The comments received with respect to proposed § 301.6221(b)–1 (regarding the election out of the centralized partnership audit regime) cover three general areas: (1) determining the number of partners of the partnership for purposes of determining whether the partnership has 100 or fewer partners under section 6221(b); (2) determining what partners constitute eligible partners for purposes of determining whether the partnership is an eligible partnership under section 6221(b); and (3) the mechanics of making the election under section 6221(b).

Proposed § 301.6221(b)–1(b)(1) provides that a partnership is eligible to elect out of the centralized partnership audit regime if the partnership has 100 or fewer partners for the taxable year, and all of the partners are eligible partners. Proposed § 301.6221(b)–1(b)(1)(i) provides that a partnership has 100 or fewer partners for the taxable year if it is required to furnish 100 or fewer statements under section 6031(b).

Several comments suggested that statements furnished to certain types of partners should not be taken into account for purposes of determining whether the partnership is required to furnish 100 or fewer statements under section 6031(b) (the 100-or-fewer threshold). For example, one comment recommended that statements furnished to pass-through entities and disregarded entities should not count toward the 100-or-fewer threshold, and another comment recommended that spouses should count as a single partner for this purpose.

Section 6031(b) generally requires a partnership to furnish a statement to each person that is a partner in the partnership during the partnership taxable year regarding that partner’s interest in the partnership for such year. If a pass-through entity or disregarded entity is a partner in the partnership, the partnership is required to furnish a statement under section 6031(b) to that pass-through entity or disregarded entity. See § 1.6031(b)–1T(a)(1) (statements required to be furnished to every person who was a partner (within the meaning of section 7701(a)(2)) at any time during the taxable year). Additionally, if two individuals are partners in a partnership, the partnership is required to furnish a statement under section 6031(b) to each of those individuals, regardless of whether they are married to one another. Id. Even though a pass-through entity or a disregarded entity is not an eligible partner (and a partnership with such partners would not be eligible to make an election under section 6221(b) regardless of the number of its partners), because the statute expressly provides that the 100-or-fewer threshold turns on the number of statements required to be furnished under section 6031(b), and section 6031(b) requires that the partnership furnish statements to all partners in the partnership during such taxable year regardless of whether the partner is a pass-through entity, a disregarded entity, or an individual who is married to another partner, these comments suggesting to the contrary were not adopted.

One comment suggested that the IRS should establish procedures to quickly address uncertainties regarding whether a statement was required to be issued under section 6031(b) for purposes of making an election under section 6221(b). The comment suggested that this could be accomplished through the private letter ruling process. Eligible partnerships can file an election out of the centralized partnership audit regime for taxable years beginning on or after January 1, 2018. Until the first partnership returns for taxable years subject to the new regime are filed and any elections out of the new regime are reviewed, it is difficult to determine whether a pre-filing procedure for providing legal determinations regarding section 6031(b) for purposes of making the election under section 6221(b) would be helpful or appropriate. Additionally, there is long-standing guidance regarding whether a partnership is required to furnish a statement under section 6031(b) to a particular person. Id. Therefore, because there is sufficient existing guidance regarding whether statements are required to be furnished under section 6031(b) and because the centralized partnership audit regime does not alter that existing guidance, the Treasury Department and the IRS have chosen not to adopt the suggestion to establish a pre-filing procedure specific to section 6221(b) in the final regulations. The IRS may reconsider whether a pre-filing procedure would be helpful after gaining experience with the election out procedures under section 6221(b). If it becomes apparent that a pre-filing procedure might prove useful in the context of section 6221(b), the Treasury Department and the IRS will consider at that time whether to establish such a procedure in other guidance, forms, or instructions. Additionally, nothing in these regulations prohibits a partnership from utilizing existing procedures for requesting private letter rulings or other guidance from the IRS concerning section 6031(b).

Two comments were received with respect to Example 2 under proposed § 301.6221(b)–1(b)(2)(iii). One comment suggested removing certain assumptions set forth in the example because those assumptions were not relevant to the conclusion reached in the example. Specifically, the comment suggested removing the following assumed facts – 1) that Spouse 1 and Spouse 2 have lived in a community property state at all times since they were married; and 2) that Spouse 1 acquired the partnership interest while married to Spouse 2. The comment suggested replacing those assumed facts with a statement that Spouse 2 only has a community property interest in the partnership. A second comment recommended that the regulations expressly state that one spouse’s community property interest is not taken into account for purposes of determining the number of statements the partnership is required to furnish under section 6031(b).

The intent of Example 2 under proposed § 301.6221(b)–1(b)(2)(iii) was to illustrate that whether a partnership is required to furnish a statement for purposes of section 6221(b) is determined by looking only to section 6031(b). The example was not intended to illustrate any principles of the various states’ community property laws. For these reasons, the two facts identified by the first comment were removed and replaced with a statement that, as a matter of state law, Spouse 2 has a community property interest in Spouse 1’s partnership interest.

The second comment suggested that the regulations under section 6221(b) specifically address community property interests. The determination of whether a partnership is required to furnish a statement is governed by section 6031(b) and the regulations thereunder. Creating a specific rule potentially at odds with the existing rules under section 6031(b) in these regulations could result in confusion regarding the proper operation of existing section 6031(b) rules and is not necessary for implementation of section 6221(b). Accordingly, the second comment suggesting the regulations expressly state that one spouse’s community property interest is not taken into account for purposes of determining the number of statements the partnership is required to furnish under section 6031(b) was not adopted.

Several comments were received regarding the statement in the preamble of the June 14 NPRM that noted the IRS’ intention to carefully scrutinize whether two or more partnerships that have elected out under section 6221(b) should be recast under existing judicial doctrines and general federal tax principles as having formed one or more constructive or de facto partnerships for federal income tax purposes. The preamble also listed several factors the IRS would consider when examining such arrangements and noted that, if two or more partnerships were recast under those doctrines and principles, the constructive or de facto partnership would be subject to the centralized partnership audit regime because it would not have made a timely election under section 6221(b). Several comments suggested rules to address those statements in the preamble, including suggesting that the final regulations should provide: 1) clear standards and safe harbors for when the IRS will determine if a constructive or de facto partnership exists and the effects of determining that two or more partnerships are constructively a single partnership; 2) a rule that any constructive or de facto partnership should be able to appeal that determination, including to the United States Tax Court; and 3) a reasonable amount of time for a constructive or de facto partnership to make an election under section 6221(b).

The statements in the preamble of the June 14 NPRM referencing the IRS’s intention to carefully examine whether two or more partnerships should be recast or be treated as having formed one or more constructive or de facto partnerships for federal income tax purposes reference existing judicial doctrines and general federal tax principles existing outside the centralized partnership audit regime. These existing judicial doctrines and bodies of law under the Internal Revenue Code (Code) govern whether a partnership is in existence, which is not an issue specific to (or altered by) the centralized partnership audit regime. However, if the IRS were to invoke these existing judicial doctrines and bodies of law and recast two partnerships as one or determine a partnership existed where no return was filed, there would likely be consequences under the centralized partnership audit regime as outlined in the preamble to the June 14 NPRM. For that reason, the statements in the preamble to the June 14 NPRM were meant to alert taxpayers to these existing judicial doctrines and bodies of law and to the fact that they might be applicable. Nothing in the June 14 NPRM or in this Treasury Decision alters these existing judicial doctrines and bodies of law governing whether a partnership is in existence. Accordingly, the final regulations do not adopt the comments requesting rules under the existing judicial doctrines and bodies of law governing whether a partnership is in existence.

Any application by the IRS of those existing judicial doctrines and bodies of law to two or more partnerships would require the IRS to follow all applicable due process requirements, including those under the centralized partnership audit regime. A taxpayer would have any applicable administrative review in accordance with IRS procedures and judicial review as provided by existing provisions of law.

With regard to the comment requesting a reasonable amount of time for a constructive or de facto partnership to make an election under section 6221(b), the time to make an election under section 6221(b) is specifically prescribed by statute. Section 6221(b)(1)(D)(i) expressly provides that an election under section 6221(b) is made on a timely filed return for the taxable year.

Finally, the United States Tax Court is a court of limited jurisdiction. See section 7442. The Treasury Department and the IRS do not have authority to confer jurisdiction on the United States Tax Court. As the IRS gains experience with the centralized partnership audit regime, the IRS may consider issuing sub-regulatory guidance covering elections under section 6221(b) in the context of constructive and de facto partnerships. The comments regarding constructive and de facto partnerships, however, were not adopted in these final regulations.

Under section 6221(b)(1)(C), one of the criteria for a partnership to make an election under section 6221(b) is that each of the partners of the partnership is an individual, C corporation, foreign entity that would be treated as a C corporation if it were a domestic entity, S corporation, or estate of a deceased partner. Proposed § 301.6221(b)–1(b)(3) describes these partners as “eligible partners”. Proposed § 301.6221(b)–1(b)(3)(ii) provides that some partners are not eligible partners, such as partnerships, trusts, disregarded entities, nominees or other similar persons that hold an interest on behalf of another person, and estates other than the estate of a deceased partner. In the case of an eligible partner that is an S corporation (S corporation partner), the statements required to be furnished by the S corporation partner under section 6037(b) for its taxable year ending with or within the partnership’s taxable year are treated as statements furnished by the partnership for purposes of determining whether the partnership is required to furnish 100 or fewer statements. Section 6221(b)(2)(A)(ii). The statement furnished to the S corporation partner by the partnership also counts towards the 100-or-fewer threshold. In addition, the partnership must disclose the names and taxpayer identification numbers (TIN) for each person with respect to whom the S corporation partner was required to furnish a statement under section 6037(b). Under section 6221(b)(2)(C), the Secretary is authorized by regulation or other guidance to prescribe rules similar to the rules for S corporation partners with respect to other types of persons not specifically described as eligible partners under section 6221(b)(1)(C).

The preamble to the June 14 NPRM explains that the Treasury Department and the IRS considered but did not adopt comments in response to Notice 2016–23, 2016–13 I.R.B. 490 (March 28, 2016) that suggested that the Treasury Department and the IRS exercise authority under section 6221(b)(2)(C) to expand the types of persons that are eligible partners for purposes of the election out rules under section 6221(b). The June 14 NPRM explains that broadening the scope of the election out provisions to include additional types of partners or partnership structures would increase the administrative burden on the IRS because those structures and partners would need to be audited under the deficiency procedures. The preamble to the June 14 NPRM requested comments on any potential expansion of the election out rules, noting that comments are particularly helpful if they address the additional burdens that expansion of the rules would impose on the IRS, in addition to the decreased burden on taxpayers resulting from such an expansion.

In response to the June 14 NPRM, the Treasury Department and the IRS received many comments similar to the comments received in response to Notice 2016–23 requesting that the Treasury Department and the IRS exercise the discretionary authority provided in section 6221(b)(2)(C) to expand the definition of eligible partner. Comments suggested that partnerships, disregarded entities, trusts (including tax-exempt trusts, revocable trusts, charitable remainder trusts, grantor trusts, and nongrantor trusts), individual retirement accounts, nominees, qualified pension plans, profit-sharing plans, and stock bonus plans should be considered eligible partners for purposes of making an election under section 6221(b). Comments specifically suggested that because certain types of entities, such as trusts, are similarly situated to certain eligible partners, such as S corporations because those entities are audited and report items to their owners similarly, they should be included within the definition of eligible partner, and that excluding them could lead to treating similarly situated taxpayers differently. For example, one comment noted that a tax-exempt organization organized as a C corporation is an eligible partner while a tax-exempt organization organized as a trust is not an eligible partner, even though both organizations are taxed the same way.

