)). On March 1, 2001, the ACC(I) delegated to the APA Director the authority to execute APAs on behalf of the IRS. See Chief Counsel Notice CC-2001-016. The APA is executed for the taxpayer by an appropriate corporate officer.

In 2003, the APA Office continued to emphasize training as a high priority. Training sessions regarded APA-related current developments, new APA office practices and procedures, and international tax law issues. The APA New Hire Training materials were updated, as necessary, throughout the year. The updated materials are available to the public through the APA internet site on the IRS Digital Daily (www.irs.gov). These materials do not constitute guidance on the application of the arm’s length standard.

The vast majority of APAs have covered transactions that involve numerous business functions and risks. For instance, with respect to functions, companies that manufacture products have typically conducted research and development, engaged in product design and engineering, manufactured the product, marketed and distributed the product, and performed support functions such as legal, finance, and human resources services. Regarding risks, companies have been subject to market risks, R&D risks, financial risks, credit and collection risks, product liability risks, and general business risks. In the APA evaluation process a significant amount of time and effort is devoted to understanding how the functions and risks are allocated amongst the controlled group of companies that are party to the covered transactions.

In its APA submission, the taxpayer must provide a functional analysis. The functional analysis identifies the economic activities performed, the assets employed, the economic costs incurred, and the risks assumed by each of the controlled parties. The importance of the functional analysis derives from the fact that economic theory posits that there is a positive relationship between risk and expected return and that different functions provide different value and have different opportunity costs associated with them. It is important that the functional analysis go beyond simply categorizing the tested party as, say, a distributor. It should provide more specific information since, in the example of distributors, not all distributors undertake similar functions and risks.

Thus, the functional analysis is critical in determining the TPM (including the selection of comparables). Although functional comparability is an essential factor in evaluating the reliability of the TPM (including the selection of comparables), the APA evaluation process also involves consideration of economic conditions such as the economic condition of the particular industry.

In evaluating the functional analysis, the APA program considers contractual terms between the controlled parties and the consistency of the conduct of the parties with respect to the allocation of risk. In accord with the section 482 regulations, the APA program also gives consideration to the ability of controlled parties to fund losses that might be expected to occur as the result of the assumption of risk. Another relevant factor considered in evaluating the functional analysis is the extent to which each controlled party exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. The section 482 regulations posit that parties at arm’s length will ordinarily bear a greater share of those risks over which they have relatively more control.

The TPMs used in APAs completed during 2003 were based on the section 482 regulations. Under Treas. Reg. § 1.482-3, the arm’s length amount for controlled transfers of tangible property may be determined using the Comparable Uncontrolled Price (CUP) method, the Resale Price Method, the Cost Plus Method, the Comparable Profits Method (CPM), or the Profit Split method. Under Treas. Reg. § 1.482-4, the arm’s length amount for controlled transfers of intangible property may be determined using the Comparable Uncontrolled Transaction (CUT) method, CPM, or the Profit Split Method. An “Unspecified Method” may be used for both tangible and intangible property if it provides a more reliable result than the enumerated methods under the best method rule of Treas. Reg. § 1.482-1(c). For transfers involving the provision of services, Treas. Reg. § 1.482-2(b) provides that services performed for the benefit of another member of a controlled group should bear an arm’s length charge, either deemed to be equal to the cost of providing the services (when non-integral, see Treas. Reg. § 1.482-2(b)(3)) or which should be an amount that would have been charged between independent parties.

In addition, Treas. Reg. § 1.482-2(a) provides rules concerning the proper treatment of loans or advances, and Treas. Reg. § 1.482-7 provides rules for qualified cost sharing arrangements under which the parties agree to share the costs of development of intangibles in proportion to their shares of reasonably anticipated benefits. APAs involving cost sharing arrangements generally address both the method of allocating costs among the parties as well as determining the appropriate amount of the “buy-in” payment due for the transfer of intangibles to the controlled participants.

