Sections 3.02 and 3.03 of this notice describe the substance of regulations that the IRS and the Treasury Department expect to issue. Pending the promulgation and effective date of future administrative or regulatory guidance, this notice provides interim guidance on which taxpayers may rely with respect to qualified tax credit bonds issued under section 54A. For further information regarding the effective date and scope of application, see Section 7 of this notice.

(a) Allowance of credit—(1) General rule. In general, a taxpayer that holds a qualified tax credit bond on one or more credit allowance dates (as defined in section 54A(e)(1)) of the bond occurring during a taxable year is allowed as a credit against income tax for the taxable year an amount equal to the sum of the credits determined under section 54A(b) with respect to those credit allowance dates. Unless otherwise specifically provided, for purposes of this notice references to the “allowance of a credit” or an “allowed credit” mean the amount of the credit determined under section 54A(b) (as limited by sections 54C(b) and 54D(b)) before application of the limitation under section 54A(c).

(2) Allowance of a credit treated as a payment of stated interest on a taxable bond. For Federal income tax purposes, the allowance of a credit on a qualified tax credit bond on a credit allowance date is treated as a payment, in the amount of the allowed credit, of stated interest on a debt obligation the interest on which is includable in gross income. Thus, the allowance of a credit on a bond that has not undergone a stripping transaction is treated as a payment of qualified stated interest (within the meaning of § 1.1273-1(c) of the Income Tax Regulations) to the same extent that a payment of stated interest in cash in the same amount and on the same date would have been so treated.

(3) Accounting method—(i) General rule. In general, a holder’s regular method of accounting determines when the holder recognizes qualified stated interest income from a qualified tax credit bond. Thus, if the holder of a qualified tax credit bond uses the cash receipts and disbursements method of accounting, interest income in the amount of the allowed credit is generally included in income on the credit allowance date. If the holder of such a bond uses an accrual method of accounting, this interest income is included in income as it accrues over each accrual period. See § 1.1272-1(b)(1)(ii) to determine the accrual periods and § 1.446-2(b) to determine how qualified stated interest accrues over the accrual period (or periods) to which it is attributable. (For qualified tax credit bonds that have not undergone a stripping transaction, because of the regular quarterly credit allowance dates, the maximum permitted length of the accrual periods is three months.)

(ii) Other rules with respect to accounting for interest. Under certain circumstances, other rules may require the holder of a bond (including a tax credit bond) to adjust the amount of interest income that the holder recognizes. See, e.g. , section 171 (amortization of bond premium by a bond purchaser); § 1.61-7(c) (purchaser’s treatment of a bond purchased between interest payment dates); § 1.61-7(d) (seller’s treatment of a bond sold between interest payment dates); section 1272 (accrual of original issue discount (OID) by a holder); and Section 3.03 of this notice and section 1286 (treatment of stripping transactions).

(4) Examples. The following examples illustrate the application of this Section 3.02(a):

Example 1. Assume that, on December 15, 2011, City X issues a qualified tax credit bond with a stated principal amount of $12,000, a credit rate of 10% compounded quarterly, and a maturity date of December 15, 2013. B purchases the bond at original issue for $12,000 and thus has a $12,000 basis in the bond. B is a calendar year taxpayer that uses the cash receipts and disbursements method of accounting. Under Section 3.02(a) of this notice and § 1.1273-1(c), the allowance of the $300 tax credit on each credit allowance date is treated as a payment of qualified stated interest of $300 on those dates. On March 16, 2012, B sells the bond for $12,000. On March 15, 2012, the first credit allowance date occurring after the issuance of the bond, B becomes entitled to a $300 tax credit and, with respect to that credit, must include in income $300 of interest in 2012. No interest is includable in 2011.

Example 2. The facts are the same as in Example 1, except that B uses an accrual method of accounting. As in Example 1, B becomes entitled to a $300 tax credit on March 15, 2012. B, however, must include in income $50 of interest in 2011 and $250 of interest in 2012 (based on a 30 day/360 day counting convention).

Example 3—(i) The facts are the same as in Example 1, except that on March 16, 2012, B sells the bond for $12,100 to C, a taxpayer that uses the cash receipts and disbursements method and the calendar year. C has not previously elected to amortize bond premium under section 171. Under § 1.61-7(d), B treats the entire $12,100 as sales proceeds. Because B’s basis in the bond was $12,000, B has a $100 gain on the sale. C has a $12,100 basis in the bond. Because C acquired the bond with premium of $100, C may elect to amortize the $100 bond premium under section 171.

