(a) In general—(1) Amounts borrowed. This section applies to amounts borrowed for use in an activity described in section 465(c)(1) or (c)(3)(A). Amounts borrowed with respect to an activity will not increase the borrower’s amount at risk in the activity if the lender has an interest in the activity other than that of a creditor or is related to a person (other than the borrower) who has an interest in the activity other than that of a creditor. This rule applies even if the borrower is personally liable for the repayment of the loan or the loan is secured by property not used in the activity. For additional rules relating to the treatment of amounts borrowed from these persons, see §1.465-20.

(2) Certain borrowed amounts excepted. (i) For purposes of determining a corporation’s amount at risk, an interest in the corporation as a shareholder is not an interest in any activity of the corporation. Thus, amounts borrowed by a corporation from a shareholder may increase the corporation’s amount at risk.

(ii) For purposes of determining a taxpayer’s amount at risk in an activity of holding real property, paragraph (a)(1) of this section does not apply to financing that is secured by real property used in the activity and is either—

(A) Qualified nonrecourse financing described in section 465(b)(6)(B); or

(B) Financing that, if it were nonrecourse, would be financing described in section 465(b)(6)(B).

(b) Loans for which the borrower is personally liable for repayment—(1) General rule. If a borrower is personally liable for the repayment of a loan for use in an activity, a person shall be considered a person with an interest in the activity other than that of a creditor only if the person has either a capital interest in the activity or an interest in the net profits of the activity.

(2) Capital interest. For the purposes of this section, a capital interest in an activity means an interest in the assets of the activity which is distributable to the owner of the capital interest upon the liquidation of the activity. The partners of a partnership and the shareholders of an S corporation are considered to have capital interests in the activities conducted by the partnership or S corporation.

(3) Interest in net profits. For the purposes of this section, it is not necessary for a person to have any incidents of ownership in the activity in order to have an interest in the net profits of the activity. For example, an employee or independent contractor any part of whose compensation is determined with reference to the net profits of the activity will be considered to have an interest in the net profits of the activity.

(4) Examples. The provisions of this paragraph may be illustrated by the following examples:

Example 1. A, the owner of a herd of cattle sells the herd to partnership BCD. BCD pays A $10,000 in cash and executes a note for $30,000 payable to A. The three partners, B, C, and D, each assumes personal liability for repayment of the amount owed A. In addition, BCD enters into an agreement with A under which A is to take care of the cattle for BCD in return for compensation equal to 6 percent of BCD’s net profits from the activity. Because A has an interest in the net profits of BCD’s farming activity, A is considered to have an interest in the activity other than that of a creditor. Accordingly, amounts payable to A for use in that activity do not increase the partners’ amount at risk even though the partners assume personal liability for repayment.

Example 2. Assume the same facts as in Example 1 except that instead of receiving compensation equal to 6 percent of BCD’s net profits from the activity, A instead receives compensation equal to 1 percent of the gross receipts from the activity. A does not have a capital interest in BCD. A’s interest in the gross receipts is not considered an interest in the net profits. Because B, C, and D assumed personal liability for the amounts payable to A, and A has neither a capital interest nor an interest in the net profits of the activity, A is not considered to have an interest in the activity other than that of a creditor with respect to the $30,000 loan. Accordingly, B, C, and D are at risk for their share of the loan if the other provisions of section 465 are met.

Example 3. Assume the same facts as in Example 1 except that instead of receiving compensation equal to 6 percent of BCD’s net profits from the activity, A instead receives compensation equal to 6 percent of the net profits from the activity or $15,000, whichever is greater. A is considered to have an interest in the net profits from the activity and accordingly will be treated as a person with an interest in the activity other than that of a creditor.

(c) Nonrecourse loans secured by assets with a readily ascertainable fair market value—(1) General rule. This paragraph shall apply in the case of a nonrecourse loan for use in an activity where the loan is secured by property which has a readily ascertainable fair market value. In the case of such a loan, a person shall be considered a person with an interest in the activity other than that of a creditor only if the person has either a capital interest in the activity or an interest in the net profits of the activity.

(2) Example. The provisions of this paragraph (c) may be illustrated by the following example:

Example. X is an investor in an activity described in section 465(c)(1). In order to raise money for the investment, X borrows money from A, the promoter (the person who brought X together with other taxpayers for the purpose of investing in the activity). The loan is secured by stock unrelated to the activity which is listed on a national securities exchange. X’s stock has a readily ascertainable fair market value. A does not have a capital interest in the activity or an interest in its net profits. Accordingly, with respect to the loan secured by X’s stock, A does not have an interest in the activity other than that of a creditor.

(d) Nonrecourse loans secured by assets without a readily ascertainable fair market value—(1) General rule. This paragraph shall apply in the case of a nonrecourse loan for use in an activity where the loan is secured by property which does not have a readily ascertainable fair market value. In the case of such a loan, a person shall be considered a person with an interest in the activity other than that of a creditor if the person stands to receive financial gain (other than interest) from the activity or from the sale of interests in the activity. For the purposes of this section, persons who stand to receive financial gain from the activity include persons who receive compensation for services rendered in connection with the organization or operation of the activity or for the sale of interests in the activity. Such a person will generally include the promoter of the activity who organizes the activity or solicits potential investors in the activity.

(2) Example. The provisions of this paragraph (d) may be illustrated by the following example:

Example. A is the promoter of an activity described in section 465(c)(1). As the promoter, A organizes the activity and solicits potential investors. For these services, A is paid a flat fee of $130x. This fee is paid out of the amounts contributed by the investors to the activity. X, one of the investors in the activity, borrows money from A for use in the activity. X is not personally liable for repayment to A of the amount borrowed. As security for the loan, X pledges an asset which does not have a readily ascertainable fair market value. A is considered a person with an interest in the activity other than that of a creditor with respect to this loan because the asset pledged as security does not have a readily ascertainable fair market value, X is not personally liable for repayment of the loan, and A received financial gain from the activity. Accordingly, X’s amount at risk in the activity is not increased despite the fact that property was pledged as security.

(e) Effective date. This section applies to amounts borrowed after May 3, 2004.

(a) General rule. The following amounts are treated in the same manner as borrowed amounts for which the taxpayer has no personal liability and for which no security is pledged—

(1) Amounts that do not increase the taxpayer’s amount at risk because they are borrowed from a person who has an interest in the activity other than that of a creditor or from a person who is related to a person (other than the taxpayer) who has an interest in the activity other than that of a creditor; and

(2) Amounts (whether or not borrowed) that are protected against loss.

(b) Interest other than that of a creditor; cross reference. See §1.465-8 for additional rules relating to amounts borrowed from a person who has an interest in the activity other than that of a creditor or is related to a person (other than the taxpayer) who has an interest in the activity other than that of a creditor.

(c) Amounts protected against loss; cross reference. See §1.465-6 for rules relating to amounts protected against loss.

(d) Effective date. This section applies to amounts borrowed after May 3, 2004.

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

Approved April 26, 2004.

Gregory F. Jenner,
Acting Assistant Secretary of the Treasury .

Section 901(b)(5) provides that an individual who is a partner will, subject to certain limitations, qualify for the foreign tax credit for his proportionate share of taxes of the partnership paid or accrued during the taxable year to a foreign country or to any possession of the United States. Section 702(a)(6) provides that each partner shall take into account separately his distributive share of the partnership’s taxes, described in section 901, paid or accrued to foreign countries and to possessions of the United States. Section 703(a)(2)(B) provides that the partnership is not entitled to the deduction for taxes provided in section 164(a) with respect to taxes, described in section 901, paid or accrued to foreign countries and to possessions of the United States. Section 703(b)(3) provides that elections affecting the computation of taxable income derived from a partnership shall be made by the partnership, except that any election under section 901 (relating to taxes of foreign countries and possessions of the United States), will be made by each partner separately.

These temporary regulations clarify the application of the regulations under section 704 to creditable foreign tax expenditures for which the partnership bears legal liability as described in §1.901-2(f). Unlike most other trade or business expenses, foreign taxes described in section 901 or 903 are fully creditable against a partner’s U.S. tax liability, subject to certain limitations, including primarily the foreign tax credit limitation under section 904. For this reason, the temporary regulations provide that partnership allocations of creditable foreign tax expenditures cannot have substantial economic effect and, therefore, must be allocated in accordance with the partners’ interests in the partnership. A creditable foreign tax is a foreign tax paid or accrued for U.S. tax purposes by a partnership and that is eligible for a credit under section 901(a). A foreign tax is a creditable foreign tax for these purposes without regard to whether a partner receiving an allocation of such foreign tax elects to claim a credit for such amount.

The temporary regulations establish a safe harbor under which partnership allocations of foreign tax expenditures will be deemed to be in accordance with the partners’ interests in the partnership. Under this safe harbor, if the partnership agreement satisfies the requirements of §1.704-1(b)(2)(ii)(b) or (d) (i.e., capital account maintenance, liquidation according to capital accounts, and either deficit restoration obligations or qualified income offsets), then an allocation of a foreign tax expenditure that is proportionate to a partner’s distributive share of the partnership income to which such taxes relate (including income allocated pursuant to section 704(c)) will be deemed to be in accordance with the partners’ interests in the partnership. This rule is consistent with the underlying purposes of the foreign tax credit, which is to avoid double taxation of foreign source income, and the foreign tax credit limitation, which is to prevent foreign tax credits from offsetting tax liability on a taxpayer’s U.S. source income. Also, this rule achieves greater parity between entities that are taxed under foreign law at the partner level and entities that are taxed under foreign law at the entity level. If a partnership were taxed under foreign law at the partner level, then the amount of foreign taxes imposed on a partner generally would be proportionate to the partner’s share of the income subject to the foreign tax. The partner would take into account this amount of foreign tax in computing U.S. tax liability. Likewise, for partnerships that are taxed under foreign law at the entity level, the safe harbor provides that a partner is allowed to take into account in computing U.S. tax liability the share of the partnership’s foreign tax expenditures that is proportionate to the partner’s share of the income to which such taxes relate.