One comment suggested that all tiered partnerships should be eligible to make an election under section 6221(b) under rules similar to the rules that apply to S corporation partners, which would require counting the number of statements required to be furnished by each pass-through partner toward the 100-or-fewer threshold under proposed § 301.6221(b)–1(b)(2). Another comment recommended that the IRS develop an administrable election out for tiered partnerships. The comments suggested that such rules could allow for tiered partnerships to be collapsed down to their ultimate beneficial owners and permit that collapsed structure to make an election out, provided there was a “manageable” number of ultimate beneficial owners and the beneficial owners were all eligible partners.

In addition, multiple comments suggested that the authority granted in section 6221(b)(2)(C) signified a congressional expectation that the Treasury Department and the IRS would expand the list of eligible partners under section 6221(b)(1)(C). Multiple comments also suggested that the General Explanations of Tax Legislation Enacted in 2015 prepared by the Joint Committee on Taxation supported an expansion of the section 6221(b)(1)(C) list. See Joint Comm. on Taxation, JCS-1–16, General Explanation of Tax Legislation Enacted in 2015, 59–60 (2016). Other comments observed that the differences between the election out rules under section 6221(b) and the small partnership exception under the Tax Equity and Fiscal Responsibility Act of 1982, Public Law 97–248 (TEFRA) – the increase from 10 to 100 partners and the inclusion of S corporation partners – reflected an awareness that the IRS would face additional administrative burdens as a result of the election out rules.

Comments suggested that in some situations there would be minimal or no additional burdens imposed on the IRS resulting from an expansion of the definition of eligible partner. For example, comments suggested that, because there is only one additional layer of ownership beyond an entity that is disregarded as an entity separate from its owner for Federal tax purposes, adding those types of entities to the definition of eligible partner would not increase audit complexity or administrative burden for the IRS.

Some comments suggested that maintaining the current definition of eligible partner in proposed § 301.6221(b)–1(b)(3) would actually lead to more administrative burden for the IRS. For example, one comment suggested that because some tiered partnerships are ultimately owned by members of the same affiliated group, it would be more burdensome to conduct separate examinations (one for the partnership under the centralized partnership audit regime and one for the consolidated group under the deficiency procedures), rather than examining all entities as part of the same proceeding. Another comment observed that in some cases, certain partnership structures that are relatively complex and therefore difficult to audit would be able to elect out, while other more simple structures, which are potentially less burdensome to audit, could not elect out. One comment suggested that by not expanding the types of entities that are eligible partners more partnerships will be subject to the centralized partnership audit regime, and the IRS and taxpayers will face additional burdens because they have to apply the new audit rules, rather than applying longstanding rules familiar to both the IRS and to taxpayers.

Other comments noted the consequences to partnerships and partnership interests of not expanding the definition of eligible partner to include disregarded entities or trusts. For example, one comment suggested that not expanding the types of entities that are eligible partners would result in taxpayers transferring partnership interests from disregarded entities to eligible partners, leading to unnecessary filings and paperwork with limited effect on the ultimate taxpayers’ liabilities. Another comment suggested that not expanding the types of entities that are eligible partners would cause a reduction in value of limited partnership interests because of the increased risks and burdens associated with an audit under the centralized partnership audit regime. Another comment noted that the centralized partnership audit regime shifts certain administrative functions from the IRS to taxpayers, functions that were typically performed by the IRS under TEFRA.

The Treasury Department and the IRS have carefully considered all of the comments suggesting an expansion of the definition of eligible partner, but have decided not to adopt these comments at this time. In making this determination, the Treasury Department and the IRS considered the burdens of the centralized partnership audit regime on taxpayers and have concluded that the interests of efficient tax administration outweigh those potential burdens. Accordingly, the final regulations do not expand the definition of eligible partner to include entities other than those entities expressly provided in section 6221(b)(1)(C). After gaining experience with the centralized partnership audit regime, the Treasury Department and the IRS will be in a better position to reconsider any expansion of partnerships eligible to elect out of the regime.

Expanding the current definition of eligible partner would result in more partnerships electing out of the centralized partnership audit regime. In turn, this would result in more audits under the deficiency procedures for taxpayers owning interests in partnerships. When a partnership makes a valid election out of the centralized partnership audit regime under section 6221(b), the IRS must follow the deficiency procedures to audit, assess, and collect tax from the ultimate owners of that partnership. Under the partnership audit procedures enacted as part of TEFRA, the IRS conducted a unified examination of the partnership’s items at the partnership level, but was still required to separately assess and collect tax from the ultimate owners of the partnership (sometimes through deficiency procedures).

The centralized partnership audit regime is designed to improve upon both the TEFRA rules and the deficiency procedures by providing for a centralized audit proceeding with respect to the partnership and mandating centralized assessment and collection of tax, penalties, and interest from the partnership. It follows then that rules designed to limit the number of partnerships that can elect out of the new regime is consistent with this objective.

Further, for each additional type of partner that is added to the list of eligible partners, the IRS will be required to follow deficiency procedures with respect to the indirect partners of that partner to assess and collect tax resulting from a partnership audit that could otherwise be assessed and collected against a single partnership under the centralized partnership audit regime. As noted in the preamble to the June 14 NPRM, the number of partnerships has grown substantially in recent years and is likely to continue to grow, compounding the audit and collection inefficiencies extant outside of the new regime for the IRS with each expansion of the eligible partner list. It would undermine the benefits of the new regime to expand the group of partnerships that are eligible to elect out of the new regime. Moreover, it would be unwise to do so at a time before the first returns for taxable years subject to the new regime have been filed.

There may be some situations where expanding eligible partners would not add significantly more complexity to an examination, even under the deficiency procedures. However, while this may occur in some instances, the rules under section 6221(b) are designed to be of general applicability to all partnerships, regardless of size and composition of partners. Section 6221(b)(1) sets the parameters for making an election out of the centralized partnership audit regime, and partnerships that meet these requirements are eligible to make an election under section 6221(b) regardless of how complex or simple their partnership structure is. While certain types of partnerships that elect out may present less audit burden than others, as the total number of partners increases, so too does the number and the complexity of deficiency proceedings. Therefore, any potential simplification of an audit for one particular partnership that might result from the expansion of the election out rules must be appropriately balanced against the increasing audit burden on the IRS if the total number of partnerships that can elect out is increased.

The Treasury Department and the IRS acknowledge that the new rules are a significant change in the way partnerships have been traditionally audited, particularly in the imposition of an imputed underpayment at the partnership level. Comments have raised concerns that the imputed underpayment may not accurately reflect the tax liability that would have been owed had the partnership and the partners reported correctly in the reviewed year taking the partners’ specific facts and circumstances into account. However, partnerships and partners have the means to mitigate those concerns by utilizing the modification procedures under section 6225 or making the election under section 6226 (the alternative to payment of the imputed underpayment).

As the Treasury Department and the IRS gain experience with the centralized partnership audit regime, the definition of eligible partner may be revisited. Section 6221(b)(2)(C) allows the Treasury Department and the IRS to expand the types of eligible partners through “other guidance,” which includes sub-regulatory guidance that can be more easily tailored and adapted as the Treasury Department and the IRS gain experience with the new regime. Until that time, however, the list of eligible partners will remain the list specifically set forth by Congress in section 6221(b)(1)(C).

In addition to the comments about expanding the definition of eligible partner, one comment recommended clarifying the meaning and application of the phrase “a nominee or other similar person that holds an interest on behalf of another person” under proposed § 301.6221(b)–1(b)(3)(ii)(E). The comment stated that the meaning of the quoted language was unclear. The intent of this provision was not to create a new concept that does not currently exist in the Code and regulations. Instead, the intent of the provision was to include in the list of ineligible partners situations where the partner holds an interest on behalf of another person. To remove the ambiguity, the quoted language was clarified to remove the word “nominee” as a separate clause and provides instead that a partner is not an eligible partner if that partner holds an interest in the partnership on behalf of another person.

Proposed § 301.6221(b)–1(c) provides that an election out of the centralized partnership audit regime must be made on an eligible partnership’s timely filed return, including extensions, for the taxable year to which the election applies, and, once made cannot be revoked without the consent of the IRS. Additionally, under proposed § 301.6221(b)–1(c)(2), the election must include each partner’s name, correct U.S. TIN, and Federal tax classification. If the election is being made by a partnership that has an S corporation as a partner, proposed § 301.6221(b)–1(c)(2) provides that the election must also include each S corporation shareholder’s name, correct U.S. TIN, and Federal tax classification. Proposed § 301.6221(b)–1(c)(2) also provides that the election must include an affirmative statement that the partner is an eligible partner and any other information required by the IRS in forms, instructions, or other guidance. Under proposed § 301.6221(b)–1(c)(3), if a partnership makes an election under section 6221(b), the partnership must notify its partners of the election within 30 days of making the election. Under proposed § 301.6221(b)–1(e)(2), if the IRS determines that a purported election by a partnership is invalid, the IRS will notify the partnership in writing, and the provisions of the centralized partnership audit regime will apply to the partnership.

One comment suggested that the regulations clarify whether a “timely filed return” under proposed § 301.6221(b)–1(c)(1) is limited to the partnership’s original return or whether it also includes any amended returns filed before the due date of the original return. The definition of whether a return is a timely filed return is covered by other provisions of the Code, and the proposed regulations do not modify the longstanding interpretation of those provisions. Under that longstanding interpretation, a return is timely filed if it is filed prior to the due date of the return (taking into account any applicable extensions), regardless of whether it is the original return filed by the partnership or a return filed subsequent to the original return but before the extended due date of the return. See Haggar Co. v. Helvering, 308 U.S. 389 (1940). Therefore, the comment requesting that the regulations clarify the phrase “timely filed return” in proposed § 301.6221(b)–1(c)(1) was not adopted.

Two comments were received regarding the rule under proposed § 301.6221(b)–1(c)(1) that requires consent of the IRS to revoke an election previously made by the partnership. One comment suggested that partnerships should have the ability to revoke the election under section 6221(b) without the consent of the IRS and suggested that such a rule could result in more partnerships revoking elections and therefore becoming subject to the centralized partnership audit regime. Section 6221(b) is silent as to whether a partnership may revoke its election.

