This document contains amendments to 26 CFR part 1 under section 337(d) of the Internal Revenue Code (Code).

In General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), the Supreme Court held that corporations generally could distribute appreciated property to their shareholders without the recognition of any corporate-level gain (General Utilities doctrine). Beginning with legislation in 1969 and culminating in the Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085), Congress repealed the General Utilities doctrine by enacting section 336(a) to apply gain and loss recognition to liquidating distributions. Section 337(d) directs the Secretary of the Treasury (Secretary) to prescribe regulations that are necessary or appropriate to carry out the purposes of General Utilities repeal, including “regulations to ensure that such purposes may not be circumvented through the use of any provision of law or regulations (including . . . part III of this subchapter) or through the use of a regulated investment company, real estate investment trust, or tax exempt entity. . . .”

On June 8, 2016, the Department of the Treasury (Treasury Department) and the IRS published temporary regulations (TD 9770) under section 337(d) (Temporary Regulations) in the Federal Register (81 FR 36793) effecting the repeal of the General Utilities doctrine as applied to certain transfers of property to RICs and REITs. A notice of proposed rulemaking (REG-126452-15) was published in the Federal Register (81 FR 36816) on the same day (2016 Proposed Regulations). The text of the Temporary Regulations served as the text for part of the 2016 Proposed Regulations, which also included an amendment not included in the Temporary Regulations. A correction to the Temporary Regulations was published in the Federal Register (81 FR 41800) on June 28, 2016.

In response to the 2016 Proposed Regulations, the Treasury Department and the IRS received one written comment and a letter addressed to the Secretary by the Chairmen and Ranking Members of the Ways and Means Committee of the U.S. House of Representatives and the Finance Committee of the U.S. Senate (Letter). The comment requested a public hearing, which was held on November 9, 2016.

After consideration of the written comment, the Letter, and comments made at the public hearing, the Treasury Department and the IRS adopted the 2016 Proposed Regulations, in part, in final regulations (TD 9810) published in the Federal Register (82 FR 5387) on January 18, 2017 (2017 Final Regulations). The 2017 Final Regulations adopted a definition of the term “recognition period” consistent with the definition used in section 1374(d), regarding S corporations, and amended and removed corresponding provisions in the Temporary Regulations. The preamble to the 2017 Final Regulations indicated that the Treasury Department and the IRS would continue to study other issues addressed in the Temporary Regulations and the 2016 Proposed Regulations.

Executive Order 13789 (E.O. 13789), issued on April 21, 2017, instructed the Secretary to review all significant tax regulations issued on or after January 1, 2016, and to take concrete action to alleviate the burdens of regulations that (i) impose an undue financial burden on U.S. taxpayers; (ii) add undue complexity to the Federal tax laws; or (iii) exceed the statutory authority of the IRS. E.O. 13789 further instructed the Secretary to submit to the President within 60 days an interim report identifying regulations that meet these criteria.

Notice 2017-38 (2017-30 I.R.B. 147 (July 24, 2017)) included the Temporary Regulations in a list of eight regulations identified by the Secretary in the interim report as meeting at least one of the first two criteria specified in E.O. 13789. In particular, Notice 2017-38 mentioned a concern raised by commenters that the Temporary Regulations “could result in over-inclusion of gain in some cases, particularly where a large corporation acquires a small corporation that engaged in a Section 355 spinoff and the large corporation subsequently makes a REIT election.” See also Executive Order 13789—Second Report to the President on Identifying and Reducing Tax Regulatory Burdens (Second Report), 82 FR 48013 (October 16, 2017) (stating that the Treasury Department and the IRS “agree that the temporary regulations may produce inappropriate results in some cases”). In response to comments received addressing the Temporary Regulations and the 2016 Proposed Regulations, the Treasury Department and the IRS published a notice of proposed rulemaking (REG-113943-17) addressing the potential over-inclusion of gain in the Federal Register (84 FR 11259) on March 26, 2019 (2019 Proposed Regulations). A correction to the 2019 Proposed Regulations was published in the Federal Register (84 FR 18999) on May 3, 2019. One substantive comment was received in response to the 2019 Proposed Regulations.

This Summary of Comments and Explanation of Revisions discusses the comments received in response to the 2016 Proposed Regulations, Notice 2017-38, and the 2019 Proposed Regulations. However, certain comments received in response to the 2016 Proposed Regulations and Notice 2017-38 were addressed in the Explanation of Provisions in the preamble to the 2019 Proposed Regulations and are not repeated in this Summary of Comments and Explanation of Revisions.

This regulation is not subject to review under section 6(b) of Executive Order 12866 pursuant to the Memorandum of Agreement (April 11, 2018) between the Treasury Department and the Office of Management and Budget regarding review of tax regulations. Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that these final regulations will not have a significant economic impact on a substantial number of small entities. These final regulations would affect transactions in which property of a C corporation becomes the property of a REIT following a section 355 distribution of controlled C corporation stock. Generally, these section 355 distributions involve publicly traded C corporations, which typically are not small entities as defined by the Regulatory Flexibility Act. Transactions in which the property of such C corporation becomes the property of a REIT generally involve the transfer of all of the assets of the C corporation. Therefore, the transferee REIT likely also would not be a small entity, as defined by the Regulatory Flexibility Act. As a result, this certification is based on the conclusion that these final regulations would primarily affect large C corporations and REITs that have substantial numbers of shareholders. Therefore, a regulatory flexibility analysis is not required. Pursuant to section 7805(f) of the Code, the proposed rule preceding this final regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business and no comments were received.

The principal author of these regulations is Austin Diamond-Jones, Office of Associate Chief Counsel (Corporate). However, other personnel from the Treasury Department and the IRS participated in their development.

Accordingly, 26 CFR part 1 is amended as follows:

Part 1—INCOME TAXES

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

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

Par. 2. Section 1.337(d)-7 is amended by:

1. Revising paragraphs (a)(1) and (a)(2)(vi) through (vii).

2. Adding paragraph (a)(2)(viii).

3. Revising paragraphs (b)(4), (c)(1) and (6), (f), and (g)(2)(ii).

The revisions and additions read as follows:

§1.337(d)-7 Tax on property owned by a C corporation that becomes property of a RIC or REIT.

(a) General rule—(1) Property owned by a C corporation that becomes property of a RIC or a REIT. If property owned by a C corporation (as defined in paragraph (a)(2)(i) of this section) becomes the property of a RIC or a REIT in a conversion transaction (as defined in paragraph (a)(2)(ii) of this section), then section 1374 treatment will apply as described in paragraph (b) of this section, unless the C corporation elects, or is treated as electing, deemed sale treatment with respect to the conversion transaction as provided in paragraph (c) of this section. See paragraph (d) of this section for exceptions to this paragraph (a).

(2) * * *

(vi) Section 355 distribution. The term section 355 distribution means any distribution to which section 355 (or so much of section 356 as relates to section 355) applies, including a distribution on which the distributing corporation recognizes gain pursuant to sections 355(d) or 355(e).

(vii) Converted property. The term converted property means—

(A) Property owned by a C corporation that becomes the property of a RIC or a REIT; and

(B) Any other property of a RIC or a REIT the basis of which is determined, directly or indirectly, in whole or in part, by reference to the basis of property described in paragraph (a)(2)(vii)(A) of this section.

(viii) Distribution property. The term distribution property means—

(A) Property owned immediately after a section 355 distribution by the distributing corporation, a controlled corporation (as those terms are defined in section 355(a)(1)), or a member of a separate affiliated group (as defined in section 355(b)(3)(B)) of which the distributing corporation or a controlled corporation is the common parent (but no formulation of the step transaction doctrine will be used to determine whether property acquired after the distribution is distribution property pursuant to this paragraph (a)(2)(viii)(A)); and

(B) Property with a basis determined, directly or indirectly, in whole or in part, by reference to property described in paragraph (a)(2)(viii)(A) of this section.

(b) * * *

(4) Section 355 distribution following a conversion transaction—(i) In general. If a REIT is described in paragraph (f)(1) of this section and the related section 355 distribution (as defined in paragraph (f)(1)(i) of this section) follows a conversion transaction, then for the taxable year in which the related section 355 distribution occurs, §1.1374-2(a)(1) and (2) (as modified by paragraph (b)(2)(i) of this section) do not apply, and the REIT’s net recognized built-in gain for such taxable year is the amount of its net unrealized built-in gain limitation (as defined in §1.1374-2(a)(3)) for such taxable year.

(ii) Basis adjustment—(A) In general. If a REIT recognizes gain under paragraph (b)(4)(i) of this section, the aggregate basis of the converted property held by the REIT at the end of the taxable year in which the related section 355 distribution occurs shall be increased by an amount equal to the amount of gain so recognized, increased by the amount of the REIT’s recognized built-in loss for such taxable year, and reduced by the amount of the REIT’s recognized built-in gain and recognized built-in gain carryover for such taxable year.

(B) Allocation of basis increase. The aggregate increase in basis by reason of paragraph (b)(4)(ii)(A) of this section shall be allocated among the converted property in proportion to their respective built-in gains on the date of the conversion transaction.

* * * * *

(c) Election of deemed sale treatment—(1) In general. Paragraph (b) of this section does not apply if the C corporation that qualifies as a RIC or a REIT or transfers property to a RIC or a REIT makes the election described in paragraph (c)(5) of this section or is treated as making such election under paragraph (c)(6) of this section, except to the extent permitted by paragraph (c)(6)(ii) of this section. A C corporation that makes, or that is treated as making, such an election recognizes gain and loss as if it sold the converted property to an unrelated party at fair market value on the deemed sale date (as defined in paragraph (c)(3) of this section). See paragraph (c)(4) of this section concerning limitations on the use of loss in computing gain. Paragraph (c) of this section does not apply if its application would result in the recognition of a net loss. For this purpose, net loss is the excess of aggregate losses over aggregate gains (including items of income), without regard to character.

* * * * *

(6) Conversion transaction following a section 355 distribution—(i) In general. Except as provided in paragraph (c)(6)(ii) of this section, a C corporation described in paragraph (f)(1) of this section is treated as having made the election under paragraph (c)(5) of this section with respect to a conversion transaction if the conversion transaction occurs following the related section 355 distribution (as defined in paragraph (f)(1)(i) of this section) and the C corporation has not made such an election.

(ii) Limitation. A C corporation treated as having made the election under paragraph (c)(5) of this section as a result of paragraph (c)(6)(i) of this section is not treated as having made the election with respect to property that the taxpayer establishes is not distribution property with respect to the related section 355 distribution. For purposes of this paragraph (c)(6)(ii), any property with an adjusted basis in excess of its fair market value as of the date of the conversion transaction will not be treated as distribution property unless the taxpayer establishes that it owned such asset immediately after the related section 355 distribution. Paragraph (b) of this section will apply to property with respect to which the taxpayer is not treated as having made the election under paragraph (c)(5) of this section as a result of this paragraph (c)(6)(ii).

* * * * *

(f) Conversion transaction preceding or following a section 355 distribution—(1) In general. A C corporation or a REIT is described in this paragraph (f)(1) if—

(i) The C corporation or the REIT engages in a conversion transaction involving a REIT during the twenty-year period beginning on the date that is ten years before the date of a section 355 distribution (the related section 355 distribution); and

(ii) The C corporation or the REIT engaging in the related section 355 distribution is either—

(A) The distributing corporation or the controlled corporation, as those terms are defined in section 355(a)(1); or

(B) A member of the separate affiliated group (as defined in section 355(b)(3)(B)) of the distributing corporation or the controlled corporation.

(2) Predecessors and successors. For purposes of this paragraph (f), any reference to a controlled corporation, a distributing corporation, or a member of the separate affiliated group of a distributing corporation or a controlled corporation includes a reference to any predecessor or successor of such corporation. Successors include corporations which succeed to and take into account items described in section 381(c) of the distributing corporation or the controlled corporation. Predecessors include corporations having such items to which the distributing corporation or the controlled corporation succeeded and took into account.

(3) Exclusion of certain conversion transactions. A C corporation or a REIT is not described in paragraph (f)(1) of this section if—

(i) The distributing corporation and the controlled corporation are both REITs immediately after the related section 355 distribution (including by reason of elections under section 856(c)(1) made after the related section 355 distribution that are effective before the related section 355 distribution) and at all times during the two years thereafter;

(ii) Section 355(h)(1) does not apply to the related section 355 distribution by reason of section 355(h)(2)(B); or

(iii) The related section 355 distribution occurred before December 7, 2015, or is described in a ruling request referred to in section 311(c) of Division Q of the Consolidated Appropriations Act, 2016, Public Law 114-113, 129 Stat. 2422.

(g) * * *

(2) * * *

(ii) Conversion transactions occurring on or after June 7, 2019, and certain prior conversion transactions. Paragraphs (a)(1), (a)(2)(vi), (vii), and (viii), (b)(4), (c)(1) and (6), and (f) of this section apply to conversion transactions occurring on or after June 7, 2019, and to conversion transactions and related section 355 distributions for which the conversion transaction occurs before, and the related section 355 distribution occurs on or after, June 7, 2019. For conversion transactions that occurred on or after June 7, 2016, and before June 7, 2019 (other than conversion transactions and related section 355 distributions for which the conversion transaction occurs before, and the related section 355 distribution occurs on or after, June 7, 2019), see §§1.337(d)-7 and 1.337(d)-7T as contained in 26 CFR part 1 in effect on April 1, 2019.

* * * * *

§1.337(d)-7T [Removed]

Par. 3. Section 1.337(d)-7T is removed.

Kirsten Wielobob,

Deputy Commissioner for Services and Enforcement.

Approved: May 29, 2019.

David J. Kautter,

Assistant Secretary of the Treasury (Tax Policy).

These regulations are proposed to apply to taxable years of United States persons that are shareholders in certain foreign corporations beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register. However, until these regulations are finalized, taxpayers may choose to apply these proposed regulations (other than the proposed regulations under §§1.1297-4 and 1.1297-5) in their entirety to all open tax years as if they were final regulations provided that taxpayers consistently apply the rules of these proposed regulations. Until finalization, United States persons that are shareholders in certain foreign corporations may apply the rules of §§1.1297-4 and 1.1297-5 for taxable years beginning after December 31, 2017, provided those United States persons consistently apply the rules of §§1.1297-4 and 1.1297-5 as if they were final regulations. In addition, taxpayers may continue to rely on Notice 88-22 until these regulations are finalized.

Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are timely submitted to the IRS as prescribed in this preamble under the “Addresses” heading. The Treasury Department and the IRS specifically request comments on all aspects of the proposed rules. All comments will be available for public inspection and copying at www.regulations.gov or upon request. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time and place for the public hearing will be published in the Federal Register.

IRS Revenue Procedures, Revenue Rulings, notices, and other guidance cited in this document are published in the Internal Revenue Bulletin (or Cumulative Bulletin) and are available from the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402, or by visiting the IRS website at www.irs.gov.

The principal drafters of these regulations are Josephine Firehock, Rose E. Jenkins, and Jorge M. Oben of the Office of Associate Chief Counsel (International). Other personnel from the Treasury Department and the IRS also participated in the development of these regulations.

Accordingly, under the authority of 26 U.S.C. 7805, the notice of proposed rulemaking (REG-108214-15) that was published in the Federal Register on April 24, 2015, (80 FR 50814) is withdrawn.

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding entries for §§ 1.1297-1, 1.1297-2, 1.1297-4, 1.1298-2, and 1.1298-4 in numerical order to read in part as follows:

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

Section 1.1297-1 also issued under 26 U.S.C. 1298(g).

Section 1.1297-2 also issued under 26 U.S.C. 1298(g).

* * * * *

Section 1.1297-4 also issued under 26 U.S.C. 1297(b)(2)(B) and 1298(g).

* * * * *

Section 1.1298-2 also issued under 26 U.S.C. 1298(b)(3) and (g).

Section 1.1298-4 also issued under 26 U.S.C. 1298(g).

* * * * *

Par. 2. Section 1.1291-0 is amended by revising the heading for §1.1291-1 and adding entries for §1.1291-1(b)(8)(iv)(A) and (B), (b)(8)(iv)(B)(1) and (2), (b)(8)(iv)(C), and (b)(8)(iv)(C)(1) and (2) to read as follows:

§1.1291-0 Treatment of shareholders of certain passive foreign investment companies; table of contents.

* * * * *

§1.1291-1 Taxation of United States persons that indirectly own PFIC stock.

* * * * *

(b) * * *

(8) * * *

(iv) * * *

(A) Example 1.

(B) Example 2.

(1) Facts.

(2) Results.

(C) Example 3.

(1) Facts.

(2) Results.

* * * * *

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

1. Revising the section heading.

2. Revising the second sentence of paragraph (b)(8)(ii)(B).

3. Revising paragraphs (b)(8)(iii)(A), (B), and (C).

4. Designating Example 1 in paragraph (b)(8)(iv) as paragraph (b)(8)(iv)(A).

5. Adding paragraphs (b)(8)(iv)(B) and (C).

6. Revising paragraph (j)(3).

7. Adding paragraph (j)(4).

The revision and additions read as follows:

§1.1291-1 Taxation of United States persons that indirectly own PFIC stock.

* * * * *

(b) * * *

(8) * * *

(ii) * * *

(B) * * * Sections 1297(d) and 1298(b)(7) and §1.1297-4(b)(2) and (f)(2) do not apply in determining whether a foreign corporation is a PFIC for purposes of this paragraph (b)(8)(ii)(B).

* * * * *

(iii) Ownership through pass-through entities—(A) Partnerships. Except as otherwise provided in this paragraph (b)(8)(iii)(A), if a foreign or domestic partnership directly or indirectly owns stock, the partners of the partnership are considered to own such stock proportionately in accordance with their ownership interests in the partnership. Solely for purposes of determining whether a person satisfies the ownership threshold described in paragraph (b)(8)(ii)(A) of this section with respect to a foreign corporation that is not a PFIC (determined without applying sections 1297(d) and 1298(b)(7)), the first sentence of this paragraph (b)(8)(iii)(A) applies only in the case of a partner that owns 50 percent or more of the ownership interests in the partnership that directly or indirectly owns the stock of the foreign corporation.

(B) S Corporations. Except as otherwise provided in this paragraph (b)(8)(iii)(B), if an S corporation directly or indirectly owns stock, each S corporation shareholder is considered to own such stock proportionately in accordance with the shareholder’s ownership interest in the S corporation. Solely for purposes of determining whether a person satisfies the ownership threshold described in paragraph (b)(8)(ii)(A) of this section with respect to a foreign corporation that is not a PFIC (determined without applying sections 1297(d) and 1298(b)(7)), the first sentence of this paragraph (b)(8)(iii)(B) applies only in the case of a S corporation shareholder that owns 50 percent or more of the ownership interests in the S corporation that directly or indirectly owns the stock of the foreign corporation.

(C) Estates and nongrantor trusts. Except as otherwise provided in this paragraph (b)(8)(iii)(C), if a foreign or domestic estate or nongrantor trust (other than an employees’ trust described in section 401(a) that is exempt from tax under section 501(a)) directly or indirectly owns stock, each beneficiary of the estate or trust is considered to own a proportionate amount of such stock. For purposes of this paragraph (b)(8)(iii)(C), a nongrantor trust is any trust or portion of a trust that is not treated as owned by one or more persons under sections 671 through 679. Solely for purposes of determining whether a person satisfies the ownership threshold described in paragraph (b)(8)(ii)(A) of this section with respect to a foreign corporation that is not a PFIC (determined without applying sections 1297(d) and 1298(b)(7)), the first sentence of this paragraph (b)(8)(iii)(C) applies only in the case of a beneficiary whose proportionate share of the estate or trust that directly or indirectly owns the stock of the foreign corporation is 50 percent or more.

* * * * *

(iv) * * *

(B) Example 2—(1) Facts. A, a United States citizen, owns 50% of the interests in Foreign Partnership, a foreign partnership, the remaining interests in which are owned by an unrelated foreign person. Foreign Partnership owns 100% of the stock of FC1 and 50% of the stock of FC2, the remainder of which is owned by an unrelated foreign person. Both FC1 and FC2 are foreign corporations that are not PFICs (determined without applying sections 1297(d) and 1298(b)(7)). FC1 and FC2 each own 50% of the stock of FC3, a foreign corporation that is a PFIC.

(2) Results. Under paragraph (b)(8)(iii)(A) of this section, for purposes of determining whether A is a shareholder of FC3, A is considered to own 50% (50%x100%), or 50% or more, of FC1, because A owns 50% or more of Foreign Partnership, but 25% (50%x50%) of FC2. Thus, under paragraph (b)(8) of this section, A is considered to own 25% of the stock of FC3 (50%x100%x50%) indirectly through FC1, and thus is a shareholder of FC3 for purposes of the PFIC provisions, but is not considered to own any stock of FC3 indirectly through FC2.

(C) Example 3—(1) Facts. The facts are the same as in paragraph (b)(8)(iv)(B)(1) of this section (the facts in Example 2), except that A owns 40% of the interests in Foreign Partnership.

(2) Results. Under paragraph (b)(8)(iii)(A) of this section, for purposes of determining whether A is a shareholder of FC3, A is not considered to own 50% or more of FC1 or FC2 because it does not own 50% or more of the interests in Foreign Partnership. Thus, under paragraph (b)(8) of this section, A is not considered to own any stock of FC3 indirectly through FC1 or FC2.

* * * * *

(j) * * *

(3) Except as otherwise provided in paragraph (j)(4) of this section, paragraphs (b)(2)(ii) and (v), (b)(7) and (8), and (e)(2) of this section apply to taxable years of shareholders ending on or after December 31, 2013.

(4) Paragraphs (b)(8)(ii)(B), (b)(8)(iii)(A), (B), and (C), and (b)(8)(iv)(B) and (C) of this section apply to taxable years of shareholders beginning on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.

Par. 4. Section 1.1297-0 is amended by revising the introductory text and adding entries for §§1.1297-1, 1.1297-2, and 1.1297-4 in numerical order to read as follows:

§1.1297-0 Table of contents.

This section contains a listing of the headings for §§1.1297-1, 1.1297-2, 1.1297-3, 1.1297-4, and 1.1297-5.

§1.1297-1 Definition of passive foreign investment company.

(a) Overview.

(b) Dividends included in gross income.

(1) General rule.

(2) Example.

(i) Facts.

(ii) Results.

(c) Passive income.

(1) Foreign personal holding company income.

(i) General rule.

(ii) Determination of gross income or gain on a net basis for certain items of foreign personal holding company income.

(iii) Dividends.

(2) Treatment of share of partnership income.

(i) Look-through partnership.

(ii) Less-than-25-percent-owned partnership.

(3) Exception for certain interest, dividends, rents, and royalties received from a related person.

(i) Allocation of interest.

(ii) Allocation of dividends.

(iii) Allocation of rents and royalties.

(iv) Determination of whether amounts are received or accrued from a related person.

(d) Asset test.

(1) Calculation of average annual value (or adjusted bases).

(i) General rule.

(ii) Measuring period.

(A) General rule.

(B) Election to use alternative measuring period.

(C) Short taxable year.

(iii) Adjusted basis.

(A) [Reserved]

(B) Election.

(iv) Time and manner of elections and revocations.

(A) Elections.

(B) Revocations and subsequent elections.

(v) Change in method of measuring assets.

(A) General rule.

(B) Example.

(1) Facts.

(2) Results.

(2) Dual-character assets.

(i) General rule.

(ii) Special rule when only part of an asset produces income.

(iii) Special rule for stock that produced income that was excluded from passive income under section 1297(b)(2)(C).

(iv) Example.

(A) Facts.

(B) Results.

(3) Partnership interest.

(i) Look-through partnership.

(ii) Less-than-25-percent-owned partnership.

(4) Dealer property.

(e) Stapled stock.

(f) Definitions.

(1) Look-through partnership.

(2) Measuring date.

(3) Measuring period.

(4) Non-passive asset.

(5) Non-passive income.

(6) Passive asset.

(7) Passive income.

(8) Tested foreign corporation.

(g) Applicability date.

(1) [Reserved]

(2) In general.

§1.1297-2 Special rules regarding look-through subsidiaries.

(a) Overview.

(b) General rules.

(1) Tested foreign corporation’s ownership of a corporation.

(2) Tested foreign corporation’s proportionate share of the assets and income of a look-through subsidiary.

(i) Proportionate share of assets.

(ii) Proportionate share of income.

(A) General rule.

(B) Special rule.

(iii) Coordination of section 1297(c) with section 1298(b)(7).

(3) Examples.

(i) Example 1.

(A) Facts.

(B) Results.

(ii) Example 2.

(A) Facts.

(B) Results.

(iii) Example 3.

(A) Facts.

(B) Results.

(c) Elimination of certain intercompany assets and income.

(1) General rule for asset test.

(2) General rule for income test.

(3) Partnerships.

(4) Examples.

(i) Example 1.

(A) Facts.

(B) Results.

(ii) Example 2.

(A) Facts.

(B) Results.

(iii) Example 3.

(A) Facts.

(B) Results.

(d) Related person determination for purposes of section 1297(b)(2)(C).

(1) General rule.

(2) Example.

(i) Facts.

(ii) Results.

(e) Treatment of activities of certain look-through subsidiaries and look-through partnerships for purposes of section 954(c)(2)(A) active rents and royalties exception.

(1) General rule.

(2) Examples.

(i) Example 1.

(A) Facts.

(B) Results.

(ii) Example 2.

(A) Facts.

(B) Results.

(f) Gain on disposition of stock in a look-through subsidiary.

(1) Amount of gain taken into account.

(2) Characterization of residual gain as passive income.

(3) Examples.

(i) Example 1.

(A) Facts.

(B) Results.

(ii) Example 2.

(A) Facts.

(B) Results.

(iii) Example 3.

(A) Facts.

(B) Results.

(g) Definitions.

(1) Look-through subsidiary.

(2) LTS debt.

(3) LTS stock.

(4) Residual gain.

(5) Unremitted earnings.

(h) Applicability date.

* * * * *

§1.1297-4 Qualifying insurance corporation.

(a) Scope.

(b) Qualifying insurance corporation.

(c) 25 percent test.

(d) Election to apply the alternative facts and circumstances test.

(1) In general.

(2) Predominantly engaged in an insurance business.

(i) In general.

(ii) Facts and circumstances.

(iii) Examples of facts indicating a foreign corporation is not predominantly engaged in an insurance business.

(3) Runoff-related circumstances.

(4) Rating-related circumstances.

(5) Election.

(i) In general.

(ii) Information provided by foreign corporation.

(iii) Time and manner for making the election.

(e) Rules limiting the amount of applicable insurance liabilities.

(1) In general.

(2) General limitation on applicable insurance liabilities.

(3) Additional limitation on amount of applicable insurance liabilities for a foreign corporation that does not prepare a financial statement based on a financial reporting standard.

(i) In general.

(ii) Choice of accounting method.

(4) Changes to financial statements prepared.

(f) Definitions.

(1) Applicable financial statement.

(2) Applicable insurance liabilities.

(3) Applicable insurance regulatory body.

(4) Financial reporting standard.

(5) Generally accepted accounting principles or GAAP.

(6) Insurance business.

(7) Total assets.

(g) Applicability date.

§1.1297-5 Exception from the definition of passive income for active insurance income.

(a) Scope.

(b) Exclusion from passive income of active insurance income.

(c) Income derived by a QIC in the active conduct of an insurance business.

(1) In general.

(2) Insurance business.

(3) Active conduct of an insurance business.

(i) In general.

(ii) Control test.

(A) Ownership.

(1) Ownership by or of a corporation.

(2) Ownership of a partnership.

(B) Control and supervision.

(C) Compensation.

(4) Active conduct percentage.

(i) In general.

(ii) Related expense determination.

(iii) Ceding commission.

(d) Income of qualifying domestic insurance corporation.

(e) Exclusion of assets for purposes of the passive asset test under section 1297(a)(2).

(f) Treatment of income and assets of certain look-through subsidiaries and look-through partnerships for purposes of the section 1297(b)(2)(B) exception.

(1) General rule.

(2) Applicable statement for tested foreign corporations applying paragraph (g)(1) of this section.

(g) No double counting.

(h) Definitions.

(1) Insurance services.

(2) Investment activity.

(3) Qualifying insurance corporation or QIC.

(i) Applicability date.

Par. 5. Sections 1.1297-1 and 1.1297-2 are added to read as follows:

§1.1297-1 Definition of passive foreign investment company.

(a) Overview. This section provides rules concerning the income test set forth in section 1297(a)(1) and the asset test set forth in section 1297(a)(2). Paragraph (b) of this section provides a rule relating to the definition of gross income for purposes of section 1297. Paragraph (c) of this section sets forth rules relating to the definition of passive income for purposes of section 1297. Paragraph (d) of this section provides rules relating to the asset test of section 1297. See §§1.1297-2 and 1.1298-4 for additional rules concerning the treatment of the income and assets of a corporation subject to look-through treatment under section 1297(c). Paragraph (e) of this section sets forth rules relating to the determination of passive foreign investment company (PFIC) status for stapled entities. Paragraph (f) of this section sets forth definitions applicable for this section, and paragraph (g) of this section sets forth the applicability date of this section.

(b) Dividends included in gross income—(1) General rule. For purposes of section 1297, gross income includes dividends that are excluded from gross income under section 1502 and §1.1502-13.

(2) Example—(i) Facts. USP is a domestic corporation that owns 30% of TFC, a foreign corporation. The remaining 70% of TFC is owned by FP, a foreign corporation that is unrelated to USP. TFC owns 25% of the value of USS1, a domestic corporation. USS1 owns 80% of the value of USS2, a domestic corporation. USS1 and USS2 are members of an affiliated group (as defined in section 1504(a)) filing a consolidated return. USS2 distributes a dividend to USS1 that is excluded from USS1’s income pursuant to §1.1502-13 for purposes of determining the U.S. Federal income tax liability of the affiliated group of which USS1 and USS2 are members.

(ii) Results. Although the dividend received by USS1 from USS2 is excluded from USS1’s income for purposes of determining the U.S. Federal income tax liability of the affiliated group of which USS1 and USS2 are members, pursuant to paragraph (b)(1) of this section, for purposes of section 1297, USS1’s gross income includes the USS2 dividend. Accordingly, for purposes of section 1297, TFC’s gross income includes 25% of the dividend received by USS1 from USS2 pursuant to section 1297(c) and §1.1297-2(b)(2)(ii). See section 1298(b)(7) and §1.1298-4 for rules concerning the characterization of the USS2 dividend.

(c) Passive income—(1) Foreign personal holding company income—(i) General rule. For purposes of section 1297, except as otherwise provided in section 1297(b)(2), this section, and §1.1297-4, the term passive income means income of a kind that would be foreign personal holding company income as defined under section 954(c)(1). For the purpose of this paragraph (c)(1)—

(A) The exceptions to foreign personal holding company income in section 954(c)(1), 954(c)(2)(A) (relating to active rents and royalties), 954(c)(2)(B) (relating to export financing income), 954(c)(2)(C) (relating to dealers), and 954(h) (relating to entities engaged in the active conduct of a banking, financing, or similar business) are taken into account;

(B) The exceptions in section 954(c)(3) (relating to certain income received from related persons), 954(c)(6) (relating to certain amounts received from related controlled foreign corporations), and 954(i) (relating to entities engaged in the active conduct of an insurance business) are not taken into account;

(C) The rules in section 954(c)(4) (relating to sales of certain partnership interests) and 954(c)(5) (relating to certain commodity hedging transactions) are taken into account; and

(D) An entity is treated as a controlled foreign corporation within the meaning of section 957(a) for purposes of applying an exception to foreign personal holding company income in section 954(c) and (h) and for purposes of identifying whether a person is a related person with respect to such entity within the meaning of section 954(d)(3).

(ii) Determination of gross income on a net basis for certain items of foreign personal holding company income. For purposes of section 1297, the excess of gains over losses from property transactions described in section 954(c)(1)(B), the excess of gains over losses from transactions in commodities described in section 954(c)(1)(C), the excess of foreign currency gains over foreign currency losses described in section 954(c)(1)(D), and positive net income from notional principal contracts described in section 954(c)(1)(F) are taken into account as gross income. The excess of gains over losses and positive net income is calculated separately with respect to the tested foreign corporation and each look-through subsidiary (as defined in §1.1297-2(g)(1)).

(iii) Dividends. For purposes of section 1297, the term dividend includes all amounts treated as dividends for purposes of this chapter, including amounts treated as dividends pursuant to sections 302, 304, 356(a)(2), 964(e), and 1248.

(2) Treatment of share of partnership income—(i) Look-through partnership. A tested foreign corporation is treated as if it received directly its share of any item of income of a look-through partnership, and the exceptions to passive income in section 1297(b)(2) and the relevant exceptions to foreign personal holding company income in section 954(c) and (h) that are based on whether income is derived in the active conduct of a business or whether a corporation is engaged in the active conduct of a business apply to such income only if the exception would have applied to exclude the income from passive income or foreign personal holding company in the hands of the partnership, determined by taking into account only the activities of the partnership. See §1.1297-2(e) for rules that allow the activities of certain other entities to be taken into account for purposes of determining the characterization of a tested foreign corporation’s share of partnership income. See also §1.1297-2(d) for rules determining whether a person is a related person for purposes of applying section 1297(b)(2)(C) in the case of income received or accrued by a partnership that is treated as received directly by a tested foreign corporation pursuant to this paragraph (c)(2).