If the taxpayer does not satisfy this safe harbor, then the taxpayer’s allocations will be tested under the partners’ interests in the partnership standard set forth in §1.704-1(b)(3). Under that standard, the determination of a partner’s interest in a partnership is made by taking into account all facts and circumstances relating to the economic arrangement of the partners. Among the facts to be considered are: (a) the partners’ relative contributions to the partnership; (b) the interests of the partners in economic profits and losses (if different than their interests in taxable income or loss); (c) the interests of the partners in cash flow and other non-liquidating distributions; and (d) the rights of the partners to distributions of capital upon liquidation. Ultimately, the partners’ interests in the partnership signify the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated. The sharing arrangement with respect to a particular item may or may not correspond to the overall economic arrangement of the partners. Thus, a partnership’s allocation of a foreign tax expenditure that does not satisfy the safe harbor contained in these temporary regulations, may, in unusual circumstances (such as where there is substantial certainty that U.S partners will deduct, rather than credit, foreign taxes) be in accordance with partners’ interests in the partnership under §1.704-1(b)(3).

As discussed above, in determining if the economic effect of a partnership allocation is substantial, the partnership must consider the after-tax economic consequences to the partners. The IRS and Treasury have become aware that some partnerships are taking the position that, in determining if the economic effect of a partnership allocation is substantial, they need not consider any tax consequences to an owner of the partner that result from the allocation. The IRS and Treasury believe that such a position is inconsistent with the policies underlying the substantial economic effect rules, because it would allow a partnership to make tax-advantaged allocations if the tax advantages of the allocations were to accrue to an owner of a partner, rather than to the partner itself. The IRS and Treasury are planning to issue guidance on the application of the section 704(b) regulations to these situations.

The provisions of these regulations generally apply for partnership taxable years beginning on or after the date that the temporary regulations are published in the Federal Register. A transition rule is also provided for existing partnerships. Under the transition rule, if a partnership agreement was entered into before April 21, 2004, then the partnership may apply the provisions of §1.704-1(b), as if the amendments made by this temporary regulation had not occurred, until any subsequent material modification to the partnership agreement, which includes any change in ownership, occurs. This transition rule does not apply if, as of April 20, 2004, persons that are related to each other (within the meaning of section 267(b) and 707(b)) collectively have the power to amend the partnership agreement without the consent of any unrelated party. No inference regarding the treatment of allocations of foreign taxes under §1.704-1(b) (prior to the amendments made by this temporary regulation) is intended.

* * * * *

(b) Determination of partner’s distributive share—(0) Cross-references.

* * * * *

* * * * *

(1) * * *

(ii) * * *(a) Generally.

(b) Foreign tax expenditures. [Reserved]. For further guidance, see §1.704-1T(b)(1)(ii)(b).

* * * * *

(4) * * *

(viii) [Reserved].

(ix) [Reserved].

(x) [Reserved].

(xi) Allocation of creditable foreign taxes. [Reserved]. For further guidance, see §1.704-1T(b)(4)(xi).

(5) * * * *

Examples (20) through (24). [Reserved].

Examples (25) through (28). [Reserved]. For further guidance, see §1.704-1T(b)(5), Examples (25) through (28).

Par. 3. Section 1.704-1T is added to read as follows:

(a) through (b)(1)(ii)(a) [Reserved]. For further guidance, see §1.704-1(a) through (b)(1)(ii)(a).

(b)(1)(ii)(b) Rules relating to foreign tax expenditures—(1) In general. The provisions of paragraphs (b)(4)(xi) (regarding the allocation of foreign tax expenditures) apply for partnership taxable years beginning on or after April 21, 2004.

(2) Transition rule. If a partnership agreement was entered into before April 21, 2004, then the partnership may apply the provisions of this paragraph (b) as if the amendments made by this temporary regulation had not occurred, until any subsequent material modification to the partnership agreement, which includes any change in ownership, occurs. This transition rule does not apply if, as of April 20, 2004, persons that are related to each other (within the meaning of section 267(b) and 707(b)) collectively have the power to amend the partnership agreement without the consent of any unrelated party.

(b)(1)(iii) through (b)(4)(vii) [Reserved]. For further guidance, see §1.704-1(b)(1)(iii) through (b)(4)(vii).

(b)(4)(viii) through (b)(4)(x) [Reserved].

(b)(4)(xi) Allocations of creditable foreign taxes—(a) In general. Allocations of creditable foreign taxes cannot have substantial economic effect and, accordingly, such expenditures must be allocated in accordance with the partners’ interests in the partnership. An allocation of a creditable foreign tax will be deemed to be in accordance with the partners’ interests in the partnership if—

(1) The requirements of either paragraph (b)(2)(ii)(b) or (b)(2)(ii)(d) of this section are satisfied (i.e., capital accounts are maintained in accordance with paragraph (b)(2)(iv) of this section, liquidating distributions are required to be made in accordance with positive capital account balances, and each partner either has an unconditional deficit restoration obligation or agrees to a qualified income offset); and

(2) The partnership agreement provides for the allocation of the creditable foreign tax in proportion to the partners’ distributive shares of income (including income allocated pursuant to section 704(c)) to which the creditable foreign tax relates.

(b) Creditable foreign taxes. A creditable foreign tax is a foreign tax paid or accrued for U.S. tax purposes by a partnership and that is eligible for a credit under section 901(a). A foreign tax is a creditable foreign tax for these purposes without regard to whether a partner receiving an allocation of such foreign tax elects to claim a credit for such amount.

(c) Income related to foreign taxes. A foreign tax is related to income if the income is included in the base upon which the taxes are imposed, which determination must be made in accordance with the principles of §1.904-6. See Examples (25) through (28) of paragraph (b)(5) of this section.

(b)(5)***

Examples 1 through 19 [Reserved]. For further guidance, see §1.704-1(b)(5), Examples 1 through 19.

Examples 20 through 24 [Reserved].

Example 25. (i) A and B form AB, an eligible entity (as defined in §301.7701-3(a) of this chapter), treated as a partnership for U.S. tax purposes. AB’s partnership agreement (within the meaning of paragraph (b)(2)(ii)(j) of this section) provides that the partners’ capital accounts will be determined and maintained in accordance with paragraph (b)(2)(iv) of this section, that liquidation proceeds will be distributed in accordance with the partners’ positive capital account balances, and that any partner with a deficit balance in his capital account following the liquidation of his interest must restore that deficit to the partnership. AB operates business M and earns income from passive investments in country X. Assume that country X imposes a 40 percent tax on business M income, which tax is a creditable foreign tax, but exempts from tax income from passive investments. In year 1, AB earns $100 of income from business M and $30 from passive investments and pays or accrues $40 of country X taxes. For purposes of section 904(d), the income from business M is general limitation income and the income from the passive investments is passive income. Pursuant to the partnership agreement, all partnership items, including creditable foreign taxes, from business M are allocated 60 percent to A and 40 percent to B, and all partnership items, including creditable foreign taxes, from passive investments are allocated 80 percent to A and 20 percent to B. Accordingly, A is allocated 60 percent of the business M income ($60) and 60 percent of the country X taxes ($24), and B is allocated 40 percent of the business M income ($40) and 40 percent of the country X taxes ($16).

(ii) Under paragraph (b)(4)(xi) of this section, the $40 of taxes is related to the $100 of general limitation income and no portion of the taxes is related to the passive income. Because AB’s partnership agreement allocates the general limitation income 60/40 and the country X taxes 60/40, the allocations of the country X taxes are in proportion to the allocation of the income to which the foreign tax relates. Because AB satisfies the requirement of paragraph (b)(4)(xi) of this section, the allocations of the country X taxes are deemed to be in accordance with the partners’ interests in the partnership.

Example 26. (i) A and B form AB, an eligible entity (as defined in §301.7701-3(a) of this chapter), treated as a partnership for U.S. tax purposes. AB’s partnership agreement (within the meaning paragraph (b)(2)(ii)(j) of this section) provides that the partners’ capital accounts will be determined and maintained in accordance with paragraph (b)(2)(iv) of this section, that liquidation proceeds will be distributed in accordance with the partners’ positive capital account balances, and that any partner with a deficit balance in his capital account following the liquidation of his interest must restore that deficit to the partnership. AB operates business M in country X and business N in country Y. Assume that country X imposes a 40 percent tax on business M income, country Y imposes a 20 percent tax on business N income, and the country X and country Y taxes are creditable foreign taxes. In year 1, AB has $100 of income from business M and $50 of income from business N. Country X imposes $40 of tax on the income from business M and country Y imposes $10 of tax on the income of business N. Pursuant to the partnership agreement, all partnership items, including creditable foreign taxes, from business M are allocated 75 percent to A and 25 percent to B, and all partnership items, including creditable foreign taxes, from business N are split evenly between A and B (50/50). Accordingly, A is allocated 75 percent of the income from business M ($75), 75 percent of the country X taxes ($30), 50 percent of the income from business N ($25), and 50 percent of the country Y taxes ($5). B is allocated 25 percent of the income from business M ($25), 25 percent of the country X taxes ($10), 50 percent of the income from business N ($25), and 50 percent of the country Y taxes ($5).

(ii) Because the income from business M and business N is general limitation income and the partnership agreement provides for different allocations with respect to such income, it is necessary to determine which foreign taxes are related to the business M income and which foreign taxes are related to the business N income. Under paragraph (b)(4)(xi) of this section, the $40 of country X taxes is related to business M and the $10 of country Y taxes is related to business N. Because AB’s partnership agreement allocates the $40 of country X taxes in the same proportion as the general limitation income from business M, and the $10 of country Y taxes in the same proportion as the general limitation income from business N, the allocations of the country X taxes and the country Y taxes are in proportion to the allocation of the income to which the foreign taxes relate. Because AB satisfies the requirements of paragraph (b)(4)(xi), the allocations of the country X and country Y taxes are deemed to be in accordance with the partners’ interests in the partnership.