(ii) Assume further that C holds the bond until its retirement on December 15, 2013. C has $900 of tax credits in 2012 and $1,200 in 2013. If C does not elect to amortize the bond premium, C has $900 of interest income in taxable year 2012 and $1,200 of interest income in taxable year 2013. In addition, C has a $100 loss in taxable year 2013. If C elects to amortize the $100 of bond premium, the amortized portion of that bond premium reduces C’s interest income in 2012 and 2013, and C does not have a $100 loss in taxable year 2013.

Example 4. The facts are the same as in Example 3, except that B sells the bond to C on January 15, 2012, at a sales price of $12,100. (Based on the treatment of the credits under section 3.02(a)(2) of this notice, there was $100 of accrued but unpaid interest with respect to the bond on the sale date.) Under § 1.61-7(d), B treats $100 of the sales price as the receipt of interest accrued on the bond, includes this amount in income in 2012, and treats the remaining $12,000 as sales proceeds. Because B’s basis in the bond is $12,000, B has no gain or loss on the sale of the bond. On March 15, 2012, C becomes entitled to the $300 credit. Under § 1.61-7(c), the amount of interest income included by C with respect to the credit is $200, and C’s basis in the bond is $12,000.

(b) Limitation based on amount of tax—(1) In general. The credit allowed under section 54A(a) and this Section 3.02 is subject to the limitation in section 54A(c)(1) based on the taxpayer’s income tax liability.

(2) Carryover of unused credit—(i) In general. Under section 54A(c)(2), if the credit allowable for the taxable year under section 54A(a) exceeds the limitation imposed for the taxable year by section 54A(c)(1), the excess credit (an excess credit) is carried to the succeeding taxable year and added to the credit allowable under section 54A(a) (as adjusted by sections 54C(b) and 54D(b)) for the succeeding taxable year (determined before the application of the limitation for the succeeding taxable year under section 54A(c)(1)).

(ii) No time limit on carryovers of excess credits. An excess credit under section 54A(c)(2) can be carried forward to succeeding taxable years and used in a succeeding year to the extent that the excess credit does not exceed the limitation for that taxable year. Any allowed credit, including any excess credit from a prior year, however, must be taken for the first taxable year in which, and to the extent that, the allowed credit, including the excess credit, does not exceed the limitation under section 54A(c)(1) and Section 3.02(b)(2)(i) of this notice.

(c) Qualified tax credit bonds and corporate earnings and profits—(1) Adjustments to earnings and profits. A corporation generally adjusts its earnings and profits in accordance with its method of accounting. See § 1.312-6. For this purpose, a corporation increases its earnings and profits for interest income (including interest described in section 54A(f)). A corporation reduces its earnings and profits when, and to the extent that, it would have reduced its earnings and profits had it satisfied its tax liability with cash rather than reducing that liability with tax credits from qualified tax credit bonds.

(2) RICs and REITs. If, under section 853A or section 54A(h), a regulated investment company or a real estate investment trust, respectively, distributes with respect to its stock a tax credit from a qualified tax credit bond or from a stripped credit coupon from a qualified tax credit bond (including a credit passed through from a partnership or trust), then the earnings and profits of the regulated investment company or real estate investment trust are reduced when, and to the extent that, the earnings and profits would have been reduced if the distribution had consisted of cash in the amount of the credit.

(a) Overview. This Section 3.03 addresses stripping transactions involving qualified tax credit bonds. Section 54A(i)(1) provides generally that, under regulations, there may be a separation, including at issuance, of the ownership of a qualified tax credit bond and the entitlement to a credit under section 54A with respect to the bond. In the case of any such separation, the credit is allowed to the person who on the credit allowance date holds the instrument evidencing the entitlement to the credit and not to the holder of the bond. Section 54A(i)(2) further provides that, in the case of such a separation, the rules of section 1286 are to apply to the qualified tax credit bond as if it were a stripped bond and to the credit as if it were a stripped coupon.

(b) Definitions. The following definitions apply for purposes of this Section 3:

(1) Credit coupon means the right to receive a tax credit under section 54A with respect to a qualified tax credit bond on a credit allowance date.