(ii) Less-than-25-percent-owned partnership. For purposes of section 1297, a tested foreign corporation’s share of any item of income of a partnership in which the corporation owns, directly or indirectly, less than 25 percent of the value is treated as passive income.

(3) Exception for certain interest, dividends, rents, and royalties received from a related person—(i) Allocation of interest. For purposes of section 1297(b)(2)(C), interest that is received or accrued, as applicable based on the recipient’s method of accounting, from a related person (as defined in section 1297(b)) is allocated to income of the related person that is not passive income in proportion to the ratio of the portion of the related person’s non-passive income for its taxable year to the total amount of the related person’s income for the taxable year that ends with or within the taxable year of the recipient.

(ii) Allocation of dividends. For purposes of section 1297(b)(2)(C), dividends that are received or accrued, as applicable based on the recipient’s method of accounting, from a related person are allocated to income of the related person that is not passive income based on the relative portion of the related person’s current earnings and profits for its taxable year that ends with or within the taxable year of the recipient that are attributable to non-passive income.

(iii) Allocation of rents and royalties. For purposes of section 1297(b)(2)(C), rents and royalties that are received or accrued, as applicable based on the recipient’s method of accounting, from a related person are allocated to income of the related person that is not passive income to the extent the related person’s deduction for the rent or royalty is allocated to non-passive income of the related person under the principles of §§1.861-8 through 1.861-14T.

(iv) Determination of whether amounts are received or accrued from a related person. For purposes of section 1297(b)(2)(C), the determination of whether interest, dividends, rents, and royalties were received or accrued from a related person is made on the date of the receipt or accrual, as applicable based on the recipient’s method of accounting, of the interest, dividend, rent, or royalty.

(d) Asset test—(1) Calculation of average annual value (or adjusted bases)—(i) General rule. For purposes of section 1297, the calculation of the average percentage of assets held by a tested foreign corporation during its taxable year that produce passive income or that are held for the production of passive income is determined based on the average of the fair market values (or the average of the adjusted bases) of the passive assets and total assets held by the foreign corporation on the last day of each measuring period (measuring date) of the foreign corporation’s taxable year. The average of the fair market values (or the average of the adjusted bases) of the foreign corporation’s passive assets or total assets for the taxable year is equal to the sum of the values (or adjusted bases) of the passive assets or total assets, as applicable, on each measuring date of the foreign corporation’s taxable year, divided by the number of measuring dates in the taxable year.

(ii) Measuring period—(A) General rule. Except as otherwise provided in paragraph (d)(1)(ii)(B) of this section, the measuring periods for a tested foreign corporation are the four quarters that make up the foreign corporation’s taxable year.

(B) Election to use alternative measuring period. The average percentage of assets held by a tested foreign corporation during its taxable year that produce passive income or that are held for the production of passive income may be calculated using a period that is shorter than a quarter (such as a week or month). The same period must be used to measure the assets of the foreign corporation for the first year (including a short taxable year) that this alternative measuring period is used, and for any and all subsequent years, unless a revocation is made. An election to use an alternative measuring period or a revocation of such an election must be made in accordance with the rules of paragraph (d)(1)(iv) of this section.

(C) Short taxable year. For purposes of applying section 1297 to a tested foreign corporation that has a taxable year of less than twelve months (short taxable year), the average values (or adjusted bases) are determined based on the measuring dates of the foreign corporation’s taxable year (determined as if the taxable year were not a short taxable year), and by treating the last day of the short taxable year as a measuring date.

(iii) Adjusted basis. (A) [Reserved]

(B) Election. An election under section 1297(e)(2)(B) with respect to an eligible tested foreign corporation or a revocation of such an election must be made in accordance with the rules of paragraph (d)(1)(iv) of this section.

(iv) Time and manner of elections and revocations—(A) Elections. An owner (as defined in this paragraph (d)(1)(iv)) of a foreign corporation makes an election described in paragraph (d)(1)(ii)(B) or (d)(1)(iii)(B) of this section for a taxable year in the manner provided in the Instructions to Form 8621 (or successor form), if the owner is required to file a Form 8621 (or successor form) with respect to the foreign corporation for the taxable year of the owner in which or with which the taxable year of the foreign corporation for which the election is made ends. If the owner is not required to file Form 8621 (or successor form) with respect to the foreign corporation for the taxable year, the owner makes such an election by filing a written statement providing for the election and attaching the statement to an original or amended Federal income tax return for the taxable year of the owner in which or with which the taxable year of the foreign corporation for which the election is made ends clearly indicating that such election has been made. An election can be made by an owner only if the owner’s taxable year for which the election is made, and all taxable years that are affected by the election, are not closed by the period of limitations on assessments under section 6501. Elections described in in paragraphs (d)(1)(ii)(B) and (d)(1)(iii)(B) of this section are not eligible for relief under §301.9100-3 of this chapter. For purposes of this paragraph (d)(1)(iv), an owner of a foreign corporation is a United States person that is eligible under §1.1295-1(d) to make a section 1295 election with respect to the foreign corporation, or would be eligible under §1.1295-1(d) to make a section 1295 election if the foreign corporation were a PFIC.

(B) Revocations and subsequent elections. An election described in paragraph (d)(1)(ii)(B) or (d)(1)(iii)(B) of this section made pursuant to paragraph (d)(1)(iv)(A) of this section is effective for the taxable year of the foreign corporation for which it is made and all subsequent taxable years of such corporation unless revoked by the Commissioner or the owner (as defined in paragraph (d)(1)(iv)(A) of this section) of the foreign corporation. The owner of a foreign corporation may revoke such an election at any time. If an election described in paragraph (d)(1)(ii)(B) or (d)(1)(iii)(B) of this section has been revoked under this paragraph (d)(1)(iv)(B), a new election described in paragraph (d)(1)(ii)(B) or (d)(1)(iii)(B) of this section, as applicable, cannot be made until the sixth taxable year following the year for which the previous such election was revoked, and such subsequent election cannot be revoked until the sixth taxable year following the year for which the subsequent election was made. The owner revokes the election for a taxable year in the manner provided in the Instructions to Form 8621 (or successor form), if the owner is required to file a Form 8621 (or successor form) with respect to the foreign corporation for the taxable year of the owner in which or with which the taxable year of the foreign corporation for which the election is revoked ends, or by filing a written statement providing for the revocation and attaching the statement to an original or amended Federal income tax return for the taxable year of the owner in which or with which the taxable year of the foreign corporation for which the election is revoked ends clearly indicating that such election has been revoked, if the owner is not required to file Form 8621 (or successor form) with respect to the foreign corporation for the taxable year.

(v) Change in method of measuring assets—(A) General rule. For purposes of section 1297, when stock of a foreign corporation is not publicly traded for an entire taxable year, the assets of the foreign corporation must be measured for all measuring periods of the taxable year on the basis of value if the corporation was publicly traded on the majority of days during the year or section 1297(e)(2) did not otherwise apply to the corporation on the majority of days of the year, and on the basis of adjusted basis otherwise.

(B) Example. The following example illustrates the application of this paragraph (d)(1)(v).

(1) Facts. TFC is a controlled foreign corporation, 90% of the stock of which is wholly owned by USP at the beginning of its taxable year ending December 31 and throughout the year. The remaining 10% of its stock has historically been regularly traded on a national securities exchange that is registered with the Securities and Exchange Commission and continues to be until September 1 of the taxable year, when USP acquires all of it pursuant to a tender offer.

(2) Results. Because TFC was publicly traded on the majority of days during the year, the assets of the foreign corporation must be measured for all measuring periods of the taxable year on the basis of value.

(2) Dual-character assets—(i) General rule. Except as otherwise provided in paragraph (d)(2)(ii) of this section, for purposes of section 1297, an asset (or portion of an asset) that produces both passive income and non-passive income during a taxable year (dual-character asset) is treated as two assets for each measuring period in the taxable year, one of which is a passive asset and one of which is a non-passive asset. The value (or adjusted basis) of the dual-character asset is allocated between the passive asset and the non-passive asset in proportion to the relative amounts of passive income and non-passive income produced by the asset (or portion of an asset) during the taxable year. See paragraph (d)(2)(iii) of this section for a special rule concerning stock that has previously produced dividends subject to the exception provided in section 1297(b)(2)(C).

(ii) Special rule when only part of an asset produces income. For purposes of section 1297, when only a portion of an asset produces income during a taxable year, the asset is treated as two assets, one of which is characterized as a passive asset or a non-passive asset based on the income that it produces, and one of which is characterized based on the income that it is held to produce. The value (or adjusted basis) of the asset is allocated between the two assets pursuant to the method that most reasonably reflects the uses of the property. In the case of real property, an allocation based on the physical use of the property generally is the most reasonable method.

(iii) Special rule for stock that produced income that was excluded from passive income under section 1297(b)(2)(C). Stock with respect to which no dividends are accrued or received, as applicable based on the recipient’s method of accounting, during a taxable year but with respect to which dividends accrued or received, as applicable based on the recipient’s method of accounting, during a prior taxable year were in whole or in part excluded from passive income under section 1297(b)(2)(C) and paragraph (c)(3)(ii) of this section is treated as two assets, one of which is a passive asset and one of which is a non-passive asset. The value (or adjusted basis) of the asset is allocated between the two assets in proportion to the average percentage of dividends that were characterized as passive income, and the average percentage of dividends characterized as non-passive income, for the previous two taxable years pursuant to section 1297(b)(2)(C) and paragraph (c)(3)(ii) of this section.

(iv) Example. The following example illustrates the application of this paragraph (d)(2).

(A) Facts. (1) USP is a domestic corporation that owns 30% of TFC, a foreign corporation. The remaining 70% of TFC is owned by FP, a foreign corporation that is unrelated to USP. TFC owns 20% of the value of FS1, a foreign corporation, and FP owns the remaining 80% of the value of FS1. FP, TFC, and FS1 are not controlled foreign corporations within the meaning of section 957(a), and each has a calendar year taxable year. For purposes of section 1297(b)(2)(C), FP is a “related person” with respect to TFC because FP owns more than 50% of the vote or value of TFC, and FS1 is a “related person” with respect to TFC because FP owns more than 50% of the vote or value of both TFC and of FS1.

(2) During Year 3, FP has only passive income, and FS1 has passive income of $200x and non-passive income of $800x. FS1 does not pay dividends during Year 3, but did pay $100x of dividends in Year 2 and $300x of dividends in Year 1. In Year 2, FS1 had current earnings and profits of $1000x, attributable to passive income of $100x and non-passive income of $900x; and, in Year 1, FS1 had current earnings and profits of $1000x, attributable to passive income of $500x and non-passive income of $500x. Throughout Year 3, TFC holds an obligation of FS1 with respect to which FS1 pays $100x of interest.

(3) In addition to the stock in FS1 and the FS1 obligation, TFC holds an office building, 40% of which is rented to FP throughout Year 3 for $100x per quarter. For the first two quarters of Year 3, 60% of the office building is used by TFC in a trade or business generating non-passive income. For the last two quarters of Year 3, 60% of the office building is rented to an unrelated person for $300x per quarter, and TFC’s own officers or staff of employees regularly perform active and substantial management and operational functions while the property is leased.

(B) Results. (1) Under paragraph (c)(3)(ii) of this section, the dividends paid by FS1 in Year 2 were characterized as 10% passive income and 90% non-passive income. Under paragraph (c)(3)(ii) of this section, the dividends paid by FS1 in Year 1 were characterized as 50% passive income and 50% non-passive income. Accordingly, the average percentage of dividends for the previous two taxable years that were characterized as passive income is 40% (((10% x $100x) + (50% x $300x))/($100x + $300x)), and the average percentage of dividends characterized as non-passive income is 60% (((90% x $100x) + (50% x $300x))/($100x + $300x)). Thus, under paragraph (d)(2)(iii) of this section, 60% of each share of stock of FS1 is characterized as a non-passive asset and 40% is characterized as a passive asset for each quarter of Year 3 for purposes of applying section 1297(a)(2) to determine whether TFC is a PFIC.

(2) Under paragraph (c)(3)(i) of this section, the interest received by TFC from FS1 is characterized as 20% ($200x/($200x+$800x)) passive income and thus 80% non-passive income for purposes of applying section 1297(a)(1) to determine whether TFC is a PFIC. Accordingly, under paragraph (d)(2)(i) of this section, 20% of the obligation of FS1 is characterized as a passive asset and 80% as a non-passive asset for each quarter of Year 3 for purposes of applying section 1297(a)(2) to determine whether TFC is a PFIC.

(3) Under paragraph (c)(3)(iii) of this section, the rent received from FP throughout Year 3 is characterized as 100% passive income. Under paragraph (c)(1)(i)(A) of this section and section 954(c)(2)(A), the rent received from the unrelated person during the last two quarters is characterized as 100% non-passive income. Accordingly, under paragraph (d)(2)(i) of this section, 40% (($100x x 4)/(($100x x 4)+($300x x 2))) of the office building is a passive asset, and 60% (($300x x 2)/(($100x x 4)+($300x x 2))) is a non-passive asset for purposes of applying section 1297(a)(2) to determine whether TFC is a PFIC. Paragraph (d)(2)(ii) of this section does not apply because both portions of the office building generate income during Year 3.

(3) Partnership interest—(i) Look-through partnership. A tested foreign corporation is treated as holding directly its proportionate share of the assets held by a look-through partnership. The rules and principles of sections 701 through 761 apply to determine the corporate partner’s proportionate share of the value of the partnership assets, as well as the proportionate share of the partnership’s adjusted basis in the partnership’s assets (taking into account any adjustments to such basis with respect to such partner under section 743). A tested foreign corporation’s proportionate share of a partnership asset is treated as producing passive income, or being held to produce passive income, to the extent the asset produced, or was held to produce, passive income in the hands of the partnership under the rules in paragraph (c)(2) of this section.

(ii) Less-than-25-percent-owned partnership. For purposes of section 1297, a tested foreign corporation’s interest in a partnership in which the corporation owns, directly or indirectly, less than 25 percent of the value is treated as a passive asset.

(4) Dealer property. For purposes of section 1297(a)(2), an asset that produces, or would produce upon disposition, income or gain that is, or would be, excluded from passive income pursuant to section 954(c)(2)(C) is treated as a non-passive asset.

(e) Stapled stock. For purposes of determining whether stapled entities (as defined in section 269B(c)(2)) are a PFIC, all entities that are stapled entities with respect to each other are treated as a single entity that holds all of the assets of the stapled entities, conducts all of the activities of the stapled entities, and derives all of the income of the stapled entities.

(f) Definitions. The following definitions apply for purposes of this section:

(1) Look-through partnership. The term look-through partnership means, with respect to a tested foreign corporation—

(i) For purposes of section 1297(a)(2), a partnership at least 25 percent of the value of which is owned (as determined under §1.1297-2(b)(1) as if the partnership were a corporation) by the tested foreign corporation on the measuring date; and

(ii) For purposes of section 1297(a)(1), a partnership for which the value owned (as determined under §1.1297-2(b)(1) as if the partnership were a corporation) by the tested foreign corporation on the date on which income is received or accrued by the partnership is at least 25 percent of the value of the partnership.

(2) Measuring date. The term measuring date has the meaning provided in paragraph (d)(1)(i) of this section.

(3) Measuring period. The term measuring period means a quarter or an alternative measuring period, as determined in accordance with paragraph (d)(1)(ii) of this section.

(4) Non-passive asset. The term non-passive asset means an asset other than a passive asset.

(5) Non-passive income. The term non-passive income means income other than passive income.

(6) Passive asset. The term passive asset means an asset that produces passive income, or which is held for the production of passive income, taking into account the rules in paragraphs (c) and (d) of this section.

(7) Passive income. The term passive income has the meaning provided in paragraph (c)(1) of this section.

(8) Tested foreign corporation. The term tested foreign corporation means a foreign corporation the PFIC status of which is being tested under section 1297(a).

(g) Applicability date. (1) [Reserved]

(2) In general. The rules of this section apply to taxable years of shareholders beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

§1.1297-2 Special rules regarding look-through subsidiaries.

(a) Overview. This section provides rules concerning the treatment of income and assets of a look-through subsidiary for purposes of determining whether a tested foreign corporation (as defined in §1.1297-1(f)(8)) is a passive foreign investment company (PFIC) under section 1297(a). Paragraph (b) of this section provides guidance for purposes of section 1297(c) on how to determine a tested foreign corporation’s ownership in a corporation and how to determine a tested foreign corporation’s proportionate share of a look-through subsidiary’s assets and income. Paragraph (c) of this section provides rules that eliminate certain income and assets related to look-through subsidiaries and look-through partnerships (as defined in §1.1297-1(f)(1)) for purposes of determining a tested foreign corporation’s PFIC status. Paragraph (d) of this section sets forth a rule to determine whether certain income received or accrued by look-through subsidiaries and look-through partnerships is received or accrued from a related person for purposes of section 1297(b)(2)(C). Paragraph (e) of this section sets forth rules concerning the attribution of activities from a look-through subsidiary or look-through partnership. Paragraph (f) of this section provides rules for determining the amount of gain from the sale or exchange of stock of a look-through subsidiary that is taken into account under section 1297(a) and for determining the passive or non-passive character of the gain. Paragraph (g) of this section sets forth definitions applicable for this section, and paragraph (h) of this section sets forth the applicability date of this section.

(b) General rules—(1) Tested foreign corporation’s ownership of a corporation. For purposes of section 1297(c) and the regulations in this section, the principles of section 958(a) and the regulations in this chapter under that section applicable to determining direct or indirect ownership by value apply to determine a tested foreign corporation’s percentage ownership (by value) in the stock of another corporation. These principles apply whether an intermediate entity is domestic or foreign.

(2) Tested foreign corporation’s proportionate share of the assets and income of a look-through subsidiary—(i) Proportionate share of assets. For each measuring period (as defined in §1.1297-1(f)(3)), a tested foreign corporation is treated as if it held its proportionate share of each asset of a look-through subsidiary, determined based on the tested foreign corporation’s percentage ownership (by value) (as determined under paragraph (b)(1) of this section)) of the look-through subsidiary on the measuring date (as defined in §1.1297-1(f)(2)).

(ii) Proportionate share of income—(A) General rule. A tested foreign corporation is treated as if it received directly its proportionate share of each item of gross income of a corporation for a taxable year if the corporation is a look-through subsidiary with respect to the tested foreign corporation for the taxable year of the tested foreign corporation. In such case, a tested foreign corporation’s proportionate share of a look-through subsidiary’s gross income is determined based on the corporation’s average percentage ownership (by value) of the look-through subsidiary.

(B) Special rule. When a corporation is not a look-through subsidiary with respect to a tested foreign corporation for a taxable year of the tested foreign corporation, the tested foreign corporation may be treated as if it received directly its proportionate share of the gross income of the first corporation for each measuring period in the year for which the first corporation is a look-through subsidiary, provided that the gross income of the first corporation for each such measuring period can be established. In such case, a tested foreign corporation’s proportionate share of a look-through subsidiary’s gross income is determined based on the tested foreign corporation’s percentage ownership (by value) (as determined under paragraph (b)(1) of this section) of the look-through subsidiary on the relevant measuring date.

(iii) Coordination of section 1297(c) with section 1298(b)(7). A tested foreign corporation is not treated under section 1297(c) and this paragraph (b) as holding its proportionate share of the assets of a domestic corporation, or receiving directly its proportionate share of the gross income of such corporation, if the stock of the corporation is treated as an asset that is not a passive asset (as defined in §1.1297-1(f)(6)) that produces income that is not passive income (as defined in §1.1297-1(f)(7)) under section 1298(b)(7) (concerning the treatment of certain foreign corporations owning stock in certain 25 percent owned domestic corporations). See §1.1298-4 for rules governing the application of section 1298(b)(7).

(3) Examples. The following examples illustrate the rules of this paragraph (b). For purposes of the examples in this paragraph (b)(3), for TFC’s and LTS’s entire taxable years, USP is a domestic corporation; USP owns 30% of TFC; TFC owns the amount of stock of LTS provided in each example; LTS owns 25% of the only class of FS stock; and TFC, LTS, and FS are foreign corporations that are not controlled foreign corporations within the meaning of section 957(a).

(i) Example 1—(A) Facts. TFC directly owns 80% of the only class of LTS stock for TFC’s and LTS’s entire taxable year. Pursuant to the principles of section 958(a), TFC owns 80% of the value of LTS, LTS owns 25% of the value of FS, and TFC owns 20% of the value of FS.

(B) Results. Under paragraph (b) of this section, in determining whether LTS is a PFIC under section 1297(a), LTS is treated as if it held 25% of each of FS’s assets on each of the measuring dates in its taxable year, and received directly 25% of the gross income of FS for the taxable year. In determining whether TFC is a PFIC under section 1297(a), TFC is treated as if it held an 80% interest in each of LTS’s assets on each of the measuring dates in its taxable year, and received directly 80% of the income of LTS for the taxable year. However, TFC is treated as if it held a 20% interest in the stock of FS (and not the assets of FS), and received 80% of any dividends paid from FS to LTS (and not any income of FS).

(ii) Example 2—(A) Facts. TFC directly owns 25% of the only class of LTS stock on the last day of each of the first three quarters of its taxable year, but disposes of its entire interest in LTS during the fourth quarter of its taxable year. Pursuant to the principles of section 958(a), on each of its first three measuring dates, TFC owns 25% of the value of LTS and 6.25% of the value of FS.

(B) Results. Under paragraph (b) of this section, in determining whether TFC is a PFIC under section 1297(a), TFC is treated as if it held 25% of LTS’s assets on each of the first three measuring dates in its taxable year. However, because it held an average of 18.75% of the value of LTS on the measuring dates in the taxable year, it is not treated as receiving directly the gross income of LTS for the taxable year. If information about the gross income for LTS for each of the first three quarters of its taxable year is available, TFC may be treated as receiving directly 25% of the income of LTS for each of those quarters, because it owned 25% of the value of LTS on the measuring dates with respect to those measuring periods. For each of its first three quarters, TFC is treated as if it held a 6.25% interest in the stock of FS (and not the assets of FS) and may, if information about the income for LTS for each of the first three quarters of its taxable year is available, be treated as receiving 25% of any dividends paid from FS to LTS (and not any income of FS).

(iii) Example 3—(A) Facts. TFC directly owns 100% of the only class of LTS stock for TFC’s and LTS’s entire taxable year. Pursuant to the principles of section 958(a), TFC owns 100% of the value of LTS, and TFC owns 25% of the value of FS. TFC earns $5x of rents from renting a building to LTS, a related person with respect to TFC within the meaning of section 954(d)(3). TFC also sells one item of property described in section 954(c)(1)(B)(i) for a gain of $25x and another for a loss of $10x, and no exception from passive income applies to either amount. LTS has $100x of revenues from selling property described in section 1221(a)(1) to unrelated persons, but $150x of cost of goods sold with respect to such property. None of LTS’s deduction for the rent paid to TFC is allocated to non-passive income under the principles of §§1.861-8 through 1.861-14T. During the taxable year, FS sells one item of property described in section 954(c)(1)(B)(i) for a gain of $50x and another for a loss of $100x, and no exception from passive income applies to either amount.

(B) Results. Under paragraph (b) of this section, in determining whether TFC is a PFIC under section 1297(a), TFC is treated as if it held 100% of LTS’s assets on each of the measuring dates in its taxable year, and received directly 100% of the gross income of LTS for the taxable year. Accordingly, TFC is treated as receiving directly $0x of gross income from the sale of property by LTS given that LTS revenues are fully offset by costs of goods sold. Furthermore, TFC is treated as if it held a 25% interest in FS’s assets, and received directly 25% of the gross income of FS. Pursuant to §1.1297-1(c)(1)(ii), only the excess of gains over losses from property transactions described in section 954(c)(1)(B) is taken into account as gross income for purposes of section 1297. Accordingly, TFC is treated as receiving directly $0x of gross income from the sales of property by FS. TFC’s rental income constitutes passive income pursuant to §1.1297-1(c) and section 954(c)(1)(A), the exception in section 954(c)(2)(A) does not apply, and, taking into account §1.1297-1(c)(3)(iii), section 1297(b)(2)(c) does not apply to characterize any of the rental income as non-passive income. TFC’s income from its sales of property constitutes passive income pursuant to §1.1297-1(c) and section 954(c)(1)(B), although, pursuant to §1.1297-1(c)(1)(ii), only the excess of gains over losses is taken into account as gross income for purposes of section 1297. As a result, TFC’s income, all of which is passive income, equals $20x ($5x + ($25x-$10x)) of gross income.

(c) Elimination of certain intercompany assets and income—(1) General rule for asset test. For purposes of section 1297, a tested foreign corporation does not take into account the value (or adjusted basis) of stock of a look-through subsidiary (LTS stock) or its proportionate share of an obligation of a look-through subsidiary (LTS debt) that it owns on a measuring date, including LTS stock and LTS debt that it is treated as owning pursuant to section 1297(c) and paragraph (b)(2) of this section or §1.1297-1(c)(2). The tested foreign corporation’s proportionate share of a LTS debt is the value (or adjusted basis) of the debt multiplied by the tested foreign corporation’s percentage ownership (by value) in the debtor look-through subsidiary. Furthermore, for purposes of section 1297, a tested foreign corporation does not take into account the value (or adjusted basis) of stock or obligations of the tested foreign corporation that it is treated as owning pursuant to section 1297(c) and paragraph (b)(2) of this section or §1.1297-1(c)(2).

(2) General rule for income test. For purposes of section 1297, a tested foreign corporation does not take into account dividends derived with respect to LTS stock or its proportionate share of interest derived with respect to LTS debt, including amounts that it is treated as receiving pursuant to section 1297(c) and paragraph (b)(2) of this section or §1.1297-1(c)(2), other than dividends that are attributable to income that was not treated as received directly by the tested foreign corporation pursuant to paragraph (b)(2) of this section. The tested foreign corporation’s proportionate share of interest is the amount of interest multiplied by the tested foreign corporation’s percentage ownership (by value) in the debtor look-through subsidiary. Furthermore, for purposes of section 1297, a tested foreign corporation does not take into account dividends or interest with respect to stock or obligations of the tested foreign corporation that it is treated as receiving pursuant to section 1297(c) and paragraph (b)(2) of this section or §1.1297-1(c)(2).

(3) Partnerships. For purposes of section 1297, the principles of paragraphs (c)(1) and (2) of this section apply with respect to ownership interests in and debt of a look-through partnership and with respect to distributions by a look-through partnership, other than distributions that are attributable to income that was not treated as received directly by the tested foreign corporation pursuant to §1.1297-1(c)(2), and interest derived with respect to the debt of a look-through partnership.

(4) Examples. The following examples illustrate the rules of this paragraph (c). For purposes of the examples in this paragraph (c)(4), USP is a domestic corporation; USP owns 30% of TFC; TFC, LTS1, and LTS2 are foreign corporations that are not controlled foreign corporations within the meaning of section 957(a); FPS is a foreign partnership; and TFC, LTS1, and LTS2 measure assets for purposes of section 1297(a)(2) based on value.

(i) Example 1—(A) Facts. TFC directly owns 40% of the value of LTS1 stock on each of the measuring dates, and thus is treated under paragraph (b)(1) of this section as owning 40% of LTS1 on each of the measuring dates. TFC’s assets include a loan to LTS1 with a balance of $1,000x on each of the measuring dates. During the first quarter of the taxable year, TFC received $20x of dividends from LTS1, which were attributable to income of LTS1 treated as received directly by TFC pursuant to paragraph (b)(2) of this section, and $30x of interest on the loan, both of which were paid in cash.

(B) Results. Under paragraph (c) of this section, for purposes of applying section 1297(a), TFC’s assets do not include the stock of LTS1, and TFC’s income does not include the $20x of dividends received from LTS1. Similarly, TFC’s assets include only $600x ($1,000x loan – (40% x $1,000x)) of the loan to LTS1, and TFC’s income includes only $18x ($30x interest – (40% x $30x)) of the interest from LTS1. However, TFC’s assets include the entire $50x of cash ($20x of dividends and $30x of interest) received from LTS1.

(ii) Example 2—(A) Facts. The facts are the same as in paragraph (c)(4)(i)(A) of this section (the facts in Example 1), except that TFC also directly owns 30% of the value of LTS2 stock on each of the measuring dates, and thus is treated under paragraph (b)(1) of this section as owning 30% of LTS2, and LTS1’s assets also include a loan to LTS2 with a balance of $200x on each of the measuring dates. During the first quarter of the taxable year, LTS1 received $5x of interest on the loan, which was paid in cash.

(B) Results. The results are the same as in paragraph (c)(4)(i)(B) of this section (the results in Example 1), except that TFC’s assets also do not include the stock of LTS2. Similarly, although TFC would be treated under paragraph (b)(2) of this section as owning $80x (40% x $200x) of the LTS1 loan to LTS2, under paragraph (c) of this section, TFC does not take into account $60x (30% x $200x)) of the loan to LTS2, and accordingly, its assets include only $20x ($80x-$60x) of the loan to LTS1. Furthermore, although TFC would be treated under paragraph (b)(2) of this section as receiving $2x (40% x $5x) of the interest received by LTS1 from LTS2, under paragraph (c) of this section, TFC does not take into account $1.5x (30% x $5x) of the interest received by LTS1, and accordingly, its income includes only $0.5x ($2x-$1.5x) of the interest from LTS2. Furthermore, TFC’s assets include $2x (40% x $5x) of LTS1’s cash received from LTS2.

(iii) Example 3—(A) Facts. TFC directly owns 80% of the value of LTS1 stock on each of the measuring dates, and thus is treated under paragraph (b)(1) of this section as owning 80% of LTS1 on each of the measuring dates. TFC also directly owns 50% of the value in FPS on each of the measuring dates. LTS1’s assets include the remaining 50% of the value in FPS and a loan to FPS with a balance of $500x on each of the measuring dates. FPS’s assets include a loan to TFC with a balance of $1000x on each of the measuring dates. During the first measuring period of the taxable year, FPS received $30x of interest from TFC, and LTS1 received $15x of interest from FPS, both of which were paid in cash. During the last measuring period of the taxable year, FPS received $80x of income from an unrelated person in cash and distributed $60x of such income in cash to TFC and LTS1 in proportion to their interests in FPS.

(B) Results. Under paragraph (c) of this section, for purposes of applying section 1297(a), TFC’s assets do not include the stock of LTS1, the interests in FPS owned by TFC directly and through LTS1, any of the loan by FPS to TFC, or any of the loan by LTS1 to FPS. Similarly, TFC’s income does not include any of the $30x of interest received by FPS from TFC, any of the $15x of interest received by LTS1 from FPS, or any of the $60x of distributions received by TFC and LTS1 from FPS. However, on each of the measuring dates, TFC’s assets include $27x ((50% x $30x) + (80% x 50% x $30x)) of the $30 of cash received by FPS from TFC and $12x (80% x $15x) of the $15 of cash received by LTS1 from FPS. Moreover, on the last measuring date of the taxable year, TFC’s assets include $18x ((50% x $20x) + (80% x 50% x $20x)) of the $20x ($80x - $60x) of cash received by FPS from the unrelated person and retained and $54 ((50% x $60x) + (80% x 50% x $60x)) of the $60x cash received by FPS from the unrelated person and distributed. Furthermore, TFC’s income includes $72x ((50% x $80x) + (80% x 50% x $80x)) of the $80x of income received by FPS from an unrelated person.

(d) Related person determination for purposes of section 1297(b)(2)(C)—(1) General rule. For purposes of section 1297(b)(2)(C), interest, dividends, rents, or royalties received or accrued by a look-through subsidiary (and treated as received directly by a tested foreign corporation pursuant to section 1297(c) and paragraph (b)(2) of this section) are considered received or accrued from a related person only if the payor of the interest, dividend, rent or royalty is a related person (within the meaning of section 954(d)(3)) with respect to the look-through subsidiary, taking into account §1.1297-1(c)(1)(i)(D). Similarly, for purposes of 1297(b)(2)(C), interest, dividends, rents, or royalties received or accrued by a look-through partnership (and treated as received directly by a tested foreign corporation pursuant to §1.1297-1(c)(2)) are considered received or accrued from a related person only if the payor of the interest, dividend, rent or royalty is a related person (within the meaning of section 954(d)(3)) with respect to the look-through partnership, taking into account §1.1297-1(c)(1)(i)(D).

(2) Example. The following example illustrates the rule of this paragraph (d).

(i) Facts. USP is a domestic corporation that owns 30% of TFC. TFC directly owns 30% of the value of FS1 stock, and thus under paragraph (b) of this section is treated as owning 30% of FS1. FS1 directly owns 60% of the vote of FS2 stock and 20% of the value of FS2 stock. The remaining vote and value of FS2 stock are owned by an unrelated foreign person. TFC, FS1, and FS2 are foreign corporations that are not controlled foreign corporations within the meaning of section 957(a). FS1 receives a $100x dividend from FS2.

(ii) Results. Pursuant to section 1297(c) and paragraph (b)(2) of this section, TFC is treated as receiving directly $30x of the dividend income received by FS1. FS2 is a “related person” with respect to FS1 for purposes of section 1297(b)(2)(C) because FS1 owns more than 50% of the vote of FS2. FS2 is not a “related person” with respect to TFC for purposes of section 1297(b)(2)(C). Under paragraph (d) of this section, for purposes of determining whether the dividend income received by FS1 is subject to the exception in section 1297(b)(2)(C) for purposes of testing the PFIC status of TFC, the dividend is treated as received from a related person because FS1 and FS2 are related persons within the meaning of section 1297(b)(2)(C). Therefore, to the extent the dividend income received by FS1 would be properly allocable to income of FS2 that is not passive income, the dividend income that TFC is treated as receiving under section 1297(c) is treated as non-passive income (as defined in §1.1297-1(f)(5)).

(e) Treatment of activities of certain look-through subsidiaries and look-through partnerships for purposes of section 954(c)(2)(A) active rents and royalties exception—(1) General rule. An item of rent or royalty income received by a tested foreign corporation (including an amount treated as received or accrued pursuant to section 1297(c) and paragraph (b)(2) of this section or pursuant to §1.1297-1(c)(2)) that would be passive income in the hands of the entity that actually received or accrued it is not passive income pursuant to §1.1297-1(c)(1)(i)(A) and section 954(c)(2)(A) if the item would be excluded from foreign personal holding company income under section 954(c)(2)(A) and §1.954-2(b)(6), (c), and (d), determined by taking into account the activities performed by the officers and staff of employees of the tested foreign corporation as well as activities performed by the officers and staff of employees of any look-through subsidiary in which the tested foreign corporation owns more than 50 percent by value (as determined under paragraph (b)(1) of this section) and any look-through partnership in which the tested foreign corporation owns, directly or indirectly, more than 50 percent.

(2) Examples. The following examples illustrate the rule of this paragraph (e).

(i) Example 1—(A) Facts. USP is a domestic corporation that directly owns 20% of the outstanding stock of FS1. The remaining 80% of the outstanding stock of FS1 is directly owned by a foreign person that is not related to USP. FS1 directly owns 100% of the value of the outstanding stock of FS2 and directly owns 80% of the value of the outstanding stock of FS3. The remaining 20% of the outstanding stock of the value of the FS3 is directly owned by a foreign person that is not related to USP. FS2 directly owns 80% of the value of the outstanding stock of FS4. The remaining 20% of the value of the outstanding stock of FS4 is directly owned by a foreign person that is not related to USP. FS1, FS2, FS3 and FS4 are all organized in Country A and are not controlled foreign corporations within the meaning of section 957(a). FS4 owns real property that is leased to a person that is not a related person, but does not perform any activities. FS1 and FS2 also do not perform any activities. Officers and employees of FS3 in Country A perform activities with respect to the real property of FS4 that, if performed by officers or employees of FS4, would allow the rental income in the hands of FS4 to qualify for the exception from foreign personal holding company income in section 954(c)(2)(A) and §1.954-2(b)(6) and (c)(1)(ii).

(B) Results. Under this paragraph (e), for purposes of determining whether the rental income treated under section 1297(c) and paragraph (b)(2) of this section as received directly by FS1 with respect to the real property owned and rented by FS4 is passive income for purposes of section 1297, the activities of FS3 are taken into account as a result of FS1’s ownership of 80% by value (as determined under paragraph (b)(1) of this section) of FS3. Thus, the exception in section 954(c)(2)(A) would apply, and the rental income treated as received by FS1 would be treated as non-passive income for purposes of determining whether FS1 is a PFIC. Because FS2 and FS4 do not own more than 50 percent by value (as determined under paragraph (b)(1) of this section) of FS3, the activities of FS3 are not taken into account for purposes of determining whether the rental income treated as received by FS2 and actually received by FS4 with respect to the real property owned and rented by FS4 is passive income for purposes of section 1297. Thus, the exception in section 954(c)(2)(A) would not apply, and the rental income treated as received by FS2 and actually received by FS4 would be treated as passive income for purposes of determining whether FS2 and FS4 are PFICs.

(ii) Example 2—(A) Facts. The facts are the same as in paragraph (e)(2)(i)(A) of this section (the facts in Example 1), except that FS2 also owns real property that is leased to a person that is not a related person, and the officers and employees of FS2 in Country A engage in activities that would allow rental income received by FS2 with respect to its real property to qualify for the exception in section 954(c)(2)(A) and §1.954-2(b)(6) and (c)(1)(iv), relying on the rule in §1.954-2(c)(2)(ii) that provides that an organization is substantial in relation to rents if active leasing expenses equal or exceed 25 percent of adjusted leasing profit. However, the active leasing expenses of FS1 are less than 25 percent of its adjusted leasing profit, which includes the rental income of FS4 treated as received directly by FS1 as well as the rental income of FS2 treated as received directly by FS1.

(B) Results. Because FS2’s rental income constitutes non-passive income as a result of the application of §1.1297-1(c)(1)(i)(A) and section 954(c)(2)(A), it is treated as non-passive income treated as received by FS1 for purposes of determining whether FS1 is a PFIC, and accordingly, it is not necessary to rely on paragraph (e) of this section.

(f) Gain on disposition of stock in a look-through subsidiary—(1) Amount of gain taken into account. The amount of gain derived from a tested foreign corporation’s direct disposition of stock of a look-through subsidiary, or an indirect disposition resulting from the disposition of stock of a look-through subsidiary by other look-through subsidiaries or by look-through partnerships, that is taken into account by the tested foreign corporation for purposes of section 1297(a)(1), section 1298(b)(3), and §1.1298-2 is the residual gain. The residual gain equals the total gain recognized by the tested foreign corporation (including gain treated as recognized by the tested foreign corporation pursuant to section 1297(c) and paragraph (b)(2) of this section or §1.1297-1(c)(2)) from the disposition of the stock of the look-through subsidiary reduced (but not below zero) by unremitted earnings. Unremitted earnings are the excess (if any) of the aggregate income (if any) taken into account by the tested foreign corporation pursuant to section 1297(c) and paragraph (b)(2) of this section or §1.1297-1(c)(2) with respect to the stock of the disposed-of look-through subsidiary (including with respect to any other look-through subsidiary, to the extent it is owned by the tested foreign corporation indirectly through the disposed-of look-through subsidiary) over the aggregate dividends (if any) received by the tested foreign corporation from the disposed-of look-through subsidiary with respect to the stock. For purposes of this paragraph (f)(1), the amount of gain derived from the disposition of stock of a look-through subsidiary and income of and dividends received from the look-through subsidiary is determined on a share-by-share basis.

(2) Characterization of residual gain as passive income. For purposes of section 1297(a)(1), section 1298(b)(3), and §1.1298-2, the residual gain is characterized as passive income or non-passive income based on the relative amounts of passive assets and non-passive assets (as defined in §1.1297-1(f)(6) and (4), respectively) of the disposed-of look-through subsidiary (and any other look-through subsidiary to the extent owned indirectly through the look-through subsidiary) treated as held by the tested foreign corporation on the date of the disposition of the look-through subsidiary. For the purpose of this paragraph (f)(2), the relative amounts of passive assets and non-passive assets held by the look-through subsidiary are measured under the same method (value or adjusted bases) used to measure the assets of the tested foreign corporation for purposes of section 1297(a)(2).

(3) Examples. The following examples illustrate the rules of this paragraph (f). For purposes of the examples in this paragraph (f)(3), USP is a domestic corporation, TFC and FS are foreign corporations that are not controlled foreign corporations within the meaning of section 957(a), and USP, TFC, and FS each has outstanding a single class of stock with 100 shares outstanding and a calendar taxable year.

(i) Example 1—(A) Facts. USP owned 30% of the outstanding stock of TFC throughout Years 1, 2, 3, and 4. In Year 1, TFC purchased 5 shares of FS stock, representing 5% of the stock of FS, from an unrelated person. On the first day of Year 3, TFC purchased 20 shares of FS stock, representing 20% of the stock of FS, from an unrelated person. TFC owned 25% of the outstanding stock of FS throughout Years 3 and 4. Prior to Year 3, TFC did not include any amount in income with respect to FS under section 1297(c)(2). During Years 3 and 4, for purposes of section 1297(a)(1), TFC included in income, in the aggregate, $40x of income with respect to FS under section 1297(c) and paragraph (b)(2) of this section. TFC did not receive dividends from FS during Year 1, 2, 3, or 4. For purposes of section 1297(a)(2), TFC measures its assets based on their fair market value as provided under section 1297(e). On the last day of Year 4, TFC recognizes a loss with respect to the sale of 5 shares of FS stock, and a $110x gain with respect to the sale of 20 shares of FS stock. On the date of the sale, FS owns non-passive assets with an aggregate fair market value of $150x, and passive assets with an aggregate fair market value of $50x.

(B) Results. For purposes of applying section 1297(a)(1) to TFC for Year 4, TFC must take into account $78x of residual gain, as provided by paragraph (f)(1) of this section, which equals the amount by which the $110x gain recognized on the sale of 20 shares exceeds the aggregate pro rata share of $32x income ($40x x 20/25) taken into account by TFC with respect to the 20 shares in FS under section 1297(c) and paragraph (b)(2) of this section during Years 3 and 4. There is zero residual gain on the sale of 5 shares of FS stock because they were sold at a loss. Under paragraph (f)(2) of this section, $58.50x of the residual gain is non-passive income ($78x x ($150x/$200x)) and $19.50x is passive income ($78x x ($50x/$200x)).

(ii) Example 2—(A) Facts. The facts are the same as in paragraph (f)(3)(i)(A) of this section (the facts in Example 1), except that in Year 1, TFC purchased 15 shares of FS stock, representing 15% of the stock of FS, from an unrelated person, and on the first day of Year 3, TFC purchased an additional 15 shares of FS stock, representing 15% of the stock of FS, from an unrelated person, and on the last day of Year 4, TFC recognizes gain of $10x of the sale of 15 shares of FS stock purchased in Year 1, and gain of $60x on the sale of the other 15 shares of FS stock purchased in Year 3.

(B) Results. For purposes of applying section 1297(a)(1) to TFC for Year 4, TFC must take into account $40x of residual gain, as provided by paragraph (f)(1) of this section, which equals the amount by which the $60x gain recognized on the sale of the 15 shares acquired in Year 3 exceeds the pro rata aggregate share of $20x income ($40x x 15/30) taken into account by TFC with respect to the 15 shares in FS under section 1297(c)(2) during Years 3 and 4. There is zero residual gain on the sale of the other 15 shares of FS stock because the $10x of gain does not exceed the aggregate pro rata share of $20x income taken into account by TFC with respect to the other 15 shares of FS under section 1297(c) and paragraph (b)(2) of this section. Under paragraph (f)(2) of this section, $30x of the residual gain is non-passive income ($40x x ($150x/$200x)) and $10x is passive income ($40x x ($50x/$200x)).

(iii) Example 3—(i) Facts. The facts are the same as in paragraph (f)(3)(ii)(A) of this section (the facts in Example 2), except that TFC received, in the aggregate, $20x of dividends from FS during Year 2.

(B) Results. The results are the same as in paragraph (f)(3)(ii)(B) of this section (the results in Example 2), except that the residual gain is $50x, which equals the $40x of residual gain attributable to the 15 shares acquired in Year 3, as computed in paragraph (f)(3)(ii)(B) of this section (the results in Example 2), plus the $10x of gain recognized on the 15 shares acquired in Year 1 reduced by $0x, the amount by which the pro rata share of aggregate income ($20x) taken into account by TFC with respect to those 15 shares of FS stock under section 1297(c) and paragraph (b)(2) of this section exceeds the aggregate pro rata amount of dividends with respect to those 15 shares of FS stock ($20x) received by TFC from FS. Under paragraph (f)(2) of this section, $35x of the residual gain is non-passive income ($50x x ($150x/$200x)) and $15x is passive income ($50x x ($50x/$200x)).

(g) Definitions. The following definitions apply for purposes of this section:

(1) Look-through subsidiary. The term look-through subsidiary means, with respect to a tested foreign corporation—

(i) For purposes of section 1297(a)(2) and paragraph (b)(2)(i) of this section, a corporation at least 25 percent of the value of the stock of which is owned (as determined under paragraph (b)(1) of this section) by the tested foreign corporation on the measuring date;

(ii) For purposes of section 1297(a)(1)—

(A) For the taxable year, a corporation with respect to which the average percentage ownership (which is equal to the percentage ownership (by value) (as determined under paragraph (b)(1) of this section)) on each measuring date during the taxable year, divided by the number of measuring dates in the year) by the tested foreign corporation during the tested foreign corporation’s taxable year is at least 25 percent; or

(B) For a measuring period, a corporation at least 25 percent of the value of the stock of which is owned (as determined under paragraph (b)(1) of this section) by the tested foreign corporation on the measuring date, provided all items of gross income of the corporation for each of the measuring periods in the taxable year for which the tested foreign corporation owns at least 25 percent of the value (as determined under paragraph (b)(1) of this section) on the relevant measuring dates can be established; and

(iii) For purposes of paragraph (f) of this section and §1.1298-2, a corporation at least 25 percent of the value of the stock of which is owned (as determined under paragraph (b)(1) of this section) by the tested foreign corporation immediately before the disposition of stock of the corporation.

(2) LTS debt. The term LTS debt has the meaning provided in paragraph (c)(1) of this section.

(3) LTS stock. The term LTS stock has the meaning provided in paragraph (c)(1) of this section.

(4) Residual gain. The term residual gain has the meaning provided in paragraph (f)(1) of this section.

(5) Unremitted earnings. The term unremitted earnings has the meaning provided in paragraph (f)(1) of this section.

(h) Applicability date. The rules of this section apply to taxable years of shareholders beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par.6 Sections 1.1297-4 and 1.1297-5 are added to read as follows:

§1.1297-4 Qualifying insurance corporation.

(a) Scope. This section provides rules for determining whether a foreign corporation is a qualifying insurance corporation for purposes of section 1297(f). Paragraph (b) of this section provides the general rule for determining whether a foreign corporation is a qualifying insurance corporation. Paragraph (c) of this section describes the 25 percent test in section 1297(f)(1)(B). Paragraph (d) of this section contains rules for applying the alternative facts and circumstances test in section 1297(f)(2). Paragraph (e) of this section contains rules limiting the amount of applicable insurance liabilities for purposes of the 25 percent test described in paragraph (c) of this section and the alternative facts and circumstances test described in paragraph (d) of this section. Paragraph (f) of this section provides definitions that apply for purposes of this section. Paragraph (g) of this section provides the applicability date of this section.

(b) Qualifying insurance corporation. For purposes of section 1297(b)(2)(B), this section and §1.1297-5, a qualifying insurance corporation (QIC) is a foreign corporation that—

(1) Is an insurance company as defined in section 816(a) that would be subject to tax under subchapter L if the corporation were a domestic corporation; and

(2) Satisfies—

(i) The 25 percent test described in paragraph (c) of this section; or

(ii) The requirements for an election to apply the alternative facts and circumstances test as described in paragraph (d) of this section and a United States person has made an election as described in paragraph (d)(5) of this section.

(c) 25 percent test. A foreign corporation satisfies the 25 percent test if the amount of its applicable insurance liabilities exceeds 25 percent of its total assets. This determination is made on the basis of the liabilities and assets reported on the corporation’s applicable financial statement for the last year ending with or within the taxable year.

(d) Election to apply the alternative facts and circumstances test—(1) In general. A United States person that owns stock in a foreign corporation that fails to qualify as a QIC solely because of the 25 percent test may elect to treat the stock of the corporation as stock of a QIC if the foreign corporation—

(i) Is predominantly engaged in an insurance business as described in paragraph (d)(2) of this section;

(ii) Failed to satisfy the 25 percent test solely due to runoff-related circumstances, as described in paragraph (d)(3) of this section, or rating-related circumstances, as described in paragraph (d)(4) of this section; and

(iii) Reports an amount of applicable insurance liabilities that is at least 10 percent of the amount of the total assets on its applicable financial statement for the last annual reporting period ending with or within the corporation’s taxable year (the 10 percent test).

(2) Predominantly engaged in an insurance business—(i) In general. A foreign corporation is predominantly engaged in an insurance business in any taxable year during which more than half of the business of the foreign corporation is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. This determination is made based on whether the particular facts and circumstances of the foreign corporation are comparable to commercial insurance arrangements providing similar lines of coverage to unrelated parties in arm’s length transactions. The fact that a foreign corporation has been holding itself out as an insurer for a long period is not determinative of whether the foreign corporation is predominantly engaged in an insurance business.

(ii) Facts and circumstances. Facts and circumstances to consider in determining whether a foreign corporation is predominantly engaged in an insurance business include—

(A) Claims payment patterns for the current year and prior years;

(B) The foreign corporation’s loss exposure as calculated for a regulator or for a credit rating agency, or, if those are not calculated, for internal pricing purposes;

(C) The percentage of gross receipts constituting premiums for the current and prior years; and

(D) The number and size of insurance contracts issued or taken on through reinsurance by the foreign corporation.

(iii) Examples of facts indicating a foreign corporation is not predominantly engaged in an insurance business. Examples of facts that may indicate a foreign corporation is not predominantly engaged in an insurance business include—

(A) A small overall number of insured risks with low likelihood but large potential costs;

(B) Employees and agents of the foreign corporation focused to a greater degree on investment activities than underwriting activities; and

(C) Low loss exposure.

(3) Runoff-related circumstances. During the annual reporting period covered by the applicable financial statement, a foreign corporation fails to satisfy the 25 percent test solely due to runoff-related circumstances only if the corporation—

(i) Was actively engaged in the process of terminating its pre-existing, active insurance or reinsurance underwriting operations pursuant to an adopted plan of liquidation or a termination of operations under the supervision of its applicable insurance regulatory body;

(ii) Did not issue or enter into any insurance, annuity, or reinsurance contract, other than a contractually obligated renewal of an existing insurance contract or a reinsurance contract pursuant to and consistent with the plan of liquidation or a termination of operations; and

(iii) Made payments during the annual reporting period covered by the applicable financial statement to satisfy the claims under insurance, annuity, or reinsurance contracts, and the payments cause the corporation to fail to satisfy the 25 percent test.

(4) Rating-related circumstances. A foreign corporation fails to satisfy the 25 percent test solely due to rating-related circumstances only if—

(i) The 25 percent test is not met as a result of the specific requirements with respect to capital and surplus that a generally recognized credit rating agency imposes; and

(ii) The foreign corporation complies with the requirements of the credit rating agency in order to maintain the minimum credit rating required for the foreign corporation to be classified as secure to write new insurance business for the current year.

(5) Election—(i) In general. A United States person may make the election under section 1297(f)(2) if the foreign corporation directly provides the United States person a statement, signed by a responsible officer of the foreign corporation or an authorized representative of the foreign corporation, or the foreign corporation makes a publicly available statement (such as in a public filing, disclosure statement, or other notice provided to United States persons that are shareholders of the foreign corporation) that it satisfied the requirements of section 1297(f)(2) and paragraph (d)(1) of this section during the foreign corporation’s the taxable year. However, a United States person may not rely upon any statement by the foreign corporation to make the election under section 1297(f)(2) if the shareholder knows or has reason to know that the statement made by the foreign corporation was incorrect.

(ii) Information provided by foreign corporation. In addition to a statement that the foreign corporation satisfied the requirements of section 1297(f)(2) and paragraph (d)(1) of this section, the statement described in paragraph (d)(5)(i) of this section also must include:

(A) The ratio of applicable insurance liabilities to total assets for the taxable year; and

(B) A statement indicating whether the failure to satisfy the 25 percent test described in paragraph (c) of this section was the result of runoff-related or rating-related circumstances, along with a brief description of those circumstances.

(iii) Time and manner for making the election. The election described in paragraph (d)(1) of this section must be made by a United States person who owns stock in the foreign corporation (directly or indirectly) by completing the appropriate part of Form 8621 (or successor form) for each year in which the election applies. A United States person must attach the Form 8621 (or successor form) to its Federal income tax return for the taxable year to which the election relates on or before the due date (including extensions) for the filing of the return. The United States person must attach to the Form 8621 the statement provided by the foreign corporation described in paragraph (d)(1) of this section. If the foreign corporation makes a publicly available statement instead of providing a statement to the United States person, the United States person must attach a statement to the Form 8621 incorporating the information provided in the publicly available statement.

(e) Rules limiting the amount of applicable insurance liabilities—(1) In general. For purposes of determining whether a foreign corporation satisfies the 25 percent test described in paragraph (c) of this section or the 10 percent test described in paragraph (d)(1)(iii) of this section, the rules of this paragraph (e) apply to limit the amount of applicable insurance liabilities of the foreign corporation.

(2) General limitation on applicable insurance liabilities. The amount of applicable insurance liabilities may not exceed the lesser of:

(i) The amount of applicable insurance liabilities shown on the most recent applicable financial statement;

(ii) The minimum amount of applicable insurance liabilities required by the applicable law or regulation of the jurisdiction of the applicable regulatory body; or

(iii) For a foreign corporation that prepares a financial statement on the basis of a financial reporting standard for a purpose other than financial reporting, the amount of the applicable insurance liabilities on that financial statement.

(3) Additional limitation on amount of applicable insurance liabilities for a foreign corporation that does not prepare a financial statement based on a financial reporting standard—(i) In general. If a foreign corporation has an applicable financial statement described in paragraph (f)(1)(iii) of this section and the applicable financial statement does not discount incurred but unpaid losses and loss reserves on an economically reasonable basis, the amount of applicable insurance liabilities may not exceed the amount of applicable insurance liabilities on the applicable financial statement reduced in accordance with the discounting principles that would have applied under a financial reporting standard, if the foreign corporation had prepared a financial statement under a financial reporting standard for the last year ending with or within the taxable year.

(ii) Choice of accounting method. The foreign corporation may choose whether to apply generally accepted accounting principles or international financial reporting principles to calculate the discounted amount of its applicable insurance liabilities for purposes of paragraph (e)(3)(i)(B) of this section. If the foreign corporation does not choose between these financial reporting standards, generally accepted accounting principles will apply.

(4) Changes to financial statements prepared. Any foreign corporation that has prepared a financial statement on the basis of a financial reporting standard for an annual reporting period that included December 22, 2017, or any subsequent annual reporting period, must continue to prepare its applicable financial statement using a financial reporting standard unless the foreign corporation has a non-Federal tax business purpose for using the annual statement described in paragraph (f)(1)(iii) of this section. If a foreign corporation has no non-Federal tax business purpose for using the annual statement described in paragraph (f)(1)(iii) of this section and does not continue to prepare an applicable financial statement using a financial reporting standard, its applicable insurance liabilities are treated as $0 for purposes of this section.

(f) Definitions. For purposes of this section, the following terms have the meanings described in this paragraph (f).

(1) Applicable financial statement. The term applicable financial statement means the financial statement that is used by the foreign corporation for financial reporting purposes and that is—

(i) Made on the basis of generally accepted accounting principles;

(ii) Made on the basis of international financial reporting standards, if there is no statement that is made on the basis of generally accepted accounting principles; or

(iii) The annual statement required to be filed with the applicable insurance regulatory body, as defined in paragraph (f)(3) of this section, if there is no statement made on the basis of either general accounting principles or international financial reporting standards. The annual statement required to be filed with the applicable insurance regulatory body must provide complete information regarding the foreign corporation’s operations and financial condition for the annual reporting period ending with or within the taxable year.

(2) Applicable insurance liabilities. With respect to any life or property and casualty insurance business of a foreign corporation, the term applicable insurance liabilities means—

(i) Occurred losses for which the foreign corporation has become liable but has not paid before the end of the last annual reporting period ending with or within the taxable year, including unpaid claims for death benefits, annuity contracts, and health insurance benefits;

(ii) Unpaid expenses (including reasonable estimates of anticipated expenses) of investigating and adjusted unpaid losses described in paragraph (f)(2)(i) of this section; and

(iii) The aggregate amount of reserves (excluding deficiency, contingency, or unearned premium reserves) held for future, unaccrued health insurance claims and claims with respect to contracts providing coverage for mortality or morbidity risks, including annuity benefits dependent upon the life expectancy of one or more individuals.

(3) Applicable insurance regulatory body. The term applicable insurance regulatory body means the entity that has been established by law to license or authorize a corporation to engage in an insurance business, to regulate insurance company solvency and to which the applicable financial statement is provided.

(4) Financial reporting standard. The term financial reporting standard means either GAAP or international financial reporting standards.

(5) Generally accepted accounting principles or GAAP. The term generally accepted accounting principles or GAAP means United States generally accepted accounting principles.

(6) Insurance business. Solely for purposes of this section, insurance business has the meaning described in §1.1297-5(c)(2).

(7) Total assets. For purposes of section 1297(f) and this section, a foreign corporation’s total assets are the aggregate end-of-period value of the real property and personal property that the foreign corporation reports on its applicable financial statement for the last annual accounting period ending with or within the taxable year.

(g) Applicability date. This section applies to taxable years of United States persons that are shareholders in certain foreign corporations beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

§1.1297-5 Exception from the definition of passive income for active insurance income.

(a) Scope. This section provides rules pertaining to the exception from passive income under section 1297(b)(2)(B) for income derived in the active conduct of an insurance business and rules related to certain income of a qualifying domestic insurance corporation. Paragraph (b) of this section provides a general rule that excludes from passive income certain income of a qualifying insurance corporation (QIC) and certain income of a qualifying domestic insurance corporation. Paragraph (c) of this section provides rules for determining the amount of income derived by a QIC in the active conduct of an insurance business. Paragraph (d) of this section defines income of a qualifying domestic insurance corporation that is not treated as passive for purposes of section 1297. Paragraph (e) of this section provides rules excluding certain assets for purposes of the passive asset test under section 1297(a)(2). Paragraph (f) of this section provides rules concerning the treatment of income and assets of certain look-through subsidiaries and look-through partnerships of a QIC. Paragraph (g) of this section provides a rule prohibiting the double counting of any item for purposes of this section. Paragraph (h) of this section provides definitions applicable to the rules of this section. Paragraph (i) of this section provides the applicability date of this section.

(b) Exclusion from passive income of active insurance income. For purposes of section 1297 and §1.1297-1, passive income does not include—

(1) Income that a QIC derives in the active conduct of an insurance business as determined under paragraph (c) of this section; and

(2) Income from a qualifying domestic insurance corporation as determined under paragraph (d) of this section, except that this exclusion does not apply to determine whether a tested foreign corporation (as defined in §1.1297-1(f)(8)) is a PFIC for purposes of section 1298(a)(2) and §1.1291-1(b)(8)(ii).

(c) Income derived by a QIC in the active conduct of an insurance business—(1) In general. Income that a QIC derives in the active conduct of an insurance business is an amount equal to the QIC’s passive income (as defined in §1.1297-1(c) and taking into account the exceptions in section 1297(b)(2) other than the exception provided in section 1297(b)(2)(B) and this section) earned with respect to assets of a QIC that are available to satisfy liabilities of the QIC related to its insurance business (as described in paragraph (c)(2) of this section), multiplied by—

(i) 100 percent if the active conduct percentage determined under paragraph (c)(4) of this section equals or exceeds 50 percent; or

(ii) Zero if the active conduct percentage determined under paragraph (c)(4) of this section is less than 50 percent.

(2) Insurance business. Solely for purposes of §1.1297-4 and this section, an insurance business is the business of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with those investment activities and administrative services that are required to support (or that are substantially related to) those insurance, annuity, or reinsurance contracts issued or entered into by the QIC.

(3) Active conduct of an insurance business—(i) In general. For purposes of determining whether a QIC engages in the active conduct of an insurance business, active conduct is determined based on all the facts and circumstances. In general, a QIC actively conducts an insurance business only if the officers and employees of the QIC carry out substantial managerial and operational activities. A QIC’s officers and employees are considered to include the officers and employees of another entity only if the QIC satisfies the control test described in paragraph (c)(3)(ii) with respect to the officers and employees of the other entity. In determining whether the officers and employees of the QIC carry out substantial managerial and operational activities, however, the activities of independent contractors are disregarded.

(ii) Control test. A QIC’s officers and employees are considered to include the officers and employees of another entity when the requirements of paragraphs (c)(3)(ii)(A) through (C) of this section are satisfied.

(A) Ownership—(1) Ownership by or of a corporation. If the other entity is a corporation—

(i) The QIC owns, or is considered to own within the meaning of section 958(a), determined without regard to whether an intermediate entity is domestic or foreign, more than 50 percent of the total combined voting power of all classes of stock of the other corporation entitled to vote, and more than 50 percent of the total value of the stock of the other corporation; or

(ii) A common parent owns, or is considered to own within the meaning of section 958(a), determined without regard to whether an intermediate entity is domestic or foreign, more than 80 percent of the total combined voting power of all classes of stock entitled to vote and more than 80 percent of the total value of the stock of each of the QIC and the other corporation.

(2) Ownership of a partnership. If the other entity is a partnership—

(i) The QIC owns, directly or indirectly, more than 50 percent of the interests in the capital and profits in the entity; or

(ii) A common parent owns, directly or indirectly, more than 80 percent of the interests in the capital and profits in the entity and owns, or is considered to own within the meaning of section 958(a), determined without regard to whether an intermediate entity is domestic or foreign, more than 80 percent of the total combined voting power of all classes of stock entitled to vote and more than 80 percent of the total value of the stock of the QIC.

(B) Control and supervision. The QIC exercises regular oversight and supervision over the services performed by the other entity’s officers and employees for the QIC.

(C) Compensation. The QIC either—

(1) Pays directly all the compensation of the other entity’s officers and employees attributable to services performed for the production or acquisition of premiums and investment income on assets held to meet its obligations under the insurance, annuity, or reinsurance contracts issued or entered into by the QIC (insurance services);

(2) Reimburses the other entity for the portion of its expenses, including compensation and related expenses (determined in accordance with section 482 and taking into account all expenses that would be included in the total services costs under §1.482-9(j) and (k)(2)) for the insurance services performed for the QIC or by the other entity’s officers and employees; or

(3) Otherwise pays arm’s length compensation in accordance with section 482 on a fee-related basis to the other entity for the insurance services provided.

(4) Active conduct percentage—(i) In general. A QIC’s active conduct percentage for a taxable year is the percentage calculated (to the nearest percent) by dividing—

(A) The aggregate amount of expenses, including compensation (or reimbursement of compensation) and related expenses, for services of the officers and employees of the QIC (or another entity under an arrangement that satisfies the requirements of paragraph (c)(3)(ii) of this section) incurred by the QIC for the taxable year that are related to the production or acquisition of premiums and investment income on assets held to meet its obligations under the insurance, annuity, or reinsurance contracts issued or entered into by the QIC, by;

(B) The aggregate of—

(1) The amount described in paragraph (c)(4)(i)(A) of this section; and

(2) The amount of all expenses paid for the taxable year by the QIC to a person other than a person whose services for the QIC are covered by the expenses included in paragraph (c)(4)(i)(A) of this section for the production or acquisition of premiums and investment income on assets held to meet obligations under the insurance, annuity, or reinsurance contracts issued or entered into by the QIC.

(ii) Related expense determination. For purposes of determining the amount included in the numerator under paragraph (c)(4)(i)(A) of this section, the cost of compensation and related expenses include all costs in cash or in kind (including stock-based compensation) that, based on analysis of the facts and circumstances, are directly identified with, or reasonably allocated in accordance with the principles of §1.482-9(k)(2) to, the services of the officers and employees of the insurance company (or related party, as appropriate). In general, costs for the purpose of this paragraph (c)(4)(ii) include all resources expended, used, or made available to achieve the specific objective for which the service of the officer or employee is rendered. For the purpose of this paragraph (c)(4)(ii), reference to generally accepted accounting principles or Federal income tax accounting rules may provide a useful starting point but will not necessarily be conclusive regarding inclusion of costs, and such costs do not include interest expense, foreign income taxes (as defined in §1.901-2(a)), or Federal income taxes.

(iii) Ceding commission. For purposes of paragraph (c)(4)(i) of this section, ceding commissions are not taken into account in either the numerator or denominator of the active conduct percentage.

(d) Income of qualifying domestic insurance corporation. The income of a domestic corporation is income of a qualifying domestic insurance corporation if the domestic corporation is subject to—

(1) Tax as an insurance company under subchapter L of chapter 1 of subtitle A of the Internal Revenue Code; and

(2) Federal income tax on its net income.

(e) Exclusion of assets for purposes of the passive asset test under section 1297(a)(2). For purposes of section 1297 and §1.1297-1, passive assets (as defined in §1.1297-1(f)(6)), do not include—

(1) Assets of a QIC available to satisfy liabilities of the QIC related to its insurance business (as described in paragraph (c)(2) of this section), if the active conduct percentage of the QIC equals or exceeds 50 percent; and

(2) Assets of a qualifying domestic insurance corporation that meets the requirements described in paragraph (d) of this section, except that this exclusion does not apply to determine whether a tested foreign corporation (as defined in §1.1297-1(f)(8)) is a PFIC for purposes of section 1298(a)(2) and §1.1291-1(b)(8)(ii).

(f) Treatment of income and assets of certain look-through subsidiaries and look-through partnerships for purposes of the section 1297(b)(2)(B) exception—(1) General rule. An item of income treated as received or accrued or an asset treated as held by a QIC pursuant to section 1297(c) and §1.1297-2(b)(2) or pursuant to §1.1297-1(c)(2) or (d)(3) that would be passive income or a passive asset is treated as an item of income or an asset of the QIC for purposes of paragraphs (c) and (e) of this section.

(2) Applicable statements for tested foreign corporations applying paragraph (f)(1) of this section. For purposes of paragraph (f)(1) of this section, an item of passive income or passive asset in the hands of an entity other than a QIC (subsidiary entity) may only be treated as an item of income or an asset used in the active conduct of an insurance business by a foreign corporation treated as a QIC for purposes of paragraphs (c) and (e) of this section if the applicable financial statement used to test the QIC status of the foreign corporation includes the assets and liabilities of the subsidiary entity.

(g) No double counting. Nothing in this section or §1.1297-4 permits any item to be counted more than once.

(h) Definitions. For purposes of this section, the following terms have the meanings described in this paragraph (h).

(1) Insurance services. The term insurance services has the meaning provided in paragraph (c)(3)(ii)(C)(1) of this section.

(2) Investment activity. The term investment activity means any activity engaged in by a QIC to produce income of a kind that would be passive income (as defined in §1.1297-1(c)). Investment activities include those activities that are required to support or are substantially related to insurance and annuity contracts issued or reinsured by a QIC only to the extent that income produced by the activities is generated by assets available to satisfy liabilities of the QIC related to the insurance business, as described in paragraph (c)(2) of this section.

(3) Qualifying insurance corporation or QIC. The term qualifying insurance corporation or QIC has the meaning described in §1.1297-4.

(i) Applicability date. This section applies to taxable years of United States persons that are shareholders in certain foreign corporations beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par. 7. Section 1.1298-0 is amended by:

1. Revising the introductory text.

2. Adding entries for §§1.1298-2 and 1.1298-4 in numerical order.

The revision and additions read as follows:

§1.1298-0 Passive foreign investment company—table of contents.

This section contains a listing of the paragraph headings for §§1.1298-1, 1.1298-2, 1.1298-3, and 1.1298-4.

* * * * *

§1.1298-2 Rules for certain corporations changing businesses.

(a) Overview.

(b) Change of business exception.

(c) Special rules.

(d) Disposition of stock in a look-through subsidiary.

(e) Application of change of business exception.

(f) Examples.

(1) Example 1.

(i) Facts

(ii) Results.

(2) Example 2.

(i) Facts

(ii) Results.

(g) Applicability date.

* * * * *

§1.1298-4 Rules for certain foreign corporations owning stock in 25-percent-owned domestic corporations.

(a) Overview.

(b) Treatment of certain foreign corporations owning stock in a 25-percent-owned domestic corporation.

(1) General rule.

(2) Qualified stock.

(c) Indirect ownership of stock through a partnership.

(d) Section 531 tax.

(1) Subject to section 531 tax.

(2) Waiver of treaty benefits.

(i) Tested foreign corporation that files, or is required to file, a Federal income tax return.

(ii) Tested foreign corporation that is not required to file a Federal income tax return.

(e) Interaction of section 1298(b)(7) and section 1298(a)(2).

(f) Anti-abuse rules.

(1) Classification as PFIC excluding qualified stock.

(2) Avoidance principal purposes.

(g) Applicability date.

Par. 8. Section 1.1298-2 is added to read as follows:

§1.1298-2 Rules for certain corporations changing businesses.

(a) Overview. This section provides rules under section 1298(b)(3) and 1298(g) that apply to certain foreign corporations that dispose of one or more active trades or businesses for purposes of determining whether a foreign corporation is treated as a passive foreign investment company (PFIC). Paragraph (b) of this section sets forth a rule that applies to certain foreign corporations that dispose of one or more active trades or businesses. Paragraph (c) of this section provides special rules. Paragraph (d) of this section sets forth a rule for the treatment of the disposition of the stock of a look-through subsidiary (as defined in §1.1297-2(g)(1)). Paragraph (e) of this section provides guidance on the application of the rules in this section. Paragraph (f) provides examples illustrating the application of the rules in this section. Paragraph (g) sets forth the applicability date for this section.

(b) Change of business exception. A corporation is not treated as a PFIC for a taxable year if—

(1) Neither the corporation (nor any predecessor) was a PFIC for any prior taxable year;

(2) Either—

(i) Substantially all of the passive income of the corporation for the taxable year is attributable to proceeds from the disposition of one or more active trades or businesses; or

(ii) Following the disposition of one or more active trades or businesses, substantially all of the passive assets of the corporation on each of the measuring dates that occur during the taxable year and after the disposition are attributable to proceeds from the disposition; and

(3) The corporation is not a PFIC for either of the first two taxable years following the taxable year.

(c) Special rules. The rules in this paragraph (c) apply for purposes of section 1298(b)(3) and this section.

(1) Income is attributable to proceeds from the disposition of one or more active trades or businesses to the extent the income is derived from the investment of the proceeds from the disposition of assets used in the active trade or businesses.

(2) Assets are attributable to proceeds from the disposition of one or more active trades or businesses only to the extent the assets are the proceeds of the disposition of assets used in the active trade or businesses, or are derived from the investment of the proceeds.

(3) The determination of the existence of an active trade or business and whether assets are used in an active trade or business is made under §1.367(a)-2(d)(2), (3), and (5), except that officers and employees do not include the officers and employees of related entities as provided in §1.367(a)-2(d)(3). However, if activities performed by the officers and staff of employees of a look-through subsidiary of a corporation (including a look-through subsidiary with respect to which paragraph (d) of this section applies) or of a look-through partnership would be taken into account by the corporation pursuant to §1.1297-2(e) if it applied, or if activities performed by a related person would be taken into account by the corporation pursuant to section 954(h)(3)(E), such activities are taken into account for purposes of the determination of the existence of an active trade or business and the determination of whether assets are used in an active trade or business.

(4) In the case of a corporation that satisfies the condition in paragraph (b)(2)(ii) of this section, the condition in paragraph (b)(3) of this section is deemed to be satisfied if the corporation completely liquidates by the end of the taxable year following the year with respect to which the shareholder applies the exception in paragraph (b) of this section.

(d) Disposition of stock of a look-through subsidiary. For purposes of paragraph (b) of this section, the proceeds from a tested foreign corporation’s disposition of the stock of a look-through subsidiary are treated as proceeds from the disposition of a proportionate share of the assets held by the look-through subsidiary on the date of the disposition, based on the method (value or adjusted bases) used to measure the assets of the tested foreign corporation for purposes of section 1297(a)(2). The proceeds attributable to assets used by the look-through subsidiary in an active trade or business are treated as proceeds attributable to the disposition of an active trade or business.

(e) Application of change of business exception. A shareholder can apply the exception in paragraph (b) of this section with respect to a taxable year of a disposition of an active trade or business or an immediately succeeding taxable year, but cannot apply the exception with respect to more than one taxable year for a disposition.

(f) Examples. The following examples illustrate the rules of this section. For purposes of the examples in this paragraph (f): USP is a domestic corporation; TFC and FS are foreign corporations that are not controlled foreign corporations (within the meaning of section 957(a)); each corporation has outstanding a single class of stock; USP has owned its interest in TFC since the formation of TFC; each of USP, TFC, and FS have a calendar taxable year; and for purposes of section 1297(a)(2), TFC measures the amount of its assets based on value.

(1) Example 1—(i) Facts. (A) USP owns 15% of the outstanding stock of TFC. TFC owns 30% of the outstanding stock of FS. FS operates an active trade or business and 100% of its assets are used in the active trade or business. The value of FS’s non-passive assets (as defined in §1.1297-1(f)) is $900x; the value of FS’s passive assets (which include cash and accounts receivable) is $100x. TFC has not been treated as a PFIC for any taxable year prior to Year 1 and has no predecessor corporations. In addition to holding the FS stock, TFC directly conducts its own active trade or business. The value of TFC’s non-passive assets (other than FS stock) is $50x; the value of TFC’s passive assets (other than FS stock and assets received during Year 1) is $30x. TFC earns $1x of non-passive income (as defined in §1.1297-1(f)) from its directly conducted active trade or business.

(B) On January 1, Year 1, TFC sells all of its FS stock for $300x. The residual gain computed under §1.1297-2(f)(1) on the sale of the FS stock is $10x. Under §1.1297-2(f)(2), $9x of residual gain is characterized as non-passive income and $1x of residual gain is characterized as passive income. During the first quarter of Year 1 and apart from the sale of the FS stock, TFC earned $20x of passive income from the investment of the proceeds from the disposition of the FS stock, and TFC maintained such earnings as well as the disposition proceeds in cash for the remainder of the year. TFC reinvests the proceeds of the FS stock sale in an active trade or business during Year 2, and, thus, TFC is not a PFIC in Year 2 and Year 3. Less than 75% of TFC’s gross income in Year 1 is passive income (($20x + $1x)/($10x + $20x + $1x) = 68%). However, subject to the application of section 1298(b)(3) and this section, TFC would be a PFIC in Year 1 under section 1297(a)(2) because the proceeds from the sale of the FS stock ($300x) together with TFC’s other passive assets ($30x + $20x) exceed 50% of TFC’s total assets ($300x + $30x + $20x + $50x).

(ii) Results. (A) Under paragraph (d) of this section, for purposes of applying section 1298(b)(3)(B)(i) in Year 1, TFC’s proceeds from the disposition of the stock of FS that are attributable to assets used by FS in an active trade or business are considered as from the disposition of an active trade or business. Because 100% of FS’s assets are used in its active trade or business, all of TFC’s proceeds are considered as from the disposition of an active trade or business. Therefore, under paragraph (c)(1) of this section, the passive income considered attributable to proceeds from a disposition of one or more active trades or businesses is $20x (from investment of disposition proceeds). Because TFC reasonably does not expect to be a PFIC in Year 2 and Year 3, and TFC is not, in fact, a PFIC for those years, TFC will not be treated as a PFIC in Year 1 by reason of section 1298(b)(3) and paragraph (b) of this section, based on the satisfaction of the condition in paragraph (b)(2)(i) of this section, assuming that the 95% (($20x/($20x + $1x)) of TFC’s passive income for Year 1 that is attributable to proceeds of the disposition of FS’s active trade or business constitutes substantially all of its passive income.

(B) TFC would also not be treated as a PFIC in Year 1 by reason of section 1298(b)(3) and paragraph (b) of this section, based on the satisfaction of the condition in paragraph (b)(2)(ii) of this section, assuming that the 91% (($320x x 4)/(($320x + $30x) x 4)) of TFC’s passive assets on the quarterly measuring dates during Year 1 following the disposition of the stock of FS that is attributable to proceeds of the disposition of FS’s active trade or business constitutes substantially all of its passive assets.

(C) Under paragraph (e) of this section, TFC cannot claim the section 1298(b)(3) exception in relation to the income attributable to the proceeds of the FS stock sale in Year 2.

(2) Example 2—(i) Facts. The facts are the same as in paragraph (f)(1)(i) of this section (the facts in Example 1), except that during the first quarter of Year 1, TFC earned only $10x of passive income from the investment of the proceeds from the disposition of the FS stock and $10x of passive income from its other passive assets and maintained such earnings in cash for the remainder of the year.

(ii) Results. The results are the same as in paragraph (f)(1)(ii) of this section (the facts in Example 1), except that under paragraph (c)(1) of this section, the passive income considered attributable to proceeds from a disposition of one or more active trades or businesses is $10x. Because 48% ($10x/($10x + $10x + $1x)), and not substantially all, of TFC’s passive income for Year 1 is attributable to proceeds of the disposition of FS’s active trade or business, TFC does not qualify for the exception from treatment as a PFIC in section 1298(b)(3) for Year 1. However, under paragraphs (b)(2) and (d) of this section, $310x ($300x disposition proceeds + $10x from investment of disposition proceeds) of TFC’s passive assets held on each quarterly measuring date after the disposition is considered attributable to the disposition of an active trade or business. Because TFC reasonably does not expect to be a PFIC in Year 2 and Year 3, and TFC is not, in fact, a PFIC for those years, TFC will not be treated as a PFIC in Year 1 by reason of paragraph (b) of this section, based on the satisfaction of the condition in paragraph (b)(2)(ii) of this section, assuming that the 89% (($310x x 4)/(($310x + $10x + $30x) x 4)) of TFC’s passive assets on the quarterly measuring dates during Year 1 following the disposition of the stock of FS that is attributable to proceeds of the disposition of FS’s active trade or business constitutes substantially all of its passive assets.

(g) Applicability date. The rules of this section apply to taxable years of shareholders beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par.9. Section 1.1298-4 is added to read as follows:

§1.1298-4 Rules for certain foreign corporations owning stock in 25-percent-owned domestic corporations.

(a) Overview. This section provides rules under section 1298(b)(7) that apply to certain foreign corporations that own stock in 25-percent-owned domestic corporations (as defined in paragraph (b) of this section) for purposes of determining whether a foreign corporation is a passive foreign investment company (PFIC). Paragraph (b) of this section provides the general rule. Paragraph (c) of this section sets forth rules concerning ownership of 25-percent-owned domestic corporations or qualified stock (as defined in paragraph (b)(2) of this section) through partnerships. Paragraph (d) of this section sets forth rules for determining whether a foreign corporation is subject to the tax imposed by section 531 (the section 531 tax) and for waiving treaty benefits that would prevent the imposition of such tax. Paragraph (e) of this section sets forth a rule governing the interaction of section 1298(b)(7) and section 1298(a)(2). Paragraph (f) of this section sets forth anti-abuse rules for the application of section 1298(b)(7). Paragraph (g) sets forth the applicability date for this section.

(b) Treatment of certain foreign corporations owning stock in a 25-percent-owned domestic corporation—(1) General rule. Except as otherwise provided in paragraphs (e) and (f) of this section, when a tested foreign corporation (as defined in §1.1297-1(f)) is subject to the section 531 tax (or waives any benefit under any treaty that would otherwise prevent the imposition of the tax), and owns (directly or indirectly under the rules in paragraph (c) of this section) at least 25 percent (by value) of the stock of a domestic corporation (a 25-percent-owned domestic corporation), for purposes of determining whether the foreign corporation is a PFIC, any qualified stock held directly or indirectly under the rules in paragraph (c) of this section by the 25-percent-owned domestic corporation is treated as an asset that does not produce passive income (and is not held for the production of passive income), and any amount included in gross income with respect to the qualified stock is not treated as passive income.

(2) Qualified stock. For purposes of paragraph (b)(1) of this section, the term qualified stock means any stock in a C corporation that is a domestic corporation and that is not a regulated investment company or real estate investment trust.

(c) Indirect ownership of stock through a partnership. For purposes of paragraph (b)(1) of this section, a tested foreign corporation that is a partner in a partnership is considered to own its proportionate share of any stock of a domestic corporation held by the partnership, and a domestic corporation that is a partner in a partnership is considered to own its proportionate share of any qualified stock held by the partnership. The rules and principles of sections 701 through 761 apply to determine the corporation’s proportionate share of the stock of the domestic corporation or of the qualified stock. An upper-tier partnership’s attributable share of the stock of a domestic corporation or of qualified stock held by a lower-tier partnership is treated as held by the upper-tier partnership for purposes of applying the rule in this paragraph (c).

(d) Section 531 tax—(1) Subject to section 531 tax. For purposes of paragraph (b) of this section, a tested foreign corporation is considered subject to the section 531 tax regardless of whether the tax is imposed on the corporation and of whether the requirements of §1.532-1(c) are met.

(2) Waiver of treaty benefits—(i) Tested foreign corporation that files, or is required to file, a Federal income tax return. For purposes of paragraph (b) of this section, a tested foreign corporation that files, or is required to file, a Federal income tax return waives the benefit under a treaty that would otherwise prevent the imposition of the section 531 tax by attaching to its original or amended return for the taxable year for which section 1298(b)(7) and paragraph (b)(1) of this section are applied or any prior taxable year a statement that it irrevocably waives treaty protection against the imposition of the section 531 tax, effective for all prior, current, and future taxable years, provided the taxable year for which the return is filed and all subsequent taxable years are not closed by the period of limitations on assessments under section 6501.

(ii) Tested foreign corporation that is not required to file a Federal income tax return. For purposes of paragraph (b) of this section, a tested foreign corporation that is not required to file a Federal income tax return waives the benefit under a treaty that would otherwise prevent the imposition of the section 531 tax by a date no later than nine months following the close of the taxable year for which section 1298(b)(7) and paragraph (b)(1) of this section are applied by—

(A) Adopting a resolution or similar governance document that confirms that it has irrevocably waived any treaty protection against the imposition of the section 531 tax, effective for all prior, current, and future taxable years, and maintaining a copy of the resolution (or other governance document) in its records; or

(B) In the case of a tested foreign corporation described in section 1297(e)(3), including in its public filings a statement that it irrevocably waives treaty protection against the imposition of the section 531 tax, effective for all prior, current, and future taxable years.

(e) Interaction of section 1298(b)(7) and section 1298(a)(2). Section 1298(b)(7) does not apply to determine whether a tested foreign corporation is a PFIC for purposes of section 1298(a)(2) and §1.1291-1(b)(8)(ii).

(f) Anti-abuse rules—(1) Classification as PFIC excluding qualified stock. Paragraph (b) of this section does not apply when—

(i) 75 percent or more of the gross income of the tested foreign corporation for the taxable year (taking into account §1.1297-2 and excluding any amount included in gross income with respect to qualified stock) is passive income (as defined in §1.1297-1(c)(1)); or

(ii) The average percentage of assets held by the tested foreign corporation (taking into account §1.1297-2 and excluding qualified stock) that are passive assets (as defined in §1.1297-1(f)) is at least 50 percent.

(2) Avoidance principal purpose. Paragraph (b) of this section does not apply when a principal purpose for the tested foreign corporation’s formation or acquisition of the stock of the 25-percent-owned domestic corporation that holds the qualified stock is to avoid classification of the tested foreign corporation as a PFIC. A principal purpose to avoid classification of the tested foreign corporation as a PFIC is deemed to exist when the 25-percent-owned domestic corporation is not engaged in an active trade or business in the United States. The existence of an active trade or business is determined under §1.367(a)-2(d)(2) and (3), except that officers and employees of the 25-percent-owned domestic corporation do not include the officers and employees of related entities as provided in §1.367(a)-2(d)(3). However, activities performed by the officers and staff of employees of a look-through subsidiary of the 25-percent-owned domestic corporation or a partnership that would be taken into account by the corporation pursuant to §1.1297-2(e) if it applied are taken into account for purposes of the determination of the existence of an active trade or business.

(g) Applicability date. The rules of this section apply to taxable years of shareholders beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Kirsten Wielobob,

Deputy Commissioner for Services and Enforcement

This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) under sections 199A and 1388 of the Code.

Section 199A was enacted on December 22, 2017, by section 11011 of “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” Public Law 115-97, 131 Stat. 2054, 2063 (TCJA). Parts of section 199A were amended on March 23, 2018, as if included in TCJA, by section 101 of Division T of the Consolidated Appropriations Act, 2018, Public Law 115-141, 132 Stat. 348, 1151 (2018 Act). Section 199A applies to taxable years beginning after 2017 and before 2026. Unless otherwise indicated, all references to section 199A are to section 199A as amended by the 2018 Act.

In addition, section 13305 of the TCJA repealed section 199 (former section 199), which provided a deduction for income attributable to domestic production activities (section 199 deduction). Public Law 115-97, 131 Stat. 2054, 2126. The repeal of former section 199 is effective for all taxable years beginning after 2017. This notice of proposed rulemaking therefore proposes to remove the final regulations under former section 199, and withdraws proposed regulations under former section 199.

Section 199A(a) provides taxpayers a deduction of up to 20 percent of QBI from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate, and up to 20 percent of qualified real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income (section 199A(a) deduction). Section 199A(b)(7) requires patrons of Specified Cooperatives to reduce their section 199A(a) deduction if those patrons receive certain payments from such cooperatives. Section 199A(g) provides a deduction for Specified Cooperatives and their patrons (section 199A(g) deduction) that is based on the former section 199 deduction. Before the amendments of the 2018 Act, section 199A(g) provided a modified version of the section 199A(a) deduction for Specified Cooperatives.

The Treasury Department and the IRS published proposed regulations (REG-107892-18) providing guidance on the section 199A(a) deduction in the Federal Register (83 FR 40884) on August 16, 2018 (August 2018 NPRM). The final regulations were published in the Federal Register (84 FR 2952) on February 8, 2019 (TD 9847).

TD 9847 did not address patrons’ treatment of payments received from Cooperatives for purposes of section 199A(a) or the section 199A(g) deduction for Specified Cooperatives, though it did restate the reduction required under section 199A(b)(7). See §1.199A-1(e)(7). The August 2018 NPRM preamble stated that the Treasury Department and the IRS would continue to study the area and intended to issue separate proposed regulations describing rules for applying section 199A to Specified Cooperatives and their patrons. This notice of proposed rulemaking sets forth those proposed regulations and provides additional guidance to patrons calculating their 199A(a) deduction.

The purpose of these proposed regulations is to provide guidance regarding the application of sections 199A(a), 199A(b)(7), and 199A(g) to Cooperatives and their patrons as well as to Specified Cooperatives and their patrons. Whereas section 199A(a) is generally available to patrons of all Cooperatives, sections 199A(b)(7) and 199A(g) apply only to Specified Cooperatives and their patrons.

These proposed regulations are organized into six sections: proposed §§1.199A-7 through 1.199A-12. Proposed §1.199A-7 describes rules for patrons of Cooperatives to calculate their section 199A(a) deduction and rules for patrons of Specified Cooperatives to calculate the reduction to their section 199A(a) deduction as required by section 199A(b)(7). Unless otherwise provided in these proposed regulations, all of the rules set forth in TD 9847 relating to the section 199A(a) deduction apply to Cooperatives and their patrons. Specified Cooperatives are a subset of Cooperatives; therefore, the requirements of proposed §1.199A-7 also apply to Specified Cooperatives.

Proposed §1.199A-8 sets out the criteria that Specified Cooperatives must satisfy to qualify for the section 199A(g) deduction, and sets forth four steps necessary to calculate this deduction. These proposed regulations provide that the section 199A(g) deduction available to Specified Cooperatives and their patrons is generally computed only with respect to patronage gross receipts and related deductions. Exempt Specified Cooperatives (those that qualify under section 521) may compute their section 199A(g) deductions with respect to both patronage and nonpatronage gross receipts and related deductions.

Proposed §§1.199A-9 through 1.199A-11 provide additional guidance, based on the regulations under former section 199, regarding the four steps set forth in proposed §1.199A-8. Proposed §1.199A-9 provides additional rules for determining a Specified Cooperative’s domestic production gross receipts (DPGR). Proposed §1.199A-10 provides additional rules for calculating costs (including cost of goods sold (COGS) and other expenses, losses, and deductions) allocable to a Specified Cooperative’s DPGR. Proposed §1.199A-11 provides additional rules for determining the W-2 wage limitation in section 199A(g)(1)(B). Proposed §1.199A-12 details rules for applying section 199A(g) in the context of an expanded affiliated group (EAG) and other special rules contained in section 199A(g)(5) that are not otherwise addressed in these proposed regulations.

These proposed regulations also include, under section 1388, a single definition of patronage and nonpatronage in proposed §1.1388-1(f), which is intended to reflect the current case law under section 1388. This Explanation of Provisions describes each section of the proposed regulations in more detail.

Section 7805(b)(1)(A) and (B) of the Code generally provide that no temporary, proposed, or final regulation relating to the internal revenue laws may apply to any taxable period ending before the earliest of (A) the date on which such regulation is filed with the Federal Register, or (B) in the case of a final regulation, the date on which a proposed or temporary regulation to which the final regulation relates was filed with the Federal Register.

Consistent with authority provided by section 7805(b)(1)(A), the proposed regulations are proposed to apply to taxable years beginning after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. Taxpayers may rely upon these proposed regulations, in their entirety, before the date of publication of the Treasury Decision adopting these rules as final regulations in the Federal Register.

The Treasury Department and the IRS request comments on all aspects of the proposed rules. Before these proposed regulations are adopted as final regulations, consideration will be given to any written or electronic comments that are submitted timely to the IRS. All comments will be available for public inspection and copying. A public hearing may be scheduled if requested in writing by any person who timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in the Federal Register.

IRS Revenue Procedures, Revenue Rulings, Notices and other guidance cited in this document are published in the Internal Revenue Bulletin and are available from the Superintendent of Documents, U.S. Government Publishing Office, Washington, DC 20402, or by visiting the IRS website at http://www.irs.gov.

The principal author of these proposed regulations is Theresa Melchiorre, Office of Associate Chief Counsel (Passthroughs and Special Industries). Other personnel from the Treasury Department and the IRS participated in their development.

* * * * *

Accordingly, under the authority of 26 U.S.C. 7805, the notice of proposed rulemaking (REG-136459-09) published in the Federal Register (80 FR 51978) on August 27, 2015, is withdrawn.

Accordingly, 26 CFR parts 1 is proposed to be amended as follows:

Paragraph 1. The authority citation for part 1 is amended by:

1. Removing the entries for §§ 1.199-0 through 1.199-9, and

2. Adding entries in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805

* * * * *

Section 1.199A-7 also issued under 26 U.S.C. 199A(f)(4) and (g)(6).

Section 1.199A-8 also issued under 26 U.S.C. 199A(g)(6).

Section 1.199A-9 also issued under 26 U.S.C. 199A(g)(6).

Section 1.199A-10 also issued under 26 U.S.C. 199A(g)(6).

Section 1.199A-11 also issued under 26 U.S.C. 199A(g)(6).

Section 1.199A-12 also issued under 26 U.S.C. 199A(g)(6).

* * * * *

§§1.199-0 through 1.199-9 [Removed]

Par. 2. Sections 1.199-0 through 1.199-9 are removed.

Par. 3. Sections 1.199A-7 through 1.199A-12 are added to read as follows:

Sec.

* * * * *

1.199A-7 Section 199A(a) Rules for Cooperatives and their Patrons.

1.199A-8 Deduction for income attributable to domestic production activities of specified agricultural or horticultural cooperatives.

1.199A-9 Domestic production gross receipts.

1.199A-10 Allocation of costs of goods sold (COGS) and other deductions to domestic production gross receipts (DPGR), and other rules.

1.199A-11 Wage limitation for the section 199A(g) deduction.

1.199A-12 Expanded affiliated groups.

* * * * *

§1.199A-7 Section 199A(a) Rules for Cooperatives and their Patrons.

(a) Overview—(1) In general. This section provides guidance and special rules on the application of the rules of §§1.199A-1 through 1.199A-6 regarding the deduction for qualified business income (QBI) under section 199A(a) (section 199A(a) deduction) of the Internal Revenue Code (Code) by patrons (patrons) of cooperatives to which Part I of subchapter T of chapter 1 of subtitle A of the Code applies (Cooperatives). Unless otherwise provided in this section, all of the rules in §§1.199A-1 through 1.199A-6 relating to calculating the section 199A(a) deduction apply to patrons and Cooperatives. Paragraph (b) of this section provides special rules for patrons relating to trades or businesses. Paragraph (c) of this section provides special rules for patrons and Cooperatives relating to the definition of QBI. Paragraph (d) of this section provides special rules for patrons and Cooperatives relating to specified service trades or businesses (SSTBs). Paragraph (e) of this section provides special rules for patrons relating to the statutory limitations based on W-2 wages and unadjusted basis immediately after acquisition (UBIA) of qualified property. Paragraph (f) of this section provides special rules for specified agricultural or horticultural cooperatives (Specified Cooperatives) and paragraph (g) of this section provides examples for Specified Cooperatives and their patrons. Paragraph (h) of this section sets forth the applicability date of this section and a special transition rule relating to Specified Cooperatives and their patrons.

(2) At patron level. The section 199A(a) deduction is applied at the patron level, and patrons who are individuals (as defined in §1.199A-1(a)(2)) may take the section 199A(a) deduction.

(3) Definitions. For purposes of section 199A and §1.199A-7, the following definitions apply—

(i) Individual is defined in §1.199A-1(a)(2).

(ii) Patron is defined in §1.1388-1(e).

(iii) Patronage and nonpatronage is defined in §1.1388-1(f).

(iv) Relevant Passthrough Entity (RPE) is defined in §1.199A-1(a)(9).

(v) Qualified payment is defined in §1.199A-8(d)(2)(ii).

(vi) Specified Cooperative is defined in §1.199A-8(a)(2) and is a subset of Cooperatives defined in §1.199A-7(a)(1).

(b) Trade or business. A patron (whether the patron is an RPE or an individual) must determine whether it has one or more trades or businesses that it directly conducts as defined in §1.199A-1(b)(14). To the extent a patron operating a trade or business has income directly from that business, the patron must follow the rules of §§1.199A-1 through 1.199A-6 to calculate the section 199A deduction. Patronage dividends or similar payments are considered to be generated from the trade or business the Cooperative conducts on behalf of or with the patron, and are tested by the Cooperative at its trade or business level. A patron that receives patronage dividends or similar payments, as described in paragraph (c)(1) of this section, from a Cooperative must follow the rules of paragraphs (c) through (e) of this section to calculate the section 199A deduction.

(c) Qualified Business Income—(1) In general. QBI means the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business as determined under the rules of §1.199A-3(b). A qualified item of income includes distributions for which the Cooperative is allowed a deduction under section 1382(b) and (c)(2) (including patronage dividends or similar payments, such as money, property, qualified written notices of allocations, and qualified per-unit retain certificates, as well as money or property paid in redemption of a nonqualified written notice of allocation (collectively patronage dividends or similar payments)), provided such distribution is otherwise a qualified item of income, gain, deduction, or loss. See special rule in paragraph (d)(3) of this section relating to SSTBs that may affect QBI.

(2) QBI determinations made by patron. A patron must determine QBI for each trade or business it directly conducts. In situations where the patron receives distributions described in paragraph (c)(1) of this section, the Cooperative must determine whether those distributions include qualified items of income, gain, deduction, and loss. These distributions may be included in the QBI of the patron’s trade or business:

(i) To the extent that those payments are related to the patron’s trade or business;

(ii) Are qualified items of income, gain, deduction, and loss at the Cooperative’s trade or business level;

(iii) Are not income from an SSTB at the Cooperative’s trade or business level (except as permitted by the threshold rules (see §1.199A-5(a)(2)); and

(iv) Provided the patron receives certain information from the Cooperative about these payments as provided in paragraphs (c)(3) and (d)(3) of this section.

(3) Qualified items of income, gain, deduction, and loss determinations made and reported by Cooperatives. In the case of a Cooperative that makes distributions described in paragraph (c)(1) of this section to a patron, the Cooperative must determine the amount of qualified items of income, gain, deduction, and loss in those distributions. Pursuant to this paragraph (c)(3), the Cooperative must report the amounts of qualified items with respect to any non-SSTB of the Cooperative in the distributions made to the patron on an attachment to or on the Form 1099-PATR, Taxable Distributions Received From Cooperatives (Form 1099-PATR), (or any successor form) issued by the Cooperative to the patron, unless otherwise provided by the instructions to the Form. If the Cooperative does not report on or before the due date of the Form 1099-PATR the amount of such qualified items of income, gain, deduction, and loss in the distributions to the patron, the amount of distributions from the Cooperative that may be included in the patron’s QBI is presumed to be zero. See special rule in paragraph (d)(3) of this section relating to reporting of qualified items of income, gain, deduction, and loss with respect to SSTBs of the Cooperative.

(d) Specified Service Trades or Businesses—(1) In general. This section provides guidance on the determination of SSTBs. Unless otherwise provided in this section, all of the rules in §1.199A-5 relating to SSTBs apply to patrons of Cooperatives.

(2) SSTB determinations made by patron. A patron (whether an RPE or an individual) must determine whether each trade or business it directly conducts is an SSTB.

(3) SSTB determinations made and reported by Cooperatives. In the case of a Cooperative that makes distributions described in paragraph (c)(1) of this section to a patron, the Cooperative must determine whether the distributions from the Cooperative include items of income, gain, deduction, and loss from an SSTB directly conducted by the Cooperative, and whether such items are qualified items of income, gain, deduction, and loss with respect to such SSTB. The Cooperative must report to the patron the amount of income, gain, deduction, and loss in the distributions that is a qualified item of income, gain, deduction, and loss with respect to such SSTB. The Cooperative must report the amount on an attachment to or on the Form 1099-PATR (or any successor form) issued by the Cooperative to the patron, unless otherwise provided by the instructions to the Form. If the Cooperative does not report the amount on or before the due date of the Form 1099-PATR, then only the amount that a Cooperative reports as qualified items of income, gain, deduction, and loss under §1.199A-7(c)(3) may be included in the patron’s QBI, and the remaining amount of distributions from the Cooperative that may be included in the patron’s QBI is presumed to be zero.

(e) W-2 wages and unadjusted basis immediately after acquisition of qualified property—(1) In general. This section provides guidance on calculating a trade or business’s W-2 wages and the UBIA of qualified property properly allocable to QBI.

(2) Determinations made by patron. The determination of W-2 wages and UBIA of qualified property must be made for each trade or business by the patron (whether an RPE or individual) that directly conducts the trade or business before applying the aggregation rules of §1.199A-4. Unlike RPEs, Cooperatives do not allocate their W-2 wages and UBIA of qualified property to patrons.

(f) Special rules for patrons of Specified Cooperatives—(1) Section 199A(b)(7) reduction. A patron of a Specified Cooperative that receives a qualified payment must reduce its section 199A(a) deduction as provided in §1.199A-1(e)(7). This reduction applies whether the Specified Cooperative passes through all, some, or none of the Specified Cooperative’s section 199A(g) deduction to the patron in that taxable year. The proposed rules relating to the section 199A(g) deduction can be found in §§1.199A-8 through 1.199A-12.

(2) Deduction Calculation—(i) Allocation method. If in any taxable year, a patron receives both qualified payments and income that is not a qualified payment in a trade or business, the patron must allocate those items and related deductions using a reasonable method based on all the facts and circumstances. Different reasonable methods may be used for different items and related deductions of income, gain, deduction, and loss. The chosen reasonable method for each item must be consistently applied from one taxable year of the patron to another, and must clearly reflect the income and expenses of each trade or business. The overall combination of methods must also be reasonable based on all the facts and circumstances. The books and records maintained for a trade or business must be consistent with any allocations under this paragraph (f)(2)(i).

(ii) Safe harbor. A patron with taxable income under the threshold amount set forth in section 199A(e)(2) is eligible to use the safe harbor set forth in this paragraph (f)(2)(ii) instead of the allocation method set forth in paragraph (f)(2)(i) of this section for any taxable year in which the patron receives qualified payments and income from other than qualified payments in its trade or business. Under the safe harbor the patron may apportion its deductions and W-2 wages ratably between income from qualified payments and income from other than qualified payments for purposes of calculating the reduction in paragraph (f)(1) of this section. Accordingly, the amount of deductions apportioned to determine QBI allocable to qualified payments is equal to the proportion of the total deductions that the amount of qualified payments bears to total gross receipts used to determine QBI. The same proportion applies to determine the amount of W-2 wages allocable to the portion of the trade or business that received qualified payments.

(3) Qualified payments notice requirement. A Specified Cooperative must report the amount of the qualified payments made to the eligible taxpayer, as defined in section 199A(g)(2)(D), on an attachment to or on the Form 1099-PATR (or any successor form) issued by the Cooperative to the patron, unless otherwise provided by the instructions to the Form.

(g) Examples. The following examples illustrate the provisions of paragraph (f) of this section. For purposes of these examples, assume that the Specified Cooperative has satisfied the applicable written notice requirements in paragraphs (c)(3), (d)(3) and (f)(3) of this section.

(1) Example 1. Patron of Specified Cooperative with W-2 wages. (i) P, a grain farmer and patron of nonexempt Specified Cooperative (C), delivered to C during 2018 2% of all grain marketed through C during such year. During 2019, P receives $20,000 in patronage dividends and $1,000 of allocated section 199A(g) deduction from C related to the grain delivered to C during 2018.

(ii) P has taxable income of $75,000 for 2019 (determined without regard to section 199A) and has a filing status of married filing jointly. P’s QBI related to its grain trade or business for 2019 is $50,000, which consists of gross receipts of $150,000 from sales to an independent grain elevator, per-unit retain allocations received from C during 2019 of $80,000, patronage dividends received from C during 2019 related to C’s 2018 net earnings of $20,000, and expenses of $200,000 (including $50,000 of W-2 wages).

(iii) The portion of QBI from P’s grain trade or business related to qualified payments received from C during 2019 is $10,000, which consists of per-unit retain allocations received from C during 2019 of $80,000, patronage dividends received from C during 2019 related to C’s 2018 net earnings of $20,000, and properly allocable expenses of $90,000 (including $25,000 of W-2 wages).

(iv) P’s deductible amount related to the grain trade or business is 20% of QBI ($10,000) reduced by the lesser of 9% of QBI related to qualified payments received from C ($900) or 50% of W-2 wages related to qualified payments received from C ($12,500), or $9,100. As P does not have any other trades or businesses, the combined QBI amount is also $9,100.

(v) P’s deduction under section 199A for 2019 is $10,100, which consists of the combined QBI amount of $9,100, plus P’s deduction passed through from C of $1,000.

(2) Example 2. Patron of Specified Cooperative without W-2 wages. (i) C and P have the same facts for 2018 and 2019 as Example 1, except that P has expenses of $200,000 that include zero W-2 wages during 2019.

(ii) P’s deductible amount related to the grain trade or business is 20% of QBI ($10,000) reduced by the lesser of 9% of QBI related to qualified payments received from C ($900) or 50% of W-2 wages related to qualified payments received from C ($0), or $10,000.

(iii) P’s deduction under section 199A for 2019 is $11,000, which consists of the combined QBI amount of $10,000, plus P’s deduction passed through from C of $1,000.

(3) Example 3. Patron of Specified Cooperative – Qualified Payments do not equal QBI and no section 199A(g) passthrough. (i) P, a grain farmer and a patron of a nonexempt Specified Cooperative (C), during 2019, receives $60,000 in patronage dividends, $100,000 in per-unit retain allocations, and $0 of allocated section 199A(g) deduction from C related to the grain delivered to C. C notifies P that only $150,000 of the patronage dividends and per-unit retain allocations are qualified payments because $10,000 of the payments are not attributable to C’s qualified production activities income (QPAI).

(ii) P has taxable income of $90,000 (determined without regard to section 199A) and has a filing status of married filing jointly. P’s QBI related to its grain trade or business is $45,000, which consists of gross receipts of $95,000 from sales to an independent grain elevator, plus $160,000 from C (all payments from C qualify as qualified items of income, gain, deduction, and loss), less expenses of $210,000 (including $30,000 of W-2 wages).

(iii) The portion of QBI from P’s grain trade or business related to qualified payments received from C is $25,000, which consists of the qualified payments received from C of $150,000, less the properly allocable expenses of $125,000 (including $18,000 of W-2 wages), which were determined using a reasonable method under paragraph (f)(2)(ii) of this section.

(iv) P’s patron reduction is $2,250, which is the lesser of 9% of QBI related to qualified payments received from C, $2,250 (9% x $25,000), or 50% of W-2 wages related to qualified payments received from C, $9,000 (50% x $18,000). As P does not have any other trades or businesses, the combined QBI amount is $6,750 (20% of P’s total QBI, $9,000 (20% x $45,000), reduced by the patron reduction of $2,250).

(v) P’s deduction under section 199A is $6,750, which consists of the combined QBI amount of $6,750.

(4) Example 4. Patron of Specified Cooperative – Reasonable Method under paragraph (f)(2)(ii) of this section. P is a grain farmer that has $45,000 of QBI related to P’s grain trade or business in 2019. P’s QBI consists of $105,000 of sales to an independent grain elevator, $100,000 of per-unit retain allocations, and $50,000 of patronage dividends from a nonexempt Specified Cooperative (C), for which C reports $150,000 of qualified payments to P as required by paragraph (f)(3) of this section. P’s grain trade or business has $210,000 of expenses (including $30,000 of W-2 wages). P delivered 65x bushels of grain to C and sold 35x bushels of comparable grain to the independent grain elevator. To allocate the expenses between qualified payments ($150,000) and other income ($105,000), P compares the bushels of grain delivered to C (65x) to the total bushels of grain delivered to C and sold to the independent grain elevator (100x). P determines $136,500 (65% x $210,000) of expenses (including $19,500 of W-2 wages) are properly allocable to the qualified payments. The portion of QBI from P’s grain trade or business related to qualified payments received from C is $13,500, which consists of qualified payments of $150,000 less the properly allocable expenses of $136,500 (including $19,500 of W-2 wages). P’s method of allocating expenses is a reasonable method under paragraph (f)(2)(ii) of this section.

(5) Example 5. Patron of Specified Cooperative using safe harbor to allocate. (i) P is a grain farmer with taxable income of $100,000 for 2019 (determined without regard to section 199A) and has a filing status of married filing jointly. P’s QBI related to P’s grain trade or business for 2019 is $50,000, which consists of gross receipts of $180,000 from sales to an independent grain elevator, per-unit retain allocations received from a Specified Cooperative (C) during 2019 of $15,000, patronage dividends received from C during 2019 related to C’s 2018 net earnings of $5,000, and expenses of $150,000 (including $50,000 of W-2 wages). C also passed through $1,800 of the section 199A(g) deduction to P, which related to the grain delivered by P to the Specified Cooperative during 2018. P uses the safe harbor in paragraph (f)(2)(iii) of this section to determine the expenses (including W-2 wages) allocable to the qualified payments.

(ii) Using the safe harbor to allocate P’s $150,000 of expenses, P allocates $15,000 of the expenses to the qualified payments ($150,000 of expenses multiplied by the ratio (0.10) of qualified payments ($20,000) to total gross receipts ($200,000)). Using the same ratio, P also determines there are $5,000 of W-2 wages allocable ($50,000 multiplied by 0.10) to the qualified payments.

(iii) The portion of QBI from P’s grain trade or business related to qualified payments received from C during 2019 is $5,000, which consists of per-unit retain allocations received from C during 2019 of $15,000, patronage dividends of $5,000, and properly allocable expenses of $15,000 (including $5,000 of W-2 wages).

(iv) P’s QBI related to the grain trade or business is 20% of QBI ($10,000) reduced by the lesser of 9% of QBI related to qualified payments received from C ($450) or 50% of W-2 wages related to qualified payments received from C ($2,500), or $9,550. As P does not have any other trades or businesses, the combined QBI amount is also $9,550.

(v) P’s deduction under section 199A for 2019 is $11,350, which consists of the combined QBI amount of $9,550, plus P’s deduction passed through from C of $1,800.

(h) Effective/applicability date—(1) General rule. Except as provided in paragraph (h)(2) of this section, the provisions of this section apply to taxable years ending after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register. Taxpayers, however, may rely on these regulations until that date, but only if the taxpayers apply the rules in their entirety and in a consistent manner.

(2) Transition rule for qualified payments of patrons of Cooperatives. No deductions under section 199A are allowed to patrons for any qualified payments that are attributable to QPAI with respect to which a deduction is allowable to the Specified Cooperative under section 199 as in effect on and before December 31, 2017, for a taxable year of the Specified Cooperative beginning before January 1, 2018.

(3) Notice from the Cooperative. If a patron of a Cooperative cannot claim a deduction under section 199A for any qualified payments described in the transition rule set forth in paragraph (h)(2) of this section, the Cooperative must report this information on an attachment to or on the Form 1099-PATR (or any successor form) issued by the Cooperative to the patron, unless otherwise provided by the instructions to the Form.

§1.199A-8 Deduction for income attributable to domestic production activities of specified agricultural or horticultural cooperatives.

(a) Overview—(1) In general. This section provides rules relating to the deduction for income attributable to domestic production activities of a specified agricultural or horticultural cooperative (Specified Cooperative). This paragraph (a) provides an overview and definitions of certain terms. Paragraph (b) of this section provides rules explaining the steps a nonexempt Specified Cooperative performs to calculate its section 199A(g) deduction and includes definitions of relevant terms. Paragraph (c) of this section provides rules explaining the steps an exempt Specified Cooperative performs to calculate its section 199A(g) deduction. Paragraph (d) of this section provides rules for Specified Cooperatives passing through the section 199A(g) deduction to patrons. Paragraph (e) of this section provides examples that illustrate the provisions of paragraphs (b), (c), and (d) of this section. Paragraph (f) of this section provides guidance for Specified Cooperatives that are partners in a partnership. Paragraph (g) of this section provides guidance on the recapture of a claimed section 199A(g) deduction. Paragraph (h) of this section provides effective dates. For additional rules addressing an expanded affiliated group (EAG) see §1.199A-12. The principles of this section apply to the EAG rules in §1.199A-12.

(2) Specified Cooperative—(i) In general. Specified Cooperative means a cooperative to which Part I of subchapter T of chapter 1 of subtitle A of the Internal Revenue Code (Code) applies and which—

(A) Manufactures, produces, grows, or extracts (MPGE) in whole or significant part within the United States any agricultural or horticultural product, or

(B) Is engaged in the marketing of agricultural or horticultural products that have been MPGE in whole or significant part within the United States by the patrons of the cooperative.

(ii) Additional rules. See §1.199A-9 for rules to determine if a Specified Cooperative has MPGE an agricultural or horticultural product in whole or significant part within the United States.

(iii) Types of Specified Cooperatives. A Specified Cooperative that is qualified as a farmer’s cooperative organization under section 521 is an exempt Specified Cooperative, while a Specified Cooperative not so qualified is a nonexempt Specified Cooperative.

(3) Patron is defined in §1.1388-1(e).

(4) Agricultural or horticultural products are agricultural, horticultural, viticultural, and dairy products, livestock and the products thereof, the products of poultry and bee raising, the edible products of forestry, and any and all products raised or produced on farms and processed or manufactured products thereof within the meaning of the Cooperative Marketing Act of 1926, 44 Stat. 802 (1926). Agricultural or horticultural products also include aquatic products that are farmed whether by an exempt or a nonexempt Specified Cooperative. In addition, agricultural or horticultural products include fertilizer, diesel fuel, and other supplies used in agricultural or horticultural production that are MPGE by a Specified Cooperative. Agricultural or horticultural products, however, do not include intangible property (other than as provided in the exception in §1.199A-9(b)(2)); for example, an agricultural or horticultural product includes a seed that is grown, but does not include the intangible property right to reproduce a seed for sale. This exclusion of intangible property does not apply to intangible characteristics of any particular agricultural or horticultural product. For example, gross receipts from the sale of different varieties of oranges would all qualify as DPGR from the disposition of agricultural or horticultural products (assuming all other requirements of section 199A(g) are met). However, gross receipts from the license of the right to produce and sell a certain variety of an orange would be considered separate from the orange and not from an agricultural or horticultural product.

(b) Steps for a nonexempt Specified Cooperative in calculating deduction—(1) In general. Except as provided in paragraph (c)(3) of this section, this paragraph (b) applies only to nonexempt Specified Cooperatives.

(2) Step 1 - Gross receipts and related deductions—(i) Identify. To determine the section 199A(g) deduction, a Specified Cooperative first identifies its patronage and nonpatronage gross receipts and related cost of goods sold (COGS), deductible expenses, W-2 wages, etc. (deductions) and allocates them between patronage and nonpatronage. A single definition for the term patronage and nonpatronage is found in §1.1388-1(f).

(ii) Applicable gross receipts and deductions. For all purposes of the section 199A(g) deduction, a Specified Cooperative can use only patronage gross receipts and related deductions to calculate qualified production activities income (QPAI) as defined in paragraph (b)(4)(ii) of this section, oil-related QPAI as defined in paragraph (b)(7)(ii) of this section, or the W-2 wage limitation in paragraph (b)(5)(ii)(B) of this section. A Specified Cooperative cannot use its nonpatronage gross receipts and related deductions to calculate its section 199A(g) deduction.

(iii) Gross receipts are the Specified Cooperative’s receipts for the taxable year that are recognized under the Specified Cooperative’s methods of accounting used for Federal income tax purposes for the taxable year. See §1.199A-12 if the gross receipts are recognized in an intercompany transaction within the meaning of §1.1502-13. Gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments and from incidental or outside sources. For example, gross receipts include interest (except interest under section 103 but including original issue discount), dividends, rents, royalties, and annuities, regardless of whether the amounts are derived in the ordinary course of the Specified Cooperative’s trade or business. Gross receipts are not reduced by COGS or by the cost of property sold if such property is described in section 1221(a)(1), (2), (3), (4), or (5). Finally, gross receipts do not include amounts received by the Specified Cooperative with respect to sales tax or other similar state or local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service and the Specified Cooperative merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the Specified Cooperative under the applicable law, then gross receipts include the amounts received that are allocable to the payment of such tax.

(3) Step 2 – Determine gross receipts that are DPGR—(i) In general. A Specified Cooperative examines its patronage gross receipts to determine which of these are DPGR. A Specified Cooperative does not use nonpatronage gross receipts to determine DPGR.

(ii) DPGR are the gross receipts of the Specified Cooperative that are derived from any lease, rental, license, sale, exchange, or other disposition of an agricultural or horticultural product that is MPGE by the Specified Cooperative or its patrons in whole or significant part within the United States. DPGR does not include gross receipts derived from services or the lease, rental, license, sale, exchange, or other disposition of land unless a de minimis or other exception applies. See §1.199A-9 for additional rules on determining if gross receipts are DPGR.

(4) Step 3 – Determine QPAI—(i) In general. A Specified Cooperative determines QPAI from patronage DPGR and patronage deductions identified in paragraphs (b)(3)(ii) and (b)(2)(i) of this section, respectively. A Specified Cooperative does not use nonpatronage gross receipts or deductions to determine QPAI.

(ii) QPAI for the taxable year means an amount equal to the excess (if any) of—

(A) DPGR for the taxable year, over

(B) The sum of—

(1) COGS that are allocable to DPGR, and

(2) Other expenses, losses, or deductions (other than the section 199A(g) deduction) that are properly allocable to DPGR.

(C) QPAI computational rules. QPAI is computed without taking into account the section 199A(g) deduction or any deduction allowed under section 1382(b). See §1.199A-10 for additional rules on calculating QPAI.

(5) Step 4 – Calculate deduction—(i) In general. From QPAI and taxable income, a Specified Cooperative calculates its section 199A(g) deduction as provided in paragraph (b)(5)(ii) of this section.

(ii) Deduction—(A) In general. A Specified Cooperative is allowed a deduction equal to 9 percent of the lesser of—

(1) QPAI of the Specified Cooperative for the taxable year, or

(2) Taxable income of the Specified Cooperative for the taxable year.

(B) W-2 wage limitation. The deduction allowed under paragraph (b)(5)(ii)(A) of this section for any taxable year cannot exceed 50 percent of the patronage W-2 wages attributable to DPGR for the taxable year. See §1.199A-11 for additional rules on calculating the patronage W-2 wage limitation.

(C) Taxable income. Taxable income is defined in section 1382 and §1.1382-1 and §1.1382-2. For purposes of determining the amount of the deduction allowed under paragraph (b)(5)(ii) of this section, taxable income is limited to taxable income and related deductions from patronage sources. Patronage net operating losses (NOLs) reduce taxable income. Taxable income is computed without taking into account the section 199A(g) deduction or any deduction allowable under section 1382(b). Taxable income is determined using the same method of accounting used to determine distributions under section 1382(b) and qualified payments to eligible taxpayers.

(6) Use of patronage section 199A(g) deduction. Except as provided in §1.199A-12(c)(2) related to the rules for EAGs, the patronage section 199A(g) deduction cannot create or increase a patronage or nonpatronage NOL or the amount of a patronage or nonpatronage NOL carryover or carryback, if applicable, in accordance with section 172. A patronage section 199A(g) deduction can be applied only against patronage income and deductions. A patronage section 199A(g) deduction that is not used in the appropriate taxable year is lost.

(7) Special rules for nonexempt Specified Cooperatives that have oil-related QPAI—(i) Reduction of section 199A(g) deduction. If a Specified Cooperative has oil-related QPAI for any taxable year, the amount otherwise allowable as a deduction under paragraph (b)(5)(ii) of this section must be reduced by 3 percent of the least of—

(A) Oil-related QPAI of the Specified Cooperative for the taxable year,

(B) QPAI of the Specified Cooperative for the taxable year, or

(C) Taxable income of the Specified Cooperative for the taxable year.

(ii) Oil-related QPAI means, for any taxable year, the patronage QPAI that is attributable to the production, refining, processing, transportation, or distribution of oil, gas, or any primary product thereof (within the meaning of section 927(a)(2)(C), as in effect before its repeal) during such taxable year. Oil-related QPAI for any taxable year is an amount equal to the excess (if any) of patronage DPGR derived from the production, refining or processing of oil, gas, or any primary product thereof (oil-related DPGR) over the sum of—

(A) COGS of the Specified Cooperative that is allocable to such receipts; and

(B) Other expenses, losses, or deductions (other than the section 199A(g) deduction) that are properly allocable to such receipts.

(iii) Special rule for patronage oil-related DPGR. Oil-related DPGR does not include gross receipts derived from the transportation or distribution of oil, gas, or any primary product thereof. However, to the extent that the nonexempt Specified Cooperative treats gross receipts derived from transportation or distribution of oil, gas, or any primary product thereof as part of DPGR under §1.199A-9(j)(3)(i), or under §1.199A-9(j)(3)(i)(B), then the Specified Cooperative must treat those patronage gross receipts as oil-related DGPR.

(iv) Oil includes oil recovered from both conventional and non-conventional recovery methods, including crude oil, shale oil, and oil recovered from tar/oil sands. The primary product from oil includes all products derived from the destructive distillation of oil, including volatile products, light oils such as motor fuel and kerosene, distillates such as naphtha, lubricating oils, greases and waxes, and residues such as fuel oil. The primary product from gas means all gas and associated hydrocarbon components from gas wells or oil wells, whether recovered at the lease or upon further processing, including natural gas, condensates, liquefied petroleum gases such as ethane, propane, and butane, and liquid products such as natural gasoline. The primary products from oil and gas provided in this paragraph (b)(7)(iv) are not intended to represent either the only primary products from oil or gas, or the only processes from which primary products may be derived under existing and future technologies. Examples of non-primary products include, but are not limited to, petrochemicals, medicinal products, insecticides, and alcohols.

(c) Exempt Specified Cooperatives—(1) In general. This paragraph (c) applies only to exempt Specified Cooperatives.

(2) Two section 199A(g) deductions. The Specified Cooperative must calculate two separate section 199A(g) deductions, one patronage sourced and the other nonpatronage sourced. Patronage and nonpatronage gross receipts, related COGS that are allocable to DPGR, and other expenses, losses, or deductions (other than the section 199A(g) deduction) that are properly allocable to DPGR (deductions), DPGR, QPAI, NOLs, W-2 wages, etc. are not netted to calculate these two separate section 199A(g) deductions.

(3) Exempt Specified Cooperative patronage section 199A(g) deduction. The Specified Cooperative calculates its patronage section 199A(g) deduction following steps 1 through 4 in paragraphs (b)(2) through (5) of this section as if it were a nonexempt Specified Cooperative.

(4) Exempt Specified Cooperative nonpatronage section 199A(g) deduction—(i) In general. The Specified Cooperative calculates its nonpatronage section 199A(g) deduction following steps 2 through 4 in paragraphs (b)(2) through (5) of this section using only nonpatronage gross receipts and related nonpatronage deductions. For purposes of determining the amount of the nonpatronage section 199A(g) deduction allowed under paragraph (b)(5)(ii) of this section, taxable income is limited to taxable income and related deductions from nonpatronage sources. Nonpatronage NOLs reduce taxable income. Taxable income is computed without taking into account the section 199A(g) deduction or any deduction allowable under section 1382(c). Taxable income is determined using the same method of accounting used to determine distributions under section 1382(c)(2).

(ii) Use of nonpatronage section 199A(g) deduction. Except as provided in §1.199A-12(c)(2) related to the rules for EAGs, the nonpatronage section 199A(g) deduction cannot create or increase a nonpatronage NOL or the amount of nonpatronage NOL carryover or carryback, if applicable, in accordance with section 172. A Specified Cooperative cannot allocate its nonpatronage section 199A(g) deduction under paragraph (d) of this section and can apply the nonpatronage section 199A(g) deduction only against its nonpatronage income and deductions. As is the case for the patronage section 199A(g) deduction, the nonpatronage section 199A(g) deduction that a Specified Cooperative does not use in the appropriate taxable year is lost.

(d) Discretion to pass through deduction—(1) In general. A Specified Cooperative may, at its discretion, pass through all, some, or none of its patronage section 199A(g) deduction to an eligible taxpayer. An eligible taxpayer is a patron other than a C corporation or a Specified Cooperative. A Specified Cooperative member of a federated cooperative may pass through the patronage section 199A(g) deduction it receives from the federated cooperative to its member patrons that are eligible taxpayers.

(2) Amount of deduction being passed through—(i) In general. A Specified Cooperative is permitted to pass through to an eligible taxpayer an amount equal to the portion of the Specified Cooperative’s section 199A(g) deduction that is allowed with respect to the portion of the cooperative’s QPAI that is attributable to the qualified payments the Specified Cooperative distributed to the eligible taxpayer during the taxable year and identified on the notice required in §1.199A-7(f)(3) on an attachment to or on the Form 1099-PATR, Taxable Distributions Received From Cooperatives (Form 1099-PATR), (or any successor form) issued by the Specified Cooperative to the eligible taxpayer, unless otherwise provided by the instructions to the Form. The notice requirement to pass through the section 199A(g) deduction is in paragraph (d)(3) of this section.

(ii) Qualified payment means any amount of a patronage dividend or per-unit retain allocation, as described in section 1385(a)(1) or (3) received by a patron from a Specified Cooperative that is attributable to the portion of the Specified Cooperative’s QPAI, for which the cooperative is allowed a section 199A(g) deduction. For this purpose, patronage dividends include any advances on patronage and per-unit retain allocations include per-unit retains paid in money during the taxable year. A Specified Cooperative calculates its qualified payment using the same method of accounting it uses to calculate its taxable income.

(3) Notice requirement to pass through deduction. A Specified Cooperative must identify in a written notice the amount of the section 199A(g) deduction being passed through to the eligible taxpayer. This written notice must be mailed by the Specified Cooperative to the eligible taxpayer no later than the 15th day of the ninth month following the close of the taxable year of the Specified Cooperative. The Specified Cooperative may use the same written notice, if any, that it uses to notify the eligible taxpayer of the eligible taxpayer’s respective allocations of patronage distributions, or may use a separate timely written notice(s) to comply with this section. The Specified Cooperative must report the amount of section 199A(g) deduction passed through to the eligible taxpayer on an attachment to or on the Form 1099-PATR (or any successor form) issued by the Specified Cooperative to the eligible taxpayer, unless otherwise provided by the instructions to the Form.

(4) Section 199A(g) deduction allocated to eligible taxpayer. An eligible taxpayer may deduct the lesser of the section 199A(g) deduction identified on the notice described in paragraph (d)(3) of this section or the eligible taxpayer’s taxable income in the taxable year in which the eligible taxpayer receives the timely written notice described in paragraph (d)(3) of this section. For this purpose, the eligible taxpayer’s taxable income is determined without taking into account the section 199A(g) deduction being passed through to the eligible taxpayer and after taking into account any section 199A(a) deduction allowed to the eligible taxpayer. Any section 199A(g) deduction the eligible taxpayer does not use in the taxable year in which the eligible taxpayer receives the notice (received on or before the due date of the Form 1099-PATR) is lost and cannot be carried forward or back to other taxable years. The taxable income limitation for the section 199A(a) deduction set forth in section 199A(b)(3) and §1.199A-1(a) and (b) does not apply to limit the deductibility of the section 199A(g) deduction passed through to the eligible taxpayer.

(5) Special rules for eligible taxpayers that are Specified Cooperatives. A Specified Cooperative that receives a section 199A(g) deduction as an eligible taxpayer can take the deduction only against patronage gross income and related deductions.

(6) W-2 wage limitation. The W-2 wage limitation described in paragraph (b)(5)(ii)(B) of this section is applied at the cooperative level whether or not the Specified Cooperative chooses to pass through some or all of the section 199A(g) deduction. Any section 199A(g) deduction that has been passed through by a Specified Cooperative to an eligible taxpayer is not subject to the W-2 wage limitation a second time at the eligible taxpayer’s level.

(7) Specified Cooperative denied section 1382 deduction for portion of qualified payments. A Specified Cooperative must reduce its section 1382 deduction under section 1382(b) and/or (c), as applicable) by an amount equal to the portion of any qualified payment that is attributable to the Specified Cooperative’s section 199A(g) deduction passed through to the eligible taxpayer. This means the Specified Cooperative must reduce its section 1382 deduction in an amount equal to the section 199A(g) deduction passed through to its eligible taxpayers.

(8) No double counting. A qualified payment received by a Specified Cooperative that is a patron of a Specified Cooperative is not taken into account by the patron for purposes of section 199A(g).

(e) Examples. The following examples illustrate the application of paragraphs (b), (c), and (d) of this section. Assume for each example that the Specified Cooperative sent all required notices to patrons on or before the due date of the Form 1099-PATR.

(1) Example 1. Nonexempt Specified Cooperative calculating section 199A(g) deduction. (i) C is a grain marketing nonexempt Specified Cooperative, with $5,250,000 in gross receipts during 2018 from the sale of grain grown by its patrons. C paid $4,000,000 to its patrons at the time the grain was delivered in the form of per-unit retain allocations pursuant to an agreement and another $1,000,000 in patronage dividends after the close of the 2018 taxable year. C has other expenses of $250,000 during 2018, including $100,000 of W-2 wages.

(ii) C has DPGR of $5,250,000 and QPAI as defined in §1.199A-8(b)(4)(ii) of $5,000,000 for 2018. C’s section 199A(g) deduction is equal to the least of 9% of QPAI ($450,000), 9% of taxable income ($450,000), or 50% of W-2 wages ($50,000). C passes through the entire section 199A(g) deduction to its patrons. Accordingly, C reduces its $5,000,000 deduction allowable under section 1382(b) (relating to the $1,000,000 patronage dividends and $4,000,000 per-unit retain allocations) by $50,000.

(2) Example 2. Nonexempt Specified Cooperative calculating section 199A(g) deduction with purchases. Same facts as Example 1, except C purchased grain from its patrons for $4,000,000 and these purchases are not per-unit retain allocations described in section 1388(f). C allocated and reported the $1,000,000 patronage dividends to its patrons and provided notification (in accordance with the requirements of §1.199A-7(f)(3)) that only the patronage dividends are treated as qualified payments for purposes of its section 199A(g) deduction. C has QPAI and taxable income of $1,000,000 ($5,250,000 – $4,000,000 – $250,000). C’s section 199A(g) deduction is the lesser of 9% of QPAI ($90,000), 9% of taxable income without taking into account any deduction under section 1382(b) ($90,000), or 50% of W-2 wages ($50,000). C passes through the entire section 199A(g) deduction to its patrons. Accordingly, C reduces its $1,000,000 deduction allowable under section 1382(b) by $50,000. Patrons do not include any of the $4,000,000 of payments when determining the reduction amount under section 199A(b)(7).

(3) Example 3. Nonexempt Specified Cooperative determines amounts included in QPAI and taxable income. (i) C, a nonexempt Specified Cooperative, offers harvesting services and markets the grain of patrons and nonpatrons. C had gross receipts from harvesting services and grain sales, and expenses related to both. All of C’s harvesting services were performed for their patrons, and 75% of the grain sales were for patrons.

(ii) C identifies 75% of the gross receipts and related expenses from grain sales and 100% of the gross receipts and related expenses from the harvesting services as patronage sourced. C identifies 25% of the gross receipts and related expenses from grain sales as nonpatronage sourced.

(iii) C does not include any nonpatronage gross receipts or related expenses from grain sales in either QPAI or taxable income when calculating the section 199A(g) deduction. C’s QPAI includes the patronage DPGR, less related expenses (allocable COGS, wages and other expenses). C’s taxable income includes the patronage gross receipts, whether such gross receipts are DPGR or non-DPGR.

(iv) C allocates and reports patronage dividends to its harvesting patrons and grain marketing patrons. C also notifies its grain marketing patrons (in accordance with the requirements of §1.199A-7(f)(3)) that their patronage dividends are qualified payments used in C’s section 199A(g) computation. The patrons must use this information for purposes of computing their section 199A(b)(7) reduction to their section 199A(a) deduction (see §1.199A-7(f)).

(4) Example 4. Nonexempt Specified Cooperative with patronage and nonpatronage gross receipts and related deductions. (i) C, a nonexempt Specified Cooperative, markets corn grown by its patrons in the United States. For the calendar year ending December 31, 2020, C derives gross receipts from the marketing activity of $1,800. Such gross receipts qualify as DPGR. Assume C has $800 of expenses (including COGS, other expenses, and $400 of W-2 wages) properly allocable to DPGR, and a $1,000 deduction allowed under section 1382(b). C also derives gross receipts from nonpatronage sources in the amount of $500, and has nonpatronage deductions in the amount of $400 (including COGS, other expenses, and $100 of W-2 wages).

(ii) C does not include any gross receipts or deductions from nonpatronage sources when calculating the deduction under paragraph (b)(5)(ii) of this section. C’s QPAI and taxable income both equal $1,000 ($1,800 – 800). C’s deduction under paragraph (b)(5)(ii) of this section for the taxable year is equal to $90 (9% of $1,000), which does not exceed $200 (50% of C’s W-2 wages properly allocable to DPGR). C passes through $90 of the deduction to patrons and C reduces its section 1382(b) deduction by $90.

(5) Example 5. Exempt Specified Cooperative with patronage and nonpatronage income and deductions. (i) C, an exempt Specified Cooperative, markets corn MPGE by its patrons in the United States. For the calendar year ending December 31, 2020, C derives gross receipts from the marketing activity of $1,800. For this activity assume C has $800 of expenses (including COGS, other expenses, and $400 of W-2 wages) properly allocable to DPGR, and a $1,000 deduction under section 1382(b). C also derives gross receipts from nonpatronage sources in the amount of $500. Assume the gross receipts qualify as DPGR. For this activity assume C has $400 of expenses (including COGS, other expenses, and $20 of W-2 wages) properly allocable to DPGR and no deduction under section 1382(c).

(ii) C calculates two separate section 199A(g) deduction amounts. C’s section 199A(g) deduction attributable to patronage sources is the same as the deduction calculated by the nonexempt Specified Cooperative in Example 1 in paragraph (e)(1) of this section.

(iii) C’s nonpatronage QPAI and taxable income is equal to $100 ($500 – $400). C’s deduction under paragraph (c)(3) of this section that directs C to use paragraph (b)(5)(ii) of this section attributable to nonpatronage sources is equal to $9 (9% of $100), which does not exceed $10 (50% of C’s W-2 wages properly allocable to DPGR). C cannot pass through any of the nonpatronage section 199A(g) deduction amount to its patrons.

(6) Example 6. NOL. C, a nonexempt Specified Cooperative, MPGE agricultural or horticultural products. C is not part of an EAG as defined in §1.199A-12. In 2018, C generates QPAI and taxable income is $600, without taking into account any of its deductions under section 1382(b), the deduction under section 199A(g), or an NOL deduction. During 2018, C incurs W-2 wages as defined in §1.199A-11 of $300. C has an NOL carryover to 2018 of $500. C’s deduction under this section for 2018 is $9 (9% × (lesser of QPAI of $600 and taxable income of $100 ($600 taxable income – $500 NOL)). Under these facts the wage limitation does not act to limit the deduction because the wage limitation is $150 (50% × $300).

(7) Example 7. NOL. (i) C, a nonexempt Specified Cooperative, MPGE agricultural or horticultural products. C is not part of an EAG. In 2018, C generates QPAI and taxable income of $100, without taking into account any of its deductions under section 1382(b), the deduction under section 199A(g), or an NOL deduction. C has an NOL carryover to 2018 of $500 that reduces its taxable income for 2018 to $0. C’s section 199A(g) deduction for 2018 is $0 (9% × (lesser of QPAI of $100 and taxable income of $0)).

(ii) Carryover to 2019. C’s taxable income for purposes of determining its NOL carryover to 2019 is $100. Accordingly, for purposes of section 199A(g), C’s NOL carryover to 2019 is $400 ($500 NOL carryover to 2018 – $100 NOL used in 2018).

(f) Special rule for Specified Cooperative partners. In the case described in section 199A(g)(5)(B), where a Specified Cooperative is a partner in a partnership, the partnership must separately identify and report on the Schedule K-1 of the Form 1065, U.S. Return of Partnership Income (or any successor form) issued to the Specified Cooperative the cooperative’s share of gross receipts and related deductions, unless otherwise provided by the instructions to the Form. The Specified Cooperative determines what gross receipts reported by the partnership qualify as DPGR and includes these gross receipts and related deductions to calculate one section 199A(g) deduction (in the case of a nonexempt Specified Cooperative) or two section 199A(g) deductions (in the case of an exempt Specified Cooperative) using the steps set forth in paragraphs (b) and (c) of this section.

(g) Recapture of section 199A(g) deduction. If the amount of the section 199A(g) deduction that was passed through to eligible taxpayers exceeds the amount allowable as a section 199A(g) deduction as determined on examination or reported on an amended return, then recapture of the excess will occur at the Specified Cooperative level in the taxable year the Specified Cooperative took the excess section 199A(g) deduction.

(h) Applicability date. Except as provided in paragraph (h)(2) of §1.199A-7, the provisions of this section apply to taxable years ending after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register. Taxpayers, however, may rely on these regulations until that date, but only if the taxpayers apply the rules in their entirety and in a consistent manner.

(a) Domestic production gross receipts—(1) In general. The provisions of this section apply solely for purposes of section 199A(g) of the Internal Revenue Code (Code). The provisions of this section provide guidance to determine what gross receipts (defined in §1.199A-8(b)(2)(iii)) are domestic production gross receipts (DPGR) (defined in §1.199A-8(b)(3)(ii)). DPGR does not include gross receipts derived from services or the lease, rental, license, sale, exchange, or other disposition of land unless a de minimis or other exception applies. Partners, including partners in an EAG partnership described in §1.199A-12(i)(1), may not treat guaranteed payments under section 707(c) as DPGR.

(2) Application to marketing cooperatives. For purposes of determining DPGR, a Specified Cooperative (defined in §1.199A-8(a)(2)) will be treated as having manufactured, produced, grown, or extracted (MPGE) (defined in paragraph (f) of this section) in whole or significant part (defined in paragraph (h) of this section) any agricultural or horticultural product (defined in §1.199A-8(a)(4)) within the United States (defined in paragraph (i) of this section) marketed by the Specified Cooperative which its patrons (defined in §1.1388-1(e)) have so MPGE.

(b) Related persons—(1) In general. Pursuant to 199A(g)(3)(D)(ii), DPGR does not include any gross receipts derived from agricultural or horticultural products leased, licensed, or rented by the Specified Cooperative for use by any related person. A person is treated as related to another person if both persons are treated as a single employer under either section 52(a) or (b) (without regard to section 1563(b)), or section 414(m) or (o). Any other person is an unrelated person for purposes of the section 199A(g) deduction.

(2) Exceptions. Notwithstanding paragraph (b)(1) of this section, gross receipts derived from any agricultural or horticultural product leased or rented by the Specified Cooperative to a related person may qualify as DPGR if the agricultural or horticultural product is held for sublease or rent, or is subleased or rented, by the related person to an unrelated person for the ultimate use of the unrelated person. Similarly, notwithstanding paragraph (b)(1) of this section, gross receipts derived from a license of the right to reproduce an agricultural or horticultural product to a related person for reproduction and sale, exchange, lease, or rental to an unrelated person for the ultimate use of the unrelated person are treated as gross receipts from a disposition of an agricultural or horticultural product and may qualify as DPGR.

(c) Allocating gross receipts—(1) In general. A Specified Cooperative must determine the portion of its gross receipts for the taxable year that is DPGR and the portion of its gross receipts that is non-DPGR using a reasonable method based on all the facts and circumstances. Applicable Federal income tax principles apply to determine whether a transaction is, in substance, a lease, rental, license, sale, exchange, or other disposition the gross receipts of which may constitute DPGR, whether it is a service the gross receipts of which may constitute non-DPGR, or some combination thereof. For example, if a Specified Cooperative sells an agricultural or horticultural product and, in connection with that sale, also provides services, the Specified Cooperative must allocate its gross receipts from the transaction using a reasonable method based on all the facts and circumstances that accurately identifies the gross receipts that constitute DPGR and non-DPGR in accordance with the requirements of §§1.199A-8(b) and/or (c). The chosen reasonable method must be consistently applied from one taxable year to another and must clearly reflect the portion of gross receipts for the taxable year that is DPGR and the portion of gross receipts that is non-DPGR. The books and records maintained for gross receipts must be consistent with any allocations under this paragraph (c)(1).

(2) Reasonable method of allocation. If a Specified Cooperative has the information readily available and can, without undue burden or expense, specifically identify whether the gross receipts are derived from an item (and thus, are DPGR), then the Specified Cooperative must use that specific identification to determine DPGR. If the Specified Cooperative does not have information readily available to specifically identify whether gross receipts are derived from an item or cannot, without undue burden or expense, specifically identify whether gross receipts are derived from an item, then the Specified Cooperative is not required to use a method that specifically identifies whether the gross receipts are derived from an item but can use a reasonable allocation method. Factors taken into consideration in determining whether the Specified Cooperative’s method of allocating gross receipts between DPGR and non-DPGR is reasonable include whether the Specified Cooperative uses the most accurate information available; the relationship between the gross receipts and the method used; the accuracy of the method chosen as compared with other possible methods; whether the method is used by the Specified Cooperative for internal management or other business purposes; whether the method is used for other Federal or state income tax purposes; the time, burden, and cost of using alternative methods; and whether the Specified Cooperative applies the method consistently from year to year.

(3) De minimis rules—(i) DPGR. A Specified Cooperative’s applicable gross receipts as provided in §§1.199A-8(b) and/or (c) may be treated as DPGR if less than 5 percent of the Specified Cooperative’s total gross receipts are non-DPGR (after application of the exceptions provided in §1.199A-9(j)(3)). If the amount of the Specified Cooperative’s gross receipts that are non-DPGR equals or exceeds 5 percent of the Specified Cooperative’s total gross receipts, then, except as provided in paragraph (c)(3)(ii) of this section, the Specified Cooperative is required to allocate all gross receipts between DPGR and non-DPGR in accordance with paragraph (c)(1) of this section. If a Specified Cooperative is a member of an expanded affiliated group (EAG) (defined in §1.199A-12), but is not a member of a consolidated group, then the determination of whether less than 5 percent of the Specified Cooperative’s total gross receipts are non-DPGR is made at the Specified Cooperative level. If a Specified Cooperative is a member of a consolidated group, then the determination of whether less than 5 percent of the Specified Cooperative’s total gross receipts are non-DPGR is made at the consolidated group level. See §1.199A-12(d).

(ii) Non-DPGR. A Specified Cooperative’s applicable gross receipts as provided in §§1.199A-8(b) and/or (c) may be treated as non-DPGR if less than 5 percent of the Specified Cooperative’s total gross receipts are DPGR. If a Specified Cooperative is a member of an EAG, but is not a member of a consolidated group, then the determination of whether less than 5 percent of the Specified Cooperative’s total gross receipts are DPGR is made at the Specified Cooperative level. If a Specified Cooperative is a member of a consolidated group, then the determination of whether less than 5 percent of the Specified Cooperative’s total gross receipts are DPGR is made at the consolidated group level.

(d) Use of historical data for multiple-year transactions. If a Specified Cooperative recognizes and reports gross receipts from upfront payments or other similar payments on a Federal income tax return for a taxable year, then the Specified Cooperative’s use of historical data in making an allocation of gross receipts from the transaction between DPGR and non-DPGR may constitute a reasonable method. If a Specified Cooperative makes allocations using historical data, and subsequently updates the data, then the Specified Cooperative must use the more recent or updated data, starting in the taxable year in which the update is made.

(e) Determining DPGR item-by-item—(1) In general. For purposes of the section 199A(g) deduction, a Specified Cooperative determines, using a reasonable method based on all the facts and circumstances, whether gross receipts qualify as DPGR on an item-by-item basis (and not, for example, on a division-by-division, product line-by-product line, or transaction-by-transaction basis). The chosen reasonable method must be consistently applied from one taxable year to another and must clearly reflect the portion of gross receipts that is DPGR. The books and records maintained for gross receipts must be consistent with any allocations under this paragraph (e)(1).

(i) The term item means the agricultural or horticultural product offered by the Specified Cooperative in the normal course of its trade or business for lease, rental, license, sale, exchange, or other disposition (for purposes of this paragraph (e), collectively referred to as disposition) to customers, if the gross receipts from the disposition of such product qualify as DPGR; or

(ii) If paragraph (e)(1)(i) of this section does not apply to the product, then any component of the product described in paragraph (e)(1)(i) of this section is treated as the item, provided that the gross receipts from the disposition of the product described in paragraph (e)(1)(i) of this section that are attributable to such component qualify as DPGR. Each component that meets the requirements under this paragraph (e)(1)(ii) must be treated as a separate item and a component that meets the requirements under this paragraph (e)(1)(ii) may not be combined with a component that does not meet these requirements.

(2) Special rules. (i) For purposes of paragraph (e)(1)(i) of this section, in no event may a single item consist of two or more products unless those products are offered for disposition, in the normal course of the Specified Cooperative’s trade or business, as a single item (regardless of how the products are packaged).

(ii) In the case of agricultural or horticultural products customarily sold by weight or by volume, the item is determined using the most common custom of the industry (for example, barrels of oil).

(3) Exception. If the Specified Cooperative MPGE agricultural or horticultural products within the United States that it disposes of, and the Specified Cooperative leases, rents, licenses, purchases, or otherwise acquires property that contains or may contain the agricultural or horticultural products (or a portion thereof), and the Specified Cooperative cannot reasonably determine, without undue burden and expense, whether the acquired property contains any of the original agricultural or horticultural products MPGE by the Specified Cooperative, then the Specified Cooperative is not required to determine whether any portion of the acquired property qualifies as an item for purposes of paragraph (e)(1) of this section. Therefore, the gross receipts derived from the disposition of the acquired property may be treated as non-DPGR. Similarly, the preceding sentences apply if the Specified Cooperative can reasonably determine that the acquired property contains agricultural or horticultural products (or a portion thereof) MPGE by the Specified Cooperative, but cannot reasonably determine, without undue burden or expense, how much, or what type, grade, etc., of the agricultural or horticultural MPGE by the Specified Cooperative the acquired property contains.

(f) Definition of manufactured, produced, grown, or extracted (MPGE)—(1) In general. Except as provided in paragraphs (f)(2) and (3) of this section, the term MPGE includes manufacturing, producing, growing, extracting, installing, developing, improving, and creating agricultural or horticultural products; making agricultural or horticultural products out of material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles; cultivating soil, raising livestock, and farming aquatic products. The term MPGE also includes storage, handling, or other processing activities (other than transportation activities) within the United States related to the sale, exchange, or other disposition of agricultural or horticultural products only if the products are consumed in connection with or incorporated into the MPGE of agricultural or horticultural products, whether or not by the Specified Cooperative. The Specified Cooperative (or the patron if section 1.199A-9(a)(2) applies) must have the benefits and burdens of ownership of the agricultural or horticultural products under Federal income tax principles during the period the MPGE activity occurs in order for the gross receipts derived from the MPGE of the agricultural or horticultural products to qualify as DPGR.

(2) Packaging, repackaging, or labeling. If the Specified Cooperative packages, repackages, or labels agricultural or horticultural products and engages in no other MPGE activity with respect to those agricultural or horticultural products, the packaging, repackaging, or labeling does not qualify as MPGE with respect to those agricultural or horticultural products.

(3) Installing. If a Specified Cooperative installs agricultural or horticultural products and engages in no other MPGE activity with respect to the agricultural or horticultural products, the Specified Cooperative’s installing activity does not qualify as an MPGE activity. Notwithstanding paragraph (j)(3)(i)(A) of this section, if the Specified Cooperative installs agricultural or horticultural products MPGE by the Specified Cooperative and the Specified Cooperative has the benefits and burdens of ownership of the agricultural or horticultural products under Federal income tax principles during the period the installing activity occurs, then the portion of the installing activity that relates to the agricultural or horticultural products is an MPGE activity.

(4) Consistency with section 263A. A Specified Cooperative that has MPGE agricultural or horticultural products for the taxable year must treat itself as a producer under section 263A with respect to the agricultural or horticultural products unless the Specified Cooperative is not subject to section 263A. A Specified Cooperative that currently is not properly accounting for its production activities under section 263A, and wishes to change its method of accounting to comply with the producer requirements of section 263A, must follow the applicable administrative procedures issued under §1.446-1(e)(3)(ii) for obtaining the Commissioner’s consent to a change in accounting method (for further guidance, for example, see Rev. Proc. 2015-13, 2015-5 IRB 419, or any applicable subsequent guidance (see §601.601(d)(2) of this chapter)).

(g) By the taxpayer. With respect to the exception of the rules applicable to an EAG and EAG partnerships under §1.199A-12, only one Specified Cooperative may claim the section 199A(g) deduction with respect to any qualifying activity under paragraph (f) of this section performed in connection with the same agricultural or horticultural product. If an unrelated party performs a qualifying activity under paragraph (f) of this section pursuant to a contract with a Specified Cooperative (or its patron as relevant under paragraph (a)(2) of this section), then only if the Specified Cooperative (or its patron) has the benefits and burdens of ownership of the agricultural or horticultural product under Federal income tax principles during the period in which the qualifying activity occurs is the Specified Cooperative (or its patron) treated as engaging in the qualifying activity.

(h) In whole or significant part defined—(1) In general. Agricultural or horticultural products must be MPGE in whole or significant part by the Specified Cooperative (or its patrons in the case described in paragraph (a)(2) of this section) and in whole or significant part within the United States to qualify under section 199A(g)(3)(D)(i). If a Specified Cooperative enters into a contract with an unrelated person for the unrelated person to MPGE agricultural or horticultural products for the Specified Cooperative and the Specified Cooperative has the benefits and burdens of ownership of the agricultural or horticultural products under applicable Federal income tax principles during the period the MPGE activity occurs, then, pursuant to paragraph (g) of this section, the Specified Cooperative is considered to MPGE the agricultural or horticultural products under this section. The unrelated person must perform the MPGE activity on behalf of the Specified Cooperative in whole or significant part within the United States in order for the Specified Cooperative to satisfy the requirements of this paragraph (h)(1).

(2) Substantial in nature. Agricultural or horticultural products will be treated as MPGE in whole or in significant part by the Specified Cooperative (or its patrons in the case described in paragraph (a)(2) of this section) within the United States for purposes of paragraph (h)(1) of this section if the MPGE of the agricultural or horticultural products by the Specified Cooperative within the United States is substantial in nature taking into account all the facts and circumstances, including the relative value added by, and relative cost of, the Specified Cooperative’s MPGE within the United States, the nature of the agricultural or horticultural products, and the nature of the MPGE activity that the Specified Cooperative performs within the United States. The MPGE of a key component of an agricultural or horticultural product does not, in itself, meet the substantial-in-nature requirement with respect to an agricultural or horticultural product under this paragraph (h)(2). In the case of an agricultural or horticultural product, research and experimental activities under section 174 and the creation of intangible assets are not taken into account in determining whether the MPGE of the agricultural or horticultural product is substantial in nature.

(3) Safe harbor—(i) In general. A Specified Cooperative (or its patrons in the case described in paragraph (a)(2) of this section) will be treated as having MPGE an agricultural or horticultural product in whole or in significant part within the United States for purposes of paragraph (h)(1) of this section if the direct labor and overhead of such Specified Cooperative to MPGE the agricultural or horticultural product within the United States account for 20 percent or more of the Specified Cooperative’s COGS of the agricultural or horticultural product, or in a transaction without COGS (for example, a lease, rental, or license), account for 20 percent or more of the Specified Cooperative’s unadjusted depreciable basis (as defined in paragraph (h)(3)(ii) of this section) in property included in the definition of agricultural or horticultural products. For Specified Cooperatives subject to section 263A, overhead is all costs required to be capitalized under section 263A except direct materials and direct labor. For Specified Cooperatives not subject to section 263A, overhead may be computed using a reasonable method based on all the facts and circumstances, but may not include any cost, or amount of any cost, that would not be required to be capitalized under section 263A if the Specified Cooperative were subject to section 263A. Research and experimental expenditures under section 174 and the costs of creating intangible assets are not taken into account in determining direct labor or overhead for any agricultural or horticultural product. In the case of agricultural or horticultural products, research and experimental expenditures under section 174 and any other costs incurred in the creation of intangible assets may be excluded from COGS or unadjusted depreciable basis for purposes of determining whether the Specified Cooperative meets the safe harbor under this paragraph (h)(3). For Specified Cooperatives not subject to section 263A, the chosen reasonable method to compute overhead must be consistently applied from one taxable year to another and must clearly reflect the Specified Cooperative’s portion of overhead not subject to section 263A. The method must also be reasonable based on all the facts and circumstances. The books and records maintained for overhead must be consistent with any allocations under this paragraph (h)(3)(i).

(ii) Unadjusted depreciable basis. The term unadjusted depreciable basis means the basis of property for purposes of section 1011 without regard to any adjustments described in section 1016(a)(2) and (3). This basis does not reflect the reduction in basis for—

(A) Any portion of the basis the Specified Cooperative properly elects to treat as an expense under sections 179 or 179C; or

(B) Any adjustments to basis provided by other provisions of the Code and the regulations under the Code (for example, a reduction in basis by the amount of the disabled access credit pursuant to section 44(d)(7)).

(4) Special rules—(i) Contract with an unrelated person. If a Specified Cooperative enters into a contract with an unrelated person for the unrelated person to MPGE an agricultural or horticultural product within the United States for the Specified Cooperative, and the Specified Cooperative is considered to MPGE the agricultural or horticultural product pursuant to paragraph (f)(1) of this section, then, for purposes of the substantial-in-nature requirement under paragraph (h)(2) of this section and the safe harbor under paragraph (h)(3)(i) of this section, the Specified Cooperative’s MPGE activities or direct labor and overhead must include both the Specified Cooperative’s MPGE activities or direct labor and overhead to MPGE the agricultural or horticultural product within the United States as well as the MPGE activities or direct labor and overhead of the unrelated person to MPGE the agricultural or horticultural product within the United States under the contract.

(ii) Aggregation. In determining whether the substantial-in-nature requirement under paragraph (h)(2) of this section or the safe harbor under paragraph (h)(3)(i) of this section is met at the time the Specified Cooperative disposes of an agricultural or horticultural product—

(A) An EAG member must take into account all of the previous MPGE activities or direct labor and overhead of the other members of the EAG;

(B) An EAG partnership as defined in §1.199A-12(i)(1) must take into account all of the previous MPGE activities or direct labor and overhead of all members of the EAG in which the partners of the EAG partnership are members (as well as the previous MPGE activities of any other EAG partnerships owned by members of the same EAG); and

(C) A member of an EAG in which the partners of an EAG partnership are members must take into account all of the previous MPGE activities or direct labor and overhead of the EAG partnership (as well as those of any other members of the EAG and any previous MPGE activities of any other EAG partnerships owned by members of the same EAG).

(i) United States defined. For purposes of section 199A(g), the term United States includes the 50 states, the District of Columbia, the territorial waters of the United States, and the seabed and subsoil of those submarine areas that are adjacent to the territorial waters of the United States and over which the United States has exclusive rights, in accordance with international law, with respect to the exploration and exploitation of natural resources. Consistent with its definition in section 7701(a)(9), the term United States does not include possessions and territories of the United States or the airspace or space over the United States and these areas.

(j) Derived from the lease, rental, license, sale, exchange, or other disposition—(1) In general—(i) Definition. The term derived from the lease, rental, license, sale, exchange, or other disposition is defined as, and limited to, the gross receipts directly derived from the lease, rental, license, sale, exchange, or other disposition of agricultural or horticultural products even if the Specified Cooperative has already recognized receipts from a previous lease, rental, license, sale, exchange, or other disposition of the same agricultural or horticultural products. Applicable Federal income tax principles apply to determine whether a transaction is, in substance, a lease, rental, license, sale, exchange, or other disposition, whether it is a service, or whether it is some combination thereof.

(ii) Lease income. The financing and interest components of a lease of agricultural or horticultural products are considered to be derived from the lease of such agricultural or horticultural products. However, any portion of the lease income that is attributable to services or non-qualified property as defined in paragraph (j)(3) of this section is not derived from the lease of agricultural or horticultural products.

(iii) Income substitutes. The proceeds from business interruption insurance, governmental subsidies, and governmental payments not to produce are treated as gross receipts derived from the lease, rental, license, sale, exchange, or other disposition to the extent they are substitutes for gross receipts that would qualify as DPGR.

(iv) Exchange of property—(A) Taxable exchanges. The value of property received by the Specified Cooperative in a taxable exchange of agricultural or horticultural products MPGE in whole or in significant part by the Specified Cooperative within the United States is DPGR for the Specified Cooperative (assuming all the other requirements of this section are met). However, unless the Specified Cooperative meets all of the requirements under this section with respect to any additional MPGE by the Specified Cooperative of the agricultural or horticultural products received in the taxable exchange, any gross receipts derived from the sale by the Specified Cooperative of the property received in the taxable exchange are non-DPGR, because the Specified Cooperative did not MPGE such property, even if the property was an agricultural or horticultural product in the hands of the other party to the transaction.

(B) Safe harbor. For purposes of paragraph (j)(1)(iv)(A) of this section, the gross receipts derived by the Specified Cooperative from the sale of eligible property (as defined in paragraph (j)(1)(iv)(C) of this section) received in a taxable exchange, net of any adjustments between the parties involved in the taxable exchange to account for differences in the eligible property exchanged (for example, location differentials and product differentials), may be treated as the value of the eligible property received by the Specified Cooperative in the taxable exchange. For purposes of the preceding sentence, the taxable exchange is deemed to occur on the date of the sale of the eligible property received in the taxable exchange by the Specified Cooperative, to the extent the sale occurs no later than the last day of the month following the month in which the exchanged eligible property is received by the Specified Cooperative. In addition, if the Specified Cooperative engages in any further MPGE activity with respect to the eligible property received in the taxable exchange, then, unless the Specified Cooperative meets the in-whole-or-in-significant-part requirement under paragraph (h)(1) of this section with respect to the property sold, for purposes of this paragraph (j)(1)(iv)(B), the Specified Cooperative must also value the property sold without taking into account the gross receipts attributable to the further MPGE activity.

(C) Eligible property. For purposes of paragraph (j)(1)(iv)(B) of this section, eligible property is—

(1) Oil, natural gas, or petrochemicals, or products derived from oil, natural gas, or petrochemicals; or

(2) Any other property or product designated by publication in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter).

(3) For this purpose, the term natural gas includes only natural gas extracted from a natural deposit and does not include, for example, methane gas extracted from a landfill. In the case of natural gas, production activities include all activities involved in extracting natural gas from the ground and processing the gas into pipeline quality gas.

(2) Hedging transactions—(i) In general. For purposes of this section, if a transaction is a hedging transaction within the meaning of section 1221(b)(2)(A) and §1.1221-2(b), is properly identified as a hedging transaction in accordance with §1.1221-2(f), and the risk being hedged relates to property described in section 1221(a)(1) that gives rise to DPGR or to property described in section 1221(a)(8) that is consumed in an activity that gives rise to DPGR, then—

(A) In the case of a hedge of purchases of property described in section 1221(a)(1), income, deduction, gain, or loss on the hedging transaction must be taken into account in determining COGS;

(B) In the case of a hedge of sales of property described in section 1221(a)(1), income, deduction, gain, or loss on the hedging transaction must be taken into account in determining DPGR; and

(C) In the case of a hedge of purchases of property described in section 1221(a)(8), income, deduction, gain, or loss on the hedging transaction must be taken into account in determining DPGR.

(ii) Allocation. The income, deduction, gain and loss from hedging transactions described in paragraph (j)(2) of this section must be allocated between the patronage and nonpatronage (defined in §1.1388-1(f)) sourced income and related deductions of the Specified Cooperatives consistent with the cooperative’s method for determining patronage and nonpatronage income and deductions.

(iii) Effect of identification and nonidentification. The principles of §1.1221-2(g) apply to a Specified Cooperative that identifies or fails to identify a transaction as a hedging transaction, except that the consequence of identifying as a hedging transaction a transaction that is not in fact a hedging transaction described in paragraph (j)(2) of this section, or of failing to identify a transaction that the Specified Cooperative has no reasonable grounds for treating as other than a hedging transaction described in paragraph (j)(2) of this section, is that deduction or loss (but not income or gain) from the transaction is taken into account under paragraph (j)(2) of this section.

(iv) Other rules. See §1.1221-2(e) for rules applicable to hedging by members of a consolidated group and §1.446-4 for rules regarding the timing of income, deductions, gains or losses with respect to hedging transactions.

(3) Allocation of gross receipts to embedded services and non-qualified property—(i) Embedded services and non-qualified property—(A) In general. Except as otherwise provided in paragraph (j)(3)(i)(B) of this section, gross receipts derived from the performance of services do not qualify as DPGR. In the case of an embedded service, that is, a service the price of which, in the normal course of the business, is not separately stated from the amount charged for the lease, rental, license, sale, exchange, or other disposition of agricultural or horticultural products, DPGR includes only the gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of agricultural or horticultural products (assuming all the other requirements of this section are met) and not any receipts attributable to the embedded service. In addition, DPGR does not include gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of property that does not meet all of the requirements under this section (non-qualified property). The allocation of the gross receipts attributable to the embedded services or non-qualified property will be deemed to be reasonable if the allocation reflects the fair market value of the embedded services or non-qualified property.

(B) Exceptions. There are five exceptions to the rules under paragraph (j)(3)(i)(A) of this section regarding embedded services and non-qualified property. A Specified Cooperative may include in DPGR, if all the other requirements of this section are met with respect to the underlying item of agricultural or horticultural products to which the embedded services or non-qualified property relate, the gross receipts derived from—

(1) A qualified warranty, that is, a warranty that is provided in connection with the lease, rental, license, sale, exchange, or other disposition of agricultural or horticultural products if, in the normal course of the Specified Cooperative’s business—

(i) The price for the warranty is not separately stated from the amount charged for the lease, rental, license, sale, exchange, or other disposition of the agricultural or horticultural products; and

(ii) The warranty is neither separately offered by the Specified Cooperative nor separately bargained for with customers (that is, a customer cannot purchase the agricultural or horticultural products without the warranty);

(2) A qualified delivery, that is, a delivery or distribution service that is provided in connection with the lease, rental, license, sale, exchange, or other disposition of agricultural or horticultural products if, in the normal course of the Specified Cooperative’s business—

(i) The price for the delivery or distribution service is not separately stated from the amount charged for the lease, rental, license, sale, exchange, or other disposition of the agricultural or horticultural products; and

(ii) The delivery or distribution service is neither separately offered by the Specified Cooperative nor separately bargained for with customers (that is, a customer cannot purchase the agricultural or horticultural products without the delivery or distribution service).

(3) A qualified operating manual, that is, a manual of instructions that is provided in connection with the lease, rental, license, sale, exchange, or other disposition of the agricultural or horticultural products if, in the normal course of the Specified Cooperative’s business—

(i) The price for the manual is not separately stated from the amount charged for the lease, rental, license, sale, exchange, or other disposition of the agricultural or horticultural products;

(ii) The manual is neither separately offered by the Specified Cooperative nor separately bargained for with customers (that is, a customer cannot purchase the agricultural or horticultural products without the manual); and

(iii) The manual is not provided in connection with a training course for customers.

(4) A qualified installation, that is, an installation service for agricultural or horticultural products that is provided in connection with the lease, rental, license, sale, exchange, or other disposition of the agricultural or horticultural products if, in the normal course of the Specified Cooperative’s business—

(i) The price for the installation service is not separately stated from the amount charged for the lease, rental, license, sale, exchange, or other disposition of the agricultural or horticultural products; and

(ii) The installation is neither separately offered by the Specified Cooperative nor separately bargained for with customers (that is, a customer cannot purchase the agricultural or horticultural products without the installation service).

(5) A de minimis amount of gross receipts from embedded services and non-qualified property for each item of agricultural or horticultural products may qualify. For purposes of this exception, a de minimis amount of gross receipts from embedded services and non-qualified property is less than 5 percent of the total gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of each item of agricultural or horticultural products. In the case of gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of agricultural or horticultural products that are received over a period of time (for example, a multi-year lease or installment sale), this de minimis exception is applied by taking into account the total gross receipts for the entire period derived (and to be derived) from the lease, rental, license, sale, exchange, or other disposition of the item of agricultural or horticultural products. For purposes of the preceding sentence, if a Specified Cooperative treats gross receipts as DPGR under this de minimis exception, then the Specified Cooperative must treat the gross receipts recognized in each taxable year consistently as DPGR. The gross receipts that the Specified Cooperative treats as DPGR under paragraphs (j)(3)(i)(B)(1) through (4) of this section are treated as DPGR for purposes of applying this de minimis exception. This de minimis exception does not apply if the price of a service or non-qualified property is separately stated by the Specified Cooperative, or if the service or non-qualified property is separately offered or separately bargained for with the customer (that is, the customer can purchase the agricultural or horticultural products without the service or non-qualified property).

(ii) Non-DPGR. Applicable gross receipts as provided in §§1.199A-8(b) and/or (c) derived from the lease, rental, license, sale, exchange or other disposition of an item of agricultural or horticultural products may be treated as non-DPGR if less than 5 percent of the Specified Cooperative’s total gross receipts derived from the lease, rental, license, sale, exchange or other disposition of that item are DPGR (taking into account embedded services and non-qualified property included in such disposition, but not part of the item). In the case of gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of agricultural or horticultural products that are received over a period of time (for example, a multi-year lease or installment sale), this paragraph (j)(5)(ii) is applied by taking into account the total gross receipts for the entire period derived (and to be derived) from the lease, rental, license, sale, exchange, or other disposition of the item of agricultural or horticultural products. For purposes of the preceding sentence, if the Specified Cooperative treats gross receipts as non-DPGR under this de minimis exception, then the Specified Cooperative must treat the gross receipts recognized in each taxable year consistently as non-DPGR.

(k) Applicability date. The provisions of this section apply to taxable years ending after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register. Taxpayers, however, may rely on these regulations until that date, but only if the taxpayers apply the rules in their entirety and in a consistent manner.

(a) In general. The provisions of this section apply solely for purposes of section 199A(g) of the Internal Revenue Code (Code). The provisions of this section provide additional guidance on determining qualified production activities income (QPAI) as described and defined in §1.199A-8(b)(4)(ii).

(b) COGS allocable to DPGR—(1) In general. When determining its QPAI, the Specified Cooperative (defined in §1.199A-8(a)(2)) must subtract from its DPGR (defined in §1.199A-8(b)(3)(ii)) the COGS allocable to its DPGR. The Specified Cooperative determines its COGS allocable to DPGR in accordance with this paragraph (b)(1) or, if applicable, paragraph (f) of this section. In the case of a sale, exchange, or other disposition of inventory, COGS is equal to beginning inventory of the Specified Cooperative plus purchases and production costs incurred during the taxable year and included in inventory costs by the Specified Cooperative, less ending inventory of the Specified Cooperative. In determining its QPAI, the Specified Cooperative does not include in COGS any payment made, whether during the taxable year, or included in beginning inventory, for which a deduction is allowed under section 1382(b) and/or (c), as applicable. See §1.199A-8(b)(4)(C). COGS is determined under the methods of accounting that the Specified Cooperative uses to compute taxable income. See sections 263A, 471, and 472. If section 263A requires the Specified Cooperative to include additional section 263A costs (as defined in §1.263A-1(d)(3)) in inventory, additional section 263A costs must be included in determining COGS. COGS also includes the Specified Cooperative’s inventory valuation adjustments such as write-downs under the lower of cost or market method. In the case of a sale, exchange, or other disposition (including, for example, theft, casualty, or abandonment) by the Specified Cooperative of non-inventory property, COGS for purposes of this section includes the adjusted basis of the property.

(2) Allocating COGS—(i) In general. A Specified Cooperative must use a reasonable method based on all the facts and circumstances to allocate COGS between DPGR and non-DPGR. Whether an allocation method is reasonable is based on all the facts and circumstances, including whether the Specified Cooperative uses the most accurate information available; the relationship between COGS and the method used; the accuracy of the method chosen as compared with other possible methods; whether the method is used by the Specified Cooperative for internal management or other business purposes; whether the method is used for other Federal or state income tax purposes; the availability of costing information; the time, burden, and cost of using alternative methods; and whether the Specified Cooperative applies the method consistently from year to year. Depending on the facts and circumstances, reasonable methods may include methods based on gross receipts (defined in §1.199A-8(b)(2)(iii)), number of units sold, number of units produced, or total production costs. Ordinarily, if a Specified Cooperative uses a method to allocate gross receipts between DPGR and non-DPGR, then the use of a different method to allocate COGS that is not demonstrably more accurate than the method used to allocate gross receipts will not be considered reasonable. However, if a Specified Cooperative has information readily available to specifically identify COGS allocable to DPGR and can specifically identify that amount without undue burden or expense, COGS allocable to DPGR is that amount irrespective of whether the Specified Cooperative uses another allocation method to allocate gross receipts between DPGR and non-DPGR. A Specified Cooperative that does not have information readily available to specifically identify COGS allocable to DPGR and that cannot, without undue burden or expense, specifically identify that amount is not required to use a method that specifically identifies COGS allocable to DPGR. The chosen reasonable method must be consistently applied from one taxable year to another and must clearly reflect the portion of COGS between DPGR and non-DPGR. The method must also be reasonable based on all the facts and circumstances. The books and records maintained for COGS must be consistent with any allocations under this paragraph (b)(2).

(ii) Gross receipts recognized in an earlier taxable year. If the Specified Cooperative (other than a Specified Cooperative that uses the small business simplified overall method of paragraph (f) of this section) recognizes and reports gross receipts on a Federal income tax return for a taxable year, and incurs COGS related to such gross receipts in a subsequent taxable year, then regardless of whether the gross receipts ultimately qualify as DPGR, the Specified Cooperative must allocate the COGS to—

(A) DPGR if the Specified Cooperative identified the related gross receipts as DPGR in the prior taxable year; or

(B) Non-DPGR if the Specified Cooperative identified the related gross receipts as non-DPGR in the prior taxable year or if the Specified Cooperative recognized under the Specified Cooperative’s methods of accounting those gross receipts in a taxable year to which section 199A(g) does not apply.

(iii) COGS associated with activities undertaken in an earlier taxable year—(A) In general. A Specified Cooperative must allocate its COGS between DPGR and non-DPGR under the rules provided in paragraphs (b)(2)(i) and (iii) of this section, regardless of whether certain costs included in its COGS can be associated with activities undertaken in an earlier taxable year (including a year prior to the effective date of section 199A(g)). A Specified Cooperative may not segregate its COGS into component costs and allocate those component costs between DPGR and non-DPGR.

(B) Example. The following example illustrates an application of paragraph (b)(2)(iii)(A) of this section.

(1) Example. During the 2018 taxable year, nonexempt Specified Cooperative X grew and sold Horticultural Product A. All of the patronage gross receipts from sales recognized by X in 2018 were from the sale of Horticultural Product A and qualified as DPGR. Employee 1 of X was involved in X’s production process until he retired in 2013. In 2018, X paid $30 directly from its general assets for Employee 1’s medical expenses pursuant to an unfunded, self-insured plan for retired X employees. For purposes of computing X’s 2018 taxable income, X capitalized those medical costs to inventory under section 263A. In 2018, the COGS for a unit of Horticultural Product A was $100 (including the applicable portion of the $30 paid for Employee 1’s medical costs that was allocated to COGS under X’s allocation method for additional section 263A costs). X has information readily available to specifically identify COGS allocable to DPGR and can identify that amount without undue burden and expense because all of X’s gross receipts from sales in 2018 are attributable to the sale of Horticultural Product A and qualify as DPGR. The inventory cost of each unit of Horticultural Product A sold in 2018, including the applicable portion of retiree medical costs, is related to X’s gross receipts from the sale of Horticultural Product A in 2018. X may not segregate the 2018 COGS by separately allocating the retiree medical costs, which are components of COGS, to DPGR and non-DPGR. Thus, even though the retiree medical costs can be associated with activities undertaken in prior years, $100 of inventory cost of each unit of Horticultural Product A sold in 2018, including the applicable portion of the retiree medical expense cost component, is allocable to DPGR in 2018.

(3) Special allocation rules. Section 199A(g)(3)(C) provides the following two special rules—

(i) For purposes of determining the COGS that are allocable to DPGR, any item or service brought into the United States (defined in §1.199A-9(i)) is treated as acquired by purchase, and its cost is treated as not less than its value immediately after it entered the United States. A similar rule applies in determining the adjusted basis of leased or rented property where the lease or rental gives rise to DPGR.

(ii) In the case of any property described in paragraph (b)(3)(i) of this section that has been exported by the Specified Cooperative for further manufacture, the increase in cost or adjusted basis under paragraph (b)(3)(i) of this section cannot exceed the difference between the value of the property when exported and the value of the property when brought back into the United States after the further manufacture. For the purposes of this paragraph (b)(3), the value of property is its customs value as defined in section 1059A(b)(1).

(4) Rules for inventories valued at market or bona fide selling prices. If part of COGS is attributable to the Specified Cooperative’s inventory valuation adjustments, then COGS allocable to DPGR includes inventory adjustments to agricultural or horticultural products that are MPGE in whole or significant part within the United States. Accordingly, a Specified Cooperative that values its inventory under §1.471-4 (inventories at cost or market, whichever is lower) or §1.471-2(c) (subnormal goods at bona fide selling prices) must allocate a proper share of such adjustments (for example, write-downs) to DPGR based on a reasonable method based on all the facts and circumstances. Factors taken into account in determining whether the method is reasonable include whether the Specified Cooperative uses the most accurate information available; the relationship between the adjustment and the allocation base chosen; the accuracy of the method chosen as compared with other possible methods; whether the method is used by the Specified Cooperative for internal management or other business purposes; whether the method is used for other Federal or state income tax purposes; the time, burden, and cost of using alternative methods; and whether the Specified Cooperative applies the method consistently from year to year. If the Specified Cooperative has information readily available to specifically identify the proper amount of inventory valuation adjustments allocable to DPGR, then the Specified Cooperative must allocate that amount to DPGR. The Specified Cooperative that does not have information readily available to specifically identify the proper amount of its inventory valuation adjustments allocable to DPGR and that cannot, without undue burden or expense, specifically identify the proper amount of its inventory valuation adjustments allocable to DPGR, is not required to use a method that specifically identifies inventory valuation adjustments to DPGR. The chosen reasonable method must be consistently applied from one taxable year to another and must clearly reflect inventory adjustments. The method must also be reasonable based on all the facts and circumstances. The books and records maintained for inventory adjustments must be consistent with any allocations under this paragraph (b)(4).

(5) Rules applicable to inventories accounted for under the last-in, first-out inventory method—(i) In general. This paragraph (b)(5) applies to inventories accounted for using the specific goods last-in, first-out (LIFO) method or the dollar-value LIFO method. Whenever a specific goods grouping or a dollar-value pool contains agricultural or horticultural products that produce DPGR and goods that do not, the Specified Cooperative must allocate COGS attributable to that grouping or pool between DPGR and non-DPGR using a reasonable method based on all the facts and circumstances. Whether a method of allocating COGS between DPGR and non-DPGR is reasonable must be determined in accordance with paragraph (b)(2) of this section. In addition, this paragraph (b)(5) provides methods that a Specified Cooperative may use to allocate COGS for a Specified Cooperative’s inventories accounted for using the LIFO method. If the Specified Cooperative uses the LIFO/FIFO ratio method provided in paragraph (b)(5)(ii) of this section or the change in relative base-year cost method provided in paragraph (b)(5)(iii) of this section, then the Specified Cooperative must use that method for all of the Specified Cooperative’s inventory accounted for under the LIFO method. The chosen reasonable method must be consistently applied from one taxable year to another and must clearly reflect the inventory method. The method must also be reasonable based on all the facts and circumstances. The books and records maintained for the inventory method must be consistent with any allocations under this paragraph (b)(5).

(ii) LIFO/FIFO ratio method. The LIFO/FIFO ratio method is applied with respect to the LIFO inventory on a grouping-by-grouping or pool-by-pool basis. Under the LIFO/FIFO ratio method, a Specified Cooperative computes the COGS of a grouping or pool allocable to DPGR by multiplying the COGS of agricultural or horticultural products (defined in §1.199A-8(a)(4)) in the grouping or pool that produced DPGR computed using the FIFO method by the LIFO/FIFO ratio of the grouping or pool. The LIFO/FIFO ratio of a grouping or pool is equal to the total COGS of the grouping or pool computed using the LIFO method over the total COGS of the grouping or pool computed using the FIFO method.

(iii) Change in relative base-year cost method. A Specified Cooperative using the dollar-value LIFO method may use the change in relative base-year cost method. The change in relative base-year cost method for a Specified Cooperative using the dollar-value LIFO method is applied to all LIFO inventory on a pool-by-pool basis. The change in relative base-year cost method determines the COGS allocable to DPGR by increasing or decreasing the total production costs (section 471 costs and additional section 263A costs) of agricultural or horticultural products that generate DPGR by a portion of any increment or liquidation of the dollar-value pool. The portion of an increment or liquidation allocable to DPGR is determined by multiplying the LIFO value of the increment or liquidation (expressed as a positive number) by the ratio of the change in total base-year cost (expressed as a positive number) of agricultural or horticultural products that will generate DPGR in ending inventory to the change in total base-year cost (expressed as a positive number) of all goods in ending inventory. The portion of an increment or liquidation allocable to DPGR may be zero but cannot exceed the amount of the increment or liquidation. Thus, a ratio in excess of 1.0 must be treated as 1.0.

(6) Specified Cooperative using a simplified method for additional section 263A costs to ending inventory. A Specified Cooperative that uses a simplified method specifically described in the section 263A regulations to allocate additional section 263A costs to ending inventory must follow the rules in paragraph (b)(2) of this section to determine the amount of additional section 263A costs allocable to DPGR. Allocable additional section 263A costs include additional section 263A costs included in the Specified Cooperative’s beginning inventory as well as additional section 263A costs incurred during the taxable year by the Specified Cooperative. Ordinarily, if the Specified Cooperative uses a simplified method specifically described in the section 263A regulations to allocate its additional section 263A costs to its ending inventory, the additional section 263A costs must be allocated in the same proportion as section 471 costs are allocated.

(c) Other deductions properly allocable to DPGR or gross income attributable to DPGR—(1) In general. In determining its QPAI, the Specified Cooperative must subtract from its DPGR (in addition to the COGS), the deductions that are properly allocable and apportioned to DPGR. A Specified Cooperative generally must allocate and apportion these deductions using the rules of the section 861 method provided in paragraph (d) of this section. In lieu of the section 861 method, an eligible Specified Cooperative may apportion these deductions using the simplified deduction method provided in paragraph (e) of this section. Paragraph (f) of this section provides a small business simplified overall method that may be used by a qualifying small Specified Cooperative. A Specified Cooperative using the simplified deduction method or the small business simplified overall method must use that method for all deductions. A Specified Cooperative eligible to use the small business simplified overall method may choose at any time for any taxable year to use the small business simplified overall method or the simplified deduction method for a taxable year.

(2) Treatment of net operating losses. A deduction under section 172 for a net operating loss (NOL) is not allocated or apportioned to DPGR or gross income attributable to DPGR.

(3) W-2 wages. Although only W-2 wages as described in §1.199A-11 are taken into account in computing the W-2 wage limitation, all wages paid (or incurred in the case of an accrual method taxpayer) in the taxable year are taken into account in computing QPAI for that taxable year.

(d) Section 861 method. Under the section 861 method, the Specified Cooperative must allocate and apportion its deductions using the allocation and apportionment rules provided under the section 861 regulations under which section 199A(g) is treated as an operative section described in §1.861-8(f). Accordingly, the Specified Cooperative applies the rules of the section 861 regulations to allocate and apportion deductions (including, if applicable, its distributive share of deductions from passthrough entities) to gross income attributable to DPGR. If the Specified Cooperative applies the allocation and apportionment rules of the section 861 regulations for section 199A(g) and another operative section, then the Specified Cooperative must use the same method of allocation and the same principles of apportionment for purposes of all operative sections. Research and experimental expenditures must be allocated and apportioned in accordance with §1.861-17 without taking into account the exclusive apportionment rule of §1.861-17(b). Deductions for charitable contributions (as allowed under section 170 and section 873(b)(2) or 882(c)(1)(B)) must be ratably apportioned between gross income attributable to DPGR and gross income attributable to non-DPGR based on the relative amounts of gross income.

(e) Simplified deduction method—(1) In general. An eligible Specified Cooperative (defined in paragraph (e)(2) of this section) may use the simplified deduction method to apportion business deductions between DPGR and non-DPGR. The simplified deduction method does not apply to COGS. Under the simplified deduction method, the business deductions (except the NOL deduction) are ratably apportioned between DPGR and non-DPGR based on relative gross receipts. Accordingly, the amount of deductions for the current taxable year apportioned to DPGR is equal to the proportion of the total business deductions for the current taxable year that the amount of DPGR bears to total gross receipts.

(2) Eligible Specified Cooperative. For purposes of this paragraph (e), an eligible Specified Cooperative is—

(i) A Specified Cooperative that has average annual total gross receipts (as defined in paragraph (g) of this section) of $100,000,000 or less; or

(ii) A Specified Cooperative that has total assets (as defined in paragraph (e)(3) of this section) of $10,000,000 or less.

(3) Total assets.—(i) In general. For purposes of the simplified deduction method, total assets mean the total assets the Specified Cooperative has at the end of the taxable year.

(ii) Members of an expanded affiliated group. To compute the total assets of an expanded affiliated group (EAG) at the end of the taxable year, the total assets at the end of the taxable year of each member of the EAG at the end of the taxable year that ends with or within the taxable year of the computing member (as described in §1.199A-12(g)) are aggregated.

(4) Members of an expanded affiliated group—(i) In general. Whether the members of an EAG may use the simplified deduction method is determined by reference to all the members of the EAG. If the average annual gross receipts of the EAG are less than or equal to $100,000,000 or the total assets of the EAG are less than or equal to $10,000,000, then each member of the EAG may individually determine whether to use the simplified deduction method, regardless of the cost allocation method used by the other members.

(ii) Exception. Notwithstanding paragraph (e)(4)(i) of this section, all members of the same consolidated group must use the same cost allocation method.

(f) Small business simplified overall method—(1) In general. A qualifying small Specified Cooperative may use the small business simplified overall method to apportion COGS and deductions between DPGR and non-DPGR. Under the small business simplified overall method, a Specified Cooperative’s total costs for the current taxable year (as defined in paragraph (f)(3) of this section) are apportioned between DPGR and non-DPGR based on relative gross receipts. Accordingly, the amount of total costs for the current taxable year apportioned to DPGR is equal to the proportion of total costs for the current taxable year that the amount of DPGR bears to total gross receipts.

(2) Qualifying small Specified Cooperative. For purposes of this paragraph (f), a qualifying small Specified Cooperative is a Specified Cooperative that has average annual total gross receipts (as defined in paragraph (g) of this section) of $25,000,000 or less.

(3) Total costs for the current taxable year. For purposes of the small business simplified overall method, total costs for the current taxable year means the total COGS and deductions for the current taxable year. Total costs for the current taxable year are determined under the methods of accounting that the Specified Cooperative uses to compute taxable income.

(4) Members of an expanded affiliated group—(i) In general. Whether the members of an EAG may use the small business simplified overall method is determined by reference to all the members of the EAG. If the average annual gross receipts of the EAG are less than or equal to $25,000,000 then each member of the EAG may individually determine whether to use the small business simplified overall method, regardless of the cost allocation method used by the other members.

(ii) Exception. Notwithstanding paragraph (f)(4)(i) of this section, all members of the same consolidated group must use the same cost allocation method.

(g) Average annual gross receipts—(1) In general. For purposes of the simplified deduction method and the small business simplified overall method, average annual gross receipts means the average annual gross receipts of the Specified Cooperative for the 3 taxable years (or, if fewer, the taxable years during which the taxpayer was in existence) preceding the current taxable year, even if one or more of such taxable years began before the effective date of section 199A(g). In the case of any taxable year of less than 12 months (a short taxable year), the gross receipts of the Specified Cooperative are annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period.

(2) Members of an expanded affiliated group—(i) In general. To compute the average annual gross receipts of an EAG, the gross receipts for the entire taxable year of each member that is a member of the EAG at the end of its taxable year that ends with or within the taxable year are aggregated. For purposes of this paragraph (g)(2), a consolidated group is treated as one member of an EAG.

(ii) Exception. Notwithstanding paragraph (g)(1)(i) of this section, all members of the same consolidated group must use the same cost allocation method.

(h) Cost allocation methods for determining oil-related QPAI—(1) Section 861 method. A Specified Cooperative that uses the section 861 method to determine deductions that are allocated and apportioned to gross income attributable to DPGR must use the section 861 method to determine deductions that are allocated and apportioned to gross income attributable to oil-related DPGR.

(2) Simplified deduction method. A Specified Cooperative that uses the simplified deduction method to apportion deductions between DPGR and non-DPGR must determine the portion of deductions allocable to oil-related DPGR by multiplying the deductions allocable to DPGR by the ratio of oil-related DPGR to DPGR from all activities.

(3) Small business simplified overall method. A Specified Cooperative that uses the small business simplified overall method to apportion total costs (COGS and deductions) between DPGR and non-DPGR must determine the portion of total costs allocable to oil-related DPGR by multiplying the total costs allocable to DPGR by the ratio of oil-related DPGR to DPGR from all activities.

(i) Applicability date. The provisions of this section apply to taxable years ending after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register. Taxpayers, however, may rely on these regulations until that date, but only if the taxpayers apply the rules in their entirety and in a consistent manner.

(a) Rules of application—(1) In general. The provisions of this section apply solely for purposes of section 199A(g) of the Internal Revenue Code (Code). The provisions of this section provide guidance on determining the W-2 wage limitation as defined in §1.199A-8(b)(5)(ii)(B). Except as provided in paragraph (d)(2) of this section, the Form W-2, Wage and Tax Statement, or any subsequent form or document used in determining the amount of W-2 wages, are those issued for the calendar year ending during the taxable year of the Specified Cooperative (defined in §1.199A-8(a)(2)) for wages paid to employees (or former employees) of the Specified Cooperative for employment by the Specified Cooperative. Employees are limited to employees defined in section 3121(d)(1) and (2) (that is, officers of a corporate taxpayer and employees of the taxpayer under the common law rules). See paragraph (a)(5) of this section for the requirement that W-2 wages must have been included in a return filed with the Social Security Administration (SSA) within 60 days after the due date (including extensions) of the return. See also section 199A(a)(4)(C).

(2) Wage limitation for section 199A(g) deduction. The amount of the deduction allowable under section 199A(g) to the Specified Cooperative for any taxable year cannot exceed 50 percent of the W-2 wages (as defined in section 199A(g)(1)(B)(ii) and paragraph (b) of this section) for the taxable year that are attributable to domestic production gross receipts (DPGR), defined in §1.199A-8(b)(3)(ii), of agricultural or horticultural products defined in §1.199A-8(a)(4).

(3) Wages paid by entity other than common law employer. In determining W-2 wages, the Specified Cooperative may take into account any W-2 wages paid by another entity and reported by the other entity on Forms W-2 with the other entity as the employer listed in Box c of the Forms W-2, provided that the W-2 wages were paid to common law employees or officers of the Specified Cooperative for employment by the Specified Cooperative. In such cases, the entity paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that entity. For purposes of this paragraph (a)(4), entities that pay and report W-2 wages on behalf of or with respect to other taxpayers can include, but are not limited to, certified professional employer organizations under section 7705, statutory employers under section 3401(d)(1), and agents under section 3504.

(4) Requirement that wages must be reported on return filed with the Social Security Administration—(i) In general. Pursuant to section 199A(g)(1)(B)(ii) and section 199A(b)(4)(C), the term W-2 wages does not include any amount that is not properly included in a return filed with SSA on or before the 60th day after the due date (including extensions) for such return. Under §31.6051-2 of this chapter, each Form W-2 and the transmittal Form W-3, Transmittal of Wage and Tax Statements, together constitute an information return to be filed with SSA. Similarly, each Form W-2c, Corrected Wage and Tax Statement, and the transmittal Form W-3 or W-3c, Transmittal of Corrected Wage and Tax Statements, together constitute an information return to be filed with SSA. In determining whether any amount has been properly included in a return filed with SSA on or before the 60th day after the due date (including extensions) for such return, each Form W-2 together with its accompanying Form W-3 is considered a separate information return and each Form W-2c together with its accompanying Form W-3 or Form W-3c is considered a separate information return. Section 6071(c) provides that Forms W-2 and W-3 must be filed on or before January 31 of the year following the calendar year to which such returns relate (but see the special rule in §31.6071(a)-1T(a)(3)(1) of this chapter for monthly returns filed under §31.6011(a)-5(a) of this chapter). Corrected Forms W-2 are required to be filed with SSA on or before January 31 of the year following the year in which the correction is made.

(ii) Corrected return filed to correct a return that was filed within 60 days of the due date. If a corrected information return (Return B) is filed with SSA on or before the 60th day after the due date (including extensions) of Return B to correct an information return (Return A) that was filed with SSA on or before the 60th day after the due date (including extensions) of the information return (Return A) and paragraph (a)(5)(iii) of this section does not apply, then the wage information on Return B must be included in determining W-2 wages. If a corrected information return (Return D) is filed with SSA later than the 60th day after the due date (including extensions) of Return D to correct an information return (Return C) that was filed with SSA on or before the 60th day after the due date (including extensions) of the information return (Return C), then if Return D reports an increase (or increases) in wages included in determining W-2 wages from the wage amounts reported on Return C, such increase (or increases) on Return D is disregarded in determining W-2 wages (and only the wage amounts on Return C may be included in determining W-2 wages). If Return D reports a decrease (or decreases) in wages included in determining W-2 wages from the amounts reported on Return C, then, in determining W-2 wages, the wages reported on Return C must be reduced by the decrease (or decreases) reflected on Return D.

(iii) Corrected return filed to correct a return that was filed later than 60 days after the due date. If an information return (Return F) is filed to correct an information return (Return E) that was not filed with SSA on or before the 60th day after the due date (including extensions) of Return E, then Return F (and any subsequent information returns filed with respect to Return E) will not be considered filed on or before the 60th day after the due date (including extensions) of Return F (or the subsequent corrected information return). Thus, if a Form W-2c is filed to correct a Form W-2 that was not filed with SSA on or before the 60th day after the due date (including extensions) of the Form W-2 (or to correct a Form W-2c relating to a Form W-2 that had not been filed with SSA on or before the 60th day after the due date (including extensions) of the Form W-2), then this Form W-2c is not to be considered to have been filed with SSA on or before the 60th day after the due date (including extensions) for this Form W-2c, regardless of when the Form W-2c is filed.

(b) Definition of W-2 wages—(1) In general. Section 199A(g)(1)(B)(ii) provides that the W-2 wages of the Specified Cooperative must be determined in the same manner as under section 199A(b)(4) (without regard to section 199A(b)(4)(B) and after application of section 199A(b)(5)). Section 199A(b)(4)(A) provides that the term W-2 wages means with respect to any person for any taxable year of such person, the amounts described in paragraphs (3) and (8) of section 6051(a) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year. Thus, the term W-2 wages includes the total amount of wages as defined in section 3401(a); the total amount of elective deferrals (within the meaning of section 402(g)(3)); the compensation deferred under section 457; and the amount of designated Roth contributions (as defined in section 402A).

(2) Section 199A(g) deduction. Pursuant to section 199A(g)(3)(A), W-2 wages do not include any amount which is not properly allocable to DPGR for purposes of calculating qualified production activities income (QPAI) as defined in §1.199A-8(b)(4)(ii). The Specified Cooperative may determine the amount of wages that is properly allocable to DPGR using a reasonable method based on all the facts and circumstances. The chosen reasonable method must be consistently applied from one taxable year to another and must clearly reflect the wages allocable to DPGR for purposes of QPAI. The books and records maintained for wages allocable to DPGR for purposes of QPAI must be consistent with any allocations under this paragraph (b)(2).

(c) Methods for calculating W-2 wages. The Secretary may provide for methods to be used in calculating W-2 wages, including W-2 wages for short taxable years by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter).

(d) Wage limitation — acquisitions, dispositions, and short taxable years—(1) In general. For purposes of computing the deduction under section 199A(g) of the Specified Cooperative, in the case of an acquisition or disposition (as defined in section 199A(b)(5) and paragraph (d)(3) of this section) that causes more than one Specified Cooperative to be an employer of the employees of the acquired or disposed of Specified Cooperative during the calendar year, the W-2 wages of the Specified Cooperative for the calendar year of the acquisition or disposition are allocated between or among each Specified Cooperative based on the period during which the employees of the acquired or disposed of Specified Cooperatives were employed by the Specified Cooperative, regardless of which permissible method is used for reporting predecessor and successor wages on Form W-2, Wage and Tax Statement.

(2) Short taxable year that does not include December 31. If the Specified Cooperative has a short taxable year that does not contain a calendar year ending during such short taxable year, wages paid to employees for employment by the Specified Cooperative during the short taxable year are treated as W-2 wages for such short taxable year for purposes of paragraph (a) of this section (if the wages would otherwise meet the requirements to be W-2 wages under this section but for the requirement that a calendar year must end during the short taxable year).

(3) Acquisition or disposition. For purposes of paragraph (d)(1) and (2) of this section, the terms acquisition and disposition include an incorporation, a liquidation, a reorganization, or a purchase or sale of assets.

(e) Application in the case of a Specified Cooperative with a short taxable year. In the case of a Specified Cooperative with a short taxable year, subject to the rules of paragraph (a) of this section, the W-2 wages of the Specified Cooperative for the short taxable year can include only those wages paid during the short taxable year to employees of the Specified Cooperative, only those elective deferrals (within the meaning of section 402(g)(3)) made during the short taxable year by employees of the Specified Cooperative, and only compensation actually deferred under section 457 during the short taxable year with respect to employees of the Specified Cooperative.

(f) Non-duplication rule. Amounts that are treated as W-2 wages for a taxable year under any method cannot be treated as W-2 wages of any other taxable year. Also, an amount cannot be treated as W-2 wages by more than one taxpayer. Finally, an amount cannot be treated as W-2 wages by the Specified Cooperative both in determining patronage and nonpatronage W-2 wages.

(g) Wage expense safe harbor—(1) In general. A Specified Cooperative using either the section 861 method of cost allocation under §1.199A-10(d) or the simplified deduction method under §1.199A-10(e) may determine the amount of W-2 wages that are properly allocable to DPGR for a taxable year by multiplying the amount of W-2 wages determined under paragraph (b)(1) of this section for the taxable year by the ratio of the Specified Cooperative’s wage expense included in calculating QPAI for the taxable year to the Specified Cooperative’s total wage expense used in calculating the Specified Cooperative’s taxable income for the taxable year, without regard to any wage expense disallowed by section 465, 469, 704(d), or 1366(d). A Specified Cooperative that uses either the section 861 method of cost allocation or the simplified deduction method to determine QPAI must use the same expense allocation and apportionment methods that it uses to determine QPAI to allocate and apportion wage expense for purposes of this safe harbor. For purposes of this paragraph (g)(1), the term wage expense means wages (that is, compensation paid by the employer in the active conduct of a trade or business to its employees) that are properly taken into account under the Specified Cooperative’s method of accounting.

(2) Wage expense included in cost of goods sold. For purposes of paragraph (g)(1) of this section, a Specified Cooperative may determine its wage expense included in cost of goods sold (COGS) using a reasonable method based on all the facts and circumstances, such as using the amount of direct labor included in COGS or using section 263A labor costs (as defined in §1.263A-1(h)(4)(ii)) included in COGS. The chosen reasonable method must be consistently applied from one taxable year to another and must clearly reflect the portion of wage expense included in COGS. The method must also be reasonable based on all the facts and circumstances. The books and records maintained for wage expense included in COGS must be consistent with any allocations under this paragraph (g)(2).

(3) Small business simplified overall method safe harbor. The Specified Cooperative that uses the small business simplified overall method under §1.199A-10(f) may use the small business simplified overall method safe harbor for determining the amount of W-2 wages determined under paragraph (b)(1) of this section that is properly allocable to DPGR. Under this safe harbor, the amount of W-2 wages determined under paragraph (b)(1) of this section that is properly allocable to DPGR is equal to the same proportion of W-2 wages determined under paragraph (b)(1) of this section that the amount of DPGR bears to the Specified Cooperative’s total gross receipts.

(h) Applicability date. The provisions of this section apply to taxable years ending after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register. Taxpayers, however, may rely on these regulations until that date, but only if the taxpayers apply the rules in their entirety and in a consistent manner.

(a) In general. The provisions of this section apply solely for purposes of section 199A(g) of the Internal Revenue Code (Code). Except as otherwise provided in the Code or regulations issued under the relevant section of the Code (for example, sections 199A(g)(3)(D)(ii) and 267, §1.199A-8(c), paragraph (a)(3) of this section, and the consolidated return regulations under section 1502, each Specified Cooperative whether exempt or nonexempt (as defined in §1.199A-8(a)(2)(iii)) that is a member of an expanded affiliated group (EAG) (defined in paragraph (a)(1) of this section) computes its own taxable income or loss, qualified production activities income (QPAI) (defined in §1.199A-8(b)(4)(ii)), and W-2 wages (defined in §1.199A-11(b)). If a Specified Cooperative is also a member of a consolidated group, see paragraph (d) of this section.

(1) Definition of an expanded affiliated group. An EAG is an affiliated group as defined in section 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent” in each place it appears and without regard to section 1504(b)(2) and (4).

(2) Identification of members of an expanded affiliated group—(i) In general. Each Specified Cooperative must determine if it is a member of an EAG on a daily basis.

(ii) Becoming or ceasing to be a member of an expanded affiliated group. If a Specified Cooperative becomes or ceases to be a member of an EAG, the Specified Cooperative is treated as becoming or ceasing to be a member of the EAG at the end of the day on which its status as a member changes.

(3) Attribution of activities—(i) In general. Except as provided in paragraph (a)(3)(iv) of this section, if a Specified Cooperative that is a member of an EAG (disposing member) derives gross receipts (defined in §1.199A-8(b)(2)(iii)) from the lease, rental, license, sale, exchange, or other disposition (defined in §1.199A-9(j)) of agricultural or horticultural products (defined in §1.199A-8(a)(4)) that were manufactured, produced, grown or extracted (MPGE) (as defined in §1.199A-9(f)), in whole or significant part (as defined in §1.199A-9(h)) in the United States (as defined in §1.199A-9(i)) by another Specified Cooperative, then the disposing member is treated as conducting the previous activities conducted by such other Specified Cooperative with respect to the agricultural or horticultural products in determining whether its gross receipts are domestic production gross receipts (DPGR) (defined in §1.199A-8(b)(3)(ii)) if—

(A) Such property was MPGE by such other Specified Cooperative, and

(B) The disposing member is a member of the same EAG as such other Specified Cooperative at the time that the disposing member disposes of the agricultural or horticultural products.

(ii) Date of disposition for leases, rentals, or licenses. Except as provided in paragraph (a)(3)(iv) of this section, with respect to a lease, rental, or license, the disposing member described in paragraph (a)(3)(i) of this section is treated as having disposed of the agricultural or horticultural products on the date or dates on which it takes into account the gross receipts derived from the lease, rental, or license under its methods of accounting.

(iii) Date of disposition for sales, exchanges, or other dispositions. Except as provided in paragraph (a)(3)(iv) of this section, with respect to a sale, exchange, or other disposition, the disposing member is treated as having disposed of the agricultural or horticultural products on the date on which it ceases to own the agricultural or horticultural products for Federal income tax purposes, even if no gain or loss is taken into account.

(iv) Exception. Nonexempt Specified Cooperatives. A nonexempt Specified Cooperative is not attributed nonpatronage activities conducted by another Specified Cooperative. See §1.199A-8(b)(2)(ii).

(4) Marketing Specified Cooperatives. A Specified Cooperative will be treated as having MPGE in whole or significant part any agricultural or horticultural product within the United States marketed by the Specified Cooperative which its patrons have so MPGE. Patrons are defined in §1.1388-1(e).

(5) Anti-avoidance rule. If a transaction between members of an EAG is engaged in or structured with a principal purpose of qualifying for, or increasing the amount of, the section 199A(g) deduction of the EAG or the portion of the section 199A(g) deduction allocated to one or more members of the EAG, the Secretary may make adjustments to eliminate the effect of the transaction on the computation of the section 199A(g) deduction.

(b) Computation of EAG’s section 199A(g) deduction.—(1) In general. The section 199A(g) deduction for an EAG is determined by separately computing the section 199A(g) deduction from the patronage sources of Specified Cooperatives that are members of the EAG and the section 199A(g) deduction from the nonpatronage sources of exempt Specified Cooperatives that are members of the EAG. The section 199A(g) deduction from patronage sources of Specified Cooperatives is determined by aggregating the income or loss, QPAI, and W-2 wages, if any, of each patronage source of a Specified Cooperative that is a member of the EAG (whether an exempt or nonexempt Specified Cooperative). The section 199A(g) deduction from nonpatronage sources of exempt Specified Cooperatives is determined by aggregating the income or loss, QPAI, and W-2 wages, if any, of each nonpatronage source of exempt Specified Cooperatives that are members of the EAG. For purposes of this determination, a member’s QPAI may be positive or negative. A Specified Cooperative’s taxable income or loss and QPAI will be determined by reference to the Specified Cooperative’s method of accounting. For purposes of determining the section 199A(g) deduction for an EAG, taxable income or loss, QPAI, and W-2 wages of a nonexempt Specified Cooperative from nonpatronage sources are considered to be zero. See §1.199A-8(b)(2)(ii).

(2) Example. The following examples illustrates the application of paragraph (b)(1) of this section.

(i) Example. Nonexempt Specified Cooperatives X, Y, and Z, calendar year taxpayers, are the only members of an EAG and are not members of a consolidated group. X’s patronage source has taxable income of $50,000, QPAI of $15,000, and W-2 wages of $0. Y has patronage source taxable income of ($20,000), QPAI of ($1,000), and W-2 wages of $750. Z’s patronage source has taxable income of $0, QPAI of $0, and W-2 wages of $3,000. In determining the EAG’s section 199A(g) deduction, the EAG aggregates each member’s patronage source’s taxable income or loss, QPAI, and W-2 wages. Thus, the EAG’s patronage source has taxable income of $30,000, the sum of X’s patronage source taxable income of $50,000, Y’s patronage source taxable income of ($20,000), and Z’s patronage source taxable income of $0. The EAG has QPAI of $14,000, the sum of X’s QPAI of $15,000, Y’s QPAI of ($1,000), and Z’s QPAI of $0. The EAG has W-2 wages of $3,750, the sum of X’s W-2 wages of $0, Y’s W-2 wages of $750, and Z’s W-2 wages of $3,000. Accordingly, the EAG’s section 199A(g) deduction equals $1,260, 9% of $14,000, the lesser of the QPAI and patronage source taxable income, but not greater than $1,875, 50% of its W-2 wages of $3,750. This result would be the same if X had a nonpatronage source income or loss, because nonpatronage source income of a nonexempt Specified Cooperative is not taken into account in determining the section 199A(g) deduction.

(3) Net operating loss carryovers/carrybacks. In determining the taxable income of an EAG, if a Specified Cooperative has a net operating loss (NOL) from its patronage sources that may be carried over or carried back, if applicable, (in accordance with section 172), to the taxable year, then for purposes of determining the taxable income of the Specified Cooperative, the amount of the NOL used to offset taxable income cannot exceed the taxable income of the patronage source of that Specified Cooperative. Similarly, if a Specified Cooperative has an NOL from its nonpatronage sources that may be carried over to the taxable year, then for purposes of determining the taxable income of the Specified Cooperative, the amount of the NOL used to offset taxable income cannot exceed the taxable income of the nonpatronage sources of that Specified Cooperative.

(4) Losses used to reduce taxable income of an expanded affiliated group. The amount of an NOL sustained by a Specified Cooperative member of an EAG that is used in the year sustained in determining an EAG’s taxable income limitation under §1.199A-8(b)(5)(ii)(C) (for nonexempt Specified Cooperatives) or §1.199A-8(c)(4)(i) (for exempt Specified Cooperatives), as applicable, is not treated as an NOL carryover to any taxable year in determining the taxable income limitation under §1.199A-8(b)(5)(ii)(C) or §1.199A-8(c)(4)(i), as applicable. For purposes of this paragraph (b)(4), an NOL is considered to be used if it reduces an EAG’s aggregate taxable income from patronage source or nonpatronage source, as the case may be, regardless of whether the use of the NOL actually reduces the amount of the section 199A(g) deduction that the EAG would otherwise derive. An NOL is not considered to be used to the extent that it reduces an EAG’s aggregate taxable income from patronage source or nonpatronage source, as the case may be, to an amount less than zero. If more than one Specified Cooperative has an NOL used in the same taxable year to reduce the EAG’s taxable income from patronage or nonpatronage sources, as the case may be, the respective NOLs are deemed used in proportion to the amount of each Specified Cooperative’s NOL.

(5) Example. The following example illustrates the application of paragraph (b)(4) of this section.

(i) Example—(A) Facts. Nonexempt Specified Cooperatives A and B are the only two members of an EAG. A and B are both calendar year taxpayers and they do not join in the filing of a consolidated Federal income tax return. Neither A nor B had taxable income or loss prior to 2018. In 2018, A has patronage QPAI and taxable income of $1,000 and B has patronage QPAI of $1,000 and a patronage NOL of $1,500. A also has nonpatronage income of $3,000. B has no activities other than from its patronage activities. In 2019, A has patronage QPAI of $2,000 and patronage taxable income of $1,000 and B has patronage QPAI of $2,000 and patronage taxable income prior to the NOL deduction allowed under section 172 of $2,000. Neither A nor B has nonpatronage activities in 2019. A’s and B’s patronage activities have aggregate W-2 wages in excess of the section 199A(g)(1)(B) wage limitation in both 2018 and 2019.

(B) Section 199A(g) deduction for 2018. In determining the EAG’s section 199A(g) deduction for 2018, A’s $1,000 of QPAI and B’s $1,000 of QPAI are aggregated, as are A’s $1,000 of taxable income from its patronage activities and B’s $1,500 NOL from its patronage activities. A’s nonpatronage income is not included. Thus, for 2018, the EAG has patronage QPAI of $2,000 and patronage taxable income of ($500). The EAG’s section 199A(g) deduction for 2018 is 9% of the lesser of its patronage QPAI or its patronage taxable income. Because the EAG has a taxable loss from patronage sources in 2018, the EAG’s section 199A(g) deduction is $0.

(C) Section 199A(a) deduction for 2019. In determining the EAG’s section 199A deduction for 2019, A’s patronage QPAI of $2,000 and B’s patronage QPAI of $2,000 are aggregated, resulting in the EAG having patronage QPAI of $4,000. Also, $1,000 of B’s patronage NOL from 2018 was used in 2018 to reduce the EAG’s taxable income from patronage sources to $0. The remaining $500 of B’s patronage NOL from 2018 is not considered to have been used in 2018 because it reduced the EAG’s patronage taxable income to less than $0. Accordingly, for purposes of determining the EAG’s taxable income limitation under §1.199A-8(b)(5) in 2019, B is deemed to have only a $500 NOL carryover from its patronage sources from 2018 to offset a portion of its 2019 taxable income from its patronage sources. Thus, B’s taxable income from its patronage sources in 2019 is $1,500, which is aggregated with A’s $1,000 of taxable income from its patronage sources. The EAG’s taxable income limitation in 2019 is $2,500. The EAG’s section 199A(g) deduction is 9% of the lesser of its patronage sourced QPAI of $4,000 and its taxable income from patronage sources of $2,500. Thus, the EAG’s section 199A(g) deduction in 2019 is 9% of $2,500, or $225. The results for 2019 would be the same if neither A nor B had patronage sourced QPAI in 2018.

(c) Allocation of an expanded affiliated group’s section 199A(g) deduction among members of the expanded affiliated group—(1) In general. An EAG’s section 199A(g) deduction from its patronage sources, as determined in paragraph (b) of this section, is allocated among the Specified Cooperatives that are members of the EAG in proportion to each Specified Cooperative’s patronage QPAI, regardless of whether the Specified Cooperative has patronage taxable income or W-2 wages for the taxable year. An EAG’s section 199A(g) deduction from its nonpatronage sources, as determined in paragraph (b) of this section, is allocated among the Specified Cooperatives that are members of the EAG in proportion to each Specified Cooperative’s nonpatronage QPAI, regardless of whether the Specified Cooperative has nonpatronage taxable income or W-2 wages for the taxable year. For these purposes, if a Specified Cooperative has negative patronage or nonpatronage QPAI, such QPAI is treated as zero. Pursuant to §1.199A-8(b)(6), a patronage section 199A(g) deduction can be applied only against patronage income and deductions. Pursuant to §1.199A-8(c)(ii), a nonpatronage section 199A(g) deduction and can be applied only against nonpatronage income and deductions.

(2) Use of section 199A(g) deduction to create or increase a net operating loss. If a Specified Cooperative that is a member of an EAG has some or all of the EAG’s section 199A(g) deduction allocated to it under paragraph (c)(1) of this section and the amount allocated exceeds patronage or nonpatronage taxable income, determined as described in this section and prior to allocation of the section 199A(g) deduction, the section 199A(g) deduction will create an NOL for the patronage source or nonpatronage source. Similarly, if a Specified Cooperative that is a member of an EAG, prior to the allocation of some or all of the EAG’s section 199A(g) deduction to the member, has a patronage or nonpatronage NOL for the taxable year, the portion of the EAG’s section 199A(g) deduction allocated to the member will increase such NOL.

(d) Special rules for members of the same consolidated group—(1) Intercompany transactions. In the case of an intercompany transaction between consolidated group members S and B (as the terms intercompany transaction, S and B are defined in §1.1502-13(b)(1)), S takes the intercompany transaction into account in computing the section 199A(g) deduction at the same time and in the same proportion as S takes into account the income, gain, deduction, or loss from the intercompany transaction under §1.1502-13.

(2) Application of the simplified deduction method and the small business simplified overall method. For purposes of applying the simplified deduction method under §1.199A-10(e) and the small business simplified overall method under §1.199A-10(f), a Specified Cooperative that is part of a consolidated group determines its QPAI using its members’ DPGR, non-DPGR, cost of goods sold (COGS), and all other deductions, expenses, or losses (hereinafter deductions), determined after application of §1.1502-13.

(3) Determining the section 199A(g) deduction—(i) Expanded affiliated group consists of consolidated group and non-consolidated group members. In determining the section 199A(g) deduction, if an EAG includes Specified Cooperatives that are members of the same consolidated group and Specified Cooperatives that are not members of the same consolidated group, the consolidated taxable income or loss, QPAI, and W-2 wages, from patronage sources, if any, of the consolidated group (and not the separate taxable income or loss, QPAI, and W-2 wages from patronage sources of the members of the consolidated group), are aggregated with the taxable income or loss, QPAI, and W-2 wages, from patronage sources, if any, of the non-consolidated group members. A similar rule applies with respect to nonpatronage taxable income or loss, QPAI, and W-2 wages. For example, if A, B, C, S1, and S2 are Specified Cooperatives that are members of the same EAG, and A, S1, and S2 are members of the same consolidated group (the A consolidated group), then the A consolidated group is treated as one member of the EAG. Accordingly, the EAG is considered to have three members, the A consolidated group, B, and C. The consolidated taxable income or loss, QPAI, and W-2 wages from patronage sources, if any, of the A consolidated group are aggregated with the taxable income or loss from patronage sources, QPAI, and W-2 wages, if any, of B and C in determining the EAG’s section 199A(g) deduction from patronage sources. Similarly, the consolidated taxable income or loss, QPAI, and W-2 wages from nonpatronage sources, if any, of the A consolidated group are aggregated with the taxable income or loss from nonpatronage sources, QPAI, and W-2 wages, if any, of B and C in determining the EAG’s section 199A(g) deduction from nonpatronage sources. Pursuant to §1.199A-8(b)(6), a patronage section 199A(g) deduction can be applied only against patronage income and deductions. Pursuant to §1.199A-8(c)(ii), a nonpatronage section 199A(g) deduction and can be applied only against nonpatronage income and deductions.

(ii) Expanded affiliated group consists only of members of a single consolidated group. If all of the Specified Cooperatives that are members of an EAG are also members of the same consolidated group, the consolidated group’s section 199A(g) deduction is determined using the consolidated group’s consolidated taxable income or loss, QPAI, and W-2 wages, from patronage sources or nonpatronage sources, as the case may be, rather than the separate taxable income or loss, QPAI, and W-2 wages from patronage sources or nonpatronage sources of its members.

(4) Allocation of the section 199A(g) deduction of a consolidated group among its members. The section 199A(g) deduction from patronage sources of a consolidated group (or the section 199A(g) deduction allocated to a consolidated group that is a member of an EAG) is allocated among the patronage sources of Specified Cooperatives in proportion to each Specified Cooperative’s patronage QPAI, regardless of whether the Specified Cooperative has patronage separate taxable income or W-2 wages for the taxable year. In allocating the section 199A(g) deduction of a patronage source of a Specified Cooperative that is part of a consolidated group among patronage sources of other members of the same group, any redetermination of a member’s patronage receipts, COGS, or other deductions from an intercompany transaction under §1.1502-13(c)(1)(i) or (c)(4) is not taken into account for purposes of section 199A(g). Also, for purposes of this allocation, if a patronage source of a Specified Cooperative that is a member of a consolidated group has negative QPAI, the QPAI of the patronage source is treated as zero.

(e) Examples. The following examples illustrate the application of paragraphs (a) through (d) of this section.

(i) Example 1. Specified Cooperatives X, Y, and Z are members of the same EAG but are not members of a consolidated group. X, Y, and Z each files Federal income tax returns on a calendar year basis. None of X, Y, or Z have activities other than from its patronage sources. Prior to 2018, X had no taxable income or loss. In 2018, X has taxable income of $0, QPAI of $2,000, and W-2 wages of $0, Y has taxable income of $4,000, QPAI of $3,000, and W-2 wages of $500, and Z has taxable income of $4,000, QPAI of $5,000, and W-2 wages of $2,500. Accordingly, the EAG’s patronage source taxable income is $8,000, the sum of X’s taxable income of $0, Y’s taxable income of $4,000, and Z’s taxable income of $4,000. The EAG has QPAI of $10,000, the sum of X’s QPAI of $2,000, Y’s QPAI of $3,000, and Z’s QPAI of $5,000. The EAG’s W-2 wages are $3,000, the sum of X’s W-2 wages of $0, Y’s W-2 wages of $500, and Z’s W-2 wages of $2,500. Thus, the EAG’s section 199A(g) deduction for 2018 is $720 (9% of the lesser of the EAG’s patronage source taxable income of $8,000 and the EAG’s QPAI of $10,000, but no greater than 50% of its W-2 wages of $3,000, i.e., $1,500). Pursuant to paragraph (c)(1) of this section, the $720 section 199A(g) deduction is allocated to X, Y, and Z in proportion to their respective amounts of QPAI, that is $144 to X ($720 × $2,000/$10,000), $216 to Y ($720 × $3,000/$10,000), and $360 to Z ($720 × $5,000/$10,000). Although X’s patronage source taxable income for 2018 determined prior to allocation of a portion of the EAG’s section 199A(g) deduction to it was $0, pursuant to paragraph (c)(2) of this section, X will have an NOL from its patronage source for 2018 equal to $144, which will be a carryover to 2019.

(ii) Example 2. (A) Facts. Corporation X is the common parent of a consolidated group, consisting of X and Y, which has filed a consolidated Federal income tax return for many years. Corporation P is the common parent of a consolidated group, consisting of P and S, which has filed a consolidated Federal income tax return for many years. The X and P consolidated groups each file their consolidated Federal income tax returns on a calendar year basis. X, Y, P, and S are each Specified Cooperatives, and none of X, Y, P, or S has ever had activities other than from its patronage sources. The X consolidated group and the P consolidated group are members of the same EAG in 2019. In 2018, the X consolidated group incurred a consolidated net operating loss (CNOL) of $25,000. Neither P nor S (nor the P consolidated group) has ever incurred an NOL. In 2019, the X consolidated group has (prior to the deduction under section 172) taxable income of $8,000 and the P consolidated group has taxable income of $20,000. X’s QPAI is $8,000, Y’s QPAI is ($13,000), P’s QPAI is $16,000 and S’s QPAI is $4,000. There are sufficient W-2 wages to exceed the section 199A(g)(1)(B) limitation.

(B) Analysis. The X consolidated group uses $8,000 of its CNOL from 2018 to offset the X consolidated group’s taxable income in 2019. None of the X consolidated group’s remaining CNOL may be used to offset taxable income of the P consolidated group under paragraph (b)(3) of this section. Accordingly, for purposes of determining the EAG’s section 199A(g) deduction for 2019, the EAG has taxable income of $20,000 (the X consolidated group’s taxable income, after the deduction under section 172, of $0 plus the P consolidated group’s taxable income of $20,000). The EAG has QPAI of $15,000 (the X consolidated group’s QPAI of ($5,000) (X’s $8,000 + Y’s ($13,000)), and the P consolidated group’s QPAI of $20,000 (P’s $16,000 + S’s $4,000)). The EAG’s section 199A(g) deduction equals $1,350, 9% of the lesser of its taxable income of $20,000 and its QPAI of $15,000. The section 199A(g) deduction is allocated between the X and P consolidated groups in proportion to their respective QPAI. Because the X consolidated group has negative QPAI, all of the section 199A(g) deduction of $1,350 is allocated to the P consolidated group. This $1,350 is allocated between P and S, the members of the P consolidated group, in proportion to their QPAI. Accordingly, P is allocated $1,080 ($1,350 x ($16,000/$20,000) and S is allocated $270 ($1,350 x $4,000/$20,000)).

(f) Allocation of patronage income and loss by a Specified Cooperative that is a member of the expanded affiliated group for only a portion of the year—(1) In general. A Specified Cooperative that becomes or ceases to be a member of an EAG during its taxable year must allocate its taxable income or loss, QPAI, and W-2 wages between the portion of the taxable year that the Specified Cooperative is a member of the EAG and the portion of the taxable year that the Specified Cooperative is not a member of the EAG. This allocation of items is made by using the pro rata allocation method described in this paragraph (f)(1). Under the pro rata allocation method, an equal portion of patronage taxable income or loss, QPAI, and W-2 wages, and nonpatronage taxable income or loss, QPAI, and W-2 wages for the taxable year is assigned to each day of the Specified Cooperative’s taxable year. Those items assigned to those days that the Specified Cooperative was a member of the EAG are then aggregated.

(2) Coordination with rules relating to the allocation of income under §1.1502-76(b). If §1.1502-76(b) (relating to items included in a consolidated return) applies to a Specified Cooperative that is a member of an EAG, then any allocation of items required under this paragraph (f) is made only after the allocation of the items pursuant to §1.1502-76(b).

(g) Total section 199A(g) deduction for a Specified Cooperative that is a member of an expanded affiliated group for some or all of its taxable year—(1) Member of the same EAG for the entire taxable year. If a Specified Cooperative is a member of the same EAG for its entire taxable year, the Specified Cooperative’s section 199A(g) deduction for the taxable year (whether patronage sourced or nonpatronage sourced) is the amount of the section 199A(g) deduction allocated to it by the EAG under paragraph (c)(1) of this section.

(2) Member of the expanded affiliated group for a portion of the taxable year. If a Specified Cooperative is a member of an EAG for only a portion of its taxable year and is either not a member of any EAG or is a member of another EAG, or both, for another portion of the taxable year, the Specified Cooperative’s section 199A(g) deduction for the taxable year (whether patronage sourced or nonpatronage sourced) is the sum of its section 199A(g) deductions for each portion of the taxable year.

(3) Example. The following example illustrates the application of paragraphs (f) and (g) of this section.

(i) Example—(A) Facts. Specified Cooperatives X and Y, calendar year taxpayers, are members of the same EAG for the entire 2018 taxable year. Specified Cooperative Z, also a calendar year taxpayer, is a member of the EAG of which X and Y are members for the first half of 2018 and not a member of any EAG for the second half of 2018. Assume that X, Y, and Z each has W-2 wages in excess of the section 199A(g)(1)(B) wage limitation for all relevant periods. In 2018, X’s patronage source has taxable income of $2,000 and QPAI of $600, Y’s patronage source has a taxable loss of $400 and QPAI of ($200), and Z’s patronage source has taxable income of $1,400 and QPAI of $2,400.

(B) Analysis. Pursuant to the pro rata allocation method, $700 of Z’s 2018 patronage taxable income and $1,200 of its 2018 QPAI are allocated to the first half of the 2018 taxable year (the period in which Z is a member of the EAG) and $700 of Z’s 2018 patronage taxable income and $1,200 of its 2018 QPAI are allocated to the second half of the 2018 taxable year (the period in which Z is not a member of any EAG). Accordingly, in 2018, the EAG has taxable income from patronage source of $2,300 (X’s $2,000 + Y’s ($400) + Z’s $700) and QPAI of $1,600 (X’s $600 + Y’s ($200) + Z’s $1,200). The EAG’s section 199A(g) deduction for 2018 is $144 (9% of the lesser of the EAG’s taxable income from patronage source of $2,300 or QPAI of $1,600). Pursuant to §1.199A-14(c)(1), this $144 deduction is allocated to X’s, Y’s, and Z’s patronage source in proportion to their respective QPAI. Accordingly, X’s patronage source is allocated $48 of the EAG’s section 199A(g) deduction ($144 x ($600/($600 + $0 + $1,200))), Y’s patronage source is allocated $0 of the EAG’s section 199A(g) deduction ($144 x ($0 / ($600 + $0 + $1,200))), and Z’s patronage source is allocated $96 of the EAG’s section 199A(g) deduction ($144 x ($1,200 / ($600 + $0 + $1,200))). For the second half of 2018, Z’s patronage source has taxable income of $700 and QPAI of $1,200. Therefore, for the second half of 2018, Z’s patronage source has a section 199A(g) deduction of $63 (9% of the lesser of its taxable income of $700 or its QPAI of $1,200 for the second half of 2018). Accordingly, X’s 2018 section 199A(g) deduction is $48 and Y’s 2018 section 199A(g) deduction is $0. Z’s 2018 section 199A(g) deduction is $159, the sum of the $96 section 199A(g) deduction of the EAG allocated to Z for the first half of 2018 and Z’s $63 section 199A(g) deduction for the second half of 2018.

(h) Computation of section 199A(g) deduction for members of an expanded affiliated group with different taxable years—(1) In general. If Specified Cooperatives that are members of an EAG have different taxable years, in determining the section 199A(g) deduction of a member (the computing member), the computing member is required to take into account the taxable income or loss, determined without regard to the section 199A(g) deduction, QPAI, and W-2 wages of each other group member that are both—

(i) Attributable to the period that each other member of the EAG and the computing member are members of the EAG; and

(ii) Taken into account in a taxable year that begins after the effective date of section 199A(g) and ends with or within the taxable year of the computing member with respect to which the section 199A(g) deduction is computed.

(2) Example. The following example illustrates the application of this paragraph (h).

(i) Example. (A) Specified Cooperatives X, Y, and Z are members of the same EAG. Neither X, Y, nor Z is a member of a consolidated group. X and Y are calendar year taxpayers and Z is a June 30 fiscal year taxpayer. Z came into existence on July 1, 2017. All of X, Y’s, and Z’s activities are patronage sourced. Each Specified Cooperative has taxable income that exceeds its QPAI and W-2 wages in excess of the section 199A(g)(1)(B) wage limitation. For the taxable year ending December 31, 2018, X’s QPAI is $8,000 and Y’s QPAI is ($6,000). For its taxable year ending June 30, 2019, Z’s QPAI is $2,000.

(B) In computing X’s and Y’s respective section 199A(g) deductions for their taxable years ending December 31, 2018, X’s taxable income or loss, QPAI and W-2 wages and Y’s taxable income or loss, QPAI, and W-2 wages from their respective taxable years ending December 31, 2018, are aggregated. The EAG’s QPAI for this purpose is $2,000 (X’s QPAI of $8,000 + Y’s QPAI of ($6,000)). The $180 deduction is allocated to each of X and Y in proportion to their respective QPAI as a percentage of the QPAI of each member of the EAG that was taken into account in computing the EAG’s section 199A(g) deduction. Pursuant to paragraph (c)(1) of this section, in allocating the section 199A(g) deduction between X and Y, because Y’s QPAI is negative, Y’s QPAI is treated as being $0. Accordingly, X’s section 199A(g) deduction for its taxable year ending December 31, 2018, is $180 ($180 × $8,000/($8,000 + $0)). Y’s section 199A(g) deduction for its taxable year ending December 31, 2018, is $0 ($180 × $0/($8,000 + $0)).

(C) In computing Z’s section 199A(g) deduction for its taxable year ending June 30, 2019, X’s and Y’s items from their respective taxable years ending December 31, 2018, are taken into account. Therefore, X’s taxable income or loss and Y’s taxable income or loss, determined without regard to the section 199A(g) deduction, QPAI, and W-2 wages from their taxable years ending December 31, 2018, are aggregated with Z’s taxable income or loss, QPAI, and W-2 wages from its taxable year ending June 30, 2019. The EAG’s QPAI is $4,000 (X’s QPAI of $8,000 + Y’s QPAI of ($6,000) + Z’s QPAI of $2,000). The EAG’s section 199A(g) deduction is $360 (9% × $4,000). A portion of the $360 deduction is allocated to Z in proportion to its QPAI as a percentage of the QPAI of each member of the EAG that was taken into account in computing the EAG’s section 199A(g) deduction. Pursuant to paragraph (c)(1) of this section, in allocating a portion of the $360 deduction to Z, Y’s QPAI is treated as being $0 because Y’s QPAI is negative. Z’s section 199A(g) deduction for its taxable year ending June 30, 2019, is $72 ($360 × ($2,000/($8,000 + $0 + $2,000))).

(i) Partnership owned by expanded affiliated group—(1) In general. For purposes of section 199A(g)(3)(D) relating to DPGR, if all of the interests in the capital and profits of a partnership are owned by members of a single EAG at all times during the taxable year of such partnership (EAG partnership), then the EAG partnership and all members of that EAG are treated as a single taxpayer during such period.

(2) Attribution of activities—(i) In general. If a Specified Cooperative which is a member of an EAG (disposing member) derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE by an EAG partnership, all the partners of which are members of the same EAG to which the disposing member belongs at the time that the disposing member disposes of such property, then the disposing member is treated as conducting the MPGE activities previously conducted by the EAG partnership with respect to that property. The previous sentence applies only for those taxable years in which the disposing member is a member of the EAG of which all the partners of the EAG partnership are members for the entire taxable year of the EAG partnership. With respect to a lease, rental, or license, the disposing member is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the disposing member is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. Likewise, if an EAG partnership derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE by a member (or members) of the same EAG (the producing member) to which all the partners of the EAG partnership belong at the time that the EAG partnership disposes of such property, then the EAG partnership is treated as conducting the MPGE activities previously conducted by the producing member with respect to that property. The previous sentence applies only for those taxable years in which the producing member is a member of the EAG of which all the partners of the EAG partnership are members for the entire taxable year of the EAG partnership. With respect to a lease, rental, or license, the EAG partnership is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts derived from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the EAG partnership is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account.

(ii) Attribution between expanded affiliated group partnerships. If an EAG partnership (disposing partnership) derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE by another EAG partnership (producing partnership), then the disposing partnership is treated as conducting the MPGE activities previously conducted by the producing partnership with respect to that property, provided that each of these partnerships (the producing partnership and the disposing partnership) is owned for its entire taxable year in which the disposing partnership disposes of such property by members of the same EAG. With respect to a lease, rental, or license, the disposing partnership is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the disposing partnership is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account.

(iii) Exception. No member of an EAG other than an exempt Specified Cooperative is attributed nonpatronage activities conducted by an EAG partnership. An EAG partnership is not attributed nonpatronage activities conducted by any member of the EAG or by another EAG partnership.

(j) Applicability date. The provisions of this section apply to taxable years ending after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register. Taxpayers, however, may rely on these regulations until that date, but only if the taxpayers apply the rules in their entirety and in a consistent manner.

Par. 3. Section 1.1388-1 is amended by adding paragraphs (f) and (g).

The additions read as follows:

* * * * *

(f) Patronage and nonpatronage. Whether an item of income or deduction is patronage or nonpatronage sourced is determined by applying the directly related use test. The directly related use test provides that if the income or deduction is produced by a transaction that actually facilitates the accomplishment of the cooperative’s marketing, purchasing, or services activities, the income or deduction is from patronage sources. However, if the transaction producing the income or deduction does not actually facilitate the accomplishment of these activities but merely enhances the overall profitability of the cooperative, being merely incidental to the association’s cooperative operation, the income or deduction is from nonpatronage sources. Patronage and nonpatronage income or deductions cannot be netted unless otherwise permitted by the Internal Revenue Code or regulations issued under the relevant section of the Internal Revenue Code, or guidance published in the Internal Revenue Bulletin (see §601.601(d)(2) of this chapter).

(g) Effective/applicability date. The provisions of paragraph (f) of this section apply to taxable years ending after the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register. However, taxpayers may rely on the provisions of paragraph (f) of this section until the date the Treasury decision adopting these regulations as final regulations is published in the Federal Register.

Kirsten Wielobob,

Deputy Commissioner for Services and Enforcement.

(Filed by the Office of the Federal Register on June 18, 2019, 8:45 a.m., and published in the issue of the Federal Register for June 19, 2019, 84 F.R. 28668)

¹ General economic principles do not clearly prescribe the efficient relative tax treatment of passive income versus non-passive income and therefore do not indicate whether a shift in investment from passive-income-producing activities to non-passive-income-producing activities is economically beneficial. This economic analysis draws conclusions about the efficient tax treatment of different investments by evaluating incentives in light of the intents and purposes of the underlying statutes.

² Other units could have been considered, such as months or weeks, but these three options span the reasonable possibilities.

³ It would further generally be difficult for a U.S. owner to calculate, on his or her own, the value of PFIC assets on a daily basis, especially if the owner were a minority shareholder.

⁴ For purposes of the rest of this discussion, FC1 can be considered the parent corporation with U.S. owners that is tested as to whether it is a PFIC or not. FC2 is a subsidiary of FC1.

⁵ While PFICs are corporations, partnerships are included in our count given taxpayers may own an interest in a foreign corporation through a foreign partnership. More robust reporting on Form 8938 started in 2016 so we do not include prior years in our estimate.

⁶ To be conservative, C corporations reporting more than $6 billion of total income are excluded since we suspect these amounts are improperly reported.