In reviewing the TPMs applicable to transfers of tangible and intangible property reflected in Table 16, the majority of the APAs followed the specified methods. However, there are several distinguishing points that should be made. The Regulations note that for transfers of tangible property, the Comparable Uncontrolled Price (CUP) method will generally be the most direct and reliable measure of an arm’s length price for the controlled transaction if sufficiently reliable comparable transactions can be identified. Treas. Reg. § 1.482-3(b)(2)(ii)(A). It was the experience of the APA Program in 2003 that in the cases that came into the APA Program, sufficiently reliable CUP transactions were difficult to find. In APAs executed in 2003, there were two covered transactions that used the CUP method; both used internal data on transactions between the taxpayer and unrelated parties.

Similar to the CUP method, for transfers of intangible property, the CUT method will generally provide the most reliable measure of an arm’s length result if sufficiently reliable comparables may be found. Treas. Reg. § 1.482-4(c)(2)(ii). It has generally been difficult to identify external comparables, and APAs using the CUT method tend to rely on internal transactions between the taxpayer and unrelated parties. In 2003, there were four covered transactions that utilized the CUT TPM.

The Cost Plus Method (tangibles only) and Resale Price Method were applied in 2003 in two and three APAs respectively. See Treas. Reg. § 1.482-3(c), (d).

The CPM is frequently applied in APAs. This is because reliable public data on comparable business activities of independent companies may be more readily available than potential CUP data, and comparability of resources employed, functions, risks, and other relevant considerations is more likely to exist than comparability of product. The CPM also tends to be less sensitive than other methods to differences in accounting practices between the tested party and comparable companies, e.g., classification of expenses as cost of goods sold or operating expenses. Treas. Reg. § 1.482-3(c)(3)(iii)(B), and -3(d)(3)(iii)(B). In addition, the degree of functional comparability required to obtain a reliable result under the CPM is generally less than required under the Resale Price or Cost Plus methods, because differences in functions performed often are reflected in operating expenses, and thus taxpayers performing different functions may have very different gross profit margins but earn similar levels of operating profit. Treas. Reg. § 1.482-5(c)(2).

Table 16 reflects 28 uses of the CPM (with varying PLIs) in covered transactions involving tangible or intangible property. The CPM was also used in some APAs concurrently with other methods.

The CPM has proven to be versatile in part because of the various PLIs that can be used in connection with the method. Reaching agreement on the appropriate PLI has been the subject of much discussion in many of the cases, and it depends heavily on the facts and circumstances. Some APAs have called for different PLIs to apply to different parts of the covered transactions or with one PLI used as a check against the primary PLI.

The CPM also was used regularly with services as the covered transactions in APAs executed in 2003. There were a total of 10 services covered transactions using the CPM method with various PLIs according to the specific facts of the taxpayers involved. Table 17 reflects the methods used to determine the arm’s length results for APAs involving services transactions.

In 2003, there were two APAs involving tangible or intangible property that used the residual profit split, Treas. Reg. § 1.482-6(c)(3). In residual profit split cases, routine contributions by the controlled parties are allocated routine market returns, and the residual income is allocated among the controlled taxpayers based upon the relative value of their contributions of intangible property to the relevant business activity.

Profit splits have also been used in a number of financial product APAs in which the primary income-producing functions are performed in more than one jurisdiction. Two APAs executed in 2003 applied such a profit split.

There were three financial product APAs involving interbranch allocations. These involve a single taxpayer with branches that act autonomously with respect to the covered transactions, generally involving foreign currency exchanges. These particular APAs determine the appropriate amount of profits attributable to each branch from the activity by reference to the branches’ internal accounting methods. The results take into account all trades, and test the arms length results using statistical tests to verify that controlled trades are priced the same as uncontrolled trades.