The June 14 NPRM allows a partnership to request revocation of its election under section 6221(b) with consent of the IRS. IRS consent is necessary for this type of election revocation because of the potential for detrimental effects on tax administration. By making an election under section 6221(b), the partnership is representing to the IRS that the partnership seeks to elect out of the centralized partnership audit regime. If a partnership is able to unilaterally revoke the election, the partnership is changing that representation without the IRS’s knowledge which, under certain circumstances, could be detrimental to tax administration. For example, a partnership could make an election under section 6221(b) and subsequently revoke the election at a time when the period of limitations on making partnership adjustments under section 6235 is close to expiring, or would have already expired, even though the individual partners’ periods of limitations on assessment might still be open. If unilateral revocations were permissible, the IRS would have to obtain protective statute extensions creating unnecessary burden on both partners and the IRS. Because the partnership’s unilateral revocation of an election under section 6221(b) could be detrimental to tax administration, it is necessary to require IRS consent prior to any revocation. While allowing revocation without consent could potentially result in more partnerships subject to the centralized partnership audit regime, there is no reason to believe that requiring consent significantly alters the number of potential revocations, except in situations where the revocation was clearly detrimental to tax administration. Accordingly, the comment suggesting that the partnership can revoke the election without the consent of the IRS was not adopted.

Another comment recommended that the IRS provide rules on how a partnership requests the consent of the IRS to revoke an election and the standards the IRS will use to grant or deny such requests. The Treasury Department and the IRS have determined that these procedures are more appropriately addressed in non-regulatory guidance. This will enable the IRS to more quickly adjust the process, respond to feedback, and fix any potential problems as it gains more experience with elections under section 6221(b). Accordingly, these final regulations do not adopt this comment.

Section 6221(b)(2)(B) provides that the IRS may provide an alternative form of identification for foreign partners. The June 14 NPRM does not provide for a form of alternative identification for foreign partners, but instead requires that all partners of an eligible partnership have a U.S. TIN. The preamble to the June 14 NPRM explains that partners in a U.S partnership, including foreign partners, are required to have a U.S TIN, so an alternative form of identification may be unnecessary. However, the June 14 NPRM requested comments regarding situations in which a foreign partner subject to the centralized partnership audit regime may not otherwise be required to have a U.S. TIN, other than for the election under section 6221(b), and requested recommendations for alternative identification procedures that could be used in such cases.

Two comments made suggestions regarding a possible alternative method for identifying foreign partners when the partnership discloses partner information to the IRS as part of an election under section 6221(b). One comment recommended that “in the case of foreign partners who are individuals, the final Regulations provide that the partnership can submit a completed Form W-8 in lieu of the foreign partner’s TIN.” Another comment suggested that all foreign partners should be required to have TINs for a partnership to be eligible to make an election under section 6221(b).

Consistent with the second comment, the final regulations retain the approach of the proposed regulations and require a partnership to provide a correct U.S. TIN for all partners (foreign and domestic) as part of a valid election under section 6221(b). Requiring a U.S. TIN for all partners of a partnership treats all partners the same, regardless of whether they are foreign or domestic, and ensures that the partners of the partnership can be easily identified. However, the Treasury Department and the IRS intend to continue to study this issue and may, in the future, provide for alternative identification for foreign partners in forms, instructions, and other guidance. To account for any future forms of alternative identification for foreign partners, § 301.6221(b)–1(c)(2) provides that a partnership must disclose the name and U.S. TIN, or alternative form of identification required by forms, instructions, or other guidance, for each partner of the partnership or each shareholder of an S corporation partner.

Another comment stated that the language in proposed § 301.6221(b)–1(c)(2), which requires a partnership to provide information regarding “each shareholder of the S corporation”, was not clear because it did not specify whether the partnership was required to provide information regarding S corporation shareholders as of a specific date or whether information was required of any person who was a shareholder at any point during the S corporation’s taxable year. The IRS and Treasury Department agree that the language in proposed § 301.6221(b)–1(c)(2) should be clarified. Section 6221(b)(2)(A)(i) provides that the S corporation shareholders the partnership must identify are those shareholders with respect to whom the S corporation partner is required to furnish statements under section 6037(b) for the taxable year of the S corporation ending with or within the partnership taxable year for which the election is being made. Accordingly, the final regulations in § 301.6221(b)–1(c)(2) provide that, as part of a valid election, a partnership must disclose the required information about each person who was a shareholder in the S corporation partner at any time during the taxable year of the S corporation ending with or within the partnership’s taxable year.

Regarding the requirement that a partnership making an election under section 6221(b) include an affirmative statement that each partner is an eligible partner, a comment was received recommending that the affirmative statement should appear on the bottom of the form for making the election or be a return attachment that could be signed by anyone eligible to sign the partnership return. This comment and recommendation concerns forms and instructions that will be prescribed by the IRS, and therefore the comment is outside the scope of these regulations. However, the IRS will consider this comment when creating the forms and instructions necessary to implement the election out of the centralized partnership audit regime.

Two comments addressed the requirement that the partnership notify its partners of any election made under section 6221(b) within 30 days of making the election. Proposed § 301.6221(b)–1(c)(3) requires a partnership that makes an election under section 6221(b) to notify its partners within 30 days of making the election. One comment requested that the final regulations clarify whether the partnership has to notify shareholders of an S corporation partner that the partnership has made the election. Under TEFRA, the term “partner” was defined to include both direct and indirect partners. See section 6231(a)(2) (prior to amendment by the BBA). Section 1101(a) of the BBA repealed the partnership audit procedures under TEFRA, including the definition of partner. As a result, the only operative definition of the term “partner” in the Code is located in section 7701(a)(2). Under that definition, shareholders of an S corporation partner are not partners in the partnership making the election under section 6221(b) because they are not members of the partnership. Therefore, the partnership does not have to provide notice to the shareholders of an S corporation partner because those shareholders are not “its partners” within the meaning of § 301.6221(b)–1(c)(3). Accordingly, because the regulation is clear that the partnership only has to provide notice to its partners, this comment recommending that the regulation be clarified on this point was not adopted. Further, it would be burdensome for the partnership making the election to have to notify both the S corporation and the S corporation shareholders. It should be sufficient that the partnership notify its partner, the S corporation. Whether and how the S corporation wishes to notify its shareholders is something that is left to the S corporation and its shareholders to determine.

Two comments suggested that the IRS should add a checkbox to the statements required to be furnished by the partnership under section 6031(b) indicating that the partnership has made an election under section 6221(b). The checkbox would serve as the notification of the election as required by § 301.6221(b)–1(c)(3). This comment was not adopted because the regulations intentionally do not prescribe the method a partnership must use to notify its partners of the election. Under the regulations, the partnership has the flexibility to notify its partners in the manner that is in the best interests of the partnership and its partners. At this point, the Treasury Department and the IRS have considered the method the partnership notifies its partners to be a business decision of the partnership. Section 6221(b) requires only that the partnership notify its partners in the manner prescribed by the Treasury Department and the IRS. Accordingly, the Treasury Department and the IRS have refrained from regulating more specifically on this issue, and therefore this comment was not adopted. However, the proposed regulations are amended in the final regulations to make clear that the manner of notification is left to the partnership to determine.

One comment recommended that the final regulations include a mechanism for allowing the partnership to make corrections to the election to cure any compliance errors. The Treasury Department and the IRS determined that these procedures, if needed, are more appropriately addressed in sub-regulatory guidance, which is more routinely updated and can be improved based upon experience. Under § 301.6221(b)–1(e) and as explained more fully in the preamble to the June 14 NPRM, an election under section 6221(b) may be relied upon unless challenged by the IRS. That includes situations where the election is not fully compliant with all applicable rules. As provided under § 301.6221(b)–1(e)(2), the IRS will notify the partnership if the IRS determines the partnership’s election is invalid. Nothing in these regulations prohibits the partnership from working with the IRS if an election is deficient to correct any minor errors. By not providing a correction procedure in the regulations, the IRS and the partnership have more flexibility to address any errors in an election that may not be afforded if the regulations provided for rules for some situations but not others. Accordingly, the comment to include a correction procedure in the regulations was not adopted.

Finally, one comment recommended that the final regulations place a reasonable restriction on the time the IRS has to determine whether an election under section 6221(b) is invalid. The comment suggested that a period of 180 days from the filing of the return would be a reasonable time. This comment was not adopted because this would effectively impose a significant shortening of the period of limitations on when the IRS would be able to examine a partnership’s return and make adjustments. Limiting the time within which the IRS may review the validity of an election would effectively force the IRS to decide within that specified time period whether it intended to review the election, even if the IRS had no intention at that time of ultimately examining the partnership’s return.

Section 6221(b) did not provide a specific period of limitations for a determination that an election under section 6221(b) is invalid. Nevertheless, the period for determining an election purportedly made under section 6221(b) is invalid is not unlimited. The period of limitations on making adjustments under section 6235 limits the time within which the IRS may make a partnership adjustment, which will also serve as a practical limitation on when the IRS must decide whether to determine an election under section 6221(b) is invalid. If a purported election is determined to be invalid by the IRS, the partnership would be subject to the centralized partnership audit regime, and no partnership adjustment could be made by the IRS after the period prescribed in section 6235. For the reasons state above, the comment to establish a separate period for evaluating elections was not adopted.

In addition to addressing the comments received in response to the June 14 NPRM, this Treasury Decision also makes editorial, non-substantive changes to the proposed regulations under section 6221(b).

The Treasury Department and the IRS are aware that in cases where specified foreign corporations have inclusion years that end in or with different taxable years of the same United States shareholder, section 965 could result in double-counting such shareholder’s aggregate foreign cash position for purposes of determining the shareholder’s deduction under section 965(c). For example, assume USP, a calendar year taxpayer, wholly owns CFC1, which has an inclusion year ending December 31, 2017, and CFC2, which has an inclusion year ending November 30, 2018. In addition, assume that USP’s pro rata share of the cash position of each of CFC1 and CFC2 on all relevant cash measurement dates is $100, with the result that USP’s aggregate foreign cash position is $200. Under section 965(c), the amount allowed as a deduction in the taxable year of a United States shareholder for which the United States shareholder takes a section 965(a) inclusion amount into gross income is based on the aggregate foreign cash position of the United States shareholder. One interpretation of section 965(c) could result in the 15.5 percent rate equivalent percentage applying to as much as $400 of the aggregate section 965(a) inclusion amounts of CFC1 and CFC2 taken into account by USP, because USP’s aggregate foreign cash position for its 2017 taxable year (in which CFC1’s section 965(a) inclusion amount is taken into account) is $200 and its aggregate foreign cash position for its 2018 taxable year (in which CFC2’s section 965(a) inclusion amount is taken into account) is also $200.

The Treasury Department and the IRS intend to issue regulations providing that in the case of a United States shareholder that has a section 965(a) inclusion amount in more than one taxable year, the aggregate foreign cash position taken into account in the first taxable year will equal the lesser of the United States shareholder’s aggregate foreign cash position or the aggregate of the section 965(a) inclusion amounts taken into account by the United States shareholder in that taxable year. Furthermore, the amount of the United States shareholder’s aggregate foreign cash position taken into account in any succeeding taxable year will be its aggregate foreign cash position reduced by the amount of its aggregate foreign cash position taken into account in any preceding taxable year.

Example. (i) Facts. USP, a domestic corporation, owns all of the stock of CFC1, a foreign corporation, which owns all of the stock of CFC2, also a foreign corporation. USP is a calendar year taxpayer. CFC1’s inclusion year ends December 31, 2017, and CFC2’s inclusion year ends November 30, 2018. The cash position of each of CFC1 and CFC2 on all relevant cash measurement dates is $200, with the result that USP has an aggregate foreign cash position of $400. For its 2017 taxable year, USP takes into account CFC1’s section 965(a) inclusion amount of $300, and for its 2018 taxable year, USP takes into account CFC2’s section 965(a) inclusion amount of $300.

(ii) Analysis. USP’s aggregate foreign cash position taken into account in 2017 is $300, the lesser of USP’s aggregate foreign cash position ($400) or the section 965(a) inclusion amount ($300) that USP takes into account in 2017. The amount of USP’s aggregate foreign cash position taken into account in 2018 is $100, USP’s aggregate foreign cash position ($400) reduced by the amount of its aggregate foreign cash position taken into account in 2017 ($300).

In addition, in cases in which, for example, a calendar year United States shareholder owns specified foreign corporations with inclusion years that end in or with different taxable years of the United States shareholder, at least one specified foreign corporation of such United States shareholder will have a final cash measurement date in 2017 (for example, December 31, 2017) and at least one other such specified foreign corporation will have a final cash measurement date in 2018 (for example, November 30, 2018). The Treasury Department and the IRS are aware that a United States shareholder in this situation may not be able to determine its aggregate foreign cash position for purposes of calculating its deduction under section 965(c) for its 2017 taxable year by the date that its return for such taxable year must be filed (including extensions).

For purposes of determining the aggregate foreign cash position of a United States shareholder for a taxable year in which it takes into account a section 965(a) inclusion amount, future regulations will provide that the United States shareholder can assume that its pro rata share of the cash position of any specified foreign corporation with an inclusion year ending after the date the return for such taxable year of such United States shareholder is timely filed (including extensions, if any) will be zero as of the cash measurement date with which the inclusion year ends. If a United States shareholder’s pro rata share of the cash position of a specified foreign corporation was treated as zero pursuant to the preceding sentence, and the amount described in section 965(c)(3)(A)(i) in fact exceeds the amount described in section 965(c)(3)(A)(ii) with respect to such United States shareholder, the United States shareholder must make appropriate adjustments to reflect that the 15.5 percent rate equivalent percentage applies to a greater amount of the aggregate section 965(a) inclusion amounts taken into account. The Treasury Department and the IRS expect to issue future guidance regarding the appropriate method for making such an adjustment.

Example. (i) Facts. USP, a domestic corporation, owns all of the stock of CFC1, a foreign corporation, which owns all of the stock of CFC2, also a foreign corporation. USP is a calendar year taxpayer. CFC1’s inclusion year ends December 31, 2017, and CFC2’s inclusion year ends November 30, 2018. The cash position of CFC1 on each of December 31, 2015, December 31, 2016, and December 31, 2017, is $100. The cash position of CFC2 on each of November 30, 2015, and November 30, 2016, is $200. CFC1 has a section 965(a) inclusion amount.

(ii) Analysis. In determining its aggregate foreign cash position for its 2017 taxable year, USP may assume that its pro rata share of the cash position of CFC2 will be zero as of November 30, 2018, for purposes of filing its U.S. federal income tax return due on April 15, 2018 (or due on October 15, 2018, with extension). Therefore, USP’s aggregate foreign cash position is treated as $300, which is the greater of (a) $300, 50% of the sum of USP’s pro rata shares of the cash position of CFC1 as of December 31, 2015, and December 31, 2016, and of the cash position of CFC2 as of November 30, 2015, and November 30, 2016, and (b) $100, USP’s pro rata share of the cash position of CFC1 as of December 31, 2017. If USP’s pro rata share of the cash position of CFC2 as of November 30, 2018, in fact exceeds $200, which would result in USP’s aggregate foreign cash position being greater than $300, USP must make appropriate adjustments to reflect a higher aggregate foreign cash position, under future guidance to be issued by the Treasury Department and the IRS.

Net accounts receivables and short-term obligations between related specified foreign corporations may inflate the aggregate foreign cash position of a United States shareholder relative to the actual aggregate amount of liquid assets (other than the intercompany receivables) owned by the specified foreign corporations of the United States shareholder. For example, if a United States shareholder wholly owns two specified foreign corporations and one specified foreign corporation makes a short-term loan to the other specified foreign corporation, the borrowing corporation may invest the proceeds of such financing in illiquid assets or may spend the cash on operating expenses. The resulting intercompany receivable would be included in the United States shareholder’s aggregate foreign cash position, notwithstanding that, if the specified foreign corporations were treated as a single corporation, the liquid assets of the specified foreign corporations would have been reduced by the amount of the borrowed proceeds.

Accordingly, for purposes of determining the cash position of a specified foreign corporation with respect to net accounts receivable and short-term obligations, the Treasury Department and the IRS intend to issue regulations providing that, with respect to a United States shareholder, any receivable or payable of a specified foreign corporation from or to a related specified foreign corporation will be disregarded to the extent of the common ownership of such specified foreign corporations by the United States shareholder. For this purpose, a specified foreign corporation will be treated as related to another specified foreign corporation to the extent that the specified foreign corporations are related persons within the meaning of section 954(d)(3), substituting the term “specified foreign corporation” for “controlled foreign corporation” in each place that it appears.

Under section 965(c)(3)(B)(iii)(V), the Secretary may identify any asset as being economically equivalent to any asset described in section 965(c)(3)(B). The Treasury Department and the IRS intend to issue regulations that address the treatment of derivative financial instruments for purposes of measuring the cash position of a specified foreign corporation. Derivative financial instruments include notional principal contracts, options contracts, forward contracts, futures contracts, short positions in securities and commodities, and any similar financial instruments. These regulations will provide that the cash position of any specified foreign corporation will include the fair market value of each derivative financial instrument held by the specified foreign corporation that is not a “bona fide hedging transaction” (as defined in this section 3.01(c)). The Treasury Department and the IRS are considering whether future guidance should exclude derivative financial instruments that are not actively traded or that do not reference an asset described in section 965(c)(3)(B) (a “cash-equivalent asset”) from the definition of cash position. The value of each derivative financial instrument that must be taken into account in determining the cash position of a specified foreign corporation may be positive or negative; however, the aggregate amount taken into account for all derivative financial instruments (excluding bona fide hedging transactions) of a specified foreign corporation cannot be less than zero. Furthermore, derivative financial instruments between related specified foreign corporations will be disregarded on the same terms as receivables and payables described in section 3.01(b) of this notice.

For purposes of this section 3.01(c), a bona fide hedging transaction means a hedging transaction that meets the requirements of a bona fide hedging transaction described in § 1.954–2(a)(4)(ii) and that is properly identified as such in accordance with the requirements of that subparagraph. Consistent with the definition of a bona fide hedging transaction in § 1.954–2(a)(4)(ii), in the case of an asset hedging transaction, the risk being hedged may be with respect to ordinary property, section 1231 property, or a section 988 transaction. Because the identification requirements of § 1.954–2(a)(4)(ii) are generally relevant only to CFCs whereas section 965 applies to all specified foreign corporations, the Treasury Department and the IRS will provide guidance in the future on identifying bona fide hedging transactions of specified foreign corporations that are not CFCs.

If a derivative financial transaction is a bona fide hedging transaction that is used to hedge a cash-equivalent asset, the value of the cash-equivalent asset identified on the taxpayer’s books and records as the asset being hedged must be adjusted by the fair market value of the bona fide hedging transaction that is used to hedge such cash-equivalent asset (such hedging transaction, a “cash-equivalent asset hedging transaction”). The value of a cash-equivalent asset hedging transaction must be taken into account in determining the cash position of a specified foreign corporation whether the cash-equivalent asset hedging transaction has positive or negative value, but only to the extent that the cash-equivalent asset hedging transaction (or transactions) does not reduce the fair market value of the asset being hedged below zero.

Finally, a bona fide hedging transaction with respect to an asset that is not a cash-equivalent asset or with respect to a liability (as described in § 1.1221–2(b)(2)) is not included in a specified foreign corporation’s cash position for purposes of section 965(c)(3)(B).

Certain transactions between specified foreign corporations may result in earnings and profits of a specified foreign corporation being taken into account more than once or not at all by a United States shareholder under section 965(a). In this regard, the Conference Report accompanying the Act states:

In order to avoid double-counting and double non-counting of earnings, the Secretary may provide guidance to adjust the amount of post-1986 earnings and profits of a specified foreign corporation to ensure that a single item of a specified foreign corporation is taken into account only once in determining the income of a United States shareholder subject to this provision. Such an adjustment may be necessary, for example, when there is a deductible payment (e.g., interest or royalties) from one specified foreign corporation to another specified foreign corporation between measurement dates.

H.R. Rep. No. 115–466, at 619 (2017). Consistent with congressional intent, the Treasury Department and the IRS intend to issue regulations to address the possibility of double-counting or double non-counting in the computation of post-1986 earnings and profits arising from amounts paid or incurred (including certain dividends) between related specified foreign corporations of a United States shareholder that occur between measurement dates and that would otherwise reduce the post-1986 earnings and profits as of December 31, 2017, of the specified foreign corporation that paid or incurred such amounts. For purposes of this section 3.02(a), the term “related” has the same meaning as given in section 3.01(b) of this notice.

The following examples illustrate fact patterns involving double-counting or double non-counting that will be addressed by future regulations.

Example 1. (i) Facts. USP, a domestic corporation, owns all of the stock of CFC1, a foreign corporation, which owns all of the stock of CFC2, also a foreign corporation. USP, CFC1, and CFC2 have calendar year taxable years. On November 2, 2017, each of CFC1 and CFC2 has post-1986 earnings and profits of 100u. Neither CFC1 nor CFC2 has previously taxed income or effectively connected income for any taxable year, and therefore each of CFC1’s and CFC2’s accumulated post-1986 deferred foreign income is equal to such corporation’s post-1986 earnings and profits. On November 3, 2017, CFC2 makes a deductible payment of 10u to CFC1. The payment does not constitute subpart F income. CFC1 and CFC2 have no other items of income or deduction.

(ii) Analysis. Absent any adjustments, on December 31, 2017, CFC1 has post-1986 earnings and profits of 110u (100u plus 10u income from the deductible payment), and CFC2 has post-1986 earnings and profits of 90u (100u minus 10u deductible expense). The section 965(a) earnings amount with respect to CFC1 would be 110u, the greater of 100u accumulated post-1986 deferred foreign income on November 2, 2017, and 110u accumulated post-1986 deferred foreign income on December 31, 2017, and the section 965(a) earnings amount with respect to CFC2 would be 100u, the greater of 100u accumulated post-1986 deferred foreign income on November 2, 2017, and 90u accumulated post-1986 deferred foreign income on December 31, 2017. Disregarding the intercompany deductible payment, CFC1 and CFC2 would have, in the aggregate, section 965(a) earnings amounts of 200u. However, taking the deductible payment into account, CFC1 and CFC2 would have, in the aggregate, section 965(a) earnings amounts of 210u, because the 10u of income from the deductible payment would increase the post-1986 earnings and profits of CFC1 as of December 31, 2017, but the 10u of deductible expense would not decrease the post-1986 earnings and profits of CFC2 as of November 2, 2017. Under regulations to be issued by the Treasury Department and the IRS, an adjustment would be made with the result that CFC1 and CFC2 would have, in the aggregate, section 965(a) earnings amounts of 200u.

Example 2. (i) Facts. Assume the same facts as in Example 1, except instead of a deductible payment to CFC1, CFC2 makes a 10u distribution on November 3, 2017. The distribution increases CFC1’s post-1986 earnings and profits as of December 31, 2017, by 10u and reduces CFC2’s post-1986 earnings and profits as of December 31, 2017, by the same amount under section 965(d)(3)(B).

(ii) Analysis. Similar to the analysis in Example 1, the section 965(a) earnings amount with respect to CFC1 would be 110u, and the section 965(a) earnings amount with respect to CFC2 would be 100u, resulting in aggregate section 965(a) earnings amounts of 210u. Under regulations to be issued by the Treasury Department and the IRS, an adjustment would be made with the result that CFC1 and CFC2 would have, in the aggregate, section 965(a) earnings amounts of 200u. For an additional rule relating to dividends paid by one specified foreign corporation to another specified foreign corporation, see section 3.02(b) of this notice.

Example 3. (i) Facts. Assume the same facts as in Example 1, except that CFC2 does not make a deductible payment to CFC1, and, between measurement dates, CFC2 accrues gross income of 20u from a person that is not related to CFC2, and CFC1 incurs a deductible expense of 20u to a person that is not related to CFC1.

(ii) Analysis. Absent any adjustments, on December 31, 2017, CFC1 has post-1986 earnings and profits of 80u (100u minus 20u deductible expense), and CFC2 has post-1986 earnings and profits of 120u (100u plus 20u gross income). The section 965(a) earnings amount with respect to CFC1 would be 100u, the greater of 100u accumulated post-1986 deferred foreign income on November 2, 2017, and 80u accumulated post-1986 deferred foreign income on December 31, 2017, and the section 965(a) earnings amount with respect to CFC2 would be 120u, the greater of 100u accumulated post-1986 deferred foreign income on November 2, 2017, and 120u accumulated post-1986 deferred foreign income on December 31, 2017. CFC1 and CFC2 have, in the aggregate, section 965(a) earnings amounts of 220u. The section 965(a) earnings amounts, in the aggregate, are 20u greater than in Example 1, notwithstanding that CFC1 and CFC2 have, in the aggregate, earned no additional income. However, the additional 20u of section 965(a) earnings amount does not arise from an amount paid or incurred between specified foreign corporations that are related. The regulations to be issued by the Treasury Department and the IRS will not adjust the aggregate section 965(a) earnings amounts of CFC1 and CFC2.

Example 4. (i) Facts. Assume the same facts as in Example 3, except that CFC2 also makes a deductible payment of 10u to CFC1 on November 3, 2017.

(ii) Analysis. Absent any adjustments, on December 31, 2017, CFC1 has post-1986 earnings and profits of 90u (100u minus 20u deductible expense plus 10u intercompany income from the deductible payment), and CFC2 has post-1986 earnings and profits of 110u (100u plus 20u gross income minus10u intercompany deductible expense). The section 965(a) earnings amount with respect to CFC1 would be 100u, the greater of 100u accumulated post-1986 deferred foreign income on November 2, 2017, and 90u accumulated post-1986 deferred foreign income on December 31, 2017, and the section 965(a) earnings amount with respect to CFC2 would be 110u, the greater of 100u accumulated post-1986 deferred foreign income on November 2, 2017, and 110u accumulated post-1986 deferred foreign income on December 31, 2017. Taking the intercompany deductible payment into account, CFC1 and CFC2 would have, in the aggregate, section 965(a) earnings amounts of 210u, because the 10u of income from the deductible payment would not increase the post-1986 earnings and profits of CFC1 as of November 2, 2017, but the 10u of deductible expense would decrease the post-1986 earnings and profits of CFC2 as of December 31, 2017. However, disregarding the intercompany deductible payment, CFC1 and CFC2 would have, in the aggregate, section 965(a) earnings amounts of 220u. Under regulations to be issued by the Treasury Department and the IRS, an adjustment would be made with the result that CFC1 and CFC2 would have, in the aggregate, section 965(a) earnings amounts of 220u.

The post-1986 earnings and profits of a specified foreign corporation are reduced to reflect dividends distributed during the corporation’s inclusion year to another specified foreign corporation (“the dividend reduction rule”). Section 965(d)(3)(B). As a result, a dividend paid by a specified foreign corporation to another specified foreign corporation (whether in an inclusion year or a prior taxable year, including a prior taxable year that includes a measurement date) generally reduces the corporation’s post-1986 earnings and profits with respect to any measurement date that such dividend precedes.

The dividend reduction rule is intended to address the potential double-counting of the earnings and profits of the distributing specified foreign corporation in calculating the section 965(a) inclusion amounts taken into account by a United States shareholder with respect to the distributing specified foreign corporation and the distributee specified foreign corporation. (See Example 2 in section 3.02(a) of this notice illustrating double-counting arising from dividends paid between measurement dates notwithstanding the application of the dividend reduction rule.) To the extent that a portion of a distribution reduces the post-1986 earnings and profits of a distributing specified foreign corporation (for example, by reason of a reduction pursuant to section 312(a)(3)) in an amount in excess of the increase in the post-1986 earnings and profits of the distributee specified foreign corporation, such reduction would not relieve double-counting and thus would be inconsistent with the purpose of the rule.

Accordingly, the Treasury Department and the IRS intend to issue regulations to clarify that the amount by which the post-1986 earnings and profits of a specified foreign corporation is reduced under section 965(d)(3)(B) as a result of a distribution made to a specified foreign corporation in the inclusion year may not exceed the amount by which the post-1986 earnings and profits of the distributee corporation is increased as a result of the distribution.

In the case of a CFC that has shareholders that are not United States shareholders on a measurement date, the Treasury Department and the IRS intend to issue regulations providing that the accumulated post-1986 deferred foreign income of the CFC on such measurement date will be reduced by amounts that would be described in section 965(d)(2)(B) if such shareholders were United States shareholders. In such cases, the regulations will follow the principles of Revenue Ruling 82–16, 1982–1 C.B. 106, in order to determine the amounts by which accumulated post-1986 deferred foreign income is reduced.

Example. (i) Facts. USP, a domestic corporation, and FP, a foreign corporation unrelated to USP, have owned 70% and 30% respectively, by vote and value, of the only class of stock of FS, a foreign corporation, from January 1, 2016, until December 31, 2017. USP and FS both have a calendar year taxable year. FS had no income until its taxable year ending December 31, 2016, in which it had 100u of income, all of which constituted subpart F income, and USP included 70u in income with respect to FS under section 951(a)(1) for such year. FS earned no income in 2017. Therefore, FS’s post-1986 earnings and profits are 100u as of both of the measurement dates.

(ii) Analysis. Because USP included 70u in income with respect to FS under section 951(a)(1), 70u of such post-1986 earnings and profits is previously taxed income and, if distributed, would be excluded from the gross income of USP under section 959. Thus, FS’s accumulated post-1986 deferred foreign income would be reduced by 70u pursuant to section 965(d)(2)(B). Furthermore, the accumulated post-1986 deferred foreign income of FS is reduced by amounts that would be described in section 965(d)(2)(B) if FP were a United States shareholder, consistent with the principles of Revenue Ruling 82–16. Accordingly, FS’s accumulated post-1986 deferred foreign income would be reduced by the remaining 30u of the 100u of post-1986 earnings and profits to which USP’s 70u of section 951(a)(1) income inclusions were attributable. Accordingly, FS’s accumulated post-1986 deferred foreign income is 0u (100u minus 70u minus 30u).

The accumulated post-1986 deferred foreign income of a specified foreign corporation that is a CFC excludes earnings to the extent that they would, if distributed, be excluded from the gross income of a United States shareholder under section 959 (that is, previously taxed income). Section 965(d)(2)(B). Post-1986 earnings and profits of a specified foreign corporation are determined without diminution by reason of dividends distributed during the inclusion year, other than dividends distributed to another specified foreign corporation. Section 965(d)(3)(B).

In general, earnings and profits of a foreign corporation attributable to amounts which are, or have been, included in the gross income of a United States shareholder under section 951(a) are not again included in the gross income of such United States shareholder when distributed (or when they would but for section 959(a) be included under section 951(a)(1)(B)). Section 959(a). For purposes of applying section 959(a), a distribution from a foreign corporation is treated as attributable first to earnings and profits included in gross income under section 951(a)(1)(B), then to earnings and profits included in gross income under section 951(a)(1)(A), and then to other earnings and profits. Section 959(c). A distribution excluded from gross income under section 959(a) is treated, for purposes of Chapter 1, as a distribution which is not a dividend, except that such distributions immediately reduce earnings and profits. Section 959(d). Actual distributions are taken into account before amounts that would be included under section 951(a)(1)(B). Section 959(f)(2).

The Treasury Department and the IRS intend to issue regulations to clarify the interaction between the rules under sections 959 and 965 in the inclusion year of a DFIC and the taxable year of a United States shareholder of the DFIC in which or with which such inclusion year ends. Such regulations will describe the following steps for determining the section 965(a) inclusion amount of a DFIC, the treatment of distributions under section 959, and the amount of an inclusion under sections 951(a)(1)(B) and 956 with respect to a DFIC:

Example. (i) Facts. USP, a domestic corporation, owns all of the stock of CFC1, a foreign corporation, which owns all of the stock of CFC2, also a foreign corporation. USP, CFC1, and CFC2 all have taxable years ending December 31, 2017. As of January 1, 2017, CFC1 has no earnings and profits, and CFC2 has 100u of earnings and profits described in section 959(c)(3) that were accumulated in taxable years beginning after December 31, 1986, while CFC2 was a specified foreign corporation. On March 1, 2017, CFC1 earns 30u of subpart F income (as defined in section 952), and CFC2 earns 20u of subpart F income. On July 1, 2017, CFC2 distributes 40u to CFC1, and the exception described in section 954(c)(6)(A) applies to such distribution. On November 1, 2017, CFC1 distributes 60u to USP.

(ii) Analysis. (A) Application of section 959 without regard to section 965. USP determines its inclusion under section 951(a)(1)(A) without regard to section 965(a), which is 30u with respect to CFC1 and 20u with respect to CFC2 for their taxable years ending December 31, 2017. As a result of the inclusions under section 951(a)(1)(A), CFC1 and CFC2 increase their earnings and profits described in section 959(c)(2) by 30u and 20u, respectively.

(B) Distributions between specified foreign corporations before January 1, 2018. The distribution of 40u from CFC2 to CFC1 is treated as a distribution of 20u out of earnings and profits described in section 959(c)(2) (attributable to inclusions under section 951(a)(1)(A) that are not by reason of section 965(a)) and 20u out of earnings and profits described in section 959(c)(3).

(C) Section 965(a) inclusion amount. USP determines CFC1’s and CFC2’s section 965(a) inclusion amounts. Because there are no aggregate foreign E&P deficits to be allocated to CFC1 and CFC2, the section 965(a) inclusion amount of CFC1 and CFC2 equals the section 965(a) earnings amount with respect to CFC1 and CFC2, respectively.

(1) CFC1 section 965(a) earnings amount. The section 965(a) earnings amount with respect to CFC1 is 20u, the amount of its accumulated post-1986 deferred foreign income as of both November 2, 2017, and December 31, 2017, which is equal to 70u of post-1986 earnings and profits (30u earned and 40u attributable to the CFC2 distribution) reduced by 50u of previously taxed income described in section 959(c)(2) (30u earned and 20u attributable to the CFC2 distribution) under section 965(d)(2)(B). Under section 965(d)(3)(B), the post-1986 earnings and profits of CFC1 are not reduced by the 60u distribution to USP.

(2) CFC2 section 965(a) earnings amount. The section 965(a) earnings amount with respect to CFC2 is 80u, the amount of its accumulated post-1986 deferred foreign income as of both November 2, 2017, and December 31, 2017, which is equal to the amount of CFC2’s post-1986 earnings and profits of 80u. For purposes of calculating CFC2’s accumulated post-1986 deferred foreign income, CFC2 has no previously taxed income and therefore no adjustment is made under section 965(d)(2)(B). CFC2’s 80u of post-1986 earnings and profits consists of 120u of earnings and profits that it earned, reduced by the 40u distribution to CFC1 under section 965(d)(3)(B). The amount of the reduction to the post-1986 earnings and profits of CFC2 for the 40u distribution is not limited by the rules described in section 3.02(b) of this notice because CFC1’s post-1986 earnings and profits are increased by 40u as a result of the distribution. Furthermore, because the 40u distribution was made on July 1, 2017, which is prior to any measurement date, section 3.02(a) of this notice is not relevant.

(3) Effect on previously taxed income. CFC1 and CFC2 increase their previously taxed income described in section 959(c)(2) by their section 965(a) inclusion amounts taken into account by USP, 20u and 80u, respectively, and reduce their earnings and profits described in section 959(c)(3) by an equivalent amount.

(D) Distribution to United States shareholder. The distribution from CFC1 to USP is treated as a distribution of 60u out of the earnings and profits of CFC1 described in section 959(c)(2), which include earnings and profits attributable to the section 965(a) inclusion amount taken into account by USP.

Section 965(o) authorizes the Treasury Department and the IRS to issue regulations or other guidance to provide appropriate basis adjustments in order to carry out the provisions of section 965. In order to provide certainty regarding the application of the rules described in section 961 with respect to amounts included under section 965, the Treasury Department and the IRS intend to issue regulations providing that if a United States shareholder receives distributions from a DFIC during the inclusion year that are attributable to previously taxed income described in section 959(c)(2) by reason of section 965(a), the amount of gain recognized by the United States shareholder with respect to the stock of the DFIC under section 961(b)(2) will be reduced (but not below zero) by the section 965(a) inclusion amount.

Section 954 defines foreign base company income (FBCI), which generally is income earned by a CFC that is taken into account in computing the amount that a United States shareholder of the CFC must include in income under section 951(a)(1)(A). Under section 954(a)(1), FBCI includes FPHCI, which is defined in section 954(c). The excess of foreign currency gains over foreign currency losses from section 988 transactions is generally included in FPHCI pursuant to section 954(c)(1)(D).

Section 988 transactions generally include the following: the accrual of any item of income or expense that is to be paid or received in a nonfunctional currency after the date of accrual; lending or borrowing in a nonfunctional currency; entering into or acquiring a forward, future, option, or similar contract denominated in a nonfunctional currency; and the disposition of nonfunctional currency. See section 988(c). Thus, accruals in connection with ordinary business transactions, such as purchases and sales of inventory or the provision of services, are section 988 transactions if the receivable or payable is denominated in, or determined by reference to, a currency other than the taxpayer’s functional currency, as determined under § 1.985–1.

Notwithstanding the general rule that includes the excess of foreign currency gains over foreign currency losses from section 988 transactions in FPHCI, section 954(c)(1)(D) excludes from FPHCI any foreign currency gain or loss attributable to a transaction directly related to the business needs of the CFC (business needs exclusion). To qualify for the business needs exclusion, a foreign currency gain or loss must, in addition to satisfying other requirements, arise from a transaction entered into, or property used, in the normal course of the CFC’s business that does not itself (and could not reasonably be expected to) give rise to subpart F income (as defined in section 952) other than foreign currency gain or loss. See § 1.954–2(g)(2)(ii)(B)(1).

Foreign currency gain or loss attributable to a bona fide hedging transaction (as defined in § 1.954–2(a)(4)(ii)) with respect to a transaction or property that qualifies for the business needs exclusion also qualifies for the business needs exclusion, provided that any gain or loss with respect to such transaction or property that is attributable to changes in exchange rates is clearly determinable from the records of the CFC as being derived from such property or transaction. See § 1.954–2(g)(2)(ii)(B)(2). Generally, bona fide hedging transactions are transactions that meet the requirements for a hedging transaction under § 1.1221–2(a) through (d), except that a bona fide hedging transaction also includes a transaction entered into in the normal course of business primarily to manage risk with respect to section 1231 property or a section 988 transaction. Under § 1.1221–2(b), a hedging transaction is defined as a transaction that a taxpayer enters into in the normal course of its trade or business primarily to manage the risk of price changes or currency fluctuations with respect to ordinary property that is held or to be held by the taxpayer, or to manage the risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer. Transactions that manage risks related to assets that would produce capital gain or loss on disposition (capital assets), or assets owned or liabilities owed by a related party, do not qualify as hedging transactions under § 1.1221–2(b). To qualify as a bona fide hedging transaction, the transaction must be clearly identified as a hedging transaction before the end of the day on which the CFC acquired, originated, or entered into the transaction. See §§ 1.1221–2(f) and 1.954–2(a)(4)(ii)(A) and (B).

Section 1.954–2(g)(2)(ii)(C) provides special rules for applying the business needs exclusion to CFCs that are regular dealers as defined in § 1.954–2(a)(4)(iv). Transactions in dealer property (as defined in § 1.954–2(a)(4)(v)) that are entered into by a CFC that is a regular dealer in such property in its capacity as a dealer are treated as directly related to the business needs of the CFC. See § 1.954–2(g)(2)(ii)(C)(1). In addition, an interest–bearing liability denominated in a nonfunctional currency and incurred by a regular dealer is treated as dealer property if it reduces the CFC’s currency risk with respect to dealer property and is identified on the CFC’s records as a liability treated as dealer property. See § 1.954–2(g)(2)(ii)(C)(2). A regular dealer is a CFC that regularly and actively offers to, and in fact does, purchase property from and sell property to unrelated customers in the ordinary course of business, or that regularly and actively offers to, and in fact does, enter into, assume, offset, assign or otherwise terminate positions in property with unrelated customers in the ordinary course of business. See § 1.954–2(a)(4)(iv).

Under section 954(c)(1)(D), although a foreign currency loss that does not qualify for the business needs exclusion reduces the amount of foreign currency gain that is included in FPHCI, an excess of foreign currency losses over foreign currency gains from section 988 transactions generally does not reduce FPHCI. Such a net foreign currency loss does, however, reduce earnings and profits for purposes of the current earnings and profits limitation on subpart F income in section 952(c)(1). Additionally, as described in Part D of this Background section, when an election under § 1.954–2(g)(3) or (4) is in effect, a foreign currency loss can reduce FPHCI or, in the case of an election under § 1.954–2(g)(3), another category of subpart F income.

In order for the business needs exclusion to apply to exclude foreign currency gain and loss from the computation of FPHCI, the foreign currency gain or loss must arise from a transaction or property that does not itself (and could not reasonably be expected to) give rise to any subpart F income other than foreign currency gain or loss. For example, foreign currency gains and losses related to the purchase and sale of inventory are excluded from the computation of FPHCI if none of the income from the purchase and sale is subpart F income under section 952. However, if the transaction or property gives rise to, or could reasonably be expected to give rise to, any amount of subpart F income (other than foreign currency gain or loss), none of the foreign currency gain or loss attributable to the transaction or property would qualify for the business needs exclusion. Thus, there is a cliff effect: if even a de minimis amount of income or gain from the transaction or property is subpart F income, the entire amount of the foreign currency gain or loss from the transaction or property, or from a bona fide hedging transaction with respect to the transaction or property, is included in the FPHCI computation.

A CFC may conduct business through a qualified business unit (as defined in § 1.989(a)–1) (QBU) that is not treated as a separate entity for federal income tax purposes, either because it is a branch or division of the CFC or because it is a business entity that is disregarded as separate from its owner. Although the QBU is not treated as a separate entity, it may have a functional currency under § 1.985–1 that is different from that of the CFC owner, with consequences for the determination of foreign currency gain and loss under sections 987 and 988. The QBU’s transactions in its own functional currency are not section 988 transactions of the CFC, and accordingly the CFC does not realize foreign currency gain or loss on such transactions. The CFC generally must, however, take into account under section 987 foreign currency gain or loss with respect to the QBU upon remittances from the QBU.

For business and financial accounting reasons, a CFC may enter into transactions to manage the exchange rate risk associated with its net investment in its QBU. Under generally accepted accounting principles in the United States (U.S. GAAP), a majority owner of a business entity (parent corporation) must consolidate the accounts of the majority-owned entity, including a foreign entity, with its own accounts for purposes of financial reporting. Under U.S. GAAP, the income, assets, liabilities, and other financial results of foreign operations that are conducted in a functional currency that differs from the consolidated parent’s functional currency must be translated into the functional currency of the consolidated parent. Foreign currency gains or losses arising from the translation are recorded in a “cumulative translation adjustment” account and reported as a component of shareholders’ equity on the balance sheet. See generally Accounting Standards Codification (ASC) 830–30–45. Foreign currency gain or loss from transactions that effectively hedge the risk of currency fluctuations in the net equity investment in foreign operations also are recorded in the cumulative translation adjustment account. See ASC 815–35–35. A cumulative translation adjustment is not taken into account in computing the income of the consolidated group until the relevant operations are disposed of or liquidated.

The transactions that a CFC uses to manage its exchange rate risk with respect to its net investment in a QBU are typically section 988 transactions. Thus, foreign currency gains or losses attributable to those transactions are taken into account in computing FPHCI, unless the transactions qualify as bona fide hedging transactions that satisfy the requirements of the business needs exclusion. See § 1.954–2(g)(2)(ii)(B)(2). Neither the Code nor the section 954 regulations provide specific guidance on whether a transaction entered into to manage exchange rate risk arising from a CFC’s net investment in a QBU can qualify as a bona fide hedging transaction eligible for the business needs exclusion. This issue can be consequential because foreign currency gain, but not loss, from a transaction erroneously identified as a bona fide hedging transaction is included in the computation of FPHCI, unless the CFC qualifies for the inadvertent identification exception. See § 1.954–2(a)(4)(ii)(C) and (g)(2)(ii)(B)(2). Additionally, even if a transaction entered into to manage exchange rate risk arising from a CFC’s net investment in a QBU is eligible for treatment as a bona fide hedging transaction, the transaction would not qualify for the business needs exclusion unless the hedged property did not, and could not reasonably be expected to, give rise to any subpart F income.

Also for business and financial accounting reasons, a CFC may enter into transactions to manage the exchange rate risk with respect to its net investment in a subsidiary CFC. A transaction that manages the risk of price or currency fluctuation with respect to a CFC’s net investment in a subsidiary CFC is not considered a hedging transaction for federal income tax purposes. In Hoover Co. v. Commissioner, 72 T.C. 706 (1979), the Tax Court held that transactions entered into to manage the risk of a decline in value of a taxpayer’s net investment in a foreign subsidiary that might occur if the value of the subsidiary’s functional currency declined relative to the U.S. dollar were not hedging transactions for federal income tax purposes. See also § 1.1221–2(b) (providing that a hedging transaction must manage risk with respect to “ordinary property . . . that is held or to be held by the taxpayer”). Thus, foreign currency gains and losses on transactions that manage the risk of currency fluctuation on a CFC’s net investment in a subsidiary CFC are taken into account in computing FPHCI.

Section 1.446–4 generally requires gain or loss from a hedging transaction, as defined in § 1.1221–2(b), to be taken into account at the same time as the gain or loss from the item being hedged. As noted in Part A.1 of this Background section, bona fide hedging transactions under § 1.954–2(a)(4)(ii) include both hedging transactions as defined in § 1.1221–2(b) and transactions that manage the risk of price or currency fluctuation with respect to section 1231 property and section 988 transactions. Thus, § 1.446–4 does not explicitly apply to all bona fide hedging transactions, which has led to some uncertainty about whether gain or loss from a bona fide hedging transaction that is not described in § 1.1221–2(b) is properly taken into account in the same taxable year as gain or loss on the hedged item. The Department of the Treasury (Treasury Department) and the IRS understand that some taxpayers have applied the hedge timing rules of § 1.446–4 to all bona fide hedging transactions, irrespective of whether those transactions are hedging transactions as defined in § 1.1221–2(b).

The Treasury Department and the IRS believe that foreign currency gain or loss arising from a transaction or property, or from a bona hedging transaction with respect to such a transaction or property, should be eligible for the business needs exclusion to the extent the transaction or property generates non-subpart F income. Accordingly, proposed § 1.954–2(g)(2)(ii)(C)(1) provides that foreign currency gain or loss attributable to a transaction or property that gives rise to both subpart F income and non-subpart F income, and that otherwise satisfies the requirements of the business needs exclusion, is allocated between subpart F income and non-subpart F income in the same proportion as the income from the underlying transaction or property. As a result, the amount of foreign currency gain or loss allocable to non-subpart F income qualifies for the business needs exclusion, and the amount allocable to subpart F income is taken into account in computing FPHCI. Under proposed § 1.954–2(g)(2)(ii)(C)(1), the entire foreign currency gain or loss arising from property that does not give rise to income (as defined in § 1.954–2(e)(3)), or from a bona fide hedging transaction with respect to such property, is attributable to subpart F income because any gain upon a disposition of such property would be subpart F income.

The Treasury Department and the IRS believe that a transaction that manages exchange rate risk with respect to a CFC’s net investment in a QBU that is not treated as a separate entity for federal income tax purposes should qualify for the business needs exclusion to the extent the underlying property of the QBU does not give rise to subpart F income. Accordingly, proposed § 1.954–2(g)(2)(ii)(C)(2) provides that the qualifying portion of any foreign currency gain or loss that arises from a “financial statement hedging transaction” with respect to a QBU and that is allocable to non-subpart F income is directly related to the business needs of a CFC. A financial statement hedging transaction is defined as a transaction that is entered into by a CFC for the purpose of managing exchange rate risk with respect to part or all of that CFC’s net investment in a QBU that is included in the consolidated financial statements of a United States shareholder of the CFC or a corporation that directly or indirectly owns such United States shareholder. The qualifying portion is defined as the amount of foreign currency gain or loss arising from a financial statement hedging transaction that is properly accounted for under U.S. GAAP as a cumulative foreign currency translation adjustment to shareholders’ equity. The qualifying portion of any foreign currency gain or loss arising from a financial statement hedging transaction must be allocated between subpart F income and non-subpart F income using the principles of § 1.987–6(b). The amount of the qualifying portion allocated to non-subpart F income qualifies for the business needs exclusion.

The proposed amendment to § 1.446–4(a), discussed in Part B.1 of this Explanation of Provisions section, provides that a bona fide hedging transaction (as defined in § 1.954–2(a)(4)(ii)) is subject to the hedge timing rules of § 1.446–4. Additionally, as noted earlier, proposed § 1.954–2(g)(2)(ii)(C)(2) provides that part or all of the qualifying portion of any foreign currency gain or loss arising from a financial statement hedging transaction is eligible for the business needs exclusion. However, financial statement hedging transactions are not included in the definition of bona fide hedging transaction under § 1.954–2(a)(4)(ii), as proposed to be amended pursuant to these proposed regulations. Thus, foreign currency gain or loss arising from a financial statement hedging transaction is not subject to the hedge timing rules of § 1.446–4 and is taken into account in accordance with the taxpayer’s method of accounting. Generally, a taxpayer’s financial statement hedging transaction is a section 988 transaction with respect to the taxpayer. Accordingly, to the extent that the taxpayer elects to use a mark-to-market method of accounting for section 988 gain or loss under proposed § 1.988–7, and also makes the annual deemed termination election described in § 1.987–8T(d), the taxpayer generally would recognize annually foreign currency gain or loss from both the financial statement hedging transaction and the QBU with respect to which exchange rate risk is managed. The Treasury Department and the IRS request comments regarding whether the hedge timing rules of § 1.446–4 should apply to a financial statement hedging transaction (as defined in proposed § 1.954–2(g)(2)(ii)(C)(2)) with respect to section 987 QBUs with respect to which no annual deemed termination election is in effect, and, if so, how the appropriate matching should be achieved.

The Treasury Department and the IRS also request comments regarding whether the business needs exclusion should apply to a transaction that is entered into for the purpose of managing the risk of foreign currency fluctuation with respect to a CFC’s net investment in a subsidiary CFC. Comments are requested regarding how the gain or loss on such a transaction could or should be allocated between subpart F and non-subpart F income and whether and how the gain or loss could or should be matched with the foreign currency gain or loss on the “hedged” item.

The Treasury Department and the IRS are aware that a CFC may enter into a transaction that manages exchange rate risk arising from a disregarded loan to a QBU. The Treasury Department and the IRS understand that, for U.S. GAAP purposes, exchange gain or loss with respect to a transaction that manages exchange rate risk with respect to the disregarded loan generally would not be reflected as a cumulative foreign currency translation adjustment. For federal income tax purposes, the loan would be disregarded, and exchange gain or loss on the hedging transaction potentially could be subpart F income. The Treasury Department and the IRS request comments regarding whether, taking into account the amendments in the proposed regulations, additional amendments to the business needs exclusion are appropriate to account for foreign currency gain or loss arising from a transaction that is entered into for the purpose of managing the risk of foreign currency fluctuation with respect to disregarded transactions, including disregarded loans, between a CFC and its QBU. Specifically, comments are requested regarding how the foreign currency gain or loss on such a hedging transaction could or should be allocated between subpart F and non-subpart F income and when such foreign currency gain or should be recognized.

The proposed amendment to § 1.446–4(a) extends the hedge timing rules of § 1.446–4 to all bona fide hedging transactions as defined in § 1.954–2(a)(4)(ii). Although this amendment will be particularly useful in connection with foreign currency gains and losses from bona fide hedging transactions of treasury center CFCs, the amendment will eliminate timing mismatches for gains and losses arising from all bona fide hedging transactions and from the hedged property or transaction.

In addition, proposed § 1.954–2(a)(4)(ii) revises the definition of a bona fide hedging transaction to permit the acquisition of a debt instrument by a CFC to be treated as a bona fide hedging transaction with respect to an interest-bearing liability of the CFC, provided that the acquisition of the debt instrument has the effect of managing the CFC’s exchange rate risk with respect to the liability within the meaning of § 1.1221–2(c)(4) and (d), determined without regard to § 1.1221–2(d)(5), and otherwise meets the requirements of a bona fide hedging transaction. If a CFC, including a treasury center CFC, identifies a debt instrument that manages exchange rate risk as a hedge of an interest-bearing liability, the foreign currency gain or loss arising from that debt instrument will be taken into account under § 1.446–4 at the same time as the foreign currency gain or loss arising from the hedged interest-bearing liability.

Treating a debt instrument as a hedge of an interest-bearing liability, rather than treating the interest-bearing liability as a hedge of the debt instrument, is consistent with the principles underlying § 1.861–9T(b)(2), which allocates and apportions foreign currency gain or losses on a transaction that hedges an interest-bearing liability in the same manner as interest expense with respect to the liability is allocated and apportioned. See part C of this Explanation of Provisions section for further discussion of the impact of this rule on the allocation of foreign currency gain or loss on a debt instrument between subpart F income and non-subpart F income.

Proposed § 1.988–7 permits a taxpayer, including a CFC, to elect to use a mark-to-market method of accounting for section 988 gain or loss with respect to section 988 transactions, including becoming an obligor under an interest-bearing liability. This elective mark-to-market method of accounting takes into account only changes in the value of the section 988 transaction attributable to exchange rate fluctuations and does not take into account changes in value due to other factors, such as changes in market interest rates or the creditworthiness of the borrower. The proposed regulations require appropriate adjustments to be made to prevent section 988 gain or loss taken into account under the mark-to-market method of accounting from being taken into account again under section 988 or another provision of the Code.

This election is available to any taxpayer but is expected to be particularly relevant in the case of a treasury center CFC. A treasury center CFC that uses a mark-to-market method for securities under section 475 and that makes the election under proposed § 1.988–7 will be able to match the timing of foreign currency gain or loss with respect to an interest-bearing liability (such as a loan from a related or unrelated party) with economically offsetting foreign currency loss or gain arising from its nonfunctional currency-denominated assets (such as a receivable from a related party). Whether the corresponding foreign currency gains and losses qualify for the business needs exclusion is determined under the rules of § 1.954–2(g)(2), as proposed to be amended pursuant to these proposed regulations. Thus, if the foreign currency gains or losses do not fully offset each other, the difference may increase or decrease the CFC’s FPHCI. However, the election under proposed § 1.988–7 does not apply to the following: (1) any securities that are marked to market under any other provision; (2) any securities that, pursuant to an election or an identification made by the taxpayer, are excepted from mark-to-market treatment under any other provision; (3) any transactions of a QBU that is subject to section 987; or (4) any section 988 transactions denominated in, or determined by reference to, a hyperinflationary currency.

The election applies for the year in which the election is made and all subsequent taxable years unless it is revoked by the Commissioner or the taxpayer or, in the case of a CFC, the controlling domestic shareholders of the CFC. Proposed § 1.988–7(d) permits a taxpayer or CFC to revoke the election to use a mark-to-market method of accounting for foreign currency gains or losses on section 988 transactions at any time. A subsequent election cannot be made until the sixth taxable year following the year of revocation and cannot be revoked until the sixth taxable year following the year of such subsequent election.

(a) In general. Except as provided in this paragraph (a), a hedging transaction as defined in § 1.1221–2(b) (whether or not the character of gain or loss from the transaction is determined under § 1.1221–2) and a bona fide hedging transaction as defined in § 1.954–2(a)(4)(ii) must be accounted for under the rules of this section. * * *

* * * * *

(g) Applicability date. * * * This section applies to a bona fide hedging transaction (as defined in § 1.954–2(a)(4)(ii)) entered into on or after the date that these regulations are published as final regulations in the Federal Register.

Par. 3. Section 1.954–0(b) is amended by:

The additions and revision read as follows:

* * * * *

(b) * * *

* * * * *

(g) * * *

(2) * * *

(ii) * * *

(C) Foreign currency gains and losses arising from a transaction or property that gives rise to both non-subpart F income and subpart F income or from a bona fide hedging transaction with respect to such a transaction or property.

(1) In general.

(2) Financial statement hedging transaction with respect to the net investment in a qualified business unit.

* * * * *

(iii) Special rule for foreign currency gain or loss from an interest-bearing liability and bona fide hedges of an interest-bearing liability.

* * * * *

Par. 4. Section 1.954–2 is amended by:

The additions and revisions read as follows:

(a) * * *

(4) * * *

(ii) * * *

(A) * * * Additionally, the acquisition of a debt instrument by a controlled foreign corporation may be treated as a bona fide hedging transaction with respect to an interest-bearing liability of the controlled foreign corporation, provided that the acquisition of the debt instrument has the effect of managing the controlled foreign corporation’s exchange rate risk with respect to the liability within the meaning of § 1.1221–2(c)(4) and (d), determined without regard to § 1.1221–2(d)(5), and otherwise meets the requirements of paragraph (a)(4)(ii) of this section. * * *

* * * * *

(g) * * *

(2) * * *

(ii) * * *

(C) Foreign currency gains and losses arising from a transaction or property that gives rise to both non-subpart F income and subpart F income or from a bona fide hedging transaction with respect to such a transaction or property—(1) In general. If a foreign currency gain or loss would be directly related to the business needs of the controlled foreign corporation pursuant to paragraph (g)(2)(ii)(B)(1) or (2) of this section except that it arises from a transaction or property that gives rise, or is reasonably expected to give rise, to both non-subpart F income and subpart F income (other than foreign currency gain or loss), or from a bona fide hedging transaction with respect to such a transaction or property, the amount of foreign currency gain or loss that is allocable to non-subpart F income under this paragraph (g)(2)(ii)(C)(1) is directly related to the business needs of the controlled foreign corporation. The amount of foreign currency gain or loss arising from a transaction or property described in this paragraph (g)(2)(ii)(C)(1), or from a bona fide hedging transaction with respect to such a transaction or property, that is allocable to non-subpart F income equals the product of the total amount of foreign currency gain or loss arising from the transaction or property and the ratio of non-subpart F income (other than foreign currency gain or loss) that the transaction or property gives rise to, or is reasonably expected to give rise to, to the total income that the transaction or property gives rise to, or is reasonably expected to give rise to. However, none of the foreign currency gain or loss arising from property that does not give rise to income (as defined in paragraph (e)(3) of this section), or from a bona fide hedging transaction with respect to such property, is allocable to non-subpart F income.

(2) Financial statement hedging transaction with respect to a qualified business unit. If foreign currency gain or loss arises from a financial statement hedging transaction (as defined in this paragraph (g)(2)(ii)(C)(2)) with respect to a qualified business unit (as defined in § 1.989(a)–1) (QBU) of a controlled foreign corporation that is not treated as an entity separate from the controlled foreign corporation for federal income tax purposes, either because it is a branch or division of the controlled foreign corporation or because it is a business entity that is disregarded as separate from its owner under § 301.7701–3 of this chapter, the amount of the qualifying portion (as determined under this paragraph (g)(2)(ii)(C)(2)) of foreign currency gain or loss that is allocable to non-subpart F income under this paragraph (g)(2)(ii)(C)(2) is directly related to the business needs of the controlled foreign corporation. Generally, the controlled foreign corporation must allocate the qualifying portion of foreign currency gain or loss arising from the financial statement hedging transaction between subpart F income and non-subpart F income in the same proportion as it would characterize gain or loss determined under section 987 as subpart F income and non-subpart F income under the principles of § 1.987–6(b). A financial statement hedging transaction is a transaction that is entered into by a CFC for the purpose of managing exchange rate risk with respect to part or all of that CFC’s net investment in a QBU that is included in the consolidated financial statements of a United States shareholder of the CFC (or a corporation that directly or indirectly owns such United States shareholder). The qualifying portion of foreign currency gain or loss is the amount of foreign currency gain or loss arising from a financial statement hedging transaction that is properly accounted for under U.S. generally accepted accounting principles as a cumulative foreign currency translation adjustment to shareholders’ equity.

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(iii) Special rule for foreign currency gain or loss from an interest-bearing liability and bona fide hedges of an interest-bearing liability. Except as provided in paragraph (g)(2)(ii)(D)(2) or (g)(5)(iv) of this section, foreign currency gain or loss arising from an interest-bearing liability is characterized as subpart F income and non-subpart F income in the same manner that interest expense associated with the liability would be allocated and apportioned between subpart F income and non-subpart F income under §§ 1.861–9T and 1.861–12T. Likewise, foreign currency gain or loss arising from a bona fide hedging transaction entered into by the controlled foreign corporation that has the effect of managing exchange rate risk with respect to an interest-bearing liability that is not subject to paragraph (g)(2)(ii)(D)(2) (certain interest-bearing liabilities treated as dealer property) or (g)(5)(iv) (gain or loss allocated under § 1.861–9) of this section is characterized as subpart F income and non-subpart F income in the same manner that interest expense associated with the interest-bearing liability would be allocated and apportioned between subpart F income and non-subpart F income under §§ 1.861–9T and 1.861–12T. Paragraph (g)(2)(ii) of this section does not apply to any foreign currency gain or loss described in this paragraph (g)(2)(iii).

(3) * * *

(iii) Revocation of election. This election is effective for the taxable year of the controlled foreign corporation for which it is made and all subsequent taxable years of such corporation unless revoked by the Commissioner or the controlling United States shareholders (as defined in § 1.964–1(c)(5)) of the controlled foreign corporation. The controlling United States shareholders of a controlled foreign corporation may revoke such corporation’s election at any time. If an election has been revoked under this paragraph (g)(3)(iii), a new election under paragraph (g)(3) of this section cannot be made until the sixth taxable year following the year in which the previous election was revoked, and such subsequent election cannot be revoked until the sixth taxable year following the year in which the subsequent election was made. The controlling United States shareholders revoke an election on behalf of a controlled foreign corporation by filing a statement that clearly indicates such election has been revoked with their original or amended income tax returns for the taxable year of such United States shareholders ending with or within the taxable year of the controlled foreign corporation for which the election is revoked.

* * * * *

(4) * * *

(iii) Revocation of election. This election is effective for the taxable year of the controlled foreign corporation for which it is made and all subsequent taxable years of such corporation unless revoked by the Commissioner or the controlling United States shareholders (as defined in § 1.964–1(c)(5)) of the controlled foreign corporation. The controlling United States shareholders of a controlled foreign corporation may revoke such corporation’s election at any time. If an election has been revoked under this paragraph (g)(4)(iii), a new election under paragraph (g)(4) of this section cannot be made until the sixth taxable year following the year in which the previous election was revoked, and such subsequent election cannot be revoked until the sixth taxable year following the year in which the subsequent election was made. The controlling United States shareholders revoke an election on behalf of a controlled foreign corporation by filing a statement that clearly indicates such election has been revoked with their original or amended income tax returns for the taxable year of such United States shareholders ending with or within the taxable year of the controlled foreign corporation for which the election is revoked.

* * * * *

(i) * * *

(2) Other paragraphs. * * * The second sentence of paragraph (a)(4)(ii)(A), paragraph (g)(2)(ii)(C)(1), and the second sentence of paragraph (g)(2)(iii) apply to a bona fide hedging transaction entered into on or after the date the proposed regulations are published as final regulations in the Federal Register. Paragraphs (g)(2)(ii)(C) (other paragraph (g)(2)(ii)(C)(1), insofar as it applies to a bona fide hedging transaction), (g)(3)(iii), and (g)(4)(iii) of this section apply to taxable years of controlled foreign corporations ending on or after the date that these regulations are published as final regulations in the Federal Register.

Par. 5. Section 1.988–7 is added to read as follows:

(a) In general. Except as provided in paragraph (b) of this section, a taxpayer may elect under this section to apply the foreign currency mark-to-market method of accounting described in this section with respect to all section 988 transactions (including the acquisition and holding of nonfunctional currency described in section 988(c)(1)(C)(ii)). Under the foreign currency mark-to-market method of accounting, the timing of section 988 gain or loss on section 988 transactions is determined under the principles of section 1256. Only section 988 gain or loss is taken into account under the foreign currency mark-to-market method of accounting. Consistent with section 1256(a)(2), appropriate adjustments must be made to prevent the section 988 gain or loss from being taken into account again under section 988 or another provision of the Code or regulations. A section 988 transaction subject to this election is not subject to the “netting rule” of section 988(b) and § 1.988–2(b)(8), under which exchange gain or loss is limited to overall gain or loss realized in a transaction, in taxable years prior to the taxable year in which section 988 gain or loss would be recognized with respect to such section 988 transaction but for this election.

(b) Exceptions. The election described in paragraph (a) of this section does not apply to:

(1) Any security, commodity, or section 1256 contract that is marked to market under any other provision, including section 475 or section 1256;

(2) Any security, commodity, or section 1256 contract that, pursuant to an election or an identification made by the taxpayer, is excepted from mark-to-market treatment under another provision, including section 475 or section 1256;

(3) Any transaction of a qualified business unit (as defined in section 1.989(a)–1(b)) that is subject to section 987; or

(4) Any section 988 transaction denominated in, or determined by reference to, a hyperinflationary currency. See § 1.988–2(b)(15), (d)(5), and (e)(7) for rules relating to such transactions.

(c) Time and manner of election. A taxpayer makes the election under paragraph (a) of this section by filing a statement that clearly indicates that such election has been made with the taxpayer’s timely-filed original federal income tax return for the taxable year for which the election is made. In the case of a controlled foreign corporation, the controlling United States shareholders (as defined in § 1.964–1(c)(5)) make the election under paragraph (a) of this section on behalf of the controlled foreign corporation by filing a statement that clearly indicates that such election has been made with their timely-filed, original federal income tax returns for the taxable year of such United States shareholders ending with or within the taxable year of the controlled foreign corporation for which the election is made.

(d) Revocation and subsequent election. A taxpayer may revoke its election under paragraph (a) of this section at any time. If an election has been revoked under this paragraph (d), a new election under paragraph (a) of this section cannot be made until the sixth taxable year following the year in which the previous election was revoked, and such subsequent election cannot be revoked until the sixth taxable year following the year in which the subsequent election was made. A taxpayer revokes the election by filing a statement that clearly indicates that such election has been revoked with its original or amended federal income tax return for the taxable year for which the election is revoked. In the case of a controlled foreign corporation, the controlling United States shareholders revoke the election on behalf of the controlled foreign corporation by filing a statement that clearly indicates that such election has been revoked with their original or amended federal income tax returns for the taxable year of such United States shareholders ending with or within the taxable year of the controlled foreign corporation for which the election is revoked.

(e) Applicability dates. This section applies to taxable years of taxpayers (including controlled foreign corporations) ending on or after the date these regulations are published as final regulations in the Federal Register.