(2) Issue means issue as defined in § 1.150-1(c) except that, in applying that definition for purposes of this Section 3.03, the only bonds taken into account are qualified tax credit bonds as defined in section 54A(d)(1).

(3) Stripping transaction means a transaction that results in the separation in ownership between any credit coupon with respect to a qualified tax credit bond for any credit allowance date that has not yet occurred and any right to receive cash (whether stated principal or stated interest) that has not yet become payable. Notwithstanding the preceding sentence, the term stripping transaction does not include a transaction with respect to a particular bond in which the post-transaction future rights (that is, rights to cash that is not yet payable and credits whose credit allowance dates have not yet occurred) reflect a pro rata division of all the pre-transaction future rights.

(4) Stripped credit coupon means a credit coupon with respect to a qualified tax credit bond if the bond has undergone a stripping transaction.

(c) Strippable Issue. For purposes of this notice, the term “strippable issue” means an issue of qualified tax credit bonds that complies with all of the following requirements:

(1) Designation requirement. The issuer on or before the date of issue includes a statement in the bond documents (as defined in § 1.150-1(b)) that the issue of qualified tax credit bonds is strippable. For an issue of qualified tax credit bonds that is issued before March 31, 2010, this designation may be effected on or before May 17, 2010.

(2) Identification requirement. On an information return filed with the IRS under section 54A(d)(3), the issuer identifies the issue of qualified tax credit bonds as a strippable issue. Except as provided in the next sentence, the identification must be on the first information return filed under section 54A(d)(3) with respect to the issue of qualified tax credit bonds. For an issue of qualified tax credit bonds that is issued before March 31, 2010, the identification may instead be on an amended information return filed before May 17, 2010.

(3) Registration requirement. The issue of qualified tax credit bonds is issued in registered form. For this purpose, registered form means that all rights to stated principal, stated cash interest, and tax credits under the bond may be transferred only through book entry on the registration books of the issuer or an agent or nominee (or chain of nominees) for this purpose. In addition, a bond is not considered to be in registered form unless book entries are maintained (by the issuer, an agent, or nominee) in a manner that makes all the entries available for inspection upon request by the Commissioner or his designees.

(4) CUSIP number requirement. A CUSIP number is assigned to the issue of qualified tax credit bonds, a separate CUSIP number is assigned to all rights to receive tax credits on each credit allowance date with respect to the issue, and at least one separate CUSIP number is assigned to all rights to receive cash (whether stated principal or stated interest) with respect to the issue.

(d) Allowance of the tax credit to a holder of a stripped credit coupon. A taxpayer who holds a stripped credit coupon on a credit allowance date is allowed the tax credit only if all of the following requirements are satisfied:

(1) Strippable issue. The bond is part of a strippable issue within the meaning of paragraph (c) of this Section 3.03.

(2) Stripped credit coupons. The stripped credit coupon is either a whole credit coupon or a proportional share of a whole credit coupon. Thus, if a person holds any other division of a whole credit coupon, including any direct or indirect division or modification of a whole credit coupon effected through a partnership, trust, or other investment arrangement that, in substance, causes the person to hold a variable share of the whole credit coupon, then no tax credit is allowed with respect to that interest in the credit coupon. For example, if a person holds an interest in a partnership or a share of a trust that effects any division of a whole credit coupon held by the partnership or trust other than a proportional division, then that person (and any other person to whom the person directly or indirectly passes the credit) is not entitled to a tax credit with respect to the person’s allocable share or beneficial interest in that division of the whole credit coupon.

(3) Broker accounts. The taxpayer holds the stripped credit coupon in an account with—

(i) A broker as defined in section 6045(c)(1); or

(ii) Any other person to the extent provided by the Commissioner in published guidance.

(e) Treatment of a stripping transaction involving a qualified tax credit bond—(1) In general. Except to the extent that a provision of this Section 3.03 explicitly provides otherwise, subsections (a), (b), and (e) of section 1286 apply to stripping transactions involving qualified tax credit bonds. In applying these provisions of section 1286, the allowance of a credit is treated in the same manner as a cash payment of stated interest on the credit allowance date. See Section 3.02(a)(2) of this notice.