APAs include critical assumptions upon which their respective TPMs depend. A critical assumption is any fact (whether or not within the control of the taxpayer) related to the taxpayer, a third party, an industry, or business and economic conditions, the continued existence of which is material to the taxpayer’s proposed TPM. Critical assumptions might include, for example, a particular mode of conducting business operations, a particular corporate or business structure, or a range of expected business volume. Rev. Proc. 96-53, § 5.07. Failure to meet a critical assumption may render an APA inappropriate or unworkable.

A critical assumption may change (and/or fail to materialize) due to uncontrollable changes in economic circumstances, such as a fundamental and dramatic change in the economic conditions of a particular industry. In addition, a critical assumption may change (and/or fail to materialize) due to a taxpayer’s actions that are initiated for good faith business reasons, such as a change in business strategy, mode of conducting operations, or the cessation or transfer of a business segment or entity covered by the APA.

If a critical assumption has not been met, the APA may be revised by agreement of the parties. If such agreement cannot be achieved, the APA may be canceled. If a critical assumption has not been met, it requires taxpayer’s notice to and discussion with the Service, and, in the case of a bilateral APA, competent authority consideration. Rev. Proc. 96-53, § 11.07.

At the core of most APAs are comparables. The APA program works closely with taxpayers to find the best and most reliable comparables for each covered transaction. In some cases, CUPs or CUTs can be identified. In other cases, comparable business activities of independent companies are utilized in applying the CPM or residual profit split methods. Generally, in the APA Program’s experience since 1991, CUPs and CUTs have been most often derived from the internal transactions of the taxpayer.

For profit-based methods in which comparable business activities or functions of independent companies are sought, the APA Program typically has applied a three-part process. First, a pool of potential comparables has been identified through broad searches. From this pool, companies having transactions that are clearly not comparable to those of the tested party have been eliminated through the use of quantitative and qualitative analyses, i.e., quantitative screens and business descriptions. Then, based on a review of available descriptive and financial data, a set of comparable transactions or business activities of independent companies has been finalized. The comparability of the finalized set has then been enhanced through the application of adjustments.

Comparables used in APAs can be U.S. or foreign. This depends on the relevant market, the type of transaction being evaluated, and the results of the functional and risk analyses. In general, comparables have been located by searching a variety of databases that provide data on U.S. publicly traded companies and on a combination of public and private non-U.S. companies. Table 20 shows the various databases and other sources used in selecting comparables for the APAs executed in 2003.

Although comparables were most often identified from the databases cited in Table 20, in some cases comparables were found from other sources, such as comparables derived internally from taxpayer transactions with third parties.

Initial pools of potential comparables generally are derived from the databases using a combination of industry and keyword identifiers. Then, the pool is refined using a variety of selection criteria specific to the transaction or business activity being tested and the TPM being used.

The listed databases allow for searches by industrial classification, by keywords, or by both. These searches can yield a number of companies whose business activities may or may not be comparable to those of the entity being tested. Therefore, comparables based solely on industry classification or keyword searches are rarely used in APAs. Instead, the pool of comparables is examined closely, and companies are selected based on a combination of screens, business descriptions, and other information found in the companies’ Annual Reports to shareholders and filings with the U.S. Securities and Exchange Commission (SEC).

Business activities are required to meet certain basic comparability criteria to be considered comparables. Functions, risks, economic conditions, and the property (product or intangible) and services associated with the transaction must be comparable. Determining comparability can be difficult — the goal has been to use comparability criteria restrictive enough to eliminate business activities that are not comparable, but yet not so restrictive as to have no comparables remaining. The APA Program normally has begun with relatively strict comparability criteria and then has relaxed them slightly if necessary to derive a pool of reliable comparables. A determination on the appropriate size of the comparables set, as well as the business activities that comprise the set, is highly fact specific and depends on the reliability of the results.

In addition, the APA Program, consistent with the section 482 regulations, generally has looked at the results of comparables over a multi-year period. Sometimes this has been a three-year period, but it has been more or less, depending on the circumstances of the controlled transaction. Using a shorter period might result in the inclusion of comparables in different stages of economic development or use of atypical years of a comparable due to cyclical fluctuations in business conditions.

Many covered transactions have been tested with comparables that have been chosen using additional criteria and/or screens. These include sales level criteria and tests for financial distress and product comparability. These common selection criteria and screens have been used to increase the overall comparability of a group of companies and as a basis for further research. The sales level screen, for example, has been used to remove companies that, due to their size, might face fundamentally different economic conditions from those of the transaction or business activities being tested. In addition, APA analyses have incorporated selection criteria related to removing companies experiencing “financial distress” due to concerns that companies in financial distress often have experienced unusual circumstances that render them not comparable to the business activity being tested. These criteria include: an unfavorable auditor’s opinion, bankruptcy, and, in certain circumstances, operating losses in a given number of years.

An additional important class of selection criteria is the development and ownership of intangible property. In some cases in which the business activity being tested is a manufacturer, several criteria have been used to ensure, for example, that if the controlled entity does not own significant manufacturing intangibles or conduct research and development (R&D), then neither will the comparables. These selection criteria have included determining the importance of patents to a company or screening for R&D expenditures as a percentage of sales. Again, quantitative screens related to identifying comparables with significant intangible property generally have been used in conjunction with an understanding of the comparable derived from publicly available business information.

Selection criteria relating to asset comparability and operating expense comparability have also been used at times. A screen of property, plant, and equipment (PP&E) as a percentage of sales or assets, combined with a reading of a company’s SEC filings, has been used to help ensure that distributors (generally lower PP&E) were not compared with manufacturers (generally higher PP&E), regardless of their industry classification. Similarly, a test involving the ratio of operating expenses to sales has helped to determine whether a company undertakes a significant marketing and distribution function.

Table 23 shows the number of times various screens were used in APAs executed in 2003:

After the comparables have been selected, the regulations require that “[i]f there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results.” Treas. Reg. § 1.482-1(d)(2). In almost all cases involving income-statement-based PLIs, certain “asset intensity” or “balance sheet” adjustments for factors that have generally agreed-upon effects on profits are calculated. In addition, in specific cases, additional adjustments are performed to improve reliability.

The most common balance sheet adjustments used in APAs are adjustments for differences in accounts receivable, inventories, and accounts payable. The APA Program generally has required adjustments for receivables, inventory, and payables based on the principle that there is an opportunity cost for holding assets. For these assets it is generally assumed that the cost is a short-term debt interest rate.

To compare the profits of two business activities with different relative levels of receivables, inventory, or payables, the APA Program estimates the carrying costs of each item and adjusts profits accordingly. Although different formulas have been used in specific APA cases, Attachment B presents one set of formulas used in many APAs. Underlying these formulas are the notions that (1) balance sheet items should be expressed as mid-year averages, (2) formulas should try to avoid using data items that are being tested by the TPM (for example, if sales are controlled, then the denominator of the balance sheet ratio should not be sales), (3) a short-term interest rate should be used, and (4) an interest factor should recognize the average holding period of the relevant asset.

The APA Program also requires that data be compared on a consistent accounting basis. For example, although financial statements may be prepared on a first-in first-out (FIFO) basis, cross-company comparisons are less meaningful if one or more of the comparables use LIFO inventory accounting methods. This adjustment directly affects costs of goods sold and inventories, and therefore affects both profitability measures and inventory adjustments.

Still important in some cases is the adjustment for differences in relative levels of PP&E between a tested business activity and the comparables. Ideally, comparables and the business activity being tested will have fairly similar relative levels of PP&E, since major differences can be a sign of fundamentally different functions and risks. Typically, the PP&E adjustment is made using a medium term interest rate.