Example 27. (i) The facts are the same as in Example 26, except that AB does not actually receive the $50 accrued with respect to business N until year 2. Also assume that A, B and AB each report taxable income on an accrual basis for U.S. tax purposes and AB reports taxable income on a cash basis for country X and country Y purposes. In year 1, AB pays country X taxes of $40. In year 2, AB pays country Y taxes of $10. Pursuant to the partnership agreement, in year 1, A is allocated 75 percent of business M income ($75) and country X taxes ($30) and 50 percent of business N income ($25). B is allocated 25 percent of business M income ($25) and country X taxes ($10) and 50 percent of business N income ($25). In year 2, A and B will each be allocated 50 percent of the country Y taxes ($5).

(ii) Because the income from business M and business N is general limitation income and the partnership agreement provides for different allocations with respect to such income, it is necessary to determine which foreign taxes are related to business M income and which foreign taxes are related to business N income. Under paragraph (b)(4)(xi) of this section, $40 of country X taxes is related to the $100 of general limitation income from business M. Under paragraph (b)(4)(xi), the country Y tax imposed in year 2 is allocable to the $50 of business N income AB recognizes in year 2 under country Y law and is treated as paid in year 2 on the $50 of business N income recognized for U.S. tax purposes in year 1. See §1.904-6(a)(1)(iv) and (c), Example 5. Accordingly, the $10 of country Y taxes is related to the $50 of general limitation income from business N. Because AB’s partnership agreement allocates the $40 of country X taxes in proportion to the general limitation income from business M, and the $10 of country X taxes from business N in proportion to the year 1 general limitation income from business N, the allocations of the country X and country Y taxes are in proportion to the allocation of the income to which the foreign taxes relate. Therefore, AB’s partnership agreement satisfies the requirement of paragraph (b)(4)(xi)(a)(2) of this section. Because AB also satisfies the requirements of paragraph (b)(4)(xi)(a)(1) of this section, the allocations of the country X and Y taxes are deemed to be in accordance with the partners’ interests in the partnership under paragraph (b)(4)(xi) of this section.

Example 28. (i) A and B form AB, an eligible entity (as defined in §301.7701-3(a) of this chapter), treated as a partnership for U.S. tax purposes. AB’s partnership agreement provides that the partners’ capital accounts will be determined and maintained in accordance with paragraph (b)(2)(iv) of this section, that liquidation proceeds will be distributed in accordance with the partners’ positive capital account balances, and that any partner with a deficit balance in his capital account following the liquidation of his interest must restore that deficit to the partnership. AB operates business M in country X. Assume that country X imposes a 20 percent tax on the net income from business M, which tax is a creditable foreign tax. In year 1, AB earns $300 of gross income, has deductible expenses, exclusive of creditable foreign taxes, of $100, and pays or accrues $40 of country X tax. For purposes of section 904(d), all income from business M is general limitation income. Pursuant to the partnership agreement, the first $100 of gross income each year is allocated to A as a return on excess capital contributed by A. All remaining partnership items, including creditable foreign taxes, are split evenly (50/50) between A and B. Assume that the gross income allocation is not deductible for country X purposes.

(ii) Under paragraph (b)(4)(xi) of this section, the $40 of taxes is related to the $200 of general limitation net income. In year 1, AB’s partnership agreement allocates $150 or 75 percent of the general limitation income to A ($100 attributable to the gross income allocation plus $50 of the remaining $100 of net income) and $50 or 25 percent of the net income to B. AB’s partnership agreement allocates the country X taxes in accordance with the partners’ shares of partnership items remaining after the $100 gross income allocation. Therefore, AB allocates the country X taxes 50 percent to A ($20) and 50 percent to B ($20). Under paragraph (b)(4)(xi) of this section, the allocation of country X taxes cannot have substantial economic effect and must be allocated in accordance with the partners’ interests in the partnership. AB’s allocations of country X taxes are not deemed to be in accordance with the partners’ interests in the partnership under paragraph (b)(4)(xi) of this section, because they are not in proportion to the allocation of the income to which the country X taxes relates.

(c) through (e)(4)(ii)(b) [Reserved]. For further guidance, see §1.704-1(c) through (e)(4)(ii)(b).

John M. Dalrymple,
Acting Deputy Commissioner for
Services and Enforcement.

Approved March 25, 2004.

Gregory F. Jenner,
Acting Assistant Secretary of the Treasury.

One commentator recommended that the regulations provide guidance regarding the determination of post-October “net reduction in value” of PFIC stock held by a RIC under section 852(b)(10). Section 852(b)(10) provides that taxable income of a RIC (other than a RIC to which an election under section 4982(e)(4) applies) shall be computed without regard to any net reduction in value occurring after October 31 of the taxable year of any stock of a PFIC with respect to which an election under section 1296(k) is in effect and that any such reduction shall be treated as occurring on the first day of the following taxable year.

To address concerns relating to a RIC’s post-October period, the commentator provided three recommendations. First, that the regulations clarify whether the deferral of post-October PFIC losses under section 852(b)(10) is elective or mandatory; second, that RICs be permitted to defer their post-October losses under rules similar to those that apply to foreign currency gains and losses under §1.852-11; and third, that RICs be allowed to include actual post-October dispositions of PFIC stock when computing losses eligible for deferral.

The IRS and Treasury have considered these recommendations and determined that the issues raised with respect to section 852(b)(10) are issues under the RIC tax provisions that are beyond the scope of this regulations project.

One commentator requested guidance in instances where the RIC and a foreign corporation in which it invests have different or “mismatching” taxable years. This commentator noted that a RIC may experience uncertainties with respect to determining its taxable income and minimum distribution amount in situations where, following the end of its taxable year, the RIC learns that a foreign corporation in which it has invested is a PFIC or that the foreign corporation no longer satisfies the income or asset tests of section 1297(a) for the current taxable year. To address administrative concerns arising in this situation, this commentator recommended that RICs be permitted to recognize a change in a foreign corporation’s PFIC status in the RIC’s taxable year within which the taxable year of the foreign corporation ends.

Issues arising from different taxable years are not specific to PFICs for which a taxpayer has made a section 1296 election. Accordingly, this issue is beyond the scope of this regulations project. However, comments are requested for approaches that address issues arising when a taxpayer and a PFIC have different taxable years. Such issues may be addressed in a future regulations project.

One commentator suggested that the regulations should address certain issues that arise with respect to a shareholder that has made a section 1296 election for its PFIC stock and the foreign corporation does not satisfy the income or asset test in section 1297(a) for the year. First, the commentator suggested that the regulations clarify that the character of gains from the disposition of the stock of the foreign corporation during the time that the corporation did not qualify as a PFIC should be capital gain. The commentator also requested that the regulations provide that the character of losses with respect to stock for which a section 1296 election was made but that is recognized in a taxable year during which the foreign corporation is not a PFIC be treated as ordinary income to the extent of any unreversed inclusions at the time of disposition.

After consideration of these comments, and in accordance with the statutory provisions of section 1296, the IRS and Treasury have adopted the first comment, but not the second comment. Accordingly, two examples were added to the regulations. Example 2 in §1.1296-1(c)(7) clarifies that any gain from the disposition of stock of a foreign corporation that does not qualify as a PFIC for the year of disposition will be capital gain because section 1296(c)(1)(A) no longer applies at such time. In the case of losses with respect to stock for which a section 1296 election was made but that is recognized in a taxable year during which the foreign corporation is not a PFIC, Example 4 in §1.1296-1(c)(7) was added to clarify that any loss from the disposition of such stock will be a capital loss because section 1296(c)(1)(B) no longer applies at such time.

Second, the commentator recommended that the regulations provide automatic consent for RICs to terminate a section 1296 election during a year that a foreign corporation no longer satisfies the requirements for PFIC status. The IRS and Treasury have not adopted this recommendation. The IRS and Treasury believe that it is appropriate to require consent of the Commissioner to terminate a section 1296 election. Under §1.1296-1(h)(3), a shareholder can request the consent of the Commissioner to revoke a section 1296 election upon a finding of a substantial change in circumstances, which may include a foreign corporation ceasing to be a PFIC.

A commentator suggested that the regulations should clarify how the former proposed §1.1291-8 (see Notice 92-53, 1992-2 C.B. 384) and the current statutory PFIC mark to market rules under section 1296 interact. For example, the commentator requested clarification concerning the RIC’s adjustments to the basis of its PFIC stock to reflect gains previously included under the former proposed §1.1291-8.

The IRS and Treasury believe that no additional clarification is needed. To the extent a taxpayer increased its basis or received a new holding period under the former proposed §1.1291-8, those consequences will be respected even though the proposed regulations were withdrawn without being finalized following the enactment of current section 1296 (see INTL-941-86, 1991-1 C.B. 1255 [64 FR 5015] (February 2, 1999) withdrawing proposed §1.1291-8). As a result, the suggestion was not adopted.

This same commentator also recommended that Example 2 of proposed §1.1296-1(i)(4) be clarified by specifically providing that the RIC had not made a mark to market election under the former proposed §1.1291-8. The commentator suggested this modification to eliminate potential ambiguities that may arise over the relationship between an election under the former proposed §1.1291-8 and section 1296. This suggestion was adopted, and the example has been revised accordingly.

One commentator recommended that the regulations should provide rules similar to those contained in the qualified electing fund (QEF) regime for purposes of making a retroactive QEF election. The IRS and Treasury have considered this comment and continue to believe that the appropriate process for retroactive relief for late mark to market elections is under the §301.9100 relief provisions, as set forth in §1.1296-1(h)(1)(iii). Accordingly, this suggestion was not adopted.

One commentator suggested permitting a taxpayer with an existing section 1296 election to make a QEF election and terminate its existing 1296 election without the consent of the Commissioner. The proposed regulations were structured to facilitate an election for mark to market treatment by permitting a taxpayer with an existing QEF election to make a section 1296 election and terminate the existing QEF election without requiring the consent of the Commissioner. Conversely, a taxpayer with an existing section 1296 election is permitted to make a QEF election only if the section 1296 election is terminated as provided by section 1296 and the regulations thereunder (e.g., if the PFIC stock ceases to be marketable) or is revoked with consent of the Commissioner. This approach reflects consideration of the relative administrative burdens imposed under each set of rules, and the stated intent of Congress that one of the purposes for enacting section 1296 was to provide another alternative to the interest charge rules of section 1291 that would be available in instances where taxpayers cannot obtain sufficient information to make a QEF election. See H.R. Rep. No. 105-148, at 533 (1997); S. Rep. No. 105-33 at 94 (1997). After consideration of the comment, the IRS and Treasury continue to believe the rules coordinating QEF elections and mark to market elections under section 1296 are appropriate for the reasons discussed above. Accordingly, this recommendation was not adopted.

One commentator provided two suggestions focused on enhancing the utility of QEF elections for RICs. Specifically, the commentator first suggested allowing RICs to use U.S. Generally Accepted Accounting Principles (U.S. GAAP) or International Financial Reporting Standards (IFRS) for purposes of computing QEF inclusions under section 1295(a)(2). The commentator also suggested revising the retroactive QEF election rules in cases where a RIC learns of the PFIC status of a foreign corporation immediately prior to the deadline for making a QEF election. These comments, which raise issues regarding the QEF rules, are beyond the scope of this regulation. Accordingly, these comments were not adopted but will be considered in the context of any guidance to be issued under the appropriate substantive provisions.

The final regulations also clarify that the regulations apply to taxable years beginning on or after May 3, 2004. Additionally, the several examples in proposed §1.1296-1(c) have been grouped together in new §1.1296-1(c)(7) in order to make the regulation more readable.

This section contains a listing of the headings for §§1.1291-1, 1.1291-9, and 1.1291-10.

(a) through (b) [Reserved].

(c) Coordination with other PFIC rules.

(1) and (2) [Reserved].

(3) Coordination with section 1296: distributions and dispositions.

(4) Coordination with mark to market rules under chapter 1 of the Internal Revenue Code other than section 1296.

(i) In general.

(ii) Coordination rule.

(d) [Reserved].

(e) Exempt organization as shareholder.

(1) In general.

(2) Effective date.

(f) through (i) [Reserved].

(j) Effective date.

* * * * *

Par. 3. Section 1.1291-1 is amended by:

1. Revising paragraphs (a) through (d).

2. Adding paragraphs (f) through (j).

The revisions and additions read as follows:

(a) and (b) [Reserved].

(c) Coordination with other PFIC rules.

(1) and (2) [Reserved].

(3) Coordination with section 1296: distributions and dispositions. If PFIC stock is marked to market under section 1296 for any taxable year, then, except as provided in §1.1296-1(i), section 1291 and the regulations thereunder shall not apply to any distribution with respect to section 1296 stock (as defined in §1.1296-1(a)(2)), or to any disposition of such stock, for such taxable year.

(4) Coordination with mark to market rules under chapter 1 of the Internal Revenue Code other than section 1296—(i) In general. If PFIC stock is marked to market for any taxable year under section 475 or any other provision of chapter 1 of the Internal Revenue Code, other than section 1296, regardless of whether the application of such provision is mandatory or results from an election by the taxpayer or another person, then, except as provided in paragraph (c)(4)(ii) of this section, section 1291 and the regulations thereunder shall not apply to any distribution with respect to such PFIC stock or to any disposition of such PFIC stock for such taxable year. See §§1.1295-1(i)(3) and 1.1296-1(h)(3)(i) for rules regarding the automatic termination of an existing election under section 1295 or section 1296 when a taxpayer marks to market PFIC stock under section 475 or any other provision of chapter 1 of the Internal Revenue Code.

(ii) Coordination rule—(A) Notwithstanding any provision in this section to the contrary, the rule of paragraph (c)(4)(ii)(B) of this section shall apply to the first taxable year in which a United States person marks to market its PFIC stock under a provision of chapter 1 of the Internal Revenue Code, other than section 1296, if such foreign corporation was a PFIC for any taxable year, prior to such first taxable year, during the United States person’s holding period (as defined in section 1291(a)(3)(A) and §1.1296-1(f)) in such stock, and for which such corporation was not treated as a QEF with respect to such United States person.

(B) For the first taxable year of a United States person that marks to market its PFIC stock under any provision of chapter 1 of the Internal Revenue Code, other than section 1296, such United States person shall, in lieu of the rules under which the United States person marks to market, apply the rules of §1.1296-1(i)(2) and (3) as if the United States person had made an election under section 1296 for such first taxable year.

(d) [Reserved].

* * * * *

(f) through (i) [Reserved].

(j) Effective dates. This section applies for taxable years beginning on or after May 3, 2004, except as otherwise provided in paragraph (e)(2) of this section.

Par. 4. §1.1295-0 (table of contents) is amended by:

1. Revising the entries for §1.1295-1(i)(3) and (i)(4) and adding paragraph (i)(5), (i)(5)(i), and (i)(5)(ii).

2. Revising the entry for §1.1295-1(k).

The revisions and addition read as follows:

* * * * *

(i) * * *

(3) Automatic termination.

(4) Effect of invalidation, termination or revocation.

(5) Election after invalidation, termination or revocation.

(i) In general.

(ii) Special rule.

* * * * *

(k) Effective dates.

* * * * *

Par. 5. Section 1.1295-1 is amended by:

1. Redesignating paragraphs (i)(3) and (i)(4) as paragraphs (i)(4) and (i)(5), respectively.

2. Adding a new paragraph (i)(3).

3. Revising newly designated paragraph (i)(5).

4. Revising paragraph (k).

The revisions and addition read as follows:

* * * * *

(i) * * *

(3) Automatic termination. If a United States person, or the United States shareholder on behalf of a controlled foreign corporation, makes an election pursuant to section 1296 and the regulations thereunder with respect to PFIC stock for which a QEF election is in effect, or marks to market such stock under another provision of chapter 1 of the Internal Revenue Code, the QEF election is automatically terminated with respect to such stock that is marked to market under section 1296 or another provision of chapter 1 of the Internal Revenue Code. Such termination shall be effective on the last day of the shareholder’s taxable year preceding the first taxable year for which the section 1296 election is in effect or such stock is marked to market under another provision of chapter 1 of the Internal Revenue Code.

Example. Corp Y, a domestic corporation, owns directly 100 shares of marketable stock in foreign corporation FX, a PFIC. Corp Y also owns a 50 percent interest in FP, a foreign partnership that owns 200 shares of FX stock. Accordingly, under section 1298(a)(3) and §1.1296-1(e)(1), Corp Y is treated as indirectly owning 100 shares of FX stock. Corp Y also owns 100 percent of the stock of FZ, a foreign corporation that is not a PFIC. FZ owns 100 shares of FX stock, and therefore under section 1298(a)(2)(A), Corp Y is treated as owning the 100 shares of FX stock owned by FZ. For taxable year 2005, Corp Y has a QEF election in effect with respect to all 300 shares of FX stock that it owns directly or indirectly. See generally §1.1295-1(c)(1). For taxable year 2006, Corp Y makes a timely election pursuant to section 1296 and the regulations thereunder. For purposes of section 1296, Corp Y is treated as owning stock held indirectly through a partnership, but not through a foreign corporation. Section 1296(g); §1.1296-1(e)(1). Accordingly, Corp Y’s section 1296 election covers the 100 shares it owns directly and the 100 shares it owns indirectly through FP, but not the 100 shares owned by FZ. With respect to the first 200 shares, Corp Y’s QEF election is automatically terminated effective December 31, 2005. With respect to the 100 shares Corp Y owns through foreign FZ, Corp Y’s QEF election remains in effect unless invalidated, terminated, or revoked pursuant to this paragraph (i).

* * * * *

(5) Effect after invalidation, termination, or revocation— (i) In general. Without the Commissioner’s consent, a shareholder whose section 1295 election was invalidated, terminated, or revoked under this paragraph (i) may not make the section 1295 election with respect to the PFIC before the sixth taxable year in which the invalidation, termination, or revocation became effective.

(ii) Special rule. Notwithstanding paragraph (i)(5)(i) of this section, a shareholder whose section 1295 election was terminated pursuant to paragraph (i)(3) of this section, and either whose section 1296 election has subsequently been terminated because its PFIC stock ceased to be marketable or who no longer marks to market such stock under another provision of chapter 1 of the Internal Revenue Code, may make a section 1295 election with respect to its PFIC stock before the sixth taxable year in which its prior section 1295 election was terminated.

* * * * *

(k) Effective dates. Except as otherwise provided, paragraphs (b)(2)(iii), (b)(3), (b)(4), and (c) through (j) of this section are applicable to taxable years of shareholders beginning after December 31, 1997. However, taxpayers may apply the rules under paragraphs (b)(4), (f) and (g) of this section to a taxable year beginning before January 1, 1998, provided the statute of limitations on the assessment of tax has not expired as of April 27, 1998, and, in the case of paragraph (b)(4) of this section, the taxpayers who filed the joint return have consistently applied the rules of that section to all taxable years following the year the election was made. Paragraph (b)(3)(v) of this section is applicable as of February 7, 2000, however, a taxpayer may apply the rules to a taxable year prior to the applicable date provided the statute of limitations on the assessment of tax for that taxable year has not expired. Paragraphs (i)(3) and (i)(5)(ii) of this section are applicable for taxable years beginning on or after May 3, 2004.

Par. 6. Section 1.1296-1 is added to read as follows:

(a) Definitions—(1) Eligible RIC. An eligible RIC is a regulated investment company that offers for sale, or has outstanding, any stock of which it is the issuer and which is redeemable at net asset value, or that publishes net asset valuations at least annually.

(2) Section 1296 stock. The term section 1296 stock means marketable stock in a passive foreign investment company (PFIC), including any PFIC stock owned directly or indirectly by an eligible RIC, for which there is a valid section 1296 election. Section 1296 stock does not include stock of a foreign corporation that previously had been a PFIC, and for which a section 1296 election remains in effect.

(3) Unreversed inclusions—(i) General rule. The term unreversed inclusions means with respect to any section 1296 stock, the excess, if any, of—

(A) The amount of mark to market gain included in gross income of the United States person under paragraph (c)(1) of this section with respect to such stock for prior taxable years; over

(B) The amount allowed as a deduction to the United States person under paragraph (c)(3) of this section with respect to such stock for prior taxable years.

(ii) Section 1291 adjustment. The amount referred to in paragraph (a)(3)(i)(A) of this section shall include any amount subject to section 1291 under the coordination rule of paragraph (i)(2)(ii) of this section.

(iii) Example. An example of the computation of unreversed inclusions is as follows:

Example. A, a United States person, acquired stock in Corp X, a foreign corporation, on January 1, 2005, for $150. At such time and at all times thereafter, Corp X was a PFIC and A’s stock in Corp X was marketable. For taxable years 2005 and 2006, Corp X was a nonqualified fund subject to taxation under section 1291. A made a timely section 1296 election with respect to the X stock, effective for taxable year 2007. The fair market value of the X stock was $200 as of December 31, 2006, and $240 as of December 31, 2007. Additionally, Corp X made no distribution with respect to its stock for the taxable years at issue. In 2007, pursuant to paragraph (i)(2)(ii) of this section, A must include the $90 gain in the X stock in accordance with the rules of section 1291 for purposes of determining the deferred tax amount and any applicable interest. Nonetheless, for purposes of determining the amount of the unreversed inclusions pursuant to paragraph (a)(3)(ii) of this section, A will include the $90 of gain that was taxed under section 1291 and not the interest thereon.

(iv) Special rule for regulated investment companies. In the case of a regulated investment company which had elected to mark to market the PFIC stock held by such company as of the last day of the taxable year preceding such company’s first taxable year for which such company makes a section 1296 election, the amount referred to in paragraph (a)(3)(i)(A) of this section shall include amounts previously included in gross income by the company pursuant to such mark to market election with respect to such stock for prior taxable years. For further guidance, see Notice 92-53, 1992-2 C.B. 384, (see also 601.601(d)(2) of this chapter).

(b) Application of section 1296 election—(1) In general. Any United States person and any controlled foreign corporation (CFC) that owns directly, or is treated as owning under this section, marketable stock, as defined in §1.1296-2, in a PFIC may make an election to mark to market such stock in accordance with the provisions of section 1296 and this section.

(2) Election applicable to specific United States person. A section 1296 election applies only to the United States person (or CFC that is treated as a U.S. person under paragraph (g)(2) of this section) that makes the election. Accordingly, a United States person’s section 1296 election will not apply to a transferee of section 1296 stock.

(3) Election applicable to specific corporation only. A section 1296 election is made with respect to a single foreign corporation, and thus a separate section 1296 election must be made for each foreign corporation that otherwise meets the requirements of this section. A United States person’s section 1296 election with respect to stock in a foreign corporation applies to all marketable stock of the corporation that the person owns directly, or is treated as owning under paragraph (e) of this section, at the time of the election or that is subsequently acquired.

(c) Effect of election—(1) Recognition of gain. If the fair market value of section 1296 stock on the last day of the United States person’s taxable year exceeds its adjusted basis, the United States person shall include in gross income for its taxable year the excess of the fair market value of such stock over its adjusted basis (mark to market gain).

(2) Character of gain. Mark to market gain, and any gain on the sale or other disposition of section 1296 stock, shall be treated as ordinary income.

(3) Recognition of loss. If the adjusted basis of section 1296 stock exceeds its fair market value on the last day of the United States person’s taxable year, such person shall be allowed a deduction for such taxable year equal to the lesser of the amount of such excess or the unreversed inclusions with respect to such stock (mark to market loss).

(4) Character of loss—(i) Losses not in excess of unreversed inclusions. Any mark to market loss allowed as a deduction under paragraph (c)(3) of this section, and any loss on the sale or other disposition of section 1296 stock, to the extent that such loss does not exceed the unreversed inclusions attributable to such stock, shall be treated as an ordinary loss, deductible in computing adjusted gross income.

(ii) Losses in excess of unreversed inclusions. Any loss recognized on the sale or other disposition of section 1296 stock in excess of any prior unreversed inclusions will be subject to the rules generally applicable to losses provided elsewhere in the Internal Revenue Code and the regulations thereunder.

(5) Application of election to separate lots of stock. In the case in which a United States person purchased or acquired shares of stock in a PFIC at different prices, the rules of this section shall be applied in a manner consistent with the rules of §1.1012-1.

(6) Source rules. The source of any amount included in gross income under paragraph (c)(1) of this section, or the allocation and apportionment of any amount allowed as a deduction under paragraph (c)(3) of this section, shall be determined in the same manner as if such amounts were gain or loss (as the case may be) from the sale of stock in the PFIC.

(7) Examples. The following examples illustrate this paragraph (c):

Example 1. Treatment of gain as ordinary income. A, a United States individual, purchases stock in FX, a foreign corporation that is not a PFIC, in 1990 for $1,000. On January 1, 2005, when the fair market value of the FX stock is $1,100, FX becomes a PFIC. A makes a timely section 1296 election for taxable year 2005. On December 31, 2005, the fair market value of the FX stock is $1,200. For taxable year 2005, A includes $200 of mark to market gain (the excess of the fair market value of FX stock ($1,200) over A’s adjusted basis ($1,000)) in gross income as ordinary income and pursuant to paragraph (d)(1) of this section increases his basis in the FX stock by that amount.

Example 2. Treatment of gain as capital gain. The facts are the same as in Example 1. For taxable year 2006, FX does not satisfy either the asset test or the income test of section 1297(a). A does not revoke the section 1296 election it made with respect to the FX stock. On December 1, 2006, A sells the FX stock when the fair market value of the stock is $1,500. For taxable year 2006, A includes $300 of gain (the excess of the fair market value of FX stock ($1,500) over A’s adjusted basis ($1,200)) in gross income as long-term capital gain because at the time of sale of the FX stock by A, FX did not qualify as a PFIC, and, therefore, the FX stock was not section 1296 stock at the time of the disposition. Further, A’s holding period for non-PFIC purposes was more than one year.

Example 3. Treatment of losses as ordinary where they do not exceed unreversed inclusions. The facts are the same as in Example 1. On December 1, 2006, A sells the stock in FX for $1,100. At that time, A’s unreversed inclusions (the amount A included in income as mark to market gain) with respect to the stock in FX are $200. Accordingly, for taxable year 2006, A recognizes a loss on the sale of the FX stock of $100, (the fair market value of the FX stock ($1,100) minus A’s adjusted basis ($1,200) in the stock) that is treated as an ordinary loss because the loss does not exceed the unreversed inclusions attributable to the stock of FX.

Example 4. Treatment of losses as long-term capital losses. The facts are the same as in Example 3, except that FX does not satisfy either the asset test or the income test of section 1297(a) for taxable year 2006. For taxable year 2006, A’s $100 loss from the sale of the FX stock is treated as long-term capital loss because at the time of the sale of the FX stock by A FX did not qualify as a PFIC, and, therefore, the FX stock was not section 1296 stock at the time of the disposition. Further, A’s holding period in the FX stock for non-PFIC purposes was more than one year.

Example 5. Long-term capital loss treatment of losses in excess of unreversed inclusions. The facts are the same as in Example 3, except that A sells his FX stock for $900. At the time of A’s sale of the FX stock on December 1, 2006, A’s unreversed inclusions with respect to the FX stock are $200. Accordingly, the $300 loss recognized by A on the disposition is treated as an ordinary loss to the extent of his unreversed inclusions ($200). The amount of the loss in excess of A’s unreversed inclusions ($100) will be treated as a long-term capital loss because A’s holding period in the FC stock for non-PFIC purposes was more than one year.

Example 6. Application of section 1296 election to separate lots of stock. On January 1, 2005, Corp A, a domestic corporation, purchased 100 shares (first lot) of stock in FX, a PFIC, for $500 ($5 per share). On June 1, 2005, Corp A purchased 100 shares (second lot) of FX stock for $1,000 ($10 per share). Corp A made a timely section 1296 election with respect to its FX stock for taxable year 2005. On December 31, 2005, the fair market value of FX stock was $8 per share. For taxable year 2005, Corp A includes $300 of gain in gross income as ordinary income under paragraph (c)(1) of this section with respect to the first lot, and adjusts its basis in that lot to $800 pursuant to paragraph (d)(1) of this section. With respect to the second lot, Corp A is not permitted to recognize a loss under paragraph (c)(3) of this section for taxable year 2005. Although Corp A’s adjusted basis in that stock exceeds its fair market value by $200, Corp A has no unreversed inclusions with respect to that particular lot of stock. On July 1, 2006, Corp A sells 100 shares of FX stock for $900. Assuming that Corp A adequately identifies (in accordance with the rules of §1.1012-1(c)) the shares of FX stock sold as being from the second lot, Corp A recognizes $100 of long term capital loss pursuant to paragraph (c)(4)(ii) of this section.

(d) Adjustment to basis—(1) Stock held directly. The adjusted basis of the section 1296 stock shall be increased by the amount included in the gross income of the United States person under paragraph (c)(1) of this section with respect to such stock, and decreased by the amount allowed as a deduction to the United States person under paragraph (c)(3) of this section with respect to such stock.

(2) Stock owned through certain foreign entities. (i) In the case of section 1296 stock that a United States person is treated as owning through certain foreign entities pursuant to paragraph (e) of this section, the basis adjustments under paragraph (d)(1) of this section shall apply to such stock in the hands of the foreign entity actually holding such stock, but only for purposes of determining the subsequent treatment under chapter 1 of the Internal Revenue Code of the United States person with respect to such stock. Such increase or decrease in the adjusted basis of the section 1296 stock shall constitute an adjustment to the basis of partnership property only with respect to the partner making the section 1296 election. Corresponding adjustments shall be made to the adjusted basis of the United States person’s interest in the foreign entity and in any intermediary entity described in paragraph (e) of this section through which the United States person holds the PFIC stock.

(ii) Example. The following example illustrates this paragraph (d)(2):

Example. FP is a foreign partnership. Corp A, a domestic corporation, owns a 20 percent interest in FP. Corp B, a domestic corporation, owns a 30 percent interest in FP. Corp C, a foreign corporation, with no direct or indirect shareholders that are U.S. persons, owns a 50% interest in FP. Corp A, Corp B, and FP all use a calendar year for their taxable year. In 2005, FP purchases stock in FX, a foreign corporation and a PFIC, for $1,000. Corp A makes a timely section 1296 election for taxable year 2005. On December 31, 2005, the fair market value of the PFIC stock is $1,100. Corp A includes $20 of ordinary income in taxable year 2005 under paragraphs (c)(1) and (2) of this section. Corp A increases its basis in its FP partnership interest by $20. FP increases its basis in the FX stock to $1,020 solely for purposes of determining the subsequent treatment of Corp A, under chapter 1 of the Internal Revenue Code, with respect to such stock. In 2006, FP sells the FX stock for $1,200. For purposes of determining the amount of gain of Corp A, FP will be treated as having $180 in gain of which $20 is allocated to Corp A. Corp A’s $20 of gain will be treated as ordinary income under paragraph (c)(2) of this section. For purposes of determining the amount of gain attributable to Corp B, FP will be treated as having $200 gain, $60 of which will be allocated to Corp B.

(3) Stock owned indirectly by an eligible RIC. Paragraph (d)(2) of this section shall also apply to an eligible RIC which is an indirect shareholder under §1.1296-2(f) of stock in a PFIC and has a valid section 1296 election in effect with respect to the PFIC stock.

(4) Stock acquired from a decedent. In the case of stock of a PFIC which is acquired by bequest, devise, or inheritance (or by the decedent’s estate) and with respect to which a section 1296 election was in effect as of the date of the decedent’s death, notwithstanding section 1014, the basis of such stock in the hands of the person so acquiring it shall be the adjusted basis of such stock in the hands of the decedent immediately before his death (or, if lesser, the basis which would have been determined under section 1014 without regard to this paragraph).

(5) Transition rule for individuals becoming subject to United States income taxation—(i) In general. If any individual becomes a United States person in a taxable year beginning after December 31, 1997, solely for purposes of this section, the adjusted basis, before adjustments under this paragraph (d), of any section 1296 stock owned by such individual on the first day of such taxable year shall be treated as being the greater of its fair market value or its adjusted basis on such first day.

(ii) An example of the transition rule for individuals becoming subject to United States income taxation is as follows:

Example. A, a nonresident alien individual, purchases marketable stock in FX, a PFIC, for $50 in 1995. On January 1, 2005, A becomes a United States person and makes a timely section 1296 election with respect to the stock in accordance with paragraph (h) of this section. The fair market value of the FX stock on January 1, 2005, is $100. The fair market value of the FX stock on December 31, 2005, is $110. Under paragraph (d)(5)(i) of this section, A computes the amount of mark to market gain or loss for the FX stock in 2005 by reference to an adjusted basis of $100, and therefore A includes $10 in gross income as mark to market gain under paragraph (c)(1) of this section. Additionally, under paragraph (d)(1) of this section, A’s adjusted basis in the FX stock for purposes of this section is increased to $110 (and to $60 for all other tax purposes). A sells the FX stock in 2006 for $120. For purposes of applying section 1001, A must use its original basis of $50, with any adjustments under paragraph (d)(1) of this section, $10 in this case, and therefore A recognizes $60 of gain. Under paragraph (c)(2) of this section (which is applied using an adjusted basis of $110), $10 of such gain is treated as ordinary income. The remaining $50 of gain from the sale of the FX stock is long term capital gain because A held such stock for more than one year.

(e) Stock owned through certain foreign entities—(1) In general. Except as provided in paragraph (e)(2) of this section, the following rules shall apply in determining stock ownership for purposes of this section. PFIC stock owned, directly or indirectly, by or for a foreign partnership, foreign trust (other than a foreign trust described in sections 671 through 679), or foreign estate shall be considered as being owned proportionately by its partners or beneficiaries. PFIC stock owned, directly or indirectly, by or for a foreign trust described in sections 671 through 679 shall be considered as being owned proportionately by its grantors or other persons treated as owners under sections 671 through 679 of any portion of the trust that includes the stock. The determination of a person’s proportionate interest in a foreign partnership, foreign trust or foreign estate will be made on the basis of all the facts and circumstances. Stock considered owned by reason of this paragraph shall, for purposes of applying the rules of this section, be treated as actually owned by such person.

(2) Stock owned indirectly by eligible RICs. The rules for attributing ownership of stock contained in §1.1296-2(f) will apply to determine the indirect ownership of PFIC stock by an eligible RIC.

(f) Holding period. Solely for purposes of sections 1291 through 1298, if section 1296 applied to stock with respect to the taxpayer for any prior taxable year, the taxpayer’s holding period in such stock shall be treated as beginning on the first day of the first taxable year beginning after the last taxable year for which section 1296 so applied.

(g) Special rules—(1) Certain dispositions of stock. To the extent a United States person is treated as actually owning stock in a PFIC under paragraph (e) of this section, any disposition which results in the United States person being treated as no longer owning such stock, and any disposition by the person owning such stock, shall be treated as a disposition by the United States person of the stock in the PFIC.

(2) Treatment of CFC as a United States person. In the case of a CFC that owns, or is treated as owning under paragraph (e) of this section, section 1296 stock:

(i) Other than with respect to the sourcing rules in paragraph (c)(6) of this section, this section shall apply to the CFC in the same manner as if such corporation were a United States person. The CFC will be treated as a foreign person for purposes of applying the source rules of paragraph (c)(6).

(ii) For purposes of subpart F of part III of subchapter N of the Internal Revenue Code—

(A) Amounts included in the CFC’s gross income under paragraph (c)(1) or (i)(2)(ii) of this section shall be treated as foreign personal holding company income under section 954(c)(1)(A); and

(B) Amounts allowed as a deduction under paragraph (c)(3) of this section shall be treated as a deduction allocable to foreign personal holding company income for purposes of computing net foreign base company income under §1.954-1(c).

(iii) A United States shareholder, as defined in section 951(b), of the CFC shall not be subject to section 1291 with respect to any stock of the PFIC for the period during which the section 1296 election is in effect for that stock, and the holding period rule of paragraph (f) of this section shall apply to such United States shareholder.

(iv) The rules of this paragraph (g)(2) shall not apply to a United States person that is a shareholder of the PFIC for purposes of section 1291, but is not a United States shareholder under section 951(b) with respect to the CFC making a section 1296 election.

(3) Timing of inclusions for stock owned through certain foreign entities. In the case of section 1296 stock that a United States person is treated as owning through certain foreign entities pursuant to paragraph (e) of this section, the mark to market gain or mark to market loss is determined in accordance with paragraphs (c) and (i)(2)(ii) of this section as of the last day of the taxable year of the foreign partnership, foreign trust or foreign estate and then included in the taxable year of such United States person that includes the last day of the taxable year of the entity.

(h) Elections—(1) Timing and manner for making a section 1296 election—(i) United States persons. A United States person that owns marketable stock in a PFIC, or is treated as owning marketable stock under paragraph (e) of this section, on the last day of the taxable year of such person, and that wants to make a section 1296 election, must make a section 1296 election for such taxable year on or before the due date (including extensions) of the United States person’s income tax return for that year. The section 1296 election must be made on the Form 8621, “Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund”, included with the original tax return of the United States person for that year, or on an amended return, provided that the amended return is filed on or before the election due date.

(ii) Controlled foreign corporations. A section 1296 election by a CFC shall be made by its controlling United States shareholders, as defined in §1.964-1(c)(5), and shall be included with the Form 5471, “Information Return of U.S. Persons With Respect To Certain Foreign Corporations”, for that CFC by the due date (including extensions) of the original income tax returns of the controlling United States shareholders for that year. A section 1296 election by a CFC shall be binding on all United States shareholders of the CFC.

(iii) Retroactive elections for PFIC stock held in prior years. A late section 1296 election may be permitted only in accordance with §301.9100 of this chapter.

(2) Effect of section 1296 election—(i) A section 1296 election will apply to the taxable year for which such election is made and remain in effect for each succeeding taxable year unless such election is revoked or terminated pursuant to paragraph (h)(3) of this section.

(ii) Cessation of a foreign corporation as a PFIC. A United States person will not include mark to market gain or loss pursuant to paragraph (c) of this section with respect to any stock of a foreign corporation for any taxable year that such foreign corporation is not a PFIC under section 1297 or treated as a PFIC under section 1298(b)(1) (taking into account the holding period rule of paragraph (f) of this section). Cessation of a foreign corporation’s status as a PFIC will not, however, terminate a section 1296 election. Thus, if a foreign corporation is a PFIC in a taxable year after a year in which it is not treated as a PFIC, the United States person’s original election (unless revoked or terminated in accordance with paragraph (h)(3) of this section) continues to apply and the shareholder must include any mark to market gain or loss in such year.

(3) Revocation or termination of election—(i) In general. A United States person’s section 1296 election is terminated if the section 1296 stock ceases to be marketable; if the United States person elects, or is required, to mark to market the section 1296 stock under another provision of chapter 1 of the Internal Revenue Code; or if the Commissioner, in the Commissioner’s discretion, consents to the United States person’s request to revoke its section 1296 election upon a finding of a substantial change in circumstances. A substantial change in circumstances for this purpose may include a foreign corporation ceasing to be a PFIC.

(ii) Timing of termination or revocation. Where a section 1296 election is terminated automatically (e.g., the stock ceases to be marketable), section 1296 will cease to apply beginning with the taxable year in which such termination occurs. Where a section 1296 election is revoked with the consent of the Commissioner, section 1296 will cease to apply beginning with the first taxable year of the United States person after the revocation is granted unless otherwise provided by the Commissioner.

(4) Examples. The operation of the rules of this paragraph (h) is illustrated by the following examples:

Example 1. A, a United States person, owns stock in FX, a PFIC. A makes a QEF election in 1996 with respect to the FX stock. For taxable year 2005, A makes a timely section 1296 election with respect to its stock, and thus its QEF election is automatically terminated pursuant to §1.1295-1(i)(3). In 2006, A’s stock in FX ceases to be marketable, and therefore its section 1296 election is automatically terminated under paragraph (h)(3) of this section. Beginning with taxable year 2006, A is subject to the rules of section 1291 with respect to its FX stock unless it makes a new QEF election. See §1.1295-1(i)(5).

Example 2. The facts are the same as in Example 1, except that A’s stock in FX becomes marketable again in 2007. A may make a new section 1296 election with respect to the FX stock for its taxable year 2007, or thereafter. A will be subject to the coordination rules under paragraph (i) of this section unless it made a new QEF election in 2006.

(i) Coordination rules for first year of election—(1) In general. Notwithstanding any provision in this section to the contrary, the rules of this paragraph (i) shall apply to the first taxable year in which a section 1296 election is effective with respect to marketable stock of a PFIC if such foreign corporation was a PFIC for any taxable year, prior to such first taxable year, during the United States person’s holding period (as defined in paragraph (f) of this section) in such stock, and for which such corporation was not treated as a QEF with respect to such United States person.

(2) Shareholders other than regulated investment companies. For the first taxable year of a United States person (other than a regulated investment company) for which a section 1296 election is in effect with respect to the stock of a PFIC, such United States person shall, in lieu of the rules of paragraphs (c) and (d) of this section—

(i) Apply the rules of section 1291 to any distributions with respect to, or disposition of, section 1296 stock;

(ii) Apply section 1291 to the amount of the excess, if any, of the fair market value of such section 1296 stock on the last day of the United States person’s taxable year over its adjusted basis, as if such amount were gain recognized from the disposition of stock on the last day of the taxpayer’s taxable year; and

(iii) Increase its adjusted basis in the section 1296 stock by the amount of excess, if any, subject to section 1291 under paragraph (i)(2)(ii) of this section.

(3) Shareholders that are regulated investment companies. For the first taxable year of a regulated investment company for which a section 1296 election is in effect with respect to the stock of a PFIC, such regulated investment company shall increase its tax under section 852 by the amount of interest that would have been imposed under section 1291(c)(3) for such taxable year if such regulated investment company were subject to the rules of paragraph (i)(2) of this section, and not this paragraph (i)(3). No deduction or increase in basis shall be allowed for the increase in tax imposed under this paragraph (i)(3).

(4) The operation of the rules of this paragraph (i) is illustrated by the following examples:

Example (1). A, a United States person and a calendar year taxpayer, owns marketable stock in FX, a PFIC that it acquired on January 1, 1992. At all times, A’s FX stock was a nonqualified fund subject to taxation under section 1291. A made a timely section 1296 election effective for taxable year 2005. At the close of taxable year 2005, the fair market value of A’s FX stock exceeded its adjusted basis by $10. Pursuant to paragraph (i)(2)(ii) of this section, A must treat the $10 gain under section 1291 as if the FX stock were disposed of on December 31, 2005. Further, A increases its adjusted basis in the FX stock by the $10 in accordance with paragraph (i)(2)(iii) of this section.

Example (2). Assume the same facts as in Example (1), except that A is a RIC that had not made an election prior to 2005 to mark to market the PFIC stock. In taxable year 2005, A includes $10 of ordinary income under paragraph (c)(1) of this section, and such amount is not subject to section 1291. A also increases its tax imposed under section 852 by the amount of interest that would have been determined under section 1291(c)(3), and no deduction is permitted for such amount. Finally, under paragraph (d)(1) of this section, A increases its adjusted basis in the FX stock by $10.

(j) Effective date. The provisions in this section are applicable for taxable years beginning on or after May 3, 2004.

Par. 7. Section 1.1296(e)-1 is redesignated as §1.1296-2 and amended by:

1. Revising paragraph (b)(2).

2. Adding paragraph (b)(3).

3. Revising both references to “sections 958(a)(1) and (2)” in paragraph (f)(1) to read “section 1298(a)”.

The revisions and addition read as follows:

* * * * *

(b) * * *

(2) Special rule for year of initial public offering. For the calendar year in which a corporation initiates a public offering of a class of stock for trading on one or more qualified exchanges or other markets, as defined in paragraph (c) of this section, such class of stock meets the requirements of paragraph (b)(1) of this section for such year if the stock is regularly traded on such exchanges or markets, other than in de minimis quantities, on 1/6 of the days remaining in the quarter in which the offering occurs, and on at least 15 days during each remaining quarter of the taxpayer’s calendar year. In cases where a corporation initiates a public offering of a class of stock in the fourth quarter of the calendar year, such class of stock meets the requirements of paragraph (b)(1) of this section in the calendar year of the offering if the stock is regularly traded on such exchanges or markets, other than in de minimis quantities, on the greater of 1/6 of the days remaining in the quarter in which the offering occurs, or 5 days.

(3) Anti-abuse rule. Trades that have as one of their principal purposes the meeting of the trading requirements of paragraph (b)(1) or (2) of this section shall be disregarded. Further, a class of stock shall not be treated as meeting the trading requirement of paragraph (b)(1) or (2) of this section if there is a pattern of trades conducted to meet the requirement of paragraph (b)(1) or (2) of this section. Similarly, paragraph (b)(2) of this section shall not apply to a public offering of stock that has as one of its principal purposes to avail itself of the reduced trading requirements under the special rule for the calendar year of an initial public offering. For purposes of applying the immediately preceding sentence, consideration will be given to whether the trading requirements of paragraph (b)(1) of this section are satisfied in the subsequent calendar year.

* * * * *

Par. 8. Section 1.6031(a)-1 is amended by:

1. Redesignating the text of paragraph (b)(1) as (b)(1)(i).

2. Adding a heading to newly designated paragraph (b)(1)(i).

3. Adding paragraph (b)(1)(ii).

The additions read as follows:

* * * * *

(b) * * * (1) * * * (i) Filing requirement. * * *

(ii) Special rule. For purposes of this paragraph (b)(1) and paragraph (b)(3)(iii) of this section, a foreign partnership will not be considered to have derived income from sources within the United States solely because a U.S. partner marks to market his pro rata share of PFIC stock held by the foreign partnership pursuant to an election under section 1296.

* * * * *

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

Approved April 7, 2004.

Gregory F. Jenner,
Acting Assistant Secretary of the Treasury .

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(b) * * *

(1) * * *

(ii) * * *

(b) [The text of this proposed amendment is the same as the text of §1.704-1T(b)(1)(ii)(b) published elsewhere in this issue of the Bulletin].

* * * * *

(4) * * *

(xi) [The text of this proposed amendment is the same as the text of §1.704-1T(b)(4)(xi) published elsewhere in this issue of the Bulletin].

* * * * *

(5) [The text of this proposed amendment of §1.704-1(b)(5) is the same as the text of §1.704-1T(b)(5) published elsewhere in this issue of the Bulletin].

John M. Dalrymple,
Acting Deputy Commissioner for
Services and Enforcement.

(a) In the case of an exchange or distribution to which section 354 or 355 applies in which, under the law applicable to the year in which the exchange is made, only nonrecognition property is received, the sum of the basis of all of the stock and securities in the corporation whose stock and securities are exchanged or with respect to which the distribution is made, held immediately after the transaction, plus the basis of all stock and securities received in the transaction shall be the same as the basis of all the stock and securities in such corporation held immediately before the transaction allocated in the manner described in §1.358-2. In the case of an exchange to which section 351 or 361 applies in which, under the law applicable to the year in which the exchange was made, only nonrecognition property is received, the basis of all the stock and securities received in the exchange shall be the same as the basis of all property exchanged therefor. If in an exchange or distribution to which section 351, 356, or 361 applies both nonrecognition property and “other property” are received, the basis of all the property except “other property” held after the transaction shall be determined as described in the preceding two sentences decreased by the sum of the money and the fair market value of the “other property” (as of the date of the transaction) and increased by the sum of the amount treated as a dividend (if any) and the amount of the gain recognized on the exchange, but the term gain as here used does not include any portion of the recognized gain that was treated as a dividend. In any case in which a taxpayer transfers property with respect to which loss is recognized, such loss shall be reflected in determining the basis of the property received in the exchange. The basis of the “other property” is its fair market value as of the date of the transaction. See §1.460-4(k)(3)(iv)(A) for rules relating to stock basis adjustments required where a contract accounted for using a long-term contract method of accounting is transferred in a transaction described in section 351 or a reorganization described in section 368(a)(1)(D) with respect to which the requirements of section 355 (or so much of section 356 as relates to section 355) are met.

* * * * *

(c) Effective date. Paragraph (a) of this section applies to exchanges or distributions of stock and securities after the date these regulations are published as final regulations in the Federal Register. Paragraph (b) of this section applies to exchanges or distributions of stock and securities after December 31, 1953.

Par. 3. Section 1.358-2 is amended by:

1. Revising paragraphs (a)(1) and (a)(2).

2. Removing paragraphs (a)(3), (a)(4), and (a)(5).

3. Revising paragraphs (b)(1) and (c).

4. Adding paragraph (d).

The revisions and addition read as follows:

(a) Allocation of basis in exchanges or distributions to which section 354, 355, or 356 applies. (1) As used in this paragraph, the term stock means stock which is not “other property” under section 356. The term securities means securities (including, where appropriate, fractional parts of securities) which are not “other property” under section 356.

(2)(i) If a shareholder or security holder surrenders a share of stock or a security in an exchange under the terms of section 354, 355, or 356, the basis of each share of stock or security received in the exchange shall be the same as the basis of the allocable portion of the share or shares of stock or security or securities exchanged therefor (as adjusted under §1.358-1). If more than one share of stock or security is received in exchange for one share of stock or one security, the basis of the share of stock or security surrendered shall be allocated to the shares of stock or securities received in the exchange in proportion to the fair market value of the shares of stock or securities received. If one share of stock or security is received in respect of more than one share of stock or security or a fraction of a share of stock or security is received, the basis of the shares of stock or securities surrendered must be allocated to the shares of stock or securities received in a manner that reflects, to the greatest extent possible, that a share of stock or security received is received in respect of shares of stock or securities acquired on the same date and at the same price.

(ii) If a shareholder or security holder receives one or more shares of stock or one or more securities in a distribution under the terms of section 355 (or so much of section 356 as relates to section 355) and does not surrender any shares of stock or securities in connection with the distribution, the basis of each share of stock or security of the distributing corporation (as defined in §1.355-1(b)), as adjusted under §1.358-1, shall be allocated between the share of stock or security of the distributing corporation with respect to which the distribution is made and the share or shares of stock or security or securities (or allocable portions thereof) received with respect to the share of stock or security of the distributing corporation in proportion to their fair market values. If one share of stock or security is received in respect of more than one share of stock or security or a fraction of a share of stock or security is received, the basis of each share of stock or security of the distributing corporation must be allocated to the shares of stock or securities received in a manner that reflects that, to the greatest extent possible, a share of stock or security received is received in respect of shares of stock or securities acquired on the same date and at the same price.

(iii) If a shareholder or security holder that purchased or acquired shares of stock or securities in a corporation on different dates or at different prices exchanges such shares of stock or securities under the terms of section 354, 355, or 356, or receives a distribution of shares of stock or securities under the terms of section 355, and the shareholder or security holder is not able to identify which particular share of stock or security (or portion of a share of stock or security) is received in exchange for, or with respect to, a particular share of stock or security, the shareholder or security holder may designate which share of stock or security is received in exchange for, or with respect to, a particular share of stock or security, provided that such designation is consistent with the terms of the exchange or distribution. The designation must be made on or before the first date on which the basis of a share of stock or security received is relevant. The basis of the shares or securities received, for example, is relevant when such shares or securities are sold or otherwise transferred. The designation will be binding for purposes of determining the Federal tax consequences of any sale or transfer of, or distribution with respect to, the shares or securities received. If the shareholder fails to make a designation, then the shareholder will not be able to identify which shares are sold or transferred for purposes of determining the basis of property sold or transferred under section 1012 and §1.1012-1(c) and, instead, will be treated as selling or transferring the share received in respect of the earliest share purchased or acquired.

(iv) Paragraphs (a)(2)(i) through (iii) of this section shall not apply to determine the basis of a share of stock or security received by a shareholder or security holder in an exchange described in both section 351 and section 354 or section 356, if, in connection with the exchange, the shareholder or security holder exchanges property for stock or securities in an exchange to which neither section 354 nor 356 applies or liabilities of the shareholder or security holder are assumed.

(b) Allocation of basis in exchanges to which section 351 or 361 applies. (1) As used in this paragraph (b), the term stock refers only to stock which is not “other property” under section 351 or 361 and the term securities refers only to securities which are not “other property” under section 351 or 361.

* * * * *

(c) Examples. The application of paragraphs (a) and (b) of this section is illustrated by the following examples:

Example 1. (i) Facts. F, an individual, acquired 20 shares of Corporation N stock on Date 1 for $3 each and 10 shares of Corporation N stock on Date 2 for $6 each. On Date 3, Corporation O acquires the assets of Corporation N in a reorganization under section 368(a)(1)(A). Pursuant to the terms of the plan of reorganization, F receives 2 shares of Corporation O stock for each share of Corporation N stock. Therefore, F receives 60 shares of Corporation O stock. Pursuant to section 354, F recognizes no gain or loss on the exchange. F is not able to identify which shares of Corporation O stock are received in exchange for each share of Corporation N stock.

(ii) Analysis. Under paragraph (a)(2) of this section, F has 40 shares of Corporation O each of which has a basis of $1.50 and is treated as having been acquired on Date 1 and 20 shares of Corporation O each of which has a basis of $3 and is treated as having been acquired on Date 2. On or before the date on which the basis of a share of Corporation O stock received becomes relevant, F may designate which of the shares of Corporation O have a basis of $1.50 and which have a basis of $3.

Example 2. (i) Facts. The facts are the same as in Example 1, except that instead of receiving 2 shares of Corporation O stock for each share of Corporation N stock, F receives 1 shares of Corporation O stock for each share of Corporation N stock. Therefore, F receives 45 shares of Corporation O stock. Again, F is not able to identify which shares (or portions of shares) of Corporation O stock are received in exchange for each share of Corporation N stock.

(ii) Analysis. Under paragraph (a)(2) of this section, F has 30 shares of Corporation O each of which has a basis of $2 and is treated as having been acquired on Date 1 and 15 shares of Corporation O each of which has a basis of $4 and is treated as having been acquired on Date 2. On or before the date on which the basis of a share of Corporation O stock received becomes relevant, F may designate which of the shares of Corporation O have a basis of $2 and which have a basis of $4.

Example 3. (i) Facts. E, an individual, purchased 20 shares of Class A stock of Corporation P on Date 1 for $3 per share and 10 shares of Class B stock of Corporation P on Date 2 for $3 per share. On Date 3, E exchanges each share of Class A stock for one share of new Class C stock and one share of new Class D stock in a reorganization under section 368(a)(1)(E). Pursuant to section 354, E recognizes no gain or loss on the exchange. On the date of the exchange, the fair market value of each share of Class A stock is $6, the fair market value of each share of Class C stock is $2, and the fair market value of each share of Class D stock is $4. E is not able to identify which shares of Class C and Class D stock of Corporation P are received in exchange for each share of Class A stock of Corporation P.

(ii) Analysis. Under paragraph (a)(2) of this section, because E receives one share of Class C stock and one share of Class D stock for each share of Class A stock, the basis of each share of Class A stock surrendered is allocated to one share of Class C stock and one share of Class D stock in proportion to their fair market values. Therefore, $1 of the basis of each share of Class A stock is allocated to each share of Class C stock and $2 of the basis of each share of Class A stock is allocated to each share of Class D stock. E’s basis in each share of Class B stock remains $3.

Example 4. (i) Facts. G, an individual, purchased 10 shares of Corporation Q stock on Date 1 for $2 per share and 10 shares of Corporation Q stock on Date 2 for $5 per share. On Date 3, Corporation R acquires the stock of Corporation Q in a reorganization under section 368(a)(1)(B). Pursuant to the terms of the reorganization, G receives one share of Corporation R stock for every 2 shares of Corporation Q stock. Pursuant to section 354, G recognizes no gain or loss on the exchange. G is not able to identify which portion of each share of Corporation R stock is received in exchange for each share of Corporation Q stock.

(ii) Analysis. Under paragraph (a)(2) of this section, G has 5 shares of Corporation R each of which has a basis of $4 and is treated as having been acquired on Date 1 and 5 shares of Corporation R each of which has a basis of $10 and is treated as having been acquired on Date 2. On or before the date on which the basis of a share of Corporation R stock received becomes relevant, G may designate which of the shares of Corporation R have a basis of $4 and which have a basis of $10.

Example 5. (i) Facts. The facts are the same as in Example 4, except that, in addition to transferring the stock of Corporation Q to Corporation R, G transfers land to Corporation R. In addition, after the transaction, G owns stock of Corporation R satisfying the requirements of section 368(c). G’s transfer of the Corporation Q stock to Corporation R is an exchange described in sections 351 and 354. G’s transfer of land to Corporation R is an exchange described in section 351.

(ii) Analysis. Pursuant to paragraph (a)(2)(iv) of this section, because neither section 354 nor section 356 applies to the transfer of land to Corporation R, the rules of paragraphs (a)(2)(i) through (iii) of this section do not apply to determine G’s basis in the Corporation R stock received in the transaction.

Example 6. (i) Facts. H, an individual, purchased 10 shares of Corporation T stock on Date 1 for $3 per share and 10 shares of Corporation T stock on Date 2 for $6 per share. On Date 3, Corporation V, a newly formed, wholly owned subsidiary of Corporation U, merges with and into Corporation T with Corporation T surviving. As part of the plan of merger, H receives one share of Corporation U stock for each share of Corporation T stock. In connection with the transaction, Corporation U assumes a liability of H. In addition, after the transaction, H owns stock of Corporation U satisfying the requirements of section 368(c). H’s transfer of the Corporation T stock to Corporation U is an exchange described in sections 351 and 354.

(ii) Analysis. Pursuant to paragraph (a)(2)(iv) of this section, because, in connection with the transfer of the Corporation T stock to Corporation U, Corporation U assumed a liability of H, the rules of paragraphs (a)(2)(i) through (iii) of this section do not apply to determine H’s basis in the Corporation U stock received in the transaction.

Example 7. (i) Facts. J, an individual, purchased 5 shares of Corporation X stock for $4 per share on Date 1 and 5 shares of Corporation X stock for $8 per share on Date 2. Corporation X owns all of the outstanding stock of Corporation Y. The fair market value of the stock of Corporation X, excluding the stock of Corporation Y, is $900. The fair market value of the stock of Corporation Y is $900. In a distribution to which section 355 applies, Corporation X distributes all of the stock of Corporation Y pro rata to its shareholders. No stock of Corporation X is surrendered in connection with the distribution. In the distribution, J receives 2 shares of Corporation Y stock with respect to each share of Corporation X stock. Pursuant to section 355, J recognizes no gain or loss on the receipt of the shares of Corporation Y stock. J is not able to identify which share of Corporation Y stock is received in respect of each share of Corporation X stock.

(ii) Analysis. Under paragraph (a)(2) of this section, because J receives 2 shares of Corporation Y stock with respect to each share of Corporation X stock, the basis of each share of Corporation X stock is allocated between such share of Corporation X stock and two shares of Corporation Y stock in proportion to the fair market value of those shares. Therefore, each of the 5 shares of Corporation X stock acquired on Date 1 will have a basis of $2 and each of the 10 shares of Corporation Y stock received with respect to those shares will have a basis of $1. In addition, each of the 5 shares of Corporation X stock acquired on Date 2 will have a basis of $4 and each of the 10 shares of Corporation Y stock received with respect to those shares will have a basis of $2. On or before the date on which the basis of a share of Corporation Y stock received becomes relevant, H may designate which of the shares of Corporation Y have a basis of $1 and which have a basis of $2.

(d) Effective date. This section applies to exchanges or distributions of stock and securities after the date these regulations are published as final regulations in the Federal Register.

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