(2) Aggregation and other rules. If, on a single date, a taxpayer purchases (including a purchase under section 1286(b)(4)), as part of a single transaction or series of related transactions, more than one component (stated principal, stated cash interest, or credit coupons) of a qualified tax credit bond that has been subject to a stripping transaction, then, for purposes of sections 1271 through 1286 and the regulations thereunder, the taxpayer must treat the components so purchased as a single debt instrument (the aggregated debt instrument) that was newly issued on the purchase date. Notwithstanding the prior sentence, none of the payments on the aggregated debt instrument is treated as qualified stated interest under § 1.1273-1(c). If, in a manner described in the first sentence of this Section 3.03(e)(2), the taxpayer purchases all of the then-outstanding components of a qualified tax credit bond, then the resulting aggregated debt instrument is treated as of the purchase date as if it had not been subject to a previous stripping transaction, and thus the second sentence of this Section 3.03(e)(2) does not apply.

(f) Examples. The rules in this Section 3.03 are illustrated by the following examples.

Example 1—(i) Facts. On December 15, 2011, City X issues an issue of qualified school construction bonds as a single bond with a stated principal amount of $12,000, a credit rate of 10% compounded quarterly, and a maturity date of December 15, 2013. Assume that none of the interest on the bond is payable in cash. (That is, there is no supplemental cash interest coupon.) X, on or before the date of issue, includes in the bond documents a statement that the issue is strippable and issues the issue in registered form. X obtains 10 CUSIP numbers with respect to the issue (1 CUSIP number for the $12,000 issue of qualified school construction bonds, a separate CUSIP for the credit coupons for each of the 8 credit allowance dates through the scheduled maturity of the issue, and 1 CUSIP number for the scheduled principal payment at maturity). On the first information return that X files with the IRS with respect to this issue under section 54A(d)(3), X indicates that the issue is a strippable issue of qualified school construction bonds.

(ii) Analysis. X’s issue of qualified school construction bonds is a strippable issue because it satisfies the requirements of Section 3.03(c)(1) through (4) of this notice.

Example 2. The facts are the same as in Example 1, except that, on December 15, 2011, X sells the $12,000 bond to Y. Y sells on December 15, 2011, a $6,000 pro rata portion of the bond to A, a cash method, calendar year taxpayer, and a $6,000 pro rata portion of the bond to B, an accrual method, calendar year taxpayer. (Thus, Y’s sales to A and B do not constitute a stripping transaction, because they effect a pro rata division of the future rights under the bond.) The purchase prices paid by A and B were $6,000 each. On March 15, 2012 (and all subsequent credit allowance dates), subject to the limitations contained in section 54A(c)(1) and Section 3.02(b)(1) of this notice, A and B are each entitled to claim a $150 tax credit.

Example 3—(i) Facts. The facts are the same as in Example 2, except that, on December 15, 2011, A sells the December 15, 2013, credit coupon of $150 to C, a cash method calendar year taxpayer for $123.75 (its fair market value). After the sale, A holds the right to receive $6,000 at maturity as well as the first 7 credit coupons (the “8 retained components”), and C holds only the December 15, 2013, credit coupon.

(ii) Application of definitions. The sale is a stripping transaction within the meaning of Section 3.03(b)(3) of this notice. The credit coupon held by C and the 7 credit coupons retained by A are all stripped credit coupons. The treatment of B’s bond is not affected by the sale.

(iii) A’s treatment of the sale. Under Section 3.03(e)(1) of this notice, section 1286(b) applies to this stripping transaction. Section 1286(b)(4) treats A as having purchased the 8 retained components on the date on which A sells the December 15, 2013, credit coupon to C. Under Section 3.03(e)(2) of this notice, the 8 retained components must be treated as an aggregated debt instrument that is newly issued on the date of the sale of that credit coupon.

Prior to the sale of the credit coupon, A’s basis in the unstripped $6,000 bond is A’s purchase price of $6,000. Because no interest is treated as having accrued on the bond prior to the sale, A is not required to include an amount in income under section 1286(b)(1)(A), and thus no amount needs to be added to A’s basis under section 1286(b)(2). Pursuant to section 1286(b)(3), A must allocate its basis in the bond ($6,000) between the credit coupon that A sold and A’s aggregated debt instrument, based on their respective fair market values. Assume that, on the date of the sale, the fair market value of A’s aggregated debt instrument is $5,877.10 and the fair market value of the December 15, 2013, credit coupon sold by A is $123.75 (total fair market value of $6,000.85). Based on these fair market values, A’s basis in the aggregated debt instrument is $5,876.27 ($6,000 basis x [$5,877.10 / $6,000.85]) and A’s basis in the December 15, 2013, credit coupon is $123.73 ($6,000 basis x [$123.75 / $6,000.85]). As a result, A realizes a gain of $0.02 on the sale of the December 15, 2013, credit coupon (amount realized of $123.75, minus basis of $123.73).

(iv) A’s treatment of the aggregated debt instrument. Under section 1286(b)(4), A is treated as purchasing the aggregated debt instrument for $5,876.27. The purchase is treated as taking place on the date of the sale to C, and the purchase price is equal to the portion ($5,876.27) of A’s $6,000 basis that is allocated to the aggregated debt instrument. Under Section 3.03(e)(2) of this notice, A must treat the aggregated debt instrument as newly issued on that date for $5,876.27. Thus, the aggregated debt instrument has an issue price of $5,876.27. Under Section 3.03(e)(2) of this notice, no payment on the aggregated debt instrument is qualified stated interest under § 1.1273-1(c). As a result, the stated redemption price at maturity of the aggregated debt instrument is $7,050 ($6,000 + [7 × $150]). The aggregated debt instrument, therefore, has OID of $1,173.73 ($7,050 - $5,876.27). Although A generally uses the cash receipts and disbursements method of accounting, A must include the OID in income as it accrues on a constant yield basis over the term of the aggregated debt instrument in accordance with section 1272 and the regulations thereunder.

(v) C’s treatment of the stripped tax credit coupon. Under Section 3.03(e)(1) of this notice, section 1286(a) applies to C’s purchase of the December 15, 2013, stripped credit coupon. Section 1286(a) requires C to treat the purchase of this stripped credit coupon as the purchase of a zero coupon bond that is issued on the date of purchase (December 15, 2011). The stripped credit coupon has a stated redemption price at maturity of $150 and an issue price of $123.75, resulting in OID of $26.25 ($150 - $123.75). The term of the stripped credit coupon begins on December 15, 2011, and ends on December 15, 2013. Although C generally uses the cash receipts and disbursements method of accounting, C must include the OID in income as it accrues on a constant yield basis over that term in accordance with section 1272 and the regulations thereunder.

C’s basis in the stripped credit coupon is increased by the amount of OID that is included in C’s income. As a result, C’s basis in the stripped credit coupon on the December 15, 2013, credit allowance date will be $150. On that date, C will become entitled to the $150 of credit. Thus, C does not have any gain or loss when the coupon matures and C becomes entitled to the $150 tax credit.

Qualified tax credit bonds—in particular, stripping transactions involving these bonds—raise significant tax compliance and tax administration issues. The Treasury Department and the IRS plan to implement and maintain a robust system of information reporting in this area to facilitate tax compliance and strengthen tax administration.

Section 54A(d)(3) requires issuers of qualified tax credit bonds to submit information reports regarding the bonds similar to the reports required under section 149(e).

Section 6049(d)(9)(A) provides that, for purposes of the information reporting requirements under section 6049(a) regarding payments of interest, the term interest includes amounts includible in gross income under section 54A, and those amounts are treated as paid on the credit allowance date.

Under section 6049(d)(6), section 6049(a) generally requires OID on any obligation to be reported as if it were paid at the time that the OID is includible in income under section 1272. This provision governs section 6049 information reporting when a tax credit under a qualified tax credit bond is included in an instrument’s stated redemption price at maturity, and thus contributes to OID. (This occurs when the allowance of the credit is not treated as a payment of qualified stated interest on an instrument, for example, when a stripped credit coupon is part of an aggregated debt instrument that is subject to the second sentence of Section 3.03(e)(2) of this notice.)

Section 6049(b)(2)(B)(i) and section 6049(b)(4) generally exempt from information reporting interest that is paid to certain persons. Section 6049(d)(9)(B), however, generally makes this exemption inapplicable for interest on qualified tax credit bonds that is treated as paid to the following entities: (i) corporations; (ii) dealers in securities or commodities required to register under the laws of the United States, any State, the District of Columbia or any United States possession; (iii) real estate investment trusts (as defined in section 856); (iv) entities registered at all times during the taxable year under the Investment Company Act of 1940; (v) common trust funds (as defined in section 584(a); and (vi) trusts exempt from tax under section 664(c). Notwithstanding the preceding sentence, the exemption continues to apply to interest that is covered by an express regulatory exception.

Section 6049(d)(9)(C) provides broad authority to the Treasury Department to issue regulations as necessary or appropriate to carry out the purposes of section 6049(d)(9), including regulations that require more frequent or more detailed reporting.

The Treasury Department and the IRS will attempt to ensure that both the IRS and investors receive accurate information about interest income (including OID) that is includable in income as a result of holding qualified tax credit bonds and components stripped from these bonds. The Treasury Department and the IRS will also seek to ensure that tax credits from qualified tax credit bonds (including tax credits from stripped credit coupons) are claimed only when the claimant is entitled to those credits.

To these ends, the Treasury Department and the IRS anticipate implementing the integrated system of information reporting that is described below in this Section 4. This may involve implementing new requirements. Revised forms and, if necessary, regulations will be issued to implement these information reporting requirements. For example, when a taxpayer holds a stripped credit coupon in an account with a broker as defined in section 6045(c)(1) (see Section 3.03(d)(3) of this notice), future guidance is expected to require the broker to compute, and report to the holder of the stripped credit coupon and to the IRS, the OID that accrues on that coupon under Section 3.03(e) of this notice and section 1286(a)-(b).

This system of information reporting will be subject to the same penalties that apply generally with respect to the failure to accurately file required forms. These include but are not limited to the penalties under sections 6049, 6721, and 6722 (which are applied to issuers, issuers’ agents, and independent intermediaries) and the penalty under section 6694 and Rev. Proc. 2009-11, 2009-3 I.R.B. 313 (which is applied to paid preparers).

As the forms and instructions to be used to implement the integrated information reporting system become available for use or for review in draft form, the IRS plans to publish them on its web site at http://www.irs.gov/app/picklist/list/formsInstructions.html and http://www.irs.gov/app/picklist/list/draftTaxForms.html, respectively. Taxpayers wishing to provide comments to the IRS on draft tax forms can do so on the IRS web site at http://www.irs.gov/formspubs/page/0,,id=10179,00.html.

Section 54A(d)(3) requires issuers of qualified tax credit bonds to file information returns. Although Form 8038 is now used for this purpose, the IRS intends to publish a new form (Form 8038-TC) to be used in this situation. As is provided by Section 3.03(c)(2) of this notice, the issuer of a strippable issue is now required, as part of this reporting obligation, to identify the issue as a strippable issue and to provide all of the CUSIP numbers that Section 3.03(c)(4) of this notice requires. Issuers must provide this information on Form 8038 or an attachment thereto until the new Form 8038-TC becomes available and thereafter on this new form.

If a taxpayer claims on its income tax return a tax credit authorized by section 54A, the taxpayer is required to include Form 8912 as part of the return. The IRS and Treasury Department anticipate that the information required on this form will be modified to include not only the type of tax credit bond and the amount of credit claimed but also the tax identification number of the issuer of the bond and the CUSIP number for the qualified tax credit bond (or the stripped credit coupon) that is the basis of the credit being claimed.

Under section 6049, the IRS expects to publish a new form, Form 1097-BTC, to inform both the IRS and any recipient of a credit under section 54A of the amount of the tax credit that the credit recipient has received for each credit allowance date. The amount to be reported is the amount of the allowed credit to which the recipient is entitled within the meaning of Section 3.02(a)(1). It is anticipated that this form will be used in two distinct situations. First, it will have to be filed by, or on behalf of, the issuer. Second, a filing will also be required of each broker or intermediary that is not acting on behalf of the issuer (an independent intermediary).

As for the issuer requirement, the principles under section 6049(d)(4) are expected to apply to limit this requirement to the last responsible person or intermediary acting on behalf of the issuer.

The requirement for independent intermediaries is expected to apply whenever such an intermediary serves as an agent or nominee with respect to a credit or the intermediary receives a credit and passes it on either to another independent intermediary or to the taxpayer that will ultimately claim the credit. (Examples of independent intermediaries include a broker that is not reporting on behalf of the issuer, a partnership, a trust, an estate, and a regulated investment company or real estate investment trust that distributes tax credits with respect to its stock under section 853A or section 54A(h)).

It is anticipated that this form will operate in the following fashion—

(a) For qualified tax credit bonds, information reporting for interest and OID under section 6049 will be expanded. Responsible persons under section 6049 will generally be required annually to provide the IRS and the holder of a qualified tax credit bond or stripped credit coupon with an information return indicating the amount of interest income paid (or treated as paid for purposes of section 6049) to the holder during that annual period with respect to any qualified tax credit bond. As stated above, when a taxpayer holds a stripped credit coupon in an account with a broker as defined in section 6045(c)(1) (see Section 3.03(d)(3) of this notice), future guidance is expected to require the broker to compute, and report, the OID on that coupon that accrues under Section 3.03(e) of this notice and section 1286(a)-(b). An analogous requirement may apply to any other stripped component from a qualified tax credit bond.

(b) It is expected that if a regulated investment company or a real estate investment trust receives tax credits allowed by section 54A (either because it holds a qualified tax credit bond or stripped coupon or because it received the credits from an independent intermediary) and distributes with respect to its stock some or all of those credits, then when that entity reports under section 6042 dividends paid to its shareholders, the entity must include distributed tax credits that are treated as dividends.

.01 A life insurance company is required to account for its obligations to policyholders using reserve methods of accounting. Statutory Accounting Principles (SAP) govern the preparation of the company’s annual statement, which is filed with the relevant state insurance regulators. Generally Accepted Accounting Principles (GAAP) govern the preparation of an insurer’s financial statements, which are provided to shareholders, bondholders, banks and rating agencies. GAAP differs in some respects from SAP.

.02 Clear reflection of the income of a life insurance company for federal income tax purposes requires an appropriate measurement of the company’s life insurance reserves. Tax accounting rules used to compute the taxable income of a life insurance company differ in some respects from SAP or GAAP, including with respect to the computation of life insurance reserves.

.03 Although all insurance companies are required by the respective states in which they do business to maintain reserves, not all reserves that a company maintains (or is required to maintain) qualify as “life insurance reserves” for Federal income tax purposes.

.04 Under § 816(a), an insurance company is a life insurance company if the sum of (1) its life insurance reserves, plus (2) unearned premiums, and unpaid losses (whether or not ascertained), on noncancellable life, accident, or health policies not included in life insurance reserves, comprise more than 50 percent of its total reserves.

.05 Section 816(c) defines “total reserves” as the sum of (1) life insurance reserves, (2) unearned premiums, and unpaid losses (whether or not ascertained), not included in life insurance reserves, and (3) all other insurance reserves required by law.

.06 Section 816(b) defines “life insurance reserves” as amounts that are (1) computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and (2) set aside to mature or liquidate, either by payment or reinsurance, future unaccrued claims arising from life insurance, annuity, and noncancellable accident and health insurance contracts (including life insurance or annuity contracts combined with noncancellable accident and health insurance) involving, at the time with respect to which the reserve is computed, life, accident, or health contingencies. Reserves generally must be required by law to qualify as life insurance reserves. See also § 1.801-4(d) and (e) (setting forth reserves that qualify, and reserves that do not qualify, as life insurance reserves for Federal income tax purposes under the predecessor of § 816); Rev. Rul. 67-435, 1967-2 C.B. 232 (concluding that a reserve maintained for abnormal mortality or depreciation and losses on assets owned by the company is not a life insurance reserve).

.07 A life insurance company must pay tax on its “life insurance company taxable income,” which is defined in § 801(b) as life insurance gross income less life insurance deductions. Life insurance gross income is defined in § 803(a) to mean the sum of (i) premiums, (ii) net decreases in certain reserves under § 807(a), and (iii) other amounts generally included by a taxpayer in gross income. Life insurance deductions are defined in § 804 to mean the general deductions provided under § 805 and the small life insurance deduction (if any) determined under § 806. Section 805(a)(2) authorizes a deduction for the net increase in certain reserves under § 807(b). The reserves taken into account under § 807(a) and (b) include life insurance reserves (as defined in § 816(b)). See § 807(c)(1).

.08 Section 807(d) through (f) sets forth rules to compute the amount of the life insurance reserve for a contract for purposes of determining taxable income. Section 807(d)(1) provides that the amount of the life insurance reserve for any contract is the greater of the net surrender value of the contract (determined under § 807(e)(1)) or the federally prescribed reserve determined under § 807(d)(2). This amount cannot, however, exceed the amount that would be taken into account with respect to the contract in determining “statutory reserves” (as defined in § 807(d)(6)).

.09 Section 807(e)(1) provides that the net surrender value of any contract is determined with regard to any penalty or charge that would be imposed on surrender but without regard to any market value adjustment on surrender (except for certain modified guaranteed contracts defined in § 817A(d)).

.10 Section 807(d)(2) provides that the federally prescribed reserve for a contract is computed using (a) the “tax reserve method” applicable to the contract, (b) the greater of the applicable Federal interest rate (“AFIR”) or the prevailing State assumed interest rate (“PSAIR”), and (c) the prevailing commissioners’ standard tables for mortality and morbidity, adjusted as appropriate to reflect the risks (such as substandard risks) incurred under the contract which are not otherwise taken into account.

.11 In the case of a contract to which the Commissioners’ Annuities Reserve Valuation Method (“CARVM”) applies (generally, an annuity contract), § 807(d)(3)(A)(ii) and 807(d)(3)(B)(ii) provides that the tax reserve method applicable to the contract is the CARVM as prescribed by the NAIC which is in effect on the date the contract is issued. Other parameters, such as the appropriate interest rate and mortality tables, are likewise generally determined with reference to the date the contract is issued.

.12 Section 807(d)(6) provides that the term “statutory reserves” means the aggregate amount set forth in the annual statement with respect to items described in § 807(c). See also Rev. Rul. 2008-37, 2008-28 I.R.B. 77 (statutory reserves under § 807(d)(6) equal the highest aggregate reserve amount for § 807(c) items actually held and set forth on the annual statement pursuant to the minimum reserve requirements of any state in which a taxpayer does business). The term does not, however, include any reserve attributable to a deferred and uncollected premium if the establishment of such a reserve is not permitted under § 811(c).

.13 Section 807(f) provides that if the basis for determining any item referred to in § 807(c) (for example, life insurance reserves taken into account under § 807(c)(1)) as of the close of any taxable year differs from the basis for that determination as of the close of the preceding taxable year, then so much of the difference between the amount of the item at the close of the taxable year computed on the new basis, and the amount of the item at the close of the taxable year computed on the old basis, as is attributable to contracts issued before the taxable year is taken into account ratably for each of the succeeding ten taxable years.

.14 Notice 2008-18, 2008-5 I.R.B. 363, was published on February 4, 2008, and described two reserve methodology projects that were then in development by the NAIC: One would provide a principles-based approach for calculating statutory reserves for life insurance contracts (Proposed Life PBR); the other, which was subsequently adopted as AG 43, would set forth a new Actuarial Guideline that would constitute CARVM for variable annuities (Proposed AG VACARVM). Notice 2008-18 alerted life insurance companies to federal income tax issues that could arise as a result of the adoption of either project and requested comments on those issues. Several organizations submitted comments in response to the notice.

.15 The NAIC adopted Proposed AG VACARVM as AG 43 with regard to contracts issued on or after January 1, 1981, effective December 31, 2009. Section V of AG 43 provides, however, that where the application of AG 43 produces higher reserves than a company had otherwise established by its previously used interpretation, the company may request a grade-in period, not to exceed three years, from the domiciliary insurance commissioner upon satisfactory demonstration of the previous interpretation, and that such a delay of implementation will not cause a hazardous financial condition or potential harm to policyholders.

.16 The purpose of AG 43 is to interpret the standards for the valuation of reserves for variable annuity and other contracts involving certain guaranteed benefits similar to those offered with variable annuities. Generally, AG 43 requires that the aggregate reserve for contracts falling within its scope equal the Conditional Tail Expectation Amount (the “CTE Amount”)^[1] but not be less than the Standard Scenario Amount.^[2]

.17 Based on the requirements of §§ 807 and 816, the terms of AG 43, and the data that are available to date, the Treasury Department and the Internal Revenue Service (IRS) have reached interim conclusions as to some of the issues identified in Notice 2008-18 and are continuing to consider others. Accordingly, section 3 of this notice provides interim guidance to taxpayers on some of the issues that arise under AG 43.