Additional adjustments used less frequently include those for differences in other balance sheet items, operating expenses, R&D, or currency risk. Accounting adjustments, such as reclassifying items from cost of goods sold to operating expenses, for example, are also made when warranted to increase reliability. Often, data is not available for both the controlled and uncontrolled transactions in sufficient detail to allow for these types of adjustments.

The adjustments made to comparables or tested parties in APAs executed in 2003 are reflected in Table 22 above.

Treas. Reg. § 1.482-1(e)(1) states that sometimes a pricing method will yield “a single result that is the most reliable measure of an arm’s length result.” Sometimes, however, a method may yield “a range of reliable results,” called the “arm’s length range.” A taxpayer whose results fall within the arm’s length range will not be subject to adjustment.

Under Treas. Reg. § 1.482-1(e)(2)(i), such a range is normally derived by considering a set of more than one comparable uncontrolled transaction of similar comparability and reliability. If these comparables are of very high quality, as defined in the Regulations, then under Treas. Reg. § 1.482-1(e)(2)(iii)(A), the arm’s length range includes the results of all of the comparables (from the least to the greatest). However, the APA Program has only rarely identified cases meeting the requirements for the full range. If the comparables are of lesser quality, then under Treas. Reg. § 1.482-1(e)(2)(iii)(B), “the reliability of the analysis must be increased, when it is possible to do so, by adjusting the range through application of a valid statistical method to the results of all of the uncontrolled comparables.” One such method, the “interquartile range,” is ordinarily acceptable, although a different statistical method “may be applied if it provides a more reliable measure.” The “interquartile range” is defined as, roughly, the range from the 25th to the 75th percentile of the comparables’ results. See Treas. Reg. § 1.482-1(e)(2)(iii)(C). The interquartile range was used 31 times in 2003.

Nineteen covered transactions reflected on Table 24 specified a single, specific result, or “point.” Three of these covered transactions involved a CPM in which the taxpayer agreed to a specific result. Some APAs specify not a point or a range, but a “floor” or a “ceiling”. When a floor is used, the tested party’s result must be greater than or equal to some particular value. When a ceiling is used, the tested party’s result must be less than or equal to some particular value. Six APAs executed in 2003 used a floor and two used a ceiling.

Some APAs look to a tested party’s results over a period of years (multi-year averaging) to determine whether a taxpayer has complied with the APA. In 2003, rolling multi-year averaging was used for 10 covered transactions. Seven of those used three-year averages, one used a four-year average, and the other two used five-year averages. Cumulative multi-year averages were used for three covered transactions. Additionally, six covered transactions used term averages, and one covered transaction used a partial term average.

Under Treas. Reg. § 1.482-1(e)(3), if a taxpayer’s results fall outside the arm’s length range, the Service may adjust the result “to any point within the arm’s length range.” Accordingly, an APA may permit or require a taxpayer and its related parties to make an adjustment after the year’s end to put the year’s results within the range, or at the point specified by the APA. Similarly, to enforce the terms of an APA, the Service may make such an adjustment. When the APA specifies a range, the adjustment is sometimes to the closest edge of the range, and sometimes to another point such as the median of the interquartile range. Depending on the facts of each case, such automatic adjustments are not always permitted. APAs may specify that in such a case there will be a negotiation between the competent authorities involved to determine whether and to what extent an adjustment should be made. APAs may permit automatic adjustments unless the result is far outside the range specified in the APA. Thus APAs provide flexibility and efficiency, permitting adjustments when normal business fluctuations and uncertainties push the result somewhat outside the range.

In order to conform the taxpayer’s books to these tax adjustments, the APA usually permits a “compensating adjustment” as long as certain requirements are met. Such compensating adjustments may be paid between the related parties with no interest, and the amount transferred will not be considered for purposes of penalties for failure to pay estimated tax. See § 11.02 Rev. Proc. 96-53.

Number of rollback years to which an APA TPM was applied in 2003 is set forth in Table 27 below: