* * * * *

(i) Election inapplicable to shareholder of a former PFIC or of a section 1297(e) PFIC. A shareholder may not make the section 1295 and deemed dividend elections if the foreign corporation is a former PFIC (as defined in paragraph (j)(2)(iv) of this section) or a section 1297(e) PFIC (as defined in paragraph (j)(2)(v) of this section) with respect to the shareholder. For the rules regarding the election by a shareholder of a former PFIC, see §1.1298-3. For the rules regarding the election by a shareholder of a section 1297(e) PFIC, see §1.1297-3.

(j) * * *

(2) * * *

(v) Section 1297(e) PFIC. A foreign corporation is a section 1297(e) PFIC with respect to a shareholder (as defined in paragraph (j)(3) of this section) if—

(A) The foreign corporation qualifies as a PFIC under section 1297(a) on the first day on which the qualified portion of the shareholder’s holding period in the foreign corporation begins, as determined under section 1297(e)(2); and

(B) The stock of the foreign corporation held by the shareholder is treated as stock of a PFIC, pursuant to section 1298(b)(1), because, at any time during the shareholder’s holding period of the stock, other than the qualified portion, the corporation was a PFIC that was not a QEF.

(k) Effective/applicability date. (1) The rules of this section, except for paragraph (j)(2)(v) of this section, are applicable as of April 1, 1995.

(2) The rules of paragraph (j)(2)(v) of this section are applicable as of December 8, 2005.

This section contains a listing of the headings for §1.1297-3.

(a) In general.

(b) Application of deemed sale election rules.

(1) Eligibility to make the deemed sale election.

(2) Effect of the deemed sale election.

(3) Time for making the deemed sale election.

(4) Manner of making the deemed sale election.

(5) Adjustments to basis.

(6) Treatment of holding period.

(c) Application of deemed dividend election rules.

(1) Eligibility to make the deemed dividend election.

(2) Effect of the deemed dividend election.

(3) Post-1986 earnings and profits defined.

(4) Time for making the deemed dividend election.

(5) Manner of making the deemed dividend election.

(6) Adjustments to basis.

(7) Treatment of holding period.

(8) Coordination with section 959(e).

(d) CFC qualification date.

(e) Late purging elections requiring special consent.

(1) In general.

(2) Prejudice to the interests of the U.S. government.

(3) Procedural requirements.

(4) Time and manner of making late election.

(5) Multiple late elections.

(f) Effective/applicability date.

(a) In general. A shareholder (as defined in §1.1291-9(j)(3)) of a foreign corporation that is a section 1297(e) passive foreign investment company (PFIC) (as defined in §1.1291-9(j)(2)(v)) with respect to such shareholder, shall be treated for tax purposes as holding stock in a PFIC and therefore continues to be subject to taxation under section 1291 unless the shareholder makes a purging election under section 1298(b)(1). A purging election under section 1298(b)(1) is made under rules similar to the rules of section 1291(d)(2). Section 1291(d)(2) allows a shareholder to purge the continuing PFIC taint by either making a deemed sale election or a deemed dividend election.

(b) Application of deemed sale election rules—(1) Eligibility to make the deemed sale election. A shareholder of a foreign corporation that is a section 1297(e) PFIC with respect to such shareholder may make a deemed sale election under section 1298(b)(1) by applying the rules of this paragraph (b).

(2) Effect of the deemed sale election. A shareholder making the deemed sale election with respect to a section 1297(e) PFIC shall be treated as having sold all of its stock in the section 1297(e) PFIC for its fair market value on the controlled foreign corporation (CFC) qualification date, as defined in paragraph (d) of this section. A deemed sale under this section is treated as a disposition subject to taxation under section 1291. Thus, the gain from the deemed sale is taxed as an excess distribution received on the CFC qualification date. In the case of an election made by an indirect shareholder, the amount of gain to be recognized and taxed as an excess distribution is the amount of gain that the direct owner of the stock of the PFIC would have realized on an actual sale or disposition of the stock of the PFIC indirectly owned by the shareholder. Any loss realized on the deemed sale is not recognized. After the deemed sale election, the shareholder’s stock with respect to which the election was made under this paragraph (b) shall not be treated as stock in a PFIC and the shareholder shall not be subject to taxation under section 1291 with respect to such stock unless the qualified portion of the shareholder’s holding period ends, as determined under section 1297(e)(2), and the foreign corporation thereafter qualifies as a PFIC under section 1297(a).

(3) Time for making the deemed sale election. Except as provided in paragraph (e) of this section, a shareholder shall make the deemed sale election under this paragraph (b) and section 1298(b)(1) in the shareholder’s original or amended return for the taxable year that includes the CFC qualification date (election year). If the deemed sale election is made in an amended return, the return must be filed by a date that is within three years of the due date, as extended under section 6081, of the original return for the election year.

(4) Manner of making the deemed sale election. A shareholder makes the deemed sale election under this paragraph (b) by filing Form 8621, “Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund”, with the return of the shareholder for the election year, reporting the gain as an excess distribution pursuant to section 1291(a) as if such sale occurred under section 1291(d)(2), and paying the tax and interest due on the excess distribution. A shareholder that makes the deemed sale election after the due date of the return (determined without regard to extensions) for the election year must pay additional interest, pursuant to section 6601, on the amount of underpayment of tax for that year. An electing shareholder that realizes a loss shall report the loss on Form 8621, but shall not recognize the loss.

(5) Adjustments to basis. A shareholder that makes the deemed sale election increases its adjusted basis of the PFIC stock owned directly by the amount of gain recognized on the deemed sale. If the shareholder makes the deemed sale election with respect to a PFIC of which it is an indirect shareholder, the shareholder’s adjusted basis of the stock or other property owned directly by the shareholder, through which ownership of the PFIC is attributed to the shareholder, is increased by the amount of gain recognized by the shareholder. In addition, solely for purposes of determining the subsequent treatment under the Internal Revenue Code (Code) and regulations of a shareholder of the stock of the PFIC, the adjusted basis of the direct owner of the stock of the PFIC is increased by the amount of gain recognized on the deemed sale. A shareholder shall not adjust the basis of any stock with respect to which the shareholder realized a loss on the deemed sale, which loss is not recognized under paragraph (b)(2) of this section.

(6) Treatment of holding period. If a shareholder of a foreign corporation has made a deemed sale election, then, for purposes of applying sections 1291 through 1298 to such shareholder after the deemed sale, the shareholder’s holding period in the stock of the foreign corporation begins on the CFC qualification date, without regard to whether the shareholder recognized gain on the deemed sale. For other purposes of the Code and regulations, this holding period rule does not apply.

(c) Application of deemed dividend election rules—(1) Eligibility to make the deemed dividend election. A shareholder of a foreign corporation that is a section 1297(e) PFIC with respect to such shareholder may make the deemed dividend election under the rules of this paragraph (c). A deemed dividend election may be made by a shareholder whose pro rata share of the post-1986 earnings and profits of the PFIC attributable to the PFIC stock held on the CFC qualification date is zero.

(2) Effect of the deemed dividend election. A shareholder making the deemed dividend election with respect to a section 1297(e) PFIC shall include in income as a dividend its pro rata share of the post-1986 earnings and profits of the PFIC attributable to all of the stock it held, directly or indirectly on the CFC qualification date, as defined in paragraph (d) of this section. The deemed dividend is taxed under section 1291 as an excess distribution received on the CFC qualification date. The excess distribution determined under this paragraph (c) is allocated under section 1291(a)(1)(A) only to each day of the shareholder’s holding period of the stock during which the foreign corporation qualified as a PFIC. For purposes of the preceding sentence, the shareholder’s holding period of the PFIC stock ends on the day before the CFC qualification date. After the deemed dividend election, the shareholder’s stock with respect to which the election was made under this paragraph (c) shall not be treated as stock in a PFIC and the shareholder shall not be subject to taxation under section 1291 with respect to such stock unless the qualified portion of the shareholder’s holding period ends, as determined under section 1297(e)(2), and the foreign corporation thereafter qualifies as a PFIC under section 1297(a).

(3) Post-1986 earnings and profits defined—(i) In general—(A) General rule. For purposes of this section, the term post-1986 earnings and profits means the post-1986 undistributed earnings, within the meaning of section 902(c)(1) (determined without regard to section 902(c)(3)), as of the day before the CFC qualification date, that were accumulated and not distributed in taxable years of the PFIC beginning after 1986 and during which it was a PFIC, without regard to whether the earnings related to a period during which the PFIC was a CFC.

(B) Special rule. If the CFC qualification date is a day that is after the first day of the taxable year, the term post-1986 earnings and profits means the post-1986 undistributed earnings, within the meaning of section 902(c)(1) (determined without regard to section 902(c)(3)), as of the close of the taxable year that includes the CFC qualification date. For purposes of this computation, only earnings and profits accumulated in taxable years during which the foreign corporation was a PFIC shall be taken into account, but without regard to whether the earnings related to a period during which the PFIC was a CFC.

(ii) Pro rata share of post-1986 earnings and profits attributable to shareholder’s stock—(A) In general. A shareholder’s pro rata share of the post-1986 earnings and profits of the PFIC attributable to the stock held by the shareholder on the CFC qualification date is the amount of post-1986 earnings and profits of the PFIC accumulated during any portion of the shareholder’s holding period ending at the close of the day before the CFC qualification date and attributable, under the principles of section 1248 and the regulations under that section, to the PFIC stock held on the CFC qualification date.

(B) Reduction for previously taxed amounts. A shareholder’s pro rata share of the post-1986 earnings and profits of the PFIC does not include any amount that the shareholder demonstrates to the satisfaction of the Commissioner (in the manner provided in paragraph (c)(5)(ii) of this section) was, pursuant to another provision of the law, previously included in the income of the shareholder, or of another U.S. person if the shareholder’s holding period of the PFIC stock includes the period during which the stock was held by that other U.S. person.

(4) Time for making the deemed dividend election. Except as provided in paragraph (e) of this section, the shareholder shall make the deemed dividend election under this paragraph (c) and section 1298(b)(1) in the shareholder’s original or amended return for the taxable year that includes the CFC qualification date (election year). If the deemed dividend election is made in an amended return, the return must be filed by a date that is within three years of the due date, as extended under section 6081, of the original return for the election year.

(5) Manner of making the deemed dividend election—(i) In general. A shareholder makes the deemed dividend election by filing Form 8621 and the attachment to Form 8621 described in paragraph (c)(5)(ii) of this section with the return of the shareholder for the election year, reporting the deemed dividend as an excess distribution pursuant to section 1291(a)(1), and paying the tax and interest due on the excess distribution. A shareholder that makes the deemed dividend election after the due date of the return (determined without regard to extensions) for the election year must pay additional interest, pursuant to section 6601, on the amount of underpayment of tax for that year.

(ii) Attachment to Form 8621. The shareholder must attach a schedule to Form 8621 that demonstrates the calculation of the shareholder’s pro rata share of the post-1986 earnings and profits of the PFIC that is treated as distributed to the shareholder on the CFC qualification date, pursuant to this paragraph (c). If the shareholder is claiming an exclusion from its pro rata share of the post-1986 earnings and profits for an amount previously included in its income or the income of another U.S. person, the shareholder must include the following information:

(A) The name, address and taxpayer identification number of each U.S. person that previously included an amount in income, the amount previously included in income by each such U.S. person, the provision of law, pursuant to which the amount was previously included in income, and the taxable year or years of inclusion of each amount.

(B) A description of the transaction pursuant to which the shareholder acquired, directly or indirectly, the stock of the PFIC from another U.S. person, and the provision of law pursuant to which the shareholder’s holding period includes the period the other U.S. person held the CFC stock.

(6) Adjustments to basis. A shareholder that makes the deemed dividend election increases its adjusted basis of the stock of the PFIC owned directly by the shareholder by the amount of the deemed dividend. If the shareholder makes the deemed dividend election with respect to a PFIC of which it is an indirect shareholder, the shareholder’s adjusted basis of the stock or other property owned directly by the shareholder, through which ownership of the PFIC is attributed to the shareholder, is increased by the amount of the deemed dividend. In addition, solely for purposes of determining the subsequent treatment under the Code and regulations of a shareholder of the stock of the PFIC, the adjusted basis of the direct owner of the stock of the PFIC is increased by the amount of the deemed dividend.

(7) Treatment of holding period. If the shareholder of a foreign corporation has made a deemed dividend election, then, for purposes of applying sections 1291 through 1298 to such shareholder after the deemed dividend, the shareholder’s holding period of the stock of the foreign corporation begins on the CFC qualification date. For other purposes of the Code and regulations, this holding period rule does not apply.

(8) Coordination with section 959(e). For purposes of section 959(e), the entire deemed dividend is treated as having been included in gross income under section 1248(a).

(d) CFC qualification date. For purposes of this section, the CFC qualification date is the first day on which the qualified portion of the shareholder’s holding period in the section 1297(e) PFIC begins, as determined under section 1297(e).

(e) Late purging elections requiring special consent—(1) In general. This section prescribes the exclusive rules under which a shareholder of a section 1297(e) PFIC may make a section 1298(b)(1) election after the time prescribed in paragraph (b)(3) or (c)(4) of this section for making a deemed sale or a deemed dividend election has elapsed (late purging election). Therefore, a shareholder may not seek such relief under any other provisions of the law, including §301.9100-3 of this chapter. A shareholder may request the consent of the Commissioner to make a late deemed sale or deemed dividend election for the taxable year of the shareholder that includes the CFC qualification date provided the shareholder satisfies the requirements set forth in this paragraph (e). The Commissioner may, in his discretion, grant relief under this paragraph (e) only if—

(i) In a case where the shareholder is requesting consent under this paragraph (e) after December 31, 2005, the shareholder requests such consent before a representative of the Internal Revenue Service (IRS) raises upon audit the PFIC status of the foreign corporation for any taxable year of the shareholder;

(ii) The shareholder has agreed in a closing agreement with the Commissioner, described in paragraph (e)(3) of this section, to eliminate any prejudice to the interests of the U.S. government, as determined under paragraph (e)(2) of this section, as a consequence of the shareholder’s inability to file amended returns for its taxable year in which the CFC qualification date falls or an earlier closed taxable year in which the shareholder has taken a position that is inconsistent with the treatment of the foreign corporation as a PFIC; and

(iii) The shareholder satisfies the procedural requirements set forth in paragraph (e)(3) of this section.

(2) Prejudice to the interests of the U.S. government. The interests of the U.S. government are prejudiced if granting relief would result in the shareholder having a lower tax liability (other than by a de minimis amount), taking into account applicable interest charges, for the taxable year that includes the CFC qualification date (or a prior taxable year in which the taxpayer took a position on a return that was inconsistent with the treatment of the foreign corporation as a PFIC) than the shareholder would have had if the shareholder had properly made the section 1298(b)(1) election in the time prescribed in paragraph (b)(2) or (c)(3) of this section (or had not taken a position in a return for an earlier year that was inconsistent with the status of the foreign corporation as a PFIC). The time value of money is taken into account for purposes of this computation.

(3) Procedural requirements—(i) In general. The amount due with respect to a late purging election is determined in the same manner as if the purging election had been timely filed. However, the shareholder is also liable for interest on the amount due, pursuant to section 6601, determined for the period beginning on the due date (without extensions) for the taxpayer’s income tax return for the year in which the CFC qualification date falls and ending on the date the late purging election is filed with the IRS.

(ii) Filing instructions. A late purging election is made by filing a completed Form 8621-A, “Return by a Shareholder Making Certain Late Elections To End Treatment as a Passive Foreign Investment Company.”

(4) Time and manner of making late election—(i) Time for making a late purging election. A shareholder may make a late purging election in the manner provided in paragraph (e)(4)(ii) of this section at any time. The date the election is filed with the IRS will determine the amount of interest due under paragraph (e)(3) of this section.

(ii) Manner of making a late purging election. A shareholder makes a late purging election by completing Form 8621-A in the manner required by that form and this section and filing that form with the Internal Revenue Service, DP 8621-A, Ogden, UT 84201.

(5) Multiple late elections—(i) General rule. A shareholder of a foreign corporation may make multiple late purging elections under the rules of this paragraph (e) or §1.1298-3(e) to the same extent such multiple purging elections could have been made if those purging elections had been filed within the time prescribed under paragraph (b)(3) or (c)(4) of this section or §1.1298-3(b)(3) or (c)(4).

(ii) Example. The rule of this paragraph (e)(5) is illustrated by the following example:

Example. (i) In 1991, X, a U.S person, acquired a five percent interest in the stock of FC, a controlled foreign corporation, as defined in section 957(a). In years 1991, 1992, 1995, 1996 and 1997, FC satisfied either the income test or the asset test of section 1297(a). X did not make a QEF election with regard to FC. In years 1993 and 1994, FC did not satisfy either the income or the asset test of section 1297(a). In 1998, X acquired additional stock in FC such that X was a U.S. shareholder (as defined in section 951(b)) of FC.

(ii) Because FC qualified as a PFIC in 1991, FC will be treated as a PFIC with respect to all of the stock held by X, under the “once a PFIC always a PFIC” rule of section 1298(b)(1), unless X makes an election to purge the PFIC taint. Because X ceased to satisfy either the income or asset test in 1993, X could have made an election under §1.1298-3 to purge the PFIC taint of FC for that year if X had filed such an election within the time prescribed under §1.1298-3(b)(3) or (c)(4). If X had done so, the stock X held in FC would not be treated as stock in a PFIC for the years 1993 and 1994. Because X became a U.S. shareholder of FC in 1998, X then could have made a deemed sale or deemed dividend election under this section to purge the PFIC taint of FC for the years 1995 through 1997 if X had filed within the time prescribed under paragraph (b)(3) or (c)(4) of this section. Accordingly, X may make a late purging election to purge the PFIC taint of FC for the years 1991 and 1992 under the rules of §1.1298-3(e) and may also make a late purging election to purge the PFIC taint of FC for the years 1995 through 1997 under the rules of this paragraph (e).

(f) Effective/applicability date. The rules of this section are applicable as of December 8, 2005.

This section contains a listing of the paragraph headings for §1.1298-3.

(a) In general.

(b) Application of deemed sale election rules.

(1) Eligibility to make the deemed sale election.

(2) Effect of the deemed sale election.

(3) Time for making the deemed sale election.

(4) Manner of making the deemed sale election.

(5) Adjustments to basis.

(6) Treatment of holding period.

(c) Application of deemed dividend election rules.

(1) Eligibility to make the deemed dividend election.

(2) Effect of the deemed dividend election.

(3) Post-1986 earnings and profits defined.

(4) Time for making the deemed dividend election.

(5) Manner of making the deemed dividend election.

(6) Adjustments to basis.

(7) Treatment of holding period.

(8) Coordination with section 959(e).

(d) Termination date.

(e) Late purging elections requiring special consent.

(1) In general.

(2) Prejudice to the interests of the U.S. government.

(3) Procedural requirements.

(4) Time and manner of making late election.

(5) Multiple late elections.

(f) Effective/applicability date.

* * * * *

(e) Late purging elections requiring special consent—(1) In general. This section prescribes the exclusive rules under which a shareholder of a former PFIC may make a section 1298(b)(1) election after the time prescribed in paragraph (b)(3) or (c)(4) of this section for making a deemed sale or a deemed dividend election has elapsed (late purging election). Therefore, a shareholder may not seek such relief under any other provisions of the law, including §301.9100-3 of this chapter. A shareholder may request the consent of the Commissioner to make a late purging election for the taxable year of the shareholder that includes the termination date provided the shareholder satisfies the requirements set forth in this paragraph (e). The Commissioner may, in his discretion, grant relief under this paragraph (e) only if—

(i) In a case where the shareholder is requesting consent under this paragraph (e) after December 31, 2005, the shareholder requests such consent before a representative of the Internal Revenue Service raises upon audit the PFIC status of the foreign corporation for any taxable year of the shareholder;

(ii) The shareholder has agreed in a closing agreement with the Commissioner, described in paragraph (e)(3) of this section, to eliminate any prejudice to the interests of the U.S. government, as determined under paragraph (e)(2) of this section, as a consequence of the shareholder’s inability to file amended returns for its taxable year in which the termination date falls or an earlier closed taxable year in which the shareholder has taken a position that is inconsistent with the treatment of the foreign corporation as a PFIC; and

(iii) The shareholder satisfies the procedural requirements set forth in paragraph (e)(3) of this section.

(2) Prejudice to the interests of the U.S. government. The interests of the U.S. government are prejudiced if granting relief would result in the shareholder having a lower tax liability (other than by a de minimis amount), taking into account applicable interest charges, for the taxable year that includes the termination date (or a prior taxable year in which the taxpayer took a position on a return that was inconsistent with the treatment of the foreign corporation as a PFIC) than the shareholder would have had if the shareholder had properly made the section 1298(b)(1) election in the time prescribed in paragraph (b)(2) or (c)(3) of this section (or had not taken a position in a return for an earlier year that was inconsistent with the status of the foreign corporation as a PFIC). The time value of money is taken into account for purposes of this computation.

(3) Procedural requirements—(i) In general. The amount due with respect to a late purging election is determined in the same manner as if the purging election had been timely filed. However, the shareholder is also liable for interest on the amount due, pursuant to section 6601, determined for the period beginning on the due date (without extensions) for the taxpayer’s income tax return for the year in which the termination date falls and ending on the date the late purging election is filed with the IRS.

(ii) Filing instructions. A late purging election is made by filing a completed Form 8621-A, “Return by a Shareholder Making Certain Late Elections To End Treatment as a Passive Foreign Investment Company.”

(4) Time and manner of making late election—(i) Time for making a late purging election. A shareholder may make a late purging election in the manner provided in paragraph (e)(4)(ii) of this section at any time. The date the election is filed with the IRS will determine the amount of interest due under paragraph (e)(3) of this section.

(ii) Manner of making a late purging election. A shareholder makes a late purging election by completing Form 8621-A in the manner required by that form and this section and filing that form with the Internal Revenue Service, DP 8621-A, Ogden, UT 84201.

(5) Multiple late elections. For rules regarding the circumstances under which a shareholder of a foreign corporation may make multiple late purging elections under this paragraph (e) or §1.1297-3(e), see §1.1297-3(e)(5).

(f) Effective/applicability date. The rules of this section are applicable as of December 8, 2005.

* * * * *

* * * * *

(e) * * *

(3) Special rules relating to stock owned by members of a family.

Par. 3. Section 1.1361-1 is amended by:

1. Revising paragraphs (b)(1)(i) and (e)(1).

2. Adding paragraphs (e)(3), (h)(1)(vii), and (h)(3)(i)(G).

3. Adding a new sentence to the end of paragraph (j)(8).

4. Adding a new sentence to the end of paragraph (k)(2)(i).

5. Revising paragraphs (m)(2)(ii)(A), (m)(4)(iii), and (m)(4)(vi).

6. Revising paragraph (m)(8), Example 2.

7. Revising the seventh sentence of paragraph (m)(8), Example 5.

8. Revising paragraph (m)(8), Example 7.

9. Adding paragraph (m)(8), Example 8.

10. Adding paragraph (m)(8), Example 9.

11. Adding a sentence to the end of paragraph (m)(9).

The revisions and additions read as follows:

* * * * *

(b) * * * (1) * * *

(i) More than the number of shareholders provided in section 1361(b)(1)(A);

* * * * *

(e) Number of shareholders—(1) General rule. A corporation does not qualify as a small business corporation if it has more than the number of shareholders provided in section 1361(b)(1)(A). Ordinarily, the person who would have to include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation) is considered to be the shareholder of the corporation. For example, if stock (owned other than by a husband and wife or members of a family described in section 1361(c)(1)) is owned by tenants in common or joint tenants, each tenant in common or joint tenant is generally considered to be a shareholder of the corporation. (For special rules relating to stock owned by husband and wife or members of a family, see paragraphs (e)(2) and (3) of this section, respectively; for special rules relating to restricted stock, see paragraphs (b)(3) and (6) of this section.) The person for whom stock of a corporation is held by a nominee, guardian, custodian, or an agent is considered to be the shareholder of the corporation for purposes of this paragraph (e) and paragraphs (f) and (g) of this section. For example, a partnership may be a nominee of S corporation stock for a person who qualifies as a shareholder of an S corporation. However, if the partnership is the beneficial owner of the stock, then the partnership is the shareholder, and the corporation does not qualify as a small business corporation. In addition, in the case of stock held for a minor under a uniform transfers to minors or similar statute, the minor and not the custodian is the shareholder. Except as otherwise provided in paragraphs (h) and (j) of this section, and for purposes of this paragraph (e) and paragraphs (f) and (g) of this section, if stock is held by a decedent’s estate or a trust described in section 1361(c)(2)(A)(ii) or (iii), the estate or trust (and not the beneficiaries of the estate or trust) is considered to be the shareholder; however, if stock is held by a subpart E trust (which includes a voting trust) or an electing QSST described in section 1361(d)(1), the deemed owner of the trust is considered to be the shareholder. If stock is held by an ESBT described in section 1361(c)(2)(A)(v), each potential current beneficiary of the trust shall be treated as a shareholder, except that the trust shall be treated as the shareholder during any period in which there is no potential current beneficiary of the trust. If stock is held by a trust described in section 1361(c)(2)(A)(vi), the individual for whose benefit the trust was created shall be treated as the shareholder. See paragraph (h) of this section for special rules relating to trusts.

* * * * *

(3) Special rules relating to stock owned by members of a family—(i) In general. For purposes of paragraph (e)(1) of this section, stock owned by members of a family is treated as owned by one shareholder. Members of a family include a common ancestor, any lineal descendant of the common ancestor, and any spouse (or former spouse) of the common ancestor or of any lineal descendants of the common ancestor. An individual shall not be considered to be a common ancestor if, on the applicable date, the individual is more than six generations removed from the youngest generation of shareholders who would (but for this six-generation test) be members of the family. For purposes of this test, a spouse (or former spouse) is treated as being of the same generation as the individual to whom the spouse is or was married. This test is applied on the latest of the date the election under section 1362(a) is made for the corporation, the earliest date that a member of the family holds stock in the corporation, or October 22, 2004. For this purpose, the date the election under section 1362(a) is made for the corporation is the effective date of the election, not the date it is signed or received by any person. The test is only applied as of the applicable date, and lineal descendants (and spouses) more than six generations removed from the common ancestor will be treated as members of the family even if they acquire stock in the corporation after that date. The members of a family are treated as one shareholder under this paragraph (e)(3) solely for purposes of section 1361(b)(1)(A), and not for any other purpose, whether under section 1361 or any other provision. Specifically, each member of the family who owns or is deemed to own stock must meet the requirements of sections 1361(b)(1)(B) and (C) (regarding permissible shareholders) and section 1362(a)(2) (regarding shareholder consents to an S corporation election). Although a person may be a member of more than one family under this paragraph (e)(3), each family (not all of whose members are also members of the other family) will be treated as one shareholder. For purposes of this paragraph (e)(3), any legally adopted child of an individual, any child who is lawfully placed with an individual for legal adoption by that individual, and any eligible foster child of an individual (within the meaning of section 152(f)(1)(C)), shall be treated as a child of such individual by blood.

(ii) Certain entities treated as members of a family. For purposes of this paragraph (e)(3), the estate or trust (described in section 1361(c)(2)(A)(ii) or (iii)) of a deceased member of the family will be considered to be a member of the family during the period in which the estate or such trust (if the trust is described in section 1361(c)(2)(A)(ii) or (iii)), holds stock in the S corporation. The members of the family also will include—

(A) In the case of an ESBT, each potential current beneficiary who is a member of the family;

(B) In the case of a QSST, the income beneficiary who makes the QSST election, if that income beneficiary is a member of the family;

(C) In the case of a trust created primarily to exercise the voting power of stock transferred to it, each beneficiary who is a member of the family;

(D) The individual for whose benefit a trust described in section 1361(c)(2)(A)(vi) was created, if that individual is a member of the family;

(E) The deemed owner of a trust described in section 1361(c)(2)(A)(i) if that deemed owner is a member of the family; and

(F) The owner of an entity disregarded as an entity separate from its owner under §301.7701-3 of the Procedure and Administration Regulations, if that owner is a member of the family.

* * * * *

(h)* * * (1)* * *

(vii) Individual retirement accounts. In the case of a corporation which is a bank (as defined in section 581) or a depository institution holding company (as defined in section 3(w)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(w)(1)), a trust which constitutes an individual retirement account under section 408(a), including one designated as a Roth IRA under section 408A, but only to the extent of the stock held by such trust in such bank or company as of October 22, 2004. Individual retirement accounts (including Roth IRAs) are not otherwise eligible S corporation shareholders.

* * * * *

(3)* * * (i) * * *

(G) If stock in an S corporation bank or depository institution holding company is held by an individual retirement account (including a Roth IRA) described in paragraph (h)(1)(vii) of this section, the individual for whose benefit the trust was created shall be treated as the shareholder.

* * * * *

(j)* * *

(8)* * * However, solely for purposes of applying sections 465 and 469 to the income beneficiary, a disposition of S corporation stock by a QSST shall be treated as a disposition by the income beneficiary.

* * * * *

(k)* * *(2) * * *

(i) * * * Paragraphs (b)(1)(i), (e)(1), (e)(3), (h)(1)(vii), (h)(3)(i)(G), and the fifth sentence of paragraph (j)(8) are effective on and after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

* * * * *

(m)* * *(2)* * *

(ii)* * *

(A) The name, address, and taxpayer identification number of the trust, the potential current beneficiaries, and the S corporations in which the trust currently holds stock. If the trust includes a power described in paragraph (m)(4)(vi)(B) of this section, then the election statement must include a statement that such a power is included in the instrument, but does not need to include the name, address, or taxpayer identification number of any particular charity or any other information regarding the power.

* * * * *

(4)* * *

(iii) Special rule for dispositions of stock. Notwithstanding the provisions of paragraph (m)(4)(i) of this section, if a trust disposes of all of the stock which it holds in an S corporation, then, with respect to that corporation, any person who first met the definition of a potential current beneficiary during the 1-year period ending on the date of such disposition is not a potential current beneficiary and thus is not a shareholder of that corporation.

* * * * *

(vi) Currently exercisable powers of appointment and other powers—(A) Powers of appointment. A person to whom a distribution may be made during any period pursuant to a power of appointment (as described for transfer tax purposes in section 2041 and §20.2041-1(b) of this chapter and section 2514 and §25.2514-1(b) of this chapter) is not a potential current beneficiary unless the power is exercised in favor of that person during the period. It is immaterial for purposes of this paragraph (m)(4)(vi)(A) whether such power of appointment is a “general power of appointment” for transfer tax purposes as described in §20.2041-1(c) and §25.2514-1(c) of this chapter. The mere existence of one or more powers of appointment during the lifetime of a power holder that would permit current distributions from the trust to be made to more than the number of persons described in section 1361(b)(1)(A) or to a person described in section 1361(b)(1)(B) or (C), will not cause the S corporation election to terminate unless one or more of such powers are exercised, collectively, in favor of an excessive number of persons or in favor of a person who is ineligible to be an S corporation shareholder. For purposes of this paragraph (m)(4)(vi)(A), a “power of appointment” includes a power, regardless of by whom held, to add a beneficiary or class of beneficiaries to the class of potential current beneficiaries, but generally does not include a power held by a fiduciary who is not also a beneficiary of the trust to spray or sprinkle trust distributions among beneficiaries. Nothing in this paragraph (m)(4)(vi)(A) alters the definition of “power of appointment” for purposes of any provision of the Internal Revenue Code or the regulations.

(B) Powers to distribute to certain organizations not pursuant to powers of appointment. If a trustee or other fiduciary has a power (that does not constitute a power of appointment for transfer tax purposes as described in §§20.2041-1(b) and 25.2514-1(b) of this chapter) to make distributions from the trust to one or more members of a class of organizations described in section 1361(c)(6), such organizations will be counted collectively as only one potential current beneficiary for purposes of this paragraph (m), except that each organization receiving a distribution also will be counted as a potential current beneficiary. This paragraph (m)(4)(vi)(B) shall not apply to a power to currently distribute to one or more particular charitable organizations named in the instrument. Each of such organizations is a potential current beneficiary of the trust.

* * * * *

(8)* * *

Example 2. (i) Invalid potential current beneficiary. Effective January 1, 2005, Trust makes a valid ESBT election. On January 1, 2006, A, a nonresident alien, becomes a potential current beneficiary of Trust. Trust does not dispose of all of its S corporation stock within one year after January 1, 2006. As of January 1, 2006, A is the potential current beneficiary of Trust and therefore is treated as a shareholder of the S corporation. Because A is not an eligible shareholder of an S corporation under section 1361(b)(1), the S corporation election of any corporation in which Trust holds stock terminates effective January 1, 2006. Relief may be available under section 1362(f).

(ii) Invalid potential current beneficiary and disposition of S stock. Assume the same facts as in Example 2 (i) except that within one year after January 1, 2006, trustee of Trust disposes of all Trust’s S corporation stock. A is not considered a potential current beneficiary of Trust and therefore is not treated as a shareholder of any S corporation in which Trust previously held stock.

* * * * *

Example 5.* * *Trust-2 itself will not be counted toward the shareholder limit of section 1361(b)(1)(A).* * *

* * * * *

Example 7. Potential current beneficiaries and powers of appointment. M creates Trust from which A has a right to all net income and funds it with S corporation stock. A also has a currently exercisable power to appoint income or principal to anyone except A, A’s creditors, A’s estate, and the creditors of A’s estate. The potential current beneficiaries of Trust for any period will be A and each person who receives a distribution from Trust pursuant to A’s exercise of A’s power of appointment during that period.

Example 8. Power to distribute to an unlimited class of charitable organizations not pursuant to a power of appointment. M creates Trust from which A has a right to all net income and funds it with S corporation stock. In addition, the trustee of Trust, who is not A or a descendant of M, has the power to make discretionary distributions of principal to the living descendants of M and to any organizations described in section 1361(c)(6). The potential current beneficiaries of Trust for any period will be A, each then-living descendant of M, and each exempt organization described in section 1361(c)(6) that receives a distribution during that period. In addition, the class of exempt organizations will be counted as one potential current beneficiary.

Example 9. Power to distribute to a class of named charitable organizations not pursuant to a power of appointment. M creates Trust from which A has a right to all net income and funds it with S corporation stock. In addition, the trustee of Trust, who is not A or a descendant of M, has the power to make discretionary distributions of principal to the living descendants of M and to X, Y, and Z, each of which is an organization described in section 1361(c)(6). The potential current beneficiaries of Trust for any period will be A, X, Y, Z, and each living descendant of M.

(9) Effective/applicability date. * * *

Paragraphs (m)(2)(ii)(A), (m)(4)(iii) and (vi), and (m)(8), Example 2, Example 5, Example 7, Example 8, and Example 9 are effective on and after the date of publication of the Treasury decision adopting these rules as final regulations is published in the Federal Register.

Par. 4. Section 1.1361-4 is amended by revising paragraph (a)(1) and adding new paragraph (a)(9) to read as follows:

(a) Separate existence ignored—(1) In general. Except as otherwise provided in paragraphs (a)(3), (a)(6), (a)(7), (a)(8), and (a)(9) of this section, for Federal tax purposes—

(i) A corporation which is a QSub shall not be treated as a separate corporation; and

(ii) All assets, liabilities, and items of income, deduction, and credit of a QSub shall be treated as assets, liabilities, and items of income, deduction, and credit of the S corporation.

* * * * *

(9) Information returns—(i) In general. Except to the extent provided by the Secretary, paragraph (a)(1) of this section shall not apply to part III of subchapter A of chapter 61, relating to information returns.

(ii) Effective/applicability date. This paragraph (a)(9) is effective on and after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

* * * * *

Par. 5. Section 1.1361-6 is amended by revising the first sentence as follows:

Except as provided in §§1.1361-4(a)(3)(iii), 1.1361-4(a)(5)(i), 1.1361-4(a)(6)(iii), 1.1361-4(a)(7)(ii), 1.1361-4(a)(8)(ii), 1.1361-4(a)(9), and 1.1361-5(c)(2), the provisions of §§1.1361-2 through 1.1361-5 apply to taxable years beginning on or after January 20, 2000; however, taxpayers may elect to apply the regulations in whole, but not in part (aside from those sections with special dates of applicability), for taxable years beginning on or after January 1, 2000, provided all affected taxpayers apply the regulations in a consistent manner. * * *

Par. 6. Section 1.1362-0 is amended by revising the heading of the table of contents for §1.1362-4 to read as follows:

* * * * *

* * * * *

Par. 7. Section 1.1362-4 is amended by:

1. Revising the section heading and paragraphs (a), (b), (c), (d), and (f).

2. Adding paragraph (g).

The addition and revisions read as follows:

(a) In general. A corporation is treated as continuing to be an S corporation or a QSub (or, an invalid election to be either an S corporation or a QSub is treated as valid) during the period specified by the Commissioner if—

(1) The corporation made a valid election under section 1362(a) or section 1361(b)(3) and the election terminated or the corporation made an election under section 1362(a) or section 1361(b)(3) that was invalid;

(2) The Commissioner determines that the termination or invalidity was inadvertent;

(3) Steps were taken by the corporation to return to or qualify for small business corporation or QSub status within a reasonable period after discovery of the terminating event or invalid election, or the required shareholder consents are acquired; and

(4) The corporation and shareholders agree to adjustments that the Commissioner may require for the period.

(b) Inadvertent termination or inadvertently invalid election. For purposes of paragraph (a) of this section, the determination of whether a termination or invalid election was inadvertent is made by the Commissioner. The corporation has the burden of establishing that under the relevant facts and circumstances the Commissioner should determine that the termination or invalid election was inadvertent. The fact that the terminating event or invalidity of the election was not reasonably within the control of the corporation and, in the case of a termination, was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the knowledge of the corporation, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination or invalidity of the election was inadvertent.

(c) Corporation’s request for determination of an inadvertent termination or invalid election. A corporation that believes that the termination or invalidity of its election was inadvertent may request a determination from the Commissioner that the termination or invalidity of its election was inadvertent. The request is made in the form of a ruling request and should set forth all relevant facts pertaining to the event or circumstance including, but not limited to, the facts described in paragraph (b) of this section, the date of the corporation’s election (or intended election) under section 1362(a) or 1361(b)(3), a detailed explanation of the event or circumstance causing the termination or invalidity, when and how the event or circumstance was discovered, and the steps taken under paragraph (a)(3) of this section.

(d) Adjustments. The Commissioner may require any adjustments that are appropriate. In general, the adjustments required should be consistent with the treatment of the corporation as an S corporation or QSub during the period specified by the Commissioner. In the case of stock held by an ineligible shareholder that causes an inadvertent termination or invalid election for an S corporation under section 1362(f), the Commissioner may require the ineligible shareholder to be treated as a shareholder of the S corporation during the period the ineligible shareholder actually held stock in the corporation. Moreover, the Commissioner may require protective adjustments that prevent the loss of any revenue due to the holding of stock by an ineligible shareholder (for example, a nonresident alien).

* * * * *

(f) Status of corporation. The status of the corporation after the terminating event or invalid election and before the determination of inadvertence is determined by the Commissioner. Inadvertent termination or inadvertent invalid election relief may be granted retroactively for all years for which the terminating event or circumstance giving rise to invalidity is effective, in which case the corporation is treated as if its election was valid or had not terminated. Alternatively, relief may be granted only for the period in which the corporation became eligible for subchapter S or QSub treatment, in which case the corporation is treated as a C corporation or, in the case of a QSub with an inadvertently terminated or invalid election, as a separate C corporation, during the period for which the corporation was not eligible for its intended status.

(g) Effective/applicability date. Paragraphs (a), (b), (c), (d), and (f) of this section are effective on and after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par. 8. Section 1.1366-0 is amended by adding new entries in the table of contents for §1.1366-2(a)(5)(i) through (iii) to read as follows:

* * * * *

(a) * * *

(5) * * * (i) In general.

(ii) Exceptions for transfers of stock under section 1041(a).

(iii) Examples.

Par. 9. Section 1.1366-2(a)(5) is amended by:

1. Adding a heading and revising the first sentence of paragraph (a)(5)(i).

2. Adding paragraphs (a)(5)(ii) and (a)(5)(iii).

The revisions and additions read as follows:

(a) In general.* * *

(5) Nontransferability of losses and deductions—(i) In general. Except as provided in paragraph (a)(5)(ii) of this section, any loss or deduction disallowed under paragraph (a)(1) of this section is personal to the shareholder and cannot in any manner be transferred to another person. * * *

(ii) Exceptions for transfers of stock under section 1041(a). If a shareholder transfers stock of an S corporation after December 31, 2004, in a transfer described in section 1041(a), any loss or deduction with respect to the transferred stock that is disallowed to the transferring shareholder under paragraph (a)(1) of this section shall be treated as incurred by the corporation in the following taxable year with respect to the transferee spouse or former spouse. The amount of any loss or deduction with respect to the stock transferred shall be determined by prorating any losses or deductions disallowed under paragraph (a)(1) for the year of the transfer between the transferor and the spouse or former spouse based on the stock ownership at the beginning of the following taxable year. If a transferor claims a deduction for losses in the taxable year of transfer, then under paragraph (a)(4) of this section, if the transferor’s pro rata share of the losses and deductions in the year of transfer exceeds the transferor’s basis in stock or the indebtedness of the corporation to the transferor, then the limitation must be allocated among the transferor spouse’s pro rata share of each loss or deduction, including disallowed losses and deductions carried over from the prior year.

(iii) Examples. The following examples illustrates the provisions of paragraph (a)(5)(ii) of this section:

Example 1. A owns all 100 shares in X, a calendar year S corporation. For X’s taxable year ending December 31, 2006, A has zero basis in the shares and X does not have any indebtedness to A. For the 2006 taxable year, X had $100 in losses which A cannot use because of the basis limitation in section 1366(d)(1) and which are treated as incurred by the corporation with respect to A in the following taxable year. Halfway through the 2007 taxable year, A transfers 50 shares to B, A’s former spouse in a transfer to which section 1041(a) applies. In the 2007 taxable year, X has $80 in losses. On A’s 2007 individual income tax return, A may use the entire $100 carryover loss from 2006, as well as A’s share of the $80 2007 loss determined under section 1377(a) ($60), assuming A acquires sufficient basis in the X stock. On B’s 2007 individual income tax return, B may use B’s share of the $80 2007 loss determined under section 1377(a) ($20), assuming B has sufficient basis in the X stock. If any disallowed 2006 loss is disallowed to A under section 1366(d)(1) in 2007, that loss is prorated between A and B based on their stock ownership at the beginning of 2008. On B’s 2008 individual income tax return, B may use that loss, assuming B acquires sufficient basis in the X stock. If neither A nor B acquires any basis during the 2007 taxable year, then as of the beginning of 2008, the corporation will be treated as incurring $50 of loss with respect to A and $50 of loss with respect to B for the $100 of disallowed 2006 loss, and the corporation will be treated as incurring $60 of loss with respect to A and $20 with respect to B for the $80 of disallowed 2007 loss.

Example 2. Assume the same facts as Example 1, except that during the 2007 taxable year, A acquires $10 of basis in A’s shares in X. For the 2007 taxable year, A may claim a $10 loss deduction, which represents $6.25 of the disallowed 2006 loss of $100 and $3.75 of A’s 2007 loss of $60. The disallowed 2006 loss is reduced to $93.75. As of the beginning of 2008, the corporation will be treated as incurring half of the remaining $93.75 of loss with respect to A and half of that loss with respect to B for the remaining $93.75 of disallowed 2006 loss, and if B does not acquire any basis during 2007, the corporation will be treated as incurring $56.25 of loss with respect to A and $20 with respect to B for the remaining disallowed 2007 loss.

* * * * *

Par. 10. Section 1.1366-5 is amended by adding a new sentence at the end.

The addition reads as follows:

* * * Paragraphs 1.1366-2(a)(5)(i), (ii) and (iii) are effective on and after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

* * * * *

* * * * *

(d) * * *

(4) Cost-of living adjustment.

* * * * *

* * * * *

(d) Pooled financings — treatment of conduit borrowers.

* * * * *

* * * * *

(k) Certain arbitrage guidance updates.

(1) In general.

(2) Permissive earlier application.

(3) Rebate overpayment recovery.

(4) Small issuer exception to rebate requirement for conduit borrowers of pooled financings.

* * * * *

Par. 3. Section 1.148-3 is amended by revising paragraph (d)(1)(iv) and adding a new paragraph (d)(4) as follows:

* * * * *

(d) * * *

(1) * * *

(iv) On the last day of each bond year during which there are amounts allocated to gross proceeds of an issue that are subject to the rebate requirement, and on the final maturity date, a computation credit of $1,400 for any bond year ending in 2007 and, for bond years ending after 2007, a computation credit in the amount determined under paragraph (d)(4) of this section; and

* * * * *

(4) Cost-of-living adjustment. For any calendar year after 2007, the $1,400 computation credit set forth in paragraph (d)(1)(iv) shall be increased by an amount equal to such dollar amount multiplied by the cost-of-living adjustment determined under section 1(f)(3) for such year as modified by this paragraph (d)(4). In applying section 1(f)(3) to determine this cost-of-living adjustment, the reference to “calendar year 1992” in section 1(f)(3)(B) shall be changed to “calendar year 2006.” If any such increase determined under this paragraph (d)(4) is not a multiple of $10, such increase shall be rounded to the nearest multiple thereof.

* * * * *

Par. 4. Section 1.148-3(j) is amended by revising Example 2(iii)(D) to read as follows:

* * * * *

(j) * * *

Example 2. * * *

(iii) * * *

(D) If the yield during the second computation period were, instead, 7.0000 percent, the rebate amount computed as of July 1, 2004, would be $1,320,891. The future value of the payment made on July 1, 1999, would be $1,471,007. Although the future value of the payment made on July 1, 1999 ($1,471,007), exceeds the rebate amount computed as of July 1, 2004 ($1,320,891), §1.148-3(i) limits the amount recoverable as a defined overpayment of rebate under section 148 to the excess of the total “amount paid” over the sum of the amount determined under the future value method to be the “rebate amount” as of the most recent computation date and all other amounts that are otherwise required to be paid under section 148 as of the date the recovery is requested. Because the total amount that the issuer paid on July 1, 1999 ($1,042,824.60), does not exceed the rebate amount as of July 1, 2004 ($1,320,891), the issuer would not be entitled to recover any overpayment of rebate in this case.

* * * * *

Par. 5. Section 1.148-4(a) is revised to read as follows:

(a) In general. The yield on an issue of bonds is used to apply investment yield restrictions under section 148(a) and to compute rebate liability under section 148(f). Yield is computed under the economic accrual method using any consistently applied compounding interval of not more than one year. A short first compounding interval and a short last compounding interval may be used. Yield is expressed as an annual percentage rate that is calculated to at least four decimal places (for example, 5.2525 percent). Other reasonable, standard financial conventions, such as the 30 days per month/360 days per year convention, may be used in computing yield but must be consistently applied. The yield on an issue that would be a purpose investment (absent section 148(b)(3)(A)) is equal to the yield on the conduit financing issue that financed that purpose investment.

* * * * *

Par. 6. Section 1.148-4 is amended by:

1. Revising paragraph (b)(3)(i), and adding a new sentence at the end of paragraph (h)(2)(ii)(A).

2. Revising the heading and introductory text of paragraph (h)(2)(v).

3. Amending paragraph (h)(2)(v)(B) by revising the last sentence.

4. Adding paragraphs (h)(2)(v)(B)(1), (2) and (3).

5. Adding a new sentence at the end of paragraph (h)(2)(vi).

6. Revising the heading and first sentence of paragraph (h)(2)(viii).

7. Amending paragraph (h)(3)(iv)(B) by adding a new sentence immediately after the first sentence.

8. Adding a new sentence at the end of paragraph (h)(4)(i)(C).

The revised and added provisions read as follows:

* * * * *

(b) * * *

(3) Yield on certain fixed yield bonds subject to optional early redemption—(i) In general. If a fixed yield bond is subject to optional early redemption and is described in paragraph (b)(3)(ii) of this section, the yield on the issue containing the bond is computed by treating the bond as redeemed at its stated redemption price on the optional redemption date that would produce the lowest yield on that bond.

* * * * *

(h) * * *

(2) * * *

(ii) * * * (A) * * * For purposes of applying the definition of periodic payment under §1.446-3 to determine whether a hedge has a significant investment element under this paragraph (h)(2)(ii)(A), the definition of “specified index” under §1.446-3 (upon which periodic payments are required to be based) is deemed also to include payments an issuer receives under a hedge that are computed to be equal to the issuer’s cost of funds, such as the issuer’s actual market-based tax-exempt variable interest rate on its bonds.

* * * * *

(v) Interest-based contract and size and scope of hedge. The contract is primarily interest-based (for example, a hedge based on a debt index rather than an equity index). In addition, the size and scope of the hedge under the contract is limited to that which is reasonably necessary to hedge the issuer’s risk with respect to interest rate changes on the hedged bonds. For example, a contract is limited to hedging an issuer’s risk with respect to interest rate changes on the hedged bonds if the hedge is based on the issuer’s principal amount of bonds and reasonably expected interest requirements rather than based on a greater notional amount or an interest rate level greater than the expected interest requirements. A contract is not primarily interest based unless —

* * * * *

(B) * * * For this purpose, differences that would not prevent the resulting bond from being substantially similar to another type of bond or to result in overhedging include:

(1) A difference between the interest rate used to compute payments on the hedged bond and the interest rate used to compute payments on the hedge where one interest rate is substantially the same as, but not identical to, the other. For this purpose, if an interest rate swap under which the issuer pays the hedge provider a fixed interest payment and receives from the hedge provider a floating interest rate that is based on a taxable interest rate or a taxable market interest rate index, the floating rate on the hedge and the variable rate on the hedged bonds will be treated as being substantially the same only if:

(i) The difference between the interest rate on the issuer’s hedged bonds and the floating interest rate on the hedge does not exceed one quarter of one percent (.25 percent, or 25 basis points) on the date that the issuer enters into the hedge; and

(ii) For a three-year period that ends on the date the issuer enters into the hedge, the average difference between the issuer’s actual tax-exempt interest rate on comparable variable-rate bonds (or, if no such comparable bonds exist, rates from a reasonable tax-exempt interest rate index, such as the SIFMA Municipal Swap Index, for that same period) and interest rates determined in the same manner as the floating interest rate on the hedge and as of the same dates as the issuer’s comparable variable-rate bonds (or the tax-exempt market index, if applicable) does not exceed one-quarter of one percent (.25 percent, or 25 basis points). For example, if the floating rate on the hedge is 67 percent of LIBOR, then 67 percent of LIBOR, determined as of the same dates as the issuer’s actual interest rates (or tax-exempt market index, if applicable) is compared to those actual interest rates (or the tax-exempt market index, if applicable) for the three-year period ending on the date the hedge is entered into and the differences are averaged to determine whether the average difference exceeds one-quarter of one percent. For this purpose, a reasonable sample may be used if the sample for the issuer’s actual rates (or tax-exempt market index rates, if applicable) and the sample of floating rates used for the hedge are determined as of the same dates.

(2) A difference resulting from the payment of a fixed premium for a cap (for example, payments for a cap that are made in other than level installments).

(3) A difference resulting from the allocation of a termination payment if the termination was unexpected as of the date that the parties entered into the hedge contract.

(vi) * * * For this purpose, such payments will be treated as corresponding closely in time under this paragraph (h)(2)(vi) if they are made within 60 calendar days of each other.

* * * * *

(viii) Reasonably contemporaneous identification. The contract must be identified by the actual issuer on its books and records maintained for the hedged bonds not later than 15 calendar days after the date on which the issuer and the hedge provider enter into the hedge contract. * * *

(3) * * *

(iv) * * *

(B) * * * The amount of the termination payment in a termination or deemed termination is equal to the fair market value of the qualified hedge on the date of the termination.* * *

* * * * *

(4) * * *

(i) * * *

(C) * * * Except for an anticipatory hedge that is terminated or otherwise closed substantially contemporaneously with the hedged bond in accordance with paragraph (h)(5)(ii) or (h)(5)(iii) of this section, a hedge based on a taxable interest rate or taxable interest index (for example, the London Interbank Offered Rate or LIBOR) does not meet the requirements of this paragraph (C).

* * * * *

Par. 7. Section 1.148-5(c) is amended by:

1. Removing existing paragraph (c)(3)(ii).

2. Adding introductory language to paragraph (c)(3).

3. Removing the heading in paragraph (c)(3)(i) and redesignating the existing text in paragraph (c)(3)(i)(A) as the text in paragraph (c)(3)(i).

4. Redesignate existing paragraphs (c)(3)(i)(B), (c)(3)(i)(C), (c)(3)(i)(D), (c)(3)(i)(E), (c)(3)(i)(F), and (c)(3)(i)(G) as paragraphs (c)(3)(ii), (c)(3)(iii), (c)(3)(iv), (c)(3)(v), (c)(3)(vi), and (c)(3)(vii), respectively.

5. Redesignate existing paragraphs (c)(3)(i)(C)(1) and (c)(3)(i)(C)(2) as paragraphs (c)(3)(iii)(A) and (c)(3)(iii)(B), respectively, in newly redesignated paragraph (c)(3)(iii).

6. Redesignate existing paragraphs (c)(3)(i)(E)(1) and (c)(3)(i)(E)(2) as paragraphs (c)(3)(v)(A) and (c)(3)(v)(B), respectively, in newly redesignated paragraph (c)(3)(v).

7. Amend newly redesignated paragraph (c)(3)(i), (c)(3)(ii), (c)(3)(iii), (c)(3)(iv), (c)(3)(v), (c)(3)(vi) and (c)(3)(vii) by adding headings to each paragraph.

8. Revise newly redesignated paragraph (c)(3)(v).

9. Revise newly redesignated paragraph (c)(3)(vi).

10. Amend newly redesignated paragraph (c)(3)(vii) by removing the period at the end of the paragraph and replacing it with a semicolon.

11. Amending paragraph (c)(3) by adding new paragraphs (c)(3)(viii) and (c)(3)(ix).

The revised and added provisions read as follows:

* * * * *

(c) * * *

(3) Applicability of special yield reduction rule. Except as otherwise expressly provided in paragraphs (c)(3)(i) through (ix) of this section, paragraph (c) applies only to investments listed in paragraphs (c)(3)(i) through (c)(3)(ix) of this section that are allocated to proceeds of an issue other than gross proceeds of an advance refunding issue.

(i) Nonpurpose investments allocated to proceeds of an issue that qualified for certain temporary periods. * * *

(ii) Investments allocable to certain variable yield issues. * * *

(iii) Nonpurpose investments allocable to certain transferred proceeds. * * *

(A) * * *

(B) * * *

(iv) Purpose investments allocable to certain qualified student loans. * * *

(v) Nonpurpose investments allocable to gross proceeds in certain reserve funds. Nonpurpose investments allocable to gross proceeds of an issue in a reasonably required reserve or replacement fund or a fund that, except for its failure to satisfy the size limitation in §1.148-2(f)(2)(ii), would qualify as a reasonably required reserve or replacement fund, but only to the extent the requirements in paragraphs (c)(3)(v)(A) or (B) of this section are met. This paragraph (c)(3)(v) includes nonpurpose investments described in this paragraph that are allocable to transferred proceeds of an advance refunding issue, but only to the extent necessary to satisfy yield restriction under section 148(a) on those proceeds treating all investments allocable to those proceeds as a separate class.

(A) * * *

(B) * * *

(vi) Nonpurpose investments allocable to certain replacement proceeds of refunded issues. Nonpurpose investments allocated to replacement proceeds of a refunded issue, including a refunded issue that is an advance refunding issue, as a result of the application of the universal cap to amounts in a refunding escrow;

(vii) Investments allocable to replacement proceeds under a certain transition rule. * * *

(viii) Nonpurpose investments allocable to proceeds when SLGS are unavailable. Nonpurpose investments allocable to proceeds of an issue, including an advance refunding issue, that an issuer purchases on a date when the issuer is unable to purchase State and Local Government Series Securities (SLGS) because the U.S. Department of Treasury, Bureau of Public Debt, has suspended sales of those securities; and

(ix) Nonpurpose investments allocable to proceeds of certain variable-yield advance refunding issues. Nonpurpose investments allocable to proceeds of a variable-yield advance refunding issue (the hedged bond issue) deposited in a yield restricted defeasance escrow if—

(A) The issuer has entered into a qualified hedge under §1.148-4(h)(2) with respect to all of the variable-yield bonds of the issue allocable to the yield restricted defeasance escrow and that hedge is in the form of a variable-to-fixed interest rate swap under which the issuer pays the hedge provider a fixed interest rate and receives from the hedge provider a floating interest rate;

(B) Such qualified hedge covers a period beginning on the issue date of the hedged bond issue and ending on or after the date on which the final payment is to be made from the yield restricted defeasance escrow; and

(C) The issuer restricts the yield on the yield restricted defeasance escrow to a yield that is not greater than the yield on the hedged bond issue, determined by taking into account the issuer’s fixed payments to be made under the hedge and by assuming that the issuer’s variable yield payments to be paid on the hedged bonds are equal to the floating payments to be received by the issuer under the qualified hedge and are paid on the same dates (that is, such yield reduction payments can only be made to address basis risk differences between the variable yield payments on the hedged bonds and the floating payments received on the hedge).

* * * * *

Par. 8. Section 1.148-5(d)(6) is amended by revising paragraphs (d)(6)(iii)(A)(1) and (d)(6)(iii)(A)(6) to read as follows:

* * * * *

(d) * * *

(6) * * *

(iii) * * *

(A) * * *

(1) The bid specifications are in writing and are timely forwarded, or are made available on an internet website or other similar electronic media that is regularly used to post bid specifications, to potential bidders. For purposes of this paragraph (d)(6)(iii)(A), a writing includes a hard copy, a fax, or an electronic email copy.

* * * * *

(6) All potential providers have an equal opportunity to bid. If the bidding process affords any opportunity for a potential provider to review other bids before providing a bid, then providers have an equal opportunity to bid only if all potential providers have an equal opportunity to review other bids. Thus, no potential provider may be given an opportunity to review other bids that is not equally given to all potential providers (that is, no exclusive “last look”).

* * * * *

Par. 9. Section 1.148-5(e)(2) is amended by revising the second sentence of paragraph (e)(2)(ii)(B) to read as follows:

* * * * *

(e) * * *

(2) * * *

(ii) * * *

(B) External commingled funds. * * * For purposes of this paragraph (e)(2)(ii)(B), a fund is treated as widely held only if, during the immediately preceding fixed, semiannual period chosen by the fund (for example, semiannual periods ending June 30 and December 31), the fund had a daily average of more than 15 investors that were not related parties, and at least 16 of the unrelated investors each maintained a daily average amount invested in the fund that was not less than the lesser of $500,000 and one percent (1%) of the daily average of the total amount invested in the fund (with it being understood that additional smaller investors will not disqualify the fund). * * *

* * * * *

Par. 10. Section 1.148-8(d) is revised to read as follows:

* * * * *

(d) Pooled financings — treatment of conduit borrowers. A loan to a conduit borrower in a pooled financing qualifies for the small issuer exception, regardless of the size of either the pooled financing or of any loan to other conduit borrowers, only if—

(1) The bonds of the pooled financing are not private activity bonds;

(2) None of the loans to conduit borrowers are private activity bonds; and

(3) The loan to the conduit borrower meets all the requirements of the small issue exception.

* * * * *

Par. 11. Section 1.148-11 is revised by adding new paragraph (k) as follows:

* * * * *

(k) Certain arbitrage guidance updates.

(1) In general. Sections 1.148-3(d)(1)(iv); 1.148-3(d)(4); 1.148-4(a); 1.148-4(b)(3)(i); 1.148-4(h)(2)(ii)(A); 1.148-4(h)(2)(v); 1.148-4(h)(2)(vi); 1.148-4(h)(2)(viii); 1.148-4(h)(3)(iv)(B); 1.148-4(h)(4)(i)(C); 1.148-5(c)(3); 1.148-5(d)(6)(iii)(A) and 1.148-5(e)(2)(ii)(B), as in effect on the effective date of the final regulations (the revised provisions), apply to bonds sold on or after the date that is 90 days after publication of the final regulations in the Federal Register, for bonds subject to such applicable section of the regulations as in effect before the effective date of the final regulations.

(2) Permissive earlier application. To the extent provided in paragraphs (k)(2)(i) through (vi) of this section, issuers may apply the proposed regulations to bonds sold before the date that is 90 days after publication of the final regulations in the Federal Register.

(i) Section 1.148-3(d)(1)(iv) and §1.148-3(d)(4) may be applied for bond years ending on or after the date of publication of the proposed regulations in the Federal Register for bonds to which 1.148-3(d)(1)(iv) applies.

(ii) Section 1.148-4(b)(3)(i) may be applied for bonds sold on or after the date of publication of the proposed regulations in the Federal Register for bonds to which that section applies.

(iii) Sections 1.148-4(h)(2)(ii)(A), 1.148-4(h)(2)(v), 1.148-4(h)(2)(vi), 1.148-4(h)(2)(viii), 1.148-4(h)(3)(iv)(B), and 1.148-4(h)(4)(i)(C) may be applied, in whole but not in part, for qualified hedges entered into on or after the date of publication of the proposed regulations in the Federal Register for bonds to which §1.148-4(h) applies.

(iv) Section 1.148-5(c)(3) may be applied for investments purchased on or after the date of publication of the proposed regulations in the Federal Register for bonds to which that section applies.

(v) Section 1.148-5(d)(6)(iii)(A) may be applied to guaranteed investment contracts entered into on or after the date of publication of the proposed regulations in the Federal Register for bonds to which §1.148-5(d)(6)(iii) applies.

(vi) Section 1.148-5(e)(2)(ii)(B) may be applied with respect to investors investing in the fund on or after the date of publication of the proposed regulations in the Federal Register for bonds to which that section applies.

(3) Rebate overpayment recovery. Section 1.148-3(j) applies to bonds subject to §1.148-3(i).

(4) Small issuer exception to rebate requirement for conduit borrowers of pooled financings. Section 1.148-8(d) applies to bonds issued after May 17, 2006.

* * * * *

(b) * * *

(7) Patented transactions—(i) In general. A patented transaction is a transaction for which a taxpayer pays (directly or indirectly) a fee in any amount to a patent holder or the patent holder’s agent for the legal right to use a tax planning method that the taxpayer knows or has reason to know is the subject of the patent. A patented transaction also is a transaction for which a taxpayer (the patent holder or the patent holder’s agent) has the right to payment for another person’s use of a tax planning method that is the subject of the patent.

(ii) Definitions. For purposes of this paragraph (b)(7), the following definitions apply:

(A) Fee. The term fee means consideration in whatever form paid, whether in cash or in kind, for the right to use a tax planning method that is the subject of a patent. The term fee includes any consideration the taxpayer knows or has reason to know will be paid indirectly to the patent holder or patent holder’s agent, such as through a referral fee, fee-sharing arrangement, or license. The term fee does not include amounts paid in settlement of, or as the award of damages in, a suit for damages for infringement of the patent.

(B) Patent. The term patent means a patent granted under the provisions of title 35 of the United States Code, or any foreign patent granting rights generally similar to those under a United States patent. See §1.1235-2(a). The term patent includes patents that have been applied for but not yet granted.

(C) Patent holder. A person is a patent holder if—

(1) The person is a holder as defined in §1.1235-2(d) and (e);

(2) The person would be a holder as defined in §1.1235-2(d)(2) if the phrase S corporation or trust was substituted for the word partnership and the phrase shareholder or beneficiary was substituted for the words member and partner;

(3) The person is an employer of a holder as defined in §1.1235-2(d) and the holder transferred to the employer all substantial rights to the patent as defined in §1.1235-2(b); or

(4) The person receives all substantial rights to the patent as defined in §1.1235-2(b) in exchange (directly or indirectly) for consideration in any form.

(D) Patent holder’s agent. The term patent holder’s agent means any person who has the permission of the patent holder to offer for sale or exchange, to sell or exchange, or to market a tax planning method that is the subject of a patent. The term patent holder’s agent also means any person who receives (directly or indirectly) for or on behalf of a patent holder a fee in any amount for a tax planning method that is the subject of a patent.

(E) Payment. The term payment includes consideration in whatever form paid, whether in cash or in kind, for the right to use a tax planning method that is the subject of a patent. For example, if a patent holder or patent holder’s agent receives payment for a patented transaction and a separate payment for another transaction, part or all of the payment for the other transaction may be treated as payment for the patented transaction if the facts and circumstances indicate that the payment for the other transaction is in consideration for the patented transaction. The term payment also includes amounts paid in settlement of, or as the award of damages in, a suit for damages for infringement of the patent.

(F) Tax planning method. The term tax planning method means any plan, strategy, technique, or structure designed to affect Federal income, estate, gift, generation skipping transfer, employment, or excise taxes. A patent issued solely for tax preparation software or other tools used to perform or model mathematical calculations or to provide mechanical assistance in the preparation of tax or information returns is not a tax planning method.

(iii) Related parties. For purposes of this paragraph (b)(7), persons who bear a relationship to each other as described in section 267(b) or 707(b) will be treated as the same person.

* * * * *

(c) * * *

(3) * * *

(i) * * *

(F) Patented transactions. A taxpayer has participated in a patented transaction, as defined in paragraph (b)(7) of this section, if the taxpayer’s tax return reflects a tax benefit from the transaction (including a deduction for fees paid in any amount to the patent holder or patent holder’s agent). A taxpayer also has participated in a patented transaction, as defined in paragraph (b)(7) of this section, if the taxpayer is the patent holder or patent holder’s agent and the taxpayer’s tax return reflects a tax benefit in relation to obtaining a patent for a tax planning method (including any deduction for amounts paid to the United States Patent and Trademark Office as required by title 35 of the United States Code and attorney’s fees) or reflects income from a payment received from another person for the use of the tax planning method that is the subject of the patent.

* * * * *

(ii) * * *

Example 4. (i) A, an individual, creates a tax planning method and applies for a U.S. patent. A pays attorney fees in relation to obtaining the patent and A pays the fee required under title 35 of the United States Code for the patent application. Subsequently, C pays a fee to A for the legal right to use the tax planning method that C knows or has reason to know is the subject of A’s patent. A’s tax return reflects both a deduction for an amount paid in relation to obtaining a patent and income from C’s payment to A for the legal right to use the tax planning method that is the subject of the patent. C’s tax return reflects a deduction for an amount paid to A for the right to use the tax planning method that is the subject of the patent.

(ii) A is a patent holder under paragraph (b)(7)(ii)(C)(1) of this section. The transaction is a reportable transaction for A under paragraph (b)(7) of this section because A has the right to payment for another person’s use of the tax planning method that is the subject of the patent. The transaction is a reportable transaction for C under paragraph (b)(7) of this section, because C paid a fee to A for the legal right to use a tax planning method that C knew or had reason to know was the subject of a patent. A has participated in the transaction in the year in which A’s tax return reflects a tax benefit in relation to obtaining the patent or reflects income from C’s payment to A for the legal right to use the tax planning method that is the subject of the patent. C has participated in the transaction in the year in which C’s tax return reflects the deduction for any amount paid to A for the legal right to use the tax planning method that is the subject of the patent. C also participates in the transaction for any years for which any other tax benefit from the transaction is reflected on C’s tax return.

Example 5. (i) A, an individual, is the employee of B, a corporation. A creates a tax planning method and applies for a U.S. patent but B pays the fee required under title 35 of the United States Code for A’s patent application. Pursuant to A’s employment contract with B, B holds all substantial rights to the patent. B’s tax return reflects a deduction for the amount paid in relation to obtaining the patent.

(ii) A and B are patent holders under paragraph (b)(7)(ii)(C)(1) and (3) of this section, respectively. The transaction is not a reportable transaction for A under paragraph (b)(7) of this section because A does not have the right to payment for another person’s use of the tax planning method that is the subject of the patent. The transaction is a reportable transaction for B under paragraph (b)(7) of this section because B holds all substantial rights to the patent and has the right to payment for another person’s use of the tax planning method that is the subject of the patent. B has participated in the transaction in the year in which B’s tax return reflects a tax benefit in relation to obtaining the patent. B also participates in the transaction for any years for which B’s tax return reflects income from a payment received from another person for the use of the tax planning method that is the subject of the patent.

Example 6. (i) Assume the facts as in Example 4, except that A agrees to license the patent to F, a financial institution. The license agreement between A and F provides that F may offer the tax planning method to its clients and if a client decides to use the tax planning method, F must pay A for each client’s use of the tax planning method. F offers the tax planning method to G who uses the tax planning method and knows or has reason to know it is the subject of a patent. F charges G for financial planning services and pays A for G’s use of the tax planning method. A’s tax return reflects income from the payment received from F. F’s tax return reflects income from the payment received from G, and G’s tax return reflects a deduction for the fees paid to F.

(ii) F is a patent holder’s agent under paragraph (b)(7)(ii)(D) of this section because F has the permission of the patent holder to offer for sale or exchange, to sell or exchange, or to market a tax planning method that is the subject of a patent. F also is a patent holder’s agent under paragraph (b)(7)(ii)(D) of this section because F receives (directly or indirectly) a fee in any amount for a tax planning method that is the subject of a patent for or on behalf of a patent holder. The transaction is a reportable transaction for both A and F under paragraph (b)(7) of this section because A and F each have the right to payment for another person’s use of the tax planning method that is the subject of the patent. The transaction is a reportable transaction for G under paragraph (b)(7) of this section because G paid a fee (directly or indirectly) to a patent holder or a patent holder’s agent for the legal right to use a tax planning method that G knew or had reason to know was the subject of the patent. A has participated in the transaction in the years in which A’s tax return reflects income from the payment received from F for G’s use of the tax planning method that is the subject of the patent. F has participated in the transaction in the years in which F’s tax return reflects income from the payment received from G for use of the tax planning method that is the subject of the patent. G has participated in the transaction in the years in which G’s tax return reflects a deduction for the fees paid to F. G also participates in the transaction for any years for which any other tax benefit from the transaction is reflected on G’s tax return.

Example 7. Assume the same facts as in Example 4. J uses a tax planning method that is the same as the tax planning method that is the subject of A’s patent. J does not pay any fees to any patent holder or patent holder’s agent with respect to the tax planning method that is the subject of the patent. A sues J for infringement of the patent and J pays A an amount for damages. A’s tax return reflects as income the amounts for damages received from J. The transaction is not a reportable transaction for J under paragraph (b)(7) of this section because J did not pay any fees (as defined in paragraph (b)(7)(ii)(A) of this section) (directly or indirectly) to a patent holder or patent holder’s agent for the legal right to use a tax planning method that J knew or had reason to know was the subject of the patent. A has participated in a reportable transaction under paragraph (b)(7) of this section in the year in which A’s tax return reflects income from a payment (the amount received as an award for damages in a suit for damages for infringement of the patent) received from another person for the use of the tax planning method that is the subject of a patent.

* * * * *

(h) * * *

(2) Patented transactions. Upon the publication of the Treasury decision adopting these rules as final regulations in the Federal Register, paragraphs (b)(7), (c)(3)(i)(F), and (c)(3)(ii) Examples 4 through 7 of this section will apply to transactions entered into on or after September 26, 2007.

* * * * *

(b) * * *

(2) * * *

(ii) * * *

(E) Patented transactions. A statement relates to a tax aspect of a transaction that causes it to be a patented transaction if the statement is made or provided by the patent holder or by the patent holder’s agent, as defined in §1.6011-4(b)(7)(ii)(C) or (D) of this chapter, and concerns the tax planning method that is the subject of the patent.

* * * * *

(3) * * *

(i) * * *

(C) Patented transactions. For patented transactions described in §1.6011-4(b)(7) of this chapter, the threshold amounts in §301.6111-3(b)(3)(i)(A) are reduced from $50,000 to $250 and from $250,000 to $500.

* * * * *

(i) * * *

(2) Patented transactions. Upon the publication of the Treasury decision adopting these rules as final regulations in the Federal Register, paragraphs (b)(2)(ii)(E) and (b)(3)(i)(C) of this section will apply to transactions with respect to which a material advisor makes a tax statement on or after September 26, 2007.