This document amends 26 CFR part 1 under section 148 of the Internal Revenue Code by providing rules for determining when certain brokers' commissions or similar fees are qualified administrative costs (the final regulations). On August 27, 1999, the IRS published in the Federal Register a notice of proposed rulemaking (REG-105565-99, 1999-2 C.B. 418 [64 FR 46876]) (the proposed regulations). The proposed regulations modify §1.148-5(e)(2) to provide a safe harbor for determining whether brokers' commissions and similar fees incurred in connection with the acquisition of guaranteed investment contracts or investments purchased for a yield restricted defeasance escrow are treated as qualified administrative costs. Comments on the proposed regulations were received and a hearing was held on December 14, 1999. After consideration of all the comments, the proposed regulations are adopted as revised by this Treasury decision. The revisions are discussed below.

Section 148 limits the yield on investments purchased with proceeds of tax-exempt bonds. In general, under §1.148-5(b)(1) of the existing regulations, the yield on an investment is computed by comparing receipts from the investment to payments for the investment. Section 1.148-5(e)(1) provides that the yield on an investment generally is not adjusted to take into account any costs or expenses paid, directly or indirectly, to purchase, carry, sell, or retire the investment (administrative costs). However, §1.148-5(e)(2)(i) provides that the yield on nonpurpose investments (as defined in §1.148-1(b)) is adjusted to take into account qualified administrative costs. Qualified administrative costs are reasonable, direct administrative costs, other than carrying costs, such as separately stated brokerage or selling commissions, but not legal and accounting fees, recordkeeping, custody, and similar costs. In general, under §1.148-5(e)(2)(i), administrative costs are not reasonable unless they are comparable to administrative costs that would be charged for the same investment or a reasonably comparable investment if acquired with a source of funds other than gross proceeds of tax-exempt bonds (the comparability standard).

Section 1.148-5(e)(2)(iii) of the existing regulations provides that, for a guaranteed investment contract, a broker's commission or similar fee paid on behalf of either an issuer or the guaranteed investment contract provider generally is a qualified administrative cost to the extent that the present value of the commission, as of the date the contract is allocated to the issue, does not exceed the lesser of (x) a reasonable amount within the meaning of §1.148-5(e)(2)(i) or (y) the present value of annual payments equal to .05 percent of the weighted average amount reasonably expected to be invested each year of the term of the contract. Present value is computed using the taxable discount rate used by the parties to compute the commission, or if not readily ascertainable, the yield to the issuer on the investment contract or other reasonable taxable discount rate.

Section 1.148-5(e)(2)(iv) of the existing regulations provides that, for investments purchased for a yield restricted defeasance escrow, a fee paid to a bidding agent is a qualified administrative cost only if the fee is comparable to a fee that would be charged for a reasonably comparable investment if acquired with a source of funds other than gross proceeds of tax-exempt bonds, and it is reasonable. The fee is deemed to meet both the comparability and reasonableness requirements if it does not exceed the lesser of $10,000 or .1 percent of the initial principal amount of investments deposited in the yield restricted defeasance escrow.

The proposed regulations were issued in response to comments stating that issuers were having difficulty applying §1.148-5(e)(2)(iii) and (iv), primarily because of uncertainty about whether a particular broker's commission or similar fee is reasonable. The proposed regulations delete the existing provisions of §1.148-5(e)(2)(iii) and (iv) and create a single rule for qualified administrative costs that treats a broker's commission or similar fee incurred in connection with a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow as a qualified administrative cost if the fee is reasonable within the meaning of §1.148-5(e)(2)(i) of the existing regulations.

The proposed regulations also set forth a safe harbor, which treats a broker's commission or similar fee incurred in connection with the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow as reasonable within the meaning of §1.148-5(e)(2)(i) if two requirements are met. Under the first requirement for the safe harbor, the amount of the broker's commission or similar fee treated by the issuer as a qualified administrative cost cannot exceed the lesser of $25,000 or 0.2 percent of the computational base (the per-investment safe harbor). For guaranteed investment contracts, the computational base is the aggregate amount reasonably expected as of the issue date to be deposited over the term of the contract. For example, for a guaranteed investment contract used to earn a return on what otherwise would be idle cash balances from maturing investments in a yield restricted defeasance escrow, the aggregate amount reasonably expected to be deposited includes all periodic deposits reasonably expected to be made pursuant to the terms of the contract. For investments, other than guaranteed investment contracts, deposited in a yield restricted defeasance escrow, the computational base is the initial amount invested in those investments. Under the second requirement for the safe harbor, for any issue of bonds, the issuer cannot treat as qualified administrative costs more than $75,000 in brokers' commissions or similar fees with respect to all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue (the per-issue safe harbor).

Some commentators suggested that the existing regulations, coupled with competitive market forces, work well to produce reasonable brokers' fees. Commentators also suggested that the proposed regulations will eliminate much of the incentive for the independent bidding agent to actively participate in the market, with the result that, in many cases, tax-exempt bond proceeds will be placed in lower-yielding and often riskier investments. These commentators recommended against adopting the safe harbor in the proposed regulations.

Other commentators suggested that the existing regulations do not work well. They stated that the current rules provide little practical guidance upon which an issuer can rely to determine whether a broker's fee for a guaranteed investment contract is a reasonable amount. These commentators recommended that the safe harbor be adopted with modifications. They suggested that the safe harbor will provide a much needed level of certainty.

The IRS and Treasury Department do not believe the final regulations will result in tax-exempt bond proceeds being invested in low-yielding, risky investments because the regulations do not adversely affect an issuer's incentive to realize investment earnings and to invest in secure investments. To provide simplicity and certainty, the final regulations retain the safe harbor, with certain modifications discussed below. The final regulations do not limit the amount of brokers' fees that may be paid by issuers. Thus, for example, the final regulations do not restrict the ability of an issuer to pay a particular fee that exceeds the safe harbor amount. Furthermore, brokers' commissions or similar fees in excess of the safe harbor are qualified administrative costs if they are reasonable within the meaning of §1.148-5(e)(2)(i).

Commentators suggested that, if the per-investment safe harbor is retained, it should be increased. These commentators stated that in some circumstances the safe harbor does not reflect the value provided by brokers, particularly in the case of small or large transactions and long-term debt service reserve fund investments. Suggestions for modifying the per-investment safe harbor included adding a minimum fee for smaller transactions and a sliding scale for larger transactions. Commentators also suggested increasing the computational base for long-term guaranteed investment contracts by treating them as a series of shorter-term contracts.

The final regulations increase the $25,000 amount to $30,000 and provide for a minimum fee of $3,000. Thus, if 0.2 percent of the computational base is less than $3,000, the per-investment safe harbor is $3,000. The final regulations do not adopt a sliding scale and do not treat long-term contracts as a series of shorter-term contracts because the IRS and Treasury Department have concluded that the per-investment safe harbor in the final regulations provides much needed certainty without requiring issuers to pay less than fair market value for brokers' fees.

Commentators recommended that the per-issue safe harbor be increased or eliminated. Some commentators suggested replacing the per-issue safe harbor with an anti-abuse rule to prevent the artificial creation of multiple investments when a single investment would be appropriate. Suggestions included aggregating separate investments that (1) are made at or about the same time if the bond proceeds being invested have similar rebate or yield characteristics, or (2) would normally be bid together as a single investment unless there was a good business reason for the separation.

The final regulations retain the per-issue safe harbor and increase the $75,000 amount to $85,000. To maintain simplicity and certainty, the final regulations do not adopt the suggestion to replace the per-issue safe harbor with an anti-abuse rule. The IRS and Treasury Department have concluded that the per-issue safe harbor in the final regulations limits artificial separation of investments without requiring issuers to pay less than fair market value for brokers' fees.

Some commentators requested guidance on the factors for determining whether a fee in excess of the safe harbor is reasonable. Suggested factors included the duration of the contract, the complexity of its terms, the creditworthiness of the issuer, the availability of providers to deliver the contract, the presence of unusual features in the issue or the contract, custom in the industry, and the level of risk to the broker. The IRS and Treasury Department have considered the suggested factors and have concluded that they do not represent administrable standards for determining whether a particular fee is reasonable. Therefore, the final regulations do not specify factors for determining the reasonableness of fees in excess of the safe harbor. Under the final regulations, the determination of whether a fee is reasonable is made based on all the facts and circumstances, including whether the fee satisfies the comparability standard in §1.148-5(e)(2)(i).

Some commentators suggested that the portion of a fee that is within the safe harbor should be a qualified administrative cost, even if the total fee exceeds the safe harbor. The final regulations adopt this suggestion.

Commentators suggested that the computational base for a guaranteed investment contract should be determined as of the date the contract is acquired, rather than the issue date, so that the safe harbor may be applied to guaranteed investment contracts that are not anticipated on the issue date. The final regulations adopt this suggestion.

Commentators requested that the final regulations provide for periodic adjustments to the dollar limits in the safe harbor to reflect inflation. The final regulations provide a cost-of-living adjustment for both the per-investment safe harbor and the per-issue safe harbor. The adjusted safe harbor dollar amounts will be published in the annual revenue procedure that sets forth inflation-adjusted items.

One commentator questioned whether the proposed regulations should have been classified as a legislative rule. The IRS and Treasury Department have reviewed the applicable authorities and have determined that the regulations are properly classified as an interpretative rule.

The final regulations apply to bonds sold on or after February 9, 2004. In the case of bonds sold before February 9, 2004, that are subject to §1.148-5 (pre-effective date bonds), issuers may apply the final regulations, in whole but not in part, with respect to transactions entered into on or after December 11, 2003. If an issuer applies the final regulations to pre-effective date bonds, the per-issue safe harbor is applied by taking into account all brokers' commissions or similar fees with respect to guaranteed investment contracts and investments for yield restricted defeasance escrows that the issuer treats as qualified administrative costs for the issue, including all such commissions or fees paid before February 9, 2004. For purposes of §§1.148-5(e)(2)(iii)(B)(3) and 1.148-5(e)(2)(iii)(B)(6) of the final regulations (relating to cost-of-living adjustments), transactions entered into before 2003 are treated as entered into in 2003.

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. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the rule does not impose a collection of information on small entities, the provisions of the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply.

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

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

Par. 2. Section 1.148-0 is amended by revising the entry in paragraph (c) for §1.148-11 (i) to read as follows:

P is a domestic corporation that is a calendar year taxpayer. FS is an entity that is organized under the laws of Country X. FS has only one class of equity interests outstanding, all of which is owned by P. Since the date of its organization, FS has derived all of its gross receipts from manufacturing operations. FS is indebted to P and to trade creditors. All of FS's indebtedness constitutes valid indebtedness for federal tax purposes and is recourse to FS. FS is an eligible entity within the meaning of § 301.7701-3(a) and, prior to July 1, 2003, FS is treated as a corporation within the meaning of § 7701(a)(3) for federal tax purposes.

On December 31, 2002, P's FS stock was not worthless. On July 1, 2003, P files a valid Form 8832, Entity Classification Election, changing the classification of FS from a corporation to a disregarded entity for federal tax purposes effective as of that date. The election has no effect on the treatment of FS under Country X law. After the election is effective, FS continues its manufacturing operations. At the close of the day immediately before the effective date of the election, the fair market value of FS's assets, including intangible assets such as goodwill and going concern value, exceeds the sum of its liabilities. However, at that time, the fair market value of FS's assets, excluding intangible assets such as goodwill and going concern value, does not exceed the sum of its liabilities.

The facts are the same as in Situation 1, except that at the close of the day immediately before the effective date of the election, the fair market value of FS's assets, including intangible assets such as goodwill and going concern value, does not exceed the sum of its liabilities.

Section 1221 defines a capital asset as property that is not described in § 1221(a)(1) through § 1221(a)(8). Among the excluded classes of property are the transactions described in § 1221(a)(7) that are clearly identified as hedging transactions before the close of the day on which they are acquired, originated, or entered into. Thus, to be excluded from treatment as a capital asset under § 1221(a)(7), a transaction must fall within the definition of a hedging transaction and must be properly identified as a hedging transaction.

The term “hedging transaction” is defined in § 1221(b)(2)(A) and § 1.1221-2(b) as any transaction entered into by a taxpayer in the normal course of the taxpayer's trade or business primarily to manage the risks specified in § 1221(b)(2)(A)(i) through (iii). Because the contract is entered into in the normal course of H's business primarily to manage the risk of interest rate changes with respect to a borrowing, the contract falls within the definition of a hedge set forth in § 1221(b)(2)(A)(i) and § 1.1221-2(b)(2).

The general requirements for a proper identification, as required by § 1221(a)(7), are set forth in § 1.1221-2(f). Additional identification requirements are set forth in § 1.446-4(d)(2). Furthermore, § 1221(b)(2)(B) specifically directs the Secretary to prescribe regulations that properly characterize any income, gain, expense, or loss arising from a transaction that (1) is a hedging transaction but is not properly identified under § 1221(a)(7) or (2) is not a hedging transaction but is so identified. Section 1.1221-2(g)(2) generally provides that a failure to make a proper identification under § 1.1221-2(f)(1) “establishes that a transaction is not a hedging transaction” and that the rules of § 1.1221-2(a)(1) and (2) (providing special rules for the character of gain or loss) do not apply. Consequently, because H fails to identify the contract as a hedging transaction under § 1.1221-2(f), and because the exceptions set forth in §§ 1.1221-2(g)(2)(ii) or (iii) do not apply, then § 1.1221-2(a)(1) and (2) do not apply to the contract.

Section 1.446-4(a) provides that “a hedging transaction as defined in § 1.1221-2(b) (whether or not the character of the gain or loss from the transaction is determined under § 1.1221-2) must be accounted for under the rules of [§ 1.446-4].” Because § 1.1221-2(g) causes H's contract to fail to be a hedging transaction for purposes of § 1.1221-2(a)(1) and (2), the question arises whether H's contract also fails to be a hedging transaction for purposes of § 1.446-4(a).

H's contract is a hedging transaction for purposes of § 1.446-4. First, the definitions of a hedging transaction set forth in § 1221(b)(2)(A) and § 1.1221-2(b) do not contain an identification requirement. In fact, § 1221(b)(2)(B) refers to a transaction “which is a hedging transaction but which was not identified as such in accordance with [§ 1221(a)(7)] ... .” This language indicates that, even though § 1221(a)(7) does not cause the transaction to give rise to ordinary income or loss unless it is properly identified, that transaction may nevertheless be a hedging transaction.

Second, § 1.446-4(a) refers only to the definition of a hedging transaction in § 1.1221-2(b) and does not refer to the additional rules contained in § 1.1221-2(g)(2) regarding the treatment of unidentified transactions.

Third, the purpose of §§ 1221(a)(7) and 1221(b) is to address the character of income or loss. Specifically, these sections match the character of the hedge to that of the hedged item in a manner that is generally advantageous to taxpayers. The purpose of § 1.446-4 is to clearly reflect income by matching the timing of income, gain, loss, and deductions of a hedging transaction to income, gain, loss and deductions of a hedged item. This purpose is independent of character of income and loss. Thus, § 1.1221-2(g)(1) and (2) affects the character of income or loss but does not modify the definition of a hedging transaction under § 1221(b)(2)(A) and § 1.1221-2(b). Despite H's failure to identify the contract as a hedging transaction under § 1.1221-2(f)(1), H's failure to identify the hedged item, items, or aggregate risk under § 1.1221-2(f)(2), and H's failure to comply with the identification requirements in § 1.446-4(d)(2), H must account for income, deduction, gain, or loss on the contract using a method of accounting that clearly reflects income under § 1.446-4.

Section 1.446-4 provides guidance regarding methods of accounting that clearly reflect income from hedging transactions. See § 1.446-4(b), which states that “[t]o clearly reflect income, the method used must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the timing of the income, deduction, gain, or loss from the item or items being hedged.” Each method of accounting used by a taxpayer must clearly reflect income.

Section 1.446-4(c) generally permits a taxpayer to adopt a method of accounting that clearly reflects the taxpayer's income from a particular type of transaction. Different methods of accounting may be used for different types of hedging transactions and for transactions that hedge different types of items. Once a taxpayer adopts a method of accounting, however, that method must be applied consistently and may only be changed with the consent of the Commissioner, as provided by § 446(e) and the applicable regulations and procedures.

Rev. Rul. 90-38, 1990-1 C.B. 57, holds that in determining gross income or deductions, the treatment of a material item in the same way for two or more consecutively filed tax returns represents consistent treatment of that item for purposes of § 1.446-1(e)(2)(ii)(a). If a taxpayer treats an item properly in the first return that reflects the item, however, the taxpayer need not have treated the item consistently in two or more consecutive tax returns to have adopted a method of accounting. If a taxpayer has adopted a method of accounting, the taxpayer may not change the method by amending its prior income tax returns.

Despite H's failure to identify the contract as a hedging transaction under § 1.1221-2(f) and H's failure to comply with the identification requirements in § 1.446-4(d)(2), H must account for the gain or loss on the contract using a method of accounting that clearly reflects income under § 1.446-4. See § 1.446-1(b)(1) (which provides that if the taxpayer does not regularly employ a method of accounting which clearly reflects income, the computation of taxable income shall be made in a manner which, in the opinion of the Commissioner, does clearly reflect income). Because H has previously adopted a method of accounting for the same type of hedging transaction, H must use that method to account for the gain or loss on the contract unless H obtains the consent of the Commissioner to change to a method that satisfies § 1.446-4. See § 1.446-1(e)(2)(i) (which provides that a taxpayer must obtain the consent of the Commissioner before changing its method of accounting, whether or not its method of accounting is permissible) and § 446(f) (which provides that failure to file a request to change the method of accounting does not prevent the imposition, or diminish the amount of, any penalties or additions to tax). See Rev. Proc. 97-27, 1997-1 C.B. 680, for the procedure to obtain the Commissioner's consent to change to a permissible method.

Section 61(a)(12) of the Internal Revenue Code (Code) provides that gross income includes income from the discharge of indebtedness, except as provided by law. Section 108(a) provides that, in certain cases, gross income of a C corporation does not include certain amounts of discharge of indebtedness income that would otherwise be includible in gross income. In these cases, however, the taxpayer must reduce its tax attributes, including the basis of property, by the excluded amount of discharge of indebtedness income (excluded COD income). This provision reflects Congressional intent of “deferring, but eventually collecting within a reasonable period, tax on ordinary income realized from debt discharge.” See H.R. Rep. 96-833 at 9 (1980); S. Rep. No. 96-1035 at 10 (1980).

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 (the original regulations). The original regulations provide guidance regarding the determination of the attributes that are available for reduction when a member of a consolidated group realizes excluded COD income and the method for reducing those attributes. As explained in the preamble to the original regulations, those regulations adopt a consolidated approach that is intended to reduce all attributes that are available to the debtor member and contain a rule governing the order in which attributes are reduced. In particular, under the original regulations, the attributes attributable to the debtor member are first subject to reduction. For this purpose, attributes attributable to the debtor member include (1) consolidated attributes attributable to the debtor member, (2) attributes that arose in separate return limitation years of the debtor member, and (3) the basis of property of the debtor member. To the extent that the excluded COD income exceeds the attributes attributable to the debtor member, the original regulations require the reduction of consolidated attributes attributable to other members and attributes attributable to other members that arose (or are treated as arising) in a separate return limitation year to the extent that the debtor member is a member of the separate return limitation year subgroup with respect to such attribute.

The IRS and Treasury Department have become aware that the original regulations may not provide for the reduction of all the attributes that are in fact available to the debtor member. In particular, those regulations may not require the reduction of tax attributes attributable to members other than the debtor member that arise in a separate return year and that are not subject to a SRLY limitation. Such attributes, for example, include attributes from separate return limitation years that are not subject to a SRLY limitation as a result of the application of the overlap rule of §1.1502-15(g) or §1.1502-21(g).

These temporary regulations, therefore, amend the original regulations to include among the tax attributes that are subject to reduction, after the reduction of the tax attributes attributable to the debtor member, tax attributes attributable to members other than the debtor member (other than asset basis) that arose in a separate return year or that arose (or are treated as arising) in a separate return limitation year to the extent that no SRLY limitation applies to the use of such attributes by the group. This amendment is consistent with the approach of the original regulations to make available for reduction all of the attributes that are available to offset income of the debtor member.

These amendments to the original regulations generally apply to discharges of indebtedness that occur after August 29, 2003, but only if the discharge occurs during a taxable year the original return for which is due (without regard to extensions) after December 10, 2003.

The IRS and Treasury Department are aware that there are a number of other technical issues that have been identified regarding the operation of the original regulations. The IRS and Treasury Department are currently studying these issues, including the application of section 1245 to property the basis of which has been reduced, the timing of certain basis adjustments, and the timing of taking into account certain excess loss accounts. It is expected that guidance regarding these issues will be issued in the near future and may be available on a retroactive basis.

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 application of previously promulgated regulations regarding 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 effective 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 Federal Register. Pursuant to section 7805(f) of the 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 continues to read in part as follows:

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

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

Par. 2. Section 1.1502-28T is amended by revising paragraphs (a)(4) and (d) to read as follows:

Temporary regulations in this issue of the Bulletin amend 26 CFR part 1 relating to section 1502. The text of the temporary 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. 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. Moreover, the number of taxpayers affected and the average burden are minimal. 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 specifically request comments on the clarity of the proposed rules and how they may 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 continues 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 1.1502-28 is added to read as follows: